Download Pareto Efficiency

Chapter 10: Market Failures and
the Role of Government
Learning Objectives
• In this chapter, you will learn about:
– the role of monopolies and the consequences
in the market for healthcare services
– the role of other market structures in the
market for health care
– the role of government in correcting
competitive market imperfections
Pareto Efficiency
• According to Pareto, an economically efficient
outcome in society is one under which it is
impossible to improve the situation of any person
without hurting someone else
– Pareto efficiency also implies that no further
exchanges can be found that improve the
situation of everyone to some degree
• The First Fundamental Theorem of Welfare
Economics relies crucially on markets being
perfectly competitive—any breakdown in the
underlying assumptions, such as freedom of market
entry and exit, will lead to distortions in prices,
quantities, and social efficiency
– The First Fundamental Theorem states that
competitive markets under certain conditions are
economically efficient
Externalities
• Externalities, or spillover effects, are costs and
benefits incurred in the consumption or production
of goods and services that are not borne by the
individual consumer or producer
– The spillover effects can be positive or negative
• Healthcare markets will not lead to Pareto
efficiency if there are externalities.
• There are four types of externalities:
– External Costs of Production (MEC>0; SMC>PMC)
– External Benefits of Production (MEC>0;
SMC>PMC)
– External Costs of Consumption (MEB<0; SMB<
PMB)
– External Benefits of Consumption (MEB>0;
SMB>PMB)
Public Goods
• Public goods are goods which may be jointly
consumed by everyone
• Specifically, public goods have two
characteristics
– Nonrivalry. This means that the consumption
of a good or service by one individual will not
prevent the consumption of the same good or
service by others
– Nonexcludability. This means that it is not
possible to provide a good or service to one
individual without letting others also consume
it
– When goods have these features they will not
be provided in the private market
Public Goods
• Public goods are provided by the government,
which then compels individuals to finance their
provision via some form of taxation
• Pareto efficiency requires that the level of
provision of a public good occurs where
SMB=SMC
• Most healthcare products and services are not
public goods because they are both rival and
excludable
• There are some healthcare programs that do
have public good properties
– An example is public health interventions
aimed at preventing the spread of bird flu
Information Imperfections
Imperfect information arises in health care due to uncertainty
and to imperfect knowledge
With uncertainty, a market is unable to function properly
because consumers and producers do not know how much
of a good to demand and supply
They are therefore unable to equate the private marginal
benefits with the private marginal cost
• Unless consumers and producers are well informed, they
may take actions that are not in their best interests
– they will be unable to equate private marginal benefits
with private marginal costs, and therefore private
efficiency (and thus, Pareto efficiency) is unlikely to be
achieved
• The assumption of perfect knowledge on the part of
consumers means that they are aware of their health status
and of all the options open to them to maintain or improve
their health
– Although this may be the case for some illnesses, it is
clearly not the case for the majority
Monopoly Model
• If a firm has some market power, the competitive
model is not appropriate and a noncompetitive
model should be used
– A noncompetitive firm with some degree of
market power faces a downward-sloping
demand curve
• therefore has some ability to influence the
market price
• A pure monopoly is a market where only one
producer of a good or service is in the market
Monopoly Compared to Perfect
Competition
• A monopoly is the sole provider of a good or service in a
well-defined market with no close substitutes
– Because it is the only seller in the market, it faces the
market demand curve, which is always downward sloping
due to substitution and income effects associated with a
price change
• The monopolist charges a higher price and a lower quantity
of the drug than under the perfectly competitive conditions
– The consumer surplus is reduced under the monopoly
structure, but the producer surplus is increased
– This implies that the monopoly underproduces the drug
and therefore misallocates society’s scarce resources
– The cost of the monopoly shows up in the deadweight
loss
Barriers to Entry
• For a firm to maintain its market power for an extended
period of time, some types of barriers to entry must exist
to prevent other firms from entering the industry
• Barriers to entry make it costly for new firms to enter the
market and do not exist under perfect competition
conditions
• Technical or legal issues account for these barriers
– Exclusive control over an input or economies of scale
can lead to barriers
• other firms will not have the resources to make the
substitute product
– Legal restrictions that prevent other firms from
entering the market and providing goods or services
similar to the existing firms are also barriers to entry
– Patents on pharmaceutical products, occupational
licensing, and other laws are examples of legal entry
barriers in healthcare markets
Monopolistic Competition
• In the monopolistically competitive structure, there
are many firms with minimal barriers to entry
• The main distinguishing characteristic of this market
model is that firms sell differentiated products
– This implies that the firm earns zero economic
profits in the long run because price equals MC,
which is the same result as in the perfectly
competitive case
– The monopolistically competitive firm does not
produce at a level where P=MC, as in the
perfectly competitive model
• This may imply that the monopolistically
competitive firm is producing output
inefficiently, but this would best be determined
by examining the costs and benefits of product
differentiation
Competitive Aspects of Product
Differentiation
• In the perfectly competitive framework,
consumers are treated as being perfectly
informed about the prices and quantity of all
goods and services in the market
– The assumption concerning perfect
information implies that all firms selling
identical products sell at the same lowest
possible price
– Otherwise, firms with higher prices lose
business to firms charging less when
consumers are perfectly informed
– In some situations, people choose to be less
than perfectly informed, or rationally ignorant
Competitive Aspects of Product
Differentiation
• Given imperfect information about many goods and
services in the real world, some economists state
that product differentiation, such as advertising and
branding, can lead to improved information for the
consumers
– Other economists argue that branding can serve
a similar purpose to advertising for promoting
competition
• Some economists think that advertising and
branding can lead to anticompetitive behavior
through habit purchases rather than informed
purchases, created through brand loyalty
– According to the anticompetitive viewpoint,
product differentiation manipulates the demand
for a product
Oligopoly
• An oligopoly is a market model with a few large
firms and relatively high barriers to entry
• There may be large number of firms in the industry,
but the other firms may be small price takers, with
limited market share
• The dominant firms must be sufficiently sized and
limited in number so that the pricing or output
decisions of one firm affect the same types of
decisions for the other dominant firms in the market
– This mutual interdependence among the firms
distinguishes the oligopoly structure from other
market models
Oligopoly
– According the collusive oligopoly model, all
firms cooperate rather than compete on price
and output and jointly maximize profits by
collectively acting like a monopoly
• Collusion among the firms may be overt or tacit
– Overt collusion refers to a situation where
representatives of firms formally meet, and
coordinate prices and market shares
– Tacit collusion occurs when firms informally
coordination their prices
Competitive Oligopoly
• Competitive oligopolies are where firms act
competitively, do not cooperate, and seek to
maximize their own profits
• If the market consists of goods or services that
are relatively homogeneous, firms will set the
price equal to MC because there are many close
substitutes for the product
– Market price equals MC, and resources are
efficiently allocated—even though there are a
few dominant firms in the market
The Role of Government
• The public interest and special interest group theories
describe the motivation behind government intervention
in the healthcare market
• The public interest theory states that the government
intervenes in the best interest of society to promote
efficiency and equity in the market
• The public interest is served when the government
attempts to restore efficiency or to distribute income
equitably by encouraging competition, providing
information, reducing harmful externalities or
redistributing income in society
– Therefore, the public interest theory of government
behavior predicts that the laws, regulations, and other
government interventions enhance efficiency and
equity
The Role of Government
• The special interest group theory states that the
political venue can be treated like any private
market for goods and services so that amounts and
types of legislation are determined by supply and
demand for such legislation The successful
politician stays in office by combining legislative
programs of various special interest groups into an
overall fiscal package to be advanced in the
political arena
• The special interest group model of government
behavior implies that the typical consumer is taken
by wealth transferring legislation
– Therefore, to protect the public, government
intervention includes regulations and laws
because some special interest group benefits at
the expense of the general public
Forms of Government
Intervention
• The government can promote efficiency
and equity by providing public goods,
levying taxes, correcting for externalities,
imposing regulations, enforcing antitrust
laws, operating public enterprises, and
sponsoring redistribution programs
Antitrust Issues
• Economists, and also courts dealing with
antitrust cases, often use the concept of crossprice elasticity of demand to measure whether a
firm has monopoly power in supplying a good or
service in the given market
• The cross-price elasticity of demand measures
the degree to which the quantity demanded of a
good X is related to the price of another good Y
• (% change in quantity of X demanded)
• (% change in price of Y)
Antitrust Issues
• The contemporary market for physician services
provides some examples of behavior that we
associate with collusive oligopoly or cartels, which
are organizations that set output quotas and
sometimes directly set prices
• A series of Supreme Court decisions beginning in
the 1970s, have interpreted antitrust law as
applying to hospitals
– Difficulty in defining relevant geographic markets
in which hospitals operate has led to very limited
success on the part of the government in
blocking large hospital mergers to date
• government policy remains suspicious of
increasing concentration in the hospital sector
Social Insurance Programs
• The principles of social insurance are quite
different from those that pertain to the private
market
• Social insurance programs are generally funded
by mandatory contributions through some form
of taxation
• They usually have goals in addition to pooling of
risk, which include transfers of benefits between
groups, from the more affluent to the poor, from
younger adults to senior citizens, from adults to
children, or from the able-bodied to the disabled
• The goal is to equate marginal social benefits
with marginal social costs in the provision of
optimal insurance packages
Social Insurance Programs
• Social insurance in the United States is limited to
certain categories of citizens and residents, such
as senior citizens, a segment of the poor, and
people with qualified disabilities, all of whom are
covered by Medicare and Medicaid
• A few other special groups are covered by public
insurance programs, including Native Americans
on reservations, veterans of armed forces,
members of Congress, and low-income families
with children.
• Some states have also expanded social
insurance programs to families who would not
otherwise be covered by the federal programs.
Provision of Information
• When market failure in health care arises due to
imperfect information, the government may help
to correct the problem via the provision of
information
• An example is the provision of information to the
general public on the benefits of certain types of
health care, such as the safety of the mumps,
measles, and rubella (MMR) vaccine
Summary
• The model of a pure monopoly is the exact opposite of the
perfectly competitive market
– This market model is characterized by one seller with
one product and perfect barriers to entry
• Monopolistic competition is noted as an intermediate market
model
– Its main distinguishing feature being its differentiated
product
• Oligopoly is also considered an intermediate market model
– A few dominant firms and mutual interdependence
between the firms distinguishes an oligopoly from the
other market models
– Government intervention is based on the special interest
or public interest theories
• The public interest theory focuses on efficiency in the
market
• The special interest theory levels the playing field in
the legislative marketplace