2008
Economics of Vertical Integration in
Health Care
Marrit Nauta
Studentnummer: 1594249
Master Economics
Faculteit Economie & Bedrijfskunde
Content
Abstract 4
1. Introduction 6
1.1 Background 6
1.2 Research Question 7
1.3 Plan of the thesis 8
2. Methodology 9
3. Is the health care market different? 10
3.1 The health care market – a general overview 10
3.2 Product market 11
3.2.1 Health care 11
3.2.2 Health insurance 13
3.3 Geographic market 13
3.3.1 The hospital market 14
3.3.2 The health insurance market 15
3.4 Conclusion 17
4. Vertical integration 18
4.1 Definition 18
4.2 A model of the Dutch health care market 19
4.3 Effects of vertical integration from economic perspective 22
4.3.1 Market power increase, in absence of efficiency gains 22
4.3.2 Efficiency gains 27
4.3.3 Pro-collusive effects 35
4.3.4 Free-riding problem 40
4.5 Vertical restraints 46
4.5.1 Forms of vertical restraints 46
4.5.2 Vertical restraints versus vertical integration in the health care sector 49 4.5.3 Conclusion 50
4.6 Conclusion 52
5. Learning effects of Managed Care in the United States 54
5.1 United States – Managed Care 54
5.1.1 Managed care 54
5.1.2 Learning effects of managed care 55
5.2 Conclusion 59
6. Discussion 60
7. Conclusion 63
Literature 65
Table overview Table 1: Number of health care institutions, January 2007 15
Table 2: Effects of vertical integration in the health care problem 45
Table 3: Overview of the effects of vertical restraints 51
Table 4: Advantages and disadvantages of vertical integration 53
Figure overview Figure 1: The Dutch health care market 10
Figure 2: Vertical integration 18
Figure 3: The vertical integrated health care market 19
Figure 4: Competitive downstream and upstream market with single integration 20
Abstract
The Dutch government has allowed vertical mergers between health insurers and health care providers since 2006. This study focuses on the welfare effects of vertical integration in this special industry. Characteristics of the health care market are information asymmetry, uncertainty, and moral hazard. Moreover, three parties are present: health care provider, health insurer and the consumer/ patient. A model of the health care industry is set up. Upstream firms are the insurance companies and downstream firms are the health care providers. As the market concentration between urban areas and rural areas of both health insurance companies and health care providers differ, several market structures are taken into account.
I argue that vertical integration reduces transaction costs and increases efficiency at the supply side of the system. Anticompetitive effects and related to that, pro-collusive effects are disadvantages of vertical integration. Although vertical integration is a much discussed solution for the double marginalisation problem, this is not highly relevant in this sector. Free-riding is another economic problem, which will be reduced especially in the upstream market. Not each effect has a similar weight. It turns out that the beneficial effects of increased internal efficiency and transaction cost outweigh the downside effects due to increased market concentration.
Further, the effects of vertical restraints to the economic problems in the health care sector compared to vertical integration are discussed. If vertical integration is not possible, insurers might have other forms of vertical control in order get control over the downstream firm. It turns out that all types of vertical restraints have their beneficial and downside effects. Exclusive contracts have most beneficial effects compared to the other vertical restraints and approaches vertical integration. The largest difference between exclusive contracts and vertical integration is the time horizon. Although the effects of both are the same, vertical integration is preferred because there is no uncertainty anymore about for example opportunistic behaviour of renegotiating contracts.
1. Introduction
This section introduces the subject of this thesis. I will deal with the question why this study is relevant and contributes to the current knowledge and studies in this area. Consequently the central research question will be presented, followed by a brief overview of the plan of the thesis.
1.1 Background
Since 2006, the Health Insurance Act (Zorgverzekeringswet, ZVW) enhances the opportunities for insurers to merge hospitals. The background of this development is the gradual introduction of the market in the health care sector to contain cost. Since 1992, the Dutch government has invested in implementing the preconditions for deregulation and market-oriented reform. The liberalization of this sector arose from the raising cost of health care (appendix A). In the period between 1995 and 2004 health care expenditures have raised with 1.1 as percentage of GDP. Taken into account that GDP has raised both absolutely and relatively, health care spending has been risen extremely (OECD 2006). Furthermore, due to ageing of the population in the coming decades and new medical technologies, the expectation is that the health care expenditures are still growing.
In this perspective, the Dutch government has introduced market elements, among others permitting vertical integration, in the health care sector. Insurers may selectively contract health care providers and are allowed to extend their regional working area. In the negotiations, health insurers are permitted to negotiate lower fees than the current officially approved prices (Centraal bureau Tarieven Gezondheidszorg, CTG). Moreover, new insurers may enter the health insurance market. Open enrolment periods are introduced and citizens are free to choose where to enrol. Further, health insurers bear a growing financial risk for the medical cost of their members (Helderman et. al. 2005). Currently, funds bear about 53% of their financial risk. Risk-adjusted premium subsidies compensate insurers for high risk enrolees (individuals with higher than expected expenditures).
On the supply side entry barriers of new health care providers decrease since private clinics (zelfstandige behandelcentra, ZBC) are allowed. Simultaneously with selective contracting by health insurers, this puts market pressure on the health care providers in order to be more efficient. Moreover, hospitals are increasingly responsible for their (capital) cost. For a good overview of the transformation process in the Dutch health care sector I recommend to read the article of Helderman et. al. (2005).
providers through negotiating about prices and selectively contracting health care providers. In this way, insurers can compete for enrolees by offering health plans that are attractively priced, but still give a reasonably broad choice of health care providers. In order to make the hospital market competitive, insurers need to have sufficient bargaining power in order to intervene in and reduce inefficiency and profit margins of hospitals.
To support these developments, in 2006 the ‘Health Insurance Act’ (Zorgverzekeringswet, ZVW) was enforced. The Health Insurance Act allows insurers to own their own institutions. This enables insurers to deliver health care. What drives insurers to vertical integration is the involvement in the delivery of health care to achieve greater efficiencies and control costs. Although there are many definitions of efficiency, the focus is on X-efficiency: firm’s actual costs of producing any output are greater than the minimum possible cost. The important potential disadvantage of integration is the anticompetitive effects. Up until now, much attention has been paid to horizontal competition among hospitals and health insurance companies. Indeed, hospitals and insurers are increasingly competing due to several policy changes. In contrast, vertical relations in health care have not extensively been studied.
The question arises which consequences vertical integration has for, among others, the affordability and the performance of the health care system. Measuring the effects is important. Not only because insurers have to pay the costs of health care, but the insurant (patient) also indirectly pays via a higher premium price for the consumer. Moreover, it is the responsibility of the government that qualitative health care remains financially accessible for all inhabitants.
1.2 Research Question
This study focuses on the economic effects of vertical integration. Important advantages of vertical integration are the reduction in transaction costs and the increase in efficiency at the supply side of the system. Anticompetitive effects are a potential disadvantage. The question is whether vertical integration is welfare enhancing in such a specific market as the health care market compared to the current situation where health insurers contract health care providers.
This paper will explore and describe the potential effects of vertical integration for the Dutch health care market. The main research question of the thesis is:
Is vertical integration of health insurers and hospitals welfare improving given the conditions of the current Dutch health care market?
1.3 Plan of the thesis
2. Methodology
The purpose of this study is to explore and describe potential effects of vertical integration between health insurers and health care providers. A start is made by describing the relevance of studying the potential effect of vertical integration in this specific industry. For that reason, the policy background is briefly explained.
The Dutch Competition Authority (Nederlandse Mededingingsautoriteit, NMa) is authorized with giving permission for mergers between health insurers and health care providers. In order to give a founded economic opinion, it is necessary to describe the relevant product and geographic market. Market structure is one of the major indicators determining the effects of vertical integration. Due to the lack of quantitative data about the effects on price and profits of vertical integration in the Dutch context, a theoretical research approach has to be used. The microeconomic fundament is based on the books of Motta (2004) and Tirole (1989). Other studies about vertical integration focus on specific elements. These are used in addition to explore the effects in the special context of the health care sectors. Therefore I have extensively used electronic databases like Jstor, the National Bureau of Economic Research (NBER) and Econlit, and Pubmed. Via the ‘snowball method’, useful articles can be found. Search terms used are mainly vertical integration in combination with a specific subject like collusion, efficiency or transaction costs.
3. Is the health care industry different?
The introduction of vertical integration of insurance companies with hospitals is a new step in the transformation process of liberalizing the health care sector. The Dutch Competition Authority and The Dutch Health Authority (Nederlandse Zorgautoriteit, NZa) have an important role in monitoring the effects of vertical integration and in approving vertical integration between insurance companies and hospitals.
The NZa is the supervisor on the health care market in the Netherlands. The NZa monitors market conditions in the deregulated segment and the influence on public interests: quality, accessibility and price. The focus is on cost containment via the payment of health care providers and on supervising the implementation of the insurance acts in the care sector. In order to assess the effects of vertical integration, the relevant market which can be defined as “the set of products and geographical markets to which the products of the merging firms belong”, has to be determined. Chapter 3 provides a detailed overview of the health care industry.
3.1 The health care market – a general overview
The health care market can be distinguished in three separated markets, which are presented in figure 1. There is no clear demand and supply, like in normal markets where only two parties are active. First, there is a market between health insurers and health care providers. The health insurer has to contract and pay health care providers. Consequently, the health care provider is obliged to provide care to the enrolees of the insurance company. The second market describes the relation between the health care providers (supplier) and patient (demander). The patient needs care, which will be provided by the health care provider. Often, the payment of care occurs via the insurer. The third market is the health insurance market, which describes the relation between patient/customer and insurer.
Health insurers
Health insurance Health purchasing
Market market
Consumers/patients Health care providers
Health delivery market
3.2 Product market
In general, the SSNIP (Small but Significant Non-transitory Increase in Prices) test is used to trace the relevant market (Motta 2004). The test calculates whether it is profitable for a monopolist to increase prices in the relevant product and geographical market. If a monopolist can profitably increase its price, it faces few competitive constraints.
In the health care sector it is more relevant to look at the characteristics of the health care product in order to determine the relevant product market, rather than to do the SSNIP test. In the health care market two products can be distinguished: health care and health insurance. This section will give a short description of the two products. The emphasis is on the imperfections these product markets face.
3.2.1 Health care
‘In the health care sector, goods and services are produced that people believe they are entitled
to as a basic human right’ - Enthoven (1988)
Health care is a service and all services are by their nature inherently heterogeneous and non-tradable. There is uncertainty in the incidence, the diagnosis, the amount, and the outcome of care. The efficacy of treatment is pervasive and depends on the genetic qualities. The product health care can only be purchased by direct interchange. The market for medical care is characterized by large asymmetries in information about the needs for and the benefits of treatments. Patients rely on providers to help them to articulate their demand for care. Often they give partial or complete authority to providers to make the treatment decision. Specialists act as agents on behalf of the patient (Enthoven 1988).
The differentiation of the product is visible in the classification of hospital care: (1) elective care, (2) urgent care, and (3) top clinical care. Increasingly, patients assess and choose their own treatments and compare specialists. In particular, this concerns elective care. Urgent care is care which should be delivered immediately; otherwise the patient will die or has severe damage. The patient is not able to assess its treatment, but is totally depending on the specialist. Last, top clinical care is highly specialist care concentrated in academic hospitals. Often, this kind of care is relatively expensive (NZa 2006).
price is the only possible indicator of quality (Thoma 2006). However, when citizens are insured they do not experience the costs of their treatment. The insurer has to act as a supervisor in order to prevent poor quality relative to the price. Important to note is that in the case of credence goods, in unregulated markets prices of credence goods tend to converge. High and low quality goods will be charged for similar prices. The reason is that suppliers of credence goods tend to overcharge for low quality services, since the customers are not able to assess quality, while competitive pressures and pressures of insurers reduce prices of high quality services.
Besides the inability of consumers to assess the product they consume, moral hazard is an important problem in this market. The term moral hazard covers the phenomenon that people with insurance may use more services than they otherwise would. On the one hand, patients may overuse health care because they do not directly pay for the care they receive. In addition, the insured may use more costly services and prefer more quality-enhancing but cost-increasing technologies. On the other hand, there might be supplier-induced demand. Physicians’ utility depends partly on their income. Information asymmetry enables specialists to increase demand for their services and hence, raise their income. Further, due to external effects the government stimulates the use of health care for paternalistic motives in order to avoid costly treatments and negative external effects. Government intervention is the result of the short time horizon most individuals have concerning their current behaviour (Lapré et. al. 1999).
3.2.2 Health Insurance
People insure themselves because they are risk averse. Risk aversion is related to behaviour of consumers under uncertainty. People want to avoid high, unexpected expenditures in exchange of a sure monthly premium. To protect citizens who are not able to foresee these high expenditures, the government took the following paternalistic policy measure. In the Dutch health insurance system citizens above the age of 18 are mandatory insured for at least the standard benefit package, which encompasses necessary care. People below the age of 18 are insured for free.
Consumers/patients and insurers have asymmetric information about health state and hence, the probability of the use of health care (Arrow 1963). Information asymmetry can lead to adverse selection. Adverse selection can lead to segmentation of the health insurance market. Risk selection occurs when enrolees choose the health plan corresponding to their health state. In that way insurers can distinguish good and bad risks.
To cadre the product market of basic insurance policies, one has to distinguish the ‘in kind’ policy, the restitution policy and the combination policy. Currently, 55 standard benefit packages are offered by health insurers. Besides the mandatory standard benefit package, citizens can voluntarily insure them additionally. In 2007 insurers provided circa four to five policies for specific patient categories. Furthermore, most people have the choice to insure themselves individually or collectively via for example their employer.
Because of the high demand substitutability between the standard benefit package and additional insurance polices, there is uncertainty whether these two product belong to the same product market. Moreover, supply substitution is also relatively high. It is simple for the insurer to change its supply of health insurance policies. One reason to define the product market for additional insurance separately is because of the lack of demand substitution in this market. In contrast to additional insurance, each citizen is obliged to be insured for the standard benefit package. Moreover, insurers are not obliged to accept each citizen for additional insurance (NZa 2007).
3.3 Geographic market
3.3.1 The hospital market
The Dutch hospital market has monopolistic characteristics. The large number of mergers (86) between hospitals and the fact that 36 relatively small (local) hospitals are closed recently support this. The hospital market exists of four kind of health care providers: academic hospitals, general (local/regional) hospitals, categorical hospitals and the so called ‘zelfstandige behandelcentra’ (ZBC). Each health institution has its own working area.
The Dutch hospital market exists of eight academic hospitals. Academic centres take a unique position in the hospital market. They provide acute care, chronic and elective care, and top-clinical and top-preferential care. These institutions are linked to universities. An important part of their working area is research and education. The geographical market of academic hospital is national. Further, there are 85 general hospitals, which are geographically spread. General hospitals are relatively small hospitals and offer less specialist treatments compared to academic centres. General hospitals focus on the regional market.
In 2007, ten categorical hospitals have been settled in the Dutch hospital market (Boerakker et. al. 2005). Categorical institutions provide medical care focused on specific diseases or patients, for instance revalidation and dialyse. Categorical hospital can be classified in six categories: (1) revalidation, (2) asthma/lung, (3) epilepsy, (4) dialyse, (5) audiological, and (6) radiotherapeutisch. Catergorical institutions offer specialist service. For that reason, they operate in the national geographical market (RIVM 2007).
Up until December 2005 126 institutions are registered as a ZBC. In the period of January 2006 to early 2007, 49 institutions got the permission to provide care as allowed by a ZBC. Most centres are concentrated around the four big cities in the Netherlands. Officially, since the implementation of the WTZi, the term ZBC is substituted by "Institutions for specialist care” (instellingen voor medisch-specialistische zorg, IMSZ). Former ZBC’s may provide care within a time period of 24 hour. Patients are not allowed to stay a night in those centres. Their focus is on the A-segment: planned, non-acute care (RIVM 2007).
Table 1: Number of health care institutions, January 2007
Health care institution Number
Academic hospital 8
General hospital 85
Categorical hospital 10
ZBC 175
(Ministry of Health Affairs 2007, RIVM 2007)
Trends in the hospital market
The trend in this sector is a decrease of the number and a differentiation of hospitals. The first development is a reaction on the mergers among health insurers. In order to have a strong bargaining position to health insurers and other health care providers, the expectation is that hospitals increasingly merge. The number of institutions will decrease. Estimations vary between 40 till 70 hospitals in 2014, partly as a result of horizontal mergers. Moreover, in the line of increased liberalization, health care institutions are allowed to make profit since 2012 (Boerakker et. al. 2005).
Another development is that hospital care becomes more differentiated. Merged hospitals may choose to concentrate special functions at one location. This implies that some hospitals experience an expansion of their tasks, while other hospitals see their variety of tasks declining (specialisation). Simultaneously, health care will be increasingly delivered at the polyclinic.
Last, it is important to notice that hospitals will face an increase demand for health care. One development which contributes to this expectation is ageing. Furthermore patients become increasingly informed and new medical technology is available. This results in more consultations. Informed patients require a visitation of the medical specialist.
3.3.2 The health insurance market
Recent developments make the Dutch health insurance market highly volatile. The financial accountability of insurers increased. Further, insurers may selectively contract health care providers. The liberalization of the market makes that both health insurers and insurants are looking for a new position in this market.
In 2007, 32 health insurers are operating in the Dutch health insurance market. Those insurers can be classified into 14 concerns (see appendix A). In 2006, some health insurance companies got the permission from the Dutch Health Authority (Nederlandse Zorgautoriteit, NZa) to merge. OZ and CZ merged, just as VGZ-IZA-Trias and Univé (NZa 2007).
Currently, each health insurer offers the standard benefit package. There are nearly differentiated insurance policies for specific regional areas. Furthermore, insurers supply collective insurance policies offered at the national level. For instance, the employer can make an agreement with an insurer to get a discount on the insurance premium for its employees. In turn, the number of insurants of the insurer increases. Since insurance is based on ‘the law of the large numbers’, this is a healthy deal for the insurance company.
The concentration index of health insurance is between 652 and 9139 on the purchasing market, which is high (NZa 2007). The high variance is the result of whether the HHI is measured at the regional or national level. At the regional level the market concentration is low. A high HHI implies that on many purchasing markets a few insurers have a high market share. A lack of competition between insurers could result. Compared to a pure competitive market, one might expect that a lack of competition has negative consequences for the consumer. However, a dominant market position does not necessarily result in abuse of market power. The dominant party could strongly bargain in order to reduce its costs and hence, set a competitive premium price.
Trends in the health insurance market
in substantial cost advantages. Hence, there will be high entry barriers for new health insurers in this region. This is called the ‘regional mechanism’. In line with this, one can increasingly observe price competition between health insurers. Citizens are price sensitive and change from insurance company more easily. The expectation is that in the near future this development becomes stronger.
3.4 Conclusion
From the previous analysis it appears that multiple market imperfections characterize the health care market. The health care market is characterized by the presence of three parties, namely health care providers, health insurers and consumers/patients. Information asymmetry, uncertainty and moral hazard are central features at the health care market. Because there is no clear demand and supply, the price mechanism is not a mean to achieve an equilibrium situation in this market. Although it is clear that health care providers supply health care, the demander can be either the patient or the insurer. Whereas the patient gets health care, the insurer pays the care.
Two products can be distinguished in the health care market: health care and health insurance. Health care is a non-tradable service. Hospital care can be classified into three categories: elective care, urgent care and top clinical care. The demand for health care will still be increasing. People insure themselves against health costs because of risk aversion. Each citizen above the age of 18 is obliged to be insured for the standard benefit package. Important problems in this market are risk selection and adverse selection.
4 Vertical integration in the health care sector
Vertical coordination is an integral part of the liberalization process in the health care industry. It is important because it allows insurers to have control over health care institutions. This section describes the concept vertical integration, the definition, the effects in a theoretical and in a technical way and the market conditions under which vertical mergers might improve welfare in the health care sector. On the base of the previous section, the size of the potential effects can be approximated.
4.1 Definition
Integration is bringing together previously separated and independent organisations into a unified structure (Tirole 1989). The production and/or distribution of a product or service is controlled by a single entity. Whereas horizontal integration reflects the process of a company that integrates several activities at the same level of the production chain, vertical integration refers to the extent in which a firm participates in more than one stage of the production or distribution of goods and services. In microeconomics, vertical integration describes a style of ownership and control. It studies the relationship between an upstream firm and downstream firms, where the downstream firms are customers of the upstream firm (see figure 2). A firm is vertical integrated if it directly or indirectly controls all the decisions made by the vertical integrated firm (Tirole 1989). Traditionally, the concept of vertical integration is used when a firm is 100% owned by the other firm. Other forms of vertical integration are categorised in several quasi-integration structures.
Decisions of downstream firms affect the profit of the upstream firm and vice versa. This could be a reason for the upstream (downstream) firm to control the decisions made by the downstream (upstream) firm. The upstream firm integrates the downstream firm to get control over its distribution, so called forward integration. Another form is backward integration; a downstream firm controls an upstream firm (Vidal 2007).
Upstream firm Upstream firm
Downstream firm Downstream firm
Consumer Consumer
Health care market
In the health care market, vertical integration can exist between health care providers, like hospitals and general practitioners. In this thesis the emphasis is on vertical integration between health insurers and hospitals/health care providers. Vertical integration changes the product market and geographic market. Compared to figure 1, the health care system will not exist of three separated markets. By integration, the market will look as presented in figure 3.
Health insurer Health care provider
Consumer/patient
Figure 3: The vertical integrated health care market
From the perspective that the insurer has the central function in the Dutch health care system in order to reduce costs by contracting health care providers, the insurer is taken as the upstream firm. The downstream firms will be the hospitals. In some circumstances, the upstream firm is not able or might find it difficult to use vertical restraints that induce behaviour they want from the downstream firm. In such a case, they could use vertical integration; they merge with or take over the downstream firm(s). Consequently, when they belong to the same firm, their objectives should be more easily reconciled.
4.2 A model of the Dutch health care market
outcome of vertical integration on an economic problem. First, at the national level one can assume a certain level of competition in the upstream and downstream market. Second, the regional market should be taken into consideration. Either an insurance company or a hospital could have a monopolistic position at the regional market.
In addition, the difference between single integration and multiple integration should be taken into account. Whether single or multiple integration takes place, might have implications for the final health care market. Under single integration, only one upstream and one downstream firm merges. The other firms in the market are still operating independently (figure 4). If further integration takes place, it will be called multiple integration (figure 5).
Upstream firm Upstream firm Upstream firm Upstream firm
Downstream firm Downstream firm Downstream firm Downstream firm
Figure 4: Competitive downstream and upstream market with single integration
Upstream firm Upstream firm Upstream firm
Downstream firm Downstream firm Downstream firm Downstream firm
Figure 5: Competitive multiple (full) integrated market
In the following, I propose a model of the Dutch health care market. The Dutch health care market is a market with a stochastic, uncertain and information asymmetric environment. In practice, the product health care is a service. In this model I assume, for simplicity, that health care is a homogenous good. Remark the similarity with elective care. The institutions are profit maximizing. The firms compete in prices, the most visible indicator for the final consumer. Quality and service (effort level, e) are for largest part reflected in the insurance premium, because it is difficult to be quantified by the consumer.
The model of the current health care market exists of vertically separated firms, n upstream firms
(
Ui, =i 1,2,...,n)
and m downstream firms(
Di, =i 1,2,...,m)
. The demand isgiven by
∑
≠ − − = j i j i i a bq d qof the wholesale price w and a unit cost of resale that is taken equal to zero for simplicity.One can assume that firms in the health care market compete as Bertrand oligopolists; independently the firms set prices. In stage one, the upstream firms offer each downstream firm a contract with linear prices (w). In stage two, the downstream firm decides whether or not to accept the contract.
Further, few insurers and health care providers currently have a dominant market position, Therefore, a vertically separated regional market consisting of one upstream firm (U1)
and one downstream firm (D1) should also be taken into consideration. Total demand is Q = a –
p. Similarly, the upstream firm offers the downstream firm a contract with linear prices (w) in stage one. In stage two, the downstream firm decides whether or not to accept the contract.
Vertical integration Consider the national market, n > 1 and m > 1, with single integration. U1
and D1 merge and (n – 1) upstream firms and (m – 1) downstream firms are still operating
independently. Suppose m > n, so that each upstream firm could at least merge m ≥ 2 downstream firms. All firms are competing in prices. The integrated firm has a market share α on the upstream market and a market share λ on the downstream market, where the other firms have a market
share − − 1 1 n
α
and − − 1 1 mλ
. I assume in this model that integration results in an increase in
market share and market power: n 1 >
α
, and m 1 >λ
. The integrated firms’ market shareincreases relative to the market share of the other non-integrated firms. In stage one, the upstream firms make an offer to the downstream firms; also the integrated upstream firm makes an offer to the non-integrated downstream firms. The other (n – 1 ) upstream firms are not able to do an offer to D1. In stage two, the downstream firms will decide whether to accept or reject the offer except
of D1. Next, the resale prices will be determined.
4.3 Effects of vertical integration from economic perspective In the economic literature there are abundant studies that show the impact of vertical integration. This section focuses on the effects of a merger on price (consumer surplus), producer surplus and total welfare with respect to the health care market. First, the focus will be on the increase in market power. Second, the efficiency effects that can be obtained by vertical integration are presented. The double marginalization problem is one of the effects which will be dealt with. Further, pro-collusive effects are handled. The focus is in particular on the effect of vertical integration on upstream and downstream firm collusion. How vertical integration is a solution to the free-riding problem is the last economic issue presented.
The effects will be explained theoretically. Next, the effects will be put in a model. I compare the one-shot non co-operative equilibrium in the industry before and after the merger for each potential effect and apply this to the health care industry.
4.3.1 Market power increase, in absence of efficiency gains
Vertical mergers can lead to market foreclosure and hence, be harmful to competition. The idea behind market foreclosure is that an upstream firm, by merging with one of the downstream firms, effectively removes the downstream firm’s purchases from the open upstream market. In line with this, merging firms search market power or a strong competitive position in order to increase profits. The Chicago School favours the reliance on the laissez-faire principle.
Market power is generally defined as the ability of a firm to raise price (p) above marginal cost (mc) or the ability of firms to profitably raise the price above the competitive level. The Lerner index, an indicator of market power,
− = p c p
L is determined by firm’s market share, the market demand elasticity and the elasticity of supply of rivals (Motta 2004). Market power adversely affects allocative efficiency because the market equilibrium moves away from the maximum efficiency achieved at p = mc. Thus, higher market power implies poorer market performance and a lower consumer surplus. In contrast, producer surplus might increase if demand elasticity is low. The effect on total welfare is ambiguous.
Concentration There is a direct relationship between the level of market concentration and the
average level of market power the firms possess. Other things being equal, the lower the number of independent vertical chains and non-integrated firms operating after the merger, the more likely it is detrimental to consumers. Fewer competitors are harmful for the degree of competition in the market which could result in a price increase (Motta 2004). Additionally, the possibility of collusion increases. In a highly concentrated market, explicit or tacit agreements are more likely keeping prices artificially high.
The ability of one firm to exert market power depends highly on the number and the size of rivals. Under vertical separation, entry of new firms is more likely because it is financially less risky to enter one stage rather than two stages. Low concentration, big rivals and competitive pressures of entrants make it difficult for incumbent firms to keep prices artificially high. In the case of a merger to monopoly, the new firm will not face any restraints from competitors in its price decisions when entry barriers are sufficiently high. In a fragmented market, where the vertical integrated firm has only a small market share, the impact of a merger on price will be irrelevant (Farrell and Shapiro 1990). In that case, it is unlikely adverse effects arise.
One has to look for the initial level of concentration and to the predicted change in concentration due to the merger. By vertical integration with more than one downstream firm, the market becomes more concentrated. The equations below show the effect of concentration on collusion. The larger is the number of firms n, the less likely is collusion. δ is the discount factor, which can be expressed as δ = 1 / (1 + r ), where r is the interest rate between two time periods. Equation 1 shows that collusion will have place when the left hand side of the equation (collusive profit) is larger than one period monopoly profit under optimal deviation, the right hand side. The collusive profit is divided among all n firms and discounted for the next periods. At the right hand side, in the deviation phase the deviated firm get all profits, but in the following periods the firm gets zero profit. In this punishment phase all firms revert to the Nash equilibrium forever. By transforming equation 1, equation 2 can be obtained. Equation 2 demonstrates that the larger is the number of firms, the less likely is collusion. In sum, increasing concentration makes artificially high prices more likely. One remark, asymmetries in products might increase concentration ratios and hinder collusion.
In the health care sector, national concentration should be distinguished from regional concentration. Most general hospitals have a more relevant local or regional market rather than a national market. Consumers/patients choose health care providers who give them the highest utility (lowest travelling time/costs). Thereby, they give the provider market power, since switching to another health care provider will reduce a consumer's utility. The less substitutable are hospitals for one another, the greater is the degree of market power.
Since insurers are not selectively contracting, the insurance market can be considered as a national market.On a national market vertical integration may provide means to overcome some barriers to competition, since firms are integrating in order to reduce costs. Consequently, price competition increase (prices decrease).However, historically insurers are settled and dominant in certain regions. If insurance companies are merging hospitals in the same region, the problem of dominance by the integrated firm arises. The integrated firm is able to raise premium prices up to monopoly level.
Market foreclosure If an integrated firm is able to obtain a dominant position in the market it
could create exclusionary effects. A vertical merger might allow a dominant upstream firm to deter entry into the downstream market by foreclosing a crucial input or by making it more difficult or expensive for the entrant to obtain such input (Motta 2004). Additionally, a vertically integrated firm that possesses market power on an essential input may exercise the power over non-integrated rivals and can place them at a cost disadvantage. This might result into complete foreclosure of firms and lead to a price rise up to the monopoly level.
Riordan (1998) developed a theory of anticompetitive vertical integration by raising the input costs of rivals via vertical market foreclosure. According his theory, vertical integration is a strategy for deterring entry. Moreover vertical integration raises the upstream barrier for expansion. Salinger (1988, 1991) proposes an alternative theory of raising rivals’ cost: vertical integration changes the incentives of upstream firms in setting prices. Prices will increase.
conclusion that vertical integration is welfare enhancing must be tempered if significant market structure changes result from integration, in particular at the regional level.
Another example of market foreclosure are the substantial cost a new firm should invest before entering the market, so called sunk cost (F). Although economic profits motivate new firms to enter the market, the extent to which potential entrants restrain the market power of incumbents crucially depends on sunk costs. The larger are the costs that an entrant has to incur, the higher is the scope for a price rise by the incumbent. The contestable market theory (Baumol 1982) defines contestability as the effectiveness of barriers to entry and exit in a market. The incumbent firms will behave competitively if there is a lack of barriers. Barriers hinder those firms to obtain monopoly profits and to possess market power. Post-merger prices might rise transitory or not at all. Therefore, the theory of contestable markets endogenizes the determination of market structure.
Additionally, if entry to the separate stages of the production process is already difficult before the merger because of for instance large capital requirements, integration of the stages will raise additional entry barriers. New entrants must enter two stages instead of one (Comanor, 1967). Moreover, the investment hinders besides entry also exit of firms, because of these high sunk cost the firm will stay as long as possible in the market.
Model In the health care industry, setting up an insurance company or a new health care institution requires high investments. An insurance company is obliged to have a minimum level of financial reserves and has to guarantee its enrolees to fulfil its orders. Setting up a new health care institution requires a lot of capital, both physical and mental. However, entry of new ZBC’s is relatively easy. Given the game described in section 5.2, the problem of high entry or exit barriers is as follows. Suppose a market for a homogenous product with n upstream firms and m downstream firms, where demand is p = 1 – Q. Q the total demand of all downstream firms together. Consider that entry barriers under vertical separation are sufficiently low; F = 0, but that these barriers rise if the upstream and downstream market are vertically integrated, F = x2.
the first derivative and equalling to zero, the optimal quantity under Bertrand competition will be
(
)
1 + − = n w a q .Next, the problem of the upstream entrant can be solved, max
(
)
(
)
F n w a c w u − + − ∗ − = 1π
. F n c w n c w Q n c w w u − + − = + − = + + = 2 1 , 1 , 1π
Under vertical separation an upstream firm will enter the market as long as the profit
π
u is positive.Vertical integration Suppose now that full multiple integration. A new integrated entrant has to incur fixed sunk cost F = x2 in order to enter the merged upstream and downstream market. The problem is as follows,
(
)
2 2 2 2 1 x c x Q c p vi − − = − ∗ − =π
2x should be at least as large as
2 2 1 − c
, otherwise it is not profitable for potential entrants to enter the vertically integrated market. One can conclude that, given the conditions of this example, integration hinders entry if high entry costs are involved. This might result in a favourable structure for prices agreements and other forms of collusion.
Demand Demand variables, and especially demand elasticity, should be taken into account to
Since demand elasticity enters the incentive constraint for collusion only through the expression of profits and these cancel out, this variable has no obvious effect on the likelihood of collusion. Hence, in theory it has no effect on prices.
Consumers Power The larger the power consumers have in the relevant market, the less likely
that firms, even a monopolistic firm, are able to raise their prices. Consumers can use their ‘voice’. If that is not effective the possibility of exit by the consumer would make it unprofitable for a firm to increase prices. The availability of substitutes is required. In the health care sector, the large asymmetry in information characterizes the relationship between consumer and supplier. The medical specialist is the agent. Although the gap gradually declines, in most circumstances the consumer is dependent of the medical specialist. Consumer power is only organized in national patient organizations; their influence on price setting behavior by health care providers is nil.
In the health insurers market, consumers are shopping between health insurers. Insurers respond on this development by offering packages for the lowest price or for the best price-quality/service ratio. Consumers’ power set in this part of the health care sector. A similar argument as under demand elasticity can be made, since consumer power likewise does not appear in the expression of profits and hence, it does not affect prices in this model.
4.3.2 Efficiency effects
This section is mainly concerned with efficiency reasons for vertical integration. Efficiency arguments are associated with cost reducing and cost minimizing economic activities. A profit-maximizing firm would already be efficient. The expectation is that many efficiency gains can be realised in the health care sector. Insurers argue that especially on the supply side efficiency effects can be obtained; hospitals can operate more internally efficient and can use less costly treatments. Furthermore, the section deals with the synergy effects of integration (economies of scale and scope, double marginalisation) and the transaction cost.
There are different definitions of efficiency: X-efficiency, dynamic efficiency, static efficiency, allocative efficiency, distributive efficiency and productive efficiency. X-efficiency is used throughout this paper. X-efficiency focuses on whether firm’s actual costs of producing any output are greater than the minimum possible cost.
Efficiency effects Vertical integration could be a manner to increase profits because a merger
impact of evolutionary changes faster. Moreover, the upstream firm can intervene in the organisational and logistic structure of the downstream firm and improve monitoring (Gaynor 2006). In that way, moral hazard can be controlled.Moreover, supplier-induced demand is a form of downstream moral hazard. Through integration, incentives of insurers and providers are unified. Thereby, the use of costly medical technologies can be controlled. Providers have no longer an incentive (financial) or opportunity (gatekeeping and utilization review) to induce demand of their patients (Glied 2000).
Salinger (1988) proposes that, where some economists expect vertical mergers are harmful for competition, other economists view that vertical mergers do not enhance market power and often lead to a price reduction of the final product. If the upstream firm is a monopolist, vertical integration does not increase its profits or result in different prices. This argument is related to the theory posed by the Chicago school. According to the Chicago School arguments, vertical integration increases efficiency and not monopoly power. The theory holds that there is no monopoly reason for vertical control. Suppose an upstream monopolist who sells to perfectly competitive downstream firms. In this situation, the upstream firm has all bargaining power and consequently is able to extract all profits from downstream firms. A vertical merger would not add market power to the monopolist. Thus, if a firm vertical merge, it must be for efficiency reasons. According to Posner (1979) vertical integration is beneficial since it reduces costs, while it simultaneously increases supply.
Model 1 The Chicago School claims that vertical mergers are efficient. This claim is based on a model in which an upstream monopolist sells to perfectly competitive downstream firms. Under such conditions, the upstream monopolist is able to extract all the profits from the market, since there is no double marginalization problem. Hence, a vertical merger would not add market power to the monopolist. Assume constant marginal costs c > 0,
− − =
∑
≠ j i j i q q a p , a > c.Vertical separation The problem of the competitive downstream firm is easily solved. Under price competition, price equals marginal cost. Downstream firms profits’ are zero. The upstream firm obtains the monopoly profit, since the monopolist is able to set optimal wholesale prices. The problem of the upstream monopolist can be solved as follows,
Max
π
u =(
a−Q−c)
∗Q2 2 , 2 , 2 − = + = − = a c w a c a c Q
π
uVertical integration Consider that the upstream monopolist merges the downstream firms. The problem of the integrated monopolist can be solved as follows,
Max
π
vi =(
a−Q−c)
∗Q, where∑
≠ + = j i j i q q Q .Take the first order condition with respect to Q and equalling to zero gives:
2 2 , 2 , 2 − = + = − = a c p a c a c Q
π
viIn this model there is no difference in profit for the upstream firm under vertical separation and vertical integration. The reason to integrate will not be an increase in market power. Efficiency gains through vertical integration could increase profits, as the Chicago school argues.
The argument of the Chicago School partly can be applied to the context of the health care market. Given that the national health care market consists of n upstream firms and m downstream firms, the upstream firm has no dominant position in the national market. However, it should be noticed that some insurance companies have a dominant regional market position as explained in section 5.2. The upstream firm could integrate hospitals for efficiency reasons. Consumer surplus will increase since prices are lower, producer surplus will increases and hence, total welfare increases.
Up until now it is argued that vertical integration stimulates the realisation of transitory efficiency gains. Vertical integration provides the former upstream firm access to information about the cost and the internal process of the downstream firm. The large information asymmetry between insurer and supplier diminishes. Integration enables the insurance company to intervene in the organisational and logistic structure of the hospital; inefficiencies can be removed. Furthermore, it could inform and advise the specialist about the use of the most cost-effective treatments. This leads to the following example.
vertical integration the downstream firm realizes efficiency gains 0 < e < 1. Cost of the firm under vertical integration are therefore 0 < ce < c.
Vertical separation Competition between upstream firms and downstream firms constrain the firms to exercise market power. In theory, if a firm tries to increase prices in a significant way, many among its current consumers would move to another hospital. For that reason, the firm will refrain from doing so. Its market power is therefore limited by the presence of the competitive downstream firms.
Under price competition, the price set by downstream firms equals the marginal cost. Downstream firms’ profit is therefore equal to zero. The upstream firms have to determine the wholesale price. For the upstream firm the problem will be as follows,
Max
π
u =(
w−c) (
∗ a− p)
Taking the first order condition to wholesale price and equalling to zero gives,
(
)
(
)
8 , 2 2 c a c a w u − = − =π
Vertical integration Suppose full multiple integration will have place. Instead of maximizing their profits separately, the firms will now jointly maximize their profits. Consider the situation where efficiency effects are realized, so that ce < c. The problem of the integrated firm will be,
Max
π
vi =(
p−ce) (
∗ a−p)
Taking the first order derivative to price and equalling to zero,
(
)
(
)
(
)
4 , 2 , 2 2 ce a ce a q ce a p vi − = − = + =π
One can observe that the profit under vertical integration is larger than the profit under vertical separation since,
π
u +π
d <π
vi. Besides, vertical integration leads to lower prices, which means that consumer surplus and hence, total welfare increases.Double marginalisation problem Spengler (1950) was the first who emphasized the double
with respect to what would be optimal from the consumers point of view. If the two firms merge, only one mark-up will be put over the actual cost. Vertical integration is efficient since it allows them to coordinate on the optimal outcome or to control for the externality that they impose on each other. The result after the correction for this externality is that not only firms but also consumers gain from the vertical merger (Motta 2004).
Model Although at the national level there is no upstream and no downstream firm having a monopolistic position (not taking into account the highly specialised hospitals), at the regional level it could occur that an insurer and a hospital have a dominant market position. Suppose that in a certain region there are one upstream firm U and one downstream firm D. Assume U has all bargaining power. U makes an offer to the downstream firm. Demand is given by q = a – p, where a > 0, q is demand en p is the final price. The upstream firm has a unit production cost
c < a, and the cost of the downstream firm is the wholesale price w. I also assume that all agents have perfect information.
Vertical separation In t=1, the upstream firm chooses wholesale price w. Then, the downstream firm chooses the final price. I will apply backward induction and look for the solution of the downstream firm, given w.
Max
π
d =(
p−w) (
∗ a−p)
By taking the first derivative and equalling to zero, price, quantity and profit are:
(
)
(
)
(
)
4 , 2 , 2 2 w a w a q w a p d − = − = + =π
The upstream firm chooses a wholesale price to maximise its own profit,
Max
(
)
− ∗ − = 2 w a c w uπ
By taking the first order condition and equalling to zero, the wholesale price and profit of the upstream firm become,
(
)
(
)
8 , 2 2 c a c a w u − = + =π
(
)
(
)
(
)
4 , 2 , 2 2 c a c a q c a p vi − = − = + =π
It appears that under vertical integration, prices are lower (improvement consumer surplus), profits are higher (improvement producer surplus) and hence, total welfare rises. If either the upstream firm or the downstream firm is competitive, in the sense that it sells at marginal cost (w = c, or p = w), then vertical integration does not increase the joint profit of the integrated firm. There is no price distortion in the competitive sector and hence, there is no externality. Notice that market structure is the variable that determines whether vertical integration is welfare improving. If one of the markets is competitive, the double marginalisation problem does not occur.
Although insurers and health care provider could have a dominant regional market position, it turns out that the double marginalisation problem is not an important problem in this industry.
Transaction cost Another beneficial effect of vertical integration is about the transaction costs
made in the open market. Williamson’s transaction cost theory makes a contribution to the relationship between uncertainty and transaction cost. He distinguished two factors ‘transactional factors’ and ‘human factors’. The first argument is concerned with the characteristics of the relevant market. The emphasis is on market uncertainty and the number of firms in the downstream market. Market uncertainty raises the cost of market exchange. “If events were predictable the price mechanism would render its signalling service at no cost” (Malmgrem 1961:401). In general, the greater the uncertainty in a market, the more lengthy and complex will be the contracts that are negotiated. Vertical integration reduces market uncertainty and hence, transaction costs.
The second argument is about human factors like ‘opportunistic behaviour’ and ‘bounded rationality”. Bounded rationality implies uncertainty at the individual level even there is no market uncertainty. Opportunism suggests a decision process which includes the pursuit of ‘self-interest with guile’ (Williamson 1979:957). Both factors increase uncertainty and the transaction cost will be higher in the open market than under vertical integration.
market exchange by an internal transfer. Resource allocation is coordinated by the integrated firm. Coase (1937) wrote about the transaction cost advantage:
Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur coordinator, who directs production. It is clear that these are alternative methods of coordinating production. Coase (1937: 333).
Model Suppose a market where n upstream firms and m downstream firms are operating. Total demand q = a – p. In t = 1, the upstream firms offer the downstream firms a contract with linear prices (w). In t = 2, the downstream firm decides whether or not to accept this contract. When they accept the contract, the firm faces additional transaction cost T.
Vertical separation Start in stage two, where the downstream firms decide whether or not to accept the offer of the upstream firm. Profit of the downstream firm,
(
p w) (
a p)
Td = − ∗ − −
π
Taking the first order condition and equalling it to zero,
(
)
(
)
(
)
T w a w a q w a p d − − = − = + = 2 , 2 , 2π
In continue with stage one, the profit of the upstream firm can be calculated. The profit of the upstream firm is the same as in normal circumstances,
(
)
− = 8 2 c a u
π
Vertical integration Under vertical integration, the integrated firm does not face any transaction cost anymore: T = 0. In the standard problem of the monopolist, profit can be calculated as follows, Max
π
vi =(
p−c) (
∗ a−p)
The solution of this problem is similar as before,
(
)
(
)
(
)
4 , 2 , 2 2 c a c a q c a p= + = −π
vi = −Compare the profit of the integrated firm with the profits of the separated firms
One can conclude that producer surplus under vertical integration is higher than under vertical separation. Therefore, it is profitable for the downstream firm to integrate when transaction cost will be cancelled out. If the separated downstream firm will not pass on the transaction costs to the final resale price, consumer surplus (not producer surplus) is the same under both circumstances. Focusing on these two effects, if transaction costs are substantially high, total welfare will be higher when firms vertically integrate.
The transaction cost motive is challenged by advocates of the bureaucratic cost hypothesis. Can economies of integration exceed the bureaucracy costs? The question is whose cost is minimized. If the focus is on one party, cost minimization can be realized. However, if the entire integrated firm is taken into account, total costs do not necessarily decrease. Three forms of bureaucratic cost should be taken into account in the analysis (1) implementation cost, (2) strategic cost, and (3) production cost. The costs of realizing vertical integration including the preliminary phase are considerable. For instance, the firm may face substantial legal fees to arrange the merger with another firm (Carlton and Perloff 2005). Further, as the size of a firm gets larger, it is more difficult to manage and consequently, the costs of managing increase. Instead of market transactions, expenditures are required regarding for instance internal control and coordination. Moreover, there is a loss of market pressure and an increase of strategic inflexibility due to increased barriers (D’Aveni & Ravenscraft 1994). According to D’Aveni and Ilinitch (1992) vertically integrated firms have a higher risk of bankruptcy than non-integrated firms, because of the lower flexibility. Some processes will still be operative, and adjustments and technological improvements will still take place, regardless of firms are vertical integrated.
Model Consider the health care market where n upstream firms and m downstream firms are operating. In stage one, the upstream firms offer a contract (w) to the downstream firms. In stage two, the downstream firms decide whether or not to accept the offer and determine the resale price. Marginal costs are c > 0.
Vertical separation Under vertical separation the problem of the downstream firm will first be solved, max
π
d =(
p−w) (
∗ a−p)
.Taking the first order condition with respect to price and equalling to zero,
The problem of the upstream firm is, max
(
)
− ∗ − = 2 w a c w uπ
Taking the first order condition to wholesale price and equalling to zero,
(
)
4 , 2 2 c a c a w u + = + =π
Vertical integration Under vertical integration, the upstream monopolist and downstream monopolist merge. The costs of the merger are F. These costs should be lower than the profit under vertical integration; otherwise the merger will not take place,
Max
π
vi =(
p−c) (
* a−p)
−FTaking the first order condition with respect to price and equalling to zero,
(
)
(
)
4 , 4 , 2 , 2 2 2 c a F F c a c a q c a p vi − ≤ − − = − = + =π
Because the bureaucracy cost will not enter the first order conditions, it will not affect consumer surplus. However, producer surplus will decrease with F and hence total welfare will decrease. The larger is F, the less likely the firm merges.
Focusing on the health care sector, the expectation is that transaction cost will be lower under vertical integration than in a vertically separated market. Negotiation about contracts is still in its infancy and is going together with high cost. If this process is internalised, the transaction cost will be minimized.
In contrast, vertical integration between insurance companies and hospitals might also involve costs. The integration process takes time, energy and juridical cost are involved. Further, one have to take into account the unique position of the specialist in this process. Not only the hospital board should come to an agreement with the insurer, similarly the medical specialist has to come to an agreement. Because of their professional autonomy, this could become a difficult, long-term process where high costs are involved. Once integrated, insurers continually control and monitor the medical treatments. Whereas transaction costs decrease; bureaucratic costs increase. The final effect depends on which effect dominates.
4.3.3 Pro-collusive effects
