Courts have also reached different opinions in their prospective assessments of the potential competitive effects of proposed hospital mergers. For example, in two recent proposed mergers, the lower courts allowed the mergers to proceed but the appellate courts overturned these decisions.
This article advances one reason why different hospital mergers can have different effects on prices that has not been widely discussed in academic literature or in merger enforcement: complementarities across hospitals in their value to insurers. Products that are complements deliver more value when consumed together than the sum of the values that each delivers alone. Complementarities are important to merger analysis in general because the merger of complementary products can lead to price decreases. For hospitals, prices are determined by negotiation between hospitals and insurers. Thus, if two hospitals that are complements to an insurer merge, the insurer may actually be able to negotiate lower prices with the newly merged entity than it could when negotiating with the hospitals individually.
Why might hospitals be complements to insurers? A key role that insurers perform is in the construction of networks of hospitals and other providers. The attractiveness of a provider network, and the marketability of an insurer’s plan, will depend on how well that network can deliver the medical care required by plan enrollees, who often will not know in advance what health care services they and their families will require. For this reason, insurers generally need a broad network of hospital providers, offering the range of health services most frequently needed, in a geographic area to successfully sell insurance products in that area. Therefore, two hospitals can be complements to insurers when each offers a critical service in a geographic area that the other does not. In the extreme, if both hospitals are required for a plan’s marketability, each hospital may offer no value to the insurer on its own, but together would create a marketable plan.
I. A Framework for Analyzing Hospital Competition
To explain how complementarities may impact hospital prices and the effect of mergers, it is first helpful to define a framework for how hospitals compete. We present a framework in which competition takes place in three stages. This framework builds on models of competition used in policy settings and academic studies of hospital and insurer bargaining, often with the goal of understanding the price impacts of hospital mergers.
- In the first stage, hospitals negotiate with insurers over network inclusion and reimbursement levels. Insurers also determine enrollee cost sharing (in the form of copays or coinsurance) for care received at different hospitals, which will typically be lower at in-network hospitals. It is in this stage of competition that insurers and hospitals negotiate prices and hence in this stage that complementarities could affect prices. When modeling these negotiations, researchers commonly assume that an insurer and a hospital will split the marginal surplus of each negotiation in some fixed proportion.
- In the second stage of competition, insurers set premiums that individuals pay to enroll in their plans, and individuals select insurance plans after observing each plan’s hospital network, cost-sharing arrangements, and premiums.
- In the third stage of competition, some enrollees require hospital treatment and select a hospital. Patients choose among available hospitals taking into account the network status of each hospital, the copay or coinsurance amounts (in cases where there are meaningful differences in these amounts across hospitals), a hospital’s location, and its quality for treating particular conditions, among other potential factors.
We will refer to these three stages of competition as we discuss how hospitals can be complements and how complementarities can affect negotiated hospital prices.
II. Hospital Complementarities and the Impact of Mergers
In this section, we first review the economic definition of complements. We then discuss circumstances under which hospitals can be complements from the perspective of an insurer negotiating over network inclusion and reimbursement levels at the first stage of competition. We then analyze how complementarities can result in hospital mergers lowering prices.
A. What Do We Mean by Complements?
Formally, two products are complements when they provide more value together than the sum of the values that each product provides on its own. An example of two products that are complements is a left shoe and a right shoe. Individuals usually derive more value from their left shoes because they also have matching right shoes; one shoe on its own is not useful in most circumstances. In comparison, two products are substitutes when they provide less value together than the sum of the value that each product provides on its own. An example of two substitute products is butter and margarine. Consumers who have already chosen to buy butter will derive less value from buying margarine, since butter can frequently take the place of margarine.
B. How Can Hospitals Be Complements to Insurers?
It is easy to envision how two hospitals can be substitutes for one another at each stage of competition. Consider an extreme case where two hospitals, A and B, offer the same services and amenities, provide the same quality of care, and are also located right next to each other. From the perspective of a patient seeking care at the third stage of competition, the two hospitals are interchangeable. For an employer or an individual purchasing health insurance at the second stage of competition, a plan with either hospital is equally valuable as a plan with both. Finally, from the insurer’s perspective at the first stage of competition, a plan that included either hospital A or B would be more marketable and increase profits relative to a plan without either hospital in-network, but a plan that included both A and B would be no more valuable than a plan that included just one. Enrollees (or employers) would not be willing to pay any more for plans that included the second, perfectly interchangeable hospital, which means that the addition of the second hospital to a network that already included one would add no value to the insurer. In this case, hospitals A and B are perfect substitutes.
More generally, most research and policy applications assume, through their modeling framework, that hospitals are substitutes (albeit imperfect ones) rather than complements at the first stage of competition. This derives from the assumptions in these applications that (1) a hospital’s value to an insurer at the first stage of competition is proportional to the average value of the hospital to patients at the third stage of competition (where the average is taken over all possible health conditions), or, that is, insurers’ preferences and patients’ preferences are perfectly aligned; and (2) patients must select a single hospital for treating each condition at the third stage of competition. Together, these assumptions imply that hospitals are at least weak substitutes; they rule out any possibility that having two hospitals in-network together would add more value to the insurer than the values the insurer receives from having either hospital in-network alone. This typical empirical model simply does not allow for complementarities in the first stage; and this is true even if the hospitals have differences in services, quality, and location—unlike our extreme example above.
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