Economics of health care
1st November 2002
Topic 4. Market failure in health care
1. ‘Perfect competition’ and efficiency
On the supply side:
No barriers to entry and exit
Large number of firms
Highly competitive – no ‘price setting
power’
On the demand side:
Consumers have perfect information
(prices, quality)
Make decisions in their own best
interests
Predictions of the model of perfect competition:
P = MC
Economic profits = zero
Allocatively efficient quantity of the good will
be produced and consumed.
Perfect competition and perfect contestability.
2. Market failure and the rationale
Government involvement in health care
for
Deviations from perfect competition
Allocative inefficiency
The positive and normative economics
of market failure.
Principal sources of market failure:
External effects
Merit goods
Public goods
Asymmetric information and imperfect
agency
Imperfect competition
3. Externalities
Where the benefits (or costs) of consumption (or
production) spill over onto others.
External costs
External benefits
External benefits mean that the MV
society > MV private.
‘Too little’ will be consumed in a private
market.
£
MVsocial
MC
MVprivate
Quantity
of the
good
Vaccinations, externalities & herd effects.
MV
£
MV social
MV private
Quantity of
vaccinations
Herd immunity
achieved
Eg. 80%
coverage
100% coverage
MVprivate falls to zero once herd immunity has
been achieved. MVsocial shows increasing
external benefit per vaccination up until the point
of herd immunity, where it also falls to zero.
Q: Is this a reasonable way of representing the
likely MVprivate and MVsocial for vaccinations?
What other shapes might these have?
Implications for allocative efficiency
MV
£
MV social
MC3
MV private
MC2
MC1
Q3
Q2
Q4
Quantity of
vaccinations
Q1
100% coverage
Herd immunity
achieved
e.g. 80%
coverage
At low marginal cost (MC1): market will deliver
the socially optimal quantity of vaccinations (Q1).
The external effect is irrelevant.
At medium marginal cost (e.g. MC2): consumers
choose Q2 which is < social optimum (Q1) which
is the herd immunity quantity of vaccinations.
At a high MC (e.g. MC3): socially optimal
quantity of vaccinations (Q4) will be > that
resulting from the market (Q3) – but the social
optimum (Q4) will be less than herd immunity
(Q1).
4. Merit goods
5. Caring externalities
Interdependent utility functions
Maximisation of utility
‘efficient redistribution’
MU of
B’s
income
to A
MU of
A’s
income
to A
A’s
income
B’s
income
6. Public goods (and why most health care is
not a public good)
‘Pure’ public goods have two characteristics:
Non-rival
Non-excludable
Implications for market failure.
Free rider effects
Q: Is health care a public good?
Are there any aspects of the benefits of health
services that have public good characteristics?
7. Asymmetric Information, agency
& the Supplier Induced Demand (SID)
hypothesis.
Asymmetric information
Principal agent theory
Imperfect agency
Conditions for SID to be possible:
Asymmetric information
Financial incentives for inducement
Issues in defining SID
“Demand inducement occurs when a physician
provides or recommends the provision of
medical services that differ from what the patient
would choose if he or she had available the
same information and knowledge as the
physician” (Rice 1984)
i.e. a positive definition, as distinct from
normative definitions which may invoke:
Over-treatment (more than is ‘needed’)
Unethical SID: demand greater than it ‘should
be’.
Rice’s definition does not require SID to be ‘a
response to financial incentives’.
Static (comparative) SID: SID exists if actual
demand is greater than it would be under
some condition where inducement did not
exist.
= tautological; difficult to test
Compensatory SID: doctors respond to a
change in supply (or other market conditions)
by ‘shifting’ their patients’ demand schedules.
= forms the basis for much empirical testing of
SID.
Testing the SID hypothesis
i.The relationship between quantity demanded
and doctor:population ratios.
ii.The relationship between
doctor:population ratios.
prices
and
(see accompanying slides, not reproduced here)
Problem: results may appear ‘suggestive’ of
SID but are consistent with the outcomes of a
competitive (non-inducement) model.
iii. The response of doctors to a change in
payment rates.
Target income hypothesis.
Problem: Under ‘backward bending supply’
conditions, a reduction in payment rates would
lead to an increase in quantity supplied – so
results cannot distinguish between inducement
and non-inducement.
(see accompanying slide, not reproduced here)
iv. Doctors (& their families) as perfectly
informed consumers.
Problem: differences in prices charged and
other relevant characteristics.
8. Imperfect competition: barriers to entry,
profit and pricing.
Monopoly (price setting) power
Barriers to entry in the hospital (and other
health services) sector
9. Where does equity fit in as a rationale for
Government involvement in health?