Transcript Health Economics ch5-1

Market Structure In the Healthcare
Industry
Professor Vivian Ho
Health Economics
Fall 2009
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


All economic agents possess perfect information


New firms can enter the industry
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 profit-maximizing 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



May promote quality competition


People benefit from real diversity & choice
Cheap info to customers to distinguish b/w products
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 brand-specific direct-toconsumer (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 – 2,043 = 19,457, but all would be
supplied.
 Equilibrium transplants rise from 13,500 to 19,457 =
44%

Excess Demand if Sales are Banned
$
S
$160,0
00
Exces
s
Dema
nd
Q0
# Transplants
D
Market for Organs
$
$175,20
S
e*
S
*
0
$160,00
0
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.