Market failure - Monopoly and externality

Market failure - Externality

Objectives
1. To have an understanding of how health care differs from other goods and services.

2. To be able to explain externalities and provide examples with respect to health care
markets.

Contents
1. Introduction
2. Externalities
3. Summary
4. Keywords
_________________________________________________________________

1. Introduction
The focus of much economic analysis is on markets and their ability to achieve an efficient
outcome; that is the composition of output reflects consumers’ wants. Under ideal market
conditions – which are described in the economists’ model of perfect competition and
approximated in many industries – the commodities which consumers demand are produced at
minimum cost.

In previous topics we considered demand side imperfections in healthcare markets, specifically

the role of information and agency, and supply side sources of market failure, specifically
monopoly. In this topic we consider the existence of externalities in health markets. Which
assumptions of the perfect competitive model hold in healthcare markets where there are
externalities, but more importantly which assumptions are less likely to hold, and what are the
implications of this? We can also consider the role of governments and health policy, and the
extent to which government intervention can ameliorate any negative impacts of market failure.

2. Externalities
Another characteristic which differentiates the health care market from the competitive market
model are ‘spillover’ costs and benefits – or externalities. Spillover benefits are experienced by
people other than the person using the health service and can occur on either the demand or
supply sides of the market. Immunisation services are a classic example of a demand side
externality: if one person is immunised against measles, other people benefit because the
probability of their catching measles is reduced. Because the externality has a positive effect on

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Market failure - Monopoly and externality

health outcomes, it is referred to as a positive externality. Similarly, people may value the
improvements in health of others, even though their own health is unchanged. The utility
derived from seeing others made better off has been termed a ‘caring externality’.

If positive externalities such as these exist, the amount of health care demanded by individuals
in a competitive market will be below the amount that is socially optimal. We can think of this as
the marginal social benefit (MSB) as being higher than the marginal private benefit (MPB).
This is because people do not take the spillover benefits into account when making their
purchasing decisions, thereby underestimating the full benefit of health care to the community.

The institutional response to positive externalities is to offset this shortfall by reducing the
market price (through subsidy) in order to encourage increased consumption. The existence of
externalities will not automatically justify the complete removal of price through a full subsidy
since, as long as patients expect to receive some personal benefit from their consumption, they
should be willing to pay something to receive it.

However externalities can also be negative, that is they may reduce utility experienced by
others or shift costs to other entities. A good example of a negative externality where costs
are shifted by producers or firms, is pollution. If a firm has no incentive to reduce pollution, i.e.
the costs of reducing pollution are a cost to the firm, then pollution will be the result and this will
be a cost to society.

Where there are externalities there are inefficiencies in the market, for a negative externality
such as pollution, the marginal social cost is higher than the marginal private cost (i.e. the cost
faced by the producer). This can be seen from the firm’s perspective in Figure 1. If the industry
is competitive then the firm will produce goods at the competitive market price Pi, the firm will
produce where its marginal cost curve (MC) intersects with Pi at quantity, q (in a competitive
market price, marginal benefit and demand are the same, P=MB=D). However factoring in the
social cost of pollution means that the marginal social cost (MSC) will intersect with Pi at a
lower quantity q*. The difference between MC and MSC is due to the externality, and we can
call this the marginal external cost, or MEC. If all firms in the industry are producing pollution,
then the analysis of the industry will be the sum of all the individual firms (but the industry will
face a downward sloping demand curve). The competitive industry price will be at Pi but the
price if the costs of pollution were taken into account would be at P*.

One government or institutional response will be to put a tax on pollution, so the firm will have
an incentive to reduce pollution or incur tax liabilities. For the tax to be effective, it would be set
somewhere close to the MEC. An alternative is to regulate against pollution and ensure that
firms face heavy penalties if they do pollute.

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Market failure - Monopoly and externality

FIRM INDUSTRY

MSCi

Pri MSC Pri

ce ce

MC MCi
P*

Pi D Pi
MECi

MEC
Demand

q* q Firms’ output Q* Qi Industry output

Figure 1: Negative Externality from Pollution – firm and industry

Externalities
Economic theory of competitive markets assumes that all costs & benefits
of a transaction are internalised by the producer or the consumers. An
externality is when an unintended cost or benefit (‘spillover’ effect) of a
market transaction (consumption or production) impacts on a party not
immediately involved in the transaction. An externality creates a
difference between the private & social benefits or costs of economic
activity.

The individual consumer has no incentive to take external consumption

benefits into account when making consumption decisions, for example
immunisation (positive consumption externality) or smoking (negative
consumption externality). Similarly, the individual firm has no incentive to
take external production costs into account when making production
decisions, for example factory pollution (negative production externality).

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Market failure - Monopoly and externality

3. Summary
There are segments of the health care system in which markets would be conducive to
efficiency, however other parts of the system are characterised to a greater or lesser degree by
‘market failure’. A majority of specialist health economists regard the differences between
health care and most other commodities as important and many of them doubt:

 whether individuals are capable of making rational decisions about their health and the
use of health services (role of information); and
 whether the supply of health services is (or can be) organised in such a way as to
produce efficiency outcomes (i.e. produce the most desired mix of services at least
cost), without resort to government intervention.

4. Keywords
 Positive externality
 Marginal Private Cost
 Marginal Social Cost
 Marginal Social Benefit
 Negative externality
 Marginal External Cost
 Marginal Private Benefit