1 1 Market Failure Farid Abolhassani Learning Objectives
1 1 Market Failure Farid Abolhassani
Learning Objectives After working through this chapter, you will be able to: � Categorize and describe the activities of government � Describe why monopoly power, externalities and information asymmetries constitute market failures � Explain the consequences for price, output and efficiency for each market failure � Explain how monopoly power, externalities and information asymmetries manifest themselves in the health care market � Suggest some possible government strategies for
Key Terms Adverse Selection When a party enters into an agreement in which they can use their own private information to the disadvantage of another party. Barriers to entry Factors which prevent a firm from entering a market. Deadweight loss The loss in allocative efficiency resulting from the loss of consumer surplus is greater than the gain in producer surplus. Externality Cost or benefit arising from an individual’s production or consumption decision which indirectly affects the well-being of others. Fee-for-service A means of paying health care staff on the basis of the actual items of care provided. Monopoly power Ability of a monopoly to raise price by restricting output.
Key Terms Moral hazard A situation in which one of the parties to an agreement has an incentive, after the agreement is made, to act in a manner that brings additional benefits to themselves at the expense of the other party. Natural monopoly A situation where one firm can meet market demand at a lower average cost than two or more firms could meet that demand. Price discrimination Offering the same product at different prices to different people. Public good A good or service that can be consumed simultaneously by everyone and from which no one can be excluded. Social cost Private cost plus external cost. Supplier-induced demand Increased demand as a result of a provider (e. g. a doctor) exploiting an asymmetry of information. Transaction costs The costs of engaging in trade – i. e. the costs arising from finding someone with whom to do business, of reaching an agreement and of ensuring the terms of the agreement are fulfilled.
Main Areas of Government Activity �Redistribution of wealth and income; �Stabilization of the macro-economy (to keep unemployment, inflation and economic growth at reasonable levels); �Correction of microeconomic market failure. �Ensuring and protecting public goods; �Controlling monopoly power; �Reducing externalities; �Reducing asymmetry of information.
Public Good A public good is “a good or service that can be consumed simultaneously by everyone” and from which no individuals can be Is healthexcluded care a public good?
Perfect Competiti
Demand, Price and Revenue in Perfect Competition
Total Revenue, Total Cost and Economic Profit
Profit-maximizing Output
Three Possible Profit Outcomes in the Short -Run
A Firm’s Supply Curve • If a firm shuts down and produces no output, it incurs an economic loss equal to its total fixed cost. • This loss is the largest that a firm need incur. • A firm shuts down if price falls below Industry Supply the Curve minimum average variable cost.
Short-run Equilibrium
Entry and Exit
Monopoly
Market Power Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale. Firms in perfect competition have no market po
Monopoly A monopoly is a firm that produces a good or service • for which no close substitute exists and ; • which is protected by a barrier that prevents other firms from selling that In monopoly, the firm is the industry good or service
Barriers to Entry �Legal barriers �Monopoly franchise �Government license �Patent �Copyright �Natural barriers �An industry in which one firm can supply the entire market at a lower price than two or more firms can
Natural Monopoly LRAC: Long Run Average Cost
Monopoly Price-setting Strategies �Price discrimination �Single price
Price and Marginal Revenue
Marginal Revenue and Elasticity A profit maximizing monopoly never produces an output in the inelastic range of its demand curve
A Monopoly’s Output and Price Decision
A Monopoly’s Output and Price A monopoly produces the profit-maximizing quantity and sells that quantity for the highest price it can get
Single-price Monopoly and Competition Compared What will happen if a single firm buys out all small firms and creates a monopoly? �Will the price rise or fall? �Will the quantity produced increase or decrease? �Will economic profit increase or decrease? �Will either the original competitive situation or the new monopoly situation be efficient?
Monopoly’s Smaller Output and Higher Price Compared to a perfectly competitive industry, a singleprice monopoly restricts its output and charges a higher price.
Inefficiency of Monopoly
The Effects of Monopoly on Consumer Interests �It produces less �It increases the cost of production �It increases the price above the increased cost of production
Price Discrimination Price discrimination is charging different prices for a single good or service because of differences in buyers’ willingness to pay and not because of differences in production costs
Requirements of Price Discrimination To be able to price discriminate, a monopoly must: �Identify and separate different buyer types �Sell a product that can not be resold
Price Discrimination Methods �Among units of a good: Charging each buyer a good different price on each unit of a good bought �Among groups of buyers: Charging different buyers groups of buyers differently
Price Discrimination among Groups of Buyers
Perfect Price Discrimination The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive output and the more efficient is the outcome.
Gains from Monopoly �Incentives to innovation �Economies of scale and economies of scope
Regulating a Natural Monopoly
Externalities
Definition �Production Externality: A cost or a benefit that arises from production of a good or service and falls on someone other than the producer �Consumption Externality: A cost or benefit that arises from consumption of a good or service and falls on someone other than the consumer
Classification � Negative production externalities: Environmental pollution � Positive production externalities: Orange blossom honey production � Negative consumption externalities: Smoking � Positive consumption externalities: Vaccination
An External Cost How is an external cost valued?
Inefficiency with an External Cost
Property Rights Achieve and Efficient Outcome
Government Actions in the Face of External Costs �Taxes: Taxes setting the tax rate equal to the marginal external cost �Emission Charges: Charges setting a price per unit of pollution �Marketable Permits: Permits issuing each firm a permit to emit a certain amount of pollution, and firms can buy and sell these permits
A Pollution Tax
An External Benefit
Government Actions in the Face of External Benefits �Public provision �Private subsidies �Vouchers �Patents and copyrights
Public provision or Private Subsidy to Achieve an Efficient Outcome
Vouchers Achieve an Efficient Outcome
Asymmetric Information
Asymmetry of Information �Asymmetry of information exists when one person in an economic transaction has more relevant information than the other person. �It requires that the cost to the uninformed person of accessing this information is prohibitively high
Types of Asymmetrical Information �Moral hazard exists when one of the parties to an agreement has an incentive after the agreement is made to act in a way that brings him or herself benefit at the expense of the other party �Adverse selection is the tendency for people to enter into agreements in which their personal information can be used to their own advantage over less informed parties
Market Failure In Health Care
Market Failure in Health Care �Failure of the health insurance market �Health care externalities (already discussed) �Failure of the health care market
Failure of the Health Insurance Market �Why is there a lack of competition in the health insurance market? Economy of Scale �What policies are used to counteract moral hazard in the health insurance market? �What groups of people are likely to be without health insurance?
Policies to Counteract Moral Hazard �Consumer side: �Co-payments �Deductibles �Putting an upper limit on the payout �Provider side: �Prospective payments (HMOs) �Building protocols into their contracts
Uninsured Groups �Those who consider themselves to be of low risk but cannot find an insurance policy that reflects this low risk �Those at high risk who cannot afford to pay an actuarially fair premium
Causes of Health Care Market Failure �Barriers to entry and exit: Licensing �Monopoly power even when there are many providers �Asymmetrical information �Heterogeneous services
Unexpected Market Response Price D D’ S S’ P’E PE P 1 QE Q 1 Q’E Quantity
Major Features of Health Care �Uncertainty and risk �Derived demand �The health itself is invaluable �Asymmetrical information �Supplier-induced demand �Extreme importance of equity Catastroph ic health expenditur e
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