HMGT 435 WEEK 5 DISC 5

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

16

C o p y r i g h t 2 0 1 9 . H e a l t h A d m i n i s t r a t i o n P r e s s .

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EBSCO Publishing : eBook Collection (EBSCOhost) - printed on 1/31/2023 9:45 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition Account: s4264928.main.eds

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

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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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