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Vertical Restraints Among Hospitals, Physicians and Health Insurers that Raise Rivals’ Costs

A Case Study of Reazin v. Blue Cross and Blue Shield of Kansas, Inc. and Ocean State Physicians Health Plan, Inc. v. Blue Cross and Blue Shield of Rhode Island

Published online by Cambridge University Press:  24 February 2021

Jonathan B. Baker
Jonathan B. Baker*
Affiliation:
The Amos Tuck School of Business Administration, Dartmouth College
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Abstract

Two recent district court opinions consider whether affiliations among hospitals, doctors and health insurers — through contract or ownership — violate the antitrust laws. This Article applies a raising rivals’ costs framework to the facts of those cases in order to assess whether the practices at issue were unreasonable.

Type
Articles
Information
American Journal of Law & Medicine , Volume 14 , Issue 2-3: Antitrust Issues in Health Care , 1988 , pp. 147 - 169
Copyright
Copyright © American Society of Law, Medicine and Ethics and Boston University 1988

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Footnotes

*

The author is indebted to William Blumenthal, Robert Lande, Monica Noether, Steven Salop, and Joseph Simons.

References

1 For example, the term “hospital services” includes the services of non-physician professionals (such as nurses, dieticians, technicians and physical therapists) and non-professional staff” (such as orderlies) provided in hospital settings, in addition to the use of specialized medical equipment. Moreover, some physician specialties not involving direct care, such as pathology or radiology, might be considered part of hospital rather than doctor services.

2 To the extent that patients delegate health care decisions to their doctor, the choice of a hospital may be made by the physician rather than the patient.

3 See infra notes 18-20 and accompanying text.

4 Doctors and hospitals, however, generally accept affiliations with multiple insurers.

5 HMOs and PPOs may be set up in a variety of organizational forms that differ in the extent to which affiliated doctors and hospitals share risks and profits. See generally Havighurst, , Doctors and Hospitals: An Antitrust Perspective on Traditional Relationships, 1984 DUKE L.J. 1070, 1073 n.3 (1984)Google Scholar(HMO organization); Gasparovich, , Preferred Provider Organizations and Provider Contracting: New Analyses Under the Sherman Act, 37 HASTINGS L.J. 377, 379-80 (1985)Google Scholar(PPO organization).

6 “A Preferred Provider Organization sells the health care services of independent providers to third party payors at a discounted rate in exchange for expedited payment and preferential access to insured consumers. Insured consumers are free to use providers who are not part of the PPO, but usually face increased cost-sharing if they do so. PPOs may be organized by independent entrepreneurs or by hospitals.” FURROW, B., JOHNSON, S., JOST, T. & SCHWARTZ, R., HEALTH LAW: CASES, MATERIALS AND PROBLEMS 476 (1987).Google Scholar

7 The state Blue Cross and Blue Shield plans named as defendants in the two cases discussed below had merged by the time of the litigation.

8 Blue Cross and Blue Shield insurance plans often are controlled by a group of doctors or hospitals. Although the market for health insurance has grown larger and more competi tive in recent decades, the Blues have preserved large market shares in many localities, perhaps as a result of a reputational advantage associated with early entry. In many states these insurers are organized as non-profit firms in order to secure tax advantages. See generally Pauly, Competition in Health Insurance Markets,— L. & CONTEMP. PROBS.—(1989)(in press).

9 The Ocean State court argues incorrectly that antitrust law evaluates vertical business practices without regard to the market share of the firms involved. See Ocean State Physicians Health Plan, Inc. v. Blue Cross & Blue Shield of R.I., 692 F. Supp. 52, 71 (D. R.I. 1988). In fact, most vertical restraints are tested under the rule of reason, which requires an analysis of market power. None are tested under a standard of per se legality. See generally ABA ANTITRUST SECTION, ANTITRUST LAW DEVELOPMENTS 55-108 (2d ed. 1984). Thus, antitrust law requires closer scrutiny of vertical practices implemented by a dominant firm, like BC/BS, than those created by firms with small market share. See Miller, Vertical Restraints and Powerful Health Insurers: Exclusionary Conduct Masquerading as Managed Care—L. & CONTEMP. PROBS.—(1989)(in press)(evaluating legal consequences of BC/BS monopsony).

10 In antitrust usage, vertical arrangements are agreements between firms and their customers, distributors or suppliers. Thus, vertically related firms sell complementary products. This contrasts with horizontal arrangements between rivals that sell substitute products. These traditional antitrust distinctions are being undermined by the raising rivals’costs analysis applied in this Article, which focuses on the horizontal effects of vertical practices. Krattenmaker, & Salop, , Anticompetitive Exclusion: Raising Rivals’ Costs To Achieve Power over Price, 96 YALE L.J. 209, 215 (1986).CrossRefGoogle Scholar

Contracts among hospitals, doctors, and health insurers are classified in this article as vertical because patients treat the services of each as (demand) complements in providing health care. Similarly, a contract between an automobile manufacturer and a steel manufacturer is a vertical arrangement because car buyers view the contributions of the steel producer and the firm which transforms that steel into an automobile as complements in providing transportation services. The role of supply, demand, and transactions complements in antitrust law is discussed in detail in Baker, Antitrust Analysis of Hospital Mergers and the Transformation of the Hospital Industry, — L. & CONTEMP. PROBS. (1989)(in press).

11 See, e.g., Ball Mem. Hosp., Inc. v. Mutual Hosp. Ins., Inc., 784 F.2d 1325 (7th Cir. 1986)(BC/BS introduction of PPO upheld); Barry v. Blue Cross Calif., 805 F.2d 866 (9th Cir. 1986)(Blue Cross introduction of PPO upheld); Brillhart v. Mutual Med. Ins. Inc., 768 F.2d 196 (7th Cir. 1985)(BC/BS introduction of PPO upheld); Kartell v. Blue Shield Mass., Inc., 749 F.2d 922 (1st Cir. 1984)(upholding insurer's contractual requirement that participating physicians accept insurer reimbursement as payment in full), cert, denied, 471 U.S. 1029 (1985).

The reorganization of the health care industry also has led to two other types of antitrust cases not discussed in this article: lawsuits challenging the denial to doctors of hospital staff privileges, and litigation challenging the propriety of horizontal agreements among physicians forming a PPO. See, e.g., Enders, Federal Antitrust Issues Involved in the Denial of Medical Staff Privileges, 17 LOYOLA U. CHI. LJ. 331 (1986); Greaney & Sindelar, Physician-Sponsored Joint Ventures: An Antitrust Analysis of Preferred Provider Organizations, 18 RUTGERS L.J. 513, 551-59 (1987); Gasparovich, supra note 5, at 377.

12 663 F. Supp. 1360 (D. Kan. 1987). An earlier opinion in this litigation, Reazin v. Blue Cross & Blue Shield of Kans., Inc., 635 F. Supp. 1287 (D. Kan. 1986), will hereinafter be referred to as Reazin I.

13 692 F. Supp. 52 (D. R.I. 1988).

14 Before the mid-1970s, courts reviewing antitrust cases were hostile to vertical restraints and mergers. Since that time, the antitrust regulation of vertical practices has changed dramatically. See Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36 (1977), overruling U.S. v. Arnold, Schwinn & Co., 388 U.S. 365 (1967). Moreover, after GTE Sylvania, courts and governmental enforcers generally have upheld non-price vertical restraints against antitrust challenge. See generally J. KWOKA, JR. & L. WHITE, THE ANTITRUST REVOLUTION 264-72 (1989). Today the mainstream view accepts a relaxed scrutiny of vertical restraints, presuming that such arrangements were created to lower production distribution costs or otherwise improve the efficiency of resource allocation. See infra note 37; but cf. Fox & Sullivan, Antitrust — Retrospective and Prospective: Where Are We Coming From? Where Are IVe Going?, 62 N.Y.U. L. REV. 936, 956 (1987)(The Supreme Court “has never incorporated the claim of the radical right that antitrust law should reprehend only that which is allocatively inefficient, or their insistence that private business transactions are efficient.“).

15 Krattenmaker, , Lande, & Salop, , Monopoly Power and Market Power in Antitrust Law, 76 GEO. L.J. 241 (1987);Google Scholar Salop, & Scheffman, , Cost-Raising Strategies, 36 J. INDUS. ECON. 19 (1987);CrossRefGoogle Scholar Krattenmaker & Salop, supranote 10, at 243. Vertical restraints also can confer market power through mechanisms not involving raising rivals’ costs, for example by facilitating horizontal coordination among dealers or by facilitating manufacturer collusion through raising entry barriers.

16 The power to raise prices encompasses the power to keep prices from declining when the competitive price falls, as may occur when seller's marginal costs decline. Krattenmaker, Lande & Salop, supra note 15, at 258.

17 Horizontal price fixing and a raising rivals’ costs practice both create market power by reducing aggregate industry output below what a competitive industry would produce and raising industry prices above competitive levels. If, however, a practice that raises rivals’ costs produces a reduction in an industry's output equal to that created by collusion among the excluding firm and its rivals, the social loss from raising rivals’ costs most likely would be larger than from interfirm cooperation. Both anticompetitive schemes require that firms expend resources on ensuring that the market price rises: it is costly for an excluding firm to bar its rivals from low-cost inputs or to create some other instrument of non-price predation, and it is costly for a cartel to coordinate and police its agreement. But if an excluding firm successfully raises rivals’ costs, a production inefficiency is created insofar as more resources are employed in production by the disfavored rivals than would be employed under a collusive agreement. See Krattenmaker, Lande & Salop, supra note 15, at 247-48 (comparing the market power exercised by restraining one's own output with the market power exercised by restraining rivals’ output).

18 In this diagram, MD1 and MD2. each could be thought of as single doctors or as a group medical practice. Differences among medical specialties are ignored; it is assumed that MD1 and MD2 provide the same services. Similarly, the hospitals, HSP1 and HSP2, could each represent a set of affiliated hospitals (under common ownership or management). Moreover, figure 1 — suitably generalized with additional hospitals, doctors, and insurers — is presumed to include all providers within the geographic market in which health care competition occurs.

19 This stylized model is intended to emphasize the changes in industry structure reflected in Reazin and Ocean State. It is not intended to encompass all variations in the organization of health care provision characteristic of the past or present. Other commentators have described the transformation of the health care industry similarly. See, e.g., Havighurst, supra note 5, at 1071-75 (new forms of industry organization); Reazin v. Blue Cross & Blue Shield of Kan., Inc., 663 F. Supp. 1360, 1371 (D. Kan. 1987) (“Perhaps more so than any federal antitrust litigation to date, this case results from the unprecedented economic pressures and turmoil within the health care services and financing industries from the beginning of this decade.”).

20 Patients who do not seek private insurance can self-insure, rely on governmental programs (Medicare and Medicaid), or can receive benefits from employers who self-insure.

21 Further, with the expansion of deductibles and co-payment provisions in health insurance contracts, patients have increased incentive to economize and to instruct their providers to control costs.

22 In addition, these arrangements help lower the costs of care by allowing better insurer monitoring of provider care decisions. See infra note 45.

23 Dr. Walter Reazin was the Chairman of the Wesley Board of Trustees. Wesley was a large, successful tertiary care teaching hospital associated with the University of Kansas School of Medicine. Reazin, 663 F. Supp. at 1371, 1373.

24 In 1984, Wesley accounted for 43% of city inpatient admissions and 35% of the city's 2,264 hospital beds. The two rival hospitals that were alleged to have conspired with BC/BS served 30% and 22% of total admissions, and controlled 34% and 25% of the city's hospital beds. A fourth hospital obtained 5% of total admissions and accounted for 6% of city hospital beds. Reazin I, 635 F. Supp. 1287, 1297 (D. Kan. 1986).

25 The district court found that Health Care Plus (HCP) is an “individual practice association,” or “gatekeeper,” model HMO in which members must select a primary care physician from those under contract with HCP. A member's monthly premiums pay for all needed medical care so long as it is obtained from the chosen primary care physician, or a specialist or hospital authorized by that physician as needed, [citations omitted]. Each physician contracting with HCP is paid a capitation fee, a specified amount for each member choosing that physician as his or her primary care provider. HCP does not separately contract with specialists; rather, each primary care physician determines in his own discretion whether to refer to an HCP patient elsewhere for needed medical attention, upon which HCP pays the specialist's fees. HCP sets aside a portion of the capitation fund …, and a hospital fund, to cover specialist and hospital costs for services rendered HCP patients. Funds not used at the end of a year are returned to the contracting physicians, each of whom receives a pro rata share of the refund based on the number of HCP patients treated.

Although not contracting with specialists, HCP does contract with hospitals. HCP has capitation agreements with Wesley and [another Wichita hospital]. Under these contracts the hospitals are paid a certain monthly figure per member. These amounts are paid whether or not the members receive care at the hospitals, but if the members do seek services there the hospitals must provide care and are paid no more than the monthly capitation. HCP has fee-for-service contracts with [two other Wichita hospitals], under which those hospitals are not paid capitation but are simply reimbursed for any services which may be provided HCP members.

Reazin, 663 F. Supp. at 1374-75 (citations omitted).

26 BC/BS was the largest nonfederal source of revenues to hospitals in its service area. It accounted for 16% of a large Wichita hospital's (not Wesley) revenues, while no other competitor accounted for as much as 5%. Id. at 1416-17.

27 Id. at 1398-99 (market definition), 1416 (BC/BS’ share), 1465 (finding no. 21)(Health Care Plus’ share). Measured by premiums dollars, BC/BS had 62% of the private health care financing business in Kansas, while its next largest competitors, Bankers Life and Aetna, had 4% and 3% of the market respectively. Id. at 1464 (finding no. 16).

28 In early 1984, responding to pressure from patients, legislators, and state regulators to reduce the rapid rate of increase in patient premiums and hospital utilization, BC/BS replaced cost-plus reimbursement of hospitals with a program that established a reimbursement maximum based upon a patient's entering diagnosis. The contracts between BC/BS and hospitals to implement this program also included a “most favored nations” clause, under which participating hospitals agreed that BC/BS reimbursements never would exceed the reimbursements the hospital accepted from competing insurers for the same patient diagnosis. Id. at 1375.

Also in 1984, BC/BS responded to cost-cutting pressures and the presence of a competing HMO by setting up an HMO of its own. The BC/BS HMO was far less successful than Health Care Plus. Health Care Plus’ early presence in Wichita provided it with an advantage over the BC/BS HMO plan in attracting patients. Furthermore, Health Care Plus’ higher capitation rates provided an advantage in attracting physicians. Id. at 1376; cf. infra note 72 (subscriber switching costs). In consequence, the BC/BS HMO abandoned the Wichita market, although it continued to operate elsewhere in Kansas. Id. at 1377.

In 1985, BC/BS attempted to introduce a preferred provider organization into Wichita and to reintroduce an HMO. The BC/BS PPO had difficulty developing a reimbursement system satisfactory simultaneously to physicians and hospitals. While Wesley participated actively in negotiating terms for the BC/BS PPO, a BC/BS executive allegedly attributed Wesley's desire to participate to HCA's intention to force a rival Wichita hospital out of business. Id. at 1378-79. BC/BS and two Wichita hospitals other than Wesley developed a new HMO plan. Those negotiations also involved the possibility that the rival hospitals would give BC/BS discounts on the level of diagnosis-based reimbursements they would accept, contingent on BC/BS termination of Wesley. Id. at 1380-82. BC/BS’ contract with Wesley permitted termination on 120 days notice. Id. at 1389.

On August 1, 1985, the Wall Street Journalreported that HCA intended to introduce group health insurance and a PPO plan in approximately twenty cities over the next eighteen months, as part of a corporate effort to become a fully-integrated health care company. Id. at 1380. Later that month, the BC/BS executive committee voted to terminate its diagnosisbased reimbursement contract with Wesley, effective January 1, 1986. BC/BS would continue to reimburse its subscribers for care at Wesley, but at levels no higher than reimbursements given rival hospitals for the same services. BC/BS would no longer directly pay Wesley any subscriber reimbursement. Id. at 1383-85.

By early November, BC/BS had negotiated discount reimbursement contracts with the two rival hospitals. In November, Wesley and its affiliate Health Care Plus filed suit against BC/BS and the two competing Wichita hospitals charging that the termination of Wesley was illegal. Id. at 1387-88. BC/BS counterclaimed, alleging in part that HCA's acquisitions of Wesley and Health Care Plus were undertaken in order to eliminate competition from BC/BS and competing Wichita hospitals. Id. at 1390.

29 Id. at 1386 (quoting Blue Cross & Blue Shield of Kan., Inc., press release (Aug. 29, 1985)). The court does not explain how contract termination would have injured either Wesley or consumers when, had it been effected, BC/BS subscribers would have continued to receive some reimbursement for care obtained at Wesley. The court appears to presume that Wesley would have lost customers to rival hospitals, perhaps because patients would find it relatively more expensive to use Wesley once they were required to handle the administrative costs of reimbursement rather than having their insurer deal directly with the hospital, see Reazin I, 635 F. Supp. 1287, 1295-96 (D. Kan. 1986), or perhaps because patients would not have been fully reimbursed for expenses incurred at high cost tertiary care teaching hospitals if BC/BS rates were determined by charges at competitive hospitals. See Reazin, 663 F. Supp. at 1425-27 (upholding award of damages to Wesley). Moreover, contract termination may have increased the proportion of patients failing to pay Wesley.

30 Hospital Corporation of America (HCA) acquired Wesley as part of a national strategy of acquiring tertiary care “centers of excellence” throughout the country in order to meet patient preferences for quality health care. Reazin, 663 F. Supp. at 1377. HCA acquired Health Care Plus as a way of developing the internal management experience necessary to create and market HMOs elsewhere in the country. Id. at 1378. Both affiliates had substantial management autonomy, and their interaction with HCA largely was financial. Id. at 1378. After the events which led to litigation, HCA decided to withdraw from the health care financing business, and reduced its affiliation with Health Care Plus to that of a passive investor. Id. at 1475 (finding no. 88).

31 Although other area hospitals had contracted with Health Care Plus, they also had negotiated with BC/BS concerning BC/BS’ termination of Wesley. Id. at 1374-75, 1382, 1474 (finding no. 77).

32 See supra note 28.

33 The jury found that the contract termination injured Wesley by causing it to lose some business from BC/BS subscribers, and determined that Wesley suffered more than 1.5 million in damages. Reazin, 663 F. Supp. at 1425-27. These damages were trebled and punitive damages of 750,000 were awarded on the state law tortious interference claim. Id. at 1427- 30. Defendants also were required to pay more than 2.4 million in costs and attorneys fees. Id. at 1449-59. The large damage award to Wesley was upheld even though the date of contract termination had yet to occur when the complaint was filed, and even though the parties agreed to maintain the status quo (by staying termination of BC/BS’ contract with Wesley) pending the outcome of the litigation.

34 Ocean State Physicians Health Plan, Inc. v. Blue Cross & Blue Shield of R.I., 692 F. Supp. 52, 57-58 (D. R.I. 1988).

35 The most favored nations clause was termed the “prudent buyer policy.” It required physicians accepting a low reimbursement from a provider, such as Ocean State, to charge no higher rate to BC/BS if they decided to accept BC/BS’ reimbursement. Id. at 60.

Ocean State also Complained about two other BC/BS programs: the new HealthMate product, and “adverse selection rating factors.” BC/BS marketed HealthMate as an alternative to the Ocean State HMO. HealthMate was offered only when BC/BS was competing with Ocean State for business, as when an employer allowed employees to select among health care alternatives (A state law mandated that employers offer an HMO to their employees as a health insurance option if an HMO provided services in the area where an employee resided. Id. at 57). HealthMate offered greater coverage than the standard BC/BS product, but limited subscribers to participating physicians: All BC/BS participating physicians were required to accept the HealthMate payment as payment in full. HealthMate was marketed with a financial incentive to employers. Id. at 58.

BC/BS introduced “adverse selection rating factors” whenever it feared it would lose healthier subscribers to an HMO. BC/BS charged employers the lowest rate on its standard policy when employers offered only standard BC/BS coverage. It charged a higher rate when employers offered standard BC/BS, HealthMate, and a competing HMO such as Ocean State. It charged the highest rate to employers offering standard BC/BS and competing HMO, but not offering HealthMate. Id. at 59.

36 From its inception in 1983, Ocean State withheld 20% of its physician fees until the end of the year, paying them to doctors only if the HMOs revenues exceeded costs. From BC/BS’ perspective, Ocean State was obtaining medical services at a discount of up to 20% when compared to the fees BC/BS was required to pay. Only in 1984 did the HMO return the withheld funds to affiliated doctors. The competitive responses of BC/BS that prompted the Ocean State litigation occurred in 1986. Id. at 60.

37 Id. at 71. The court further held that it was entitled to conclude that the jury found no antitrust violation, despite the jury's express finding of a violation of Sherman Act Section 2, because the jury awarded no damages on the antitrust claim and, in consequence, must have found no harm to the plaintiff. Id. at 66. In reaching the conclusion that plaintiff suffered no loss, the court ignored the 2.5 million compensatory damages (and 500,000 punitive damages) found by the jury on Ocean State's tort claim against BC/BS for intentional interference with contractual relationships, apparently on the bootstrap theory that this loss did not arise from an antitrust violation. The court also granted defendant's motion for a new trial on plaintiff's state tort law claim, holding that the jury's verdict against BC/BS contradicted the clear weight of the evidence that BC/BS’ actions were justified responses to competitive conditions. Id. at 73.

38 But cf. Ball Mem. Hosp., Inc. v. Mutual Hosp. Ins., Inc., 784 F.2d 1325 (7th Cir. 1986)(hospitals challenged BC/BS’ introduction of a PPO).

39 Cf. Barry v. Blue Cross Calif, 805 F.2d 866 (9th Cir. 1986) (physicians challenged Blue Cross’ introduction of a preferred provider plan in a state where the Blue Cross market share was 16%). The smaller the market share of the firms imposing the vertical restraint, the less likely the practice would create market power, even if it were predatory.

40 See, e.g., Preston, Territorial Restraints: GTE Sylvania, in J. KWOKA, JR. & L. WHITE, supra note 13, at 273-89; see generally Fisher, Johnson, & Lande, Do the DO] Vertical Restraints Guidelines Provide Guidance? 32 ANTITRUST BULL. 609, 615-16 (1987); R. BORK, THE ANTITRUST PARADOX 288-309, 330-81 (1978)(influential commentary advocating relaxed scrutiny of vertical practices); R. POSNER, ANTITRUST LAW 171-211 (1976) (influential commentary advocating relaxed scrutiny of vertical practices).

41 Non-price vertical restraints are unlawful only if they are unreasonable, with the exception of some forms of tying which are illegal per se. Both the tying exception and the per se prohibition against resale price maintenance are narrowly construed. Business Elec. Corp. v. Sharp Elec. Corp., 108 S. Ct. 1515, 1520-22 (1988) (announcing presumption in favor of a rule-of-reason standard); see Jefferson Parish Hosp. Dist. No 2 v. Hyde, 466 U.S. 2, 32 (1984)(O'Connor, J., concurring)(Chief Justice Burger and Associate Justices Powell and Rehnquist joined in the concurring opinion by Associate Justice O'Connor which advocated abolishing application of per se doctrine to tying arrangements).

42 One commentator terms Medicare's shift during the mid-1980s from retrospective cost reimbursement to prospectively determined rates as “the most important change in federal health policy since the adoption of the Medicare and Medicaid programs.” Havighurst, supra note 5, at 1077 n.14.

43 See generally Joskow, Alternative Regulatory Mechanisms for Controlling Hospital Costs, in A NEW APPROACH TO THE ECONOMICS OF HEALTH CARE (M. Olson, ed., 1981); NATIONAL HEALTH INSURANCE: WHAT NOW, WHAT LATER, WHAT NEVER? (M. Pauly, ed. 1980). Moreover, under a cost-based reimbursement scheme, physicians have a diminished incentive to control their charges to insurers if the “cost”of care is determined by reference to their own customary rates rather than regional averages.

44 Typical utilization controls include requiring second opinions before costly procedures are undertaken, restricting hospital lengths of stay, and reviewing care decisions before reimbursing providers.

45 However, prospective reimbursement, subscriber copayments, and insurer utilization review have also been introduced by traditional fee-for-service health insurers.

46 If patients obtain care from unaffiliated providers, the HMO or PPO can limit its expenditures by refusing to reimburse subscribers completely for the charges made by those unaffiliated doctors and hospitals. Unaffiliated providers, however, are not subject to the utilization controls imposed by insurers to reduce physician and hospital incentives to provide more care than necessary. Moreover, it is conceivable that an association of doctors, hospitals, and insurers can conserve more resources than the traditional organization of health care provision through achieving scale economies or through better forecasting of patient demand. In addition, such an association may be better able than unintegrated providers to cut costs by tailoring its operation to avoid shortages or excess capacity.

47 In a memorandum to all Kansas hospitals defending its termination of Wesley, BC/BS’ President wrote:

With the size and resources of HCA …we could only come to the conclusion that our role with the Wesley Medical Center has drastically changed. We no longer fit into their long range plans. Thus, [we arrived at] our decision to cease contracting with HCA and … Wesley ….

We cannot stand idly by and watch insurance-hospital corporations, such as HCA, monopolize the delivery and financing of care by seeking to enroll Blue Cross and Blue Shield subscribers in their insurance program … . [I]f hospitals decide to compete with Blue Cross and Blue Shield in the manner that HCA is competing, Blue Cross and Blue Shield must make a business decision about its future relationship with those entities. Hospitals that … do not seek to enroll subscribers in other programs … will experience no change in the contractual relationship that has historically served Kansans well.

Reazin v. Blue Cross & Blue Shield of Kan., Inc., 663 F. Supp. 1360, 1387-88 (D. Kan. 1987). In court, BC/BS offered a similar defense. Id. at 1392.

48 The author is grateful to Joseph Simons for this observation.

49 If insurer reimbursement is partial, the transactions costs involved in paying for hospital services may be increased if hospitals bill patients, and patients then seek reimbursement on their own from insurers; rather than if hospitals bill both patients and insurers, and insurers pay hospitals directly. Cf. ReazinI, 635 F. Supp. 1287, 1295 (D. Kan. 1986)(a non-contracting hospital must submit its claims on paper rather than using the less costly tape-to-tape billing program). To the extent patients bear the transactions costs increase, such increase operates as a higher co-payment to raise the patients’ incentive to economize on utilization. In the instant case, Wesley announced that other than existing deductibles and co-payments, BC/BS subscribers would not be required to pay any excess charges. Reazin, 663 F. Supp. at 1380. Under such circumstances, there could be no transaction costs reduction from altering the existing system in which BC/BS handles the administrative tasks of reimbursement on behalf of its subscribers.

50 See Reazin I, 635 F. Supp. at 1295-96 (BC/BS cost containment programs are implemented through insurer contracts with hospitals).

51 Reazin, 663 F. Supp. at 1411.

52 Ocean State Physicians Health Plan, Inc. v. Blue Cross & Blue Shield of R.I., 692 F. Supp. at 52, 60, 71 (D. R.I. 1988).

53 At the time of the litigation, Ocean State had entered into contracts with almost half of all of the doctors in Rhode Island. Id. at 68.

54 Lower physician charges could generate an efficiency gain if doctors had previously been charging monopoly rates. See M. WATERSON, ECONOMIC THEORY OF THE INDUSTRY 83- 106 (1984) (describing benefits of eliminating successive monopolies through vertical affiliation or integration). Lower doctor fees, however, also could reflect an anticompetitive exercise of insurer monopsony power in the physician market.

55 Further, Ocean State paid doctors less than those physicians billed BC/BS not because doctors lowered their rates to HMO subscribers, but rather because the doctors affiliated with Ocean State agreed to share the HMO's risks. The physicians affiliated with Ocean State allowed their reimbursement to vary with the financial health of the HMO. See supra note 36.

56 While the most favored nations provision was introduced at the same time BC/BS introduced a product similar to an HMO, see supra note 35, BC/BS offered its new health insurance plan only if a competing HMO was also being marketed, for example, by an employer to its employees. Thus, neither BC/BS initiative appears directed primarily at reducing costs, although some efficiencies could have arisen as ancillary consequences of a scheme aimed primarily at creating market power.

57 Ocean Slate, 692 F. Supp. at 61.

58 However, some departures were not prompted by the most favored nations clause. Id. at 61, 73.

59 Similarly, a practice that raises entry barriers could harm patients by permitting horizontal collusion among physicians, hospitals, or health insurers, or by permitting the exercise of market power by a dominant insurer. Practices that raise entry barriers can be thought of as raising rivals’ costs, where the relevant rivals are potential entrants rather than existing competitors.

60 Cf. Ball Mem. Hosp., Inc. v. Mutual Hosp. Ins., Inc., 784 F.2d 1235, 1339-40 (7th Cir. 1986)(rejecting theory that BC/BS intended its PPO to raise rivals’ costs).

61 Practices that create market power by raising rivals’ costs can be thought of as creating an involuntary cartel. By raising costs to its rivals, the predator forces those rivals to reduce output much as the rivals would be required to do were they to cooperate with the predator to fix prices. Thus, a practice of raising rivals’ costs and horizontal price fixing can lead to a similar injury to competition.

62 See generally ABA ANTITRUST SECTION, MONOGRAPH NO. 12, HORIZONTAL MERGERS: LAW AND POLICY 5-26 (1986); cf.Krattenmaker, Lande & Salop, supra note 15, at 245 n.25 (comparing narrow and broad views of consumer welfare). As used in this article, the term economic efficiency means the maximization of the aggregate (producer's plus consumers’) surplus. The technical difference between this criterion and the Pareto efficiency criterion is unimportant in this context. See generally R. JUST, D. HUETH & A. SCHMITZ, APPLIED WELFARE ECONOMICS AND PUBLIC POLICY (1982).

63 Krattenmaker & Salop, supra note 10, at 215-19. As a basis for antitrust intervention, the raising rivals’ costs logic is controversial because it leads to prohibiting some vertical arrangements. Those who believe that harmful vertical practices are rare fear that courts will apply this rationale inappropriately and that as a consequence many procompetitive vertical arrangements will be inhibited. See, e.g., Brennan, Understanding “Raising Rivals’ Costs”, 33 ANTITRUST BULL. 95, 110 (1988) (arguing that raising rivals’ costs may lend academic authority to discredited foreclosure and predations doctrines).

64 These two theories allocate the anticompetitive effect of BC/BS’ actions to different markets. The first theory supposes that BC/BS acts to help its affiliated hospitals obtain or preserve market power in the hospital market. The second theory supposes that BC/BS obtains or preserves market power for itself in the insurance market.

65 This theory is suggested by two bodies of economic literature. The first set of economic articles shows how firms can profit by creating a reputation as a price cutter because they can deter existing and future rivals from acting competitively. See Saloner, , Predation, Mergers, and Incomplete Information, 18 RAND J. ECON. 165 (1987);CrossRefGoogle Scholar Burns, , Predatory Pricing and the Acquisition Costs of Competitors, 94 J. POL. ECON. 226 (1986);CrossRefGoogle Scholar Milgrom, & Roberts, , Predation, Reputation, and Entry Deterrence, 27 J. ECON. THEORY 280 (1982);CrossRefGoogle Scholar Kreps, & Wilson, , Reputation and Imperfect Information, 27 J. ECON. THEORY 253 (1982).CrossRefGoogle Scholar The second body of economic literature shows how firms can employ strategic instruments to gain or preserve market power by deterring entry. See generally Salop, Strategic Entry Deterrence, 69 AM. ECON. REV. 335 (1979). Although this is not, strictly speaking, a raising rivals’ costs practice, the logic of this argument is sufficiently similar to one to justify treating it as an action raising rivals’ costs.

66 In the alternative, the jury could have concluded that Wesley would bear higher administrative costs if it billed patients itself rather than contracting with BC/BS for that service. No evidence in the opinions, however, bears on this possibility.

67 Alternatively, by reducing Wesley's market share to the point where the hospital's contribution to profits would not cover its unavoidable fixed costs (including its administrative overhead and the salvage value of its plant and equipment), the contract termination might harm competition in the Wichita hospital market, even if Wesley's marginal costs do not increase. Under such circumstances, Wesley would exit from the market, allowing the rival hospitals affiliated with BC/BS to raise prices free of competition. As with the anticompetitive story described in the text, this theory depends upon both a substantial number of patients switching away from Wesley in response to its termination of its contract with BC/BS, and the existence of entry barriers in the hospital market.

It also is possible that the reorganization of the Wichita health care industry raised Health Care Plus’ costs by precluding the HMO from contracting with the better quality providers of medical services. This argument is founded on the facts of the instant case, however, because Wesley is a desirable hospital and the HMO affiliated doctors are highly respected.

68 If the antitrust market is in provider services rather than health insurance, then the tacitly colluding hospitals or doctors would compensate BC/BS in their reimbursement arrangement for managing what effectively is a provider cartel. See infranote 74.

69 Baker, supra note 10 (metropolitan areas are plausible geographic markets for many hospital services). The case for a physician market most likely depends upon the willingness of new medical school graduates to locate at large distances from their medical school in response to high doctor salaries. The case for a health insurer market likely relies on the costs of patient switching among health care financing plans. Both of these alternatives are explored further below, in connection with an evaluation of a raising rivals’ costs story on the Ocean State facts. See infra notes 73-78 and accompanying text.

70 Under this theory, both Wesley and patients suffer injury directly resulting from the practices that harm competition, and the competing HMO is injured insofar as BC/BS’ contract termination with Wesley causes the HMO to lose patients who have become unwilling to commit to obtaining care at Wesley. Hence, the court properly found that Wesley and the HMO have standing to challenge BC/BS’ action. Reazin I, 635 F. Supp. 1287, 1315-17, 1319 (D. Kan. 1986).

71 Reazin v. Blue Cross & Blue Shield of Kan., Inc., 663 F. Supp. 1360, 1381-82 (D. Kan. 1987). The inference of harm to competitors would have been stronger had BC/BS not announced that it would continue partial reimbursement of its subscribers for care at Wesley, and had BC/BS convinced the rival Wichita hospitals to end their association with Health Care Plus.

72 Some argue that entry into the business of providing health insurance is extremely easy. One reason for this belief is that large employers can readily invite insurers from neighboring states to offer coverage to their employees, bypassing the local carriers. See Ball Mem. Hosp., Inc. v. Mutual Hosp. Ins., Inc., 784 F.2d 1325 (7th Cir. 1986)(insurer access to capital is unlimited and patients are not the captive of existing insurers).

In contrast to this view, it may in fact be expensive for patients to change insurers, particularly when such switching would be associated with a change of medical providers (as most likely would be true if the new insurer were an HMO). See Neipp, & Zeckhauser, , Persistence in the Choice of Health Plans, 6 ADVANCES HEALTH ECON. & HEALTH RES. 47, 48-49 (1985).Google Scholar If switching costs are large, then new insurers would be forced to incur substantial promotional expenses (such as low introductory prices) as well as substantial delay (as potential switching patients wait for their existing insurance contracts to expire, or as unaffiliated new subscribers slowly move into the new insurer's market area). Assuming BC/BS is the dominant insurer, successful entry into health insurance markets then would depend upon the entrant obtaining affiliations with physicians and hospitals presently affiliated with BC/BS, some of whom may have exclusive affiliations. Even if it is easy for a new entrant to obtain physician affiliations, as is plausible, and hospital affiliations, as is possible (depending upon contractual relationships with existing insurers), the entrant may not be able to convince many patients to switch their coverage unless their preferred doctor and hospital combination is affiliated with the new insurer.

73 The restriction could equally harm competition through the alternative mechanism of raising entry barriers. If patients find it expensive to switch insurers, then a most favored nations clause in BC/BS’ contracts with physicians will raise entry barriers into the insurance market and protect BC/BS’ dominant position to the extent that the contract provision makes is less likely that a new HMO would be able to attract affiliations from doctors also affiliated with BC/BS.

If, however, the most favored nations clause at issue in the Rhode Island litigation were anticompetitive solely because it raised entry barriers to new insurance competition, the existing HMO rival would not be an appropriate plaintiff for vindicating competition. The existing rival would not have standing because it would lack antitrust injury. Health care consumers, or the state or federal government, would remain appropriate plaintiffs.

74 Among those who believe that market power is present in health care markets, it is not settled whether BC/BS plans are mechanisms by which doctors and hospitals exercise market power in selling health care to patients, or mechanisms by which BC/BS exercises monopsony power in acquiring provider services. In either case the insurer management may appropriate the resulting rents. Alternatively, subscribers may obtain the benefits of an insurer monopsony through lower fees. See generally Pauly, supra note 8; Miller, supra note 9.

If physicians were to cooperate to raise prices, they would surely require the help of a cartel manager such as BC/BS because the large number of doctors in any area would make the costs of coordination otherwise prohibitive. Cf. Krattenmaker & Salop, supranote 10, at 238 (cartel ring master). Moreover, several factors render it plausible that the physicians in any metropolitan area form an antitrust market: the demand for many medical services is likely to be inelastic, entry from established physicians moving from other metropolitan areas is not plausible, and entry from new physicians choosing metropolitan areas in which to establish a practice is limited by the capacity of graduating medical school classes and by the degree to which new doctors are responsive to small changes in starting salaries in choosing where to settle.

Similarly, a hospital cartel also might be successful if formed in many regions of the country. In contrast with physicians, concentration may be sufficiently high in such markets as to make it possible for hospitals to coordinate their cooperative arrangement without need for a cartel manager such as BC/BS. See generally Baker, supra note 10.

75 A doctor would be willing to accept a lower reimbursement rate from a HMO, thereby cheating on the tacit physician cartel, if he or she expects that the lower cost of physician services provided through the HMO would induce a large number of patients to switch from BC/BS and its affiliated doctors.

76 Thus, a most favored nations clause facilitates collusion among horizontal rivals by allowing each rival to commit to bearing large costs of cheating on a cooperative arrangement. See generally Salop, Practices that (Credibly) Facilitate Oligopoly Co-ordination, in NEW DEVELOPMENTS IN THE ANALYSIS OF MARKET STRUCTURE 265-90 (J. Stiglitz & G. Mathewson eds., 1986). An HMO might attempt to avoid the disincentive for doctors to affiliate with it created by the BC/BS’ most favored nations clause by restructuring its physician compensation arrangement, described supra at note 36, to allow its doctors to reduce their fees without triggering the clause in bad years. For example, the HMO might characterize the withheld physician reimbursements as a capital contribution. BC/BS, however, presumably could respond by rewriting its contracts to preserve the disincentive for its affiliated doctors to participate in the HMO.

77 For example, if the record contained evidence that BC/BS’ physician reimbursement rates were higher in Rhode Island than in states where BC/BS does not have as large a market share (after controlling for regional variation in the costs of providing medical insurance and physician services), the jury might reasonably have inferred that Rhode Island doctors were exercising market power.

78 In support of this theory, Ocean State alleged that physician shortages in certain vital medical specialities, such as cardiac surgery, resulted from BC/BS’ introduction of the challenged contract provision. Ocean State Physicians Health Plan, Inc. v. Blue Cross & Blue Shield of R.I., 692 F. Supp. 52, 61 (D. R.I. 1988). If Ocean State could remedy the crucial shortages at little additional expense, however, as by offering slightly higher reimbursement rates to cardiac surgeons, its costs would not have increased substantially.

This theory also requires that entry barriers preserve BC/BS from new competition in the health care market. Although this proposition is controversial in the abstract, see supra note 72, the most favored nations clause may have created an entry barrier for new insurers in the instant case by making it difficult for them to obtain physician affiliations.

79 Ocean State, 692 F. Supp. at 64-65.

80 See supra notes 52-56 and accompanying text.

81 See supra notes 73-78 and accompanying text.

82 See Reazin v. Blue Cross & Blue Shield of Kan., Inc., 663 F. Supp. 1360, 1410 (D. Kan. 1987)(standard of review).

83 See supra notes 47-51 and accompanying text.

84 See supra notes 66-70 and accompanying text.

85 See supra notes 71-72 and accompanying text.