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
- No asymmetric information
- Complete markets
- Negligible transaction costs and therefore also perfect information
- Price existing for every asset in every possible state of the world
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Violations due to Externalities, Internalities & Public Goods in Health Care
Externalities exist when:
- One agent's actions make another agent worse/better off
- The first agent does not incur a cost/ receive a benefit as a result of their effect on the second agent
If consumers maximise utility and firms maximise profits, they do not take into account the effect of their decision on others, leading to a market failure.
The most traditional and important policy response to externalities are Pigouvian taxes and subsidy. Pigouvian tax set taxes on goods with negative externalities, so that consumption reduces to socially efficient level. Subsidies, subsidises goods with positive externalities, so that consumption increases to socially efficient levels. These try to internalise the cost/benefit of their actions on others.
Internalities imply that perceived private marginal benefits of consumption are different from actual private marginal benefits of consumption. Internalities often occur when buying goods involves present cost with future benefit. When this happens, a behavioural Pigouvian subsidy equal to the difference between self-perceived and actual private marginal benefits of consumption may move the consumption to the individually optimal level.
Public goods, which is
- non-rival: one person's consumption of good does not prevent others from also consuming it
- non-excludable: if the good is provided for one person, it is impossible to exclude others from enjoying the benefits
can cause market failure. It is an extreme case of positive externalities. If one provides/consumes a good, all others will benefit. However, the provider/consumer will not take this into account, and therefore do not contribute enough to reach a socially efficient level. It is also subject to a free rider problem, which gives people an incentive not contribute in hope that others will. This often leads to funding via tax system and provision by the government.
Violations due to Information Asymmetries in Health Care
In situations where either consumers or producers can have an advantage due to asymmetries of information, prices cannot operate effectively to signal true demands or costs and this will lead to market failure.
Health care is often regarded as a credence good. It is difficult or even impossible for a consumer to evaluate the goods' characteristics, quality, and utility even after consumption. This contrasts with others such as search goods (goods that are easy to evaluate before consumption) or experience goods (goods that are possible to evaluate after consumption but not before). This characteristics of health care as a credence good is often explained by its:
- Complexity: patient can evaluate how they feel after receiving treatment, but specialist medical knowledge is required to understand the extent to which post-treatment health state is due to treatment, or to know what kind of outcome an alternative treatment would have resulted.
- Uncertainty: there is no 1-to-1 relationship between inputs (treatments) and outputs (health status).
- Lack of information: patients generally lack information about their diagnosis, possible treatments, and prognosis.
The relationship between patients and doctors can be seen as a principal-agent relationship. This is a relationship in which a principal enters into a relationship with an agent in order to get the agent to undertake a specific task. One might seek for such a relationship because the agent has more information to carry on the task, or because the principal cannot undertake the task while the agent can. The problem is that this relationship may not always end up ideally under asymmetric information between the principal and the agent. In the case of health care, it is hard for the patient to assess the efficacy of the contractual relationship between the doctor due to the credence nature of health care. Moreover, the problem can be worsened by the third party payment often seen in health care. Because patients rarely pay directly for the care they have received, the have less incentives for vigilance over the cost implications of their decisions.
One typical consequence of asymmetric information between doctors and patients is the possibility of physician-induced demand. There might be excess of demand from what a patient would have chosen if they had the same information and knowledge as the physician. This is a potential feature of any market for a credence good. It is often difficult to empirically support this argument, but some studies argue:
- Positive relationship between doctor/population ratios and health care prices or utilisation rates per capita.
- Wide variation in utilisation between areas in the same country and between countries.
- Relationship between physician reimbursement rates & levels of health care services provided.
However, these form of evidence are prone to underlying health status of the population and therefore might be biased. Other more reliable studies feature on exogenous changes in demand conditions, or exogenous changes in reimbursement rates.
There are many theories explaining how this occurs, one of which is presented by Dartmouth Atlas of Health Care. It divides health care into: 1) effective care; 2) preference-sensitive care; 3) supply-sensitive care. Physician-induced demand may not necessarily be driven by doctors' income-maximising behaviour, but may be driven by preference-sensitive care (a care whose health benefits are low or unknown, so utilisation depends on supply). In this case, physician-induced demand is more of a consequence of the huge uncertainty concerning benefits of treatments, leading doctors to refer patients when there is spare capacity.
Further consideration: Association between Asymmetric Information & Monopoly
Particular characteristics of health care as a commodity might give doctors a monopolistic power in the market due to asymmetry of information. As the degree of specialisation, indivisibility, uncertainty and lock-in increases, the number of providers may decrease and doctor's would regain monopoly power, and policy challenge may arise on how to regulate this.
- Specialisation: as the complexity of the disease or treatment increases, the fixed costs of acquiring expertise will increase and lead to specialisation. This will lead to increasing returns to scale, and causing economies of scale. At the end, this will result in lower numbers of providers, and confer an increased market power on remaining providers.
- Indivisibility: complex patients with multiple comorbidities make attribution of costs difficult. In this case, the advantage from economies of scope will generate an increasing returns to scale, and confer monopoly power on a single provider of care.
- Uncertainty & lock-in: outcomes in treatment can vary widely even for observationally equivalent patients (often due to unobservable differences or pure chance). Under higher uncertainty of treatment outcomes, it is difficult for the consumer to choose the product because they cannot properly evaluate the utility gain from the product. Furthermore, it is difficult for a patient to switch providers in the midst of treatment, and they can be locked-in to a specific provider. This uncertainty and lock-in may increase market power of care providers.
Common policy response to monopoly:
- Promote competition between multiple providers
- Competitive tendering
- Vertical integration
- Price regulation & prospective reimbursement
- Public ownership / non-profit provision
- Non-market responses (medical self-regulation, external regulation)