Question

Discuss how an individiual's optimal health stock and rate of return (cost of capital) is affected in the Grossman model, when an individual continues to invest in health past the optimal amount of health. Use the MEC curve to facilitiate your answer.

Answer 1

Optimality condition is when:

Marginal cost (of investing in H) = Marginal benefit

Marginal cost = r + ?,

and

Marginal benefit = (W*G)/C

where

r = rate of interest (on other investments)

? = opportunity cost, i.e. rate of depreciation of health

W = wage rate,

G = marginal product (rate of return) of health investment

C = direct cost of investment

Marginal Benefit curve is the MEC (marginal efficiency of capital).

Now, we know that MEC curve is downward sloping due to a decreasing MR. Hence, if an individual continues to invest in health past the optimal amount of health, he/ she will experience reduced benefits and higher costs. Hence, their return will decline significantly.