CONSOLIDATION IN U.S. HEALTH CARE

This 5-part conversation begins with an article from the NY Times By Walt Bogdanich on March 4, 2002.  The theme is expanded in conversations between Kip Sullivan and Uwe Reinhardt.

Medicine's Middlemen: 2 Powerful Groups Hold Sway Over Buying at Many Hospitals By Walt Bogdanich

These two private groups (Premier and Novation) act as middlemen for about half the nation's nonprofit hospitals, negotiating contracts last year for some $34 billion in supplies, from pharmaceuticals to pacemakers, bandages to beds. Each group has the same basic mission: to use the market power of its more than 1,500 hospitals to find the best medical products at the lowest prices. But many in the medical world - Mr. Kiani among them - question whether that mission is being compromised by financial ties that the groups, Premier and Novation, have to medical supply companies, ties that, according to an investigation by The New York Times (news/quote), are both extensive and highly unusual.

The problem begins with this simple fact: The buying groups are financed not by the hospitals that buy products but by the companies that sell them. In other words, the groups take money from the very companies they are supposed to evaluate objectively. Each year, companies pay Premier and Novation hundreds of millions of dollars in fees that represent a percentage of hospital purchases. The more hospitals spend on medical supplies, the more dollars Premier and Novation get from the suppliers. In a few cases, Premier or some of its officials have also received stock or options from companies with which Premier contracts.

Critics say such conflicts of interest can mean that the buying groups do not always choose the products that are best for patients, hospitals or the taxpayers and insurers that pay their bills. Larry Dickson oversees purchasing through Novation for Providence Health System in Seattle.. He says he cannot get specific information on fees, despite the critical role he plays in supplying his hospitals.

Larry Dickson, purchaser for Providence Health System:

Why is this so secret? There is an accountability question that is very much concerning a lot of people in health care. And if you ask, and the response you get is, 'That's none of your business,' that raises more questions than it answers.

Comment from Don McCanne: MARKETPLACE DYNAMICS

This is yet one more example of marketplace dynamics in our health care system. Theoretically, these middlemen organizations negotiate discounts with the manufacturers of the medical supplies. Bulk purchasing and negotiated pricing are very legitimate methods to help control health care costs. But, because of this business model, most of the benefit passes to the shareholders and executives, with only enough savings passed on to the hospital-providers to create some semblance of lower pricing. With only two major middlemen, this oligopolistic market borders on a monopoly, preventing the realization of the full potential benefit for the hospitals and ultimately the patients.

Another concern about oligopolistic middlemen medical suppliers, which would apply to the oligopolistic pharmacy benefit managers as well, is that competitive bidding will negatively impact the manufacturers that do not receive the contracts, and some of them could actually fail. Those that would remain might defensively increase merger activity and would thereby create an oligopoly of manufacturers. With the oligopolistic middlemen already in place, prices would be driven up sharply.

Health Care and the Public Sector By David M. Cutler, Ph.D., Professor of Economics, Harvard University

The make or buy decision in health care has been a subject of debate for decades. The traditional debate pitted arguments of monopoly and monopsony on the one side, and innovation on the other. Government intervention was justified because of monopoly power of physicians and the information problems noted above (in his paper). By controlling medical provision, it was believed that the government could use its monopsony power to purchase such services at a low price. The counter-argument focused on incentives for efficiency. Without market incentives, it was feared that government production would be technologically inefficient and innovation would be stifled.

Empirically countries where the public sector runs the medical system spend less on medical care than countries with private providers. In OECD countries, for example, the correlation between the public sector share of financing and the share of GDP devoted to medical care is -0.41. More formal analysis controlling for additional variables also finds this conclusion (Globerman and Vining, 1998). There is also evidence for the inefficiency view. People in many European countries are disenchanted with the quality of medical care, and these countries have struggled to increase the efficiency of the medical care system in recent years (Cutler, 2001).

A recent literature emphasizing the role of public sector contracting has expanded the dimension of this analysis, considering issues of allocational as well as technical efficiency (Hart, Shleifer, and Vishny, 1997; Shleifer, 1998). Consider the question of whether a government should provide hospital services itself or contract with a for-profit hospital company to provide the services. For-profit companies will respond to financial incentives more rapidly than government-run companies, since for-profit managers receive more of the payoff from responding to these incentives. Thus, contracting to a for-profit provider will be preferred IF the incentives that the firm faces are the correct ones. If the incentives are not correct, however, having more responsive for-profit firms may lead to poor outcomes, and providing the service in house might be preferred.

http://papers.nber.org/papers/w8802

From Don McCanne: THE EXISTING INCENTIVES

Although Dr. Cutler is referring to health care services, his comments can apply to the narrower topic of medical supplies and pharmaceuticals. Contracting to a for-profit provider (e.g., middlemen firms) will be preferred IF the incentives... are the correct ones. But we now have more than ample evidence that the incentives of for-profit firms derive from maximizing profit. This can only result in compromise of the public interest to negotiate the maximum benefit for the patient. So the middleman function should be provided in house, that is, by a public negotiator.

In the single payer model of reform, the system becomes the single, monopsonistic purchaser of services and goods (supplies, pharmaceuticals, etc.). The negotiations are made with all manufacturers. By shifting emphasis from an oligopoly of manufacturers to a monopsonistic purchaser, the public single payer negotiator will gain control of the negotiating process. Because the negotiator is representing the public good, negotiations will be in the interests of the patients. That means fair prices, not only for the benefit of patients, but also for the manufacturers since it is in the public interest to assure the financial viability of the producers of the products.

Dr. Cutler's comments about the European disenchantment with quality as representing the inefficiency view of public sector health care must be viewed from the perspective that European health care budgets are significantly smaller than the amount that is already dedicated to health care in the United States. A system of public funding in this country could avoid patient disenchantment by locking into the budget our current high level of funding.

Since the incentives of the for-profit firms can never provide the motivation to place the interests of patients over the interests of investors, let's finally quit trying to make that model work. Instead, let's go ahead and use an in-house negotiator that places the interests of patients above all else, avoiding disenchantment by targeting our abundant resources for health care. Let's adopt a publicly administered, single payer health care system.

Kip Sullivan responds: ON HEALTH CARE OLIGOPOLIES

If I were the New York Times reporter who wrote this sentence, I would have written it this way: The problem is two-fold: (1) The buying groups are financed by companies that stand to gain from the buying groups' decisions, and (2) the buying groups are the natural outgrowth of a health-care system which has forced all players into a race to get big. The article discusses the problem of oligopoly, but it doesn't call the reader's attention to the basic cause of rampant consolidation in the hospital industry.

The most fundamental problem is that the introduction of HMOs into the US health care system by the HMO Act of 1973 eventually made size the highest priority for all participants in the health care system. That was not, of course, the stated goal of HMO proponents. HMO proponents argued that HMOs would save money because they would improve medical practice -- ignorant and greedy doctors would be induced or forced to cut out unnecessary services and beef up the provision of preventive services. In fact, HMOs saved money by rationing and extracting large discounts from providers. Both tactics were executed most successfully by the largest HMOs and, eventually, the largest traditional insurers which morphed into managed-care plans. HMO advocates most definitely did not argue that the creation of an HMO industry would confer oligopsony power upon the nation's dominant health insurers, and that this power would be used to force doctors to cut medical services and to extract discounts from providers. But they might as well have, because that's what we got.

It didn't take long for the rest of the health care system to respond in kind. By the mid-1980s, the pace of consolidation had picked up throughout the entire health care industry, and by 1993, when politicians everywhere endorsed managed competition, the pace became just plain frantic. With the possible exception of the federal and state enforcers of anti-trust laws, there is no force capable of stopping this rush to feudalism. But even if anti-trust authorities wake up, it's unlikely anti-trust suits will ever force a significant deconsolidation of the system. Anti-trust suits are just too slow and too expensive.

My off-the-cuff opinion is that deconsolidation is only possible under a single-payer system, and even then it won't be easy to accomplish. My on-the-cuff opinion is that it'll never happen under the current system.

Uwe Reinhardt responds: A BRIEF HISTORY OF CONSOLIDATION

Like the airline industry, the hospital industry is characterized by high operating leverage--that is, high fixed costs relative to variable costs. When such an industry slides into a state of excess capacity--as it had by the mid 1980s--it would engage in price wars under competition. Until 1990s, the hospitals weathered this condition, because the private insurance industry paid them 130% of average cost, which was enough to finance an average occupancy ratio of 60% or so. (Medicare probably paid full cost calculated at full occupancy).

When the demand side started to force real price competition on the hospitals sector, it initially was driven into price wars that pushed many hospitals into the red. The only way to react to this threat is what the airlines did earlier: consolidate or slice up the market. The airlines did both--and used frequent flyer miles to cement a clientele in place. Hospitals simply aggregated into larger oligopolies.

Under a single payer system you would ultimately need capacity planning. No single payer would sit by idly, covering the full costs of half empty hospitals. Thus, the choice in the 1980s was never competition vs. regulation, but oligopoly vs. regulation.

Kip Sullivan: ON ENORMITY AS THE HOLY GRAIL

(1) it was HMO size -- not HMO brilliance at teaching doctors how to be better doctors -- that allowed HMOs to cut costs and take market share from the traditional insurers, and

(2) once the race to get big was unleashed in the insurance industry, it had to spread to the rest of the health care industry.

Uwe is correct that our choice in the 1980s was oligopoly versus regulation, not, as HMO advocates put it, competition versus regulation. My point was that the HMO gurus should have told us that. They didn't. They told us HMOs would compete on their ability to turn doctors into better doctors. They never warned us gigantism would become the Holy Grail of the entire health care industry.

Uwe Reinhardt: PRICE COMPETITION AS A REGULATOR HAS LONG BEEN KNOWN AS A FAILURE

There is a remarkable document that emerged about a year ago from a one year soul searching effort by the California health care elite--virtually anyone there making over $200,000 a year off health care on one way or another. They concluded ruefully that the experiment with price competition a la Jackson Hole had failed in California and that a new paradigm (I love the term!) was needed to set things right. They called the new paradigm cooperation. Kip and I would call it, less politely, cozy oligopoly all around.

Germany uses that approach, but with one significant twist: the goverment hovers above the cozy deals hashed out by the private oligopolists in an Apache helicopter and swoops down with compulsory arbitration or sectoral budget caps whenever the cozy deals among members of the ologopolistic club bust preterdermined overall global spending budgets (a la Clinton health plan).

Eventually we will get there, too. In the meantime, we shall continue to march to Churchill's well-kown dictum: In the long run Americans will always do the right thing--after exploring all other alternatives. It is our enthusiasm for the perpetual exploration of known things that makes us appear so cute in the eyes of the rest of the world. Of course, we proudly call it research and entrepreneurship. That is cute as well.

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