Market Structure In the Healthcare Industry

1. Market Structure In the Healthcare Industry Professor Vivian Ho Health Economics Fall 2007 These notes draw from material in Santerre & Neun, Health Economics, Theories, Insights and Industry Studies. Dryden 2007

2. Outline • Defining perfect competition • Comparative statics • The market structure continuum • Monopoly • Monopolistic competition • Oligopoly

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. Comparative Statics • How does the market react to events that influence the demand for or supply of medical services? • Recall that changes in factors other than output price will cause the demand or supply curve to shift • An increase in consumer income will cause the demand curve for physician visits to shift to the right • An increase in the wage of nurses will cause the supply curve for hospital stays to shift to the left

7. Comparative Statics • These shifts in the demand or supply curves will lead to a change in equilibrium price and quantity • Predicting such changes is referred to as comparative static analysis

8. Comparative Statics • In the mid-1980s, the AIDs epidemic led to an increase in the demand for latex gloves among health care workers • The epidemic led to a shift to the right in the demand curve for latex gloves • Excess demand for gloves developed, leading to a temporary shortage of gloves

9. Comparative Statics (Long run) Dollars per pair S F E P0 D1 D0 Q0 Market output of latex gloves (Q) Excess demand

10. Comparative Statics (Long run) • The shortage of gloves led buyers to bid the price of gloves upwards • As the price bid for gloves rose, sellers increased their quantity supplied of gloves • This process continued until a new short-run equilibrium was reached • From 1986 to 1990, annual sales of latex gloves increased by ~58%

11. Comparative Statics (Long run) Dollars per pair S P1 P0 D1 D0 Q0 Q1 Market output of latex gloves (Q)

12. Comparative Statics (Long run) • Before the epidemic, each glove maker was earning 0 profits • The increase in equilibrium price after the epidemic implies that all glove makers are earning positive profits •  = (P1 x Q1) – (Q1 x ATC(Q1))

13. Comparative Statics (Long run) Dollars per pair MC ATC d1 = MR1 P1 P0 d0 = MR0 Q0 Q1 Market output of latex gloves (Q)

14. Comparative Statics (Long run) • Other medical suppliers made plans to build new manufacturing plants to make gloves, in the hopes of making profits • In 1988, 116 permits were pending in Malaysia for building latex glove factories • Entry of the new plants into the market increased the supply of latex gloves in the long run • The supply curve for gloves shifted out

15. Comparative Statics (Long run) Dollars per pair S0 S1 P1 P0 D1 D0 Q0 Q1 Q2 Market output of latex gloves (Q)

16. Comparative Statics (Long run) • As the supply curve for gloves shifts out, the price of gloves begins to fall • Note that the quantity of gloves sold on the market also increases • As the price of gloves fall, profits also fall • The process continues, until the price of gloves falls back to P0, where profits for all glove makers are again equal to 0

17. Comparative Statics (Long run) Dollars per pair MC ATC d1 = MR1 P1 P0 d0 = MR0 Q0 Q1 Market output of latex gloves (Q)

18. 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

19. 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?

20. 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

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

22. 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

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

24. 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*

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

26. 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

27. 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

28. 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)

29. 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

30. 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

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

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

33. 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

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

35. 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

36. 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

37. 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)

38. 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

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

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

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

42. 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?

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

44. 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