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THE SOCIAL BENEFITS OF PRICE COMPETITION IN MEDICINE H. E. FRECH III* I. Introduction As any observer knows, there has been much discussion in governmental and academic circles of competition in health care. Procompetition bills have been introduced into Congress for the past several years, and the Reagan administration has embraced a version of the idea. In what follows, I will picture what the medical market would look like if a procompetition policy were to succeed and what die benefits to society and die medical profession might be from such a success. First, I must paint a picture of the nature of competition in health care now. II. The Nature ofCompetition in Health Care Now It may appear to the casual observer that the American health care industry would be almost perfectly competitive, especially in large cities. After all, in the United States, there are thousands of hospitals and hundreds of thousands of physicians. A large city may have 50 or 100 hospitals and thousands of physicians. Thus, the condition that there be many sellers for perfect competition is fulfilled. However, as any participant in these markets knows, competition in health care is very imperfect, even in the large cities where the number ofsellers is especially large. There are two related reasons for this. First, consumers are poorly informed about the prices and quality levels of alternative hospitals and physicians. Second, the type of health insurance common in the United States makes many consumers unwilling to respond to favorable price differences even when they are aware of them. Also, this common type of insurance reduces the incentives of»Professor of economics, University of California, Santa Barbara, California 93106.© 1984 by The University of Chicago. AU rights reserved. 0031-5982/85/2801-0407$01.00 40 I H. E. Freeh III ¦ Social Benefits ofPrice Competition consumers to become informed about alternatives, thus exacerbating the information problem. Let us take up these factors in turn. Consumer ignorance about competing physicians and hospitals derives pardy from consumers' general ignorance about medical technology and biology. In itself, this ignorance is not a major obstacle to competition . Consumers are ignorant of the technology involved in many products and services, from television to financial advice to automobile repair. In these markets, competition is perhaps made imperfect by consumer ignorance, but it is certainly not eliminated. In any case, the consumer ignorance means that consumers must rely on indirect sources of information. In practice, this often means the recommendation of friends and relatives or the recommendation of the consumer's physician, himself or herself selected, at least originally, on the basis of recommendations of others. It would be unusual for a consumer to receive much information about more than a handful ofhospitals and physicians from friends and relatives. The choices of hospital and physician are interdependent. If the consumer already has a physician in whom he has confidence, he is likely to limit himself to the hospital(s) where his physician has privileges. On the other hand, the consumer may use a hospital with a good reputation as a source of information about the physician. For example, a newcomer to Boston may limit himself to physicians who practice at the Harvard teaching hospitals. Through this process, the competition among physicians is closely related to the competition among hospitals. Hospitals are selected partly because oftheir physicians, and physicians are selected pardy because of their hospitals. Consumer ignorance has been exacerbated by public policy. The traditional prohibition of advertising and price competition by physicians has been largely backed by the licensure and hospital certification systems . These traditional anticompetitive activities have in recent years come under antitrust attack, so that physician groups and hospitals now must be more subde than before ifthey want to discourage competition. For these reasons, if we take a quick survey of consumer information at any point in time, we see that the consumer has knowledge of only a few hospitals and physicians then. Therefore, he cannot respond to price differentials favoring any other sources of care. This reduces die incentives of the physicians or hospitals to set lower prices. Lower prices will, of course, lead some consumers to switch—but not as many as would...


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