• The industrial organization of health care markets

    That’s the title of a new NBER working paper by Martin Gaynor, Kate Ho, and Robert Town. I confess to not reading the whole thing thoroughly, yet it’s worth knowing about if only for reference. Here are a few highlights:

    The hospital sector, at $850.6 billion, represents 5.6% of US GDP, physician services constitute 3.6%, and health insurance is 1%. [Footnote: Health insurance is measured as the “net cost of health insurance,” the difference between premiums collected and benefits paid in a calendar year.] This makes the hospital and physician sectors some of the largest industries in the US economy, larger than construction (3.6% of GDP), mining and oil and gas extraction (1.95%), agriculture (1.37%), computer and electronic products (1.29%), broadcasting and telecommunications (2.5%), automobile manufacturing (0.33%), or even breweries (0.11%).

    Even breweries!!! 

    Employers pass through higher health care costs dollar for dollar to workers, either by reducing wages or fringe benefits, or even dropping health insurance coverage entirely (see, e.g., Gruber, 1994; Bhattacharya and Bundorf, 2005; Baicker and Chandra, 2006; Emanuel and Fuchs, 2008) [Links added.]

    I know this well-supported fact is very hard for some people to swallow. Consider this a test of how scientific you are.

    We structure our discussion of this literature around a multi-stage model of the market. In the first stage providers (hospitals and physicians) make investments that determine their quality. In addition to being influenced by horizontal competition, these investments may be affected by demand-side factors such as the amount of information on quality that is provided to consumers and the amount of choice they are offered when they need medical care. In the second stage, given their quality levels, providers negotiate with insurers to determine insurers’ provider networks and the prices paid to providers. This complex interaction has been analyzed in a growing number of papers; it has substantial implications for consumer welfare and for costs. Third, insurers choose their premiums to maximize their objective functions, taking into account their own characteristics and those of competing insurers. In the fourth stage consumers observe each insurer’s provider network and other characteristics, including premiums, and choose their insurers. Finally, when the enrollment process is complete, some consumers get sick and utilize providers either from within their insurers’ networks or (incurring a larger out-of-pocket payment) from outside the network.

    Each stage of this model has an impact on the equilibrium outcome, and therefore on welfare. Clearly every stage is related to the others: optimal choices in one stage are functions of expectations regarding the rest.

    It’s probably surprising to non-health economists how much we don’t know about health care markets, though we know some things. This passage suggests why. It’s extremely complex. The authors continue,

    [V]ery few papers try to address more than one or two stages of the model, in part because of modeling issues (model complexity and the difficulty of identifying a complete model of all the stages), and in part due to lack of data required to estimate a complete model. Most instead focus on one of the stages.

    The rest of the paper, which walks through what is known about the various linkages in health care markets, is worth at least a skim, just to know what’s in it.


  • Bilateral oligopoly: Some help from the blogosphere

    I know Joshua Gans only in the sense that I read his blog, have exchanged a handful of e-mails with him, and have heard him on a radio program or two. Despite that rather weak (non)relationship, he kindly sent me the following in response to my request for leads on bilateral oligopoly theory:

    Start here:

    Also look up the work of McAfee and Hendricks.I recall that David Dranove also has a paper as does a Matt Grennan at Rotman (Toronto) on health insurance specifically.

    Now I feel bad that I haven’t yet read Gans’ book, Parentonomics: An Economist Dad Looks at Parenting. I do think I’d enjoy it. It’s now on my reading list.

  • Hospital antitrust considerations

    I struggle to understand health care antitrust issues. It’s not for lack of trying. It’s just that I find much writing by lawyers to be difficult to parse. Not so the 2010 Boston University Law Review article by Erica Rice titled “Evanston’s Legacy: A Prescription for Addressing Two-Stage Competition in Hospital Merger Antitrust Analysis.” Even with a title like that, it is very readable. For those interested in antitrust, I recommend reading the whole thing.

    Back-story: The 2007 case of the Evanston Northwestern Healthcare Corporation (ENH) reversed government’s ten-year-plus losing streak in challenging hospital mergers. The case was notable for several other reasons. It was a rare post-merger challenge, coming years after the year 2000 consummation of ENH’s merger with Lakeland Health Services in Northern Illinois. More importantly for Rice’s analysis, the court focused on “first-stage” competition–that between hospitals and managed care organizations–and not “second stage competition”–in which hospitals compete for patients.  That is, the ENH case was adjudicated in the context of the balance of power between hospitals and insurers, a focus of this blog over the past year.

    Rice’s article is in three parts. I’ll mostly focus on Parts I and II, which provide an overview of antitrust enforcement and reviews some basic concepts in analysis of anticompetitive effects of hospital mergers.

    With respect to mergers, the Agencies’ [FTC’s and DOJ’s] antitrust work generally occurs before a merger is consummated. [… F]irms of sufficient size wishing to merge must notify the Agencies of their intentions. […] [Over the next] thirty days, the Agencies will decide whether to challenge the merger as anticompetitive.  […]

    If the Agencies determine, according to the [1992 Horizontal] Merger Guidelines, that the merger would lead to anticompetitive effects, they can go to a federal court and request a preliminary injunction. Often the threat of a preliminary injunction will cause the parties to abandon the proposed merger [… or if] the court grants the injunction, the parties usually abandon the merger plans. […]

    [T]he [1996] Health Care Guidelines defined a “safety zone” for acute care hospital mergers that will generally not be challenged under antitrust laws. The safety zone applies if one of the hospitals involved in the merger has an average of fewer than one hundred beds and fewer than forty inpatients at a time over the past three years. The safety zone does not apply if that hospital is less than five years old.

    If a merger falls outside the safety zone, it will be evaluated under the five analytical steps in the Merger Guidelines, which are applicable to all industries. The five steps are: 1) market definition, measurement and concentration; 2) the potential adverse competitive effects of mergers; 3) entry analysis; 4) efficiencies; and 5) failure and exiting assets.

    These five steps provide, roughly, an outline for Part II of Rice’s article. Below I focus on market definitions and some of the arguments used to rebut the presumption of anticompetitive effects, those based on entry, efficiencies, and failing firms.

    Market Definition(s). The first step of analysis toward a determination of anticompetitive effects is to define the market. That has two parts, definition of the product market and definition of the geographic market. What is the product market for a hospital? Is it all inpatient and outpatient services? Or are those two separate markets? In FTC v. Butterworth Health Corp., the court ruled that the choice between inpatient and outpatient care is made on the basis of “medical judgement” and not cost. Therefore, they are not substitutes and do not belong to the same product market. A related product market question is whether anchor (or “must have” or “star”) hospitals really compete in the same market as other hospitals.

    I’ve discussed ideas pertaining to geographic market definition in two prior posts, so I’ll skip it here. I’ve also written extensively on the market concentration (mis)measurement used by DOJ/FTC, Herfindahl index or Herfindahl-Hirschman index (HHI), so I’ll skip that too.

    Rebuttals. A merger that causes an HHI increase of more than 100 points in a highly concentrated market (HHI above 2500, according to revised Horizontal Merger Guidelines) is presumed anticompetitive. Firms can rebut this presumption in several ways. If there are no significant barriers to entry than the high HHI will draw competitors. Thus, the merger is unlikely to have anticompetitive effects. The hospital industry has large regulatory barriers to entry so this is not a reasonable defense in that industry.

    A second defense hinges on efficiencies. Rice writes,

    A merger is not anticompetitive if it exploits efficiencies and passes the benefits on to consumers. […] Over time, courts have become more willing to accept hospitals’ claims that savings and efficiencies will lead to benefits for consumers that will far outweigh any anticompetitive effects of a merger. [… E]fficiencies defenses have been hugely successful for hospitals, allowing them to realize a seven-case winning streak against the government in hospital merger antitrust enforcement actions.

    A final defense is that one of the firms involved in a merger would otherwise fail (and meets other criteria).

    The remainder of Rice’s article focuses on the ENH case specifically and draws lessons in several areas. In particular, she notes the need for a focus on how hospital prices are set,

    [T]he ALJ [administrative law judge] in Evanston explicitly differentiated between the two stages of competition, identifying the “relationship between hospital[] and managed care organizations” as “first stage competition” and the “relationship between patients and hospitals” as “second stage competition.” Importantly, the ALJ recognized that competition at the second stage is not based on price because prices are set at the first stage when hospitals contract with MCOs. Thus, hospitals compete to attract patients through other nonprice factors. Because the underlying question in any antitrust merger analysis is whether the merged entity will be able to exploit market power to raise prices above the competitive level, the ALJ rightly determined that the “critical concern” was the merger’s effects on first stage competition.

    The problem with ignoring the complexity of hospital competition is that antitrust analysis differs depending on which stage of competition the analysis is based. For example, “both product and geographic markets may differ between the first and second stages of competition . . . , and the effect of a hospital merger, may differ across the two stages.” Clearly, which stage is used can greatly affect the outcome. A reduction in competition at one stage does not necessarily imply a reduction at the other. Going forward, courts should clearly explain who the relevant consumer is and at which stage potential anticompetitive effects are being evaluated.

    To me, the careful distinction between the implications of competition between hospitals and insurers for those entities versus for consumers is critical. In particular, one cannot conclude consumer harm from a concentrated hospital market or a concentrated insurer market. As I’ve written many times, it’s the balance of power between the two that is relevant (as in the figure in this post). Moreover, as Rice points out, market definitions may differ in the two stages, further challenging our ability to draw inferences about one market from characteristics of the other.

    In cases where illegal market power is found, guidelines for allocating damages among the entities at various levels of competition (direct and indirect payers) have yet to be established. Now throw in the fact that the health care market landscape will shift as consumers pay more for care (consumer directed health plans) and hospitals and their associated integrated delivery system are at higher risk for costs and have even high market power (ACOs), and antitrust regulators and courts have a very complex market to parse.

    If you’ve read this much, you’ll likely enjoy reading Rice’s full article. It’s worth it, and I left out a lot.

  • Health care is different (no, I’m not done with this yet)

    Last Friday, I suggested readers try to come up with other industries that share the following property with health care: the quality of the outcomes, what you ultimately are buying, depends not just on what you directly pay for but also your own personal characteristics. That is, you, or your insurance company, or the government, buy services from health providers and some health-related products (e.g. drugs). What you ultimately want is health. The quality of the health you achieve is not merely determined by the medical goods and services but by your own traits, habits, genetics, and so forth.

    What else is like that? Education. It is exactly like that. You or your parents or your government pay for teachers and school buildings. What you want is knowledge and skills. The quality of the knowledge and skills you walk away with depends, in large part, on you (and your family and community), not just on your teachers and books.

    A less good example is, perhaps, gym memberships. You pay for the facility, equipment, and trainer. What you get out of it in terms of fitness depends a lot on what you put in, your own habits and effort. Commercial diet plans and products are like this too. So is marriage or any relationship (though those aren’t industries). How it turns out depends a lot on you.

    But one way in which health care is pretty different from education and gym memberships and everything else I can think of that has quality that depends on personal characteristics is this: the poorer quality the outcomes the more you consume.* Why? Because if you stop when things get worse you might die. If you have a minor and routine operation and you get an infection, you don’t stop consuming care. You don’t say, “Health care sucks. I’m outta here.” No, you pack your body with antibiotics and do what the doctor orders. If you should happen to have an allergic reaction to the antibiotics or other things go haywire and organs begin to shut down, you generally don’t call it a life, you go on the ventilator, the dialysis machine, … you do what it takes. (You’ll consume more auto mechanic services as things go wrong too, but that’s just one way health care is like auto repair. It isn’t like it in other ways.)

    Going back to my earlier posts on how health care is different, I believe health care is unique in that it has all of the following three characteristics:

    • It involves mortality and morbidity,
    • Quality of outcomes depend, in part, on personal characteristics,
    • The worse the outcome, the more you consume.

    These are not trivial aspects of the industry. The are essential features of it that contribute to why we consume health care the way we do (we can’t easily accept that poorer health states can’t be improved), why it is psychologically difficult to commit to doing otherwise (death and illness are powerful motivators of consumption), and why it is hard to agree on how to allocate the cost risk (heterogeneity really matters since outcomes depend on individual characteristics–do people in different circumstances deserve the same burden of cost risk?). Add to these information asymmetry, third-party payment, the importance of trust in the provider, barriers to entry, differentiated and complex products, and the fact that providers, like everyone else, want good and increasing standards of living and you’ve got something that bears very little resemblance to any other industry.

    So, finally, I conclude that the notion that health care is like some other industry is, well, just wrong. It is only like this or that in a small number of dimensions, not including the combination of all three bulleted ones above. Thus, health care in total is not like anything else, and it never will be.

    Really, this should be self-evident. If health care were so much like cell phones or auto repair or credit cards we’d have solved the health care cost problem by now. There are reasons it is a hard problem, why all previous well-intentioned approaches have failed (manged care, Medicare PPS, Medicare Advantage and its predecessors, and so on), and they are not all entirely due to politics, though it plays a large role. Health care is deeply personal, complicated, and deals with scary stuff. Treating it like it is just another commodity completely misses what is so diabolically special about it. That’s not to say we can’t make headway on health care and its costs. I just don’t think we can do so by trivializing its unique combination of important characteristics. We have to embrace and understand its full complexity and do something that respects the totality of health care and our relationship with it. And, on top if it all, we can only do something that is also politically viable.

    What is that something? I won’t even pretend I know. I seriously doubt anyone truly does.

    *Having a bad health outcome doesn’t require any use of care. Even folks who use no care can have bad health outcomes. In fact, failure to deal obtain good, preventative or maintenance care is a standard way toward poor health. Nevertheless, those who use care and, for whatever reason, experience a bad outcome, are likely to seek more, not less, care.

  • Health care is different (what I forgot)

    This is my fourth “health care is different” post this week (links to first and second and third). What I forgot in the others was this: the ultimate “product” we attempt to buy with health care spending is health, not health insurance, not health services, but health. The important thing that follows is that the quality of health, unlike that of many other goods and services, is not just a function of that for which we directly pay. It isn’t a function only of the characteristics of health care providers or of health care insurers. It’s also a function of your personal characteristics.

    That is, whether you experience good or poor health outcomes depends, in part, on things about you, as well as things about the care you receive. That makes health care very different from many other products and services. (I can think of a few others that also have this dependence on personal characteristics. As a weekend exercise, I’ll let you ponder.)

    That’s also exactly why health policy is hard. How much about individuals ought to be considered when crafting policy? How responsible can and should people be about their health? Do the unhealthy get penalized because their lifestyle contributed to their condition? Or is their circumstance the result of random events over which they had no control (and, so, you could be next)? Of course, it is some of both. But what does that mean for subsidies, for insurance design, and so forth?

    Health care is not like buying a cell phone. There’s nothing about you that changes the nature of the quality of the cell phone. It’s got specs. They’re invariant to who picks up the device. But two people who get the same operation from the same doctor could experience very different outcomes leading to very different down-stream costs. What do we do about that? Who pays? And why? These are not simple questions.

  • Collusion, entry barriers, and economies of scale/scope

    Recently, I explained that there are many possible causes of high market concentration. Furthermore, its effect on consumer price and market entry is theoretically ambiguous. In principle, dominant firms in concentrated markets (such as those in many health insurance markets today) could benefit from economies of scale or scope. If the resulting cost savings are not retained by the dominant firms, consumers may benefit from lower prices. This could happen if there exists the plausible entry of a potential rival that would undercut the dominant firms if they raised their prices.

    On the other hand,* if economies of scale or scope don’t exist or are not large, there may be no consumer benefit from market concentration. There only exists downside risk of higher prices, particularly in the presence of barriers to entry. An unpublished paper presented to the Chicago Fed in March 2010 by Hilliard, Ghosh, and Santerre (pdf of slides available) describes what is known about these factors with respect to health insurance, providing some useful references in the literature.

    Demsetz (1973) argues that while the large firm‐sizes involved in concentrated markets may make collusion more likely, they may also allow exploitation of economies of scale and scope. Such concentrated markets may be beneficial to consumers, if the cost savings are passed on in the form of lower prices. There is little evidence, though, that scale and scope economies are important for health insurance. Engberg, et al. (2004) is the most recent study to reject the presence of scale economies in health insurance. …

    The AMA suggests that exclusive control over health care provider networks acts as a sufficiently high entry barrier to prevent competitiveness. … [N]ew entry can … [also] be prevented if high concentration permits existing firms to prevent [rental] access to their networks in an effort to counter new business. Furthermore, contestability theory suggests that high sunk costs may deter entry by acting as an exit barrier (Baumol, et al. (1982)). … [I]mportant start‐up costs that are not recoverable include marketing and the cost of setting up provider networks (when renting is too expensive), which may be sufficient to deter entry. Perhaps the most significant barrier to entry, relatively unique to health insurers, is very high consumer switching costs. Samuelson and Zeckhauser (1988) show that status quo bias generates high insurance switching costs in general. This bias is amplified when most customers obtain health insurance through employer‐sponsored group plans with limited provider networks.

    Not mentioned by the authors are barriers to entry associated with state regulation. If compliance with state rules about network adequacy or other properties of product offerings is challenging (perhaps due to lobbying by incumbent firms), that is a deterrence to entry as well.

    *Economists always have another hand handy. Annoying, isn’t it?


    Baumol, W. J., J. C. Panzar, and R. D. Willig, 1982, Contestable markets and the theory of industry structure (San Diego: Harcourt Brace Jovanovich).

    Demsetz, H., 1973, Industry structure, market rivalry, and public policy, Journal of Law and Economics 16, 1‐9.

    Engberg, J., D. Wholey, R. Feldman, and J. B. Christianson, 2004, The effect of mergers on firms’ costs: Evidence from the HMO industry, The Quarterly Review of Economics and Finance 44, 574‐600.

    Samuelson, W., and R. Zeckhauser, 1988, Status quo bias in decision making, Journal of Risk and Uncertainty 1, 7‐59.

  • Health care is different (from other industries)

    It’s clear to me from Ezra Klein’s reference to my “Health care is different” post that I need to say more.

    Many suggest that the solution to our health care system’s problems is to be found in a more market-based approach. Consumer-directed health plans are at the center of this concept. If you make people spend more of their own money, they’ll be more prudent users of care and seek better value at lower prices. That’s how other industries work, and we don’t complain much about them. Why should health care be any different? Get the government out of the way. Give vouchers to Medicare and Medicaid beneficiaries. Let people shop for the best deal on the unfettered market. And, moreover, reduce first-dollar, third-party payment by encouraging high-deductible plans.

    About now you’re thinking I disagree with the notions I just expressed. Actually I don’t. They have merit, which I recognize, accept, and support. Where I take issue is that they are not solutions to all the problems in our system. They can address, at least in part, some of the problems, though even there more is required. It’s just not that simple. (Again I strongly encourage those who thinks otherwise to read Katherine Baicker and Amitabh Chandra, “Myths and misconceptions about U.S. health insurance.”)

    That brings me to the post to which Klein referred. I illustrated how health care is like other industries,

    • Health care markets and the airline industry both have barriers to entry. The former requires special licenses, the latter requires considerable capital and regulatory compliance.
    • Trust in one’s doctor is important, as is trust in one’s lawyer.
    • Information assymetries exist in health care as in auto repair. Your mechanic (doctor) knows more about your car (your internal organs) than you do.
    • Health services and health insurance products are differentiated and complex, as are other products like cell phones or personal computers.
    • Health professionals want a good income, as do those in other fields.

    That would suggest that if we just make health care even more like any of those industries, by reducing third-party payment, government regulation, and so forth, we could harness all the characteristics of the free market–characteristics that we don’t complain about (and even like) with respect to other products and services. True!

    Except that health care is different, in one crucial way. I said it, and so did Klein:

    First, if you don’t get good health care, you might die. That makes it hard for individuals to say no to things, it makes it hard for insurers to resist the backlash that comes when they say no to things, and it makes it hard for government to say no to things. [Bold mine.]

    This may not seem important to the wealthy, young, and healthy. But to poorer, older, and sicker individuals (e.g. those on Medicaid and Medicare) it dominates. It is very hard to be a prudent purchaser of care when you’re in the ICU or responsible for the health of a vulnerable population. That alone suggests that an emphasis of moving the cost risk to individuals isn’t sufficient. There is plenty of cost risk to spread around. Some of it should be borne by physicians and hospitals, some by insurers (public and private), and some by individuals.

    The optimal allocation of risk across these entities is not likely to be the same for the young and healthy as for the old and sick. That might be OK for buying a cell phone–overpaying for or under-utilizing cell phones won’t do you much harm–but it isn’t for buying health care. Why? Because health care is different. A mistake costs far more (your life) and you really do know far less about it than the salesman or practitioner, particularly when you’re very sick.

    Some reduction in costs at minimal to no reduction in health may be possible with increased personal responsibility. The RAND health insurance experiment has demonstrated that, on average. However, that fact does not hold for all sub-populations. The health of individuals with certain chronic illnesses included in the RAND HIE was harmed by increased cost sharing. The RAND HIE did not include the elderly. More recent work has shown that increased cost sharing for Medicare beneficiaries can lead to adverse outcomes and doesn’t necessarily save taxpayers money.

    I’m all for using square pegs in square holes. But when the hole is round, it just doesn’t fit. Forcing it is bound to break something, or someone. And it isn’t necessary. A health policy more nuanced than “free market for all” isn’t really that much harder. It just takes a little more thinking than can be conveyed on a bumper sticker.

  • Health care is different

    Some sentences I agree with:

    • Health care markets and the airline industry both have barriers to entry. The former requires special licenses, the latter requires considerable capital and regulatory compliance.
    • Trust in one’s doctor is important, as is trust in one’s lawyer.
    • Information assymetries exist in health care as in auto repair. Your mechanic (doctor) knows more about your car (your internal organs) than you do.
    • Health services and health insurance products are differentiated and complex, as are other products like cell phones or personal computers.
    • Health professionals want a good income, as do those in other fields.

    Every single way one can characterize health care services, insurance, or markets, one can find another product, service, or market that is similar in that way. But, how many other products, services, or markets, possess every feature of health care that contributes to its failure as a market or the cost problems associated with it? Moreover, how many do so to the same degree? Lastly, how many also involve life and death decisions?

    There are reasons health care costs are hard to control. Some of them can be addressed, at least in part, by changes that would make health care markets more like those of other industries. Some of them can’t. Except in very rare cases, make a mistake with your choice of airline, lawyer, auto mechanic, or cell phone and you’ll be inconvenienced for a time, until you switch products or practitioners. Much less rarely, make a mistake with your health care and you could pay for it for or with your life.

    Health care is different. (See also “Like a breath of fresh air.”)

  • More hospital mergers

    I’ve wondered what the role of non-profit hospitals will be once nearly all Americans have health insurance. The problem of uncompensated care will largely go away. Will the non-profits retain their tax-preferred status? One way they might not is via merger with a for-profit hospital. Jenny Gold of Kaiser Health News reports that some hospitals are considering doing just that.

    [H]ospital mergers and acquisitions tend to go in boom-and-bust cycles. “My guess is that this is entering a period of expansion again,” says Gerard Anderson, director of the Johns Hopkins Center for Hospital Finance and Management.

    One big reason is that the new health overhaul law will eventually extend coverage to an additional 32 million people, reducing the financial burden of the DMC and other hospitals that treat a lot of uninsured patients. “Health reform gets rid of a big chunk of the uncompensated care problem,” making urban hospitals more attractive acquisition targets, says Jack Wheeler, a professor of health management and policy at the University of Michigan.

    Hospitals are merging while the political focus is on increasing competition in the insurance market. If market power swings (further) in favor of hospitals, there’s really very little reason to be optimistic about a market-based solution to reducing health care costs on the private side. The only element of the new health reform law that might help is the Cadillac tax. That doesn’t kick in until 2018 and won’t have a substantial effect for at least a decade after that. I don’t think the American public is going to be satisfied with the rate of premium growth over the next two decades.

    I’ll just throw in the relevant figure again (below). Moving in the direction of “A” is probably more costly than in the direction of “C” because most health care premium dollars (~85%) collected by insurers flow to providers. (In math speak: the slope between “A” and “B” is larger in magnitude than between “B” and “C”.) Thus, all other things being equal, increasing market concentration among providers leads to a higher absolute markup in prices (premiums).

    ins-prov power

    By the way, this figure isn’t just based on my own imagining. I’ve shown it to many health economists and all agree it has the right shape. Also, I’ve roughed out some theory that reproduces it algebraically. I’m confident in saying that the health care market really has the qualitative characteristics the figure suggests.

  • The downside of ACOs

    The time has come to dig a bit deeper into the current vision for the future of health care in America: accountable care organizations (ACOs). ACOs represent a new model (or a new-ish version of familiar ideas) of health provider organization and payment and are the current best hope for controlling health care costs, at least for public programs. Plans for Medicare and Medicaid ACO pilot projects are included in the new health reform law. If successful, they may be implemented widely. Someday we may all receive care from ACOs.

    In brief, an ACO is a group of health care providers and institutions that are collectively responsible for (and held accountable to measures of) the health of a population. An ACO has an organizational structure that permits the encouragement of improvements in quality and lower costs through payment incentives. If that was a bunch of mumbo-jumbo to you, then read my earlier post on ACOs or Michelle Andrews’ NY Times’ Prescriptions post on the topic.

    There are two key elements to an ACO, one pertains to its structure the other to how it is paid. Since an ACO is responsible for the health of a population it must include a set of health care providers such that individuals seeing those providers (mostly) don’t receive care outside the ACO. This is most easily understood by counter-example. If you see three providers–X, Y, and Z–but only providers X and Y are in the ACO then that ACO isn’t accountable for all the care you receive. Some of your care, that given by provider Z, is outside the ACO. That violates the ACO concept. You can imagine that ACOs must therefore be quite large.

    The reason ACOs need to include all providers caring for a population relates to the second element of an ACO, how it is paid. In contrast to the fee for service model of payment, which encourages provision of care independent of its need or quality, ACOs would receive a bundled payment based only partially on services provided. Some portion of the payment would be based on the achievement of quality and cost performance goals. The incentives of the payment system would be designed to lower costs and improve quality.

    The bundled incentive payments received by an ACO would be distributed to particular providers within that ACO according to its internal governance. Given this, you can imagine that whatever entity manages the ACO would wield considerable power. Currently hospitals are the most powerful of provider entities so one might expect they would be the source of ACO management. As I’ll argue below, that’s probably a bad idea.

    Abstracting from the details, ACOs include two important economic concepts: (1) provider organization and (2) incentive payments. While the first is necessary for the second it also raises the possibility of increased market power on the part of providers. If providers consolidate as they organize into ACOs–and some are already doing just that–they may gain increased market power that could be used to negotiate higher prices from insurers, seek additional rents from legislators, and game the payment system.

    In this sense, the organization necessary for payment reform may offset its intended effects. This brings us back to my favorite graph that relates health care premiums (a stand in for costs in general) to concentration in the health insurance market. (Other posts that use this graph are found under the “health care market theory” tag.)

    ins-prov power

    Recall that this graph is drawn for a fixed level of provider market concentration. While provider payment reform (via ACOs) may lower public costs, additional provider market power will push the system further toward the left along this curve (toward the point “A”). Private costs and premiums could rise. (Note, this is not the standard cost shifting argument. Private costs don’t rise because public payments fall. They rise due to changes in the balance of market power between providers and insurers.)

    That’s no good. But there is a way around this problem. The key is to recognize that a great deal of cost in the health care system is for hospital based services while relatively little is for primary care services. Suppose primary care doctors, not hospitals, are permitted to manage ACO-like entities. That is primary care doctors could be made to be the gateway to non-emergent specialty and hospital care (sounds familiar).

    The advantage of such an arrangement is that additional market power of primary care doctors would not itself drive costs up much since the services they directly provide don’t cost very much. Yet if the primary care doctor organizations were held accountable for the care their patients receive they would be responsive to the incentives of the payment system. They would refer their patients to higher quality, lower cost specialists and hospitals. One could expect costs to come down under payment reform without substantial upward pressure due to increased primary care physician market power.

    The key to all of this is wrestling control out of the hands of hospitals. I can think of a few political problems with this idea.