Evolving oligopolies. (Integrated Delivery Systems).

THE FEAR OF HEALTH CARE REFORM AFTER THE 1992 election coupled with the move toward managed care resulted in the proliferation of integrated delivery systems (IDSs) throughout the United States. An IDS typically includes a hospital and a physician component. Many systems are adding a payment component, such as a managed care organization. These three components can constitute a single corporation or they can be owned by a parent company. Depending on the structure of an organization, the control of an IDS can reside with any of the three components.

The growth of IDSs in regional health care markets has resulted in the movement of these markets from a monopolistic competitive model of behavior to an oligopoly. An understanding of the basic characteristics of an oligopoly is essential to understanding the evolution of IDSs and developing future strategies for survival as regional managed care markets mature.

Competition among the few

Oligopoly is synonymous with competition among the few as a small number of firms supply a dominant share of an industry's total output. Firms tend to be large relative to the markets they serve. The southeast Michigan health care market is characteristic of many regional markets that are experiencing significant integration of services. In 1996, seven health care systems accounted for 89 percent of the market. These seven systems included 74 hospitals, 490 ambulatory sites, and represented 98,296 full time employees.

Mutual interdependence

Integration is achieved through mergers and acquisitions as IDSs attempt to gain a dominant market share. The enthusiasm for merging represents the second key feature of an oligopoly: There is mutual interdependence among the actions and behaviors of competing firms. Each merger and acquisition provides access to a new geographic area or patient base and is met by counter mergers and acquisitions by rival systems. These reactionary behaviors, not sound business strategies, are the initial force behind the integration of services in most regional markets.

Product differentiation 

Oligopolies can have either standard (homogeneous) or differentiated products. Health care, like most oligopolies, has differentiated products. In differentiated oligopolies, increased market share is commonly achieved through marketing differences in service, performance, and/or reliability. In today's health care market, many IDSs attempt to differentiate specialty services. The Centers of Excellence model is a good example as cardiology, oncology, geriatrics, and women's health are differentiated to promote consumer loyalty and provide an IDS with a dominant market identity.

Barriers to entry

There exist significant barriers to entering an oligopolistic market. Large IDSs promise "cradle to grave" services. The push to provide seamless health care to a population requires significant manpower, technology, capital, and expertise. The cost of providing these services and expertise poses the most significant barrier for new entry into the regional health care market.

Other factors can present additional barriers to entering the market. Each state regulates the number of licensed hospital beds. There are state requirements for new HMOs and antitrust laws regulating ownership of IDSs. Finally, regional markets tend to demonstrate significant consumer loyalty when national competitors initially enter the market.

Kinked demand curve model of oligopoly

Regional health care markets experience varied percentages of managed care reimbursement methodologies. Despite these reimbursement differences, the price for services remains in a very narrow range. This has resulted in a kinked demand curve model for the market (please see Figure 1). If price in a market is raised above the prevailing market price (PMP), rival firms will ignore the increase and the firm will lose a large portion of market share. If there is a price cut, rival firms will match the reduction, limiting the potential to increase market share. In other terms, the demand curve tends to be highly elastic above the PMP and relatively inelastic below the PMP. The PMP is at the kink. The only chance of pricing above the kink without losing market share is to initiate strong consumer loyalty by creating significant product differentiation.

Economies of scale

Most markets that move to oligopolies do so because firms experience a downward sloping long run average cost curve (please see Figure 2). These firms will increase profits by expanding output and/or merging to take advantage of the principle of economies of scale. Economies of scale allows for lower costs because: (1) Administrative costs can be reduced as more facilities are managed by fewer administrators; (2) a full range of products or services can be utilized to meet all customer needs; (3) marketing costs are reduced through shared advertising; (4) common technology can produce many products and/or eliminate duplicative services; and (5) larger enterprises have higher debt capacity and more ability to raise capital to invest in new technology and/or withstand the risks of cyclical downturns. (2)

Integrated delivery systems initially benefited from economies of scale as ancillary services, such as laboratory, laundry, and maintenance, were consolidated. The cost for supplies decreased by eliminating multiple suppliers and increasing efficiencies in the purchasing process. However, many systems have become so large they are currently experiencing the negative effects of diseconomies of scale.

Diseconomies of scale

Diseconomies of scale occurs when a firm's long run average cost curve turns upward (Please see area B of Figure 2). This increase in cost results from the difficulties of managing an enterprise that has grown too large. Bureaucracy slows decision-making and results in an inability to respond to rapidly changing markets. (2) An IDS can decrease problems with diseconomies of scale by getting smaller and shifting to the downward portion of their long run average cost curve (Moving from B to A in Figure 2). This change in philosophy from expansion to "downsizing" is difficult for an IDS to embrace, but is essential to their long-term survival.

The future

Regional markets will continue to see significant integration. National competitors will enter most regional markets. These competitors have the capital and cost structure to overcome barriers to entry. Initially, national competitors will initiate price wars with regional competitors. Price wars will eliminate weaker IDSs and/or stimulate further mergers as the market remains an oligopoly with a fewer number of competitors.

IDSs will become more cost effective to survive. They will "rightsize" their systems to function at the lowest point on their long run average cost curve. Excess bed capacity and duplicative tertiary care services will be eliminated. Facilities will close and employee numbers will be reduced to decrease total fixed costs. New costing methodologies will be implemented. Market share will be obtained by differentiating services based on quality, access, service, and consumer satisfaction. Over time, a fewer number of competitors will endure in a more cooperative environment.

References

(1.) McFarland, D. "Leading hospitals and hospital companies." Crains Detroit Business. Page 15. April 14, 1997.

(2.) Thompson, A.A, Jr., Formby, J.P. Economics of the Firm. New Jersey; Prentice Hall, Inc., 1993.

Thomas A. Malone, MD, is Corporate Director of Neonatology at Oakwood Healthcare System in Dearborn, Michigan. He is currently enrolled in the MBA program at the University of Notre Dame. He can be reached by calling 313/593-7490, via fax at 313/436-2082, or via email at [e-mail].