Optimal regulation of multiply-regulated industries: the case of physician services.

• Author: Rizzo, John A.

1. Introduction

   An important type of regulatory failure occurs when agencies neglect to coordinate their actions. A growing body of research has found that coordination failures confound government efforts to implement optimal public policies. For example, see Baron [1]; Coate [5]; Hansson and Stuart [12]; Kotlikoff [16]; and Veall [24]. These studies have typically focused on coordination failures between the public and private sectors.(1) Our analysis examines coordination failures among agencies involved in different aspects of regulation within a given industry.

   Given the varied institutional contexts in which multiple regulation occurs, formal representations may be most insightful when tailored to the specifics of each industry, as Bernheim and Whinston [2] have noted.(2) This paper models physician services as a market regulated by two governmental agencies, each concerned with a different aspect of market performance. One branch of the government, the Health Care Financing Administration (HCFA), currently sets Medicare reimbursement rates while another branch, the Agency for Health Care Policy and Research (AHCPR), sets practice or quality standards for physicians' services. While the standards set are merely guidelines, not rules, there are potentially costly implications to physicians from ignoring the guidelines.

   Coordination failures arise in our model when two agencies, one charged with price regulation, the other with setting medical practice guidelines, fail to take full account of each other's actions and goals. Although the basic model may be generalized to a number of settings, the physician services industry provides a particularly vivid example, given the current policy concerns about the cost and quality of medical care.

   The remainder of the paper is organized as follows. Part II discusses the current regulatory environment under Medicare. Part III presents a model of optimal practice guidelines and physician reimbursement. Part IV solves the model for the socially optimal case. Part V compares outcomes under coordination failure to the social optimum. In particular, the implications of coordination failures for cost, quality, medical practice characteristics, and quantity of care are derived. These are the salient outcomes of concern for health care regulatory agencies and for society. Part VI summarizes the results and discusses their policy implications.

2. Institutional Background

   Practice guidelines are continuing to be developed by AHCPR. These guidelines set standards and try to affect the quality and appropriateness of care. Medicare payments to physicians are now set by HCFA according to the recently implemented Resource Based Relative Value Scales (RBRVS).

   Practice Guidelines

   With the establishment in 1989 of the Agency for Health Care Policy and Research (AHCPR), the federal government made the development of practice guidelines an important component of health care regulation. AHCPR has initiated work on 16 practice guidelines. The Institute of Medicine and many other health care organizations are concurrently involved in guideline development.(3)

   Guidelines may be developed in a variety of ways. AHCPR is funding research on outcomes assessments to aid in the development of guidelines for specific procedures. More common methods than engaging in original research to develop guidelines are use of literature reviews of available scientific evidence and/or expert panels.

   Guidelines may focus on diagnosis, evaluation of individual services, or appropriate treatment regimens for specific conditions (management guidelines).(4) The first two types of guidelines identify illnesses and evaluate specific medical technologies or services, respectively. Management guidelines, however, prescribe appropriate treatments for an entire episode of care for a patient with a given medical condition. A report by the Physician Payment Review Commission [20] indicates that AHCPR is currently devoting the vast majority of its efforts to the development of diagnostic and management guidelines.

   Such guidelines may have significant effects on physician behavior. First, they may lead physicians to rethink the type and level of care deemed appropriate. Second, deviations from the guidelines may impose costs on the physician, such as anxiety or increased malpractice exposure.

   Reimbursement

   The Resource Based Relative Value Scale (RBRVS), effective as of January 1, 1992, is part of Medicare's recent effort to implement a physician fee schedule. The RBRVS computes "relative values" of physicians' services across specialties. It factors into the relative values the physician's time, the complexity of services, practice costs, and opportunity costs of medical training.

   The RBRVS approach is designed to base reimbursement on the costs of providing care, rather than on actual charges, which was the previous approach. See Hsiao [13] and Hadley [11] for further details. By itself, the RBRVS is not a fee schedule. However, once relative values have been computed, a fee schedule is obtained by multiplying the RBRVS by a conversion factor. Although intended to address market imperfections in the physician services market, RBRVS has drawn considerable criticism from economists.(5)

3. A Model of Reimbursement and Practice Guidelines

   The model presented below applies to the physician services market, especially with regard to the Medicare sector. Physician fees (prices) are set by HCFA, while AHCPR establishes practice guidelines. In this initial formulation of the model, government agencies engage in non-cooperative behavior. Cost control is a common objective of each agency.(6) In addition, HFCA sets prices to promote patient access to and satisfaction with care, while ACHPR sets guidelines to promote quality.

   Each agency is assumed to take the physician's profit maximizing behavior into account in setting price and guidelines. The implications of this model are then compared to the social optimum. In the social optimum, both agencies cooperate to promote quality and other characteristics, while controlling cost.

   We assume that there is a single payer, Medicare,(7) which sets the reimbursement rates for physician services and pays the entire bill for Medicare patients.(8) As patients incur no out-of-pocket expenses for their care, their demand for care is insensitive to price. This simplifying assumption is reasonable given that: 1) the vast majority of physicians accept Medicare reimbursement as payment in full, 2) copayments are relatively small and 3) balance-billing amounts are smaller still.(9)

   We further assume that patients have difficulty judging the appropriateness of medical treatment. Thus, physicians alone determine the course of treatment in our model.

   Search Model

   In this model of the physicians' services market, there are many (M) physicians who compete for patients, and numerous (N) consumers who search for appropriate physicians. As the cost of care is paid for entirely by Medicare, there is no price competition. Physicians compete for patients through non-price competition, in this case, by offering practice attributes that consumers value.(10) These attributes enhance the attractiveness and accessibility of the physician.(11) This search model is based on an earlier model due to Satterthwaite [22; 23]. As in Satterthwaite [22], we assume that physicians and consumers are homogeneous. However, consumers have different preferences over the attributes offered by physicians. One consumer may prefer the attributes offered by physician j; another will prefer those of physician i. Thus, instead of Satterthwaite's price competition, our model has non-price competition in the form of medical practice attributes.

   The model posits physicians as being in short run equilibrium.(12) In this steady state, however, patients may leave their current physician in favor of alternative ones. Patients may leave for demographic reasons such as individuals changing their area of residence. Some patients may also search for new physicians because they are not satisfied with the attributes of their current physicians and want to search for ones who will appeal to their particular tastes.

   For an equilibrium to exist, for each physician, the expected number of patients entering the practice must equal the expected number departing. Following Satterthwaite [22; 23], define [v.sub.i] as the probability that a randomly selected consumer from physician i's current practice will come to the physician for an office visit within a week.(13) We assume that [v.sub.i] is an increasing function of the attributes physician i provides, [A.sub.i]. The physician i therefore expects to have [v.sub.i][N.sub.i] patient visits per week.

   Define [s.sub.i] as the probability that a randomly chosen member of physician i's practice will decide to leave that practice in any given week, and [w.sub.i] as the probability that a randomly chosen consumer who has quit another's practice will join physician i's practice. It is assumed that [s.sub.i] is decreasing in [A.sub.i], and increasing in the attributes offered by all other physicians. Further, [w.sub.i] is increasing in [A.sub.i], and decreasing in all A save for the ith physician. This leads to the equilibrium condition:

   [Mathematical Expression Omitted].

   Satterthwaite [22] has shown that this equilibrium condition implies that the number of patients physician i expects to receive, [N.sub.i], is a decreasing function of his or her price. A symmetric argument implies that [N.sub.i] is increasing in attributes [A.sub.i].

   Physician Behavior

   We model physician behavior as consisting of sequential stages. In the first stage, physicians set the level of attributes A to attract...