Quality Competition, Insurance, and Consumer Choice in Health Care Markets Thomas P. Lyon in Journal of Economics & Management Strategy (1999) presented by John Strandholm February 16, 2016 Thomas P. Lyon Lyon on Consumer Choice in Health Care 1
Research Question • How does a consumer’s freedom of choice among different hospitals affect each hospital’s behavior? – Model allows consumers to choose between two types of insurance, one where they are forced to go to one hospital and one where they can choose • Model matches some stylized facts Thomas P. Lyon Lyon on Consumer Choice in Health Care 2
Contributions • Consumers can choose between two types of insurance • Uncertainty over quality improvements • Simple model that matches reality quite well Thomas P. Lyon Lyon on Consumer Choice in Health Care 3
Model Structure • Two hospitals located at the extremes of a Hotelling line (Salop style), inelastic demand • Both hospitals start with some quality and make an investment in a fixed level increase in quality ∆ – Hospitals invest in the probability of successful increase in quality ρ i – Cost of investment is F i ( ρ i ; ∆ , γ ) increasing and convex in all arguments – γ is a cost parameter – comes into play later • Zero marginal costs to treating additional patients Thomas P. Lyon Lyon on Consumer Choice in Health Care 4
Basic Setup of the Model • Utility from each hospital: – U 0 ( x ) = q 0 − tx − p 0 – U 1 ( x ) = q 1 − t (1 − x ) − p 1 Thomas P. Lyon Lyon on Consumer Choice in Health Care 5
Model Timeline Thomas P. Lyon Lyon on Consumer Choice in Health Care 6
Paper Outline 1 Welfare Maximizing Benchmark 2 Pure Managed Care – Consumers locked into a hospital when they select their health plan 3 Pure Insurance – Consumers not locked into a hospital when they select their health plan 4 Mixed Regime: Consumers have a choice of plans – Some go managed care some go insurance Thomas P. Lyon Lyon on Consumer Choice in Health Care 7
Welfare-Max: Switching Consumers Thomas P. Lyon Lyon on Consumer Choice in Health Care 8
Welfare-max Notes • Consumers divided into three groups • Optimal investment when ρ = 1 2 • Fraction of population with choice increases with ∆ and decreases with t Thomas P. Lyon Lyon on Consumer Choice in Health Care 9
Pure Managed Case • Patients lock into a hospital based on expected quality • Prices set to maximize hospital profits taking into account investment in quality • Symmetric investments in quality cancel each other out and have no effect on prices – improving quality increases fixed costs but not variable (shortcoming?) • Underinvestment in quality for costly improvements and • Overinvestment in quality for inexpensive impreovements • More costly quality investments can increase profits (depending on cost function) Thomas P. Lyon Lyon on Consumer Choice in Health Care 10
Pure Insurance Case • This structure dominated US health care market until 1980s • Consumers only differentiate on distance to hospital, so consumers all pay the same premium – Premium set to maximize consumer surplus taking cost of care as given – In reality, we know that consumers are heterogeneous in their risk, can this be accounted for in this model? • Hospitals have an incentive to raise prices – a one dollar increase in price only increases the premium by a fraction Thomas P. Lyon Lyon on Consumer Choice in Health Care 11
Pure Insurance Case • Pricing equilibria is such that neither hospital wants uninsured consumers – Raise prices until every consumer is just covered • Pure Insurance results in higher prices and higher quality than pure managed care • Firms compete over market share through quality • Results in an overinvestment in quality Thomas P. Lyon Lyon on Consumer Choice in Health Care 12
Comparison of Regimes Thomas P. Lyon Lyon on Consumer Choice in Health Care 13
Now for choice! → Mixed Regime • Each hospital vertically integrates with an insurance provider and is the exclusive hospital for the patients in that plan • Consumers have a choice to either enter into an HMO and choose a hospital ex ante or buy insurance and choose hospital ex post • Consumers divided into three groups: 1 Only HMO 1 2 Choose between HMO 1 and insurance contract 3 Only HMO 2 Thomas P. Lyon Lyon on Consumer Choice in Health Care 14
Mixed Regime Mechanics • If only one hospital is successful in improving quality then all insurance patients go to that hospital • If both (or neither) succeeds, then the patients go to the closest hospital • Consumers will not pay more for managed care than insurance • To the hospital, a managed care patient is certain revenue while an insurance patient is not • Managed care is key for a hospital to expand their market share and guard against losing insurance patients (but must be offered at a lower price than insurance) Thomas P. Lyon Lyon on Consumer Choice in Health Care 15
Equilibrium Comparison • Prices: – Pure Insurance > Pure Managed Care > Insurance Mix > HMO Mix • Not enough choice in equilibrium – Too few consumers buy insurance – The more costly quality is the less choice there is • Prisoner’s Dilemma! – If only one hospital offers managed care → higher profits for that hospital – If both firms offer managed care → lower profits for both Thomas P. Lyon Lyon on Consumer Choice in Health Care 16
Existence of Mixed Regime • If potential quality improvement ∆ is low then the mixed regime will not exist – low cost → pure insurance – high cost → pure managed care • If ∆ is high and: – low cost → pure insurance – high cost → pure managed care – in the middle → mixed Thomas P. Lyon Lyon on Consumer Choice in Health Care 17
Summary • Pure insurance allows hospitals to charge a huge price and capture consumers by overinvesting in quality • As the cost of quality increases, managed care plans are used to lock up the market to prevent choice if the hospital is unsuccessful in improving quality, but prices and revenues fall Thomas P. Lyon Lyon on Consumer Choice in Health Care 18
Comments • Homogeneous consumers in terms of risk • Same level of quality improvement • In reality, not all consumers can afford insurance • How much uncertainty is there and can consumers accurately evaluate it? • Zero marginal costs to treating patients Thomas P. Lyon Lyon on Consumer Choice in Health Care 19
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