Large government entities such as Hennepin County and Minnesota State Colleges and Universities get better rates on HMO coverage for their employees than do smaller, private sector businesses, according to recent news reports.
Moreover, HMOs continued to charge preferential rates to government entities even when such rates made them “lose money.”
This may not be a surprise to economists or accountants, but for some firms staring at much higher rates it is seen as an injustice. What economic rationale, if any, is there for such disparities in health care pricing?
There are a number of reasons why an insurer or HMO would charge lower rates to larger customers and at least one explanation for setting lower rates for government bodies than for private companies. Whether such practices are “fair” or not is another question.
Let’s tackle the size question first. The simplest explanation is a variation of “economies of scale.”
An HMO faces certain administrative expenses involved in managing a health care contract for an employer. These expenses do not vary much with the number of employees covered. The larger the number of employees included under the contract, the smaller these fixed administrative costs are on a per-person basis. Thus, an employer with 8,000 covered employees costs the HMO less per person than one with 80 and much less than one with eight.
The cost question involves deeper complications however.
Costs at any enterprise fall into two categories: variable and fixed. Variable costs are for those inputs that vary with output. For an auto manufacturer these include steel, glass and hourly labor. For a farmer, seed, fertilizer and fuel are variable costs. Fixed costs are those that don’t change with output. For the auto manufacturer they would include interest and depreciation on plant and machinery and the salaries of corporate managers. A farmer similarly would pay interest on land and interest and depreciation on on machinery as well as insurance and other overhead costs.
In the specific case of health care, fixed costs are very high and variable costs relatively low. If an HMO has an existing client base, including employees of a large city or county or public university, its managers have to ask themselves: “If we lose this customer, how much will our revenue drop and how much will our costs drop?” In most cases, the drop in variable costs from having to treat fewer patients will not offset the drop in revenue.
Yes, in the long run, doctors and nurses can be laid off if the patient base is curtailed and clinics can be closed. Moreover, in the long run all costs have to be paid if the enterprise is to survive. But in the short and medium term, if rates can be set to cover variable costs and at least some of the fixed costs, it is financially better for an HMO to set a rate that does not cover all their costs than to demand a higher price that would lose the customer.
Large employers, such as Hennepin County or the state colleges and universities, inevitably come out better in a “how would our costs and our revenues change if we lose this contract” judgments than does the pizza joint up the street.
The issue of an HMO charging lower rates to government than to private employers with equal numbers of workers is more troublesome. Experience may have taught the HMO that public employees use fewer services than those in the private sector. Perhaps public employees are younger or more health conscious. I am not aware that this is the case, but it is a possible explanation.
Another possibility is that HMOs operate in a politically charged environment and they want to curry favor with government officials. This would be a variation of the cafe owner who gives free coffee and donuts to cops on the beat to ensure that they give special attention to his property.
Finally, the market for HMO services is far from the ideal of “perfect competition” described in intoductory economics texts. There are only a handful of providers in any given geographic market. There may be many employers buying such services, but a small number of very large employers may represent a large fraction of all potential patients.
In economic jargon, there is a strong element of monopoly power on the HMO side and large employers have significant monopsony — or single buyer — power. Price outcomes in such a situation of “imperfect competition” are murky to say the least. Large entities, public or private, inevitably will do better than small ones with no ability to affect the market as a whole.
Fostering a greater role for the private sector in health care may introduce some incentive for efficient use of resources but this outcome is far from guaranteed.
Large government entities such as Hennepin County and Minnesota State Colleges and Universities get better rates on HMO coverage for their employees than do smaller, private sector businesses, according to recent news reports.
Moreover, HMOs continued to charge preferential rates to government entities even when such rates made them “lose money.”
This may not be a surprise to economists or accountants, but for some firms staring at much higher rates it is seen as an injustice. What economic rationale, if any, is there for such disparities in health care pricing?
There are a number of reasons why an insurer or HMO would charge lower rates to larger customers and at least one explanation for setting lower rates for government bodies than for private companies. Whether such practices are “fair” or not is another question.
Let’s tackle the size question first. The simplest explanation is a variation of “economies of scale.”
An HMO faces certain administrative expenses involved in managing a health care contract for an employer. These expenses do not vary much with the number of employees covered. The larger the number of employees included under the contract, the smaller these fixed administrative costs are on a per-person basis. Thus, an employer with 8,000 covered employees costs the HMO less per person than one with 80 and much less than one with eight.
The cost question involves deeper complications however.
Costs at any enterprise fall into two categories: variable and fixed. Variable costs are for those inputs that vary with output. For an auto manufacturer these include steel, glass and hourly labor. For a farmer, seed, fertilizer and fuel are variable costs. Fixed costs are those that don’t change with output. For the auto manufacturer they would include interest and depreciation on plant and machinery and the salaries of corporate managers. A farmer similarly would pay interest on land and interest and depreciation on on machinery as well as insurance and other overhead costs.
In the specific case of health care, fixed costs are very high and variable costs relatively low. If an HMO has an existing client base, including employees of a large city or county or public university, its managers have to ask themselves: “If we lose this customer, how much will our revenue drop and how much will our costs drop?” In most cases, the drop in variable costs from having to treat fewer patients will not offset the drop in revenue.
Yes, in the long run, doctors and nurses can be laid off if the patient base is curtailed and clinics can be closed. Moreover, in the long run all costs have to be paid if the enterprise is to survive. But in the short and medium term, if rates can be set to cover variable costs and at least some of the fixed costs, it is financially better for an HMO to set a rate that does not cover all their costs than to demand a higher price that would lose the customer.
Large employers, such as Hennepin County or the state colleges and universities, inevitably come out better in a “how would our costs and our revenues change if we lose this contract” judgments than does the pizza joint up the street.
The issue of an HMO charging lower rates to government than to private employers with equal numbers of workers is more troublesome. Experience may have taught the HMO that public employees use fewer services than those in the private sector. Perhaps public employees are younger or more health conscious. I am not aware that this is the case, but it is a possible explanation.
Another possibility is that HMOs operate in a politically charged environment and they want to curry favor with government officials. This would be a variation of the cafe owner who gives free coffee and donuts to cops on the beat to ensure that they give special attention to his property.
Finally, the market for HMO services is far from the ideal of “perfect competition” described in introductory economics texts. There are only a handful of providers in any given geographic market. There may be many employers buying such services, but a small number of very large employers may represent a large fraction of all potential patients.
In economic jargon, there is a strong element of monopoly power on the HMO side and large employers have significant monopsony — or single buyer — power. Price outcomes in such a situation of “imperfect competition” are murky to say the least. Large entities, public or private, inevitably will do better than small ones with no ability to affect the market as a whole.
Fostering a greater role for the private sector in health care may introduce some incentives for efficient use of resources but this outcome is far from guaranteed.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.