Government Regulation Government Regulation and Interventionand Intervention

Part 1Part 1

Vivian Ho

Health Economics

This material draws heavily from Santerre & Neun, Health Economics, Theories, Insights, and Industry Studies, Dryden Press.

IntroductionIntroduction

Causes and consequences of government intervention in health care.

Types of government intervention. Case studies

– Cigarette taxes.– Price ceilings on health care services.– Hospital antitrust litigation.

Why Government Intervention?Why Government Intervention?

Perfectly competitive markets lead to efficient outcomes. Why?

Recall that the demand curve for any given product has a negative slope.– If consumers are visiting the doctor 2 times

per year when the price of a visit is $100, the price must fall below $100 in order to encourage consumers to see the doctor more often.

Why Government Intervention?Why Government Intervention?

Thus, the demand curve reflects the consumer’s marginal benefit from consumption.– The marginal utility from the third visit to

the doctor is lower than the marginal benefit from the second visit.

Similarly, we can define a demand curve for society’s preferences as a whole, which reflects the marginal social benefit of medical services.

Why Government Intervention?Why Government Intervention?

Quantity of medical services

Price

MSB

Why Government Intervention?Why Government Intervention?

Recall that the supply curve for any given product slopes upwards.– If a pharmacy is being paid $30 per

prescription to fill 300 prescriptions per day, it must be paid more than $30 per unit to fill 400 orders per day.

This reflects the fact that the marginal costs of production usually rise as output increases.

Why Government Intervention?Why Government Intervention?

At the societal level, the marginal social costs of providing services will also rise as output increases.– e.g. The marginal cost of achieving an

infant mortality rate of 20 per 100,000 live births may be fairly low, but the marginal cost of reducing the rate to 5 per 100,000 will be much higher.

Why Government Intervention?Why Government Intervention?

Quantity of medical services

Price

MSC

Why Government Intervention?Why Government Intervention?

Equilibrium is reached where MSB=MSC

Quantity

Price

MSB

MSC

P0

Q0

Why Government Intervention?Why Government Intervention?

In equilibrium, all services are exchanged at the price P0.

– But for all services less than Q0 (e.g. the 1st and 2nd physician visit), the marginal social benefit exceeds P0.

– The difference between marginal social benefit and the equilibrium price is called consumer surplus.

Why Government Intervention?Why Government Intervention?

Quantity

Price

MSB

MSC

P0

Q0

Consumer Surplus

Why Government Intervention?Why Government Intervention?

For all services less than Q0, the marginal social cost is lower than P0.

– The difference between marginal social cost and the equilibrium price is called producer surplus.

Why Government Intervention?Why Government Intervention?

Quantity

Price

MSB

MSC

P0

Q0

Producer Surplus

Why Government Intervention?Why Government Intervention?

Perfect competition is considered efficient, because it maximizes social welfare = consumer surplus + producer surplus.

Quantity

Price

D

SConsumer Surplus

Producer Surplus

Criteria for perfect Criteria for perfect competition competition

All firms and consumers are price takers.

Consumers and firms have perfect information.

All firms produce an identical product. Firms can freely enter an exit an

industry.

Market imperfections may lead to inefficient Market imperfections may lead to inefficient or inequitable distribution of resources.or inequitable distribution of resources.

Imperfect consumer information Monopoly Externalities

Government intervenes to restore efficiency and/or equity.• “Public interest theory.”

An opposing theory: The amount and types An opposing theory: The amount and types of government intervention are determined of government intervention are determined by supply and demand.by supply and demand.

Vote-maximizing politicians “supply” legislation.

Wealth maximizing special interest groups are the buyers.

Successful politicians stay in office by satisfying special interest groups.

““Special interest group theory”Special interest group theory”

Examples:Examples:

Extended patent protection for brand name drugs.

Rejection of national health insurance in favor of private insurance companies.

Special interest group theory claims that special Special interest group theory claims that special interest groups gain at the expense of the general interest groups gain at the expense of the general public. public.

Consumers are diverse, fragmented, more costly for them to organize.

Inefficient, inequitable resource allocation by government.

Which theory do you believe? C-B analysis is needed to identify

winners and losers.

Types of Government InterventionTypes of Government Intervention

Provide public goods.

Correct for externalities

Impose regulations. Enforce antitrust laws. Sponsor redistribution

programs. Operate public

enterprises.

Fund medical research.

Tax cigarettes, pollution.

FDA Bar hospital mergers. Medicare and Medicaid.

VA hospitals

Public GoodsPublic Goods

>1 individual simultaneously receives benefits from the good. i.e., no rivalry in consumption.

Costly to exclude nonpayers from consumption of the good.

Private firms unwilling to produce and sell public goods.

Are most medical services public goods?

ExternalitiesExternalities

Definition: An unpriced byproduct of production or consumption that adversely affects another party not directly involved in the market transaction.

Cigarette smoking Pollution Medical treatment for cyclists who don’t

wear helmets Drunk drivers

Demand-side externality: Marginal Social Benefit Marginal

Private Benefit

Supply-side externality: Marginal Social Cost Marginal Private

Cost

Cigarette smoking is an example of a Cigarette smoking is an example of a (negative) demand-side externality.(negative) demand-side externality.

Smokers impose work-related costs on nonsmokers.

Health insurance, pensions, sick leave, disability, group life insurance financed collectively by smokers and nonsmokers. But smokers, die earlier, pay less taxes,

premiums.

Smokers also impose health care Smokers also impose health care costs on nonsmokers.costs on nonsmokers.

Smokers usually incur higher health care costs. But nonsmokers die prematurely from

passive smoking, smoking-related fires.

The total external costs of cigarette smoking are estimated to be 15¢ per pack. (Manning et al., 1991)

Keep in mind:Keep in mind:

The problem which calls for government intervention is external costs, not internal costs.

The full extent of external costs must be measured using a lifetime approach.

Manning et al.’s methodsManning et al.’s methods

Numerator takes into account life expectancy for smokers and the costs (savings due to early death) incurred each year.

smokedpacksostscexternalLifetime

#15 =4

External Cost ComponentsExternal Cost Components

Covered medical costs. Covered work loss and disability. Group life insurance. Widow’s social security bonus. Covered nursing home costs. Pensions. Taxes on earnings. Fires.

At Q0 MSC0 > MSB0

Cigarettes are being over-consumed.

Cigarette Packs

$ per

pack

D=MPB

MSB

S=MPC=MSC

Q0

MSC0

MSB0

Q1

Government can use taxes and subsidies to Government can use taxes and subsidies to alter economic incentives, correct for alter economic incentives, correct for externalities.externalities.

Charge a tax on cigarettes that reduces consumption to the socially optimal level Q1.

Levy a per-unit tax T on cigarette makers equal to vertical distance between MPB and MSB at Q1.

Cigarette packs

$ per pack

D=MPB

MSB

MPC0=MSC

MPC0+ T

Q0Q1

P0

P2

P1

With tax:With tax:

Market price of cigarettes = P1

Cigarette manufacturers receive P2 per pack.

Tax burden Consumer pays P1 - P0

Seller pays P0 - P2

The relative tax burden on consumers vs. The relative tax burden on consumers vs. producers depends on price elasticities for producers depends on price elasticities for supply and demand.supply and demand.

If demand for cigarettes is inelastic, consumers bear a larger?/smaller? Share of the tax burden.

Further issuesFurther issues

The current tax per pack exceeds external costs. Is this “OK”?

Should smokers or cigarette companies be responsible for the external costs of smoking?

“Thank you for smoking.” Is this moral??

RegulationsRegulations

Government can attempt to control price, quantity, or quality of health care products.

Example: Price Ceilings in The Canadian Health Care System.– Consumers are fully insured by the

government.– The government fixes the price the

physician receives for each visit.

RegulationsRegulations Because consumers are fully insured,

they will demand the number of visits as if the price per visit = 0.

Assume that the government sets a reimbursement rate for physician visits equal to PC.

Physician visits

Price

D

S

QDQS

PC

With full insurance, consumers want QD visits.

But the government has fixed the price of visits at PC.

– Only QS visits will be provided.

Shortage of physician visits = QD - QS.

ConsequencesConsequences

1)Physicians may treat patients on 1st-come, 1st-served basis, regardless of severity/urgency.

2)Patients will have to queue for care/not receive care.

3)Unethical doctors may take bribes from patients trying to jump the queue.

Lesson: There is no free lunch under cost Lesson: There is no free lunch under cost containment. Price ceilings can lead to:containment. Price ceilings can lead to:

1) Shortages.

2) Longer waiting lines.

3) Nonprice rationing.

4) Poorer health outcomes.

The FDA and Drug AdvertisingThe FDA and Drug Advertising

Fine Print in Drug Ads Sparks a Debate– WSJ 4/1/97

What does the new advertising of drugs on TV say about special interest vs. public interest theory?– Who are the special interest groups?– What is in the public’s best interest?

Do drug companies all agree?

THE NEW YORK TIMESTHE NEW YORK TIMES

Editorial: The Need for Regulation:For All of the

Nation’s Imports9/16/2007