• Vertical restraints

    What are some of the potential effects of vertical integration or, more broadly, “restraints,” between a health care plan and a health care provider? In economics, this question falls under the category of “vertical restraints,” about which Martin Gaynor and Robert Town write in Section 7, Chapter 9, Volume 2 of the Handbook of Health Economics. (If it helps, a draft of their chapter exists as an NBER working paper.) What follows pertains only to subsection 7.1.1. More on the rest another time.

    First, what is meant by “vertical restraints”? Wikipedia offers a fine definition:

    Vertical restraints are competition restrictions in agreements between firms or individuals at different levels of the production and distribution process.

    Health care plans and health care providers are certainly at different levels in the production and distribution of health care. The former is, at a minimum, a financing or administrative vehicle, though care management and utilization incentives can be on board. The latter actually delivers the care. It’s the “sharp end,” quite literally so in the case of surgery.

    That’s the “vertical” part. What about the “restraint” part. Well, if health care provider A exclusively contracts with health care plan B, that certainly restrains what would otherwise be freer competition. If you’re not in plan B you won’t get your care covered at provider A, a restriction of access and choice. Gaynor and Ma (1996) show that this can cause a loss of consumer welfare.

    Gaynor and Town review the literature and point to some other potential consequences of vertical restraints between plans and providers, including:

    • Elimination of “double marginalizationhold-up problems, transaction costs, and information asymmetries (improved monitoring).” [Hyperlinks mine. Follow them for definitions.]
    • “Insurers and hospitals make decisions over many matters like pricing, information systems, etc. which affect each other. Integration can allow for efficient coordination on such choices.” In a footnote to this, they write that Eggleston et al. (2004) “find that vertical integration does not necessarily increase net revenues.”
    • “Gal-Or (1997, 1999) shows that at an exclusionary equilibrium (all insurers and hospitals are exclusive pairs), insurers obtain lower prices from hospitals in exchange for guaranteed larger volume and consumers are better off (provided that there is not too much differentiation).”
    • “Another source of possible efficiencies is the elimination of inefficient substitution. If there are multiple hospitals, say, and one hospital has greater market power than the others, and thus higher markups, an insurer will inefficiently substitute away from the hospital with market power to the other hospitals. If hospitals are not perfect substitutes to patients then this will result in a loss of utility.”
    • “It is also possible that vertical integration can lead to reduced prices. Suppose that integration eliminates double marginalization and that the integrated firm is not exclusive, i.e. it buys and sells with other market participants. Then other hospitals have to set their prices at least as low as the marginal cost of the hospital in the integrated firm in order to sell to the insurer in the integrated firm. If the hospital in the integrated firm wants to sell to outside insurers, it has to set its price as low as the outside hospitals. So, it is possible (but not necessary) that integration could lower prices via this mechanism.”

    The concern that probably comes most readily to mind about plan-provider integration is market power. Gaynor and Town point to many papers on anti-competitive effects of such integration: Ma (1997), Bijlsma et al. (2009), Douven et al. (2011), de Fontenay and Gans (2007), Halbersma and Katona (2011). They also offer this intriguing possibility:

    [A possible] horizontal effect is that integration may facilitate collusion. If the insurer in the integrated firm buys from outside hospitals, it can communicate pricing information between the hospital in the integrated firm and its rivals, thereby facilitating collusion.

    Finally, plan-provider integration can lead to risk segmentation, which can be a welfare loss, though a model by Baranes and Bardey (2004) show it can improve welfare.


    Baranes, E. & Bardey, D. (2004). Competition in health care markets and vertical restraints. Cahiers de Recherche du LASER 013-03-04, Laboratoire de Sciences É conomiques de Richter (LASER), Université de Montpellier, Montpellier, France.

    Bijlsma, M., Boone, J., & Zwart, G. (2009). Selective contracting and foreclosure in health care markets. Tilburg University.

    De Fontenay, C. & Gans, J. (2007). Bilateral bargaining with externalities. University of Melbourne.

    Douven, R., Halbersma, R., Katona, K., & Shestalova, V. (2011). Vertical integration and exclusive vertical restraints between insurers and hospitals. Tilburg University.

    Gaynor, M. & Ma, C.-t. A. (1996). Insurance, vertical restraints, and competition. Carnegie Mellon University.

    Eggleston, K., Pepall, L., and Normany, G. (2004). Pricing coordination failures and health care provider integration. Contributions to Economic Analysis and Policy, 3(1), 129.

    Gal-Or, E. (1997). Exclusionary equilibria in health-care markets. Journal of Economics and Management Strategy, 6(1), 543.

    Gal-Or, E. (1999). Mergers and exclusionary practices in health care markets. Journal of Economics and Management Strategy, 8(3), 315-350.

    Halbersma, R. & Katona, K. (2011). Vertical restraints in health care markets. Tilburg University.

    Ma, C. -t. A. (1997). Option contracts and vertical foreclosure. Journal of Economics and Management Strategy, 6(4), 725-753.


    Comments closed
    • It seems to me, just based on experience, that the three way integration of a plan, physicians and hospitals creates pricing power for the hospitals, and, downstream from them, the physicians. I see two dynamics. First, it raises the switching costs for purchsers, requiring not just a change of plan, but a disruption in patient relationships with hospitals and physicians. Patients as employees are more likely to be upset by a plan switch that requires a physician switch; that ‘upset’ is a cost to employers. And in integrated provider-plan arrangements, the integrated Plan is essentially precluded from shifting its panels to competing hospitals and physicians — IDS X’s health plan is not going to drop its relationship with IDS X’s group practice and hospitals . That results in pricing power for those providers. And gives other providers in the market pricing power with the plans with whom they contract? A concentration effect based on a narrow range of alternatives for other Plans? That’s how it feels.