Are factor substitutions in HMO industry operations cost saving?

• Author: Okunade, Albert A.

1. Introduction

   As the number of HMOs increases, there is pressure on managed care entities, including mature staff-model HMOs, to reduce their costs ... For a managed care system, it is just as important to control such factors as inpatient hospitalization and the use of expensive diagnostic and therapeutic technologies. If (emphasis added) providing access to both generalist and specialist physicians is a substitute for the use of expensive technologies and hospitals, or if physicians are effective in their health promotion and disease prevention activities, investment in health professionals may actually reduce some downstream costs.

   Hart et al. (1997, p. 68)

   Coverage in traditional fee-for-service health insurance for private employees with group insurance fell significantly from 98% in 1979 to 15% in 1997. Managed care enrollment grew from 2 to 85% in the same period. More specifically, coverage in managed care (Kongstvedt 1997) grew from 19% in 1992 to 30% in 1997 in health maintenance organizations (HMOs), from 27% to 35% in preferred provider organizations (PPOs), and from 7% to 20% in point-of-service (POS) plans (Henderson 1999, p. 274). These health plans are "economically driven medical care models" (Etheredge, Jones, and Lewin 1996). Due to their increased dominance arising from cost-saving competitive features and production structures, managed care models such as open-access HMO systems offering the benefits of point-of-service products (Sachs 1997) are projected to play significant roles in future medical care delivery and related policy reforms in both the private and public health sectors. HMOs are entities that integrate the financing and delivery of health-care services to covered lives. In 1995, 89% of the HMO revenues derived from employee benefit plans, with the balance of 5% from Medicaid and 6% from Medicare enrollments. HMO expenses in 1995 (as percentage of total premiums) were comprised of physician and outpatient (41%), inpatient (31%), outside referrals (7%), emergency (3%), administrative (13%), and profit (5%). Private sector HMOs have become important prototypes for public sector managed care (Fox 1997). (1)

   Recent studies of medical care in HMOs report about 15% cost savings compared with those under traditional indemnity insurance (Getzen 1997). These cost savings, achieved at an average quality of care level similar to the fee-for-service (FFS) arrangement (Miller and Luft 1997), have largely been attributed to (a) a huge reduction in the relatively expensive hospital days per enrollee (Etheredge, Jones, and Lewin 1996); (b) large volume discounts (e.g., provider networks) in acquiring hospital, physician, laboratory, and pharmacy services (Getzen 1997; Henderson 1999); and (c) cost-effective organizational strategies (e.g., use of more midlevel providers and generalists than specialists) that influence patient and provider behavior (Flood et al. 1998).

   Cost studies of HMOs agree that specific economies characterize the multiple output production structure. Wholey et al. (1996) and Given (1996b) independently confirm substantial economies of scale and diseconomies of scope. They estimated differently specified multiproduct translog cost models using dissimilar data sets and time periods to arrive at remarkably consistent conclusions. Currently, there is no inquiry on whether the robust findings on economies of scale and scope extend to the scope for factor substitution possibilities implicit in the production technology. Past research is largely mute on the extent to which the HMOs are capable of reorganizing input ratios to contain operational costs when relative factor prices change, (2) all else equal. Because the HMOs offered a more diverse mix of products and reaped diseconomies of scope during the 1990s, there is also an interesting and unexplained phenomenon that an investigation of factor substitutions could help to resolve. For instance, if the core skill of HMOs is administrative efficiency, and administrative services complement physician services for Medicare patients but substitute for commercial patients, then adding Medicare product could thwart the substitution of administrative services for physician services. This makes the curvature of the isoquant critical to the degree of cost savings.

   The relative factor prices in the health care industry, and particularly for the HMOs, have changed for the period analyzed in this study. These include health care inflation overall, which rose from 2.5% in October 1997 to 3.0% in April 1998 (Zelver 1998). The producer price index, or PPI, for all hospital care had a net deceleration from 1.2% in January 1997 to 0.2% in December 1997. Deceleration of the indexes was partly driven by general medical inpatient (from 1.2% to -1.0%), general Medicaid inpatient (from -0.1% to -0.8%), general Medicare outpatient (from 1.9% to 1.6%), and psychiatric Medicare inpatient (from 1.2% to 1.1%) care. The all-physician-care PPI inflation fell from 1.3% in January 1997 to 1.2% in December 1997. A stable 0.3% inflation in Medicare physician care and a non-Medicare physician inflation falling from 1.6% to 1.5% fueled the deceleration. Overall, the Medicare price indexes for internal medicine, surgery, pediatrics, and obstetrics and gynecology (OB/GYN) rose. Finally, the 12-mo nth PPI inflation rates (%) for December 1997 included hospital care (0.2%), physician care (1.2%), medical laboratories (0.9%), nursing homes (4.2%), and prescription drugs (3.6%).

   Consequently, the goal of this study is to estimate the degree of factor substitution inherent in the structure of HMO production technology. That is, given the production technology structure of HMOs at constant output and the corresponding cost function, to what extent can cost savings be realized when relative factor prices change? Policy-driven estimates of the scopes for factor interchange exist for the health care services of general hospitals (Cowing and Holtmann 1983), physician practices (Escarce and Pauly 1998), hospital pharmacies (Okunade 1993, 2001), specialized hospital pharmacies (Okunade and Suraratdecha 1998), nursing (Eastaugh 1990), and outpatient dentistry (Okunade 1999). Despite the broad significance of the HMO industry, there is currently no similar study based on more recent data. Research on potentially cost-saving factor interchange has operational policy implications for the optimal reorganization of inputs in HMOs as the industry competition intensifies in geographic markets (Given 1996a). Therefore, findings of the current study are expected to augment the earlier conclusions on the economies of scale and scope technology aspects of HMOs and further provide a baseline set of factor substitution estimates with which to compare future substitution possibilities as HMOs continue their competitive evolution. The numerical estimates of pairwise factor substitutions and their informational contents (i.e., confidence interval bounds) could also aid in the understanding of whether inputs relate decidedly as complements or substitutes as competitive HMOs respond to relative input wage changes at a constant output set. How the HMOs react to the higher price of hospitals versus home health or outpatient pharmaceutical intervention for Medicare enrollees is, for example, a factor-factor substitution issue. (3) Other than the now-dated Bothwell--Cooley (1980) study, which used 1976-1977 data and a conceptually flawed elasticity of substitution concept, our present study utilizing the alternative c onceptual measures and more recent data sets is unique and timely in its approach to estimating the scope for cost-saving factor substitutions in HMOs.

   Section 2 reviews the scant economic cost studies of HMO production and examines the different conceptual bases of the elasticity of factor substitutions and their implications for HMO isoquant shapes. Section 3 implements these concepts and discusses the findings using the translog cost model parameter estimates of each of the cost studies of HMOs published to date in peer-refereed economics journals. Section 4 concludes with the health policy and operational cost containment implications and advances the agenda for future HMO production studies.

2. Economic Cost Models of HMO Production Activities

   The Appendix summarizes the regrettably anemic current literature (Given 1996b, p. 689) on the econometric models of HMO production cost behavior. With the exception of Schlesinger, Blumenthal, and Schlesinger (1986), whose methodology is not a translog economic cost model, the other three studies included at least four factor inputs and two or three intermediate outputs in their multiproduct translog cost representations of HMO operations in the United States. (4) The studies utilized data from different settings and operational periods to confirm positive scale economies and no economies of scope. Production characteristics have cost implications. Scale economies reduce unit costs with output expansion, economies of scope relate to the capacity of joint outputs to reduce costs compared with separate production, and potential cost savings from factor substitutions investigated here pertain to production economies arising from possible reorganization of input ratios at constant outputs when relative input prices change.

   Translog Cost Model and the Alternative Concepts of Factor Substitutions

   The translog cost models that Bothwell and Cooley (1980), Wholey et al. (1996), and Given (1996b) fitted to different HMO data sets rejected the statistical hypothesis test of a homothetic production structure. The model by Bothwell and Cooley (1980) is

   ln C = [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

   where C(*) is total cost, [Y.sub.i] (i = 1, 2, 3) are outputs, [w.sub.i] (i = 1, ... , 5) are input prices. Factor cost share equations are [M.sub.j] = [partial] log C/[partial][w.sub.j] = [w.sub.j][x.sub.j]/C = [[beta].sub.j]...