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Chapter 9: Government, Health, and Medical Care

Health Economics

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?

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?

Thus, the demand curve reflects the consumers 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 societys preferences as a whole, which reflects the marginal social benefit of medical services.

Why Government Intervention?



Quantity of medical services

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?

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?


Quantity of medical services

Why Government Intervention?

Equilibrium is reached where MSB=MSC






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?

Price Consumer Surplus






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?


Producer Surplus MSB



Why Government Intervention?

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

Producer Surplus

D Quantity

Criteria for perfect 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 or inequitable distribution of resources.

Imperfect consumer information Monopoly Externalities


intervenes to restore efficiency and/or equity.

Public interest theory.

An opposing theory: The amount and types of government intervention are determined 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 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 interest groups gain at the expense of the general 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 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 Goods

>1 individual simultaneously receives benefits from the good.


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?

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


treatment for cyclists who dont 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 (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.


smokers, die earlier, pay less taxes, premiums.

Smokers also impose health care costs on nonsmokers.

Smokers usually incur higher health care costs.


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:
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 methods

Lifetime external costs 154 # packs smoked

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

External Cost Components

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

$ per pack S=MPC=MSC

MSC0 D=MPB MSB Q1 Q0 Cigarette Packs


At Q0 MSC0 > MSB0

Cigarettes are being over-consumed.

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

Charge a tax on cigarettes that reduces consumption to the socially optimal level Q 1.
a per-unit tax T on cigarette makers equal to vertical distance between MPB and MSB at Q1.


$ per pack



P0 P2
D=MPB MSB Q1 Q0 Cigarette packs

With tax:
Market price of cigarettes = P1 Cigarette manufacturers receive P2 per pack.

Tax burden

pays P1 - P0 Seller pays P0 - P2

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

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

Further 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??


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.


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

With full insurance, consumers want QD visits. But the government has fixed the price of visits at PC.

Only QS visits will be provided.


of physician visits = QD - QS.

1)Physicians may treat patients on 1stcome, 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 containment. Price ceilings can lead to:

1) Shortages. 2) Longer waiting lines. 3) Nonprice rationing. 4) Poorer health outcomes.

Types 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

Antitrust: Sherman Antitrust Act

Section 1: Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several states or with foreign nations, is hereby declared illegal.

Section 2: Every person who shall monopolize, or conspire with any other person or persons to monopolize any part of the trade or commerce among the several states, or with foreign nations, shall be guilty of a misdemeanor.

The Act prohibits anticompetitive business practices that promote inefficiency and inequity in the marketplace, such as:

Price fixing - when business rivals enter a collusive agreement to refrain from price competition; fix the price of a good or service.

in a given city cannot jointly establish the price of various hospital services.

Boycott - agreement among competitors not to deal with a supplier or a customer.


in an area cant collectively agree to deny services to a particular managed care organization.

Market allocation - when competitors agree to compete with one another in specific market area.

in the same city cant collectively set geographic service boundaries.

Price fixing, boycotting, and market allocations are illegal per se.

plaintiff must only prove these actions took place for the defendant to be in violation of the Act.

In contrast, rule of reason doctrine is used to evaluate horizontal mergers under the Act.

horizontal mergers may force price above the competitive level, they may also create benefits which could be passed on to the customer.

Potential benefits of mergers

Economies of scale in production. Organizational economies.

less administrative staff

Better access to technological innovations. The potential anti- and pro-competitive effects must be weighed by the courts in determining the social desirability of a merger.

Antitrust in the health care industry

Is the health care industry subject to as much anti-competitive behavior as other industries? Will mergers in health care help/harm consumer welfare?


of non-profit organizations Consolidation on the consumer side to counteract consolidation on the provider side.

The Governments View

Prior to the mid-1970s, antitrust was not widely applied in the health care field, because members of the medical profession claimed they were exempt. 1975, Goldfarb v. Virginia State Bar (Supreme Court)

The nature of an occupation, standing alone, does not provide sanctuary from the Sherman Actnor is the public service aspect of professional practice controlling in determining whether section 1 includes professions.

1982 - Arizona v. Maricopa Medical Society Physicians formed a medical society which agreed on maximum reimbursement fees they could be paid by insurance companies that agree to send patients.


periodic upward revisions of the maximum-fee schedules have the effect of stabilizing and enhancing the level of actual charges by physicians.


the schedules impose a meaningful limit on physicians chargesthe advance agreement by doctors to accept the maxima enables the insurance carriers to calculate more efficiently the risks they underwrite and therefore serves as an effective cost-containment mechanism


The per se rule is violated here by a restraint that tends to provide the same economic rewards to all practitioners regardless of their skill, experience, training, or willingness to employ innovative and difficult procedures in individual cases. Such a restraint may also discourage entry into the market and may deter experimentation and new developments by new entrepreneurs.

Antitrust and Hospital Mergers

Traditional Dept. of Justice Analysis


the product, and challenge mergers that lead to very high market concentration. 50% market share by the proposed merged entity.

DOJ tends to challenge mergers in rural areas and small cities.

1997: DOJ challenged merger of 2 teaching hospitals in metropolitan New York.

Long Island Jewish, North Shore Manhasset. New Argument: Unilateral Effects Analysis.

merger would give the hospitals the ability to raise the price charged to managed care networks. Managed care networks need a prestigious teaching hospital as an anchor.

Courts Decision: The DOJ argument was not credible.

1) LI Jewish and N Shore had many competitors in the area.


of their care was primary or secondary. Tertiary care was available in several teaching hospitals nearby.

2) The market had several other buyers in addition to managed care.


patients. Self-pay patients. Physicians who control admissions. Medicare and Medicaid. Employers. Government payers.

3) Managed care executives gave conflicting testimony on the effects of the merger.

Is unilateral effects analysis flawed, or did the DOJ just goof in preparing their argument?

The government often taxes one group and uses the revenues to subsidize another. Why? Interdependent utility functions.


get utility from increasing the welfare of recipients. rider problem.

Why is the government involved?


Two notions of equity in redistribution programs

Vertical equity

should be treated unequally. People who earn more should pay higher taxes.

Horizontal equity

should be treated equally. Two persons with the same income level should pay the same in net taxes.

Vertical equity in practice

How much more in taxes should higher income people pay?

Suppose high income households pay $4,000 in taxes on average, and low income households pay $2,000. Is this equitable?

If the high income household makes $100,000, they pay a 4% tax.

If the low income household makes $10,000, they pay a 20% tax. notion of equity in taxation depends not just on total tax revenues, but on income levels and tax rates as well.


In practice, vertical equity is achieved when the net tax system is sufficiently progressive.

as a fraction of income rise with income. Federal income tax system.

Other forms of redistribution


fraction of income going to taxes is constant as income rises. The Medicare tax is a fixed % of payroll income.


fraction of income going to taxes falls as income rises. Sales tax

Implementing redistribution

Supply-side subsidies

funding aimed at reducing the costs of producing a consumer good or service. Subsidy to a public hospital. Tuition for nurses or doctors.

Potentially violates notion of vertical equity


all persons have equal access to the subsidized product.

Demand-side subsidies - government funding for consumers. In-kind: vouchers or reimbursements for specific services.

stamps, Medicare, Medicaid

Cash: government-provided income that people can use at their own discretion.

Supplemental Security Income

Keep in mind: It is difficult to guarantee horizontal equity with multiple programs in operation.

Back to the Start

Does government intervention correct for market imperfections, or is it ruled by special interest groups?

A Final Caveat
Market failure is a necessary, but not sufficient condition for government intervention. It may cost the government $10m to correct a problem in the marketplace, which imposes $8m in damages. While markets may fail and impose societal costs, the costs of government intervention may be greater.