Transcript 3 Basic Steps in Economic Evaluation

Market Structure In the Healthcare
Industry
Professor Vivian Ho
Health Economics
Fall 2009
These notes draw from material in Santerre & Neun, Health Economics,
Theories, Insights and Industry Studies. Southwestern Cengate 2010
Outline

Defining perfect competition

The market structure continuum
 Monopoly
 Monopolistic
competition
 Oligopoly

The market for organs
Characteristics of Perfect Competition

Consumers pay the full price of the
product
 Consumers
will respond to differences in
prices among sellers

All firms maximize profits
 Firms
have incentives to satisfy consumer
wants and produce efficiently
Characteristics of Perfect Competition (cont.)

There is a large number of buyers and
sellers, each of which is small relative to
the total market
 No
one buyer or seller is powerful enough
to influence or manipulate the market price
of a product

All firms in the same industry produce a
homogeneous product
 A consumer
can easily find substitutes for
the product of any given firm
Characteristics of Perfect Competition (cont.)

No barriers to entry or exit exist
 New

firms can enter the industry
All economic agents possess perfect
information
 Consumers
and firms can make informed
choices

All firms face nondecreasing average
costs of production
 Rules
out a “natural monopoly”
Monopoly Model

In contrast to perfect competition, a
monopoly market has the following
features:
 One
seller
 Homogeneous or differentiated product
 Complete barriers to entry

Because there is only one firm, that firm
faces the market demand curve, which
is downward sloping
Monopoly Model (cont.)

What is the profit-maximizing price and
quantity for a monopolist?
 Recall
that all firms will maximize profits
where MR=MC
 We have already seen that the marginal
cost curve for a firm depends on its
production function and input prices
 What does the firm’s MR curve look like?
Monopoly Model (cont.)
MR = P + Q • (P/Q)
Because the second term in this formula
represents a revenue loss, it is always
negative
 Thus, at each level of output, marginal
revenue is always lower than price
 The marginal revenue curve lies under
the demand curve

Monopoly Model (cont.)
Dollars
per unit
MR
Demand
Quantity
Monopoly Model (cont.)
We are now ready to find the profitmaximizing output for a monopolist
 The monopolist sets output at a level
where MR=MC

 On
a graph, find the level of Q where the
MR and MC curves intersect

To determine the price the monopolist
will charge, locate the price on the
demand curve at this same output level
Monopoly Model (cont.)
Dollars
per unit
MC
P*
MR
Q*
Demand
Quantity
Monopoly Model (cont.)

The monopolist’s level of profits can
then be determined by adding its
average total cost curve to the graph

Profits will be the difference between P*
and ATC, multiplied by Q*
Monopoly Model (cont.)
Dollars
per unit
MC
P*
ATC
Profits
ATC*
MR
Q*
Demand
Quantity
Contrast to Perfect Competition
Dollars
per unit
Under perfect competition,
the market equilibrium would
MC instead be where P=MC
ATC
PC
MR
QC
Demand
Quantity
The higher price and lower output in a monopolized market is why
economists claim that competition is better for social welfare
Monopoly Model (cont.)

A monopoly only maintains its status if
there are no substitutes for the product
it sells
 There
must be barriers to entry, so that
other firms cannot enter the market to
compete
 The two most common barriers to entry:
Economies of scale
 Legal restrictions

Monopoly Model (cont.)

Economies of scale
 If
a monopoly is producing output at a level
where long run average costs are
declining, then new firms cannot compete
on a cost basis
 A monopoly hospital in a small town may
have substantial economies of scale if it
can meet demand with only 40-50 beds

Unless a new hospital could take away a
substantial share of the existing hospital’s
patients, it could not match the existing hospital
in costs (and therefore profits as well)
Monopoly Model (cont.)

Legal restrictions
 Physicians
require a license to practice
medicine
 Many states require that providers obtain a
Certificate of Need to offer a new service
 Drug companies obtain patents for new
pharmaceutical products
The Market Structure Continuum

We have talked about 2 extremes of the
market structure continuum
 Perfect
Competition
 Pure Monopoly

Along this continuum, there are 2 more
levels of competitiveness that we will
encounter in the health care sector
The Market Structure Continuum
Perfect
Competition
Oligopoly
Monopolistic
Competition
Monopoly
Monopolistic Competition
Many sellers
 Differentiated product
 No barriers to entry


Examples
 Breakfast
cereals
 Ibuprofen (Advil, Motrin, etc.)
 Cigarettes
Monopolistic Competition (cont.)

Because products are differentiated across
firms, each seller has some ability to control
price
 Each
seller faces a slightly downward sloping
demand curve

Sellers have an incentive to “differentiate”
their product from competitors
 Doing
so is likely to raise demand for their product
Monopolistic Competition (cont.)
Dollars
per Unit
Demand under
monopolistic competition
Demand under
perfect competition
2 potential demand curves for an
individual firm
Output
Monopolistic Competition (cont.)

How do sellers differentiate their
product?
 Advertising

Is advertising bad for consumers?
 Creates
imaginary or artificial wants
 Persuasive, not informative
 Business stealing, w/ no benefits to
consumer
 Habit buying is a barrier to entry
Monopolistic Competition (cont.)

Benefits of advertising
 May
convey important info on value of a
good or service
People benefit from real diversity & choice
 Cheap info to customers to distinguish b/w
products

 May

promote quality competition
Firms willing to invest in creating a brand name
reputation will work to keep it
 May
inform the consumer of good or
service they weren’t aware of

Shift the D curve out
DTC Drug Advertising

August 1997, FDA permitted brandspecific direct-to-consumer (DTC)
advertising w/o “brief summary” of drug
effectiveness, side effects, and
contraindications

DTC advertising rose from $800m in
1996 to $2.5b in 2000
 What
were the consequences?
(Iizuka & Jin, 2003)
DTC Drug Advertising

Iizuka & Jin track monthly expenditures
on DTC advertising for 1994-2000

They also track monthly visits to the
doctor in a recurring national survey for
1994-2000
 Survey
indicates whether a drug was
prescribed during the visit, and for what
class
DTC Drug Advertising

Classes of drugs w/ heavy advertising
had large ↑ in prescribing
DTC Drug Advertising

Classes of drugs w/ less advertising had
no ↑in prescriptions
DTC Drug Advertising

IV column: After deregulation, each $1 ↑ in
DTC Ads raises # of visits w/ a prescription
by .0464
DTC Drug Advertising

IV column: After deregulation, each $1 ↑ in
DTC Ads raises # of visits w/ a prescription
by .0464

How much ad spending is needed to get
one extra prescription?
 1/.0464=$21.55

Does DTC advertising look profitable to
drug companies?
Oligopoly
Few, dominant sellers
 Homogeneous or differentiated product
 Substantial barriers to entry


Examples
 Tertiary
services at teaching hospitals
 Many prescription drugs
Oligopoly

Because there are only a few dominant
sellers, actions of any one firm can
change the overall market price

Like monopoly, oligopoly will lead to
lower output and higher prices than
would be observed under perfect
competition
 Regulators
are concerned about consumer
welfare in oligopolistic markets
Markets for Organs
Should we allow markets for organs for
transplant surgery?
 Payment to donors of organs is
currently forbidden in developed
countries.
 Yet there is persistent excess demand
for organ transplants (Becker and Elias,
JEP 2007)

Markets for Organs
Markets for Organs
Markets for Organs

Estimate excess demand from the
growth in the waiting list in any year,
plus # deaths for those on waiting list.
 Excess
demand in kidney market grew
from 2,500 persons in 1991 to 7,000 in
2000.
The Price of an Organ
How much pay is required to induce an
individual to sell an organ?
 Compensate individual for:

-
Risk of death
Time lost during recovery
Risk of reduced quality of life
Pricing Risk of Death
risk of death x Value of a statistical life
 Estimated range $1.5 - $10 m for
someone with a $35,000 average
annual income in 2005.
 Risk of death ~ .1%
 e.g. $5 m x .1% = $5,000

Time Lost During Recovery

Assume donor earns $35,000 / year

Loses 4 weeks of work while in recovery

$35,000 x 4 weeks => $2,700
Risk of
Quality of Life
No comprehensive data on how kidney
donation affects QOL.
 Some studies suggest kidney donors
can live normal lives, unless high
physical contact (e.g. athletes).
 But other studies find kidney donors at
high risk of high blood pressure.
 Could arbitrarily assume $7,500.

Market for Organs

Cost of Performing Kidney transplant
surgery = $160K
– Risk of Death
– Time Lost in Recovery
– Risk of QOL
$5,000
2,700
7,500
$15,200
Live donors raise total price 15,200 / 160,000 = 9.5%,
but supply is perfectly elastic.
Markets for Organs





13,500 kidney transplants in 2005,
8000 on waiting list
=> excess demand = 21,500
Assume εD for organ transplants = -1

price 9.5% => demand 9.5%
9.5% x 21,500 = 2,043
Demand = 21,500 – 2043 = 19,457, but all would be
supplied.
Equilibrium transplants rise from 13,500 to 19,457 =
44%
Excess Demand if Sales are Banned
$
S
$160,000
Excess
Demand
D
Q0
# Transplants
Market for Organs
$
$175,200
S
e*
S*
$160,000
D
Q0 Q1
# Transplants
Markets for Organs

Under a range of assumptions, allowing
the sale of live donor organs
substantially raises the # of transplants.

See Table 3, Becker.