Policy Strategy Jan 1, 2008

Games Hospitals Play

How hospitals cope with competition

Based on the research of

Leemore S. Dafny

Listening: Interview with Leemore Dafny


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Businesses generally find competition unwelcome. When facing the possible arrival of a new competitor in their market, many firms work to make the newcomer’s entry more difficult. Cutting prices, investing in more capacity and new technology, and increasing advertising are prime examples of strategic behavior intended to dissuade fresh rivals from entering the market.

Leemore Dafny, assistant professor in the Kellogg School’s Department of Management and Strategy, decided to investigate whether the principle of strategic behavior applies to hospitals and other medical institutions. “The main idea is to examine healthcare providers using general economic theory that incorporates profit maximization,” Dafny explains. “That sounds like an obvious approach, but in an industry in which the product is viewed so differently from products of other industries and the suppliers are mainly nonprofit or government-owned, the objectives are potentially different.” In an analysis reported in the Journal of Economics and Management Strategy, she finds that the behavior of the medical business is not so different after all.

Identifying strategic behavior is difficult because several variables influence decisions that have present or potential strategic consequences for competitors. Dafny wanted a data source for her study that removed one of the key confounding variables — namely price. Her choice: data from the Medicare claims database MedPAR on Medicare claims for electrophysiological studies (EP), a procedure intended to identify and correct heart arrhythmias. Medicare dictates a fixed price for every procedure it funds, “To make money on the EPs, hospitals must do more of them,” she explains. “So productivity becomes the key factor to examine.”

Second, Dafny chose to focus on growth in the number of EP procedures between 1988 and 1989. Medicare had announced that it would probably increase its payment for the procedure in 1990. Since the increases would more than quadruple hospitals’ reimbursements, Dafny explains, “The attractiveness of entry increased dramatically in fiscal year 1990.” Medical institutions that already performed EPs then faced a conundrum. They could continue to operate as before, knowing that they would face competition from new EP market entrants. Or they could take measures to deter the entry of those competitors. They might boost their staffing and technical resources, for example. Alternatively, they could advertise themselves as “centers of excellence” in EP, thereby implying that they would provide better service than any potential competitors. All such efforts would show up in higher numbers of EPs.

How can the growth in EP numbers indicate strategic responses to the impending change? Under normal circumstances, the number of procedures performed at specific hospitals would increase at a pace commensurate with market size. “In bigger markets, you should see larger volumes, other things being equal,” Dafny says. If hospitals felt threatened by the entry of competitors, however, that pattern would change. “If you see higher growth in markets of intermediate attractiveness, where potential entrants are on the fence and therefore most likely to be swayed by incumbents’ actions,” Dafny continues, “you can attribute that to strategic behavior.”

To tease out the results most effectively, Dafny took a closer look at “monopolist incumbents” — hospitals that faced no competitors offering EP procedures in their local marketplace before 1990. Her reasoning: Monopolists stood to lose more from the entry of new competitors than organizations that already faced competition. Some of these monopolists were in attractive markets where entry was extremely likely or unlikely, hence investing to deter entrants would have a low payoff. However, in those middle-of-the-road markets, investing could help the incumbent protect its turf. As expected, Dafny found exceptionally high EP volume growth for this group. These results did not change when Dafny corrected for alternative factors that might influence the volume of EP procedures. These included the possibility that some incumbent hospitals fearing the entry of just one potential competitor were already growing faster than other incumbents, and the likelihood that some incumbent hospitals had recently reached a critical mass, at which point the number of EP procedures they performed would rise rapidly.

Put simply, hospitals facing the entry of competitors that threatened to eat into their revenues from EP acted strategically to dissuade the potential competitors from entering the market. “These results offer empirical support for theoretical models of strategic investment and suggest that hospitals could use experience to deter entry,” Dafny summarizes. “The results imply that, under certain circumstances, healthcare providers alter real aspects of care (specifically, they induce demand) when faced with compelling incentives to do so.”

That result did not surprise Dafny. “There is a lot of hospital advertising that focuses on experience,” she explains. “So focusing on experience strategically is not surprising. The recent proliferation of self-proclaimed “centers of excellence” in specific diagnoses may be a manifestation of this strategy.” In other words, the study indicates that medical institutions act in a business-like way. “Hospitals, just like other firms, make investments in order to compete, and those investments have implications on the healthcare you receive,” Dafny says.

What message should patients, doctors, hospital administrators, and other individuals involved in the medical business take from the study? “Recognizing that hospitals, insurance companies, and doctors are economic agents reacting to the economic conditions they face would go a long way to understanding healthcare,” Dafny concludes. “This paper contributes to the mounting evidence that the Hippocratic oath does not suffice to protect patients from undergoing unnecessary but profitable treatments.”

Featured Faculty

Leemore S. Dafny

Member of the Department of Strategy from 2002-2016

About the Writer

Peter Gwynne

About the Research

Dafny, Leemore S. (2005). “Games Hospitals Play: Entry Deterrence in Hospital Procedure Markets,” Journal of Economics and Management Strategy, 14 (3): 513-542

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