The Market for Physicians’Services Chapter 5

Long-Run v. Short-Run Decisions Economists’ distinction between short- and long-run Short-run: price and output; MD hours of work; non-MD input choices Long-run: decision to become MD; specialty choice; type of practice?, location Assumption that decision makers are forward-looking. How short-run feeds into long-run decisions

Concepts of Shortage and Surplus Shortage and surplus in common parlance Shortage and surplus in economics Why shortages and surpluses of MDs hard to predict: future demand (payment policy, technological change, other factors of production, etc.); sources of future supply (domestic, out- and in-migration of MDs)

Fig. 5.1. The Economic Concept of Shortage (Excess Demand) and Surplus (Excess Supply)

Choice of Medicine as a Career Role of financial incentives Role of non-financial incentives (extrinsic v. intrinsic motivation) Compensating wage differentials Concepts of present value and internal rate of return (on investments in medical education)

Choice of Medicine as a Career, cont.  For each individual m and each career alternative j, there is a stream of anticipated future earnings (ymj) and non-pecuniary attributes of the occupation (Aj). Non-pecuniary attributes: occupation’s prestige, intellectual content, types of people one interacts with, flexibility of work schedule, risk of injury, and job-related stress. Values of ymj vary not only by j but also by m Individuals differ in utility that they attach to earnings and non-Pecuniary attributes of job.

Choice of Medicine as a Career, cont. Let Um = Um(ymj, Aj) (5.1) ymj & Aj substitutes. Higher level of anticipated earnings compensate an individual for accepting work in an occupation with a lower Aj. Since adding an additional unit of Aj differs among individuals, people require different compensating earnings differentials to make them equally well off if they select an occupation with lower A.

Fig. 5.2. Determinants of Equilibrium Earnings in an Occupation Supply Demand Market Equilibrium S Earnings ($) O Number of employees Employees E2 E1 L1 L2 D E* L* MP↑→ Demand curve shift outward

Fig. 5.3. The Equalizing Earnings Differential between the Two Occupations

Concept of Present Value PVj = (Rj1-Cj1)/(1+i) + (Rj2-C2j)/(1+i)2 + (Rj3-Cj3)/(1+i)3 … + (Rjn-Cjn)/(1+i)n + Sjn (5.2) Where: PVj = present value of returns net of the cost of an investment in training in occupation j i = market rate of interest Rjt = earnings in year t Cjt = cost associated with investment in training for occupation j in year t n = number of periods (years) in which person expects to be active in occupation j Sjn = value of the sale of the asset at year n, e.g., the sale of a physician practice

Concept of Internal Rate of Return The internal rate of return on an investment is the internal rate r which makes the present value of the right hand side of eq. (5.2) zero. 0= (Rj1-Cj1)/(1+i) + (Rj2-Cj2)/(1+i)2 + (Rj3-Cj3)/(1+i)3 ...+ (Rjn-Cjn)/(1+i)n + Sjn (5.3) where n shows time horizon relevant for the project (n=number of periods). If r ≥ to marginal cost of funds, project is undertaken. If r < than marginal cost of funds, the project is not undertaken. For careers, a person can only accept 1 “project.” Choice of projects is mutually exclusive.

Fig. 5.4. The Relationship between the Marginal Cost of Funds and the Amount of Investment in Human Capital Marginal Cost ($) O Cost of Capital (COC) X C COC' X+1 C' Scholarship or grants for education Amount of Investment

Choice of Mode of Practice (e.g., solo v. group practice) Scale v. scope economies. What are they and why do they arise? Motives for joining group practice? Scale & scope economies, referrals, patient coverage, reduced MD earnings fluctuations How financial incentives facing individual MD differ: salary; revenue sharing; expense sharing, etc.

Let OOP = out-of-pocket payment (by patient)

Net Marginal Revenue to MD (MR) and Marginal Cost to Patient of Additional Unit (MC) of Service MR to MD MC to patient + MD paid FFS and patient pays OOP MD paid FFS and patient pays 0 OOP MD salaried and patient pays OOP MD salaried and patients pays 0 OOP - MD capitated and patient pays OOP MD capitated and patient pays 0 OOP

Physicians’ Short-Run Decisions

Argument that Standard Neoclassical Model Does Not Apply to the Physician Services’ Market What does neoclassical model predict? Why do we care what the neoclassical model or any alternative to this model predicts? Why do people question the neoclassical model? (1) adequacy of predictions; (2) underlying assumptions: perfect information; (3) higher-income persons sometimes pay higher MD fees (price discrimination); (4) lack of systematic relationship between fees and quality of care; (5) fees often higher not lower in areas of high MD density; (6) when government reduces fees it pays, sometimes quantity of service rises

Reconciling Theory and Empirical Evidence (“stylized facts”) Why individual physician’s demand curve may be downward sloping: monopolistic competition model Why fees may be higher not lower in areas with higher physician density? (1) confounding; (2) Pauly-Satterthwaite model; (3) quality-amenities model Why administered price reductions may lead to higher quantity of services? Backward-bending supply of MD services

Alternative Models Target income hypothesis Supplier-induced demand (U(ym,l,E)) where U=utility; ym=consumption of goods and services made possible by earnings; l=leisure time; E=ethics (violated when induce demand) Is being ethical a normal good? Does supplier-induced demand apply in low-income country? Implications if it does or does not?

Fig. 5.5. Equilibrium in Pure Monopoly and Monopolistic Competition

Equilibrium in Pure Monopoly and Monopolistic Competition, cont. Reason for the negative relationship between prices and quantities provided Concept of a backward-bending labor supply curve comes from microeconomic theory. Rewrite eq. (5.1) as follows Ui = Ui(yi,Ai) (5.4)

Hours of Work Decision Individual i’s utility is a function of income or goods and leisure (li) yi = (T- li)w + yo (5.5) The person’s income depends on the number of hours s/he works (T- li), where T = total amount of time available to allocate between market work and leisure yoi = other income unrelated to work hours, such as from investments or public subsidies. Individual’s decision problem is to find that level of li which maximizes utility subject to the constraint given by eq. (5.5).

Fig. 5.6. The Physician Work-Leisure Decision

MD Price and Output Decision with 2 Markets MD price setter in 1 market MD price price taker in 2nd market Necessary condition for price discrimination that price elasticities of demand differ Also cannot have arbitrage between 2 markets

Fig. 5.7. The Physician as Price Setter and Price Taker

Comparative Statics What comparative statics are Comparative statics in this context: evaluate exogenous changes in demand in price setting market, price change in price taking market, change in practice cost affecting both markets

Fig.5.8. The Effect of an Increase in Demand in the Non-Medicaid Market Price MC Quantity O p2 p1 x1 x2 Dp D'p MR'p MRp

Fig. 5.9. The Effect of Rising Marginal Costs in the Medicaid and the Non- Medicaid Market Price MC Quantity O p2 x2 xT Dp x'T DM=MRM MRp MC'