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 l Defining perfect competition l The market structure continuum  Monopoly  Monopolistic competition  Oligopoly l The market for organs

Characteristics of Perfect Competition l Consumers pay the full price of the product  Consumers will respond to differences in prices among sellers l All firms maximize profits  Firms have incentives to satisfy consumer wants and produce efficiently

Characteristics of Perfect Competition (cont.) l 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 l 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.) l No barriers to entry or exit exist  New firms can enter the industry l All economic agents possess perfect information  Consumers and firms can make informed choices l All firms face nondecreasing average costs of production  Rules out a “natural monopoly”

Monopoly Model l In contrast to perfect competition, a monopoly market has the following features:  One seller  Homogeneous or differentiated product  Complete barriers to entry l Because there is only one firm, that firm faces the market demand curve, which is downward sloping

Monopoly Model (cont.) l 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) l 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.) Quantity Dollars per unit Demand MR

Monopoly Model (cont.) l We are now ready to find the profit- maximizing output for a monopolist l 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 l To determine the price the monopolist will charge, locate the price on the demand curve at this same output level

Monopoly Model (cont.) Quantity Dollars per unit Demand MR MC P* Q*

Monopoly Model (cont.) l The monopolist’s level of profits can then be determined by adding its average total cost curve to the graph l Profits will be the difference between P* and ATC, multiplied by Q*

Monopoly Model (cont.) Quantity Dollars per unit Demand MR MC P* Q* ATC ATC* Profits

Contrast to Perfect Competition Quantity Dollars per unit Demand MR MC PCPC QCQC ATC Under perfect competition, the market equilibrium would instead be where P=MC The higher price and lower output in a monopolized market is why economists claim that competition is better for social welfare

Monopoly Model (cont.) l 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: l Economies of scale l Legal restrictions

Monopoly Model (cont.) l 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 beds l 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.) l 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 l We have talked about 2 extremes of the market structure continuum  Perfect Competition  Pure Monopoly l 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 Monopolistic Competition Oligopoly Monopoly

Monopolistic Competition l Many sellers l Differentiated product l No barriers to entry l Examples  Breakfast cereals  Ibuprofen (Advil, Motrin, etc.)  Cigarettes

Monopolistic Competition (cont.) l Because products are differentiated across firms, each seller has some ability to control price  Each seller faces a slightly downward sloping demand curve l Sellers have an incentive to “differentiate” their product from competitors  Doing so is likely to raise demand for their product

Monopolistic Competition (cont.) Output Dollars per Unit Demand under perfect competition Demand under monopolistic competition 2 potential demand curves for an individual firm

Monopolistic Competition (cont.) l How do sellers differentiate their product?  Advertising l 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.) l Benefits of advertising  May convey important info on value of a good or service l People benefit from real diversity & choice l Cheap info to customers to distinguish b/w products  May promote quality competition l 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 l Shift the D curve out

DTC Drug Advertising l August 1997, FDA permitted brand- specific direct-to-consumer (DTC) advertising w/o “brief summary” of drug effectiveness, side effects, and contraindications l DTC advertising rose from $800m in 1996 to $2.5b in 2000  What were the consequences? (Iizuka & Jin, 2003)

DTC Drug Advertising l Iizuka & Jin track monthly expenditures on DTC advertising for l They also track monthly visits to the doctor in a recurring national survey for  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 l How much ad spending is needed to get one extra prescription?  1/.0464=$21.55 l Does DTC advertising look profitable to drug companies?

Oligopoly l Few, dominant sellers l Homogeneous or differentiated product l Substantial barriers to entry l Examples  Tertiary services at teaching hospitals  Many prescription drugs

Oligopoly l Because there are only a few dominant sellers, actions of any one firm can change the overall market price l 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 l Should we allow markets for organs for transplant surgery? l Payment to donors of organs is currently forbidden in developed countries. l Yet there is persistent excess demand for organ transplants (Becker and Elias, JEP 2007)

Markets for Organs

l 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 l How much pay is required to induce an individual to sell an organ? l Compensate individual for: - Risk of death - Time lost during recovery - Risk of reduced quality of life

Pricing Risk of Death l risk of death x Value of a statistical life l Estimated range $1.5 - $10 m for someone with a $35,000 average annual income in l Risk of death ~.1% l e.g. $5 m x.1% = $5,000

Time Lost During Recovery l Assume donor earns $35,000 / year l Loses 4 weeks of work while in recovery l $35,000 x 4 weeks => $2,700

Risk of Quality of Life l No comprehensive data on how kidney donation affects QOL. l Some studies suggest kidney donors can live normal lives, unless high physical contact (e.g. athletes). l But other studies find kidney donors at high risk of high blood pressure. l Could arbitrarily assume $7,500.

Market for Organs l l l 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 Organs l 13,500 kidney transplants in 2005, 8000 on waiting list =>excess demand = 21,500 Assume ε D for organ transplants = -1  price 9.5% => demand 9.5% l 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 $ $ 160,000 S D Q 0 # Transplants Excess Demand

Market for Organs $ $ 160,000 S D Q 0 Q 1 # Transplants S*S* $ 175,200 e*e*

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