Reminders of Art Buchwald

I cannot locate the article, but I think it was Art Buchwald who once wrote a humorous piece about competition between the two airlines who ran shuttle services between New York and Washington, DC. It went something like this:

The piece opens with a phone call to the US Airways agent. "I see you just raised your fares to New York."

"Yes, we did that to compete against Pan Am. They just raised their fares."

"Wait, I thought the idea of competition was to lower prices."

"Why would we do that? If we lowered our fares, and they followed suit, it would be a race to the bottom. We would both lose money."

Recently, Tufts Health Plan (730,000 members) and Harvard Pilgrim Health Care (1 million members) announced a plan to merge here in Massachusetts. This would leave two major insurers in the state, along with Blue Cross Blue Shield (3 million members).

Not surprisingly, the leaders of the two suitors have said that the merger would cut health costs in the state. Rob Weisman and Kay Lazar at the Boston Globe summarize that view in this article, but in this one, Lazar raises an opposing view:

The bargaining clout of a larger company could help it negotiate better prices from hospitals, but one less major insurer might also mean consumers would have less choice and end up paying more, said officials of leading consumer and business groups.

“Like a town with two gas stations versus four gas stations,’’ said Jon Hurst, president of the 3,000-member Retailers Association of Massachusetts. “Two can copy each other with gas prices, but if you have four, someone is always going to be looking for the edge.’’

Has Mr. Hurst landed on an important distinction? It is one thing to assert that the merger will reduce health costs. That is certainly likely if providers have only two insurers with whom to negotiate payment rates. It is another thing altogether to argue that a merger will reduce premiums. Why?

Well, in a duopoly, as noted by Mr. Buchwald, there is a tendency for the two market participants to fix prices. That is especially the case if one participant is much larger than the other. The dominant player sets the price ceiling and enjoys what economists call "monopoly rents." The secondary player needs only to use that ceiling to establish its prices, at a level just below that of the dominant firm, but also at a level that is higher than would be possible in a truly competitive market, a contestable one that would be characterized by free entry.

Let's think about it this way. If you are on the Board of Tufts or HPHC, why would you merge? The first reason, and the one that I think motivates this decision, is survival. Most observers think an insurance company needs about 2 million subscribers to compete. You need this many to have sufficient economies of scale to drive down transaction costs. You also need that scale to have sufficient access to capital. And, you also need that scale to participate in the national insurance market that now characterizes the needs of large business customers.

Beyond survival, the Board members have to believe that the financial results for the combined entity would be greater than for each one standing alone. Some improvement in that regard can come from eliminating redundant positions and otherwise reducing administrative costs, and some can come from economies of scale in electronic processing of claims and payments. Some would likely come from increased leverage over providers, who will no longer be able to play off one firm against the other.

But what is to prevent some improvement from being derived by the market power of a duopoly, an improvement that would be solely based on extracting more from consumers than would otherwise be the case?

The answer here, as in other industries, must be state regulation. As a former regulator, I will tell you that state regulation is a crude alternative to competition. It is inherently ex post in nature, and it is extremely difficult to get the facts and data you need to do a thorough job.

Nonetheless, with diligent, expert staff, a regulatory agency can do a pretty good job. In this situation, however, the ability of regulators to do well will be dramatically enhanced if the public is let into the process by having total transparency of the accounts of the insurance companies, the premiums they are setting, and the payments being made to the providers.

In essence, the insurance companies in the state have now positioned themselves as public utilities. The secrecy of rates, charges, premiums, actuarial methodology, and the like that have characterized the system have no place in a duopoly environment. To extent current law does not permit this kind of openness, the state should act to make it a condition for the future.