HMGT 435 WEEK 3 PRO 3

CHAPTER

257

16GOVERNMENT INTERVENTION IN HEALTHCARE MARKETS

Learning Objectives

After reading this chapter, students will be able to

• describe the advantages of perfectly competitive markets, • explain when markets may be inefficient, and • discuss alternative approaches to market failure.

Key Concepts

• Given the right conditions, competitive markets can produce optimal outcomes.

• Markets organize vast amounts of information about costs and preferences.

• Perfectly competitive markets lead to efficient production and consumption.

• Markets are dynamically efficient. • Most markets are imperfect. • Markets may be inefficient when externalities or public goods are

present. • Markets may be inefficient when competition or information is

imperfect. • Efficient market outcomes may not be equitable. • Clear assignment of property rights may improve market outcomes. • Taxes or subsidies may improve the efficiency of some markets. • Public provision of some products may be efficient.

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C o p y r i g h t 2 0 1 9 . H e a l t h A d m i n i s t r a t i o n P r e s s .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Economics for Healthcare Managers258

16.1 Government Intervention in Healthcare

Government intervention in healthcare is extensive, even in a market- oriented society such as the United States. This chapter explores the rationale for government intervention, assuming that the goal is the promotion of the public well-being. We will begin by looking at the virtues of markets and then examine problems with markets. The chapter concludes by considering ways that governments might intervene.

16.1.1 On the Virtues of Markets Under the right conditions, competitive markets can lead to an allocation of resources that is Pareto optimal—that is, no one can be made better off without making someone worse off (Debreu 1959). These conditions are restrictive:

• Each market should have large numbers of buyers and sellers. • Products are undifferentiated. • All buyers and sellers know all the relevant information about the

market.

Markets also require maintenance of law, order, and property rights, so this list of conditions may be incomplete. Nonetheless, these conditions are sel- dom satisfied, leaving us with questions that are more complex and more dif- ficult. Would relying more on markets to allocate resources make us better or worse off? Would changing the laws and regulations make us better or worse off? The difficulty is that we must choose not between perfect markets and perfect governments but between imperfect versions of each. Much of this chapter focuses on the shortcomings of markets. First, though, let us explore some of the virtues of markets.

16.1.2 Information Processing What should the price of gasoline be? Is an additional flight between Chi- cago and Tulsa, Oklahoma, worth enough to consumers to justify the cost of operating it? Are consumers willing to pay for the capabilities of satellite tele- phones? Is there a shortage of nurses? Markets help us answer such questions.

In an ideal market, goods and services are made, distributed, and used so that the market value of production is as large as possible. The result- ing prices spread information throughout the economy, coordinating the decisions of many decentralized producers and consumers. The quest for profits encourages producers to seek low-cost ways of creating the products consumers most want while using resources in the most valuable way pos- sible. Because the decisions made by consumers are designed to maximize

Pareto optimal An allocation of resources in which no reallocation of resources is possible that will improve the well-being of one person without worsening the well-being of another.

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Chapter 16: Government Inter vention in Healthcare Markets 259

satisfaction, maximizing market values results in maximizing well-being. The equilibrium of an ideal market is Pareto optimal. Furthermore, market exchange is voluntary. Individuals can choose to trade or not, affording con- siderable freedom to participants.

In a planned economy, well-intentioned officials who use their power wisely and justly may find price setting difficult. The planning process does not automatically yield the information needed to set prices. In addition, because price setting is a political act in a planned econ omy, officials may have difficulty setting prices correctly even when they know the proper levels.

Setting Prices for Walkers

Walmart sells a walker called the Carex Explorer for $63.98. Medicare covers the Explorer, but it

used to pay between $99.77 and $143.65 (CGS 2015). As a result of competitive bidding, the current price ranges from $44.90 to $50.61 (CGS 2018). Between 1989 and 2011, Medicare paid for equipment such as walkers using a fee schedule equal to 95 percent of a product’s average wholesale price (an unverified number provided by manufac- turers). This system kept Medicare fees substantially higher than typi- cal retail prices.

As a part of the Medicare Modernization Act of 2003, Medicare accepted bids for ten types of equipment in ten metropolitan areas. The median accepted bid was 26 percent lower than the existing Medi- care fee. Equipment manufacturers and retailers responded by lobby- ing Congress to discard the bids and delay the program, and the House of Representatives obliged by passing a bill to ditch the bids. In fact, it was only with the passage of the Affordable Care Act that Medicare was able to launch competitive bidding in 2011 (Newman, Barrette, and McGraves-Lloyd 2017). Even though Medicare anticipated savings of 45 percent on competitively bid products and 72 percent for mail-order products, in 2015 then congressman Tom Price and 82 cosponsors introduced a bill to suspend competitive bidding (Newman, Barrette, and McGraves-Lloyd 2017). Although the bill did not become law, this example demonstrates three points. First, a well-designed bidding process can result in lower prices for public programs. Second, such programs are expensive and take a long time to set up and implement.

Case 16.1

(continued)

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16.1.3 Static Resource Allocation Perfectly competitive markets allocate products efficiently to the consumers most willing to pay for them. In other words, production and consumption are efficient. Products are produced as inexpensively as possible. No resources are wasted in making goods and providing services. Reorganization of pro- duction would increase costs.

Exchanges of goods and services in perfectly competitive markets all take place at the same price. As a result, consumers who value products will buy them. Products are not wasted on consumers who feel the products are worth less than the amount spent to produce them.

Perfectly competitive markets result in an optimal mix of output. Their combination of lowest-cost production and highest-value consumption means that changes would reduce satisfaction. At the competitive optimum, price equals marginal benefit, which in turn equals marginal cost. Shifts in the output of the economy would cause the marginal cost to be higher or lower than the marginal value to consumers, which would not be optimal.

Third, efforts to switch to a bidding process will encounter opposition from those whose profits are at risk.

Some supplier organizations argue that that the program encour- ages bidders to offer only the lowest-cost products rather than those best suited to beneficiaries’ needs. An analysis reported that competi- tive bidding did not affect beneficiary access and satisfaction (US Gov- ernment Accountability Office 2014).

Discussion Questions • What are the risks of a bidding process like the one described in

this case?

• Why would elected representatives side with the manufacturers and retailers on this issue?

• If Medicare sought bids for cardiac care to serve beneficiaries in your hometown, what would happen economically and politically?

• Bidding has led to a drop in the number of medical equipment firms. Is this drop a concern?

• Could you design a way of insulating Medicare from political pressure? Would you want to?

• What problems other than paying too much might distorted fee schedules cause?

Case 16.1 (continued)

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Chapter 16: Government Inter vention in Healthcare Markets 261

Perfectly competitive markets are not necessarily fair. Different dis- tributions of incomes result in different market outcomes. A perfectly com- petitive market might lead to an efficient outcome in which most consumers have comparable incomes, or a perfectly competitive market might lead to an efficient outcome in which most consumers are ill-housed and ill-nourished and only a handful live in palaces.

16.1.4 Dynamic Resource Allocation In a market economy, successful innovations are highly profitable. Unsuccess- ful innovations and inertia are highly unprofitable. As a result, markets are efficient in a dynamic sense. They respond quickly to changes in economic conditions and encourage innovation.

At the simplest level, markets squelch products that customers do not want. A product that does not create more value for potential buyers than its alternatives will fail quickly. Compounding this effect, those in authority or those with established products have difficulty preventing change; rivals are free to develop new products, and customers are free to buy them.

More important, markets reward innovation that customers want. A product that is as good as its alternatives is not likely to be more profitable than the others, whereas a better product promises high short-term profits. Customers will pay a premium for a better product, and substantial profits will follow if the market is large enough. Before too long, though, competi- tors will introduce similar products, and profit margins will fall. Producers must innovate continuously to maintain above-average profit margins.

Because innovation is intrinsic to market economies, we often fail to notice it. For most of human history, however, innovation was not routine. Before 1700, most people used the same technology their grandparents used. Income per capita changed little for hundreds of years (Mazzucato and Semieniuk 2017).

The dynamic efficiency of markets is so important that it may trump static efficiency concerns. Suppose, for example, that a market is dominated by a few large firms. In this market, prices will be somewhat higher than they would be in a more competitive market. But if those large firms invest more in research and development than smaller firms would, it might not be long before the resulting innovation would make consumers better off.

16.2 Market Failure

Despite their many virtues, markets do not always perform well. We will now consider the main reasons markets fail:

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Economics for Healthcare Managers262

• Externalities • Public goods • Imperfect competition • Imperfect information • Natural monopoly • Income redistribution

We will explore these in detail.

16.2.1 Externalities Production or consumption of some products may directly affect others. These side effects are called externalities. When the side effects benefit oth- ers, they are called external benefits. When the side effects harm others, they are called external costs. When these side effects are not considered in market exchanges, the resulting equilibrium may entail volumes that are too high or too low.

For example, immunization confers external benefits on people who have not been immunized. If you are immunized, my risk of becoming ill decreases. In return for this benefit, I might be willing to pay a part of the cost of your immunization and part of the cost of others’ immunizations. As a practical matter, though, providing subsidies to the thousands of people I want to help would be difficult. I would be able to subsidize only a small number of immunizations, which defeats the purpose of my offer.

Exhibit 16.1 illustrates this concept. The private demand curve, which ignores the product’s external benefits, is DP. The social demand curve, which incorporates these benefits, is DS. The market equilibrium, which ignores the external benefits of immunization, results in a volume of QP. An equilibrium that takes the external benefits into account would result in the larger volume of QS. In short, the market equilibrium is not fully efficient.

Externalities need not be positive. If I let my untreated sewage con- taminate your well, I am imposing external costs on you to have the sewage treated. I am considering the amount I would have to spend on water to get rid of wastes, but I am not considering your costs. If the society includes just the two of us, you could pay me to produce less sewage. If the society includes 100 people like me, and our sewage affects 500 or 5,000 people, these private payments will become complex, and problems are likely to ensue. External benefits and costs that affect large numbers of people are characteristic of public goods (see section 16.2.2).

A classic example of an externality is the tragedy of the commons. If everyone in a village can graze livestock on a common pasture, each person has an individual incentive to overuse the resource. The overgrazing may become so severe that all the livestock starve and the village collapses. In

externality A benefit or cost accruing to someone who is not a party to the transaction that causes it.

external benefit A positive impact of a transaction for a consumer or producer not involved in the transaction.

external cost A negative impact of a transaction for a consumer or producer not involved in the transaction.

tragedy of the commons Over- or underuse of a resource that occurs when ownership of the resource is unclear and users produce externalities.

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Chapter 16: Government Inter vention in Healthcare Markets 263

other words, each person’s livestock consume resources that imperil every- one else’s livestock. More contemporary examples include vehicle congestion in cities, in which each driver ignores the costs imposed on others; overuse of the Ogallala aquifer in the central United States, in which each farmer’s pumping increases costs for others; and excessive production of greenhouse gases by one country that causes a climate change affecting all countries.

The use of antibiotics in healthcare is another example of the tragedy of the commons. Patients benefit from the liberal use of antibiotics, but society suffers because overuse speeds the development of antibiotic-resistant strains.

The flip side of the tragedy of the commons is a network external- ity—a value each additional user adds for existing users. Communications equipment of all sorts promotes network externalities. Electronic health record systems are a good example. An electronic health record system is valuable to a hospital. It transmits records quickly throughout the hospital, and any physician can instantly access a patient’s record. If the other hos- pitals in town adopt compatible systems, the value of that electronic health record system increases. Its value increases further if all providers in the country adopt compatible systems. The hospital will be able to offer more appropriate treatment to an emergency department patient from another town because it will have access to that patient’s past treatments, test results, and vital signs.

Standards also promote network externalities. For example, one rea- son that healthcare costs are high in the United States is the absence of widely

network externality The effect each additional user of a product or service has on the value of that product or service to existing users.

EXHIBIT 16.1 Market Equilibrium with External Benefits

D S

S

Q P

Q S

D P

Pr ic

e

Quantity

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Economics for Healthcare Managers264

accepted standards for billing. Insurers have their own systems, and providers must submit bills in a wide range of formats to be paid in a timely fashion. If two insurers adopt a common standard, they will save some money, but hospitals and clinics (which are not parties to the decision to standardize) will save even more. The value of this standardization increases as more and more insurers join.

16.2.2 Public Goods A public good is an extreme example of externalities. A pure public good has two unusual characteristics: Consumption by one person does not pre- vent consumption by another, and exclusion is difficult. One person’s use of a pure public good does not interfere with another’s use of it, resulting in nonrival consumption: The marginal cost of letting one more person use the public good is zero. For instance, my enjoyment of clean air in the country does not limit your enjoyment of it. Alternatively, I can use the new research you are using. In addition, preventing people from using pure public goods is difficult, so their use is nonexcludable consumption, meaning that everyone has access to them.

A radio broadcast illustrates the difference between these two con- cepts. When a program is broadcast, anyone in the reception area can get the signal. Adding another listener does not affect current listeners, so consump- tion of the broadcast is clearly nonrival. In contrast, a radio broadcast may or may not be excludable. Most commercial radio in the United States does not exclude any potential listeners, but SiriusXM satellite radio is only available to subscribers, so exclusion is possible. Because exclusion is possible, radio broadcasts are not public goods.

In contrast, a reduction in levels of sulfur dioxide in the air is a public good. One person’s enjoyment of better air quality does not prevent another person from enjoying it too, so consumption of improved air quality is non- rival. In addition, preventing anyone from taking advantage of cleaner air would be hard to imagine, so consumption is nonexcludable.

Markets are not likely to result in the right amounts of public goods being consumed. If market transactions lead to any consumption of public goods, the quantities are likely to be too small.

Because everyone can simultaneously enjoy a public good, the mar- ginal benefit of a public good equals the sum of the marginal benefits for everyone in society. So, if a 1 percent reduction in sulfur dioxide in the atmo- sphere is worth $1 to Jordan, $2 to Kim, and $4 to Logan, it will be worth $7 to the three of them. The marginal benefit to society is the sum of the marginal benefits to the members of society, and the members of this three- person society should be seeking an outcome in which the marginal benefit to society equals the marginal cost.

public good A good whose consumption is nonrival and nonexcludable.

nonrival consumption Use by one person that does not prevent simultaneous use by another person.

nonexcludable consumption The situation that occurs when preventing use by someone who did not pay for a product is infeasible.

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Chapter 16: Government Inter vention in Healthcare Markets 265

Exhibit 16.2 illustrates this situation. If the three members of society act independently, only Logan will pay for sulfur dioxide reduction and the level chosen will be small. At this cost, Jordan and Kim will be unwilling to pay for any reduction in sulfur dioxide, although they will benefit from Logan’s spending. However, they will be willing to pay for a much larger reduction in sulfur dioxide if they recognize that reducing sulfur dioxide lev- els is a public good and pool their resources. This level of reduction, which equates the marginal benefit and marginal cost, would be optimal for this three-person society.

Cooperation could therefore lead to an optimal result. The difficulty is that Jordan would be even better off if Kim and Logan paid for the reduction in sulfur dioxide. After all, Jordan will benefit whether he pays or not. This situation is called the free rider problem. In a three-person society everyone could probably be persuaded to pay, but cooperation is less likely to be pos- sible in a society of 3 million or 300 million people.

free rider Someone who benefits from a public good without bearing its cost.

EXHIBIT 16.2 Demand for a Public Good

To Vaccinate or Not

When students start school, they have to prove that they were vaccinated against diseases such

as chicken pox, polio, and measles, which can spread quickly through an unprotected group. Students with compromised immune systems can be exempted from the requirement because the immunizations might be dangerous to them. In most states, parents also can get exemptions based on personal beliefs.

Case 16.2

(continued)

+D Kim

+D Jordan

D Logan

Q Logan

Q Social

S

Sulfur Dioxide Reduction

W ill

in gn

es s

to P

ay

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Economics for Healthcare Managers266

California Senate Bill 277, passed in 2015, eliminated personal-belief exemptions. The law was prompted by a measles outbreak that started

at Disneyland in 2014 and infected more than 150 people. That out- break was likely exacerbated by low vaccination rates.

California’s law sought to remove personal-belief exemptions to increase vaccination rates and herd immunity, a form of indirect protec- tion that occurs when a large percentage of a population has become immune. Herd immunity helps protect people who, because of medi- cal reasons, cannot be vaccinated and are vulnerable to infections. It seems to have worked. The percentage of California’s kindergartners with all required vaccinations rose from 93 percent in fall 2014 to 96 percent in fall 2016 (Lin 2017).

Not everyone supported Senate Bill 277. The president of A Voice for Choice, a group that opposed the bill, was quoted as saying, “It’s not right for children to be prevented from going to school because of their vaccination status” (Siripurapu 2016). This opinion appears to be a minority view, as a referendum to repeal the law got too few signa- tures to make the ballot. “It’s going to ensure that all children are safe in school from dangerous, preventable diseases,” said state senator Richard Pan, the bill’s author (Siripurapu 2016).

Discussion Questions • What are the external effects of a vaccine?

• Are people who rely solely on herd effects free riders?

• What are the scientifically verified potential harms of vaccines?

• What are the possible health outcomes of chicken pox, polio, and measles?

• What are the external effects of these diseases?

• Have vaccination rates risen or fallen in the United States?

• Would too few people be vaccinated if it were not mandatory? Is there evidence?

• Are vaccination rates lower in states with personal-belief exemptions?

• What steps do governments take to increase vaccination rates?

• What steps do private companies take to increase vaccination rates? Why?

Case 16.2 (continued)

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Chapter 16: Government Inter vention in Healthcare Markets 267

16.2.3 Imperfect Competition At equilibrium in a perfectly competitive market, price equals marginal cost. Producing more volume than that produced at equilibrium would be inef- ficient because the value of the additional output would be less than its cost. In an imperfectly competitive market, however, every producer has some market power, so producers will set prices to make marginal revenue equal marginal cost.

Exhibit 16.3 illustrates an imperfectly competitive market. Because the producer has some price flexibility, marginal revenue is less than price. To maximize profits, the producer sets the price so that marginal revenue (MR) equals marginal cost (a point on the supply curve). As a result, volume will be QP. In a perfectly competitive market, the price would equal marginal cost and volume would be QS.

16.2.4 Imperfect Information and Incomplete Markets The efficiency of market outcomes rests on the assumption that buyers and sellers have perfect information, which is seldom the case in healthcare. As Arrow (1963) argued, the purpose of a visit to a physician is often the reduction of uncertainty; people seek care because they need more complete information. If patients are unsure about the benefit they will gain from a physician visit, they may decide to forgo the visit, which can lead to less-than- optimal market outcomes.

EXHIBIT 16.3 Imperfect Markets and Market OutcomesD

S

MR

Q P

Q S

Quantity

Pr ic

e

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Economics for Healthcare Managers268

Exhibit 16.4 illustrates three possible outcomes for this scenario. D1, D2, and D3 describe different consumers’ willingness to pay for care. D1 rep- resents the willingness of a consumer who correctly understands the value of a physician visit. Given the marginal cost of producing this information, the consumer will buy Q1. D2 describes the willingness of a consumer who overstates the value of a physician visit. This consumer will buy Q2, which is substantially larger than Q1. More important, the true value of the visit at Q2 is well below marginal cost. (The true value lies on the D1 demand curve.) This individual would be better off reallocating spending to other products. Finally, D3 describes the willingness of a consumer who understates the value of a physician visit. In this example, the consumer makes no visits and forgoes all the benefits those visits might have provided. This consumer would be better off reallocating spending from other areas to physician visits. In short, we cannot be sure that the market outcome will be optimal if information is imperfect.

The situation is even more complex than exhibit 16.4 suggests. Phy- sicians and other experts may have discretion in recommending services. Even after a service has been provided, the consumer may have difficulty ascertaining whether the expert made the best recommendation, especially if the expert reaps large profits from the recommended service. Insurance further complicates matters. Insurers have difficulty tracking the true costs of services, and the conven tional wisdom is that slow adjustments in insurance fees distort the profitability of some services. For example, the cost of MRI (magnetic resonance imaging) equipment has dropped sharply even as the

EXHIBIT 16.4 Market

Outcomes with Imperfect

Information

Quantity

D 1

D 2

S

Q 2

Q 1

D 3

Pr ic

e

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Chapter 16: Government Inter vention in Healthcare Markets 269

quality of images has increased and the time needed to obtain an image has gone down. As a result, the cost of produc ing a scan dropped, but prices for scans went down only slowly. As a result, MRI scans became so profitable that many individual physicians began installing them in their offices, and the use of MRI scans increased rapidly. Growth has slowed considera bly, as coverage has become more restrictive and patients face higher copay ments (Andrews 2017).

16.2.5 Natural Monopoly If fixed costs are so high that only one firm can survive in the long run, that firm is a natural monopoly. Monopolies develop relative to the structure of costs and the size of the market. In a small market, only one hospital may be able to survive. In a larger market, multiple competitors can thrive.

The larger the investment needed to set up a firm, the more likely the firm is to be a natural monopoly. If an imaging center has fixed costs of $20 million, it will be a natural monopoly in many markets. If an imaging center has fixed costs of $2 million, it will be a natural monopoly only in the smallest markets. Like any monopoly, natural monopolies tend to sell their products and services at overly high prices, resulting in low sales.

16.2.6 Income Redistribution A substantial part of government spending can be described as insurance or redistribution. Medicaid and Social Security Disability Insurance are exam- ples. Taxes are levied on the healthy and wealthy to provide medical care and income to those less fortunate.

Redistribution is usually rationalized in one of two ways. One views redistribution as a public good. We all have some sympathy for the unfor- tunate, and we all benefit if someone offers them aid. Individual gains are small, however, and we may be tempted to let others provide our share of the redistribution. People who obtain a benefit at another’s expense or without the usual cost or effort are free riders. Free riding results in underprovision of the public good.

A related approach introduced by Rawls (1971) argues that if we were ignorant of our circumstances, we would want a society that allowed for some redistribution. In this approach, we would decide on how much redistribu- tion was appropriate behind a “veil of ignorance,” meaning that we would not know whether we were healthy or unhealthy, wealthy or poor.

16.3 Remedies

The remainder of this chapter explores possible remedies for market failure. Remember that doing nothing is always an option. Government intervention

natural monopoly A market that can be most efficiently served by a single firm.

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Economics for Healthcare Managers270

will not necessarily improve the situation. Governments also fail, and inter- vention could even worsen the situation.

16.3.1 Assignment of Property Rights Many externalities result from ambiguities about the ownership of property rights. For example, does a downstream city have a right to clean water, or does an upstream city have a right to use a river as a sewer? Often the first step in solving externality problems is defining who has the right to use an asset. Once users are defined, asset sales, private agreements, regulations, or taxes can be used to produce efficient outcomes.

An influential analysis by Coase (1960) pointed out that ambiguity about property rights underlies many externality problems. As long as the costs of reaching and enforcing an agreement are small, the people involved in an externality case can reach agreements that solve the problem. For example, if the upstream city has the right to pollute, the downstream city can pay it to refrain from polluting the river. If the downstream city has the right to pure water, the upstream city will have to pay for the right to pollute (and will usually find it can pay less if it limits its pollution). Either way, the property owners can reach an efficient solution. With unclear property rights, who should pay whom is unclear, and too much of the externality is likely to be produced. If it is not clear that the upstream city has to pay for the right to pollute or it is not clear that the downstream city has to pay to prevent pollution, the upstream city is likely to underestimate the cost of pollution as a way of disposing of waste and dump too much waste into the water.

If an externality affects many people or is caused by many people, the costs of reaching and enforcing an agreement will be high. As a result, workable private agreements will be hard to reach. For example, pollution of Chesapeake Bay is caused by millions of people and affects millions of people. In such cases, governments typically claim property rights and use a variety of tools to improve outcomes.

In recent years, governments have taken steps to create markets for pollutants. First, the government asserts its ownership of the property right affected by pollution. Then, firms or jurisdictions are issued permits to pollute. These permits are worth more to firms or jurisdictions that have difficulty reducing pollution and are worth less to firms that reduce pollu- tion more easily. Trades among potential polluters establish a price per unit of pollution and push potential polluters to equalize the costs of pollution reduction. Firms that incur low costs to reduce pollution have an incentive to do more to clean up than do firms that incur high costs to reduce pollution; the latter buy permits so that they can limit their cleanup efforts.

The 1990 Clean Air Act amendments set national caps for emission of sulfur dioxide by power plants, issued permits equal to this cap to plants,

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Chapter 16: Government Inter vention in Healthcare Markets 271

and allowed plants to trade permits. This program significantly reduced emis- sions of sulfur dioxide, and most observers consider it a success. The price of compliance was low, so compliance was high, and firms were encouraged to innovate to reduce emissions.

16.3.2 Taxes and Subsidies If a product generates significant external benefits, a subsidy can be used to make the market outcome more efficient. Whether the subsidy goes to pro- ducers or consumers does not matter. Either way, the market price will fall and consumption will rise.

Exhibit 16.5 illustrates the effects of a subsidy. The demand curve D1 describes the willingness of consumers to pay for a product. Because it yields external benefits, the market outcome will be Q1, which is inefficiently small. Giving consumers a subsidy will expand consumption to Q2, which will be the efficient level if the right subsidy has been chosen. Alternatively, one could subsidize producers, thereby reducing the marginal cost (and shifting out the supply curve). This subsidy will also cause consumption to increase to Q2.

If this product generated external costs, a tax could be imposed to reduce consumption. The challenge with the tax or subsidy is determining the appropriate rate. Changing tax or subsidy rates is not an easy political process, and the market will not always make the appropriate rate evident.

EXHIBIT 16.5 Market Outcomes with a Subsidy

Q 1

Q 2

S Subsidy

D Subsidy S

W ill

in gn

es s

to P

ay

Quantity

D 1

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16.3.3 Public Production Public provision of products is another approach to market failure. Public provision is especially useful for pure public goods. When significant exter- nalities are present and excluding certain potential customers is difficult or inefficient, public provision may be the best response. Even if private firms can profitably produce some of the output consumers seek, using prices (as private firms must) to pay for such products is undesirable. For example, private research firms might be able to profitably conduct some public health research by disseminating the results only to organizations that pay to get access to it. But this approach is inefficient because too few people will get access to the research. The cost of sharing the results with additional orga- nizations is small, and the value of the research is not reduced if it is more widely shared.

If redistribution is a goal, using prices to affect product consumption may also be undesirable. For example, prices that are high enough to allow a clinic to survive may also be high enough to prevent low-income citizens from using the clinic.

Public provision does not necessarily mean public production. For example, medical research has many of the attributes of public goods. Although government employees perform medical research, a large share of research is performed by scholars who are not government employees but private researchers competing for tax-supported research funds. In another example of public provision with private production, medical care for the poor is usually provided to improve the health of our least fortunate citi- zens, meaning that the goal is largely redistribution. In some cases, this care is provided by government hospitals and clinics. More commonly, though, care is provided by private hospitals and clinics but funded by tax-supported programs such as Medicaid.

16.3.4 Regulation The next chapter examines regulation. Regulation is an important form of government intervention in markets, especially in healthcare. Markets need rules to work, so regulation is not an alternative to markets. Some regulations cause markets to work well; other regulations have the opposite effect.

16.4 Conclusion

Markets have many virtues, not the least of which is the ability to reveal information about cost and value. Many forms of government intervention falter because key information about cost and value is lacking. In addition, the impulse to innovate inherent in markets is important for improved health

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Chapter 16: Government Inter vention in Healthcare Markets 273

and well-being. A long-standing criticism of governments is their bias toward inaction and the status quo.

A key question about government intervention is hard to answer: Will intervention improve the well-being of the public? Intervention will not necessarily improve an imperfect market. Effective interventions are hard to design and even harder to implement. In the rough-and-tumble of political life, good intentions do not always translate into good effects, and proposals backed by advocates are not always good ideas. Furthermore, government interventions can improve the well-being of individuals or groups even if the interventions do not improve overall well-being.

This critique should not be pushed too far. Government support for research has problems, but the strong consensus seems to be that the over- all benefits are considerable and that government action is necessary. The government’s public health activities also have problems, but there is no consensus that ending these activities would make our citizens better off. On the other hand, some interventions should be ended. The challenge is to determine what new programs to start and which existing programs to expand, contract, or terminate.

Exercises

16.1 Global warming is a classic example of a public good. Analyze this comment and explain your answer.

16.2 The existence of market failure does not signal what should be done in response. Analyze this comment and explain your answer.

16.3 Imperfect competition is the norm, so healthcare markets cannot work. Analyze this comment and explain your answer.

16.4 Markets work; governments do not. Analyze this comment and explain your answer.

16.5 Are market forces strong enough to deliver efficient healthcare? Please explain.

16.6 For each scenario, assess whether an externality is present. a. Vaccinating children against influenza reduces its incidence

among the elderly. b. Newly graduated nurses flock to teaching hospitals for training.

After working for a year, many leave to work for competitors. c. A couple who planned to move to Florida to retire find that the

plummeting housing market has wiped out their equity. d. Physicians complain that they spend a third of their time

explaining to patients why television advertisements about medications for their conditions do not apply to them.

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16.7 The supply of measles vaccine is given by Q = 450 × P. The demand for measles vaccine is given by Q = 20,000 − 50 × P. a. What is the market equilibrium price and quantity? b. The demand curve implies that private willingness to pay is P =

400 − Q/50. However, external benefits are associated with each measles vaccination, so the social demand curve is Q = 20,000 − 50 × (P − 5). What are the equilibrium price and quantity if these external benefits are considered?

c. Propose an intervention that will result in this equilibrium volume. 16.8 The supply of an antibiotic is Q = 30 × P − 200. The demand for it

is Q = 8,800 − 20 × P. a. What is the market equilibrium price and quantity? b. Use of the antibiotic creates $20 in external costs due to water

pollution. Would the market outcome be different if a $20 tax were levied on producers instead?

16.9 Vaccination schedules are predictable, meaning that insurance coverage for vaccinations does not protect consumers against risks. Insurance coverage for vaccinations drives up costs because more people get vaccinated if coverage is available and because insurers have overhead costs. Does insurance coverage for vaccines do anything useful? Explain your answer.

16.10 About two-thirds of funding for substance abuse treatment comes from taxpayers. Does substance abuse treatment have external benefits that warrant this level of public funding?

16.11 Provide examples of the following types of government intervention in healthcare: a. Government production b. Subsidies for products c. Taxes on products d. Price regulation e. Quality regulation f. Inaction

16.12 Provide healthcare examples of the following types of market failure: a. External benefits b. External costs c. Public goods d. Imperfect competition e. Imperfect information

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Chapter 16: Government Inter vention in Healthcare Markets 275

16.13 Private foundations support medical research. Does this fact prove that tax funding of medical research is unnecessary? Please explain.

16.14 Public health information can be broadcast at a cost of $100. Public health information is a pure public good, in that many people can use the information simultaneously and preventing people from using the information is difficult. One group of residents has a demand curve for public health information of the form Q = 50 − P. Here Q is the number of public health broadcasts per month and P is the price per broadcast. Another group has a demand curve of Q = 140 − P. a. At a price of $100 per broadcast, how many broadcasts per

month will be demanded? (Add the quantities demanded by each group.)

b. What is the total willingness to pay for 85 broadcasts? (Recast the demand curve to reveal willingness to pay and add the amounts for the two groups. For one group, willingness to pay equals 50 − Q. For the other, it equals 140 − Q. For both groups the minimum is $0.)

c. At what level of output does willingness to pay equal $100? d. What do these results imply?

16.15 Every 1 percent reduction in the level of particulates in the air costs $200,000. Low-income residents in a region have a demand for particulate reduction of R = 10 − P, where R is the level of particulate reduction and P is the price per 1 percent reduction. High-income residents have a demand for particulate reduction of R = 40 − 2P. a. Is reduction of the level of particulates a public or private good? b. What will the market demand for particulate reduction be? c. What is the optimal level of particulate reduction?

16.16 Few orthopedic surgeons publish data describing their surgical volumes, infection rates, mortality rates, functional gain rates, or customer satisfaction rates. a. How much would a regulation requiring publication of such data

cost? b. Would such a regulation improve the workings of the market? c. Would such regulation be an appropriate government activity? d. Do we need a regulation requiring publication of data for

surgeons if private physician rating firms already exist?

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