Competition and Specialization in the Hospital Industry: An Application of Hotelling’s Location Model BY PAUL S. CALEM, JOHN A. RIZZO XIAODONG(ERIC) LANG 1

Motivation Specialty Mix Rapidly increase of technological advancement leads to new service and treatment arrangement, along with increased specialization by hospitals Affects its ability to meet patient-specific needs Clustering and dispersion both common Current research Little analysis of service mix differentiation No formal modeling of joint quality and service mix competition XIAODONG(ERIC) LANG 2

Introduction Model Hospitals compete wrt both specialty mix and quality of service Variant of Hotelling duopoly model Different in two respects (1)Choose specialty mix and quality rather than location and price (2)“Transport” costs are shared by hospital and patients. Conflicting Incentives For max revenue: move toward the median For transfer accommodation cost: move away from median Competition is more intense: move away from median XIAODONG(ERIC) LANG 3

Findings Social Benefit competition differentiate their specialties either too much or too little versus cooperate (social optimum) Hospital mergers may yield efficiency gains independent of economies of scale. XIAODONG(ERIC) LANG 4

Accommodation Costs Cost for hospitals Mismatch between hospital’s proficiencies and an individual patient's needs can lead malpractice litigation or damage to reputation Cost incure Maintaining standby capacity Rapidly reorganizing production processes Planning and preparing transfer Cost for patient Patient-specific quality losses XIAODONG(ERIC) LANG 5

Hospital Behavior XIAODONG(ERIC) LANG 6

Consumer XIAODONG(ERIC) LANG 7

Market Areas 0 1 a 1-b XIAODONG(ERIC) LANG 8

Assume: Quality is exogenous Duopoly Solution XIAODONG(ERIC) LANG 9

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Monopoly Solution XIAODONG(ERIC) LANG 12

MonopolyDuopoly Strategyaccommodation costMarket share and accommodation cost Result Degree of differentiation is socially optimal XIAODONG(ERIC) LANG 13

Quality is choice variable Monopoly Same result as previous version. Since the monopoly still only solving patient accommodation costs minimization problem. Duopoly Two stage game (1 st stage service mix, 2 nd stage qualities) Logically consistent for a firm consider “what to produce” first, then determine “quality of service” Simultaneous game will yield the same result as the erogenous quality case. XIAODONG(ERIC) LANG 14

2 nd stage: XIAODONG(ERIC) LANG 15

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1 st Stage: XIAODONG(ERIC) LANG 17

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Comparative Statics for Service Mix XIAODONG(ERIC) LANG 19

Monopoly vs. Competition in 2 stage game XIAODONG(ERIC) LANG 20

Ruinous Competition When p-c sufficiently large, hospitals earn negative profits in two-stage equilibrium. Proved in Appendix 3 Since higher p makes more intense competition, which leading high quality in equilibrium. But high quality only increase the cost, no change for the revenue. Question: why higher quality has no effect on revenues? Cost increase quadratically, whereas revenues increase only linearly. XIAODONG(ERIC) LANG 21

Conclusion Conflicting Incentives Higher markup, for max revenue: move toward the median Higher accommodation cost, transfer the patient out: move away from median Competition is more intense, higher quality : move away from median Third part reimbursement Higher markups will lead increased differentiation where quality is intense. Hospital mergers may lead socially optimal Competing hospitals differentiate either too much or too little Higher reimbursement also leads higher competition cost, may have negative profit in extreme case XIAODONG(ERIC) LANG 22

Contribution Firms compete with respect to specialty mix and quality of service Previous literature assume identical hospitals compete wrt technological advancement This model added specialty mix which allow specialization. More realistic Accommodation cost is shared between hospital and patient Imperfect match incur cost for both Very creative borrow Hotelling’s spatial competition model to apply specialty mix. Good model explained why “clustering and dispersion both common among hospitals in local markets” XIAODONG(ERIC) LANG 23

Questions Hard to understand the consumer utility Maybe add altruism to the model What the model will be in Salop model? XIAODONG(ERIC) LANG 24