An Arm and a Leg . . . Scope Economies and Hospital Consolidation

The health care industry has been in transformation since at least the 1990s. As health care expenditures have risen steadilyfrom 6 or 7 percent of GDP thirty years ago to nearly 18 percent todaypatients, insurance companies, and the doctors and hospital service providers themselves have all been forced to adjust to new market pressures. One manifestation of this transformation has been a continuing wave of hospital mergers and consolidation. Since 1997, the average Herfindahl Index for hospital services in metropolitan areas has increased from 4200 to nearly 4800 today. Because the DOJ/FTC Merger Guidelines define any market with an index over 2500 to be highly concentrated and any increase over 100 points in such markets to be significant, these data show that the typical urban hospital market is one in which hospitals may have considerable and growing market power.

Cost efficiency has been a major motivation behind the hospital merger wave and scope economies are likely an important source for any such cost savings. There may, for example, be important scope economies between serving patients needing surgery and follow-up in-hospital care such as amputees and those receiving hip or knee replacements, with serving patients needing continuing disease control and/or rehabilitation because many of the nursing and monitoring services required are the same. Similar scope economies may exist between inpatient and outpatient care. In addition, scope economies may be realized by combining in one hospital both those who specialize in various functional areas with generalists who treat diseases that affect those areas and others. For example, because prostate and colorectal are two of the most common kinds of cancers, it may be less costly to house proctology and urology specialists in the same hospital as oncologists.

Of course, acquiring market power may be another motivation behind the hospital merger wave. These issues came to a head recently when the Federal Trade Commission blocked a merger between Pro Medica Health System and St. Luke's Hospital in Toledo, Ohio. The merging hospitals argued that their joining was necessary to coordinate care and controlling costs especially in light of the changes instituted by the Affordable Care Act. The FTC provided data showing that this consolidation would substantially increase concentration in the Toledo area hospital market. It also gave evidence implying that Pro Medica's hospitalization fees were among the highest. FTC officials saw the merger as a classic case of an attempt to eliminate (buy out) a low-cost rival. In the FTC's view, even if the scope economies were realized there was no guarantee that these savings would be passed on to the public given the market power the newly merged firm would have. The FTC was not against saving lives and limbs more efficiently. It just wanted to make sure that it did not end up costing patients an arm and a leg. Source: R. Pear, "Regulator Orders Hospitals to Undo a Merger in Ohio," New York Times, April 3, 2012, p. A11.

NB: DOJ Stands for Department of Justice while FTCstands for Federal Trade Commission

Read the case given above carefully and armed with your knowledge of Managerial Economics, answer the following questions:

1. Describe the problem that this case embodies that has necessitated government intervention. (10 marks)

2. From the view point of a hospital and using examples, explain the meaning of cost efficiency as used in this case. What benefits would obtain from cost efficiency that you can pick from this case? (10 marks)

3. Clearly explain the concept of economies of scope and identify examples present in this case. Using examples compare and contrast between economies of scope and scale in relation to an industry. (10 marks)

4. Explain the concept of concentration starting from its usage in this case without necessarily limiting yourself to the given content. (10 marks)

5. The case mentions Herfindahl index in relation to an Industry's size and concentration. What exactly does this index measure and how is it calculated and interpreted?

(10 marks)