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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.
Market Equilibrium (cont.)
Dollars
per bottle
Supply
P0
Demand
Q0
Market output of
generic aspirin (Q)
Market Equilibrium (cont.)

Equilibrium occurs when no tendency
for further change exists.
At the equilibrium price of P0,
consumers are willing to purchase Q0
bottles of aspirin.
 Aspirin manufacturers are willing to sell
Q0 bottles of aspirin at P0.

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 P1 on the
following graph, sellers will want to sell
QB bottles of aspirin, but consumers will
only want to purchase QA bottles.
 The
distance between QA and QB
represents the amount of excess supply of
aspirin.
Market Equilibrium (cont.)
Dollars
per bottle
Supply
P1
Demand
QA
Excess Supply
QB
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 P2 on the
following graph, consumers will want to
buy QF bottles of aspirin, but sellers will
only want to sell QE bottles.
 The
distance between QE and QF
represents the amount of excess demand
of aspirin.
Market Equilibrium (cont.)
Dollars
per bottle
Supply
P2
Demand
QE
QF
Excess 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
P0
E
F
D1
D0
Q0
Excess demand
Market output of
generic aspirin (Q)
Comparative Statics (Example 1)

The consumers who are willing, but not
able to buy aspirin at P0 will bid the
price of aspirin upwards.
 i.e.
They will offer sellers more than P0 to
buy a bottle of aspirin.

Because sellers are being offered a
higher price than P0, they will increase
their output of aspirin above Q0.
Comparative Statics (Example 1)

As the price of aspirin begins to rise
above P0, 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
P1
P0
E
F
D1
D0
Q0 Q1
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
S0
P0
A
S1
B
D0
Q0
Excess supply
Market output of
generic aspirin (Q)
Comparative Statics (Example 2)

The firms that are willing, but not able to
sell aspirin at P0 will lower the price they
charge for aspirin.
 i.e.
They will offer charge consumers a
price of aspirin which is below P0.

Because consumers are being offered a
higher lower than P0, they will increase
their quantity of aspirin demanded
above Q0.
Comparative Statics (Example 2)

As the price of aspirin begins to fall
below P0, firms reduce their supply of
aspirin.

This process will continue until the
market reaches a new equilibrium.
Comparative Statics (Example 2)
Dollars
per bottle
P0
S0
A
S1
B
New equilibrium
P1
D0
Q0
Q1
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.
Comparative Statics (Long run)
Dollars
per pair
S
P0
E
F
D1
D0
Q0
Excess demand
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%.
Comparative Statics (Long run)
Dollars
per pair
S
P1
P0
D1
D0
Q0 Q1
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.

= (P1 x Q1) – (Q1 x ATC(Q1))
Comparative Statics (Long run)
Dollars
per pair
MC
ATC
P1
d1 = MR1
P0
d0 = MR0
Q0 Q1
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.
Comparative Statics (Long run)
Dollars
per pair
S0
S1
P1
P0
D1
D0
Q0 Q1
Q2
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 P0, where profits for all
glove makers are again equal to 0.
Comparative Statics (Long run)
Dollars
per pair
MC
ATC
P1
d1 = MR1
P0
d0 = MR0
Q0 Q1
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.
Monopoly Model (cont.)
Dollars
per unit
If a monopolist wishes to
increase its output sold from Q0
to Q1, it will need to lower the
price it charges from P0 to P1.
P0
P1
Demand
Q0 Q1
Quantity
Monopoly Model (cont.)
Dollars
per unit
When reducing its price from P0 to
P1, the monopolist loses the
difference between P0 and P1 for all
units of output up to Q0.
P0
revenue loss
P1
Demand
Q0 Q1
Quantity
Monopoly Model (cont.)
Dollars
per unit
However, the monopolist also gains
the value of P1 for each increase in
output from Q0 to Q1.
P0
P1
$
g
a
i
n
Q0 Q1
Demand
Quantity
Monopoly Model (cont.)

The marginal revenue from increasing
sales from Q0 to Q1 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.

Monopoly Model (cont.)
Dollars
per unit
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.
Monopoly Model (cont.)
Dollars
per unit
MC
P*
MR
Q*
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*.
Monopoly Model (cont.)
Dollars
per unit
MC
P*
ATC
Profits
ATC*
MR
Q*
Demand
Quantity
Contrast to Perfect Competition
Dollars
per unit
Under perfect competition,
the market equilibrium would
MC instead be where P=MC.
ATC
PC
MR
QC
Demand
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
Oligopoly
Monopolistic
Competition
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
Demand under
perfect competition
2 potential demand curves for an
individual firm.
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.