An essay on the theoretical and empirical aspects of the two most important market failures in the healthcare sector

1.??Introduction

There has been a lot of debate about the extent to which healthcare should be left to the workings of Adam Smith’s ‘invisible hand’ in a free market, and kept clear of intervention through government-led central planning (Hsaio, 1995). The case for a laissez-faire approach to healthcare is made on the basis that markets enable efficient allocation of resources and offer consumers (i.e., patients) a varied choice of products, and competition amongst producers (i.e., healthcare providers) helps dictate competitive pricing and better quality (Aggarwal et al., 2010). This assertion is made on the basis of economic theory because the ideal market structure, one that is based on perfect competition, maximises social welfare through allocative efficiency (Palmer & Torgerson, 1999) that ensures that an equilibrium point has been reached where no one can be made better off without making someone else worse off.

It is, however, impractical to assume that the complex healthcare sector can reach such an idealistic level of equilibrium. Many countries encourage a more pragmatic approach through a combination of market-led provision of healthcare interspersed with government regulation (Kikuzawa et al., 2008). This intervention is required because the healthcare market cannot allocate resources efficiently enough to ensure that no one would be worse off if someone else was made better off; that is, Pareto efficiency is not achieved in reality and markets fail to maximise social welfare, which is referred to as ‘market failure’ (Guinness & Wiseman, 2011).

This essay discusses the two most important causes of market failures in the healthcare sector: imperfect competition and externalities. Section 2 briefly discusses the theory behind, and the different types of, market failures. Section 3 and 4 discuss the theoretical and empirical aspects underpinning the causes and effects on the market of imperfect competition and externalities. Section 5 concludes the essay.

?2.??The theory behind market failures

It is possible to achieve an ideal market condition, or Pareto efficiency, if the following two conditions are satisfied (Sloman et al., 2015):

1.????The market structure follows that of perfect competition.

2.????There are no externalities, which are costs or benefits to the society in addition to those experienced by the producer or consumer.?

Further, Guinness and Wiseman (2011) list down the following prerequisites for a perfectly competitive market:

a.????The products are homogenous in nature.

b.????There are many sellers and buyers.

c.????Buyers and sellers can easily enter and exit the market.

d.????All the players in the market have complete information about the products and prices.

These conditions are essential to achieve Pareto efficiency, and thereby maximise social welfare, but are so restrictive in practicality that it is nearly impossible to achieve all of them together. The actual market thus deviates from the ideal condition, leading to market failure, and either producers, or consumers, or both, are unable to achieve a combined maximum level of welfare. The deviations can be caused by one or more of the following key reasons (Folland et al., 2017; Guinness & Wiseman, 2011; Sloman et al., 2015):

Imperfect competition

Market power of players can be skewed if there is imperfect competition, such as in a monopoly, monopsony, etc., and this condition will not allow for maximisation of social welfare. Market power can also be skewed because of barriers to entry of other players, or non-homogeneity of products. These situations are quite common in healthcare; for example, a single diagnostics provider in a village would make it a price setter; strict licensing regulations mean that only a fixed number of medical professionals may practice; and different dentists in a city may offer varying levels of service for root canal treatments.

Public Goods

Markets can fail in providing Pareto-efficient allocation of resources if public goods are involved. These are products or services that are non-rival (i.e., that can be consumed by everyone simultaneously) and non-excludable (i.e., that cannot exclude anyone from consuming them), subsequently leading to a ‘free-rider’ problem where consumers will enjoy the utility of such public goods without having an incentive to pay for them (Parkin et al., 2008). Public health measures, such as malarial management, is an example of a public good because residents enjoying the benefits of mosquito control know that the government will carry it out whether they pay for it or not (Mills & Gilson, 1988).

Externalities

These are costs or benefits that occur during transactions that remain unaccounted for and lead to an under-supply or over-supply of goods in a market. In negative externalities, producers or consumers are incurring costs that are not reflected in the equilibrium price and quantity; in positive externalities, producers or consumers are gaining benefit that is not reflected in the equilibrium price or quantity. A typical health-related negative externality is second-hand smoking: the smoker does not incur the cost of causing harm to other people who inhale their smoke.

Markets may also fail due to asymmetry of information, in which one player in an economic transaction has more knowledge about the transaction than the other player. This can lead to inefficiencies in the markets through (Guinness & Wiseman, 2011):

1.????Adverse selection, where knowledge about a player’s own situation may lead others to take sub-optimal decisions.

2.????Moral hazard, where a well-informed player may take advantage of this information against the uninformed player in the transaction.

3.????Principal-agent problem, where someone who is taking a decision on behalf of another person may use prior knowledge to their advantage.

3.??Imperfect competition

?When a market structure deviates from being perfectly competitive, one or more players in the market may benefit by gaining control over price and quantity (Sloman et al., 2015).

One of the most commonly discussed deviation from perfect competition in healthcare is that of a monopoly, which is the presence of a single producer in the market, either created naturally, through barriers to entry, or by the presence of only a few substitutes (Guinness & Wiseman, 2011). The cost curve model for a perfectly competitive market is shown in Figure 1, where S is the Supply curve (and the Marginal Cost curve) and D is the Demand curve.

Fig 1. Perfectly competitive market (as drawn in Guinness and Wiseman (2011))

In a monopolistic market structure, there is only one producer, who is now a price setter instead of a price taker. This implies that its marginal revenue curve (MR) will be independent of the market demand curve, and the producer will aim to supply an equilibrium quantity where its marginal cost equals its marginal revenue. This occurs at the lowest average cost (AC), and is shown in Figure 2.

Fig 2. Monopolistic market structure (as drawn in Guinness and Wiseman (2011))

The resulting effect is that the monopolist charges a price (Pmon) that is higher than the equilibrium price in perfect competition (Pcomp), whilst supplying a quantity (Qmon) that is less than the equilibrium quantity in perfect competition (Qcomp). Figure 2 also shows how this results in a loss in allocative efficiency: as the market deviates from being perfectly competitive, the producer converts consumer surplus into producer surplus. In a monopoly, the loss in consumer surplus is greater than the gain in producer surplus, which is referred to as ‘deadweight loss’, and is a reduction in societal welfare. Even if the market structure involves two large producers (duopoly) or a few large producers (oligopoly), it still results in an inefficient allocation of resources, and the price-setting producers will be in a favourable position to charge a higher price for products than the equilibrium price in a perfectly competitive market.

Governments can intervene if the market fails and starts creating welfare loss to the society, although the level of intervention also depends on the socio-political makeup of the country and the ideology of the ruling party. Government policies can ‘correct’ for market failure by improving patient information levels, mandating health coverage, and aligning incentive models of all providers (Kellis et al., 2010); introducing price ceilings to support patients or price floors to support providers (Li & Wu, 2021); or by incentivising new entrants into the market, and tightening anti-trust scrutiny of existing players (Gaynor et al., 2017). ?

Imperfect competition is one of the two most important causes of market failure in healthcare for several reasons. Firstly, the different ways that a healthcare market can deviate from perfect competition are common in the healthcare sector. Barriers to entry into the market may build up through high investment requirements, such as those that would be needed to set up a hospital, or the long and expensive process of developing a new drug (Mwachofi & Al-Assaf, 2011). The company(s) that is able to invest such a large amount will eventually act as a monopolist in the market. Pharmaceutical organisations are a classic example of price-setting players that use drug patents to their advantage by charging monopoly rents. The patented Hepatitis C drug sofosbuvir was being sold for almost $50,000 in the United States at the same time that a generic version of the same drug was being sold in India for less than $400 (Baker, 2021); a situation that leads to inefficient resource allocation and welfare loss of the consumer. Even though drug patent policy provides an economic incentive for the pharmaceutical to develop it in the first place, government intervention in the form of price ceilings is sometimes implemented to lower the price and prevent smuggling and counterfeiting, as well as to benefit the consumer.

Another barrier to entry can be created through government intervention, by limiting the number of licenses that are issued for medical practitioners and restricting the number of training places available. This can lead to loss in patient surplus, as discovered by Ketel et al. (2019) in the case of Dutch dentists. Here, a government-mandated licensing restriction led to a maldistribution of dentists across the country, with regions of lower competition being associated with higher wages. Other reasons for spatial maldistribution of healthcare producers can be avoidance of underdeveloped areas (Mwachofi & Al-Assaf, 2011), and this can also lead to monopoly rents.

Secondly, the price elasticity of demand of patients in the healthcare sector differs from that of consumers in other sectors because the utility sought is the improvement and longevity of human life, and patients exhibit generally inelastic responsiveness to price signals (Conrad, 1997). More specifically, however, the price elasticity of demand can vary according to the severity of their condition, and thus influence the market power of producers in the healthcare sector. This affects the extent to which producers can extract monopoly rents. For example, a duopoly of cosmetic surgery clinics in a small town may not be able to charge the same level of premium for services as a duopoly of dental clinics because the demand for dental treatments would be more inelastic than that of elective cosmetic surgery. In cases where price and quality are non-complementary attributes in treatment, the impact of market competition on quality depends on how the elasticity of demand with respect to quality compares to elasticity of demand with respect to price (Roos et al., 2020). Although research on this topic is primarily limited to hospitals at the moment, the relationship between the two elasticities is also a function of information symmetry between patients and providers, and the level of price regulation in the market (Gaynor, 2006). The complex nature of the patient-provider-payer relationship means that empirical evidence does not necessarily follow from economic theory in this case.

Thirdly, even though imperfect competition is common in the healthcare sector, there is still debate about whether (and to what extent) the level of competition in a healthcare market affects the quality of service provided to the patients. On one side, there is evidence, such as that of Bloom et al. (2015), that increased hospital competition leads to improved management quality and hospital performance in terms of productivity and staff satisfaction, although their prediction is based on emergency heart attack admissions only. A relatively similar conclusion was drawn by Croes et al. (2018), asserting that hospitals in competitive markets had better scores of quality indicators for two out of three diagnosis groups that were studied (cataract, adenoid and tonsils, and bladder tumour). Studying the effect of the government’s deregulation of patients’ choice of hospitals in UK’s National Health Service in 2006, Moscelli et al. (2018) found that the resulting increase in competition reduced mortality rates for hip fractures. Recent evidence provided by Awoyemi and Olaniyan (2021) points to similar findings in an underdeveloped country, where a less concentrated (i.e., more competitive) market of hospitals was associated with lower prices and higher quality of healthcare. However, as noted by Moscelli et al. (2018), not only is there debate on whether increased competition improves patient welfare and utility, but the heterogeneity of results is also a function of patient case mix and market conditions. The contrary side of the debate includes the work of Liao et al. (2018) who assert that market competition has a negative or negligible effect on medical care quality of stroke patients. Although their analysis encompasses an 11-year population-based study and incorporates four outcome indicators (as opposed to mortality rates only), their work was limited by data quality in Taiwan. Nevertheless, a similar conclusion was found by Propper et al. (2004) in the UK, and by Propper et al. (2008) in the US; in both cases they used mortality rates due to Acute Myocardial Infarction as metrics for quality, and found that policies leading to increased hospital competition were decreasing the quality of treatments. The indicators of quality on both sides of the debate have been defined in different ways, so generalising the results has its limitations. Future research on this topic should also assess quality across different treatment groups, as acute and trauma patients may receive better quality of care than chronic and long-term patients.

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4. Externalities

The second important cause of market failure in healthcare is an externality, which is a cost or benefit in an economic transaction that is, respectively, borne or enjoyed by someone who is not part of the transaction (Guinness & Wiseman, 2011). The market ‘fails’ when the true cost or benefit of a transaction is not reflected in the equilibrium price or quantity.

Figure 3 shows the effect of a positive externality of consumption on the system. Marginal Social Benefit (MSB) is the sum of Marginal Private Benefit (MPB) and Marginal External Benefits. That is,

MSB = MPB + MEB ???????????????????????????????????????????????????????????????????????????????????????????????????????????(1)

Similarly, for costs:

MSC = MPC + MEC?????????????????????????????????????????????????????????????????????????????????????????????????????????????(2)

where MSC is Marginal Social Cost, MPC is Marginal Private Cost, and MEC is Marginal External Cost.

In a positive externality, such as the effect of vaccinations of a part of a community on the entire community, MSB is larger than MPB by an amount of MEB. The profit-maximising price and output is Pe and Qe, respectively, but the allocatively-efficient price and quantity should have been P* and Q*, respectively. The benefits to the society are not being reflected in the equilibrium price, and thus the market is under-supplying the socially optimal level. The deadweight loss to society, indicated by the shaded area, is the overall welfare loss in this market failure.

Fig 3. Positive externality in consumption, causing market failure (as drawn in Guinness and Wiseman (2011))

The case of a negative externality in consumption is shown in Figure 4.

Fig 4. Negative externality in consumption, causing market failure

An example of a negative externality is alcohol consumption, where the ill effects of drunkenness, such as increased anti-social behaviour and risk of accidents, reduce the social benefit beyond the private benefit derived by the person consuming the alcohol. The market ‘fails’ because the socially-optimal ‘quantity’ is much less than that being consumed in the market, and the true price of the risks (P*) is actually higher than the equilibrium price Pe. There also exist positive and negative externalities in production, where the producer bears the benefit or cost of someone else’s activities, respectively.?

Government intervention depends on whether the action has to be encouraged or discouraged. ‘Pigouvian taxes’ have been introduced in many countries on tobacco products and alcohol in an effort to reduce the quantity consumed to a more socially-optimal level by adding to the product the estimated cost borne by the society from the consumption (Carruthers, 2015). However, such taxes often face resistance because they can be regressive in nature and vilified as an attack on personal freedom (Cummings, 2010). Governments can also incentivise positive externalities by subsidising and deregulating any limitations on products and services that benefit the population, such as cultivation of organic crops and marketing of healthier foods, but often face resistance from business lobbies (Hemphill, 2018).

Externalities are the second important cause of market failure in the healthcare sector for several reasons. Firstly, externalities generally tend to be within the public health domain, so the costs or benefits can create a ‘ripple effect’ on a larger group. For example, infection control leads to a positive externality that affects a larger group of people than the ones being treated, as communicable diseases can spread rapidly through population and increase social cost. According to a study done by Bethune and Korinek (2020) early into the COVID-19 pandemic, the perceived cost of an additional infection was approximated at $80,000, whereas the true social cost was calculated to be almost three times higher. The negative effects of an external source on health and wellbeing can be multifold, and not necessarily visible at the onset. Research by Whiteford and Weissman (2017) discuss the layered external costs associated with eating disorders, a condition that would otherwise be thought of affecting only an individual. Their work uncovers how mental disorders can also have a large impact on those people who are close to the patient. Further, society may lose out on the potential economic benefits (such as the impact of education) of a patient who suffers from a young age. Negative externalities lead to market failure by creating an impact beyond the patient and reducing marginal social benefit.

Secondly, health-related externalities are embedded in attributes of basic human nature, as research has pinned the root cause of the sources of such externalities to altruism, or the lack of it. The work of Hurley and Mentzakis (2013) lists three types of altruistic preferences that are exhibited by people: pure altruism, pure paternalistic altruism, and health-focused altruism. They also mention the work of Jacobsson et al. (2005), who found evidence that health-related altruism tends to increase beyond self-benefit as the severity of illness increases; as well as the work of Smith (2007), who found increasing willingness to pay for benefits that had external health-related impact, in addition to benefits to oneself. Despite differences in research methodologies amongst the three papers, their results show that the key underpinning of positive externalities in healthcare or public health is based on people’s desire to be helpful to others in health-related matters. This frames negative externalities in an interesting light, as it seems that selfishness of individuals and of organisations overpowers their desire to be beneficial to others.

Thirdly, some externalities are caused by strong habits and addictions, and it is neither easy to rid people of these habits, nor is it simple to uncover the external costs borne by society. For example, the external costs associated with smoking and alcohol consumption are linked to effects of second-hand smoking and antisocial behaviour, respectively. Other negative externalities, such as obesity, may have large associated institutional costs. In a widely cited study that involved an instrumental variables (IV) approach and an analysis of the causal effects of obesity (as opposed to correlation analysis in most research), Cawley and Meyerhoefer (2012) estimate that obesity in the US increases third-party (public and private insurers) medical expenditures by $2418 annually, which is 88% of the effect of obesity on total medical costs. Their work also underlines how Body Mass Index (BMI) and obesity have corresponding effects on costs related to inpatient care, outpatient services, and prescription drugs. The worrying aspect, the authors highlight, is that the effect of obesity on medical costs is significantly higher than policy makers assume; over 20% of U.S. national health expenditure is spent treating obesity-related illness compared to the previous estimate of 9.1%. With health insurance coverage being a very common (and sometimes, a compulsory) public policy in the West, where obesity is already quite prevalent, there have been arguments blaming health insurance for subsidizing obesity itself (Bhattacharya & Sood, 2006), as the phenomenon of moral hazard distracts the obese from focusing on weight loss. However, as Bhattacharya and Sood (2006) show through a model of optimal weight in the presence of insurance, this insurance externality depends on whether the premiums are corrected for the weight of the obese. The deadweight loss to society is actually caused by a distortion in consumer-decision making, which arises due to pooling of risks of the obese and the non-obese (Bhattacharya & Sood, 2011).

While externalities are usually produced in the public health domain, the ‘knock-on’ effect of market failure substantially affects providers and insurers as well, making this a very important point of focus from a policy perspective.?

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5.??Conclusion

The aim of this essay was to introduce different types of market failures that occur in the healthcare sector and explain, using theory and empirical research, why imperfect competition and externalities are the two most important types in this sector.

In imperfect competition, market power shifts into the hands of one or a few providers (or consumers), creating deadweight loss to the society. There is debate on the extent to which competition affects the quality of patient treatment, but government regulation can be introduced to minimise welfare loss.

Externalities are benefits or costs that are borne by someone outside the economic transaction. The common external costs prevalent in the public health domain are those caused by smoking, alcohol consumption, and obesity. While government intervention, in the form of taxes (or subsidies for positive externalities), can be applied efficiently to discourage consumption (or encourage consumption for positive externalities), governments have to balance this against backlash from lobbyists and consortiums.

The utility sought by patients is the preservation of life itself, which is a very valuable ‘economic good’. The market is characterised by a relatively inelastic demand and a complex patient-provider-payer structure. Therefore, it is important that market failures in the healthcare sector are constantly evaluated and corrected to ensure optimal social welfare in the form of better health and wellbeing of the population.

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