Government Regulation
and Intervention
Part 1
Vivian Ho
Health Economics
This material draws heavily from Santerre & Neun: Health Economics, Theories Insights and
Industry Studies, Southwestern Cengate 2010
Introduction
Causes and consequences of
government intervention in health care.
 Types of government intervention.
 Case studies

– Cigarette taxes.
– Price ceilings on health care services.
– Hospital antitrust litigation.
Criteria for perfect
competition
All firms and consumers are price
takers.
 Consumers and firms have perfect
information.
 All firms produce an identical product.
 Firms can freely enter an exit an
industry.

Market imperfections may lead to inefficient
or inequitable distribution of resources.
Imperfect consumer information
 Monopoly
 Externalities

 Government
intervenes to restore
efficiency and/or equity.
• “Public interest theory.”
An opposing theory: The amount and types
of government intervention are determined
by supply and demand.
Vote-maximizing politicians “supply”
legislation.
 Wealth maximizing special interest
groups are the buyers.
 Successful politicians stay in office by
satisfying special interest groups.

“Special interest group theory”
Examples:

Extended patent protection for brand
name drugs.

Rejection of national health insurance in
favor of private insurance companies.
Special interest group theory claims that special
interest groups gain at the expense of the general
public.
Consumers are diverse, fragmented,
more costly for them to organize.
 Inefficient, inequitable resource
allocation by government.

Which theory do you believe?
 C-B analysis is needed to identify
winners and losers.

Types of Government Intervention

Provide public goods.
 Fund medical research.

Correct for externalities
 Tax cigarettes, pollution.

Impose regulations.
Enforce antitrust laws.
Sponsor redistribution
programs.
Operate public
enterprises.
 FDA
 Bar hospital mergers.
 Medicare and Medicaid.



 VA hospitals
Public Goods

>1 individual simultaneously receives
benefits from the good.
 i.e.,
no rivalry in consumption.
Costly to exclude nonpayers from
consumption of the good.
 Private firms unwilling to produce and sell
public goods.
 Are most medical services public goods?

Externalities
Definition: An unpriced byproduct of
production or consumption that adversely
affects another party not directly involved
in the market transaction.
 Cigarette
smoking
 Pollution
 Medical
treatment for cyclists who don’t
wear helmets
 Drunk drivers
Demand-side externality:
 Marginal Social Benefit  Marginal
Private Benefit

Supply-side externality:
 Marginal Social Cost  Marginal Private
Cost

Cigarette smoking is an example of a
(negative) demand-side externality.
Smokers impose work-related costs on
nonsmokers.
 Health insurance, pensions, sick leave,
disability, group life insurance financed
collectively by smokers and
nonsmokers.

 But
smokers, die earlier, pay less taxes,
premiums.
Smokers also impose health care
costs on nonsmokers.

Smokers usually incur higher health
care costs.
 But
nonsmokers die prematurely from
passive smoking, smoking-related fires.

The total external costs of cigarette
smoking are estimated to be 15¢ per
pack.
(Manning et al., 1991)
Keep in mind:
The problem which calls for government
intervention is external costs, not
internal costs.
 The full extent of external costs must be
measured using a lifetime approach.

Manning et al.’s methods
Lifetime external costs
154 
# packs smoked

Numerator takes into account life
expectancy for smokers and the costs
(savings due to early death) incurred
each year.
External Cost Components
Covered medical costs.
 Covered work loss and disability.
 Group life insurance.
 Widow’s social security bonus.
 Covered nursing home costs.
 Pensions.
 Taxes on earnings.
 Fires.

$ per
S=MPC=MSC
pack
MSC0
D=MPB
MSB0
MSB
Q1

Q0
Cigarette Packs
At Q0 MSC0 > MSB0
Cigarettes are being over-consumed.
Government can use taxes and subsidies to
alter economic incentives, correct for
externalities.

Charge a tax on cigarettes that reduces
consumption to the socially optimal level
Q 1.
 Levy
a per-unit tax T on cigarette
makers equal to vertical distance
between MPB and MSB at Q1.
$ per
pack
MPC0+ T
MPC0=MSC
P1
P0
P2
D=MPB
MSB
Q1
Q0
Cigarette packs
With tax:
Market price of cigarettes = P1
 Cigarette manufacturers receive P2 per
pack.


Tax burden
 Consumer
pays P1 - P0
 Seller pays P0 - P2
The relative tax burden on consumers vs.
producers depends on price elasticities for
supply and demand.

If demand for cigarettes is inelastic,
consumers bear a larger?/smaller?
Share of the tax burden.
Further issues
The current tax per pack exceeds
external costs. Is this “OK”?
 Should smokers or cigarette companies
be responsible for the external costs of
smoking?
 “Thank you for smoking.” Is this
moral??

Regulations

Government can attempt to control
price, quantity, or quality of health care
products.

Example: Price Ceilings in The
Canadian Health Care System.
– Consumers are fully insured by the
government.
– The government fixes the price the
physician receives for each visit.
Regulations

Because consumers are fully insured,
they will demand the number of visits as
if the price per visit = 0.

Assume that the government sets a
reimbursement rate for physician visits
equal to PC.
Price
S
PC
D
QS QD
Physician visits
With full insurance, consumers want QD
visits.
 But the government has fixed the price
of visits at PC.

– Only QS visits will be provided.
 Shortage
of physician visits = QD - QS.
Consequences
1)Physicians may treat patients on 1stcome, 1st-served basis, regardless of
severity/urgency.
2)Patients will have to queue for care/not
receive care.
3)Unethical doctors may take bribes from
patients trying to jump the queue.
Lesson: There is no free lunch under cost
containment. Price ceilings can lead to:
1) Shortages.
2) Longer waiting lines.
3) Nonprice rationing.
4) Poorer health outcomes.
Antitrust: Sherman Antitrust Act
Section 1:
Every contract, combination in the form
of trust or otherwise, or conspiracy, in
restraint of trade or commerce among
the several states or with foreign
nations, is hereby declared illegal.


Section 2:
Every person who shall monopolize, or
conspire with any other person or
persons to monopolize any part of the
trade or commerce among the several
states, or with foreign nations, shall be
guilty of a misdemeanor.
The Act prohibits anticompetitive business
practices that promote inefficiency and
inequity in the marketplace, such as:

Price fixing - when business rivals enter
a collusive agreement to refrain from
price competition; fix the price of a good
or service.
 Hospitals
in a given city cannot jointly
establish the price of various hospital
services.

Boycott - agreement among competitors
not to deal with a supplier or a
customer.
 Physicians
in an area can’t collectively
agree to deny services to a particular
managed care organization.

Market allocation - when competitors
agree to compete with one another in
specific market area.
 Hospitals
in the same city can’t collectively
set geographic service boundaries.

Price fixing, boycotting, and market
allocations are illegal per se.
 The
plaintiff must only prove these actions
took place for the defendant to be in
violation of the Act.

In contrast, rule of reason doctrine is
used to evaluate horizontal mergers
under the Act.
 While
horizontal mergers may force price
above the competitive level, they may also
create benefits which could be passed on
to the customer.
Redistribution
The government often taxes one group
and uses the revenues to subsidize
another. Why?
 Interdependent utility functions.

 Donors
get utility from increasing the
welfare of recipients.

Why is the government involved?
 “free
rider” problem.
Two notions of equity in redistribution
programs

Vertical equity
 “Unequals
should be treated unequally.”
 People who earn more should pay higher
taxes.

Horizontal equity
 “Equals
should be treated equally.”
 Two persons with the same income level
should pay the same in net taxes.
Vertical equity in practice

How much more in taxes should higher
income people pay?

Suppose high income households pay
$4,000 in taxes on average, and low
income households pay $2,000. Is this
equitable?

If the high income household makes
$100,000, they pay a 4% tax.

If the low income household makes
$10,000, they pay a 20% tax.
 The
notion of equity in taxation depends
not just on total tax revenues, but on
income levels and tax rates as well.

In practice, vertical equity is achieved
when the net tax system is sufficiently
progressive.
 Taxes
as a fraction of income rise with
income.
 Federal income tax system.
Other forms of redistribution

Proportional.
 The
fraction of income going to taxes is
constant as income rises.
 The Medicare tax is a fixed % of payroll
income.

Regressive.
 The
fraction of income going to taxes falls
as income rises.
 Sales tax
Implementing redistribution

Supply-side subsidies
 Government
funding aimed at reducing the
costs of producing a consumer good or
service.
 Subsidy to a public hospital.
 Tuition for nurses or doctors.

Potentially violates notion of vertical
equity
 if
all persons have equal access to the
subsidized product.
Demand-side subsidies - government
funding for consumers.
 In-kind: vouchers or reimbursements for
specific services.

 Food

stamps, Medicare, Medicaid
Cash: government-provided income that
people can use at their own discretion.
 AFDC,
Supplemental Security Income
Keep in mind: It is difficult to guarantee
horizontal equity with multiple programs
in operation.
Consumer Groups Accuse U.S. of
Negligence on Food Safety
– The New York Times, October 15, 2002
Back to the Start

Does government intervention correct
for market imperfections, or is it ruled by
special interest groups?
A Final Caveat
Market failure is a necessary, but not
sufficient condition for government
intervention.
 It may cost the government $10m to
correct a problem in the marketplace,
which imposes $8m in damages.
 While markets may fail and impose
societal costs, the costs of government
intervention may be greater.
