• Market predation

    This has more to do with health care than it may seem at first. Stick with me.

    Whether there is solid evidence for it or not (I don’t know), many believe WalMart, Home Depot, and other big box stores engage in predatory pricing. The hypothesis is that they move into the outskirts of town, set prices low–even below their own costs–and drive the downtown mom and pop stores out of business. Then they raise prices, sit back and count their cash. Even if is a money losing strategy in the short term, in the long run driving competition out of business and cornering the market is a money maker (until the antitrust regulators show up, perhaps).

    That’s one type of market predation. But there’s another: raising rivals’ costs. That’s also the title of a widely cited 1983 American Economic Review article on the topic by Salop and Scheffman. Engaging in practices that raise rivals’ costs has some advantages over predatory pricing. Salop and Scheffman explain,

    It is better to compete against high-cost firms than low-cost ones. Thus, raising rivals’ costs can be profitable even if the rival does not exit from the market. Nor is it necessary to sacrifice profits in the short run for “speculative and indeterminate” profits in the long run. A higher-cost rival quickly reduces output, allowing the predator to immediately raise price or market share. Third, unlike classical predatory pricing, cost-increasing strategies do not require a “deeper pocket” or superior access to financial resources. In contrast to pricing conduct, where the large predator loses money in the short run faster than its smaller “victim,” it may be relatively inexpensive for a dominant firm to raise rivals’ costs substantially. For example, a mandatory product standard may exclude rivals while being virtually costless to the predator.

    There are a variety of ways to raise rivals’ costs, including engaging in exclusive contracts with the lowest cost (or only) suppliers, supporting regulatory standards with which the predatory firm is already efficient, engaging in an ad or R&D war (if the predatory firm can do so at lower costs than its rivals due, say, to economies of scale), among others.

    Turning to health care, it is by now well known (to readers of this blog at least) that the majority of hospital and insurance markets are highly concentrated, by FTC/DOJ standards, and have become more so over the past decade or two. How did this happen exactly?  The detailed story is probably different in every market. However, postulating that maneuvers by dominant firms to raise rivals’ costs played a role in at least some markets, what specific instantiations of them might health insurers or health care providers have implemented (or implement in the future)? Here I am speculating only. I invite readers to offer their own ideas, and suggest relevant academic literature should they be aware of any.

    To raise rivals’ costs, health insurers might:

    • Enter exclusive contracts with health care providers (locking up the most profitable network participants),
    • Enter exclusive contracts with large employers,
    • Establish relationships with more efficient agents and agent entities (UnitedHealth partners with AARP, for example),
    • Conduct advertising blitzes during open enrollment periods (with the most efficient ad agencies or ad buys),
    • Lobby state and federal lawmakers and regulators in support of rules more costly for rivals to comply with.

    To raise rivals’ costs, health providers (let’s just focus on hospitals) might:

    • Enter exclusive contracts with health care insurers (locking up the most profitable source of patients),
    • Commence a medical technology arms race (provided the predator can obtain equipment at costs lower than that of rivals),
    • Conduct ad campaigns,
    • Lobby state and federal lawmakers and regulators in support of favorable rules (e.g. certificate of need regs).

    I’m not making any moral judgments here. The aforementioned actions are consistent with sound business strategy and competition. Contracting with the lowest cost suppliers, perhaps preventing rivals from doing so if only due to the suppliers’ capacity constraints, is what we should expect from competitive pressures. Markets are just like this, or so I speculate. Any thoughts?

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    • Austin,

      You mention entering into exclusive contracts with health insurers. I was under the impression that this isn’t an issue anymore. At a recent conference, Bob Town made the point that insurers lose a lot of surplus by not having pretty much every hospital in their networks. While we do a lot of modeling of option demand networks, trying to find the value of having a hospital in network, my impression was that most insurers (except perhaps the staff-model HMOs) have all hospitals in network nowadays. I know this is the case with the largest insurers in your area (and anyone can look up their websites to see this). Do you have any information that suggests otherwise?

      GrandArch

      • @GrandArch – Gaynor and Vogt (Handbook of Health Econ., 2000) noted that exclusive contracts “appear to be relatively rare between insurers and health care providers [though] long term services contracts are common, and may confer a degree of exclusivity on an insurer who is a large buyer” due to capacity constraints.

    • Thanks. I’ll see if I can find any examples. I’m not sure I’ve ever seen such a scenario in the typical urban tertiary care hospitals . But I suppose it wouldn’t be unreasonable in more rural areas with limited capacity. Or it certainly wouldn’t be unreasonable to see hospitals have less of an incentive to compete on price in negotiations with smaller insurers if they’ve already got a contract with a dominant insurer.