317_L13, Feb 5, 2008, J. Schaafsma 1 Review of the Last Lecture finished our discussion of the demand for healthcare today begin our discussion of market failures will look at what a market failure is list four sources of market failure will note that health insurance is a source of market failure then look at why there is a demand for health insurance

317_L13, Feb 5, 2008, J. Schaafsma 2 Section 5: Market Failures A market failure occurs when the interaction between supply and demand fails to maximize social welfare given the distribution of income underlying the demand curve. begin by looking at how, under certain conditions, perfect competition maximizes social welfare given the existing income distribution

317_L13, Feb 5, 2008, J. Schaafsma 3 The Efficiency Condition for Optimal Output (given the distribution of income) The efficiency condition for optimal output (the condition that must be met to maximize welfare given the income distribution) is: MB = MC If MB > MC are foregoing consumer surplus (diagram) If MB < MC are wasting resources (diagram)

317_L13, Feb 5, 2008, J. Schaafsma 4 Competitive Markets and Efficiency in the Absence of Externalities in a competitive market all consumers and firms are price takers and pay/receive the same price, P (Assume same info available to all, unrestricted entry & exit, no externalities, no insurance, all are price takers, i.e., no market power) profit maximizing firm produces to the point where MC = MR = P utility maximizing consumer consumes to the point where MB = P since all face the same market P ~> MB = MC thus, in the absence of market imperfections, a competitive market achieves efficiency => maximizes welfare given the income distribution

317_L13, Feb 5, 2008, J. Schaafsma 5 Four Sources of Market Failure in the Healthcare Sector 1.Risk 2.Externalities 3.Information asymmetry 4.Monopoly power each results in the inefficient output of HC (too much or too little) => a welfare loss or consumer surplus foregone Consider first Risk as a source of market failure

317_L13, Feb 5, 2008, J. Schaafsma 6 Risk difference between risk and uncertainty? risk ~> can attach a probability to the occurrence of an event uncertainty ~> event may or may not occur. However, can’t compute a probability for the event occuring can insure against risks, not against uncertain events: reason ~> for risks can compute the expected loss ~> qL, where q is the probability of the event occurring, and L is the loss if the event occurs, can’t do this for uncertain events (no q available) incidence of illness generally known for a given period of time, thus can compute the probability of getting ill ~> can compute qL for the illness, can thus insure for the loss. Not true for all illnesses

317_L13, Feb 5, 2008, J. Schaafsma 7 Why Does Health Insurance Create Market Failure? health insurance drives a wedge between the price received by the producer and the price paid by the consumer producer price = P Consumer effective price = (1 – ir)P, where ir is the insurance rate, ir ≤ 1 since P > (1 – ir)P ~> MC > MB ~> inefficient ~> over production ~> market failure (Diagram) have already shown this earlier in our discussion of insurance and demand

317_L13, Feb 5, 2008, J. Schaafsma 8 Why Is There Demand for Health Insurance? most western countries have health insurance Canada has Medicare ~> public insurance for hospital and physician care, 0 coinsurance; some insurance for prescription drugs in the U.S. 85% of the pop under age 65 have some form of health insurance, all 65+ in U.S. covered by Medicare (public insurance), all poor of any age covered by Medicaid (public insurance) why a demand for health insurance, given the welfare loss? REASON: if a person is risk averse, buying insurance will, under certain conditions, increase utility vis-à-vis no insurance

317_L13, Feb 5, 2008, J. Schaafsma 9 Risk Averse Defined a person is risk averse if the person’s marginal utility of wealth declines as wealth increases (see diagram) this person would prefer a gift of $15,000 to a lottery ticket with two outcomes: $10,000 and $20,000 each outcome with a probability of 0.5 the gift and the lottery ticket have the same expected value ($15,000); however, the gift has a higher utility than the lottery ticket REASON: because of declining MU of wealth, the utility from the additional $5,000 above $15,000 is less than the loss in utility if the lottery pays $5,000 less than the $15,000 (SEE DIAGRAM) if not risk averse => indifferent between gift and lottery ticket of equal expected value (MU of wealth constant) SEE DIAGRAM

317_L13, Feb 5, 2008, J. Schaafsma 10 Expected Wealth and Expected Utility: No Health Insurance assume the person is risk averse let q = probability of becoming ill, thus (1 – q) = prob not ill let L = financial loss if ill let W 0 = wealth if not ill, thus wealth if ill = W 0 – L in the absence of insurance, expected wealth is (SEE DIAGRAM): E(W) = q(W 0 – L) + (1 – q)(W 0 ) = W 0 – qL in the absence of insurance, expected utility is (SEE DIAGRAM): E(Utility) = qU(W 0 – L) + (1 – q)U(W 0 )

317_L13, Feb 5, 2008, J. Schaafsma 11 Expected Wealth and Expected Utility: With Health Insurance assume insurance can be purchased at an actuarially fair premium (premium = expected loss = qL) this assumption is convenient to illustrate our point but unrealistic ~> insurance companies incur admin costs and also need a normal return ~> in real world, premium will exceed qL (will discuss later) if insurance purchased, wealth = W 0 - qL (same as without insurance) if insurance purchased, utility will be U(W 0 – qL) N.B. Because of declining MU of Wealth: U(W 0 – qL) > qU(W 0 – L) + (1 – q)U(W 0 ) (SEE DIAGRAM)

317_L13, Feb 5, 2008, J. Schaafsma 12 Utility Gain From Health Insurance utility gain from health insurance is the difference between the utility from (wealth - insurance premium), and the expected utility in the absence of insurance (SEE DIAGRAM) without insurance the combination of expected utility and expected wealth lies on the straight line joining the two extreme outcomes without insurance (wealth and utility if ill and not ill), since the same weights are used in computing expected wealth and expected utility [q and (1-q)]. if MU(W) constant, no gain from insurance (see diagram)