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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

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market structure in the healthcare industry

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
Outline
  • Defining perfect competition
  • The market structure continuum
    • Monopoly
    • Monopolistic competition
    • Oligopoly
  • The market for organs
characteristics of perfect 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
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 cont5
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
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
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 cont8
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 cont9
Monopoly Model (cont.)

Dollars per unit

Demand

MR

Quantity

monopoly model cont10
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 cont11
Monopoly Model (cont.)

Dollars per unit

MC

P*

Demand

MR

Q*

Quantity

monopoly model cont12
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 cont13
Monopoly Model (cont.)

Dollars per unit

MC

P*

ATC

Profits

ATC*

Demand

MR

Q*

Quantity

contrast to perfect competition
Contrast to Perfect Competition

Dollars per unit

Under perfect competition, the market equilibrium would instead be where P=MC

MC

ATC

PC

Demand

MR

QC

Quantity

The higher price and lower output in a monopolized market is why economists claim that competition is better for social welfare

monopoly model cont15
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 cont16
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 cont17
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
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 continuum19
The Market Structure Continuum

Perfect Competition

Oligopoly

Monopoly

Monopolistic Competition

monopolistic competition
Monopolistic Competition
  • Many sellers
  • Differentiated product
  • No barriers to entry
  • Examples
    • Breakfast cereals
    • Ibuprofen (Advil, Motrin, etc.)
    • Cigarettes
monopolistic competition cont
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 cont22
Monopolistic Competition (cont.)

Dollars per Unit

Demand under monopolistic competition

Demand under perfect competition

Output

2 potential demand curves for an individual firm

monopolistic competition cont23
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 cont24
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
DTC Drug Advertising
  • August 1997, FDA permitted brand-specific 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 advertising26
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 advertising27
DTC Drug Advertising
  • Classes of drugs w/ heavy advertising had large ↑ in prescribing
dtc drug advertising28
DTC Drug Advertising
  • Classes of drugs w/ less advertising had no ↑in prescriptions
dtc drug advertising29
DTC Drug Advertising
  • IV column: After deregulation, each $1 ↑ in DTC Ads raises # of visits w/ a prescription by .0464
dtc drug advertising30
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
Oligopoly
  • Few, dominant sellers
  • Homogeneous or differentiated product
  • Substantial barriers to entry
  • Examples
    • Tertiary services at teaching hospitals
    • Many prescription drugs
oligopoly32
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
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 organs36
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
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
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
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
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
Market for Organs
  • Cost of Performing Kidney transplant surgery = $160K
        • Risk of Death $5,000
        • Time Lost in Recovery 2,700
        • Risk of QOL 7,500

$15,200

Live donors raise total price 15,200 / 160,000 = 9.5%,

but supply is perfectly elastic.

markets for organs42
Markets for Organs
  • 13,500 kidney transplants in 2005,

8000 on waiting list

=> excess demand = 21,500

  • Assume εDfor 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 if Sales are Banned

Excess

Demand

D

Q0

# Transplants

market for organs44
Market for Organs

S

$

e*

S*

$175,200

$160,000

D

Q0 Q1

# Transplants

markets for organs45
Markets for Organs
  • Under a range of assumptions, allowing the sale of live donor organs substantially raises the # of transplants.
  • See Table 3, Becker.