HMGT 435 WK 4 DISC 4

CHAPTER

185

12PRICING

Learning Objectives

After reading this chapter, students will be able to

• apply the standard marginal cost pricing model, • explain why price discrimination can increase profits, • explain the link between pricing and profits, and • discuss the importance of price setting.

Key Concepts

• Pricing is important. • Marginal cost pricing maximizes profits in most cases. • The consequences of setting prices incorrectly can be substantial. • Price discrimination is common in healthcare and other industries. • Price discrimination can substantially increase profits. • Contracting demands the same information as pricing.

12.1 Introduction

Pricing is important. Prices set too low or too high will drag down profits. The trick is to set prices so that your organization captures profitable busi- ness and discourages unprofitable business. To maximize profits, marginal revenue should just equal marginal cost (assuming the product line is profit- able). To maximize other objectives, organizations should start with profit- maximizing prices.

Pricing is a continuing challenge for healthcare organizations for three reasons. First, many managers do not have a clear pricing strategy. They lack the necessary data to make good decisions and may be mispricing their prod- ucts or selling the wrong product lines. Second, many managers lack skills and experience in setting prices and negotiating contracts. Third, the pricing strategy that is best for the organization may not be the pricing strategy that

Lee.indd 185 1/2/19 3:15 PM

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 .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition Account: s4264928.main.eds

Economics for Healthcare Managers186

certain departments or clinics prefer. Managers of these units may have incen- tives to price products too high or too low. In the absence of a clear strategy and good data, how prices are actually set will be up for grabs.

12.2 The Economic Model of Pricing

The economic model of pricing, marginal cost pricing, clearly identifies a pricing strategy that will maximize profits. This strategy also identifies the information needed to set prices.

The economic model of pricing is simple. First, find out what your incremental costs are. (Remember, incremental costs are the same as marginal costs.) Second, estimate the price elasticity of demand facing your organiza- tion’s product. (Demand for the products of your organization will usually be much more elastic than the overall demand for the product. See chapter 8 for more information about elasticity.) Third, calculate the appropriate markup, which will equal ε/(1 + ε). (Here, ε represents the price elasticity of demand for your organization’s product.) Multiplying this markup by your organization’s incremental cost gives you the profit-maximizing price. The profit-maximizing price will equal [ε/(1 + ε)] × MC, where MC represents the incremental cost. So, if the price elasticity of demand is −2.5 and the incremental cost is $3.00, the profit-maximizing price would be [−2.5/(1 − 2.5)] × 3.00, or $5.00.

By now you may have noted that the pricing rule is just a restatement of the profit maximization rule from chapter 11, which states that marginal revenue equals marginal cost. The formula for marginal revenue is Price × (1 + ε)/ε, so MC = Price × (1 + ε)/ε. Solve this formula for Price by dividing both sides by (1 + ε)/ε, and you end up with Price = MC/[(1 + ε)/ε], which is the same as [ε/(1 + ε)] × MC.

Data on incremental costs are important for a wide range of manage- ment decisions. Pricing is one more reason to estimate incremental costs. Estimating the right price elasticity of demand can be more of a challenge. Three strategies can provide you with this information. One would be to hire a marketing consultant. Depending on how much your organization is will- ing to spend, the consultant can provide you with a rough or fairly detailed estimate. Another strategy would be to combine information on overall market price elasticities of demand with information on your market share for this product line. (Chapter 8 lists a number of market price elasticities.) Dividing the overall price elasticity of demand by your market share gives an estimate of the price elasticity your organization faces. For example, if the overall price elasticity is −0.3 and your organization commands an eighth of

marginal cost pricing Using information about incremental costs and the price elasticity of demand to set profit-maximizing prices. The profit- maximizing price will equal [ε/(1 + ε)] × incremental cost, with ε representing the price elasticity of demand.

Lee.indd 186 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Chapter 12: Pr ic ing 187

the market, you would estimate that your organization faces a price elasticity of demand of −0.3/0.125, or −2.4. The third strategy would be to experi- ment. For example, raise a product’s price by 5 percent and see how much demand falls. Because the price elasticity of demand equals the percentage change in quantity sold divided by the percentage change in price, this cal- culation is straightforward.

Exhibit 12.1 illustrates how different profit-maximizing markups can be. An organization facing a price elasticity of demand of −2.5 and an incre- mental cost of $10.00 should have a markup of $6.67. In contrast, a similar organization facing a price elasticity of demand of −5.5 should set a markup of $2.22. Each of these choices maximizes profits, given the market envi- ronment each firm faces. Clearly, organizations that face less elastic demand enjoy larger markups. The payoffs of differentiating your products can be substantial because these products face less elastic demand.

12.3 Pricing and Profits

What should you do if the rate of return from a line of business is inadequate? The obvious solution is to raise prices. Unfortunately, like many obvious strategies, this one will often be wrong. If a product line yields an inadequate return on investment, four strategies should be explored.

1. Make sure your price is not too high or too low. Return to the maximum pricing formula and see if you calculated incorrectly, or whether your estimate of the price elasticity of demand was inaccurate.

Elasticity Price

−1.5 $30.00

−2.5 $16.67

−3.5 $14.00

−4.5 $12.86

−5.5 $12.22

−6.5 $11.82

−7.5 $11.54

−8.5 $11.33

−9.5 $11.18

EXHIBIT 12.1 Profit- Maximizing Prices When Incremental Costs Equal $10

Lee.indd 187 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Economics for Healthcare Managers188

2. Reassess your estimate of incremental costs. If it is too high, your prices will also be too high, and vice versa.

3. See how much you can cut your costs. Most healthcare firms should be able to reduce costs substantially. To see whether yours can be brought down, take a look at costs and business practices in firms you think are efficient.

4. If all else fails, exit the line of business.

The consequences of setting price incorrectly can be substantial. In exhibit 12.2 the profit-maximizing price should be $15.00. Setting a price much lower or much higher than $15.00 reduces profits significantly. Note, though, that being a bit too high or a bit too low is not disastrous. Being a little off in your estimates of incremental cost or the price elasticity of demand will usually mean your profits will be a little smaller than they could have been.

Pricing is an important component of marketing. How is the marginal cost pricing model too simple? The main concern is that it does not account for strategy. For example, demand for an innovative product will typically be inelastic. The resulting high margins, unfortunately, will attract a host of rivals. Your organization may want to forgo some immediate profits to discourage entry by competitors. Alternatively, aggressive price cutting in mature markets is likely to encourage price cutting by your competitors. In markets with relatively few competitors, not rocking the boat by cutting prices may allow everyone to enjoy stable, high prices and high profits. These factors demand careful study, but even if you do not follow the marginal cost pricing scenario, it should be your starting point.

Price Profits

$5.00 ($881,059)

$7.50 ($130,527)

$10.00 $0

$12.50 $28,194

$15.00 $32,632

$17.50 $30,824

$20.00 $27,533

$22.50 $24,172

$25.00 $21,145

EXHIBIT 12.2 Profits When Incremental and Average

Costs Equal $10 and the Price

Elasticity of Demand Equals

−3.0

Lee.indd 188 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Chapter 12: Pr ic ing 189

12.4 Price Discrimination

Price discrimination is common in healthcare, as it is in other industries. Price discrimination refers to charging different customers different prices for the same product. Price discrimination makes sense if different custom- ers have different price elasticities of demand and if resale of the product by customers is not possible. Most healthcare providers and their products meet these criteria. Healthcare providers contract with an array of individuals and insurance plans. The price sensitivities of those purchasers differ widely, and services can seldom be resold. So, profit-maximizing healthcare firms will want to explore opportunities for price discrimination (or more politely, dif- ferent discounts for different customers).

Price discrimination can increase profits. Suppose half your customers (group A) have price elasticities of −3.00 and half (group B) have price elas- ticities of −6.00. The demand curve for group A is 16,000 − 800 × Price, and the demand curve for group B is 16,000 − 1,045 × Price. (You can verify that the group A elasticity is −3.00 at a price of $15.00 and the group B elasticity is −6.00 at a price of $12.00.) Your average and incremental costs are $10. In setting prices you could use the average price elasticity of demand (−4.50) and charge everyone $12.86. Or you could charge group A $12.00 and charge group B $15.00 (which is what the marginal cost pricing model tells us to do). As exhibit 12.3 illustrates, not using price discrimination leaves a substantial amount on the table.

So, aside from managers (who are eager to learn new ways to improve profits) and consumers (who are eager to learn new ways to get discounts), why should price discrimination matter to anyone? Some observers think the different prices reflect cost shifting, not price discrimination. According to the cost shifting hypothesis, price reductions negotiated by PPOs or imposed by Medicaid will raise costs for everybody else. The cost shifting hypothesis is widely believed. For example, Morrison (2017) argued that employers and consumers were paying billions more each year because Medicare and Med- icaid payments were too low.

price discrimination Selling similar products to different buyers at different prices.

cost shifting The hypothesis that price differences are due to efforts by providers to make up for losses in some lines of business by charging higher prices in other lines of business.

Without Price Discrimination With Price Discrimination

Group Price Quantity Profit Price Quantity Profit

A $12.86 5,712 $16,336 $15.00 4,000 $20,000

B $12.86 2,561 $7,324 $12.00 3,460 $6,920

8,273 $23,660 7,460 $26,920

EXHIBIT 12.3 Profits With and Without Price Discrimination

Lee.indd 189 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Economics for Healthcare Managers190

The cost shifting hypothesis might be true but probably is not. Most of the empirical evidence from the contemporary marketplace is inconsistent with the cost shifting hypothesis (White 2013). Why does the hypothesis persist? There are three possibilities. First, the cost shifting hypothesis may be a ratio- nalization for widespread discounting. No customer likes getting the smallest discount, so perhaps healthcare firms lead the customer to believe a small dis- count is due to cost shifting (“We could give you a better price if it weren’t for the big discount we’re forced to give Medicare!”). This scenario is the most likely. Second, cost shifting might be real, reflecting poor management on the part of profit-seeking organizations. If a firm raised prices for some customers because other customers negotiated a discount, either prices were too low to begin with or the firm was acting imprudently in raising prices. Third, cost shifting might be real, reflecting responses of not-for-profit firms that had set prices lower than a well-managed, for-profit firm would have. However, pres- sure on the bottom lines of healthcare organizations—profit and nonprofit— means that, if it existed, cost shifting is probably a thing of the past.

Similar price differences are common in other industries with similar characteristics. Have you ever wondered why it makes sense for one passenger to have paid $340 for a flight and another passenger in the same row to have paid $99? Why does it make sense for a matinee to cost half as much as the same movie shown two hours later?

When the incremental cost of production is small, when buyers can be separated into groups that have different price elasticities of demand, and when resale is not possible, price discrimination is usually profitable. Most healthcare firms, both not-for-profit and for-profit, fit this profile, so their managers need to know how to price discriminate. With no margin, there is no mission. Price discrimination helps increase margins.

Price Discrimination in Practice

What do American Airlines, Home Depot, Staples, Stanford University, AT&T, the Mayo Clinic, and

Safeway have in common? They all price discriminate (Howe 2017). They charge different customers different amounts for the same product.

Pharmaceutical discounts are the clearest examples of healthcare price discrimination because the products are identical. Only the prices differ. A cash customer (e.g., someone without insurance coverage) may pay the highest price, the list price. However, in some instances,

Case 12.1

(continued)

Lee.indd 190 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Chapter 12: Pr ic ing 191

insured customers may pay more because insurers have not passed on discounts to their beneficia- ries (Ornstein and Thomas 2017).

Most customers pay much less than list prices. Insurers negotiate discounts with manufacturers and pharmacies. These discounts are typically about 30 percent (Goldberg 2017). Some hospitals and HMOs have their own pharmacies and can negotiate even better deals with manufacturers. These organizations sometimes pay as little as 40 per- cent of list prices. Most discounts come in the form of rebates, mean- ing that a purchaser pays the list price up front but gets a payment from the seller later. This makes resale more difficult and limits price transparency (Morgan, Daw, and Thomson 2013).

The federal government has multiple discount programs. The larg- est is the Medicaid rebate program, which requires manufacturers to pay a rebate that varies by the type of drug. Prices, formularies, and copayments vary from state to state, so it is not clear that the Medic- aid rebate program covers the most effective medications or gets the best prices (Luthra 2017). Many federally funded clinics and hospitals are eligible for the Medicaid discount. However, these agencies can often negotiate better deals because they can buy wholesale and because they can choose drugs for their formularies.

Tribal and territorial governments can use the prices on the Federal Supply Schedule, which federal agencies use to buy common supplies and services. The Department of Defense, the Department of Veter- ans Affairs (VA), the Public Health Service, and the Coast Guard may get prices that are slightly lower than Federal Supply Schedule prices because of a provision called the federal ceiling price. This provision caps the price using a formula based on private-sector transactions. Finally, these agencies can try to negotiate prices below the federal ceil- ing price. The VA, which uses a national formulary, has used its bargain- ing power to get substantially better prices. Good, Emmendorfer, and Valentino (2017) report that the VA gets the steepest discounts in the country, with prices as much as 44 percent lower than Medicare prices.

Discussion Questions • Why do drug firms give discounts voluntarily?

• Do other healthcare providers routinely give discounts to some customers?

• Why do the uninsured typically pay the highest prices?

Case 12.1 (continued)

(continued)

Lee.indd 191 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Economics for Healthcare Managers192

12.5 Multipart Pricing

Thus far we have focused on simple pricing models. In fact, a wide range of pricing models may be applicable. One is the multipart pricing model, in which customers pay a fee to be eligible to use a service and pay separate additional fees as they use the services. An obvious example would be a man- aged care plan. The trade-off is that a low entry fee (premium) yields more customers. High copayments reduce costs (either increasing profit margins or reducing premiums), but at some point high copayments will drive away customers. The right combination is always a balancing act. A related pricing strategy is tying. Tying links the prices of multiple products. Again, the goal is to balance multiple prices so as to maximize profits.

EXHIBIT 12.4 Marketing

Forecast

What Should You Charge?

Suppose that exhibit 12.4 is your practice’s mar- keting forecast.

Case 12.2

(continued)

Price Low-Income

Clients High-Income

Clients Total

$35.75 2,125 14,250 16,375

$35.25 2,375 14,750 17,125

$34.75 2,625 15,250 17,875

$34.25 2,875 15,750 18,625

• Why is the cash price sometimes lower than the insurance price?

• Why would a hospital usually get a better price for a drug than an insurance company?

• Why does the VA get such low prices?

• Suppose a law was enacted that required drug manufacturers to give state Medicaid agencies the same price they negotiated with the VA. How would Medicaid and VA prices change?

• Should Medicare adopt the VA formulary?

Case 12.1 (continued)

Lee.indd 192 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Chapter 12: Pr ic ing 193

Discussion Questions • By law, you must charge everyone the same price. What do you

charge?

• Your costs equal $100,000 plus $20 per visit. What are your revenues, costs, and profits?

• If you could charge the two groups different prices, what prices would you charge each group?

• What would your revenues, costs, and profits be?

• Would this scenario be ethical?

• How could you identify the two groups? (You cannot do income surveys of your patients.)

Case 12.2 (continued)

Price Low-Income

Clients High-Income

Clients Total

$33.75 3,125 16,250 19,375

$33.25 3,375 16,750 20,125

$32.75 3,625 17,250 20,875

$32.25 3,875 17,750 21,625

$31.75 4,125 18,250 22,375

$31.25 4,375 18,750 23,125

$30.75 4,625 19,250 23,875

$30.25 4,875 19,750 24,625

$29.75 5,125 20,250 25,375

$29.25 5,375 20,750 26,125

$28.75 5,625 21,250 26,875

$28.25 5,875 21,750 27,625

$27.75 6,125 22,250 28,375

$27.25 6,375 22,750 29,125

EXHIBIT 12.4 Marketing Forecast (continued)

Lee.indd 193 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Economics for Healthcare Managers194

12.6 Pricing and Managed Care

Are these issues relevant in markets dominated by managed care? Yes. One needs the same information to set a price or to evaluate a contract. Accept- ing a contract in which marginal revenue is less than incremental cost almost never makes sense because such a situation reduces profits. Such contracts make sense only when these losses are really marketing expenses, and even in these cases the money probably could be better spent elsewhere. Similarly, giving a large discount to a buyer who is not sensitive to price almost never makes sense. For example, a managed care plan that needs your organiza- tion’s participation to offer a competitive network is not in a good bargaining position and should not get the best discount.

The flip side of the pricing problem, contracting, is even tougher. Eco- nomic models of pricing tell us that managers need to know what their incre- mental costs are, what markup over incremental costs they should expect, and what their rivals will bid. Each of these will be uncertain to some degree, and many healthcare firms have only sketchy cost data. This fact is especially true for incremental costs, which many firms are not prepared to track. Without good data on incremental costs, managers will be flying blind and may be tempted to base their bids on average costs. This reaction usually costs some profitable business opportunities.

Should My Firm Accept This Contract?

You are the manager of a 20-physician cardiology practice. You are getting ready to advise your board about a proposal for capitated spe- cialty care from a local HMO. Data from your fee-for-service practice show billings per member per month of $100 for visits, $80 for cath- eterizations, and $115 for lab services. The practice owns the labs, and the profits are shared among the partners. Your estimate is that costs (aside from physician income) equal 25 percent of charges.

The proposal from the HMO is for a rate of $275 per member per month. Your immediate reaction is to reject it. Your chief financial officer makes two comments that give you pause: “Our overhead will drop significantly if we accept this proposal and convert 25 percent of

Case 12.3

(continued)

Lee.indd 194 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Chapter 12: Pr ic ing 195

12.7 Conclusion

Pricing is important, but many healthcare firms lack direction. Without a clear model of pricing, managers are unable to realize their firm’s goals. They do not know what their incremental costs are or what sort of price elasticity of demand their organization faces. As a result, they do not know what prices to charge. This lack of knowledge reduces profits in two ways. The organiza- tion may set its prices too high or too low. Alternatively, the organization may participate in the wrong markets. It may accept contracts it should refuse or refuse contracts it should accept.

The economic model of pricing tells managers what they should do. Its implications apply to both pricing and contracting, so it remains an important part of every healthcare manager’s tool kit. Actually applying this model will not always be easy, but not knowing what to do is harder still.

Price discrimination is everywhere in healthcare, and many organiza- tions rely on it to remain profitable. Profitable price discrimination requires a little more information than setting a single price, so effective price discrimi- nation is challenging. In addition, many healthcare managers are mesmerized by tales of cost shifting. Cost shifting is unlikely to be responsible for differ- ences in price. If managers genuinely believe cost shifting is occurring, the belief steers them in the wrong direction.

our business to capitation. In addition, we should anticipate that our rates for visits, catheterizations, and tests will drop significantly once we convert.”

In this case the town has only two other cardiology groups. You are not sure whether they have been asked to bid or not. Your legal counsel has warned you that direct discussions with your rivals might leave you open to an antitrust suit.

Discussion Questions • Why is your initial response to reject the offer?

• Why might overhead go down if you accept the contract?

• Why might utilization rates go down?

• What are the risks of accepting or refusing?

• What should you do next? Should you accept the proposal? Should you make a counteroffer?

Case 12.3 (continued)

Lee.indd 195 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Economics for Healthcare Managers196

Exercises

12.1 The marginal cost pricing model calculates a markup over marginal costs using estimates of the price elasticity of demand. Will any other pricing strategy result in higher profits?

12.2 If cost shifting is just a useful public relations ploy, why does it get so much attention?

12.3 Will raising prices increase the rate of return from a line of business? 12.4 Can you think of a healthcare firm that does not price discriminate

(i.e., charge different customers different amounts for the same product)?

12.5 Price discrimination requires the ability to distinguish customers who are the most price sensitive and the ability to prevent arbitrage (resale of your products by customers who buy at low prices). What attributes of healthcare products make these tasks easy to do?

12.6 Your pharmacy provides services to Medicare and PPO patients. You estimate a price elasticity of demand of −2.2 for Medicare patients and −5.3 for PPO patients. Your marginal and average cost for dispensing a prescription is $2. What is the profit-maximizing dispensing fee for Medicare and PPO patients? Why might the price elasticities of demand differ?

12.7 Your dental clinic provides 3,000 exams for private pay patients and 1,000 exams for members of a union. Your fixed costs are $50,000 and your incremental cost is $40. a. Private pay patients have a price elasticity of demand of −3. What

do you charge them? b. The union has negotiated a fee of $50. Is it profitable to treat

members of the union? c. What would happen to your profits if you stopped treating

members of the union? d. If the union negotiated a fee of $45 instead, what would you

charge private pay patients? e. What does this tell you about cost shifting versus price

discrimination? 12.8 You provide therapeutic massage services, focusing on stress

reduction services that are not covered by insurance. Your monthly overhead is $2,000. You value your time at $20 per half hour (how long a therapeutic massage takes). Supplies per massage cost $4. You currently charge $75 per massage and have a volume of 100 clients per month. Your trade journal says that a 5 percent reduction in prices typically results in a 7.5 percent increase in volume. What

Lee.indd 196 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Chapter 12: Pr ic ing 197

would happen to your volume, revenues, and profits if you cut your price to $70? If you raised your price to $80?

12.9 The table shows case-mix-adjusted price and volume data for Dunes Hospital. Calculate its marginal cost, marginal revenue, and profits at each level of output. What price should it choose?

12.10 Your firm spent $100 million developing a new drug. It has now been approved for sale, and each pill costs $1 to manufacture. Your market research suggests that the price elasticity of demand in the general public is −1.1. a. What price do you charge the public? b. What would happen to profits if you charged twice as much? c. What role does the $100 million in development costs play in

your pricing decision? d. The Medicaid agency has made a take-it-or-leave-it offer of $2

per pill. Do you accept? Why or why not? 12.11 Why are most healthcare providers able to charge different groups

of purchasers different prices for the same products? 12.12 A clinic has incremental costs per case of $10 and overhead costs of

$100,000. It faces a price elasticity of demand of −2. a. What is the clinic’s profit-maximizing price? b. How would the profit-maximizing price change if overhead costs

doubled? c. With excess capacity, would serving Medicaid customers for a fee

of $16 make sense? d. How would the profit-maximizing price change if Medicaid raised

its fee to $18? 12.13 You manage a not-for-profit hospital in a competitive market.

Suppose you decide to charge less than the profit-maximizing price to your customers. a. What effect would that decision have on profits? b. What effect would that decision have on you and your career?

12.14 Assume the price elasticity of demand for physicians’ services is −0.2. If your marginal cost per visit is $20, what is your profit-maximizing

Admissions 6,552 9,048 9,672 9,984 10,296

Revenue $52,416,000 $70,574,400 $73,507,200 $73,881,600 $74,131,200

Cost $42,588,000 $59,264,400 $63,835,200 $66,393,600 $68,983,200

Price $8,000 $7,800 $7,600 $7,400 $7,200

Lee.indd 197 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use

Economics for Healthcare Managers198

price if you control 5 percent of the market? What is your profit- maximizing price if you control 15 percent of the market? What lessons do you draw from this information?

12.15 A busy urgent care clinic has average costs of $40 and incremental costs of $60. a. How could incremental costs be higher than average costs? b. The clinic charges $80 for a visit. What price elasticity of demand

does this information imply? c. Volume is currently 200 visits per week. What are the clinic’s

profits? d. An HMO guarantees at least ten patients per week. It proposes a

fee of $55. Should the clinic accept the contract? e. What happens to profits if it accepts the contract?

References

Goldberg, R. 2017. “Reduce Drug Prices by Eliminating PBM Rebates.” The Hill. Published February 14. http://thehill.com/blogs/congress-blog/healthcare /319479-reduce-drug-prices-by-eliminating-pbm-rebates.

Good, C. B., T. Emmendorfer, and M. Valentino. 2017. “VA Responds to Concerns About Collaboration with ICER.” Health Affairs Blog. Published October 25. www.healthaffairs.org/do/10.1377/hblog20171024.745943/full/.

Howe, N. 2017. “A Special Price Just for You.” Forbes. Published November 17. www .forbes.com/sites/neilhowe/2017/11/17/a-special-price-just-for-you/.

Luthra, S. 2017. “Massachusetts Grabs Spotlight by Proposing New Twist on Medic- aid Drug Coverage.” Kaiser Health News. Published November 21. https:// khn.org/news/massachusetts-grabs-spotlight-by-proposing-new-twist-on -medicaid-drug-coverage/.

Morgan, S., J. Daw, and P. Thomson. 2013. “International Best Practices for Nego- tiating ‘Reimbursement Contracts’ with Price Rebates from Pharmaceutical Companies.” Health Affairs 32 (4): 771–77.

Morrison, I. 2017. “Spotlight on Healthcare Costs.” Leader’s Edge. Published Nov- ember. http://ianmorrison.com/spotlight-on-healthcare-costs.

Ornstein, C., and K. Thomas. 2017. “Prescription Drugs May Cost More with Insurance Than Without It.” New York Times. Published December 9. www. nytimes.com/2017/12/09/health/drug-prices-generics-insurance.html.

White, C. 2013. “Contrary to Cost-Shift Theory, Lower Medicare Hospital Pay- ment Rates for Inpatient Care Lead to Lower Private Payment Rates.” Health Affairs 32 (5): 935–43.

Lee.indd 198 1/2/19 3:15 PM

EBSCOhost - printed on 1/19/2023 11:25 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use