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3.1
Consumer demand and price competition
The identification strategy can be understood analogously to a difference-
in-differences framework. Prices for both kinds of services are effected
by competition, but theoretically the magnitude of the effects should
differ across services. The rationale for the strategy is best understood by
considering how health care services can be characterized. An important
feature with health care markets is that consumers buy information, in the
form of diagnostic services and other assessments of their health status.
This information is then used as a basis for decision-making about future
consumption (Pauly, 1978). The consumption can thus be divided into two
stages.
Following Pauly’s (1978) classification, services in the first stage can be
characterized as being primarily “informative”, whereas services in the
second stage can be characterized as “active-therapeutic”. Hence, the first
stage consist of examinations and diagnostics (first-stage services) and the
second stage consists of somewhat more extensive treatments (follow-on
services) – if found necessary in the first stage.
As mentioned above, providers are assumed to have some market power,
which is mainly driven by consumers’ imperfect information. However,
as first-stage services are consumed relatively frequently, consumers can
become informed about these services at a low cost (Pauly, 1978). On the
other hand, most consumers purchase follow-on services infrequently and
becoming informed about these services are costly. Hence, consumers are
on average more able to evaluate prices for first-stage services compared
to follow-on services. In addition, evaluating prices for follow-on services
is costly and thus it is reasonable to assume that the price elasticity of
demand is greater for first-stage services than for follow-on services.
Moreover, first-stage services is the kind a service a patient would get
when visiting a provider for the first time. These services are therefore
more likely to be subject to price comparisons among patients.
The difference in the price elasticity of demand across stages implies that
price competition will be more intense for first-stage services compared
to follow-on services. This argument is reinforced by considering that
consumers will face a cost for switching provider between the first and
the second stage. This cost is over and above the search cost for finding
and evaluating a new provider in the second stage. The switching cost may
be either perceived or real, but have in common that consumers will find
it cheaper to buy all services from the same provider. Consumers would
therefore become “locked-in” after purchasing first-stage services from
a given provider, which makes demand for follow-on services less elastic.
In addition, switching costs make new customers valuable from the
perspective of sellers, because of their future purchases (Farrell and
Klemperer, 2007; Klemperer, 1995). A standard results from models of
switching costs is therefore that sellers compete fiercely to attract new
customers and exploit locked-in customers, by charging higher prices
(Padilla, 1991). These arguments all suggest that price competition will
be more intense for first-stage services compared to follow-on services.
