EAE 309

LECTURE 6

MARKET SYSTEM AND HEALTH

PECULIARITIES OF HEALTHCARE MARKETS

The following factors make medical care markets to be different from other markets.

I. uncertainty

• Health care Demand is irregular and uncertain;

➢ in case of an accident, one cannot be denied care if they don’t have money.
• Supply is uncertain:
➢ Asymmetric information- sick people do not understand treatment they need and
must trust doctors in their diagnosis.
➢ Also, different doctors may suggest different treatments due to uncertainty of
outcome.
➢ It is hard to judge the quality of medical care.

2. Prominence of insurance

• People buy insurance to cover themselves against risk of illness.

• Demand for health care may rise in case of insurance.
• Treatment recommendations are adjusted to insurance status.

3. Large role of not-for-profit providers

• There are many non profit organisations in the health care markets. This goes against
economists’ assumption that firms aim to maximise profits.

4. Role of equity and need

• People ought to get health care whether or not they can afford it.

PECULIARITIES OF HEALTH CARE GOODS

Health care differs from other commodities in many ways which leads to various government
intervention.

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1. The extent of government intervention

• Health care is the most intervened sector by the governments.

• For example;
➢ Health practioners require licence to practice.
➢ Government provides subsidies to finance health either through insurance or direct
free health services.
➢ Government controls the direct economic behaviour of health care providers such as
hospitals, nursing home etc far more other sectors in the economy.
➢ Government regulates direct controls on the decision to enter business of providing
health care.
➢ Medical research and education are also characterized by government regulations.

2. Uncertainty

• There is dominant presence of uncertainty at all levels of health care.

• Illness is unpredictable unlike other goods and future health status is uncertain.
• There is uncertainty in consumer-patient in health care for example;
➢ Many decisions to use health care begin with seemingly random events e.g accidents
➢ Many decisions are also caused by the concern of individuals about the possibility of
some illness.
• Uncertainty on the side of health care provider: doctors often recommend treatments at
different rates and at times can diverge greatly on which treatments they recommend.
• Uncertainty in regulations: approach to licencing drugs is different from new surgical
techniques.

3. Asymmetric knowledge

• There is large difference in knowledge between doctors or health workers and their
patients.
• For example;
➢ Doctors have considerably more knowledge on the illness than patients while patients
are often willing to reveal information to doctors the opposite is not necessarily the
case.
➢ There is incentive for doctors to deceive patients if they want to make money.

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➢ The patient cannot choose the best hospital for emergency due to emergency or
because they cannot judge whether the treatment is adequate.

4. Externalities

• This happens when the production or consumption of a private good or service have
social consequences without compensation to either party.
• It occurs when a transaction affects uncompensated party.
• Can be positive e.g vaccination against communicable diseases or negative e.g drunk
driving.

MARKET FAILURE IN HEALTH CARE

• Market failure is a situation in which the free-market system fails to satisfy society’s
wants (When the invisible hand doesn’t work and the first fundamental theorem of
welfare economics doesn’t hold.)
• Market failure occurs when Private markets do not efficiently bring about the optimal
allocation of resources (Pareto optimal conditions are not met) and as a result the
government must step in to satisfy society’s wants.
• An efficient market require;
➢ Availability of accurate information
➢ Protection of property rights
➢ Enforcement of contract obligations
➢ Zero externalities or no external costs and benefits.
➢ Competitive markets

Sources of market failure

1. Externalities

• Occurs when an economic agent engages in an activity that influences the well being
of another and yet neither pays or receives compensation for that effect.
• Sometimes called spill overs or neighbourhood effects.
• It can be positive or negative
• Positive externality is an external benefit imposed on someone while Negative
externality is external cost imposed on someone.

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• Externalities cause markets to be inefficient and therefore fail to maximise total

surplus.
• A negative externality such as pollution will cause inefficiency in the health care
markets. That is there will be too much consumption or production of the good.
Therefore in market equilibrium the social marginal costs will exceed the social
marginal benefits. See diagram below

Marginal Social Cost

Price Marginal private cost

Deadweight loss

Quantity

• A positive externality such as research and development, education will cause health
care market inefficiency. This is because there will be too little consumption or
production of the good or service. Therefore, in the market equilibrium the social
marginal benefits will exceed the social marginal costs. See diagram below.

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Social marginal cost

Price Deadweight Loss

Marginal Social Benefit

Marginal Private Benefit

Quantity

Methods of correcting externalities

i. Direct regulation
• Is where the amount of a good people allowed to consume or produce is directly
limited by the government.
• It is inefficient because it achieves the goal in a more costly manner than necessary
ii. Taxes
• Taxes are imposed by the governments on the level of negative externality created.
• Taxation method produces desirable results because individuals are able to structure
their activities in a way that is consistent with the desired results.
• This measure also brings about fairness because the lower the amount of external cost
the lower the taxes and vice versa.
iii. Coase theorem.
• Private bargains and negotiations are likely to lead to an efficient solution in many
social damage cases without any government involvement at all.
• For coase theorem to work the following conditions must be met;
➢ Basic rights at issue must be assigned and clearly understood
➢ There are no impediments to bargaining
➢ Only a few people could be involved.

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iv. Voluntary reductions:

• These leave individuals free to choose whether to follow what is socially optimal or
what is privately optimal.
• If a person’s social conscience and willingness to do things for the good of society
generally depend on his or her belief that others will also be helping.
v. Subsidies:
• The government can impose a “Pigouvian” subsidy on producers of positive
externalities, which increases its output.
• If the subsidy equals the external marginal benefit at the socially optimal quantity, the
firm will increase production to that point.
• The subsidy also shifts the private marginal cost. The firm cost cuts expand output,
which is a good thing when there is a positive externality.
2. Public goods

• Also known as social or collective goods

• They are non rival in consumption and non excludable in benefits.
• A good is non rival in consumption if one person’s consumption does not interfere with
another person’s consumption. That is if it has been provided to one person it is difficult
or impossible to stop another from enjoying it.
• A good is non excludable if once produced no one can be excluded from enjoying its
benefits. That is the good cannot be withheld from those that don’t pay for it.
• Public goods have characteristics that make it difficult for the private sector to produce
them optimally (market failure)

3. Asymmetric information

• Complete and perfect information is necessary for markets to achieve efficient allocation
of resources.
• Market operations assume actors are fully informed about market specifics e.g know
prices, incomes, market demand etc. however many markets do not have this degree of
information.
• The problem of asymmetric information arises where; parties on the opposite side of a
transaction have different amounts of information.
• Examples of asymmetric information in health care include;
➢ Patients know their risks insurance companies may not

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➢ Doctors understand the proper treatments, patients may not.

• Asymmetric information generates two types of outcomes:
i. Adverse selection; occurs when a buyer or seller enters into an exchange with
another party who has more information.
• A classic example is insurance markets; Individuals know more about their risks (pre-
existing conditions) than insurance company. This causes insurance companies to lose
money and hence market failure.
• Also, in the hospitals the doctors have more information than the patient and can give
unnecessary medical care.
• Adverse selection can be corrected by screening, signalling etc
ii. Moral hazard; arises when one party to a contract passes the cost of his or her
behaviour on to the other party to the contract.
• Occurs when an insurance policy or some other arrangement changes the economic
incentives being faced thus leading to change of behaviour, usually in a way that is
detrimental to the market.
• In this case it contracting parties cannot always determine the future behaviour of the
person with whom they are contracting.
• Moral hazard in insurance markets can be corrected through co-payment, coinsurance,
maximum coverage cap(max an insurance co can pay in case of an event.)

4. Imperfect competition

• A competitive firm expands its production until the price of the last unit of output is just
equal to the market price of the resources needed to produce that unit. If the other firms in
the economy are also competitive, the market price of these resources is just equal to the
market value of the other goods that could have been produced with these same resources.

5. Incomplete Markets
• It occurs when the market supply is insufficient to meet the needs of the consumers.
Market may form but will fail to develop completely. Incomplete markets fail to make an
optimal allocation of assets.

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Role Of Government Arising from Peculiarity of Health Care Goods

• Overcoming market failures

• Caring for the poor and for the rural population
• Implementing appropriate government mandates and regulations
• Policy making
• Financing public health activities
• Public health protection
• Collection and dissemination of information
• Capacity building for population health
• Direct management of services
• Training and education for the public health workforce.

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