The free market model envisages large numbers of buyers and sellers - all of whom have no power individually to influence the market price. However, a significant proportion of health care is delivered by hospitals and these hospitals can often exercise monopoly power within the health care market in the local area.
Why should hospitals be able to act like monopolies? The answer is that hospitals have an incentive to grow in size and in the range of service provided. This leads to the emergence of one large hospital in an area rather than a large number of small hospitals. The incentive to grow is falling unit costs - what economists call internal economies of scale and economies of scope.
Internal economies of scale have led to the emergence of large hospitals which often are the only hospital in the area.
Economies of scale Why should the average cost of providing treatment fall as a hospital becomes larger? There are a number of reasons.
A large institution is able to make more use of specialisation. This can involve both people and capital. A large hospital is able to develop specialist medical units employing both highly skilled surgeons and specialist capital equipment. Such a hospital is also able to employ specialised managers and ancillary staff which will allow it to operate more efficiently.
A large hospital prevents wasteful duplication of facilities. There will only be a limited number of patients with a particular condition needing particular skills and equipment in any one area. Concentrating the treatment in one place allows the most efficient use of resources.
Economies of scope
In many cases it costs less to provide a range of services in a single hospital than to have several hospitals each just producing one or two services. For example, emergency surgery and treatment of heart attacks are more cost effectively provided in a single hospital rather than two separate ones.
In this situation, the hospital as supplier of health care services has considerable power to bargain over price. Instead of being a price taker it is a price maker. In this situation a free market does not lead automatically to a Pareto efficientoutcome. In particular, if the hospital is profit maximising then it will set price above marginal costs giving an allocatively inefficientoutcome. Also it is likely that the hospital will be productively inefficient, since it lacks the incentive to reduce costs which would be provided by competition.
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