HMGT 435 WEEK 6 DISC 6

1

· Include the two questions that you selected to discuss at the top of your initial posting.

· What factors must exist for there to be an efficient market?

· What does it mean when there is market failure? Give an example of market failure in the healthcare market?

· What is the economic impact of government price controls? Provide an example of price controls in the healthcare area.

· What economic rationale supports the government provision of health insurance to the poor.

· What are the characteristics of a “public good”? Why is it difficult for a private company to provide a public good?

· Do you think licensing of physicians increases quality of health care?

· What is the impact of physician licensing on the quantity of physicians, does licensing increase or decrease the quantity?

· What market failure does the regulation of nursing home quality issues address?

APA Requirements -Include Scholarly Evidence: Include at least TWO APA formatted references with correlating in-text citations. 

CHAPTER

501

THE ROLE OF GOVERNMENT IN MEDICAL
CARE

Government intervention in the financing and delivery of medical services
is pervasive. On the financing side, the Affordable Care Act (ACA)
provides subsidies and tax credits to individuals, small businesses, and

low-income employees, and employers are required to provide health insurance
benefits to their employees. Further, hospital and physician services for the
aged are subsidized (Medicare), and a separate payroll tax pays for those sub-
sidies. Medicaid, a federal/state matching program, pays for medical services
for the poor and near-poor. Further, a large network of state and county hos-
pitals is in place; health professional schools are subsidized; loan programs for
students in the health professions are guaranteed by the government; employer-
paid health insurance is excluded from taxable income; military members,
retirees, and their families have access to a separate healthcare program called
TRICARE; and medical research is subsidized. In all, government pays for
more than 50 percent of total health expenditures.

In addition to these financing programs, extensive government regula-
tions influence the financing and delivery of medical services. For example, state
licensing boards determine the criteria for entry into different professions, and
practice regulations determine which tasks can be performed by which profes-
sional groups. In some states, hospital investment is subject to state review,
hospital and physician prices under Medicare are regulated, health insurance
companies are regulated by the states, and each state mandates which benefits
(e.g., in Minnesota, hair transplants) and providers (e.g., in Washington, natu-
ropaths) should be included in health insurance sold in that state (Bunce 2013).

The role of government in the financing and delivery of medical ser-
vices (and through federal and state regulations) is extensive. To understand
the reasons for these different types of government intervention, and at times
seemingly contradictory policies, it is necessary to understand the two theories
that underlie the government’s objectives.

Public-Interest Theory of Government

The public-interest, or traditional, theory of government can be classified accord-
ing to its policy objectives and the policy instruments used to achieve those

31

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AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition
Account: s4264928.main.eds

Health Pol icy Issues: An Economic Perspect ive502

objectives. The objectives of government in the healthcare field are twofold:
(1) to redistribute medical resources to those least able to purchase medical
services and (2) to improve the economic efficiency by which medical services
are purchased and delivered. These traditional objectives of government—redis-
tribution and economic efficiency (also referred to as market failure)—can be
achieved by using one or more of the following policy instruments: expenditure,
taxation, and regulation. (Government provision of services, such as in Veterans
Affairs hospitals, is rarely proposed as a policy instrument in the United States.)

These policy instruments—expenditure, taxation, and regulation—can
be applied to the purchaser (demand) side or the supplier (provider) side of the
market. For example, expenditure policies on the demand side are Medicare
and Medicaid, and on the supply side are subsidies for hospital construction
and health manpower training programs. Taxation policies on the demand side
cover tax-exempt employer-paid health insurance, and on the supply side are
tax-exempt bonds for nonprofit hospitals. The individual mandate to buy health
insurance is a regulation policy on the demand side; on the supply side are
licensing requirements, restrictions on the tasks various healthcare professionals
can perform, entry barriers to building a hospital or a new hospice in a region,
and regulated provider prices for hospitals and physicians under Medicare.

These policy objectives and instruments—which can be used to classify
each type of government health policy according to objectives, the type of
policy instrument used, and whether the policy instrument is directed toward
the demand side or supply side of the market—are shown in exhibit 31.1.
According to the public-interest theory, each policy should achieve one of the
two government objectives.

Redistribution
Redistribution causes a change in wealth. According to the public-interest
theory of government, society makes a value judgment that medical services

Government Policy and
Instruments

Government Objectives

Redistribution
Efficiency

Improvement

Expenditure { Demand side

Supply side

Taxation (+/–) { Demand side

Supply side

Regulation { Demand side

Supply side

EXHIBIT 31.1
Health Policy

Objectives and
Interventions

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Chapter 31: The Role of Government in Medical Care 503

should be provided to those with low income and should be financed by taxing
those with high income. Redistributive programs typically lower the cost of
services to a particular group by enabling members of that group to purchase
those services at below-market prices. These benefits are financed by imposing
a cost on some other group. Two large redistributive programs are Medicare
for the aged and Medicaid for the medically indigent. Any redistributive medi-
cal program such as Medicaid should have the redistributive effects shown in
exhibit 31.2.

Efficiency Improvement
The second traditional objective of government is to improve the efficiency
with which society allocates resources. Inefficiency in resource allocation can
occur, for example, when firms in a market have monopoly power or when
externalities exist. A firm has monopoly power when it is able to charge a price
that exceeds its cost by more than a normal profit. Monopoly is inefficient
because it produces a level of service (output) that is too small. The additional
benefit to purchasers from consuming a service (as indicated by its price) is
greater than the cost of producing that benefit; therefore, more resources
should flow into that industry until the additional benefit equals the additional
cost of producing it.

Several bases of monopoly power exist: (1) The market may have only
one firm, as with a natural monopoly such as an electric company; (2) barriers
to entry into a market may exist; (3) firms may collude on raising their prices;
and (4) a lack of information may mean consumers are unable to judge the
differences in price, quality, and service among suppliers. In each of these situa-
tions, the prices charged will exceed the costs of producing the product (which
include a normal profit). The appropriate government remedy for decreasing
monopoly power is to eliminate barriers to entry into a market, prevent price
collusion, and improve dissemination of information among consumers.

The other situation in which the allocation of resources can be improved
is when externalities occur—that is, when someone undertakes an action and in
so doing affects others who are not part of that transaction. The effects on others
could be positive or negative. For example, a utility company using high-sulfur
coal to produce electricity also produces air pollution. As a result of the air pol-
lution, residents in surrounding communities may have a higher-than-average
incidence of respiratory illness. Resources are misallocated because the cost

Low Income High Income

Benefits X

Costs X

EXHIBIT 31.2
Determining the
Redistributive
Effects of
Government
Programs

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Health Pol icy Issues: An Economic Perspect ive504

of producing electricity excludes the costs imposed on others. As a result, too
much electricity is being generated. If the costs of electricity production also
include the costs imposed on others, the price of electricity would be higher
and its demand lower. The allocation of resources would be improved if the
utility’s costs include production and external costs. The appropriate role of
government in such a situation is to determine the costs imposed on others
and to tax the utility company an equivalent amount. (This subject is discussed
more completely in chapter 33.)

According to the public-interest theory, if a policy does not have redis-
tribution as its objective, then its goal should be to achieve greater economic
efficiency.

Economic Theory of Regulation

Dissatisfaction with the public-interest theory occurred for several reasons.
Instead of simply regulating natural monopolies, government has also regulated
competitive industries (e.g., airlines, trucks, taxicabs), as well as various profes-
sions. Further, unregulated firms always want to enter regulated markets. To
prevent entry into regulated industries, the government establishes entry barri-
ers. If the government supposedly reduces prices in regulated markets—hence,
the firm’s profitability—why should firms seek to enter a regulated industry?

To reconcile these apparent contradictions with the public-interest theory
of government, an alternative theory of government behavior—the economic
theory of regulation—was developed (Stigler 1971). (For a more complete
discussion of this theory and its applicability to the healthcare field, see Feldstein
[2006].) The basic assumption underlying the economic theory is that political
markets are no different from economic markets; individuals and firms seek to
further their self-interest. Firms undertake investments in private markets to
achieve a high rate of return. Why would the same firms not invest in legisla-
tion if it also offered a high rate of return? Organized groups are willing to
pay a price for legislative benefits. This price is political support, which brings
together the suppliers and demanders of legislative benefits.

The Suppliers: Legislators
The suppliers of legislative benefits are legislators, and their assumed goal is to
maximize their chances for reelection. As the late Senator Everett Dirksen said,
“The first law of politics is to get elected; the second law is to be reelected.” To
be reelected requires political support, which consists of campaign contribu-
tions, votes, and volunteer time. Legislators are assumed to be rational—that
is, to make cost–benefit calculations when faced with demands for legisla-
tion. However, the legislator’s cost–benefit calculations are not the costs and

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Chapter 31: The Role of Government in Medical Care 505

benefits to society of enacting particular legislation. Instead, the benefits are
the additional political support the legislator would receive from supporting
the legislation, and the costs are the political support she would lose as a result
of supporting the legislation. When the benefits to the legislators exceed the
costs, they will support the legislation.

The Demanders: Those with a Concentrated Interest
Those who have a concentrated interest—that is, those for whom the legisla-
tion will have a large economic effect—are more likely to be successful in the
legislative marketplace. It becomes worthwhile for the group to incur the costs
to organize, represent its interests before legislators, and raise political support
to achieve the profits that favorable legislation can provide. For this reason,
only those with a concentrated interest will demand legislative benefits.

Diffuse Costs
When legislative benefits are provided to one group, others must bear the costs.
When only one group has a concentrated interest in the legislation, that group is
more likely to be successful if the costs to finance those benefits are not obvious
and can be spread over a large number of people. When this occurs, the costs are
said to be diffuse. For example, assume that ten firms are in an industry, and if
legislation is enacted that limits imports that compete with their products, they
will be able to raise their prices, thereby receiving $300 million in legislative
benefits. These firms have a concentrated interest ($300 million) in trying to
enact such legislation. The costs of these legislative benefits are financed by a
small increase in the price of the product amounting to $1 per person.

Often, the fact that legislation raises their costs is not obvious to con-
sumers. Further, even if consumers were aware of the legislation’s effect, it
would not be worthwhile for them to organize and represent their interests to
forestall a price increase of only $1 a year. The costs of trying to prevent the
price increase would exceed the potential savings.

It is easier (less costly) for providers than for consumers to organize,
provide political support, and impose a diffuse cost on others. For this reason,
much legislation has affected entry into the healthcare professions, which tasks
are reserved for certain professions, how (and which) providers are paid under
public medical programs, why subsidies for medical education are given to
schools and not to students (otherwise, schools would have to compete for
students), and so on. Most health issues have been relatively technical, such
as the training of health professionals, certification of their quality, methods
of payment, controls on hospital capital investment, and so forth. The higher
medical prices resulting from regulations that benefit physicians, for example,
by successfully placing limits on nurses’ scope of practice, have been diffuse
and not visible to consumers.

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Health Pol icy Issues: An Economic Perspect ive506

Entry Barriers to Regulated Markets
The economic theory of regulation provides an explanation for these dissatisfac-
tions with the public-interest theory. Firms in competitive markets seek regula-
tion to earn higher profits than would be available without regulation. Prices in
regulated markets (e.g., interstate air travel) were always higher than those in
unregulated markets (e.g., intrastate air travel), enabling regulated firms to earn
greater profits. These higher prices gave unregulated firms an incentive to try
to enter regulated markets. Government, on behalf of the regulated industry,
imposed barriers to prevent low-priced competitors from gaining entry. Other-
wise, the regulated firms could not earn more than a competitive rate of return.

Through legislation, firms try to receive the monopoly profits they are
unable to achieve through market competition.

Opposing Concentrated Interests
When only one group has a concentrated interest in the outcome of legislation
and the costs are diffuse, legislators will respond to the political support provided
by the group that seeks to have favorable legislation enacted. When there are
opposing groups, each with a concentrated interest in the outcome, legislators
are likely to reach a compromise between the competing demanders of legisla-
tive benefits. Rather than balancing the gain in political support from one group
against the loss from the other, legislators prefer to receive political support from
both groups and impose diffuse costs on those offering little political support.

Visible Redistributive Effects
When the beneficiaries are specific population groups, such as the aged, the
redistributive effects of legislation are meant to be visible. Medicare is an
example. By making clear which population groups will benefit, legislators
hope to receive their political support. The costs (taxes) of financing such vis-
ible redistributive programs, however, are still designed to be diffuse so as not
to generate political opposition from others.

A small, diffuse tax imposed on many people, such as a sales or a pay-
roll tax, is the only way large sums of money can be raised to finance vis-
ible redistributive programs with little opposition. These taxes are regressive;
the tax represents a greater portion of income from low-income employees
and consumers. Economists have determined that payroll taxes, even when
imposed on the employer, are borne mostly by the employee. (The employer
is only interested in the total cost of an employee; thus, the employee eventu-
ally receives a lower wage than he would have received if these costs had not
been imposed.) Imposing part of the tax on the employer, however, gives the
impression that employees are paying a smaller portion of it than they really
are. The remainder of the tax is shifted forward to consumers in the form of
higher prices for the goods and services they purchase, which is also regressive.

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Chapter 31: The Role of Government in Medical Care 507

Medicare: A Case Study of the Success of Concentrated Interests
The concentrated interests of medical providers and the subsequent diffuse
(small) costs imposed on consumers explain much of the legislative history of
the financing and delivery of medical services until the early 1960s. The enact-
ment and design of Medicare illustrate the real purpose of visible redistribution
policy: to redistribute wealth—that is, increase benefits to politically powerful
groups without their paying the full costs of those benefits by shifting the costs
to the less politically powerful.

Throughout the 1950s and early 1960s, the American Federation of
Labor and Congress of Industrial Organizations (AFL-CIO) unions had a con-
centrated interest in their retirees’ medical costs that placed them in opposition to
the American Medical Association (AMA). Employers had not prefunded union
retirees’ medical costs, but instead paid them as part of current labor expenses.
If union retirees’ medical expenses could be shifted away from the employer,
those funds would be available to spend as higher wages to union employees.

To ensure that their union retirees would be eligible for Medicare, AFL-
CIO insisted that eligibility be based on having paid into the Social Security
system while working, and that the new Medicare program (hospital services) be
financed by a separate Medicare payroll tax to be included as part of the Social
Security tax. Although the current retirees had not contributed to the proposed
Medicare program, they were to become immediately eligible because they had
paid Social Security taxes. The use of the Social Security system to determine
eligibility became the central issue in the debate over Medicare (Feldstein 2006).

The AMA was willing to have government assistance go to those unable
to afford medical services, which would have increased the demand for phy-
sicians. Thus, the AMA favored a means-tested program funded by general
tax revenues because it was concerned that including the nonpoor in the new
program would merely substitute government payment for private payment.
The AMA believed such a program would cost too much, leading to controls
on hospital and physician fees.

With the landslide victory of President Johnson in 1964, AFL-CIO
achieved its objective. Once Social Security financing was used to determine
Medicare eligibility, Medicare Part B (physician services) was added, financed
by general tax revenues. Although AFL-CIO won on the financing mecha-
nism, Congress acceded to the demands of the AMA (as well as the American
Hospital Association) on all other aspects of the legislation. The system of
payment to hospitals and physicians promoted inefficiency (cost-plus payments
to hospitals), and restrictions limiting competition were placed on alternative
delivery systems.

This historic conflict between opposing concentrated interests in medical
care left both sides victorious, and it illustrates how the power of government
can be used to benefit politically important groups. As a result of Medicare, a

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Health Pol icy Issues: An Economic Perspect ive508

massive redistribution of wealth took place in society. The beneficiaries were the
aged, union members, and medical providers, and the benefits were financed
by a diffuse, regressive tax (the Medicare payroll tax) on a large group—the
working population, who also paid higher prices for their medical services and
more income taxes to finance Medicare Part B. Medicare was designed to be
both inefficient and inequitable simply because it was in the economic interests
of those with concentrated interests.

Medicaid and Medicare
To understand the two main redistributive programs in the United States, one
must recognize the differences in the sources of political support. Medicaid
is a means-tested program for the poor funded from general tax revenues.
Because the poor (who have low voting participation rates) are unable to pro-
vide legislators with political support, the support for Medicaid comes from
the middle class (who must agree to higher taxes to provide the poor with
medical benefits). The inadequacy of Medicaid in every state, the conditions
necessary to achieve Medicaid eligibility, the low levels of eligibility, and ben-
eficiaries’ lack of access to medical providers are related to the generosity (or
lack thereof) of the middle class. The beneficiaries of Medicare, on the other
hand, are the elderly (who generally have the highest voting participation rate
of any age group). The aged, together with their adult children, provide the
political support for the program. As the cost of Medicare has risen, govern-
ment has raised the Medicare payroll tax and lowered payments to providers
rather than reduce benefits to this politically powerful group.1

The political necessity of keeping costs diffuse explains why Medicare and
producer regulation were financed using regressive taxes—either payroll taxes
or higher prices for medical services. Spreading the costs over large populations
keeps those costs diffuse, with the net effect being that low-income people pay
the costs and high-income people (e.g., physicians, well-to-do elderly) receive
the benefits. Determining who receives the benefits and who bears the costs,
according to the economic theory, is not based on income (see exhibit 31.2),
but rather on which groups are able to offer political support (the beneficiaries)
and which groups are unable to do so (those who bear the costs). Regressive
taxes typically are used to finance producer regulation and provide benefits to
specific population groups.

Changes in Health Policies
Health policies change over time because groups who previously bore a diffuse
cost develop a concentrated interest. Until the 1960s, medical societies were
the main groups with a concentrated interest in the financing and delivery of
medical services. Thus, the delivery system was structured to benefit physi-
cians. The physician-to-population ratio remained constant for 15 years (until

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Chapter 31: The Role of Government in Medical Care 509

the mid-1960s) at 141 per 100,000 (see exhibit 4.1), state restrictions were
imposed on health maintenance organizations (HMOs) to limit their develop-
ment, advertising was prohibited, and restrictions were placed on other health
professionals to limit their ability to compete with physicians. Financing mecha-
nisms also benefited physicians; until the 1980s, capitation payment for HMOs
was prohibited under Medicare and Medicaid, and competitors to physicians
were excluded from reimbursement under public and private insurance systems.

As the costs of medical care continued to increase rapidly for govern-
ment and employers, their previously diffuse costs became concentrated. Under
Medicare, the federal government was faced with the choice of raising taxes
or reducing benefits to the aged, both of which would have cost the John-
son administration political support. Successive administrations developed a
concentrated interest in lowering the rate of increase in medical expenditures.
Similarly, large employers worried that rising medical costs were making them
less competitive internationally. The pressures for cost containment increased
as the costs of an inefficient delivery and payment system grew larger. Rising
medical expenditures are no longer a diffuse cost to large purchasers of medi-
cal services.

Other professional organizations, such as the associations for psycholo-
gists, chiropractors, podiatrists, nurse practitioners, and nurse anesthetists, saw
the potentially greater revenues their members could receive if they were better
able to compete with physicians. These groups developed a concentrated inter-
est in securing payment for their members under public and private insurance
systems and in expanding their scope of practice. The increase in opposing
concentrated interests weakened the political influence of organized medicine.

Political Markets Compared with Economic Markets

The usefulness of the different theories of government should be judged by
their predictive ability. While it is unlikely that any one theory can explain
all or even a high percentage of all legislation, a theory is necessary to try to
understand why certain types of legislation are passed and why others are not,
unless one believes that all legislation is ad hoc. Organizing our observations
in some meaningful manner is natural. The criteria for selecting one theory
over another should be based on pragmatic grounds; which approach is better
at explaining events under a broad range of circumstances? To reject a theory,
it is necessary to have a better theory.

Similarities Between Political and Economic Markets
The economic theory of government assumes that human behavior is no differ-
ent in political markets than in private markets. Individuals, groups, firms, and

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Health Pol icy Issues: An Economic Perspect ive510

legislators seek to enhance their self-interests; they are assumed to be rational
in assessing the benefits and costs of their actions. This behavioral assumption
enables us to predict that firms in competitive markets will try to produce
their products and services as efficiently as possible to keep their costs down,
and that they will set their prices to make as much profit as possible. They will
be motivated to enter markets in which the profit potential is greatest and,
similarly, to leave markets in which the profit potential is low.

Including political markets is merely an extension of the earlier discus-
sion. Individuals and firms attempt to use the power of the state to further their
own interests. Firms try to gain competitive advantages in private markets by
investing in technology and advertising. Why shouldn’t they also make political
investments to use the powers of government to increase or maintain profit?

The actions of groups of individuals are no different from those of firms.
Many people would like to use the power of the state to assist them in accom-
plishing what they cannot otherwise achieve. For some, this may mean using
the state to help them impose their religious or social preferences on others.
Still other groups would like to use the state to provide them with monetary
benefits—such as low-cost education for their children, pension payments in
excess of their contributions, and subsidized medical benefits—that they could
not earn in the market and that others would not voluntarily provide to them.

It is usually with regard to our public servants that the assumption of
acting in one’s self-interest becomes difficult to accept. After all, why would
a person run for office if not to serve the public interest? However, success in
the electoral process requires legislators to behave in a manner that enhances
their reelection prospects. Political support, votes, and contributions are the
bases for reelection. Legislators must therefore understand the sources of such
support and the requirements for receiving it. A hungry man quickly realizes
that if money buys food, he must have money to eat. Legislators act no dif-
ferently from others.

Differences Between Political and Economic Markets
Political markets have several characteristics that differentiate them from eco-
nomic markets. These differences make it possible for organized interests to
benefit at the expense of majorities. First, individuals are not as informed about
political issues as they are about the goods and services on which they spend
their own funds.

Second, in private markets individuals make separate decisions regarding
each item they purchase. They do not have to choose between sets of packages,
such as different combinations of automobile models and home sizes. Yet in
political markets, their choices are between two sets of votes by competing
legislators on a wide variety of issues.

Third, voting participation rates differ by age group. The young do
not vote; however policies are enacted that impose costs on them. Future

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Chapter 31: The Role of Government in Medical Care 511

generations depend on current generations and voters to protect their interests.
However, as has been the case many times, such as with respect to the federal
deficit, Social Security, and Medicare, their interests have been sacrificed to
current voters.

Fourth, legislators use different decision criteria from those used in the
private sector. A firm or an individual making an investment considers both
the benefits and the costs of that investment. Legislators, however, have a dif-
ferent time horizon, which not only affects the emphasis they place on costs
and benefits but also affects when each is incurred. Because members of the
House of Representatives run for reelection every two years, they are likely to
favor programs that provide immediate benefits (presumably just before the
election) while delaying the costs until after the election or years later.

Fifth, from the legislator’s perspective, the program does not even have
to meet the criterion that the benefits exceed the costs, only that the imme-
diate benefits exceed any immediate costs. Future legislators can worry about
future costs.

For these reasons, organized groups are able to receive legislative benefits
while imposing the costs of those benefits on the remainder of the population.
For those bearing the costs, it may be perfectly rational not to oppose such
legislation. As long as the cost of changing political outcomes exceeds the lost
wealth imposed by the legislation, it is rational for voters to lose some wealth
rather than to organize and bear the cost of trying to change the legislative
outcome.

At times, self-interest legislation may be in the public interest. When
this occurs, however, it is a by-product of the outcome rather than its intended
effect.

Summary

The public-interest theory of government and economic theory of regula-
tion provide opposing predictions of the redistributive and efficiency effects
of government legislation, as shown in exhibit 31.3. To determine which of
these contrasting theories is a more accurate description of government, we
must match the actual outcomes of legislation to each theory’s predictions.
Do the benefits of redistributive programs go to those with low income, and
are they financed by taxes that impose a larger burden on those with higher
income? Does the government try to improve the allocation of resources by
reducing barriers to entry and, in markets in which information is limited, by
monitoring the quality of physicians and other medical services and making
this information available to the public?

The economic theory of regulation provides a better explanation of
why health policies are enacted and why they have changed over time. An

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Health Pol icy Issues: An Economic Perspect ive512

indication of the inadequacy of the public-interest theory is the difficulty in
placing demand-side and supply-side policies for each of the three policy instru-
ments—expenditure, taxation, and regulation (described in exhibit 31.1)—into
a redistribution or efficiency improvement framework. The economic theory
predicts that government is not concerned with efficiency issues. Redistribution
is the main objective of government, but the purpose is to redistribute wealth to
those who are able to offer political support from those who are unable to do
so. Thus, medical licensing boards are inadequately staffed, have never required
reexamination for relicensure, and have failed to monitor practicing physicians
because organized medicine has been opposed to any approaches seeking to
increase quality that would adversely affect physicians’ income. Regressive
taxes are used to finance programs such as Medicare and the ACA’s employer
mandate, not because legislators are unaware of their regressive nature, but
because the taxes are designed to be diffuse and not obvious to those with low
income (who actually bear the burden of the benefits provided to those who
have a concentrated interest).

The structure and financing of medical services is rational; the partici-
pants act according to their calculations of costs and benefits. Viewed in its
entirety, however, health policy is uncoordinated and seemingly contradic-
tory. Health policies are inequitable and inefficient; low-income people end
up subsidizing those with higher income. These results, however, are the
consequences of a rational system. The outcomes were the result of policies
enacted by legislators.

Discussion Questions

1. What were the dissatisfactions with the public-interest theory of
government?

Theories of
Government

Objective of Government

Redistribution Efficiency Improvement

Public-interest
theory

Assist those with low income Remove (and prevent) monop-
oly abuses and protect environ-
ment (externalities)

Economic theory
of regulation

Provide benefits to those able
to deliver political support and
finance it from those offering
little political support

Efficiency objective unimport-
ant; more likely to protect
industries to provide them with
redistributive benefits

EXHIBIT 31.3
Health Policy

Objectives
Under Different

Theories of
Government

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Chapter 31: The Role of Government in Medical Care 513

2. Contrast the benefit–cost calculations of legislators under the public-
interest theory of government and the economic theory of regulation.

3. Why are concentrated interests and diffuse costs important in predicting
legislative outcomes?

4. Contrast the predictions of the public-interest and economic theories
regarding redistributive policies.

5. Evaluate the following policies according to the two differing theories:
a. Medicare and Medicaid beneficiaries, taxation, and generosity of

benefits
b. The performance of state licensing boards in monitoring physician

quality
6. In what ways are political and economic markets similar?
7. In what ways are political and economic markets different?

Note

1. The political support offered by providers, such as hospitals and
physicians, is important in determining how such redistributive
legislation is designed. Providers benefit because such programs increase
demand by those with low income. However, medical societies have
opposed government coverage of entire population groups (e.g., the
aged) regardless of income level because government payment would
merely substitute for private payment for those who are not poor.
Physicians were concerned that if government covered everyone or all
of the aged, regardless of income, the cost of such programs would rise
and the government would eventually control physician fees. This was
the AMA’s basic reason for opposing Medicare. To gain the political
support of physicians, Congress acceded to physicians’ preferences
when Medicare was established by permitting them to decide whether
or not to accept the government payment for treating Medicare
patients. Medicaid was not controversial because it covered those with
low income; hospitals were paid for their costs, and physicians were
paid fee-for-service and could allocate their time as they wished. As the
federal and state governments experienced large expenditure increases
under each of these programs, government developed a concentrated
interest in controlling hospital and medical spending.

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Health Pol icy Issues: An Economic Perspect ive514

References

Bunce, V. 2013. Health Insurance Mandates in the States 2012. Alexandria, VA: Council
for Affordable Health Insurance.

Feldstein, P. J. 2006. The Politics of Health Legislation: An Economic Perspective, 3rd
ed. Chicago: Health Administration Press.

Stigler, G. J. 1971. “The Theory of Economic Regulation.” Bell Journal of Economics
2 (1): 3–21.

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CHAPTER

43

IN WHOSE INTEREST DOES THE PHYSICIAN
ACT?

Physicians have always played a crucial role in the delivery of medical
services. Although only 23.5 percent of personal medical expenditures
in 2016 were for physician services, physicians control the use of a much

larger portion of total medical resources (Centers for Medicare & Medicaid
Services 2017). In addition to their own services, physicians determine admis-
sions to the hospital; lengths of stay; the use of ancillary services and prescrip-
tion drugs; referrals to specialists; and even the necessity for services in
nonhospital settings, such as home care. Any public policies that affect the
financing and delivery of medical services must consider physicians’ responses
to those policies. Their knowledge and motivation will affect the efficiency
with which medical services are delivered

.

The physician’s role has been shaped by two important characteristics
of the healthcare system. First, only physicians are legally permitted to provide
certain services. Second, both patients and insurers lack the necessary informa-
tion to make many medically related decisions. The patient depends on the
physician for diagnosis and treatment and has limited information regarding
the physician’s qualifications or those of the specialist to whom the patient is
referred. This lack of information places the patient in a unique relationship
with the physician: The physician becomes the patient’s agent (McGuire 2000).

The Perfect Agent

The agency relationship gives rise to a major controversy in the medical eco-
nomics literature. In whose best interest does the physician act? If the physi-
cian were a perfect agent for the patient, he or she would prescribe the mix of
institutional settings and the amount of care based on the patient’s medical
needs, ability to pay for medical services, and preferences. The physician and
the patient would behave as if the patient were as well informed as the physi-
cian. Traditional insurance, once the prevalent form of health plan coverage,
reimbursed the physician on a fee-for-service basis; neither the physician nor
the patient was fiscally responsible or at risk for using the hospital and medical
services.

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Health Pol icy Issues: An Economic Perspect ive44

Before the 1980s, Blue Cross predominantly covered hospital care; all
inpatient services were covered without any patient cost sharing. Although hos-
pital stays are costlier than outpatient care in terms of resources used, patients
paid less to receive a diagnostic workup in the hospital than in an outpatient
setting. Although doing so was an inefficient use of resources, the physician
acted in the patient’s interest and not the insurer’s. Similarly, if a woman wanted
to stay a few extra days in the hospital after giving birth, the physician would
not discharge her before she felt ready to return home.

As the patient’s agent, the physician prescribed the quantity and type of
services based on their value to the patient and the patient’s cost for that care.
As long as the value exceeded the cost, the physician would prescribe it. By
considering only the services’ costs and benefits to the patient, the physician
neglected the costs to society and the insurance company.

Insurance and the role of the physician as the patient’s agent led the
physician to practice what Fuchs (1968) referred to as the technologic imperative.
Regardless of how small the benefit to the patient or how costly to the insurer,
the physician prescribed the best medical care technically possible. Consequently,
heroic measures were provided to patients in the last few months of their lives,
and inpatient hospital costs rose rapidly. Prescribing “low-benefit” care was a
rational economic decision because it still exceeded the patient’s cost, which
was virtually zero with comprehensive insurance.

Supplier-Induced Demand or the Imperfect Agent

The view of the physician as the patient’s agent, however, neglects the physician’s
economic self-interest. As shown in exhibit 4.1, large increases in the total num-
ber of physicians and the number of physicians relative to the population have
occurred since the 1970s. The number of physicians has tripled since 1970, and
the physician-to-population ratio has doubled. The standard economic model,
which assumes the physician is a perfect agent for the patient, predicts that growth
in supply—other things (e.g., higher consumer income) being equal—results in
a decline in physician fees and, consequently, in physician income.

Increases in the physician-to-population ratio, however, did not lead
to decreases in physician income. This observation led to the development of
an alternative theory of physician behavior. Physicians are believed to behave
differently when their own income is adversely affected. In addition to being
patients’ agents, physicians are suppliers of a service. Under fee-for-service
payment, physicians’ income depends on how much service they supply. Do
physicians use their information advantage over patients and insurers to benefit
themselves? This model of physician behavior is referred to as supplier-induced
demand.

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Chapter 4: In Whose Interest Does the Physic ian Act? 45

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Health Pol icy Issues: An Economic Perspect ive46

The supplier-induced demand theory assumes that if the physician’s
income falls, the physician will use her role as the patient’s agent to prescribe
additional services. The physician provides the patient with misinformation to
influence the patient to demand more services, thereby adding to the physician’s
income. In other words, the physician becomes an imperfect agent.

Physicians who are imperfect agents might rationalize some demand
inducement by arguing that additional services or tests would benefit the
patient. However, as the physician prescribes more and more services, he or she
must choose between the extra income received and the psychological cost of
knowing that these services are not really necessary. At some point, the former
is not worth the latter. The physician must make a trade-off between increased
revenue and the dissatisfaction of deliberately providing too many services.

Thus, one might envisage a spectrum of demand inducement that reflects
the psychological cost to the physician. At one end of the spectrum are physi-
cians who act solely in their patients’ interests; they do not induce demand to
inflate or even maintain their income. At the other end of the spectrum are
physicians who attempt to earn as much money as possible by inducing demand;
these physicians presumably incur little psychological cost. In the middle of
the spectrum are physicians who induce demand to achieve or maintain some
target level of income (referred to as the target income theory).

The extent to which the physician is willing and able to generate addi-
tional demand for medical services is controversial. Few people believe that the
majority of physicians generate demand for services solely to maximize their
income. Similarly, few people would disagree that physicians are able to induce
demand. Thus, the choice is between the concept of physicians as perfect agents
for patients and physicians as imperfect agents who induce demand according
to the target income theory. The issue is how much demand physicians can
and will induce.

Demand inducement is limited to some extent by the patient’s recog-
nition that the additional medical benefits are not worth the time or cost of
returning to the physician. The patient’s evaluation of these benefits, however,
varies according to the treatment prescribed. Patients may easily determine
that monthly office visits are not worth their time; however, they may have
more difficulty evaluating the benefits of certain surgical services. Presumably,
demand inducement is more likely to occur for services about which the patient
knows the least; consequently, patients are more concerned about inducement
in such cases.

Many studies have attempted to determine the extent of demand induce-
ment (e.g., Feldstein 2011, 270–72), but the magnitude of the problem remains
unresolved. A recent study found that once information from a clinical trial
regarding the ineffectiveness of a certain type of knee surgery was presented
to surgeons, the number of such procedures declined; however, the decline

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Chapter 4: In Whose Interest Does the Physic ian Act? 47

was smaller in physician-owned surgery centers (Howard, David, and Hock-
enberry 2016).

Evidence shows that cities and counties that have many physicians (in
relation to the population) also have high per capita use of physician services.
This relationship, however, may merely indicate that physicians establish their
practices where the population has a high rate of insurance coverage and,
thus, where the demand for their services is great. The positive correlation
between the number of surgeons and the number of surgeries has been used
as empirical support for the supplier-induced demand theory. Furthermore,
studies have found that rates of procedures such as tonsillectomies and hys-
terectomies are higher when physicians are paid fee-for-service than through
other incentives (e.g., those available to physicians in a health maintenance
organization [HMO]).

Increase in Physician Supply

The growth in physician supply since the 1970s illustrates the importance
of knowing which model of physician behavior—perfect agent or imperfect
agent (operating under supplier-induced demand)—is prevalent. As a perfect
agent, the physician would consider only the patient’s medical and economic
interests when prescribing a treatment, regardless of the possibility that her
income may decline because the greater supply of physicians may decrease the
number of patients she sees.

On the other hand, as an imperfect agent, the physician facing a great
supply of competitors would generate demand to prevent his income from fall-
ing. Total physician expenditures also would rise as more physicians, each with
fewer patients, attempt to maintain their income. Thus, whether one believes in
the standard economic model (perfect agent) or the supplier-induced demand
model (imperfect agent), a larger number of physicians leads to opposite pre-
dictions of their effect on physician prices and income.

Insurers’ Response to Demand Inducement

Insurers recognize that under fee-for-service payment, physicians act as patients’
perfect agents or as imperfect agents. In either case, the value of the additional
services prescribed is lower than the insurer’s cost for those services. Conse-
quently, insurance premiums in a fee-for-service environment are higher than
those for managed care plans, which theoretically attempt to relate the value of
additional medical treatments to the resource costs of those services. Because
of the higher relative premium for fee-for-service plans, more of the insurer’s

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Health Pol icy Issues: An Economic Perspect ive48

subscribers switched to managed care in the 1990s. Since about 2000, insurance
companies have developed mechanisms to overcome physicians’ information
advantage over both insurers and patients.

Insurers, for example, have implemented second-opinion requirements
for surgery. Once a physician recommends certain types of surgery of ques-
tionable medical necessity (e.g., back surgery), a patient may be required to
obtain a second opinion from a list of physicians approved by the insurance
company. Another approach is the creation of preferred provider organizations.
Physicians who maintain lower fees, recommend fewer medical services, and
are considered to be of high quality are selected by insurers. Utilization review
is yet another approach. Before being admitted to the hospital or undergoing
a surgical procedure, a patient must receive the insurer’s approval; otherwise,
the patient is subject to a financial penalty. The length of stay in the hospital
is also subject to the insurer’s approval.

These cost-containment approaches are insurers’ attempts to address the
imbalances in physician and patient incentives under a fee-for-service system.
Furthermore, they ensure that the patient receives appropriate care (when the
physician acts to increase his own income) and that the resource costs of a
treatment are considered along with its expected benefits.

HMO Incentives by Imperfect Agents

The growth of HMOs and capitation payment provides physicians with income-
raising incentives that are opposite those of the traditional fee-for-service
approach. HMOs typically pay medical groups annual capitation payments
per enrollee and may reward their physicians with profit sharing or bonuses if
their enrollees’ medical costs are lower than their annual capitation payments.
What are the likely effects of the two models of physician behavior—perfect
agent and imperfect agent—on an HMO’s patients?

In an HMO setting, a perfect-agent physician would continue to pro-
vide the patient with appropriate medical services. Regardless of the effect
of profit sharing on her income or pressures from the HMO to reduce use
of services, the perfect agent would be primarily concerned with protecting
patients’ interests and providing them with the best medical care, so there is
little likelihood of underservice. In an HMO, the physician does not need to
be concerned about whether the patient’s health plan covers the medical cost
in different settings. HMO patients are also responsible for fewer deductibles
and copayments. Thus, the settings chosen for the patient’s treatment are likely
to be less costly for both the patient and the HMO.

The possibility that patients would be underserved in an HMO exists
among imperfect-agent physicians (those who attempt to boost their own

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Chapter 4: In Whose Interest Does the Physic ian Act? 49

income). HMO physicians have an incentive to provide fewer services to patients
and to serve a large number of patients. HMO physicians who are primarily
concerned with the size of their income are more likely to respond to profit-
sharing incentives. At times, a physician (who may even be salaried) may suc-
cumb to an HMO’s pressures to reduce use of services and thereby become
an imperfect agent.

If HMO patients believe they are being denied timely access to primary
care physicians, specialist services, or needed technology, they are likely to
switch physicians or disenroll at the next open-enrollment period. A high dis-
satisfaction rate with certain HMO physicians could indicate that their patients
are underserved. An HMO should be concerned about underservice by its
physicians. Although the HMO’s profitability will improve if its physicians
provide too few services, an HMO that limits access to care and fails to satisfy
its subscribers risks losing market share to its competitors.

The more knowledgeable that subscribers are regarding access to care
provided by different HMOs, the greater will be the HMO’s financial incentive
not to pressure its physicians to underserve patients. Instead, it will monitor
physicians to guard against underservice. Gathering information on HMOs
and their physicians and how well enrollees are served is costly (in terms of
time and money) for individuals. It is less costly for employers to gather this
information, make the information available to employees, and even limit the
HMOs from which employees can choose.

Informed Purchasers

Informed purchasers are necessary if the market is to discipline imperfect agents.
An HMO’s reputation is an expensive asset that can be damaged by imperfect
agents underserving their patients. Performance information and competition
among HMOs for informed purchasers should prevent organizations from
underserving their enrollees. The financial, reputation, and legal costs of under-
service should mitigate the financial incentives to underprescribe in an HMO.

Both insurers and HMOs lack information about a patient’s diagnosis
and treatment needs. Thus, the insurer’s or HMO’s profitability depends on
the physician’s knowledge and treatment recommendations. Depending on the
type of health plan and the incentives physicians face, a potential inefficiency
exists in the provision of medical services. Physicians may prescribe too many
or too few services. When they prescribe too many services, the value to the
patient may not be worth the costs of producing the additional services. Pre-
scribing too few services is also inefficient in that patients may not realize that
the value of the services and technology they did not receive (and for which
they were willing to pay) was greater than their physician led them to believe.

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Health Pol icy Issues: An Economic Perspect ive50

To decrease these inefficiencies, insurers who pay physicians on a fee-for-service
basis have instituted cost-containment methods.

Medicare, a fee-for-service insurer for physician services for the aged, has
not yet undertaken similar cost-containment methods to limit supplier-induced
demand. Until Medicare institutes such mechanisms, imperfect agents will be
able to manipulate the information provided to their aged patients, change
the visit coding to receive higher payment, and decrease the time spent per
visit with these patients. (See chapter 10 for a discussion of the new Medicare
physician payment system.)

Monitoring of physician behavior in HMOs and other managed care
settings has increased. Physicians who were previously in fee-for-service systems
and boosted their income by prescribing too many services are being reviewed
to ensure that they understand the change in incentives. Once they are aware
of the new incentives, these imperfect agents must continue being monitored
to ensure that they do not underserve their HMO patients.

The market for medical services is changing. Insurers and large employ-
ers are attempting to overcome physicians’ information advantage by profiling
physicians according to their prices, use and appropriateness of their services,
and treatment outcomes. These profiles provide imperfect agents with less
opportunity to benefit at the expense of the insurer. Information on physician
performance is available on the internet, and some states (e.g., New York) pub-
lish data on physician and hospital performance (e.g., risk-adjusted mortality
rates for different types of surgery).1 Demand inducement, to the extent that
it exists, will diminish. One hopes that with improved monitoring systems and
better measures of patient outcomes, physicians will behave as perfect agents,
providing the appropriate quantity and quality of medical services by consider-
ing the costs and benefits of additional treatment.

Insurers serving millions of enrollees maintain very large data sets, and
information technology allows insurers to use these data sets to analyze differ-
ent treatment methods and physician practice patterns. These data will enable
insurers to determine which physicians deviate from accepted medical norms.

Not all insurers or employers, however, are engaged in these informa-
tional and cost-containment activities. Those who are not are at a disadvan-
tage with regard to the physician and the HMO. Insurers and employers who
are less knowledgeable regarding the services provided to their enrollees and
employees pay for overuse of services and demand-inducing behavior by fee-
for-service providers, as well as underservice by HMO physicians. Medicare
and Medicaid, whose payment methods are primarily fee-for-service, are also
limited in cost-containment activities to reduce demand inducement. At some
point, such purchasers will realize that investing in more information will lower
their medical expenditures and improve the quality of care provided.

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Chapter 4: In Whose Interest Does the Physic ian Act? 51

Summary

Under fee-for-service payment, the inability of patients and their insurers to
distinguish between imperfect agents and perfect agents has led to the growth
of cost-containment methods. The changes occurring in the private sector and
in government physician payment systems must take into account the differ-
ent types of physicians and the fact that, unless physicians are appropriately
monitored, the response by imperfect agents will make achieving the intended
objectives difficult.

Discussion Questions

1. Why do physicians play such a crucial role in the delivery of medical
services?

2. How might a decrease in physician income, possibly the result of an
increase in the number of physicians, affect the physician’s role as the
patient’s agent?

3. What are some ways in which insurers seek to compensate for
physicians’ information advantage?

4. What forces currently limit supplier-induced demand?
5. How do fee-for-service and capitation payment systems affect the

physician’s role as the patient’s agent?

Note

1. Information on websites and reports on physician and hospital
performance are from www.consumerhealthratings.com/index.
php?action=showSubCats&cat_id=30. That website includes links to
different state reports, such as the following:
• Massachusetts: Adult Coronary Artery Bypass Graft Surgery in

the Commonwealth of Massachusetts: Hospital Risk-Standardized
30-Day Mortality Rates, Fiscal Year 2014 Report—www.mass.gov/
files/documents/2017/12/14/cabg-fy2014

• New Jersey: Cardiac Surgery in New Jersey, 2013—www.state.nj.
us/health/healthcarequality/documents/cardconsumer16

• New York: Adult Cardiac Surgery in New York State, 2012–2014
(ratings of hospitals and surgeons)—www.health.ny.gov/statistics/
diseases/cardiovascular/heart_disease/docs/2012-2014_adult_
cardiac_surgery

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Health Pol icy Issues: An Economic Perspect ive52

Additional Reading

Mitchell, J. M. 2010. “Effect of Physician Ownership of Specialty Hospitals and Ambula-
tory Surgery Centers on Frequency of Use of Outpatient Orthopedic Surgery.”
Archives of Surgery 145 (8): 732–38.

References

American Medical Association. 2015. Physician Characteristics and Distribution in the
US, 2015 Edition. Chicago: American Medical Association.

———. 2012. Physician Characteristics and Distribution in the US, 2012 Edition.
Chicago: American Medical Association.

———. 1982. Physician Characteristics and Distribution in the US, 1981 Edition.
Chicago: American Medical Association.

Centers for Medicare & Medicaid Services. 2017. “National Health Expenditure
Data.” Modified December 21. http://cms.gov/Research-Statistics-Data-and-
Systems/Statistics-Trends-and-Reports/NationalHealthExpendData/index.
html.

Feldstein, P. J. 2011. Health Care Economics, 7th ed. Albany, NY: Delmar.
Fuchs, V. R. 1968. “The Growing Demand for Medical Care.” New England Journal

of Medicine 279 (4): 190–95.
Howard, D., G. David, and J. Hockenberry. 2016. “Selective Hearing: Physician-

Ownership and Physicians’ Response to New Evidence.” National Bureau of
Economic Research Working Paper No. 22171. Published April. www.nber.
org/papers/w22171.

McGuire, T. G. 2000. “Physician Agency.” In Handbook of Health Economics, vol.
1A, edited by A. J. Culyer and J. P. Newhouse, 461–536. New York: North-
Holland Press.

US Census Bureau. 2016. Monthly Population Estimates for the United States: April
1, 2010 to December 1, 2017: 2016 Population Estimates. Published December.
www2.census.gov/programs-surveys/popest/tables/2010-2016/national/
totals/na-est2016-01.xlsx.

———. 2012. Statistical Abstract of the United States. Various editions. www.census.
gov/library/publications/time-series/statistical_abstracts.html.

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CHAPTER

257

16GOVERNMENT INTERVENTION IN
HEALTHCARE MARKET

S

Learning Objectives

After reading this chapter, students will be able to

• describe the advantages of perfectly competitive markets,
• explain when markets may be inefficient, and
• discuss alternative approaches to market failure.

Key Concepts

• Given the right conditions, competitive markets can produce optimal
outcomes.

• Markets organize vast amounts of information about costs and
preferences.

• Perfectly competitive markets lead to efficient production and
consumption.

• Markets are dynamically efficient.
• Most markets are imperfect.
• Markets may be inefficient when externalities or public goods are

present.
• Markets may be inefficient when competition or information is

imperfect.
• Efficient market outcomes may not be equitable.
• Clear assignment of property rights may improve market outcomes.
• Taxes or subsidies may improve the efficiency of some markets.
• Public provision of some products may be efficient.

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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
Account: s4264928.main.eds

Economics for Healthcare Managers258

16.1 Government Intervention in Healthcare

Government intervention in healthcare is extensive, even in a market-
oriented society such as the United States. This chapter explores the rationale
for government intervention, assuming that the goal is the promotion of the
public well-being. We will begin by looking at the virtues of markets and then
examine problems with markets. The chapter concludes by considering ways
that governments might intervene.

16.1.1 On the Virtues of Markets
Under the right conditions, competitive markets can lead to an allocation
of resources that is Pareto optimal—that is, no one can be made better off
without making someone worse off (Debreu 1959). These conditions are
restrictive:

• Each market should have large numbers of buyers and sellers.
• Products are undifferentiated.
• All buyers and sellers know all the relevant information about the

market.

Markets also require maintenance of law, order, and property rights, so this
list of conditions may be incomplete. Nonetheless, these conditions are sel-
dom satisfied, leaving us with questions that are more complex and more dif-
ficult. Would relying more on markets to allocate resources make us better or
worse off? Would changing the laws and regulations make us better or worse
off? The difficulty is that we must choose not between perfect markets and
perfect governments but between imperfect versions of each. Much of this
chapter focuses on the shortcomings of markets. First, though, let us explore
some of the virtues of markets.

16.1.2 Information Processing
What should the price of gasoline be? Is an additional flight between Chi-
cago and Tulsa, Oklahoma, worth enough to consumers to justify the cost of
operating it? Are consumers willing to pay for the capabilities of satellite tele-
phones? Is there a shortage of nurses? Markets help us answer such questions.

In an ideal market, goods and services are made, distributed, and used
so that the market value of production is as large as possible. The result-
ing prices spread information throughout the economy, coordinating the
decisions of many decentralized producers and consumers. The quest for
profits encourages producers to seek low-cost ways of creating the products
consumers most want while using resources in the most valuable way pos-
sible. Because the decisions made by consumers are designed to maximize

Pareto optimal
An allocation of
resources in which
no reallocation
of resources is
possible that
will improve the
well-being of one
person without
worsening the
well-being of
another.

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Chapter 16: Government Inter vention in Healthcare Markets 259

satisfaction, maximizing market values results in maximizing well-being.
The equilibrium of an ideal market is Pareto optimal. Furthermore, market
exchange is voluntary. Individuals can choose to trade or not, affording con-
siderable freedom to participants.

In a planned economy, well-intentioned officials who use their power
wisely and justly may find price setting difficult. The planning process does
not automatically yield the information needed to set prices. In addition,
because price setting is a political act in a planned econ omy, officials may
have difficulty setting prices correctly even when they know the proper levels.

Setting Prices for Walkers

Walmart sells a walker called the Carex Explorer
for $63.98. Medicare covers the Explorer, but it

used to pay between $99.77 and $143.65 (CGS 2015). As a result of
competitive bidding, the current price ranges from $44.90 to $50.61
(CGS 2018). Between 1989 and 2011, Medicare paid for equipment such
as walkers using a fee schedule equal to 95 percent of a product’s
average wholesale price (an unverified number provided by manufac-
turers). This system kept Medicare fees substantially higher than typi-
cal retail prices.

As a part of the Medicare Modernization Act of 2003, Medicare
accepted bids for ten types of equipment in ten metropolitan areas.
The median accepted bid was 26 percent lower than the existing Medi-
care fee. Equipment manufacturers and retailers responded by lobby-
ing Congress to discard the bids and delay the program, and the House
of Representatives obliged by passing a bill to ditch the bids. In fact,
it was only with the passage of the Affordable Care Act that Medicare
was able to launch competitive bidding in 2011 (Newman, Barrette, and
McGraves-Lloyd 2017). Even though Medicare anticipated savings of
45 percent on competitively bid products and 72 percent for mail-order
products, in 2015 then congressman Tom Price and 82 cosponsors
introduced a bill to suspend competitive bidding (Newman, Barrette,
and McGraves-Lloyd 2017). Although the bill did not become law, this
example demonstrates three points. First, a well-designed bidding
process can result in lower prices for public programs. Second, such
programs are expensive and take a long time to set up and implement.

Case 16.1

(continued)

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Economics for Healthcare Managers260

16.1.3 Static Resource Allocation
Perfectly competitive markets allocate products efficiently to the consumers
most willing to pay for them. In other words, production and consumption
are efficient. Products are produced as inexpensively as possible. No resources
are wasted in making goods and providing services. Reorganization of pro-
duction would increase costs.

Exchanges of goods and services in perfectly competitive markets all
take place at the same price. As a result, consumers who value products will
buy them. Products are not wasted on consumers who feel the products are
worth less than the amount spent to produce them.

Perfectly competitive markets result in an optimal mix of output.
Their combination of lowest-cost production and highest-value consumption
means that changes would reduce satisfaction. At the competitive optimum,
price equals marginal benefit, which in turn equals marginal cost. Shifts in the
output of the economy would cause the marginal cost to be higher or lower
than the marginal value to consumers, which would not be optimal.

Third, efforts to switch to a bidding process will
encounter opposition from those whose profits are
at risk.

Some supplier organizations argue that that the program encour-
ages bidders to offer only the lowest-cost products rather than those
best suited to beneficiaries’ needs. An analysis reported that competi-
tive bidding did not affect beneficiary access and satisfaction (US Gov-
ernment Accountability Office 2014).

Discussion Questions
• What are the risks of a bidding process like the one described in

this case?

• Why would elected representatives side with the manufacturers and
retailers on this issue?

• If Medicare sought bids for cardiac care to serve beneficiaries in
your hometown, what would happen economically and politically?

• Bidding has led to a drop in the number of medical equipment
firms. Is this drop a concern?

• Could you design a way of insulating Medicare from political
pressure? Would you want to?

• What problems other than paying too much might distorted fee
schedules cause?

Case 16.1
(continued)

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Chapter 16: Government Inter vention in Healthcare Markets 261

Perfectly competitive markets are not necessarily fair. Different dis-
tributions of incomes result in different market outcomes. A perfectly com-
petitive market might lead to an efficient outcome in which most consumers
have comparable incomes, or a perfectly competitive market might lead to an
efficient outcome in which most consumers are ill-housed and ill-nourished
and only a handful live in palaces.

16.1.4 Dynamic Resource Allocation
In a market economy, successful innovations are highly profitable. Unsuccess-
ful innovations and inertia are highly unprofitable. As a result, markets are
efficient in a dynamic sense. They respond quickly to changes in economic
conditions and encourage innovation.

At the simplest level, markets squelch products that customers do not
want. A product that does not create more value for potential buyers than its
alternatives will fail quickly. Compounding this effect, those in authority or
those with established products have difficulty preventing change; rivals are
free to develop new products, and customers are free to buy them.

More important, markets reward innovation that customers want. A
product that is as good as its alternatives is not likely to be more profitable
than the others, whereas a better product promises high short-term profits.
Customers will pay a premium for a better product, and substantial profits
will follow if the market is large enough. Before too long, though, competi-
tors will introduce similar products, and profit margins will fall. Producers
must innovate continuously to maintain above-average profit margins.

Because innovation is intrinsic to market economies, we often fail to
notice it. For most of human history, however, innovation was not routine.
Before 1700, most people used the same technology their grandparents
used. Income per capita changed little for hundreds of years (Mazzucato and
Semieniuk 2017).

The dynamic efficiency of markets is so important that it may trump
static efficiency concerns. Suppose, for example, that a market is dominated
by a few large firms. In this market, prices will be somewhat higher than they
would be in a more competitive market. But if those large firms invest more
in research and development than smaller firms would, it might not be long
before the resulting innovation would make consumers better off.

16.2 Market Failure

Despite their many virtues, markets do not always perform well. We will now
consider the main reasons markets fail:

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Economics for Healthcare Managers262

• Externalities
• Public goods
• Imperfect competition
• Imperfect information
• Natural monopoly
• Income redistribution

We will explore these in detail.

16.2.1 Externalities
Production or consumption of some products may directly affect others.
These side effects are called externalities. When the side effects benefit oth-
ers, they are called external benefits. When the side effects harm others,
they are called external costs. When these side effects are not considered in
market exchanges, the resulting equilibrium may entail volumes that are too
high or too low.

For example, immunization confers external benefits on people who
have not been immunized. If you are immunized, my risk of becoming ill
decreases. In return for this benefit, I might be willing to pay a part of the
cost of your immunization and part of the cost of others’ immunizations. As
a practical matter, though, providing subsidies to the thousands of people I
want to help would be difficult. I would be able to subsidize only a small
number of immunizations, which defeats the purpose of my offer.

Exhibit 16.1 illustrates this concept. The private demand curve, which
ignores the product’s external benefits, is DP. The social demand curve,
which incorporates these benefits, is DS. The market equilibrium, which
ignores the external benefits of immunization, results in a volume of QP. An
equilibrium that takes the external benefits into account would result in the
larger volume of QS. In short, the market equilibrium is not fully efficient.

Externalities need not be positive. If I let my untreated sewage con-
taminate your well, I am imposing external costs on you to have the sewage
treated. I am considering the amount I would have to spend on water to get
rid of wastes, but I am not considering your costs. If the society includes
just the two of us, you could pay me to produce less sewage. If the society
includes 100 people like me, and our sewage affects 500 or 5,000 people,
these private payments will become complex, and problems are likely to
ensue. External benefits and costs that affect large numbers of people are
characteristic of public goods (see section 16.2.2).

A classic example of an externality is the tragedy of the commons. If
everyone in a village can graze livestock on a common pasture, each person
has an individual incentive to overuse the resource. The overgrazing may
become so severe that all the livestock starve and the village collapses. In

externality
A benefit or
cost accruing to
someone who is
not a party to the
transaction that
causes it.

external benefit
A positive impact
of a transaction
for a consumer
or producer not
involved in the
transaction.

external cost
A negative impact
of a transaction
for a consumer
or producer not
involved in the
transaction.

tragedy of the
commons
Over- or underuse
of a resource
that occurs when
ownership of the
resource is unclear
and users produce
externalities.

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Chapter 16: Government Inter vention in Healthcare Markets 263

other words, each person’s livestock consume resources that imperil every-
one else’s livestock. More contemporary examples include vehicle congestion
in cities, in which each driver ignores the costs imposed on others; overuse
of the Ogallala aquifer in the central United States, in which each farmer’s
pumping increases costs for others; and excessive production of greenhouse
gases by one country that causes a climate change affecting all countries.

The use of antibiotics in healthcare is another example of the tragedy
of the commons. Patients benefit from the liberal use of antibiotics, but
society suffers because overuse speeds the development of antibiotic-resistant
strains.

The flip side of the tragedy of the commons is a network external-
ity—a value each additional user adds for existing users. Communications
equipment of all sorts promotes network externalities. Electronic health
record systems are a good example. An electronic health record system is
valuable to a hospital. It transmits records quickly throughout the hospital,
and any physician can instantly access a patient’s record. If the other hos-
pitals in town adopt compatible systems, the value of that electronic health
record system increases. Its value increases further if all providers in the
country adopt compatible systems. The hospital will be able to offer more
appropriate treatment to an emergency department patient from another
town because it will have access to that patient’s past treatments, test results,
and vital signs.

Standards also promote network externalities. For example, one rea-
son that healthcare costs are high in the United States is the absence of widely

network
externality
The effect each
additional user
of a product or
service has on
the value of that
product or service
to existing users.

EXHIBIT 16.1
Market
Equilibrium
with External
Benefits

D
S

S

Q
P

Q
S

D
P

Pr
ic

e

Quantity

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Economics for Healthcare Managers264

accepted standards for billing. Insurers have their own systems, and providers
must submit bills in a wide range of formats to be paid in a timely fashion.
If two insurers adopt a common standard, they will save some money, but
hospitals and clinics (which are not parties to the decision to standardize)
will save even more. The value of this standardization increases as more and
more insurers join.

16.2.2 Public Goods
A public good is an extreme example of externalities. A pure public good
has two unusual characteristics: Consumption by one person does not pre-
vent consumption by another, and exclusion is difficult. One person’s use
of a pure public good does not interfere with another’s use of it, resulting
in nonrival consumption: The marginal cost of letting one more person
use the public good is zero. For instance, my enjoyment of clean air in the
country does not limit your enjoyment of it. Alternatively, I can use the new
research you are using. In addition, preventing people from using pure public
goods is difficult, so their use is nonexcludable consumption, meaning that
everyone has access to them.

A radio broadcast illustrates the difference between these two con-
cepts. When a program is broadcast, anyone in the reception area can get the
signal. Adding another listener does not affect current listeners, so consump-
tion of the broadcast is clearly nonrival. In contrast, a radio broadcast may or
may not be excludable. Most commercial radio in the United States does not
exclude any potential listeners, but SiriusXM satellite radio is only available
to subscribers, so exclusion is possible. Because exclusion is possible, radio
broadcasts are not public goods.

In contrast, a reduction in levels of sulfur dioxide in the air is a public
good. One person’s enjoyment of better air quality does not prevent another
person from enjoying it too, so consumption of improved air quality is non-
rival. In addition, preventing anyone from taking advantage of cleaner air
would be hard to imagine, so consumption is nonexcludable.

Markets are not likely to result in the right amounts of public goods
being consumed. If market transactions lead to any consumption of public
goods, the quantities are likely to be too small.

Because everyone can simultaneously enjoy a public good, the mar-
ginal benefit of a public good equals the sum of the marginal benefits for
everyone in society. So, if a 1 percent reduction in sulfur dioxide in the atmo-
sphere is worth $1 to Jordan, $2 to Kim, and $4 to Logan, it will be worth
$7 to the three of them. The marginal benefit to society is the sum of the
marginal benefits to the members of society, and the members of this three-
person society should be seeking an outcome in which the marginal benefit
to society equals the marginal cost.

public good
A good whose
consumption
is nonrival and
nonexcludable.

nonrival
consumption
Use by one
person that
does not prevent
simultaneous use
by another person.

nonexcludable
consumption
The situation
that occurs when
preventing use
by someone
who did not pay
for a product is
infeasible.

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Chapter 16: Government Inter vention in Healthcare Markets 265

Exhibit 16.2 illustrates this situation. If the three members of society
act independently, only Logan will pay for sulfur dioxide reduction and the
level chosen will be small. At this cost, Jordan and Kim will be unwilling
to pay for any reduction in sulfur dioxide, although they will benefit from
Logan’s spending. However, they will be willing to pay for a much larger
reduction in sulfur dioxide if they recognize that reducing sulfur dioxide lev-
els is a public good and pool their resources. This level of reduction, which
equates the marginal benefit and marginal cost, would be optimal for this
three-person society.

Cooperation could therefore lead to an optimal result. The difficulty is
that Jordan would be even better off if Kim and Logan paid for the reduction
in sulfur dioxide. After all, Jordan will benefit whether he pays or not. This
situation is called the free rider problem. In a three-person society everyone
could probably be persuaded to pay, but cooperation is less likely to be pos-
sible in a society of 3 million or 300 million people.

free rider
Someone who
benefits from
a public good
without bearing
its cost.

EXHIBIT 16.2
Demand for a
Public Good

To Vaccinate or Not

When students start school, they have to prove
that they were vaccinated against diseases such

as chicken pox, polio, and measles, which can spread quickly through
an unprotected group. Students with compromised immune systems
can be exempted from the requirement because the immunizations
might be dangerous to them. In most states, parents also can get
exemptions based on personal beliefs.

Case 16.2

(continued)

+D
Kim

+D
Jordan

D
Logan

Q
Logan

Q
Social

S

Sulfur Dioxide Reduction

W
ill

in
gn

es
s

to
P

ay

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Economics for Healthcare Managers266

California Senate Bill 277, passed in 2015,
eliminated personal-belief exemptions. The law
was prompted by a measles outbreak that started

at Disneyland in 2014 and infected more than 150 people. That out-
break was likely exacerbated by low vaccination rates.

California’s law sought to remove personal-belief exemptions to
increase vaccination rates and herd immunity, a form of indirect protec-
tion that occurs when a large percentage of a population has become
immune. Herd immunity helps protect people who, because of medi-
cal reasons, cannot be vaccinated and are vulnerable to infections. It
seems to have worked. The percentage of California’s kindergartners
with all required vaccinations rose from 93 percent in fall 2014 to 96
percent in fall 2016 (Lin 2017).

Not everyone supported Senate Bill 277. The president of A Voice
for Choice, a group that opposed the bill, was quoted as saying, “It’s
not right for children to be prevented from going to school because of
their vaccination status” (Siripurapu 2016). This opinion appears to be
a minority view, as a referendum to repeal the law got too few signa-
tures to make the ballot. “It’s going to ensure that all children are safe
in school from dangerous, preventable diseases,” said state senator
Richard Pan, the bill’s author (Siripurapu 2016).

Discussion Questions
• What are the external effects of a vaccine?

• Are people who rely solely on herd effects free riders?

• What are the scientifically verified potential harms of vaccines?

• What are the possible health outcomes of chicken pox, polio, and
measles?

• What are the external effects of these diseases?

• Have vaccination rates risen or fallen in the United States?

• Would too few people be vaccinated if it were not mandatory? Is
there evidence?

• Are vaccination rates lower in states with personal-belief
exemptions?

• What steps do governments take to increase vaccination rates?

• What steps do private companies take to increase vaccination
rates? Why?

Case 16.2
(continued)

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Chapter 16: Government Inter vention in Healthcare Markets 267

16.2.3 Imperfect Competition
At equilibrium in a perfectly competitive market, price equals marginal cost.
Producing more volume than that produced at equilibrium would be inef-
ficient because the value of the additional output would be less than its cost.
In an imperfectly competitive market, however, every producer has some
market power, so producers will set prices to make marginal revenue equal
marginal cost.

Exhibit 16.3 illustrates an imperfectly competitive market. Because the
producer has some price flexibility, marginal revenue is less than price. To
maximize profits, the producer sets the price so that marginal revenue (MR)
equals marginal cost (a point on the supply curve). As a result, volume will
be QP. In a perfectly competitive market, the price would equal marginal cost
and volume would be QS.

16.2.4 Imperfect Information and Incomplete Markets
The efficiency of market outcomes rests on the assumption that buyers and
sellers have perfect information, which is seldom the case in healthcare.
As Arrow (1963) argued, the purpose of a visit to a physician is often the
reduction of uncertainty; people seek care because they need more complete
information. If patients are unsure about the benefit they will gain from a
physician visit, they may decide to forgo the visit, which can lead to less-than-
optimal market outcomes.

EXHIBIT 16.3
Imperfect
Markets
and Market
OutcomesD

S

MR

Q
P

Q
S

Quantity

Pr
ic

e

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Economics for Healthcare Managers268

Exhibit 16.4 illustrates three possible outcomes for this scenario. D1,
D2, and D3 describe different consumers’ willingness to pay for care. D1 rep-
resents the willingness of a consumer who correctly understands the value
of a physician visit. Given the marginal cost of producing this information,
the consumer will buy Q1. D2 describes the willingness of a consumer who
overstates the value of a physician visit. This consumer will buy Q2, which is
substantially larger than Q1. More important, the true value of the visit at Q2
is well below marginal cost. (The true value lies on the D1 demand curve.)
This individual would be better off reallocating spending to other products.
Finally, D3 describes the willingness of a consumer who understates the value
of a physician visit. In this example, the consumer makes no visits and forgoes
all the benefits those visits might have provided. This consumer would be
better off reallocating spending from other areas to physician visits. In short,
we cannot be sure that the market outcome will be optimal if information is
imperfect.

The situation is even more complex than exhibit 16.4 suggests. Phy-
sicians and other experts may have discretion in recommending services.
Even after a service has been provided, the consumer may have difficulty
ascertaining whether the expert made the best recommendation, especially
if the expert reaps large profits from the recommended service. Insurance
further complicates matters. Insurers have difficulty tracking the true costs of
services, and the conven tional wisdom is that slow adjustments in insurance
fees distort the profitability of some services. For example, the cost of MRI
(magnetic resonance imaging) equipment has dropped sharply even as the

EXHIBIT 16.4
Market

Outcomes
with Imperfect

Information

Quantity

D
1

D
2

S

Q
2

Q
1

D
3

Pr
ic

e

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Chapter 16: Government Inter vention in Healthcare Markets 269

quality of images has increased and the time needed to obtain an image has
gone down. As a result, the cost of produc ing a scan dropped, but prices for
scans went down only slowly. As a result, MRI scans became so profitable
that many individual physicians began installing them in their offices, and
the use of MRI scans increased rapidly. Growth has slowed considera bly, as
coverage has become more restrictive and patients face higher copay ments
(Andrews 2017).

16.2.5 Natural Monopoly
If fixed costs are so high that only one firm can survive in the long run, that
firm is a natural monopoly. Monopolies develop relative to the structure of
costs and the size of the market. In a small market, only one hospital may be
able to survive. In a larger market, multiple competitors can thrive.

The larger the investment needed to set up a firm, the more likely the
firm is to be a natural monopoly. If an imaging center has fixed costs of $20
million, it will be a natural monopoly in many markets. If an imaging center
has fixed costs of $2 million, it will be a natural monopoly only in the smallest
markets. Like any monopoly, natural monopolies tend to sell their products
and services at overly high prices, resulting in low sales.

16.2.6 Income Redistribution
A substantial part of government spending can be described as insurance or
redistribution. Medicaid and Social Security Disability Insurance are exam-
ples. Taxes are levied on the healthy and wealthy to provide medical care and
income to those less fortunate.

Redistribution is usually rationalized in one of two ways. One views
redistribution as a public good. We all have some sympathy for the unfor-
tunate, and we all benefit if someone offers them aid. Individual gains are
small, however, and we may be tempted to let others provide our share of the
redistribution. People who obtain a benefit at another’s expense or without
the usual cost or effort are free riders. Free riding results in underprovision
of the public good.

A related approach introduced by Rawls (1971) argues that if we were
ignorant of our circumstances, we would want a society that allowed for some
redistribution. In this approach, we would decide on how much redistribu-
tion was appropriate behind a “veil of ignorance,” meaning that we would
not know whether we were healthy or unhealthy, wealthy or poor.

16.3 Remedies

The remainder of this chapter explores possible remedies for market failure.
Remember that doing nothing is always an option. Government intervention

natural monopoly
A market that can
be most efficiently
served by a single
firm.

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Economics for Healthcare Managers270

will not necessarily improve the situation. Governments also fail, and inter-
vention could even worsen the situation.

16.3.1 Assignment of Property Rights
Many externalities result from ambiguities about the ownership of property
rights. For example, does a downstream city have a right to clean water, or
does an upstream city have a right to use a river as a sewer? Often the first
step in solving externality problems is defining who has the right to use an
asset. Once users are defined, asset sales, private agreements, regulations, or
taxes can be used to produce efficient outcomes.

An influential analysis by Coase (1960) pointed out that ambiguity
about property rights underlies many externality problems. As long as the
costs of reaching and enforcing an agreement are small, the people involved
in an externality case can reach agreements that solve the problem. For
example, if the upstream city has the right to pollute, the downstream city
can pay it to refrain from polluting the river. If the downstream city has the
right to pure water, the upstream city will have to pay for the right to pollute
(and will usually find it can pay less if it limits its pollution). Either way, the
property owners can reach an efficient solution. With unclear property rights,
who should pay whom is unclear, and too much of the externality is likely to
be produced. If it is not clear that the upstream city has to pay for the right
to pollute or it is not clear that the downstream city has to pay to prevent
pollution, the upstream city is likely to underestimate the cost of pollution as
a way of disposing of waste and dump too much waste into the water.

If an externality affects many people or is caused by many people,
the costs of reaching and enforcing an agreement will be high. As a result,
workable private agreements will be hard to reach. For example, pollution of
Chesapeake Bay is caused by millions of people and affects millions of people.
In such cases, governments typically claim property rights and use a variety
of tools to improve outcomes.

In recent years, governments have taken steps to create markets for
pollutants. First, the government asserts its ownership of the property right
affected by pollution. Then, firms or jurisdictions are issued permits to
pollute. These permits are worth more to firms or jurisdictions that have
difficulty reducing pollution and are worth less to firms that reduce pollu-
tion more easily. Trades among potential polluters establish a price per unit
of pollution and push potential polluters to equalize the costs of pollution
reduction. Firms that incur low costs to reduce pollution have an incentive to
do more to clean up than do firms that incur high costs to reduce pollution;
the latter buy permits so that they can limit their cleanup efforts.

The 1990 Clean Air Act amendments set national caps for emission
of sulfur dioxide by power plants, issued permits equal to this cap to plants,

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Chapter 16: Government Inter vention in Healthcare Markets 271

and allowed plants to trade permits. This program significantly reduced emis-
sions of sulfur dioxide, and most observers consider it a success. The price of
compliance was low, so compliance was high, and firms were encouraged to
innovate to reduce emissions.

16.3.2 Taxes and Subsidies
If a product generates significant external benefits, a subsidy can be used to
make the market outcome more efficient. Whether the subsidy goes to pro-
ducers or consumers does not matter. Either way, the market price will fall
and consumption will rise.

Exhibit 16.5 illustrates the effects of a subsidy. The demand curve D1
describes the willingness of consumers to pay for a product. Because it yields
external benefits, the market outcome will be Q1, which is inefficiently small.
Giving consumers a subsidy will expand consumption to Q2, which will be
the efficient level if the right subsidy has been chosen. Alternatively, one
could subsidize producers, thereby reducing the marginal cost (and shifting
out the supply curve). This subsidy will also cause consumption to increase
to Q2.

If this product generated external costs, a tax could be imposed to
reduce consumption. The challenge with the tax or subsidy is determining
the appropriate rate. Changing tax or subsidy rates is not an easy political
process, and the market will not always make the appropriate rate evident.

EXHIBIT 16.5
Market
Outcomes with
a Subsidy

Q
1

Q
2

S
Subsidy

D
Subsidy S

W
ill

in
gn

es
s

to
P

ay

Quantity

D
1

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Economics for Healthcare Managers272

16.3.3 Public Production
Public provision of products is another approach to market failure. Public
provision is especially useful for pure public goods. When significant exter-
nalities are present and excluding certain potential customers is difficult or
inefficient, public provision may be the best response. Even if private firms
can profitably produce some of the output consumers seek, using prices (as
private firms must) to pay for such products is undesirable. For example,
private research firms might be able to profitably conduct some public health
research by disseminating the results only to organizations that pay to get
access to it. But this approach is inefficient because too few people will get
access to the research. The cost of sharing the results with additional orga-
nizations is small, and the value of the research is not reduced if it is more
widely shared.

If redistribution is a goal, using prices to affect product consumption
may also be undesirable. For example, prices that are high enough to allow
a clinic to survive may also be high enough to prevent low-income citizens
from using the clinic.

Public provision does not necessarily mean public production. For
example, medical research has many of the attributes of public goods.
Although government employees perform medical research, a large share of
research is performed by scholars who are not government employees but
private researchers competing for tax-supported research funds. In another
example of public provision with private production, medical care for the
poor is usually provided to improve the health of our least fortunate citi-
zens, meaning that the goal is largely redistribution. In some cases, this care
is provided by government hospitals and clinics. More commonly, though,
care is provided by private hospitals and clinics but funded by tax-supported
programs such as Medicaid.

16.3.4 Regulation
The next chapter examines regulation. Regulation is an important form of
government intervention in markets, especially in healthcare. Markets need
rules to work, so regulation is not an alternative to markets. Some regulations
cause markets to work well; other regulations have the opposite effect.

16.4 Conclusion

Markets have many virtues, not the least of which is the ability to reveal
information about cost and value. Many forms of government intervention
falter because key information about cost and value is lacking. In addition,
the impulse to innovate inherent in markets is important for improved health

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Chapter 16: Government Inter vention in Healthcare Markets 273

and well-being. A long-standing criticism of governments is their bias toward
inaction and the status quo.

A key question about government intervention is hard to answer:
Will intervention improve the well-being of the public? Intervention will not
necessarily improve an imperfect market. Effective interventions are hard to
design and even harder to implement. In the rough-and-tumble of political
life, good intentions do not always translate into good effects, and proposals
backed by advocates are not always good ideas. Furthermore, government
interventions can improve the well-being of individuals or groups even if the
interventions do not improve overall well-being.

This critique should not be pushed too far. Government support for
research has problems, but the strong consensus seems to be that the over-
all benefits are considerable and that government action is necessary. The
government’s public health activities also have problems, but there is no
consensus that ending these activities would make our citizens better off.
On the other hand, some interventions should be ended. The challenge is
to determine what new programs to start and which existing programs to
expand, contract, or terminate.

Exercises

16.1 Global warming is a classic example of a public good. Analyze this
comment and explain your answer.

16.2 The existence of market failure does not signal what should be done
in response. Analyze this comment and explain your answer.

16.3 Imperfect competition is the norm, so healthcare markets cannot
work. Analyze this comment and explain your answer.

16.4 Markets work; governments do not. Analyze this comment and
explain your answer.

16.5 Are market forces strong enough to deliver efficient healthcare?
Please explain.

16.6 For each scenario, assess whether an externality is present.
a. Vaccinating children against influenza reduces its incidence

among the elderly.
b. Newly graduated nurses flock to teaching hospitals for training.

After working for a year, many leave to work for competitors.
c. A couple who planned to move to Florida to retire find that the

plummeting housing market has wiped out their equity.
d. Physicians complain that they spend a third of their time

explaining to patients why television advertisements about
medications for their conditions do not apply to them.

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Economics for Healthcare Managers274

16.7 The supply of measles vaccine is given by Q = 450 × P. The demand
for measles vaccine is given by Q = 20,000 − 50 × P.
a. What is the market equilibrium price and quantity?
b. The demand curve implies that private willingness to pay is P =

400 − Q/50. However, external benefits are associated with each
measles vaccination, so the social demand curve is Q = 20,000 −
50 × (P − 5). What are the equilibrium price and quantity if these
external benefits are considered?

c. Propose an intervention that will result in this equilibrium volume.
16.8 The supply of an antibiotic is Q = 30 × P − 200. The demand for it

is Q = 8,800 − 20 × P.
a. What is the market equilibrium price and quantity?
b. Use of the antibiotic creates $20 in external costs due to water

pollution. Would the market outcome be different if a $20 tax
were levied on producers instead?

16.9 Vaccination schedules are predictable, meaning that insurance
coverage for vaccinations does not protect consumers against risks.
Insurance coverage for vaccinations drives up costs because more
people get vaccinated if coverage is available and because insurers
have overhead costs. Does insurance coverage for vaccines do
anything useful? Explain your answer.

16.10 About two-thirds of funding for substance abuse treatment comes
from taxpayers. Does substance abuse treatment have external
benefits that warrant this level of public funding?

16.11 Provide examples of the following types of government intervention
in healthcare:
a. Government production
b. Subsidies for products
c. Taxes on products
d. Price regulation
e. Quality regulation
f. Inaction

16.12 Provide healthcare examples of the following types of market
failure:
a. External benefits
b. External costs
c. Public goods
d. Imperfect competition
e. Imperfect information

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Chapter 16: Government Inter vention in Healthcare Markets 275

16.13 Private foundations support medical research. Does this fact prove
that tax funding of medical research is unnecessary? Please explain.

16.14 Public health information can be broadcast at a cost of $100. Public
health information is a pure public good, in that many people can
use the information simultaneously and preventing people from
using the information is difficult. One group of residents has a
demand curve for public health information of the form Q = 50 − P.
Here Q is the number of public health broadcasts per month and P
is the price per broadcast. Another group has a demand curve of Q
= 140 − P.
a. At a price of $100 per broadcast, how many broadcasts per

month will be demanded? (Add the quantities demanded by each
group.)

b. What is the total willingness to pay for 85 broadcasts? (Recast the
demand curve to reveal willingness to pay and add the amounts
for the two groups. For one group, willingness to pay equals
50 − Q. For the other, it equals 140 − Q. For both groups the
minimum is $0.)

c. At what level of output does willingness to pay equal $100?
d. What do these results imply?

16.15 Every 1 percent reduction in the level of particulates in the air
costs $200,000. Low-income residents in a region have a demand
for particulate reduction of R = 10 − P, where R is the level of
particulate reduction and P is the price per 1 percent reduction.
High-income residents have a demand for particulate reduction of R
= 40 − 2P.
a. Is reduction of the level of particulates a public or private good?
b. What will the market demand for particulate reduction be?
c. What is the optimal level of particulate reduction?

16.16 Few orthopedic surgeons publish data describing their surgical
volumes, infection rates, mortality rates, functional gain rates, or
customer satisfaction rates.
a. How much would a regulation requiring publication of such data

cost?
b. Would such a regulation improve the workings of the market?
c. Would such regulation be an appropriate government activity?
d. Do we need a regulation requiring publication of data for

surgeons if private physician rating firms already exist?

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Economics for Healthcare Managers276

References

Andrews, M. 2017. “Anthem Says No to Many Scans Done by Hospital-Owned
Clinics.” NPR. Published September 27. www.npr.org/sections/health
-shots/2017/09/27/553483496/anthem-says-no-to-many-scans-done-by
-hospital-owned-clinics.

Arrow, K. J. 1963. “Uncertainty and the Welfare Economics of Medical Care.”
American Economic Review 53 (5): 941–73.

CGS. 2018. “Jurisdiction C DMEPOS Fee Schedules.” Accessed September 21.
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. 2015. “Jurisdiction C DMEPOS Fee Schedules.” Accessed September 21,
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Coase, R. H. 1960. “The Problem of Social Cost.” Journal of Law and Economics
3: 1–44.

Debreu, G. 1959. Theory of Value. New York: Wiley.
Lin, R. G. II. 2017. “How California Got More Children Vaccinated After the

Disneyland Measles Outbreak.” Los Angeles Times. Published April 13. www
.latimes.com/local/lanow/la-me-vaccination-explainer-20170413-story.html.

Mazzucato, M., and G. Semieniuk. 2017. “Public Financing of Innovation: New
Questions.” Oxford Review of Economic Policy 33 (1): 24–48.

Newman, D., E. Barrette, and K. McGraves-Lloyd. 2017. “Medicare Competitive
Bidding Program Realized Price Savings for Durable Medical Equipment
Purchases.” Health Affairs 36 (8): 1367–75.

Rawls, J. 1971. A Theory of Justice. Cambridge, MA: Harvard University Press.
Siripurapu, A. 2016. “California’s New Child Vaccination Rule Takes Effect.” Sacra-

mento Bee. Published June 30. www.sacbee.com/news/politics-government/
capitol-alert/article87023212.html.

US Government Accountability Office. 2014. “Medicare: Second Year Update for
CMS’s Durable Medical Equipment Competitive Bidding Program Round 1
Rebid.” Published March 7. www.gao.gov/products/GAO-14-156.

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CHAPTER

455

THE PHARMACEUTICAL INDUSTRY:
A PUBLIC POLICY DILEMMA

The pharmaceutical industry is subject to a great deal of criticism regarding
the high prices charged for its drugs, its large (some would say “waste-
ful”) marketing expenditures, and its emphasis on “lifestyle” and “me-

too” drugs over drugs to treat infectious diseases and chronic conditions.
However, the industry has developed important drugs that have saved lives,
reduced pain, and improved the lives of many. Public policy that attempts to
respond to industry critics may at the same time change the industry’s incen-
tives for research and development (R&D), thereby reducing the number of
potentially blockbuster drugs. To evaluate the criticisms of this profitable indus-
try and the consequences of public policy directed toward it, an understanding
of the structure of the pharmaceutical industry is needed

.

The pharmaceutical industry is made up of two distinct types of drug
manufacturers: (1) pharmaceutical manufacturers, which engage in R&D (or
buy newly developed drugs from small R&D firms) and market brand-name
drugs, and (2) generic manufacturers. Pharmaceutical manufacturers invest
large sums in R&D, whereas generic manufacturers do not. Consequently,
the former group develops innovative branded drugs for new therapeutic uses,
while generic firms sell copies of branded drugs (when their patents expire)
at greatly reduced prices. These two types of manufacturers differ in their
economic performance and in the public policies directed toward them. Most
public policy is directed at pharmaceutical manufacturers.

Understanding the distribution channel for prescription drugs is also
essential in understanding the structure of the industry. Manufacturers produce
the drugs and, for the most part, sell them to wholesalers, which then sell them
to pharmacies, where the drugs are purchased by patients; manufacturers also
sell to pharmacy benefit managers (PBMs), who manage prescriptions for insur-
ers and employers. Pharmacies can take many forms and are found in various
places, including chain drugstores such as Walgreens, mass merchandisers such
as Walmart and Target, grocery store pharmacies such as Kroger, mail-order
and retail pharmacies, and pharmacy websites. Over time, the number of inde-
pendent retail pharmacies has declined. Wholesalers and retail pharmacies are
each competitive industries.

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AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition
Account: s4264928.main.eds

Health Pol icy Issues: An Economic Perspect ive45

6

Public Policy Dilemma

An important characteristic of the drug industry is the low cost of actually pro-
ducing a drug once it has been discovered. Very large costs are incurred by the
pharmaceutical manufacturer in the R&D phase and in marketing the new drug
once it has been approved by the Food and Drug Administration (FDA). A new
drug’s price is not determined by its R&D costs, however, because these costs have
already been incurred. Instead, the price is based on the demand for that drug,
which is determined by its therapeutic value and whether it has close substitutes.
Because the production costs of a drug (marginal costs) are low, a drug with great
therapeutic value and few, if any, substitutes will command a high price. The result-
ing markup of price over production costs will therefore be high, leading to criti-
cism of the drug company that the drug is priced too high for those who need it.

Grabowski and colleagues (2012) estimated the economic value of
statins, a breakthrough drug used for the treatment of cardiovascular disease.
The authors estimated that between 1987 and 2008, the economic value was
$1.25 trillion. The use of statins resulted in fewer deaths, and it reduced heart
attacks and strokes and their associated costs. Subtracting the actual payments
made for the drug, $300 billion, over that period from the economic benefits
results in a net benefit (social value) to society of about $950 billion. The
social value (which economists refer to as “consumer surplus”) represents the
amount people who benefited would have been willing to pay, but did not,
to receive the benefits of statin drugs. The net benefits of statins would have
been much greater if the analysis had been extended for more years, if all those
in the United States who could have benefited from the drug actually took it,
and if the analysis were extended to other countries.

The public policy dilemma is that if the high price markups over cost are
decreased so that more people can buy the drug, profits will also be lowered,
thereby reducing future R&D investment and the discovery of new drugs with
great therapeutic value.

Structure of the Pharmaceutical Industry

The structure of the pharmaceutical industry, together with regulatory restraints
and government payment policies, affects drug prices and the rate of investment
in innovative drugs. Industry performance is generally measured by the number
of blockbuster drugs produced. High price markups for innovative, high-value
drugs with no existing substitutes appear justified; high price markups on older
drugs are simply an indication of the lack of price competition, because the
industry is unable (or lacks the incentive) to produce innovative drugs to take
their place. Industry performance is also affected by regulations that raise the
cost of developing new drugs, the time it takes for a new drug to receive FDA

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 457

approval, and whether the government establishes the prices it will pay for new
drugs; each of these government policies affects the profitability of new drugs
and, hence, incentives for R&D investment.

The growth in regulatory requirements over the past several decades has
adversely affected the discovery of new drugs by increasing the cost of develop-
ing them. The costs of enrolling patients in phase 3 clinical trials (representing
about 90 percent of the total cost of clinical trials), as well as the length of time
spent in clinical trials, have been increasing; bringing a new drug to market can
take about 12 years and cost as much as $2.5 billion (in 2013 dollars) (DiMasi,
Grabowski, and Hansen 2016). Given the time to bring the drug to market
and the size of the investment required, little time is available to recoup the
investment because the patent expires in 20 years.

Drug firms are also experiencing a more difficult reimbursement climate.
The patent periods on several blockbuster drugs (e.g., Lipitor) have expired,
and the drugs have been replaced by generic substitutes. Medicare Part D drug
plans use formularies, forcing drug firms to compete on price to have their
drug included in the formulary. Managed care plans use similar approaches to
reduce their enrollees’ pharmacy costs.

Mergers and Acquisitions
Since the mid-1990s, many mergers have taken place among pharmaceutical
companies. These mergers have been of two types.

The first type is a vertical merger, whereby a firm diversifies into another
product line. The growth of managed care and the greater importance of PBMs
led several large drug manufacturers to spend many billions of dollars to buy
PBMs in the early 1990s. (Merck, for example, paid $6.6 billion for the PBM
Medco in 1993.) These drug firms believed that, by buying PBMs, they could
gain more control over the market for their drugs; the PBMs would presumably
substitute their drugs for those of their competitors, increasing their market
share and drug sales. PBMs, however, were unable to simply include their
owners’ drugs to the exclusion of others because their credibility in serving
health plans would have been adversely affected.

The drug firms’ PBM strategy does not appear to have been worthwhile.
Pharmaceutical companies that did not buy PBMs were also able to increase drug
sales, and some companies that bought PBMs sold them. The growth of managed
care turned out to be a benefit rather than a threat to drug manufacturers. As
more people enrolled in managed care, they received prescription drug cover-
age, use of prescription drugs grew, and sales at all drug firms sharply increased.

The second type is horizontal merger, in which one drug manufacturer
purchases another. There are several reasons for horizontal mergers. First, by
becoming larger, firms expect that economies of scale will increase efficiency
and decrease costs. Merging two companies can lower administrative costs and
raise the efficiency of the two companies’ sales forces, which is critical to the

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Health Pol icy Issues: An Economic Perspect ive458

success of any drug firm. Drug firms with distinctive products are able to use
a single distribution system and sales force when they merge, which results in
significant cost savings. Consolidating research units can eliminate competing
efforts, and mergers can reduce duplicative manufacturing costs.

Second, for some large firms, mergers are a response to patent expira-
tions and gaps in a firm’s product pipeline (Danzon, Epstein, and Nicholson
2007). A wider array of prescription drugs diversifies the financial risk of a firm
that produces only a few best-selling drugs. Third, for small pharmaceutical
firms, mergers are primarily an exit strategy, an indication of financial trouble.
Fourth, horizontal mergers can improve the combined drug firms’ market
power. However, few mergers have occurred between firms with drugs in the
same therapeutic category. Instead, the drugs offered by the combined drug
firms are in different therapeutic categories, offering a broader range of pre-
scription drugs across many therapeutic categories to large purchasers.

Pharmaceutical Firms’ New Research Strategy
The pharmaceutical industry has undergone major changes in the past several
decades. Previously, most pharmaceutical firms were large, able to take advan-
tage of economies of scale, and vertically integrated—that is, most activities
were performed in-house, from drug discovery to clinical trials to regulatory
approval processes to marketing. The firm’s investments in R&D were financed
by internally generated funds. Large drug firms’ drug development relied on
having very large research staffs to screen millions of compounds to discover
the next blockbuster drug that would be used by large population groups.
This strategy, however, resulted in finding very few new blockbuster drugs.

Revolutionary discoveries in biologic sciences in the 1970s changed the
structure of the industry. Thousands of new biotechnology firms emerged.
Venture capital funded many of these startups, which were not expected to be
profitable for a number of years. Although the risk was high, the profit potential
from new drug discoveries was believed to be so high that investors were willing
to risk substantial sums on these new firms. The biotechnology industry became
a major source of drug innovation (Cockburn, Stern, and Zausner 2011).

Scientific advances in genetics and biology enabled drug discovery to
become more focused, targeting the particular pathway that causes a disease
in relatively small population groups. Biotechnology firms attempt to discover
genetically targeted drugs that treat relatively small populations, but because of
the effectiveness of these new drugs, the drug’s price can be as high as $100,000
a year. Because there are no close substitutes, insurers are willing to pay higher
prices compared with what they would pay for drugs for common diseases, such
as high cholesterol, for which there are many generic substitutes. These specialty
drugs are generally able to receive regulatory approval in a shorter period; the time
required to bring a new drug to market is reduced from 12 years to about 6 years.

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 459

Large drug firms were concerned that they had fallen behind small bio-
technology firms in their ability to develop innovative drugs. Small companies
were more likely to take greater scientific risks and devote a greater number of
researchers to a particular idea, whereas large companies became more bureau-
cratic in their scientific decision making. Large drug firms began to depend on
small biotechnology firms to fill their drug pipelines.

The new approach to drug discovery also changed the size of a drug
manufacturer’s research efforts. Large research staffs have been downsized and
reorganized. The firm’s research team has been greatly reduced to only 20 to
40 focused teams. Drug companies believe that smaller research units may be
willing to take greater risks and be more innovative than large bureaucracies.

Another major change in drug firms’ research strategy has been to
become venture capitalists. Rather than investing $1 billion to find the next
blockbuster drug, large drug firms are minimizing their financial risks by devel-
oping contractual relationships with and investing in a number of small bio-
technology companies to find promising new drugs (Walker and Loftus 2013).

Most of the small, new biotechnology firms did not possess the large
drug firms’ capabilities to bring a new product to market. At the same time,
large drug firms recognized the profit potential of the drug research being
undertaken by these small firms. Both types of firms realized that developing
relationships would enable them to capitalize on each other’s strengths. These
small firms face large risks and huge investment costs before their products
can be marketed. The process of discovery, clinical trials, and drug approval
is lengthy and costs several billion dollars. Larger firms are able to bear these
costs and have the expertise to navigate the drug-approval process. Greater risk
pooling also occurs when many drugs are in the discovery and development
phase, as only a few of the many drugs developed will be successful. Only a
large firm can afford to undertake these large research efforts. Small firms may
not have the financial resources to complete the long drug-approval process
or the expertise to perform all of the steps required (Golec and Vernon 2009;
Lazonick and Tulum 2011).

Although the research innovation is being generated by small firms, large
firms have an advantage when it comes to marketing and selling their drugs.
They are able to offer drugs to health plans and PBMs (which contract with
large employers and medical plans) for almost all therapeutic categories at a
package discount. Providing a full line of drugs for different therapeutic areas
at a discount lowers the cost to the PBM by removing the need to negotiate
with multiple firms, while enabling the large pharmaceutical firm to include
drugs in its package that the PBM might not otherwise select. The Medicare
Part D drug benefit reinforces these marketing advantages for the large firm;
they are better able to provide the range of drugs in the restricted formularies
used by the drug plans offering the Part D benefit to Medicare beneficiaries.

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Health Pol icy Issues: An Economic Perspect ive460

Scientific advances have changed the structure of the pharmaceutical
industry by stimulating the growth of many small biotechnology firms, shifting
the direction of drug research, downsizing research teams, and creating a new
role for large drug firms as venture capitalists.

Industry Competitiveness
The pharmaceutical industry appears to be relatively competitive, as measured
by the degree of market concentration. Concentration—which is measured by
the combined market share of the top four firms—was only about 21 percent in
2016, based on data from PAREXEL International (2017, 36). However, when
therapeutic categories are used, the degree of market concentration is much
higher (in some cases, 100 percent) as a therapeutic category may include only
one drug. Thus, the competitiveness of the pharmaceutical industry depends
on the definition of the market.

Markets that are less concentrated (i.e., have more competitors) are
typically more price competitive. The higher the degree of market concentra-
tion and the fewer the substitutes available for a particular drug, the greater
the firm’s market power—that is, the ability to raise the price without losing
sales. Thus, the manufacturer of the first breakthrough drug in a therapeutic
category has a great deal of market power. As additional branded drugs are
developed in that therapeutic category, substitutes become available and price
competition increases. When the patents on those drugs expire and generic
versions are introduced, a great deal of price competition occurs. At each of
these stages, purchasers are able to buy the prescription drug at a lower price.

Development of New Drugs by the US Pharmaceutical
Industry

Several measures are used to indicate the productivity of the US pharma-
ceutical industry. One measure is designation as a global new chemical entity
(NCE), a drug that is marketed to a majority of the world’s leading purchas-
ers of drugs; this designation is preferred over total NCEs as an indicator of
a drug’s commercial and therapeutic importance. First in (a therapeutic) class
is another designation that reveals the innovativeness of a drug. In addition,
the introduction of biotechnology and orphan drugs is examined, as both are
major sources of industry growth and innovation.

Grabowski and Wang (2006) analyzed all NCEs introduced worldwide
between 1982 and 2003. During that period, 919 NCEs were introduced; 42
percent were global NCEs, 13 percent were first in class, 10 percent were bio-
technology drugs, and 8 percent were orphan drugs. Over this period, the total
number of NCEs introduced each year exhibited a downward trend. However,
measures of the drugs’ importance (global NCEs, first in class, biotechnology

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 461

drugs, and orphan drugs) increased during the same period. Grabowski and
Wang (2006) concluded that although the trend in total NCEs declined, the
relative quality of new drugs increased, and most of the biotechnology and
orphan drugs were introduced from 1993 to 2003. The number of NCEs con-
sidered global or first in class varied by therapeutic category, with the highest
number being oncology drugs, which are emphasized by the biotechnology
industry. (The United States is the dominant source of biotechnology drugs.)

When Grabowski and Wang (2006) analyzed the introduction of drugs
by country, the United States was found to be a leader in the development of
innovative drugs, particularly from 1993 to 2003. As shown in exhibit 28.1,
30 of 62 first-in-class drugs (48 percent), 37 of 71 biotechnology products
(52 percent), and 27 of 49 orphan drugs (55 percent) are manufactured in the
United States. Further, when these authors examined the countries in which
important new drugs were first introduced (as opposed to developed), the
United States was again a strong leader compared with the rest of the world in
the most recent period for which data are available (i.e., 1993 to 2003). Both
foreign and domestic drug firms preferred to introduce their important new
drugs first in the US market. US patients benefit from having earlier access to
important new drugs (although there is an associated risk with being the first
users of such drugs).

Country

All NCEs Global NCEs
First-in-Class

NCEs Biotech NCEs Orphan NCEs

82–92 93–03 82–92 93–03 82–92 93–03 82–92 93–03 82–92 93–03

EU total 230 183 99 112 23 27 6 23 9 20

France 35 18 9 11 2 3 0 3 0 4

Germany 53 42 21 27 5 5 2 6 2 5

Italy 29 14 4 1 1 0 0 0 0 0

Switzerland 42 41 26 30 8 11 3 8 1 8

U.K. 34 36 23 27 6 7 0 3 5 2

Others 38 33 17 16 2 2 1 3 1 2

Japan 125 88 12 12 5 3 5 9 1 0

U.S. 120 152 66 81 24 30 9 37 10 27

ROW 7 13 3 1 0 2 0 2 0 2

Total 482 437 179 206 53 62 19 71 20 49

Notes: EU is European Union. ROW is rest of world.

Source: Reprinted with permission as it appeared in Henry G. Grabowski and Y. Richard Wang, “The
Quantity and Quality of Worldwide New Drug Introductions, 1982–2003,” Health Affairs, 25 (2),
March/April 2006: 425–60, Exhibit 4. © 2006 Project HOPE-The People-to-People Health Founda-
tion, Inc.

EXHIBIT 28.1
Country-Level
Output of
New Chemical
Entities (NCEs)
by Category and
Time Period,
1982–1992 and
1993–2003

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Health Pol icy Issues: An Economic Perspect ive462

Unfortunately, no updates to these figures are available. However,
although the data in exhibit 28.2 are not comparable to those in exhibit 28.1,
they are more recent and indicate that the United States still leads in the dis-
covery of new chemical or biological entities. Biotechnology drugs, in which
the United States is a leader, have been a source of important new drugs and
industry productivity growth.

The US market provides greater incentives to drug firms than do other
countries for developing important new drugs and for first introducing innova-
tive drugs. Whether the predominance of the United States in drug innovation
and in being the first place of introduction will continue depends on govern-
ment payment policies to reduce the costs of new drugs.

The Political Attractiveness of Price Controls on
Prescription Drugs

For many years, the high price of prescription drugs was a major concern of
the elderly. When Medicare was enacted in 1965, prescription drugs were not
included as a benefit. Many elderly beneficiaries, who are the highest users of
prescription drugs, could not afford to buy needed drugs; attaining a prescrip-
tion drug benefit became their highest political priority. In 2003, the Medicare
Modernization Act was enacted. It included a new voluntary Medicare Part
D prescription drug benefit, which became effective in 2006 (see chapter 8).

Part D increased seniors’ demand for prescription drugs, and pharma-
ceutical manufacturers benefited from higher revenues. However, increased
revenues to the pharmaceutical companies meant higher federal expenditures
for prescription drugs. Part D, similar to Medicare Part B, became another
unfunded federal entitlement; no matter how much was spent on drugs by the
elderly, Medicare was committed to paying 75 percent of those expenditures.
(As part of the 2010 Affordable Care Act [ACA], Part D beneficiaries’ cost
sharing for prescription drugs is reduced over time, leading to greater use of
prescription drugs and higher drug expenditures.)

Region 1997–2001 2002–2006 2007–2011 2012–2016

Europe 79 46 52 75

United States 84 67 65 88

Japan 29 21 20 32

Other 4 14 12 38

Source: Data from STATISTA (2017).

EXHIBIT 28.2
Output of New

Chemical or
Biological

Entities by
Region of Origin
and Time Period

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 463

The Medicare Modernization Act and the ACA prohibited the federal
government from negotiating drug prices with pharmaceutical firms. Elderly
individuals enroll in a private drug plan, which then negotiates prices with the
drug manufacturer. The cost of the Medicare drug benefits has been much less
than expected, which generally has been attributed to the use of formularies
by competing drug plans, which enable them to negotiate lower prices from
pharmaceutical firms. Pharmaceutical companies are, however, concerned that
Congress will change the law and have the government regulate drug prices
because of the high prices of specialty drugs, which can exceed $100,000 a
year. (Several legislators have proposed changing the law to allow the federal
government to negotiate directly with pharmaceutical companies.) As long as
the government is ultimately responsible for paying for the drug expenses of
Part D enrollees, regardless of who administers the benefit, there is concern
that drug expenditures will eventually be regulated, as the government cur-
rently regulates payment for each type of provider participating in Medicare.

Proponents of government regulation of drug prices claim that in addi-
tion to reducing federal expenditures, the aged would also benefit by lower-
ing their out-of-pocket drug expenses and their premium for the Medicare
drug benefit, which equals 25 percent of total Medicare drug expenditures.
As evidence of the benefits of price controls, proponents claim that prices on
branded drugs are as much as 30 percent higher in the United States than they
are in Canada, which uses price controls.

Price controls on new breakthrough drugs are politically attractive.
Politicians try to provide their constituents with short-term visible benefits,
seemingly at no cost. In the short run, drug prices would be reduced and there
would be no decrease in access to drugs currently on the market. Because the
costs of R&D have already been incurred, the only cost to produce an existing
drug is its relatively small variable cost. As long as the regulated drug price is
greater than the drug’s variable costs, the firm will continue selling the drug.
Profits from that drug will be lower, but the firm will make more money by
continuing to sell the drug, even at the regulated price, than by not selling it.

Consequences of Price Controls on Prescription Drugs

Price controls would not decrease access to innovative drugs currently on the
market or even to those currently in the drug-approval process. Those who
would benefit include patients who cannot afford expensive drugs, states with
rapidly increasing Medicaid expenditures, and the federal government, which
is responsible for bearing 75 percent of the cost of the prescription drug ben-
efit. The aged (who have the highest voting-participation rate), state Medicaid
programs, and legislators interested in decreasing federal drug expenditures

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Health Pol icy Issues: An Economic Perspect ive464

are likely to favor legislation to reduce drug prices. The only apparent loser
would be drug companies.

The real problem with price controls is their effect not on current drugs
but on R&D for future drugs. Price controls reduce the profitability of new
drugs. With lower expected profits, drug companies will be less willing to risk
hundreds of millions of dollars on R&D. Most new drugs (70 to 80 percent)
are not therapeutic breakthroughs and, although their price may exceed their
variable costs, do not generate sufficient profit to cover their R&D investments.
Thus, the drug company loses money on these drugs (see exhibit 26.4).

The small percentage of drugs that are considered blockbuster drugs
have high price markups over their variable costs. The large profits generated
by these blockbuster drugs provide the funding for the drugs that lose money.
Although there is a short-term visible benefit to price controls, they impose
a long-term cost on patients. This long-term cost is not obvious because it
occurs in the future, and the public would be unaware of breakthrough drugs
that were never developed.

Blockbuster drugs, with their high price markups, would be targeted by
price controls. With price controls, profit would be insufficient to provide R&D
funding for new drugs. Fewer breakthrough drugs would lead to more costly
treatment for a disease, whereas such drugs might make surgical intervention
unnecessary or even prevent the disease from developing. Through R&D and
the development of new drugs, the total cost of medical treatment is lowered,
such as has occurred with Sovaldi (sofosbuvir) for treatment of hepatitis C.
With price controls, R&D investments would decline. Drug companies would
also redirect their R&D efforts away from diseases affecting the elderly (where
price controls limit profits) and toward diseases affecting other population
groups (where profits are not limited).

Exhibits 28.3 and 28.4 illustrate the effects of price controls on the
product life cycle of a blockbuster drug (Helms 2004). During the beginning
phases of R&D, including clinical trials, the company incurs a negative cash
flow. Once the FDA approves the drug and the drug company markets the
drug, the cash flow is positive—until other branded drugs (substitutes) enter
the market, and eventually the patent expires and generics enter the market.

If price controls are imposed on a drug after it is approved by the FDA
and marketed, the positive cash flow from the new drug is greatly diminished,
as shown by the black, dotted curve in exhibit 28.4. To illustrate the financial
effects of imposing price controls in the previous example, one would have to
examine the present value of both the cash outlay and the positive cash return.

Money received in the future is worth less than the same amount of
money received today. These money outflows (before the drug is sold) and
inflows occur at different times. The cost of developing a new drug includes
all the costs of bringing it to market, such as research expenditures, the cost of
clinical trials, the cost of having the drug approved by the FDA, and marketing

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 465

– Cash flow

– $20 million

R&D

Clinical trials

Promotion Competition

Approval

0 5 10 15 20 30

Years

40

0

+ Cash flow

+ $20 million

N
et

R
ev

en
ue

(
$,

in
M

il
li

on
s)

Expected net returns
on a new drug

Note: R&D = research and development.

Source: Helms (2004).

EXHIBIT 28.3
Life Cycle of a
New Drug

– Cash flow

R&D

Clinical trials

Promotion Competition

Approval

0 5 10 15 20 30

Years

40

0

+ Cash flow

N
et

R
ev

en
ue

(
$,

in
M

il
li

on
s)

Expected net returns on a new drug

Expected net returns on a new drug if price controls are imposed

Note: R&D = research and development.

Source: Helms (2004).

EXHIBIT 28.4
Effect of Price
Controls on
Drug Returns

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Health Pol icy Issues: An Economic Perspect ive466

costs once it is approved. A company would calculate what it could have earned
on that investment if the funds were instead invested in a corporate bond and
gained interest. For example, if $10 were invested today and earned 6 percent
interest per year, in five years that initial investment would grow to $13.38.
Thus, in calculating the cost of developing a new drug, the firm calculates both
its cash outlay and what it could have earned on that money (the opportunity
cost). Similarly, in calculating the return received from that new drug, which
generates a positive cash flow in the future, it is necessary to discount (using
the same interest rate) the positive cash flow and determine what the money
received in the future is worth in today’s dollars (the present value).

Using the example shown in exhibits 28.3 and 28.4, if a firm invests $20
million in year 5, the present value of that investment equals $14.95 million.
(In other words, $14.95 million invested today would be worth $20 million
in five years.) If, after 15 years, a new drug earns $20 million, the present
value of that return is only $8.35 million. Clearly, the $20 million spent and
the $20 million earned are not equal. In this example, the drug firm would
lose $6.6 million on its investment. Thus, the longer it takes to bring a drug
to market, the longer the negative cash flow and the smaller the present value
of the positive cash flow once the drug is marketed.

If price controls are imposed on a drug once it is marketed, as shown
by the dotted line in exhibit 28.4, both its positive cash flow and the present
value of that reduced cash flow will be lower. Thus, if the firm earns only $10
million in year 15, the present value equals only $4.17 million. The present
value of the cash outflow remains at $14.95 million (Helms 2004).

In the previous example, a drug firm would change its investment strat-
egy. It would decrease its overall investment in R&D, invest in drugs with a
quicker payoff, seek drugs with less risky profitability outcomes, and invest in
drugs whose market potential is very large and profitable, thereby abandoning
research on drugs for diseases affecting relatively few people.

Examples of Price Controls on US Prescription Drugs
The debate over President Clinton’s health plan, introduced in the fall of 1993,
provides an indication of the likely effect of price controls on prescription
drugs. Included in the plan was the Advisory Council on Breakthrough Drugs,
whose purpose was to review prices of new drugs. If the proposed council
believed that a new drug’s price was excessive, it would try to have it reduced
or, failing that, have the drug excluded from health insurance payment. The
targeted drugs were those that were the most profitable and had high price
markups—namely breakthrough drugs.

The pharmaceutical industry was concerned that if the plan were enacted,
price controls would be imposed on prescription drugs and the profitability
of new drugs would be decreased. As a result, the annual rate of increase in

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 467

R&D expenditures declined sharply, falling from 18.2 percent in 1992 to 5.6
percent by 1994, the smallest annual rate of increase in 30 years (see exhibit
28.5). Once it became clear that the Clinton health plan would be defeated
and price controls would not be imposed on new drugs, the annual rate of
increase in pharmaceutical R&D spending rose again.

The next threat to the drug companies occurred in 2002 when the firms
believed Congress was going to legalize reimportation of drugs from Canada
and Europe (without the approval of the secretary of the US Department of
Health and Human Services). As a result, in 2002 R&D expenditures grew
by only 4.2 percent, after having increased by 14.4 percent in 2001. Once the
threat of reimportation did not materialize, R&D expenditures again rose—to
11.1 percent in 2003.

In 2008 and 2009, R&D expenditures sharply decreased over concerns
that the newly elected Democratic president and large Democratic majorities
in Congress would pass legislation that adversely affected the industry by
requiring reductions in Medicare and Medicaid prescription drug prices. In
the fee-for-service section of Medicaid, drug firms pay a rebate to Medicaid
for each drug the program purchases on behalf of its beneficiaries. President
Obama’s 2010 budget proposed an increase in that rebate (ultimately lower-
ing the price that drug firms charged). Proposals were also made to require
a rebate on drugs purchased by Medicare Part D beneficiaries. As the data
indicate, R&D expenditures are sensitive to possible legislative changes that
would reduce drug firms’ profits (Congressional Budget Office 2009).

History does not offer much hope for drug manufacturers evading price
controls. Governments in other countries have used various approaches to lower
their drug expenditures. In a study of 19 OECD (Organisation for Economic
Co-operation and Development) countries, Sood and colleagues (2008) found
various forms of regulation that decreased pharmaceutical revenues. The types
of controls used by these countries included fixing the price of drugs, delaying
approval for expensive new drugs for several years, restricting the use of a drug
once it has been approved, establishing global (country) budget caps, setting
annual budget limits for physicians’ prescriptions, applying profit controls,
and setting the price of all drugs within a specific therapeutic category at the
cost of the lowest-priced drug. While a majority of the regulations decrease
pharmaceutical revenues, direct price controls have the largest negative effect
on revenues. If similar price controls were imposed in the United States, phar-
maceutical revenues would fall as much as 20 percent. Further, the longer the
regulations are in place, the greater their impact on revenues.

Several approaches have already been used in the United States to reduce
government expenditures for prescription drugs (Vernon and Golec 2009).
Because of their tight budgets, state Medicaid programs have more restrictive
formularies than do managed care plans. Newer drugs that are more expensive

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Health Pol icy Issues: An Economic Perspect ive468

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 469

but more effective are more likely to be excluded in favor of less expensive
generics. Further, Medicaid programs delay inclusion of expensive innovative
drugs in their formularies for several years. Studies have shown that the effect
of limiting access to preferred drugs results in a shift toward more costly set-
tings, higher nursing home admissions, and greater risk of hospitalization
among Medicaid populations (Soumerai 2004). Further, the savings in drug
costs were offset by increases in the costs of hospitalization and emergency
department care (Hsu et al. 2006).

A price-control approach that has been used by the federal government
requires the drug manufacturer to sell the drug to the government at its “best”
price. In the 1980s, as a result of price competition among drug companies
to persuade health maintenance organizations (HMOs) and group purchasing
organizations (GPOs) to include their drugs in HMO and GPO drug formular-
ies, drug manufacturers gave large price discounts to certain HMOs and GPOs.
In 1990, the federal government, in an attempt to reduce Medicaid expendi-
tures, enacted a law that required drug manufacturers to give state Medicaid
programs the same discounts they gave their best customers. Consequently,
the drug companies gave smaller discounts to HMOs and GPOs. A study by
the Congressional Budget Office (1996) found that the best (largest) price
discount given to HMOs and GPOs declined from 24 percent and 28 percent,
respectively, in 1991 to 14 percent and 15 percent, respectively, in 1994, the
minimum amount required by the government.

The study concluded that drug companies were much less willing to give
steep discounts to large purchasers when they had to give the same discounts
to Medicaid. Drug prices and expenditures consequently increased for many
private buyers.

Summary

Two important characteristics of the pharmaceutical industry are (1) the low
costs of actually producing a drug and (2) the high cost of developing a new
drug. The price at which a new drug is sold is determined not by its cost of
production or the R&D investment in that drug, but by its value to purchasers
and whether any close substitutes to that drug are available. Valuable drugs
that have no close substitutes (blockbuster drugs) will be priced high relative
to their costs of production. Lowering the price of these blockbuster drugs to
make them more affordable will decrease pharmaceutical companies’ incentive
to invest hundreds of millions of dollars in drugs that may have great value to
society. That is the public policy dilemma.

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Health Pol icy Issues: An Economic Perspect ive470

The pharmaceutical industry has been changing over time from large,
vertically integrated organizations to an industry that still consists of large
firms but also has many small biotechnology firms (funded by venture capital)
that are engaged in developing new blockbuster drugs. A great deal of private
money is invested in these highly risky ventures in the hope of developing a
valuable (and profitable) new drug.

Compared with the rest of the world, the United States has been a leader
in developing important new drugs, and it is the country of first choice for
introducing innovative drugs. Government payment policies to reduce drug
expenditures threaten both the US industry’s leadership and patients’ access
to innovative drugs.

A growing concern is that the federal government, which has become a
large indirect purchaser of prescription drugs as a result of including Part D in
Medicare, will attempt to lower its drug expenses by “negotiating” the price of
prescription drugs. Direct government negotiations with drug companies over the
price of their drugs will be tantamount to the government fixing the price of drugs.

Implementing price controls will not have any immediate effect on
seniors’ access to drugs. However, over time, drug companies will invest less
in R&D and redirect their R&D toward population groups and diseases that
offer greater profitability.

In coming years, enormous scientific progress is likely. The mapping of
the human genome and advances in molecular biology are expected to lead
to drug solutions for many diseases. Drug prices and expenditures will also
likely be higher to reflect the increased willingness of people to pay for these
new discoveries. It would be unfortunate if the desire to reduce the cost of
drugs through price controls decreased the availability of breakthrough drugs.

Any public policy must deal with trade-offs: reducing the high price
markup of breakthrough drugs versus maintaining incentives for investing in
R&D. It is important to distinguish between the short- and long-term effects
of public policy. Using price controls to lower drug prices results in a visible
short-term benefit, but it comes at a less visible longer-term cost of fewer
breakthrough drugs. Patients in the future would be willing to pay for lifesaving
breakthrough drugs that were not developed because the government removed
the incentives to do so. Given the trade-off between instituting regulation to
reduce the cost of drugs and having innovative drugs to cure disease, reduce
mortality, and lower the overall cost of medical treatment, society would likely
choose the full benefits that scientific discovery will offer.

Discussion Questions

1. How has the structure of the pharmaceutical industry changed over time?

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 471

2. What are alternative ways of judging whether the pharmaceutical
industry is competitive?

3. Why are price controls on prescription drugs politically attractive?
4. Why would price controls not limit access to blockbuster drugs that

are either currently on the market or have almost completed the FDA
approval process?

5. What are the expected long-term consequences of price controls on
R&D investments, quality of life, mortality rates, and the cost of
medical care?

References

Cockburn, I., S. Stern, and J. Zausner. 2011. “Finding the Endless Frontier: Lessons
from the Life Sciences Innovation System for Energy R&D.” In Accelerating
Energy Innovation: Insights from Multiple Sectors, edited by R. Henderson and
R. Newell, 113–57. Chicago: University of Chicago Press.

Congressional Budget Office. 2009. “Pharmaceutical R&D and the Evolving Market
for Prescription Drugs.” Published October 26. www.cbo.gov/ftpdocs/106xx/
doc10681/10-26-DrugR&D .

——— . 1996. How the Medicaid Rebate on Prescription Drugs Affects Pricing in the
Pharmaceutical Industry. Washington, DC: US Government Printing Office.

Danzon, P., A. Epstein, and S. Nicholson. 2007. “Mergers and Acquisitions in the
Pharmaceutical and Biotech Industries.” Managerial and Decision Economics
28 (4–5): 307–28.

DiMasi, J. A., H. G. Grabowski, and R. W. Hansen. 2016. “Innovation in the Pharma-
ceutical Industry: New Estimates of R&D Costs.” Journal of Health Economics
47: 20–33.

Golec, J., and J. A. Vernon. 2009. “Financial Risk of the Biotech Industry Versus the
Pharmaceutical Industry.” Applied Health Economics and Policy 7 (3): 155–65.

Grabowski, D. C., D. N. Lakdawalla, D. P. Goldman, M. Eber, L. Z. Liu, T. Abdel-
gawad, A. Kuznik, M. E. Chernew, and T. Philipson. 2012. “The Large Social
Value Resulting from Use of Statins Warrants Steps to Improve Adherence and
Broaden Treatment.” Health Affairs 31 (10): 2276–85.

Grabowski, H. G., and Y. R. Wang. 2006. “The Quantity and Quality of Worldwide
New Drug Introductions, 1982–2003.” Health Affairs 25 (2): 452–60.

Helms, R. 2004. “The Economics of Price Regulation and Innovation.” Managed
Care 13 (6 Suppl): 10–12.

Hsu, J., M. Price, J. Huang, R. Brand, V. Fung, R. Hui, B. Fireman, J. Newhouse,
and J. Selby. 2006. “Unintended Consequences of Caps on Medicare Drug
Benefits.” New England Journal of Medicine 354 (22): 2349–59.

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Health Pol icy Issues: An Economic Perspect ive472

Lazonick, W., and O. Tulum. 2011. “US Biopharmaceutical Finance and the Sustain-
ability of the Biotech Business Model.” Research Policy 40 (9): 1170–87.

PAREXEL International. 2017. PAREXEL Biopharmaceutical R&D Statistical Source-
book, 2017/2018 Edition. Waltham, MA: PAREXEL International.

Pharmaceutical Research and Manufacturers of America (PhRMA). 2018. 2017 PhRMA
Annual Membership Survey. Accessed May. http://phrma-docs.phrma.org/
files/dmfile/PhRMA_membership-survey_2017 .

Sood, N., H. deVries, I. Gutierrez, D. Lakdawalla, and D. Goldman. 2008. “The Effect
of Regulation on Pharmaceutical Revenues: Experience in Nineteen Countries.”
Health Affairs 28 (1): w125–w135.

Soumerai, S. 2004. “Benefits and Risks of Increasing Restrictions on Access to Costly
Drugs in Medicaid.” Health Affairs 23 (1): 135–46.

STATISTA. 2017. “Number of New Chemical or Biological Entities Developed Between
1992 and 2016, by Region of Origin.” Accessed May 2018. www.statista.com/
statistics/275262/pharmaceutical-industry-new-entities-by-region/.

Vernon, J., and J. Golec. 2009. Pharmaceutical Price Regulation: Public Perceptions,
Economic Realities, and Empirical Evidence. Washington, DC: American Enter-
prise Institute Press.

Walker, J., and P. Loftus. 2013. “Merck to Cut Staff by 20% as Big Pharma Trims
R&D.” Wall Street Journal. Published October 2. www.wsj.com/articles/
merck-plans-further-cuts-in-revamp-of-commercial-rampd-arm-1380630165.

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CHAPTER

277

17REGULATION

Learning Objectives

After reading this chapter, students will be able to

• describe the importance of regulation for managers;
• explain the interest group model of regulation;
• analyze the effects of regulations on firms, rivals, and consumers; and
• discuss alternative approaches to market failure.

Key Concepts

• Healthcare is extensively regulated.
• Regulation can make or break an organization (or its competitors).
• The objective of regulation is consumer protection.
• The rationale for consumer protection regulations is consumer

ignorance.
• Legislation and regulation reflect interest group politics.
• When markets are imperfect, regulation cannot always improve

outcomes.
• Providers are likely to “capture” the regulatory process.
• Market responses to consumer ignorance can limit the need for

regulation.

17.1 Introduction

Healthcare is extensively regulated, and new regulations are constantly under
consideration. Regulation is important to managers for five reasons:

1. Changes to regulations can make or break an organization. For
example, in 2016 some health insurers withdrew from Affordable Care
Act marketplaces. Many of those who withdrew concluded that the

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Economics for Healthcare Managers278

reinsurance, risk corridor, and risk adjustment regulations created too
much uncertainty for them to remain (Adelberg and Bagley 2016).

2. In some circumstances, firms can use regulations to gain a competitive
edge, especially when the regulations can be used to prevent entry by
a potential rival. For example, Carilion Children’s Hospital was able to
use the Virginia certificate-of-need law to prevent the construction
of a competing neonatal intensive care unit (Boehm 2017). Claims of
regulatory violations by competitors can delay or derail projects, even
if the claims are ultimately dismissed. For these reasons, managers must
understand the impact of regulations on their organizations, react
effectively to changes to regulations, and know when political action is
necessary.

3. Managers need to understand the impetus behind healthcare
regulation. Regulations are politically acceptable because the
complexity of healthcare makes consumers feel vulnerable. Healthcare
organizations must address these feelings of vulnerability because
failure to do so invites additional regulation or loss of business.

4. Managers need to understand that legislating and regulating are
continuing political contests. Most organizations have little to gain and
much to lose in these risky contests. Few organizations can command
enough political power to win lasting advantages through the political
process, but all organizations need to be aware of the threats these
contests pose.

5. Some regulations work poorly because they conflict with powerful
financial incentives. Many of the same incentives that reinforce or
undermine regulations also affect private contracts. Managers must
know when regulations or contracts will work and when incentives will
undermine them.

As noted in chapter 16, markets and regulation are inseparable. Mar-
kets function badly with poorly designed rules, and regulations work badly
when they conflict with market incentives. How well a market functions
depends crucially on its regulatory structure.

17.2 Market Imperfections

Objections to regulation often stress that unfettered markets serve consumers
well. This assertion may be true for perfectly competitive markets, but most
healthcare markets fall far short of this ideal. At the heart of these imperfec-
tions lies “rational ignorance,” or consumers’ inability to make good choices.
Before we discuss this important issue in healthcare regulation, let us look at

certificate-of-need
law
A law that requires
state approval
of healthcare
construction
projects.

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Chapter 17: Regulat ion 279

the three other main imperfections that beset healthcare markets: insurance,
market power, and externalities.

17.2.1 Insurance
By distorting consumers’ incentives, insurance reduces the likelihood that
healthcare markets will function ideally. Patients are shielded from the true
costs of healthcare, and even the most ethical provider will feel comfortable
recommending goods and services that the patient would be unwilling to
buy if the patient faced the full cost. Moreover, the healthcare system in
the United States limits the role of consumers in choosing insurance plans.
Because patients are insulated from the true costs of care, their healthcare
choices are unlikely to fully reflect their values. This lack of connection
between what consumers value and what healthcare products cost is an
important market imperfection.

17.2.2 Market Power
Most healthcare providers have some market power, which means prices will
exceed marginal cost. To guarantee that markets will allocate resources at
least as well as any other system, prices need to reflect the opportunity cost
of using a good or service. By driving a wedge between the costs and prices
of products, market power compounds the distortions introduced by insur-
ance and may cause markets to function poorly. Moreover, in markets with
firms that have market power, price controls can be useful tools. In a perfectly
competitive market, price controls can be irrelevant (when market prices fall
below regulated levels) or harmful (when market prices rise above regulated
levels). When organizations have significant market power, a third outcome
is possible: Price controls can result in lower prices and higher output. Price
controls are not guaranteed to work in such markets, however; they can still
be irrelevant or harmful. But price controls can be beneficial if the distortions
they create are smaller than the distortions they remove.

17.2.3 Externalities
Some healthcare issues involve significant externalities. As noted in chapter
16, an externality is a benefit received by, or a cost imposed on, someone
who is not a party to a transaction. For example, installation of a catalytic
converter in a car in Los Angeles will make the air cleaner not only for the
owner of the car but also for others who live there and across the country.
Markets tend not to work well when externalities are significant. Consumers
and producers generally focus on the private benefits of transactions, which
results in underconsumption of products that generate external benefits
and overconsumption of products that generate external costs. Not surpris-
ingly, the regulatory role of government tends to be substantial in these

externality
A benefit or
cost accruing to
someone who is
not a party to the
transaction that
causes it.

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Economics for Healthcare Managers280

instances. For example, consider three activities that generate externalities:
the search for new knowledge, the control of communicable diseases, and
the maintenance of the environment. Patent and copyright laws restrict
use of new knowledge, so producers are able to profit from selling it and
thus are motivated to produce it. Public health regulations can mandate
immunizations or require treatment of those infected with communicable
diseases. Environmental regulations may restrict how resources are used or
effectively change ownership rights. The details of these regulations can
be controversial, but few societies leave resource allocation in such areas
entirely to market forces.

17.3 Rational Consumer Ignorance

Healthcare regulations serve multiple purposes, but the ostensible objective
of most regulations has long been consumer protection. The argument is that
consumers need protection because they are rationally ignorant about the
healthcare choices they must make.

At some point, everyone has difficulty making healthcare choices.
In many cases decision makers have to rely on ambiguous or incomplete
information. Although the scientific aura of modern medicine may suggest
otherwise, many therapies lack a firm scientific basis. Even when the scientific
evidence is good (in cases where investigators have carried out controlled
clinical trials), decision makers may have a hard time applying it. Moreover,
the results of controlled trials do not always translate to the uncontrolled
environment of community practice. Even valid evidence involves probabili-
ties, and most people (including most healthcare providers) have difficulty
using this sort of information well. We tend to see patterns where none exist,
place too much emphasis on cases that are memorable or recent, and ignore
the rules of probability.

Patients face additional problems. They often must make decisions
when they do not feel well and are experiencing a great deal of stress. They
typically lack the experience, information, and skills they need to make
healthcare choices. Even after they have chosen a course of action, consum-
ers may have difficulty assessing whether they were diagnosed correctly,
whether they were prescribed the right therapy, and whether that therapy
was executed properly.

The ignorance of most patients is explainable. Few of us know the
healthcare choices we will have to make or when we will have to make them.
We do not want to invest the time to inform ourselves because we might
not ever use the information. We would rather have somebody else do the
research. Of course, rational ignorance is not universal. Patients with chronic

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Chapter 17: Regulat ion 281

illnesses often are well informed about their care because they expect to make
ongoing decisions and are motivated to become knowledgeable.

Consumers’ struggle with medical decisions makes them vulnerable in
a number of ways. Consumers often do not know when to seek care. They
can have difficulty evaluating the recommendations of healthcare profession-
als, the quality of care, or the price of that care. They may be unable to dif-
ferentiate care that is worth more from care that costs more. To reduce their
vulnerability, consumers may turn to medical professionals for advice.

Unfortunately, securing provider recommendations does not render
consumers unassailable. Providers often have incentives to be imperfect
agents. A provider may sell a product because the provider is being paid by
the producer to sell it, or a provider may recommend a therapy because it
is more profitable than another treatment. Patients may wind up undergo-
ing treatment that is ineffective or harmful, or they may take the advice of
incompetent or unethical providers. In short, relying on providers for advice
can reduce, but not necessarily efface, consumers’ vulnerability.

For these reasons, providers have an interest in reducing consumers’
concerns about their vulnerability. Consumers who cannot distinguish good
advice from bad may ignore all of it. Consumers who cannot distinguish
reliable from unreliable healthcare professionals may decide to forgo care.
Regulations serve provider interests by signaling quality to consumers. As
long as competent, trustworthy professionals find it easier to live with the
regulations than incompetent, untrustworthy professionals do, regulations
can be useful for both consumers and providers. Indeed, for this reason,
much of the demand for regulation comes from the groups to be regulated,
and many groups engage in self-regulation. For example, a group of physi-
cians with a particular specialty may decide to create regulations that will keep
lesser-qualified physicians out of the specialty. This approach would help the
group’s own market share and help the public.

Rational ignorance and distortions induced by insurance, market
power, and externalities will continue to make healthcare markets imperfect.
Remember, however, that market regulation of such influences does not
guarantee improved outcomes. Regulations are usually imperfectly designed
and imperfectly implemented. In addition, the consumer protection rationale
of regulations may be just that: a rationale. Regulations can be used to gain
a competitive advantage and may harm, not help, consumers.

17.4 The Interest Group Model of Regulation

Legislation need not serve the public interest. Given that groups can use reg-
ulations to expand their markets and gain market power, the interest group

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Economics for Healthcare Managers282

model of regulation argues that legislatures are similar to markets, in that
individuals and groups seek regulations to further their interests. Regulatory
barriers to competition are often better than other competitive advantages
because they are often harder for competitors to breach (especially for new
firms or firms from outside an area, which have little or no political influ-
ence). Product features can be duplicated and marketing plans can be copied
by even the most insignificant start-up firm, but large, well-established firms
have significant political advantage.

17.4.1 Limiting Competition
One of the best ways to gain market power is to limit competition. Regula-
tion is an effective way of limiting competition. For example, licensure laws
appear to have been used to limit entry by telehealth providers (Gaynor,
Mostashari, and Ginsburg 2017). Similarly, dental societies have long sup-
ported state laws prohibiting persons not licensed as dentists to fit and dis-
pense dentures. Although lobbying the legislature to pass laws to prevent
competition is legal, working together to prevent competition is illegal. In
addition, the industry being regulated is likely to control the regulatory
process, so consumer protection legislation may protect existing firms, not
the consumer. Managers cannot ignore politics; doing so can put an orga-
nization at risk.

17.4.2 Licensure
Licensure is professional control of the regulatory process. A profession can
be regulated in many ways. Professional regulation often protects the eco-
nomic interests of the regulated group far better than it protects the health
and safety interests of the public. States generally regulate health profession-
als via licensure, certification, and registration. Licensure prohibits people
from performing the duties of a profession without meeting requirements set
by the state. Certification prohibits those who do not meet requirements set
by the state from using a title, but not from practicing. Registration requires
practitioners to file their names, addresses, and relevant qualifications.

Licensure is the most restrictive form of regulation. It can prohibit
practice by individuals without the right qualifications or require that they
practice under the supervision of another professional. Its use is often
justified by concerns about safety. While recognizing that certification
considerably reduces consumer ignorance, advocates of licensure contend
that it prevents unwary consumers from making unsafe choices. In some
cases, however, licensure can prevent consumers from making choices
that might make sense for them. Furthermore, it forces consumers to use
highly trained, expensive personnel even when viable alternatives may be
available.

interest group
model of
regulation
A view of
regulations as
attempts to further
the interests of
affected groups,
usually producer
groups.

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Chapter 17: Regulat ion 283

17.4.3 Regulation as a Competitive Strategy
Regulations that affect the structure or process of an organization’s opera-
tions typically increase its costs and reduce its flexibility. Naturally, firms
resist regulation (even if their business plans are consistent with the goals
of the regulation). For these reasons, imposing regulations on rivals (but
not on oneself) can be an effective competitive strategy. Most regulation
of the health professions has been a result of this strategy because existing
professionals have been grandfathered in and regulations apply only to newly
licensed practitioners.

17.5 Regulatory Imperfections

When markets are not perfect, regulation can improve outcomes. For three
reasons, however, regulation is likely to be equally imperfect: the need for
decentralized decision making, conflicts between regulatory and financial
incentives, and capture by regulated firms. Therefore, although new regula-
tions can improve outcomes, this result is not guaranteed.

Regulations work best when decision making is centralized and when
“one size fits all.” Healthcare does not fit these criteria. Patients’ healthcare
needs, preferences, and circumstances vary considerably, so decision making
needs to be decentralized and individualized. In addition, regulatory and
financial incentives need to be aligned to work well. When they are not, regu-
lations are likely to be ignored or circumvented. For example, we know that
healthcare organizations respond to financial incentives. If physicians find
that treating patients in the hospital is more convenient than treating them
in their offices, and the physicians receive no financial incentives to encour-
age outpatient care, utilization review (an analysis of patterns of care by an
employer or insurer) is unlikely to reduce hospitalization rates.

Furthermore, the groups being regulated are likely to capture regu-
lations even if the regulations were well intended. Capture occurs when a
group gains control of the administration of regulations. Capture matters
because the way the laws are implemented and enforced is as important as the
laws themselves, and sooner or later the groups being regulated are likely to
take control of the enforcement process. They have better information than
consumers, pay more attention to the regulatory process than consumers,
and have a more intense interest in the regulatory process than consum-
ers. Regulation does not eliminate consumers’ rational ignorance (although
regulations about disclosing information may reduce it). As a result, regula-
tors are likely to be members of the regulated group or are likely to rely on
members of the regulated group for advice. Compounding this dependence
is the regulated group’s ongoing interest in the regulations. Consumers and

capture
The takeover of
the regulatory
process by a
special interest.

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Economics for Healthcare Managers284

their advocates, in contrast, are likely to lose interest once the problems that
led to the regulations have eased. Finally, the group being regulated typically
has an intense interest in the outcome of the process, and most consumers
do not. This disparity further increases the odds of capture because in the
political arena, a small group with an intense interest is likely to prevail over
a larger group with more diffuse interests. As a result, regulation can best be
described as “for the profession” rather than “of the profession.”

Monks, Caskets, and the Supreme
Court

The Louisiana State Board of Embalmers and Funeral Directors was
formed in 1914 to regulate embalmers, funeral homes, and funeral
directors and to handle consumer complaints. The board has one con-
sumer representative. The other members all work in funeral homes
(Louisiana State Board of Embalmers & Funeral Directors 2018).

Louisiana does not require burials in caskets, nor does it set any
standards for caskets. Buying a casket online is perfectly legal. None-
theless, Louisiana deemed it a crime to sell “funeral merchandise”
without a funeral director’s license (Institute for Justice 2018).

The monks of Louisiana’s Saint Joseph Abbey have to work to sup-
port it. After a number of inquiries from consumers, they decided to
sell the cypress caskets in which Saint Joseph Abbey has long buried
its dead. A funeral director filed a complaint arguing that “illegal third-
party casket sales place funeral homes in an unfavorable position
with families” (Institute for Justice 2018). The Louisiana State Board of
Embalmers & Funeral Directors moved to prevent the monks from sell-
ing caskets. To meet the board’s standards, each monk would have to
earn 30 hours of college credit and apprentice for a year at a licensed
funeral home. None of the skills thus gained would be related to coffin
building.

After failing to get the law changed because of opposition from the
funeral industry, the abbey sued the board. The abbey won in the dis-
trict court in 2011 and in the US Fifth Circuit Court of Appeals in 2013.
In its unanimous decision, the Circuit Court said, “The great deference
due state economic regulation does not demand judicial blindness to
the history of a challenged rule or the context of its adoption nor does

Case 17.1

(continued)

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Chapter 17: Regulat ion 285

17.6 Market Responses to Market Imperfections

Market responses to consumer ignorance can limit the need for regulation.
Even imperfectly functioning markets incorporate incentives to serve con-
sumers well. For most providers, repeat sales and customers are essential, so
the incentives to meet customers’ expectations are strong. Even when repeat
customers are not major contributors to the business (as with a nursing home
or plastic surgeon), the provider’s reputation is one of its most important
assets. Customers are not likely to detect profound agency problems. (See
chapter 13 for a fuller discussion of asymmetric information and agency.)
Aware of their ineptitude for assessing poor performance, they often are
willing to pay for information about quality and turn to consumer organiza-
tions (e.g., AARP) or information services (e.g., the National Committee for
Quality Assurance) to aid them.

it require courts to accept nonsensical explana-
tions for regulation” (Institute for Justice 2018).
The US Supreme Court rejected a petition for

review, so the Circuit Court’s ruling stands (Institute for Justice 2018).

Discussion Questions
• Why were funeral directors so opposed to the monks making

caskets?

• Why would licensing casket makers be a good idea?

• How does licensing casket makers protect the public?

• Does your state license funeral directors?

• In a state that licenses funeral directors, what is the composition of
the board?

• Who sits on your state board that regulates pharmacy? Medicine?
Dentistry?

• Are members of the profession a majority of the board?

• Is this case an example of regulatory capture?

• Would allowing entry into the casket market reduce prices?

• Are funerals subject to other anticompetitive laws and regulations?

• In medicine, licensure and certification coexist. Is this coexistence
present in any other fields?

• How do licensure and certification differ in their protections for ill-
informed consumers?

Case 17.1
(continued)

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Economics for Healthcare Managers286

17.6.1 Tort Law and Contract Law
Tort law, which addresses compensation for a broad array of injuries, and
contract law, which addresses breaches of agreement, can also remediate the
shortcomings of healthcare markets. These legal remedies have powerful
advantages. First, the threat of action is often enough to ensure compliance
with explicit or implicit norms. If the probability of detecting noncompli-
ance is high enough and the penalties are large enough, the threat of legal
action will keep firms’ behavior in check. Second, an agent’s financial liability
for nonperformance of a treatment usually exceeds the expected costs of
the treatment, so tort law and contract law create incentives for providers
to perform. Aside from prompting legal costs, fines, and penalties, liability
can damage the agent’s reputation. Third, legal liability is outcome oriented.
Historically, regulation has focused on whether the structure of care and the
processes of care comply with unverified norms, so its utility in matters of
law is limited. Fourth, the legal system is more difficult to capture than most
regulatory systems, especially when plaintiffs can take their cases to juries.
Because consumers can initiate legal action themselves and because some
lawyers are willing to accept the financial risks of failed suits by accepting
contingency fees, access to legal remedies is more difficult to restrict than
access to regulatory remedies.

Despite the power of tort law and contract law, their use also has
disadvantages. To begin, legal remedies are costly to apply. Because of the
costs of bringing suit, consumers may face barriers when accessing the legal
system. Second, consumer ignorance may compromise the effectiveness of
legal remedies. If consumers do not realize that their bad outcome resulted
from a breach of duty on the part of their provider, they will not bring suit.
Alternatively, ignorant consumers may file suits when undesired outcomes
resulted from bad luck, not negligence.

Absent a credible threat of being sued, incompetent or unscrupulous
providers can continue unchecked. Even worse, the incentive for competent,
scrupulous providers to invest resources in improving the quality of care may
become diluted.

17.6.2 Information Dissemination
The legal system is both powerful and limited. First, it limits physicians
to areas in which they are competent, more effectively than state licensing
boards do. Medical licenses do not recognize differences in the skills of phy-
sicians. Were licenses the only guide, family practitioners would be able to
perform neurosurgery. In fear of liability claims, hospitals also limit physicians
to specific practices. Physicians, too, restrict their practices.

Second, studies of medical malpractice have shown that the major-
ity of consumers who have suffered serious injuries as a result of negligence

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Chapter 17: Regulat ion 287

do not sue and receive no compensation. In addition, a high proportion of
malpractice suits do not appear to involve provider negligence (Sohn 2013).
As a result, the malpractice system does not provide useful information on
quality, and malpractice litigation’s effect on the quality of care is not clear.
In principle, publication of providers’ malpractice histories should help con-
sumers choose. Publication of risk-adjusted outcomes data would be better
because it would put pressure on organizations to improve quality and could
reduce consumer ignorance.

17.6.3 Contracts
Contracts are a private regulatory system (albeit one that does not work when
collective mechanisms for enforcing contracts do not function effectively).
As with public regulations, contracts work best when financial and regula-
tory incentives are aligned. A contract that pays more for better performance
will usually produce more satisfactory results than a contract that stipulates
minimum performance requirements.

For example, modification of physicians’ practice patterns is a chal-
lenge for physician organizations seeking to become medical homes or
accountable care organizations. These new organizations need new payment
systems to align incentives for physicians (Hilligoss, Song, and McAlearney
2017). These new contracts with physicians may blend capitation, pay for
performance, gainsharing, and fee-for-service payment. For example, a pri-
mary care physician might receive a base capitation payment, share a bonus
if the practice met patient satisfaction targets, and share another bonus if the
practice met cost targets. These contracts seek to change practice patterns by
aligning the organization’s and physicians’ incentives. Realignment of finan-
cial incentives, however, is just part of the necessary modification.

Changing Consumer Information

Physician quality report cards are everywhere: The
federal government, consumer groups, profes-

sional organizations, US News and World Report, and ProPublica all
produce reports on physicians’ quality of care. However, accurately
assessing physician performance is difficult. The measures must be
valid and reliable. This assessment requires getting enough appropri-
ate data that are risk adjusted. If the data are good, presenting the
results in a patient-friendly way can still be challenging.

valid
When a measure
accurately
measures what it
is supposed to.

reliable
When a measure
always gives the
same result unless
the facts have
changed.

Case 17.2

(continued)

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Economics for Healthcare Managers288

17.7 Conclusion

Markets and regulations complement each other. Well-regulated markets
generally work well, and badly regulated markets generally work poorly.
The usual reaction of managers is that less regulation is better than more,

The ProPublica Surgeon Scorecard illustrates
just how difficult creating a good report card is.
ProPublica used inpatient Medicare data for eight

surgeries to rate surgeons. It measured complications as a composite
of inpatient mortality and readmission rates. Although this method
sounds reasonable, the strategy excluded 82 percent of the cases,
missed 84 percent of complications, and was only weakly correlated
with generally accepted surgical outcomes, such as the overall death
rate, infections, or morbidity (Ban et al. 2016).

Researchers have found little evidence that physician report cards
have a significant impact (Shi et al. 2017). In principle, report cards
may push out low-quality firms, induce entry by high-quality firms,
or encourage existing firms to improve quality, but the evidence is far
from compelling. Most studies have found that report cards have mod-
est impacts on referrals and market share, probably because referring
physicians already steer patients to higher-quality providers.

Discussion Questions
• Do patients actually use report cards?

• What evidence can you find that report cards have improved
quality?

• How could report cards improve reported outcomes?

• Does the scarcity of scientific evidence on the effectiveness of
report cards matter?

• Could publication of performance data be advantageous to
physicians?

• How do report cards address information asymmetries?

• Would reducing information asymmetries guarantee better
markets?

• Does it matter whether report cards are produced by governments
or private organizations?

• Why are a few patient switches enough to influence market
outcomes?

Case 17.2
(continued)

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Chapter 17: Regulat ion 289

but this view is not always true. For example, in 2003 (18 years after it was
established) Medicare Advantage enrolled only 5.3 million beneficiaries, but
subsequent changes in its regulations sharply increased its attractiveness, and
the number of enrollees more than tripled by 2017 (Jacobson et al. 2017).

Healthcare managers must understand the importance of regulations
for their organizations and incorporate the effects of regulations in their
decision making. Losses in the legislative or bureaucratic arenas may instigate
regulations that put an organization at a significant disadvantage. Although
managers may be tempted to see regulations as competitive tools, in prac-
tice their value is usually limited in competing with rivals in the same sector.
Although zoning laws and certificate-of-need laws are notable exceptions,
regulations usually apply the same rules for all the competitors in a sector.

Even when regulations could afford a competitive advantage (perhaps
by suppressing competition from rivals from other sectors), few organizations
have the political strength and staying power to secure a long-lasting com-
petitive advantage through political action. The exceptions tend to be large
organizations that have a well-defined goal shared by all members, are well
funded, and have a positive reputation. For most organizations the challenge
will be to resist the creation of laws and regulations that threaten to put them
at a disadvantage. Fortunately, preventing change usually takes much less
influence than does causing it.

The interests of healthcare providers appear to require more regulation
than governments can be induced to develop. Nongovernmental regulation
is widespread in healthcare. For example, certification of health plans and
physicians grew out of the need to give customers more detailed information
about quality than regulatory bodies could provide. This trend is likely to
continue. Managers need to prepare their organizations to compete in envi-
ronments in which competitive pressures force the release of detailed, audited
information about costs and outcomes. Organizations that do not perform
well, and are thus unable to attract well-informed customers, are likely to fail.

Markets need a sound regulatory underpinning to secure property
rights, define liability, enforce contracts, and constrain or sanction forms
of competition. However, designing effective regulations is not easy. Even
well-intentioned regulations can stifle innovation, and regulations do not
guarantee improved outcomes.

Exercises

17.1 Why are many consumers apt to be rationally ignorant about their
options?

17.2 Why would insurance coverage tend to increase rational ignorance?

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Economics for Healthcare Managers290

17.3 A proposal has been advanced to limit advertising of pharmaceutical
prices to prevent unfair pricing by national chains. You estimate that
limits on price advertising will change the price elasticity of demand
from −5.63 to −4.43. The marginal cost of a typical prescription is
$40. A typical small pharmacy fills 25 prescriptions per day. A typical
consumer fills 20 prescriptions per year. What economic effects will
the limit have on consumers and on pharmacists? Which group is
likely to be the more effective advocate for its position?

17.4 Prices for a medical procedure average $1,000 and range from $800
to $1,200. How much could a consumer paying full price save by
getting the best price? Suppose that insurance is responsible for 75
percent of the consumer’s spending and that out-of-pocket spending
is limited to $250. How much could the consumer save by getting
the best price?

17.5 Why are many economists opposed to licensure of medical facilities
and personnel?

17.6 Identify circumstances in which both public and private regulation
are present. Which serves consumers better? Why?

17.7 Find out who is on the board of the licensing agency for one of
the health professions for your state. Does the board include more
members of the profession being regulated or more consumers?

17.8 To reduce the costs of resolving insurance disputes, insurers have
required that customers use arbitration. Arbitrators are required to
be knowledgeable about medicine and insurance contracts. Why
might you anticipate that the arbitration mechanism would wind up
favoring the interests of the insurers?

17.9 How might the Food and Drug Administration be subject to
capture? Who would be likely to capture the agency?

17.10 Hospital privileges usually restrict what physicians can do. Medical
licenses do not. What drives this difference?

17.11 Consumers Union, the Leapfrog Group, and the US Department
of Health and Human Services have websites that provide
consumer information about hospitals. Why are multiple sources of
information available? Which of these sources did you find the most
interesting?

17.12 Give an example of a healthcare product that is financed by the
government but produced by private firms. Can you explain why
this arrangement exists?

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Chapter 17: Regulat ion 291

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