Price Effects of Hospital Mergers When the Hospitals are in Different Markets

There is substantial evidence that hospital mergers lead to increases in negotiated prices (e.g. Dafny 2009, Capps Dranove 2004).  The previous literature analyzing these effects primarily focuses on mergers within a specific geographic market (Capps et al 2003; Town and Vistnes 2001). These studies construct a measure of hospital market power called “Willingness-to-Pay” (WTP), which is based on the increment in expected utility for an insurer’s enrollees associated with adding the hospital in question to the insurer’s hospital network. A regression of negotiated (i.e., privately-insured) hospital prices or profits on WTP yields a positive significant coefficient, suggesting that WTP is a reasonable predictor of the rents hospitals can extract.  These papers argue that mergers between two substitute hospitals in a market can increase prices by increasing the WTP of the combined entity.  For example, two hospitals may be close substitutes and individually have a low WTP, but a high WTP when combined.  The price effects of such mergers can be substantial. More recent papers (e.g., Brand et al 2013) build on this idea by modeling the bargaining process where an insurer, acting as an agent for captive enrollees, seeks to maximize an objective function equal to the WTP of its network less its costs.

The models used in the previous literature predict price effects of mergers only when the merging hospitals are direct substitutes for a given service, as only then would an insurer’s loss from dropping the merged entity exceed the sum of its losses from dropping each hospital separately.  However, there is both anecdotal and systematic empirical evidence of price effects from mergers of non-substitute hospitals (Lewis and Pflum 2013), and this effect is difficult to explain using existing models.

Our paper addresses this gap by specifying a more complete bargaining model with an explicit mechanism through which price effects of non-substitutable hospital mergers can occur. Building on Ho and Lee (2013), we add insurer competition to the bargaining framework of the previous literature, allow enrollees to switch insurers in response to a network change, and specify an insurer’s objective function to be its realized profit (as a function of the utility it provides to consumers, summarized by the WTP variable).  Competition between insurers for enrollees and employers in our model generates a concavity of the insurer’s objective function with respect to WTP.  Thus, even though a merger between non-substitutable hospitals may create a new WTP for the merged entity equal to the sum of the WTP of each individual hospital, the concavity in an insurer’s objective allows the combined entity to extract higher prices. The effect may become stronger when insurer competition increases in a market, and will also hold for mergers across geographic markets if employers choose plans for employees who live in different areas. We use data on hospital prices and affiliations to test whether this model captures actual bargaining outcomes.