Ec386. how does the presence of externalities explain government intervention in health care production and financing . carlos alonso. essay

How does the presence of

externalities explain

government intervention in

health care production and

financing?

COURSE: EC386 Public Economics

STUDENT´S NAME: Carlos Alonso I.D Nº: 13100723

EXAMINER´S NAME: Sinéad Keogh

DATE: 18th

March 2014

Para Texto Completo contactar con Carlos Alonso Rodríguez

How does the presence of externalities explain government intervention in health care

production and financing? NUI, Galway 2

EC386 Public Economics NUI, Galway 2

Abstract The following pages of this essay have the objective of understanding how the presence

of externalities can explain government intervention in health care production and

financing.

According with the First Fundamental Theorem of Welfare Economics “…an unfettered

competitive market system in which both consumers and producers are intent on

maximizing their individual net benefits will lead to the maximization of society´s net

benefit”.

It is this claim that provides the major theoretical basis for the preference for the market

over other methods of economic organisation. However, this prediction rests on certain

standard assumptions about the way the market operates. If this is not the case, market

failure will arise. This means that the market systems will not produce the equitable

level of output, for instance, if externalities appear, these produce market failure, in

such case, government intervention, through public policy, may be employed to

reallocate or redistribute resources in an effort to achieve the equitable level of output.

That government intervention happens for example, in the health care.




Table of Contents

1 Introduction

2 Positives Externalities in

Health Care

2.1 Explanation and Analysis Positives

Externalities in Health Care

2.2 Government Intervention

3 Negatives Externalities in

Health Care

3.1 Explanation and Analysis Negatives

Externalities in Health Care

3.2 Government Intervention

4 Bibliography




1 Introduction The healthcare sector may be characterised by the presence of externalities which

is one of the most readily identifiable indicators of market failure in this sector.

Due to these externalities the public sector remains the main agent responsible for

the finance and delivery of health services in the most development countries.

The externalities are defined as the uncompensated impact of one person’s action

on the well-being of a bystander, in other words, an externality occurs whenever

the actions of one party make another party worse or better off and the first party

neither bears the costs nor receives the benefits from doing so. The externalities

can be positive (or external benefits) or negative (or external costs) and can be in

the production and/or in the consumption. This definition of an externality

implicitly distinguishes between two broad categories: A production externality

occurs when the effect of the externality is on a profit relationship and a

consumption externality whenever a utility level is affected. Clearly, an

externality can be both a consumption and a production externality

simultaneously.

A good that produces a positive externality is similar to a public good, in that

some of its benefits are non-excludable and accrue to others than just the direct

consumer. However, such goods may be rivalrous and may be partially

excludable, so that some private provision occurs even if the level of production is

inadequate.

The externalities appear when private costs or benefits are out of line with social

costs or benefits. For a positive/negative externality, private benefits/costs are less

than social benefits/costs, meaning that output is below/above the socially optimal

level. The standard solution to an externality is to levy a Pigouvian tax in the case

of goods or services that produce negative externalities.

Free childhood vaccinations against infectious diseases and excise taxes on

cigarettes are the most obvious examples of government intervention in the health

sector due to the presence of externalities. A vaccinated population confers a

positive externality on society because people vaccinated against an infectious

disease for example, are not able to spread the infectious disease through the rest

of the country so that they prevent that other persons can be infected whereby in

general the healthcare of the country would better off (benefit to all in society,

including those who do not consume it) while second-hand cigarette smoke

confers a negative externality on society because smoking cigarettes harm not

only the health of the people who consume the cigarettes but the general

environment since the smoke spreads into the atmosphere and specially the people

who is close to the origin of the externality (cost to all in society, including those




who do not consume it ) ; in the absence of government intervention, vaccination

levels would be less than the socially optimal level due to higher social benefits

than private benefits, while cigarettes smoking levels would be greater than the

socially optimal level due to higher social cost than private costs. So that,

activities generating positive externalities are under-produced (too little

consumption or production) and those generating negative externalities are over-

produced (too much consumption or production). Of course, the efficacy of taxes

in changing behaviour to reflect the socially optimal level depends on the price

elasticity of demand for the good/service, the availability of substitutes, its budget

share, etc.

In the following pages we are going to use the following notation: we have

Marginal Social Benefit (MSB) is equal to the Marginal Private Benefit (MPB)

plus the Marginal External Benefit (MEB) where MEB>0 (positive externality in

consumption) and thereby MPB will not equal to MSB. Without Market Failure

the optimum would be: MPB=MSB thereby MEB=0. For negative externalities in

consumption MSB=MPB-MEB.

The decisions that consumers and producers make in the private market are based

on private marginal benefits and do not take into account the true MSB thereby

Pareto efficiency is unlikely to be achieved in the market.

On the other hand we have Marginal Social Cost (MSC) is equal to the Marginal

Private Cost (MPC) plus the Marginal External Cost (MEC) (negative externality

in production), where MEC>0 and thereby MPC will not equal to MSC. Without

Market Failure the optimum would be: MPC=MSC thereby MEC=0. For positive

externality in production MSC=MPC-MEC.

The decisions that consumers and producers make in the private market are based

on marginal private costs and do not take into account the true MSC thereby

Pareto efficiency is unlikely to be achieved in the market.




Social benefit: benefit to all in society, including those who do not be affected in

his production. Equals private benefit of production plus benefit to others.

Causes market failure (too little production).

The positive externality in production leads to a social marginal cost that is below

the private marginal cost and a social optimum quantity (Q2) that it is greater than

the competitive market equilibrium quantity (Q1).

There is under-production with an associated deadweight loss of area ABC

because the private market produces less than the socially accepted or social

optimum. Under-production in Q2-Q1. I.e. MSC<MSB. So that, in the private

market, when the production is Q1 units and the price is P1, the private market

doesn’t reach a Pareto efficient level of output, in this case we are in a Pareto

inefficient level of output. The private market does not take into account the true

MSC. The private market is producing less than optimum social.

One example of one externality positive in production which affects another

producer analytically is the next:

PMC=MPC

SMC=MSC

MB=MEB

PMB=MPB

SMB=MSB

x

f

fRMT

y

x

x

y

y

yx∂

∂−

∂

∂

∂

∂

=Φ

Φ

Φ

=+

=

=

0yx

yy

xx

fff

)x,f(y

)f(x

Φ

Φ




Where x= quantity produced by the company X and y= quantity produced by the

company Y. Note that the quantity produced by the company Y depends on the

quantity produced by the company X. You can see that in the production function

of the company Y.

But the private market operates as if

Therefore for the Private market:

As the externality in production is positive:

So, to reach additional units of the good or service produced by the company X:

“x”, the individuals are willing to give up more units of the quantity produced by

the company Y: “y” than are imposed on conditions production.

Efficiency is achieved by producing more of the good or service that generates the

positive externality, so in our case producing more units of x.

Private markets make the production of the good or service that causes the

externality positive is too little.

One example of a positive externality in production which affects at one consumer

is the next:

Where U is the utility of the consumer which depends on the quantity produced by

the company X: “x”.

The private market operates as if:

0x

y=

∂

∂Φ

I1,2,...,i RMS

f

fRMT i

yx

x

x

y

y

.comp

yx ==

∂

∂

∂

∂

=Φ

Φ

>

∂

∂0

x

yΦ

x

f

fRMT

y

x

x

y

y

realyx

∂

∂−

∂

∂

∂

∂

=Φ

Φ

Φ

.compyxRMT< I1,2,...,i RMS i

yx ==

>=

=

0' )x(z

)z,y,x(UU

ϕϕyy

xreal

yxUMg

'z

U

UMg

UMgRMS

ϕ∂

∂

+=

0z

U=

∂

∂

yx

.RMT ==

y

xcomp

yxUMg

UMgRMS




As the externality in production is positive:


“x”, the individuals are willing to give up more units of the quantity produced by


Efficiency is achieved by producing more of the good or service that generates the

positive externality, so in our case producing more units of x.


externality positive is too little.

2.) Analysis Positive Externality in Consumption.

Positive externality: where social benefit of consumption of good or service

exceeds private benefit.

Private benefit: Benefit to consumers who buy and consume the good or service.

Social benefit: benefit to all in society, including those who do not consume it.

Equals private benefit of consumption plus benefit to others.

Causes market failure (too little consumption).

P

Q

D = MPB

S = MPC = MSC

>

∂

∂0

z

U

yy

xreal

yxUMg

'z

U

UMg

UMgRMS

ϕ∂

∂

+= .compyxRMS> yxRMT=




Social cost: cost to all in society, including those who do not be affected in his

production. Equals private cost of production plus cost to others.

Causes market failure (too much production).

A negative production externality leads to a marginal social cost that is above the

marginal private cost.

0

1

2

3

4

5

0 10 20 30 Q

P

€

Demand curve shows

private value or MSB or

MPB, the value to buyers

(the prices they are willing

to pay).

Market Supply curve

shows MPC, the costs

directly incurred by

producers.

The Private market

eq’m maximizes

consumer

+ producer surplus.

€2.50

25 P= Price good or serviceQ= Quantity produced

good or service

0

1

2

3

4

5

0 10 20 30 Q

P

€

Supply (private cost)

MPC

= value of the

negative impact

on bystanders

= €1 per quantity unit

(value of harm

from negative

impact)

MSC

= MPC + MECexternal

cost




There is over-production, because the private market produces more (25) than the

socially accepted or social optimum (20). Over-production in 25-20=5. I.e.

MSC>MSB. So that, in the private market, when the production is 25 units and

the price is €2.5, the private market doesn’t reach a Pareto efficient level of

output, in this case we are in a Pareto inefficient level of output. The private

market does not take into account the true MSC. The private market is producing

more than optimum social.

One example of one negative externality in production which affects another

producer analytically is the next:

0

1

2

3

4

5

0 10 20 30 Q

P

€

DM

SM

MSC

Private Market

eq’m

(Q = 25)

is greater than

social optimum

(Q = 20).

25

This yellow

triangle is the deadweight or

welfare loss.

=+

=

=

0yx

yy

xx

fff

)x,f(y

)f(x

Φ

Φ

x

f

fRMT

y

x

x

y

y

yx∂

∂−

∂

∂

∂

∂

=Φ

Φ

Φ




Where x= quantity produced by the company X and y= quantity produced by the

company Y. Note that the quantity produced by the company Y depends on the

quantity produced by the company X. You can see that in the production function

of the company Y.

But the private market operates as if

Therefore for the Private market:

As the externality in production is negative:


“x”, the individuals are willing to give up less units of the quantity produced by


Efficiency is achieved by producing less of the good or service that generates the

negative externality, so in our case producing less units of x.


negative externality is too much.

One example of a negative externality in production which affects at one

consumer is the next:

Where U is the utility of the consumer which depends on the quantity produced by

the company X: “x”.

The private market operates as if:

As the externality in production is negative:

0x

y=

∂

∂Φ

I1,2,...,i RMS

f

fRMT i

yx

x

x

y

y

.comp

yx ==

∂

∂

∂

∂

=Φ

Φ

<

∂

∂0

x

yΦ

x

f

fRMT

y

x

x

y

y

realyx

∂

∂−

∂

∂

∂

∂

=Φ

Φ

Φ

.compyxRMT> I1,2,...,i RMS i

yx ==

>=

=

0' )x(z

)z,y,x(UU

ϕϕyy

xreal

yxUMg

'z

U

UMg

UMgRMS

ϕ∂

∂

+=

0z

U=

∂

∂

yx

.RMT ==

y

xcomp

yxUMg

UMgRMS

<

∂

∂0

z

U




A tax of t* per unit (equal to the marginal damage in the health care) increases the

firm´s marginal private cost curve from OM to O*M, which coincides with the

MSC curve in the efficient level. The quantity produced falls from QM to Q*, the

socially optimal level of production. Just as the Coasian payment, this tax

internalizes the negative externality and removes the inefficiency of the negative

externality.

Some problems could happen when we are trying to value the function of the

external cost (could vary according with the context). We can as well find

troubles at the moment knowing the consumption or production each agent (used

to calculate his tax payment). There are incentives to hide the information (to

avoid payment tax). Levy tax could affect to the efficiency. The distributive

effects, who holds finally the tax, influence on achieved equilibrium.

2.) Subsidy.

Subsidy means that the government pays to an individual or firm that lowers the

cost of consumption or production, respectively. The public sector pays per each

unit in which consumption or production of the good or service causing the

negative externality is reduced once exceeds its efficient level a subsidy whose

amount corresponds to the value of the marginal external cost in efficiency.

This means that resources are redistribute from society to those causing the

negative externality.

A subsidy of s* per unit (equal to the marginal damage in the health care)

increases the firm´s marginal private cost curve from OM to O*M, which coincides

with the MSC curve in the efficient level. The quantity produced falls from QM to

Q*, the socially optimal level of production.

Para Texto Completo contactar con Carlos Alonso Rodríguez

Economy & Finance

Ec386. how does the presence of externalities explain government intervention in health care production and financing . carlos alonso. essay