1. 1 Measuring the Welfare Effect of Entry in Differentiated Product Markets: The Case of Medicare HMOs Shiko Maruyama University of New South Wales 19 June, 2008

2. 2 Plan of the Talk 1.The research question 2.The industry 3.The empirical design and data 4.The model and estimation method 5.Results 6.Conclusions 

3. 3 Research Question Should the government subsidize entry to promote competition?

4. 4 Research Question Should the government subsidize entry to promote competition? –If a homogenous product market is assumed, theory predicts excessive entry.

5. 5 Research Question Should the government subsidize entry to promote competition? –If a homogenous product market is assumed, theory predicts excessive entry. –If differentiated markets  empirical question. This research attempts to develop an empirical framework that can deal with this question.

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9. 9 Plan of the Talk 1.The research question 2.The industry 3.The empirical design and data 4.The model and estimation method 5.Results 6.Conclusions 

10. 10 Institutional Background Medicare: –The federal entitlement program that provides health insurance coverage to individuals age 65 and older. Private Medicare Plans: –Medicare features private health plans and the government plan (traditional Medicare plan). –Private Medicare plans contract with the government on the annual basis and enter wherever they want. –Why bother having private plans in the public program?  more efficiency, more options.

11. 11 Institutional Background Private Medicare Plans (cont’d.): –The government plan is available everywhere in US, but private plans are not available unless you have one in your county. –Beneficiaries choose either traditional Medicare or one of available private plans. –Beneficiaries are permitted to switch plans or return to the government plan at the end of every month. –Most of the private plans are HMOs.

12. 12 The HMO Market Share in Medicare

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16. 16 Policy Questions Q.1: What is the welfare impact of having private health insurance plans in Medicare? Who benefits most? Q.2: What is the optimal payment (government subsidy) to private plans in terms of social welfare? Is a simple expansion good or bad?

17. 17 Plan of the Talk 1.The research question 2.The industry 3.The empirical design and data 4.The model and estimation method 5.Results 6.Conclusions 

18. 18 Empirical Design The data: constructed from publicly available data from the government. Market share data. No micro data. No cost data. A lot of plan characteristics information. The sample years: 2003 & 2004 –(2002 info also used) The unit of observation: a plan-county-year Market size varies from monopolistic to competitive markets. There are two kinds of entry. I focus on entry from other areas. i.e. location choices.

19. 19 Plan of the Talk 1.The research question 2.The industry 3.The empirical design and data 4.The model and estimation method 5.Results 6.Conclusions 

20. 20 Estimation Strategy 1)Discrete choice demand system (Nested Logit) Cf. Berry [1994]. 2)Recover MC. Obtain p( ) and q( ). 3)Estimate profit functions with an entry- exit game. Recover FC. 4)Calculate welfare estimates. 5)Counterfactual simulations.

21. 21 Demand Utility Assuming Nested Logit…

22. 22 Welfare Measures Components of social welfare gain

23. 23 Welfare Measures Components of social welfare gain Calculating consumer surplus Net Government gain: “Expected government expenditure increase without Medicare HMO plans” – “Payment to Medicare HMO plans”

24. 24 HMO Behavioral Specification Assume public information. Create and add “hypothetical entrants”.

25. 25 HMO Behavioral Specification Assume public information. Create and add “hypothetical entrants”. 1 st Stage: A sequential-move entry game 2 nd Stage: A simultaneous-move Bertrand price-setting game A certain decision order is assumed.

26. 26 HMO Behavioral Specification Assume public information. Create and add “hypothetical entrants”. 1 st Stage: A sequential-move entry game 2 nd Stage: A simultaneous-move Bertrand price-setting game A certain decision order is assumed.  Use “Subgame Perfect Nash Equilibrium”. An SPNE is solved by backward induction.

27. 27 Profit Function Assume additive separability. Marginal costs (constant) are calculated from estimated demand, by using FOC.

28. 28 Profit Function Assume additive separability. Marginal costs (constant) are calculated from estimated demand, by using FOC. The county-level profit function:

29. 29 The Estimation Algorithm Error component specification: –Assume multivariate normal distribution. Basic Framework: Maximum Likelihood

30. 30 Plan of the Talk 1.The research question 2.The industry 3.The empirical design and data 4.The model and estimation method 5.Results 6.Conclusions 

31. 31 Welfare Analysis

32. 32 Payment Rate Simulation: 2004

33. 33 Why Does Welfare Change? Three sources of welfare inefficiency: 1.Too much or too little entry? 2.Market power? 3.Too much or too little subsidy? Quantifying Each Effect?  I can do it by simulating entry-exit and market power.

34. 34 Average Incumbent Premium Changes when Payments Raised by $50: 2004

35. 35 Welfare Change Decomposition

36. 36 Entry Simulation: 2004

37. 37 Consumer Surplus by County Types: 2003

38. 38 Where New Entry Occurs when Payment Rate Raised by $50: 2004

39. 39 Plan of the Talk 1.The research question 2.The industry 3.The empirical design and data 4.The model and estimation method 5.Results 6.Conclusions 

40. 40 Three Main Findings 1.The Medicare HMOs generate additional social welfare of approximately 10.3 billion dollars in 2004. 2.Higher social welfare may be achieved by adjusting payment rates. 3.There is no evidence of excessive entry.

41. 41 Main Contribution I build on the empirical entry literature with the following three key features: 1.Heterogeneity in cost structure and product characteristics 2.Structurally modeling the demand and supply 3.Applying the entry model to a welfare analysis These three enable us to quantify the welfare effect of entry.

42. 42 Future Research Current Limitations: –Homogeneous consumers –Additive separability across markets and products in the profit functions –Commercial sector presence of HMOs –No dynamics The next step: –Endogenize product characteristics

43. 43 Appendix

44. 44 Three Closest Papers

45. 45 Descriptive Statistics of Selected Variables

46. 46 Identification Three sets of instrument variables: 1)Cost shifters --- traditional -# hospitals, # medical doctors, etc 2)Characteristics of competing firms --- traditional in the literature of product- differentiated market (Bresnahan, Berry, etc) 3)Average number of competitors in the other markets. --- Use of panel structure (Hausman, Nevo)

47. 47 Institutional Background Timing –Before the beginning of every year, an operating HMO plan must declare its product's (or products') details. –It is required to submit an application with annual prospect of profits and costs with these details. –These products characteristics are basically fixed through the year.

48. 48 Creating the Pool of Potential Entrants The pool consists of the following types: 1.Plans that operate in the county in the year 2.Plans that operate in the same state in the year 3.Plans that operate in the county in the previous year (incumbents) 4.Plans that operate in the same state in the previous year Create and add “hypothetical entrants”.

49. 49 Intermediate Results

50. 50 Maximum Simulated Likelihood GHK Simulator (Geweke-Hajivassiliou- Keane): –A smooth recursive conditioning simulator –The basic idea:  Each term is a (conditional) normal. –Unbiased, smooth, and computationally fast I modified the GHK simulator so that it can deal with strategic interactions. Trick: Harmonize GHK & Sequential Game.