Hospital and Ramsey Pricing: The Cost Shifting Issue

A discussion I had the other evening with a hospital executive centered around issues of hospital pricing, costs, Medicaid, and market power. My comments along the lines of, "Hospitals face inelastic demands and little effective competition, and they price accordingly" got the executive justifiably agitated. It was a lively evening.

Let me present a violently simplified picture of hospital pricing. I will assume we are dealing with a nonprofit hospital, which essentially faces a "balanced budget" constraint.

Suppose that the state government cuts its Medicaid reimbursements to this hospital in response to state budgetary problems. So instead of getting the list price of $10,000 for a gall bladder surgery, and for which the hospital used to receive $2500 from Medicaid, the hospital will now receive only $2,000. All reimbursements are cut in this fashion.

Faced with a balanced budget constraint, what is our hospital to do? Well, about 60% of the hospital's patients use private insurance, typically through an employer. This is a very inelastic demand. As a hospital increases its prices to private insurers, about the worst that can happen is that one or more of those insurers will cut the hospital out of their preferred supplier network. This is a relatively unlikely occurrence, but of course it depends on the current level of prices, the amount of the increase, and the competition among insurers.

In fact, what provoked my evening discussion was my work on this case in New Hampshire between Anthem BCBS and Exeter Hospital. Anthem threatened to cut Exeter Hospital out of its supplier network, claiming that Exeter had higher prices than other suppliers.

Such events do happen, but they do not present enough of a reason to reject my assumption of inelastic demand for private insurers' patients.

So what is our budget-constrained hospital to do, faced with cuts in government reimbursements. Raise prices to the private insurance market, of course! This is the infamous "cost-shifting" phenomenon in health care.

However, this turns out to be exactly what a central planner concerned with welfare maximization would do -- or, shall we say, it is exactly what the doctor would order!

There is a well-known idea in economics, Ramsey pricing. The classic problem is exactly our setup from above: How should an organization price its products or services, if it has to balance its budget (zero profit) and it wants to maximize welfare of society? The answer is to price in inverse relation to demand elasticity: the most elastic products get the lowest prices and the least elastic products get the highest prices (prices are actually relative to marginal cost of production). The sense of this is as follows. For maximum welfare, you want to create the least distortion in consumer behavior from what is optimal. What would be optimal would be for consumers to buy the product right up to where their value equalled marginal cost of production. That would take a price equal to marginal cost, and will not be feasible with the budget constraint. So we price higher to the inelastic demands, knowing that consumers will not cut back much on their purchases -- hence we will get a lot of revenue.
for the elastic demands, we keep prices closer to marginal cost, for if we raised prices there, we would get a large cutback in consumption which is inefficient.

So cost shifting to the private insurance market is just Ramsey pricing.

And in fact, take an even broader view of what is going on. We have something that the public has deemed to be good -- provision of medical care to the poor. But how to pay for this? We could use broad income taxes, but those are hard to raise, and in fact, cause inefficient distortion for production throughout the economy. So let's just force hospitals to take really low prices for services provided to the poor, knowing very well that the impact will be to raise health care prices to the privately insured. Turns out to be an efficient implicit tax scheme.

There is another angle I could pursue as well, which is a bit of what I was doing with the health care exec. This one paints nonprofit hospitals in not such a benign fashion. Faced with an inelastic demand curve, what else might we expect hospitals to do? Since they are nonprofit, they cannot make money for shareholders. But, they can certainly make life nice for anyone who works there. They can make sure that docs have all the resources they want, far beyond what a pure cost/benefit analysis would justify. They can, if faced with rising costs for whatever reason, take the easy road and raise prices rather than take the hard road of pushing back on the cost increases. If a typical for-profit business in a competitive marketplace faces rising costs, it cannot just raise prices to make it up. Hospitals often do not face that kind of competition, for a variety of reasons.