Supplier-induced Demand: Re-examining Identification and Misspecification in Cross-sectional Analysis

This paper re-examines criticisms of cross-sectional methods used to test for supplier-induced demand (SID) and re-evaluates the empirical evidence using data from Australian medical services. Cross-sectional studies of SID have been criticised on two grounds. First, and most important, the inclusion of the doctor supply in the demand equation leads to an identification problem. This criticism is shown to be invalid, as the doctor supply variable is stochastic and depends upon a variety of other variables including the desirability of the location. Second, cross-sectional studies of SID fail diagnostic tests and produce artefactual findings due to model misspecification. Contrary to this, the re-evaluation of cross-sectional Australian data indicate that demand equations that do not include the doctor supply are misspecified. Empirical evidence from the re-evaluation of Australian medical services data supports the notion of SID. Demand and supply equations are well specified and have very good explanatory power. The demand equation is identified and the desirability of a location is an important predictor of the doctor supply. Results show an average price elasticity of demand of 0.22 and an average elasticity of demand with respect to the doctor supply of 0.46, with the impact of SID becoming stronger as the doctor supply rises. The conclusion we draw from this paper is that two of the main criticisms of the empirical evidence supporting the SID hypothesis have been inappropriately levelled at the methods used. More importantly, SID provides a satisfactory, and robust, explanation of the empirical data on the demand for medical services in Australia.