• 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 An unpublished paper presented to the Chicago Fed in March 2010 by Hilliard, Ghosh, and Santerre (pdf of slides available) describes what is known about these factors with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?

    References

    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.

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