Revisiting the relationship between managed care and hospital consolidation

Health Services Research, Feb, 2007 by Robert J. Town, Douglas Wholey, Roger Feldman, Lawton R. Burns

During the 1990s, managed care displaced indemnity insurance to become the dominant form of health insurance in the private sector (Glied 2000). Over the same period, a wave of hospital mergers, acquisitions, and hospital system expansions occurred. In 1990, the mean, population weighted, hospital concentration, measured with the Herfindahl-Hirschman index (HHI) (1) in Health Services Areas (HSA) was 0.1913. By 2000, it had risen to 0.2596. Over 90 percent of the increase in concentration is a consequence of mergers, acquisitions, and hospital system expansions. (2)

Understanding the determinants of hospital market power allows the development of policies to manage hospital market power, which is important because hospital market power increases, this has negative effects on markets. First, as hospital market power improves hospitals' bargaining position with payers and increases the cost of hospital care for the privately insured population (Dranove and Satterthwaite 2000; Gaynor and Vogt 2000, provide excellent reviews of the literature studying this effect). Second, hospital market power is also associated with decreased hospital quality (Kessler and McClellan 2000; Gowrisankaran and Town 2003). Finally, there is some evidence that hospital market power decreases access to health services for underserved populations (Aizer, Currie, and Morretti 2004).

It is conventional wisdom that the rise of managed care precipitated the hospital consolidations and concentration in the 1990s. (3) Graphical analysis is consistent with conventional wisdom. Figure 1 graphs the mean, population-weighted levels of hospital HHI and HMO penetration across all HSAs. (4) Hospital concentration and HMO penetration share a common, upward trend throughout most of the 1990s. In the late 1990s there was a break in the relationship, as HMO penetration declined while hospital concentration continued to increase. While suggestive, the correlation does not prove that there is a causal link between HMO penetration and hospital concentration.

[FIGURE 1 OMITTED]

This paper tests whether there is a causal relationship, examining the proposition that the rise of managed care caused hospitals to consolidate in the 1990s. Our models explicitly account for the possibility that markets are systematically heterogeneous and this heterogeneity may bias cross-sectional estimates of the parameters of interest.

Our estimates indicate that the rise in managed care did not cause the increase in hospital concentration. In every specification we estimated, the coefficients on managed care penetration are not different from zero at traditional levels of confidence. Furthermore, our data analysis fails to suggest other possible cause(s) of the hospital consolidation wave.

The next section discusses some of the reasons why managed care might lead to hospital consolidation. The following sections present the methods, data, results, and discussion of our findings.

HOSPITAL CONSOLIDATION AND MANAGED CARE

Why Managed Care May Cause Hospital Consolidation

There are at least three reasons why managed care might cause hospital consolidation. First, managed care may reduce the demand for hospital beds and create excess capacity in the market. Second, managed care may change the bargaining power of hospitals relative to health insurers. Third, the value of contracting with an integrated hospital system may be greater for managed care organizations (MCOs) than indemnity insurers.

One of the theories underlying managed care is that by monitoring and controlling health care use, insurers can reduce health care expenditures and perhaps increase enrollee health. In the RAND health insurance experiment, enrollment in the prepaid Group Health Cooperative of Puget Sound reduced the likelihood of a hospital admission by 35 percent compared with a fee-for-service population (Manning et al. 1987). (5) However, as an explanation of hospital consolidation this finding needs embellishment because most economic models of mergers predict that the incentive to merge increases with the demand for the product (e.g., Deneckere and Davidson 1985). The intuition behind this result is straightforward--the larger the market the larger the profit gains from market power.

However, it is possible to conceive of circumstances in which a decline in demand for inpatient services leads to hospital consolidation. If demand falls far enough so the market can no longer support the old number of hospitals under the old ownership structure, then there may be an incentive to merge.

According to neo-classical economic theory, if the reduction in demand leads to lower prices and if price falls below average variable cost, the market will remove capacity in some way. Hospital closure is one way to reduce capacity. But, because hospital assets have "high specificity" and few alternative uses, hospitals may seek to raise price above average cost by combining operations in order to achieve efficiencies which reduce average costs and/or to use market power to raise prices. This explanation requires that hospitals value autonomy as well as profits. If autonomy were not valued, the hospitals would have been better off by consolidating earlier. Given the hospital industry's historical basis as a decentralized, community-based system, the assumption of autonomy being valued is plausible.