HMGT 435 WK 4 DISC 4

CHAPTER

485

SHOULD PROFITS IN HEALTHCARE BE PROHIBITED?

Statements such as the following are often made as reasons for prohibiting the profit motive in healthcare.

It is fundamentally wrong to make a profit on somebody’s illness. Patients’ healthcare decisions should not be based on making money. Profit maximization might be an appropriate goal for other areas of the economy, such as cars and housing, but not where people’s health is concerned. Should people make a profit from others’ need for life-saving treatments? Profit incen- tivizes people to provide unnecessary care, decrease quality, raise prices, and reduce care to the sick.

The policy prescription that usually follows from such comments is a single-payer healthcare system or government price controls; in both scenarios, the government determines the allocation of capital.

Trade-offs always exist. Eliminating profits must be weighed against the “costs” of doing so. Under which approach would enrollees and patients be better off? Would substituting altruism for the incentive to earn profits achieve greater efficiency, lower healthcare costs, improved care coordination, higher quality, and more rapid innovation? Does empirical evidence exist to show that government bureaucrats are wiser than entrepreneurs in their allocation of capital and in deciding which innovations should be funded? Which approach would be subject to less interference from politicians?

Definition of Profits

Accounting Definition of Profits What is the appropriate definition of profits? Accountants define profit as the difference between revenues (net of discounts) and the amount that is spent to earn those revenues. In addition to the direct costs of production, costs include administration, depreciation of capital, marketing, interest expense on loans, and taxes. These are “explicit” costs. Earnings and net income are sometimes used as substitute terms for profits.

Net profit margin is an indicator of a company’s profitability and is cal- culated by dividing net profit by net revenue, converting that number into a

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Health Pol icy Issues: An Economic Perspect ive486

percentage, and multiplying it by 100. The result is a measure of the net income (profit) generated from each dollar of revenue. For example, if a firm has $100,000 in revenue and its net profit is $10,000, then its profit margin is 10 percent. Profit margins are often used to compare profitability between firms in an industry.

According to the accounting definition of profit, any firm with positive net income is profitable.

Economic Definition of Profits Economists, however, disagree with this definition. A firm might be making a positive profit, yet economists would conclude the firm is losing money. Unless the firm can increase its profit, it may go out of business.

How can a profitable firm, according to generally accepted accounting principles, be losing money according to economists? More important, whose definition of profit is a more accurate predictor of whether the firm will be able to attract more capital and expand or perhaps be forced to merge with stronger competitors if it is to survive?

To get started in business, a firm needs capital to build a facility, hire employees, buy supplies and equipment, and so forth.1 To raise the necessary capital, the firm’s management must attract investors by promising them a return on their money. Investors are only willing to provide the firm with money if they can earn a greater return than that in comparable investments. Investors can earn a return on their capital in various ways; they can invest in other businesses, either directly or through the stock exchanges, as well as buy government bonds. Because investing in a business is riskier than buying government bonds, investors would require a greater return on their capital than the interest on government bonds. The return to investors must be com- mensurate with the risk involved.2

The return to stockholders in the form of dividends is not a business expense that is deducted from revenues. The amount of money remaining after all of the firm’s expenses are deducted from the firm’s revenues, which accoun- tants consider to be profit, is used to pay dividends to the firm’s shareholders.3

Thus, if the firm earns some profit, but not enough to pay the dividends expected by investors, the accounting statement will still show that the firm has earned a profit. However, unless these “implicit” (as well as explicit) costs are covered, capital will leave the firm and seek a higher return elsewhere. The firm will not have covered all its costs and will be unable to secure the necessary capital to enable it to grow and compete with more profitable firms.

The rate of return to investors is considered to be the cost of capital; it is a cost and is not, according to economists, part of the firm’s profit. It is the rate of return on what the firm’s capital could have earned if it had been invested in its next best use, after adjustment for risk. (This is referred to as the opportunity cost of capital.)4

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 487

A firm that makes a positive accounting profit that is insufficient to pay an adequate return to its investors is considered to be losing money.

When a firm earns enough money to cover all its costs, including its cost of capital, economists consider the firm to be making zero economic profit. (For simplicity, this term can be referred to as a normal profit.) Revenue will equal the firm’s explicit and implicit costs, thereby earning a normal profit. There would be no reason for capital to leave the firm or for investors to want to invest more funds in the firm. The firm is in equilibrium.

Firms require a normal profit to remain in business. Each of the firm’s resources is paid what they are worth in their next best use. If they do not receive that return, those resources will move to where they can earn it, likely a differ- ent firm or industry. Normal profits typically occur in competitive industries in which no firm has a comparative advantage over other firms in the industry.

Excess Profits (Economic Profit)

Firms may earn more than a normal profit, more than is necessary to pay its cost of capital. The firm is then earning “economic profit,” or simply “excess profits.”

If a firm earns excess profits, is it greedy and should those excess profits be taken away?

Healthcare providers are able to earn excess profits for one of three rea- sons; the first is beneficial for consumers and should be encouraged, whereas the other two are disadvantageous to patients and taxpayers.

Excess Profits Based on Differentiation and Innovation When the iPhone was invented, it was unique; nothing like it existed. A new product was made available to consumers that they were willing to buy because they valued it highly. Apple earned excess profits. Similarly, purchasers are will- ing to pay higher prices for innovative blockbuster drugs that treat previously untreatable diseases because the benefit they receive is worth the higher cost.

Some hospitals are able to attract a greater volume of patients (and charge insurers higher rates) because insured enrollees value those hospitals more highly than others; they have a better perceived reputation, they may offer services their competitors do not, or their location may be more convenient. These attributes differentiate them from their competitors. The same is true for some physicians. They may earn excess profits because of their reputation, their professional manner, and so on.

Hospitals, physicians, other healthcare providers, and insurers who are able to differentiate themselves in a positive manner from their competitors may be able to earn excess profits. The additional value provided to consumers justifies these excess profits.

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Health Pol icy Issues: An Economic Perspect ive488

Excess profits, earned as a result of innovation or differentiation, are temporary. Competitors begin to emulate those who earn excess profits. Over time, the differentiation between firms decreases. As imitators enter the market, prices are driven down, as are excess profits. Under competition, firms must continually strive to differentiate themselves to earn excess profits. Patients benefit when firms continually strive to develop better services to earn excess profits.

Excess Profits Based on Anticompetitive Actions Excess profits have adverse effects on consumers when they are generated by anticompetitive behavior. For example, if two hospitals, each with large mar- ket shares in a community, merge, thereby decreasing the number of hospital competitors, the merged hospitals will be able to raise their prices and make excess profits. As generally occurs with hospital mergers, the merged hospitals have not improved services or provided a higher-quality product, although that is often the reason given by hospital executives for the merger. With fewer hospital competitors in the market, health insurers have less negotiating power and must pay higher prices to the merged hospitals.

Consumers have not benefited from the merger and, in fact, are worse off because they must pay higher insurance premiums and have fewer choices for their care. Even if hospital prices are fixed by Medicare, mergers provide hospitals with greater market power. The merged hospitals have less incentive to innovate, improve quality and care coordination, or be responsive to their patient population. Patients have fewer choices with respect to the providers from whom they can seek care.

Similarly, merged health insurers that achieve market power are likely to charge higher premiums. Medical groups, or other healthcare provider orga- nizations, that merge do so to become dominant in their market and increase their profits. Merged organizations do not necessarily improve their services; instead, consumers are made worse off by having to pay higher prices from fewer providers.

Only when organizations have to compete are they more responsive to their purchasers. The higher the degree of monopoly power, achieved through anticompetitive actions, the less responsive the firm will be toward those it serves.

The federal antitrust agencies, the Federal Trade Commission, and the Department of Justice investigate mergers and other potential anticompetitive actions to determine whether consumers are harmed. These government agen- cies have investigated and brought to trial numerous cases, such as mergers between not-for-profit hospitals to gain monopoly power, boycotts by medical and dental societies against health insurers, and attempts by medical societies to engage in price fixing.

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 489

Not-for-profit healthcare organizations generally have not behaved any differently from for-profit counterparts in their search for excess profits through anticompetitive actions.

Excess Profits Based on Third-Party Payment and Lack of Patient Incentives Another reason why healthcare providers can make excess profits is health insur- ance. For example, a person enrolled in Medicaid or a Medicare patient with Supplement Part B coverage pays little out of pocket when seeking medical care. When an insured person bears little of the cost of care, he has less incen- tive to be concerned about use of medical services, to search for lower-priced providers, or to check whether the provider has billed accurately for the services received. In these situations, providers do not need to have a better reputation, provide higher-quality care, or be the only provider to make excess profits.

Fraud is particularly rampant in Medicare and Medicaid because govern- ment oversight is less vigorous than oversight by private health insurers. The US Government Accountability Office (2015) estimates that in 2015 Medicare made improper and fraudulent payments of approximately $60 billion, 10 percent of Medicare’s annual provider payments.

Excess profits generated through lack of patient and/or purchaser incen- tives to pay attention to the cost of care or inadequate monitoring of provider billings by the government have negative effects on rising medical costs, qual- ity of care, and taxpayers, who pay for government-funded programs such as Medicare and Medicaid.

Do Not-for-Profit Hospitals and Insurers Generate “Profits”?

All firms require capital to get started. Not-for-profit hospitals relied heavily on charitable capital donations from members of the community to finance their development. These charitable donors did not seek a financial return on their donation. Instead, their “return” was to ensure that their community would have a hospital that improved the health of those it served. (The “return” to some donors, similar to donors in the fields of arts and education, is a degree of immortality by having their names inscribed on a specific capital project.)

Not-for-profit Blue Cross plans were begun by not-for-profit hospitals in their region that provided the initial capital. These hospitals controlled Blue Cross plans until the 1980s. In return for their capital, Blue Cross plans sold a type of hospital insurance designed to advance the self-interest of those hospitals.5

A not-for-profit company is supposed to provide services for the benefit of the general public, and it has restrictions on how surpluses (net income or

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Health Pol icy Issues: An Economic Perspect ive490

earnings) can be distributed. Further, a not-for-profit company does not have stockholders, and its primary motive is not to increase its profit.

Legal distinctions between for-profit and not-for-profit firms are less important than any behavioral differences between the two types of orga- nizations. Currently, many not-for-profit hospitals and insurers exist. They have expanded in size, developed new services, bought physician practices, and gained excellent reputations. How have they been able to achieve all this without earning profits? Where did the capital originate for these investments?

In reality, healthcare not-for-profits earn (or try to earn) a profit. How- ever, the excess of their revenues over cost is not called profit; net margin or margin is used to refer to the difference between revenues and expenses.

If healthcare profit were eliminated, would that also include the net margins of not-for-profit hospitals and “reserves” for insurers? A statement heard repeatedly from not-for-profits is this: “no margin, no mission.” Thus, even not-for-profit hospitals must earn more money than their costs if they are to expand, innovate, develop new services, buy physician practices, and even survive in a competitive environment.6

Even if the funds were donated to a not-for-profit healthcare provider, those funds have a “cost.” That cost, however, is not included on the pro- vider’s income and expense statements. The real cost of those subsidies is their “opportunity cost,” which is the value the subsidies could have produced if they were spent on another government project, such as infant nutrition or preventive health programs. Government subsidies should have a yardstick by which to judge the value of the expenditures.

The financial return to private capital is a measure of what that private capital could have earned if invested elsewhere. Donations to not-for-profits should include a market return on the subsidy as a cost on their income and expense statements. Failing to include that return understates the true cost of the not-for-profit hospital’s efficiency in producing healthcare.

Not-for-profit institutions also raise capital by borrowing. Debt markets and banks try to ensure that their loans can be repaid. To demonstrate their creditworthiness, the borrower has to show that its earnings are several times greater than the interest payments on the debt. The additional earnings—above what is required to pay interest on the debt—would be considered profit or net margin.

Some not-for-profit healthcare organizations report substantial “prof- its.” For example, not-for-profit Kaiser Foundation Health Plan and Hospitals reported a six-month net income of $1.2 billion in 2016.7 Similarly, Blue Shield of California was reported as having a reserve or profit of $4.2 billion in 2015. Not-for-profit health insurers can use their profits in several ways, one of which is to increase the size of the reserves. Insurers’ reserves are essential if they are to pay medical claims when expenses exceed premium revenues. (State

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 491

insurance regulators are often concerned regarding whether those reserves are excessive, and premiums should instead be reduced.8)

Generally, little difference exists between for-profit and not-for-profit healthcare providers in their pricing strategies, which are based on what the market will bear.9 Both types of hospitals generally set their prices to maximize profits. For example, purchasers, such as health maintenance organizations (HMOs), who are more willing than other insurers to shift their patients to competing hospitals, receive greater not-for-profit hospital discounts than insurers who are less able to shift their use of the hospital. Automobile insur- ance companies typically do not have prenegotiated contracts with hospitals for insured enrollees who are hurt in auto accidents. Hospitals will charge these insurers much higher rates than insurers who have negotiated contracts.

The main cost advantage that not-for-profits have over for-profits is not that they don’t earn profits, but that they are exempt from federal and state income taxes and state sales taxes. One might expect that this competi- tive advantage would enable them to charge lower prices than their for-profit competitors and drive them from the market. Yet, this has not occurred.

What Are the Consequences of Eliminating “Profit” from Healthcare?

If healthcare profits were prohibited, would healthcare costs and premiums be lower and healthcare more affordable? The history of not-for-profit firms provides some indication of what would likely occur if all healthcare orga- nizations had to be not-for-profit and government were responsible for the allocation of capital.

Goals and Behavior of Not-for-Profits in Noncompetitive Markets The difference between for-profit and not-for-profit ownership lies in what each type of hospital (or insurer) does with its profits. When only normal profits are earned, each type of institution must use such profits to pay the full costs of the enterprise, including a return to capital and debt.

When excess profits are earned, either in the short or long run, share- holders in for-profit firms receive a greater return after taxes are paid. Not- for-profit hospitals may spend their excess profits in several ways. They may invest in new facilities and services (some of which may not be profitable but may increase the hospital’s prestige); they may subsidize certain unprofitable services; or they may increase employee benefits and salaries.

What the not-for-profit hospital or insurer does with its excess profits depends on management and its board of directors’ objectives. When not- for-profit hospitals are not subject to competitive pressures, their actions have

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Health Pol icy Issues: An Economic Perspect ive492

greatly varied. Some not-for-profits have used their “profits” to benefit their communities. Others have used their “profits” for ends that are less noble.10 Once hospitals no longer have to compete, and they cannot distribute their profits to stakeholders, their production costs will rise faster than they would otherwise.

Lack of Incentives to Respond to Purchasers Prohibiting, or even limiting, profits in healthcare will similarly reduce the public benefits that profits provide. The public, and patients, benefit from the profit motive among healthcare providers and insurers in the following ways.

Profits are the incentive for firms to be responsive to the desires of purchasers. Firms try to gain a competitive advantage by providing better amenities, achieving a better reputation, improving the quality of care, provid- ing better patient services and improved access to care, and achieving greater efficiencies. Firms that are more successful in meeting the needs of purchas- ers are able to increase their market share. Patients, enrollees, and purchasers (with an incentive and information to make appropriate choices) will switch to firms that are better able to meet their needs. Firms that do not adapt are driven out of business.

Only firms that have gained monopoly power through anticompetitive actions, such as monopolization of the market through mergers, price fixing, legal barriers to entry, or lack of consumer information, can continue to earn a profit while neglecting the preferences of buyers. Patient satisfaction and quality of care are lower when patients cannot choose and are unable to shift to other healthcare providers and payers.

Lack of Incentives for Innovation Patents on blockbuster drugs result in monopolies, but pharmaceutical com- pany profits are the incentive for developing innovative drugs. Without the opportunity to earn excess profits, firms would have no incentive to devote the huge amounts of capital and incur the large risk involved to develop innovative drugs that the public values and is willing to buy.

The search for profits has led to innovations in the delivery and financing of health services. Until the late 1940s, not-for-profit Blue Cross plans were the dominant insurers, offering only one type of health plan. Commercial insurers entered the health insurance market by offering greater choice of insurance plans, using deductibles and copayments to lower premiums. These for-profit insurers also based their premiums on the actuarial risk group of the enrollee (experience rating), rather than on the average risk of all insured enrollees (community rating). Blue Cross had to adapt to remain competitive.

In the 1980s and 1990s, entrepreneurs saw a great opportunity to profit if they could reduce rising healthcare costs. Hospitals were inefficient

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 493

and costly, and patients were being hospitalized who could be treated in less costly settings. The pursuit of profits led to major changes in the delivery and payment of care. For-profit entrepreneurs innovated in the use of lower- cost (and patient preferred) outpatient surgery centers, forcing not-for-profit hospitals and (hospital-controlled) Blue Cross to similarly expand their use of outpatient surgery.

The growth of HMOs and the managed care revolution continue today. Utilization was reduced and hospitals were forced to compete to join HMO networks. Hospitals had to become efficient to survive, and many went out of business. Lower HMO premiums forced existing insurers to adopt the same managed care techniques to survive. Consumers benefited through lower premiums (see exhibit 20.3).

High-deductible health plans, health savings accounts, retail medical clinics, reference pricing, clinical apps for smartphones, virtual and digital access to physicians, and large data analyses are among the many examples of ongoing private sector innovations that are lowering costs and increasing patient access to care.

The prospect of excess profits continues to change the healthcare financ- ing and delivery system. Patients are being moved to less costly and patient- preferred settings. They have an increased choice of health plans, lower pre- miums than would otherwise be the case, and greater access to care through the use of digital technology.

The profit motive has led to the entry of innovative firms that were able to lower medical costs and be more responsive to the public’s interests. Without the profit incentive, why would firms be willing to risk their capital to try and innovate to the benefit of purchasers? How would the medical sector be able to attract high-quality medical personnel and healthcare executives? If profit were prohibited, who would perform the functions of for-profit and not-for-profit firms?

Other mechanisms have been tried, such as command and control sys- tems, price regulation, and government control and allocation of capital. How- ever, historically, these alternative approaches have not been nearly as successful in improving consumer welfare as has the profit incentive.

Inefficient Allocation of Capital Government regulators are unable to allocate capital better than the private market. Without profits as a measure of success in meeting the public’s demand, where would government regulators get the information necessary to allocate capital to healthcare projects and to healthcare organizations? Profits (and expected profits) are necessary information to guide the allocation of resources.

What incentive do regulators have to take on risk and innovate? They cannot legally earn more money, and if they take any risk in allocating capital

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Health Pol icy Issues: An Economic Perspect ive494

and their project fails, they might get fired or demoted. Government regula- tors’ incentive is to play it safe and not undertake risky innovations or upset politically powerful organizations. Politics often takes precedence in regula- tory policy and in the allocation of federal capital subsidies. The following are examples of how government has allocated capital.

Certificate of Need: In 1974, Congress enacted a law, referred to as Certificate of Need (CON), to limit rising medical expenditures by controlling hospital capital expenditures. Government regional planning agencies were established to review all hospital capital expenditures exceeding $100,000. Not only did CON fail to limit hospital expenditure increases, but existing hospitals “cap- tured” the CON planning agency and used the controls on capital investment to limit competition by preventing new hospitals from entering their market (Mitchell 2016, 22–24). The law, and hospitals’ self-interest, was used to prevent competitive free-standing outpatient surgery centers from being established. Although the federal law was repealed in 1979, many states still have a CON agency, which is used to benefit existing healthcare firms by serving as an entry barrier to competitive healthcare firms.

Medicare Demonstration Project: A government demonstration project showed that Medicare could lower the cost of acquiring durable medical equip- ment (DME), but the program was not implemented. The DME providers, who would have lost revenues, objected to their legislators, and the program was cancelled (Newman et al. 2017).

Solyndra: Solyndra was a solar-panel start-up that failed, leaving taxpayers liable for $535 million in federal guarantees. Despite studies expressing doubt about the potential for success, administration officials allocated large sums of capital to Solyndra and other similar companies based on a political agenda (Leonnig and Stephens 2012).

Consumer Operated and Oriented Plans (CO-OPs) The ACA provided loans to 23 not-for-profit health insurance CO-OPs ($2.4 billion was eventually spent). The justification for establishing the CO-OPs was based on the faulty premise that the CO-OPs, being not-for-profit, would have lower costs and could charge lower premiums, thereby promoting competition on the health insurance exchanges. The CO-OPs received subsidized loans. Although the government expected that one-third of the CO-OPs would fail, the interest rate charged to the CO-OPs did not reflect the very high risk of failure. Government is less concerned about risk when taxpayer funds are used than are private investors using their own funds.

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 495

Not-for-profit health plans, such as Blue Cross and Blue Shield, and for-profit insurers were already competing on the health insurance exchanges. These plans had achieved economies of scale. How were the newly established CO-OPs expected to compete against these large Blue plans?

Of the 23 CO-OPs, only 4 were expected to offer plans in 2018. The other CO-OPs failed because of large financial losses and operational prob- lems (Norris 2017). CO-OPs exist and can even prosper in many areas of the economy, but they have grown very slowly and require sufficient capital to do so. Typically, CO-OPs accumulate reserves (profits) to finance their growth and to offset losses until they can achieve economic efficiency. The health insurance CO-OPs made many mistakes, such as hiring unqualified managers and pricing their premiums too low relative to the risk level of their enrollees; in addition, they tried to expand too rapidly (Harrington 2016). As occurs in many new businesses, their projections were inaccurate, they suffered large losses, and they required more capital but didn’t have investors who could provide additional risk capital.

An important role of private investors (for which they require a profit commensurate with their investment risk) is to evaluate the quality of the management of a start-up business. Private investors will also provide sufficient capital to sustain the start-up when it incurs losses. When hospitals started Blue Cross plans, they provided the capital to ensure that these plans succeeded.

The CO-OPs are cooperatives, owned by their enrollees. They had no backup source of capital. Consequently, once they started to incur losses, they failed. Evergreen, a Maryland co-op, stated on its website, “For far too long, health insurance carriers have put profits ahead of people. We were founded by healthcare leaders who believe there’s a better way forward—for the health of Maryland and for future of healthcare in America.” Subsequently, as its losses mounted and to prevent bankruptcy, Evergreen changed to a for-profit company to attract private investors who provided the risk capital needed to keep the co-op in business (Goldstein 2016).

Summary

Agreeing on an appropriate definition of “profit” is necessary to understand the consequences of eliminating profit from healthcare. The accounting defi- nition of profit is the difference between revenues and explicit costs, as com- monly used in financial statements. The economists’ definition differs in that it considers the rate of return on capital as a cost to the firm. It is an implicit cost, not a profit, because if capital does not earn its return, it will leave and be invested elsewhere.

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Health Pol icy Issues: An Economic Perspect ive496

The economic definition of profit leads to better predictions of the firm’s behavior. If the firm’s revenues cover all of the firm’s costs, including the rate of return on capital (adjusted for the riskiness of the investment), then the firm is making a “normal” profit. The consequence of earning less than normal profits is that the firm has not covered its cost of capital. Capital will leave and the firm will eventually go out of business.

Not-for-profit healthcare providers and insurers must also generate a profit or margin (the excess of revenues minus explicit costs); otherwise, they would not have the necessary capital to expand, invest in new equipment and technology, purchase physicians’ practices, hire staff, or even survive.

Eliminating a firm’s accounting “profit” or “margin” will cause for- profit firms to exit the healthcare industry and limit the ability of not-for-profit providers and insurers to innovate or provide additional services to patients. Patients will be worse off under such a policy.

Allowing healthcare firms to earn “excess” profits is also essential to incentivize them to innovate, improve services, reduce costs, and be responsive to patient preferences. Patients benefit when firms compete on the basis of service and quality. When a firm achieves excess profits through anticompetitive mergers or through lack of patient information or incentives to choose among less costly and higher-quality providers, these concerns should be addressed separately through antitrust actions and changing patient incentives so that cost of care is considered as well as benefits.

Access to capital is essential for innovations to occur, for firms to grow, and for patients to benefit from medical research. Without investors’ expectation of profit, capital would shift to other sectors of the economy, and healthcare would remain as it was 50 years ago.

The alternative to relying on profit (or private donations) to allocate capital is to rely on government and its regulators to decide which firms are more deserving, who should expand, what services should be provided, by which type of provider, and what innovations should be financed. When for-profit firms fail, investors lose money, not taxpayers. Government is less able than private investors (using their own funds) to properly evaluate the investment prospects and management ability of healthcare firms. Government allocation of capital is often based on politics rather than on potential economic perfor- mance. Examples of misallocation of capital are numerous in the healthcare field and other areas, such as the failed ACA CO-OPs and the Solyndra scandal.

Patients’ best interests are not served by removing profit from healthcare. The fact that a firm is not-for-profit does not guarantee that its costs are lower, its quality is higher, or it will act more in the interests of its patients than will for-profit firms. The Federal Trade Commission has successfully sued not-for- profit hospitals that have merged to gain market power and then raised their prices. Medical schools have failed to innovate in their curricula, despite many efforts to do so (Nutter and Whitcomb 2005).

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 497

The Department of Veterans Affairs healthcare system acquired a notori- ous reputation for falsifying waiting lists and denying care to veterans, result- ing in the deaths of many patients (Slack 2017). Not-for-profit firms without competition will act no differently from for-profit monopolies.

The best guarantor of efficiency and responsiveness to the consumer is price-competitive markets with informed purchasers, regardless of whether provid- ers are for-profit or not-for-profit firms.11 The role of government in a profit-driven system is to remove the impediments to competition, eliminate barriers to entry that are meant to protect incumbents, promote dissemination of information so purchasers can be informed, and subsidize those with low incomes so they have the same choices among competitive healthcare firms as everyone else.

Discussion Questions

1. What is the difference between the accounting and economic definitions of profit?

2. What is the difference between normal and excess profit? 3. Under what circumstances does excess profit benefit consumers? 4. Under what circumstances does excess profit harm consumers? 5. What remedies are available when excess profits occur because of

anticompetitive actions, lack of patient information, or comprehensive insurance coverage (because patients have little incentive to be concerned with prices)?

6. What functions do profits serve in healthcare?

Notes

1. Firms cannot start, grow, and survive on only loans. Banks and the debt markets lend money based on the risk that the loan will be repaid with interest. A firm without any assets is an extremely poor risk. As the firm has greater amounts of invested capital and improved earnings prospects, loans become less risky. Once a firm has incurred too much debt (in relation to its capital), loans again become very risky.

2. Physicians, and other healthcare professionals, also must earn a profit based on their large investment in the cost of their medical education. The capital outlay for their investment includes, in addition to tuition, cost of books, and other supplies, the opportunity cost of not earning an income comparable to other college graduates during their additional years of training. Their higher income represents the return on their education investment and their fewer working years. Physicians

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Health Pol icy Issues: An Economic Perspect ive498

in some specialties earn excess profits because entry into those residency programs is limited.

3. Instead of paying dividends, firms may reinvest their dividends and provide a return to investors in the form of a higher stock price. The tax consequences of dividends and capital gains on a higher stock price differ.

4. When a firm has both debt and investor capital (equity), then the expected cost of debt and return to equity, adjusted for risk, must be calculated to determine the firm’s overall cost of capital.

5. For example, Blue Cross sold only inpatient hospital insurance. A Blue Cross patient was entitled to a 30-day hospital stay and was not responsible for any out-of-pocket payments. Because patients did not have to pay a deductible or copays, hospitals did not have to compete on price for such patients. A Blue Cross insurer had to sign up at least 75 percent of the hospitals in its market; therefore, hospitals did not have to compete to be included in the Blue Cross provider network. Also, when outpatient surgery centers opened, Blue Cross, controlled by hospitals, refused to cover care in centers unaffiliated with existing hospitals. It was more expensive for a Blue Cross patient to go to an unaffiliated surgery center than to go to a hospital for surgery. Hospitals’ self-interest was an important reason why Blue Cross insurance was more costly than commercial insurance, which offered broader coverage and included patient copays and deductibles. Blue Cross plans eventually had to break away from hospital control to survive in a price-competitive insurance market.

6. Relying on 2013 Medicare Cost Reports and Final Rule Data from the Centers for Medicare & Medicaid Services, Bai and Anderson (2016) used the measure of net income from patient care services per adjusted discharge to calculate the profitability of acute care hospitals. They determined that seven of the ten most profitable hospitals were not-for- profit, and each of those hospitals earned more than $163 million in total profits from patient care services.

7. For the six months ending June 30, 2016, Kaiser Foundation Health Plan Inc., Kaiser Foundation Hospitals, and their respective subsidiaries reported net income of $1.2 billion, compared with $2.1 billion for the same period in 2015 (Kaiser Permanente 2016). Kaiser also reported that year-to-date capital spending was $1.28 billion, which reflects continued investments in facilities and technology to support care delivery. These investments in facilities are to ensure that Kaiser Permanente can meet the needs of its growing membership and communities.

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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 499

8. The California Franchise Tax Board removed the tax exemption of Blue Shield of California in 2015 (Cohen 2015). Blue Shield has appealed that decision. One reason given for the state’s action is that Blue Shield maintains a reserve of $4.2 billion, which critics claim is four times greater than the amount Blue Shield requires for potential future claims. Given the large reserve, greater than the amount that Blue Shield claimed it needed to meet losses and future claims, critics wondered why Blue Shield needed the rate increases it requested.

9. Little difference also exists between for-profit and not-for-profit healthcare providers in how much charity care is provided, although not-for-profit teaching hospitals provide a greater degree of charity care. (See chapter 15, “Do Nonprofit Hospitals Behave Differently Than For-Profit Hospitals?”) Congress revoked Blue Cross’s federal tax exemption in 1986. The General Accounting Office concluded that the difference between Blue Cross and Blue Shield and for-profit insurers was not sufficient to justify the Blues’ federal tax-exempt status (New York Times 1986).

10. When Medicare began, hospitals were reimbursed according to their costs of caring for the aged. Cost-based payment resulted in hospitals paying higher wages to their executives and staff. Cost reimbursement enabled hospitals to invest in the latest technology, facilities, and services. Costs increased and quality of care declined in many of these hospitals. Studies found that hospital open-heart surgery units that performed few surgeries cost more and had worse outcomes than units that performed a large number of surgeries (Robinson and Luft 1987).

11. In 1776, Adam Smith wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we can expect our dinner, but from their regard to their own interest.”

References

Bai, G., and G. Anderson. 2016. “A More Detailed Understanding of Factors Associ- ated with Hospital Profitability.” Health Affairs 35 (5): 889–97.

Cohen, R. 2015. “CA Pulls Tax-Exempt Status of Blue Shield of California.” Nonprofit Quarterly. Published March 19. https://nonprofitquarterly.org/2015/03/19/ ca-pulls-tax-exempt-status-of-nonprofit-blue-shield-of-california/.

Goldstein, A. 2016. “Maryland’s ACA Health Co-op Will Switch to For-Profit to Save Itself.” Washington Post. Published October 3. www.washingtonpost. com/news/health-science/wp/2016/10/03/marylands-aca-health-co- op-will-switch-to-for-profit-to-save-itself/.

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Harrington, S. 2016. “Review of the Affordable Care Act Health Insurance CO-OP Program.” Statement Before the Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs, US Senate, March 10, 2016. www.hsgac.senate.gov/download/harrington-testimony_- psi-2016-03-10.

Kaiser Permanente. 2016. “Kaiser Foundation Health Plan and Hospitals Report Second Quarter 2016 Financial Results.” Posted August 5. https://share. kaiserpermanente.org/article/kaiser-foundation-health-plan-hospitals-report- second-quarter-2016-financial-results/.

Leonnig, C. D., and J. Stephens. 2012. “Energy Dept. E-mails on Solyndra Provide New Details on White House Involvement.” Washington Post. Published August 9. www.washingtonpost.com/politics/energy-dept-e-mails-on-solyndra-provide- new-details-on-white-house-involvement/2012/08/08/668dc042-e162-11e1- a25e-15067bb31849_story.html.

Mitchell, M. D. 2016. “Do Certificate-of-Need Laws Limit Spending?” Mercatus work- ing paper. Published September. www.mercatus.org/system/files/mercatus- mitchell-con-healthcare-spending-v1a.pdf.

Newman, D., E. Barrette, and K. McGraves-Lloyd. 2017. “Medicare Competitive Bidding Program Realized Price Savings for Durable Medical Equipment Pur- chases.” Health Affairs 36 (8): 1367–75.

New York Times. 1986. “Blue Cross Tax Status Is Challenged.” Published July 4. www.nytimes.com/1986/07/04/us/blue-cross-tax-status-is-challenged.html.

Norris, L. 2017. “CO-OP Health Plans: Patients’ Interests First.” Healthinsurance.org. Published August 27. www.healthinsurance.org/obamacare/co-op-health- plans-put-patients-interests-first/.

Nutter, D., and M. Whitcomb. 2005. “The AAMC Project on the Clinical Education of Medical Students.” Association of American Medical Colleges. Accessed May 2018. www.aamc.org/download/68522/data/clinicalskillsnutter.pdf.

Robinson, J., and H. Luft. 1987. “Competition and the Cost of Hospital Care, 1972– 1982.” Journal of the American Medical Association 257 (23): 3241–45.

Slack, D. 2017. “VA Still in Critical Condition, Secretary David Shulkin Says.” USA Today. Published May 31. www.usatoday.com/story/news/politics/2017/05/31/ veterans-affairs-secretary-david-shulkin-state-of-va/102333422/.

Smith, A. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. Edited by E. Cannan (London: Methuen, 1904). Accessed May 2018. http://oll. libertyfund.org/titles/smith-an-inquiry-into-the-nature-and-causes-of-the- wealth-of-nations-cannan-ed-vol-1.

US Government Accountability Office. 2015. Medicare Program: Additional Actions Needed to Improve Eligibility Verification of Providers and Suppliers. Published June. www.gao.gov/assets/680/671021.pdf.

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