Assignment 6-10

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Chapter 13

The Hospital Services Industry

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The Structure of the Hospital Services Industry

Nature of competition

Intensity of the competition that currently coexists among the firms in an industry

Factors influencing the degree of actual competition

Number and size distribution of the existing firms

Degree of product differentiation

Amount of information consumers possess

The Structure of the Hospital Services Industry

Potential competition

Depends on how easy it is for new firms to enter an industry

Degree of potential competition can be measured by

Magnitude of any barriers to entry resulting from

Economies of scale

Legal impediments

Patents

Government restrictions

Number, Types, and Size Distribution of U.S. Hospitals

Ownership

Federal hospitals

Operated by the federal government

Military institutions

Run by Veterans Administration

Non-federal hospitals

Service offerings & average length of stay

Community hospitals,

Long-term general and special,

Psychiatric,

Tuberculosis hospitals

Number, Types, and Size Distribution of U.S. Hospitals

Community hospitals

86% of all hospitals

General medical and surgical services

Specialty services

Ear, nose, and throat care;

Obstetrics and gynecology;

Orthopedic services,

Short-term stays

Less than 30 days

Number, Types, and Size Distribution of U.S. Hospitals

Community hospitals

Not-for-profit hospital

59% of the community hospitals

Control 70% of all community hospital beds, 2006

For-profit hospitals

18% of all community hospitals

14% of beds

Measuring Market Concentration

Hospitals

Multiproduct firms that simultaneously offer a multitude of diagnostic and therapeutic services

Relevant product market (RPM)

Difficult to define and measure

Defined as a cluster of hospital services

Problems:

Hospital facilities provide different levels of care

Hospital and nonhospital providers offering partial product lines are excluded from RPM

Measuring Market Concentration

Primary care services

Prevention, early detection, and treatment of disease

Obstetrics, gynecology, internal medicine, and general surgery.

Some diagnostic equipment to perform X-ray and laboratory analysis.

Measuring Market Concentration

Secondary care

More sophisticated treatment

Cardiology, respiratory care, and physical therapy.

Equipment and laboratory capabilities are more sophisticated

Measuring Market Concentration

Tertiary care

Designed to arrest disease in process

Heart surgery, cancer treatments – chemotherapy

More sophisticated equipment

Community hospitals

Primary and secondary care

Some offer tertiary care.

Measuring Market Concentration

Research hospitals

Associated with university medical schools

Provide state-of-the-art quaternary-level care

Relevant geographical market (RGM)

Geopolitical boundaries

Health service areas

Fixed 5- or 15-mile radius around each hospital

Based on patient flow data

Barriers to Entry

State certificate of need (CON) laws

Excess capacity,

Sunk cost

Economies of scale

Learning curve effects

System affiliation

Barriers to Entry

State certificate of need (CON) laws

Deter entry and allow entrenched firms to raise prices, Noether (1987)

Excess capacity, Schramm and Renn (1984)

Sunk cost

Relatively huge investment in the hospital infrastructure represents a sunk cost, Baker (1988)

Barriers to Entry

Economies of scale

1960s and 1970s studies confirm it, Cowing et al., (1983)

Newer studies: hospitals as multiproduct firms

Long-run diseconomies of scale, average-size hospital

Barriers to Entry

Survivor theory

Efficient hospital size may have changed considerably over time

Long-run average cost

Of a short-term community hospital reaches its lowest point at a size of around 200 beds ± 100 beds

Barriers to Entry

Learning curve effects

Evidence to support learning by doing

Farley and Ozminkowski (1992)

Stone et al. (1992)

Learning by watching, Ho (2002)

Barriers to Entry

System affiliation:

Members of a multihospital system have four advantages that may result in lower average costs

Economic benefits

Economies of scale and access to capital;

Improved personnel and management benefits

Ability to recruit, train and retain high-quality medical and administrative staffs,

Expand patient referral networks,

Provide access to specialists to assist in coping with increasingly complex environments

Barriers to Entry

System affiliation:

Four advantages

Organizational benefits due to

Expansion of the service area, increased market penetration,

Organizational survival through reduced financial deficits, manpower shortages, and facilities problems;

Community benefits

Improved access and quality of care through enhanced resources, lower costs, and improved regional planning

Barriers to Entry

System affiliation:

Empirical evidence

System affiliation does not lead to lower costs of production

Ermann and Gabel (1984)

Renn et al. (1985)

Wilcox-Gok (2002)

Table 13.1 - Sources of Hospital Funds, 2010

	Dollars (billions)	Percent
Total hospital care expenses All private funds Out-of-pocket Private insurance Other Government Medicare Medicaid and CHIP Other	$814.0 350.0 25.9 285.8 38.2 464.0 226.5 155.6 81.9	100.0% 43.0 3.2 35.1 4.7 57.0 27.8 19.1 10.1

Number, Types, and Size Distribution of the Buyers of Hospital Services

Hospital prices and costs – can be influenced by

The government (Medicare and Medicaid)

Private sector – at local level

Depends on chosen hospital reimbursement strategy, the competitiveness of the hospital and insurance markets, and the goals of the insurer

Type of Product

Product differentiation

Causes the demand curve to become less price elastic

Enables the firm to restrict output below and raise price above the competitive level

Determinants of choice of hospital

Lane and Lindquist (1988)

Quality of care and staff,

Equipment and technology,

Convenient location

Type of Product

Marketing and advertising

$120,000 annually on marketing,

0.1 to 0.2 % of sales (Barro and Chu, 2002).

In highly competitive areas

5% of gross sales to advertising, Gray (1986)

50% of marketing budget – on advertising, Japsen (1997)

Print advertisements (43%) (newspapers and magazines)

Radio (14%); direct mail (12%), Yellow Pages (11%), television (11%), bus/billboards (4%)

Type of Product

Dorfman-Steiner approach (1954)

Hospital = Monopolist

Q = Q(P, A)

P = price of hospital services

A = advertising expenditures

Q = quantity demanded of hospital services

Increases when P decreases

Increases when A increases

Type of Product

Dorfman-Steiner approach

EP = price elasticity of market demand in absolute terms

EA = advertising elasticity of demand

Percentage change in quantity demanded resulting from a one-percentage-point change in advertising expenditures.

Measures the responsiveness of consumer demand to a change in advertising expenditures

Type of Product

Dorfman-Steiner approach

Profit-maximizing amount of advertising intensity (A/TR)

- Advertising intensity is larger when

Quantity demanded is more responsive to advertising

The gap between price and marginal cost is greater

Type of Product

Implications of Dorfman-Steiner model

A profit-maximizing hospital advertises more intensely when the advertising elasticity is higher

Advertising expenditures are greater when demand is less elastic with respect to price

Firms with greater market power tend to advertise their products more aggressively, all other factors held constant

Type of Product

Hospital = Oligopolist

Advertising could have

An industry expansion effect

A market share expansion effect

Industry expansion effect

Advertising by a single hospital may expand the size of the entire industry

Market share effect

Persuasive advertising may allow a hospital to attract some of its rivals’ customers

Diminishing returns to advertising expenditures

Type of Product

Town and Currim (2002)

Hospital advertising intensity

Greater in more concentrated market areas

For-profit hospitals

Did not advertise any differently than their not-for-profit counterparts

Hospitals spend more on advertising

Attempt to attract a greater share of the more profitable Medicare and HMO patients

Pricing Behavior of Not-for-Profit Hospitals

Utility maximization models

Assume that the manager of a not-for-profit hospital attempts to maximize his or her own personal utility

Quantity maximization, Baumol (1967)

Maximize output subject to a break-even level of profits

Managers try to expand sales at the expense of profits

Figure 13.1 - The Output Maximization Model

Number of

patient-days (Q)

D=AR

Dollars

per

unit

If so, the not-for-profit firm produces more services (Q0) but charges a lower price (P0) than an otherwise comparable for-profit hospital (P1, Q1).

Suppose the typical not-for-profit hospital faces a downward-sloping demand curve and the usually shaped average and marginal cost curves and attempts to maximize the quantity of hospital services subject to a break-even constraint (P = AC).

Pricing Behavior of Not-for-Profit Hospitals

Quantity maximization model

Long-run implications:

Hospital may generate some profits to acquire the funds it needs for expansion

Price - slightly above the average cost of production

Provide more output

Have a higher rate of expansion over time than the profit-maximizing hospital

Pricing Behavior of Not-for-Profit Hospitals

Quantity maximization model

Not-for-profit hospital

Firm - restricted by law from distributing profits

Managers: maximize quantity

Increase the firm’s market share

Enhance its prestige in the community

Board of trustees, or board of directors

Maximize quantity to increase their presence in the community

Pricing Behavior of Not-for-Profit Hospitals

Quantity maximization model

Excess capacity in hospital services

Acquire an additional piece of medical equipment even if it does not generate a profit

If it may attract a sufficient number of additional admittances.

Duplication of resources and overcapacity

Cannot explain why the cost of hospital services has been rising so rapidly

Static rather than a dynamic view of hospital behavior

Pricing Behavior of Not-for-Profit Hospitals

Quality maximization model, Lee (1971)

Managers of not-for-profit hospitals maximize utility

By attempting to enhance the status of their hospital

Maximize quality

Any increase in the quality of care

Likely to drive up the cost of producing medical services

Relatively inelastic demand for hospital services

Any increase in the cost - can be passed on to the payer through a higher price

Pricing Behavior of Not-for-Profit Hospitals

Quality and Quantity maximization

Feldstein (1971) and Newhouse (1970)

Management

Determines the quantity and quality of output

Produces the levels that maximize utility

Trade-off

Increased quality – at the expense of quantity

Management – choose that mixture of quantity and quality that maximizes their personal utility

Figure 13.2 - The Impact of Changes in Quality on Costs

Number of

patient-days (Q)

Dollars

per

unit

AC0

AC1

A not-for-profit hospital that chooses to produce with higher quality faces increased costs of AC1. As a result, the hospital must produce fewer services (Q1) when faced with a break-even constraint.

Figure 13.3 - The Quality/Quantity Maximization Model

Number of patient-days

Quality

This figure shows the various combinations of quality and quantity of hospital services that can be produced given a fixed budget constraint. To maximize their utility and given the trade-off, decision makers at a not-for-profit hospital must choose a specific point such as A or B, given their preference weights for the two goods

Pricing Behavior of Not-for-Profit Hospitals

Managerial expense preference model

Williamson, (1963)

Managers use their authority

To divert funds away from profits to serve their own self-interests

Pursue the five Ps of increased pay, perquisites, power, prestige, and patronage

Asymmetry of information between the stockholders and the managers

Pricing Behavior of Not-for-Profit Hospitals

Managerial expense preference model

Maximize discretionary expenditures

Choose the profit-maximizing level of output and price

Then absorb the profits through discretionary expenditures

Rent-seeking behavior

Manager – wants a bigger slice of the pie for herself rather than trying to enlarge the size of the pie

Figure 13.4 - The Managerial Expense Preference Model

Quantity (Q)

Dollars

per

unit

MCtrue, ACtrue

CEXP

The difference is that the not-for-profit hospital uses the discretionary profits to finance unnecessary expenditures and thereby raises the costs of production to CEXP, a point above the true costs of production. The not-for-profit hospital reports the same price and quantity of services as the for-profit hospital but shows no economic profit.

A not-for-profit hospital that maximizes discretionary profits will choose to produce at Q0 where MR = MC just like an otherwise comparable for-profit hospital.

Pricing Behavior of Not-for-Profit Hospitals

Utility maximization models explain

How firm behavior is affected

When managers address their own utility functions

Rather than attempting to maximize profits

Why the health care sector may tend toward duplication of resources and overspecialization

Why health care costs have increased over the years

Lack of concern for the bottom line causes the cost of medical care to increase.

Market Concentration and Hospital Behavior

Impact of market concentration

On the price, cost, and quality of hospital care

Medical arms race hypothesis

Robinson and Luft, (1985)

Hospitals in more competitive areas

Provide physicians with greater levels of hospital quality

Advanced medical technologies; Excess bed capacity; Amenities

In return for admitting their patients

Higher quality = higher costs

Market Concentration and Hospital Behavior

Medical arms race, empirical evidence

Data prior to mid- 1980s

Increased competition / lower HHI

Increased hospital costs (Hersch,1984; Robinson and Luft, 1985; White, 1987; Noether, 1988; Fournier and Mitchell, 1992),

Lower levels of technical efficiency (Wilson and Jadlow, 1982),

Greater excess bed capacity (Joskow, 1980; Farley, 1985),

Larger number of duplicate specialized services in local markets (Dranove et al., 1992; Farley, 1985)

Data after the mid-1980s: No support

Market Concentration and Hospital Behavior

Empirical evidence, after mid-1980s

More recent data

Payer-driven competition

Increased hospital competition

Improves technical efficiency (Rosko,2001),

Reduces excess capacity (Santerre and Adams, 2002),

Lowers hospital prices (Town and Vistnes, 2001)

Lowers hospital costs, and results in lower rates of adverse outcomes (Kessler and McClellan, 2000).

Market Concentration and Hospital Behavior

Hospital consolidations during the 1990s

Acquisitions involve hospitals in different areas

Mergers involve the combination of separate facility licenses into a single license

Involve hospitals in close proximity

Hospital Ownership and Hospital Behavior

Costs, prices, and quality of care

Reasonably similar across differently owned hospitals

Public hospitals

Provide greater amounts of uncompensated care

Uncompensated care

Bad debts and charity

Measured as a percent of total hospital expenses

Hospital Ownership and Hospital Behavior

Why do for-profit hospitals provide any uncompensated care?

Low marginal cost

Favorably impact hospital’s relationship with regulatory agencies and the community at large

Not-for-profit hospitals

Tax-exempt

Expected to provide charitable care

Uncompensated care - only 5% of expenses

Hospital Ownership and Hospital Behavior

Not-for-profit hospitals

20% of all not-for-profit hospitals do not provide uncompensated care sufficient to compensate for the tax subsidies they receive

Nicholson et al. (2000)

Not-for-profits should be expected to provide community benefits equal to those provided by for-profit hospitals plus the profits these hospitals earn

Managed Care Buyers and Hospital Behavior

Managed care

Incentives for efficiency without seriously sacrificing quality?

Greater pressure from HMOs

Improves the degree of technical efficiency experienced by hospitals

Inpatient outcomes are not systematically worse

Managed Care Buyers and Hospital Behavior

Similar quality-of-care in MCO and non-MCO plans

Empirically

Very difficult to distinguish among health plans

Some MCOs - structured as not-for-profit firms

MCOs often invest huge sums of money establishing brand names

Managed Care Buyers and Hospital Behavior

Physicians that contract with MCOs

Subscribe to the same basic ethical code of conduct as the doctors that deal with traditional insurers

Price Regulations and Hospital Behavior

States –establish rate-setting programs

Regulation of hospital fees can lower health care costs

Schneider (2003)

Rate regulation – accomplished its cost-control objective in the early years

Not sustainable over time.

In more concentrated markets

Increasingly higher operating costs over time

Relation between rate setting and quality of care – mixed evidence

Cost Shifting Behavior

Cost shifting

Lower reimbursement rates for public programs lead to higher prices paid by private payers

Empirical evidence – mixed

Inconclusive, Hadley and Feder (1985) and Zwanziger et al. (2000)

Figure 13.5 - Analysis of Hospital Cost Shifting

Suppose the two submarkets are in an initial equilibrium represented by R0, the Medicare reimbursement rate, and point A. The latter point reflects that the hospital is initially operating at the profit-maximizing number of private-pay patients. If the government lowers the Medicare reimbursement rate to R1, the hospital will not raise private price to finance the Medicare loss, L, because price is already at the profit-maximizing level in the private submarket. Hence cost shifting does not occur in this case.

Private-pay patients (Q)

Private-pay Submarket

Medicare patients (M)

Medicare Submarket

However, if the hospital is initially operating with some unexploited market power, as at point B, where the number of private-pay patients is maximized (rather than profits), hospitals may raise price in response to the Medicare loss. Thus cost shifting can occur. The ability to raise price in this case depends on the magnitude of the price elasticity of demand.

The Performance of the Hospital Services Industry

Growth of hospital expenditures,

The hospital inflation rate,

Hospital input utilization in the aggregate

Aggregate performance of the hospital services industry in the United States

The Growth in Hospital Expenditures

Expenditures on hospital services

Spending on inpatient and outpatient services

30-40% of all health care spending

As percentage of GDP

Increased to 4.6 % in 1995

Decreased to 4.2% in 2000

Success of managed care at controlling hospital costs

Table 13.2 - Hospital Expenditures in U.S., Selected Years, 1960–2010

Year	Total Hospital Expenditures (billions of dollars)	Spending as a Percentage of Gross Domestic Product
1960 1970 1980 1990 1995 2000 2005 2010	$ 9.0 27.6 101.5 253.9 343.6 413.1 605.5 814.0	1.7% 2.6 3.6 4.3 4.6 4.2 4.8 5.6

The Growth in Hospital Expenditures

Expenditures on hospital services

= Price * Quantity of hospital services

Change in hospital expenditures over time

Higher price changes,

Increased quantity of services,

Both

Hospital Services Price Inflation Rate

Hospital services index

Follow the transaction prices of selected services over time

While keeping constant price-determining characteristics

Length of stay

Medical reason for the visit

Transaction price

Actual amount the hospital receives from the insurance carrier and/or the patient’s out-of-pocket payments

Figure 13.6 - General and Hospital Services Price Inflation Rates, 1998–2011

Hospital Services Price Inflation Rate

Hospital services inflation rate

Exceeded the general price inflation rate

In every year but one over the 25-year span

Double-digit inflation rates

Eight times throughout the time span

Unlike the entire economy, which faced double-digit inflation only twice

Hospital Services Price Inflation Rate

Hospital services inflation rate

Hospital prices continued to rise more quickly than the prices of other goods

Despite the introduction of Medicare PPS & other public and private cost containment practices after 1983,

Increased managed care enrollments

May have had a disinflationary impact on hospital service prices during the early to late 1990s

Do Hospitals Provide Flat-of-the-Curve or Ineffective Medicine?

Marginal productivity of hospital care

Usually close to zero

Fisher et al.

Additional growth in health care spending is primarily driven by advances in science and technology

Flat-of-the-curve

Additional medical care services may not provide important benefits to the population served

Figure 13.7 - Model of Health Care Delivery in Different Regions

Suppose two regions initially operate at point A on total product curve TP0. Region 1 subsequently chooses high-cost, low-quality technologies and Region 2 selects low-cost, high-quality technologies.

As a result, Region 2’s total product curve shifts upward to TP2 and Region 1’s total product curve shifts upward to TP1. With the new total product curves, Region 2 moves from point A to point C and Region 1 shifts from point A to point B.

Hospital Profit Margins

Total hospital margin

Payments received for inpatient and outpatient care services from all types of payers

Plus any non-patient revenues

Less total hospital expenditures

Profit margins vary considerably

Rural and metropolitan hospitals

Nonteaching and teaching hospitals

Hospitals with different payer mixes

Figure 13.8 - Average Total Operating Margins for the U.S. Hospital Industry and the Manufacturing Sector, 1981-2009 by decade

Provisions of the Patient Protection and Affordable Care Act (PPACA) of 2010 Relating to the Hospital Services Industry

PPACA

Provides financial incentives to hospitals and other medical care providers

To establish vertical relations and form accountable care organizations

To provide tax breaks to not-for-profit hospitals

Provisions of the Patient Protection and Affordable Care Act (PPACA) of 2010 Relating to the Hospital Services Industry

Establishes a value-based purchasing program

Provides financial incentives to primary care providers

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