Download Appendix Review of Demand, Supply, Equilibrium Price, and Price

This Appendix has been written and supplied by Paul J.
Feldstein. It represents a prepublication document that
Professor Feldstein will include in his forthcoming Sixth
edition of Health Care Economics. Philip J. Held, June 17,
2003.
Appendix
Review of Demand, Supply, Equilibrium Price,
and Price Elasticity
Assumptions Underlying Supply and Demand Analysis:
Economics is concerned with being able to explain and predict
observed outcomes. Innumerable factors affect observed outcomes,
however, to make sense of which factors are, on average, most
important, a theory is needed based on some simplified
assumptions. The test of any theory is the accuracy of its
predictions rather than the realism of its assumptions. A theory
does not need to be perfect to be useful; it simply needs to be
more accurate than alternative theories.
The demand for goods and services starts with the simple
assumption that consumers attempt to maximize their utility;
that is, the satisfaction or benefits they derive from their
choices. The consumer, however, has scarce resources; (s)he is
subject to a budget constraint, consisting of their income, the
1
prices they must pay for different goods and services, and their
own time. In making choices the consumer is assumed to be
rational, that is, he or she attempts to evaluate the expected
benefits and costs of their choices. And it is further assumed
that consumers have information on the marginal benefits derived
from their different choices and the marginal costs incurred for
each of those choices, namely prices and time involved. Based on
these assumptions, it is possible to predict the effect on the
consumer’s choices when changes occur in the relative prices to
be paid for different goods and services, in their time costs,
and in their incomes.
The supply side similarly assumes that the firm, the
supplier of goods and services, has an objective, namely, to
maximize their profits, subject to a budget constraint
consisting of the prices they must pay for their inputs, labor
and capital, and the price the firm receives for its output. The
firm is also assumed to be knowledgeable regarding the most
efficient method for producing its output (the most technically
efficient production process), the prices it must pay for the
various inputs used in the production process, and the price it
receives for its output. Based on these assumptions it becomes
possible to explain how firms choose the combination of inputs
used in production and the amount of output they produce.
2
The above assumptions regarding consumer and producer
behavior are not always fulfilled, particularly with respect to
medical care; consumers have little knowledge of their illnesses
and treatment needs and physicians, non-profit hospitals, and
medical schools may have objectives other than maximizing their
profits. When assumptions and objectives are different than
hypothesized, it becomes possible to predict its consequences on
consumer and producer behavior. The economic theory described
below, when used at an aggregate level – not for individual
consumers or particular physicians - is a powerful tool for
explaining and predicting consumers and firms responses to
changes in their budget constraints.
Factors Affecting Demand
Price:
A change in the price of the service, such as a physician office
visit, would result in a movement up or down the consumer’s
demand curve for physician visits, all other factors affecting
demand being held constant. As shown in Figure 1-3, a decrease
in price from P1 to P2 would cause an increase in the quantity
demanded of physician visits from Q1 to Q2. The demand curve
pertains to a particular time period, such as quantity per month
3
or per year. The negative (inverse) relationship between price
and quantity is referred to as The Law of Demand.
There are two reasons for this inverse relationship. The
downward sloping demand curve represents the declining marginal
benefit to the consumer of purchasing additional units; the
first unit offers the highest marginal benefit, the second,
somewhat less, and so on. The quantity demanded by the consumer
will depend on the price they must pay (which is the consumer’s
marginal cost). When the price equals the marginal benefit they
receive from consuming an additional unit, then the marginal
cost to the consumer equals the marginal utility/benefit
received from that last unit. If the price declines, the
consumer would be willing to buy an additional unit whose
marginal benefit is lower than the previous unit; at that point
the marginal cost of the last unit again equals the marginal
benefit of the last unit purchased. Along the demand curve the
consumer is making a trade-off between the marginal benefit of
consuming an additional unit versus the marginal cost (price) of
buying that additional unit.
The second reason for the downward sloping demand curve is
that as the price falls, consumers who previously did not buy
that item now enter the market. For the new consumers, the
previously higher price exceeded the marginal benefit they would
have gained from consuming that item (their marginal cost
4
exceeded their marginal benefit). As the price falls, the
declining marginal cost equals their marginal benefit.
Figure 1-3 About Here
The downward sloping demand curve may be thought of as the
consumer’s continual trade-off between their marginal benefit of
buying additional units and the price (marginal cost) they must
pay for each unit.
Although the consumer would be willing to pay a high price
for the first unit and a lower price for the next unit, and so
on, when there is a single market price, the consumer only pays
one price for all the units purchased. The difference between
what the consumer is willing to pay for each unit and the amount
they have to pay is called Consumer Surplus, graphically shown
in Figure 1-4. At a price of $10 per unit the consumer would be
willing to buy one unit; at a lower price of $9 the consumer
would be willing to buy a second unit, and so on. The consumer
would have been willing to spend $40 for 5 units ($10 + $9 + $8
+ $7 + $6), which is the total value to the consumer of those
five units. However, at a market price of $6, the consumer can
buy 5 units for $30. The difference, $10, is consumer surplus.
(As will be discussed in Chapter 10, The Physician Services
5
Market, a price discriminating monopolist attempts to price
their service so as to capture the entire consumer surplus.)
Figure 1-4 About Here
Price of Substitute Products:
A shift in the consumer’s demand curve for physician office
visits will occur if there is a change in the price of a
substitute to physician office visits (substitutes can partially
replace the other service). A decrease in the price of
chiropractic visits, a substitute to some extent for physician
visits, will cause the demand curve for physician visits to
shift to the left. As shown in Figure 1-5, with the price of
physician visits unchanged, a decrease in the price of a
substitute from P1 to P2, will cause the demand curve for
physician visits to shift to the left, from D1 to D2, with a
consequent decrease in demand for physician visits from Q1 to Q2.
All other factors affecting the demand for physician services
are assumed to be unchanged.
The relationship between changes in the price of a
substitute and physician visits is positive, meaning that as the
price of the substitute decreases, so does the demand for
physician visits, or an increase in the price of a substitute
leads to an increase in demand for physician services.
6
Figure 1-5 About Here
Price of Complementary Products:
Complements are goods or services that are used together. Thus,
an increase in the price of a complement will have a negative
effect on the demand for physician visits; the demand for
physician visits will shift to the left (right) if the price of
a complement is increased (decreased). For example, as shown in
Figure 1-6, a decrease in the price of diagnostic tests from P1
to P2 will not only increase the quantity demanded of diagnostic
tests (a movement along its demand curve) but should result in
an increase in the demand for physician visits to interpret
those test results, from Q1 to Q2.
When the price of a service increases and it leads to a
decrease in demand for another service, then those two services
are complements. When the price increase leads to an increase in
demand for another service, then the two services are
substitutes.
Figure 1-6 About Here
Income:
7
An increase in a family’s income relaxes their budget constraint
and enables them to purchase more goods and services. Other
factors affecting demand being held constant, an increase in
income will cause the demand curve to shift to the right,
resulting in an increase in demand for that service. See Figure
1-7. The positive relationship between income and demand is
characteristic of a “normal” good. An “inferior” good is one
where an increase in income results in a decrease in demand; a
negative relationship. Medical care is considered to be a normal
good, meaning as incomes rise, people prefer to spend a portion
of their increased income on additional medical services.
Tastes and preferences:
There are a number of other, non-economic, factors, in addition
to the economic factors described above that will cause the
demand curve to shift, either to the right or left. Thus per
capita use of medical services will differ even if different
groups have the same incomes and face the same prices. These
non-economic factors are usually included under the category of
Tastes and Preferences. For example, an aging population will
cause the demand for medical care to shift to the right; older
males will have a greater demand for medical care (shift to the
right) than older females. Differences in educational level and
attitudes toward seeking care will cause shifts in the demand
8
for different medical services. Economists include both economic
and non-economic factors affecting demand. (A more complete
discussion of these non-economic factors is included in Chapter
5 “The Demand For Medical Care”.)
Figure 1-7 About Here
Population:
Once all the economic and non-economic factors affecting demand
have been specified, the size of the population becomes
important. The more individuals there are in a community, the
greater the demand for medical care; the demand curve shifts to
the right, as shown in Figure 1-8.
Not everyone has to be responsive to changes in price for a
demand curve to have its negative slope. Even though some people
will not change their consumption as prices change (their demand
curve is vertical), others will. When all the individual demand
curves are summed up, it is the marginal buyer, the ones that
are responsive to price changes that result in an aggregate
downward sloping demand curve.
Figure 1-8 About Here
Demand Equation:
9
A useful method for distinguishing between movements along a
demand curve and shifts in demand, as well as the direction of
those shifts is the following equation. The signs in front of
each variable indicate the direction of the variable’s effect on
demand.
Qda = f( -Pricea, +Pricesub, -Pricecompl, +Income, +Tastes) x POP
This equation states that the quantity demanded of a good or
service is functionally related to (dependent upon) its Price;
changes in price are a movement along the demand curve and the
negative sign indicates that price is inversely related to
quantity demanded. All of the remaining variables represent
shifts in the demand for the service. An increase in the price
of a substitute (positive sign) will cause the demand for A to
increase, namely shift to the right. An increase in the price of
a complement (negative sign) will cause the demand for A to
decrease, shift left. An increase in income (positive sign),
assuming it is a normal good, will cause the demand for A to
shift right. Tastes represent non-economic factors that will
cause shifts in the demand for A. The total demand for A is then
equal to the sum of all the consumers’ demand in the market.
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Factors Affecting Supply
Price:
The supply of a good or service is positively related to the
price paid for that service. Higher product prices represent a
movement along a supply curve. The producer is making a tradeoff between the marginal cost of producing an additional unit
versus the marginal benefit (price) offered for that unit. As
shown in Figure 1-9, the higher the price, from P1 to P2, the
greater the willingness of the supplier to increase output; the
firm can hire more employees and buy additional supplies to
increase production. Along a given supply curve, the prices of
labor and non-labor inputs are assumed to be unchanged.
(The firm’s supply curve in the short run is it’s marginal
cost curve (MC). Marginal cost is equal to the input price,
e.g., the wage rate, divided by the input’s marginal
productivity (MP). For example, assuming the wage rate is $10
and MP is 5 units, then MC equals $2 per unit. The reason the
firm’s supply curve is upward sloping is because of the Law of
Diminishing Returns. In the short run, meaning that time period
in which there is some fixed input that cannot be expanded, such
as the size of the building, as more labor is hired then, at
some point, continually adding labor to work in that facility
will result in a decrease in labor’s productivity. As the MP of
11
an additional employee declines, and is lower than the previous
employee hired, marginal cost increases. Thus MC = W/MP = $10/5
= $2 per unit, with another employee MC = $10/4 = $2.50 per
unit.)
The firm will produce to the point where its marginal cost
equals the price received for each unit of output. When the firm
is producing at the point where its marginal costs equal its
marginal revenue (the additional revenue received for each unit
sold – which in this example is the price of the product), then
the firm is maximizing its profits. The only way the firm can
increase its output as its marginal costs increase is to be paid
a higher price for its output. It is important to note that
included in marginal cost are all the relevant costs to the
firm, including opportunity costs, which are the sum of explicit
(dollar) and implicit (value of the resource in its best
alternative use, e.g., the highest wage the owner could have
earned elsewhere) costs. Thus economic costs are different from
accounting costs, which only include explicit costs.
Figure 1-9 About Here
Input Prices:
The firm’s supply curve will shift because of a change in the
price of either labor or non-labor inputs. An increase in the
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wage rate will shift the supply curve upward (left), from S1 to
S2. With the price of the product remaining unchanged at P1, an
increase in the wage rate will decrease supply from Q1 to Q2, as
shown in Figure 1-10. An example illustrates the shift left in
supply as the wage increases. Assume that P2 in Figure 1-10 is $2
per unit and assume that MC = W/MP = $10/5 = $2 per unit. With
both price and MC equal to $2 per unit, the firm will produce Q2
units. If the wage rate increases from $10 to $20, then MC =
$20/5 = $4 per unit. The supply curve has shifted up; to produce
the same rate of output, Q2, the price of the product would have
to increase to $4 per unit. At a price of $4 per unit, the firm
would have been able to produce a greater output with the
previous supply curve, Q1.
Figure 1-10 About Here
Technology:
Figure 1-10 can also be used to illustrate another reason for a
shift in supply. Technological improvements that increase
labor’s productivity increase each employee’s marginal product,
thereby shifting the supply curve to the right or down, from S2
to S1. Again, assuming MC = W/MP = $10/5 $2 per unit, introducing
a new technology that increases productivity would result in a
decrease in marginal cost per unit; MC = $10/10 = $1 per unit.
13
Thus the same output, Q2, can be produced for less (on the new
supply curve S1), or a greater rate of output, Q1 (on supply
curve S1), could be produced for the same price.
The following equation describes the factors affecting
supply and the direction of each factor’s effect. The price at
which the output is sold is positively related to the quantity
supplied; changes in price represent a movement along a given
supply curve. Changes in the price of labor and non-labor inputs
cause the supply curve to shift; input price changes are
inversely related to supply, an increase in input prices cause a
decrease in supply, the supply curve shifts left. Technology
that increases input productivity is positively related to
supply, the supply curve shifts right.
In addition to the price at which the product may be sold,
the price of inputs and technology, there may be other supply
factors that are relevant to a particular industry, such as
weather affecting the supply of agricultural products. However,
the determinants of supply described above, price, input prices,
and technology, affect all industry supply curves.
Number of Suppliers:
In addition to these factors, the total supply of a product or
service depends on the number of suppliers. Thus (similar to an
increase in population on the demand side) an increase in the
14
number of suppliers will cause the supply curve to shift to the
right; each supplier’s supply curve (their marginal cost curve)
is summed horizontally to equal the industry supply curve for
that product.
Supply Equation:
The following equation summarizes those factors affecting the
supply of a product common to all industry supply curves. The
quantity supplied is positively related to the price paid for
the product; the supply curve will shift left (decrease) with an
increase in the price of inputs; and supply will shift to the
right (increase) with technological improvements that increase
input productivity. An increase in the number of suppliers will
also shift the supply curve to the right.
Qsa = f( +Pricea, -Priceinputs,
+Technology) x POP
Market Equilibrium
The interaction of supply and demand curves result in market
equilibrium; a situation where, at the prevailing price, the
quantity demanded equals the quantity supplied. The equilibrium
price will not change unless there are changes in demand or
15
supply. Equilibrium is assumed to occur instantaneously, even
though in reality neither demanders nor suppliers have perfect
information when prices change.
Market forces cause price to move toward equilibrium.
Assume that the initial supply and demand curves are D1 and S1 in
Figure 1-11A. The initial equilibrium price is P1 and output is
Q1. Further assume that consumer incomes increase and that the
service is a normal good. With an increase in incomes, demand
shifts to D2. If equilibrium occurred immediately, price would
rise to P2 and output would increase to Q2. (Note, the shift in
demand results in a movement along the supply curve.)
If
consumers do not have perfect information, then with a shift in
demand, consumers would demand Q3 output at the original price
P1. Since the consumers would not be able to buy that amount of
output at price P1, they would start to bid up the price. As the
market price increases, suppliers are willing to increase the
quantity supplied (a movement along their supply curve) and
consumers realizing they have to pay a higher price move up
their new demand curve, D2. When the price reaches P2, the market
is again in equilibrium.
Figure 1-11 About Here
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Market Disequilibrium: Regulation
When the government regulates the price of the product and does
not permit the price to rise as demand increases, a shortage
will develop. At price P1 and demand curve D2 in Figure 1-11A,
demand exceeds supply and there is a shortage equal to Q3 – Q1.
Shortages are resolved in one of several ways. Suppliers might
ration the available supply, OQ1, according to who is willing to
wait to receive the service; criteria, other than waiting times,
might be used, such as favoritism, race, religion, etc. In
health care markets examples of non-price rationing are
admissions to medical schools and access to medical services
when Medicare pays physicians fees that are lower than the
market price. The Canadian health care system also uses waiting
times as a rationing mechanism. Alternatively, a black market
might develop in which consumers are willing to pay suppliers an
amount that is greater than the regulated price. Physicians in
regulated Eastern European health care systems have used this
approach. (The marginal value to consumers of output Q1 is P3,
which is the height of the demand curve at that point. Consumers
would be willing to pay P3 but are unable to do so, consequently
there will be a shift to the right in the demand for
substitutes.)
Figure 1-11B illustrates market equilibrium when there is a
shift in supply. Supply will shift up or to the left with an
17
increase in the wage rate. (The shift in supply is a movement
along the demand curve.) The higher price will result in a
decrease in the quantity demanded of the product, from Q1 to Q2.
If, however, prices are regulated and not permitted to increase
as input costs rise, there will be a shortage, Q3 – Q1, similar
to the earlier example. An example of input costs rising faster
than regulated prices are rent controls on housing.
Consequently, the quality of rent-controlled housing has
deteriorated, leading to the abandonment of large numbers of
rent-controlled buildings. (One might consider what hospitals’
response would be if Medicare payments to hospitals rose less
rapidly than hospital input costs.)
Market Equilibrium in Multiple Markets
A shift in supply (or demand) in one market will not only affect
market equilibrium in that market but will also cause changes in
equilibrium prices and quantities in markets whose products are
substitutes and complements. As shown in Figure 1-12, wage
increases in the market for hospital care lead to a shift to the
left in the supply of hospital services from S1 to S2. Hospital
prices increase from P1 to P2 and there is a decrease in the
quantity demanded of hospital care from Q1 to Q2. Outpatient
surgery centers are a substitute for certain inpatient
18
surgeries. Thus the higher price for hospital care leads to a
shift to the right in the demand for outpatient surgery centers
(which is a movement along the supply curve for outpatient
surgery). Similarly, higher hospital prices will lead to a shift
to the left in the demand for complements to hospital care.
Thus a change in any of the factors affecting demand or
supply in one market will also lead to new equilibriums in
markets that provide substitute and complementary services to
the initial market experiencing a change in price.
Figure 1-12 About Here
Elasticity
When there are price movements along the demand and supply
curves as well as shifts in demand and supply, it is important
for forecasting and public policy initiatives to have an
estimate of the magnitude of those changes. Economists use the
concept of elasticity, which standardizes the units of
measurement, to indicate the quantitative impact of the factors
affecting demand and supply.
Price Elasticity of Demand:
19
The definition of the price elasticity of demand is the “percent
change in quantity demanded divided by the percent change in
price”. Price elasticity of demand is negative because of the
inverse relationship between price and quantity demanded.
The formula for price elasticity is:
DQ/Q
%DQ
=
= -Pe
DP/P
%DP
(Change is denoted by the symbol D and percent change by %D).
For example, if price is decreased by 10 percent and quantity
demanded increases by 20 percent, then the Pe equals
-2.
+ 20%
= -2.
- 10%
Similarly, if the quantity demanded changes by only 5 % with a
10 percent decrease in price, then Pe equals
-.5
When the percent change in quantity demanded is greater
(less) than the percent change in price, then the demand curve
(at that point) is “price elastic” (“price inelastic”). Unit
price elasticity is when the percent changes in price and
quantity demanded are equal.
20
The better (or closer) the substitutes to a product, the
greater the price elasticity of demand. How the product is
defined, either broadly or narrowly, will determine the
closeness of substitutes. The aggregate demand for hospital care
in an area is typically price inelastic, since there are no
close substitutes to hospital care. However, the demand for a
particular hospital in a market with several hospitals is
typically price elastic, since the other hospitals are
substitutes to that hospital. The same occurs for all anesthesia
services (price inelastic) in a market versus a single
anesthesiologist (price elastic).
Applications of Price Elasticity:
The concept of price elasticity is useful for understanding
pricing strategies, anti-competitive behavior and anti-trust,
and public policies, such as national health insurance.
A hospital that raises its price when it has a price
elastic demand curve (close substitutes) will suffer a loss in
total revenue, since the percent change in quantity demanded
will exceed the percent increase in price. For example, if a
hospital raises its price to a health insurer and nearby
hospitals are considered to be very good substitutes, the health
insurer is likely to shift more of its enrollees to those
hospitals not raising their prices. With good substitutes, the
21
hospital raising its price will have a high price elasticity of
demand and suffer a greater than proportionate decrease in the
quantity demanded of its services; it’s total revenue will
decrease. Conversely, if the hospital is the only one in the
area, and the closest substitute is 100 miles away, then the
hospital is likely to have a price inelastic demand curve;
increasing its price will result in an increase in its total
revenue.
If all the anesthesiologists in a market formed one group,
their demand curve would be price inelastic because there are no
close substitutes to all anesthesiologists; increasing their
prices would increase their total revenue. Eliminating
competition by becoming a single firm monopolizes the market for
anesthesia services. This type of behavior is anti-competitive.
If the government subsidized the price of medical services
to the uninsured, the cost of the program will be determined by
whether the demand for medical services is price elastic or
inelastic. Total expenditures (consequently the taxes required
to finance the program) will be much higher if demand were price
elastic than if it were price inelastic. (Assuming a price
elasticity of –4.0, and the price is reduced from $100 to $50,
quantity demanded would increase from 1,000 to 3,000 visits; the
total cost of the subsidy will be $50 x 3,000 = $150,000. If
instead the price elasticity were -.5, a 50 percent reduction in
22
price would lead to an increase in quantity demanded of only 250
visits; the total subsidy cost would then be $50 x 1,250 =
$62,500.
Cross Price Elasticity
The concept of elasticity is also used to indicate the closeness
of substitutes and the effect on complementary services of a
change in price. For example, if the price of physician office
visits increased, not only would there be a movement down the
demand curve for physician visits, but there would be an
increase (a shift to the right) in the demand for substitutes,
such as chiropractic services. (See Figure 1-5.) Patient
perceptions of how good a substitute chiropractic services are
to physician services would determine how large a shift occurs
in the demand for chiropractic services. The formula for cross
price elasticity is the percent change in the demand for a
substitute (chiropractic services) divided by the percent change
in price of physician services. If the price of physician office
visits increased by 10 percent the demand for chiropractic
services might increase by 2 percent, resulting in an estimate
of +.2.
% DQchiro + 2%
= +. 2
=
% DPmd
+ 10%
23
If the price of physician office visits increased by 10
percent there would also be a decrease in demand (shift to the
left) for complementary services, such as lab tests. (See Figure
1-6.) Thus if the demand for lab tests decreased by 5 percent
then the cross price elasticity would be -.5.
- 5%
%DQlab tests
=
= -.5
%DPmd
+ 10%
Price elasticity and cross price elasticity estimates are
important for determining whether adding a new service as part
of an insurer’s benefits will increase or decrease the total
cost of that insurance. For example, if a health insurer
includes a lower priced substitute, such as home health care, to
an expensive service, such as hospital care, there will be an
increase in the quantity demanded of that new service and a
shift to the left in the demand for hospital care. Depending on
the price elasticity of demand for the new service and the cross
price elasticity of demand for hospital care, together with
their respective prices, it can be determined whether the
decrease in cost of hospital care more than offsets the
increased cost of the new service. (For an illustrative
calculation of including lower priced substitutes to decrease
24
the use of more expensive facilities see Chapter 6, Appendix 3:
“The Effect on the Insurance Premium of Extending Coverage to
Include Additional Benefits”.)
Income Elasticity of Demand
Income elasticity of demand is the percent change in demand for
a given percent change in income. (See Figure 1-5.) If income
elasticity is positive (a normal good) and the income elasticity
is 1.5 then a 10 percent increase in income will increase (shift
to the right) demand by 15 percent.
%DQMd visits + 15%
= +1.5
%DIncome
+ 10%
Supply Elasticity
The responsiveness of supply to changes in price of the service
is given by the elasticity of supply. As price increases, so
does the quantity supplied; a movement along the supply curve.
If a 10 percent increase in price leads to a 20 percent increase
in the quantity supplied, then the elasticity of supply is +2.0.
%DQMd visits + 15%
= +2.0
%DPMD visits + 10%
25
Competitive Industry Analysis
Competitive markets serve as the basis for evaluating other
types of markets, for understanding the reasons for the
existence of price differences, and for predicting the
consequences of changes in demand and supply. Although the
assumptions of competitive markets, such as a homogeneous
product, many buyers and sellers, and free entry and exit, are
rarely fulfilled in the real world, the competitive model
provides a basis for predicting the effect on prices and output
if a particular assumption were violated. Further, as long as
there are no entry barriers, competitive markets are a useful
predictive tool.
In the long run, after entry and exit from the industry has
occurred and a new equilibrium is established, competitive
prices will reflect the costs of production, including explicit
as well as implicit costs. When prices equal their production
costs, then the output of the industry is considered to be
optimal, since the marginal benefits to consumers of those last
units equal the marginal costs of producing those units. In
other, less competitive, market structures price exceeds
marginal cost; the greater the price over marginal cost, the
lower the output, hence the greater the divergence from a
competitive market.
26
When markets are reasonably competitive, then competitive
models provide an explanation for observed differences in prices
between regions (and within the same region over time). In the
long run, differences in prices are the result of differences in
cost, otherwise firms would enter the industry to compete away
excess profits (prices greater than costs).
Competitive models make it possible to predict the effects
on prices and output (and prices and output of related
industries) of changes in any of the factors affecting demand or
supply of that product. Also, the consequences of regulated
prices or barriers to entry can be predicted and evaluated using
competitive market models. Further, hospital mergers can be
evaluated for anti-trust purposes based upon whether the merger
lessens competition in a market.
(For a more complete discussion and review of competitive
markets, see Chapter 7, “The Supply of Medical Care.”)
Monopoly Analysis
Monopoly analysis emphasizes pricing behavior according to the
price elasticity of firm demand curves. When differences in
prices cannot be explained by differences in costs (the
competitive model explanation), then an economist seeks to
explain those price differences by determining whether there are
27
differences in the price elasticity of demand, which is the
monopoly explanation. Firms that have less price elastic demand
curves will be able to charge higher prices than firms that have
more price elastic demand curves, regardless of their costs.
Firms that are able to segregate their purchasers according
to their price elasticity of demand will be able to further
increase their profits by charging higher prices to those with
less price elastic demands for the service. Price discrimination
has been and continues to be important to suppliers of health
care services, such as physicians, hospitals, and pharmaceutical
companies. The political position taken by health associations
regarding government payment for their member’s services is
often based on maintaining the ability to price discriminate.
(Monopoly pricing is reviewed more completely in Chapter
10, “The Physician Services Market.”)
Understanding Political Behavior By
Using Supply and Demand Analysis
Political positions of health interest groups can be understood
using an economic framework. Health care firms compete in two
markets, economic markets and political markets. Although firms,
such as hospitals, compete against each other for patients and
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for insurance contracts, these same firms are allies when it
comes to regulations and legislation affecting hospitals. The
same is true for all health interest groups and trade
associations. Politically, health associations seek legislation
to increase their member’s incomes. The types of legislation (or
regulation) demanded by each health association are: to increase
the demand for their member’s services, subsidies to lower their
costs, increase the cost of their competitor’s services, and to
erect entry barriers. (A more complete discussion of these types
of legislation together with examples from different health
associations is in Chapter 17, “The Legislative Marketplace”.)
The economic motivation behind health associations’
legislative proposals can be illustrated using supply and demand
analysis.
Every health association wants the demand for their
member’s services increased. For example, there would be an
increase in the quantity demanded of physician services if a
greater number of people had private insurance coverage for
physician services. With insurance, the out-of-pocket price of
physician services would be reduced, resulting in a movement
down the demand curve for physician services (see Figure 1-3).
The quantity demanded of physician services would increase.
(Insurance pays the difference between the out-of-pocket price
and the provider’s fees, thus in aggregate an increase in
29
insurance represents a shift to the right in the demand curve,
see the Appendix to Chapter 5 on “The Effect of Co-insurance on
the Demand for Medical Care.”) Thus all health associations
favor continuation of the tax-exempt status for employer paid
health insurance, which is a subsidy for the purchase of health
insurance, and oppose any legislative attempts to reduce or
limit the size of this tax exemption. Similarly all health
associations favor mandated employer coverage, which would
require employers to provide their employees with health
insurance, thereby increasing the number of persons with private
health insurance.
Regulations that increase the costs, consequently prices,
of substitutes are an effective demand increasing strategy;
often these cost-increasing legislative proposals are in the
guise of increasing quality of care. For example, physician
associations have opposed legislation permitting Medicare and
Medicaid to cover substitute services, such as chiropractors.
Including chiropractors under public insurance programs would
decrease the out-of-pocket price of chiropractic services for
publicly insured patients, thereby causing a movement down the
demand curve for chiropractic services and a shift to the left
in the demand for physician services (see Figure 1-5).
Similarly, for-profit health insurers favored legislation that
would increase the costs of their non-profit substitute, Blue
30
Cross. Removing Blue Cross’ federal tax exemption would cause
Blue Cross to increase its price, thereby shifting for-profit
insurers’ demand curves to the right.
An association would experience an increase in demand for
their services (their demand curve would shift to the right) if
the price of complementary services were decreased. For example,
physicians favor including diagnostic and imaging services as an
insured benefit.
Health associations favor several supply-side legislative
policies. Legislative subsidies that reduce the cost of inputs
to the services provided by an association’s members, would
shift their members’ supply curve down (or to the right). For
example, medical associations favor legislation that would limit
increases in physicians’ malpractice premiums. Similarly,
hospital associations favor subsidies to increase the supply of
registered nurses. The price of hospital care would be reduced,
resulting in an increase in the quantity demanded of hospital
care.
Perhaps the most important legislative supply side policy
favored by associations is preventing entry by new competitors.
Referring to Figure 1-11A, an increase in demand along a given
supply curve results in higher prices. Existing suppliers
benefit from these higher prices and incomes. Over time,
however, other suppliers will be attracted to this market. As
31
new suppliers enter the market, the supply curve will shift to
the right (a movement down the new demand curve) and prices will
decline. If existing suppliers are able to limit entry of new
suppliers, the supply curve will not shift to the right and
prices will remain higher than they would have been with free
entry. Maintaining higher prices and incomes are a strong
financial incentive for suppliers to seek legislation imposing
entry barriers (usually justified on the basis of maintaining
quality of care).
Examples of entry barriers in health care are numerous.
Medical associations have long favored limits on medical school
capacity to restrict the number of new physicians. Hospitals and
even home health agencies have favored Certificate of Need
legislation that makes it difficult for new competitors to enter
their market. The American Nurses Association favors immigration
limits on foreign trained RNs, otherwise an increased supply of
RNs would result in a decrease in RN wages. All professional
health associations favor increased educational requirements
before a health professional can practice; these requirements
increase the cost of entering the profession, thereby reducing
supply and, consequently, increasing prices and incomes for
existing practitioners. Process measures for increasing quality
are favored by every health profession instead of using outcome
or testing procedures, which can be accomplished in a shorter
32
training time. When standards are increased for new entrants,
currently practicing professionals are always exempt from the
new, more rigorous, standards.
33
Price
Price
$10
$9
P1
$8
$7
P2
$6
D
D
Q1
Q2
1
Q/T
Quantity
2
3
4
5
Q/T
Quantity
Figure 1-3 A Downward Sloping Demand Curve
Figure 1-4 Consumer Surplus
Price
Price
P1
P2
P1
D1
D
D2
Q2
Q1
Physician Office Visits
Q/T
Q1
Q2
Chiropractic Services
Figure 1-5 The Effect on the Demand for Physician Office Visits of a
Decrease in the Price of a Substitute
Q/T
Price
Price
P1
P2
P1
D2
D
D1
Q1
Q2
Q/T
Q1
Physician Office Visits
Q2
Chiropractic Services
Figure 1-6 The Effect on Demand for Physician Office Visits of a
Decrease in the Price of a Complement
Price
P1
D2
D1
Q1
Q2
Q/T
Figure 1-7 The Effect on Demand of an Increase in Income
Q/T
Price
P2
P1
D
dA
0
Q1
dB
dD
dC
Q2
Q3
Q4
Q5
Q6
Q8
Q7
Q/T
Figure 1-8 Summing Individual Demand Curves to Obtain Market Demand
Price
Price
S
P2
S2
S1
P1
P1
P2
Q1
Q2
Q/T
Figure 1-9 A Movement Along a Supply Curve
Q2
Q1
Q/T
Figure 1-10 A Shift in Supply
Price
Price
S
P3
S2
S1
P2
P1
P2
P1
D2
D
D1
Q2
Q1
Q3
Q3
Q/T
A: Demand Shift
Q2
Q1
Q/T
B: Supply Shift
Figure 1-11 Market Equilibrium
Price
Price
Price
P1
P1
S2
S1
P2
P1
D2
D
Q2 Q1
D1
Q/T
Hospital Care
D1
Q1
Q2
Outpatient Surgery
Q/T
D2
Q2
Q1
Diagnostic Tests
Figure 1-12 Market Equilibrium in Multiple Markets
Q/T