3 Basic Steps in Economic Evaluation

1

Structure, Conduct, Performance, and Market
Analysis
2
Characteristics of Perfect Competition

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

3
Characteristics of Perfect Competition (cont.)

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

4
Characteristics of Perfect Competition (cont.)

• No barriers to entry or exit exist.
• New firms can enter the industry.
• All economic agents possess perfect information.
• Consumers and firms can make informed choices.
• All firms face nondecreasing average costs of
  production.
• Rules out a natural monopoly.

5
Market Equilibrium

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

6
Market Equilibrium (cont.)
Dollars per bottle
Supply
P0
Demand
Q0
Market output of generic aspirin (Q)
7
Market Equilibrium (cont.)

• Equilibrium occurs when no tendency for further
  change exists.
• At the equilibrium price of P0, consumers are
  willing to purchase Q0 bottles of aspirin.
• Aspirin manufacturers are willing to sell Q0
  bottles of aspirin at P0.

8
Market Equilibrium (cont.)

• If the price of aspirin is above the equilibrium
  level, there will be a surplus, or excess supply
  of aspirin.
• If the price of aspirin is P1 on the following
  graph, sellers will want to sell QB bottles of
  aspirin, but consumers will only want to purchase
  QA bottles.
• The distance between QA and QB represents the
  amount of excess supply of aspirin.

9
Market Equilibrium (cont.)
Dollars per bottle
Supply
P1
Demand
QB
QA
Market output of generic aspirin (Q)
Excess Supply
10
Market Equilibrium (cont.)

• If the price of aspirin is below the equilibrium
  level, there will be a shortage, or excess demand
  of aspirin.
• If the price of aspirin is P2 on the following
  graph, consumers will want to buy QF bottles of
  aspirin, but sellers will only want to sell QE
  bottles.
• The distance between QE and QF represents the
  amount of excess demand of aspirin.

11
Market Equilibrium (cont.)
Dollars per bottle
Supply
P2
Demand
QF
QE
Market output of generic aspirin (Q)
Excess Demand
12
Comparative Statics

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

13
Comparative Statics

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

14
Comparative Statics (Example 1)

• Suppose consumer income increases by a
  significant amount.
• This increase in income causes the demand curve
  to shift to the right.
• This rise in demand leads to a temporary shortage
  in aspirin, illustrated by the distance EF on the
  following graph.

15
Comparative Statics (Example 1)
Dollars per bottle
S
F
E
P0
D1
D0
Q0
Market output of generic aspirin (Q)
Excess demand
16
Comparative Statics (Example 1)

• The consumers who are willing, but not able to
  buy aspirin at P0 will bid the price of aspirin
  upwards.
• i.e. They will offer sellers more than P0 to buy
  a bottle of aspirin.
• Because sellers are being offered a higher price
  than P0, they will increase their output of
  aspirin above Q0.

17
Comparative Statics (Example 1)

• As the price of aspirin begins to rise above P0,
  consumers reduce their demand for aspirin.
• This process will continue until the market
  reaches a new equilibrium.

18
Comparative Statics (Example 1)
Dollars per bottle
S
New equilibrium
P1
F
E
P0
D1
D0
Q0
Q1
Market output of generic aspirin (Q)
19
Comparative Statics (Example 2)

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

20
Comparative Statics (Example 2)
Dollars per bottle
S0
S1
A
P0
B
D0
Q0
Market output of generic aspirin (Q)
Excess supply
21
Comparative Statics (Example 2)

• The firms that are willing, but not able to sell
  aspirin at P0 will lower the price they charge
  for aspirin.
• i.e. They will offer charge consumers a price of
  aspirin which is below P0.
• Because consumers are being offered a higher
  lower than P0, they will increase their quantity
  of aspirin demanded above Q0.

22
Comparative Statics (Example 2)

• As the price of aspirin begins to fall below P0,
  firms reduce their supply of aspirin.
• This process will continue until the market
  reaches a new equilibrium.

23
Comparative Statics (Example 2)
Dollars per bottle
S0
S1
A
P0
B
New equilibrium
P1
D0
Q0
Q1
Market output of generic aspirin (Q)
24
Comparative Statics (Long run)

• In the short run, firms cannot enter or exit a
  given market.
• i.e. In the short run, no firms producing
  generic aspirin can exit the market, and no new
  firms can start producing aspirin.
• In the long run, new firms will enter a perfectly
  competitive market if there are any profits to be
  made.
• Entry occurs until ? 0.

25
Comparative Statics (Long run)

• In the mid-1980s, the AIDs epidemic led to an
  increase in the demand for latex gloves among
  health care workers.
• The epidemic led to a shift to the right in the
  demand curve for latex gloves.
• Excess demand for gloves developed, leading to a
  temporary shortage of gloves.

26
Comparative Statics (Long run)
Dollars per pair
S
F
E
P0
D1
D0
Q0
Market output of latex gloves (Q)
Excess demand
27
Comparative Statics (Long run)

• The shortage of gloves led buyers to bid the
  price of gloves upwards.
• As the price bid for gloves rose, sellers
  increased their quantity supplied of gloves.
• This process continued until a new short-run
  equilibrium was reached.
• From 1986 to 1990, annual sales of latex gloves
  increased by 58.

28
Comparative Statics (Long run)
Dollars per pair
S
P1
P0
D1
D0
Q0
Q1
Market output of latex gloves (Q)
29
Comparative Statics (Long run)

• Before the epidemic, each glove maker was earning
  0 profits.
• The increase in equilibrium price after the
  epidemic implies that all glove makers are
  earning positive profits.
• ? (P1 x Q1) (Q1 x ATC(Q1))

30
Comparative Statics (Long run)
Dollars per pair
MC
ATC
d1 MR1
P1
d0 MR0
P0
Q0
Q1
Market output of latex gloves (Q)
31
Comparative Statics (Long run)

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

32
Comparative Statics (Long run)
Dollars per pair
S0
S1
P1
P0
D1
D0
Q0
Q1
Q2
Market output of latex gloves (Q)
33
Comparative Statics (Long run)

• As the supply curve for gloves shifts out, the
  price of gloves begins to fall.
• Note that the quantity of gloves sold on the
  market also increases.
• As the price of gloves fall, profits also fall.
• The process continues, until the price of gloves
  falls back to P0, where profits for all glove
  makers are again equal to 0.

34
Comparative Statics (Long run)
Dollars per pair
MC
ATC
d1 MR1
P1
d0 MR0
P0
Q0
Q1
Market output of latex gloves (Q)
35
Characteristics of Perfect Competition

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

36
Monopoly Model

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

37
Monopoly Model (cont.)

• What is the profit-maximizing price and quantity
  for a monopolist?
• Recall that all firms will maximize profits where
  MRMC.
• We have already seen that the marginal cost curve
  for a firm depends on its production function and
  input prices.
• What does the firms MR curve look like?

38
Monopoly Model (cont.)

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

39
Monopoly Model (cont.)
Dollars per unit
If a monopolist wishes to increase its output
sold from Q0 to Q1, it will need to lower the
price it charges from P0 to P1.
P0
P1
Demand
Q0
Q1
Quantity
40
Monopoly Model (cont.)
Dollars per unit
When reducing its price from P0 to P1, the
monopolist loses the difference between P0 and P1
for all units of output up to Q0.
P0
revenue loss
P1
Demand
Q0
Q1
Quantity
41
Monopoly Model (cont.)
Dollars per unit
However, the monopolist also gains the value of
P1 for each increase in output from Q0 to Q1.
P0
P1
gain
Demand
Q0
Q1
Quantity
42
Monopoly Model (cont.)

• The marginal revenue from increasing sales from
  Q0 to Q1 is represented by the revenue gain,
  minus the revenue loss depicted in the 2 previous
  graphs.
• In numerical terms
• MR P Q (?P/?Q)

revenue gain
revenue loss
43
Monopoly Model (cont.)

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

44
Monopoly Model (cont.)
Dollars per unit
Demand
MR
Quantity
45
Monopoly Model (cont.)

• We are now ready to find the profit-maximizing
  output for a monopolist.
• The monopolist sets output at a level where
  MRMC.
• On a graph, find the level of Q where the MR and
  MC curves intersect.
• To determine the price the monopolist will
  charge, locate the price on the demand curve at
  this same output level.

46
Monopoly Model (cont.)
Dollars per unit
MC
P
Demand
MR
Q
Quantity
47
Monopoly Model (cont.)

• The monopolists level of profits can then be
  determined by adding its average total cost curve
  to the graph.
• Profits will be the difference between P and
  ATC, multiplied by Q.

48
Monopoly Model (cont.)
Dollars per unit
MC
P
ATC
Profits
ATC
Demand
MR
Q
Quantity
49
Contrast to Perfect Competition
Dollars per unit
Under perfect competition, the market equilibrium
would instead be where PMC.
MC
ATC
PC
Demand
MR
QC
Quantity
The higher price and lower output in a
monopolized market is why economists claim that
competition is better for social welfare.
50
Monopoly Model (cont.)

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

51
Monopoly Model (cont.)

• Economies of scale
• 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.
• A monopoly hospital in a small town may have
  substantial economies of scale if it can meet
  demand with only 40-50 beds.
• Unless a new hospital could take away a
  substantial share of the existing hospitals
  patients, it could not match the existing
  hospital in costs (and therefore profits as
  well).

52
Monopoly Model (cont.)

• Legal restrictions
• Physicians require a license to practice
  medicine.
• Many states require that providers obtain a
  Certificate of Need to offer a new service.
• Drug companies obtain patents for new
  pharmaceutical products.

53
The Market Structure Continuum

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

54
The Market Structure Continuum
Perfect Competition
Oligopoly
Monopoly
Monopolistic Competition
55
Monopolistic Competition

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

56
Monopolistic Competition (cont.)

• Because products are differentiated across firms,
  each seller has some ability to control price.
• Each seller faces a slightly downward sloping
  demand curve.
• Sellers have an incentive to differentiate
  their product from competitors.
• Doing so is likely to raise demand for their
  product.

57
Monopolistic Competition (cont.)
Dollars per Unit
Demand under monopolistic competition
Demand under perfect competition
Output
2 potential demand curves for an individual firm.
58
Oligopoly

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

59
Oligopoly

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