Two-Sided Market Power. Outcomes may not be perfectly efficient if both the insurance and provider sides are characterized by incomplete market power. In the case of bilateral monopoly, both sides continue to have incentives to maximize consumer surplus, and then divide it between themselves. However, imperfect competition on both sides can create unique distortions. For example, there may be strategic incentives for exclusive dealing, which is often observed in pharmaceutical markets. Specific insurers award low co-payments to a few drugs in a specific therapeutic class. This then allows them to extract more favorable terms from the manufacturer, because they can promise higher volume sales (cf, Xxxxxxx and Xxxxxx, 2003). We simplified the problem by considering insurance policies for a single innovation. This simplification sacrifices no generality when the insurance market is perfectly competitive. Even if each insurance policy covered a large number of possible therapies, a perfectly competitive insurance industry with a large number of insurers could offer a variety of policies that covered the preferences of every consumer. However, with a limited number of insurers, but a large number of therapies, it is possible that some consumers might prefer a set of therapies that is not well-covered. This point can be demonstrated with a simple example. Suppose there are ten therapies to treat a single disease, and two innovators — innovator A sells 9 of these therapies, while innovator B sells only one. There is a single insurer, and ten consumers. Each consumer derives $100 of surplus from the therapy she prefers: Nine consumers prefer one of A’s therapies, while the tenth prefers B’s therapy. Suppose innovator A demands an exclusive contract with the insurer. This is a credible demand if all $90 of consumer surplus is extracted, and if the innovator gives the insurer $15 of this surplus. Innovator B cannot match the offer. The result is that utilization of B’s therapy is inefficient, because the patient preferring B can only buy it directly, and not through an insurance policy. This leads to the typical monopoly problem, and the under-provision it commonly implies. This suggests that market power in the insurance industry may be the root cause of inefficient utilization, rather than market power on the provider/innovator side. This also suggests that inefficiency in the insurance industry will cut against the ability of insurance to produce perfectly efficient outcomes. Nonetheles...
