The medical arms race

This is a TIE-U post associated with Jonathan Kolstad’s The Economics of Health Care and Policy (Penn’s HCMG 903-001, Spring 2012). For other posts in this series, see the course intro.

Standard economics theory teaches us that competition increases “social welfare.” But that theory is premised on a market with certain attributes that are not always present. (Strictly speaking, they’re never present, but some markets get “close enough.”) In particular, health care markets (e.g., for hospital services) deviate considerably from perfection. Consequently, competition may either increase or decrease social welfare. It’s an empirical question.

In “Is hospital competition socially wasteful?” Daniel Kessler and Mark McClellan [1] (ungated pdf available) take up that question. They study elderly Medicare beneficiaries hospitalized with cardiac conditions between 1985 and 1994. Since this period overlaps dramatic change in the nature of insurance (moving from indemnity coverage to HMOs), the authors are able to explore the impact of network contracting and managed care on the relationship between hospital competition and spending and outcomes.

We find that, before 1991, competition led to higher costs and, in some cases, lower rates of adverse health outcomes for elderly Americans with heart disease; but after 1990, competition led both to substantially lower costs and significantly lower rates of adverse outcomes. Thus, after 1990, hospital competition unambiguously improves social welfare. Increasing HMO enrollment over the sample period partially explains the dramatic change in the impact of hospital competition; hospital competition is unambiguously welfare-improving throughout the sample period in geographic areas with above-median HMO enrollment rates. Furthermore, point estimates of the magnitude of the welfare benefits of competition are uniformly larger for patients from states with high HMO enrollment as of their admission date, as compared with patients from states with low HMO enrollment.

The analysis is based on an assumption that the relative distance from a patient’s residence to two different hospitals is uncorrelated with unobservable factors that also affect cost and health outcomes. This type of “differential distance” instrument is not universally accepted as valid. One concern a critic might have is that hospitals may select their relative locations (or arrive at them via closings, mergers, etc.) in ways that do depend on important, unobservable patient factors. Obviously a hospital is not sited based on the characteristics of a single patient, but they may be sited based on the characteristics of a population and with knowledge of competitors’ locations, which some worry could introduce a systematic bias.

Having written all that, let’s, for the moment, take the results as given. How does competition among hospitals drive spending up in the pre-1991 period? The classic answer is “the medical arms race.” When insurers were relatively weak, pass-through entities, as they were before the era of managed care, hospitals did not compete on price. They competed on technology and amenities. In trying to one-up each other to attract patients, they drove cost and price up. Insurers paid it so what did the hospitals care?

The incentives of managed care (network contracting, among other things), wrung some of this from the system. Hospitals were rewarded for low prices. In a competitive market, HMOs would cut hospitals out of their network if prices rose too quickly. In such a market, technology and amenities that didn’t drive costs down were no longer profitably offered.

This medical arms race story parallels the cost shifting one I’ve told before. Like cost shifting, the medical arms race is slowed by insurers with market power in markets with sufficient competition among hospitals. As hospitals continue to consolidate and integrate with other providers (e.g., as encouraged by the ACO movement), I wonder if the medical arms race will return. If the literature supports it, an enterprising researcher could write a review article of the medical arms race literature that is the analog of my Milbank Quarterly cost shifting one. The conclusion might speculate on what we might expect in the coming years.

I’ve thought about working on such a paper myself, but I’m not likely to, not on my own or soon anyway. So, it’s just sitting there for the taking. However, for that reason, economic theory suggests that this cannot be a valuable opportunity. On the other hand, as in the social welfare of competition in hospital markets, economic theory can be ambiguous.


Kessler, Daniel and Mark McClellan (2000). “Is Hospital Competition Socially Wasteful?” Quarterly Journal of Economics, pp. 577-615.

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