MarketFailure 11 Farid Abolhassani Learning Objectives After working through this chapter, you will be able to: Categorize and describe the activities of government Describe why monopoly power, externalities andinformation asymmetries constitute market failures Explain the consequences for price, output andefficiency for each market failure Explain how monopoly power, externalities andinformation asymmetries manifest themselves in thehealth care market Suggest some possible government strategies for eachhealth care market failure Key Terms Adverse Selection When a party enters into an agreement in which they can use their own private information to the disadvantage of another party. Barriers to entry Factors which prevent a firm from entering a market. Deadweight loss The loss in allocative efficiency resulting from the loss of consumer surplus is greater than the gain in producer surplus. Externality Cost or benefit arising from an individuals production or consumption decision which indirectly affects the well-being of others. Fee-for-service A means of paying health care staff on the basis of the actual items of care provided. Monopoly power Ability of a monopoly to raise price by restricting output. Key Terms Moral hazard A situation in which one of the parties to an agreement has an incentive, after the agreement is made, to act in a manner that brings additional benefits to themselves at the expense of the other party. Natural monopoly A situation where one firm can meet market demand at a lower average cost than two or more firms could meet that demand. Price discrimination Offering the same product at different prices to different people. Public good A good or service that can be consumed simultaneously by everyone and from which no one can be excluded. Social cost Private cost plus external cost. Supplier-induced demand Increased demand as a result of a provider (e.g. a doctor) exploiting an asymmetry of information. Transaction costs The costs of engaging in trade i.e. the costs arising from finding someone with whom to do business, of reaching an agreement and of ensuring the terms of the agreement are fulfilled. Main Areas of Government Activity
Redistribution of wealth and income; Stabilization of the macro-economy (to keep unemployment, inflation and economic growth at reasonable levels); Correction of microeconomic market failure. Ensuring and protecting public goods; Controlling monopoly power; Reducing externalities; Reducing asymmetry of information. Public Good Is health care a public good?
A public good is a good or service that can be consumed simultaneously by everyone and from which no individuals can be excluded Is health care a public good? Perfect Competition Demand, Price and Revenue in Perfect Competition Total Revenue, Total Cost and Economic Profit Profit-maximizing Output Three Possible Profit Outcomes in the Short-Run A Firms Supply Curve If a firm shuts down and produces no output, it incurs an economic loss equal to its total fixed cost. This loss is the largest that a firm need incur. A firm shuts down if price falls below the minimum average variable cost. Industry Supply Curve Short-run Equilibrium Entry and Exit Monopoly Market Power Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale. Firms in perfect competition have no market power Monopoly In monopoly, the firm is the industry
A monopoly is a firm that produces a good or service for which no close substitute exists and ; which is protected by a barrier that prevents other firms from selling that good or service In monopoly, the firm is the industry Barriers to Entry Legal barriers Natural barriers Monopoly franchise
Government license Patent Copyright Natural barriers An industry in which one firm can supply the entire market at a lower price than two or more firms can Natural Monopoly LRAC: Long Run Average Cost Monopoly Price-setting Strategies
Price discrimination Single price Price and Marginal Revenue Marginal Revenue and Elasticity
A profit maximizing monopoly never produces an output in the inelastic range of its demand curve A Monopolys Output and Price Decision A Monopolys Output and Price
If firms in a perfectly competitive industry make a positive profit, new firms enter. Look at the part (b) of the chart of this slide. In a perfectly competitive market, the quantity demanded at maximal profitable output, marginal revenue is below the demand line. This means that at this marginal revenue (price in perfectly competitive market) the quantity is more than the output of existing firm. In other words there is room for other firms in the market. In case of monopoly other firms are refrained from entering the market and the existing one can sell its products at the price that the demand curve necessitates. A monopoly produces the profit-maximizing quantity and sells that quantity for the highest price it can get Single-price Monopoly and Competition Compared
What will happen if a single firm buys out all small firms and creates a monopoly? Will the price rise or fall? Will the quantity produced increase or decrease? Will economic profit increase or decrease? Will either the original competitive situation or the new monopoly situation be efficient? Monopolys Smaller Output and Higher Price
Compared to a perfectly competitive industry, a single-price monopoly restricts its output and charges a higher price. Inefficiency of Monopoly The Effects of Monopoly on Consumer Interests
It produces less It increases the cost of production It increases the price above the increased cost of production Price Discrimination Price discrimination is charging different prices for a single good or service because of differences in buyers willingness to pay and not because of differences in production costs Requirements of Price Discrimination
To be able to price discriminate, a monopoly must: Identify and separate different buyer types Sell a product that can not be resold Price Discrimination Methods
Among units of a good: Charging each buyer a different price on each unit of a good bought Among groups of buyers: Charging different groups of buyers differently Price Discrimination among Groups of Buyers Perfect Price Discrimination
The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive output and the more efficient is the outcome. Gains from Monopoly Incentives to innovation
Economies of scale and economies of scope Regulating a Natural Monopoly Externalities Definition Production Externality: A cost or a benefit that arises from production of a good or service and falls on someone other than the producer Consumption Externality: A cost or benefit that arises from consumption of a good or service and falls on someone other than the consumer Classification Negative production externalities: Environmental pollution Positive production externalities: Orange blossom honey production Negative consumption externalities: Smoking Positive consumption externalities: Vaccination An External Cost How is an external cost valued? Inefficiency with an External Cost Property Rights Achieve and Efficient Outcome Government Actions in the Face of External Costs
Taxes: setting the tax rate equal to the marginal external cost Emission Charges: setting a price per unit of pollution Marketable Permits: issuing each firm a permit to emit a certain amount of pollution, and firms can buy and sell these permits A Pollution Tax An External Benefit Government Actions in the Face of External Benefits
Public provision Private subsidies Vouchers Patents and copyrights Public provision or Private Subsidy to Achieve an Efficient Outcome Vouchers Achieve an Efficient Outcome Asymmetric Information Asymmetry of Information
Asymmetry of information exists when one person in an economic transaction has more relevant information than the other person. It requires that the cost to the uninformed person of accessing this information is prohibitively high Types of Asymmetrical Information
Moral hazard exists when one of the parties to an agreement has an incentive after the agreement is made to act in a way that brings him or herself benefit at the expense of the other party Adverse selection is the tendency for people to enter into agreements in which their personal information can be used to their own advantage over less informed parties Market Failure In Health Care Market Failure in Health Care
Failure of the health insurance market Health care externalities (already discussed) Failure of the health care market Failure of the Health Insurance Market
Why is there a lack of competition in the health insurance market? Economy of Scale What policies are used to counteract moral hazard in the health insurance market? What groups of people are likely to be without health insurance? Policies to Counteract Moral Hazard
Consumer side: Co-payments Deductibles Putting an upper limit on the payout Provider side: Prospective payments (HMOs) Building protocols into their contracts Uninsured Groups Those who consider themselves to be of low risk but cannot find an insurance policy that reflects this low risk Those at high risk who cannot afford to pay an actuarially fair premium Causes of Health Care Market Failure
Barriers to entry and exit: Licensing Monopoly power even when there are many providers Asymmetrical information Heterogeneous services Unexpected Market Response
Price S S PE PE P1 QE Q1 QE Quantity Major Features of Health Care
Uncertainty and risk Derived demand The health itself is invaluable Asymmetrical information Supplier-induced demand Extreme importance of equity Catastrophic health expenditure