Sympathy for the Insurance Companies
When assessing the effects of market concentration on competition, antitrust authorities look not just at how many competitors there are in a market, but also how they compete. In one standard model, called Cournot competition, producers set levels of output, and prices adjust in relation to supply. In another model, called Bertrand competition, producers set prices, and produce quantities sufficient to meet demand at the prices they set. In pure Cournot competition, prices vary substantially based on the number of competitors in the market. In a Cournot duopoly (a market with two competitors setting output), the producers will between them extract half of a monopoly profit. But pure Bertrand competition pushes prices down toward marginal costs no matter how many competitors there are.
While the differences between Cournot and Bertrand competition are fundamental concepts of antitrust economics, they seem to have been lost in the race to pin responsibility for rising premiums on concentration in the insurance industry. While the details of competition among insurers is complex and does not strictly follow any simple model, at a basic level they appear to engage in Bertrand competition for the business of insureds, i.e., they set premiums, and write as many policies as corresponding demand requires. In this case, we should expect them to compete prices down toward their costs regardless of market concentration. And we in fact see that insurers’ profit margins are relatively modest despite a longstanding trend of consolidation in the industry.
Providers, on the other hand, seem to engage (again, at a basic level) in Cournot competition. They produce a given amount of capacity — building hospital beds, hiring physicians — and then negotiate with insurers over the price to use it. If this is correct, then concentration in the provider market should have a significant impact on the prices that providers can charge insurers, and that insurers ultimately pass on to insureds. By the same token, concentration in the insurer market should allow insurers to pay lower prices to providers because they are also engaging in Cournot competition on the buy side — they have a certain amount of demand that is set by the needs of their insureds, and they bargain with providers over the price of fulfilling it. But because insurers are engaged in Bertrand competition on the sell side, they will tend to pass these savings on to their insureds notwithstanding their market concentration.
In this simple model at least, the ideal situation for insureds is to have a concentrated insurance market that approaches Bertrand duopoly on the sell side and Cournot duopsony (two buyers who set demand and take prices) on the buy side, with a competitive market for providers. Of course, there are complexities — such as product differentiation, switching costs, and homing asymmetries — that can both attenuate and amplify the effect of this basic market structure for consumers, and I hope to address some of them in later posts. But other things being equal, the implication is clear: concentration in the insurance industry does not necessarily harm and may well benefit consumers, while concentration among providers is a prescription for higher costs.
The Trigger: Hacker’s Competitive Check?
Jacob Hacker, the “godfather” of the public option, doesn’t like the Senate’s compromise as it would apply to those below 55 years old. It would tap the Office of Personnel Management to oversee national non-profit health plans, which Hacker believes will increase the market share of Blue Cross and Blue Shield, the “most likely national non-profit to take advantage of this new opening”. He continues,
Without an imminent threat of real competition, a strong benchmark, and effective regulations to back them up, private insurers are likely to raise premiums in anticipation of the implementation of reform.
Hacker is right. While a dominant insurer, or several large ones, can negotiate lower prices, there is no guarantee those low prices will be passed on to consumers in form of lower premiums. One way to get them to do so is via an “imminent threat of real competition” in the form of a federal plan (a real public option) that would enter if premiums are not sufficiently close to costs. That is, a trigger should be defined in terms that protect consumers from the otherwise monopolistic behavior of insurers, among other things. However, preserving the monopsonistic feature of a large buyer is still worthwhile.
This is precisely the notion of contestability, identified in the health economics literature (and elsewhere) and about which I wrote before. A government plan in waiting that serves to keep pressure on private insurers is the right role for a triggered public option even within the current compromise. Whether it is crafted to work in the fashion Hacker seems to endorse and I just sketched out remains to be seen. I am skeptical but hopeful.
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.
Insurer vs. Provider Market Power: What’s in It for Consumers?
Last week Ian and I described the risks involved in repealing health insurers’ exemption from national antitrust law. The argument encouraged a focus on the balance of market power between insurers and providers.
If health care providers have relatively more power they can charge relatively higher prices. That’s bad for consumers. On the other hand, if insurers have relatively more power they can bargain down the price of care. That’s good for consumers if those lower prices are passed on to them in the form of lower premiums. (Also, lower premiums mean lower tax-funded subsidies. That’s good for taxpayers.)
Why would an insurer that commands low prices pass the savings on to consumers? Why wouldn’t such a dominant insurer simply keep the savings for itself? These questions focus precisely on the critical balance needed for a welfare-maximizing insurer-provider market relationship. While the questions about health care markets are exceedingly tricky (formally in the domain of two-sided market theory), we can look elsewhere for some intuition.
Think Wal-Mart. It is a high-volume purchaser of many goods and, as such, commands low prices. It has market power as a purchaser. It also commands a large share of the retail market. From this fact alone it would seem to have substantial market power as a seller, enough that it could charge high prices. But it doesn’t. Wal-Mart is faced with competition significant enough that it must sell its goods at low prices. To a large extent the bargains Wal-Mart achieves as a purchaser are passed through as savings to consumers.
The competition Wal-Mart faces is not only that of other retailers in the market but also from potential market entrants. If Wal-Mart raises its prices it risks inviting the entrance of other retailers who would offer goods for less. This is the notion of contestability described by Foreman, Wilson, and Scheffler, which I described in an earlier post (Will a Monopsony Health Insurer Reduce Premiums?).
In the health insurance market, what might be the entrant in waiting? One answer is the fallback version of the public option, which is the version favored by Olympia Snowe and picked by me last spring as the winning political compromise. For the fallback option to be the source of contestability in a market its entrance would have to be triggered on some measure of insurance premium markup. If premiums were found to be too high relative to the prices paid by the insurer for care that would trigger a public option in that market.
While it may not yet be precisely clear to anyone, economists included, exactly how to structure health care markets to maximize consumer welfare, it is clear that to have any chance of doing so one must view the market as a whole. The market power relationships among providers and insurers and how those relate to government regulation and the threat of market entry of a public plan are critical. One cannot single out insurers (or providers) as the target of reform and expect a good outcome.
The health care market is a complex multi-sided system–a system that is broken in more than one way. A broken, complex system requires a comprehensive solution.
Let’s Talk Price
In Why Are Some Companies Hated By Consumers?The Finance Buff (TFB) describes the reasons why he hates AT&T, Apple, and BlackBerry. He finds frustrating the constraints they impose on users about which devices can be used on which network. He laments the higher prices charged for service plans that offer more features.
Can I get a data-only plan on the BlackBerry? Yes, AT&T has one for $35 a month, but I can’t get the BlackBerry to synchronize with my work e-mails, calendar, and address book. AT&T’s $35-a-month data plan is called BlackBerry Personal, which only gives you access to personal e-mails and web browsing. To use it with corporate e-mails and calendar, you have to buy AT&T’s BlackBerry Enterprise service, which is $50 a month. Come on, data is data.
I feel his pain. I find myself getting angry sometimes when the thing I want costs more than what I want to pay for it, that is when my reservation price is below the market price. Yet there are lots of things I’d like that I think are too costly. Am I angry that I can’t buy a personal jet? That I can’t have a yacht? That I can’t afford live-in staff? No. Why not? What’s going on?
First of all, I never want to pay more than marginal cost. I want every market in which I’m a buyer to be perfectly competitive. If that were the case then TFB could get the BlackBerry Enterprise service for less than the $50/month he doesn’t want to pay. Since, as he says, “data is data,” then in a perfectly competitive market he would only need to pay the marginal cost of transmitting the data. It wouldn’t matter whether it is corporate or personal data.
Most markets aren’t perfectly competitive. So long as the lack of competition isn’t brought about by anti-competitive practices then there is nothing illegal about it. (Whether or not that is the case in the markets TFB described I do not know.) Imperfect competition arises for many legitimate reasons. Markups above marginal cost are to be expected in imperfectly competitive markets and are related to patterns of consumer demand (as I explained in What Is the Source of Price Setting Power).
When I find the market price of a good or service upsetting it helps me to think about the economics. I am calmed by the understanding that the above-marginal-cost price serves a useful role in allocating the limited resource to those who value it most. When my reservation price is below the market price it means I don’t want it as much as someone who’s reservation price is above the market price. Put another way, I cannot extract positive consumer surplus (a measure of satisfaction) from the good or service at the market price while others can (for more on consumer surplus see An Illustrative Welfare Analysis of Google Reader). Shouldn’t those who can extract higher consumer surplus get the good?
So why does it not upset me that I can’t buy a jet or yacht or live-in staff? It isn’t necessarily that my reservation price is below market price. It is the fact that I cannot afford them. That’s a different problem. I’m not upset by things I cannot afford. When I forget the economics I might get angry when something I can afford is literally over-priced for me. I think that may be what is bothering TFB too. It isn’t that the market price is too high (presuming no illegal anti-competitive behavior), it is that his reservation price is too low. He doesn’t value the BlackBerry Enterprise service enough. So he doesn’t buy it. That’s a perfectly reasonable outcome even in an imperfectly competitive market.
What Is the Source of Price Setting Power?
This post originally appeared on The Finance Buff and was cited in the 208th edition of the Carnival of Personal Finance.
It is a common feeling among consumers that some firms charge “more than they should” for their products. Microsoft is a favorite example. What is the source of such price setting power? Many would respond: “supply and demand” or “monopolistic behavior.” In this post I dig a bit deeper.
In a prior post on the economic welfare of Google Reader I noted that in a perfectly competitive market economic welfare (of the classical sort) is maximized: the sum of the value to consumers above price paid and producer profit cannot be higher. A perfectly competitive market for a product requires, among other things, (1) barrier-free market participation and (2) no variation across producers in the product’s characteristics. Markets that come close to satisfying these requirements are rare and include those for agricultural commodities and those provided by stock exchanges. There are many traders of both grade 3 hard red wheat and Google equity. Anyone can participate in the exchanges in which futures contracts of the former and shares of the latter are traded. Properties of both are homogeneous.
The price of a good in a perfectly competitive market is the marginal cost of producing the good. This price is lower than it would be if either of the properties listed above were violated. The difference between the price under imperfect and perfect competition relative to marginal cost is known as the markup (source, p. 184). (Note that markup used here does not measure the amount by which retail price exceeds wholesale price. Imperfect competition leads to markups of the wholesale price itself.)
Thus, we can write
[Eqn. 1] market price = (marginal cost) x (1 + markup),
where markup is always nonnegative (and is zero under perfect competition). Since perfect competition is rare, markups are common; we pay them all the time. For example, for its Office product Microsoft receives much more than it would if competition for software were perfect. In Medicare, the market for stand alone prescription drug plans (PDPs) seems to be more competitive with lower markups than compared to the Medicare Advantage (MA) market.
Markups quantify “price setting power” or “market power.” The source of this power and the determinant of the size of the markup is the structure of consumer demand. To explore this further, consider a market for health insurance in which two firms, A and B, each offer a slightly different health insurance plan. Such a market has barriers to entry: insurance regulatory requirements, establishment of provider networks, among others. The products in the market are said to be “differentiated,” each plan is unique in some way (different benefits, costs, provider network, and so on). The conditions for perfect competition are violated. Markups will exist.
Suppose Eqn. 1 is the market price (premium) for plan A. With a bit of calculus and algebra well beyond the scope of this post (Hal Varian’s “conjectural variations”) one can show that the markup for plan A depends on two quantities: the proportional rates at which consumers reject plan A in favor of plan B as (1) plan A’s price increases, and (2) plan B’s price decreases. The first of these is known as plan A’s (own) price elasticity of demand. The second is the cross price elasticity of demand for plan A relative to price of plan B. Swapping A’s for B’s gives a similar set of elasticities for plan B. It is only sensible that own price elasticity is negative, indicating a plan’s enrollment decreases as its price increases. Because plan A and B are substitutes cross price elasticity is positive, indicating a plan’s enrollment decreases as its competitor’s price decreases. Price elasticities of demand encapsulate consumer preferences and patterns of substitution among products. They measure how much more (or less) of a product we would purchase when its price or that of substitutes for it (competitors) changes.
When studying a market with large numbers of products (e.g., breakfast cereals, automobiles), it is unwieldy to work with cross price elasticities between all product pairs. Clever techniques that relate elasticities to product characteristics have been developed for such circumstances (one source, another). Since the number of characteristics of principal importance to consumers can be much smaller than the number of products, this greatly simplifies analysis. (Consider automobiles, of which there are hundreds. How many product characteristics are important to you? Likely far fewer than 100. Maybe closer to 10.)
There is a beautiful circularity in all this. Price is a function of markup. In turn, markup is a function of consumer preferences with respect to substitutability. Substitutability patterns can be described in terms of characteristics of the products. Yet a product’s characteristics can be a function of the price the producer expects to receive for it. Consider an insurer designing a health insurance plan. If the insurer expects a high price (high markup) it might build in more generous benefits (product characteristics) than if it expected a low price. In the jargon of economics, price is endogenous in that it is determined simultaneously with other product characteristics. Fortunately, there are techniques for breaking the circularity problem to estimate elasticities free of the effects of bias due to endogeneity.
Of course, as consumers, we need not worry about the producer’s simultaneity problem in product design. Yet, because our collective patterns of demand and substitution drive markup and price, we play a key role in the process, one we don’t ordinarily consider. Each time you face the wall of breakfast cereals (or lot of cars or any other set of substitutable products), judging prices and characteristics, you’re voting with your wallet. When the prices adjust and your purchasing patterns with them you’ve just made a tiny contribution to the values of relevant cross price elasticities. So what’s the source of price setting power? In a sense, you are.
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