A Bit More on Premium Increases
This post is jointly authored by Austin Frakt and Ian Crosby. It is a supplement to our Kaiser Health News (KHN) column, which I also posted on this site on Sunday. If you haven’t read that column yet, do so first. This post links back to many of our prior posts on related issues. Thus it serves as a portal to further reading.
In his recent NY Times opinion piece, Reich claimed that the current antitrust exemption for insurers “is why a handful of insurers have become so dominant in their markets.” As we wrote in our KHN column, this claim is extremely dubious. Moreover, it is far more likely that premium increases are largely due to factors other than insurer concentration.
As we’ve noted previously, the exemption (under the McCarran Ferguson Act) is very narrow, and does not apply to mergers, acquisitions, and most other kinds of conduct by which companies get big. We’ve also noted that there are some types of conduct by which insurers could defend and expand their market share that arguably do fall within the scope of the exemption, but they are sufficiently modest and theoretical that is unlikely they bear much responsibility for the current state of market concentration.
We’ve also made the larger point that even if repeal of the exemption or other forms of stepped up antitrust enforcement were to have a material impact on insurer market power, there is little reason to believe it would produce tangible benefits for consumers absent parallel efforts against providers. A recent paper by Berenson, Ginsburg, and Kemper in Health Affairs documents the upward pressure on costs driven by provider organization and concentration. Based on hundreds of interviews with representatives of hospitals, physician organizations, health plans, and other stakeholders in six California health care markets, the authors conclude that
[t]he shift in who holds the upper hand in negotiating payments—once held by health insurance plans but now resting with health care providers—has had a major impact on California premium trends.
… [P]roviders are developing increased leverage through single-specialty group formation and merger-and-acquisition strategies that do not involve integration. Nevertheless, given the push in Congress and elsewhere to restructure health care delivery with accountable care organizations, it is instructive that whatever their merits in improving quality and efficiency, California-style integrated care systems currently produce higher prices that undermine cost containment.
Other work by health economists, reviewed on this blog, indicates that the high degree of market power held by insurers acts as a counterweight to that held by hospitals. Diluting the insurance market may have small downward effects on insurer profit and administrative efficiency, but it could have large upward effects on prices of health care services. Those higher prices would be passed on to consumers.
Therefore, concentration among providers, and in particular hospitals, must also be addressed. Unfortunately, permitting additional provider coordination and integration via accountable care organizations (ACOs), as envisioned in current health reform legislation, may not help matters. The bundling of payments ACOs would facilitate may save money, but only if the greater market power of additional provider integration does not act to offset those savings.
Taming health care costs will be hard. The job is made harder when we’re looking in the wrong place. Insurers may not deserve the special treatment they’ve received from the federal antitrust exemption. But they also do not deserve the level of blame they’ve received for health care costs.
Popular But Ineffective: Repealing Insurers’ Antitrust Exemption
This post is a slightly modified version of one by Austin Frakt and Ian Crosby that originally appeared at Kaiser Health News last week. Full references have been added for academic papers cited.
It is well known that concentration in the health insurance industry is to blame for rapidly rising premiums. Well known, but wrong. Taking political advantage of this common misconception, last week the House passed a bill to repeal insurers’ antitrust exemption. But even if that bill becomes law it won’t do much good, and politicians’ distraction could actually harm consumers. It’s far more likely that premium increases are largely due to other factors.
Those who claim that the antitrust exemption is the main reason a few insurers have substantial market power don’t understand the narrowness of that exemption’s scope. The law at issue, the McCarran-Ferguson Act, shields most aspects of “the business of insurance” from federal (but not state) antitrust oversight. This means that only those insurer activities dealing directly with providing insurance–think underwriting risk, setting rates, defining benefits, and the like–are not ordinarily subject to federal antitrust scrutiny.
There are exempt insurance practices that, at least in theory and under certain conditions, could help insurers defend and expand their market share against competitors. But the exemption simply does not shield the most straightforward kinds of conduct that make companies big.
Activities not connected with the basic risk-spreading function of insurance are deemed “the business of insurers” rather than “the business of insurance” under the law, and do not enjoy any federal antitrust exemption. Thus mergers and acquisitions among health insurers are as aggressively (or passively) scrutinized as those in any other industry by federal antitrust enforcers.
Health care reform advocates concerned about the high degree of concentration in today’s insurance market cite the more than 400 mergers among health plans allowed over the last 13 years. But repeal of the McCarran-Ferguson antitrust exemption would have literally no effect on this trend. Even if other forms of stepped-up antitrust enforcement or other means of encouraging competition were to have a material impact on insurer market power, there is little reason to believe it would produce tangible benefits for consumers absent parallel efforts targeting the provider side of the market.
While there is some evidence that insurers’ market concentration plays a role in premium increases, that role is small. For example, a National Bureau of Economic Research paper [1] found that only 2.1 percent of employer-sponsored health insurance premium increases between 1998 and 2006 were due to insurer concentration.
It is far more plausible that a high proportion of premium increases are due to a combination of concentration in the provider market and adverse selection, especially in the nongroup market. After all, most premium dollars are not kept by insurers and go toward payment of health care services [2]. Insurers take a little off the top, but not enough to be blamed for anything like the perennially large rate increases.
A recent Health Affairs paper [3] describes the upward pressure on costs driven by provider organization and concentration. Based on hundreds of interviews with representatives of hospitals, physician organizations, health plans and other stakeholders in six California health care markets, the authors conclude that “[t]he shift in who holds the upper hand in negotiating payments—once held by health insurance plans but now resting with health care providers—has had a major impact on California premium trends.” And we all know what those trends have looked like lately.
Perhaps counter-intuitively, large insurers can be bulwarks against high costs driven by provider consolidation. Two papers [4, 5] by health economists in the International Journal of Health Care Finance and Economics indicate that the high degree of market power held by insurers acts as a counterweight to that held by hospitals. Therefore, diluting the insurance market may have small downward effects on insurer profit and administrative costs, but it could have large upward effects on prices of health care services. Those higher prices would be passed on to consumers.
That’s why those who understand our health care system know that costs will not be tamed by a focus on the insurance market alone. The Congressional Budget Office has scored the likely effect on premiums of health insurer antitrust repeal as insignificant. Therefore, concentration among providers, and in particular hospitals, must also be addressed.
Don’t get us wrong–we don’t think that the current antitrust exemption is good law or policy. But cracking down on insurer market power without doing the same against providers may well have the opposite of its intended effect. Taming health care costs will be hard. Attacking insurers is, by comparison, very easy, as well as popular. But in this case, what is popular will not be particularly effective.
References
[1] L Dafny, M Duggan, and S Ramanarayanan (2009). Paying a premium on your premium? Consolidation in the U.S. health insurance industry. NBER Working Paper 15434.
[2] L Dafny, K Ho, and M Varela. (2010). Let them have choice: Gains from shifting away from employer-sponsored health insurance and toward an individual exchange. NBER Working Paper 15687.
[3] R Berenson, P Ginsburg, and N Kemper. (2010). Unchecked provider clout in California foreshadows challenges to health reform. Health Affairs Web Exclusive, February 25.
[4] R Feldman and D Wholey. (2001). Do HMOs have monopsony power? International Journal of Health Care Finance and Economics 1(1).
[5] L Bates and R Santerre. (2008). Do health insurers possess monopsony power in the hospital services industry? International Journal of Health Care Finance and Economics 8(1).
Kaiser Health News Opinion Column
Ian and I have a co-authored Kaiser Health News opinion column out today. We argue that repealing insurers’ antitrust exemption won’t change things much and isn’t likely to help consumers significantly. Further, a focus on competition in insurance markets has the potential to distract policymakers and the public from the principal source of increases in premiums: concentration in the provider market.
Here’s the opening paragraph:
It is well known that concentration in the health insurance industry is to blame for rapidly rising premiums. Well known, but wrong. Taking political advantage of this common misconception, last week the House passed a bill to repeal insurers’ antitrust exemption. But even if that bill becomes law it won’t do much good, and politicians’ distraction could actually harm consumers. It’s far more likely that premium increases are largely due to other factors.
Kinda makes you want to read the whole thing, right?
The Disproportionate Popularity of Repealing Insurers’ Antitrust Exemption
Jenny Gold’s Kaiser Heath News piece today on the antitrust exemption is worth a read. She rounds up the opinions and, more importantly, explains what the exemption does and doesn’t do. It’s pretty clear that repealing it, though popular, won’t do much to solve the health care cost problem, nor could it (as I’ve explained before).
The article quotes Scott Harrington (who, by the way, has a blog):
“This is just barking up the wrong tree for health insurance,” said Scott Harrington, a professor of health care management at the Wharton School at the University of Pennsylvania. While many lawmakers are eager to pass some kind of health care bill, they “don’t have a clue how the antitrust exemption works. It might sound good, but I can think of very few things in the bill that would be less consequential for consumers of health insurance.”
I’ve been saying the same thing to reporters when they ask me about antitrust repeal, only Harrington said far more artfully. And what does CBO think? Gold writes,
An analysis by the Congressional Budget Office estimated that repealing the antitrust exemption for health insurers “would have no significant effects on either the federal budget or the premiums that private insurers charged for health insurance.” The CBO found that premiums might increase or decrease, “but in either case the magnitude of the effects is likely to be quite small.”
Repeal of the exemption is popular, but like a lot of things done in anger, it isn’t particularly wise and won’t be very effective.
Non-Public Option Options
With the public option off the table, House Democrats are looking for ways to achieve by other means the reduction in premiums such an option was expected to deliver. The ideas mentioned in media reports include increasing competition among insurers by revoking their antitrust exemption.
That’s good politics but questionable economics. On this blog Ian and I have been over the issues of antitrust exemption and insurer market concentration several times. The upshot is that it is by no means clear that revoking insurers’ antitrust exemption will achieve the Democrats’ goals of reducing costs. Weaker insurers will be less able to negotiate low prices with providers. And lower health care prices paid by insurers are a necessary, though not sufficient, condition for lower premiums.
On theoretical grounds I’ve argued that a public option could play an important role in forcing insurers to pass lower prices on to consumers. A public option that serves as a competitive threat (the notion of contestability) could do just that. In the absence of a public option, what can be done to lower prices for consumers? What will help insurers (large and small) extract lower health care prices yet prevent them from keeping the savings as additional profit?
Two ideas. The first is to increase minimum required loss ratios, the fraction of premium revenue paid out in medical costs. Such increases are already in the House and Senate bills (to 85% for the large group market in both bills, 80% for the small/individual markets in the Senate bill). If they are perceived as too low then House Democrats should negotiate for increases. The higher the required loss ratio, the less is left for insurers’ non-medical expenses (profit, management, marketing, administration).
The second idea is to begin to establish incentives for provision of care that is itself lower in cost. Again, there are already a variety of ideas in health reform legislation to do just that. There was a recent blogosphere kerfuffle over whether legislative cost control ideas ever actually lead to genuine cost reductions (Tyler Cowen is skeptical, The Center on Budget and Policy Priorities is far more sanguine). My view is that we can’t tell from the current debate whether or not cost controls are likely to work because stakeholders haven’t fully engaged on this issue yet.
When the cost control debate begins in earnest (and it is coming, but not this year) will budget-concerned policymakers be able to stand up against the considerable pressure the hospital industry will bring to bear? I don’t know. A lot depends on the political and economic context.
What I do know is that if Democrats really want public option like results from non-public option reforms this is a fight they’ll need to have. That they’re hanging their hat on antitrust reveals that they don’t welcome such a fight today. That’s politically savvy but it isn’t going to get the job done on costs.
Intel, the FTC, and the State of Antitrust Law
Occasionally, an antitrust complaint comes along that is just a ripping good read, perhaps even for a non-lawyer. The Federal Trade Commission’s recent complaint against Intel is just such a one. It depicts a litany of strong-arm tactics and deception that the FTC claims has frustrated the ability of Intel’s few competitors to bring faster, cheaper microprocessors to consumers.
But what is most interesting to me as a lawyer is not what the FTC has alleged Intel did, but why it has claimed that conduct is illegal. For the FTC has not just challenged Intel’s conduct under the main monopoly statute, Section 2 of the Sherman Act, under which private suits and actions by the Department of Justice are also brought, but also under a special unfair competition statute, Section 5 of the FTC Act, that is only available in actions by the FTC.
Unfair competition under Section 5 of the FTC Act is ostensibly broader than monopolization under Sherman Act, though the FTC has had limited success in the past enforcing it against conduct that was not also an antitrust violation. Since those setbacks, however, courts have limited the scope of the antitrust laws on both economic and prudential grounds. “The result,” according to a statement by FTC Chairman Leibowitz and Commissioner Rosch, “is that some conduct harmful to consumers may be given a “free pass” under antitrust jurisprudence . . . .”
A separate statement by Commissioner Rosch identifies several examples of how courts have curtailed antitrust enforcement against conduct that may be harmful to consumers:
- Courts frequently admonish that the antitrust laws protect competition, not competitors. But in a highly concentrated market, harm to competitors may itself harm competition.
- Courts are often reluctant to condemn practices that decrease innovation without necessarily raising prices. But decreased innovation can harm consumer welfare every bit as much as monopoly pricing.
- Many courts have disparaged as “mere monopoly broth” claims based on a course of conduct whose constituent elements do not each themselves amount to antitrust violations. But acts that by themselves may be innocuous may have consequences in conjunction that are greater than the sum of their individual effects.
- Some cases have suggested that a monopolist’s intent is not relevant to the legality of its conduct. But what the monopolist hoped to achieve may be a very good indicator both of the likely consequences of its actions, and of the plausibility of its justifications for undertaking them.
In bringing unfair competition as well as monopolization claims against Intel, the FTC is setting up a test of its enforcement authority against harmful conduct that the lately-diminished antitrust laws may not reach. As an advocate of vigorous antitrust enforcement, I am not sure if I am more heartened by the FTC’s broad assertion of its mandate than I am discouraged at its acknowledgment that the state of the antitrust laws may have made that assertion necessary.
Does McCarran Matter?
We have argued that increased enforcement of competition laws against insurers without similar efforts against providers could have perverse consequences without a public option. And we’ve also observed that absent the threat of a public option, there is no reason to believe insurers would pass on to consumers the benefits of any market power they are allowed to maintain. In today’s companion post, Austin elaborates on the relationship between insurer market power and a public option.
In each instance, our remarks have been occasioned by Democratic efforts to repeal, in whole or in part, the 1945 McCarran-Ferguson Act, which provides a partial antitrust exemption that insurers currently enjoy. But they have not been premised specifically on the proposition that the exemption itself contributes to increased concentration in the health insurance market, or that such concentration would be diluted by repeal. I consider that question now.
The McCarran-Ferguson Act exempts from federal antitrust laws most aspects of “the business of insurance” to the extent regulated by the states. The exemption for “the business of insurance” applies to activities like issuing policies, underwriting risk, and setting premiums. But it does not apply to “the business of insurers” – for example, purchasing services from providers or engaging in mergers and acquisitions, in most circumstances. Nor does the exemption protect “boycott, coercion, or intimidation” from federal antitrust scrutiny.
Roughly, the exemption tracks the risk-spreading relationship between insurer and insured that has traditionally been the subject of state regulation, while mostly subjecting insurer-provider relationships and other non-insurance activities to federal scrutiny.
So what sorts of potentially market-concentrating conduct are left to exclusive state regulation after the exemptions to the exemption? Agreements to fix prices and to divide up markets are generally considered to be within the exemption’s scope. While the former type of agreement would not enhance the power of participants to bargain with providers, the latter surely could. If, for example, two insurers in a state were allowed to agree that one would market policies in one part of the state, while the other would take the rest, then each would have greater leverage over providers in its allocated region.
The same would be true in market segments, such as for large group, small group, and individual policies, that were the subject of an exempt agreement. Of course, state regulators are free to police such arrangements. But even weak policing is enough to displace federal regulation under McCarran-Ferguson.
Anticompetitive agreements are not the only conduct exempt from federal antitrust oversight. Some partial repeal proposals would still commit all manner of exclusionary conduct by individual insurers seeking to maintain or acquire monopoly to potentially lax state oversight. Federal law, for example, would still not reach a predatory pricing scheme in which a monopoly insurer lowered prices below its costs to deter entry by a new competitor in the expectation that it could recover its losses after successfully defending its monopoly. While there is much skepticism about the feasibility of predatory pricing outside markets with large economies of scale or scope, or high barriers to entry, the health insurance market has these features.
In short, there are reasons to believe, in theory, that the current antitrust exemption does promote lax regulation of practices that could lead to increased concentration in the health insurance market. Certainly, that market has come to be characterized by a high degree of concentration in recent years. While other factors have no doubt contributed to that concentration, it is not implausible that the antitrust exemption has contributed as well, whether through the conduct that it clearly allows, or the vagueness that it brings to enforcement against conduct that is not clearly outside its scope.
We don’t condone or promote the type of conduct that the antitrust exemption allows or encourages. But going easy on such conduct may be the price of maintaining the balance of power between insurers and providers if we do not enact a robust public option.
Antitrust and Health Reform
This post is co-authored by Austin Frakt and Ian Crosby.
In the wake of AHIP’s promotion of the report sham study it commissioned from PricewaterouseCoopers (PWC), Senate Democrats are pushing to repeal a 1945 statute that partially exempts insurers from national antitrust law. While it may be wise to regulate insurers at the national as opposed to the state level, legislating in anger is not. At this stage, however, this isn’t anywhere near serious legislation. It is a signal of Democrats’ intent and a warning shot across the bow of the insurance industry.
AHIP’s PWC provocation was not only poor politics, it was poor timing. Only days after its release Olympia Snowe traded a “yes” committee vote for a seat at the Senate negotiating table. It now seems less likely health reform legislation will emerge with a public option. That would be a victory for the industry and would place the burden of negotiating better treatment at lower cost on the private sector, with government regulators looking over the industry’s shoulder. It will take market muscle to shoulder that load.
But not too much market muscle. Taxpayers will be best served by insurers with sufficient market power to bargain down provider rates, but with not quite enough power to keep the savings (“rents”) for themselves. That is, we want low provider rates to translate into low premiums. Though liberals may be skeptical that this balance is achievable, it is not at odds with their objectives in principle. After all, one of the arguments for the public option is that it would be a large insurer with commensurately large negotiating power but would use that power on the behalf of consumers.
How to balance the power of insurers and providers is far from simple. Many have pointed to the alleged dominant market position of insurers as a substantial source of high health care costs. However, the health economics literature supports the notion that recent increased market power of insurers does not lead toward monopolistic pricing, but rather it provides a counter-balance to the power held by hospitals and provider groups.
Moreover, insurance companies are partially exempt from federal antitrust law for an important reason: so they can share rate-making data. This function actually benefits small insurers who would not otherwise have sufficient data to properly adjust premiums. Paradoxically, removing the legal cover for data sharing would harm small insurers more than large ones.
All this suggests that repealing the federal antitrust exemption for insurers may be misguided. Though the insurance antitrust exemption is a popular whipping boy for Democratic politicians, it is by no means clear that repealing it is practical or beneficial to consumers. Instead, antitrust law might better aid the cause of health care reform by first focusing on providers. While a few proposed hospital mergers have been blocked recently, it follows a long period of hospital consolidation.
Yet even here, antitrust exemptions may be inevitable to allow doctors and hospitals to negotiate bundled payments contingent on performance under the guise of accountable care organizations (ACOs). It is not unreasonable to worry that providers might try to use the ACO structure to lobby Congress and negotiate more favorable Medicare payments and regulation (in fact, such activities are constitutionally protected under the the Noerr-Pennington doctrine). So we have to encourage provider integration without unduly increasing the strength of providers with respect to insurers or their regulators. This will be hard indeed and could be harder still with a weakened insurance industry.
All this suggests a confused focus in Washington, though one consistent with populist sentiment. Insurers, rightly or wrongly, are the scapegoat and providers (with the exception of the drug industry) are viewed more favorably. There are clearly insurance reforms worth implementing, but weakening insurers’ market power while strengthening that of providers may not be one of them.
Beating up on the insurers feels good but may not be the right medicine.
Law and (Armchair) Economics
One of the many reasons that non-economists should care about economics is the great degree to which economics – and in particular a certain kind of economics – has insinuated itself into law and policymaking in the area of legal regulation of competition. Competition (or “antitrust”) law has come to be dominated over the last forty years by the economics of the Chicago School, and its twin pillars, the hypotheses of efficient markets and rational actors. Though the text of the principal antitrust laws has not changed in nearly a hundred and twenty years, the colonization of antitrust jurisprudence by Chicago-school thought has resulted in increased skepticism by courts and regulators about the ability of market actors to restrain competition absent collusion, and a corresponding reluctance to intervene against conduct by individual firms.
Law, however, seems to have lagged academic economics by some decades. Within the Chicago tradition, “post-Chicago” economists have considered how market inefficiencies like externalities and transaction costs can create opportunities for strategic behavior (roughly, behavior that increases the welfare of an individual firm at greater expense to aggregate welfare) that cannot easily be negated by free market competition. And behavioral economists have shown how systematically “irrational” behavior by market actors can produce exploitable market inefficiencies as well. In short, contemporary economic research has moved beyond working out the consequences of efficient market theory to empirically invalidating the universality of its key assumptions. Yet in law (with the notable exception of the Microsoft case of the 1990s, on which I will write at length another time) it is as if most of these developments in economics since the 1970s had never happened. Perhaps until now.
Last Thursday, the Department of Justice began an antitrust inquiry of IBM regarding monopolization of the mainframe computer market. It is the first major antitrust inquiry regarding conduct by a single firm since the Clinton administration. The move follows the repudiation by current antitrust chief Christine Varney of the hands-off Bush-era guidelines for antitrust enforcement against single firm conduct. Varney rejected the report “because it was driven by two faulty assumptions. First, that anti-competitive conduct is too difficult to distinguish from lawful conduct to be enforced. And second, that enforcement in such instances would result in over-deterrence.”[1]
I call the sort of assumption-driven economics exemplified by the Bush guidelines “armchair economics” because it bases policy on how rational people would behave if markets were a certain way, rather than how actual people do behave in markets as they really are. While the change of administration has clearly brought new thinking to the Department of Justice, the impression of armchair economics may prove more indelible in the jurisprudence of our Supreme Court. I was reminded of this most forcefully when reviewing the Court’s 2004 decision in Verizon v. Trinko for a client last week.
Trinko concerned the obligation of a monopoly firm to deal with its would-be competitors. In the course of severely limiting such a duty, Justice Scalia, writing for the Court, without citation to any authority, pronounced: “The opportunity to charge monopoly prices–at least for a short period–is what attracts ‘business acumen’ in the first place; it induces risk taking that produces innovation and economic growth.”
Does it? Recently, I posted on the peculiar dynamics of pharmaceutical company research and development. I cited Scherer’s research showing that the dependence of expenditures on research in that industry on current cash flows was an exception to the norm best explained by “virtuous rent-seeking” – i.e., the pursuit of monopoly profits by legitimate means that Justice Scalia contends is the rule. More usually, companies invest in research and development with quantifiable (non-monopoly) returns in excess of their cost of capital largely without respect to current cash flows. I also noted analysis by the Congressional Budget Office suggesting that rent-seeking in the pharmaceutical industry may lead to over-investment from the standpoint of total welfare. So even if rent-seeking does drive some business investment, it is not empirically true that all such investment should encouraged.
In short, it is by no means self-evident that the opportunity to charge monopoly prices is a principal driver of business investment, or that investment directed toward that end is always efficient. Whether either proposition is the case in a particular instance is liable to depend on particular facts. It is unfortunate when the highest court’s armchair economics makes fact-imperviousness a feature of positive law.
Economics of Antitrust: Hospital Mergers
This post has been cited by the Carnival of Financial Planning #99, hosted by The Skilled Investor.
Close readers of this blog may have noticed my recent interest in issues pertaining to antitrust and competition, particularly in health care. Though I study and publish on topics related to competition among private comprehensive and drug plans in Medicare, until recently I had not read much in the economics antitrust literature. I’m beginning to rectify that deficiency.
There is a large body of literature on the economics and policy of antitrust with respect to hospital mergers. Many of the ideas apply more generally so it is as good a place to start as any. How does an economist or a court measure and reason about the state of competition in a market for hospital services?
A summary of the issues pertaining to this question is provided in a 2002 paper by Capps, Dranove, Greenstein, and Satterthwaite in The Antitrust Bulletin (Antitrust Policy and Hospital Mergers: Recommendations for a New Approach 47(4), 2002) and other publications by the same authors around the same time. The 1990s saw a lot of hospital mergers, over 900 of them. The merging of hospitals can increase the market power the merged entity has with respect to insurers, permitting the extraction of higher payments for inclusion in health plan networks and being a hinderance to competition.
The Federal Trade Commission (FTC) and the Department of Justice (DoJ) lost six straight hospital antitrust cases in the 1990s. In all but one instance the definition of relevant geographic market was instrumental in the defeat. Hospitals claimed that the market was geographically large, encompassing many other hospitals. This caused the merged entity’s market share to appear low and buoyed the defendant’s claim that the merger did not increase market power to anticompetitive levels.
The approach taken in these cases to justify a market area definition was proposed by Elzinga and Hogarty in 1972 (The Demand for Beer, The Review of Economics and Statistics 54(20)). The Elzinga/Hogarty (E/H) approach is based on the flow of consumers (or patients or goods) across a market boundary. The market area is expanded until the inflow and outflow are below a cutoff (typically 10% of total market volume).
Capps, et al. make an excellent argument as to why the E/H approach can be irrelevant to issues of market power. It all comes down to selection bias. Thinking about the case of hospitals, what if patients that travel further (”travelers”) are fundamentally different than those that do not (”non-travelers”)? It is reasonable to expect that travelers for hospital care have a different taste for travel due to their condition. One is typically more willing to travel further for specialty care for certain conditions than for routine treatments for common conditions. Thus, travelers and non-travelers can be fundamentally different. The willingness of some to travel does not eliminate the market power that hospitals have locally with respect to non-travelers. The E/H approach is flawed.
Whoops! Too bad so many cases were decided on the basis of E/H methodology. What to do? Capps et al. propose three alternatives for the case of hospitals, some of which are more generally applicable (see their “Silent Majority” and “Option Demand Markets” papers [free working paper version of the latter]). All three approaches are based on statistical and econometric analysis of the causes and degree of substitutability of one hospital for another using logit models. From these models one can estimate own- and cross-price elasticities and, hence, markups (such things are explained in What Is the Source of Price Setting Power).
With a methodology to estimate markups, Capps, et al. can define a market based on the DoJ and FTC concept of a “small but significant non-transitory increase in price” (SSNIP). If the hospitals within a market can implement a SSNIP as a joint monopoly then they are highly substitutable when in competition and therefor are a relevant set of competitors. If not then the market is increased to include other hospitals until a threshold SSNIP is reached. Within a market so defined, the methodology of Capps, et al. can be applied to estimate markups that would occur under a merger of any subset of market participants.
Is this new methodology being accepted by courts in antitrust cases? As I learned at the 2009 AcademyHealth meeting there was a recent success. Aparently a court invalidated a merger of several northern Illinois hospitals on the basis of SSNIP and not E/H analysis. It is nice to see evidence of the relevance of progress in economics.
Later: See also Dranove, Sfekas. (2009). The Revolution in Health Care Antitrust: New Methods and Provocative Implications. The Milbank Quarterly 87(3):607-632.
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