Sessions on Economics

Pharm 532Lou Garrison, Ph.D.

April 13, 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

Session 2

Types of Economic Analysis

NormativePositiveBehavioral

Well-being vs. Health vs. Medical Care

Review—Key Concepts to Remember

Surplus—social, consumer, producerEconomic rentsPareto optimalEfficiency—Technical, Cost, Economic; Static vs. DynamicPrivate vs. public goodsInformation asymmetryDeadweight lossRent-seekingNash equilibriumSecond-best

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

Types of Market Failures

Public goodsExternalitiesNatural monopoliesInformation asymmetries

Provides economic rationale for public interventions.

Public GoodsPrivate goods

Rivalrous consumptionExcludable ownership

Public goodsNonrivalrous, nonexcluble, or both—in some degreePotential for congestion (externality)Any good that is not purely private

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 Good

Market Demand for Nonrivalrous Good

Toll good; no congestion

Toll good with congestion

Use leads MSC≠MPC;

Function of level of use

Taxonomy of Public vs. Private Goods

Privileged Group: Private Provision of Public Good

Overconsumption of Open Access Resource

Source: Weimer and Vining

Prisoner’s Dilemma

Source: Weimer and Vining

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

Source: Weimer and Vining

Negative Externality

Positive ExternalityMarket 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—AllocativeInefficiency (DWL)

Contestable Markets

“Contestable markets”: low barriers to entry and decreasing average costs imply threat of entry.How would threat of entry affect a “natural” monopoly?Is this applicable to branded drugs?

Monopolies and X-Inefficiency

Natural monopolies may not have strong incentive to be cost-efficient, especially if regulated.Would you expect an unregulated natural monopoly to exhibit X-inefficiency?Any implications for drug companies with blockbusters?

Information Asymmetry

Not an issue of information as a public good.Differences in information about quality of a good among buyer, seller, and agent.

Uninformed Demand

Diagnosing Information Asymmetry

Useful to distinguish goods: search vs. experience vs. post-experience goods.What affects market failure?Search goods—consumer pays a search cost.Experience goods—what can the market do to overcome the issues?Post-experience goods—what are the issues?

Risk vs. uncertainty

Other Limitations as Rationale for Public Policy—Chapter 6

Examine two fundamental assumptions:

1. Participants in markets behave competitively

2. Individual preferences are fixed, exogenous, and fully rational

Thin markets: Few Sellers or Buyers

When are participants not price takers?“Imperfect competition”

Pure monopsonyOligopoly

4 firms with 40% recognition of dependenceBasis for anti-trust law

Preferences

Where do preferences come from?Are they endogenous? Stable?Effect of advertising?Addiction?Utility interdependence—”other regarding”“Process regarding”—perceived fairness of process can matter.Are all preference legitimate?

Uncertainty

Can extend model to handle multiple periods and uncertainty.Do efficient and complete insurance markets exist in the real world?

Insurers need to know probabilitiesUncertainty and lack of independence can result in “risk premium”

Incomplete insurance markets

Adverse selectionMoral hazardUnderinsurance

Subjective Perception of Risk

People make systematic errors in assessing probabilities.Heuristics used.Expected utility hypothesis questioned

Rationality of Decision Making

Prospect TheoryEndowment effect“Behavioral economics”

Intertemporal AllocationSocial marginal rate of time preference—indifferent between exchanging current for future consumption.Equilibrium with market rate of interestCapital markets—in theory, efficiency required.Irreversible consumption of natural resources

Option demandMarket rate of interest vs. social rate of time preference

Other Issues

Adjustment costs—costlessly moving from one equilibrium to another?Economy not static; sticky prices.Macroeconomic dynamics—business cycle not fully understood, but accept monetary and fiscal policy.

Summary of Market Failures

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