The first fundamental theorem of welfare economics states that, if consumers maximise utility and producers maximise profits, the resulting competitive equilibrium allocation of resources is Pareto Efficient under the following assumptions:
- Perfect competition
- Large number of consumers and firms
- Homogenous products
- Free entry to and exit from the industry
- Complete and perfect information
- No externalities or public goods
- Complete markets
- Negligible transaction costs and therefore also perfect information
- Price existing for every asset in every possible state of the world
- No asymmetric information
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Violations of Perfect Competition
Violation due to restricted number of firms
The 1st assumption, perfect competition, can be violated in health care markets. In a perfectly competitive market, a firm will be a price taker because the product produced by a single firm is small relative to the market size. However, there are situations (e.g. Monopoly) where the price the firm can charge depends on how much they produce. This is called the Market Power and may lead to allocative inefficiency. Market power is a huge feature in health related markets because:
- Hospital competition has strong geographic component
- Patents in pharmaceutical and device markets
- Safety regulation leading to barrier to entry
- Large economies of scale in health care provision
- Distinctive feature of health care as a commodity
Under perfect competition, the firm's choice of output does not affect the price, and therefore the firm faces a horizontal demand curve: (Average Revenue: AR)=(Marginal Revenue: MR)=(Price: P) On the contrary, under monopoly, the firm's choice affects the price. An extra unit of production will lead to lower price for all infra-marginal units of products. Therefore, the firm faces a downward-sloping demand curve.
If this downward-sloping demand curve was defined as AR=P(Quantity: Q)=a-bQ, the revenue of the firm will be R=P(Q)*Q=(a-bQ)*Q. Thus the marginal revenue for the firm will be MR=dR/dQ=a-2bQ, and the marginal revenue curve lies below the average revenue curve. The monopolist will choose the quantity of output which will maximise the benefit for the firm, which is where the marginal revenue equals the marginal cost: MR=MC. Because the allocatively efficient quantity for the society will be where the Average revenue curve and marginal cost curve intersect, the quantity produced by the monopolist will be inefficient: they have restricted the output in order to be able to charge a higher price and maximise their benefit.
Similar discussion can be applied to other forms of market power such as oligopoly (small number of producers) . If there are more competitors, the demand curve becomes flatter.
Violations due to product differentiation
Restricted number of firms are not the only way perfect competition can be violated. It can also be achieved by product differentiation. Since firms will have some capacity to raise prices without losing all their demand, product differentiation will generally lead to market power, and therefore analysis by the monopoly model will be useful.
Spence (1975) defined total demand as a function of monopolists choice of output Q and quality Z: Qd(P, Z). Higher price will lead to lower demand (price elasticity of demand is negative) and higher quality will lead to higher demand (quality elasticity of demand is positive). At the same time, the total cost C(Q, Z) is defined as an increasing function of both Q and Z. The firm's objective is to choose Q and Z that maximises their benefit: R(Q, Z)=P(Q, Z) - C(Q, Z). The level of Q and Z will depend on the consumers elasticity of demand against these factors. With regards to quality, the firm will choose Z equal to the marginal willingness to pay of Z for the marginal consumer, while socially efficient Z would be an average willingness to pay for Z. Therefore, if infra-marginal consumers have higher willingness to pay for quality than the marginal consumer, firms may provide lower quality than what would be socially efficient (a marginal consumer has a lower willingness to pay for a unit of output, so it seems likely that they will have a lower willingness to pay for quality as well).
This discussion can be extended to multiple competitors by adding a function of N (number of competitors) in the model: Qd(P, Z, N). Firms now compete on both price and quality, and the effect of competition depends on the elasticity of demand on price and quality. If quantity demanded is very responsive to price but not to quality, increase in competition will likely lead to lower quality. In health care, since the quality of care is poorly observable compared to the price, more competition often leads to lower quality (providers often compete on price at the expense of quality). A typical policy reaction against this issue is prospective reimbursement of care. If prices are set in advance, firms can only compete on quality.
Further considerations: Natural Monopoly & Economies of scale
If monopoly is always bad, the solution would be simple: we can simply break them up. However, things can get more complicated due to "Natural Monopoly". Natural monopoly rises in an industry in which average cost per unit is minimised when all output are produced by a single firm, rather than by multiple smaller firms (e.g. if total cost is constructed by a fixed cost and a constant variable cost, the average cost will be minimised by a single producer). Although natural monopolist might produce outputs efficiently with less cost, they will still exploit market power by restricting the quantity of the output. Thus, policy planners will face a trade-off between: 1) encouraging economies of scale; 2) encouraging competition to discourage market power abuse.
In health care,
- Economies of scale with respect to quality as well as quantity
- Effect of competition on quality
must be considered in discussing this issue.
With regards to the impact of economies of scale, there is substantial evidence implicating a positive 'volume-outcome relationship'. This can also be interpreted as a negative relationship between cost and quantity. The effect of competition on quality depends on whether the price is regulated. If firms set price as well as the quality, competition will likely lead to lower quality as discussed above. In this case, there will be no regulatory trade-off on the quality of care (although there may be with respect to costs). If the price is set by the government, competition is more likely to lead to higher quality and there is a regulatory trade-off. So far, empirical evidence on practice shows conflicting results. There seems to be little convincing evidence that merger would lower costs and improve outcomes. By contrast, some evidence show that greater fixed-price competition between NHS hospitals have led to improved clinical quality.