Monopolistic competition in health care

According to Modern Healthcare magazine, medical ambulances charged between $26,000 and over a half million dollars for each individual flight in North Dakota over the past four years. The prices averaged around $60,000 which is extremely steep given that almost all of the flights were short trips within the state or to the nearest qualified hospital in neighboring states.  That is far more than the normal market price of hiring an equivalent private jet. For example, the average price for a private charter flight all the way across the entire country (from Virginia to Oregon) on a midsize jet was less than half the average cost of a medical taxi (about $30,000). The extra cost of an air ambulance cannot be explained by the paramedic equipment in the jets because the same paramedic equipment is installed on ordinary ambulances on the ground and they charge a small fraction of that price for trips of similar duration.

The reason costs have risen so high according to the article, is a classic case of monopolistic competition. In this kind of market structure, competitors inefficiently invest to expand capacity which increases fixed costs and then they must raise prices to pay for their excessive investment in fixed costs. The result is massive overcapacity and high prices.

“In 1997 there were about 350 helicopters doing this,” he said. “Today there are over 1,100.”…”When … customers paid [a high price], the companies tripled the number of helicopters,” he said, adding that the industry’s ability to spread its fixed costs over a large number of transports is reduced because there are too many transports. “The problem is not that [variable] operating costs have dramatically increased; rather, companies cannot spread those [fixed] costs over a reasonable number of flights,” he said. “The industry then attempts to use this self-inflicted situation as justification for their extravagant billed charges.” Aaron Todd, CEO of the operator Air Methods Corp., acknowledged …that the number of transports may exceed market need. “And if you ask me personally, do we need 900 air medical helicopters to serve this country, I’d say probably not, maybe 500, 600 could do well, but it’s an open market, these are—we don’t have certificate-of-need restrictions,”

Certificate of need restrictions are used in other parts of the healthcare industry to restrict businesses for expanding their capacity (and fixed costs) beyond what regulators think is efficient in order to hold down overall costs. For example, hospitals and nursing homes typically require this kind of permission to expand and build more space for more beds because there is wide variation in the number of hospital beds in different regions of the country and areas with more hospital beds typically have higher expenditures without achieving better results. For example, here is a map from the Dartmouth Index which shows that McAllen and Abilene Texas have about twice as many hospital beds per person than neighboring Austin. (The latter two areas are circled on the map).

Modern Healthcare magazine implies that air ambulances have become corrupt as they compete for business and increase both flights and prices:

…One insurance lobbyist, who characterized the air ambulance market as “the wild West,” complained of the sometimes aggressive ways companies find patients in the limited pool. “I’ve seen air ambulances following the police radio and showing up at the scene of an accident,” the lobbyist said. “They have all sorts of tactics to get called.” Analysis of one company’s data shows the number of medical air transports per base has declined as those bases have proliferated. According to numbers gleaned from past annual reports by Air Methods Corp… 69 bases sent out about 39 transports each per month in 2005. In 2013, 179 bases each sent out about 25 transports per month. The company’s annual number of total transports during that period increased from nearly 32,000 to just over 53,000. Rising operational costs for the air transport companies were the result of business decisions, the consultant said. “No one forced it; they just did it by themselves.” He also said transport services develop relationships with the providers who dispatch patients from one facility to another for care. About 80% of transports send a patient from one facility to another, rather than airlifting a person from the scene of an accident. Even if they don’t have a referral relationship with the air transport company, the consultant added, hospitals don’t necessarily watch out for the patients’ wallets since it isn’t their money.
“Again, you don’t have a market where buyers or sellers are agreeing to buy some quality or quantity,” he said. “None of this is a market situation.”

Unfortunately economics classes typically focus on the simplest type of market, “perfect competition,” because that is the simplest analysis to teach and perhaps because it is the most beautiful market because it is “perfect” market, so people who study markets are naturally drawn to it. But no markets are really perfect. All markets stray from perfection to various degrees and a better description of most real-world markets is a more complex model called monopolistic competition. The main difference is that in this model, competitors differentiate their products so that they aren’t selling perfect substitutes with numerous other competitors. That allows each firm to raise prices above their marginal costs, and it also encourages excessive investment in fixed costs which raises overall costs and results in inefficient scale (excessive capacity).

This describes the air ambulance market well. There is no price competition for any customer because whoever shows up first gets each customer (or for 80% of flights, it is whoever the hospital calls) and without price competition, the businesses keep raising their prices and the high prices encourage businesses to build more bases and keep too many air ambulances always ready to fly. That means excessive overcapacity and the need to raise prices to cover the fixed costs of maintaining so many bases and jets and crews that mostly sit idle waiting for a call.

Unfortunately those high costs are increasingly not fully covered by health insurance. Modern Healthcare magazine gives a typical example:

Last November, a fully insured North Dakotan was dispatched on an 84-mile medical air transport from Langdon, N.D., to Grand Forks. When the charges came in at more than $66,000, …insurance covered just $16,000. The patient was left with a $50,000 bill.

Because of these flights, which patients cannot always choose because they are sometimes unconscious after an accident, some North Dakotans have had liens placed on homes and others have gone bankrupt.

Another inefficiency of monopolistic competition is excessive fixed costs for product differentiation–advertising and marketing.  Rather than competing head-to-head over cost-efficient quality, companies avoid direct competition by selling the idea that their product is totally different from the competition.

A classic example is General Motors’ innovation in competing with Ford based on the color and style of their cars rather than on the quality and cost per mile because Ford had better quality and cost.  General Motors manufactured demand for cars as a status symbol and introduced psychological obsolescence to differentiate each new model year from competition from the used cars sold in previous years.

Whereas there is less of this kind of wasteful consumerism in the healthcare industry than in fashion-oriented production, it is a bigger problem in for-profit-oriented systems like the US than other rich nations that are more nonprofit in orientation.  For example, the US is the only nation in the world except for tiny New Zealand that allows wasteful advertising of prescription pharmaceuticals to consumers.

There are similar problems in higher education and in other parts of the economy too, but I’ll save that for another essay. For now, I’ll just end with a graphical analysis of monopolistic competition.

With complexity like that, it is easy to see why economics professors tend to just focus on the simpler analysis of markets in perfect competition. And this graph just shows a static, short-run analysis. It gets even more complicated if you delve into more realism.