1
Provide a response to
TWO of the questions below by Saturday, then provide a response to at least TWO of your peers by Tuesday:
Include the two questions that you selected to discuss at the top of your initial posting.
· What conditions must exist for a firm to be able to price discriminate? Provide an example.
· How do economists use the Hirschman -Herfindahl Index? Provide an example.
· Why are economic analyses of clinical and healthcare operations important? How can a healthcare leader apply this to their operations?
· What factors allow a firm to have monopoly profits? What should a healthcare manager need to know?
· What are the pros and cons of merger activity? Why would the government want to prevent mergers?
· What are the characteristics of monopolistic competition? Provide an example.
· Why is understanding market structure important in health economics, what does it impact?
CHAPTER
235
DO NONPROFIT HOSPITALS BEHAVE
DIFFERENTLY THAN FOR-PROFIT HOSPITALS?
Hospitals initially cared for the poor, the mentally ill, and those with con-
tagious diseases, such as tuberculosis. Many hospitals were started by
religious organizations and local communities as charitable institutions.
More affluent patients were treated in their own homes. Things began to change
with the development of ether in the mid-1800s, which allowed operations to
be conducted under anesthesia. By the late 1800s, antiseptic procedures began
to increase the chances of surviving surgery. The introduction of the X-ray
machine around the beginning of the twentieth century enabled surgeons to
become more effective by improving their ability to determine the precise loca-
tion for the surgery, and some exploratory surgery was eliminated.
Because of these improvements, hospitals became the physician’s work-
shop. Similarly, the type of patients served by the hospital changed. Hospitals were
no longer places in which to die or be incarcerated, but rather places in which
paying patients could be treated and then returned to society. The development
of drugs and improved living conditions reduced the demand for mental and
tuberculosis hospitals, and the demand for short-term general hospitals grew.
The control of private nonprofit hospitals also changed. As more of
the hospital’s income came from paying patients, reliance on trustees to raise
philanthropic funds declined. Physicians, who admitted and treated patients,
became more important to the hospital. Because they were responsible for gen-
erating the hospital’s revenue, physicians’ control over the hospital increased.
Most hospitals in the United States are nonprofit, either nongovernmental
institutions or controlled by religious organizations. Together, these are referred
to as private nonprofit hospitals. As exhibit 15.1 shows, the ownership of the
majority of hospitals (2,849 of the 4,850 hospitals in 2016) is voluntary, mean-
ing private nonprofit. In 2016, 956 state and local government and 199 federal
hospitals were in operation. Investor-owned (for-profit) institutions accounted
for 1,035 hospitals. Together, private nonprofit and for-profit hospitals admitted
83.5 percent of patients (68.5 percent and 15.0 percent, respectively).
The main legal distinctions between nonprofit and for-profit hospitals are
that nonprofits cannot distribute profits to shareholders, and their earnings and
property are exempt from federal and state taxes. They also may receive donations.
Since the mid-1980s, when managed care competition started, debate
has ensued over whether nonprofit hospitals are really different from for-profit
15
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Health Pol icy Issues: An Economic Perspect ive23
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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 237
hospitals. The issues surrounding this debate center on the following questions:
Do nonprofits charge lower prices than for-profits? Do nonprofits provide a
higher level of quality than for-profits? Do nonprofits provide more charity
care than for-profits? Or, as some critics of nonprofits maintain, is there no
difference between the two other than the tax-exempt status of nonprofits’
surpluses? If the latter position is correct, is continuing nonprofit hospitals’
tax advantages and government subsidies justified? Alternatively, if nonprofits
provide more charity care and higher-quality service and charge lower prices,
will eliminating for-profits enable nonprofits to better serve their communities?
Why Are Hospitals Predominantly Nonprofit?
Several hypotheses have been offered to explain the existence of nonprofit
hospitals. The most obvious is that when hospitals were used predominantly
as institutions to serve the poor, they depended on donations for funding.
However, the possibility of receiving donations does not explain why the
majority of hospitals continue to be nonprofit. Donations account for a small
percentage of hospital revenue. As public and private health insurance became
the dominant source of hospital revenue, the potential for profit increased, as
did the number of for-profit hospitals.
Although both public and private insurance have increased, many people
remain uninsured. Some believe that only nonprofit hospitals provide uncom-
pensated care to those who are unable to pay. Nonprofit hospitals presumably
are willing to use their surplus funds to subsidize both the poor and money-
losing services.
A related explanation is the issue of trust. A relationship based on trust
is needed in markets in which information is lacking. Patients are not sure what
services they need. They depend on the provider for diagnoses and treatment
recommendations, and they are not knowledgeable about the skill of the sur-
geon. The quality of medical and surgical treatments is difficult for patients to
judge, and they cannot tell whether the hospital failed to provide care to save
costs. In such situations, patients are more likely to rely on nonprofit provid-
ers, believing that because they are not motivated by profit, they will not take
advantage of a patient who lacks information and is seriously ill.1
Another explanation for the predominance of nonprofit status is that
the hospital’s managers and board of directors want to be part of a nonprofit
hospital, where their activities are subject to limited community oversight. The
managers and board have greater flexibility to pursue policies that reflect their
own preferences, such as offering prestigious but money-losing services even
if these services are provided by other hospitals in the community.
Furthermore, nonprofit hospitals are in physicians’ financial interest.
Being associated with nonprofit organizations allows physicians to exercise
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Health Pol icy Issues: An Economic Perspect ive238
greater control over the hospital’s policies, services offered, and investments in
facilities and equipment. In a for-profit hospital, physicians have less money avail-
able for facilities and equipment of their choosing, because surpluses must be
distributed to shareholders and the government through payment of dividends
and taxes. The hospital’s physicians also benefit from the hospital’s ability to
receive donations and from the trust placed in the hospital by the community.
The importance of trust, the provision of community benefits, and
the financial interests of physicians appear to be key reasons for the nonprofit
status of hospitals.2
Performance of Nonprofit and For-Profit Hospitals
For-profit hospitals have a more precise organizational goal—namely profit—
than do nonprofit hospitals. A concern of any organization is monitoring its
managers’ success in achieving the firm’s goals. In a for-profit firm, the objec-
tive is straightforward, and the shareholders have an incentive to monitor the
performance of managers and replace them if their performance is lacking.
A nonprofit firm has multiple objectives, making it more difficult to
monitor its managers. The various stakeholders of the nonprofit hospital—
medical staff, board members, managers, employees, and the community—have
different and sometimes conflicting objectives as to how the hospital’s surplus
should be distributed. Should profits be used to subsidize the poor, increase
compensation for managers, raise wages for employees, establish prestige facili-
ties, or provide benefits (e.g., low office rent and resources) to medical staff?
The board of directors has less incentive to monitor a nonprofit hospital, as
it has less financial interest in the hospital’s performance and must rely on
the managers for information about achieving the hospital’s multiple goals.
Furthermore, if the nonprofit hospital is not performing efficiently, it may be
able to survive on community donations.
Given the differing goals and incentive-monitoring mechanisms of for-
profit and nonprofit hospitals, it is important to examine how the behavior of
nonprofits differs from that of for-profits.
Pricing
For-profit hospitals attempt to set prices to maximize their profits.3 Do nonprofit
hospitals set lower prices than for-profit hospitals? Three aspects of hospital
pricing shed light on how nonprofit hospitals set prices.
Many people believe that nonprofit hospitals set prices to earn sufficient
revenues to cover their costs. Nonprofits set prices for private insurers that
are below their profit-maximizing prices, but raise those prices when the gov-
ernment lowers the price it pays for Medicare or Medicaid patients. For cost
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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 239
shifting to occur, a hospital (1) must have market power—that is, be able to
profitably raise its price and (2) must decide not to exploit that market power
before the government reduces its price. (A more complete discussion of cost
shifting is provided in chapter 18.)
Evidence of hospital cost shifting is based on data from before the mid-
1980s (before managed care competition). With the start of intense price com-
petition among hospitals, insurers became more sensitive to the prices charged
by hospitals. Hospitals’ market power declined because insurers were willing
to shift their volume to hospitals offering lower prices. Any ability of nonprofit
hospitals to shift cost disappeared with hospital competition for managed care
contracts. Instead, as the government reduced the prices it paid for Medicare
and Medicaid patients, hospitals experienced greater pressure to lower their
prices to be included in an insurer’s provider network.
Second, the pricing practices of nonprofit hospitals regarding uninsured
patients have received a great deal of media publicity recently. Large purchasers
of hospital services (e.g., health insurers, Medicare, Medicaid) receive deep
discounts from a hospital’s billed charges—often as high as 50 percent. Unin-
sured patients were asked to pay 100 percent of the hospital’s billed charges.
Newspaper articles have described the hardship faced by many patients who
do not have the resources to pay their hospital bills. Several lawsuits were filed
on behalf of the uninsured against nonprofit hospitals because the hospitals
charged the highest prices to those least able to pay and hounded patients for
unpaid debts. These lawsuits (several of which have been settled by hospitals)
claimed that nonprofit hospitals violated their charitable mission by overcharging
the uninsured and sought to have these hospitals’ tax-exempt status revoked.
The pricing practices of nonprofits with respect to the uninsured appear to
be no different from those of for-profits. (New federal rules for hospitals have
modified their pricing practices for the uninsured [Pear 2015].)
Third, do nonprofit hospitals increase prices if they merge with other
nonprofit hospitals? The number of hospital mergers has grown in recent years.
Consolidation of for-profit firms or hospitals in a market causes concern that
competition will decline, enabling the hospitals to raise prices. Would a merger
of nonprofit hospitals similarly result in higher hospital prices, or are nonprofit
hospitals different?
In early court cases in which the merger of nonprofit hospitals was con-
tested by federal antitrust agencies, the presiding judges ruled that nonprofit
mergers are different from for-profit mergers. The judges believed that nonprofit
mergers were unlikely to result in price increases—even if the hospitals acquired
monopoly power—because the boards of directors are themselves local citizens
and would not take advantage of their neighbors. Empirical studies, however,
contradict the judges’ belief that nonprofit ownership limits price increases after
a merger (Capps and Dranove 2004; Melnick, Keeler, and Zwanziger 1999).
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Health Pol icy Issues: An Economic Perspect ive240
Researchers found that nonprofits with great market power charge significantly
higher prices than do nonprofits in competitive markets. These results suggest
that some nonprofit hospitals merge simply to increase their market power and
to negotiate higher prices with managed care plans. This type of behavior is
no different from the behavior expected of for-profit hospitals.
In October 2005, the Federal Trade Commission (FTC) won an antitrust
suit against nonprofit Northwestern Healthcare for a previously consummated
hospital merger. The FTC claimed that a hospital merger that occurred in
2000 violated federal antitrust law because the newly created three-hospital
system sufficiently boosted its market power to illegally control hospital prices
in its market. The FTC’s decision was upheld on appeal, and the system hos-
pitals were ordered to negotiate independently with insurers, rather than have
Northwestern Healthcare divest itself of one hospital, as the initial decision
recommended.
Mergers of nonprofit hospitals are no longer likely to be viewed as dif-
ferent from mergers of for-profit hospitals (Morse et al. 2007).
The FTC (2006) claimed that, as a result of the merger, Northwest-
ern Healthcare used its postmerger market power to impose huge price
increases—40 to 60 percent and, in one case, even 190 percent—on insurers
and employers.
Quality of Care
Sloan (2000) reviewed several large-scale empirical studies of quality of care
received by Medicare beneficiaries in nonprofit and for-profit hospitals. The
studies examined various measures of quality, such as the overall care process
and the extent to which medical charts showed that specific diagnostic and
therapeutic procedures were performed competently. The studies assessed dif-
ferent hospital admissions (e.g., hip fracture, stroke, coronary heart disease,
congestive heart failure) and outcome measures (e.g., survival, functional
status, cognitive status, probability of living in a nursing home). The study
findings showed that teaching hospitals performed better; however, no statisti-
cally significant differences were found between nonteaching private nonprofit
hospitals and for-profit hospitals.
In an extensive study, McClellan and Staiger (2000) compared patient
outcomes for all elderly Medicare beneficiaries hospitalized with heart disease
(more than 350,000 per year) in for-profit and nonprofit hospitals between
1984 and 1994. McClellan and Staiger (2000, 4) found that
[o]n average, for-profit hospitals have higher mortality among elderly patients with
heart disease, and . . . this difference has grown over the last decade. However, much
of the difference appears to be associated with the location of for-profit hospitals.
Within specific markets, for-profit ownership appears if anything to be associated
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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 241
with better quality care. Moreover, the small average difference in mortality between
nonprofit and for-profit hospitals masks an enormous amount of variation in mortal-
ity within each of these ownership types. Overall, these results suggest that factors
other than for-profit status per se may be the main determinants of quality of care
in hospitals.
Charity Care
Nonprofit hospitals have a long tradition of caring for the medically indigent.
They were given tax-exempt status and community donations in the belief that
they would provide charity care. However, the advent of price competition in
the mid-1980s changed their ability to provide the level of charity care some
believe is necessary to justify their tax-exempt status. Researchers have exam-
ined the extent of charity care provided in terms of (1) hospital conversions
(a nonprofit becomes a for-profit) and (2) the effect of greater competitive
pressures from managed care.
Concern has arisen that once a hospital converts to for-profit status,
its charity care will decline as the profit motive becomes dominant. Various
studies, however, have found no difference in provision of uncompensated
care once a hospital converts from nonprofit to for-profit status. Norton and
Staiger (1994) found that for-profit hospitals are often located in areas with a
high degree of health insurance (Medicare, Medicaid, and private). However,
once differences in location are accounted for—such as by examining nonprofit
and for-profit hospitals in the same market—no difference was found in the
volume of uninsured patients treated by the two types of hospitals.
Price competition is expected to negatively affect a nonprofit hospital’s
ability to provide charity care by decreasing the “profits” or surplus available
for such care. As competition reduces the prices charged to privately insured
patients, profits decline and, thus, fewer funds are available for charity care.
Gruber (1994) found that increased competition among hospitals in California
from 1984 to 1988 led to decreased revenues from private payers, decreased
net income, and, consequently, less provision of uncompensated care. David
Walker (2005), the-then comptroller general of the United States, stated that
in four of the five states studied in 2003, state and locally owned hospitals
provided an average of twice as much uncompensated care as did nonprofit
or for-profit hospitals. In Florida, Georgia, Indiana, and Texas, nonprofits
delivered more uncompensated care than did for-profits, but the difference
was small. In California, for-profits delivered more uncompensated care than
did nonprofits. In a study of uncompensated care in five states, the Congres-
sional Budget Office (2006, 2) found that the cost of uncompensated care as
a percentage of hospital operating expenses was much larger in government
or public institutions (13 percent) than in nonprofit (4.7 percent) or for-profit
(4.2 percent) institutions.
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Health Pol icy Issues: An Economic Perspect ive242
Individual nonprofit and for-profit hospitals, however, varied widely in
the amount of uncompensated care they provided. Capps, Carlton, and David
(2017) compared the provision of charity care between nonprofit and for-profit
hospitals under different competitive conditions. They found that when both
types of hospitals achieve greater market power, the amount of charity care or
unprofitable services provided is not increased. Both types of hospitals exhibit
a similar response to financial incentives.
Overall, competitive pressures result in lower income available for charity
care in nonprofit and for-profit hospitals, whereas public hospitals experience
higher uncompensated care costs.
The Question of Tax-Exempt Status
Nonprofit hospitals have received tax advantages that obligate them to serve
the uninsured. Nonprofits, however, vary greatly in the amount of care they
provide to the uninsured. In some cases, the value of the hospital’s tax exemp-
tion exceeds the value of charity care provided. Consequently, it has been
proposed that, in return for their tax-exempt status, nonprofit hospitals should
be required to deliver a minimum amount of charity care.
If the tax exemption is to be tied to the value of charity care or com-
munity benefits, the measure to be used and the amount of care to be provided
must be defined. The following are proposed possible measures:
• Pure charity care: care for which payment is not expected and patients
are not billed
• Bad debt: value of care delivered and billed to patients believed to be
able to pay, but from whom the hospital is unable to collect
• Uncompensated care: the sum of bad debt and charity care
• Medicaid and Medicare shortfalls: the difference between charges and
the amount reimbursed by Medicare and Medicaid
• Community benefits: the previous items plus patient education,
prevention programs, medical research, and provision of money-losing
services (e.g., burn units, trauma centers)
Deciding which definition should be used and what percentage of a
nonprofit hospital’s revenue should be devoted to that measure is an important
public policy issue being debated by state and federal governments. For example,
if the charity care definition is used, is the amount of free care measured by
the hospital’s full charges (which few payers actually pay) or the lower prices
a health maintenance organization would pay? Further, using the broadest
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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 243
definition of community benefits may result in a hospital’s delivering no charity
care but relying instead on Medicare and Medicaid shortfalls and some com-
munity prevention programs, which also may be viewed as a marketing effort
by the hospital.4 If such a broad definition were used, little difference would
be found between many nonprofit and for-profit hospitals.
Many states have begun to engage in limited monitoring of the uncom-
pensated care provided by nonprofit hospitals (see, for example, Day 2006;
Reece 2011). Stringent requirements have not been imposed on hospitals to
maintain their tax-exempt status. Included as part of the Affordable Care Act
is the requirement that nonprofits conduct and submit a community needs
assessment, after which their progress toward meeting those needs will be
measured every three years. Those nonprofits that achieve little or no progress
toward meeting the identified needs in their community will risk losing their
tax-exempt status. Nonprofits also are required to ensure that their patients
are aware when free or discounted care is available. These conditions are less
severe than requiring nonprofits to spend a given percentage of their surplus
on charity or uncompensated care.
Summary
In examining whether the behavior of nonprofit hospitals is different from that
of for-profit hospitals, one must keep in mind that wide variations in behavior
exist within both types of hospitals. Although little difference has been found
between ownership type in pricing behavior, quality of care delivered, or even
the amount of uncompensated care provided, these comparisons are based on
averages.
As price competition among hospitals increases, ownership differences
become less important in determining a hospital’s behavior regarding pricing,
quality of care, and even charity care. In a price-competitive environment,
nonprofit and for-profit hospitals must behave similarly to survive; nonprofits
will have a smaller surplus with which to pursue other goals.
Ideally, the poor and uninsured should not have to rely on nonprofit or
for-profit hospitals for charity care. Expanding health insurance to the unin-
sured—either through private insurance refundable tax credits or Medicaid—will
more directly solve the problem of providing care to the medically indigent.
As more people obtain some form of coverage, the tax-exempt status of many
nonprofit hospitals is likely to be questioned. Although certain nonprofits,
such as teaching hospitals, will continue to provide care to those who remain
uninsured, the majority of nonprofit hospitals will have to justify their role in
society.
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Health Pol icy Issues: An Economic Perspect ive244
Discussion Questions
1. Discuss the differences and similarities among theories on why many
hospitals are nonprofit.
2. Do you agree with the ruling by a federal judge that mergers of
nonprofit hospitals should not be subject to the same antitrust laws as
mergers of for-profit hospitals?
3. How has price competition affected the ability of nonprofit hospitals to
achieve their mission?
4. What conditions should be imposed on nonprofit hospitals to retain
their tax-exempt status?
5. In what ways, if any, are nonprofit hospitals different from for-profit
hospitals?
Notes
1. The trust relationship between the patient and provider, however,
applies more strongly to the patient–physician relationship. The
physician diagnoses the illness, recommends treatment, refers the
patient to specialists, and monitors the care the patient receives from
different providers. Yet, physicians practice on a for-profit basis.
2. An additional explanation for the existence of nonprofit status is that
the stochastic nature of the demand for medical services requires
hospitals to maintain excess capacity for certain services. It can be very
costly for patients if they cannot access hospital care when needed. For-
profit hospitals, some believe, would be unwilling to bear the cost of
idle hospital capacity. Further, certain hospital services (e.g., emergency
departments; trauma centers; neonatal intensive care units; and
teaching, research, and care for certain groups [such as drug addicts]
that benefit the community) generally lose money and would otherwise
not be provided.
3. Lakdawalla and Philipson (2006) claimed that the traditional for-
profit analysis of a firm can be used to explain nonprofit hospitals,
but with a lower cost structure because of their nonprofit status. The
type of services a hospital chooses to offer (in addition to the pricing
strategy) will also affect its profitability. Horwitz and Nichols (2009)
found that nonprofit hospitals’ services vary according to the relative
market share of nonprofit, for-profit, and government hospitals in a
market. Nonprofits in markets with high for-profit market share were
more likely to offer relatively profitable services and less likely to offer
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Chapter 15: Do Nonprof i t Hospitals Behave Dif ferently Than For-Prof i t Hospitals? 245
unprofitable services compared with nonprofits in markets with low for-
profit penetration.
4. Young and colleagues (2013) surveyed nonprofit hospitals to determine
how much they spent on Internal Revenue Service–defined measures
of community benefit. They found that hospitals spent, on average, 7.5
percent of their operating expenses on community benefits. On average,
more than 85 percent of these expenditures went toward patient care,
and almost 50 percent of the 85 percent was used to supplement the
low prices paid by government for services provided to Medicaid and
other means-tested patients. Community benefit spending not related
to patient care was devoted to community health improvement activities
and health professions education. Only 1.9 percent of the study
hospitals’ operating expenditures was spent, on average, on charity
care.
References
American Hospital Association. n.d. Hospital Statistics. Various editions. Chicago:
American Hospital Association.
Capps, C., D. Carlton, and G. David. 2017. “Antitrust Treatment of Nonprofits: Should
Hospitals Receive Special Care?” National Bureau of Economic Research Work-
ing Paper No. 23131. Published February. www.nber.org/papers/w23131.
Capps, C., and D. Dranove. 2004. “Hospital Consolidation and Negotiated PPO
Prices.” Health Affairs 23 (2): 175–81.
Congressional Budget Office. 2006. “Nonprofit Hospitals and the Provision of Com-
munity Benefit.” Published December. www.cbo.gov/sites/default/files/cbo
files/ftpdocs/76xx/doc7695/12-06-nonprofit .
Day, K. 2006. “Hospital Charity Care Is Probed.” Washington Post. Published Septem-
ber 13. www.washingtonpost.com/wp-dyn/content/article/2006/09/12/
AR2006091201409.html.
Federal Trade Commission (FTC). 2006. “In the Matter of Evanston Northwestern
Healthcare Corporation.” Last updated April 28, 2008. www.ftc.gov/sites/
default/files/documents/cases/2007/08/070806opinion .
Gruber, J. 1994. “The Effect of Competitive Pressure on Charity: Hospital Responses
to Price Shopping in California.” Journal of Health Economics 13 (2): 183–212.
Horwitz, J., and A. Nichols. 2009. “Hospital Ownership and Medical Services: Market
Mix, Spillover Effects, and Nonprofit Objectives.” Journal of Health Economics
28 (5): 924–37.
Lakdawalla, D., and T. Philipson. 2006. “The Nonprofit Sector and Industry Perfor-
mance.” Journal of Public Economics 90 (8–9): 1681–98.
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Health Pol icy Issues: An Economic Perspect ive246
McClellan, M., and D. Staiger. 2000. “Comparing Hospital Quality at For-Profit and
Not-for-Profit Hospitals.” In The Changing Hospital Industry: Comparing Not-
for-Profit and For-Profit Institutions, edited by D. Cutler, 93–112. Chicago:
University of Chicago Press.
Melnick, G., E. Keeler, and J. Zwanziger. 1999. “Market Power and Hospital Pricing:
Are Nonprofits Different?” Health Affairs 18 (3): 167–73.
Morse, M., B. Kevin, R. McCann, and L. Bryant Jr. 2007. “Federal Trade Commission
Finds Evanston Northwestern Healthcare Merger Unlawful but Orders
‘Separate and Independent Negotiating Teams’ Rather Than Divestiture.”
Published August 17. www.lexology.com/library/detail.aspx?g=a1132f
5c-4483-41e5-a31d-dc832f51f1ea.
Norton, E., and D. Staiger. 1994. “How Hospital Ownership Affects Access to Care
for the Uninsured.” RAND Journal of Economics 25 (1): 171–85.
Pear, R. 2015. “New Rules to Limit Tactics on Hospitals’ Fee Collections.” New York
Times. Published January 11. www.nytimes.com/2015/01/12/us/politics/
new-rules-to-limit-tactics-on-hospitals-fee-collections.html.
Reece, M. 2011. “Bill Scrutinizes Nonprofit Property Tax Structure.” Flathead
Beacon. Published February 7. http://flatheadbeacon.com/2011/02/07/
bill-scrutinizes-nonprofit-property-tax-structure/.
Sloan, F. 2000. “Not-for-Profit Ownership and Hospital Behavior.” In Handbook of
Health Economics, vol. 1B, edited by A. J. Culyer and J. P. Newhouse, 1141–73.
New York: North-Holland Press.
Walker, D. M. 2005. “Nonprofit, For-Profit and Government Hospital: Uncompensated
Care and Other Community Benefits.” Testimony before the Committee on
Ways and Means, House of Representatives, GAO-05-743T. Publicly released
May 26. www.gao.gov/new.items/d05743t .
Young, G. J., C.-H. Chou, J. Alexander, S.-Y. D. Lee, and E. Raver. 2013. “Provision
of Community Benefits by Tax-Exempt U.S. Hospitals.” New England Journal
of Medicine 368 (16): 1519–27.
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CHAPTER
247
COMPETITION AMONG HOSPITALS: DOES IT
RAISE OR LOWER COSTS?
Current federal policy (the antitrust laws) encourages competition among
hospitals. Hospitals proposing a merger are scrutinized by the Federal
Trade Commission (FTC) to determine whether the merger will lessen
hospital competition in that market; if so, the FTC will oppose the merger.
Critics of this policy believe hospitals should be permitted—in fact, encour-
aged—to consolidate the facilities and services they provide. They claim that
the result will be greater efficiency, less duplication of costly services, and higher
quality of care. Who is correct, and what is the appropriate public policy for
hospitals? Competition or cooperation?
Important to understanding hospital performance are (1) the meth-
ods used to pay hospitals (different payment schemes offer hospitals different
incentives) and (2) the consequences of having different numbers of hospitals
compete with one another
.
Origins of Nonprice Competition
After the introduction of Medicare and Medicaid in 1966, hospitals were paid
for the costs of services rendered to the aged and poor. Private insurance,
which was widespread among the remainder of the population, reimbursed
hospitals generously according to their costs or their charges. The extensive
coverage of hospital services by private and public payers removed patients’
incentive to be concerned about the costs of hospital care. Patients pay lower
out-of-pocket costs for hospital care (3.0 percent in 2016) than they do for
any other medical service.
Third-party payers (government and private insurance) and patients had
virtually no incentive to be concerned about hospital efficiency and duplication
of facilities and services. Further, most hospitals are organized as nonprofit
(nongovernment) organizations that are either affiliated with religious organi-
zations or controlled by boards of trustees selected from the community. With
the introduction of extensive public and private hospital insurance after the
mid-1960s, the use of nonprofit hospitals increased. Lacking a profit motive
and assured of survival by the generous payment methods, nonprofit hospitals
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Health Pol icy Issues: An Economic Perspect ive248
also had no incentive to be efficient. Consequently, the costs of caring for
patients rose rapidly.
Exhibit 16.1 illustrates the dramatic growth in hospital expenditures
from the 1960s to 2015. After Medicare and Medicaid were enacted in 1966,
hospital expenditures rose by more than 16 percent per year, which was primar-
ily attributable to sharp increases in hospital prices (as shown in exhibit 16.2).
Price increases moderated during the early 1970s, when wage and price controls
were imposed, but then continued once the controls were removed in mid-
1974. Hospital expenditure growth was less rapid in the mid-to-late 1980s as
Medicare changed its hospital payment system and price competition increased.
The rate of increase in hospital expenditures and hospital prices continued to
slow during the 1990s.1 These declines, discussed later, are indicative of the
changes that have occurred in the market for hospital services.
In the late 1960s, the private sector also did not encourage efficiency.
Although services such as diagnostic workups could be provided less expen-
sively in an outpatient setting, BlueCross paid for such services only if they
were provided as part of a hospital admission. Small hospitals attempted to
emulate medical centers by having the latest in technology, although those
services were used infrequently.
Because cost was of little concern to patients or purchasers of services,
it did not matter whether large organizations had lower costs per unit and
higher-quality outcomes than those of small facilities. The greater the number
of hospitals in a community, the more intense was the competition among
nonprofit hospitals to become the most prestigious. Hospitals competed for
physicians by offering the same medical services available at other hospitals to
maximize the physicians’ productivity and to discourage them from referring
patients elsewhere. This wasteful form of nonprice competition was character-
ized as a “medical arms race” and caused the rapid rise in hospital expenditures.
As the costs of nonprice competition ballooned, federal and state govern-
ments attempted to change hospitals’ behavior. Regulations were enacted to
control hospital capital expenditures; hospitals were required to have certificate-
of-need (CON) approval from a state planning agency before they could under-
take large investments. According to proponents of state planning, controlling
hospital investment would eliminate unnecessary and duplicative investments.
Unfortunately, no attempts were made to change hospital payment
methods, which would have changed hospitals’ incentives to undertake such
investments.
Numerous studies concluded that CON had no effect on limiting the
growth in hospital investment. Instead, CON was used in an anticompetitive
manner to benefit existing hospitals in the community, which ended up control-
ling the CON approval process. Ambulatory surgery centers (unaffiliated with
hospitals) did not receive CON approval for construction because they would
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Chapter 16: Competit ion Among Hospitals: Does I t Raise or Lower Costs? 249
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Health Pol icy Issues: An Economic Perspect ive250
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Chapter 16: Competit ion Among Hospitals: Does I t Raise or Lower Costs? 251
take away hospital patients; health maintenance organizations (HMOs), such
as Kaiser, found entering a new market difficult because they could not receive
CON approval to build a hospital; and the courts found that the CON process
was used in an “arbitrary and capricious manner” against for-profit hospitals
attempting to enter the market of an existing nonprofit hospital (Salkever 2000).
Transition to Price Competition
Until the 1980s, hospital competition was synonymous with nonprice competi-
tion, and it was wasteful and led to rapidly rising expenditures.
During the 1980s, hospital and purchaser incentives changed. Medicare
began to pay hospitals a fixed price per admission, which varied according to the
type of admission. This new payment system—referred to as diagnosis-related
groups (DRGs)—was phased in over five years starting in 1983. Faced with a
fixed price, hospitals now had an incentive to reduce the costs of caring for aged
patients. In addition, hospitals reduced lengths of stay for aged patients, which
caused declines in hospital occupancy rates. For the first time, hospitals became
concerned with their physicians’ practice behavior. If physicians ordered too
many tests or kept patients in the hospital longer than necessary, the hospital
lost money, given the fixed DRG price.
Pressure to reduce hospital costs also came from private insurers, pri-
marily because employers became concerned about the rising costs of insuring
employees. Insurers changed their insurance benefits to encourage patients to
undergo diagnostic tests and minor surgical procedures in less costly outpatient
settings. Insurers instituted utilization review to monitor the appropriateness
of inpatient admissions, which further reduced hospital admissions and lengths
of stay. These changes in hospital and purchaser incentives reduced hospital
occupancy rates from 76 percent in 1980 to 67 percent by 1990; as of 2015,
the rate was about 63 percent. The decline in occupancy rates was much more
severe for small hospitals (with fewer than 50 beds), where rates fell to below
50 percent (American Hospital Association 2018, table 2). As occupancy rates
fell, hospitals became willing to negotiate price discounts with insurers and
HMOs that could deliver many patients to their hospitals. This initiated price
competition among hospitals by the late 1980s.
Price competition does not imply that hospitals compete only on the
basis of the lowest price. Purchasers are also interested in the characteristics
of a hospital, such as reputation, geographic location in relation to patients,
facilities and services available, patient satisfaction, and treatment outcomes. In
recent years, as mergers have taken place and price competition has lessened,
hospitals’ market power has expanded (relative to that of health insurers), and
hospital prices (adjusted for inflation) have risen rapidly (see exhibit 16.2).
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Health Pol icy Issues: An Economic Perspect ive252
Price Competition in Theory
How did hospitals respond to this new competitive environment in which
purchasers demand lower prices? Let us examine two hypothetical situations.
In the first situation, only one hospital exists in an area; it has no com-
petitors, and no substitutes for inpatient services are available. The hospital is a
monopolist in providing services and has no incentive to respond to purchaser
demands for lower prices, quality information, and patient satisfaction. The
purchaser has no choice but to use that one hospital. If the hospital is not
efficient, it can pass on the resulting higher costs to the purchaser. If patients
are dissatisfied with the services or the hospital refuses to provide outcomes
information, the purchaser and patients have no choice but to use the hospital.
(Obviously, at some point, it becomes worthwhile for patients to incur large
costs to travel to a distant hospital or facility.) When only one hospital serves
a market, that hospital is unlikely to achieve high performance. It has little
incentive to be efficient or to respond to purchaser and patient demands.
In the second situation, many hospitals—perhaps ten—serve a geographic
area. Now assume a large employer in the area is interested, on behalf of its
employees, in not only high-quality care and high patient satisfaction, but also in
low hospital costs. Further, assume each of the ten hospitals is equally accessible
to the employees in terms of short travel distances and availability of physician
appointments. How are hospitals likely to respond to this employer’s demands?
At least several of the ten hospitals would be willing—in return for gain-
ing many new patients from the employer—to negotiate on prices and accede
to demands for information on quality and patient satisfaction. As long as the
price the hospital receives from the employer is greater than the direct costs of
caring for the employees, the hospital will make more money than it would if
it did not accept this business. Further, unless each hospital is as efficient as its
competitors, it cannot hope to obtain such a contract. A more efficient hospital
is always able to charge less money. Similar to competing on price is compet-
ing on willingness to provide information about treatment outcomes. Because
hospitals rely on purchaser revenues to survive, they must respond to purchaser
demands. If Hospital A is not responsive to these demands, other hospitals will be,
and Hospital A will soon find that it has too few patients to remain in business.
When hospitals compete on quality, satisfaction, price, and other pur-
chaser demands, their performance is opposite that of a monopoly provider.
In price-competitive markets, hospitals have an incentive to be efficient and
respond to purchaser demands. What if, instead of competing with one another,
the ten hospitals agree among themselves not to compete on price or provide
purchasers with any additional information about quality or patient satisfac-
tion? The outcome would be similar to a monopoly situation. Prices would be
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Chapter 16: Competit ion Among Hospitals: Does I t Raise or Lower Costs? 253
higher, and hospitals would have less incentive to be efficient. Patients would
be worse off because they would pay more, and quality and patient satisfaction
would be lower because employers and other purchasers would be unable to
select hospitals based on these criteria.
The more competitive the market, the greater the benefits to consum-
ers. For this reason, society seeks to achieve competitive markets through its
antitrust laws. Although competitive hospitals might be harmed and driven
out of business, the evaluation of competitive markets is based on their effect
on consumers rather than on any competitors in that market. Antitrust laws
are designed to prevent hospitals from acting anticompetitively.
Price-fixing agreements, such as those described earlier, are illegal because
they reduce competition. Barriers that prevent competitors from entering a
market are also anticompetitive. If two hospitals in a market can restrict entry
into that market (perhaps through use of regulations such as CON approval),
they will have greater monopoly power and be less price competitive and less
responsive to purchaser demands. Mergers may be similarly anticompetitive. For
example, if nine of the ten hospitals merged, leaving only two organizations, the
degree of competition would be less than if ten are operating independently.
For this reason, the FTC examines hospital mergers to determine whether the
consolidation is eliminating competition in the market.
Price Competition in Practice
The previous discussion provides a theoretical basis for price competition. To
move from price competition’s theoretical benefits to reality, two questions
must be considered. First, does any market have enough hospitals for price
competition to occur? Second, is there any evidence about the actual effects
of hospital price competition?
The number of competing hospitals in a market is determined by the
cost–size relationship of hospitals (economies of scale) and the size of the market
(the population served). A large hospital—for example, one with 200 beds—is
likely to have lower average costs per patient than a hospital with the same
set of services but only 50 beds. In a large hospital, some costs can be spread
over a greater number of patients. For example, the costs of an administrator,
an X-ray technician, and imaging equipment (which can be used more fully
in a large organization) do not change whether the hospital has 50 or 200
patients. These economies of scale, however, do not continue indefinitely; at
some point, the high costs of coordinating services begin to exceed the gains
from being large. Studies generally have indicated that hospitals in the range
of 200 to 400 beds have the lowest average costs.
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Health Pol icy Issues: An Economic Perspect ive254
If the population in an area consists of only 100,000, only one hospital
of 260 beds is likely to survive (assuming 800 patient days per year per 1,000
people and 80 percent occupancy). If more than one hospital is in the area,
each has higher average costs than does one large hospital; one of the hospitals
may expand, achieve lower average costs, and be able to set its prices lower
than those of the other hospital. An area with a population of 1 million is large
enough to support three to six hospitals in the 200- to 400-bed range.
Hospital services, however, are not all the same. The economies of scale
associated with an obstetrics facility are quite different from those associated with
organ transplant services. Patients are less willing to travel great distances for
a normal delivery than for a heart transplant. The costs of traveling to another
state for a transplant represent a smaller portion of the total cost of that service
than do the costs of traveling to another state for childbirth (and the travel time
is less crucial). Thus, the number of competitors in a market depends on the
particular service. For some services, the relevant geographic market served may
be relatively small, whereas for others the market may be the state or region.
As of 2015, approximately 85 percent of hospital beds were in metro-
politan statistical areas (MSAs). An MSA may not be indicative of the particular
market in which a hospital competes. For some services, the travel time within
an MSA may be too great, whereas for other services (organ transplants), the
market may encompass multiple MSAs. However, the number of hospitals in an
MSA provides a general indication of the number of competitors in a hospital’s
market. As shown in exhibit 16.3, 212 MSAs (48 percent) have fewer than four
hospitals, and 85 MSAs (19 percent) have four or five hospitals. The remain-
ing MSAs (33 percent) have six or more hospitals; however, that 33 percent
contains 73 percent of the hospitals located in metropolitan areas. Therefore,
most hospitals in MSAs (73 percent) are in MSAs with six or more hospitals.
Even in an MSA with few hospitals, competition still occurs, and substitutes
for the hospitals’ services (e.g., outpatient surgery) are often available, which
reduce the hospitals’ monopoly power.
When few specialized facilities exist in a market (because of economies of
scale and the size of the market), the relevant geographic market is likely to be
much larger because the highly specialized services are generally not of an emer-
gency nature, and patients are willing to travel farther to access them. Insurers
negotiate prices for transplants, for example, with several regional centers of excel-
lence—hospitals that perform a high number of transplants and experience good
outcomes. Thus, price competition among hospitals appears to be feasible. As
insurers and large employers have become concerned about the costs of hospital
care and better informed about hospital prices and patient outcomes, hospitals are
being forced to respond to purchaser demands and compete according to price,
outcomes, and patient satisfaction. Exhibits 16.1 and 16.2 show how competi-
tion lowered the rate of increase in hospital expenditures and prices during the
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Chapter 16: Competit ion Among Hospitals: Does I t Raise or Lower Costs? 255
late 1990s. As hospitals competed to be included in provider panels of managed
care plans, they had to become more efficient and discount their prices.
Several studies have been published on the effects of hospital price
competition. The research findings support traditional economic expectations
regarding competitive hospital markets. The change to hospital price competi-
tion has not been uniform throughout the United States. Price competition
in California developed earlier and more rapidly than in other areas. Bamezai
and colleagues (1999) classified hospitals in California according to whether
they were in a high- or low-competition market and whether the managed care
penetration was high or low. Hospitals in more competitive markets (controlling
for other factors) were found to have a much lower rate of increase in the costs
per discharge and per capita than were hospitals in less competitive markets.
Bamezai and colleagues (1999) also found that an increase in managed
care penetration reduced the rise in hospital costs (see exhibit 16.4). The decrease
in costs, however, was much greater for hospitals in more competitive markets.
Also, regardless of the degree of managed care penetration, competition was
important in slowing hospital cost increases. These findings imply that hospital
mergers that decrease competition are likely to result in higher hospital prices.
Melnick, Chen, and Wu (2011) confirmed these findings in a subsequent study
showing that greater market concentration leads to higher hospital prices.2
66
146
85
68
32 29
18
0
20
40
60
80
100
120
140
160
1 2 or 3 4 or 5 6 to 10 11 to 15 16 to 25 26 to 86
N
um
be
r
of
M
S
A
s
Number of Hospitals
Note: MSA = metropolitan statistical area.
Source: Data from American Hospital Association (2018, table 8).
EXHIBIT 16.3
Number of
Hospitals in
Metropolitan
Statistical
Areas, 2016
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Health Pol icy Issues: An Economic Perspect ive256
Other studies have reached similar conclusions using different methods and
data on specific types of hospital treatment. For example, Kessler and McClellan
(2000) analyzed Medicare claims data (from 1985 to 1994) for patients admit-
ted to the hospital with a primary diagnosis of a heart attack. They found that
before 1991, hospital competition based on the latest technology led to higher
costs and, in some cases, lower rates of adverse health outcomes. After 1990,
hospital price competition led to substantially reduced costs and rates of adverse
outcomes. Patients had lower mortality rates in the most competitive markets.
Chandra and colleagues (2016, 2110) also described the benefits of
market competition. They found that “higher quality hospitals have higher
market shares and grow more over time. The relationship between performance
and allocation is stronger among patients who have greater scope for hospital
choice, suggesting that patient demand plays an important role in allocation.
Our findings suggest that healthcare may have more in common with ‘tradi-
tional’ sectors subject to market forces than often assumed.”
After the consumer backlash against managed care in the late 1990s and
early 2000s, health plans broadened their provider networks to give enrollees
more provider choices. As insurers included more hospitals in their networks,
their bargaining power over hospitals decreased (Dranove et al. 2008). Rein-
forcing this shift in relative bargaining power was the decrease in the number of
hospitals. Hospital closures and mergers resulted in fewer hospitals competing
within a market.3 Consequently, hospital prices increased much more rapidly.
Insurers’ reliance on broad provider networks coupled with the decreased
number of competing hospitals enabled hospitals to maintain their relative
bargaining power over insurers.
Cooper and colleagues (2015, 3) estimated the effect of hospital con-
solidation on hospital prices:
Measures of hospital market structure are strongly correlated with higher hospital
prices . . . even after controlling for . . . [many demand and cost factors] . . . We
Level of Managed
Care Penetration
Level of Hospital Competition
% DifferenceLow High
Low 65 56 16a
High 52 39 33a
% difference 25a 44a 67b
a % difference = [(High − Low)/Low].
b [Low/Low (65) − High/High (39)] / [High/High (39)].
Source: Calculations by Glenn Melnick, Rand Corporation.
EXHIBIT 16.4
Hospital Cost
Growth in the
United States
by Level of
Managed Care
Penetration and
Hospital Market
Competitive ness,
1986–1993
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Chapter 16: Competit ion Among Hospitals: Does I t Raise or Lower Costs? 257
estimate that monopoly hospitals have 15.3 percent higher prices than markets with
four or more hospitals. Similarly, hospitals in duopoly markets have prices that are
6.4 percent higher and hospitals in triopoly markets have prices that are 4.8 percent
higher than hospitals located in markets with four or more hospitals.
Many economists believe the steady erosion of competition in hospital
markets (almost one-half of all hospital markets are considered highly con-
centrated) is resulting in higher prices. In addition, the recent trend toward
hospitals employing more practicing physicians is further decreasing hospital
competition (Gaynor, Mostashari, and Ginsburg 2017).
Summary
The controversy over whether hospital competition results in higher or lower
costs is based on studies from two periods. When hospitals were paid according
to their costs, nonprice competition occurred and resulted in rapidly rising hos-
pital costs. Medicare’s switch to fixed-price hospital payment and managed care
plans’ switch to negotiated prices changed hospitals’ incentives. Hospitals had
incentives to be efficient and compete on price to be included in managed care
plans’ provider panels. Consequently, hospital costs and prices rose less rapidly
in more competitive markets. Public policies (e.g., antitrust laws) that encourage
competitive hospital markets will be of greater benefit to purchasers and patients
than will policies that enable hospitals to increase their monopoly power.
As enrollment in managed care plans rose, the demand for hospital care
fell. Hospitals developed excess capacity and were willing to discount their prices
to be included in insurers’ limited provider networks. As a result, hospital prices
declined. With excess capacity, some hospitals closed, and many merged with
financially stronger hospitals. Under public pressure to expand their provider
networks, insurers were less able to offer hospitals a greater volume of patients
in return for heavily discounted prices. With fewer hospital competitors in a
market and insurers’ willingness to contract with more hospitals, the relative
bargaining positions of hospitals and insurers changed. Hospitals’ market power
increased—as did their prices, which have been higher than in the 1990s, when
managed care limited provider networks and hospitals had excess capacity.
Discussion Questions
1. Why did hospital expenditures rise so rapidly after Medicare and
Medicaid were introduced in 1966?
2. What changes did Medicare DRGs cause in hospital behavior?
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Health Pol icy Issues: An Economic Perspect ive258
3. What is the likely response of hospitals when only one hospital is in a
market, compared with their response when ten hospitals are competing
for a large employer’s employees?
4. What determines the number of competitors in a market? Apply your
answer to obstetrics and to transplant services.
5. What are some anticompetitive hospital actions that the antitrust laws
seek to prevent?
Notes
1. Starting in the mid-1980s, hospital price increases—as calculated in
the consumer price index (CPI)—were greatly overstated because
the CPI measured “list” prices rather than actual prices charged. The
difference between the two became greater with the increase in hospital
discounting (Dranove, Shanley, and White 1991). To correct this
discrepancy, the Bureau of Labor Statistics, in constructing the CPI,
began to use data on actual hospital prices in the early 1990s.
2. In 2006, the British government tried to introduce competition by
allowing patients to choose among hospitals and providing them with
information on hospital quality and timeliness of care. Gaynor, Moreno-
Serra, and Propper (2013) found that patients discharged from hospitals
in more competitive markets were less likely to die, had shorter lengths of
stay, and incurred no more costs than patients in less competitive markets.
3. An example of the effect of fewer competing hospitals on hospital
prices is the study by Wu (2008), who analyzed hospital closures
between 1993 and 1998 and found that as the number of competitors
decreased, competitors located near the closed hospitals improved their
bargaining position over insurers. As these hospital markets became
more concentrated, hospitals were able to raise their prices more than
could those in less concentrated markets. In 2015, Trish and Herring
found that the degree of hospital competition and insurer competition
within a market affects insurance premiums.
References
American Hospital Association. 2018. Hospital Statistics. Chicago: American Hospital
Association.
Bamezai, A., J. Zwanziger, G. Melnick, and J. Mann. 1999. “Price Competition and
Hospital Cost Growth in the United States: 1989–1994.” Health Economics
8 (3): 233–43.
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Chapter 16: Competit ion Among Hospitals: Does I t Raise or Lower Costs? 259
Bureau of Labor Statistics. 2018. “Consumer Price Index Databases, All Urban Con-
sumers (Current Series).” Accessed January. www.bls.gov/cpi/data.htm.
Chandra, A., A. Finkelstein, A. Sacarny, and C. Syverson. 2016. “Health Care Excep-
tionalism? Performance and Allocation in the US Health Care Sector.” American
Economic Review 106 (8): 2110–44.
Cooper, Z., S. Craig, M. Gaynor, and J. Van Reenen. 2015. “The Price Ain’t Right?
Hospital Prices and Health Spending on the Privately Insured.” Health Care
Pricing Project. Published May. www.healthcarepricingproject.org/papers/
paper-1.
Dranove, D., R. Lindrooth, W. White, and J. Zwanziger. 2008. “Is the Impact of
Managed Care on Hospital Prices Decreasing?” Journal of Health Economics
27 (2): 362–76.
Dranove, D., M. Shanley, and W. White. 1991. “How Fast Are Hospital Prices Really
Rising?” Medical Care 29 (8): 690–96.
Gaynor, M., R. Moreno-Serra, and C. Propper. 2013. “Death by Market Power:
Reform, Competition and Patient Outcomes in the National Health Service.”
American Economic Journal: Economic Policy 5 (4): 134–66.
Gaynor, M., F. Mostashari, and P. Ginsburg. 2017. “Health Care’s Crushing
Lack of Competition.” Forbes. Published June 28. www.forbes.com/sites/
realspin/2017/06/28/health-cares-crushing-lack-of-competition/.
Kessler, D., and M. McClellan. 2000. “Is Hospital Competition Socially Wasteful?”
Quarterly Journal of Economics 115 (2): 577–615.
Melnick, G., Y. Chen, and V. Wu. 2011. “The Increased Concentration of Health
Plan Markets Can Benefit Consumers Through Lower Hospital Prices.” Health
Affairs 30 (9): 1728–33.
Salkever, D. 2000. “Regulation of Prices and Investment in Hospitals in the U.S.” In
Handbook of Health Economics, vol. 1B, edited by A. J. Culyer and J. P. New-
house, 1489–535. New York: North-Holland Press.
Trish, E. E., and B. J. Herring. 2015. “How Do Health Insurer Market Concentration
and Bargaining Power with Hospitals Affect Health Insurance Premiums?”
Journal of Health Economics 42: 104–14.
Wu, V. 2008. “The Price Effect of Hospital Closures.” Inquiry 45 (3): 280–92.
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CHAPTER
335
HAS COMPETITION BEEN TRIED—AND
HAS IT FAILED—TO IMPROVE THE
US HEALTHCARE SYSTEM?
Critics claim that market competition has been tried but has failed to
improve the US healthcare system. Healthcare costs are rising rapidly,
and per capita healthcare spending is the highest in the world, yet many
Americans are without health insurance. More of the middle class are finding
that health insurance has become too expensive, life expectancy is lower than
that in other countries, and the infant mortality rate is higher than that in some
countries with lower per capita healthcare expenditures. In other words, is it
time to try something different? Specifically, is it time for more government
regulation and control of the healthcare system? “Some say that competition
has failed, I say that competition has not yet been tried.” Alain Enthoven (1993,
28) wrote that statement in 1993, and it continues to be correct today.
This chapter discusses how medical markets differ from competitive
markets, why making medical markets more competitive is desirable, what
changes are needed to bring about greater competition, whether competitive
markets are responsible for the growing numbers of uninsured, and what role
the government plays in a competitive medical care environment.
Criteria for Judging Performance of a Country’s Medical
Sector
The health of a population, as measured by life expectancy or infant mortal-
ity rates, is not solely the consequence of the country’s medical system. How
people live and eat are more important determinants of life expectancy than
whether they have good access to medical services when they become ill. Life
expectancy is related to a number of factors, such as smoking, diet, marital
status, exercise, drug use, and cultural values. Although universal access to
health insurance is desirable, studies have shown that medical care has a smaller
effect on health levels than do personal health habits and lifestyle (see chapter
3). Therefore, assessing the medical care system on measures that are affected
more by lifestyle factors is inappropriate. After all, the financing and delivery
of medical services has been based on treating people when they are ill and
not on keeping them well.
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AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition
Account: s4264928.main.eds
Health Pol icy Issues: An Economic Perspect ive336
Several healthcare organizations in the United States have gone beyond
treating people when they become ill and have tried to lower costs by preventing
illnesses that are expensive to treat. Reducing hip fractures among the elderly
and instituting monitoring mechanisms for diabetes patients, for example, have
been shown to prevent more costly treatments later. The financial incentives for
these organizations differ from the typical fee-for-service payment incentives
used predominantly in the United States and other countries.
Assuming the purpose of a medical care system is more narrowly
defined—that is, treating those who become ill—what criteria should be used
to evaluate how well that system performs? The criteria should be the same
as those used to evaluate the performance of other markets, such as housing,
food, automobiles, and electronics—markets that produce necessities and
luxuries. The following are the performance criteria of a medical care system:
1. Information. Do consumers have sufficient information to choose
the quantity and type of services based on price, quality, and other
characteristics of the services being supplied?
2. Consumer incentives. Do consumers have incentives to ensure that the
value of the services used is not less than the cost of producing those
services?
3. Consumer choices. Does the market respond to what consumers are
willing to pay? If consumers demand more of some services, will the
market provide more of those services? If consumers differ in how much
they are willing to spend or want different types of services, will the
market respond to those varied consumer demands?
4. Supplier incentives. Do suppliers of goods and services have an incentive
to produce those goods and services (for a given level of quality) at the
lowest cost?
5. Price markups. Do the prices charged by suppliers for their services
reflect the costs of production? (This occurs when suppliers compete on
price to supply their services.)
6. Redistribution. Do those who cannot afford to pay for their medical
services receive medically necessary services?
To the extent that the medical sector approximates the first five criteria,
the system will produce its output efficiently, and medical costs will rise at a
rate that reflects the cost of producing those services.1 The type of services
available, as well as the new medical technology adopted, will be based on what
consumers are willing to pay.
Competitive markets—compared with monopoly markets or markets
with government controls on prices and investment—come closest to achieving
the first five criteria. Competitive markets are the yardstick by which all markets
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 337
are evaluated, and they underlie the antitrust laws. Proponents of competition
believe the same benefits can be achieved by applying competitive principles to
medical care. Competitive markets, however, do not help those unable to afford
the goods and services produced. It is government’s role, not the market’s, to
subsidize those with low income so that they can receive the necessary amounts
of food, housing, and medical services. When adequate subsidies in the form
of vouchers for health insurance are provided, through a competitive market,
to those with low income, providers have incentives to produce those services
efficiently, and patients have a greater choice when using them.
Market forces are powerful in motivating purchasers and suppliers. The
search for profits is an incentive for suppliers to invest a great deal of money to
satisfy purchaser demands. Suppliers innovate to become more efficient, develop
new services, and differentiate themselves from competitors, thereby increasing
their market share and becoming more profitable. Incentives exist in both com-
petitive and regulated markets. The incentives appropriate to a competitive market
are those for which both the purchaser and the supplier bear the cost and receive
the benefits of their actions. When a purchaser’s and a supplier’s costs and benefits
are not equal, the market becomes less competitive and its performance suffers.
How Medical Markets Differ from Competitive Markets
The Period Before Managed Care
Before managed care began to grow in the 1980s, health insurance cover-
age was predominantly traditional indemnity insurance. Patients had little
or no out-of-pocket cost when they used medical services, and hospitals and
physicians were paid on a fee-for-service basis. Information about providers
was nonexistent, as it was prohibited by medical and hospital associations,
and accrediting agencies (e.g., The Joint Commission) did not make their
findings public. Insurance companies merely passed higher provider costs on
to employers, who paid their employees’ insurance premiums. Medicare and
Medicaid greatly reduced their beneficiaries’ concern regarding medical prices.
Medicare paid hospitals according to their costs, and physicians were paid on
a fee-for-service basis. Medicaid paid hospitals and physicians fee-for-service.
Regulatory policies at the state and federal levels, enacted at the behest
of provider groups, led to greater market inefficiency. Restrictions were imposed
on any form of advertising; on the tasks different healthcare professionals were
permitted to perform; on entry into markets by new hospitals and free-standing
outpatient surgery centers; on health maintenance organizations (HMOs),
which were required to be nonprofit; and on which healthcare providers were
eligible for payment under Medicare, Medicaid, and even Blue Cross and Blue
Shield. Neither patients nor physicians had any incentive to be concerned about
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Health Pol icy Issues: An Economic Perspect ive338
the use or cost of services. Comprehensive health insurance results in a “moral
hazard” problem; patients use more services because their insurance has greatly
reduced the price they must pay. The additional benefit of using more services
is much less than it would be if the patient had to pay more of the cost. Exhibit
21.1 illustrates how payment for medical services has changed since 1960.
Private insurance and government now pay for most medical services;
out-of-pocket payments by patients have declined from almost 50 percent
of total medical expenditures to just 10.6 percent. Furthermore, physicians,
because they are paid on a fee-for-service basis, have a financial incentive to
provide more services. Given the lack of patient and provider incentives to be
concerned about the cost and use of services, too many services are delivered.
Wide variations in care occur because factors other than clinical value are used
to decide whether the services should be provided, and rapid increases have
occurred in the growth of medical spending.
To control rapidly rising medical costs from the late 1960s to the early
1980s, federal and state governments used regulatory approaches. The medical
sector was placed under wage and price controls from 1971 to 1974, health-
planning legislation placed controls on hospital investment, many states used
hospital rate regulations, and Medicare instituted hospital utilization review and
Year
Pe
rc
en
ta
ge
o
f N
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io
na
l H
ea
lt
h
Ex
pe
nd
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ur
es
19
60
19
70
19
80
19
90
20
00
20
10
20
16
10
0%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
State and local funds
Federal funds
Private health insurance
Out-of-pocket payments
Note: The private health insurance category includes other private funds.
Source: Data from Centers for Medicare & Medicaid Services (2017).
EXHIBIT 21.1
Trends in
Payment
for Medical
Services,
1960–2016
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 339
limited physicians’ fee increases. Medicaid simply reduced payments to hospitals
and physicians. These regulatory approaches failed to slow rising medical costs.
Managed Care
Managed care was the reaction of large employers to an out-of-control healthcare
system that brought about rapidly rising health insurance premiums. Under
pressure from large employers and unions, health insurers and providers became
adversaries. Health plans negotiated price discounts with providers and instituted
cost-containment measures that reduced use of services (gatekeepers, prior
authorization for specialist and hospital services, and coverage for care in settings
less expensive than the hospital). These cost-reduction measures achieved large
savings in insurance premiums, as shown in exhibit 20.3. When employees were
offered a choice of health plans and given an opportunity to save on monthly
premiums, they switched plans. Price competition penalized high-cost plans.
However, a backlash against managed care and its cost-containment
methods occurred by the end of the 1990s. As more low-risk users switched
to HMOs because of less expensive premiums, those remaining in traditional
indemnity plans (patients with chronic illnesses and those with established pri-
mary care physician and specialist relationships) faced high premiums. (Adverse
selection caused premiums to rise more in traditional indemnity plans.) They
joined HMOs to reduce their premiums but were dissatisfied with the restric-
tions on access to providers. The backlash against managed care was likely
driven by those who felt compelled to join HMOs.
Managed care was, at most, an example of partial market competition.
Although managed care competition achieved large private-sector cost savings
for a limited time, much of the previous regulatory and economic framework
under which competition occurred was unchanged. Any market framework
includes a set of consumer and supplier incentives, and market performance
responds to these incentives. When these incentives influence consumers and
suppliers to consider the full costs and benefits of their decisions, market
outcomes are efficient. At times, however, the legal and economic framework
within which consumers and producers make their choices distorts the costs
and benefits of these incentives, in which case markets perform inefficiently.
The following sections provide examples of how the medical care mar-
ket’s legal and economic framework has distorted consumer and producer
incentives—and, hence, their choices—and led to inefficient market outcomes.
Demand-Side Market Failures
These market failures on the demand side have limited the expansion of greater
competitive forces.
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Health Pol icy Issues: An Economic Perspect ive340
Tax-Exempt Employer-Paid Health Insurance
When an employer purchases health insurance on behalf of employees, these
contributions are not considered taxable income to the employee. Compared
with other employee purchases paid for with after-tax income, the purchase of
insurance is subsidized; thus, employees pay less for insurance than they would
if they had to buy the same amount with after-tax income. When the price of
a good or service is reduced, consumers will purchase a greater quantity of
that service (known as the law of demand).2 The price of insurance, when pur-
chased by the employer, is not the same for all employees. Those in the highest
income-tax brackets receive the largest tax subsidies. On average, changes in
the out-of-pocket price of health insurance result in a proportional change in
the quantity of insurance demanded.3 (A 5 percent decrease in price leads to
an increase of about 5 percent in the quantity demanded.) The tax subsidy for
health insurance results in employees purchasing more comprehensive cover-
age with lower deductibles and lower cost sharing (and additional benefits,
such as vision and dental care) than they would if they had to pay the entire
premium themselves.
Incentives have been distorted because consumers do not pay the full
cost of health insurance or of their medical services. When consumers pay, out
of pocket, only a small fraction of the provider’s price, they are less aware of
and concerned with the prices charged by medical providers.
Health Plan Choices
Health plan competition could have been stronger for several reasons. First,
many employers limited their employees’ choice to only one health plan.4 For
competition to occur among plans, employees must be offered a choice. Yet
throughout the 1990s and still today, about 80 percent of firms providing health
benefits offer employees only one choice of health plan. Large firms are more
likely than small firms to offer a choice of plans (55 percent compared with 17
percent) (Kaiser Family Foundation and Health Research & Educational Trust
2017, 65). When employees are unable to choose among substitutes, the single
plan being offered has less incentive to respond to employees’ preferences.
Second, many employers that offer employees a choice of health plans
either contribute more to the higher-cost health plan or contribute a fixed per-
centage of the premium to the plan the employee chooses. A fixed-percentage
contribution provides a greater dollar subsidy to the more expensive plan,
thereby reducing the employee’s incentive to select the less costly plan. (If
the employer pays 80 percent, the employee opting for the more expensive
plan pays only 20 percent of the price difference, not 100 percent.) The more
efficient health plan is at a competitive disadvantage because the more expen-
sive competitor is more heavily subsidized. When employees have a choice of
plans, and the employer contributes a fixed-dollar amount, most employees will
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 341
select a more restrictive plan—such as an HMO. “For example, 70–80 percent
of active employees and dependents covered by the University of California,
CalPERS, and Wells Fargo in California [each company makes a fixed-dollar
contribution] choose HMOs” (Enthoven and Tollen 2005, w5-429).
Third, when competing managed care plans offer broad networks with
overlapping providers, the plans are not sufficiently differentiated and do not
offer employees real choices. Overlapping provider networks make it difficult
for the plan to control costs (because it cannot exclude providers) and for
employees to identify quality differences. The plans are not competing on
their providers’ ability to manage care, on the quality of their providers, or on
patient satisfaction, and they have little incentive to invest resources to do so,
because all plans with the same providers will benefit. Consumers should be
able to select among health plans that vary in premiums, quality of care, access
to providers, provider network, and so on.
Fourth, few employers pay insurers risk-adjusted premiums for their
employees. Paying the same premium for an employee who is older and has
more risk factors than a younger employee, who is less likely to incur a large
medical expense, gives insurers an incentive to engage in risk selection by seek-
ing out younger employees. Paying risk-adjusted premiums gives insurers an
incentive to compete on price for higher-risk employees. Insurers also must
compete on how well they can manage the care of high-risk enrollees rather
than on how well they can entice low-risk employees to join their plans.
Lack of Information
Historically, healthcare providers have been opposed to being compared with
one another. The Federal Trade Commission’s (FTC) antitrust suit against the
American Medical Association—affirmed by the US Supreme Court in 1982—
involved the association’s prohibitions on advertising. A consumer seeking
information on a provider’s prices and quality was unable to find it. (Consumers
with limited cost sharing also had little incentive to search for a lower price.)
Lack of information on how well one provider compares with another enables
each competitor to charge higher prices or produce lower-quality care than they
could if consumers were informed about both providers’ prices and quality.
Wide price variations—unrelated to quality or other attributes of the
service—are unlikely to persist in a price-competitive market. Knowledgeable
purchasers will shun overpriced suppliers of a service. Currently, price infor-
mation for medical services is difficult to obtain, and the services included in
the stated price are not transparent. For example, a study by Rosenthal, Lu,
and Cram (2013) tried to determine elective pricing data (bundled payment
that includes hospital and physician fees) for total hip arthroplasty, a common
elective surgical procedure. The authors experienced difficulty obtaining price
information and observed a wide variation in the prices quoted.
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Health Pol icy Issues: An Economic Perspect ive342
One of the tenets of a competitive market is that consumers not only bear
the cost of their choices but also are informed purchasers. If consumers do not
have access to information about provider quality, providers have little incen-
tive to invest in higher-quality care because they receive the same fee as those
who do not. In recent years, provider quality and patient satisfaction measures
have been collected on report cards and disseminated to employees during
open enrollment.5 One study found that two years after publication of a report
card, “more than 20 percent of bottom-quartile surgeons stopped practicing
[coronary artery bypass grafting] surgery in New York . . . whereas only about
5 percent of surgeons in the top three quartiles did so” (Jha and Epstein 2006).
Tax subsidies for purchasing health insurance have led to a demand
for more comprehensive insurance—with lower out-of-pocket payments and
larger employer subsidies for more expensive health plans—and have lessened
consumer incentives to choose more efficient health plans. Tax subsidies, com-
bined with a lack of information on health plans and providers, have resulted in
a healthcare market where purchasers have insufficient incentives and limited
opportunity to make informed choices.
Medicare and Medicaid
About half of all medical expenditures are made by federal and state govern-
ments. Incentives for beneficiaries and Medicare and Medicaid’s provider pay-
ment policies have an important effect on the market’s performance, similar to
the impact of tax subsidies. Most Medicare beneficiaries have supplementary
health insurance to cover their Medicare cost-sharing requirements. Because
those with low income are covered by Medicaid, there is no cost sharing. Thus,
neither Medicare nor Medicaid beneficiaries have any incentive to be concerned
about provider prices or their use of medical services.
Although Medicare allows beneficiaries a choice of health plans, the elderly
have not had a strong financial incentive to choose lower-cost, restrictive Medicare
Advantage plans. Only if Medicare were to provide a fixed dollar contribution,
with beneficiaries paying the additional cost of a more expensive health plan,
would enrollees have an incentive to switch from the more costly, traditional fee-
for-service plan. Medicaid enrollees, on the other hand, are not given a choice
of health plans. Medicaid may enroll some of its enrollees (young, low-cost) in a
health plan, but most Medicaid expenditures on behalf of the aged and disabled
are paid on a fee-for-service basis to hospitals, physicians, and nursing homes.
Supply-Side Market Failures
Provider Consolidation
The greater the number of healthcare providers in a market, the greater the
competition among them to respond to purchaser demands. Conversely, when
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 343
only one provider is in a market, the patient has no choice but to go to that
provider. Providers respond when the purchaser has a substitute provider from
which to choose. A monopolist provider has no incentive to innovate, improve
quality, respond to patients’ needs, or offer lower prices.
Considerable provider consolidation has been occurring. When hospitals
in a market merge, insurers have fewer to negotiate with. The antitrust laws
are meant to prevent suppliers, such as hospitals and physicians, from gaining
market power. Unfortunately, the FTC had been unsuccessful in prevent-
ing hospital mergers that decrease competition. Federal judges, ruling in the
merged hospitals’ favor, believed that merged nonprofit hospitals would not
exercise their market power as for-profit hospitals would. Consolidated hospitals
and single-specialty groups dominate certain markets (Berenson, Ginsburg,
and Kemper 2010). One consequence of the movement toward accountable
care organizations (ACOs) and hospitals employing physicians has been fur-
ther consolidation of the provider market in many areas. As the number of
competitors has declined, health plans have been forced to pay higher prices,
which are passed on to consumers in the form of higher insurance premiums
(Ginsburg 2016).
Federal and State Regulations
The federal and state governments have enacted a number of anticompetitive
regulations that limit price competition and result in higher health insur-
ance premiums. These regulations address such areas as the training of health
professionals and the tasks they are permitted to perform, entry into medical
markets, pricing of health insurance policies, health insurance benefit coverage,
and rules covering provider networks.
More than 2,200 state mandates (as of 2017) have been enacted that
specify the benefits, population groups, and healthcare providers that must be
included in health insurance policies (National Conference of State Legisla-
tures 2018). Large business firms are legally exempt from these state mandates
since they self-insure their employees, which most large organizations do. The
higher cost burden of these state mandates falls predominantly on individuals
and small businesses, raising the cost of insurance and thereby making health
insurance unaffordable to those who prefer less expensive health plans.
The Affordable Care Act (ACA) substituted its own insurance require-
ments; it specified 10 “essential” benefits that must be included in any qualified
health plan. Many of these mandated benefits exceed the insurance coverage
people previously purchased. Many of these essential benefits, such as maternity
and newborn care as well as pediatric coverage, are not applicable to certain
population groups, such as single and older men. These additional benefits
have increased the cost of insurance, and the higher premiums have led many
to decide the benefit of having health insurance is outweighed by its cost; being
uninsured is preferable.
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Health Pol icy Issues: An Economic Perspect ive344
Although some of these state and ACA mandates may be beneficial, many
individuals and small businesses would rather have insurance they can afford
than no insurance at all. Insurers are unable to compete by offering insurance
benefits preferred by many.6
When community rating was required in state individual insurance mar-
kets, such as New York and Vermont, all types of individuals or small businesses
were placed in a common risk pool, and all were charged the same premium.
Firms whose employees were engaged in high-risk jobs were charged the same as
organizations whose employees had low-risk jobs. Firms that provide incentives
to employees to engage in healthy lifestyles were charged the same premium
as those that do not. Community rating eliminates price competition among
insurers. Instead, insurers have an incentive to engage in favorable risk selec-
tion. Community rating increases the price of insurance to low-risk individuals,
thereby leading many to drop their insurance.
The ACA regulates the pricing of health insurance. A modified form of
community rating is required in federal and state health insurance exchanges. The
medical costs of caring for individuals in their 50s and 60s (up to 65 years of age)
are higher than those for younger individuals. The ratio is 5 or 6 to 1. The ACA
requires insurers to use a ratio that is 3:1. The effect of using a smaller ratio is that
younger enrollees incur higher premiums to subsidize older enrollees, even though
younger individuals may have much less income. Price competition by insurers to
sell insurance according to an age group’s actuarial experience is unlawful. These
higher premiums have reduced the demand for insurance by younger individuals.
State certificate-of-need (CON) laws prohibit competitors from enter-
ing a market. The CON process protects existing providers from competition,
thereby giving monopoly power to the existing hospital, home health agency,
hospice, and nursing home. Training of healthcare professionals emphasizes
process measures of quality (e.g., years of education) as a prerequisite for
licensure. Reexamination for relicensure is not used, and physicians have rarely
been evaluated on outcomes-based measures of quality. Innovative methods
of training healthcare professionals are inhibited when rigid professional rules
specify training requirements. State practice acts specify the tasks that healthcare
professionals are permitted to perform; these regulations are based on political
competition among health associations over which profession is permitted to
perform certain tasks. A greater supply of health manpower is available, and care
can be delivered less expensively when performance is monitored and flexibility
is allowed in the tasks that healthcare professionals are permitted to perform.
Any willing provider (AWP) laws limit price competition among phy-
sicians (and dentists). Health plans had been able to negotiate large price
discounts from physicians by offering them exclusivity over their enrollees.
The 13 states with AWP laws that apply to physicians enable any physician
to have access to a health plan’s enrollees at the negotiated price. As a result
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 345
of AWP laws, physicians have no incentive to compete on price for a health
plan’s enrollees because they cannot be assured of receiving a higher volume
of patients in return for a lower price.
Lack of Physician Information
Competitive markets assume that demand-side and supply-side participants are
well informed. Physicians, who act as the patient’s agent and as a supplier of
a service, are considered to be knowledgeable about their patients’ diagnoses
and treatment. Further, physicians are assumed to act in their patients’ best
interests. If these assumptions are incorrect, medical services are not being
provided efficiently, quality of care is lower, and the cost of medical services is
higher than it otherwise would be.
Wide variations exist in the medical services provided by physicians in the
same specialty, to patients with the same diagnosis, and across geographic regions
(Institute of Medicine 2013). These variations in medical services are likely attrib-
utable to two factors. First, physicians are not equally proficient in their diagnostic
ability or in their knowledge of the latest treatment methods. These wide varia-
tions have given rise to evidence-based medicine, whereby large insurers analyze
the results of well-designed research as well as large data sets to determine best
practices and disseminate clinical guidelines to their network physicians.
Second, physicians have a financial interest in the quantity and type
of care they provide. Most physicians are paid fee-for-service; thus, the more
they do, the more they earn. Supplier-induced demand is the term economists
use to explain physicians’ financial incentive to increase their services. When
combined with the lack of consumer incentives regarding prices and use of
medical services, as well as consumers’ lack of knowledge regarding physi-
cians’ practice methods, both the use and cost of medical services are greatly
increased. Medicare—under which most aged have supplementary insurance
to cover their cost sharing—is a prime example of how the lack of patient
price sensitivity and medical information, together with some physicians’ lack
of knowledge and the incentives inherent in fee-for-service, have resulted in
large variations in the cost and number of services provided.
As the preceding discussion illustrates, market forces have been greatly
weakened. Given the lack of effective competition in medical markets, one
cannot claim that competition has been tried and has failed.
How Can Medical Markets Be More Competitive?
Markets always exist, but, depending on government rules, they can be efficient
or inefficient. To improve market efficiency in medical care, several changes
are needed in government regulations and in the private sector.
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Health Pol icy Issues: An Economic Perspect ive346
Government tax policy that excludes employer-paid health insurance
from an employee’s taxable income should be changed. Employer contributions
should be treated as regular income; however, it is more politically feasible to
limit the amount that is tax free.7 This change will affect the amount of insur-
ance consumers buy, which health plans they choose, and how much medical
care they use. Additional needed government reforms include removing restric-
tions on market entry and repealing laws promoting anticompetitive behavior,
such as CON and AWP laws; overriding mandates that raise health insurance
costs; eliminating insurance regulations requiring modified community rating;
enforcing antitrust laws; and reforming Medicare and Medicaid so that benefi-
ciaries pay the additional cost of more expensive health plans, thereby giving
these beneficiaries incentives to choose health plans on the basis of costs and
benefits.8 These policies should stimulate greater competition in the private
and public medical sectors.
In the private sector, employers that subsidize their employees’ health
insurance should be encouraged to offer a choice of plans, give fixed-dollar
contributions, and use risk-adjusted premiums in making such payments. With
more plan choices and employee incentives to focus on the costs and benefits of
a health plan, information is more accessible to help employees choose a plan.
When consumers can choose, information has value, and private sources (e.g.,
Healthgrades) will provide that information, as has occurred in other markets.
For competitive markets to work, not all purchasers must be informed
or switch plans in response to changes in prices and quality.9 In competitive
medical markets, as in other markets, a small percentage of knowledgeable
consumers who switch is sufficient to drive the market toward greater efficiency.
Are the Poor Disadvantaged in a Competitive Market?
Opponents of competitive medical care markets claim that the poor will be
unable to afford medical services. Competitive markets produce the most goods
and services (with a given amount of resources) and sell them at the lowest
possible price to consumers willing to buy. By doing so, competitive markets
make goods and services more affordable to those with low income. However,
competitive markets should not be evaluated on whether the poor receive all
the medical services needed.
Achieving market efficiency has little to do with ensuring that everyone’s
needs are met or that everyone receives the same quantity of services. It is the
role of government, based on voters’ preferences, to subsidize healthcare for
the poor—just as is done with food and housing. Providing the poor with
subsidies (e.g., vouchers for a health plan) to be exercised in a competitive
market is more likely than any other approach to ensure that they receive the
greatest value for those subsidies.
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 347
Competitive medical markets may be considered unfair because those
with high income are able to buy more than those with low income. The
wealthy always have been, and always will be, able to buy more goods and
services than can the poor. Even in the Canadian single-payer health system,
patients with more money can skip the waiting lines and travel to the United
States for diagnostic services and surgery.
Patient Incentives Drive Price Competition in Government
and Private Markets
The following examples illustrate how a change in patient incentives resulted
in a price-competitive healthcare market.
Medicare Part D Prescription Drug Benefit
In 2004, the Congressional Budget Office projected that the federal budget-
ary cost of the Medicare prescription drug benefit—Part D—for 2012 would
be $122 billion. In 2012, the actual federal cost was $55 billion. Unlike any
other government entitlement programs, the estimated federal cost of the
drug benefit had been constant for more than 10 years, and cost much less
than many anticipated.
The design of the Part D benefit differs from that of Medicare Parts A
and B in that Part D makes the beneficiary responsible for the additional cost
of choosing a more expensive drug plan. Under Part D, drug plans submit
bids to the federal government for providing the basic prescription drug ben-
efit to a beneficiary. The federal government calculates a national average bid
and pays 75 percent of the national average bid to the drug plan chosen by
the beneficiary, who is then responsible for the remaining 25 percent of the
monthly premium. If a beneficiary enrolls in a plan that submitted a higher
bid than the national average, the beneficiary pays the difference in addition
to the base premium.
Plans understand that any difference between a plan’s bid and the
national average bid translates directly into a price difference that will be paid
by beneficiaries.10 Beneficiaries have access to a wide variety of drug plans and
must choose among lower premium plans or costlier plans that may offer greater
benefits, such as a more desirable drug formulary. Because competing plans
vary in the brand-name drugs offered in their formulary, a person can choose
the plan that covers their preferred drug. Under Medicare Part D, beneficiaries
have an incentive to make a trade-off between additional plan benefits and the
additional costs of a higher-priced plan.
Drug plans compete for enrollees by offering lower premiums. By relying
on a drug formulary, rather than including all brand-name drugs within a disease
category, the plan is able to negotiate discounted prices with a pharmaceutical
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Health Pol icy Issues: An Economic Perspect ive348
firm by including only its drug in the formulary. Drug plans also encourage
enrollees to use less costly generics when appropriate by using lower cost
sharing for generics than for brand-name drugs. The drug plans pass on these
cost-saving strategies to beneficiaries in the form of lower premiums and cost
sharing.
Negotiating with drug manufacturers and encouraging generic substitu-
tion when appropriate are the direct result of plans competing for price-sensitive
enrollees who must pay out of pocket the additional cost of higher-priced
drug plans.
The ACA made changes to the Medicare Part D drug benefit that caused
an increase in the number of Medicare drug prescriptions and in expendi-
tures. First, the Part D “donut hole” was reduced, thereby reducing a Medi-
care beneficiary’s out-of-pocket payments for his prescription drugs. Second,
successful lobbying by the pharmaceutical association reduced competition
between pharmaceutical firms and the private drug plans. Private drug plans
now are required to include more than one drug per class in their formulary;
this change reduced private drug plans’ ability to negotiate lower drug prices
with a pharmaceutical firm.
Value-Based Purchasing and Reference Pricing
In recent years, employers and insurers have begun to provide patients with
financial incentives to choose higher-quality, lower-priced hospitals for their
surgeries. Several employers (e.g., Walmart, Safeway, Lowe’s) and insurers
(e.g., WellPoint) have used value-based purchasing or reference pricing to give
their employees a financial incentive to choose among competing providers
(Robinson and MacPherson 2012). Under these approaches, the employer
or insurer contracts for a fixed price with several centers of excellence (e.g.,
the Cleveland Clinic) for elective surgical procedures (e.g., orthopedic joint
replacement, interventional cardiology, cardiac surgery). These are expensive
procedures, whose prices vary widely, and differences in outcomes when per-
formed by different providers are relatively small. Patients are given a fixed
amount (e.g., $30,000) to cover the cost of their surgery. A patient can go to
providers other than those on the employer’s preferred list, but if the price is
greater than $30,000, the patient pays the additional cost himself.
Robinson, Brown, and Whaley (2017) found that when patients were
provided with a financial incentive, reference pricing resulted in significant sav-
ings. The most dramatic price reductions occurred in higher-priced hospitals.
Also interesting is that when patients went to providers other than those on
their employers’ or insurers’ preferred list, and when they had only $30,000 to
spend, the patients were able to negotiate large price reductions. The insurer
did not negotiate with these providers; the patients did. The authors stressed
the importance of changing patients’ financial incentives and not just relying
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 349
on direct price negotiations between insurers and providers. When patients
are responsible for the additional cost of their care, healthcare markets become
price competitive.11
What Might Competitive Medical Markets Look Like?
If healthcare markets were to become more like a competitive market, what
might one observe? As consumers (including Medicare and Medicaid enrollees)
must pay the additional cost of more expensive health plans and become more
cost conscious, the variety and number of available plans will increase. Plans
will attempt to match purchasers’ preferences and willingness to pay. Some
people would prefer to choose among health plans, which is less expensive and
time consuming than evaluating different providers.
Competitive markets may evolve in several ways. Integrated delivery
systems, as articulated by Enthoven (2004), are organizations with their own
provider networks that offer coordinated care to their enrollees. These inte-
grated delivery systems may be built around large multispecialty medical groups
with relationships to hospitals and other care settings, and they may be paid
a risk-adjusted annual capitation amount per enrollee (similar to Medicare
Advantage plans). Health plans would compete for consumers on the basis of
risk-adjusted premiums. These systems would select healthcare providers, be
responsible for monitoring quality, examine large data sets to develop evidence-
based medicine guidelines, reduce widespread variations in physicians’ practice
patterns, provide coordinated care across different care settings (the physician’s
office, hospital, ambulatory care facility, and patient’s home), have incentives
to be innovative in caring for patients with chronic conditions, and minimize
total treatment costs (not just the costs of providing care in one setting while
shifting costs to other settings). In addition, health plans would be responsible
for evaluating new technologies and, in turn, would be evaluated by how well
they perform in improving the health of their enrolled populations, as well as
how they perform with regard to premiums and patient satisfaction.
At the other end of the spectrum of financing and delivering medical
services are consumer-directed health plans (CDHPs). Under the CDHP model,
consumers purchase a high-deductible (catastrophic) plan, which provides
them with the incentive to be concerned about the use of medical services and
the prices of different healthcare providers. The health savings account (HSA)
approach combines a high-deductible plan with a savings account; money
saved in the HSA belongs to the individual and can accumulate year after year.
Health plans preferred by consumers will expand their market share,
while others will decline. Health plans and large multispecialty medical groups
will be motivated to innovate to reduce costs, improve quality and treatment
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Health Pol icy Issues: An Economic Perspect ive350
outcomes, and achieve better patient satisfaction. By doing so, they will dif-
ferentiate themselves from competitors and gain a competitive advantage.
Other health plans will copy the methods used by successful competitors, and
the process of innovation and differentiation will start over again. (Economist
Joseph Schumpeter referred to this as the process of creative destruction.)
Summary
Antitrust authorities evaluate markets on the basis of how closely they approxi-
mate a competitive market. The closer the approximation, the more likely
the market will produce products efficiently and be responsive to consumer
demands. Medical markets are not inherently different from other markets in
their ability to efficiently allocate resources. It is the regulatory framework of
medical markets that leads to inefficient outcomes.
Medical markets differ from competitive markets in significant ways. The
tax treatment of health insurance lessens consumer incentives to be concerned
about the price and use of medical services. Consumers lack the necessary
information to make economic and medical decisions; often, they are not
offered choices. Competition among suppliers is limited by laws barring market
entry, restricting the tasks healthcare professionals are permitted to perform,
preventing price competition, and regulating market prices.
These market failures have resulted in inefficiency, inappropriate care,
less-than-optimal medical outcomes, and rapidly rising medical costs. Increased
government regulation has been shown to worsen rather than improve market
performance. Several of the major inefficiencies in medical care markets are the
result of government intervention. Regulation to limit rising medical prices was
tried in the 1970s and failed. Medicare, which controls hospital and physician
fees, fails to limit overuse of services and gaming of the system; upcoding and
unbundling of services are common.12 Under a system of government regula-
tion of prices, budgets, and market entry, interest groups—such as hospitals,
physicians, unions, and large employers—are more effective in representing
their own economic interests than are consumers. Organized interest groups
also are more effective than consumers in the political marketplace. Consumer
interests are best served in competitive economic markets.
Government has an important role to play. It sets the rules for com-
petitive markets, such as eliminating practices that result in anticompetitive
behavior, monitoring inaccurate information, and enforcing antitrust laws.
The government also is responsible for raising the funds to subsidize those
unable to afford medical care; these subsidies can be provided at lower cost
and higher quality in a competitive market.
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 351
Market competition has not failed in medical care. It just has not had
a full opportunity to work. Consumer incentives must be changed so that
individuals consider the costs and benefits of their healthcare choices. When
Medicare beneficiaries had to pay the additional cost of more expensive drug
plans, drug plan competition responded by greatly lowering the projected
cost of the Medicare drug benefit. Similarly, when employees were provided
with a fixed amount for their surgeries (reference pricing) and had to pay the
additional cost themselves, they were able to negotiate reduced prices. Medi-
care enrollees should be offered a choice of health plans and given the option
to pay the additional cost of a more expensive plan. In addition, restrictions
on providers’ ability to compete on price should be removed. Without com-
petition, providers have no incentive to be efficient or to innovate, invest in
new facilities and services, improve quality, develop best practices and clinical
guidelines, or lower prices.
Discussion Questions
1. Why is it said that competition in medical care has failed?
2. What are the criteria for
a competitive market?
3. How well does medical care meet the criteria of a competitive market?
4. Is it the responsibility of a competitive market to subsidize care for
those with low income?
5. Explain why the cost of the Medicare Part D drug benefit has been
lower than its projections.
6. What changes are required for medical care to more closely approximate
a competitive market?
Notes
1. Growth of demand may result in temporary increases in prices (high
price markups over cost), which equilibrate demand and supply so
that shortages do not occur while signaling suppliers to raise their
production to meet the greater demand. Over time, as supply grows,
prices will again reflect the cost of providing those services.
2. Not every consumer purchases more when the price is reduced, but, on
average, the quantity demanded will rise.
3. The tax exclusion for employer-purchased health insurance is unfair
because employees in a higher tax bracket receive a greater subsidy
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Health Pol icy Issues: An Economic Perspect ive352
(see exhibit 6.2). It is also unfair to individuals who are not part of an
employer group, because they do not qualify for the same tax exclusion.
Individual coverage is more expensive, not only because of higher
marketing costs and insurers’ concern about adverse selection, but also
because it is paid for with after-tax dollars.
4. Many small and medium-sized businesses were unable to offer their
employees a choice of health plans; the indemnity plan was concerned
that it would receive a higher-risk group. Thus, small businesses were
typically offered only one plan for all of their employees.
5. Data on hospital quality—and to a lesser degree physician quality—
have become available from more public sector and private sector
sources. Such sources include Medicare’s Hospital Compare (www.
medicare.gov/hospitalcompare), the New York State Hospital Report
Card (www.myhealthfinder.com), California’s Office of Statewide
Health Planning and Development (www.oshpd.ca.gov/HID/),
Agency for Healthcare Research and Quality’s Healthcare Cost and
Utilization Project (www.ahrq.gov/research/data/hcup/index.html),
and Healthgrades (www.healthgrades.com).
6. Exchange enrollees are exempt from these state mandates. Many
individuals, however, buy insurance in nonexchange private markets and
they continue to be subject to these mandates.
7. Starting in 2022, the ACA will impose a 40 percent tax on insurers
of employer-sponsored health plans on the amount of employer-paid
health insurance that exceeds $10,200 for individuals and $27,500 for
family coverage.
8. Recent unsuccessful legislative proposals seeking to lower insurance
premiums in the individual and small-group markets included
permitting association health plans—organizations, such as
nonemployer groups, ethnic organizations, and small business
associations—to form and negotiate with insurers on behalf of their
members. These associations will have stable insurance pools and
greater bargaining power with insurers.
9. In some markets, such as rural areas, competition among health plans
is unlikely to be strong enough to achieve the same efficiency as that
in large urban areas. Rural populations do not have the same choices
regarding other services either.
10. When a Medicare Advantage plan’s bid is below the benchmark
premium, the plan must provide additional benefits rather than pass
the price difference on to the enrollee in the form of lower premiums.
This difference results in Medicare Part D drug plan enrollees paying
lower premiums, whereas Medicare Advantage plan enrollees must
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Chapter 21: Has Competition Been Tried—and Has It Failed—to Improve the US Healthcare System? 353
receive more benefits rather than have a choice of benefits versus lower
premiums.
11. Goodman (2011) discusses how price competition also leads to quality
competition.
12. Unbundling occurs when a provider charges separately for each of the
services previously provided together as part of a treatment. Upcoding
occurs when the provider bills for a higher-priced diagnosis or service
than was provided.
References
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———. 1993. “Why Managed Care Has Failed to Contain Health Costs.” Health
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CHAPTER
237
15PROFITS, MARKET STRUCTURE, AND
MARKET POWER
Learning Objectives
After reading this chapter, students will be able to
• describe standard models of market structure,
• discuss the importance of market power in healthcare,
• portray bargaining between insurers and providers,
• calculate the impact of market share on pricing,
• apply Porter’s model to pricing, and
• discuss the determinants of market structure.
Key Concepts
• If the demand for its products is not perfectly elastic, a firm has some
market power.
• Most healthcare firms have some market power.
• Having fewer rivals increases market power.
• Firms with no rivals are called monopolists.
• Firms with only a few rivals are called oligopolists.
• More market power allows larger markups over marginal cost.
• Barriers to entry and product differentiation can increase market power.
• Regulation can be a source of market power.
• In the United States, prices depend on bargaining between providers
and insurers.
15.1 Introduction
What distinguishes highly competitive markets (those with below-average
profit margins) from less competitive markets (those with above-average profit
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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
Account: s4264928.main.eds
Economics for Healthcare Managers238
margins)? An influential analysis by Porter (1985) argues that profitability
depends on five factors:
1. the nature of rivalry among existing firms,
2. the risk of entry by potential rivals,
3. the bargaining power of customers,
4. the bargaining power of suppliers, and
5. the threat from substitute products.
Porter’s model explains profit variations in terms of variations in market
power. Firms in industries with muted price competition, little risk of entry
by rivals, limited customer bargaining power, and few satisfactory substitutes
have significant market power. These firms face relatively inelastic demand
and can get large markups. In contrast, even though entry is usually limited
in healthcare, other firms face much more challenging markets. For example,
a recent study (Upadhyay and Smith 2016) noted that over a three-year
period, one group of hospitals in Washington consistently had a negative
operating margin while another group had an operating margin higher than
10 percent. To help understand these differences, this chapter will use the
Porter framework to explore links among profits, market structure, and mar-
ket power.
Three characteristics of healthcare markets reduce their competitive-
ness. First, many healthcare markets have only a few competitors, which
mutes rivalry. Second, this muted rivalry can persist because cost and regu-
latory barriers limit entry. Third, many healthcare products have few close
substitutes. This lack of close substitutes makes market demand less elastic
and may make the demand for an individual firm’s products less elastic. These
factors give healthcare firms market power.
In addition, consolidation has been proceeding apace for more than
20 years, and it continues unabated. More than 550 hospital mergers or
acquisitions took place between 2010 and 2015 (American Hospital Associa-
tion 2016), and increasing numbers of physicians are becoming employees of
hospitals or health systems.
These trends represent significant changes in healthcare markets. In
the United States, healthcare prices result from bargaining between insurers
and providers, so the market positions of both matter. An insurer with a small
market share will typically be forced to pay higher prices to providers. Like-
wise, a health system with a larger market share can usually negotiate higher
prices, especially if it offers services that rivals do not (Roberts, Chernew, and
McWilliams 2017).
Profit-oriented managers will usually seek to gain market power. The
most ambitious will try to change the nature of competition. For example,
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Chapter 15: Prof i ts , Market Structure, and Market Power 239
faced with determined managed care negotiators, healthcare providers may
merge to reduce costs and improve their bargaining positions, which can
improve margins. But even when an organization cannot change a market’s
competitive structure, it still has two options: It can seek to become the low-
cost producer, or it can seek to differentiate its products from those of the
competition. Either strategy can boost margins, even in competitive markets.
15.2 Rivalry Among Existing Firms
Most healthcare organizations have some market power. Price elasticities of
demand are small enough that an organization will not lose all its business to
rivals with slightly lower prices. Market power has several implications. Obvi-
ously, it means firms have some discretion in pricing because the market does
not dictate what they will charge. Flexibility in pricing and product specifica-
tions means that managers must consider a broad range of strategies, includ-
ing how to compete. Some markets have aggressive competition in price and
product innovation; other markets do not. Managers have to decide what
strategy best fits their circumstances. The prospect of market power also gives
healthcare organizations a strong incentive to differentiate their products.
The amount of market power an organization has typically depends on how
much its products differ from competitors’ in terms of quality, convenience,
or some other attribute.
The Effects of Increased Concentration
How have increases in market concentration among hospitals, medical
groups, and health plans affected consumers? Hospital consolidation
has been common since at least the early 1980s, but the implementa-
tion of the Affordable Care Act restarted hospital mergers and acquisi-
tions. A good deal of evidence shows that hospital prices are higher
in concentrated markets, which increases out-of-pocket costs and
premiums.
Evidence about the effects of consolidation on physicians’ prices
is limited, but increasingly physicians are shifting into larger practices
and practices that are owned by health systems. Although this consoli-
dation has a number of reasons, the ability to negotiate higher prices
appears to be one. For example, the price for an office visit averaged
$97 for large practices but averaged $88 for small practices dealing
with the same insurers (Roberts, Chernew, and McWilliams 2017).
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Economics for Healthcare Managers240
Healthcare organizations generally have market power because their
competitors’ products are imperfect substitutes. Reasons that competitors’
products are imperfect substitutes include differences in location or other
attributes, or even product familiarity. For example, a pharmacy across town
is less convenient than one nearby, even if it has lower prices. Because con-
sumers choose to patronize the more expensive but closer pharmacy, it has
market power.
Medical goods and services are typically “experience” products, in that
consumers must use a product to ascertain that it offers better value than
another. For instance, patients do not know whether a new dentist will meet
their needs until the first visit. Likewise, consumers must try a generic drug
to be sure it works as well as the branded version. Because of this need to try
out healthcare products, comparison of medical goods and services is costly,
and consumers tend not to change products when price differences are small.
Consumers have difficulty assessing whether experience products have good
substitutes, which increases market power.
As we will see in section 15.8, advertising decisions depend on the
differences that determine market power. Attribute-based differences usually
demand extensive advertising. Information-based differences often reward
restrictions on advertising.
Many healthcare providers have few competitors. This statement is true
for hospitals and nursing homes in most markets, and often for rural physicians.
Where the market is small, either because the population is small or because
the service is highly specialized, competitors will usually be few. And when a
firm has few rivals, all have some market power, if only because each controls a
significant share of the market. Firms with few competitors recognize that they
have flexibility in pricing and that what their rivals do will affect them.
15.3 Defining Market Structures
A perfectly competitive market, in which buyers and sellers are price takers
(i.e., a market in which both believe that they cannot alter the market price),
offers a baseline with which to contrast other market structures. In perfect
competition, firms operate under the assumption that demand is very price
elastic. The only way to realize above-normal profits is to be more efficient
than the competition. Firms disregard the actions of their rivals, in part
because potential entrants face no barriers and in part because firms have so
many rivals. In any other market structure, organizations will produce less and
charge higher prices.
Few healthcare markets even remotely resemble perfectly competitive
markets. Some have only one supplier and are said to be monopolistic. For
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Chapter 15: Prof i ts , Market Structure, and Market Power 241
example, the only pharmacist in town is a monopolist. Other markets have
many rivals, all claiming a small share of the market. At first glance these
markets may look perfectly competitive, but they have one key difference:
Customers do not view the services of one supplier as perfect substitutes
for the services of another. Each dentist has a different location, a different
personality, or a different treatment style. Firms such as these are said to be
monopolistic competitors.
Firms with only a few competitors are said to be oligopolists. Firms
with large market shares are also viewed as oligopolists even if they have
many rivals. A local market with two hospitals serving the same area is oli-
gopolistic, as is a market with 15 PPOs, the two largest of which have 40
percent of the market. Because the decisions of some competitors determine
the strategies of others, oligopolistic markets differ from other markets in an
important way. Oligopolists must act strategically and recognize their mutual
interdependence.
15.4 Customers’ Bargaining Power
A distinguishing feature of healthcare markets has long been that they con-
tain many buyers, most with limited bargaining power. Of course, in some
markets a single insurer has a large market share, meaning that it has sig-
nificant market power. For example, Blue Cross and Blue Shield of Alabama
holds 85 percent of the individual market and 93 percent of the large group
market (Kaiser Family Foundation 2016). Increasingly, insurers have sought
to identify efficient providers with low prices. So, in addition to the number
of sellers, healthcare market structures depend on the market shares of insur-
ers (including Medicare and Medicaid, where appropriate) and the number
of each in the market.
monopolist
A firm with no
rivals.
monopolistic
competitor
A firm with
multiple rivals
whose products
are imperfect
substitutes.
oligopolist
A firm with only a
few rivals or a firm
with only a few
large rivals.
Insurer Market Structure Affects Prices
Most hospitals are in markets with many insurers. In contrast, most
insurers confront local markets with only a few competing hospitals or
health systems. Not surprisingly, prices tend to be higher in markets
in which health systems have merged and lower in markets in which a
few insurers have large market shares.
(continued)
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Economics for Healthcare Managers242
Three changes are underway that may affect negotiations between
hospitals and insurers. First, insurers are merging, so concentration
is increasing in some health insurance markets. Second, insurers are
offering plans that exclude high-priced hospitals. These plans are
called narrow networks. Third, insurers anticipate selling many more
policies to individuals. They also expect that demand for these indi-
vidual policies will be much more sensitive to differences in premiums.
All these changes will tend to increase the bargaining power of private
insurers relative to hospitals. Entry into local insurance markets at
least partially offsets this gain in bargaining power. Between 2010 and
2014 hospital markets became more concentrated, but insurer markets
did not (Scheffler and Arnold 2017).
(continued)
Should Governments Participate in
Price Negotiations?
Cardiac catheterization, which involves inserting a long, flexible tube
into an artery or vein and threading it through to the heart, is used to
diagnose and treat cardiovascular conditions. Patients who are hav-
ing a heart attack often receive cardiac catheterization. In the United
States, the average payment negotiated by private insurers for cardiac
catheterization is $5,061 (International Federation of Health Plans
2016). The average payment in Australia is $487, and the average in
the United Kingdom is $4,046. The average Medicare fee for outpatient
cardiac catheterization is $2,549 plus a physician fee ranging from
$149 to $448 (depending on the nature of the procedure).
High private insurance prices represent a fundamental reason
that healthcare is so expensive in the United States. Switzerland also
has private insurance, relatively high prices, and the second highest
healthcare costs in the world. However, an abdominal CT (computed
tomography) scan averages $461 less in Switzerland than in the United
States, a colonoscopy averages $697 less, and an appendectomy
averages $9,890 less (International Federation of Health Plans 2016).
With some exceptions, most healthcare prices are much higher in the
Case 15.1
(continued)
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Chapter 15: Prof i ts , Market Structure, and Market Power 243
15.5 The Bargaining Power of Suppliers
The bargaining power of suppliers tends to be high when the following are
true:
• The market has many buyers and few suppliers.
• The supplies are differentiated, high-value products.
• Suppliers can threaten to enter the industry they currently supply.
• Buyers cannot threaten to manufacture supplies.
• The industry is not a key customer for suppliers.
The bargaining power of suppliers varies in healthcare, even though the
number of suppliers tends to be much smaller than the number of provid-
ers. Some suppliers sell highly complex, highly specialized products, such as
MRI (magnetic resonance imaging) equipment; others sell relatively generic
United States than in other rich countries. (This
discussion is about amounts paid, not amounts
charged.)
These high prices and the process that leads to them have many
consequences. Out-of-pocket costs are much higher in the United
States, and serious illnesses can result in medical bankruptcy. High
prices increase private health insurance premiums, and many Ameri-
cans cannot afford private insurance. Furthermore, private insurers
increasingly rely on narrow networks of providers to get better prices.
This reliance on narrow networks makes getting care more complex
and can expose patients to high out-of-pocket costs if they get care
from an out-of-network provider.
Discussion Questions
• Why are private prices so high in the United States?
• How are commercial insurance prices set for hospital services?
• How are Medicare prices set for physicians’ services?
• How are Medicare prices set for hospital services?
• Should governments be involved in private price negotiations?
• Would consumers be better off if healthcare prices were nationally
negotiated?
• Are other countries’ governments involved in healthcare pricing?
Case 15.1
(continued)
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Economics for Healthcare Managers244
products, such as medical gloves. Most of these product lines have multiple
suppliers, so pricing by suppliers tends to be competitive.
In some cases, providers may have a strong bargaining position. In
markets with few providers (rural or poor areas), providers can compete
with health systems in several service lines. Ambulatory surgery centers, free-
standing imaging centers, and other enterprises can compete with hospitals
and health systems, so providers have considerable leverage. In markets with
many providers, their bargaining position is much weaker.
15.6 Entry by Potential Rivals
Barriers to entry in healthcare markets may be market based or regulation
based. Generally, regulation-based barriers are more effective. Whatever the
source, restrictions on entry reduce the number of competing providers and
make demand less price elastic. In other words, entry restrictions, whether
necessary or not, increase market power.
The best way to erect entry barriers and gain market power is to have
the government do it. This strategy has two fundamental advantages. First,
it is perfectly legal and eliminates public and private suits alleging antitrust
violations. Second, the resulting market power is usually more permanent
because government-sanctioned entry barriers will not be eroded by market
competition.
State licensure forms much of the basis for market power in health-
care. Licensure prevents entry by suppliers with similar qualifications and
encroachments by suppliers with lesser qualifications. For example, state
licensure laws typically require that pharmacy technicians work under the
direct supervision of registered pharmacists and that a registered pharmacist
supervise no more than two technicians. These restrictions clearly protect
pharmacists’ jobs by limiting competition from technicians.
Intellectual property rights can also provide entry barriers. Innovat-
ing organizations can establish a monopoly for a limited period by securing
patents. A US patent gives the holder a monopoly for 17 years. The patent
holder must disclose the details of the new product or process in the applica-
tion but is free to exploit the patent and sell or license the rights. Patents are
vitally important in the pharmaceutical industry because generic products are
excluded from the market until the patent expires.
Copyrights create monopolies that protect intellectual property rights.
Unlike patents, copyrights protect only a particular expression of an idea,
not the idea itself. Copyright monopolies normally last for the life of the
author plus 70 years. Trademarks (distinctive visual images that belong to a
particular organization) also grant monopoly rights. As long as they are used
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Chapter 15: Prof i ts , Market Structure, and Market Power 245
and defended, trademarks never expire. All these legal monopolies create
formidable barriers to entry for potential competitors.
Strategic actions can also prevent or slow entry by rivals. Rivals will not
want to launch unprofitable ventures, and firms can try to ensure entrants
will lose money. Preemption, limit pricing, innovation, and mergers are
common tactics. Preemption involves moving quickly to build excess capacity
in a region or product line and thereby ward off entry. For example, build-
ing a hospital with excess capacity means that a second hospital would face
formidable barriers. Not only would it exacerbate the capacity surplus, but
this excess capacity could cause a price war. Managed care firms would not
miss the opportunity to grab larger discounts. Worse still for the prospective
entrant, most of the costs of the established firm are fixed. Its best strategy
would be to capture as much of the market as it can by aggressive price cut-
ting. In contrast, the rival’s costs are all incremental. It can avoid years of
losses by building elsewhere.
Limit pricing is another tactic established firms or those with estab-
lished products can use. Limit pricing means setting prices low enough to
discourage potential entrants. By giving up some profits now, an organization
can avoid the even bigger profit reductions that competition might cause
later. In essence, the firm acts as though demand were more elastic than it
is. Limit pricing only works if the firm is an aggressive innovator. Otherwise,
competitors will eventually enter the market with lower costs or better qual-
ity, and the payoff to limit pricing will be minimal.
Innovation by established organizations can deter entry as well.
Relentless cost reductions and quality improvement means entrants will
always have to play catch-up, which does not promise substantial profits.
Mergers increase market power by changing market structure. A well-
conceived, well-executed merger can reduce costs or increase market power,
either of which can increase profit margins. The publicized goal of most
mergers is cost reductions resulting from consolidation of some functions.
The accompanying anticipation of improvement in the firm’s bargaining
position is usually left unspoken. Customers and suppliers usually must do
business with the most powerful firms in a market. For example, failure to
contract with a dominant health system will pose problems for customers
and suppliers, so the system can anticipate better deals. Whether cost savings
or market share gains are the more important goal of a merger is debatable.
15.7 Market Structure and Markups
Having market power does not eliminate the need to set profit-maximizing
prices. Organizations should still set prices so that marginal revenue equals
preemption
Building excess
capacity in
a market to
discourage
potential entrants.
limit pricing
Setting prices
low enough to
discourage entry
into a market.
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Economics for Healthcare Managers246
marginal cost. If the return on equity is inadequate, the organization should
exit the line of business.
15.7.1 Markups
What changes with a gain in market power is markups. A firm with substantial
market power will find it profitable to set prices well above marginal cost.
Exhibit 15.1 shows that a firm with a substantial amount of market power
(ε = −2.5) will have a 67 percent markup. In contrast, a firm with a moder-
ate amount of market power (ε = −7.5) will only have a 15 percent markup.
Finally, a firm with little market power (ε = −12.0) will have a 9 percent
markup.
Organizations with market power benefit from markup. However,
their customers face higher prices, which results in their using the product
less or not at all. As a result, managers’ goals depend on whether they are
buying or selling. Managers seek to reduce their suppliers’ market power
while increasing their own. If your suppliers have substantial market power
and you have none, your profit margins will suffer.
Market
Share
Market
Elasticity
Firm’s
Elasticity
Marginal
Cost
Profit-
Maximizing Price
48% –0.60 –1.25 $10.00 $50.00
24% –0.60 –2.50 $10.00 $16.67
7.5% –0.60 –8.00 $10.00 $11.43
5% –0.60 –12.00 $10.00 $10.91
EXHIBIT 15.1
Market Share
and Markups
Mergers Result in Price Increases
Between 2000 and 2016 more than 2,500 hospital mergers and acqui-
sitions took place, meaning that the consolidation of hospital markets
continues (American Hospital Association 2016). In principle, the
merger of two hospitals allows cost savings. The merged hospitals
would need less excess capacity to cope with spikes in demand, could
avoid duplicate services, and could share some overhead expenses.
Schmitt (2017) estimates that acquired hospitals reduce their costs by
an average of 7 percent over a four-year period, but these savings only
occur when hospitals are acquired by a system. (The acquiring hospital
(continued)
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Chapter 15: Prof i ts , Market Structure, and Market Power 247
15.7.2 The Impact of Market Structure on Prices
Economists often use the Hirschman-Herfindahl Index (HHI) to identify
concentrated markets. The HHI equals the sum of the squared market
shares of the competitors in a market. The HHI gets larger as the number
of firms gets smaller or as the market shares of the largest firms increase. For
example, a market with five firms, each with 20 percent of the market, would
have an HHI of 2,000. In contrast, a market with five firms, four of which
each claimed 15 percent of the market while the fifth claimed 40 percent,
would have an HHI of 2,500. A higher HHI usually results in higher prices.
For example, a study by Baker and colleagues (2014) found that private
insurers paid cardiologists $63 for an office visit in counties with an HHI of
2,176 but paid $78 in counties with an HHI of 4,275.
Attributes other than market power can also result in high markups.
White, Reschovsky, and Bond (2014) point out that, in addition to having a
Hirschman-
Herfindahl
Index (HHI)
A measure
used to identify
concentrated
markets. (The
HHI equals the
squared market
shares of firms
in a market. For
example, if firms
had market shares
of 40, 30, 20, and
10, the HHI would
be 3,000 = 1,600 +
900 + 400 + 100. A
potential source of
confusion is that
some calculations
treat a 40% market
share as 0.40 and
others treat it
as 40. This book
uses the second
approach.)
concentrated
market
A market with few
competitors or
a few dominant
firms.
or system does not appear to experience cost reductions.) For the
most part, hospitals that are acquired by other hospitals in the same
local market do not reduce their costs, suggesting that other motives
matter as well.
The other motive for consolidation is to increase market power. A
single hospital or a two-hospital system is in a much better bargaining
position than two independent hospitals serving the same area. For
example, Dauda (2018) concludes that the merger of two hospitals in a
market with five hospitals would result in substantial price increases.
Recognizing that hospital consolidations could push prices up,
federal antitrust authorities have opposed some hospital mergers. The
authorities have lost most of these suits. Courts have generally seen
the not-for-profit status of merging hospitals as a guarantee of price
restraint, although the economics literature provides little support for
this expectation.
On the contrary, most studies have found that merged not-for-
profit hospitals significantly increase prices (Gaynor, Ho, and Town
2015), but the effects of mergers depend on the nature of the hospitals
and the nature of the competition in their market. The literature sug-
gests that if two small hospitals in a competitive market merge, their
ability to negotiate higher prices will be limited. In contrast, if two
large hospitals in a smaller market merge, their ability to negotiate can
be substantial.
(continued)
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Economics for Healthcare Managers248
large market share, providing specialized services, having a good reputation,
and being a member of a system also result in higher prices.
15.8 Market Power and Profits
Market power does not guarantee profits. A firm with market power will
set prices well above marginal cost but may not earn an adequate return on
equity. However, firms with market power can use strategies to boost profits
that firms without market power cannot.
Three competitive strategies are common among firms with market
power: price discrimination, collusion, and product differentiation. We
discussed price discrimination in chapter 12; in this chapter we will focus on
collusion and product differentiation.
15.8.1 Collusion
Collusion, or conspiring to limit competition, has a long history in medicine.
As in other industries, the temptation to avoid the rigors of market competi-
tion can be beguiling. Collusion is profitable because demand is less elastic
for the profession than for each individual participant. For example, if the
price elasticity of demand for physicians’ services is about −0.20 and the price
elasticity of demand for an individual physician’s services is about −3.00, an
individual physician can earn a greater income by cutting prices, yet raising
prices will increase the income of the profession as a whole.
Exhibit 15.2 shows how a 10 percent price increase would change
total revenue for organizations facing different elasticities. (The change in
total revenue due to a price cut equals [percentage change in price + percent-
age change in quantity] + [percentage change in price × percentage change in
quantity].) For the profession as a whole, raising prices will increase revenues
because demand is inelastic. For each individual professional, raising prices
price
discrimination
Selling similar
products to
different buyers at
different prices.
collusion
A secret agreement
between parties
for a fraudulent,
illegal, or deceitful
purpose.
product
differentiation
The process of
distinguishing
a product from
others.
Price Increase Elasticity Quantity Change Revenue Change
10% −0.1 −1% 8.9%
10% −0.2 −2% 7.8%
10% −0.3 −3% 6.7%
10% −3.0 −30% −23.0%
10% −3.5 −35% −28.5%
10% −4.0 −40% −34.0%
EXHIBIT 15.2
Elasticity
and Revenue
Changes
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Chapter 15: Prof i ts , Market Structure, and Market Power 249
will reduce revenues unless other professionals change their prices, which
would make demand less elastic. Of course, others are likely to respond to
price cuts by cutting their own prices, so revenues will climb far less than a
naïve analysis would suggest.
The implication of exhibit 15.2 is that physicians as a group would
increase their incomes if they refused to give discounts to managed care
organizations. What is good for the profession, however, is not what is good
for its individual members. Individual physicians would be tempted to decry
managed care discounts but make private deals with HMOs. From the per-
spective of the profession, penalizing defectors would prevent this problem.
In the 1930s, Oregon physicians did just that. Faced with an oversup-
ply of physicians, excess capacity in the state’s hospitals, and widespread con-
cern about the costs of healthcare, insurance companies in Oregon attempted
to restrict use of physicians’ services. Medical societies in Oregon responded
by threatening to expel physicians who participated in these insurance plans.
Because membership in a county medical society was usually a requirement
for hospital privileges, this response was a serious threat. This threat and phy-
sicians’ ultimate refusal to deal with insurance companies led the insurers to
abandon efforts to restrict use of physicians’ services (Starr 1982).
In most industries these steps would be recognized as illegal, anticom-
petitive activities. However, the belief that antitrust laws did not apply to the
medical profession was widespread until a 1982 Supreme Court decision to
the contrary. Since then the Federal Trade Commission has sued to prevent
boycotts of insurers, efforts to deny hospital privileges to participants in
managed care plans, and attempts to restrict advertising. In short, healthcare
professionals and healthcare organizations are treated no differently than
other businesses.
The benefits of collusion are clear. By restricting competition, firms
can reduce the price elasticity of demand and increase markups. Collusion
only increases profits, however, until it is detected.
15.8.2 Product Differentiation and Advertising
Product differentiation takes two forms: attribute based and information
based. In attribute-based product differentiation, customers recognize
that two products have different attributes, even though they are fairly close
substitutes, and may not respond to small price differences. In information-
based product differentiation, customers have incomplete information
about how well products suit their needs. Information is expensive to gather
and verify, so customers are reluctant to switch products once they have iden-
tified one that is acceptable. Both forms reduce the price elasticity of demand
for a product and create market power (Caves and Williamson 1985).
attribute-
based product
differentiation
Making customers
aware of
differences among
products.
information-
based product
differentiation
Making
customers aware
of a product’s
popularity,
reputation, or
other signals
that suggest high
value.
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Economics for Healthcare Managers250
Both attribute-based and information-based product differentiation
are common in healthcare. For example, a board-certified pediatrician who
practices on the west side of town clearly provides a service that is different
from a board-certified pediatrician who practices on the east side of town.
If the two practices were closer together, more customers would view them
as equivalent. Alternatively, armed only with a sense that the technical skills,
interpersonal skills, and prices of surgeons can vary significantly, a potential
customer who has found an acceptable surgeon is not likely to switch just
because a neighbor was charged a lower fee for the same procedure. Of
course, the customer might be more likely to switch if complication rates,
patient satisfaction scores, and prices for both surgeons were posted on the
Internet for easy comparison.
The role of information differs sharply in attribute-based and
information- based product differentiation. Extensive advertising makes sense
for products that differ in attributes that matter to consumers. The more
clearly customers see the differences, the less elastic demand will be and the
higher markups can be for “better” products. In contrast, restrictions on
advertising (and even restrictions on disclosure of information) make sense
in situations with information-based product differentiation. The harder it is
for customers to see that products do not differ in ways that matter to them,
the less elastic demand will be and the higher markups can be.
The coexistence of attribute-based and information-based product dif-
ferentiation in healthcare leads to confusing advertising patterns. Attribute-
based product differentiation demands advertising. Getting information
about product differences into the hands of customers is integral to this
type of product differentiation. For example, pharmaceutical manufacturers
have launched extensive direct-to-consumer advertising campaigns. On the
other hand, better customer information erodes the market power created by
information-based product differentiation. Where information-based prod-
uct differentiation is common, as it is in much of healthcare, a temptation to
restrict advertising is present. Because private restrictions on advertising are
usually illegal, the most successful limits have been based in state law.
Despite these divergent incentives, advertising has increased in recent
years. One reason has been court rulings that professional societies cannot
limit advertising. However, advertising has also increased in some sectors—
such as inpatient care—where advertising has long been legal. The real driv-
ing force seems to be increased competition for patients.
The nature of healthcare products and the nature of healthcare mar-
kets combine to make advertising more common. Most healthcare firms have
market power and competition to some degree. Advertising helps differenti-
ate one product from another, so it increases margins. In monopoly markets
(e.g., the only hospital in an isolated town), product differentiation is not
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Chapter 15: Prof i ts , Market Structure, and Market Power 251
useful. The provider already has high margins, and advertising is unlikely
to increase them. In markets with many providers (e.g., retailers of over-
the-counter pain medications), margins may be low, but differentiating one
seller from another is difficult and advertising expenditures will be unlikely
to increase revenues.
Patients cannot easily assess the quality of most healthcare goods and
services before using them. Because of this fact, advertising can perform a
useful service, that of giving consumers information they would have dif-
ficulty getting otherwise. If consumers gained no information from adver-
tising, they would probably ignore it. Having information about a product
differentiates it from products about which one does not have information.
Providers who offer exceptional values also need to advertise to ensure that
consumers are aware of their low prices or high quality. Studies of advertising
in healthcare generally find that banning advertising results in higher prices.
Indeed, increasing price transparency represents one strategy for reducing
healthcare prices (Reinhardt 2013).
The economic logic behind advertising and innovating is simple: Con-
tinue as long as the increase in revenue is greater than the increase in cost.
Stop when marginal revenue from advertising or product differentiation just
equals the marginal costs. This logic differs from the standard rule only in
that the cost of differentiation (advertising or innovating) is included in the
marginal costs. Exhibit 15.3 shows the calculations organizations need to
consider. Suppose the firm starts with profits of $100,000. In case 1 it antici-
pates that incremental advertising costs of $10,000 will allow it to increase
revenues by $50,000. Because the incremental costs of production are only
$30,000, spending more on advertising makes sense in case 1. In case 2 the
firm has the same production cost forecasts but anticipates that it will need to
spend $22,000 on advertising to increase revenues by $50,000. The higher
advertising costs in case 2 mean that an attempt to increase sales would be
unprofitable. As long as the incremental costs of production and advertising
are less than incremental revenue, increasing advertising will increase profits.
Managers need to take into account both advertising and production costs.
Advertising only makes sense for products with significant margins.
Incremental
Revenue
Incremental Costs
ProfitProduction Advertising
Baseline $100,000
Case 1 $50,000 $30,000 $10,000 $110,000
Case 2 $50,000 $30,000 $22,000 $98,000
EXHIBIT 15.3
Advertising and
Profits
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Economics for Healthcare Managers252
The profit-maximizing amount of advertising is determined by con-
sumers’ responses to advertising and prices. The profit-maximizing rule
is that advertising costs (measured as a percentage of sales) should equal
−α/ε. In other words, an organization will maximize profits when its ratio
of advertising to sales equals −1 times the ratio of the advertising elasticity
of demand, −α, to the price elasticity of demand, ε. The advertising elasticity
of demand is the percentage increase in the quantity demanded when adver-
tising expenses increase by 1 percent. Obviously, advertising that does not
increase sales is not worth doing. Firms with less elastic demand will want to
spend more on advertising. A firm with an advertising elasticity of demand
of 0.1 should spend 2.5 percent of its revenues on advertising if its price elas-
ticity of demand is −4.00, but another firm with an advertising elasticity of
demand of 0.1 should spend 5 percent of revenues on advertising if its price
elasticity of demand is −2.00.
Product differentiation (through innovation or advertising) is a pro-
cess, not an outcome. Differentiation, although potentially profitable, tends
to erode. Product differentiation can be clear-cut (e.g., an open MRI facil-
ity), less distinguishable (e.g., “patient-centered care”), barely noticeable
(e.g., “meals that do not taste like hospital food”), emotional (e.g., “doctors
who care”), or frivolous (e.g., stripes in tooth gel). In all these instances,
however, successful differentiation asks to be copied and generally is, neces-
sitating ceaseless efforts to differentiate products.
Deregulating Pharmaceutical
Advertising
Among wealthy countries, only the United States and New Zealand
allow direct-to-consumer prescription pharmaceutical advertising. The
value of direct-to-consumer advertising of prescription drugs is widely
debated, as are its effects on prescription sales and costs. Direct-to-
consumer advertising on television started in 1997, when the Food and
Drug Administration authorized it.
The case against direct-to-consumer advertising is that consumers
lack the expertise to make informed decisions about prescription med-
ications and that only expensive, branded products will be advertised,
creating barriers to entry for generic products. The case for direct-to-
consumer advertising is that it provides consumers with information
Case 15.2
(continued)
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Chapter 15: Prof i ts , Market Structure, and Market Power 253
15.9 Conclusion
Most healthcare firms have some market power. Market power allows higher
markups and can result in higher profits. As a result, firms try to acquire mar-
ket power or defend the market power they have. The best way to acquire or
defend market power is via regulation. Competitors find it more difficult to
erode market power gained as a result of government action.
Organizations can take steps to gain market power without govern-
ment action. Common strategies include preemption, limit pricing, and
innovation, all of which are designed to discourage potential entrants. Merg-
ers can also result in market power, as can collusion with rivals. Unlike other
strategies for gaining market power, mergers and collusion often create legal
problems. Mergers may result in public or private antitrust lawsuits, as does
collusion once it has been discovered.
Firms with market power can compete in a variety of ways. Where fea-
sible, firms seek to gain market power via product differentiation and adver-
tising. This situation makes managers’ roles more challenging. Of course, the
profit potential of market power creates an incentive to seek it, even without
a guarantee of profits.
about products that have been rigorously
reviewed for safety and effectiveness. Examples of
such information include more convenient dosing,
reduced side effects, and fewer interactions.
From another perspective, pharmaceutical companies use advertis-
ing to differentiate their products and increase margins.
Discussion Questions
• How could advertising be a barrier to entry?
• Could advertising reduce barriers to entry for a new product?
• Presumably drug companies are trying to differentiate their
products from the competition. Will consumers be better off or
worse off if the companies succeed?
• Consumers generally favor direct-to-consumer advertising, and
healthcare professionals generally oppose it. Does this difference in
attitudes make sense?
• Should direct-to-consumer advertising be banned?
Case 15.2
(continued)
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Economics for Healthcare Managers254
Exercises
15.1 What does it mean to have market power? Are firms with market
power extremely profitable?
15.2 Can you identify a healthcare firm with market power? What
characteristics led you to choose the firm that you did?
15.3 Why would a merger reduce costs? Why would a merger increase
markups? Why do many mergers fail nonetheless?
15.4 What information would you like to have when planning advertising
spending?
15.5 Why might banning advertising drive up prices?
15.6 Offer examples of attribute-based product differentiation and
information-based product differentiation.
15.7 Two physical therapy firms want to merge. The price elasticity
of demand for physical therapy is −0.40. Firm A has a volume of
10,400, fixed costs of $50,000, marginal costs of $20, and a market
share of 8 percent. Firm B has a volume of 15,600, fixed costs of
$60,000, marginal costs of $20, and a market share of 12 percent.
The merged firm has a volume of 26,000, fixed costs of $100,000,
marginal costs of $20, and a market share of 20 percent.
a. What are the total costs, prices, revenues, and profits for each
firm and
for the merged firm?
b. How does the merger affect markups and profits?
15.8 A local hospital offered to buy firm A in exercise 15.7 for $5,000, and
the offer was refused. However, many observers now perceive that
firm A is “in play” and may be sold if the right offer comes along.
a. In successful transactions, purchasers have typically paid ten times
current profits. How much would firm A be worth to a buyer
from outside the industry?
b. Would you expect that firm B would be willing to pay more or
less than an outside buyer?
c. What is the most firm B would be willing to pay for firm A?
15.9 Two clinics want to merge. The price elasticity of demand is −0.20,
and each clinic has fixed costs of $60,000. One clinic has a volume
of 7,200, marginal costs of $60, and a market share of 2 percent.
The other clinic has a volume of 10,800, marginal costs of $60, and
a market share of 4 percent. The merged firm would have a volume
of 18,000, fixed costs of $80,000, marginal costs of $60, and a
market share of 6 percent.
a. What are the total costs, revenues, and profits for each clinic and
for the merged firm?
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Chapter 15: Prof i ts , Market Structure, and Market Power 255
b. How does the merger affect markups and profits?
15.10 What would each of the clinics in exercise 15.9 be worth to an
outside buyer (using the guideline of ten times annual profits)?
What would each of the clinics be worth to each other?
15.11 A hospital anticipates that spending $100,000 on an advertising
campaign will increase bed days by 1,000. The marketing
department anticipates that each additional bed day will yield
$2,000 in additional revenue and will increase costs by $1,200.
Should the hospital proceed with the advertising campaign?
15.12 A clinic is considering reducing its advertising budget by $20,000.
The clinic forecasts that visits will drop by 100 as a result. Costs
are $140 per visit and revenues are $180 per visit. Should the clinic
reduce its advertising budget?
15.13 The price elasticity of demand for dental services is −0.25. In a
market with 100 dentists, the local dental society demanded and
received an 8 percent increase in prices from the dominant dental
insurance company. What should happen to the dentists’ revenues
and profits? (Assume that average costs equal marginal costs.) Would
this agreement be stable? Explain.
15.14 The marginal cost of a physician visit is $40. In a county with
50 physicians, the local medical society negotiated a rate of $90.
Previously, any physician who offered discounts to an insurer or a
patient could be cited for unethical behavior, be expelled from the
medical society, and lose admitting privileges to the county’s sole
hospital. But having lost an antitrust lawsuit, the medical society
has agreed to stop enforcing its prohibitions against discounting,
to allow any physician with a valid license to be a member of the
medical society, and to stop linking admitting privileges to medical
society membership.
a. The price elasticity of demand for physicians’ services is −0.18.
What price maximizes profits for the individual physicians in the
county?
b. If all the physicians act independently, will their incomes go up or
down?
c. Is there any way the physicians could legally act to sustain a price
of $90?
15.15 Harvoni is a lifesaving medication for people with hepatitis C. A
four-week supply averaged $32,114 for privately insured patients in
the United States in 2015. In Switzerland the price was $16,861.
Why are the prices so different? Should the government intervene to
reduce the price? How might the government intervene?
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Economics for Healthcare Managers256
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