Chapter 15 Profits, Market Structure, and Market Power Copyright 2015 Health Administration Press

After mastering this material, students will be able to  describe market structure,  discuss market power in healthcare,  calculate market share impact on pricing,  apply Porter’s model to pricing, and  discuss determinants of market structure. Copyright 2015 Health Administration Press2

MARKETS Copyright 2015 Health Administration Press3

Which markets? We will focus on product markets, but...  Product markets – Hospitals – Physicians – Pharmacies  Input markets – Nurses – Aides – Physicians  Insurance markets – PPOs – HMOs  Buyer markets – Employers – Unions Copyright 2015 Health Administration Press4

Types of Markets  Oligopoly – A few rivals – Products differ – e.g., hospitals  Monopoly – One firm – e.g., Hayes hospital  Monopolistically competitive – Many rivals – Products differ – e.g., physicians Copyright 2015 Health Administration Press5

Porter’s Five Forces Model Buyers EntrantsRivals Substi- tutes Sellers 6Copyright 2015 Health Administration Press

If demand is “not too elastic,” providers have market power.  Providers with market power – face less elastic demand, – have larger markups, and – must focus on MR, not P.  Strategies can increase profits. – Price discrimination – Product differentiation – Collusion Copyright 2015 Health Administration Press7

MR differs from P when demand is “not too elastic.” PriceElasticityMR $ $10.00 $ $10.00 $ $10.00 $ $10.00 All calculations assume a marginal cost of $10. Copyright 2015 Health Administration Press 8

When are firms “in the same market?”  If products are close substitutes – Similar uses and performance – Sold in the same area  If demands are related – Positive cross-price elasticities – Merger would increase prices Copyright 2015 Health Administration Press9

Most healthcare providers have some market power.  Often there are few rivals. – Usually true for hospitals – Often true for rural physicians  Rivals are imperfect substitutes. – Differences in location – Differences in characteristics – Differences in familiarity Copyright 2015 Health Administration Press10

Most healthcare providers have some market power.  Often there are cost-based barriers to entry. – Sometimes economies of scale – Sunk costs for existing firms  Often there are legal barriers to entry. – Certificate-of-need and licensure laws – Restrictions on advertising Copyright 2015 Health Administration Press11

Legal barriers are the best guarantees of market power.  Florida Hospital Association: “Historically, the association has opposed deregulation.”  Florida Agency for Health Care Administration: “The concern was that boutique hospitals... would take paying patients away from hospitals.” Copyright 2015 Health Administration Press12

The courts now apply competition law to healthcare.  They assume that restrictions are self- serving,  they emphasize customer choice, and  they look beyond provider interests. Copyright 2015 Health Administration Press13

IMPLICATIONS OF MARKET POWER Copyright 2015 Health Administration Press14

Market Power  Defining market power  Implications of market power – Price discrimination – High markups – Product differentiation – Collusion Copyright 2015 Health Administration Press15

Implications of Market Power  Price and quality competition matter. – Products are differentiated. – Price is a strategic decision. – Quality is a strategic decision.  Market structure matters. Copyright 2015 Health Administration Press16

Market structure is defined  by market shares, and  by the number of firms. Copyright 2015 Health Administration Press17

Markups are high in concentrated markets.  Only a few rivals – Monopoly = one firm in the market – Oligopoly = a few firms in the market  Rivals with large market shares Copyright 2015 Health Administration Press18

Measuring Market Structure  Concentration ratios – The market share of the n largest firms.  The H index – Sum of firms’ squared market shares × 10,000  Usually the hardest question is – “What is the market?” Copyright 2015 Health Administration Press19

Who competes with KU Hospital in the market for  urgent care services?  cardiac services?  organ transplant services? Copyright 2015 Health Administration Press20

Market Structure  Three firms with 25 percent shares plus five with 5 percent shares – Three firm concentration ratio of 75 percent – H index of 2,000 = 3 × × 5 2  One firm with 40 percent and 20 with 3 percent each – Three firm concentration ratio of 46 percent – H index of 1,780= × 3 2.  Twenty firms with 5 percent market shares – Three firm concentration ratio of 15 percent – H index of 500 Copyright 2015 Health Administration Press21

Wichita MSA  Looking at general hospitals – Three firm concentration ratio = 100 percent – HHI = 5,127  Including specialty hospitals – Three firm concentration ratio = 95 percent – HHI = 4,304 Copyright 2015 Health Administration Press22

IMPLICATIONS OF MARKET POWER Copyright 2015 Health Administration Press23

Implications of Market Power  Price discrimination  Product differentiation  High markups  Collusion Copyright 2015 Health Administration Press24

Price discrimination is common in healthcare.  Insurance creates distinct markets.  Arbitrage is hard for services.  Manufacturers can limit arbitrage. – Price discriminating via rebates – Price discriminating via charge-backs – Regulations prohibiting arbitrage Copyright 2015 Health Administration Press25

Product differentiation creates entry barriers.  Increases costs of entry  Reduces price elasticity of demand  Increases markups  Firms try to differentiate via – advertising, and – designing for niche markets. Copyright 2015 Health Administration Press26

Collusion has a long history in medicine.  E P differs for individuals and the profession. – E P for profession about -0.2 – E P for individual MDs about -4  After price cuts, revenues will – fall for all doctors, and – rise at first for individual doctors.  Collusion can prevent price cutting. Copyright 2015 Health Administration Press27

Collusion needs sanctions to prevent cheating.  All have incentives to cheat.  None have incentives to monitor it.  Collective action prevents price competition. – Professional societies – State laws Copyright 2015 Health Administration Press28

CONCLUSIONS Copyright 2015 Health Administration Press29

Market Power  Depends on market structure  Springs from barriers to competition – Information – Cost and legal – Product differentiation Copyright 2015 Health Administration Press30

Market Power in Healthcare Markets  Entry is usually difficult.  Typically there are few substitutes.  Supplier market power varies.  Buyer market power varies.  Degree of rivalry varies. Copyright 2015 Health Administration Press31

Implications of Market Power  Higher markups  Higher profits Copyright 2015 Health Administration Press32

Firms try to get or keep market power via  regulation,  mergers,  collusion,  advertising, and  differentiation. What are the implications for managers? Copyright 2015 Health Administration Press33