CHAPTER

The Market for Hospital Services

KEY TERMS AND CONCEPTS
Hospital economies of scale Survivor analysis
CON as an entry barrier
Hospital's geographic market Industry consolidation
HHI index
Product or demand substitutability Profit-maximizing model of hospital behavior Utility-maximizing model of hospital behavior Physician control model of the hospital Non-price hospital competition Hospital price discrimination
Medicare Diagnostic Related Groupings (DRGs) Cost shifting

Learning Objectives
Upon completing this chapter, the reader should be able to:
• 9 scuss the different theories why most hospitals are"not-for-profit."
•	_ontrast the utility maximizing, profit maximizing, and physician control
models of hospital behavior.
•	Explain why hospitals engaged in non-price competition before the 1980s.
•	Describe how hospitals competed under managed care.
•	Explain why hospitals in a price-competitive market are unable to "cost-shift."

CHAPTER 11 TheMarketforHospitalServkes • 259

BACKGROUND

The most important institutional setting to be analvzed is that of hospitals. In 2002, hospital expenditures totaled more than $486 billion, or 36.3 percent of personal health care expenditures and constitute the largest single healthcare expenditure category. Hospitals have been both the object and the beneficiary of much federal and state legislation. A great deal more emphasis is therefore devoted to hospitals than to other institutional settings.
Hospitals are classified according to the major type of service delivered, length of stay, and control or ownership. A short-term hospital is one in which its patients, on average, have lengths of stay of less than 30 days. As shown in Table 11-1, of the 5,801 hospitals listed by the American Hospital Association, 5,170 are classified as short-term hospitals. The major types of services by which short-term hospitals are classified are general, psychiatric, and tuberculosis and other respiratory diseases. The general hospital is the pre-dominant type of hospital; 4,927 hospitals have this service classification. Hospital control or ownership can be categorized as governmental (i.e., federal, state, and local), non-profit (i.e., voluntary or community), or for-profit.
Psychiatric, tuberculosis, and long-term hospitals have generally been public institutions for welfare reasons and because of externalities, such as the contagiousness of tuberculosis which led the state to pro-vide care for such persons in order to protect the rest of the population. The demand for such public institutions has decreased dramatically.
The decline in demand for tuberculosis hospitals has been the result of improved environmental conditions, widespread testing and earlier discovery, and improved treatment techniques. New treatment techniques for mental illness, including drug therapy, have shifted the demand for incarceration in a public psychiatric hospital to a demand for treatment in non-government psychiatric facilities with a shorter length of stay. Short-term general hospitals have also developed substitute facilities in the form of psychiatric units; these, together with outpatient treatment, provide psychiatric services that have left only the

poor, the senile, and the incurable to the care of mental hospitals which provide care of a different quality at much lower cost.
The decline in demand for long-term hospitals is partly attributable to the development of substitute facilities (i.e., nursing homes), along with increased patient incomes and public insurance to pay for such care.
The demand for care in short-term general and other special hospitals, however, has increased over time, particularly since the 1960s. This increased demand resulted from the growth in health insurance, an aging population, and changes in medical technology which made possible the provision of new services, such as organ transplants. Since the mid 1980s, however, innovations in medical technology have made it possible to perform many surgical procedures in an outpatient setting. And insurance companies' interest in lowering the cost of hospital care shifted the demand for many surgical procedures from the hospital to outpatient surgery centers. Continued advances in medical technology are leaving the hospital with "high tech" type services while shifting the treatment of most other types of services to an outpatient facility.
The analysis of the market for hospital services emphasizes the performance of the short-term general hospital, and within that type of hospital, the voluntary, non-profit institution. The predominant form of control and organization of the short-term general hospital is nongovernmental and non-profit; these hospitals number 2,998. State and local governmental are next in predominance, numbering 1,156; then come the for-profit (investor-owned) hospitals, with 754. When one examines the data in Table 11-1 on admissions and the number of beds, the voluntary non-profit short-term general hospital is even more predominant as the major institution involved in the delivery of hospital services. These institutions have 71 percent of the short-term general beds and admit 70 percent of the patients.
Table 11-1 reveals that the large majority of short-term general hospitals have fewer than 200 beds, with 46 percent having fewer than 100 beds. These same hospitals, however, account for only 11 percent of

260 • Health Care Economics
pWrapPolygonVertices8;7;(9528,0);(9528,86);(0,86);(0,21599);(21599,21599);(21599,0);(9528,0);fBehindDocument0Table 11-1. Selected Data on U.S. Hospitals, 2001

admissions. The vast majority of admissions, about 70 percent, occur in hospitals that have 200 beds and more.
Hospitals not only differ in their size and owner-ship, but also in the services they offer. Hospitals are multi-product firms. The services offered in a 500-bed teaching hospital are different from those found in a 150-bed community hospital. Further, while both institutions will offer some similar services, such as obstetrics, the larger teaching hospital will also have facilities to provide care in greater depth, such as for high-risk pregnancies and neonatal intensive care units.
One indication of the multi-product nature of hospitals is the high rate of technological innovation in new services. Examples of technological innovation over the last 17 years are shown in Table 11-2. The number of hospitals offering organ transplantation

has risen from 244 hospitals in 1984 to 386 hospitals in 2001. (The cost of an organ transplant is approximately $250,000, but it varies by organ. For example, while it is $100,000 for a kidney transplant, it costs $250,000 for a liver, $300,000 for heart and lung, and as high as $470,000 for an intestinal transplant.) The percentage of hospitals with new diagnostic equipment, such as Magnetic Resonance Imaging (MRI) de-vices, has risen from 3 percent to 56 percent. Thus simple comparisons of hospital costs between hospitals or over time should be used with caution since such comparisons do not allow for the vast differences in services offered or the introduction of new technology.
The picture that emerges of the hospital industry is of many small hospitals, likely located in rural areas, operating at low occupancy rates, and serving a small percentage of the patient population. The growth in medical technology has occurred at the larger-sized

CHAPTER 11 The Market for Hospital Services • 261
Table 11-2. Trends in Selected Medical Technologies Provided by Community Hospitals, 1984 and 2001

hospitals where most patients are treated, and which are located in more urban communities.
The above descriptive data illustrate the changes that have been occurring in the hospital sector. The short-term general hospital has increased in size and in the volume of services delivered; it has changed its product, and in turn there have been very large in-creases in the cost of its output. The large sums of money spent on hospitals make it important to deter-mine the efficiency with which this market performs.
Also important for understanding the behavior and performance of this industry are its special characteristics, namely, its non-profit ownership status and the role of the hospital's medical staff in control-ling the use of the hospital's resources in providing patient treatment that distinguish it from other types of firms.

DETERMINANTS OF MARKET STRUCTURE

The market structure for hospitals can be characterized according to how many hospitals compete with one another. At one extreme is the competitive market where there are many competitors. At the other end is monopoly, with only one hospital in the market. Two important factors determine how many hospitals compete within a given market: economies of scale and barriers to entry. Entry barriers increase the mar‑

ket power—hence profitability—of those hospitals currently in the market. Such barriers have, at various times, proven to be significant in determining the number of hospital competitors. For example, Certificate of Need (CON) legislation required that a hospital receive approval from a state agency before the hospital was able to build or purchase facilities or equipment that exceeded $100,000. New hospitals trying to enter a hospital's market were denied a CON. Existing hospitals also used CON legislation to prevent their competitors from adding services to compete with those offered by their own hospital.
Similar to entry controls have been quasi-controls, such as the (previous) refusal of an insurance company (e.g., Blue Cross) to pay for hospital care in certain types of institutions (e.g., for-profit hospitals). The price to the patient of going to a for-profit hospital was thereby increased relative to a non-profit hospital where the patient's Blue Cross insurance paid for everything.
During the period of managed care competition from the early 1980s to 2000, utilization management and the shift to outpatient care created excess capacity among hospitals; entry barriers were not a significant determinant of hospital market structure. More recently, however, excess capacity has declined, in part because of hospital mergers. In the many states not having Certificate of Need legislation, economies of scale is the main determinant of market structure.

262 • Health Care Economics

The Extent of Economies of Scale in Relation to the Size of the Market

Economies of scale occur when average cost falls as the size of the firm is increased. The theoretical relationship between hospital cost and size is U-shaped. As the size of the facility (and its production) is in-creased, average cost per unit decreases, reaches a minimum, and then increases. The reasons for this expected relationship are several: with a larger facility there can be greater specialization of labor; further, licensure, as a means of assuring competent personnel in the health field, limits flexibility in delegation of tasks; thus larger institutions are able to more fully use licensed and specialized personnel than can smaller hospitals. Specialized equipment and facilities can also be used to their capacity in larger institutions. Finally, larger institutions are more likely than smaller institutions to be able to take advantage of quantity discounts in purchasing.
Offsetting these advantages of size is the greater proportion of time and effort required to coordinate and control work in large organizations. In general, for sufficiently small outputs, efficiency increases with size because the advantages that accrue from the use of specialized labor and equipment far outweigh the increased cost of management. As size increases, however, the reduction in per-unit cost afforded by greater specialization begins to decline and is eventually outweighed by increased costs of coordination and control. Other things being equal, average hospital costs thus may be expected to decline initially and then rise as size is increased. How rapidly these gains and losses from scale of operation occur is what determines the shape of the long-run average cost curve.
For a given size of market, the larger the firm size required to achieve the minimum costs of production, the fewer the number of firms that will be able to compete. In a price-competitive market, when the most efficient size of firm is large, smaller firms with higher average costs will not be able to survive. Also deter-mining the competitiveness of a market is the size of the geographic market (the larger the geographic market the greater the number of competitors), and the closeness of substitutes.

Determination of market structure and the existence of hospital market power have become important in recent years because of an increase in hospital mergers. The Federal Trade Commission (FTC) and the Department of Justice (DOJ) are concerned that hospital mergers will lessen competition in the merging hospitals' market.' Crucial to the prosecution of the resulting anti-trust case are two important elements, both of which determine whether there are close substitutes to the merging hospitals: the definition of the relevant product market and the definition of the merging hospitals' geographic market (and the relative market shares of the merging hospitals within those markets).
Depending upon the definition of the geographic (and product) market, a market structure can be either monopolistic or competitive. For any least cost size of hospital, the larger the geographic size of the market, the greater are the number of hospitals that are able to compete in that market. The geographic definition of the hospital's market determines which hospitals compete with one another.
When there are no close substitutes and the particular service is the only one in a particular geographic area, then the hospital with that service has market power, that is, it has monopoly power.
Market power is generally defined as a firm being able to act without suffering any economic harm, namely, the firm would not lose a significant amount of sales if it were to raise its price, e.g., 5 percent, or provide less acceptable services. If a firm were to do either of these actions when close substitutes are
1. In addition to the argument that the merger does not lessen competition and/or that entry is easy for new firms, the merging hospitals may justify the merger on grounds that efficiency will be increased by taking advantage of economies of scale, the cost savings of which will then be passed on to consumers in the form of lower prices. Another justification used for the merger is to save a failing hospital, thereby preserving its assets for competition. With the merger there will be the same number of firms as if the hospital failed; further, that there are no other potential buyers for that failing hospital. Given the limited empirical evidence on economies of scale, it is difficult to prove large efficiencies as a result of a merger. In the latter case, the failing hospital should be acquired by the least-competitive hospital so as to not be anti-competitive. http:/ /www.ftc.gov/bc/healthindex.htm

CHAPTER 11 TheMarketforHospitalServices • 263

available and other competitors are located nearby, their higher prices or less acceptable services could not be maintained; patients would either switch to competitors, to firms that offer close substitutes, or new competitors would enter the market. In a competitive market, price and other attributes of the service would reflect their respective marginal costs. Only with market power would a firm be able to raise its price above marginal cost without fear of competitors' actions.
In merger cases, the relevant product and geographic markets as defined by the FTC are generally narrower than the definitions used by the analysts for the merging hospitals. A very narrow interpretation of the relevant product and geographic markets would find that there are no close substitutes to the hospital's service and that the geographic area served by the hospital is sufficiently small as to find few other competitors. Under this narrow definition, the merging hospitals would be found to have a high market share in both the product and geographic markets, thereby providing the merged hospitals with increased market power. Proponents of the merger typically develop broader interpretations of the geographic and product markets, thereby indicating a smaller market share for the merging hospitals.
Product or demand substitutability depends upon a willingness of purchasers or patients to use alternative services. Alternative services should be reason-able substitutes, i.e., have a high cross-price elasticity. Presumably, adult open heart surgery has low substitutability with other surgical procedures, while inpatient cataract surgery has a high substitutability with outpatient cataract surgery. One indication of how close a substitute two products are is their price differential (assuming the prices are not regulated by government). If the price of one service has a much higher price than the other, then they are usually not close substitutes. Typically, product market definitions have been less controversial in merger cases.
The determination of the relevant geographic market has been more difficult to determine. Conceptually, the relevant geographic market would include suppliers who are currently in the market; second, those firms in the market not currently pro-

viding the service but who could add that service in a reasonable time period; and third, suppliers not in the market but who are capable of entering the market within a reasonable time. Entry by new suppliers into a geographic market is easier for services that are subject to small economies of scale, such as a competitor hospital offering a wellness screening program. More complex and costly programs, such as a transplant program, could only be introduced into a market after a number of years.
The patient's willingness to travel to other suppliers of the service also defines the geographic market. Patients might be willing to travel to a more distant hospital that is less expensive (or higher quality) than be admitted to a local hospital that is more expensive (or of lower quality) when the value of their travel cost and time is less than the higher costs of going to the local hospital. The total price of hospitalization includes the implicit costs of travel and time plus the explicit out-of-pocket cost of the hospital and is the relevant price to the patient, not just the hospital portion of that price.2 Thus, when a high value is placed on patient travel relative to the cost of the service, such as for emergency care and obstetrics services, then the relevant market is smaller than when the patient is willing to travel further for more costly services, as is the case for elective surgery, such as transplants. One study found that distance has an important effect on hospital admissions for selected surgical procedures; a 10 percent decrease in distance increased admissions by 13 to 14 percent (1).
2. In addition to providing information useful for determining hospital market structure, knowledge of hospital economies of scale is also useful for planning regional hospital systems. Planning such systems requires the same information that would produce the outcomes of a competitive market. In a competitive system, economic efficiency is achieved when both implicit as well as explicit costs are minimized. Thus, in addition to economies of scale (explicit costs), there are additional costs, such as patient travel cost and the cost of not having a bed (or service) when needed. For a discussion of the economics of health facilities planning and an illustration with respect to obstetric facilities, see Millard F. Long and Paul J. Feldstein, "The Economics of Hospital Systems: Peak Loads and Regional Coordination," American Economic Review, 57(2), May 1967, 119-129.

264 • Health Care Economics

The relevant geographic market is also affected by the definition of the product market; the market area for wellness and transplant programs are not the same. The relevant geographic market thus depends upon the type of care, with primary care services having a more localized market while tertiary care has a broader geographic market.
Controversy exists as to how the geographic market for hospitals should be empirically defined (2). Several studies have used a specific geographic distance, such as a 5- or 15-mile radius around a hospital (the hypothesis being that the patient's physician is unwilling to travel long distances to admit and treat the patient). Others have used government designations, such as counties or Standard Metropolitan Statistical Areas. (Geographic definitions, such as county, are usually larger than the hospital's actual market.) Other researchers have used patient origination data, defining the market as consisting of those ZIP codes from which a hospital drew a certain percentage of its patients, e.g., 75 to 90 percent of its patients. In such cases, a hospital was defined as a competitor if it admitted a certain percent, e.g., 25 percent, of its patients from that hospital's market.
Within a geographic area, researchers have classified the market as being more or less competitive based on the number of hospitals in that area; others have used the Herfindahl-Hirschman Index (HHI), which is the measure of concentration used by the Department of Justice in its merger guidelines.3 The advantage of this index is that it is sensitive to both the number of firms and to their relative sizes (e.g., percent of total admissions). Thus for the same number of firms in the market, the index will indicate greater market concentration if a few firms have a
3. The Herfindahl Index is calculated by summing the squared market shares of each firm in the market. For example, if there are five hospitals in an area and each has the same market share, 20 percent, then the HHI is
202 + 202 + 202 + 202 + 202 = 2,000.
If the five firms had unequal market shares, the HI-II would be 402 + 302 + 102 + 102 + 102 = 2,800.

high market share than if all the firms had the same share. A merger between large firms will result in a much greater increase in the index than if two small firms merged.
Estimating whether a merger may be anti-competitive involves calculating the market share's HHI index of each of the competitors (within the relevant product and geographic markets) both before and after the proposed merger. If the new HHI exceeds 1,800 under the proposed merger, then the merger is likely to trigger an anti-trust investigation. The HHI, however, is not sufficient by itself to indicate whether the proposed merger will be anti-competitive; it is also necessary to determine the competitiveness of that market, how hospitals compete, and whether competition will be decreased as a result of the merger.
As the number of hospital mergers increase and more anti-trust cases are brought against such mergers, greater effort is being placed on defining hospital geographic markets and whether mergers lessen competition in those markets.

Empirical Findings on the Extent of Economies of Scale in Hospital Services

It has been difficult to empirically estimate the cost-size relationship of hospitals. Hospitals are not homogeneous in size or other characteristics. Hospitals are multi-product firms. In addition to producing in-patient services (which differ in their quality), the type of patient treated, and the severity of the particular case, hospitals also produce outpatient services (education, training, research, and community services). Hospitals also differ in the prices they pay for their labor and non-labor inputs as well as in their efficiency of operations. Studies have found it difficult to estimate the effect of size on average cost while holding constant all the other factors mentioned above.
For example, if larger hospitals are subject to economies of scale but they also treat more seriously ill patients, then it may appear that larger hospitals have higher per-unit costs. This problem is illustrated

CHAPTER 11 The Market for Hospital Servkes • 265

in Figure 11-1. The hospital represented by the short-run average cost curve at point C is on a lower (different) long-run average cost curve than hospital B or A because it provides fewer services. If one were to examine unadjusted (for number of services) data on average cost and size, one would observe data points that represent the relationship between hospitals D and A. It would appear that hospital D (which is smaller) has lower costs than hospital A, and that average costs increase as the size of the hospital is similarly increased.
If the different products offered by these two hospitals can be held constant, then it would be deter-mined that hospital A is producing its output in the least costly facility (it is operating in a facility that is at the minimum point on its long-run average cost curve) on long-run average cost curve LRAC3. Hospital D, however, is not only producing a different product (one that is less costly to produce than the one produced by hospital A), but it is also in a facility that is not least costly; it is at point D rather than point C.

Figure 11-1. Variations in average cost between hospitals.

Researchers have used two general approaches for estimating hospital economies of scale. The first is a multivariate analysis where the different factors affecting hospital costs are included in the empirical analysis so as to be able to determine the net effect of size on average costs per admission or per-patient day (3). Examples of measures that have been included in cost studies are the number and type of facilities and services, patient case-mix measures (the proportion of a hospital's patients classified into various diagnostic categories), quality (mortality rate, non-patient care outputs of the hospital, such as teaching programs, and the impact that interns and residents have on hospital costs), outpatient services (which may share facilities and equipment with inpatient services in the hospital), and differences among hospitals in their physicians' contribution to the hospitals' output (4). For example, teaching and community hospitals differ in their employment of staff physicians. Hospitals that employ physicians will include in their costs the physician's salary and consequently have higher costs than hospitals that do not employ physicians, although there may be no difference in either hospital's output.
To summarize the findings on economies of scale, there appear to be slight economies of scale: hospitals with approximately 200 to 300 beds appear to have the lowest average costs. The shape of this average cost curve is shallow; that is, it does not fall sharply, nor is the minimum point much below that of hospitals on the ends of the curve.4
4. To determine whether there are economies of scale, the output measure is allowed to be curvilinear; that is, either the variables are transformed into logarithms or a squared term is included for the output measure. For example, if the net effect of beds on average cost per admission is -0.04 BEDS + 0.0001 BEDS2, then the size of hospital with lowest average costs is determined by taking the partial derivative of AC with respect to BEDS, setting it equal to zero, and solving for BEDS.
yAC
= -0.04 + 0.0002 BEDS = 0
yBEDS	+ 0.0002 BEDS = +0.04
BEDS = 200
Average costs per admission would be at a minimum in hospitals with 200 beds.

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For highly specialized services such as organ trans-plants, the extent of economies of scale can be used to indicate how many such services can be offered in a given area.
Hospital cost studies have found that the mix of patients in the hospital is an important determinant of hospital costs; in some cases, case mix explains more than 50 percent of the variation in average costs between hospitals. Since large teaching hospitals have a sicker mix of patients, unless case mix is held constant, it would appear that they are subject to diseconomies of scale. (Accurate measurement of the hospitals' patient mix and the complexity of the cases is important in paying hospitals under any prospective payment system, such as Medicare and Medicaid).
The second type of study for estimating economies of scale is survivor analyses that examine changes in the size distribution of hospitals over time. Hospitals with the lowest average cost would be expected to gain market share, while those that are either too large or too small would be expected to lose market share. Survivor analyses implicitly include all the factors that affect hospital costs, such as multiple out-puts and services offered, as well as patient travel costs, whereas multivariate studies must attempt to include them and develop accurate proxy measures for each.
Survivor-type analyses have found that hospitals with less than 100 beds have lost market share over time. Thus, similar to the multivariate studies, it appears that hospitals with more than 100 beds, up to about 300 beds, have lower average cost (5).
Lending support to the finding of economies of scale is data showing changes in the size distribution of hospitals over time, shown in Table 11-1. In the period before the onset of managed care (which created excess capacity among all size hospitals), the average hospital size had been increasing. The number of hospitals in the smaller bed size categories, less than 100 beds, declined (they expanded in size), while the number of hospitals in the larger bed size categories increased. Since hospitals were reimbursed according to their costs during this period, this change in the size distribution of hospitals was not necessarily due to greater efficiency with increased size. (Since the mid 1980s with the decline in hospital use, part of the

decrease in the number of small hospitals has been a result of their closure rather than increases in their size.)
In the managed care period 1985 to the present, hospitals were no longer paid according to their costs, price competition became more pervasive, there were greater incentives for efficiency, utilization declined as a result of utilization management, and technological advances permitted many types of surgical procedures to be performed in outpatient surgery centers. Many hospitals came under severe financial pressures. As hospitals were forced to close and others to merge, the largest percent declines occurred among the larger sized hospitals, more than 300 beds. The size distribution of hospitals appears to be compressing; hospitals at greatest risk of closure or merger appear to be both very large and small (rural) hospitals. The least-cost size of hospital now appears to be about 200 beds.
Given the above findings regarding economies of scale, it becomes important to examine the geographic size of hospital markets to determine how many hospitals can compete within their markets, hence the type of market structure.

The Extent of Hospital Markets

In 2001 there were 4,907 community hospitals. Of these, 2,741 were located in metropolitan areas, and 2,166 were in non-metropolitan areas. While 56 percent of the community hospitals are located in metropolitan areas, these hospitals contain 79 percent of the beds in community hospitals. Metropolitan Statistical Areas (MSAs) are government designations for geographic areas that represent an integrated social and economic area. A city with a population of at least 50,000 would be considered an MSA. MSAs would not necessarily be indicative of a particular market in which a hospital competes since for some services the travel time might be too great while for other services (those subject to large economies of scale) the market may encompass multiple MSAs. However, the number of hospitals within an MSA provides a general indication of the number of competitors within a hospital's market.
As shown in Figure 11-2, in 2001, 169 MSAs (or 46 percent) have fewer than 4 hospitals, and 63 MSAs (18

CHAPTER 11 TheMarketforHospitalServkes • 267

percent) have 4 to 5 hospitals. The remaining MSAs (36 percent) have more than 6 hospitals. However, these 36 percent of MSAs with 6 or more hospitals contain approximately 78 percent of the community hospitals that are located in metropolitan areas.
Based on the above calculations, it would appear that for the community hospitals that are located in MSAs (56 percent of all community hospitals and 79 percent of the beds), 46 percent of the MSAs have highly concentrated markets (less than 4 hospitals), and another 18 percent of MSAs are also quite concentrated (4 to 5 hospitals). (It is important to remember that the relevant geographic market for specialized services is likely to encompass more than one MSA.) However, these concentrated markets (64 per-cent of the MSAs) represent only 22 percent of the community hospitals located in metropolitan areas (MSAs). The large majority of community hospitals (and beds) are in less concentrated MSAs, with more than six hospitals per MSA.
In concentrated hospital markets, the market structure may be characterized as being an "oligopoly," that is, the hospitals are mutually interdependent; each

hospital is aware that they are affected by their competitor's behavior. In the current price-competitive environment and limited measures of hospital quality by which hospitals can differentiate themselves, hospitals in oligopoly markets compete on price to be included in an insurer's provider network. Hospital mergers in oligopoly (concentrated) markets are likely to be closely examined by federal anti-trust agencies.
The market structure of 36 percent of the MSAs, which contains 78 percent of the community hospitals in MSAs, could be characterized as "monopolistic competition." Hospitals in these markets are also engaged in price competition. Mergers and acquisitions are being used to consolidate hospitals in these markets so that the resulting number of hospital systems within a market are representative of oligopoly markets.
The size of most hospital markets for specialized services has expanded, making these markets more competitive. Travel costs for the patient and family are a small portion of total medical costs for complex treatments. The demand for highly specialized services is generally not of an emergency nature; the relevant market in which competition for such services

Figure 11-2. The number of hospitals in metropolitan statistical areas, 2001.

268 • Health Care Economics

occurs is much larger and for some specialized services, such as organ transplants, at a regional. (Thus, it is unlikely that a case can be made for treating them as a natural monopoly.)

The Growth of Multi-Hospital Systems

The structure of the hospital market has changed over time. Until the late 1970s, hospitals were predominately non-profit, independent institutions, generally competing in local markets, and providing inpatient services. Currently, hospitals are part of a larger organization, a multi-hospital system, and provide a broad range of services, such as ambulatory care clinics, inpatient care, outpatient surgery, and home care.
Non-profit multi-hospital systems have made the industry more concentrated and vary in how closely the hospitals within each system are controlled. In some systems, the hospital affiliation agreements are relatively weak. The hospital and its medical staff are able to retain their decision-making authority over expenditures and investments. Weak forms of affiliation enable the hospital to take advantage of some economies of scale, such as joint purchasing arrangements.
In stronger affiliations, hospitals are completely merged into the larger organization; the institution loses its autonomy. The reasons favoring this type of arrangement are also to take advantage of economies of scale, such as lower interest costs and greater access to the capital markets, lower administrative costs, as well as improved cash management and lower malpractice premiums. There are also economies in marketing a large network of providers to an insurer as compared to insurers contracting with separate facilities. Further, merging hospitals in the same market consolidates that market reducing the number of competitors, and increases the combined hospitals' market power; they are able to negotiate higher prices with insurers and HMOs. Each of these reasons re-quires the institution to be more tightly integrated with the other hospitals in the system. Those hospitals facing declining occupancy rates, more stringent reimbursement policies, and declining profitability are more willing to give up their autonomy to survive.

Multi-hospital systems, which are comprised of investor owned, secular non-profit, religious, and public institutions, represent about 40 percent of the total nonfederal short-term general beds. Although there was an increase in the number of non-profit hospital systems during the 1990s, most of these systems are relatively small, between five to ten hospitals each. While the number of investor-owned systems declined (largely through mergers), the average number of hospitals per system increased to 42 hospitals per system in 2001 (6). The number of hospitals per system, however, varies greatly.
There are fewer hospitals in non-profit systems be-cause these systems attempt to increase their market share within a particular geographic area. Hospital systems have also joined together in voluntary purchasing networks to take advantage of purchasing economies. Several investor-owned systems have concentrated on non-urban markets where there is little competition; they purchase a non-profit hospital that is in financial difficulty and invest capital to add services and attract physicians. These investor-owned systems have been financially successful with this strategy.
To remain independent and profitable, an unaffiliated community hospital must be located in a growing market where a high percent of the population has private health insurance and has a high degree of market power. Not many community hospitals are in such a situation.

Vertical and Virtual Integration

The role of the hospital and its product line has been changing. Before managed care and under fee-forservice payment, hospitals were the center of the medical delivery system. The most modern technology was housed in the hospital, hospitals competed for physicians based on their technology and services, and hospital administrators were concerned with filling their beds. As managed care grew, provider incentives changed, and procedures began to be shifted outside the hospital. It became more profitable for HMOs (as well as hospitals and their physicians) to keep capitated patients out of the hospital. Medical

CHAPTER 11 TheMarketforHospitalServices • 269

technology reinforced capitation payment incentives by making possible greater use of non-hospital services such as outpatient surgery, diagnostics, sub-acute care, and home care. Hospital utilization decreased. Hospitals had to compete on price to be included in the insurer's provider network before they could compete for physicians.
Hospitals became concerned that they were being moved from the center of the delivery system to its periphery.
As the entity with the largest investment in fixed assets and greatest access to capital, hospitals sought to preserve their centrality by changing their role. In addition to integrating horizontally to take advantage of economies of scale and to increase its market power in an area, hospitals attempted to become vertically integrated organizations, also referred to as Integrated Delivery Systems (IDS). An IDS encompasses the entire production function for health care; it combines the successive stages of production and distribution of medical services into one organization. For example, in a capitated environment the IDS will include services such as wellness care, acute care, as well as recovery and rehabilitation. All of the various institutional settings are included, from ambulatory care, inpatient care, outpatient care, and home health care.
A hospital can produce a particular service itself or purchase it from suppliers. Important to the hospital's decision of "make or buy" is whether there are economies of scale in the production of the service and differences in the transaction costs of these options. These transaction costs, in addition to the actual prices paid for supplies and labor, are part of the costs of producing a service. To be efficient, a firm must also minimize its transaction costs. When the transaction costs of dealing with suppliers exceeds the trans-action cost of producing the service itself, all else being equal, then the firm is likely to vertically integrate the supply of that input.
A hospital's transaction costs (or the costs of con-trolling and coordinating the delivery of medical services) involve the collection of information about the different suppliers of each of the components of medical services, the negotiation of separate contracts

with each set of suppliers, monitoring compliance with the contract, and the hospital's ability to enforce such contracts. The necessity for frequent negotiations with suppliers, uncertainty as to the suppliers' quality, and the difficulty of monitoring a supplier's behavior increase transaction costs to the firm. (7)
When payment systems were cost based and each provider was separately reimbursed, a provider had little incentive to be concerned either with economies of scale or with transaction costs. They were not at risk for either their own or other providers' behavior.
In the new competitive environment and fixed Medicare DRG prices, the dependence of hospitals on providers in other parts of the production process particularly physicians, increased. Hospitals were placed at financial risk for their physicians' behavior and they controlled hospital referrals.
The shift to fixed DRG prices also increased the interdependency between hospitals and nursing homes. Under DRGs, hospitals have a financial incentive to discharge a patient early since they will not be reimbursed for the additional costs they incur on behalf of a patient. Many aged patients, however, can-not be immediately discharged to their home but need to be in a nursing home. Nursing homes, how-ever, have an incentive to accept less severely ill patients since they are separately reimbursed by Medicare according to maximum prices. Given the uncertainties of having adequate facilities to discharge their patients, some hospitals purchased nursing homes. It is costly for the hospital to negotiate customized contracts with the nursing home for each of its discharged patients, who vary in their care needs and discharge dates.
The dependence of hospitals upon other providers and the difficulty of specifying contracts in great de-tail resulted in hospitals purchasing the separate components of the delivery and distribution system.
By coordinating care in different settings, the IDS expected to have a competitive cost advantage over less integrated delivery systems. Patients would be able to move smoothly throughout the system and through different levels of care with their medical in-formation available to each provider and without having unnecessary duplication of services or tests.

270 • Health Care Economics

Essential to the success of an IDS are appropriate financial incentives among the various components of the system, primary care physicians, specialists, hospital administrators, etc., capital to invest in developing an exclusive physician infrastructure, and an in-formation system that enables coordination of patient care to occur without duplication of tests, etc.
Although a number of organizations attempted vertical integration, few, if any, were successful. Hospitals purchased physician practices only to find that physician productivity declined since physicians no longer had the same financial incentives as previously. Other hospitals invested in medical groups only to find that the medical groups did not share a common vision, or that the group's financial incentives resulted in conflict with the hospital. Hospitals were also unable to develop the necessary information systems to coordinate care within the entire delivery system. Physicians were also concerned with the governance of the IDS, believing that too much control rested with the hospital. The lack of a culture of cooperation between non-profit hospitals and affiliated physicians also limited the organization's integration.
Several larger medical groups believed their organization should be the one to integrate the delivery of medical services. The growth of very large medical groups resulted in an increase in their market power relative to that of hospitals. These medical groups decided that they could make more money by contracting with an HMO for all the patient's medical services. The medical group would receive a capitation payment from the HMO for either all of the medical services, such as 85 percent of the premium, or for just the medical portion, e.g., 40 percent of the premium, and share in the savings from reduced hospital use and cost. The medical group would then manage the production function for healthcare (produce medical services) less expensively by contracting with hospitals and other providers rather than integrating with a hospital under a common ownership and governance. Given hospitals' excess capacity, these large medical groups believed they could negotiate better hospital rates than if they had to purchase or use the hospitals within their own organization.
In a virtually integrated organization, the medical groups believed that the alignment of organizational

incentives were improved in a contractual rather than in an ownership relationship.
Few medical groups were successful at integrating the delivery of medical services. These groups did not have the management expertise, the necessary capital for expansion, the information systems, or the group culture for working together. Several large medical groups sold their assets to publicly traded physician management companies in return for management expertise and capital but were still unsuccessful at fulfilling their promise. Both the physician management companies and the medical groups suffered financially.
Organizations attempting vertical or virtual integration have been unsuccessful in being able to coordinate performance among the different entities in the delivery of care, developing an acceptable structure of organizational governance, and instituting an approach for managing clinical innovation.
The different providers of medical services, e.g., hospitals and physicians, have divergent interests. What are the most effective incentives to be used so that providers will coordinate their activities? Two approaches that are used to improve performance are, first, cooperation between different providers (as occurs when all providers work for one organization) and, second, relying on financial incentives, as when different providers engage in contractual relation-ships. Each approach has advantages and disadvantages. Developing specific contracts to govern all aspects of a provider's performance is difficult given differences among the patient population and their severity of illness. Alternatively, relying on provider cooperation entails weaker financial incentives for providers to be productive. Alignment of financial incentives among mutually dependent provider groups is difficult to achieve.
With regard to governance structures, the for-profit model is clear in its objectives and results in quicker response to poor management. However, for-profit companies have a shorter time horizon in calculating their investment return; they may also have less of a commitment to their communities since a subsidiary may be closed or merged with another organization depending upon its profitability. Conversely, non-profit organizations are less account-

CHAPTER 11 The Market for Hospital Services • 271

able for their performance and slower to react to market changes.
Important to the future success of any organization is their ability to innovate. Do vertically integrated systems have a greater commitment to maintaining their large investment in fixed assets and their current provider network than in developing innovations that threaten their existing stakeholders? Do virtually integrated systems have greater financial incentives to innovate than systems that rely on cooperative relationships? Which type of organization and which incentives offer the greatest encouragement to under-take risk? The rewards of risk and innovation in a large organization are diffused throughout that organization, while failure resulting from risk is more apt to be concentrated among several persons.
Organizational change is constantly occurring as the competitive market evolves. While it is difficult to anticipate new types of organizations, virtual organizations (based on contractual relationships) appear to offer more promise in solving the problems of an acceptable governance structure, performance incentives, and incentives for innovation.
HOSPITAL CONDUCT AND BEHAVIOR
To understand and to be able to evaluate the performance of the hospital industry, it is first important to examine three aspects of this sector: the determinants of the industry's structure, payment systems and their effect on hospitals' incentives, and the objectives of hospital decision-makers. The industry's market structure, based on economies of scale and le-gal restraints on entry, is typically an important factor determining the number of competitors in a market, the type of competition among firms, as well as the performance of that industry.
In addition to market structure, hospital objectives and the payment incentives facing hospitals affect the type of competition among hospitals (and their consequent performance). Most hospitals are non-profit organizations, thus it is important to determine whether their market behavior is likely to differ from for-profit hospitals.

In a competitive system, the assumption that firms will attempt to maximize their profits makes it possible to predict what a firm's supply response will be to changes in demand and/or changes in its input prices. With entry into the industry permitted, firms would be expected to minimize their costs, and their prices will reflect the costs of production; there would be no internal cross-subsidization of patients or of users of different services. If prices are higher than production costs, new firms will enter the market and sell the service at a lower price. Because of the assumption of profit maximization and entry, prices would (in the long run) be expected to equal costs (which includes a normal profit); the different mix of services provided would reflect what people are willing to pay for those services, which in turn would reflect their full costs. Competing firms would attempt to minimize their costs, and investment decisions would be based on profitability (i.e., demand and cost conditions).
Hospitals are predominantly non-profit organizations, which means restrictions are placed on how surpluses are distributed. For-profit firms can distribute surpluses (earnings) to shareholders, non-profit firms cannot. This technical distinction between firms of different ownership types is less important than any potential behavioral distinctions.
The non-profit form of organization raises several questions: Why are hospitals non-profit? For-profit firms dominate most markets with few, if any, firms organized as not-for-profit organizations. In contrast, non-profit firms have traditionally dominated healthcare markets. What does this difference in ownership imply for the behavior and performance of the hospital industry? Does it, as some persons have alleged, result in lower costs of production since the hospital does not have to earn a profit and pay dividends? Or are the objectives of the non-profit hospital decision-makers such that non-profit hospitals have poorer performance? Further, important for anti-trust issues is whether non-profits act in the community's interest and therefore should not be subject to the same merger guidelines as for-profit hospitals. A model of the non-profit hospital is needed to explain its past and current behavior.

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Why Non-Profit Firms Exist
The Public Interest Explanation: There are generally two alternative hypotheses to explain why non-profit hospitals exist. The first may be termed the "Public Interest" view; the hospital's Board of Trustees operate the non-profit hospital to primarily benefit the community. According to this view, non-profits are likely to develop for those services considered to be "collective goods," such as charity care. For-profit firms would not serve the healthcare market when there was insufficient demand to generate a profit. Yet, the importance of health and the desire of individuals to support healthcare allowed non-profit firms to exist, supported by charitable donations.
Undoubtedly, hospitals as charitable institutions are part of the explanation, particularly in the years before insurance coverage and when hospitals primarily served the poor. Further, it was difficult for state governments to monitor how well subsidies to the poor were provided. By subsidizing the non-profit hospital (and nursing homes), the hospital is trusted to provide those services desired by the government. Three types of subsidies are received by the non-profit hospital to enable them to provide charity care. Donations are tax deductible; the hospital is exempt from property taxes; and it is exempt from corporate income taxes.
The co-existence of for-profit firms suggests an-other public interest explanation. Based on imperfections in the healthcare sector, coupled with the importance of healthcare to consumers, Arrow suggested that non-profit hospitals were a response to consumers' inability to judge the quality of medical services (8). In markets where there is a lack of information (informational asymmetries), such as medical care, consumers might believe that a greater degree of trust can be placed in the non-profit form of organization. Consumers in healthcare markets cannot easily verify the quality of the services that they purchase, and if they purchase services with inferior quality, it is often difficult and costly to obtain a suit-able remedy after the fact. As a result, they must place considerable trust in the firm or organization providing the service. Non-profit ownership is taken as a

signal of quality because such firms presumably de-sire to produce high-quality services and have less of an incentive to skimp on quality and save money to increase profits.
Consequently, non-profit firms are more likely to exist in industries where the quality of the product is very important and difficult to measure and monitor. If information about quality becomes more wide-spread, one would expect the prevalence of non-profit firms to diminish because consumers can observe quality more directly (9).
If the predominance of non-profit hospitals was based on patient trust, then why does the non-profit form of organization not also apply to physicians? After all, patients have little information on their medical condition and it is the physician—not the hospital—who decides upon the medical treatment.
A Physician Control Model of Hospitals: A more cynical view of the non-profit form of organization is based on economic self interest, namely, the physician-control model. Physicians favor subsidies to their inputs of production when they are concerned with the total price of care paid by or on behalf of the patient. Inputs in a for-profit hospital have to be paid their market price. However, when hospitals are non-profit, the hospital can become the recipient of philanthropic contributions (which are tax deductible), accept volunteers (who provide services at no charge), and receive substantial government subsidies, such as the Hill-Burton program. The effect of these various subsidies is to cause hospital costs to be lower than they would be otherwise. The advantages to physicians of non-profit hospitals are several. For-profit hospitals would have to pay property, sales, and corporate income taxes as well as dividends to their shareholders, thereby leaving less of the total price available to the physician (10). Further, physicians did not have to invest their own capital to own and control the hospital—the community donated it.
Another advantage to the physician is that the non-profit hospital can only use surplus funds internally. Using a criterion other than profitability, such as prestige (which would also be consistent with the goals of the trustees and managers), would be used for the in-vestment of their funds. The institution would be more

CHAPTER 11 TheMarketforHospitalServices • 273

willing to invest in duplicative services and facilities, which would be more advantageous to the staff physicians than if it were accountable to stockholders.
Physician control also enabled physicians to en-force a cartel arrangement. In the past, medical societies have been viewed as being similar to a physicians' cartel. The individual producer in a cartel always has an incentive to increase output since the costs of doing so are less than the cartel's profit-maximizing price. Unless the cartel can prevent its members from expanding their output, the monopoly price will fall. Since there are so many physicians, it is relatively costly to monitor the output of individual physicians in their offices (although the cartel can limit the use of inputs contributing to increased production, i.e., which personnel can undertake different tasks). It was far easier to limit the number of hospital beds per physician, which also acted as a constraint on the physician's productivity. By controlling the number of hospital beds, the medical society was able to limit competition among physicians for patients. Limiting the number of hospital beds, how-ever, makes them a scarce resource. If physicians were to bid for these scarce inputs, it would transfer in-come from the physician to the hospital. To retain these monopoly profits for themselves, the physicians in control of the hospital used a form of non-price rationing, either seniority or some other standard, to distribute the scarce hospital privileges among them-selves (11).
Physician control over the hospital prevents the hospital from hiring physicians and jointly producing hospital and medical services. If it were able to do so, then the hospital would receive the difference between the average costs of production and the total price charged. Medical societies ensured that hospitals would not be able to compete with physicians by having many states enact legislation prohibiting the corporate practice of medicine; only physicians could practice medicine, not organizations operated by non-physicians. If a patient required hospitalization, they had to have a physician on the staff of that hospital.
(The physician-control model would be less applicable to university teaching hospitals where decision-making is shared among different constituencies,

such as the clinical departments, medical school, and the university.)

Theories of Hospital Behavior

Three different models of non-profit hospital behavior are analyzed and their predictions compared to actual hospital performance. The first is the Public Interest model, which assumes that the non-profit hospital acts as though it were a for-profit hospital but uses the "profits" to benefit the community it serves. The second and third models of hospital behavior are based on economic self-interest; in the second model (Utility Maximizing model) the main beneficiaries are the hospital managers and employees, while in the third (Physician-Control model), it is the medical staff. Each model of hospital behavior is examined with respect to how the hospital determines its prices, output, and investment policies. Several aspects of hospital behavior are similar in each of these models.

A Profit-Maximizing Model of Hospital Behavior

This first model of hospital behavior assumes that the non-profit hospital acts as a profit-maximizing hospital and returns the "profits" to the community.
Hospitals are assumed to have a downward sloping demand curve; each hospital has a somewhat differentiated product in that not all of its physicians have staff appointments at the other hospitals, its mix of services may differ, as does its location and reputation. To maximize profits, the hospital would select that price on the demand curve where its marginal cost curve intersects the marginal revenue curve; this is shown in Figure 11-3. The profit-maximizing price and output would be P1 and Q1, respectively, and the amount of profit would be the difference between P1 and the average cost curve at that price multiplied by Q1•
Further, since the hospital is a multi-product firm with different payers, it can increase its profits by price discriminating according to the price elasticity of demand for each class of patient and type of service. (The ability of the hospital to practice price

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Figure 11-3. Price and output policies of a profit-making hospital.
discrimination implies that the hospital has market power.) The hospital's room rate is more price elastic than is the demand for ancillary services because, once in the hospital, the patient cannot substitute other providers' ancillary services. Thus the demand for ancillary services is believed to be less price elastic. To maximize its profits, the hospital will charge higher prices (relative to costs) for those services and that class of patients whose demands are less price elastic.
The Profit-Maximizing model of hospital behavior predicts that hospitals will increase their prices if demand either increases or becomes less price elastic, or if the prices of their inputs (i.e., the hospital's marginal cost curve) increase. Hospitals are also expected to minimize their costs of operation, otherwise they forego profits. Further, hospitals will invest on the basis of which investments offer the highest rate of re-turn. Examples of the types of investments hospitals could undertake would be cost-saving technology and expanding or adding new facilities and services. New facilities and services could be profitable in their

own right or could serve to attract a greater number of physicians to the hospital's staff, thereby indirectly increasing the demand for the hospital's beds. According to this model, the hospital would deter-mine its prices as would a profit maximizer, minimize its costs (since higher costs represent foregone prof-its), and invest only in projects that offer a profitable return.
With free market entry and price-sensitive purchasers, prices in excess of average costs and above-normal profits could not persist in the long run. The performance of the industry would be similar to that of a monopolistically competitive industry; along with price competition and competition for physicians, hospitals would attempt to differentiate them-selves from other hospitals. The prices of their services and classes of patients would, in the long run, reflect their respective average costs.
A non-profit hospital acting as a profit maximizer would use its profits and contributions from the community to achieve the community's desires, such as engaging in altruistic activities, such as charity care to the poor.
A non-profit hospital is not required to pay taxes nor dividends to its stockholders, thereby providing the non-profit form of ownership with a cost advantage over the for-profit hospital. If both types of hospitals behaved similarly and were equally efficient, then the non-profit hospital would be able to drive for-profit competitors out of the market.
How well does a model of the non-profit hospital as a profit-maximizing firm reflect past hospital behavior? There is evidence that non-profit hospitals priced according to their price elasticity of demand (12). Prices have been much greater than marginal costs for those services believed to be less price elastic (ancillary services), but closer to marginal costs for those services believed to be more price elastic (room rates and delivery room). Obstetric care has lower price-cost ratios since obstetric patients have the time to compare prices among hospitals.
After the introduction of Medicare in 1966, the aged represented about 40 percent of hospital patient days, and the federal government paid hospitals their costs for providing services to the aged. Because hospitals did not have cost accounting systems in place,

CHAPTER 11 TheMarketforHospitalServkes • 275

the payment method was the "ratio of charges to charges to cost." The hospital's charges to Medicare patients as a portion of its charges to all patients was the ratio of the hospital's total costs that would be reimbursed by the government. As the proportion of Medicare charges increased, so did the portion of the hospital's costs that would be paid for by the government. Anecdotal evidence indicated that many hospitals increased their charges for those services that were used predominately by the aged, such as bed rails. The effect of these policies was to increase the portion of the hospital's total costs that was reimbursed by Medicare. Medicare patients were only responsible for a deductible when they were admitted to the hospital; the patient had little incentive to choose a less costly hospital or to be concerned with the cost of their hospital stay.
Also during this period, private hospital insurance by the non-aged increased. As shown previously in Table 3-2, out-of-pocket payments by patients for hospital care decreased so that patients were, on average, responsible for less than 10 percent of their hospital expenditures. Patient sensitivity to hospital charges diminished. Other third-party payers of hospital care (such as Blue Cross) also paid hospitals according to their costs. The effect of extensive government and private insurance payment lessened patient sensitivity to the costs of their care and enabled hospitals to engage in non-price competition, resulting in very rapid increases in hospital expenditures.
The assumption that non-profit hospitals (in general) minimized their costs and returned their profits to the community in the form of additional care to the poor is not supported by the data. The amount of charity care, bad debt care, and percent of Medicaid patients served was similar to for-profit hospitals (13). Under cost-based payment prior to the mid 1980s, non-profit hospitals invested in facilities and services that were expected to result in substantial losses; cross subsidies were provided to certain facilities and services to offset their losses rather than closing them. These money-losing facilities and services were not the sole source of such services in the community, but were instead duplicative of others.

An additional problem with this model of the hospital is that it excludes any important role for the physician. According to this model, the hospital competes for physicians who then refer their patients to the hospital. The physicians' role is a passive one, to increase demand for the hospital. The model assumes that the hospital will attempt to keep adding physicians to its staff, whereas in the past the medical staff tightly controlled staff appointments and sought to limit rather than expand physician staff appointments.

Utility Maximizing Models of Hospital Behavior

The next set of models incorporates some of the observed inconsistencies of the previous model. This model suggests that the beneficiary of the non-profit form of ownership is not the community but the decision-makers, namely the managers and trustees of non-profit hospitals. One version of this model assumes that the managers themselves benefit (in terms of higher salaries) by being the administrator of the largest full-service hospital in the area.
According to this model, hospitals act as if they wanted to maximize their output or revenues. In the short run, hospitals attempt to maximize their profits and then invest those profits either in additional capacity, cost-saving technology, or facilities and services that result in the largest increases in their output. Hospitals still have an incentive to minimize their costs since to do otherwise is to forego revenue, which could be used to increase output. With reference to Figure 11-3, an output maximizer would increase out-put to Q2, which would represent the point on the demand curve where average cost equals price. This does not mean that for every service or class of patients price equals average cost, but it does in the aggregate. For different services the hospital would set profit maximizing prices and use the profits to cross-subsidize other, money losing services.
A more sophisticated version of this model assumes that the decision-makers have a utility function that includes some measure of the quality of the institution as well as its size (14). Greater prestige is associated with being an administrator or trustee of a large prestigious hospital. Prior to the 1980s, hospital

276 • Health Care Economics

quality data was not collected, and results of surveys performed by the Joint Commission on Accreditation of Hospitals was not publicly available, thus a hospital's reputation was often indicated by the range of facilities and services offered.
Under this "quality-quantity" behavioral model, the hospital will still seek to maximize its profits in the short run through its pricing strategy, but it will then attempt to invest that profit either in increased quantity—increased capacity, cost-saving technology, or facilities and services that result in an increase in quantity of patients—or in prestige/quality investments. Because quantity and quality are to some extent substitutable for one another in the utility function, the decision-makers will have to make a trade-off according to the marginal increase in utility resulting from increased quality or from increased quantity.
The effect of adding quality to the decision-maker's objective is to cause an increase in hospital costs, as shown in Figure 11-4. Assume that the hospital is operating on average-cost curve AC1. Since it cannot keep any profits, its long-run price and output will be P1 and Q1, respectively. If the hospital invests in increased quality, the average cost curve rises to AC2, but the increased quality also results in an in-crease in the hospital's demand, shifting its demand to D2. The increase in demand may occur as a result of attracting additional physicians to the hospital.
After some point, increased expenditures for quality will result in small or negligible increases in demand (competing non-profit hospitals will attempt to match these additional investments in quality); at this point, the additional cost of increased quality may exceed the additional revenue resulting from the small increments in demand. Additions to quality beyond that point continue to raise the average cost curve to AC3 but do not result in further shifts in demand. Since funds that are used to increase quality could be used to increase quantity by adding to capacity, the decision-maker has to determine the relative weights to be placed on the quantity-quality trade-off.
The consequences for economic efficiency of a utility model of a hospital attempting to maximize both quantity and quality is that the price of hospital care

Figure 11-4. The effect on hospital costs of increases in hospital quality.
will be higher than if quality were not continually in-creased. Continued increases in quality without in-creased demand will shift the average cost curve higher, possibly decreasing quantity and raising price. Further, hospitals will be producing a higher quality product (greater unused facilities and services) than consumers might be willing to pay for. Such a behavioral model would be more typical of the cost-based payment period before managed care competition became prevalent and hospitals did not have to compete on price to be included in the insurer's provider network.
In a market characterized by entry and price competition, consumers (through their choice of health plans) would select that combination of price and quality that corresponded to what they were willing to pay rather than to the quality-quantity preferences of the hospital administrator. In a price-competitive market, quality would increase in response to consumer demands for quality.

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How consistent was the quantity-quality model with observed behavior in the period before managed care? This model still implies a profit-maximizing pricing strategy and cost-minimizing behavior since the foregone revenues could be used to increase quality or quantity. However, it does explain why hospitals made unprofitable investments and maintained unprofitable services, as long as these services added prestige to the institution. This model also suggests that hospitals invested in new technology as soon as it became available, not necessarily because of its effect on demand, but because of its effect on the perceived image of the hospital.
Hospitals having a quantity-quality objective would be expected to oppose the entry of for-profit hospitals. For-profit hospitals, which do not have a prestige objective, would not have to cross-subsidize money-losing prestige services. Thus for-profits would compete with non-profits by lowering the price of the "profitable" services in comparison with the prices charged by the non-profits. Non-profits claimed that for-profit hospitals "skimmed the cream" by not offering such money-losing services.
Extensive cross subsidization of expensive, money-losing services were often duplicative, resulted in lower quality outcomes, and should not have been offered by multiple hospitals. An example of duplication of prestigious investments was the number of hospitals with open heart surgery facilities. Luft, et al., found that for complicated types of surgery, the greater the volume of surgery performed, the lower the surgical mortality rates (after controlling for other factors that might affect mortality, such as the patient's age, sex, and health status.) (15).
One of the drawbacks to the quantity-quality model is an expectation of cost-minimizing behavior. This can be corrected by including a "slack" variable in the manager's utility function. Hospital administrators are assumed to also be interested in working in a pleasant environment, as defined by such amenities as additional administrative personnel and higher wages for employees so as to minimize conflict. This broader utility function of the hospital administrator predicts that hospitals would still price to maximize profits, and then spend those profits to achieve some combination of quantity, quality, and slack.

With the inclusion of slack in the manager's utility function, prices will be even higher than under the previous models. Under these circumstances, hospitals would compete with one another, but the competition would be to see which hospitals could become the most prestigious while providing the administrative staff with a pleasant working environment. There would be a great deal of duplication within the industry, as well as excess capacity, high costs, and rap-idly rising prices to finance the described behavior. This type of non-price competition was referred to as a "medical arms race."
These utility-maximizing models of hospital behavior explain much of the observed data in the period before the early 1980s, prior to Medicare DRGs and managed care competition. However, they attribute a passive role to physicians. The decision-makers in the foregoing models are the hospital administrators and trustees, but in reality physicians had a great deal of control over the hospital, its pricing policies, and investment behavior.

Physician-Control Model of Hospital Behavior

This model assumes that the medical staff effectively controls the hospital, and that hospital decisions reflect the medical staff's objectives. Physicians, not the community nor the administrative staff, were the major beneficiaries of the non-profit form of hospital organization.
The physician is the manager of the patient's illness, with responsibility for deciding upon the components to be used in providing treatment. Under this model, the physician combines the treatment inputs in such a manner so as to increase his or her own in-come and/or productivity. The relevant price to the consumer (e.g., under indemnity insurance in the period before Medicare and health plan physician fee schedules) is the total amount of out-of-pocket expenditure for a treatment, not the individual price of specific inputs, such as hospital care. The physician is able to retain more of the total price, the less the patient has to pay for any one component, such as hospital care.
When the total price of medical care is the relevant price to the payer, physician pricing and behavior can

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be illustrated with reference to the previous Figure 11-3. The profit-maximizing price of the treatment is that point on the demand curve above the intersection of marginal revenue and marginal cost. The amount of profit is the difference between price and average cost. The higher (lower) the cost of other inputs, the less (more) profit available to the physician. For ex-ample, if two inputs are used in providing a medical treatment—hospital and physician services—then the average cost curve represents the cost of hospital care. The difference between the price charged the patient (P1) and the amount that goes to pay the hospital (AC at Ql) is available to the physician.
The physician acts as a contractor, retaining the amount left over after all the other inputs have been paid. In this situation, the physician has an incentive to minimize the cost of providing the treatment since higher input costs represent foregone revenue to the physician. (This situation is also similar to when medical groups are capitated and have a risk-sharing bonus for reduced hospital use. The physician's incentive is to similarly minimize total treatment cost.)
Such profit-maximizing behavior on the part of the physician is not necessarily inconsistent with the physician's acting in the patient's economic interest as well. If hospital care is free to the patient (because of the pre-1980s Blue Cross hospital service benefit policy) while the patient must pay the full price for use of other components, it was in both the patient's and the physician's interest to hospitalize the patient.
With increased demands for medical services, physicians would be expected to favor increases in their hospital's capacity in order to increase their productivity, such as by increasing the number of interns and residents who provide physician services for which the physician can charge the patient; additional facilities and services, such as an excess of operating rooms and obstetric facilities so the physician does not have to wait or be inconvenienced; and facilities and services that are available in their hospital so that the physician does not have to refer a patient to another hospital and physician, thereby risking the loss of the patient and their fee. Physicians who do not have appointments at other hospitals would favor investment by their hospital even though it may be duplicative for the community because it increases

their productivity and income. (See Appendix 1: Using A Physician Control Model To Increase Physician Productivity.)
Physicians would also prefer some hospital slack if it enables them to economize on their own time.
Physician control over hospital investment policies results in economic inefficiency. It is a more costly approach for producing additional output (increased demands for medical care). The price to the physician for these other inputs is zero, particularly if some third-party payer or the government pays them in full.
Before the mid 1960s when hospital insurance was not as extensive as it is today, the physician was more concerned with the hospital's costs since the greater the patient's financial burden for hospital care, the lower would be the payment available to the physician. In large hospitals, however, the effect on any one physician's income of inefficient behavior on the part of the hospital would be small. Only in smaller hospitals, with correspondingly fewer physicians, would physicians be expected to be concerned with the efficiency of the hospital's operation.
As insurance coverage for hospital care became more widespread and as hospital payment was cost based, physicians were able to increase their charges to the patient and were unconcerned with the hospital's inefficiency and rapidly increasing costs.
The physician-control model also explains hospital pricing behavior. Prior to the widespread availability of hospital insurance, physicians preferred that the hospital assign relatively low prices to services that were complementary to the physician's services; for example, the surgeons wanted hospital charges for the operating room priced at or below cost. Similarly, obstetricians preferred the same type of pricing policy for the hospital's delivery room. As the out-of-pocket price for hospital care declined, physicians favored hospital profit-maximizing pricing policies (as long as they did not conflict with their own pricing strategies) since such prices would result in greater hospital profits which could then be invested internally ac-cording to physician preferences.
Physicians also wanted their hospital to have an outpatient department and for the hospital to provide health screening services, both of which might appear

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be illustrated with reference to the previous Figure 11-3. The profit-maximizing price of the treatment is that point on the demand curve above the intersection of marginal revenue and marginal cost. The amount of profit is the difference between price and average cost. The higher (lower) the cost of other inputs, the less (more) profit available to the physician. For ex-ample, if two inputs are used in providing a medical treatment—hospital and physician services—then the average cost curve represents the cost of hospital care. The difference between the price charged the patient (P1) and the amount that goes to pay the hospital (AC at (21) is available to the physician.
The physician acts as a contractor, retaining the amount left over after all the other inputs have been paid. In this situation, the physician has an incentive to minimize the cost of providing the treatment since higher input costs represent foregone revenue to the physician. (This situation is also similar to when medical groups are capitated and have a risk-sharing bonus for reduced hospital use. The physician's incentive is to similarly minimize total treatment cost.)
Such profit-maximizing behavior on the part of the physician is not necessarily inconsistent with the physician's acting in the patient's economic interest as well. If hospital care is free to the patient (because of the pre-1980s Blue Cross hospital service benefit policy) while the patient must pay the full price for use of other components, it was in both the patient's and the physician's interest to hospitalize the patient.
With increased demands for medical services, physicians would be expected to favor increases in their hospital's capacity in order to increase their productivity, such as by increasing the number of interns and residents who provide physician services for which the physician can charge the patient; additional facilities and services, such as an excess of operating rooms and obstetric facilities so the physician does not have to wait or be inconvenienced; and facilities and services that are available in their hospital so that the physician does not have to refer a patient to another hospital and physician, thereby risking the loss of the patient and their fee. Physicians who do not have appointments at other hospitals would favor investment by their hospital even though it may be duplicative for the community because it increases

their productivity and income. (See Appendix 1: Using A Physician Control Model To Increase Physician Productivity.)
Physicians would also prefer some hospital slack if it enables them to economize on their own time.
Physician control over hospital investment policies results in economic inefficiency. It is a more costly approach for producing additional output (increased demands for medical care). The price to the physician for these other inputs is zero, particularly if some third-party payer or the government pays them in full.
Before the mid 1960s when hospital insurance was not as extensive as it is today, the physician was more concerned with the hospital's costs since the greater the patient's financial burden for hospital care, the lower would be the payment available to the physician. In large hospitals, however, the effect on any one physician's income of inefficient behavior on the part of the hospital would be small. Only in smaller hospitals, with correspondingly fewer physicians, would physicians be expected to be concerned with the efficiency of the hospital's operation.
As insurance coverage for hospital care became more widespread and as hospital payment was cost based, physicians were able to increase their charges to the patient and were unconcerned with the hospital's inefficiency and rapidly increasing costs.
The physician-control model also explains hospital pricing behavior. Prior to the widespread availability of hospital insurance, physicians preferred that the hospital assign relatively low prices to services that were complementary to the physician's services; for example, the surgeons wanted hospital charges for the operating room priced at or below cost. Similarly, obstetricians preferred the same type of pricing policy for the hospital's delivery room. As the out-of-pocket price for hospital care declined, physicians favored hospital profit-maximizing pricing policies (as long as they did not conflict with their own pricing strategies) since such prices would result in greater hospital profits which could then be invested internally ac-cording to physician preferences.
Physicians also wanted their hospital to have an outpatient department and for the hospital to provide health screening services, both of which might appear

CHAPTER 11 The Market for HospitalServikes • 279

to be competitive with physicians. However, the out-patient department was a convenient way of avoiding the financial risk of caring for low-income patients, and physicians were relieved of providing emergency services. Physicians were thereby able to allocate more of their time to higher-income patients and/or for leisure. Similarly, when the hospital provided free screening services (a form of marketing), the physician's time is freed for acute services, which offer a higher return per unit of time. Patients with health problems are referred to physicians on the hospital's staff, thereby increasing demand for those physicians.
Physicians also had an economic interest in the size of their medical staff. The Pauly-Redisch physician-control model posits that physician incomes would be higher under a closed rather than an open staff model of the hospital. Under a closed staff model, physicians would be willing to add additional members to the staff as long as each additional physician increased the incomes of other physicians on the staff. (As long as the marginal revenue product (MRP) of additional physicians is greater than average revenue product (ARP), which is equal to average income, additional physicians would be added.) An open staff model would have a greater number of staff physicians, and the average income of staff members would be less than under a closed staff. Physicians would have an incentive to join the staff as long as staff members' in-comes were higher in that hospital than elsewhere. Thus each physician specialty, e.g., surgeons, is interested in limiting hospital privileges; too many surgeons would decrease the average surgeon's income. (If other inputs increase, for example hospital beds or residents, then this would cause an increase in the MRP and ARP curves of the medical staff.)
To sum up the physician-control model, before the mid 1960s when hospital insurance was not wide-spread and major medical insurance was more prevalent, physicians would have been expected to minimize the cost of all the medical inputs used in providing a medical treatment. Patients were concerned about their total out-of-pocket price for medical services, and physicians received the difference between the cost of the inputs and the total price of medical care charged to the patient. As hospital cov-

erage became more extensive and hospitals were reimbursed for their costs, physicians no longer had to be concerned with the cost of hospital care. Physician payment was separated from payment for hospital services, and physicians were neither financially responsible nor accountable for their decisions. There were no constraints on how the physician used the hospital or influenced its investment decisions. (During the 1970s, state health planning efforts in-tended to reduce duplication of hospital facilities failed because they were contrary to both the physicians' and the hospital's interests.)

Effect of Price Competition on Hospital Behavioral Models

Differences in hospital objectives and the degree of competitiveness in the marketplace are key factors that affect the behavior of firms. Historically, cost-based hospital payment systems enabled non-profit hospitals to achieve objectives not otherwise possible in a price-competitive market. Profit-maximizing behavior with the profits returned to the community, utility-maximizing behavior benefiting hospital management and employees, and a physician-control model benefiting the medical staff are alternative models to explain the non-profit hospital's pricing, output, and investment policies. Several models predict similar behavior, such as profit-maximizing pricing on certain services, hospital inefficiency (higher wages and a greater number of employees), and duplication of expensive facilities and services.
The ability of non-profit hospitals to achieve their non-profit objectives changed once hospital payment systems changed (see Appendix 2: Cost Shifting).
In late 1983, the federal government began to phase in a new method of hospital payment called Diagnostic Related Groupings (DRGs). The hospital was reimbursed for each Medicare admission according to a fixed price. Also in the mid 1980s, as employers and unions became more concerned with their medical costs particularly with the rising costs of hospital care, pressure was placed on insurers to reduce the rise in health insurance premiums. Managed care competition began and hospitals had to compete on price to be included in an insurer's provider network.

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Price competition among hospitals to be included in an insurer's provider network and fixed DRG prices per admission changed non-profit hospitals' behavior. To survive in the new price-competitive environment, non-profit and for-profit hospitals began to behave similarly; the difference between non-profit and for-profit hospitals narrowed. Many non-profits no longer had the funds to achieve their non-profit goals.

Empirical Evidence on Differences Between Non-Profit and For-Profit Hospitals

The for-profit form of ownership in healthcare presents the concern that to make a profit, the firm or hospital will sacrifice the consumer's interest to that of the stockholder. Will the for-profit firm raise prices more than a non-profit firm? Will the for-profit firm inadequately pay its employees to ensure dividends to its stockholders? Will the for-profit firm provide lower quality services, reduce access to care, and have lower customer satisfaction than a non-profit firm? More generally, would for-profit hospitals behave any differently than private non-profit hospitals in a price-competitive market?
A number of studies have been conducted on the differences between for-profit and non-profit hospitals (16). These studies have attempted to determine whether for-profits are more efficient than non-profits, whether for-profits charge higher prices, whether non-profits provide higher quality of care, and whether non-profits provide more charity care.
Comparative studies are difficult since there are numerous measurement problems with regard to adjusting for differences in the hospital's output, namely its case mix of patients, as well as being able to adequately measure differences in patient severity of illness, quality of care, and amenities. Also affecting the comparison are the different time periods examined. Prior to the mid 1980s, non-profit hospitals were reimbursed according to their costs; since that time, their financial incentives changed.
Ownership Status and Efficiency: The evidence on whether non-profit hospitals are less efficient (more costly) is mixed. One cannot conclude that there are significant differences in efficiency between profit

and non-profit hospitals. One study using a matched sample of hospitals found that there was no significant difference in their costs per admission adjusted for case mix, but for-profit hospitals generally charged higher prices for their ancillary services than did non-profits. One explanation for the higher mark-up prices by for-profits is that they have entered markets where the population is growing rapidly (e.g., the South and Southwest). Expanding markets typically have less price competition. Thus the association of higher prices with for-profit hospitals may have more to do with the characteristics of the markets in which they compete than with their form of ownership.
Ownership Status and Profit-Maximization: Hospital mergers that reduce competition are likely to result in higher prices at both the merging hospitals as well as their competitors. Will merging non-profit hospitals that gain market power behave any differently than merging for-profit hospitals? Proponents of non-profit mergers claim that prices will be reduced be-cause of scale economies. The federal government lost several anti-trust cases brought against merging non-profit hospitals because the judge believed that non-profit hospitals would not exploit their market power by raising prices.
Several studies analyzing non-profit hospitals' pricing behavior as a result of mergers that lessen competition have concluded that such mergers lead to higher, not lower, prices. This finding suggests that non-profit hospitals, similar to for-profit hospitals, price according to the competitiveness of the market. Empirical evidence is consistent with economic theory that competition among hospitals leads to lower prices (markups over cost). Both types of hospitals will use market power gained from mergers that lessen competition to increase their prices (17). For anti-trust analysis, therefore, ownership differences should not be considered a mitigating factor in hospital mergers that lessen competition.
Ownership Status and Quality of Care: With respect to the effect of ownership on quality of care, studies have again been inconclusive. Three types of quality measures have been used: structure (the inputs used in treatment), process (how care is provided), and outcomes. Studies using structural measures such as hospital accreditation and percent of hospitals with

CHAPTER 11 The MarketforHospitalServices • 281

cardiac and intensive care units find no differences by ownership.
Keeler, et al., reviewed 14,000 medical records for five diseases and compared several process measures of quality, namely that specific diagnostic and therapeutic treatments were competently provided, to the difference between the actual mortality rate and the expected mortality rate based on the patient's characteristics. The authors concluded that overall quality of care in for-profit and non-profit hospitals were similar (18).
Using survival, functional status, cognitive status, and probability of living in a nursing home as out-come measures, Sloan, et al., examined elderly patients hospitalized for hip fracture, stroke, coronary heart disease, and congestive heart failure by hospital ownership. The authors found that there were no significant differences between for-profit and non-profit (non-teaching) hospitals according to the above out-come measures. Major teaching hospitals, however, did perform better on several outcome measures (19).
Ownership Status and Uncompensated Care: There is very little difference in the provision of uncompensated care between non-profit (non-teaching) and for-profit hospitals. (Uncompensated care consists of charity care [care for which the hospital did not expect compensation] and bad debts [care for which the hospital did expect to be compensated at time of service].) In 1999, uncompensated care costs as a percent of total hospital costs were, on average, 4.7 percent for non-profit (non-governmental) hospitals and 4.2 percent for for-profits (20). The amount of uncompensated care varies greatly among the non-profits themselves. When comparisons are made between non-profit and for-profit hospitals located in the same area, it was found that they care for a similar number of uninsured patients. Large non-profit teaching hospitals located in urban areas amidst low-income populations provide most of the charity care. For-profits are typically not located in areas with low-income populations (21).
Competitive pressures make it difficult for non-profit hospitals to cross-subsidize patients or to be-have differently from for-profit hospitals. Increased competition to be included in an insurer's provider network increases a hospital's price elasticity of de-

mand resulting in a lower price, hence lower profitability. Studies have indicated that in highly price-competitive hospitals markets (relative to less-competitive markets), uncompensated care by non-profits has sharply decreased (22).
As non-profit hospitals merge and compete on price, their tax-exempt status is being questioned. Some communities believe that their non-profits are providing little, if anything, to the community in return for their tax-exempt status. To retain their favored tax-exempt status, several states have established standards as to the amount of charity care non-profit hospitals have to provide. Similar legislation is being considered at the federal level. (Also driving the re-examination of hospitals' non-profit status by states is the billions of new tax dollars that states and communities could receive if the tax exemption rules were changed.)
Summary of Differences by Ownership Status: On average, there does not appear to be significant differences between for-profit and private (non-governmental) non-profit hospitals in their efficiency, prices charged, quality of care, and the amount of uncompensated care provided. Major teaching hospitals, however, generally provide higher quality of care and a greater amount of uncompensated care. It is important to note that the percent of hospitals that are for-profit has remained constant (about 20 per-cent) for the last 25 years. This is an indication that neither form of ownership has a dominant economic advantage over the other. Market competitiveness is likely to be a more important determinant of performance than ownership status.
HOSPITAL PERFORMANCE

Non-Price Competition and Hospital Performance
The major determinant of hospital performance after the enactment of Medicare in 1965 was not the structure of the industry, but the methods used to pay hospitals. Medicare paid hospitals according to their costs for treating Medicare patients and private health insurers, who paid hospitals either their costs

282 • Health Care Economics

or charges, were merely a passive intermediary between the employer and provider; insurers simply passed higher hospital costs to employers in the form of higher premiums. Government and privately insured patients, the aged, the poor under Medicaid, and insured families, were not price sensitive because of their extensive hospital insurance.
Employers had little incentive to be concerned with rising hospital costs and insurance premiums because, not being subject to much import competition, they could pass on higher labor costs through in-creased product prices. Further, purchasers of hospital care had little information on which to judge hospitals according to their prices and quality. And many state laws precluded insurers from establishing provider networks based on negotiated discounts.
As budget constraints were removed from hospitals, the responsibility for hospital performance was placed on the hospital's decision-makers; their decisions were based on what objectives they hoped to achieve.
The physician played a decisive role during this period. As the patient's agent, the physician selected the hospital to which the patient was admitted. Hospitals competed for physicians by offering them greater bed availability, the latest in technology, and increased staffing. The consequence was higher costs and duplication of expensive technology and facilities. Under a hospital cost-based payment system, physicians could serve the patient and hospital as well as themselves without making any conflicting choices.
The type of competition that occurred during this period was non-price competition (23). To compete for patients, hospitals had to compete amongst them-selves for physicians. Non-price competition manifested itself in several ways. Hospitals in more competitive markets (a greater number of hospitals) maintained more excess capacity than hospitals in less competitive (more concentrated) markets. Physicians were thus assured that by affiliating with a particular hospital their patients were likely to have a bed when one was needed. Greater amenities were provided to patients as well as to physicians (offices next to the hospital at below market rents). To in-crease the productivity of physicians on their medical

staff, hospitals provided them with more support staff such as interns and residents and a higher pro-portion of registered nurses in their nursing units. Hospitals also purchased the latest in medical technology and added facilities and services. Physicians did not have to refer their patients (and possibly lose them) to other institutions. High-tech services also provided a means for the hospital to indicate to prospective patients that it was a high-quality institution.
Non-price competition led to rapidly rising hospital costs. Using data from the period 1972 and 1982, Robinson and Luft found that in more competitive markets, hospital costs were higher, they offered more services, and average length of stay was longer (24). More competitive hospitals were also reluctant to en-gage in cost containment activities for fear of losing their physician referrals.
The finding of higher costs in more competitive (less concentrated) hospital markets was contrary to the expectations of traditional economic theory, namely that in more competitive industries firms be-come more efficient. (What was lacking, however, were the incentives for hospitals to compete on price.)
As shown in Figure 11-5A, in the first few years after Medicare began (1966), hospital expenditures per capita increased at a much more rapid rate than previously. In 1971, wage and price controls were imposed on the entire economy (the Economic Stabilization Program [ESP] by the Nixon Administration. These controls were removed from the rest of the economy in 1972 and from the health industry in April 1974. Once free of price controls, per capita hospital expenditures increased sharply. For the remainder of the 1970s, hospital expenditures continued to increase rapidly.
Proponents of hospital planning argued that the way to reduce rapidly rising hospital expenditures and to eliminate "wasteful" competition it was necessary to encourage monopolization of the hospital industry. (Changing hospital incentives was not pro-posed as an alternative to government planning.)

Relying on Regulation to Improve Hospital Performance

After the passage of Medicare and Medicaid, rapidly rising hospital costs led to the imposition of regula-

Figure 11-5A. Annual percent changes in per capita hospital expenditures and consumer price index, 1960-1980.

284 • Health Care Economics

tory controls on hospitals. As Medicare hospital expenditures rose faster than expected, the federal government had to continually increase the Medicare payroll tax and the wage base to which it applied to prevent the Medicare Trust Fund from going bankrupt. Neither raising payroll taxes nor increasing the aged's financial contribution was politically popular. State Medicaid expenditures, which are funded on average equally by the states and by the federal government, were also increasing faster than anticipated. Rather than increasing state taxes or reducing other politically popular programs such as education, states sought ways to reduce their Medicaid expenditures.
Hospital regulation appeared to be a direct way of reducing the pressures on state and federal budgets (25). In the late 1960s, many states enacted Certificate of Need (CON) legislation which required hospitals to have their capital expenditures (typically in excess of $100,000) to be approved by state planning agencies. Planning proponents claimed that CON would reduce duplication of costly facilities and services and thereby reduce the rise in hospital expenditures. As hospital expenditure increases placed greater pressure on state and federal budgets, more states enacted CON in the early 1970s; in 1974 a federal CON law was enacted.
Planning controls on hospital investment were in-effective in limiting the rise in hospital expenditures. Economists conducted a number of studies and failed to find a lower rate of increase in hospital expenditures that could be contributed to state planning agencies' decisions on the allocation of hospital capital.
The failure of hospital planning to more "ration-ally" allocate hospital capital was because hospitals, who would presumably be adversely affected by in-vestment controls, used the regulatory process to benefit themselves. One study found that those states more likely to adopt CON legislation had lower occupancy levels (thereby favoring entry controls) and a higher degree of hospital concentration (the more highly concentrated the market, the easier it is for hospitals to collude and lobby for CON). Further, hospitals were the major group with a strong (concentrated) interest in the CON agencies' decisions; consequently, it appears that hospitals "captured" the decision-making process. Thus the actual effect of CON laws was to benefit hospitals.

The CON investment regulations were used to deny entry into the market by new competitors, such as for-profit hospitals; large urban hospitals used the regulations to prevent suburban hospitals from adding new facilities and thereby becoming competitors; and hospitals used the regulations to prevent free-standing (lower cost) outpatient surgery centers from entering their market for fear that they would take away some of the hospital's surgical cases.
Although Congress repealed the federal CON law in the late 1970s, CON is still used in an anti-competitive manner in many states.
Hospital rate regulation was also used to limit the rise in hospital expenditures. In 1971, President Nixon mandated economy-wide wage and price controls ("Economic Stabilization Program," or ESP) to limit the rising rate of inflation in the economy. These controls were removed in 1972, but they were kept in place for medical care until 1974. Research indicates that these stringent price controls, which were uniformly applied to hospitals, reduced hospital expenditure increases. Once removed, hospital expenditures rapidly increased.
A number of states also adopted hospital rate regulation in the 1970s. The form of rate controls used varied according to which payers were included, whether the program was voluntary, and whether the rate regulation used a hospital-by-hospital budget re-view process or a single formula was used across all hospitals. A number of states enacted rate regulation to control the rise in their Medicaid expenditures. Several states, such as Maryland, included all payers under the rate regulation.
The motivation for the rate regulation, hence its success, varied. Those states facing severe budget crises (such as New York) instituted stringent and mandatory rate regulation according to a formula that applied to all hospitals. Although these states reduced the rise in hospital costs, over time there were concerns that service quality was being reduced. States relying on less stringent approaches (such as individual hospital budget reviews) and applying rate controls to just Medicaid patients were not effective in reducing the rise in hospital costs.
In 1983, to limit its growing budgetary commitment under Medicare, the Reagan administration began to

CHAPTER 11 The Market for Hospital Services • 285

phase in (over a 5-year period) price controls on hospitals. Medicare paid hospitals fixed prices per admission according to Diagnostic Related Groupings (DRGs). (This payment system is also referred to the Prospective Payment System, or PPS). Although PPS only applied to Medicare patients, it had an important effect on hospital costs since Medicare patients represent about 40 percent of hospital patient days. The DRG system worked to limit hospital costs in two ways: first, faced with a fixed price per Medicare ad-mission, hospitals had an incentive to reduce the costs of caring for Medicare patients and to discharge them sooner; hospital occupancy rates declined. Second, Congress limited the rate of increase in DRG prices by an annual update percentage.
Hospital rate regulation, whether implemented by the federal or state governments, can be effective in reducing the rate of increase in hospital expenditures. Mandatory rate regulation applied to all hospitals ac-cording to a formula, such as used by New York State, Medicare PPS, and the Economic Stabilization Program, reduced the rate of increase in hospital expenses. These regulatory programs, however, do not achieve their savings by simply making hospitals more efficient. Stringent rate controls are based on an average of hospital costs (such as DRG prices) and an annual percent increase, which is the same for all hospitals. Thus some hospitals receive windfall gains while others losses, unrelated to their efficiency.
Further, it is not possible for a regulatory system to mimic a competitive market. Regulations provide incentives to "game" the system, such as "upcoding," which is classifying patients into a higher DRG category to receive a higher level of payment. Also, politics surrounding the federal budget influences the government's decision on the annual percent increase in DRG prices. Similar to other regulated industries (such as price controls on housing in New York), price regulation has undesirable consequences. Stringent regulated prices eventually lead to decreased access, reductions in service quality, and a lower rate of innovation.

Hospital Performance Under Managed Care

In the 1980s, hospital performance began to change. This change was brought about by a change in pur‑

chaser demands for lower hospital costs, excess hospital capacity, and the U.S. Supreme Court ruling in 1982, which upheld the applicability of the anti-trust laws to the health field.
Large employers and their unions, threatened by increased import competition, pressured their insurers to limit rising medical expenses. To compete on the basis of their premiums for large employers, insurers had to lower the cost of their benefits; they instituted utilization review, changed their benefits to include lower-cost substitutes to hospitals, and instituted increased patient cost sharing.
The competitive environment facing hospitals began to change. Hospital occupancy fell as a result of Medicare's fixed price system and private insurer's utilization management. HMOs and PPOs formed provider networks based on the provider's price, the provider's reputation, and its location. Health plans were able to influence the patient's choice of provider by channeling patients to the insurer's network providers. Before hospitals were able to compete for physicians, they first had to compete on price to be included in the insurer's network. Regardless of hospital decision-makers' previous objectives, hospitals had to minimize their costs if they were to be able to compete on price.
The movement toward shifting inpatient services to an outpatient setting also adversely affected hospitals. Currently, more surgeries are performed in out-patient facilities than in hospitals. The increase in hospital outpatient services occurred for four reasons. Third-party payers tried to decrease the use of the most costly component of care—the hospital—by expanding insurance coverage to include the outpatient setting. In addition, insurers instituted utilization re-view mechanisms to ensure that surgical procedures that could be performed in less expensive outpatient surgery centers would not be performed in the hospital. Third, when medical groups and hospitals were paid on a capitation basis, it was more profitable (less costly) to treat patients in an outpatient setting. And lastly, advances in medical technology made it possible to perform more procedures in an outpatient facility.
The change to price competition among hospitals was not uniform throughout the country. In some areas, such as in California, competition developed

286 • Health Care Economics

much more rapidly than in other areas. In 1982, California legalized selective contracting which meant that third-party payers could negotiate discounted prices with a group of hospitals while excluding other hospitals from participating in the contract. Enrollment in PPOs in California grew rapidly. HMO growth in California, which was historically high be-cause of Kaiser, also rapidly increased. Many studies, therefore, used California hospital data to determine the effect of the new competitive environment.
Hospital demand curves became more price elastic as hospitals competed on price to be included in an insurer's provider network. Empirical estimates of average hospital price elasticities of demand (as high as -5.67) shown in Table 11-3 indicate that other community hospitals are very good substitutes; a hospital increasing its price will lose significant market share.
The effect of price competition on California hospitals produced dramatic results. In a study of California hospitals, Melnick, et al., were able to ex-amine actual prices paid to hospitals by California Blue Cross. It was thus possible to determine the effect of differences in hospital market structure on actual prices paid by a large purchaser. This data shows that Blue Cross was able to receive greater discounts from hospitals located in more competitive markets; further, these discounts were larger the greater was Blue Cross' leverage within the hospital (as measured by Blue Cross' percent of that hospital's total revenue). Conversely, the greater the hospital's leverage over Blue Cross (as measured by the hospital's market share in Blue Cross' network), the higher the price charged to Blue Cross by that hospital (26).
As managed care spread to the rest of the United States, Melnick et al., using data for the period 1989 to 1994, attempted to determine the answers to two

questions: first, did areas with high managed care penetration result in lower rates of increase in hospital costs and, second, did hospital costs increase less rapidly in more competitive compared to less competitive markets (27)?
Using each hospital's HHI index as the measure of competition, the authors found results shown in Table 11-4. This table shows the percent increase in hospital costs according to whether the hospital is in a high- or low-competition market, and also whether the man-aged care penetration is high or low.
An increase in managed care penetration reduces the rise in hospital costs. The reduction, however, is much greater for hospitals in more competitive markets. Further, holding the degree of managed care penetration constant, hospitals in more competitive markets had lower rates of increase than hospitals in less competitive markets. The largest reduction occurs for competitive hospitals in high managed care markets.
A recent study examined the effect of the number of competitors in a market on hospital prices and profitability. The authors analyzed the number of hospitals providing coronary artery bypass graft surgery (CABG) in a market with HMO penetration. With only two to three CABG providers competing for HMO patients, the profitability of CABG services declines to zero. Thus it takes very few competitors in a market with a large purchaser willing to shift volume for competition to reduce prices (28).
The above findings are important for anti-trust policy that seeks to prevent hospital mergers that lessen competition. Those who advocate permitting hospital mergers that tend to monopolize the market emphasize the early studies that indicate that more competitive hospital markets lead to greater duplica‑

Table 11-3. Price Elasticities of Demand for Individual Hospital Services

CHAPTER 11 The Market for Hospital Services • 287

Table 11-4. Hospital Cost Growth in the U.S. by Level of Managed Care Penetration and Hospital Market Competitiveness, 1989-1994

tion and higher costs. The above studies, based on data from the mid 1980s to the present, demonstrating that hospital costs and prices are lower in more competitive markets provide definitive evidence that hospital mergers that lessen competition would result in higher hospital prices.
If the number of competing hospitals declined (their concentration increased), the remaining hospitals would have fewer substitutes, greater market power to increase price, and would be less responsive to purchaser demands for quality. Enforcement of the anti-trust laws is necessary to prevent mergers that increase hospital market power.
Decreased inpatient utilization and intense price competition had an adverse affect on hospitals. As in any industry facing a declining demand and/or reimbursement, a number of hospitals closed or merged with stronger institutions. Hospitals that are smaller, offer less specialized services, are located in inner cities or rural areas, and serve a greater portion of Medicaid patients were at greater risk of closure.
Increased market power was an important reason for hospital consolidation. Some merger proponents claim that fewer hospitals will result in efficiencies which will be passed on by non-profit hospitals in the form of lower prices. Opponents of this view claim that scale economies are relatively small and that non-

profit hospital boards do not have objectives that are necessarily in the community's interest; they may be-have no differently in their pricing strategies than for-profit hospitals. Further, unless the anti-trust laws are vigorously applied to mergers that tend to lessen competition, hospital prices will increase more rap-idly as hospitals gain increased market power.
The beneficial effects on hospital performance of increased price competition (which started in the mid 1980s) have been documented in a number of studies discussed earlier. An indication of the slower rate of increase in hospital expenses is shown in Figure 11-5B. The annual percent increase in hospital expenditures per capita over the period 1980 to 2000 declined relative to the previous period as a result of Medicare's PPS system, managed care, and hospital price competition. By the early 1990s, managed care and price competition had become prevalent throughout the U.S., and hospital cost increases were dramatically reduced. These slower rates of increase in expenses have occurred even though there have been continual increases in technology (see Table 11-2), an older patient population, a sicker patient mix, and treatment for illnesses for which little could have been previously provided.
The differences between Figures 11-5A and 11-5B demonstrate the changes that managed care and price competition brought about in the healthcare industry.

The Effect of Competition on Hospital Quality

Critics of price competition are concerned that in a price-competitive market, hospitals will be forced to reduce their quality of care to be able to compete on price. As profit margins decline, hospitals will be unable to adequately staff their critical care units, recruit the most qualified surgeons, and invest in the latest technology. Only in less competitive, more concentrated markets will hospitals be able to raise their prices and have the necessary funds to invest in higher quality. Consequently, these critics claim price competitive markets in healthcare will reduce patient quality.
Proponents of competition counter that in a price-competitive market, hospitals will compete not only on price but also on other attributes such as quality of

Figure 11-5B. Annual percent changes in per capita hospital expenditures and consumer price index,1981-2002.

CHAPTER 11 The Market for Hospital Services • 289

care. Patients (perhaps through their choice of physician and/or employer) choose health plans in part based on the quality of its provider network. Health plans compete on their premiums as well as their provider network, which would include those hospitals having good reputations and that perform a high volume of complex procedures. Competitive markets should therefore result in increased quality.
The research literature on the effect of hospital competition and HMO penetration rates on hospital quality is limited. However, several studies indicate that in-creased HMO penetration rates and hospital competition are associated with increased hospital quality. For example, HMO patients are more likely to be admitted to higher quality hospitals for bypass surgery than privately insured fee-for-service patients.
Outcome studies have used as quality measures risk-adjusted (for patient characteristics) hospital mortality rates for heart disease, e.g., coronary artery bypass graft (CABG). The lower the risk-adjusted mortality rate, the higher the quality. CABG surgery is often used in these studies because it is a high volume procedure performed in many community hospitals as well as in academic medical centers. CABG is also a procedure where there is a strong relationship between the volume of such surgeries and outcome.
Escarce, et al., examined the quality of hospitals used by HMO and non-HMO insured patients for CABG surgery during the period 1992 to 1994 in California and Florida. It is hypothesized that HMOs have an incentive to use high-quality hospitals when employers are interested in quality as well as premiums. When the health plan purchaser is not interested in quality or quality cannot be measured, then the HMO has an incentive to select the lowest priced hospitals. The authors found that HMO patients in California used higher quality hospitals than privately insured non-HMO patients. In Florida, there was no difference between HMO and non-HMO insured patients. The authors suggest that the difference in findings between the two states is because California was a mature managed care market with large HMOs who were able to use their market power compared to Florida. In Florida, the authors also found that Medicare HMO patients were less likely to use high-quality hospitals than Medicare non-HMO

patients. Florida Medicare HMO patients were believed to have less information on quality, they were more dependent on their physician's hospital affiliation, and there was no large buyer (like an employer) to demand quality data from the HMO (29).

The Current Market for Hospitals and A Look Ahead

The relative balance of market power between hospitals and health plans has changed in the last several years. During the 1980s and 1990s, many hospitals were independent, they had excess capacity, health plans shifted patients to those hospitals willing to provide sharply discounted prices, and hospitals competed on price to be included in an insurer's provider network. Hospital profitability declined and they were a distressed industry. Over time hospitals closed, others merged, excess capacity declined, and health plans broadened their provider networks to meet consumer demands for greater access to more providers.
The decline in excess capacity and in the number of hospital competitors in a market increased hospitals' bargaining power. With increased market power, hospitals increased their prices to health plans, and hospital profitability rose. Federal anti-trust agencies are closely examining hospital mergers for their possible anti-competitive effects.
The economic outlook for hospitals has improved, and an increasingly aged population will demand more hospital care. However, uncertainties exist that could adversely affect their profitability. Medicare, an important payer of inpatient care for the aged, faces a large budget deficit as the baby boomers begin to re-tire in 2011. To the extent that Medicare reduces the rate of increase in hospital payments to limit its future deficits, hospital profitability will decline. At the same time, hospital input costs are increasing more rapidly. A severe nursing "shortage" (see the chapter on The Market for Registered Nurses) will require hospitals to increase nurse wages. Also, hospitals will have to hire more nurses if legislation, similar to that enacted in California, on minimum nurse staffing ratios is enacted by other states. Technological advances will continue to increase hospital costs as well.

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Lastly, several physician specialties are establishing specialty hospitals, such as cardiology, oncology, and orthopedic hospitals that directly compete with their own hospital. These physicians retain their staff appointments at the community hospital but direct some patients to their own hospital. To the extent that physicians are able to move the most profitable services to their specialty hospital, the community hospital's profitability will decline. How hospitals respond to competition from their own specialists will be an important issue in coming years. (As a result of hospital lobbying, the recently enacted Medicare Prescription Drug Act placed a moratorium on new competing physician-owned specialty hospitals.)
SUMMARY

In the period before managed care, given the type of payment systems, hospitals had little concern with efficiency, hospital expenditures rose rapidly, there was unnecessary duplication of costly facilities and services, and, because many hospitals performed few complex procedures, the quality outcomes of these procedures was lower than if the volume were greater at each hospital. (Quality was perceived in terms of process or structural measures, such as the latest technology, rather than by outcomes of medical services.)
The structure of the hospital industry has been undergoing dramatic changes since the mid 1980s. The applicability of the anti-trust laws, purchaser incentives to reduce the cost of hospital care, excess hospital capacity, and increasing physician-to-population ratios changed the form of hospital competition. There was a shift from non-price to price competition. In the period before 1983, hospitals competed largely on the basis of non-price factors such as technology, bed availability, services, and amenities. Studies based on data from this earlier period concluded that hospital competition led to higher rather than lower costs. While hospitals still compete on non-price factors, they now also compete on price. Large health insurers negotiate prices with high-quality regional health centers for specialized serv

ices, such as for transplants. These regional centers are also likely to have better treatment outcomes than local institutions that perform few such complex procedures.
As a means of increasing referrals to their institution, hospitals attempted to develop stronger relationships with their medical staffs and physician groups. Many hospitals purchased physicians' practices and lost large sums on these ventures as physicians no longer had the same productivity incentives as they did previously. Hospitals are still searching for ways to work together with physicians in a price competitive environment.
In addition to price competition, hospital systems will have to compete on quality, outcomes, and patient satisfaction. Employers and insurers are developing sophisticated data systems that will enable them to determine the clinical outcomes for specific services within a hospital. In the years ahead, purchasers will have data on prices and clinical outcomes upon which to base their decisions. A competitive market whereby competition is based on prices, out-comes, and satisfaction should lead to improved market performance.
As the hospital market becomes more price competitive, there is a concern over who will serve the uninsured. Certain non-profit teaching institutions located in low-income areas provided a great deal of charity care. This care was paid for through a system of cross subsidies that is being eliminated through price competition and lower Medicare payments. Competitive markets cannot be expected to finance care for the uninsured; thus the issue of payment for the uninsured is becoming more visible and must be addressed by government.
APPENDIX 1: USING A PHYSICIAN CONTROL MODEL TO INCREASE PHYSICIAN PRODUCTIVITY

The profit-maximizing model of the physician ex-plains the American Medical Association's political positions on a number of issues. When the demand for medical care increased, it was in physicians' eco-

nomic interest that it was met by an increase in physicians' productivity which would increase physicians' incomes, rather than by an increase in the number of physicians. For example, with reference to Figure 11-6, physician and hospital services are two inputs in a production function. With an increase in the demand for medical care, the increased output, represented by the highest isoquant, can be produced with different quantities of either physician or hospital services. At the initial amount of medical care being produced, isoquant QMc1, the combination of physician and hospital care is QMm and QHl, respectively. As the quantity of medical care to be provided increases to isoquant QMC4, the number of physicians and the quantity of hospital care can be increased in the same proportions as previously. It will, however, be in the economic interest of physicians if their number re-mains the same while the quantity of hospital care is increased. With the same number of physicians, QH4 of hospital care will be required. Since the quantity of medical care produced is greater even though the number of physicians has remained unchanged, their marginal productivity has increased; correspondingly, the marginal productivity of the hospital has fallen. The higher the physician's productivity, the greater their income.

Figure 11-6. A production function for medical care.

APPENDIX 2: COST SHIFTING

Large employers have expressed concern over the pricing behavior of non-profit hospitals referred to as "cost shifting," which is the practice of raising prices to privately insured patients because Medicare, Medicaid, or the uninsured do not pay their full charges. Many employers believe that hospitals in-crease their charges to privately insured patients to make up shortfalls from the government; consequently, private insurers, hence employers and employees, subsidize those who do not pay their "fair" share. The 1990 price-to-cost ratios of Medicare (about 0.9), Medicaid (about 0.8), and private payers (about 1.3) are considered to be evidence of cost shifting.
Cost shifting would be an indication of market power; the hospital is able to increase its prices to certain classes of patients without losing a sufficient number of those patients to make the price increase profitable. To determine whether cost shifting occurs, it is necessary to understand a hospital's pricing objectives. Different objectives result in different pricing strategies.
If a hospital prices so as to maximize its profits, then the hospital will set a profit-maximizing price to each payer class. Assuming there are two types of patients, privately insured and Medicare patients, then the hospital will have two sets of prices, the fixed DRG price per admission for Medicare patients and a price for the privately insured. The hospital is a price taker in the Medicare market and a price setter in the privately insured market.
In the private market, the hospital will set price at that point on its demand curve where marginal revenue (MR) equals marginal cost (MC). As shown in Figure 11-7, this profit-maximizing price will be Pl. (This price would change only if the hospital's

Figure 11-7. Hospital cost shifting.
variable costs (MC) change or if the elasticity of the demand curve changes, thereby changing the MR curve. Changes in fixed costs would not change the profit-maximizing price.) If for some reason Medicare pays the hospital less, the MC and MR curves in the private market will not change. Consequently, the profit-maximizing price in the private market should not change.
If the hospital decided to increase the price to private patients to P2 from PI, then the hospital would be worse off, they would be foregoing profit they could have earned, the difference between MR and MC. Thus it is unlikely that the hospital would increase price if they were already at the profit-maximizing price.
Only if the hospital is not profit maximizing could the hospital increase its price and make additional profits. If the hospital were a utility-maximizer (charging less than the profit-maximizing price so as to increase its number of patients), then the hospital's price would be at P3; increasing price to PI would in-crease profits. For cost shifting to occur, the hospital's objective must have been to have a larger number of private patients rather than to maximize profits.

How likely is it that hospitals did not profit maximize so as to have more than the profit-maximizing number of private patients? As discussed previously, hospitals have certain objectives. If physicians were the dominant group in control of the hospital, they would prefer that any additional hospital revenues be used to increase their productivity and income. Increased numbers of hospital personnel, interns and residents, new equipment, or even lower charges for hospital services that are complementary to their own are examples of the opportunity costs of charging "too low" a price to private patients.
Even using a different behavioral model of the hospital, there is an opportunity cost of foregoing additional profit. Managers could be given higher salaries and more assistants, hospital staff could be paid higher wages, additional personnel could be hired, the physical facilities could be enhanced, or a greater amount of charity could be provided. Given the different ways in which the foregone profit could be used—namely, to charge private patients less or to forego ways of achieving the hospital decision-makers' objectives—it is more likely that the profit would be used by the hospital decision-makers than for a group (e.g., private-pay patients or insurance companies) that is not as politically important to the hospital.
There is little empirical evidence to support the hypothesis that hospitals are engaged in cost shifting (30). The few examples supporting the cost-shifting hypothesis are from the period before the mid 1980s, prior to price competition.
The observation that hospitals charge different prices (relative to cost) to different classes of patients is more likely to be indicative of price discrimination. A firm's ability to price discriminate depends on having purchasers with different elasticities of demand. (The second condition for price discrimination is that the purchasers cannot resell the service, which is unlikely to occur with regard to diagnosis and treatment.) The class of patients with less elastic demands for hospital care will pay higher prices relative to costs than will those with more elastic demands (e.g., a large HMO that can shift its volume to a competitor hospital). For example, with reference to Figure 13-2, the two demand curves have different elasticities of de-

CHAPTER 11 The Market for Hospital Services • 293

mand. The group of patients represented by Dl is less price elastic, hence has a higher price to cost ratio, than those represented by D2.
Price discrimination also occurs between the prices paid by privately insured and Medicare patients. The federal government, as a large purchaser of hospital care for Medicare patients, uses its market power and establishes a single hospital price for all Medicare patients. As shown in Figure 10-6, the hospital faces a horizontal demand curve for its Medicare patients. Assuming that private insurers do not have as much market power as the government, the hospital faces a downward-sloping demand curve by private (non-Medicare) patients. If the hospital sets its prices so as to maximize its profits, it will establish a price for private patients that will be higher than the fixed Medicare price; the private price will be at that point on the demand curve where the marginal revenues from both types of patients are equal. If the Medicare price were decreased, the profit-maximizing strategy for the hospital would be to decrease, not increase, the price to its private patients (assuming no change in the marginal costs of treating its private patients).
The above analysis is contrary to what many believe happens when the government reduces its payments to hospitals. The hospital may want to increase its price to private patients when it receives less from government. However, if the hospital is pricing to maximize its profits, then increasing its price beyond that point will reduce its profits. Only if the hospital's costs of serving private patients increase (e.g., inflation or a sicker mix of private patients) will the hospital raise its prices. As these costs increase and the price to private patients increase, it may be thought to be the result of low Medicare payment; however, these increased prices would have occurred anyway. The hospital may say that it will raise prices to private patients if the government pays hospitals less; how-ever, this may be more of an attempt by hospitals to scare private payers into lobbying with them against government reductions in Medicare prices.
The market for hospital services has become very price competitive. Hospital demand curves became more price elastic as private insurers formed PPOs and chose network hospitals according to their prices. Only those hospitals possessing market power are

able to "cost shift," assuming that they are not currently pricing to maximize their profits. With in-creased price competition, hospital demand curves become more price elastic, and prices will reflect the cost of providing those services. Faced with competition from other hospitals it will not be possible for a hospital to raise its prices when the government reduces its payments.
REVIEW QUESTIONS
1.	What effect do economies of scale have on the market structure of an industry?
2.	How are the following terms important for determining whether a hospital merger will be challenged on anti-trust grounds: Herfindal Index, failing hospital doctrine, economies of scale, entry barriers, and geographic and product market definition?
Contrast the use of government-determined areas, such as Counties and Metropolitan Statistical Areas (MSAs) with patient origin studies as a means of determining the geographic market of a hospital for use in hospital anti-trust cases.
Two models of hospital behavior are the profit-maximizing and utility- or prestige-maximizing models. Describe each model and then contrast their predictions in the period before and after managed care competition.
5.	What are the advantages to physicians of hospitals being organized as non-profit institutions?
6.	In a "Physician-Control" model of hospital behavior, explain how the physician's incentive to minimize the cost of producing a treatment has changed in the period before and after the introduction of managed care.
The move from cost-based payment for hospital services to payment based on DRGs was expected to change hospital behavior. Discuss what you would have expected to observe as the payment method changed.
What are the similarities and differences between DRG prices and hospital prices deter-mined in a price-competitive market?

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9.	What is "cost-shifting"? Explain why an in-crease in a hospital's fixed costs or an increase in the number of uninsured cared for by the hospital will not change the hospital's profit-maximizing price. Similarly, why would a change in a hospital's variable costs change the hospital's profit-maximizing price?
10.	Why are hospitals able to charge different purchasers different prices for the same medical services?
11.	How does cost shifting differ from price discrimination?
12.	Hospitals have always competed for patients. Contrast the effects of such competition (in terms of cost per admission, length of stay, services offered, and introduction of new technology) in the period of cost-based payment and after the introduction of managed care.
13.	Within an economic framework, discuss the changing economic outlook for hospitals.
REFERENCES
1. Harold S. Luft, et al., "Does Quality Influence Choice of Hospital?," Journal of the American Medical Association, 263(21), June 6, 1990, 2899-2906.