Transcript 3 Basic Steps in Economic Evaluation

Market Structure In the Healthcare
Industry
Professor Vivian Ho
Health Economics
Fall 2007
These notes draw from material in Santerre & Neun, Health Economics, Theories,
Insights and Industry Studies. Dryden 2007
Outline
Defining perfect competition
 Comparative statics
 The market structure continuum

 Monopoly
 Monopolistic
 Oligopoly
competition
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”
Comparative Statics
How does the market react to events
that influence the demand for or supply
of medical services?
 Recall that changes in factors other
than output price will cause the demand
or supply curve to shift

 An
increase in consumer income will cause
the demand curve for physician visits to
shift to the right
 An increase in the wage of nurses will
cause the supply curve for hospital stays to
shift to the left
Comparative Statics

These shifts in the demand or supply
curves will lead to a change in
equilibrium price and quantity

Predicting such changes is referred to
as comparative static analysis
Comparative Statics

In the mid-1980s, the AIDs epidemic led
to an increase in the demand for latex
gloves among health care workers

The epidemic led to a shift to the right in
the demand curve for latex gloves
 Excess
demand for gloves developed,
leading to a temporary shortage of gloves
Comparative Statics (Long run)
Dollars
per pair
S
P0
E
F
D1
D0
Q0
Excess demand
Market output of
latex gloves (Q)
Comparative Statics (Long run)

The shortage of gloves led buyers to bid
the price of gloves upwards

As the price bid for gloves rose, sellers
increased their quantity supplied of
gloves
 This
process continued until a new shortrun equilibrium was reached
 From 1986 to 1990, annual sales of latex
gloves increased by ~58%
Comparative Statics (Long run)
Dollars
per pair
S
P1
P0
D1
D0
Q0 Q1
Market output of
latex gloves (Q)
Comparative Statics (Long run)

Before the epidemic, each glove maker
was earning 0 profits

The increase in equilibrium price after
the epidemic implies that all glove
makers are earning positive profits

= (P1 x Q1) – (Q1 x ATC(Q1))
Comparative Statics (Long run)
Dollars
per pair
MC
ATC
P1
d1 = MR1
P0
d0 = MR0
Q0 Q1
Market output of
latex gloves (Q)
Comparative Statics (Long run)

Other medical suppliers made plans to
build new manufacturing plants to make
gloves, in the hopes of making profits
 In
1988, 116 permits were pending in
Malaysia for building latex glove factories

Entry of the new plants into the market
increased the supply of latex gloves in
the long run
 The
supply curve for gloves shifted out
Comparative Statics (Long run)
Dollars
per pair
S0
S1
P1
P0
D1
D0
Q0 Q1
Q2
Market output of
latex gloves (Q)
Comparative Statics (Long run)

As the supply curve for gloves shifts
out, the price of gloves begins to fall
 Note
that the quantity of gloves sold on the
market also increases

As the price of gloves fall, profits also
fall
 The
process continues, until the price of
gloves falls back to P0, where profits for all
glove makers are again equal to 0
Comparative Statics (Long run)
Dollars
per pair
MC
ATC
P1
d1 = MR1
P0
d0 = MR0
Q0 Q1
Market output of
latex gloves (Q)
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