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Thursday, June 29, 2006

Price Discrimination and Economic Welfare in the Market for Orthopedics

If firms have pricing power, if markets can be segmented so that there is no arbitrage between them, and if the elasticity of demand differs across the segmented markets, then a profit maximizing firm should charge a higher price where demand is more inelastic.

But if the barriers between markets break down, prices will begin to equalize. This article describes pricing in the market for orthopedics and explains how access to information about prices charged across hospitals is reducing the ability of orthopedic device suppliers to charge different prices to different customers for the identical product.

Does this type of pricing reduce economic welfare? First, we need to determine which type of price discrimination is operating. Following Varian:

Economists generally follow the taxonomy of Pigou, who used the term price discrimination to describe what we have been referring to as differential pricing. Pigou described three different forms of price differentiation:

  • First-degree price discrimination means that the producer sells different units of output for different prices and these prices may differ from person to person. This is sometimes known as the case of perfect price discrimination.
  • Second-degree price discrimination means that the producer sells different units of output for different prices, but every individual who buys the same amount of the good pays the same price. Thus prices depend on the amount of the good purchased, but not on who does the purchasing. A common example of this sort of pricing is volume discounts.
  • Third-degree price discrimination occurs when the producer sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. This is the most common form of price discrimination, and examples include senior citizens' discounts, student discounts, and so on.

The article says "hospitals that buy in the greatest volume do not typically receive the best prices" so we can rule out second degree. First degree is an idealized concept and has strict information requirements (e.g. you must know how much each hospital is willing to pay) and, as noted, third degree is more common. Interestingly, as explained after the article, it is not necessarily the case that third degree price discrimination reduces welfare. But first, here's the article:

Pricing Power at Risk for Orthopedics Makers, by Reed Abelson, NY Times: It is a market that does not appear to play by the usual rules of supply and demand. Depending on which hospital is buying an artificial knee or hip, the price charged by the manufacturer might vary by thousands of dollars. And hospitals that buy in the greatest volume do not typically receive the best prices.

For years, makers of artificial hips and other orthopedic devices have benefited from their pricing power. But the odd ways of that market may not last much longer, according to [analyst] Bruce M. Nudell... In a research report..., Mr. Nudell described the current pricing variation in artificial knees and hips as "unsustainable."

Mr. Nudell says that growing awareness among hospitals of the pricing disparities is a major threat to the orthopedic device industry. Already, pricing power is diminishing for the companies, which had been able to raise prices for artificial knees and hips an average of 8 percent annually in recent years. The increases are slowing, and he says he expects prices in coming years to be flat, or even decline. ...

Much of the market's unusual pricing dynamic is a result of the fact that the surgeon choosing the device typically does not have to pay for it — the hospital is responsible for the bill. ...

Mr. Nudell is predicting that the financial pressure on hospitals and the publicity over pricing will end the era in which device makers have felt free to raise prices every year because the hospitals had no idea what their peers were paying.

The market's unusual dynamics appear to have caught the attention of federal officials, too. Within the last week, four companies — Biomet, Zimmer Holdings, Stryker and the DePuy unit of Johnson & Johnson — said that they had received subpoenas from the Justice Department's antitrust division related to the manufacture and sale of orthopedic devices. The companies all say they are cooperating. ...

As the cost of implants devours an ever-higher share of hospitals' reimbursements, and as the pricing disparities receive greater publicity, hospital executives are growing increasingly concerned. Many of the purchasing managers surveyed mistakenly thought that they were getting better prices than their peers when, in fact, they were paying more.

"Transparency on these products is an inevitable reality and an inevitable requirement in order for the health care system to be increasingly competitive and efficient," said John A. Bardis...

I'm not sure why insurance companies wouldn't have information on prices across hospitals, but assuming the article is correct on the existence of information barriers, how does price discrimination affect economic welfare? Varian says:

Third-degree price discrimination increases welfare when it encourages a sufficiently large increase in output. If output doesn't increase, total welfare will fall. As in the case of second-degree price discrimination, third-degree price discrimination is a good thing for niche markets that would not otherwise be served under a uniform pricing policy.

The general impression that follows from this discussion is if price differentiation allows more consumers to be served it will generally increase welfare. Volume discounts, for example, can be expected to generally enhance welfare. Market segmentation that allows markets to be served that would otherwise be neglected is also a case where overall welfare can be expected to be enhanced.

On the other hand, price differentiation that merely shuffles prices paid by pre-existing customer groups and that does not result in an increase in the number of customers served, or the amount that they consume, will tend to reduce overall welfare. The key issue is whether the output of goods and services is increased or decreased by differential pricing.

And the key here is to recognize that the decision is in the hands of doctors, not patients, and doctors are not price sensitive according to this article and according to other evidence. Because of this, price discrimination would not be expected to bring about a large change in quantity in hospitals where prices are lower than they would be under uniform prices. Hence, the fall in barriers that allow price discrimination ought to enhance the economic welfare of those who need to use orthopedic products.

    Posted by on Thursday, June 29, 2006 at 01:24 AM in Economics, Health Care, Market Failure, Policy | Permalink  TrackBack (0)  Comments (42)

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