Session 1. Efficiency and the Idealized Competitive Model

Sessions on Economics

Pharm 532Lou Garrison, Ph.D.

April 8, 2009

Objective

Understand the basic principles of economics as applied to health care and integrate these principles into policy analysis.

Six Sessions on Welfare Economics and the Economics of Medical Care, Insurance, and Pharmaceuticals

Objective—gain a sense of the welfare economics origins and this perspective on economic issues related to pharmaceuticals

Six Sessions1. Competitive norm and market failures (Weimer &

Vining; pp. 54-100)2. Other market failures, especially informational issues.

(M&V, pp.100-131; Arrow)3. Welfare Economics and Government Failures (M&V,

pp. 132-191) and Economics of Health Care4. Economics of Medical Care5. Economics of Pharmaceuticals6. Global Pharmaceutical Pricing

Efficiency and the Idealized Competitive Model—Chapters 4 (Weimer and Vining)

Social Values

Efficiency, human dignity, distributional equity, economic opportunity, and political participationHow to choose among these?“Market-oriented approach”—gives primacy to “efficiency”.

Efficiency

Technical efficiency—max output given inputsCost efficiency—minimum cost given outputEconomic efficiency—technical+cost+producing right output

Idealized Competitive Model (1)

“Collective action enables society to produce, distribute, and consume a great. . . “Premise: individuals generally act in their own best interest.

“Voluntary agreement”—mostlyPolicy analysts concerned with “legitimate coercive powers of government”

Idealized Competitive Model (2)

Model: Perfectly competitive economyMany utility-maximizing consumersMany profit-maximizing producers

Under certain assumptions, leads to “efficient” global outcome—

“It would not be possible to change the patterns [of production and consumption] in such a way as to make some person better off without making some other person worse off.”

“Market failures”—violations of assumptions that would lead to inefficiency

Rationale for government/policy intervention.

Efficiency Benchmark—Competitive Economy (General Equilibrium Model)

Individuals maximize Utility [U(x1,..xn)] subject to an income constraintFirms maximize Profits π=px-c(y1..yn) subject a production relationship x=f(y1..yn)Everyone a price-takerResult: Pareto-efficient or Pareto-optimalHow would you choose between two Pareto-efficient distributions?

Pareto Efficiency

Source: Weimer and Vining

Social Surplus=Consumer Surplus+Producer Surplus

Pareto-efficient allocation also maximizes social surplus.Max social surplus Pareto-efficientConsumer surplus=difference between maximum WTP and actual priceProducer surplus= difference between price and

Consumer Surplus


Demand Curve and Deadweight Loss


Consumer Surplus

Developing a money metricCompensating variationEquivalent variationConstant-Utility Demand FunctionConstant income (Marshallian) Demand Function

Money Metrics for Utility


Firm Cost Curves


Producer Surplus

Average cost vs. marginal costEconomic profit vs. accounting profitRentsMonopoly rents Scarcity rents

Monopoly vs. Competitive Pricing & Rents


Producer Surplus


Social Surplus


General Equilibrium Model--Limitations

Static vs. Dynamic Given income distributionRents spur innovationFocus on individual marketsOthers?

Adam Smith’s “Invisible Hand”“...every individual necessarily labours to render the annual

revenue of the society as great as he can. He generally, indeed,neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

Adam Smith on Self-InterestMan has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me what I want, and you shall have this which you want, is the meaning of every such offer; and it is the manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love.

Rationales for Public Policy: Market Failures–Chapter 5 (Weimer and Vining)

Types of Market Failures

Public goodsExternalitiesNatural monopoliesInformation asymmetries

Public GoodsPrivate goods

Rivalrous consumptionExcludable ownership

Public goodsNonrivalrous, nonexcluble, or both—in some degreePotential for congestion (externality)

Excludability related to property rights—de jure vs. de facto; sometimes undefined.Nonrivalrous Social MB=Social MC for optimumCongestibilityOptimality follows as with rivalrous: P=MC; MB=P, MB=MC.

Property rights

“Sometimes de jure property rights do not exist because changes in technology or relative prices create new goods that fall outside of existing allocations.” (p. 73)

Market Demand for Exclusive GoodMarket Demand for Nonrivalrous Good

Taxonomy of Public vs. Private Goods

Toll good; no congestion

Toll good with congestionPrivileged Group: Private Provision of Public Good

Overconsumption of Open Access Resource


Prisoner’s Dilemma


Other concepts

Nash equilibrium-”In a two-person game, a pair of strategies is a Nash equilibrium if, given the strategy of the other player, neither player wishes to change strategies.”Scarcity rents; rent-seeking behaviorRent dissipation and distribution

Summary by Quadrant

NE underconsumption; need variable pricingSE free riding no market supplySW overconsumption

Externality“an valued impact (positive or negative) resulting from any action (whether related to production or consumption) that affects someone who did not fully consent to it through participation in voluntary exchange.”Good having impact is a byproduct of consumption or production.Can be positive or negative.“attenuated property rights”“missing market”

Externalities


Negative Externality Positive Externality

Market Responses to Externalities

Will the market product an efficient output level in the presence of externalities?Coase Theorem—when property rights are defined and costless to enforce, costless bargaining can lead to efficient outcome.Okay for a party of two: less applicable with large numbers.Works sometimes in neighborhoods.

Market Failure—Natural Monopoly

Average cost declines over relevant range of demand.

Natural Monopoly--DWL


For Next Time

Arrow—Uncertainty and the Welfare Economics of Medical Care

How the medical care industry differ from the “norm” of the competitive model.

First Optimality Theorem:

“If a competitive equilibrium exists at all, and if all commodities are infact priced in the market, then the equilibrium is necessarily optimal in the following precise sense (due to V. Pareto):There is no other allocation of resources to services which will make all participants better off.”

Second Optimality Theorem“If there are no increasing returns in production, and if certain other minor conditions are satisfied, then every optimal state is a competitive equilibrium corresponding to some initial distribution of purchasing power.”“Operationally, the significance of this proposition is that if the two optimality theorems are satisfied, and if the allocation mechanism in the real world satisfies the conditions for a competitive model, then social policy can confine itself to steps taken to alter the distribution of purchasing power.”

Pareto Efficiency

Source: Katz and Rosen, Microeconomics

Pareto Improvement

Source: Katz and Rosen, Microeconomics

Documents

Session 1. Efficiency and the Idealized Competitive Model