Chapter 8: Structure, Conduct,
Performance, and Market Analysis
Health Economics

Outline
 Defining perfect competition.
 Market equilibrium.
 Comparative statics.
 Applications.

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.

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.

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.”

Market Equilibrium
 Given the demand and supply curve for any given product, one can determine how many goods will be exchanged, and at what price.
 The equilibrium , or market-clearing price and output are at the point where the demand and supply curves intersect.

Dollars per bottle
Market Equilibrium (cont.)
Supply
P
0
Q
0
Demand
Market output of generic aspirin (Q)

Market Equilibrium (cont.)
 Equilibrium occurs when no tendency for further change exists.
 At the equilibrium price of P
0
, consumers are willing to purchase Q
0 bottles of aspirin.
 Aspirin manufacturers are willing to sell
Q
0 bottles of aspirin at P
0
.

Market Equilibrium (cont.)
 If the price of aspirin is above the equilibrium level, there will be a surplus , or excess supply of aspirin.
 If the price of aspirin is P
1 on the following graph, sellers will want to sell
Q
B bottles of aspirin, but consumers will only want to purchase Q
A bottles.
 The distance between Q
A and Q
B represents the amount of excess supply of aspirin.

Dollars per bottle
Market Equilibrium (cont.)
Supply
P
1
Q
A
Excess Supply
Q
B
Demand
Market output of generic aspirin (Q)

Market Equilibrium (cont.)
 If the price of aspirin is below the equilibrium level, there will be a shortage , or excess demand of aspirin.
 If the price of aspirin is P
2 on the following graph, consumers will want to buy Q
F bottles of aspirin, but sellers will only want to sell Q
E bottles.
 The distance between Q
E and Q
F represents the amount of excess demand of aspirin.

Dollars per bottle
Market Equilibrium (cont.)
Supply
P
2
Q
E
Q
F
Excess Demand
Demand
Market output of generic aspirin (Q)

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.

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 .

Comparative Statics
(Example 1)
 Suppose consumer income increases by a significant amount.
 This increase in income causes the demand curve to shift to the right.
 This rise in demand leads to a temporary shortage in aspirin, illustrated by the distance EF on the following graph.

Comparative Statics
(Example 1)
Dollars per bottle
S
P
0
E
F
Q
0
Excess demand
D
0
D
1
Market output of generic aspirin (Q)

Comparative Statics
(Example 1)
 The consumers who are willing, but not able to buy aspirin at P
0 price of aspirin upwards.
will bid the
 i.e. They will offer sellers more than P
0 buy a bottle of aspirin.
to
 Because sellers are being offered a higher price than P
0
, they will increase their output of aspirin above Q
0
.

Comparative Statics
(Example 1)
 As the price of aspirin begins to rise above P
0
, consumers reduce their demand for aspirin.
 This process will continue until the market reaches a new equilibrium.

Comparative Statics
(Example 1)
Dollars per bottle
S
New equilibrium
P
1
P
0
E
F
D
0
D
1
Q
0
Q
1 Market output of generic aspirin (Q)

Comparative Statics
(Example 2)
 Suppose manufacturers develop a technology that lowers the marginal cost of making aspirin
 This cost-saving technology causes the supply curve for aspirin to shift out.
 This increase in supply leads to a temporary surplus of aspirin, illustrated by the distance AB on the following graph.

Comparative Statics
(Example 2)
Dollars per bottle
S
0
S
1
A
P
0
B
Q
0
Excess supply
D
0
Market output of generic aspirin (Q)

Comparative Statics
(Example 2)
 The firms that are willing, but not able to sell aspirin at P
0 will lower the price they charge for aspirin.
 i.e. They will offer charge consumers a price of aspirin which is below P
0
.
 Because consumers are being offered a higher lower than P
0
, they will increase their quantity of aspirin demanded above Q
0
.

Comparative Statics
(Example 2)
 As the price of aspirin begins to fall below P
0
, firms reduce their supply of aspirin.
 This process will continue until the market reaches a new equilibrium.

Comparative Statics
(Example 2)
Dollars per bottle
S
0
S
1
P
0
P
1
A
Q
0
Q
1
B
New equilibrium
D
0
Market output of generic aspirin (Q)

Comparative Statics
(Long run)
 In the short run, firms cannot enter or exit a given market.
 i.e. In the short run, no firms producing generic aspirin can exit the market, and no new firms can start producing aspirin.
 In the long run, new firms will enter a perfectly competitive market if there are any profits to be made.
 Entry occurs until

= 0.

Comparative Statics
(Long run)
 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.

Dollars per pair
Comparative Statics
(Long run)
S
P
0
E
F
Q
0
Excess demand
D
0
D
1
Market output of latex gloves (Q)

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 shortrun equilibrium was reached.
 From 1986 to 1990, annual sales of latex gloves increased by ~58%.

Dollars per pair
Comparative Statics
(Long run)
S
P
1
P
0
Q
0
Q
1
D
0
D
1
Market output of latex gloves (Q)

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.


= (P
1 x Q
1
) – (Q
1 x ATC(Q
1
))

Dollars per pair
Comparative Statics
(Long run)
MC
P
1
P
0
ATC d
1
= MR
1 d
0
= MR
0
Q
0
Q
1 Market output of latex gloves (Q)

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.

Dollars per pair
Comparative Statics
(Long run)
S
0 S
1
P
1
P
0
Q
0
Q
1
Q
2
D
0
D
1
Market output of latex gloves (Q)

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 P
0
, where profits for all glove makers are again equal to 0.

Dollars per pair
Comparative Statics
(Long run)
MC
P
1
P
0
ATC d
1
= MR
1 d
0
= MR
0
Q
0
Q
1 Market output of latex gloves (Q)

Characteristics of Perfect Competition
 Briefly recall some of the features of a perfectly competitive market:
 Many sellers.
 Homogeneous product.
 No barriers to entry.
 Under perfect competition, each individual firm is a price taker.
 Each firm faces horizontal demand and marginal revenue curve.

Monopoly Model
 In contrast, 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.

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?

Monopoly Model (cont.)
 We know that TR = P x Q
 What is the MR = change in TR if output is increased by 1 unit?
 A monopolist faces a downward sloping demand curve.
 To increase sales by 1 unit, the price charged per unit (for each unit sold) must be lowered.

Dollars per unit
P
0
P
1
Monopoly Model (cont.)
If a monopolist wishes to increase its output sold from Q
0 to Q
1
, it will need to lower the price it charges from P
0 to P
1
.
Q
0
Q
1
Demand
Quantity

Dollars per unit
Monopoly Model (cont.)
When reducing its price from P
0
P
1
, the monopolist loses the difference between P
0 and P
1 units of output up to Q
0
.
to for all
P
0
P
1 revenue loss
Q
0
Q
1
Demand
Quantity

Dollars per unit
Monopoly Model (cont.)
However, the monopolist also gains the value of P
1 output from Q
0 for each increase in to Q
1
.
P
0
P
1
$ i n g a
Q
0
Q
1
Demand
Quantity

Monopoly Model (cont.)
 The marginal revenue from increasing sales from Q
0 to Q
1 is represented by the revenue gain, minus the revenue loss depicted in the 2 previous graphs.
 In numerical terms:
MR = P + Q • ( 
P/

Q) revenue gain revenue loss

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.

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

Monopoly Model (cont.)
 We are now ready to find the profitmaximizing 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.

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

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*.

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

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

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.

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).

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.

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.

The Market Structure Continuum
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly

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

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.

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

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

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.