Summary Chapter 1, Introduction (Mattias Fritz)

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Chapter 10. (Emma Ringbom)

Imperfect Information: Supplier-Induced Demand and Small Area Variations

This chapter deals with the problems of Supplier-Induced Demand (SID) and Small Area Variations (SAV).

SID occurs when physicians abuse the agency relationship with their patients in order to generate demand for personal gain. This is possible because physicians are more fully informed than patients.

SAV is when there are wide variations in per-capita rates of surgery, physician visits and hospitalization among otherwise similar market areas. This can occur even when the physician acts as a perfect agent. It is imperfect information on treatment outcomes that creates a problem that leads to welfare losses. Use evidenced based medicine!


When there is SID health care-providers use their superior knowledge to influence demand for self-interest. This is possible because the physician has both the role of advisor to the patient and is also provider of the service. When consumers’ demands are influenced by providers market forces may not restrain prices, limit the consumption of health care and allocate resources to their best uses. SID was discovered when correlation was found between the number of hospital beds per 1000 population and the number of hospital days per 1000 population. “A bed built is a bed filled”. This became known as Roemer’s Law.

Not all health economists accept the SID proposition though. Those who believe it exists are called B s and those who do not believe it exists are called N s. In figure 10.1 D1 and S1 represent the initial demand and short run supply of physician services with an equilibrium at Q1 and P1. If the supply of physicians increases to S2 the N s would predict the price to fall to P3 and the quantity demanded to increase to Q3. For services with an inelastic demand, such as physician care, total spending will decrease. The typical physician’s share of patients and earnings will diminish. According to the B s an increase in supply leads to an increase in demand through the SID-effect. The demand will shift to a level such as D2, the price will be P2 and the quantity demanded will be Q2. If the increase in demand is sufficiently large (D’2) the equilibrium price may even rise above the initial level. The new equilibrium price may thus be either higher or lower then the initial price. When the price becomes higher than the initial price it is called the Reinhardt fee test of inducement. In this test evidence that the fee increases when supply increases is seen as a support of the SID-proposition.

Measures to reduce SID:

  • Non-profit provider

  • Salaried physicians based on capitation or fixed provider budgets

Picture 10.1 (Bra föreläsningsanteckningar på denna figur!)

Models of SID

Price Rigidities and SID

One approach that can provide a logical explanation of demand inducement on a competitive market is to argue that prices tend to be rigid (do not adjust quickly to changes in demand and supply). If prices in figure 1 do not drop from P1 when supply increases there will be an excess supply at P1. Some physicians are not providing the quantities they would like to and they have a motive for inducing additional quantities. The motive for inducement depends on the relative gains from the additional earnings versus the costs of the additional inducement activities. This is what determines how much to the right the demand curve will shift. If it is easy to persuade patients to consume more health care the shift will be large.

The target-income model of SID

This model is often used to explain rapid increases in physician fees that occur despite rapid increase in physician availability. Increases in physician availability lead to higher fees in order for earnings to be maintained. Consumer ignorance provides physicians with discretionary influence to manipulate demand when fees are controlled. Physicians also have unexploited monopoly price power that can be used to raise fees and incomes to a target level. Under conditions of price controls investigators have found that utilization tended to increase. Evidence show that a relative decrease in fees for one group of physicians as a result of control of fees lead those physicians to provide more intensive medical and surgical care. Problems arise though in explaining how the target income is established and why physicians do not always use their monopoly power to price at a profit-maximizing level.

The density of discretion model

A researcher named Evans saw the physician as a utility-maximizing provider whose utility function is expressed: U=U(Y,W,D) where Y is net income, W is hours of work and D is the influence to augment demand. The physician has monopoly power and faces a negatively sloped demand curve that shifts inward as the number of physicians increase. Increasingly marginal disutility of augmenting demand is assumed. According to Evans physicians prefer not to induce demand and greater incremental displeasure comes with greater inducement. This displeasure must be counterbalanced by the gains to income that inducement provides. When competition tends to reduce income the physician may increase inducement to offset this. In Evan’s framework a physician will augment demand to the point where the marginal utility of the additional income equals the marginal disutility of the added work plus the marginal disutility of the influence. In figure 10.2 the variable W is suppressed and the physician’s utility depends on income (Y) and discretionary demand (D). The indifference curves represent the physician’s preferences and slope upward because one of the goods, D, is really a “bad”. Higher curves are preferred to lower. D is measured in units representing the number of induced units of service. These units are sold at a constant profit rate of T. The maximum profit level with zero inducement is T*Q0. The physician’s total profit is Y=T*Q0+T*D. This is a linear equation with an intercept of T*Q0 and a slope of T and it represents the attainable combinations of Y and D that is the physician’s income possibilities. The physician seeks to reach the highest indifference curve (point A). Increased competition leads to a reduction in the average profit rate the physician receives from providing units of service. A lower T leads to a flatter slope of the budget constraint and a lower intercept. The new equilibrium is at point B. Increased competition has thus lead to a higher degree of inducement.

One limitation of the model is that it is ambiguous in its predictions of the effect of increased physician availability. If the indifference curves look different the increased physician availability may lead to a lower degree of inducement.

A profit-maximizing model

With imperfect information and ability to induce increases in demand sellers can often improve their profits by inducing customers to buy more. These activities also raise costs so they should be undertaken only to the point where their marginal revenues equal marginal costs. The new equilibrium is shown in figure 10.3 by the combination P2,Q2. In this theory the incentive to induce has elements similar to advertising or product promotion decisions. The incentive to advertise will be linked to the gap between marginal revenue and marginal cost. A small gap, which arises under elastic demand, reduces incentives. If the physician has a high degree of monopoly power the gap will be large. Constraints on physician behaviour raise costs of imperfect agency and thereby reduce the extent of SID.

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