Chapter 8 Structure Conduct Performance and Market Analysis

Chapter 8: Structure, Conduct, Performance, and Market Analysis Health Economics

Outline Defining perfect competition. l Market equilibrium. l Comparative statics. l Applications. l

Characteristics of Perfect Competition l Consumers pay the full price of the product. u Consumers will respond to differences in prices among sellers. l All firms maximize profits. u Firms have incentives to satisfy consumer wants and produce efficiently.

Characteristics of Perfect Competition (cont. ) l There is a large number of buyers and sellers, each of which is small relative to the total market. u No one buyer or seller is powerful enough to influence or manipulate the market price of a product. l All firms in the same industry produce a homogeneous product. u. A consumer can easily find substitutes for the product of any given firm.

Characteristics of Perfect Competition (cont. ) l No barriers to entry or exit exist. u New l firms can enter the industry. All economic agents possess perfect information. u Consumers and firms can make informed choices. l All firms face nondecreasing average costs of production. u Rules out a “natural monopoly. ”

Market Equilibrium l Given the demand supply curve for any given product, one can determine how many goods will be exchanged, and at what price. l The equilibrium, or market-clearing price and output are at the point where the demand supply curves intersect.

Market Equilibrium (cont. ) Dollars per bottle Supply P 0 Demand Q 0 Market output of generic aspirin (Q)

Market Equilibrium (cont. ) l Equilibrium occurs when no tendency for further change exists. At the equilibrium price of P 0, consumers are willing to purchase Q 0 bottles of aspirin. l Aspirin manufacturers are willing to sell Q 0 bottles of aspirin at P 0. l

Market Equilibrium (cont. ) l If the price of aspirin is above the equilibrium level, there will be a surplus, or excess supply of aspirin. l If the price of aspirin is P 1 on the following graph, sellers will want to sell QB bottles of aspirin, but consumers will only want to purchase QA bottles. u The distance between QA and QB represents the amount of excess supply of aspirin.

Market Equilibrium (cont. ) Dollars per bottle Supply P 1 Demand QA Excess Supply QB Market output of generic aspirin (Q)

Market Equilibrium (cont. ) l If the price of aspirin is below the equilibrium level, there will be a shortage, or excess demand of aspirin. l If the price of aspirin is P 2 on the following graph, consumers will want to buy QF bottles of aspirin, but sellers will only want to sell QE bottles. u The distance between QE and QF represents the amount of excess demand of aspirin.

Market Equilibrium (cont. ) Dollars per bottle Supply P 2 Demand QE QF Excess Demand Market output of generic aspirin (Q)

Comparative Statics How does the market react to events that influence the demand for or supply of medical services? l Recall that changes in factors other than output price will cause the demand or supply curve to shift. l u An increase in consumer income will cause the demand curve for physician visits to shift to the right. u An increase in the wage of nurses will cause the supply curve for hospital stays to shift to the left.

Comparative Statics l These shifts in the demand or supply curves will lead to a change in equilibrium price and quantity. l Predicting such changes is referred to as comparative static analysis.

Comparative Statics (Example 1) l Suppose consumer income increases by a significant amount. u This increase in income causes the demand curve to shift to the right. l This rise in demand leads to a temporary shortage in aspirin, illustrated by the distance EF on the following graph.

Comparative Statics (Example 1) Dollars per bottle S P 0 E F D 1 D 0 Q 0 Excess demand Market output of generic aspirin (Q)

Comparative Statics (Example 1) l The consumers who are willing, but not able to buy aspirin at P 0 will bid the price of aspirin upwards. u i. e. They will offer sellers more than P 0 to buy a bottle of aspirin. l Because sellers are being offered a higher price than P 0, they will increase their output of aspirin above Q 0.

Comparative Statics (Example 1) l As the price of aspirin begins to rise above P 0, consumers reduce their demand for aspirin. l This process will continue until the market reaches a new equilibrium.

Comparative Statics (Example 1) Dollars per bottle S New equilibrium P 1 P 0 E F D 1 D 0 Q 1 Market output of generic aspirin (Q)

Comparative Statics (Example 2) l Suppose manufacturers develop a technology that lowers the marginal cost of making aspirin u This cost-saving technology causes the supply curve for aspirin to shift out. l This increase in supply leads to a temporary surplus of aspirin, illustrated by the distance AB on the following graph.

Comparative Statics (Example 2) Dollars per bottle S 0 P 0 A S 1 B D 0 Q 0 Excess supply Market output of generic aspirin (Q)

Comparative Statics (Example 2) l The firms that are willing, but not able to sell aspirin at P 0 will lower the price they charge for aspirin. u i. e. They will offer charge consumers a price of aspirin which is below P 0. l Because consumers are being offered a higher lower than P 0, they will increase their quantity of aspirin demanded above Q 0.

Comparative Statics (Example 2) l As the price of aspirin begins to fall below P 0, firms reduce their supply of aspirin. l This process will continue until the market reaches a new equilibrium.

Comparative Statics (Example 2) Dollars per bottle P 0 S 0 A S 1 B New equilibrium P 1 D 0 Q 1 Market output of generic aspirin (Q)

Comparative Statics (Long run) l In the short run, firms cannot enter or exit a given market. u i. e. In the short run, no firms producing generic aspirin can exit the market, and no new firms can start producing aspirin. l In the long run, new firms will enter a perfectly competitive market if there any profits to be made. u Entry occurs until = 0.

Comparative Statics (Long run) l In the mid-1980 s, the AIDs epidemic led to an increase in the demand for latex gloves among health care workers. l The epidemic led to a shift to the right in the demand curve for latex gloves. u Excess demand for gloves developed, leading to a temporary shortage of gloves.

Comparative Statics (Long run) Dollars per pair S P 0 E F D 1 D 0 Q 0 Excess demand Market output of latex gloves (Q)

Comparative Statics (Long run) l The shortage of gloves led buyers to bid the price of gloves upwards. l As the price bid for gloves rose, sellers increased their quantity supplied of gloves. u This process continued until a new shortrun equilibrium was reached. u From 1986 to 1990, annual sales of latex gloves increased by ~58%.

Comparative Statics (Long run) Dollars per pair S P 1 P 0 D 1 D 0 Q 1 Market output of latex gloves (Q)

Comparative Statics (Long run) l Before the epidemic, each glove maker was earning 0 profits. l The increase in equilibrium price after the epidemic implies that all glove makers are earning positive profits. u = (P 1 x Q 1) – (Q 1 x ATC(Q 1))

Comparative Statics (Long run) Dollars per pair MC ATC P 1 d 1 = MR 1 P 0 d 0 = MR 0 Q 1 Market output of latex gloves (Q)

Comparative Statics (Long run) l Other medical suppliers made plans to build new manufacturing plants to make gloves, in the hopes of making profits. u In 1988, 116 permits were pending in Malaysia for building latex glove factories. l Entry of the new plants into the market increased the supply of latex gloves in the long run. u The supply curve for gloves shifted out.

Comparative Statics (Long run) Dollars per pair S 0 S 1 P 0 D 1 D 0 Q 1 Q 2 Market output of latex gloves (Q)

Comparative Statics (Long run) l As the supply curve for gloves shifts out, the price of gloves begins to fall. u Note that the quantity of gloves sold on the market also increases. l As the price of gloves fall, profits also fall. u The process continues, until the price of gloves falls back to P 0, where profits for all glove makers are again equal to 0.

Comparative Statics (Long run) Dollars per pair MC ATC P 1 d 1 = MR 1 P 0 d 0 = MR 0 Q 1 Market output of latex gloves (Q)

Characteristics of Perfect Competition l Briefly recall some of the features of a perfectly competitive market: u Many sellers. u Homogeneous product. u No barriers to entry. l Under perfect competition, each individual firm is a price taker. u Each firm faces horizontal demand marginal revenue curve.

Monopoly Model l In contrast, a monopoly market has the following features: u One seller u Homogeneous or differentiated product. u Complete barriers to entry. l Because there is only one firm, that firm faces the market demand curve, which is downward sloping.

Monopoly Model (cont. ) l What is the profit-maximizing price and quantity for a monopolist? u Recall that all firms will maximize profits where MR=MC. u We have already seen that the marginal cost curve for a firm depends on its production function and input prices. u What does the firm’s MR curve look like?

Monopoly Model (cont. ) We know that TR = P x Q l What is the MR = change in TR if output is increased by 1 unit? l A monopolist faces a downward sloping demand curve. l u To increase sales by 1 unit, the price charged per unit (for each unit sold) must be lowered.

Monopoly Model (cont. ) Dollars per unit If a monopolist wishes to increase its output sold from Q 0 to Q 1, it will need to lower the price it charges from P 0 to P 1. P 0 P 1 Demand Q 0 Q 1 Quantity

Monopoly Model (cont. ) Dollars per unit When reducing its price from P 0 to P 1, the monopolist loses the difference between P 0 and P 1 for all units of output up to Q 0. P 0 P 1 revenue loss Demand Q 0 Q 1 Quantity

Monopoly Model (cont. ) Dollars per unit However, the monopolist also gains the value of P 1 for each increase in output from Q 0 to Q 1. P 0 P 1 $ g a i n Q 0 Q 1 Demand Quantity

Monopoly Model (cont. ) l The marginal revenue from increasing sales from Q 0 to Q 1 is represented by the revenue gain, minus the revenue loss depicted in the 2 previous graphs. l In numerical terms: MR = P + Q • ( P/ Q) revenue gain revenue loss

Monopoly Model (cont. ) MR = P + Q • ( P/ Q) Because the second term in this formula represents a revenue loss, it is always negative. Ø Thus, at each level of output, marginal revenue is always lower than price. Ø The marginal revenue curve lies under the demand curve. l

Monopoly Model (cont. ) Dollars per unit MR Demand Quantity

Monopoly Model (cont. ) We are now ready to find the profitmaximizing output for a monopolist. l The monopolist sets output at a level where MR=MC. l u On a graph, find the level of Q where the MR and MC curves intersect. l To determine the price the monopolist will charge, locate the price on the demand curve at this same output level.

Monopoly Model (cont. ) Dollars per unit MC P* MR Q* Demand Quantity

Monopoly Model (cont. ) l The monopolist’s level of profits can then be determined by adding its average total cost curve to the graph. l Profits will be the difference between P* and ATC, multiplied by Q*.

Monopoly Model (cont. ) Dollars per unit MC P* ATC Profits ATC* MR Q* Demand Quantity

Contrast to Perfect Competition Dollars per unit Under perfect competition, the market equilibrium would MC instead be where P=MC. ATC PC MR QC Demand Quantity The higher price and lower output in a monopolized market is why economists claim that competition is better for social welfare.

Monopoly Model (cont. ) l A monopoly only maintains its status if there are no substitutes for the product it sells. u There must be barriers to entry, so that other firms cannot enter the market to compete. u The two most common barriers to entry: Economies of scale. l Legal restrictions. l

Monopoly Model (cont. ) l Economies of scale u If a monopoly is producing output at a level where long run average costs are declining, then new firms cannot compete on a cost basis. u A monopoly hospital in a small town may have substantial economies of scale if it can meet demand with only 40 -50 beds. l Unless a new hospital could take away a substantial share of the existing hospital’s patients, it could not match the existing hospital in costs (and therefore profits as well).

Monopoly Model (cont. ) l Legal restrictions u Physicians require a license to practice medicine. u Many states require that providers obtain a Certificate of Need to offer a new service. u Drug companies obtain patents for new pharmaceutical products.

The Market Structure Continuum l We have talked about 2 extremes of the market structure continuum. u Perfect Competition. u Pure Monopoly l Along this continuum, there are 2 more levels of competitiveness that we will encounter in the health care sector.

The Market Structure Continuum Perfect Competition Oligopoly Monopolistic Competition Monopoly

Monopolistic Competition Many sellers. l Differentiated product. l No barriers to entry. l l Examples u Breakfast cereals. u Ibuprofin (Advil, Motrin, etc. ). u Cigarettes.

Monopolistic Competition (cont. ) l Because products are differentiated across firms, each seller has some ability to control price. u Each seller faces a slightly downward sloping demand curve. l Sellers have an incentive to “differentiate” their product from competitors. u Doing so is likely to raise demand for their product.

Monopolistic Competition (cont. ) Dollars per Unit Demand under monopolistic competition Demand under perfect competition 2 potential demand curves for an individual firm. Output

Oligopoly Few, dominant sellers. l Homogeneous or differentiated product. l Substantial barriers to entry. l l Examples u Tertiary services at teaching hospitals. u Many prescription drugs.

Oligopoly l Because there are only a few dominant sellers, actions of any one firm can change the overall market price. l Like monopoly, oligopoly will lead to lower output and higher prices than would be observed under perfect competition. Ø Regulators are concerned about consumer welfare in oligopolistic markets.