Health Economics and Policy

Free Entry and Free Exit

Free entry and free exit means that there are relatively no barriers to enter and leave the industry. Firms may not be as mobile as under perfect competition but restrictions relative to government rules and regulations are absent.

Grossman's Determinants of Health

Grossman considers the determinants of health to include, income, wealth, education, genetics, and public health.

Grossman's "Production on Health" Model

Grossman developed an economic framework for the study of medical care demand in which medical care counts only as one of the many factors used to produce good health.

Are Healthcare systems static or dynamic?

Health care systems are not static. Rather, they are dynamic in that policy makers and planners are always looking for better ways to produce, deliver, and pay for a growing menu of medical care services demanded by an insatiable public.

Negative Externalities in Production

If a sneaker factory uses clean air in production but returns dirty air to the atmosphere, that dirty air creates a negative externality. The polluted air can negatively affect people in the community through high incidences of disease, dirtier houses, etc. Although these damages are real costs, it must be emphasized that no one owns the air and the firm does not have to pay for its use. Thus, if the firm can avoid paying the costs it imposes on others - the external costs, it has lowered its cost of production. However this does not reflect the true costs to society.

Imperfect Competition

Imperfect competition refers to a market structure that does not operate under the rigid conditions of perfect competition.

Economies of Scale

It can be deemed that one firm can produce a commodity more efficiently than several firms. This cost advantage is due to economies of scale - average total cost (ATC) falls as output expands throughout the relevant output range. Public utilities like water or gas are less costly to produce by one firm than by several firms - natural monopolies.

There is widespread reliance on not-for-profit providers especially in the provision of hospital services.

It is argued that restraining the profit motive would solidify the basis for trust between patient and provider.

Markets and pricing

It is through markets and pricing that resources are most efficiently allocated. Without prices, the market cannot accomplish its tasks. This is what Adam Smith called the "invisible hand." Since everyone and everything has a price, the invisible hand can efficiently allocate resources. Everything else being equal, prices increase if more is desired and decrease if less is desired.

Profit Maximization in Monopoly

Like the other market structures, the monopolist maximizes profit at that output level where marginal cost equals marginal revenue (MC=MR). To determine the output level that maximizes profits requires that the monopolist supplement its information about market demand and prices with data on the costs of production for different levels of output.

Public goods in Medical Markets

- Also associated with externalities are exceptionally large medical expenditures. Despite the fact that about 47 million Americans are without insurance does not mean that they do not have access to medical care. Thus, there are cases where patients without insurance are sent bills that exceed their ability to pay. In cases like these the likelihood of patients defaulting on payments is very high. And when these patients default on their obligation, providers are forced to write off the expenses as bad debts thereby shifting the costs of care onto privately insured patients. - What this means is that our unwillingness to exclude anyone from access to medical care for financial reasons gives rise to the free rider problem. And it is precisely due to this free rider problem that many advocate a system that allows for mandatory health insurance coverage. -With mandatory health insurance coverage, everyone would be forced to participate in the cost of providing medical care, thereby moderating the free-rider problem.

Problems with Market Power

- In such environments, we cannot expect the free to allocate resources efficiency. Thus, the market system fails to produce efficient outcomes, thereby leading to market failure. - When prices are set at levels that exceed marginal costs, for the firm to maintain such prices, it must restrict output to levels that are less than optimum. Thus, prices will be too high, costs will be too high, resources will be underutilized, and society as a whole will suffer an economic loss. - However, this will not lead to the complete loss of customers. The firm faces a downward-sloping demand curve and the firm's marginal revenue is less than the price it charges.

Uninsured people in 2009, 2010. 2011

49.9 million people were without insurance in 2010. This accounted for 16.3% of the US population. In 2009, this figure was 16.1%. In 2011,46.3 million Americans were uninsured.

Two Types of Externalities

Negative and Positive

Joint Profit Maximization

Oligopolist may agree formally and explicitly on sales and pricing, thereby forming a cartel. Cartels engage in price fixing, raising total industry output and market shares, allocating territories, bid rigging, establishing common sales agencies and dividing profits. These activities reduce competition while increasing individual member's profits. But since competition laws forbid cartels, cartels can be broken up when competition laws exist and are enforced. To avoid situations like this, firms usually refrain from putting agreements to collude on paper.

Barriers to Entry

Oligopoly is characterized by barriers to entry. Such barriers include government authorization - entry is limited to only a few firms. High start-up costs and resource ownership also constitute barriers to entry. If these barriers to entry change over time, oligopoly can be transformed into monopolistic competition.

Identical or Differential Products

Oligopoly is characterized by some firms producing identical products while others produce differentiated products. Identical product oligopolists are those oligopolists that process raw materials or intermediate goods, which are used as inputs by other industries. Examples of identical product oligopolists are petroleum, steel and aluminium industries. Differentiated product oligopolists on the other hand, are those oligopolists engaged in the production of consumer goods that satisfy various consumer needs and wants. Examples include airline, household detergents, automobile, and computer industries.

Opportunity cost

Opportunity cost refers to the cost of any activity that is measured in terms of the value of the next best alternative forgone. It denotes "cost" of the forgone products after making a choice.

Perfect Competition

Perfect competition is an idealized conception of a market dominated by price competition.

Physical differences

Physical differences can be a determinant of product differentiation in that the product of one firm can be different from another. For example, Nike and Reebok.

Prestige considerations

Prestige considerations can be a determinant of product differentiation in the sense that some consumers may prefer to be associated with the currently popular brand product. For example, Jordan's sneakers.

Price Leadership

Price leadership under oligopoly is based on the implied understanding that a price leader does exist - one that usually has greater capital resources, economies of scale, distinct product advantage and enough advertising resources to sustain a higher price than its competitors. The price leader would communicate with other firms through press releases that they have increased prices. Those firms that follow the price leader are called price followers. If other firms don't follow, the price leader risks losing market share. Price leadership is important in averting price wars and in reaching consensus on pricing. It is also important in resolving issues that may violate anti-thrust laws.

The Kinked-Demand Curve and Rigid Prices

Price rigidity under oligopoly is based on the kinked-demand curve model. In this model the demand curve facing the oligopolist has two segments - one that is relatively elastic and the other that is relatively inelastic.

Location

Location can be a factor in product differentiation in that some consumers are reluctant to travel long distances to buy similar products. A consumer residing across the street from a Hess gas station, for example, would be reluctant to travel miles to buy gasoline at a Texaco gas station. This also applies to restaurants.

Marginal Analysis

Marginal analysis is a key to economic analysis. It is used to assist people in allocating their scarce resources to maximize the benefit of the output produced. Precisely, it is a process of identifying the benefits and costs of different alternatives by examining the incremental effect on total revenue and total cost caused by a very small (just one unit) change in output or input of each alternative.

Government Intervention in Medical Care

Medical costs have escalated over the last decade as have the number of uninsured, causing government intervention.

Differentiated Products

Monopolistic competition is characterized by firms producing differentiated products - similar products but not perfect substitutes. The implication of product differentiation is that the products exhibit enough differences that confers a "mini-monopoly" on the firms producing these products. So whereas monopolistic competition draws its competitive aspect from the "many sellers" characteristic, product differentiation gives it its monopolistic aspect.

Many Sellers, many Buyers

Monopolistic competition is characterized by the presence of many sellers and many buyers. With many sellers, no one firm has control over what other firms do. In the restaurant industry, one firm changing prices or improving service does not bring retaliatory moves from other competing firms. This is so because the marginal cost of learning changes made by competing firms outweigh the marginal benefits.

Control Over an Important Input

Monopoly can result when a single firm has exclusive control over an important input. This also becomes a barrier to entry.

Mutual Interdependence

Mutual interdependence hold sway among oligopolists. This allows each firm to shape its policies with an eye on the policies of the other firms. Mutual interdependence leads to reactions to any actions on the part of competitors. But since a firm would be worse off if it raised its price since no other firm would follow, and worse off if it lowered its price since no other firm would follow, oligopoly prices remain rigid or sticky.

Average Revenue (AR)

Total revenue divided by the number of units sold of the product (TR/q;[PXq]). For example, if the baker sells 10 loaves of bread at $5.00 a loaf, total revenue is $50.00 and average revenue is $5.00 ($50/10).

Demand in Monopolistic Competition

Under monopolistic competition, demand is relatively elastic since the monopolistically competitive firm can sell a wide range of output within a relatively narrow range of prices. Although each firm faces competition from a large number of very close substitutes, demand is not perfectly elastic. Since output of each firm is slightly different from that of other firms, products of monopolistically competitive firms are close substitutes but not perfect substitutes. Unlike under perfect competition, a monopolistically competitive firm is a price-maker in that it possesses a certain degree of control over prices. Restaurant A, for example, raising its price on hamburger from $2.75 to $3.75 will lose some customers but not all since some customers may not switch due to the restaurant's location, the ambience, customer service, etc. Because there is a wide range of substitutes and since some customers will not switch, the demand curve facing the monopolistically competitive firm will be relatively elastic. Unlike the perfectly competitive firm, the monopolistically competitive firm faces a downward sloping demand curve. The increase in the price of hamburger from $2.75 to $3.75 leads to a reduction in hamburgers sold from 2,000 a month to 700 a month.

Monopolistic Competition

Under monopolistic competition, many producers of somewhat differentiated products compete with each other. Restaurants are good examples in the sense that each has a unique name, menu, quality of service, location, yet compete with each other. Even though it may sound like an oxymoron, monopolistic competition has both features of perfect competition and monopoly.

Marginal Revenue in Monopolistic Competition

Under monopolistic competition, marginal revenue is less than price. Consider a firm selling 100 units of its products at a price of $10.00. To sell more, the firm must drop its price. Assume that to sell the 101st unit the price must drop to $9.95. In this case total revenue when 100 products are sold is $1000.00. But when 101 units are sold, total revenue will be 101 x 9.95 = $1004.95. The marginal revenue of the 101st unit will be $4.95 which is less than the price of $9.95.

Competitive markets

characterized by easy entry and exit of suppliers. Profits serve as the inducer for prospective providers. In this respect, the expectations of above normal profits for a given level of risk will induce new firms to enter the market. But this can drive down prices, which in turn will adjust profits to normal levels. When profits fall to below normal levels, we expect marginally profitable firms to start leaving the market. This will drive up prices and profits for those firms that remain.

Medicare

emerged in 1965 as a national social insurance program administered by the US federal government. It guarantees access to health insurance for US citizens and resident aliens, 65 and older, younger people with disabilities, and people with end stage renal disease.

Product Differentiation

emphasizes the uniqueness of a product be it perceived or real that helps to develop a specific product identity. It is argued that product differentiation actually lies in the eyes of the buyer who believes that whether the sellers' products are different are not, are not the same.

Market failure

exists when the free market fails to efficiently allocate resources. This can be a scenario in which individuals' pursuit of self-interest leads to bad results for society as a whole.

Americans without insurance coverage

find themselves relying on public assistance and private charity for their care. Many people get insurance coverage through their place of employment so there is a genuine concern that that coverage would be lost upon losing the job.

Legal Barriers

government might franchise only one firm to operate an industry, for example, the postal services in many countries. Govt can also provide licenses and award patents that encourage inventive activity.

The Veterans Health Administration (VHA)

implements the medical assistance program of the VA through the administration and operation of numerous VA outpatient clinics, hospitals, medical centers and long-term health care facilities (i.e. nursing homes). The VHA is the component of the United States Department of Veteran Affairs (VA) led by the Under Secretary of Veterans Affairs for Health.

Efficiency

is divided into two aspects - allocative efficiency and technical efficiency. Perfect competition guarantees both allocative and technical efficiency.

Health insurance in the United States

now primarily provided by the government in the public sector. 60-65% of healthcare provision and spending comes from such programs as Medicare, Medicaid, TRICARE, and the Veteran's Health Administration.

Healthcare facilities in the United States

predominantly owned and operated by the private sector. Government facilities are relatively small in number.

The three broad and important issues regarding the current state of US Health Care

quality, access and affordability

Technical Efficiency

refers to efficiency in production or cost.. Under perfect competition, for producers to maximize profits, costs must be minimized.

Allocative Efficiency

refers to the situation in which producers make the goods and services that consumers desire. This means that for every item, the marginal cost of production is less than or equal to the marginal benefit received by consumers.

TRICARE

serves the military population by providing civilian health benefits for military personnel, military retirees and their dependents, including some members of the Reserve Component. It is managed by Tricare Management Activity (TMA) under the authority of the Assistant Secretary of Defense (Health Affairs).

Health economics

studies issues related to efficiency, effectiveness, value and behavior in the production and consumption of health and healthcare. Broadly, it deals with how healthcare systems function.

Marginal Revenue (MR)

the additional revenue derived from the production of one more unit of the good. It represents the increase in total revenue that results from the sale of one more unit of the product (MR = ∆TR/∆q). For example, if the price of a loaf of bread is $5.00, the marginal revenue is $5,00. Because total revenue is equal to price multipled by quantity (TR=PXq), as we add one additional unit of output, total revenue will always increase by the amount of the product price, $5.00.

Market Structure Analysis

utilized by economists to categorize industries on the basis of a few characteristics. Precisely, it studies the structure of the market with respect to competition.

Medicaid

was created by the Social Security Amendments of 1965. As a health program, it serves people and families with low incomes and resources. Jointly funded by the state and federal governments, Medicaid is a means-tested program that is managed by the states.

Reasons for the need to reform US Health Care

- In the last decade, private health insurance coverage has gradually declined with the number of uninsured rising at an alarming rate. - Gaps in health insurance coverage combined with the astronomical rise in spending on medical care. - Concern over access to care for the uninsured and whether those who are currently insured would continue to be insured. - Whether the quality of medical care would suffer as managed care gradually becomes the norm for the provision of medical care.

Market power in Medical Markets

- It is difficult to find absolute market power in medical markets but the relative lack of competition poses a serious problem. Although most metropolitan areas are served by more than one hospital, in smaller communities we often find some inpatient services being shared as a way of avoiding substantial inefficiencies. This lack of competition presents a greater challenge for market proponents. - It is important to point out that even in large communities where multiple facilities could be found, a certain degree of market power may exist with some providers. Services and procedures like organ transplantation and various imaging technologies that include CT scans and MRIs which exhibit significant economies of scale would lead to some providers having a degree of market power. - Firms often engage in collusive behavior as a way of avoiding competition and increasing prices. Firms can also make it easier to collude by differentiating their products so that direct price comparisons would be difficult. They also engage in joint profit maximization in which case they may agree formally and explicitly on sales and pricing, thereby forming a cartel. These activities reduce competition while increasing individual member's profits, leading to a misallocation of resources.

Market Mechanisms that Minimize the Impact of Information Differences

- Licensing, certification, and accreditation requirements for physicians, specialists, hospitals, and medical schools assure that minimum quality standards are maintained. - Professional organizations do establish standards. - The threat of malpractice suits hangs over physicians and providers. It must be kept in mind that markets can exhibit information problems yet are relatively competitive. For example, in the market for personal computers, it the case that in general, the general public is ignorant of many technical issues, yet the market for personal computers is extremely competitive. This is because an informed minority has provided the initial discipline by writing newsletters, contributing to magazines, and participating in forums in the internet discussing vital issues about the market. These activities have created a great awareness among all consumers. It is always the case that the demand for information increases when consumers believe that acquiring and using that information serves their best interests. But as far medical markets are concerned, their complexity has led to consumers to perceive that their interests are not served by spending time and money to acquire information.

Two Important Market Defects Brought on by Asymmetric Information.

- Patients are not able to judge price and quality differences among providers. These result in providers charging prices that are above the prevailing market prices for a given level of quality. Providers may also choose to offer a lower level of quality for a given price. - There is the agency problem. The agency problem arises when the physician serves as the patient's agent, thereby leading the patient to delegate most of the decision-making authority to the physician. While the patient does this, he/she expects the physician to serve his/her best interests. Yet this dual role of provider of services on the one hand and the agent in charge of information on the other, creates a dilemma. On the one extreme, it is possible that the physician will induce the patient to purchase more medical care than the patient actually needs. In this respect, the physician can recommend medical care with little marginal value, medical care on the flat of the curve and possibly medical care that can really harm the patient. On the other extreme, patients that are enrolled in managed care organizations may be denied a chance of receiving care that offers positive net benefits simply because the managed care organizations do not be believe that it will be in their best financial interests do so.

Arguments for Government Intervention

- medical care is too complicated to be left to the free market. - patients always have to rely on the recommendations of physicians because medicine is inherently difficult to understand. - medical care being a social good, it is too important to be left to the workings of the private market. - the provision of medical care based on the ability to pay is morally repugnant.

Arguments against Government Intervention

- the US medical care system has always been market-based and should remain so since more government intervention would only lead to an escalation of cost. - A clear evidence of this, according to these opponents, is the original projection in the 1960s that Medicaid spending will reach $9 billion in 1990. Yet the actual cost of Medicaid in 1990 was $109 billion

Two Types of Short Run Profit Maximization

1) The Total-Revenue- Total Cost Approach 2) The Marginal Revenue-Marginal Cost Approach

Determinants of product differentiation

1) physical differences 2) prestige considerations 3) customer service 4) location

Characteristics of Monopolistic Competition

1. Many Sellers, many Buyers 2. Differentiated Products 3. Extensive Knowledge 4. Free Entry and Free Exit

Perfect Competition Characteristics

1. Many buyers and sellers 2. Homogeneous (Identical) Products 3. Perfect Knowledge/Information 4. Free Entry, free exit

Examples of areas in which the free market has been accused of failing

1. Market economies suffer from severe business fluctuations 2. The market distributes income unequally 3. Where markets are monopolized, they allocate resources inefficiently 4. The market deals poorly with the side effects of many economic activities 5. The market cannot readily provide public goods, such as national defense 6. The market may do a poor job of allocating resources between the present and the future

Four sources/causes of market failure

1. Market power 2. Externalities 3. Public goods 4. Asymmetric information

Three types of Imperfect Competition

1. Monopolistic Competition 2. Oligopoly 3. Monopoly

Four Types of Primary Market Structures

1. Perfect Competition 2. Monopolistic Competition 3. Oligopoly 4. Monopoly

Two ways the government can correct for negative externalities

1. Pollution Tax - designed too internalize negative externalities. Tax equal to the size of the cost would force the firm to produce the efficient level output. 2. Regulation- government could use regulation - simply prohibit certain types of activities.

Ten Key Concepts in Economics

1. Scarcity and choice 2. Opportunity cost 3. Marginal Analysis 4. Self-interest 5. Markets and pricing 6. Supply and demand 7. Competition 8. Efficiency 9. Market failure 10. Comparative advantage

Characteristics of Monopoly

1. Single Seller/Producer 2. Unique Product 3. Restricted Information/Knowledge 4. Barriers to Entry/Exit

Characteristics of Oligopoly

1. Small Number of Large Firms 2. Identical or Differential Products 3. Mutual Interdependence 4. Barriers to Entry

Theories of Oligopoly Behavior

1. The Kinked-Demand Curve and Rigid Prices 2. Price Leadership 3. Collusion 4. Joint Profit Maximization

The Unique Nature of Medical Care as a Commodity

1. The demand for medical care is irregular 2. There are information problems associated with medical care transactions. 3. There is widespread uncertainty in medical transactions. 4. There is widespread reliance on not-for-profit providers especially in the provision of hospital services.

How Do Firm's Maximize Profits?

A firm's profits equal its total revenues minus its total costs. In all types of market environments, the firm will maximize its profits at the output that maximizes the difference between total revenue and total cost, which is the same output level at which marginal revenue equals marginal cost.

Monopoly

A monopolistic market structure is one that has only one seller/producer selling a unique product that has no close substitutes.

Moral Hazard

A party can provide misleading information and thereafter changes his behavior when he does not have to face the consequences of the risk he takes. In health insurance, an individual once insured, can consume more care than optimal since he does not have to internalize the full price.

Externalities in Medical Markets

As regards externalities, we can find such cases especially in public health programs. Immunization against mumps, measles, small pox, polio and whooping cough, for example, offers protection for more than one individual, as the benefits can extend to the entire population through the elimination of potential carriers of the disease. And in private markets where fewer vaccinations would occur than is socially optimal, collective action in the form of mandates or subsidies or both becomes necessary.

Imperfect Information

A situation whereby patients are poorly informed about virtually every aspect of the medical transaction. For patients to be aware of their symptoms and syndromes is one thing but being able to understand the underlying causes of their medical conditions is a totally different thing. Thus, these patients have to rely on their physicians to form a learned opinion on their illness, their diagnosis and their prescribed treatment. Additionally, patients are often confronted with the problem of little or no knowledge about prices and the quality differences among alternative providers. This gives rise to asymmetric information.

Adverse Selection

A strategic behavior on the part of a partner that is more informed in a contract against the interest of the less informed partner(s). In health insurance, greater coverage is more likely to be selected by sicker people than healthy people. Thus, while healthy people are more likely to choose managed care, less healthy people are more likely to choose more generous plans. This makes relative prices too high and coverage too low.

"invisible hand" of the market

Adam Smith had argued in "The Wealth of Nations" that individual decision making is motivated by self-interest. According to Smith, self-serving behavior, when guided by the "invisible hand" of the market, in turn serves to promote the interests of others. What this means is that when the free market under perfectly competitive conditions encourages individuals optimizing behavior on the part of individuals and firms, this leads to efficient outcomes.

Equity-efficiency trade-off

Although equitable distribution is important in health care availability, health care like any other commodity is subject to an equity-efficiency trade-off because individual circumstances, such as age, gender, income, geographical location and insurance coverage influence access to medical care.

Asymmetric information in Medical Markets

Asymmetric information exists when one party to a transaction knows more about the transaction than the other party. Due to asymmetric information, inefficient outcomes can arise in medical markets due to adverse selection and moral hazard.

Equity

Although equity is based on some standard of fairness, ideological differences influence whether such a standard of fairness is defined in terms of outcomes or in terms of opportunities. This means that one economist may define equity in terms of fairness. For example, infant mortality rates in the US being explained in terms of differences between whites and African Americans with respect to access to medical care. On the hand, another economist might define equity in terms of opportunities. This means that even in a world of equal opportunities there will be varied outcomes.

A Change in Market Price and the Firm's Demand Curve

Although producers under perfect competition regard price as given, that does not mean that the price is constant. The position of the firm's demand curve varies with every change in the market. Assuming that the market price for bread increases as a result of an increase in market demand, the price-taking firm will receive a higher price for all its output. On the same token, when the market price decreases, say as a result of decreases in market demand, the price-taking firm will receive a lower price for all its output. Sellers are provided with current information about market demand and supply conditions as a result of price changes. Sellers respond to signals provided by such price movements so they must alter their behavior.

Supply and demand

Although they are really two separate things, supply and demand are almost always talked about together. They serve as the foundation for all economic analysis. Not only are pricing and output decisions based on the forces underlying supply and demand, but goods and services are allocated among competing uses on the basis of supply and demand.

Access to Care

An estimated 47 million of Americans are without health insurance. This situation is what drove the most recent healthcare reform. Yet having no health insurance is not the same as having no access to medical care. It is estimated that the uninsured receive about 60 percent of the medical care per capita of those with insurance.

Externalities

An externality is a cost or benefit incurred by a third party that is not directly involved in an economic transaction. An externality can exist even if the economy is competitive, since it is still possible that market system can fail to produce the efficient level output due to some side effects.

Oligopoly

An oligopolistic market is a market that is characterized by a small number of large firms selling either identical or differentiated products.

Medical Outcomes

Another issue of great concern is the health of the population. It is being suggested, especially by those who are critical of the US health care delivery system that relatively, the healthcare system has poor outcomes. Male life expectancy at birth in the US is 75.2 years while that of females is 80.4 years. This places the US among the lowest in the developed world. Infant mortality rates in the US are over two times that of Japan. Yet spending, both as a percentage of GDP and on per capita basis are much higher in the United States. But life expectancy and infant mortality rates are for the most part influenced by the environment, lifestyle choices and social problems. This means that the US must deal with these problems. Problems like, drug abuse, violence, reckless behavior, sexual promiscuity, illegitimacy, etc., complicate the delivery of medical care and are in part, responsible for poor health indicators in the US.

Arrow's "Uncertainty"

Arrow argues that healthcare doesn't fit the free market model. To Arrow, unless a patient knows much about medicine as his/her doctor, the patient cannot evaluate the quality of advice the doctor gives him/her. This, arrow calls "uncertainty."

Perfect Knowledge/Information

Consumers and producers know the prices and quality of products. Since consumers know prices offered by other sellers, they can switch from one seller to another - increasing elasticity.

Customer service

Customer service can be a determinant of product differentiation in the sense that products that are physically identical and perceived to be identical may be differentiated on the basis of how customers are treated by the seller. Polite and friendly customer service may draw more customers to that particular seller.

Competition

Due to competitive forces in the market, resource owners are forced to use to use their resources to promote the highest possible satisfaction of society. Resources owners that do well are compensated while those resource owners that inept are penalized. With competition, production is taken from the hands of the les competent and placed in the hands of the more efficient as it is the more efficient producers that constantly promote more efficient methods of production.

Self-interest

Economists assume that individuals act as if they are motivated by self-interest and respond in predictable ways to changing circumstances. For example, to worker, self-interest means pursuing a higher paying job and/or better working conditions.

How do economists evaluate markets?

Economists evaluate markets on the basis of efficiency and equity.

Efficiency.

Efficiency ensures that resources are used for the promotion of social welfare. But when resources are used inefficiently, a waste of resources occurs.

Health Care Crisis Causes

Experts on health care see the healthcare crisis as one that is borne out of the astronomical rise in aggregate spending coupled with the problems the government is experiencing in sustaining Medicare and Medicaid. But there appears to be divergence of views from experts as far as the cause of the crisis is concerned. While some argue that the problem lies in the unrestrained use of medical technology, others believe that the increased use of health insurance and tax subsidies that encourage individuals to overinsure is driving the crisis.

Extensive Knowledge

Extensive knowledge relates to the fact that producers have relatively complete information about production techniques and prevailing prices in the market. Also, although buyers do not know everything, they relatively have complete information about alternative prices, product differences, brand names, etc.

Prevalence of Third -Party Payers

In medical markets in the US, inefficiencies arise as a result of consumers not spending their own money. This contrasts with traditional markets where individuals spending their own money provide the discipline that culminates in the efficient allocation of resources. Evidently, only a small fraction of the money spent on hospital services and physician services comes directly from the patient's pocket. The bulk of the expenses are paid by third parties, primarily health insurance companies and the government. This creates a major problem in medical markets since pricing does not reflect the consumer's willingness to pay for good service and the consumer's ability to buy the good or service.

Game Theory

In oligopolistic markets, it refers to how interdependence between oligopolists would impact choices and outcomes in a game between two players.

Barriers to Entry

In the case of imperfect competition, entry barriers restrict resource movements. Such barriers in medical markets can be found mainly in the licensing and certification of practitioners. It is argued that the rigid licensing and certification of practitioners protects consumers and keeps uninformed patients from seeking services from incompetent providers. For example, Certificate-of need (CON) laws imposes an obligation on hospitals to secure government approval if they decide to add new capacity or invest in expensive equipment. However, as much as restrictions may sound good in theory, it could have the unintended consequence of limiting competition in the marketplace. Limited competition in turn leads to market power, which in turn leads to market failure.

Long Run Equilibrium

In the long run, all inputs can be varied. The monopolistically competitive firm's equilibrium will be at an output level that generates economies of scale or increasing returns to scale. This is the output level where the negatively-sloped demand curve lies at tangent to the negatively-sloped segment of the long run cost curve. A two-fold adjustment process is associated with this: First, entry and exit of firms into and out of the industry ensures that firms can earn zero economic profit and that price is equal to average cost. Second, the pursuit of profit maximization by each firm in the industry ensures that firms produce at that output level where marginal revenue equals short and long run marginal cost. Since there is some market control and since the firm faces a negatively-sloped demand curve, two equilibrium conditions emerged in the long run: MR=MC=LRMC P=AR=ATC=LRAC

Prisoner's Dilemma

In the prisoner's dilemma, two suspects are arrested by the police for stealing but the police do not have sufficient evidence for a conviction. They are held in separate cells and the DA in separate interviews offers a deal: - If neither prisoner confesses to the crime, both receive a 4 year sentence. - If both confess, both receive 10 years behind bars. - If one confesses and the other doesn't, then the one that doesn't confess gets 15 years while the one that confesses receives immunity. Each prisoner is under pressure to decide on which deal would maximize his welfare but is constrained by the fact that he does not know what move the other would take. Rational choice leads the two prisoners to confess to the crime even though each prisoner's reward by not confessing would have been greater.

Profit Maximization in Perfect Competition

Profit maximization is a process by which a firm determines the price and output level that returns the greatest profit. In perfect competition, average revenue is equal to the price of the good. Since under perfect competition additional units of a good can be sold without reducing the price of the good, marginal revenue is constant at all levels of output and equal to average revenue. Marginal revenue facing a perfectly competitive firm is equal to the price of the good. In perfect competition, then, marginal revenue, average revenue, and price are equal: P = MR = AR

Scarcity and choice

Scarcity and choice explain the fact that not enough resources are available to meet all the desires of all the people. This makes rationing in some form unavoidable. Thus, scarcity and choice address the problem of limited resources and the need to economize. Due to scarcity, we are forced to make choices among competing objectives.

Collusion

Since firms are mutually interdependent under oligopoly, temptations to collude become a natural consequence. When firms collude, they enter into an agreement, usually of a secret nature to a joint action on pricing and other matters. Since firms believe that profits would increase through joint action, the temptation to collude become stronger. Although collusion may reduce uncertainty among firms and increase potential economic profits, it is bad from society's point of view since it creates a situation whereby goods become overpriced and under produced. This leads to a misallocation of resources. When a collusion is formal and explicit, it is called a cartel. When it is tacit, it is called a tacit collusion.

There is widespread uncertainty in medical transactions.

Since it is rare to predict an illness, an individual cannot usually predict his or her demand for medical care.

Short Run Supply Curve in Monopoly

Since the monopolist is both the firm and the market/industry with market control, there is no relation between the quantity of output produced and price. The monopolist bases its supply decisions not only on marginal cost alone. It considers both the marginal cost and the marginal revenue that it receives at each price level. To determine marginal revenue requires that the monopolist know market demand, which means that the monopolist's market supply cannot be independent of market demand.

Healthcare Spending

Spending drives the debate on healthcare reform. Spending per person and spending as a share of total economic output continues to rise. - spending on hospital services rose to $648.2 billion in 2006, spending on physicians' services only amounted to 25.4 percent of the total spent on personal health care in 2006. - American consumers spent $216.7 billion on pharmaceuticals and another $59.3 billion on other medical products. - Other spending, which included payments for dentists' services and other professional services, nursing home care, and home health services combined to account for approximately 18.6 percent of all personal health care spending.

Nash Equilibrium

The Nash equilibrium establishes that a set of strategies followed by economic agents within a game is in equilibrium if no player can benefit by changing his strategy while the other players keep their strategies unchanged. In other words, agent A and agent B are in Nash equilibrium if agent A is making the best decision he can, taking into account agent B's decision, and agent B is making the best decision he can taking into account agent A's decision. With more players, a Nash equilibrium can also be established if each player is making the best decision that he can considering the decisions of the other players.

Two Methods of Profit Maximization

The Total Revenue-Total Cost method - relies on the fact that profit equals revenue minus cost The Marginal Revenue-Marginal Cost method - relies on the fact that total profit in the perfect market reaches its maximum point where marginal revenue equals marginal cost.

Homogeneous (Identical) Products

The consumer believes that all firms in competitive markets sell identical products - products that are close substitutes. For example, it is difficult, if not impossible to determine any significant and consistent qualitative differences between wheat produced by farmer A and that produced by farmer B. Under perfect competition products of all the firms are considered to be perfect substitutes.

Negative Externalities

The free market overproduces the good. The producer does not take into account the external costs when producing the good. An example is pollution.

Positive Externalities

The free market produces too little of the good as producers and buyers do not take into account the benefits to others. An example of a positive externality is education.

Demand Curve Under Perfect Competition

The individual firm is a price-taker. This means that it must sell at the market-determined price. The market price and output are determined by the intersection of the market supply and demand curves. In the market for bread, for example, the individual baker knows that he cannot sell his bread at any price above the market price. If he attempts to do this, potential customers would simply get their bread from another baker. The baker would also not knowingly charge a lower price since he could sell all he wants at the market price. Also, perfectly competitive firms can change their outputs without altering the market price. This is due to the fact that a large number of sellers are selling identical products. Each producer only provides a small fraction of the total output, meaning that a change in the amount that he offers does not have a noticeable effect on market equilibrium price. Perfect competition allows an individual firm to sell as much as it wishes to place on the market at the prevailing price. The demand curve facing the firm is perfectly elastic.

Unique Product

The monopolist's product is unique - no close substitutes.

Many buyers and sellers

The number of buyers and sellers are in the thousands or conceivably millions. Each firm is small relative to the industry. Due to this, the production decisions of each firm have no impact on the industry. Firms also have no control over prices and because of this, they are price-takers. They must take the price given by the market, which is determined by the forces of supply and demand.

The Kinked-Demand Curve - Relatively Inelastic

The relative inelastic segment is based on the assumption that one firm would consider lowering its price. In this situation all firms would have to follow since not following would lead to a loss of market share and profits, thereby making you worse off than before. Selling at a reduced price also involves lowering total revenue and reducing profits. Thus, under normal circumstances, no firm would want to lower its price.

The Kinked-Demand Curve - Relatively Elastic

The relatively elastic portion of the demand curve exists because of the assumption that one firm in the industry would increase its price. In this situation, other firms are unlikely to follow. This results in a loss of customers and market share to competitors with relatively less expensive products. The firm increasing its price will end up with a smaller marker share and smaller profits. It must be noted, however, that the firm increasing its price would not lose all its customers since there are those that would argue that a relatively less expensive substitute would not be a good replacement for the product that they are used to buying. However, there are those customers who would turn to a competitor and avoid the price hike. The competitors realizing how profitable it is to keep their old would not hike their price.

Total Revenue (TR)

The revenue that the firm receives from the sale of its products. Total revenue from the sale of products equals the price of the product (P) times the quantity (q) of units sold (TR = Pxq). For example, if a baker sells 10 loaves of bread a day for $5.00 a loaf, his total revenue is $50 ($5x10). (Lower case q denotes the single firm's output and upper case letter Q for the output of the entire market).

Free Entry, free exit

There are no significant barriers to entry and exit under perfect competition. Entrepreneurs can find it fairly easy to become suppliers of products. They can also cease being suppliers at will. However, "fairly easy" does not mean that any body from the street can instantly become an entrepreneur. What it means is that the financial, legal, educational and other barriers to entry are modest, thereby enabling large numbers of people to enter the business if they so desire.

Imperfections in Medical Markets

There are other imperfections that contribute to market failure in medical markets. These are: imperfect information barriers to entry prevalence of third -party payers

Barriers to Entry/Exit

There are significant barriers to entry in monopolistic industries. Three major barriers are: Legal Barriers Economies of Scale Control Over an Important Input

Small Number of Large Firms

There is a small number of large firms, each relatively large compared to the overall size of the market. The number of firms can be as many as twenty and as few as two. Oligopoly becomes monopolistic competition as the number of firms increase. The relative size of oligopolistics generates substantial market control.

There are information problems associated with medical care transactions.

These problems disproportionately affect patients. Although all consumers are frequently confronted with difficulties in collecting information about a product, in the case of medical care, this problem becomes more acute for consumers given that medical knowledge is very complex. Medical care consumers are poorly informed and find it very difficult to be well informed. Patients find themselves relying on physician for both their diagnosis and the prescription of treatments.

Marginal Revenue-Marginal Cost Approach

This approach compares marginal revenue and marginal cost. Profit is maximized when marginal cost is equal to marginal revenue (MC=MR). At this point profit cannot be increased by changing the level of output since that would add more to cost than revenue. This will lead to a decline of profit. Also, production cannot be decreased without subtracting more from revenue than cost thereby leading to a decline of profits.

Single Seller/Producer

This confers monopoly power on the monopolist. A single firm controls the supply-side of the market making consumers of that product to buy only from that firm. Since the firm and the market/industry are one, the firm is a price-maker.

Demand and Marginal Revenue in Monopoly

Under monopoly the firm and the industry/market are one. The demand curve facing the firm indicates the quantities that the firm can sell at different prices. The demand curve for the firm's products slopes negatively. The firm cannot set both the price and the quantity that it sells. If the firm raises its price, quantity demanded falls and if it lowers its price quantity demanded rises, ceteris paribus.

Total Revenue-Total Cost Approach

Under this approach, profit is maximized at that level of output that achieves the greatest difference between total revenue and total cost.

The Economic Perspective

Unique among the social sciences in that it establishes a context of scarcity and uncertainty

Restricted Information/Knowledge

Unlike perfect competition, monopolists are often in possession of information that are not available to others. For example, monopolists can possess specialized information in the form of legally-established patents, copyrights, or trademarks.

Market Power

When a firm controls the market price. A firm with market power is a price maker, which sets prices at levels that exceed marginal cost. The situation prevails under monopoly, oligopoly, monopolistic competition and monopsony.

Market failure

When the free market fails to promote the efficient use of resources by either producing more or less than the optimal level of output, market failure results. Sources of market failure are externalities, public goods and asymmetric information.

Comparative advantage

With comparative advantage, the individual or entity that has the lowest opportunity cost in production benefits. In this situation, that individual or entity is said to have a comparative advantage.

Social Cost

With externalities, there is a divergence between the private costs of production and the social costs of production. While private costs are limited to the producer's inputs like the cost of raw materials, labor, etc., social costs include all the costs of production of the output of a particular good or service. This includes the third party (external) costs. Thus: social cost = private + externality.

The demand for medical care is irregular

With the exception of a small percentage of care that fall under the classification of preventive, the demand for medical care follows an accidental injury or the onset of illness. This is not the case for other commodities

Capitalism

a free market system of exchange operating exclusively on the economic principle of supply and demand maintained through competition.