Pareto Efficiency• According to Pareto, an economically efficient outcome in

society is one under which it is impossible to improve the situation of any person without hurting someone else– Pareto efficiency also implies that no further exchanges

can be found that improve the situation of everyone to some degree

• The First Fundamental Theorem of Welfare Economics relies crucially on markets being perfectly competitive—any breakdown in the underlying assumptions, such as freedom of market entry and exit, will lead to distortions in prices, quantities and social efficiency– The First Fundamental Theorem states that competitive

markets under certain conditions are economically efficient

Externalities• Externalities, or spillover effects, are costs and benefits

incurred in the consumption or production of goods and services that are not borne by the individual consumer or producer– The spillover effects can be positive or negative

• Healthcare markets will not lead to Pareto efficiency if there are externalities.

• Definitions:– Marginal social benefit (MSB) – Marginal social cost (MSC)– Marginal costs to society (SMC)– Private marginal cost (PMC)– Marginal external cost (MEC)– Marginal external benefit (MEB)

Externalities

• REMEMBER! Efficient allocation of resources: marginal social benefit (MSB) = marginal social cost (MSC)

• There are four types of externalities:– External Costs of Production (MEC>0; SMC>PMC)– External Benefits of Production (MEC>0; SMC>PMC)– External Costs of Consumption (MEB<0; SMB< PMB)– External Benefits of Consumption (MEB>0; SMB>PMB)

Public Goods• Public goods are goods which may be jointly

consumed by everyone• Specifically, public goods have two characteristics

– Nonrivalry. This means that the consumption of a good or service by one individual will not prevent the consumption of the same good or service by others

– Nonexcludability. This means that it is not possible to provide a good or service to one individual without letting others also consume it

– When goods have these features they will not be provided in the private market

Public Goods

• Public goods are provided by the government, which then compels individuals to finance their provision via some form of taxation

• Pareto efficiency requires that the level of provision of a public good occurs where SMB=SMC

• Most healthcare products and services are not public goods because they are both rival and excludable

• There are some healthcare programs that do have public good properties – An example is public health interventions

aimed at preventing the spread of bird flu

Information ImperfectionsImperfect information arises in health care due to uncertainty and to imperfect knowledge With uncertainty, a market is unable to function properly because consumers and producers do not know how much of a good to demand and supply They are therefore unable to equate the private marginal benefits with the private marginal cost

• Unless consumers and producers are well informed, they may take actions that are not in their best interests – They will be unable to equate private marginal benefits with private

marginal costs, and therefore private efficiency (and thus, Pareto efficiency) is unlikely to be achieved

• The assumption of perfect knowledge on the part of consumers means that they are aware of their health status and of all the options open to them to maintain or improve their health– Although this may be the case for some illnesses, it is clearly not the

case for the majority

Monopoly Model

• If a firm has some market power, the competitive model is not appropriate and a noncompetitive model should be used– A noncompetitive firm with some degree of

market power faces a downward-sloping demand curve • therefore has some ability to influence the

market price• A pure monopoly is a market where only one

producer of a good or service is in the market

Monopoly Compared to Perfect Competition

• A monopoly is the sole provider of a good or service in a well-defined market with no close substitutes– Because it is the only seller in the market, it faces the

market demand curve, which is always downward sloping due to substitution and income effects associated with a price change

• The monopolist charges a higher price and a lower quantity of the drug than under the perfectly competitive conditions– The consumer surplus is reduced under the monopoly

structure, but the producer surplus is increased– This implies that the monopoly underproduces the drug

and therefore misallocates society’s scarce resources– The cost of the monopoly shows up in the deadweight

loss

Barriers to Entry • For a firm to maintain its market power for an extended period of

time, some types of barriers to entry must exist to prevent other firms from entering the industry

• Barriers to entry make it costly for new firms to enter the market and do not exist under perfect competition conditions

• Technical or legal issues account for these barriers– Exclusive control over an input or economies of scale can lead

to barriers • other firms will not have the resources to make the substitute

product– Legal restrictions that prevent other firms from entering the

market and providing goods or services similar to the existing firms are also barriers to entry

– Patents on pharmaceutical products, occupational licensing, and other laws are examples of legal entry barriers in healthcare markets

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Monopolistic Competition• In the monopolistically competitive structure, there are

many firms with minimal barriers to entry• The main distinguishing characteristic of this market

model is that firms sell differentiated products – This implies that the firm earns zero economic profits in

the long run because price equals MC, which is the same result as in the perfectly competitive case

– The monopolistically competitive firm does not produce at a level where P=MC, as in the perfectly competitive model• This may imply that the monopolistically competitive

firm is producing output inefficiently, but this would best be determined by examining the costs and benefits of product differentiation

Competitive Aspects of Product Differentiation

• In the perfectly competitive framework, consumers are treated as being perfectly informed about the prices and quantity of all goods and services in the market– The assumption concerning perfect information

implies that all firms selling identical products sell at the same lowest possible price

– Otherwise, firms with higher prices lose business to firms charging less when consumers are perfectly informed

– In some situations, people choose to be less than perfectly informed, or rationally ignorant

Competitive Aspects of Product Differentiation

• Given imperfect information about many goods and services in the real world, some economists state that product differentiation, such as advertising and branding, can lead to improved information for the consumers– Other economists argue that branding can serve

a similar purpose to advertising for promoting competition

• Some economists think that advertising and branding can lead to anticompetitive behavior through habit purchases rather than informed purchases, created through brand loyalty– According to the anticompetitive viewpoint,

product differentiation manipulates the demand for a product

Oligopoly• An oligopoly is  a market model with a few large firms and

relatively high barriers to entry• There may be large number of firms in the industry, but the

other firms may be small price takers, with limited market share

• The dominant firms must be sufficiently sized and limited in number so that the pricing or output decisions of one firm affect the same types of decisions for the other dominant firms in the market– This mutual interdependence among the firms distinguishes

the oligopoly structure from other market models

Oligopoly

– According the collusive oligopoly model, all firms cooperate rather than compete on price and output and jointly maximize profits by collectively acting like a monopoly

• Collusion among the firms may be overt or tacit– Overt collusion refers to a situation where

representatives of firms formally meet, and coordinate prices and market shares

– Tacit collusion occurs when firms informally coordination their prices

Competitive Oligopoly

• Competitive oligopolies are where firms act competitively, do not cooperate, and seek to maximize their own profits

• If the market consists of goods or services that are relatively homogeneous, firms will set the price equal to MC because there are many close substitutes for the product– Market price equals MC, and resources are

efficiently allocated—even though there are a few dominant firms in the market

The Role of Government• The public interest and special interest group theories

describe the motivation behind government intervention in the healthcare market

• The public interest theory states that the government intervenes in the best interest of society to promote efficiency and equity in the market

• The public interest is served when the government attempts to restore efficiency or to distribute income equitably by encouraging competition, providing information, and reducing harmful externalities or redistributing income in society – Therefore, the public interest theory of government

behavior predicts that the laws, regulations, and other government interventions enhance efficiency and equity

The Role of Government• The special interest group theory states that the political

venue can be treated like any private market for goods and services so that amounts and types of legislation are determined by supply and demand for such legislation The successful politician stays in office by combining legislative programs of various special interest groups into an overall fiscal package to be advanced in the political arena

• The special interest group model of government behavior implies that the typical consumer is “taken” by wealth transferring legislation– Therefore, to protect the public, government intervention

includes regulations and laws because some special interest group benefits at the expense of the general public

Forms of Government Intervention

• The government can promote efficiency and equity by providing public goods, levying taxes, correcting for externalities, imposing regulations, enforcing antitrust laws, operating public enterprises, and sponsoring redistribution programs

Antitrust Issues

• Economists, and also courts dealing with antitrust cases, often use the concept of cross-price elasticity of demand to measure whether a firm has monopoly power in supplying a good or service in the given market

Antitrust Issues• The contemporary market for physician services

provides some examples of behavior that we associate with collusive oligopoly or cartels, which are organizations that set output quotas and sometimes directly set prices

• A series of Supreme Court decisions beginning in the 1970s, have interpreted antitrust law as applying to hospitals – Difficulty in defining relevant geographic markets

in which hospitals operate has led to very limited success on the part of the government in blocking large hospital mergers to date• Government policy remains suspicious of

increasing concentration in the hospital sector

Social Insurance Programs • The principles of social insurance are quite different

from those that pertain to the private market• Social insurance programs are generally funded by

mandatory contributions through some form of taxation

• They usually have goals in addition to pooling of risk, which include transfers of benefits between groups, from the more affluent to the poor, from younger adults to senior citizens, from adults to children, or from the able-bodied to the disabled

• The goal is to equate marginal social benefits with marginal social costs in the provision of optimal insurance packages

Social Insurance Programs

• Social insurance in the United States: certain categories of citizens and residents, such as senior citizens, a segment of the poor, and people with qualified disabilities, all of whom are covered by Medicare and Medicaid

• A few other special groups, including Native Americans on reservations, veterans of armed forces, members of Congress, and low-income families with children.

• Some states have also expanded social insurance programs to families who would not otherwise be covered by the federal programs.

Provision of Information

• When market failure in health care arises due to imperfect information, the government may help to correct the problem via the provision of information

• An example is the provision of information to the general public on the benefits of certain types of health care, such as the safety of the mumps, measles, and rubella (MMR) vaccine

Summary• The model of a pure monopoly is the exact opposite of the

perfectly competitive market– This market model is characterized by one seller with one

product and perfect barriers to entry • Monopolistic competition is noted as an intermediate market model

– Its main distinguishing feature being its differentiated product • Oligopoly is also considered an intermediate market model

– A few dominant firms and mutual interdependence between the firms distinguishes an oligopoly from the other market models

– Government intervention is based on the special interest or public interest theories

• The public interest theory focuses on efficiency in the market • The special interest theory levels the playing field in the

legislative marketplace