Supply and Demand of Physician Services Econ 737.01

Supply and Demand of Physician Services: Outline A. General Models B. Forms of Compensation C. Physician-Induced Demand

General Models: Outline I. Supply of Physicians II. Supply of Physician Services a. Model with Complete Information b. Incomplete Information c. Objectives Besides Income

I. Supply of Physicians Summary Statistics (U.S.; 1994) 126 medical schools 16,000 graduates per year 550,000 practicing physicians 254 physicians per 100,000 residents Average net income : $182,400 Average work hours: 55/week Physicians work a lot and make a lot Market forces or shortage?

I. Supply of Physicians Market distortions Barriers to entry Educational and licensing requirements AMA controls these; incentive to restrict supply too much? This would reduce supply below socially optimal level Medical school subsidies Could raise supply above socially optimal level

I. Supply of Physicians Empirical Evidence Difficult to measure physician shortages or excess returns on investments in medical education 1900-1950 Supply side: new medical school graduates constant Demand side: average age, real per capita GDP, and insurance coverage all increased dramatically Consistent with excessively restricted entry More recently Output of medical schools has expanded dramatically in last 10-20 years Weeks et al. (1994): returns to education for physicians, lawyers, dentists, and MBAs all similar

II. Supply of Physician Services a. Model with Complete Information Monopolistic Competition Many sellers Differentiated products (physicians are imperfect substitutes) Some market power Demand exogenous from physician’s perspective Perfect information on both sides Physicians maximize profit Nonretradable goods

II. Supply of Physician Services a. Model with Complete Information Physician makes “all or nothing” offer to patient, who would prefer to consume less care at the given price Physician can price discriminate If price set by demand side (i.e. insurance companies/Medicare), physician responds by increasing quantity Quality of service is another dimension to consider

II. Supply of Physician Services b. Incomplete Information Punch line from part a: Even with perfect information, the differentiated and nonretradable nature of medical goods can keep medical expenditures above competitive levels. Relaxing the assumption of perfect information further enhances our understanding of why medical expenditures are so high.

II. Supply of Physician Services b. Incomplete Information 1) Irreducible uncertainty Doctors and patients have imperfect information about the underlying condition and effectiveness of treatments Most doctors and patients are risk averse => increased test frequency and treatment intensity

II. Supply of Physician Services b. Incomplete Information 2) Principal-agent problem Principal: patient Agent: doctor Doctors know more than patients about appropriate level of care (asymmetric information) Outcomes are often difficult for patient to observe Often gray areas about appropriate treatment => Could lead to excessive provision of care “Induced demand”

II. Supply of Physician Services b. Incomplete Information 3) Unobservable physician quality Large fixed cost with trying a new physician Information asymmetry makes it hard to observe physician quality => Prices may not fully adjust to an increase in competition

II. Supply of Physician Services c. Objectives Besides Income Parts a and b assume that physicians act to maximize income. Other considerations: 1) Medical ethics: legal and moral constraints 2) Patient’s best interest (patient’s utility enters into doctor’s utility function) Patient’s utility, not society’s utility. Why is this an important distinction? 3) Target income

II. Supply of Physician Services c. Objectives Besides Income 3) Target income Motivation: explain positive association between physicians per capita and prices of services, negative association between fees paid and quantity supplied Physicians aim to maintain a “target income” If increased competition lowers their income, they take advantage of their market power by raising prices or inducing demand to keep income relatively stable What does this say about physician behavior before the increase in competition?

II. Supply of Physician Services c. Objectives Besides Income 3) Target income Taken seriously for a long time Generally rejected now, though still subject of debate in literature If target income hypothesis is true, there should be large income effects on supply (identified using non-labor income), and this doesn’t seem to be the case Can you think of other explanations for the apparent paradoxes?

Forms of Compensation I. Fee-for-service II. Capitation III. Salary IV. Pay-for-performance

I. Fee-for-service Physicians are paid an additional amount of money for each service they provide Would expect this to increase the amount of care provided Open question how much these additional services would improve health Schuster et al. (1998) estimate up to 30% of services are not medically necessary Often supplemented with incentives to economize

I. Fee-for-service Who sets the fees? Used to be physicians In response to incentive problems, insurance plans began negotiating fees and Medicare began setting fees These groups can do this because they are large enough that they have market power (monopsony) How does this tie into the “public option” debate?

II. Capitation Physicians receive fixed amount of money for providing services to a patient for a particular period of time Incentive to keep long patient roster but give them each as little attention as possible Could lead to higher referral rates Various schemes to makes physicians share in financial risk Still need to provide enough care to attract and retain patients Incentive to select healthy patients (cream skimming; cherry picking) Fee for a patient is “risk adjusted” based on expected utilization This adjustment only accounts for 10% of variation Often supplemented with incentives to ensure sufficient quality of care Could be combined with ffs in a “mixed” system

II. Capitation Quantity Capitation seems to be effective in reducing quantity and expenditures (is this good?) Stearns et al. (1992) Group of WI employees enrolled in IPA Change from ffs to capitation system where physicians shared in financial risk of hospitatlization and specialty costs Increased primary care visits by 18% Decreased specialist visits by 45%, hospital visits by 16%, and length of stay by 12%

II. Capitation Quantity Ogden et al. (1990) Group of IL employees enrolled in IPA Switched from ffs to capitation with shared financial risk Specialist costs increased 2% compared to 12% the previous year Hospital outpatient costs dropped 7% compared to increasing 12% the previous year Little change in inpatient hospital utilization

II. Capitation Quantity Mooney (1994) GPs in Copenhagen, Denmark switched from capitation to mixed capitation-ffs Provision of services that provided extra fees increased dramatically Decrease in referrals to specialists and hospitals

II. Capitation Quality Sorbero et al. (2003): patients 36% more likely to switch physicians under capitation than ffs Shen et al. (2004): survey with hypothetical treatment decisions; physicians more “bothered” by their decisions under capitation than ffs

II. Capitation Referral rate Capitation does seem to lead to more referrals on the margin, both theoretically and empirically, if the GP does not share in the financial risk Theoretical: Barros and Martinez-Giralt (2003); Iverson and Luras (2000b) Empirical: Forrest et al. (2003); Carlsen and Norheim (2003)

III. Salary Provides fixed income to physician over a particular time period Ex. in US: Staff HMOs Incentive to do as little as possible to keep job Often supplemented with incentives to ensure reasonable quantity and quality of care Less common than others, but do see it in national health systems like UK and staff HMOs in US

IV. Pay-for-performance Ties part of physician or hospital reimbursement to meeting performance thresholds (clinical outcomes, patient satisfaction, etc.) New and largely untested >20 million in US covered (Rosenthal et al., 2004) Difficult to measure “performance” What incentive problems might result from paying on the basis of outcomes?

Physician-Induced Demand I. Theory II. Evidence from Increased Competition III. Evidence from Decreased Fees IV. Summary

I. Theory Physician-induced demand (PIP): “when the physician influences a patient’s demand for care against the physician’s interpretation of the best interest of the patient” (Handbook, p. 504) Physician exploits role as agent to alter the patient’s demand curve Distinctions that make PID challenging to identify empirically (not enough to just look at quantity) Useful agency v. inducement Demand shifting v. quantity setting

I. Theory Model Where Y=income, I=inducement, N=number of patients, m=margin, x=quantity, i=inducement Solving yields

I. Theory Testable prediction 1 N down => Y down and I down => UI less negative and UY up => -UI/UY down => x1’ and x2’ down => i1 and i2 up. So, increased competition for patients should increase the per-patient quantity of services Supply side: more physicians in market Demand side: less need for services Depends on changing tradeoff between I and Y as income changes (income effect)

I. Theory Testable prediction 2 m1 down => UY up => -UI/UY down => i1 and i2 up Income effect m1 down => lower return to inducement in sector 1 => i1 down and i2 up Substitution effect Net effect on i1 ambiguous; net effect on i2 down So, a drop in fees from one payer should increase quantity among patients with another payer

II. Evidence from Increased Competition Effect of increase in per capita number of physicians on quantity Problems Really tests joint hypothesis of induced demand and income effects Endogeneity of number of physicians (likely a response to demand)

II. Evidence from Increased Competition Fuchs (1978) Effect of supply of surgeons on surgeries 22 metropolitan areas, pooled cross sections from 1963 and 1970 IVs: metro area, hotel receipts, percent white 10% increase in surgeons => 3% increase in surgeries Cromwell and Mitchell (1986) More years, more areas, better controls Same identification strategy Same sign, smaller effect Birch (1988) and Grytten el at. (1990) More dentists per capita => more dental visits

II. Evidence from Increased Competition Rossiter and Wilensky (1983, 1984); Scott and Shell (1997) Small effects of physician density on quantity for some procedures Dranove and Wehner (1994) Falsification test: estimated “effect” of number of obstetricians on volume of births Similar IV methodology to Fuchs and Cromwell and Mitchell Found positive effect; suggests methodology is suspect

II. Evidence from Increased Competition Gruber and Owings (1996) 13.5% fall in fertility from 1970-1982 represents exogenous shock to incomes of OB/GYNs Exploited between-state over-time variation in fertility rates to identify effect on Caesarian section deliveries (more lucrative) 10% drop in fertility => 0.6% increase in P(C-section)

II. Evidence from Increased Competition Pauly (1980) Used large individual-level dataset Least informed patients should be the most susceptible to demand inducement Poor patients in big cities should be the least informed Found (small) effect of number of physicians on quantity of ambulatory care for this group

III. Evidence from Decreased Fees Hadley and Lee (1978); Mitchell et al (1989) Medicare price freezes during 1970s and 1980s led to increased utilization Hurley et al. (1990); Hurley and Labelle (1995); Escarce (1993b) No clear evidence of effect of own-fee changes on utilization Not surprising; theoretical prediction ambiguous Rochaix (1993) GPs in Quebec changed mix of services in response to lowering of fees

III. Evidence from Decreased Fees Rice (1983) 1977: Medicare began setting fees in Colorado based on state-wide averages Reduced fees in Denver-Boulder area; increased them in other areas Physicians facing declining rates increased provision of surgery, medical services, and tests

III. Evidence from Decreased Fees Nguyen and Derrick (1997) Impact of Medicare fee reductions for “overpriced procedures” For 20% of physicians who experienced the largest price reductions, 1% reduction in price => 0.4% increase in volume. Yip (1998) Reductions in Medicare fees for thoracic surgeons led to large increases in volume Surgeons recouped 70% of lost income

IV. Summary There is no perfect test for demand inducement, but theory generates predictions that lead to tests that are suggestive. “It appears that, in response to economic considerations … physicians can induce demand for their services, they sometimes do induce demand, but that such responses are nether automatic nor unrestrained” (Elgar p. 265, citing Hurley and Lebelle, 1995).