Market Structure In the HealthcareIndustryMarket Structure In the HealthcareIndustry
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
OutlineOutline
lDefining perfect competition
lThe market structure continuum
Monopoly
Monopolistic competition
Oligopoly
lThe market for organs
Characteristics of Perfect CompetitionCharacteristics of Perfect Competition
lConsumers pay the full price of theproduct
Consumers will respond to differences inprices among sellers
lAll firms maximize profits
Firms have incentives to satisfy consumerwants and produce efficiently
Characteristics of Perfect Competition (cont.)Characteristics of Perfect Competition (cont.)
lThere is a large number of buyers andsellers, each of which is small relative tothe total market
No one buyer or seller is powerful enoughto influence or manipulate the market priceof a product
lAll firms in the same industry produce ahomogeneous product
A consumer can easily find substitutes forthe product of any given firm
Characteristics of Perfect Competition (cont.)Characteristics of Perfect Competition (cont.)
lNo barriers to entry or exit exist
New firms can enter the industry
lAll economic agents possess perfectinformation
Consumers and firms can make informedchoices
lAll firms face nondecreasing averagecosts of production
Rules out a “natural monopoly”
Monopoly ModelMonopoly Model
lIn contrast to perfect competition, amonopoly market has the followingfeatures:
One seller
Homogeneous or differentiated product
Complete barriers to entry
lBecause there is only one firm, that firmfaces the market demand curve, whichis downward sloping
Monopoly Model (cont.)Monopoly Model (cont.)
lWhat is the profit-maximizing price andquantity for a monopolist?
Recall that all firms will maximize profitswhere MR=MC
We have already seen that the marginalcost curve for a firm depends on itsproduction function and input prices
What does the firm’s MR curve look like?
Monopoly Model (cont.)Monopoly Model (cont.)
MR = P + Q • (P/Q)
lBecause the second term in this formularepresents a revenue loss, it is alwaysnegative
Thus, at each level of output, marginalrevenue is always lower than price
The marginal revenue curve lies underthe demand curve
Monopoly Model (cont.)Monopoly Model (cont.)
Quantity
Dollarsper unit
Demand
MR
Monopoly Model (cont.)Monopoly Model (cont.)
lWe are now ready to find the profit-maximizing output for a monopolist
lThe monopolist sets output at a levelwhere MR=MC
On a graph, find the level of Q where theMR and MC curves intersect
lTo determine the price the monopolistwill charge, locate the price on thedemand curve at this same output level
Monopoly Model (cont.)Monopoly Model (cont.)
Quantity
Dollarsper unit
Demand
MR
MC
P*
Q*
Monopoly Model (cont.)Monopoly Model (cont.)
lThe monopolist’s level of profits canthen be determined by adding itsaverage total cost curve to the graph
lProfits will be the difference between P*and ATC, multiplied by Q*
Monopoly Model (cont.)Monopoly Model (cont.)
Quantity
Dollarsper unit
Demand
MR
MC
P*
Q*
ATC
ATC*
Profits
Contrast to Perfect CompetitionContrast to Perfect Competition
Quantity
Dollarsper unit
Demand
MR
MC
PC
QC
ATC
Under perfect competition,the market equilibrium wouldinstead be where P=MC
The higher price and lower output in a monopolized market is whyeconomists claim that competition is better for social welfare
Monopoly Model (cont.)Monopoly Model (cont.)
lA monopoly only maintains its status ifthere are no substitutes for the productit sells
There must be barriers to entry, so thatother firms cannot enter the market tocompete
The two most common barriers to entry:
lEconomies of scale
lLegal restrictions
Monopoly Model (cont.)Monopoly Model (cont.)
lEconomies of scale
If a monopoly is producing output at a levelwhere long run average costs aredeclining, then new firms cannot competeon a cost basis
A monopoly hospital in a small town mayhave substantial economies of scale if itcan meet demand with only 40-50 beds
lUnless a new hospital could take away asubstantial share of the existing hospital’spatients, it could not match the existing hospitalin costs (and therefore profits as well)
Monopoly Model (cont.)Monopoly Model (cont.)
lLegal restrictions
Physicians require a license to practicemedicine
Many states require that providers obtain aCertificate of Need to offer a new service
Drug companies obtain patents for newpharmaceutical products
The Market Structure ContinuumThe Market Structure Continuum
lWe have talked about 2 extremes of themarket structure continuum
Perfect Competition
Pure Monopoly
lAlong this continuum, there are 2 morelevels of competitiveness that we willencounter in the health care sector
The Market Structure ContinuumThe Market Structure Continuum
PerfectCompetition
MonopolisticCompetition
Oligopoly
Monopoly
Monopolistic CompetitionMonopolistic Competition
lMany sellers
lDifferentiated product
lNo barriers to entry
lExamples
Breakfast cereals
Ibuprofen (Advil, Motrin, etc.)
Cigarettes
Monopolistic Competition (cont.)Monopolistic Competition (cont.)
lBecause products are differentiated acrossfirms, each seller has some ability to controlprice
Each seller faces a slightly downward slopingdemand curve
lSellers have an incentive to “differentiate”their product from competitors
Doing so is likely to raise demand for their product
Monopolistic Competition (cont.)Monopolistic Competition (cont.)
Output
Dollarsper Unit
Demand underperfect competition
Demand undermonopolistic competition
2 potential demand curves for anindividual firm
Monopolistic Competition (cont.)Monopolistic Competition (cont.)
lHow do sellers differentiate theirproduct?
Advertising
lIs advertising bad for consumers?
Creates imaginary or artificial wants
Persuasive, not informative
Business stealing, w/ no benefits toconsumer
Habit buying is a barrier to entry
Monopolistic Competition (cont.)Monopolistic Competition (cont.)
lBenefits of advertising
May convey important info on value of agood or service
lPeople benefit from real diversity & choice
lCheap info to customers to distinguish b/wproducts
May promote quality competition
lFirms willing to invest in creating a brand namereputation will work to keep it
May inform the consumer of good orservice they weren’t aware of
lShift the D curve out
DTC Drug AdvertisingDTC Drug Advertising
lAugust 1997, FDA permitted brand-specific direct-to-consumer (DTC)advertising w/o “brief summary” of drugeffectiveness, side effects, andcontraindications
lDTC advertising rose from $800m in1996 to $2.5b in 2000
What were the consequences?
(Iizuka & Jin, 2003)
DTC Drug AdvertisingDTC Drug Advertising
lIizuka & Jin track monthly expenditureson DTC advertising for 1994-2000
lThey also track monthly visits to thedoctor in a recurring national survey for1994-2000
Survey indicates whether a drug wasprescribed during the visit, and for whatclass
DTC Drug AdvertisingDTC Drug Advertising
Classes of drugs w/ heavy advertisinghad large ↑ in prescribing
DTC Drug AdvertisingDTC Drug Advertising
Classes of drugs w/ less advertising hadno ↑in prescriptions
DTC Drug AdvertisingDTC Drug Advertising
IV column: After deregulation, each $1 ↑ inDTC Ads raises # of visits w/ a prescriptionby .0464
DTC Drug AdvertisingDTC Drug Advertising
IV column: After deregulation, each $1 ↑ inDTC Ads raises # of visits w/ a prescriptionby .0464
lHow much ad spending is needed to getone extra prescription?
1/.0464=$21.55
lDoes DTC advertising look profitable todrug companies?
OligopolyOligopoly
lFew, dominant sellers
lHomogeneous or differentiated product
lSubstantial barriers to entry
lExamples
Tertiary services at teaching hospitals
Many prescription drugs
OligopolyOligopoly
lBecause there are only a few dominantsellers, actions of any one firm canchange the overall market price
lLike monopoly, oligopoly will lead tolower output and higher prices thanwould be observed under perfectcompetition
Regulators are concerned about consumerwelfare in oligopolistic markets
Markets for OrgansMarkets for Organs
lShould we allow markets for organs fortransplant surgery?
lPayment to donors of organs iscurrently forbidden in developedcountries.
lYet there is persistent excess demandfor organ transplants (Becker and Elias,JEP 2007)
Markets for OrgansMarkets for Organs
Markets for OrgansMarkets for Organs
Markets for OrgansMarkets for Organs
lEstimate excess demand from thegrowth in the waiting list in any year,plus # deaths for those on waiting list.
Excess demand in kidney market grewfrom 2,500 persons in 1991 to 7,000 in2000.
The Price of an OrganThe Price of an Organ
lHow much pay is required to induce anindividual to sell an organ?
lCompensate individual for:
- Risk of death
-Time lost during recovery
-Risk of reduced quality of life
Pricing Risk of DeathPricing Risk of Death
l risk of death x Value of a statistical life
lEstimated range $1.5 - $10 m forsomeone with a $35,000 averageannual income in 2005.
lRisk of death ~ .1%
le.g. $5 m x .1% = $5,000
Time Lost During RecoveryTime Lost During Recovery
lAssume donor earns $35,000 / year
lLoses 4 weeks of work while in recovery
l$35,000 x 4 weeks => $2,700
Risk of Quality of LifeRisk of Quality of Life
lNo comprehensive data on how kidneydonation affects QOL.
lSome studies suggest kidney donorscan live normal lives, unless highphysical contact (e.g. athletes).
lBut other studies find kidney donors athigh risk of high blood pressure.
lCould arbitrarily assume $7,500.
Market for OrgansMarket for Organs
l
l
lCost of Performing Kidney transplantsurgery = $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 OrgansMarkets for Organs
l13,500 kidney transplants in 2005,
8000 on waiting list
=>excess demand = 21,500
Assume εD for organ transplants = -1
price 9.5% => demand 9.5%
l9.5% x 21,500 = 2,043
Demand = 21,500 – 2043 = 19,457, but all would besupplied.
Equilibrium transplants rise from 13,500 to 19,457 =44%
Excess Demand if Sales are BannedExcess Demand if Sales are Banned
$
$160,000
S
D
Q0
# Transplants
Excess
Demand
Market for OrgansMarket for Organs
$
$160,000
S
D
Q0 Q1
# Transplants
S*
$175,200
e*
Markets for OrgansMarkets for Organs
lUnder a range of assumptions, allowingthe sale of live donor organssubstantially raises the # of transplants.
lSee Table 3, Becker.