Market Structure In the Healthcare Industry

1. 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

2. Outline • Defining perfect competition • The market structure continuum • Monopoly • Monopolistic competition • Oligopoly • The market for organs

3. 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

4. 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

5. 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”

6. 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

7. 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?

8. 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

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

10. 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

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

12. 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*

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

14. 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

15. 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

16. 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)

17. 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

18. 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

19. The Market Structure Continuum Perfect Competition Oligopoly Monopoly Monopolistic Competition

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

21. 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

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

23. 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

24. 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

25. 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)

26. 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

27. DTC Drug Advertising • Classes of drugs w/ heavy advertising had large ↑ in prescribing

28. DTC Drug Advertising • Classes of drugs w/ less advertising had no ↑in prescriptions

29. DTC Drug Advertising • IV column: After deregulation, each $1 ↑ in DTC Ads raises # of visits w/ a prescription by .0464

30. 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?

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

32. 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

33. 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)

34. Markets for Organs

35. Markets for Organs

36. 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.

37. 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

38. 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

39. 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

40. 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.

41. 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.

42. 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%

43. S $ $160,000 Excess Demand if Sales are Banned Excess Demand D Q0 # Transplants

44. Market for Organs S $ e* S* $175,200 $160,000 D Q0 Q1 # Transplants

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