Transcript Effect of Cost Shifting on Hospital Profit from Private Market

Chapter 6
Hospitals
Background
In 19th Century, hospitals almshouses
 After World War II, developed technical
sophistication
 High share of total health spending led to
hospitals as target for cost containment
 Hospitals very labor-intensive (54%)
 Many payment sources

Characteristics of Hospitals
Vast majority are private not-for-profit
(NFP)
 Who are the residual claimants?
 Tripartite structure of hospital
management

The Profit-Maximizing
Hospital
The Base Case
Profit Maximization When Only Quantity
of Service is Only Decision Variable
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Assume hospital faces a downward sloping
demand curve
◦ P=p(x) inverse demand curve
◦ Let profit be π
 Then π = p(x)x - C(x)
Where C(x)= total cost of production
output at quantity x
◦ dC/dx is the first derivative of total cost
with respect to x
Profit Maximization When Only Quantity
of Service is Only Decision Variable
Continued
dC/dx is the firm’s marginal cost
 P(x)x = Total revenue R(x)
 dR/dx = dp/dxx+p(x) = Marginal revenue
 Profit is maximized at
 dπ/dx = dp/dxx+p(x)-dC/dx = 0

Profit Maximization When Only Quantity
of Service is Only Decision Variable
Continued
Quantity is set at the quantity at which marginal
revenue equals marginal cost. Once optimal quantity
x* has been determined, optimal price p* is read from
the demand curve.
The optimal values are shown graphically in Chapter 5,
Fig. 5.5, Panel A.
Profit Maximization When Quantity (Q)
and Quality (Y) are Decision Variables
Now consider a case in which the firm has
control over both quantity and quality of the
product it provides.
Let the quality level by y. Then the problem for
the firm is to set quantity, quality, and hence price,
which rises with increases in quality but falls when
quantity increases. Total cost C is positively
related to both x and y.
Profit π = p(x,y)x-C(x,y)
(6.1)
AC
MC
p
MC
p
p*
AC
p*
D
MR
x*
D
MR
x
x*
Profit (or “Cash Flow”)Maximization:
Positive and Zero Profit Cases
x
First- Order Conditions

Finding the optimal levels of x and y that
maximize π involves setting x* at the
quantity at which marginal revenue equals
marginal cost and y* at the quality at
which marginal revenue from changes in y
equals the marginal cost of changing y.
◦ dp/dxx+p(x,y) = dC/dx
and
◦ dp/dyx+p(x,y) = dC/dy
Newhouse Model
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Explains how hospitals behave when they have an
objective other than profit maximization
See introduction of paper for characteristics of hospital
author trying to explain, at least as of 1960s
Hospital maximizes utility subject to a constraint
Derive constraint and then introduce hospital utility
function
Derive Hospital’s Constraint
Fig. 6.1. Hospital Demand and Cost
Curves for Hospitals with High (H)
and Low (L) Quality
Fig. 6.2. Hospital Demand and Cost
Curves for Hospitals with High (H),
Low (L), and Very High (HH) Quality
Fig. 6.3. Hospital Quantity-Quality
Frontier
Introduce Hospital Utility Function
Fig. 6.4.The Hospital’s Optimum
Quantity and Quality
How quality is measured
More $=More quality???
 Perhaps higher ratio of staff to patients (average
daily census)
 Perhaps more and more technologically
sophisticated equipment
 Sophisticated services, such as open heart
surgery program, high level trauma unit,
treatment unit for rare cancers, neonatal
intensive care unit

Other Metrics for Hospital Quality
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Nurse staffing (to average daily census)
Facilities and services offered
Hospitals’ credentials (certifications, affiliations)
Patient outcomes: mortality rates (at discharge, at
30 days following admission, at 1 year following
admission, etc.)
Patient outcomes: rehospitalization rates
Patient outcomes: change in functional status, in
cognitive status
Process of care (chart reviews)
Comparative Statics: Effects of Exogenous
(to hospital) Changes in Following on
Hospital x and y (refer to Figure 6.4)
Wages (wage increase)
 Insurance (increase in population share covered
by insurance)
 Change in breakeven (zero profit) constraint
(hospital gets a fixed dollar subsidy per patient
admitted from city government)

Pauly-Redisch’s The Not-for-Profit
Hospital as a Physicians’ Cooperative
Not-for-profit most common form of hospital
ownership
 Doctors exercise important influence on
hospital decision-making
 Some medical staffs are “closed.”
 Trustees merely legitimize hospital actions

Concept of a Workers’ (Farmers’)
Cooperative
• What is a Worker’s Cooperative (
Yugoslavian model)?
Model
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p = p(x) Consumer has demand curve for
hospitalization (includes payment to hospital and
doctor)
phx= wL +cK Hospital has to break even. There are
two inputs, labor and capital with prices associated
with each
px= phx +yMM is the number of doctors on the
medical staff. yM is income per doctor (assumed to
be same for all doctors at the hospital)
Model, cont.
 yMM = (p - ph)x
 yM = [(p - ph)x]/M
 yM =
[px - wL- cK]/M income per doctor
rewritten
 x = x(M,L,K) hospital’s production
function:more M, L, and/or Kmore x
and lower p
Maximization Problem
Set M, L, K to maximize income per doctor at
the hospital
 That is:
maximize yM = [px - wL- cK]/M

First-Order Conditions
Labor
p x
x
p   x
 w
YM
L
x L

0
L
M
p
x 
 p  x 
L 
x
MPL

  w

MR
yM
looks like foc for labor.
K
Number of Physicians on Hospital’s
Medical Staff
p x
x
p 
 x

p  x  cK  wL
y M

M

x

M


0
2
M
M
M
Multiply through by M, then second term is y M
p x
x
get p
 x

 yM
M
x M
or
x
M
MPM
p 

 p  x    yM
x 

MR
Fig. 6.5.The Hospital’s Choice of
Labor Input
Fig. 6.6. Number of Physicians
on Hospital’s Medical Staff
Fig. 6.7. Incorporating the Supply of
Physicians to the Hospital
Fig. 6.8. Alternative Supply of MD Scenarios
Imperfect Cooperation on the Hospital’s
Medical Staff
Individual MDs on staff have control over
micro decisions (examples)
 At best, hospital can determine stock of
inputs, but MDs control their use
 How imperfect cooperation works in
practice
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Imperfect cooperation expected to
increase as MD staff size increases: Why?
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When staff size is small: (1) each MD bears
larger share of cost of his/her actions, (2)
departures from cooperative behavior more
easily monitored by MD colleagues (3) mutually
agreeable decisions more likely to be reached
Then why don’t hospitals implement
mechanisms to reduce imperfect
cooperation?
Answer is that they do.
 Medical staff organization (committees,
departments, etc.)
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Comparative Statics: Effects of
Hospital Changes Exogeneous to
Hospital
Wages or price of capital increase
 Shift in supply of physicians to hospitals
 Increase in percent of population with insurance
coverage
 Antitrust enforcement compelling hospitals to
have open medical staffs
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Why the Model of the Hospital as a
Physicians’ Cooperative is Interesting
Explains closed staffing arrangements
 Integrates hospital and physician behavior
 Shows why physicians like the not-for-profit
organizational form
 Explains some circumstances under which
hospitals are not efficient
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Limitations
Applies to not-for-profit hospitals, but not well
to government or for-profit hospitals or to
major teaching hospitals
 Does not incorporate complexities of hospital
organization (but neither do the other
economic models of hospitals)
 Just theory; no empirical research to test
theory
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Hospital Pricing and “Cost Shifting”
Hospital Pricing Under Profit
Maximization:Single Product
Review last lecture’s profit-maximizing case:
need some market power to have price setting
by hospital
 Distinguish individual hospital’s demand curve
from market demand curve
 With HMO entry, individual hospitals demand
curve may be more elastic
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Price-Setting in Models of Hospital
Behavior
Newhouse model
 Pauly-Redisch model
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Hospitals’ Sources of Payment
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Private insurance--Blue Cross: retrospective
costs or chargesnegotiated per diem prices
Private insurance—commercial: retrospective
chargesnegotiated per diem prices
Medicare: retrospective costscase-based
prospective payment based on DRG
Medicaid: retrospective costs
Self-pay: usual charges (full freight)
Concept of Cost-Shifting
What is effect of lowering Medicaid payment to
hospital on amounts charged private patients?
 What is effect of increasing the percent of
uninsured persons in the hospital’s market area
on prices charged private patients?
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Preconceived Notions of Hospital
Cost-Shifting
Hospital administrators and insurers: “It’s
obvious that hospitals cost-shift. We see it all
the time.”
 Economists: “You Dummkopf, it’s theoretically
impossible to have cost-shifting. If hospital
maximizes its profit, it will have more to
distribute for good acts.”
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Price Discriminating Monopolist
Case (no cost-shifting)
Effect of Cost Shifting on Hospital
Profit from Private Market
Profit:private
market
A
B
Quantity: private
market
Empirical Evidence on Cost-Shifting
Some empirical evidence for cost-shifting but
there is some evidence against it too.
 With growth of competition among hospitals, it
is becoming harder to cost shift if hospitals ever
could.

Hospital Ownership and
Performance
Stylized Facts
Hospital shares: NFP 59%, FP 15%, G 26%
Nonfederal short-term general hospital
Hospital spending about 33% of total
spending on personal health services
Why is the not-for-profit form
dominant?
Transactions cost of
ownership
-fiduciary relationships &
complex output
-non-contractible quality
-public goods
-implicit subsidies
-explicit subsidies
Other
-cartel theory
-low profits
Ownership Form and Hospital
Behavior
Non-distribution constraint of hospitals
(Hansmann 1996)
 NFPs dominant as response to uncertainty and
incomplete markets for risk (Arrow 1963)
 FPs will engage in behaviors that would not be
demanded if consumers were fully informed
(Weisbrod 1988)
 Larger are potential adverse consequences of
cost cutting on quality, stronger argument for
direct public provision (Hart et al. 1997); search
v. credence v. experience goods
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How Government Treats Hospitals
with Alternative Ownership Forms
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Tax status
Access to tax exempt bonds
Ability to sell stock
Access to public subsidies
Antitrust policy
Attorney general scrutiny of hospital ownership
conversions
Concerns of Critics of Hospital
Ownership Conversions
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Are the charitable assets properly valued or are
they being sold too cheaply?
Will the transaction be subject to independent
review?
Is the community at risk of losing valuable
health care services?
Will the new entity continue to provide
uncompensated care?
Will the proceeds of the sale be used to
promote the original NFP mission (which
federal tax laws requires)?
More Concerns
Will members of the NFP board of directors or
the FP purchaser benefit unfairly from the sale?
 Will the trust be independent of the hospital?
 Will hospital board members control the newly
charitable trust?
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Still More Concerns
Will conversion from G or NFP result in higher
hospital prices and expenditures?
 Will such conversions result in decreases in
quality of care at hospital?
 Why might this happen?
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Very Contentious Sets of Issues
Lots of vested interests: where you stand
depends on where you sit
 Some empirical evidence has been conflicting
 Ownership conversions occur in all directions
(also occurring in health insurance)
 Look at one study here
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Study by Sloan et al. “Is there a Dime’s
Worth of Difference?
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Study Goals
◦ Re-ask old question: How do for-profit hospitals
compare on cost and quality?
◦ Use much longer cost and outcome streams which
allow us to examine patient “steering” post discharge
◦ Have several alternative indicators of outcomes—
survival, changes in functional and cognitive status, and
in living arrangements (admission to a nursing home)
◦ Not a hospital ownership conversion study
Why Payments Might be Higher For
Patients Admitted to FP Hospitals
Upcoding of DRG
 Physician fees may be higher
 More referrals to SNFs, home health agencies
owned by firm
 Not due to more lab tests, etc.
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Study by Sloan et al. “Is there a
Dime’s Worth of Difference?
Conclusion
Adjusting for endogeneity, FPs more expensive
to U.S. Medicare, especially for downstream
payments
 Did not find differences in outcomes suggesting
that quality comparable between FPs and the
other ownership types
 Should we be bothered by the added expense
to Medicare from the FPs?
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Results
•
Medicare Payments
◦ Both total payments for 6 months and payments less
payments for index admission (“downstream payments”)
were lower if patient admitted to NFP or G hospital than if
admitted to a FP hospital.
◦ Differentials ranged from 8-11% for G and 5-6% for NFP
(see Table 5)
◦ Differentials larger for downstream payments than for total
payments
• Mortality
• None of the ownership variables were statistically
significant at even the 10% level
• Effect sizes very small
•
Results Continued
• Probability of Living in Community (Not in
Nursing Home) at NLTCS Interview Following
Admission
• Probabilities of living in community lower for
beneficiaries admitted to G and NFP hospitals, but
results not statistically significant and effect sizes are
low
• Probabilities of Worsening in ADL, IADL, and
Cognition
• Ownership effects not statistically significant
Regulation and Competition
Among Hospitals
Herfindahl- Hirschman Index (HHI)
• Keeler and coauthors measured competition within a local
market in this study and many others measured by the
Herfindahl-Hirschman Index (HHI)
(6.5)
• Si = fraction of total hospital discharges in the market that
hospital i has
• In other studies, output has been defined as patient days
rather than discharges
• If the hospital is a monopolist (has all discharges in the market)
HHI is 1
• If there are four hospitals with unequal number of discharges,
the HHI is
0.152 + 0.352 + 0.272 + 0.232 = 0.27
• As the number of hospitals in a market rises, the HHI
approaches 0 in value
• The key assumption underlying the use of the HHI as a
measure of competition is that sellers find it easier to collude
in price-setting when the HHI is higher.
Rationale for Regulation of Hospitals:
Old Style Competition
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Most people had insurance coverage for
hospital caredemand for care inelastic
Hospitals had retrospective cost- or chargebased reimbursementcould raise revenue by
raising cost
Hospital’s problem: attract patients by attracting
doctorsincrease hospital quality
Get cost-quality (upward) spiral
Quality competition (spiral)=medical arms race
(MAR)
MAR Worse When There are More
Hospitals
More hospitals in marketmore competition
among hospitals for doctors (and their
patients)more MAR
 Cost and quality much higher than is socially
optimal

Regulatory (Government)
Responses
Entry regulation: certificate of need (CON)
 Revenue or price regulation: Nixon price
controls, state rate setting programs
 Utilization review: Professional Standards
Review OrganizationsPeer Review
Organizations for Medicare
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CON
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What is need?
How is need determined?
What does or did CON cover?
Parallel to entry regulation in transportation
Effects of CON on hospital cost
Other goals of CON: promote access and
quality
Effects of CON on hospital quality
New Style Competition
Large fraction of insured population had
incentives or administrative mechanisms to
induce high degree of cost consciousness on
part of patients=new style insurance
 Under new style insurance/competition, hospital
demand curves become more elastic.

Transition from Old to New Style
Medicare PPS
 Selective contracting: insurers do not cover
care at all hospitals--done by Medicaid and
private insurers
 Insurers send all of their patients to network of
hospitals in return for a “good” price

What Happened? Empirical
Evidence
Old style=MAR: when have more hospitals in
area get higher cost and higher increase in cost
 New Style=little or no MAR: when have more
hospitals in area get more competition among
hospitals and lower cost and lower increase in
cost (about = price)
 And many states dropped CON and other
regulation
 Where CON retained, focus shifted to access
and quality promotion
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Relationship between Hospital
Volume and Quality
Many studies document that hospitals with a
higher number of surgical procedures have
better outcomes
 Holds for a variety of surgical procedures (e.g.,
Birkmeyer et al.)
 Reasons not clear: (1)practice makes perfect; (2)
some other variable correlated with hospital
 Applied most often to cardiac care, especially
coronary bypass surgery (CABG). G for graft
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How CON Relates to CABG
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Hospitals in CON states need state approval to
open a CABG unit
Competitors oppose entry
CABG and other cardiac interventions are very
profitable
Argument for CON: if have a lot of CABG unit,
each unit will have low volume and people will
die
Argument against CON: this is just
anticompetitive. Competition leads to good
outcomes overall.
Medicare Prospective Payment
System (PPS) Overview
Implemented in the U.S. in 1983-84
 About 470 diagnosis-related groups (DRGs)
 Per admission case-based prospective payment
 Ways to lessen shock of PPS to hospitals:
outliers, DSH, teaching hospital subsidies,
exclusions (e.g., psychiatric admissions, rehab)

Bottom Line: Competition versus
Regulation of Hospitals
Both regulatory and competitive strategies have
been tried, with no clear winner
 Other countries
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