May 31 2012 | 4 comments
We’ve already written about how expensive other hearing aids are and why audiologists bundle services to markup hearing aid prices, but what can economic theory say about how these factors are related and about the hearing aid market as a whole?
Some background economic theory:
First, how should the market look? In a perfectly competitive market, the hearing aid price and quantity are determined by the intersection of supply and demand. No individual firm can influence prices (all firms are “price-takers”), so firms compete by driving the market price as low as possible: to the marginal hearing aid cost. At this “efficient equilibrium,” the socially efficient number of hearing aids are bought and sold, and the consumers get all the gains (surplus) from the transactions.
How do firms set prices? Firms want to produce up until the point that marginal cost (the cost of producing the last unit) is equal to marginal revenue (the revenue from the last unit sold). This point, where marginal cost (supply) is equal to marginal revenue (demand), is the efficient equilibrium in a competitive market. If a firm produced more than that amount, marginal cost would exceed marginal revenue and the firm would lose money; likewise, if a firm were to produce less than that equilibrium quantity, it would miss out on profitable sales.
When a firm gains monopoly power, it can influence market prices and its optimal pricing strategy is no longer to sell at the socially efficient equilibrium, but rather to restrict supply and sell at a price above marginal cost. In a competitive market, the marginal price of a hearing aid cannot be influenced by any given firm, so the firm’s marginal revenue equals the competitive hearing aid price no matter how many hearing aids the firm sells.
However, a monopoly can change the market price by restricting distribution. Assuming the monopoly cannot price discriminate (that is, charge different prices to different customers), its marginal revenue will no longer be equal to the demand curve because different quantities will entail different prices (the more restrictive the supply, the higher the prices, and vice-versa). Following the optimal pricing strategy discussed above, a monopolic firm would set marginal revenue equal to marginal cost to determine the quantity of hearing aids to distribute.
Next, instead of selling the hearing aids at marginal cost as above, a monopoly will sell its hearing aids at the price implied by the demand curve at the restricted quantity (see graph below). The amount above marginal cost at which the firm can sell the hearing aid is called the markup. As a result, the firm creates abnormal profits by taking surplus from the consumer. Furthermore, the monopolic distortion creates an inefficiency known as a “deadweight loss;” a societal loss of surplus due to the inefficient allocation of resources.
The latter provides a good approximation for the hearing aid market. How can the hearing aid market be a monopoly when there are thousands of retailers and multiple manufacturers? It has all the hallmarks of monopoly: hearing aid prices three to five times above marginal cost, low adoption rates (currently around 25%), and restricted distribution; all factors indicative of monopoly power. Audiologists and medical professionals have a legal monopoly on certain aspects of the distribution of hearing aids, and have strongly opposed (http://www.boycottinternethearingaidsales.com) attempts by others to sell hearing aids without add-on services because it threatens their ability to maintain their markups.
How are these factors related, and what’s going on?
The legal protection of audiologists’ monopoly power has enabled them to create large markups, which in turn has resulted in the low adoption rate. At this point on the demand curve, demand is fairly inelastic (not responsive to price), so not only do the 25% who can and are willing to pay the markup lose, but so do those who are unable or unwilling to buy hearing aids at artificially inflated prices. We’ve already seen why hearing aids are bundled with follow-up services, but with economic theory we can see how audiologists are able to do it. As mentioned above, the demand for hearing aids is inelastic at high prices, so audiologists are able to bundle add-on services without shrinking their customer base. This allows them to extract even more surplus from consumers.
Competition will lower hearing aid prices for consumers and create greater access to affordable hearing aids. Buying hearing aids online can help create downward pressure on audiologist markups.
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