11(40)
3
Theoretical framework
This section gives the theoretical rationale for the empirical strategy to
identify the effect of competition on prices. I start out with a discussion
on assumptions about the nature of competition and a description of the
strategy outline. I then describe the theoretical background in more detail.
The nature of competition is implicitly assumed to be monopolistic
competitive in the sense that there is both an element of market power
and an element of competition. Monopolistic competition has become a
workhorse model for describing markets for health care. The reason is that
while services are differentiated, consumers cannot perfectly observe the
service attributes. Providers therefore face a downward sloping demand,
implying that they can raise prices without losing all their patients to
competing providers, selling similar but not identical services (Dranove
and Satterthwaite, 2000). However, an important aspect is that consumers
information regarding quality and price differs across types of services
(Pauly, 1978).
Another important assumption for the empirical strategy is that the
number of competitors surrounding each clinic can be used as a measure of
competition. This is because an increase in the number of clinics in a given
area will provide consumers with greater choice, making the demand facing
each clinic more elastic. At the same time, it is reasonable to assume that
the price elasticity of demand differs across types of services (Pauly, 1978).
More precisely, that demand is more price sensitive for services that are
consumed with some frequency, such as diagnostics and examinations,
compared to more uncommon therapeutic services. Competition therefore
has heterogeneous effects on prices.
By exploiting both the variation in competition across clinics and the
difference in consumers’ price sensitivity across services; I identify a
relative effect of competition on prices for diagnostic services compared
to therapeutic services. The identified effect is given by the difference
between the average effect of competition on prices for diagnostic services
and therapeutic services respectively. The purpose of the identification
strategy is to address the endogeneity of market structure, i.e. that
market structure is correlated with unobserved factors that affect prices.
The endogeneity is driven by the fact that providers are
not
randomly
allocated across the country, but rather choose to establish in areas where
demand and prices are high. An observed correlation between prices
and competition can therefore not be given a causal interpretation. By
focusing on the difference in the effect between services across levels of
competition, the unobserved endogeneity is differences away. The empirical
strategy is described in further detail in section 5. In order to assess the
absolute effect of competition on prices I perform policy simulations in
section
