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Commentary
National Affairs

Antitrust Enforcement and the Hospitals

The American hospital industry is in the midst of a wave of mergers. The Deals Practice section of the accounting firm PricewaterhouseCoopers reports that the number of such transactions reached a peak of 94 in 2012 before declining to a still-significant 79 last year, when the industry saw “a shift from traditional hospital mergers and acquisitions to partnerships, collaborations, joint ventures and other non-binding agreements.” Other sources report slightly different totals: One tallies 72 transactions involving 131 hospitals in 2012.

Whatever the specific tally, it is clear that the last few years have seen a dramatic increase in the number of hospital mergers. And as we look down the road, what PricewaterhouseCoopers’s Dan Farrell calls the need to “repurpose the healthcare system and change the clinical pathway” points to continued consolidation.

As hospitals continue to consolidate, antitrust policy regarding these mergers must balance two competing demands: the need to prevent mergers that might substantially lessen competition, and the need to allow mergers that promise potential consumer benefits, such as more efficient provision of health-care services and more rapid innovation. This is, in a sense, always the challenge of antitrust work, but the peculiar state of our health-care system and the unique importance of hospitals makes the challenge both more complex and more urgent.

Hospitals therefore offer a particularly clarifying instance of the larger challenge of pro-competitive regulation. Their special case can help us think about the larger challenges confronting antitrust regulators in 21st-century America.

DEFINING THE MARKET

In appraising the competitive impact of a proposed hospital merger, the Federal Trade Commission, which is charged with overseeing such transactions, must first delineate the arena in which competition is occurring — the practice known in the trade as defining the relevant market. That involves determining which products inhabit the market in question and the geographic area over which competition plays out, or what antitrust practitioners call the product and geographic markets.

The product market includes all goods and services that consumers regard as reasonable substitutes, or could come to regard as such substitutes, for the product in question in any given merger. These can vary quite a bit depending on specific circumstances. Thus, planes and trains would be regarded as substitutes on the New York-to-Washington, D.C., route but not on the New York-to-Los Angeles route. The geographic area in which potential merging partners compete, meanwhile, can range from local (think of bakeries in New York, which do not compete with those in San Francisco) to global (think America’s Boeing versus Europe’s Airbus). With these definitions in hand, the FTC can then attempt to decide whether a merger would produce a combined firm with a market share so large that it would threaten or substantially lessen the force of competition within its product and geographic markets.

This description of how the FTC and other antitrust-enforcement agencies go about their work suggests the flexibility of the tools at their command. The market-definition process permits them to determine just which products and which geographic areas to include in the market in which they are appraising the pre- and post-merger force of competition.

The regulators have fairly wide latitude to determine what constitutes a relevant product or geographic market, and can even take into consideration how those definitions might change. Products that are not in the relevant market in one year might well become viable consumer options at a later date, warranting their consideration as competitive alternatives. Wireless telephones, for example, are quite properly now considered competitive alternatives to the wired versions that they are replacing; they even compete with traditional cameras and wristwatches, which few could have anticipated a short while ago. Similarly, suppliers of walk-in medical care have only recently emerged as competitive alternatives to some services offered by hospitals, although they were not part of the relevant market only a few years ago.

Once the relevant product and geographic markets have been defined, the authorities must weigh other factors, most notably any efficiency gains (or losses) that might reasonably be considered a likely consequence of a merger. The financial conditions of the merging companies may also be a factor in predicting changes in efficiency.

Efficiency is no easy thing to measure. Over many years of mergers in many industries, we have seen countless claimed efficiencies go unrealized, so the regulators are right to appraise such claims with some skepticism. But in an industry such as hospitals, where institutions are under pressure to lower costs, to step up innovation, and to respond to myriad new regulations, realizable prospective efficiency gains are important consumer benefits, and claims for them are worthy of careful, if still skeptical, consideration.

The financial condition of the prospective partners also demands review, especially in instances in which proponents claim that consolidation is the only alternative to the forced exit of one of the firms from the market. This is known as “the failing firm defense,” which can be persuasive if a refusal to allow a merger might leave the market with one fewer player — the failing firm — and thereby actually leave consumers with perhaps no fewer providers but fewer facilities than if the merger had been approved.

The cost of an overly stringent regulatory approach would be to raise investors’ sense of the riskiness of involvement in the industry, and with it the cost of capital that must ultimately be borne by consumers of health-care services. The importance of this defense in the case of hospitals is illustrated by Standard & Poor’s report that “the current environment, with its high level of mergers and acquisitions, has precluded many distressed hospitals from defaulting.” And it may have additional force in the case of the 60% of hospitals that are non-governmental, are not-for-profit, and, according to the rating agencies, have less access to capital than their for-profit counterparts.

In general, if a proposed merger is likely to substantially lessen competition in a defined product market and geographic area — producing durable increases in the price of health-care services, a slowing of the rate of innovation or new entry, or other effects adverse to consumer interests — it will be challenged. And it should be: If competition is preserved, consumers can make their choices based on price and quality, and regulators can find some other use for their time.

But one significant policy problem remains: Even if the FTC decides not to challenge a merger, the decision often comes after extensive requests for data, responses to which can be expensive and time-consuming. It can be so expensive, in fact, that just the possibility of such requests can deter potential acquirers from making an offer to a prospective seller, thus preventing a possible efficiency-enhancing consolidation. There is no easy answer to this problem except to rely on the good sense of the antitrust agencies to stay their hands when there is little likelihood that they will end up opposing the merger. It is also up to the merging parties to cooperate completely and promptly, providing sufficient information to make it unnecessary for the regulators to initiate an extensive data-gathering process.

THE ENVIRONMENT FOR HOSPITALS

The accelerated pace of merger activity among hospitals cannot be due to a single cause. As with other industries, it is surely supported by conditions in money markets: Federal Reserve policy has kept interest rates low, making the cost of capital attractive for potential acquirers. Although such low interest rates won’t last forever, their persistence and the likelihood that any increases will be moderate and paced over some time suggest that this factor encouraging mergers will be with us for a while.

But there are some crucial industry-specific factors, too. One is the aforementioned pressure on failing hospitals to find the shelter provided by a stronger partner, able to make better use of the failing firm’s assets. Another factor is falling revenue; recent developments in the health-insurance industry have suppressed the revenue streams of many hospitals. The insured population is growing, which is reducing the number of charity cases, but patient volumes are more or less unchanged, while the rising proportion of outpatient care — which is reimbursed at a significantly lower rate than inpatient care — is lowering overall revenue growth. Another crucial factor driving mergers is the rising cost of compliance with the new regulations embedded in the Affordable Care Act — regulations that require a considerable investment in medical-record-keeping systems, among other things.

All in all, as Moody’s put it last year, for non-profit hospitals, “operating revenue growth dropped to an all-time low of 3.9% and was outpaced by expense growth for a second consecutive year.” This is not a welcome development in an industry that is becoming more capital intensive, and investors and the rating agencies are growing more concerned about the safety of investments in hospitals amid regulatory upheaval.

Of course, the revenue and cost prospects affecting specific merger partners will be examined by the FTC in individual cases. But the general state of the industry suggests that analysts in those cases should not be surprised if they confront unfavorable trends in some measures of the industry’s prospects, along with some signs of a brighter revenue future. Such industry-wide conditions must be given weight in the required appraisal of the future vigor of competition in the industry.

Although financial trends are indeed important, even more important is the accelerating technological change that is affecting how both product and geographic markets might be defined, and, more specifically, how the FTC determines the prospective impact of mergers on the future force of competition in those markets. Consider the market for what is generally thought of as emergency care, which by its very nature is usually local and which consists of many rather different “products” (or, in this case, services). New technology and profit opportunities have led a host of new players to enter that market. Competition from non-traditional actors is becoming more common. “Urgent-care centers” compete with emergency rooms in the provision of some, but not all, emergency services, many of which require diagnostic and other facilities that only hospitals can support. Some of these centers are in fact affiliated with major hospitals, but others are found in Walmart, CVS, Walgreens, and other stores that are now serving or will soon serve consumers whose only source of succor once was the hospital emergency room. Those traditional ERs continue to increase their services to patients, despite the efforts of the architects of the Affordable Care Act to “put a moat around us to keep people out,” in the words of the aggrieved American College of Emergency Physicians.

Clearly, new players in the emergency-services market must be counted as competitors to hospitals in some cases and as potential entrants into other product (or service) markets. In some cases, these new providers meet the test of being close enough substitutes for the traditional ER to be considered viable alternatives for consumers. But the mere general existence of these alternatives, without analysis of their effect in specific markets, should not provide a basis for waving a hospital merger through.

Other recent developments also require a re-evaluation of just what to include in the definition of relevant geographic markets, which have been broadened by advances in communications and medical technologies. The hospital in my little town in Colorado now has access to the skills and advice of the Mayo Clinic in real time, making it more competitive with the big-city hospitals to which we once fled when sophisticated care was needed. As more and more costs are shifted from third-party payers onto increasingly price-sensitive and well-informed consumers, and as the cost of communication drops and technology makes possible long-distance application of specific treatment skills, many of the boundaries of what were once geographic markets for antitrust purposes have been blurred or drastically expanded.

None of this is to say that change, ongoing or prospective, warrants a relaxed regulatory attitude toward the health sector in general or hospital mergers in particular. Deborah Feinstein, director of the FTC’s Bureau of Competition, has it right when she says that “[e]ffective antitrust enforcement is as important in a time of dynamic change as in periods of stability, if not more so.” Indeed, it is at just such times that authorities must be alert to any efforts by the victims of change to erect barriers, structural or behavioral, aimed at slowing or eliminating the change that threatens them. But it is equally important that regulators incorporate such changes into their analyses of the competitive landscape when examining possible consolidations.

COSTS, BENEFITS, AND RISKS

Ultimately, for antitrust enforcers, answering these questions almost always comes down to a cost-benefit analysis. But comparing the costs and benefits of hospital consolidations is no easy task. The benefits of a transaction might include the provision of more tightly integrated patient care through a care episode and thereafter; more sophisticated management that produces higher standards of provider practice and results in measurably better outcomes for patients; the introduction of clinician and non-clinician compensations systems that create incentives to quality care and efficiency; and lower capital costs (but only if unrelated to enhanced market power).

The costs, according to some critics of the industry, can include diseconomies of scale as organizations become too big and complex to manage. Lax enforcement can also result in incentives to increase the unnecessary use of equipment and staff, and higher prices that some say are the inevitable consequences of increased concentration.

All we can say by way of generalization is that since the authorities have challenged very few of the many hospital mergers or looser forms of integration in recent years, it is reasonable to assume that they have concluded that the benefits of most such consolidations exceed their costs. It is also likely that the challenges that have been brought have deterred potential mergers and consolidations that might not have survived the scrutiny.

The FTC’s decision to stay its hand more often than not speaks to the wisdom of restraint, in part because the commission and other policymakers face asymmetrical risks. One risk is that mergers that might prove in the future to have been anti-competitive will be waved through, but the other is that mergers that might yield considerable benefits to consumers will be aborted, either by the mere threat of challenge or by regulatory rejection.

If regulators make the first error and allow a merger that they subsequently wish they hadn’t, they do have regulatory tools that can mitigate, albeit imperfectly, some of the anti-competitive practices that emerge. To be sure, regulation is only an imperfect substitute for competition, but it can be a meaningful weapon all the same. If, instead, a merger is aborted that might have proven very useful to consumers or might have exploited otherwise unavailable new technologies and learning, that opportunity most likely is lost forever — especially if one of the prospective merging parties is forced out of the market. A likely irreversible error would seem to be the greater of the two risks.

Alfred Kahn, a student of regulation and among the most consistent advocates of the importance of vigorous antitrust enforcement, concluded after a long career as a pro-competition advocate and regulator that

while in no way counseling indulgent antitrust treatment of predatory or unfairly exclusionary competitive conduct, [experience] underline[s] the need for humility in attempting to make industries more competitive by interfering with their achievement and exploitation of economies of scope and diluting their incentives for innovation — the most powerful competition of all.

So the old rule, “first, do no harm,” seems to apply as much to the practice of antitrust enforcement in this sector as to the practice of medicine itself.

The wisdom of choosing the lesser of the two possible errors when in doubt should be buttressed by the consideration of two nascent developments that have the potential to increase competition: disruption and recasting of incentives. Disruption is the goal of entrepreneurial companies that seek not to nibble at an incumbent’s market share but to displace that incumbent entirely. Other industries provide numerous examples of just such disruption — witness the plight of newspapers as digital media provide more value to advertisers and young consumers; typewriters were converted by computers into museum pieces; taxis have been idled as Uber enters market after market around the world; and the watch and camera industries are panicking as cell phones provide both functions at far lower cost.

There is good reason to believe that just such disruption is in hospitals’ futures. The decline in inpatient volumes already reflects such a dynamic, as pharmaceuticals and telemedicine replace hospital stays. And famous Silicon Valley disrupters, from Apple to Google to Amazon — having disposed of such rivals as bulky telephone directories and traditional sellers of books, music, and other products — are turning their attention to the health-care industry, which they regard as incapable of making efficient use of its own vast data troves. These disrupters also see in health care an opportunity to meet their twin goals of profit and doing good. As the Financial Times recently put it, “A new wave of data-intensive ‘health tech’ companies is drawing talent from the internet world as cloud computing, artificial intelligence and intensive data analysis are brought to bear on health.” One company is using three-dimensional computer modeling to diagnose heart disease “without the need for more expensive invasive tests” and, along with others, is attacking “entrenched work practices among doctors.”

The point is not that these disrupters must in all circumstances be considered competitors diluting the market power that might be created by mergers. Rather, it is that in appraising the potential effect of a merger on the strength of post-merger competition — in defining the product and geographic scope of the market — the possibility of competition from sources completely outside the industry should be considered with some care rather than dismissed out of hand.

The second factor to which authorities might give weight in deciding whether the risk of waving a merger through exceeds the risk of attempting to block it is the recasting of incentives and other traditional terms of trade in health-care industries. The multifarious Affordable Care Act is now a fact of life. To say that the ACA has both vigorous supporters and equally vigorous critics is to understate the situation. But whatever one thinks of the changes being wrought by the law, no one can deny they are large and significant. The mandated switch from fee-for-service to a results-based pricing system (however that is defined), higher deductibles that make consumers more conscious of the cost of their treatments, mandated electronic record-keeping, increased insurance coverage, and other features have the industry in “the throes of great disruption,” as the Economist recently put it:

Many companies see the disruption...as the business opportunity of a lifetime....Existing health-care providers will have to adapt, or lose business. All sorts of other businesses, old and new, are seeking either to take market share from the conventional providers, or to provide the software and other tools that help hospitals, doctors, insurers and patients make the most of this new world.

It is too early to predict the full effects of the ACA on the nature and force of competition in the several sectors of the health-care industry, other than to say that ACA-induced changes demand consideration when appraising the effect of a merger on competition. Changes in the industry so far have indicated that greater price transparency, increased consumer information regarding the costs and benefits of various treatments, the relative importance of inpatient and outpatient care, the net effect on prices of cost-increasing information systems, and cost-reducing efficiencies (and rationing) will surely affect the competitive landscape. All this makes determining the probable effect of mergers on competition more difficult than it would otherwise be. The many complicating factors involved in antitrust determinations should compel policymakers in this field — legislators, regulators, financial analysts, industry managers, and academics — to approach their work with a certain sense of humility.

LIVING WITH UNCERTAINTY

It remains the case that the competitive impact of each merger will have to be judged in light of the specific competitive circumstance it is likely to produce. Product and geographic markets will have to be defined, and, in the words of the Clayton Act, mergers should be challenged “where in any line of commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or tend to create a monopoly.” The use of the words “may be” makes the Clayton Act what practitioners and scholars call “an incipiency statute,” one designed to prevent mergers that “merely set the stage” for a reduction in competition.

In enforcing that statute, the authorities must make their individual decisions about whether to wave through or challenge a merger against the background of the broad trends affecting the industry. Competition must play a key role in assuring that consumers have the widest possible choice of treatments and prices. The importance of the health-care industry, and especially of hospitals, for consumer well-being argues against any exemption for or relaxation of vigorous application of the law to these industries. And it argues against exercising a great deal of patience with those who would stifle change by engaging in anti-competitive business practices, such as tying the price and availability of a particular product to another product in which the provider has an overwhelming market share or imposes unreasonable exclusivity.

But that does not require forgoing one of the major virtues of the antitrust laws — their flexibility. Unfortunately, the very fact of that flexibility introduces a degree of uncertainty into the enforcement process: Enforcers must decide which among many possible cases to pursue, and executives must pore over precedent to decide which cases enforcers are likely to select for challenge. Unfortunately for participants in the policymaking process, even longstanding experience with the application of antitrust policy does not, and indeed cannot, provide the degree of certainty that enforcement authorities and industry executives both crave.

This is so for several reasons. First, reasonable people can and do disagree over the lessons to be derived from any set of facts and, indeed, can disagree about the facts themselves. Second, as we have seen, the pace of change is accelerating, moving in the direction of expanding consumer choice in some instances and narrowing it in others: Some relevant geographic markets can no longer be measured in miles, given the global reach of communication technologies, while other markets remain local. Third, participants in health-care markets and the officials who oversee them are required to divine the effect of various practices and structural changes on the force of competition not now but in some future in which many of the circumstances now present will have changed beyond recognition.

This means no one can be certain about what to expect from the regulators. The only way to eliminate uncertainty entirely would be to adopt per se rules that outlaw all sorts of restructurings and business conduct regardless of economic circumstances — an approach favored neither by health-care providers nor their regulators. Nonetheless, it is the responsibility of the enforcement authorities to reduce the level of uncertainty to the extent possible, perhaps by increasing the specificity of their speeches, issuing more advisory opinions, and developing any other tools that might reduce uncertainty to a minimum. It is equally the responsibility of actors in the industry to learn to treat some regulatory uncertainty as merely one of the many risks with which they are paid to cope.

Both regulators and industry actors must also recognize that forecasting any economic phenomenon, especially the likely effect of an action on competition in a changing industry, can reduce — but not eliminate — uncertainty. This reinforces the need for humility when seeking an appropriate solution to a regulatory problem.

Regulators would be well served by recognizing that there are times when “don’t do something, just stand there” is the best response to clouded crystal balls. And industry executives must recognize that regulators are often appropriately skeptical about their forecasts for the efficacy of some business practice or the efficiency anticipated by some merger, and the regulators can justifiably request evidence that those efficiencies are not achievable by less anti-competitive means.

ENABLING COMPETITION

Vigorous application of our competition laws to the various sectors of the health-care industry is indisputably in the interests of consumers and challengers to industry incumbents. They have, with only a few exceptions, been applied with sensitivity to the special circumstances of the affected industries.

In the case of health care, that sensitivity requires accounting for a multitude of different factors: the financial condition of the players involved in mergers, the impact of the regulatory environment in which the industry’s actors operate, mandated changes in incentives that are certain to affect the competitive environment, and the difficulty of forecasting the effect on competition of proposed structural changes. Given the rapid changes developing in today’s health-care industry, it also requires a recognition of technological developments that have expanded the product and geographic scopes of some (but not all) markets, current and prospective entry into local markets by firms previously outside of the industry, and the potential effect of changes on the durability of acquired market power.

And regulators must also keep in mind the increased availability of information relating to the price offered and quality of care given by various health-care providers, including posted reviews on the experience of individual patients and the continued need of consumers (often limited in their geographic choices despite the expansion of some geographic markets) for protection from any substantial lessening of competition. It would not be a novel exercise for regulators to recognize such developments when applying the flexible instruments that comprise our competition policy.

But in the end, tensions will remain between an industry that sees itself under regulatory siege and the enforcement agencies attempting to preserve competition while allowing the industry to respond to the perennial gale of creative destruction that ultimately makes life better for consumers. This is as it should be.

The purposes of our antitrust laws include making certain that no artificial impediments are placed in the path of new entrants, that incumbents do not deploy anti-competitive tactics or engage in competition-stifling mergers, and that consumer welfare is maximized. Those purposes are served by incorporating into the definition of product markets the new competitors who have already emerged — from Walmart to Walgreens — and those circling this industry and preparing to introduce still more innovations. They are also served by recognizing that changes in technology mandate a broadening of the definition of some product markets to acknowledge that a patient being treated in a small town in a remote part of the country, or indeed in the heart of a major city, can make use of far-away experts through communications and other technology. Telemedicine gives patients direct access to care that might not be as efficiently available in a nearby facility.

And yet, regulators must also see that none of these changes justifies a suspension of the need to just say “no” to mergers that remove competitive alternatives now available to consumers, unless there are overwhelming, hard proofs that the benefits more than offset the costs of such a reduction in competition. If they incorporate these insights into the traditional structure of antitrust enforcement, the regulators can balance the need for flexibility with the need to preserve competition. In other words, they can accomplish the essential and difficult task of antitrust enforcement.