Lecture 5Why Are We ConcernedSlide 3OutlineDefinition Pareto EfficiencyEdgeworth BoxFirst Fundamental Theorem of Welfare EconomicsSlide 8Second Fundamental Theorem of Welfare EconomicsHow To Redistribute?How To RedistributeSlide 12Slide 13Competitive Model AssumptionsSlide 15Competitive Model Assumptions Do they hold for health care?Slide 17Theory of the Second BestSlide 19Theory of the Second Best Classic ExampleSlide 21Theory of the Second Best Health ExampleSlide 23EquitySlide 25Equity Utility Possibility FrontierSlide 27Slide 28Equity Social Welfare FunctionNorman’s Health Care NeedConclusionsLecture 5Ch 18: Equity, Efficiency and NeedWhy Are We ConcernedEfficiency questions in health care sector arise because costs are high.Equity questions arise because many people are uninsured or under insured.Why Are We ConcernedTo really understand these concerns we need to:1. Know the definition of efficiency2. The assumptions behind efficiency3. Role of equityWe are looking at issues in Public and Welfare Economics.OutlinePareto efficiencyDefinitionEdge-worth boxFirst fundamental theorem of welfareSecond fundamental theorem of welfareAssumptions behind the competitive equilibriumTheory of the second bestEquityDefinition Pareto EfficiencyDefinition: An economically efficient (optimal) outcome in society is one under which it is impossible to make someone better off without making someone worse off.An efficient economy is one that has exhausted all means of mutual gains (trade)Edgeworth BoxIs a graphical tool used to understand what this definition of efficiency means.(rest of notes done on chalk board)First Fundamental Theoremof Welfare EconomicsThis theorem says: That an competitive equilibrium is Pareto efficientGreat, so as long as we have a competitive market, our markets left all to themselves will be efficient – but economists mean Pareto efficient “invisible hand solution”First Fundamental Theoremof Welfare EconomicsBut,Is the health care market competitive?Would a competitive market solution be equitable, or would there be a lot of people left with no health care?Second Fundamental Theoremof Welfare EconomicsThings are not so bleakTheorem states that given an appropriate endowment any Pareto efficient outcome can in principle be achieved.This means, that for any given endowment, we can redistribute the endowment to get to the efficient outcome we want (Back to chalk board)How To Redistribute?Should we subsidize certain services? i.e. health careWe can but it is not consistent with Pareto efficiency.Why? well to get to a Pareto efficient point, we had to find a tangency between both people’s indifference curve.When the face the same prices this will happen.If they face different prices, we won’t get a tangency point.How To RedistributeIncome transfers are superior way to redistribute because doesn’t change prices.How is Bush’s tax cut reallocating resources? Is it equitable?How To RedistributeSome policy makers hesitate to make large-scale income redistribution because of incentives (argument used in US more than other places)Transferring wealth away for one group pay provide a disincentive to work, and giving money to another group may provide a disincentive to work.assumes we are only stimulated by money, that all people are lazy and if given handouts don’t work.Forgets many people can’t work.How To RedistributeIf you are rich (millionaire) and someone takes 40% of that away, will you say, that is it, I won’t work to be a millionaire anymore?It you are just below the poverty line, and you know if you make more you will be taxed a lot more, well then maybe you won’t want to work as hard – how much should we be concerned about this?Could it make you work harder?Competitive Model Assumptions1. Free entry and exit of firms.No barriers to entry 2. Perfect information of firms on consumers You know the price of all doctors visits in Boulder and the quality of each doctor, and know what product you need.3. A homogenous product all doctors visits are the same4. Lots of buyers and sellers out there so firms and consumers are price takers (perfect competition)no one has market powerCompetitive Model Assumptions5. Consumers maximize their utility6. Firms maximize profits7. There are no significant externalities.Externality occurs if we receive benefits or are harmed by the actions of others.E.g. vaccinations; if you care about others health not just your own.Competitive Model AssumptionsDo they hold for health care?1. Barriers to entry: licensure laws, price controls, facility construction is expensive.2. Lots of buyers and seller: Not lots of hospitals in a town, so some degree of market power – (see assigned news paper article)3. Firms max. profits: There is more than profit motivation out there (university hospitals often looking for prestige).4. Lots of uncertainty in this market.This is why we have insurance marketsThis distorts prices so we are no longer efficient.Often prices are negotiated between supplier and consumer, so price is not determine by the marketCompetitive Model AssumptionsDo they hold for health care?5. Perfect information: There is not perfect information, we don’t know prices often!We’ll get into this more when do insurance.6. Externalities (i.e. vaccinations)Theory of the Second BestSo should we try to adhere to as many of the assumptions as possible for competitive markets?Does removing a distortion of competitive markets make competitive markets work better?Not necessarily – theory of the second best tell us whyTheory of the Second BestSay we have more than one departure from competitive market (more than one assumption does not hold). Call this departure a distortionNow there is a policy that tries to correct on of these distortions.Theory of second best says, that such a correction may not improve welfare i.e. we can’t assume welfare will be improved or that we get any closer to a competitive marketTheory of the Second BestClassic ExampleClassic Example: Polluting MonopolistSuppose we have a monopolist who is a big polluterMonopolist is a departure from perfect competition assumption.Polluter – pollution is a negative externality.Monopoly prices are higher than under perfect competition and they produce less than would be produced under perfect