University of Southern California Dissertations and Theses

The use of transaction cost economics, fuzzy set and systems theories in the development of a three-dimensional pricing model of asset specificity and contracts, and applied to health care

(USC Thesis Other)

The use of transaction cost economics, fuzzy set and systems theories in the development of a three-dimensional pricing model of asset specificity and contracts, and applied to health care

PDF

Download

Open document

Flip pages

Download a page range

Download transcript

Copy asset link

Request this asset

Transcript (if available)

Content INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. UMI films the text directly from the original or copy submitted. Thus, some thesis and dissertation copies are in typewriter face, while others may be from any type of computer printer. The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleedthrough, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send UMI a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. Oversize materials (e.g., maps, drawings, charts) are reproduced by sectioning the original, beginning at the upper left-hand com er and continuing from left to right in equal sections with small overlaps. Each original is also photographed in one exposure and is included in reduced form at the back of the book. Photographs included in the original manuscript have been reproduced xerographically in this copy. Higher quality 6” x 9” black and white photographic prints are available for any photographs or illustrations appearing in this copy for an additional charge. Contact UM I directly to order. UMI A Bell & Howell Information Company 300 North Zed) Road, Arm Arbor MI 48106-1346 USA 313/761-4700 800/521-0600 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without perm ission. T H E U SE O F TR A N SA C TIO N C O ST E C O N O M IC S , FUZZY SET A N D SY STEM S T H E O R IE S IN T H E D E V E L O PM E N T O F A T H R E E -D IM E N S IO N A L P R IC IN G M O D EL O F A SSE T S P E C IF IC IT Y A N D C O N T R A C T S, AND A PPL IE D TO H E A L T H C A R E by M ary K athleen D onneson A D issertation P resen ted to the FA CU LTY O F T H E SC H O O L O F P U B L IC A D M IN IST R A T IO N U N IV E R SIT Y OF SO U T H E R N C A L IFO R N IA In P artial Fulfillm ent of the R equirem ents fo r th e D egree D O C T O R O F PU BLIC A D M IN IST R A T IO N M ay 1998 C o p y rig h t 1998 M ary K ath leen Donneson Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 983 5179 Copyright 1998 by Donneson, Mary Kathleen A .1 I rights reserved. UMI Microform 9835179 Copyright 1998, by UMI Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. UMI 300 North Zeeb Road Ann Arbor, MI 48103 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UNIVERSITY O F SO U TH ER N CALIFO RN IA SCHOOL OF PUBUC ADMINISTR.ATION UNIVERSITY PARK LOS ANGELES. CAUFORNIA 90089 ‘ Tfvis cÛssertatiûn, written 6y Mary Kathleen Donneson under the cârection o f ^Dissertation Committee, and approved 6y a d its mem- he rs, has been presented to and accepted by the 'Jacudty of the SchooC o f DubGc Adninistration, in partied fulfidm ent o f reqtdrements o f the degree c f D OCTOR OF PUBUC ADMINISTRATION “ Dean Oate DISSERTATION COMMITTEE e y I. Chapman, Ph.D. Cnai rpersm John„J. K ir lin , Ph.D. Curtis J. Henke, Ph.D. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. DEDICATION Dedicated to my parents Robert Stokely Holmes and Neil Edith Harwood Holmes. u Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS The author gratefi’” • acknowledges the outstanding contributions provided by my Chairman, Jefifrey I. Chapman, Ph.D., and my committee members John J. Kirlin and Curtis J. Henke whose collective knowledge and support kept me directed and focused. I also wish to express my deepest gratitude to Len McCandless and Dorothy Meehan of the Sierra Health Foundation, and Butch Enkoji of the Hospital Conference of Northern and Central California whose unwavering financial and personal support made the research possible. I am fortunate to have two parents, Robert Stokely Homes and Nell Edith Harwood Holmes, who instilled in me the dedication to pursue my education. My courageous father never gave up, no matter how impossible or insurmountable the task. My mother’s patience and boundless generosity made possible my success in my academic endeavors. My parent’s strength to persevere in difficult times through sheer will and determination has been passed to me. Both parents have served as an inspiration to how much can be achieved through life-long learning, and I thank them for the knowledge, integrity, and values they unselfishly gave to me. Ill Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Words cannot express my deepest thanks to my wonderful and loving husband, Rees Michael Donneson, and my children Sara, Joseph, and Teresa Donneson. I thank them for believing in me and staying with me through the long and arduous years of study. My husband’s values, stability and drive sustained our family making it possible for me to achieve a lifetime goal. Without their sacrifices, the completion of my education would not have been possible. It is through their love and selfless devotion to my success that I have achieved so much and to them I am forever eternally grateful. IV Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS D ED ICA TIO N ............................................................................................................ii A C K N O W LED G EM EN TS..................................................................................iii LIST OF F IG U R E S ..................................................................................................x LIST OF T A B L E S ..................................................................................................xii A B ST R A C T ............................................................................................................xiii CHAPTER 1 R E S E A R C H O N T H E R E S T R U C T U R E AND O R G A N IZ A T IO N O F H E A L T H C A R E D ELIV ER Y S Y S T E M S ....................................................................................................I 1.1. Introduction........................................................................................... 1 1.2. Statem ent o f the P roblem ................................................................. 3 1.3. Research Questions and O bjectives...............................................7 1.3.1. Questions Regarding the Current Transaction Cost Theory o f Industrial Organizations:...........................................................................8 1.3.2. Questions Regarding Acute Inpatient Health Care Organization Restructuring in the Market:..................................................................... 8 1.3.3. Theory and Model Objectives............................................................... 9 1.3.4. What the Research Objectives Accomplished................................. 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1.3.5. Theory Development......................................................................10 1.4. Research Design.................................................................................11 1.5. T heorem s.............................................................................................12 1.5.1. Theorem 1 ...................................................................................... 13 1.5.2. Theorem 2 ...................................................................................... 13 1.6. Instrum entation..................................................................................13 1.7. Limitations o f the S tu d y ..................................................................14 CHAPTER 2 H E A L T H C A R E R E G U L A T IO N AND P R IC E C O M P E T IT IO N ..................................................................................... 15 2.1. The Health Care Technology S ystem ..........................................16 2.2. The Physician S y stem ..................................................................... 19 2.3. The Hospital S y stem ....................................................................... 27 2.4. The Insurance S y stem .....................................................................32 2.5. The Licensing, M onitoring, and Education System ................................................................................................... 40 2.6. Regulation and Com petition in the Physician, Hospital and Insurance M arkets..................................................... 42 2.6.1. The Regulatory Approach to Cost Constraint................................. 44 2.6.2. The Market Approach to Cost Constraint: The Rise o f the H M O ...............................................................................45 2.6.3. HMOs and Managed Care.................................................................. 48 2.7. Price C om petition............................................................................ 51 2.7.1. Patient Care Cost Shifting.................................................................. 54 2.7.2. Market Characteristics o f Cost Shifting............................................55 2.7.3. Characteristics o f Payers and Cost Shifting.....................................56 2.7.4. Characteristics o f List Prices, Transaction Prices, and Cost Shifting...................................................................................... 56 2.7.5. Characteristics o f HMO/PPO Contracts and Cost Shifting 57 2.8. Sum m ary............................................................................................. 58 VI Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.8.1. Change in Concept from Medical Care to Health Care................58 2.8.2. Market Transaction Costs..............................................................59 2.8.3. Organizational Survival.................................................................60 2.8.4. Networked Health Care Systems................................................... 61 CHAPTER 3 L IT E R A T U R E R E V IE W ...........................................................................63 3.1. The Economics of Industrial O rganization................................ 63 3.2. The Theory of the Firm .................................................................. 63 3.3. Contracts and D ecisions................................................................. 66 3.4. Organizations as Structures for Economic Exchange..............................................................................................77 3.5. Vertical Integration..........................................................................82 3.6. Pricing T heory..................................................................................85 3.7. The Use o f the Industrial Organizational Model o f H ealth Care Delivery....................................................................92 3.8. Political Econom y............................................................................95 CHAPTER 4 T H E O R E T IC A L C O N TR IB U TIO N T O T H E HYBRID U SIN G TR A N SA C TIO N C O ST E C O N O M IC S , A S S E T S P E C IF IC IT Y AND T H E O R Y O F C O N T R A C T S .........................................................................................97 4.1. Introduction...................................................................................... 97 4.2. The Firm and the M arket.............................................................. 99 4.3. Cognitive Map o f Contract......................................................... 101 4.4. Simple Contracting Schema........................................................105 4.5. Pricing Theory o f Contract.........................................................110 4.6. Firms, Hybrids and H ierarchy...................................................112 4.6.1. Market Attributes...............................................................................116 vii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.6.2. Hybrid Attributes..........................................................................116 4.6.3. Hybrid Organizations...................................................................117 4.6.4. Hierarchical Attributes.......................................................................118 4.7. Expansion o f the Pricing M odel o f Contract........................... 119 4.8. Interfacing the M arket-H ybrid-H ierarchy................................125 4.9. The Economic Model o f Governance Cost as a Function o f A daptation....................................................................126 4.10. Fuzzy Systems................................................................................139 4.11. Fuzzy Theory and the H ybrid M odel...................................... 144 4.12. The Three-Dimensional Theory o f the Market- Hybrid-Hierarchy ............................................................................. 155 4.13. A G eneral Equilibrium Optim al Pricing Model o f the H ybrid......................................................................................158 4.13.1. General Equilibrium Pricing Model o f Optimal Asset Specificity.................................................................159 4.13.2. General Equilibrium Pricing Model o f Optimal Safeguards.........................................................................161 4.14. Argument Summary and T est o f Theorem 1 .........................166 CHAPTER 5 STR U C T U R A L O R G A N IZ A T IO N O F H E A L T H C A R E D E L IV E R Y SYSTEM S AND A T H E O R E T IC A L T E S T O F T H E HYBRID M O D E L ................................................172 5.1. Introduction.......................................................................................172 5.2. Clustered Control O rganization.................................................. 173 5.3. A sset Specificity............................................................................. 175 5.4. Structural Alternatives and the Theory o f the H ybrid..................................................................................................175 5.5. Characteristics o f the H ybrid....................................................... 178 5.6. Transform ation o f the H ealth Care Delivery Infrastructure..................................................................................... 183 5.7. Structural Changes in the Physician M ark et.......................... 192 viii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5.8. Structural Changes in the Hospital M a rk e t.............................208 5.9. Hospital Network E volution........................................................211 5.10. Vertical Intergration o f Health Care System s.......................225 5.11. Health Information and Clustered C ontrol............................228 5.12. Electronic Integration o f Health Care D elivery N etw orks............................................................................................ 231 5.13. Internal and External Pricing within A cute Care H ospitals............................................................................................ 233 5.14. Proposition Sum m ary and Test o f Theorem 2 ......................240 5.15. Chapter Summary and Conclusions........................................ 247 CHAPTER 6 SU M M A R Y AND C O N C L U S IO N S ..................................................... 250 6.1. Current Transaction C ost Theory o f Industrial O rganizations....................................................................................250 6.2. Acute Inpatient H ealth Care Organizational M arket R estructure.......................................................................... 253 6.3. O bjectives.........................................................................................255 B IB L IO G R A P H Y ........................................................................................256 A P P E N D IX E S ...............................................................................................264 A. H ealth Care O rganization Definitions..........................................265 B. Fuzzy Logic and the Bit C u b e ...................................................... 271 C. Definition o f Econom ic T e rm s..................................................... 273 IX Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF FIGURES Figure Page 2-1 Basic Health Maintenance Organization Structure......................................... 46 4 -1 Williamson’s Cognitive Map of Contract....................................................... 102 4-2 Williamson’s “A Simple Contracting Schema” .............................................. 106 4-3 Pricing Theory of Contract...............................................................................109 4-4 Strategic Conception of Asset Specificity...................................................... 124 4-5 Location of Asset Specificity and the Market...................................................128 4-6 Location of Asset Specificity and the Hierarchy..............................................129 4-7 Location of Asset Specificity and the Hybrid.................................................. 131 4-8 Location of ki and k2 ....................................................................................... 134 4-9 X-Y-Z Axes of K, S, and TC....................................................................... 138 4-10 Diamond Map o f Contract................................................................................146 4-11 Market-Hybrid-Hierarchy Map of Contract................................................... 148 4-12 Market-Hybrid-Hierarchy Map of Contract ki and k:...................................151 4-13 Diamond Bit Map of Market-Hybrid-Hierarchy Model of Contract............................................................................................................. 153 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. List of Figures (Continued) 4-14 Three Dimensional Model of Bit Map Model of Contract........................... 157 5-1 Cluster Control: Hierarchical Networking Reduction in Direct Contacts. First Tiers Control Second Tiers.................................................. 174 5-2 Unclustered Control Contractual Relationships 1970s to Mid 1980s................................................................................................................... 184 5-3 Transitional Cluster Contracting Mid 1980s to Mid 1990s...........................188 5-4 Clustered Control Contracting Mid 1990s to 21“ Century...........................190 5-5 1970s Structure of the Physician Market Using the Cube Model................. 197 5-6 Physician Organization ko to ki Shift Using the Cube M odel.......................201 5-7 Foundation Model of Health Care Delivery Organization............................ 203 5-8 Small Hospital Rural Health Care Delivery Model....................................... 205 5-9 Health Care Delivery Network M odel............................................................209 5-10 Level I Hospital Integration............................................................................. 213 5-11 Level II Hospital Integration........................................................................... 215 5-12 Level HI Hospital Integration.......................................................................... 216 5-13 Model of Hospital Organizational and Contractual Relations, Early 1980s, Using the Cube Model................................................................218 5-14 Hospital Organizational Model and Contractual Relationships, 1990s Using the Cube Model...........................................................................223 5-15 Inputs and Outputs of a Consolidated Patient Record System.................... 230 5-16 Networked Managed Care Systems................................................................236 XI Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF TABLES Table Page 4-1 Characteristics o f Williamson’s Cognitive Map o f Contract........................... 104 4-2 Governance Syndrome of Attributes.................................................................115 4-3 Contracting Variables............................................................................................147 4-4 Hybrid Model Arguments.................................................................................... 166 5-1 Comparison of Japanese and Western Contracting...........................................181 5-2 Key Federal Legislation........................................................................................186 5-3 Level of Hospital Integration and Corresponding Federal Legislation.............................................................................................212 5-4 Summary o f Propositions....................................................................................240 Xll Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ABSTRACT This dissertation integrates and expands economist Oliver Williamson’s theoretical work in contracts and governance between 1985 and 1991. In the theory of markets, hybrids, and firms, the governance structure is supported by a syndrome of attributes that include contract type, market disturbance and resolution, adaptation, control, incentives and asset specificity. Research emphasizes the analysis of the hybrid and the interaction of the variables of asset specificity, contractual safeguards and transaction costs to hybrid pricing optimality. A three-dimensional model of these relationships is developed using fuzzy set theory and is tested with a general equilibrium economic model of pricing. The generated theorem states that within the hybrid there is an optimal price as a result of optimal asset specificity and optimal contractual safeguards. Between 1983 and 1989, the federal government enacted extensive legislation to constrain health care costs. As a result, hospitals merged and vertically integrated into hospital systems. These managed care networks contractually bind physicians and hospitals to insurance companies. Hospitals represent the most expensive xm Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. component of care within this health care delivery network and physicians control the delivery of health care services and, thus, price and cost of care. The three- dimensional model explains the organizational restructuring of health care delivery firms into networked health maintenance organizations between the 1970s and 1990s. The application of the model is useful in describing changes in pricing as a result of transaction costs associated with asset specificity and contractual safeguards. A theoretically derived second theorem states that health care network organizational redesign and bilateral contract arrangements provide a means of reducing the health care delivery price. Findings have relevance in several areas. The modeling of the hybrid advances work in economic theories of industrial organization and provides a theoretical bridge for application to non-manufacturing, service sector organizations such as hospitals. The theoretical work is instructive to those who conduct research in transaction cost economics and make health care policy decisions. XIV Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 1 RESEARCH ON THE RESTRUCTURE AND ORGANIZATION OF HEALTH CARE DELIVERY SYSTEMS 1.1. Introduction The health care delivery system has been organizationally restructuring using an industrial organization model (i.e., horizontal and vertical integration, use of scale economies and scope, product line development and pricing); the result is oligopoly. Concepts such as transaction cost economics, asset specificity, and contractual organizational models provide the ability to perform a system-level analysis of organizational form, development and survival drawn from the mutually inclusive economic framework that allows comparative study. The body of knowledge contained within the theories of industrial organization has produced sophisticated models in explaining the emergence of firms, organizations, and hierarchy. In neoclassic market theory, certain assumptions about economic models of individual choice, organizational form, behavior and theory have been proposed to explain why firms emerge from markets. The demarcation of the firms' boundaries, 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. individual economic behavior within firms, transaction cost and contractual theories seek to explain why individuals work for firms instead o f themselves as individual entrepreneurs. The transaction cost approach argues that individuals within firms will minimize transaction costs and select hierarchy over markets. Firms emerge when there are decreasing returns to the individual entrepreneurial function. Governance structures internalize transaction costs in coordinating and mediating exchange. Health care economic theorists have given little attention to this research direction. While the health care economics literature is thick with a 25-year history of microeconomic theory, relatively little has been written about health organizations, markets, and governance using transaction cost theories and models. The type of institutional-level economic modeling Oliver Williamson^’ ^ proposed is important to the study of health care delivery because current economic organization and change can be explained by this model regardless o f governance structure. This allows economic and contractual theory to serve as a bridge fi"om the theories of industrial organizations to nonprofit health organizations with a different developmental history fi'om that of industrial organization. As a result, new and alternative health delivery and policy options may develop. ^ Williamson, Oliver, “Comparative Economic Organization: The Analysis of Discrete Structural Mtsxnatxw^" Administrative Science Quarterly, 36 (June, 1991): 269-296. ^ Williamson, Oliver, The Economic Institutions o f Capitalism (New York, NY: The Free Press, 1985). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. If the tools of political economy can provide an explanation o f the organizational changes that have occurred in the health care delivery systems, then development of health care policy options and predictions of health care systems outcomes based on this theory would be a major contribution to institutional economics and the economic theories of health care organizations. This dissertation focuses on two major issues— expansion of institutional economic organization theory to integrated health care networks and the effects of organizational restructuring on market pricing and brokering of acute care inpatient services. 1.2. Statement of the Problem As it exists today, the health care system is a myriad of public/private organizations, quasi-public/private entities, multiple self-interested groups and parties that interact together to provide health and medical care. The industry comprises approximately one-seventh of the U.S. economy. In spite of the amount of money in the system and the wide array o f service delivery components, approximately 15% of the population (37-40 million U.S. citizens) have difficulty conventionally accessing the system. This is because (1) high service delivery prices reflect the health care costs institutionalized and embedded in the economy and (2) they are not eligible for government-sponsored public assistance programs that cover these costs. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Many of the incentives on how much is spent on the health care system have come through federal legislation. Two broad areas of fiscal constraint have been driven by both the public and private sector payer sources; (I) a mixture of incentives that control physician behavior in ordering and providing services and (2) incentives that control public and private payments through capitated rate setting using prospective rather than retrospective payment schemes. These imposed fiscal controls shape the organization of health and medical services in three areas: (1) determination o f the amount spent on health and medical services and the composition of those services, (2) selection of the best method for producing health services, including capital and equipment use relative to amounts and types of labor to provide the service, and (3) selection of a method for distributing health care services among the population. Points one and two concern efficiency; point three concerns equity.^ The dilemma of whether the health care system should move in the direction of a system of expanded provision of a publicly-funded private good or continue as a market-based private system has recently been at the center of national policy debate. Framing the policy debate in terms o f these two options has stymied health care reform progress. If health care reform issues were framed using the economic tools of industrial organization and political economy, this might broaden the array of proposals and alternative options and allow acceptable compromise positions. ^ Feldstein, Paul, Health Care Economics, 4th ed, (Albany New York: Delinar Publishers, 1993). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The health care field does yet not draw upon the wide array of transaction cost economic tools for its economic and policy analyses. In the environment of a rapidly changing and market-driven health care system, the government often imposes regulations requiring health care delivery organizations to respond. This process has had an interesting impact on the State of California which has moved rapidly to embrace the concepts of “managed care” to replace the traditional fee-for- service model for health care provision. The State made this move to slow rising health care costs and improve delivery efficiencies. The rapidity with which California has converted to managed care has left little time to analyze the implications of legislation which has shaped these changes and the consequences of the resulting reorganized systems. This is especially true in evaluating the economic consequences as the numerous independent hospitals have been merged into large hospital systems. The economics of industrial organizations and the microeconomics o f health care organizations have been theoretically developed parallel to each other. In order for Williamson's theory o f discrete structural alternatives to be tested on health care organizations, a bridge must be made between industrial organization theory and the system within which health care organizations operate. The lack of a conceptual bridge between these two bodies of economic knowledge has produced a theoretical hole. Health care economists have not yet tapped the rich literature and economic techniques in the theory of property rights, asset specificity, organizational form and innovation. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Additionally, over time the conceptual language that shifted from medical to health care (and potential conceptual economic outcomes) has not been clearly delineated (i.e.. Are health and medical care the same or different?). The term “medical care” implies a diseased state that must be cured. The term “health care” implies a state o f well being that must be maintained. These terms are used loosely and interchangeably in the literature, yet they are different concepts. Economically, they imply differing concepts of production input and output, supply and demand, substitutable and alternative products, risk-sharing and risk aversion, principal-agent theory and outcomes, policy development, social problems, and other issues not enumerated here. For example, medical care organizations were originally funded by insurance payment mechanisms based upon the risk pooling of a population segment under the medical care model. Government payment mechanisms were not originally designed with cost constraining controls that led to the cost o f medical care rising faster than the cost of living in the 1970s and mid 1980s. Government interventive measures of prospective reimbursement, based upon diagnosis o f related groups, slowed the rising costs of medical care. Current “health care” funding continues to be derived fi'om old medical care compensation models, but conceptual shifts in the delivery o f health rather than medical care, which may be clouding the economics, led to the restructuring o f the health care delivery organizations within the system. Current microeconomics of medical/health care research barely utilizes any of the current microeconomic organizational theory tools o f Williamson and the 6 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. associated line of research developed. To address this gap, two main questions arise; (1) Can the institutional economic theory tools and models be applied to health care organizations? and (2) How will such models help to elucidate and consolidate current microeconomic health care organizational theory to advance knowledge in the fields of both institutional economics in general and health care organizations specifically? 1.3. Research Questions and Objectives This dissertation examined, expanded and tested the theory of industrial organization and transaction costs, developed a model, and derived two theorems developed fi'om application of the model. The theoretical level develops and extends the work of Oliver Williamson in comparative institutional analysis by (1) developing an optimal pricing model, (2) linking Williamson's work to that of Toshihiro Nishiguchi"* as he refines Williamson's ideas in asset specificity and develops his own clustered-control organizational model of bilateral contracting and (3) integrating and extending models of the industrial organization sector to the service sector via a pricing model of asset specificity, contractual safeguards and transaction costs. The model is then used to explain health care organizational design. 4 Nishiguchi, Toshihiro, Strategic Industrial Sourcing: The Japanese Advantage (New York, NY: Oxford University Press, 1994). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The research direction led to the following questions: 1.3.1. Questions Regarding the Current Transaction Cost Theory of Industrial Organizations: • Can elements of organizational theory that are useful in the study o f industrial organizations be used to study health care organizations? • Can an optimal pricing model be developed on the basis o f Williamson's comparative organization theory based on his work between 1985 and 1991? • What is the usefulness o f Williamson's theory of interfirm contractual relationships in defining further changes in the acute inpatient health care delivery system? 1.3.2. Questions Regarding Acute Inpatient Health Care Organization Restructuring in the Market: • Can a comparative institutional system level of analysis be developed for health care organizations that identifies organizational restructuring in response to market changes that correspond to Williamson's contractual- govemance model? Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. • Did the 1980s competitive market, which produced multiple organizational forms and alternative goods and services, lead to greater organizational efficiency through organizational integration in the 1990s as defined by a competitive pricing model? • What are the economic and fiscal effects o f vertical integration of the hospital market from that of freestanding hospitals to hospital systems? Did this organizational response actually contain costs, or was it a market-environmental response to federal legislation and an organizational response to capture diminishing federal, state and private reimbursement dollars? • Are these restructured and reorganized health care delivery systems leading to a regulated oligopolistic market? For example, is vertical integration of health care organizations into health care systems leading to regulated oligopoly? 1.3.3. Theory and Model Objectives This dissertation extends the work of Oliver Williamson's discriminating alignment hypothesis of transaction cost economics and first order economizing through a general equilibrium model. This model further defines “hybrid” organization efficiency as optimal price p* with optimal asset specificity k* and optimal contractual safeguards s* on the basis of optimal level of transaction costs 9 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (te*). This new model o f the hybrid is linked to Toshihiro Nishiguchi's asset specificity and organizational design model which determines that optimal inter-firm pricing relationships are based upon cooperative bilateral contracting through organizational clustered-control mechanisms. 1.3.4. What the Research Objectives Accomplished If the objectives are met, expansion of Williamson’s work between 1985- 1991 can lead to the development of a new, generic theory of the hybrid, and a general equilibrium hybrid optimal pricing and contract model. A bridge of the theories of industrial organizations to the service sector generally and the health care sector specifically is accomplished. This bridge provides for the application of the new hybrid model to health care organizational design and service pricing. 1.3.5. Theory Development Theory development integrates and extends Williamson’s work in economic transaction cost theory and organizational control models. A new theory of the “hybrid” and general equilibrium contracting and pricing model was developed using fiizzy set theory. Within this framework, the analytical tools of transaction cost economics, which differ in their attributes with respect to governance structure, property rights and asset specificity, are explored. 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Applicability o f the new model is determined by using these concepts to explain internalizing health care transactions within mediating and integrated structures. It explains the transformation of acute care hospitals as part of integrated delivery networks; organization of physicians within firms; and contract law as it pertains to interfirm acute care inpatient economic organization, principal-agent relationships, and incentives and assumption of risk. 1.4. Research Design The Williamson model explores the firm as a result of the interface between markets and hierarchy in which each generic form of firm governance is shown to rest on a distinctive form o f contract law. Williamson proposes three organizational types that include market, hybrid and hierarchy. Within this model are joined the three streams of institutional economics, institutional environment and the institution o f governance to develop parameters to evaluate shifts in the comparative cost of governance within an equilibrium framework. In organizational theory, the focus of inquiry is on the organization and on how an organization functions both internally in its coordinating and control relationships, and in its market environment. Oliver Williamson’s work in discrete structural alternatives focuses on the economic and contractual theory of the hybrid as an intermediate form between markets and hierarchies. This research examines 11 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the relationship of price to asset specificity and contractual safeguards within the hybrid. In model development, this research advances Williamson's work in organizational hybrids and produces a new structural model of the market-hybrid- hierarchy modes. This new model explains the nature of the hybrid as an intermediate mode between market and hierarchy and explores the relationship between asset specificity, contractual safeguards and transaction costs to price. Bilateral contracting theory is integral to explaining these relationships within the hybrid mode. Mathematically modeling optimality o f price within the hybrid as a result of optimizing asset specificity, contractual safeguards and transaction costs advance the argument for the new structural model. 1.5. Theorems Transaction cost analysis, contract theory, principal-agent theory, Williamson’s comparative economic organization theory of discrete structural forms, and the new model of the hybrid contract/pricing model can be used to analyze health care organizational pricing gains through systems integration. It is suspected that monopolistic power lies within the insurance plans and not the health care delivery organizations with which they contract payer rates. It is also suspected that integration of hospitals into multi-hospital health systems has produced oligopolies as a result of franchise bidding through contract negotiations with preferred provider organizations. Contractual and pricing inefficiencies between health care delivery 12 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and reimbursement firms arise fi'om information asymmetries between the employers who contract with the insurance plans and insurance plans that contract with the direct delivery organizations. These suspicions led to the following theorems that were tested by this dissertation. 1.5.1. Theorem 1 There is an optimal price p* that can be found within the hybrid and that results from the interactions o f optimal asset specificity k*, optimal contractual safeguards s* and optimal transaction costs tc*. 1.5.2. Theorem 2 Organizational redesign of physicians, acute care hospitals, and insurance plans into integrated health maintenance organizations and bilateral contract arrangements provides a means of reducing the health care delivery price. 1.6. Instrumentation Proof of the first theorem is through a series of theoretical arguments supporting the new structural model of the hybrid. Using an expanded version of Williamson’s map of contract, fuzzy set theory, and mathematical analyses, the researcher constructs a model to identify the variables and conditions for optimal pricing. 13 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Testing the second theorem is through application of the model to organizations within integrated health care delivery systems. Theorem two is theoretically tested through a series of propositions that result from application of the new model. The unit of analysis for both hypotheses is the firm or health care organization. 1.7. Limitations of the Study The boundary of this study stops short of including game theory, specifically any “prisoner’s dilemma” analysis. The economic theory does not include production frontiers. In Williamson’s definition, transaction cost economics is first- order economics and works outside of the second-order economic production function. Conceptually, production functions are offered for illustration only (and at the transaction cost/production function interface) as the need arises; the basic unit of analysis is the firm (organization). 14 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 2 HEALTH CARE REGULATION AND PRICE COMPETITION This chapter examines the interaction of five health care systems, the influence of federal government regulation and competition on those systems, and the role of price competition in stemming rising health care delivery costs. Five major health care systems developed simultaneously in the first half of this century:^ science and technology; physician and medical education; hospitals, as centers for patient care; insurance, in the form of prepaid membership plans,^ and trade associations. All of these organizing activities were in place by the end of the 1930s. The developmental history and economic impact of each system are separately discussed. However, these five systems are inextricably bound in explaining the current health care market, the role of government, and the economics, financing and operations o f health care individuals and organizations. ^ Starr, Paul, The Social Transformation o f American Xfedicine (New York: Basic Books, Inc.,1982; NY, originally published in 1982). ^ The first prepaid medical insurance plan was developed in 1934 by a group of teachers from Baylor College. The Blue Cross plan was a nonprofit membership risk-pooling plan tliat paid hospital bills for its members. This plan was developed at tlie urging of tlie American Hospital Association. Blue Shield, a similar plan for physicians, was developed shortly tliereaher. 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.1. The Health Care Technology System In the early part of the century scientific discovery and technical change revolved around improving public health, curing communicable diseases and improving sanitation. By the middle o f the century the discovery and use o f sterile techniques, vaccinations and antibiotics were major technical advances that greatly improved patient care. In medical care, technical change has usually meant that patients who formerly could not be treated can now be cared for, and current illnesses have a higher probability o f a successful cure or a shorter patient recovery period. For example, by the latter half of the century, surgical and medical advances in treating heart disease and cancer increased and prolonged patient longevity. Scientific advances in the treatment of Acquired Immunodeficiency Disorder (AIDS) improved patient survivability. Technical change is usually measured as greater output that is produced with the same or less input. In health care, technical change has usually meant that illnesses that formerly could not be cured, can now be cared for and current illnesses have a higher probability of a successful cure or a shorter patient recovery period. Such technical change often expresses itself through a change in medical care output and may result in increased rather than decreased use of inputs such as diagnostic imaging equipment. Another example o f technical change that has led to a decrease 16 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. in inputs is the use o f new drugs, which have decreased the use o f more expensive institutional care. Both types of change occur in medical care.^ Hospitals also provide expensive technological outputs. For example, the number o f hospitals offering organ transplantation rose 100% from 244 hospitals in 1984 to 489 hospitals in 1989.* Joseph Newhouse^ argues that the main cost driver for health care is new technology and its ability to increase medicine's capabilities. He cites innovative examples such as noninvasive imaging, invasive cardiology, transplantation, monoclonal antibodies and renal dialysis contributing to the dramatic increases in costs over time. Hospitals compete with each other for physicians and for patients based in large measure on factors other than price, including available technologies and the amenities offered. An alternative explanation to Newhouse’s argument is that in a competitive market, competition is desirable. In a less competitive environment, it can lead to proliferating technologies, diminished incremental benefits and amenities that significantly raise health care costs. Because consumers are insulated from the cost of medical care through third party payer systems, price may not be a factor in selecting a hospital or physician. Hospitals market to physicians and patients based ^ Feldstein, 42. * Ibid., 221. 9 Newhouse, Joseph, “An Iconoclastic View of Health Cost Containment,” Health Affairs, 12 (1993): Supplement, 152-171. 17 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. on services and technologies offered. New technologies revolutionize the way health care is being practiced. Burton Wiesbrod^® demonstrates how the expansion o f health care insurance has paid for the development of cost increasing technologies and how the new technologies have expanded the demand for insurance. Wiesbrod asserts that the expansion of HMOs and the adoption of the DRG system of hospital pricing have altered the incentives to use existing health care resources and for the research and development sector to invest in developing medical care techniques that are of higher quality but are also more costly. Wiesbrod's article reflects on the dynamic interplay o f incentives for the research and development sector to develop particular kinds of new technologies. The central focus is on technological change as an independent variable causing changes in the form and extent of insurance coverage. Technological change can also be viewed as a dependent variable being influenced by incentives operating through the health insurance system. Wiesbrod argues that advancement in medical technology involving both diagnostics and treatment has been a driving force behind the rapid growth of health Wiesbrod, Burton, “Tlie Health Care Quadrillema: An Essay on Technological Change, Insurance, Quality of Care, and Cost Containment,” w/buma/ o f Economic Literature (June, 1991): 523-552. 18 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. care expenditures.** Consumer demand for technology improvement comes through the demand for broader health insurance coverage. The form of insurance affects the direction of research and development in terms of quality care relative to cost and the incentive to search for methods to treat the ill rather than to prevent their illness. 2.2. The Physician System As urbanization, science and technology in medicine and public health advanced through the early part of the 20th century, it became more efficient for patients to visit the physician rather than for the physician to go to the patient's house. Hospitals developed in tandem with this concept of concentrating physician labor in a single location. Training for the apprentice physician was one-on-one with another physician. The development of medical schools subsequently replaced that practice. The developmental history of the physician market is that from the (independent) soie-proprietor, private-for-profit business or business corporation forms of business organization. Ibid., "Tlie Health Care Quadrilemma,” 534-539. If a previously untrcatable condition becomes treatable, a possible outcome is that an indiiidual could encounter a larger, but unpredictable medical care expense for ueatment than was previously tlie case. A new technology can also decrease the cost of treatment; however, if demand increases for die new technology coincidental to a continued demand for the old more expensive technology, overall technology expenditures can continue to increase. Thus, both the mean and variance of an individual's health care expenditures associated with that condition could increase. Retrospective reimbursement has tended to send the signal to the research and deielopment system to develop new technologies that enliance die quality of care regardless of the eficcts on cost. 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This is an important concept economically. (1) The physician is not just in the business of selling medical knowledge, but he/she has exclusive access to methods of treatment such as pharmaceuticals. (2) The outpatient part of the practice is private and for-profit, but activities within the hospitals are carried out in non profit institutions. (3) Licensure and restrictions for practice (through limited supply of individuals who could go to medical school) create entry barriers so that physician supply can be limited. As a result, physicians can price in excess of marginal costs so that what appears to be a competitive market is actually monopolistic competition; A competitive model depends upon free entry, many firms producing homogeneous products and differences in costs to explain differences in price. When the cost-price mechanism fails, the economist looks for differences in price elasticity of demand. The monopoly model of pricing can be used to explain both variations and increases in physician fees when there is a decrease in the price elasticity of demand. The physician services market is believed to be characteristic of “monopolistic competition” both because o f the large number of competitors within a market and because each has a somewhat differentiated service, thereby providing a downward sloping demand curve. . . . Neither physicians nor their services are homogeneous. . . . [L]ack of information on competing physicians results in other physicians being less substitutable to the person’s own physician . . . [and the existence of] a monopoly model of physician pricing behavior (physician prices in excess of marginal costs).* * ^ Feldstein, 183-185. * ^ Ibid., 183-184. 20 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Up until approximately the middle half of the century, physician services were purchased through self-paying individuals. The market for inpatient hospital insurance was developing, but outpatient insurance coverage lagged behind.*"* Further, both the physician and insurance markets were developing as private sector businesses. The concept of insurance is raised at this point for only one reason. As the health insurance market matured through the 1950s and 1960s, increasing numbers of employers offered health insurance as a benefit of employment. In effect the patient stopped paying the entire bill. The bill was sent from the physician (or hospital) to the third party fiscal intermediary (the insurance company) who paid the bill once the charge was incurred. The payment scale was based on “usual, customary and reasonable” (UCR) charges. Further, it was the insurance companies who set the UCR compensation rates, but they did so by surveying the physicians (who were already operating in a competitive monopolistic market). The patient had to pay what was not covered by the bill, which amounted, on average and after a deductible, to about 20% o f the total. Accounts of the failure of the physician market include barriers to entry because of limited slots in medical school; barriers to direct treatment modalities (direct consumer purchasing) because of the licensing and regulation requirements; 14 The concept of insurance risk pooling worked for hospitalizations much better than for the outpatient maikeL Only a segment of those paying the premiums would be hospitalized at any given time. The premiums of the many cover utilization by the few. The advantages and disadvantages of insurance as a mechanism now will be explored in the section on insurance markets. Tlie insurance market fails when everyone is at risk for using tlie services. 21 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. long-term and inelastic demand because the consumer was insulated from the true cost of health care via the insurance mechanism; UCR practices that actually encouraged a monopoly rather than competition. Retrospective cost-based reimbursement (payments after the fact without an up-front estimate) provided incentives to expand the health care labor pool in all labor sectors. Rapid advances in medical technology, the rise of the medical specialist, specialty medical technologists, and increases in allied health practitioners occurred throughout the 1970s. Each additional licensed or certified medical specialty or subspecialty warranted higher compensation that limited the available labor pool and led to increasing labor costs. Greater medical subspecialization led to the formation of more specialty practice groups. The expansion o f physician supply between the mid-1970s and mid-1980s did not increase access for the population. The aggregate physician patient care hours and real revenues grew approximately in proportion to physician supply leading to inflationary effects on the economy at that time. Physicians were spending considerably more time and providing considerably more services per visit during this period. An important reason for the steady increase in spending on physicians is the regular growth in the numbers of doctors. Whereas the government presses for expenditure goals that stabilize the health sector's share of the total economy, the Pope, Gregoiy C., “Physician Inputs, Outputs, and Productivity, 1976-1986,” Inquiry (Summer 1990): 151-160. 22 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. medical association has a different aim—to protect the income of the average doctor. This forces payers to supply more money as the number of doctors grows. Much of the regulatory efforts between the mid-1980’s and now are attempts to pressure the physician market in the direction of a truly competitive market.*^ This is being accomplished through public sponsored reimbursement programs (primarily MediCare)/* with private insurance companies following suit.^^ Limiting and reducing reimbursement to hospitals and physicians through prospective and fixed reimbursement mechanisms have placed economic pressures on the hospitals to monitor the economic activities of the physicians who use their facilities. Economic pressures fi'om employers are placed on the insurance companies to bargain and broker reduced premium and service delivery costs. The idealistic view places physicians in the position of practicing medicine with a commitment to the patient, to place the latter’s interest above that of the Glaser, William A., “How Expenditure Caps and Expenditure Targets Really Work,” The Milbank Quarterly, Vol. 71, No. 1 (1993): 97-127. Monopolistic competitive equilibriiun reveals excess capacity but, if there are several firms and the goods produced are all very close substitutes so that the demand curv’ e facing each firm is flat, in the long run, tlte monopolistic competitive equilibrium is near tlie perfect market competitive equilibrium. In effect this is what is happening as physicians (voluntarily and involuntarily) join preferred provider organizations (PPOs) and independent practice associations. Tliis topic is a thread that will be explored later in discussing the hospital, insurance, and health maintenance organization madcets. 18 In 1984, as part of the Deficit Reduction Act, Medicare physician fees were frozen for 15 months. Physicians who wanted to participate as MediCare providers had to “accept assignment” This meant they could not bill (a term referred to as balance billing) or recover payment from their patients for any services rendered or charges inctured which were not covered through MediCare. 19 Holahait Jolm, and Stephen Zuckerman, “Medicare M andatory Assignment: An Unnecessary Risk?,” Health Affairs, 8 (1) (Spring, 1989): 65-79. 23 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. physician's, and always do what is in the patient’s best interest to the best of the physician’s ability. The economic view holds that physicians as business proprietors have the same economic self-interest of any other purveyor of goods and services.^® The patient-physician relationship is a classic example of a principal-agent relationship. The principal-agent relationship between physician and patient is explored in an article by Dranove and White who ask. Why can’t an incentive system be established in which the patient does not have to pay if the patient is not cured? This would compel the physician to behave in the least-cost manner. They conclude the system can’t be established because of information asymmetries. Clinical indications are difficult for the patient to observe so he/she doesn't know what outcome to expect. The patient may fake the symptoms so that he doesn’t have to pay when the expected outcome is not realized. Also, there would be great income uncertainty for the physician, and contracting and monitoring costs would be economically prohibitive.^^ Hillman, who suggests that the physician is not only the agent of the patient but also the agent of the organization, explores management monitoring and compliance (both his own and the hospital at which he is privileged).^^ Reiman, Arnold S., and Uwc Rheinhardt, “Debating For-Profit Health Care and the Ethics of Physicians,” Health Affairs, 5 (Summer, 1986); 5-31. Dranove, David, and William White, “Agency and the Organization of Health Care Deliveiy,” Inquiry, 24 (1987): 405-415. 22 Hillman, Alan, “Managing the Physician: Rules versus Incentives,” Health Affairs (Winter, 1991): 138-146. 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As agent for the patient, the physician manages the patient’s illness with the responsibility for deciding which components to use in providing treatment. Mitchell, Wedig and Cromwell argue that as agents of their patients, physicians render professional judgment regarding the use of medical services. Professional norms call for the provision of all beneficial services, but physicians paid on a fee- for-service basis have a financial incentive to provide more service in contrast to doctors paid on a capitated basis with a financial incentive to undertreat.^ The physician acts as a contractor, retaining what is left over after all o f the inputs have been paid. The physician is the manager of the patient’s illness, with responsibility for deciding upon the components to be used in providing treatment. As someone with a stake in what inputs are used, the physician might also be expected to combine the treatment inputs in such a manner so as to increase income and/or productivity. This market-oriented, profit-maximizing model of physician-as- entrepreneur can explain a number of economic anomalies in the medical field. Through hospital staff appointments, hospital services may be duplicative and unnecessary procedures performed to increase physician productivity and income.^"' However, the demand inducement model can be rebutted. Physicians have to be 23 Mitchell, Janet B., Gerard Wedig, and Jerry Cromwell, “Tlie Medicare Physician Free Freeze: What Really Happened?” Health Affairs (Spring, 1989): 21-33. Feldstein, 180-188. 25 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. carefijl. The reputation effect with peer review and monitoring could label a physician as one who overutilizes services. An alternate view to the economics of health care organizations and the professionals within them is provided in Deborah Ann Savage’s 1993 doctoral dissertation.^^ She explores the theory o f professions and the lack o f an appropriate model. According to her, the professions do not fall neatly into the theory of the firm or the market. Savage offers an alternative explanation to Feldstein’s cartel economic theory of the firm (hospitals) and the professionals (doctors) who practice within them. She argues that economic theories of the firm fail to explain the professions' existence and acceptance by society. Nor do these theories explain the relationship o f the profession as a group or the members as individuals. Economic theory fails to take into account professional knowledge in society and how that knowledge is transmitted. In health care, consumers face asymmetric information and externalities of professional production. On the other hand, professionals often have responsibilities (both tacit and contractual), and their interests may conflict with those of the consumer (i.e., physicians must consider their obligations to hospitals and third party payers when making decisions). Dranove, Da\ad, “Demand Inducement and the Physician/Patient Relationsliip.” Economic Inquiry, 26 (2) (April 1988): 281-298. Dranove argues tliat overutilizing services could give the physician reputation as someone who overprescribes medical tests and ueaunents. Savage, Deborah Ann, “Change and Response: An Economic Theory of Professions with an Application to Pharmacy,” Unpublished Dissertation, University of Connecticut, 1993. 26 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Savage promotes her own definition of a profession as a network of strategic alliances across ownership boundaries among independent practitioners sharing core competencies. Finally, Savage argues against the cartel theory noting that members of professions want to maximize the value of their membership. Networks rely on peer monitoring, reputations are flexible with informal as well as formal review mechanisms and the reputation effect creates disincentives and sanctions for bad behaviors. 2.3. The Hospital System Hospitals initially developed as charitable institutions.^^ In the 1950s hospital construction and expansion occurred as a result o f the national Hill-Burton Act which provided public hospital construction and expansion funds in both urban and rural areas. In 1992, 6,185 of the 6,720 hospitals listed by the American Hospital Association were classified as short-term hospitals. The major types of services offered by this category of hospital were general, psychiatric, and tuberculosis/other respiratory disease; 91% of short-term hospitals were classified as general hospitals. O f these hospitals, 55.4% were not-for-profit; 31.7% were governmental, 26.3% state/local controlled, 5.4% federal; and 12.8% were for-profit.^* 27 Most U.S. hospitals continue to retain tlieir 501(c)(3) nonprofit tax code status. Feldstein, 215-216. 27 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hospitals receive more than half o f their funding from federally sponsored insurance programs (Medicare and Medicaid). Private insurance reimbursement provides the bulk o f the remaining funds. Blue Cross was introduced in the mid- 1930s as the first pre-paid membership hospital insurance plan. In the mid-1960s, extension of hospital insurance benefits was provided to the elderly and poor through Medicare and Medicaid. The introduction and effects of Medicare, Medicaid, and private insurance on changing hospital patient mix have been readily apparent.^^ Medicare and Medicaid removed the incentive o f the aged and the poor to be concerned with the cost of hospital care. On the private side. Blue Cross removed any concerns over hospital prices by those with such insurance. . . . As the concern over prices was removed from patients and as budget constraints were removed from hospitals, the necessity o f either party to make choices was eliminated.^° In the 1980s, the government introduced legislation to change and improve the competitive nature o f the hospital market. Medicare prices were fixed, and there was greater price competition for patients in the private insurance market. The effect was to change the incentives facing hospitals. If hospitals did not act to minimize their costs, they could not compete. Hospital markets had not been price competitive markets: 29 R affert>', John, “Enfinnchisement and Rationing Effects of Medicare on Discretionary Hospital Use,” Health Services Research (Spring 1975): 51-65. Feldstein, 250-251. 28 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Purchasers o f hospital care have had little information on prices and quality; patients have not been price sensitive because o f extensive hospital insurance; hospitals were reimbursed their costs; prices were not indicative of different levels o f quality; and because the out-of-pocket price paid by the patient was very low, too much care was demanded. . . . Quality was also perceived in terms of process or structural measures, such as the latest technology, rather than by outcomes o f medical service. Non-inpatient operations such as outpatient services for lab and radiology diagnostics, pharmacies, surgeries, and visits, continued to contribute heavily to hospital profitability in the late 1980s, although the profitability o f these services was also declining.The increase in hospital outpatient services has occurred for two reasons. (1) Third-party payers attempted to decrease the use of the most costly component of care, the hospital, by expanding insurance coverage to the outpatient setting. (2) Insurers have instituted utilization review mechanisms to ensure that outpatient procedures are used over inpatient procedures.^^ Changes in the reimbursement system are moving hospitals into complementary product lines. Under a fixed-price reimbursement system, hospitals now have the incentive to discharge Medicare patients sooner to other institutional settings such as nursing homes and home care. This allows the hospital to receive Ibid., 248. Ibid., 236. This change has been facilitated by technology changes tliat permit more procedures to be shifted from the hospital to the outpatient setting. 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. additional reimbursement for care in those settings as owners in integrated systems. By vertically integrating into related products, the multihospital system is then able to approach employers and offer a complete product line with broad geographic coverage. The next step in the process of vertical integration will be for the multihospital system to bear some risk such as offering insurance coverage to the employers in their areas. Moreover, insurers and employers are developing their own sophisticated data systems that will enable them to determine the clinical outcomes for specific services within a hospital to determine levels of risk.^** Over 70% of health care funding goes to hospitals and physicians. The physician is the manager of the patient’s illness, with responsibility for deciding upon the components to be used in providing treatment within the hospital setting. According to Feldstein, the profit-maximizing model of the physician can be used to explain a number of apparent anomalies in the medical field. The medical staff o f a hospital is assumed to control the hospital under this model; the decisions undertaken by the hospital represent the objectives of the staff physicians. If the demand for medical care were to increase, it would be in the physicians’ interest that it be met by an increase in hospital capacity, which would increase the physicians’ productivity rather than the number of physicians. Staff physicians who do not have staff appointments at other hospitals would favor hospital investment.^^ ^ Feldstein, 254-256. Ibid., 241-240. 30 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The view of consumer demand for medical care assumes that the total price of medical care is the relevant price to the consumer, not the individual price of specific inputs such as hospital care. If two inputs are used in providing a medical treatment— hospital and physician services—then, given the patient's demand for medical care and an average-cost curve which represents the cost of hospital care, the difference between the price charged the patient and the amount that goes to pay the hospital is available to the physician. The physician acts as a contractor, retaining the amount left over after all inputs have been paid.^^ Within the hospital, changes in the organization of production and the organizational structure of the firm delivering medical services have been affected by the following: economies of scale and scope, regulations affecting entry into a market, payment systems, the applicability of antitrust laws, and the nature of transaction costs. Increased interdependence among the various providers, suppliers, and insurers has resulted in attempts to lower the transaction costs of these relationships. The development of sophisticated data systems that integrate clinical and financial information on each patient by specific providers has improved hospitals and insurers' ability to evaluate different providers. With the need for greater certainty in relationships, control of costs, and referrals of patients, this information has enabled hospitals and insurers to select providers with whom they prefer to have closer relationships that may occur through ownership or exclusive ar- Ibid., 242. 31 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. rangements. The consequence has been an increase in vertical integration in the financing and delivery o f medical services. As the cost of health care delivery has continued to rise, increasing numbers of hospitals and physicians have integrated their services. The hospital is no longer the focal point o f delivery as it has been in the past. This evolution started as hospitals merged to form multihospital systems in the 1980s, and developed a corporate structure for oversight of these multihospital systems. In the 1990s, the regional medical campus idea has emerged in which the corporate health care system is comprised of hospitals, clinics, urgent care centers, ancillary services, long-term care services, and emergency services. 2.4. The Insurance System The oldest and largest part of the social insurance system is the Old Age and Survivors Insurance (OASI) enacted in 1935, extending benefits to disabled and retired workers. National unemployment insurance came into existence as part of the 1935 Social Security Act. In 1929, a group o f teachers at Baylor University in Texas formed a group to pre-pay membership into a hospital insurance plan provided by Blue Cross. The establishment of a pre-paid membership insurance plan followed this for outpatient services provided by Blue Shield. Prepaid membership health Ibid., 234. 32 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. plans were so successful that labor unions negotiated for expanded medical and health care insurance benefits through such plans to their members.^* In 1965 and 1966 Congress amended the Social Security Act to provide health care benefits, through Medicare and Medicaid, to the elderly and poor. Social security is a transfer-payment retirement system. The Medicare part o f this system provides health insurance for the aged. Benefits are divided into two parts— hospitalization costs fully paid by the program and outpatient physician services which is an optional service benefit purchased by the individual but heavily subsidized by the Federal government. Medicare is funded by pay-as-you-go, redistributive taxation. The Medicaid program is paid for through an income tax transfer fund. Medicaid is a joint federal-state undertaking with the federal government matching state outlays by 50% or more, depending on the state’s per capita income and other factors. Medicaid provides health insurance for indigents but is not supported by premium payments by individuals. Rather it is paid for by general tax revenues. Medicaid is considered a welfare program rather than a social 39 insurance program. In 1973, the federal government passed the Health Maintenance Organization Act that required businesses with more than twenty-five employees to offer at least one qualifying HMO as an alternative to conventional insurance in their health Stair, 295-334. 39 Meier, Kennetli J., The Political Economy o f Regulation: The Case o f Insurance, Peter Colby, ed. (Albany, NY.: State University of New York Press, 1988). 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. benefit plan. If there wasn’t a qualifying HMO in the vicinity, the law provided grants and loans to develop new HMOs. The HMOs were required to charge all subscribers the same community rate and to allow open enrollment o f individuals, regardless of health, for at least thirty days once a year."*® The effect of these activities was an expansion of employer- and federal government-sponsored health insurance between the mid-1960's and early 1970s. Health care legislation passed in the 98th and 99th Congresses shifted the method of payment of Medicare benefits from retrospective to prospective reimbursement. In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) cut Medicare payments to providers, but it liberalized Medicare payment methods to Health Maintenance Organizations. In 1983, Congress amended Title VT of the Social Security Act to provide for a prospective payment system (PPS) which paid a set amount on the basis of the diagnostic related groupings of illness (DRGs). Provisions were made for a three- to four-year phase in period, and DRG adjustments were tied to the wage index. In FY 86 PPS payments to hospitals were frozen at 1985 levels. An urban-rural hospital payment differential was established based on wage indices. Exceptions to the PPS reimbursement system were cancer hospitals, psychiatric hospitals, alcohol and drug rehabilitation hospitals, children's hospitals and long-term care hospitals. Hospitals that took a disproportionate share 40 Starr, 400-401. 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. o f low-income payments were compensated at a higher rate. These different reimbursement systems led to a proliferation of specialty hospitals. Insurance plans are developed and premiums calculated through predictions o f risk. Kenneth Arrow is one of the best known economists in studying risk theory. His seminal work in 1 9 63*** tackled a number of questions regarding insurance. In analyzing the medical care market and risk. Arrow refers to the optimality theorem.**^ If the actual market differs significantly from the competitive model, the resource allocation process becomes, in most cases, impossible to complete an efficient outcome. When risk bearing is introduced, it can be extended to cover risk, but the commodity o f desired protection against many risks is not available.**^ Associated with such risk bearing is the level o f uncertainty such that information or knowledge becomes a commodity that has a cost of production and a cost of transmission. The individuals who establish the cost o f information are those who can most profit from this knowledge. This information, the form of skilled care, is what is bought from physicians. The elusive character of medical information as a commodity means that there is information asymmetry that exists between buyer (patient) and seller 41 Arrow, Kenneth, “Uncertainty and the Welfare Economics of Medical Care,” American Economics Review, 53 (1963): 941-973. Reprinted in Issues in Health Economics, eds. Roice Luke and Jeffrey L. Bauer (Aspen Publications, 1982). 42 The optimality theorem: Competitive equilibrium exists if (1) market efficiency is Pareto optimal and (2) the competitive equilibrium corresponds to some initial distribution of purchasing power such tliat tliere are no increasing returns in production. 43 Arrow, “Uncertainty and the W elfare Economics of Medical Care,” 25-27. 35 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (physician). Both parties are aware o f this trading inequality which colors the relationship."^ When a market fails to achieve an optimal state, government intervention can occur to bridge the gap through social institutions. Market failure occurs from the consumer being insulated from the true cost of care through the insurance mechanism (wedge effect). Health, as a risk, nullifies the concept o f indemnity because it alters and expands the risk pool. The special structural characteristics of the health care market are largely attempts to overcome this lack of optimality from non-marketable risk bearing and imperfect information under conditions of uncertainty. An efficient insurance market depends on the expected loss meeting conditions of risk information ex-ante. Insurance markets fail from adverse selection problems and moral haimrd. True individual behavior with regard to risk can not be revealed. Pooling equilibrium is unstable because low risks drop out or because of competitive behavior by insurers. Insurance companies that are low-risk and profitable as a result of an insurance pooling equilibrium favor contracts. Separating the pooling equilibrium is more costly to the covered high-risk participants. A partial solution is to restrict consumer choice by making membership compulsory, thus preventing low-risks from opting out. ^ Ibid., 29-30. 36 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Moral hazard also arises where the insured person can influence the expected loss at a cost lower than the expected gain and without the insurer's knowledge. Barr argues that from a social point of view, the efficient level of insurance is that at which the marginal cost of insurance is equal to the marginal reduction of insured loss. Individuals face private incentives to under-invest in preventive activities (e.g., people take less care than if they had to bear the frill loss themselves). Elective health care is a deliberate act o f consumer choice, which is uninsurable. If medical insurance pays bills in frill, the private costs facing both the doctor and the patient are zero, even though the social cost is positive and usually substantial. The result is inefficiency in the form of over-consumption of medical care."*^ Moral hazard causes a fundamental problem; the more complete the coverage and lower the risk of loss from the insured event, the less individuals have to bear the consequences of their actions and the less the incentive to behave as if they had to bear the frill loss themselves. Medical insurance can not cover all health risks for all individuals; gaps in coverage and inappropriate incentive structures make undue reliance on competitive markets problematic; competitive pressures make pooling equilibria unstable.'*^ In addition to asymmetric information in the insurance market, there is information that nobody has. If loss can’t be predicted, the insurer can’t calculate a 45 Barr, Nicholas, “Economic Tlieory and Welfare State: A Sur\'ey and Interpretation,” Journal of Economic Literature, 30 (June, 1992): 741-803. 46 Ibid., “Economic Tlieory and Welfare State: A Survey and Interpretation,” 751-753. 37 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. premium. Insurance is possible only against risk, but not against uncertainty. In insurance market failure, the incentives force insurers to seek the best risks by offering high-benefit and inexpensive policies, and to avoid the worst risks by offering low benefit expensive policies. Society's poorest must pay a high price for insurance or can not get coverage at all. Government ends up imposing and fiinding a large measure of standardization on insurance plans and may have to organize a state program for the worst risks. Something so heavily regulated and subsidized is more a government plan with administration delegated to the private sector.**^ Regulation improves the financial solidity of insurance companies making claims more likely to be paid. Regulatory policies can enhance efficiency so that the consumer is able to purchase insurance at a reasonable cost. Regulatory policies make insurance available for consumers who might otherwise not be able to purchase it, and regulatory decisions can increase the choices available to consumers providing information for rational decision-making."** Conventional medical insurance faces two sets of problems: (1) gaps in coverage which arise for risks like chronic and congenital illness, medical needs of elderly and primary health care, and (2) inefficiency which occurs in various forms such as the over-prescription of medical care as a result of third-party incentives. Ibid., 755-757. '* * Meier, 38-39. 38 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Both theory and systems performance supports the view that a hypothetical pure private market medical insurance would be highly inefficient and also inequitable.**^ Medical insurance can not cover all health risks for all individuals; gaps in coverage and inappropriate incentive structures make undue reliance on competitive markets problematic. Macro efficiency and cost control are particularly impaired when neither side of the market faces the costs of its actions such as third-party payments for medical care in open-ended funding systems. Such a system causes divergence between private and social costs and benefits. Merging the payer insurer with the physician and forcing doctors to face the cost of the treatment they prescribe is one way to deal with third-party cost driven externalities. Such an intervention may ameliorate the cost of insurance but do nothing to deal with uninsurable risks.^° The U.S. has not found a way to equitably spread the cost of insuring health risks over its entire population. The U.S. Health care financing system is based on the private insurance model; 19% of population are covered by public programs, approximately 15% have no coverage and the remainder (64%) have private insurance individually purchased or employer-sponsored. Employer-based health insurance is tax-subsidized as health insurance premiums are a tax-deductible business expense, but they are not taxed as employee compensation. 49 Barr, “Economic Tlieory and Welfare State: A Survey and Interpretation,” 754-755. Ibid., 787-795. 39 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As price competition among insurance companies has intensified, they have tried to reduce uncertainty over their provider relationships and establish greater control over their determinants of costs, namely hospitals and physicians. Previously insurers feared provider boycotts if they attempted to limit provider participation in their insurance plans. Information on physicians' performance has been difficult to gather. However, advances in computer technology and software have lowered the transaction costs of evaluating and monitoring physician behavior. Information technology and the applicability of the antitrust laws to the health sector have enabled insurers to exercise greater control over their inputs for which they were at risk. Hospital efforts to reduce transaction costs between themselves and their physicians are likely to lead to a closer integration o f physician and hospital services. The transaction costs of dealing with a large number of physicians and being at risk for their behavior are likely to lead to greater numbers of exclusive arrangements between insurers, HMOs, hospitals and physicians. 2.5. The Licensing, Monitoring, and Education System Recognizing that delivery o f hospital and physician services was knowledge- based, medical associations and societies were organized to develop standards of care and ensure a minimum level of physician skill and hospital competency through Feldstein, 233-234. 40 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. certification and licensure. In the early part of the century, organizations such as the American Hospital Association and the American Medical Association were started as membership associations to provide a mechanism for monitoring physician and hospital quality o f care and peer review. A plethora o f other associations, such as the Joint Commission on the Accreditation of Hospitals, the American Nurses Association and the American College of Hospital Administrators, quickly formed with the same intent. Over time, many of these associations developed as certifying and accrediting bodies that augmented state and federal professional licensing programs. At the close of the century, these are powerful organizations that lobby Congress on behalf of their members. People demanding legislative benefits are those organized groups, such as health associations, that seek legislative benefits for their members. In the past, much of the health legislation at both state and federal levels has been strongly influenced by these groups which have greatly influenced the structure of the health care system. The impact of health interests has been enormous (e.g.. Medicare was expected to cost $2 billion a year. It is now over $80 billion a year). Had Medicare and other health legislation been written in a different fashion, less to the liking of health interest groups, health expenditures would undoubtedly have risen at a slower pace. The redistribution of income from patients and taxpayers to health 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. professionals during this period is an indication o f the legislative success of health care professionals/^ 2.6. Regulation and Competition in the Physician, Hospital and Insurance Markets Over the past 25 years, the cost of the medical/health delivery system has risen faster than the inflation rate. Various cost constraining mechanisms have been attempted to slow the rise in cost. Through government regulation and private incentive systems costs have been constrained, but the system continues to consume greater amounts of the GNP.^^ Proponents of regulation cite numerous reasons in support of their regulation. These include inefficiencies in medical care demand from uninformed consumers (patients); supply inefficiencies through duplication o f expensive services and the lack of provider incentives to be efficient; the need to hold down large increases in governmental expenditures on medical care; and fourth, a lack o f central planning, preventing some people from having access to medical care and scarce medical resources. In economic theory, rent-seeking groups, because of the benefits which are conferred, demand regulation. The legislators supply regulatory benefits and Ibid., 242-248. U.S. Government Printing Office, CRSBriefs, Washington, D.C., 1989. 42 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. organized competitive industry producers, particularly those industries that are concentrated, demand regulation to receive the benefits of a cartelized industry. When the regulated industry is the only group with a concentrated interest in the outcome, then the outcome is similar in predictions to those of the capture theory. When several divergent interest groups are affected by a regulatory agency decision, the agency will arrive at compromise decisions. When the regulated industry is the main interest group affected by the agency's decision, the agency will produce a decision that is approximate to what the regulated industry desires. As the number o f competing interest groups increases, the agency will attempt to minimize its costs by reaching a compromise with the competing groups. If the regulatory agency prohibits entry by new firms, a well-controlled cartel (which doesn’t exist without regulation) will attempt to ensure that no excess capacity exists among its current members, lest they be encouraged to produce more than the cartel desires.^'* Non-price competition occurs when the regulated price is set higher than that which would prevail in a competitive market. This causes competition to occur on aspects other than price, thereby raising the industry's costs and diminishing the profitability of the regulated prices. Incentives for efficient operation are removed in regulated industries resulting in higher costs.^^ Technological change is introduced very slowly in regulated industries, and regulation favors survival o f firms that Feldstein, 263-267. Ibid., 261-269. 43 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. would go out of business in an unregulated environment/^ The members of organized medicine are worse off economically under a competitive system than a regulated one. Physicians have had to change their style of practice, and restrictions have been placed on their behavior through utilization review and price discounting from PPOs. Hospitals also prefer a regulatory system, and insurers favor all-payer hospital rate regulation so that non-profit companies like Blue Cross and Blue Shield no longer place them at a competitive advantage. The beneficiaries of a competitive market are consumers. 2.6.1. The Regulatory Approach to Cost Constraint The health care system has a recent history of government intervention through market mechanisms. It is believed that by the government stimulating the health care sector to behave like the rest of the economy, a more cost-effective style of medical organization and delivery would be achieved. Regulatory pressures to accomplish this include reduced health insurance benefits, enforcement of antitrust laws, selective contracting and other institutional changes. Ibid., 269. ” Ibid., 303-304. 44 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.6.2. The Market Approach to Cost Constraint: The Rise of the HMO Substitutes for existing personnel, lower cost facilities, and new treatment methods are supply phenomena that decrease the demand for existing providers. The rate of innovation in methods of delivering medical services should be greater in a competitive market system. Competition among hospitals, physicians and insurance plans should produce economic market efficiencies. What has occurred is an increase in the number of Health Maintenance Organizations (HMOs) as a more efficient organizational form of health care delivery. In the 1970s, a health maintenance organization (HMO) was a contractual relationship, either selective or nonselective, that existed between physicians, physician groups, hospitals, and insurance carriers in the delivery of medical and health care (Figure 2-1). 45 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. HEALTH MAINTENANCE ORGANIZATIONAL DESIGN P U R C H A S E R j H EA LTH I PLA N I PPO Coatract Negotiation j Data Systems 4 Utilization Review I Quality Management I Outcomes Assessment Provider Profiling PH Y SIC IA N I G R O U P H O S P IT A L Figure 2-1 Basic Health M aintenance Organization S tru ctu re 46 Reprotjucetj with permission of the copyright owner. Further reproduction prohibited without permission. Preferred provider organizations (PPOs) (defined in Appendix A) negotiated contracts between insurance companies and providers (hospitals and physicians) at discounted prices. The incentive for providers to lower their costs was a guaranteed volume o f patients. Price discounting allowed the insurance company and government third-party payers to stabilize premium rates for employers. The comprehensive coverage, reduced premiums and implementation o f employee copayments are incentives for employers to purchase HMO services and compete against traditional insurance plans on the basis of their premiums, benefits, accessibility and quality. HMOs are also a delivery system and attempt to produce their product at minimum cost. HMOs thus compete simultaneously with insurance companies, and hospitals and physicians that are paid on a fee-for-service basis. HMOs are subjected to strict regulation by the state department o f insurance. Independent Practice Association (IPA) models o f HMOs have less control of their physicians than did staff models of HMOs (e.g., Kaiser). However, as HMOs have expanded, the IP A model is more popular with physicians as they retain their non-HMO patients and, when an HMO received a contract from an employer, the HMO could contract with the IP A more quickly than hiring its own. 47 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.6.3. HMOs and Managed Care In its simplest definition, managed care refers to managing physician practice (and cost o f care) in the hospitals and the physician offices through selective contracting. Managed care contracting is a recent development in which the third- party payers have tried to exert greater monitoring o f physician behavior to achieve efficient and high quality care. The inducement for physicians to join these groups arose when the laws for Medicare reimbursement changed. With the addition of selective contracting for hospital and physician services as well as the merger of hospitals into health care systems, physicians had to join some type o f provider group to survive. Independent practice associations are groups of physicians who participate in the health plan and the hospitals associated with it. The physician remains the agent of the patient, but the monitoring of the relationship comes from the indemnity plan and the hospital associated with it. As agents of the patient, physicians resist this challenge to autonomy as they seek the best clinical interest for their patient and themselves. In adopting the health maintenance organization style of service delivery, there occurs a triangulated relationship between the hospital, the physician and the reimbursement system. Preferred provider organizations act as an agent for the health plan and negotiate the indemnity carrier reimbursement rates. These independent PPO organizations, within this triangulated relationship, maintain 48 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. data systems that monitor utilization, quality, clinical outcomes and profiles o f the clinical providers based upon resource consumption. The HMO organizational model is perceived as an efficient means in accomplishing managed care. Miller and Luff identify five types of HMO plans, which are distinguished by the type of organization that provides services and the exclusivity of the relationship between the intermediary and the provider. These are Prepaid Group Practice, Network HMO, Staff HMO, IPA HMO, and Mixed-Model HMO.^* In the prepaid group practice HMO, the health benefit intermediary has an exclusive relationship with one or more large medical groups (i.e., groups of doctors). In the network HMO, the health benefit intermediary relationship with the medical groups is nonexclusive. In the staff HMO, the health benefit intermediary directly employs physicians. In the IPA HMO, the intermediary either contracts with an IPA (that it may or may not control) that in turn contracts with solo or small group practices. In the mixed-model HMO the intermediary has various relationships with providers. For example, the intermediary may contract exclusively with medical groups and nonexclusively with solo practice physicians in the same area.^^ These HMO plans can be either capitated or uncapitated reimbursement plans. 5 g Miller, Robert H., and Harold S. Luft, “Managed Care Plan Performance Since 1980, a Literature Analysis," Journal o f the American Medical Association, \o\. 271, no. 19 (May IS, 1994): 1512- 1519. ^^Ibid., 1512-1513 49 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Under uncapitated reimbursement plans, reimbursement is determined prospectively by resource consumption defined by DRG. Under a capitated arrangement, the employer contracts with a health benefit intermediary or HMO to provide health care to enrolled recipients (enrollees) for a fixed amount per month or covered life. Recipients enrolled in the HMO receive all services, except in emergencies, from providers employed or affiliated with the HMO. The HMO is at financial risk for the services provided to enrolled recipients and may pass on financial risks and incentives to its participating providers. This is an effort to reduce unnecessary services or receive discounted prices from providers. Provider choice is limited to selected providers. Full risk capitation requires the provider to assume full risk for their enrollees. When employers sign up for an exclusive contract frill-risk capitated health plan, the plan receives a certain dollar amount per enrollee, or covered life, whether or not the enrollee uses health care services. The health plan selectively contracts with the providers who assume financial risk for over-utilization of services. Clinical indicators, practice patterns, quality, risk, provider profiling and outcome measures are ways that the health plan monitors provider performance. These measures all require the ability to capture, manage, and analyze medical and health care data. In California, the Medi-Cal Program (Medicaid of California) is a partial-risk (i.e., not all risk is assumed by the provider) capitated program being piloted by California’s Department of Health Services. Through geographic managed care 50 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (GMC), providers contract with the state through competitive bidding to provide HMO benefits to Medi-Cal recipients. Integrated health care systems have evolved in tandem with the concept o f HMOs and managed care. At the time the HMO-style of delivery was growing and maturing, the hospital industry was undergoing a transformation. In the first phase, hospitals began affiliating under a corporate style governing board. In the later phase of integration, physicians, ambulatory centers and other providers were incorporated into the overall network with integration of clinical services, integrated management and seamless health care delivery. Hospitals in integrated delivery systems are now considered cost centers rather than revenue generation centers. Formulas that relate covered lives to hospital beds and physician numbers show that even in some of the most efficient markets there is too much bed capacity and there are too many physicians. 2.7. Price Competition As identified in Figure 2-1, there are three components o f a managed care model, an inpatient delivery system (hospital) that is linked to a large physician group organized as a preferred provider organization or independent practice association, and a health plan. A comprehensive set of health care services is provided for the premium paid by the employer or the individual. 51 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Many states have considered either a competitive or regulatory approach to restructuring the health care system to slow expenditure growth. California leads the nation in a very rapid transition from the old fee-for-service model to the managed care health maintenance organizational (HMO) model. In 1986, only half of all Californians were enrolled in either an HMO or a PPO. By 1992, over 80% of the population were either in an HMO or a PPO, and only 20% remained on fee-for- • I • 6 0 service basis. California has moved faster than the rest of the United States in adopting the managed care style of delivery. Whatever the cause and effect that made this happen, expenditure reduction for health care in the six years of this conversion is evident. Mel nick and Zwanziger studied the United States overall health care expenditures and compared California to Maryland, New Jersey, New York, and Massachusetts, the top four states with the most stringent health programs in the c o u n try .“In all categories, [hospital, physician, drug, and total expenditures] the California expenditures were the least by a considerable margin. The aggregate data show that California not only did much better than the national average in controlling growth in hospital expenditures per capita, but also did better than all o f the states with hospital rate regulation programs. Melnick, Glenn A., and Jack Zwanziger, "Competition and Regulation, 1980 through 1991,” American Journal o f Public Health, Vol. 55, No. 10 (October, 1995): 1391-1396. Miller and Luft, “Managed Care Plan Performance Since 1980, a Literature Analysis,” 1394. “ Ibid., 1394. 52 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Under a competitive system, hospitals located in the more competitive markets in California are likely to face greater pressures from managed care health plans to reduce price and, ultimately, these plans may be inclined to control their payments to these hospitals. The introduction of price competition in California has caused hospitals within competitive markets to limit increases in charges. Hospital expenditures in the most competitive markets are below those in the least competitive markets.^^ Miller and Luft’s review of the HMO literature between 1980 and 1994 finds few empirical measurements of HMO performance. They also find few or no analyses of key measures of performance, including total health plan and system- level expenditures, out of pocket costs per enrollee, and the level and rate of growth of premiums.^ Compared with indemnity plans, HMO plans exhibit significantly lower utilization o f hospital services and greater use o f more expensive outpatient services or those that are discretionary procedures and tests. There are mixed results on health outcomes.*^^ “ Ibid., 1395. 64 Miller and Luft, “Managed C are Plan Performance Since 1980, a Literature Analysis,” 1512-1519. Ibid., 1518. 53 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.7 .1. Patient Care Cost Shifting Cost shifting is a descriptive term for charging different prices to different groups. The seller adjusts the price (and thus the quantity) to each buyer so that the price just covers the cost of providing the last unit of service demanded by the buyer. Static cost shifting occurs when some organizations or individuals are charged less than others. Dynamic cost shifting refers to price increases (i.e., when prices are raised to one group or to individual payers because another is paying less).^^ Michael Morrissey constructs a theory o f economic behaviors that leads to cost shifting and then explains why cost shifting within a price competitive environment will not work. His work shows that California PPOs negotiate better rates in competitive than noncompetitive markets and those markets in which the PPO has bargaining strength and the ability to direct patients elsewhere. This line of research shows that PPOs compete on a price basis and that the prices negotiated are consistent with a standard model of firm behavior. Channeling all patients to a single hospital provides the risk of the PPO being captured and being charged higher prices by the chosen hospital.^^ Morrissey, Michael A., Cost Shifting in Health Care: Separating Evidence from Rhetoric, (Washington, D.C.: Tlie AEI Press, 1994). Ibid., 58. Morrissey cites tliat only one study has been conducted after tlie implementation of Medicare PPS, the works of Melnick and Zwanziger. The natiue of hospital and insurance markets has changed dramatically since the time of tliese studies 54 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.7.2. Market Characteristics of Cost Shifting Static and dynamic cost shifting requires that providers have market power that is defined as the ability to set prices. The market enables price competition. Providers raise prices to some payers because others pay less. Cost shifting among groups does not mean certain patients are being treated at a loss. The profit- maximizing hospital will charge different prices to different categories of payers, but under dynamic cost shifting, rather than charging private payers more because the government pays less, the hospital will charge private payers less when the government pays less and more when the government pays more. Differing price sensitivity means that the consumers have different responses to prices, which typically means better or worse access to substitute sources of care. Those who can substitute services will pay lower prices.^* — Melnick, Glenn A., and Jack Zwanziger examined tlie rate of increase in hospital costs in the periods 1980-1982, 1983 and 1985. See “Hospital Beliavior Under Competition and Cost- Containment Policies,” Journal of the American Medical Association, Vol. 260, No. 18 (November 11, 1988): 2669-75. — See also, Melnick, Glenn A., and Jack Zwanziger, “The Effects of Hospital Competition and the Medicare PPS Program on Hospital Cost Behavior in California,” Journal o f Health Economics, vol. 7, No. 4 (December, 1988): 301-20. — In a later work, tliey examine tlie effects of local hospital competition and bargaining strength on negotiated price. See Melnick Gleim A., and Jack Zwanziger, Anil Bamezai, and Robert Pattison, “ Tlie Effects of Market Slructiire and Bargaining Position on Hospital Prices,” Journal o f Health Economics, Vol. 11, No.3 (October, 1992): 217-33. Morrissey, 2-23. 55 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.7.3. Characteristics o f Payers and Cost Shifting In 1990 all categories of payers paid less than that which was billed. This is because contractual or charges adjustments. Medicare and Medicaid pay lower prices than privately insured patients do, yet hospital costs per day are the same for all categories o f payers. Hospital costs per admission are somewhat higher for Medicare patients and somewhat lower for uninsured patients than for privately insured patients. The cost differences are captured in length o f stay. A large component of the price differences and cost relationships is attributed to the disproportionate differences in the hospitals used. Cost shifting is not a subsidy issue; it is an allocation o f the fixed cost argument. The strategy works as long as the group paying the high price is sufficiently price insensitive.*^^ 2.7.4. Characteristics o f List Prices, Transaction Prices, and Cost Shifting Hospital list prices have been rising much more rapidly than actual transaction prices. Also, there is a difference between what providers say they charge and what they are willing to accept as payment. There are problems with the ^ Ibid., 24-45 56 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. average transaction price because the average price can differ for a variety of cost reasons and the average may mask large differences with payer categories.™ 2.7.5. Characteristics of HMO/PPO Contracts and Cost Shifting PPOs and HMOs have contracts with several hospital providers to keep from frequently using hospitals that offer a lower price. This is because they initially choose the hospital on quality rather than price. However, only 6% of PPOs pay hospitals’ usual and customary charges and over 80% of PPOs pay negotiated discounts; the average discount is reported to be 17%.^^ Per diems and DRGs are the fastest growing and the least susceptible to the high-charge-large-discount strategies used by some hospitals. PPOs and HMOs have instituted pay caps on specified services, and hospital list prices are used as a basis of negotiation. PPOs are able to negotiate transaction prices well below list prices. This suggests that measures of hospital information based upon list prices are overstated and the spread between list price and transaction price will grow as hospitals try to compete on a price basis by offering big discounts from high list prices. ™ ™ Ibid., 23-25 Ibid., 24. ™ Ibid., 58-71 57 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Morrissey suggests that the growth in price competition over the past decade has severely limited the magnitude of any dynamic cost shifting that may have been 73 going on. 2.8. Summary Organizational restructuring of the health care delivery system continues. The delivery of health and medical services has become increasingly vertically integrated. There are a number of reasons for this. 2.8.1. Change in Concept from Medical Care to Health Care It appears that during the period between the Health Maintenance Organization Act of 1973 through the federal legislation written in the late 1980's, the conceptual shift from emphasis on medical care to emphasis on health care occurred. This is coincidental to the concomitant increase in use of outpatient rather than inpatient services, the implementation of DRG-based reimbursement, the imposition o f prohibitions on balance billing Medicare patients, and the revision of Ibid.. 71 58 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Relative Value Scale/^ In response to a series of federal regulatory changes, economics forced hospitals to convert costly in-patient care (the most expensive component) to outpatient care, and physicians were limited in scope of services for what they could collect from patients. Thus, the apparent response to government intervention into the hospital and physician markets was the development of alternative delivery systems such as urgent care centers, ambulatory care centers, and outpatient surgery centers. Reimbursement levels are maintained based on patient mix and payment source, with the hospitals as the primary force for organizational reengineering of both the inpatient and outpatient components of care. The hospital has changed its method of doing business to reduce overhead costs. This organizational restructuring is made possible by two phenomena; (1) outpatient services are not as heavily regulated by state and federal statute as inpatient services, and (2) technology has continued to upgrade and improve to make higher levels of outpatient surgery possible. 2.8.2. Market Transaction Costs The effective use of insurance as a policy mechanism requires the insurance company to be able to monitor the use of hospital and physician services. In the face 74 Balanced billing refers to tlie ability of a physician to collect from patients’ portions of bills not covered, or only partially covered by Medicare. By “accepting assignment” the physician agrees to accept wliat Medicare pays as “payment in full,” witliout billing tlie remainder to tlie patient Tlie Diagnostic Related Group is a metliod of disease classification for wliich a fixed prospective payment is made from tlie funding source. Tlie Relative Value Scale coding system is a weiglited factor by procedure from wliich outpatient charges are generated. 59 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of shrinking reimbursement, it is in the best interest of hospitals to be able to monitor the physician use of resources. Vertical integration and managed care provide mechanisms for integrated delivery networks to capture shrinking reimbursement dollars, in theory provide for scale economies that can be gained by reducing individual organizational overhead, and provide a mechanism for monitoring hospital and physician performance by both the government and the insurance companies. 2.8.3. Organizational Survival The developing integrated organizational networks are designed to provide individual (as opposed to public) “health care” not “medical care” across a continuum that ranges from prenatal care through primary care, tertiary care, long term care, and hospice care. The development of health care networks has been an organizational survival technique of hospitals. Organizations as entities within the market face two major obstacles—survival and control o f members. Vertical integration has been a survival response and a control response. As such, the individual hospital and physician models of direct market care delivery systems are becoming obsolete. They have been replaced by organizational contractual entities such as independent practice associations and preferred provider organizations. 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.8.4. Networked Health Care Systerns Legislation continues to be written to pressure a health care system level response for greater health care systems efficiencies; thus, government regulatory intrusion continues. For example, through legislation, the federal government requires that publicly funded patient bills be fully automated and transmitted through electronic data interchange systems. Through advances in telecommunications and computer networks, electronic network integration facilitates the vertical integration o f health care organizations. Sophisticated computer systems will make greater monitoring of the health care delivery system possible for the government, insurance companies and the corporate delivery organizations. However, as these organization al systems integrate in the form of insurance systems tied to delivery systems as a single marketable product, the use of insurance as a stand-alone product must be questioned. It appears that the organizational restructuring of the health care system from individual practice and independent organizations to that of vertical and horizontally integrated systems, which is now occurring, is a continued response to governmental laws and cost-control policy. If the system is bounded through integrated delivery and financing networks, perhaps spending growth in this industry will slow, eventually level off or be reduced. If one accepts Feldstein's economic arguments, then the conclusion is that physicians, hospitals and insurance companies have operated as cartels, been 61 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. subsidized through a variety o f tax exempt and government financing mechanisms with monopolistic power, and protected through health association demand for legislation. The historical justification for cartelization of the system (by the provider) is the provision o f quality health care. The historical justification of government intervention is to force market efficiency while maintaining an equitable provision of services to the poor and elderly. As a result of government-imposed cost constraint mechanisms and equity, the system will restructure for organizational survival. Savage’s argument, on the other hand, is that there is no sufficient economic model that explains the behavior o f professionals within markets and firms. It is apparent that there is a need for a theory of organizations that seeks to explain and provide a framework for both views, especially in bridging the theory of the firm to the service [and professional] sector o f the economy. 62 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 3 LITERATURE REVIEW 3.1. The Economics of Industrial Organization Political economy uses economic tools in studying the relationship of the government to markets as a complex interaction o f industry, consumers, regulators, and political elite with the environment in which they operate. Political economists have aggressively studied the impact of market and government interventions as policy tools to influence organizational operation and survival within a market economy. Contemporary models o f industrial organization have proposed that organizations are efficient entities in market exchange. These models are drawn from microeconomic and administrative theory, as well as contract law. The theories supporting these models include theories o f the firm, transaction cost economics, contract theory, property rights and principal-agent theory. 3.2. The Theory of the Firm The foundation of transaction cost economics is work by John Commons who defined the transaction as the fundamental unit of analysis and introduced this 63 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. fundamental concept for industrial organization/^ Frank Knight had already addressed the organization of firms and economic activity in efficiency terms/^ Ronald Coase developed a theory of the firm, based upon transaction costs, to explain why individuals work for firms instead of working for themselves within the market. Coase asked the question of why firms exist at all and why the market is not composed of individual entrepreneurs. Coase ultimately draws several conclusions: (1) To reduce market transaction costs, individuals within firms will minimize individual transaction costs and select hierarchy over markets. Firms emerge when there are decreasing returns to the entrepreneurial function (economic survival). (2) As the number o f transactions in the market increases, organizational structure provides a better solution for dealing with the transactions than markets (individual control mechanisms). (3) The firm tends to expand until the cost of organizing an extra transaction within the firm becomes equal to the cost of carrying out that transaction through exchange in the market or in organizing another firm. Coase’s thoughtful arguments resulted in the “Coase Theorem .Coase wrote in 1989 that he did not invent the Coase Theorem, but instead gave credit to Commons, Jolm R., “Institutional Economics,”.-)mer/can£co/70/7;;c/?ev/ew, 21 (1931): 648-57. Knight, Frank H., Risk, Uncertainty and Profit (London: London School of Economics, 1921). ^ Tlie Coase Tlieorcm states (158), “If the parties bargain to an efficient agreement and if their preferences display no wealth effects, then tlie value-creating activities tliat tliey will agree upon do not depend on tlie bargaining power of tlie parties or on what assets each owned when the bargaining began. Rather, efficiency alone determines the activity choice. The other factors can affect only decisions about how tlie costs and benefits are to be shared.” Coase, Ronald H., The Firm the Market and the Law (Cliicago, lL:Tlie University of Chicago Press, 1989). 64 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. George Stigler for articulating the theorem as he [Stigler] interpreted Coase’s work/* Within the Coase theorem, the idea of transaction costs arise as a result of bargaining and trade, and social costs (unspecified transaction costs) are identified/^ In 1991, Ronald Coase won the Nobel Prize for Economics based upon the body of knowledge that resulted fi-om his theory. Subsequently, there was a resurgence of interest in these works in the study of industrial organizations. The body of knowledge that extends Coase’s work has produced extremely sophisticated models in explaining the emergence o f organizations as a collection of utility-maximizing and profit-maximizing transactions. His works have also spawned interest in social costs that are not as easily measured as transaction costs.*® Underlying his theory are the principles of property rights; implied, verbal and written consensual contracts; and the use of organizational form as a basis of differentiating market, firm, and hierarchical transactions. ’* Ibid., 157. 79 Coase writes on private and social costs: “My conclusion was: ...tlie ultimate result (which maximizes the value of production) is independent of the legal system if tlie pricing sj’ stem is assumed to work without cost. Stigler formalized this conclusion as tlie Coase Tlieorem, which he expressed as follows: ...under perfect competition private and social costs will be equal,” 13. S O Coase points out, ‘ ‘[W]ith zero transaction costs...monopolies would be induced to ‘act like competitors.’ ....(Ijt is perhaps enougli to say tliat, with zero transaction costs, private and social costs will be equal...Social cost represents the greatest value tliat factors of production would yield in an alternative use. Producers, however, who are normally only interested in maximizing their own incomes, are not concerned with social cost and will only undertake an acti\ity if tlie value of the product of factors employed is greater than tlieir private cost. But if private cost is equal to social cost, it follows that producers will only engage in an activity if the value of the product of the factors employed is greater than the value which they would >ield in their best alternative use. That is to say, with zero transaction costs, the value of production would be maximized,” 158. 65 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.3. Contracts and Decisions Armen Alchian and Harold Demsetz, who sought to explain the role of hierarchy and organization in contractual incentive terms, launched the contractual approach to organizations. They introduced the concept of the organization as a “nexus o f contracts.A complete contract would contain provisions under every possible circumstance to which the parties to the contract must abide. The complete contract must arrange the distribution of realized costs and benefits in every contingency so that each party finds it optimal to abide by the contract te r m s .I n actuality, enacting and enforcing a complete contract is virtually impossible. Contracts are meant to align incentives. Herbert Simon first proposed the concept of the “boundedly rational” individual. Incomplete knowledge, limited foresight, and imprecise language contribute to the bounds and limits o f rational behavior. Further, the boundedly rational actor recognizes these limits in finding the best mathematical or contractual solution and, therefore, acts in an intentionally rational w ay.^ Contractual adaptations introduce the possibility of opportunistic behavior. The fear of opportunistic behavior may deter parties from negotiating the most efficient contract. The contractual response to bounded rationality, then, is that 81 Alcliian, Armen, and Harold Demsetz, “Production, Information Costs and Economic Organization,” .4O T enca/7 Economic Review, 67 (1972); 777-795. 82 Milgrotn, Paul, and Jolm Roberts, Economics, Organizations and Management (New York, NY: Prendce Hall, 1992): 127-128. ^ Simon, Herbert, Models o f Man (New York, NY: Jolm Wiley and Sons, 1956). 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of relational contracting. Relational contracting is an agreement that frames the relationship.^ Contractual relationships require commitment by both parties. An uncommitted individual could renege on the contract. Reneging is problematic for contracts because of the possibility of unstated or ambiguous interpretation. Ex-post renegotiations can also be problematic. Ex-ante, the ability to renegotiate, may lead to contract inefficiencies because the parties won’t be inclined to ex-ante negotiate the best deal if an ex-post renegotiation is possible. Ex-ante contracting problems have been fastidiously researched. Tirole has explored contract commitment and renegotiations.*^ Hayek looked at the information features of a market system. In a market system, decisions about the use of resources are left to autonomous, knowledgeable, individual consumers and firms.However, precontractual (ex-ante) asymmetrical information has led to a number of research themes that include adverse selection,*^ (adverse selection is a problem of 84 Milgrom and Roberts, 131. Tirole, Jean, The Theory o f Industrial Organization (Cambridge, MA; MIT Press, 1988). Hayek, Frederick, “Tlie Use of Knowledge in Society,” American Economic Review, 35 (1945): 519-30. 87 Akerlof, George, “The Market for Lemons: Qualitative Uncertainty and the M arket Mechanism. ” Quarterly Journal o f Economics, 84 (1970), pp. 488-500, and Stiglitz, Jolm E., and Aaron Weiss, “Credit Rationing in Markets with Imperfect Information,” American Economic Review, 71 (1981): 393-409. 67 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. contractual opportunism) principal-agent theory and incentives,** principal-agent theory and adverse selection,*^ risk, and risk-sharing,^ and decision-making under conditions of uncertainty .^^ 88 89 90 91 Moe, Terry, “ The New Economics of Organizations,” American Journal o f Political Science, 28 (November, 1984): 744-746. See also, Sappington, David E. M., “Incentives in Principal-Agent Relationships,” Journal o f Economic Perspectives, 5 (Spring, 1991): 45-66; McCubbins, Michael D., and Roger G . Noll, and Brian R Weingast, “Administrative Procedures as Instruments of Political Control,” Journal o f Law, Economics and Organization, 3 (Fall, 1987): 243-277; and Laffont, Jean-Jacques, and Jean Tirole, “ The Dynamics of Incentive Contracts,” Econometrica 56 (1986): 1153-1175. Grossman, Sanford, and Oliver Hart, “An Analysis of the Principal-Agent Problem,” Econometrica, 51 (1983): 7-45. See also Demski, Joel, and David Sappington, “Optimal Incentive Contracts with Multiple Agents,” o f Economic Theory, 33 (1984): 152-171. The most notable economist in this area of research is Kenneth Arrow in his Essays in the Theory o f Risk Bearing (Chicago, IL: Markham Pub., 1970). Much research into moral hazard and risk can be found in the insurance literature: See also Spence, A Michael, and Richard Zeckhauser, “Insurance, Information and Individual Action,” American Economic Review, 61 (1971): 380-387; Stiglitz, John, “Incentives, Risk and Information: Notes Toward a Theory of Hierarchy,” Bell Journal o f Law, Economics and Organization, 6 (1975): 552-579; and Shavell, Stephen, “Risk-Sharing and Incentives in the Principal and Agent Relationship,” Bell Journal o f Economics, 10 (1979): 55-73. Arrow, Keimeth, The Limits o f Organization (New York, NY: Norton Publishing, 1974). Kermeth Arrow is cited as a leading theorist from his earlier works: The idea that organizations are a response to market failure is developed in Arrow’s The Arrow-Debreau general eqirilibriitm model. This represents the complex activities of consumption and production by firms and decision makers throughout the economy. Externalities as missing markets are also attributed to Arrow. These early works lead to his later work: “Uncertainty and the Wel&re Economics of Medical Care,” American Economic Review, 53 (1963): 941-973. Within this article he consolidates his earlier theories and tackles the complexities of decision making under uncertainty, asymmetrical information in contract relations, and the analysis of ex-ante implied and verbal contractual risk with no guarantee of ex-post outcomes. Also see Kreps, Donald, Notes On the Theory o f Choice (Boulder, CO: Westview Press, 1988). 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A contract is not secured without an o£fer and an acceptance, and something of value to secure the exchange. Prior to monetary systems, property or some other valuable secured the contract.^^ The importance of property rights can not be understated. North writes. Economic growth will occur if property rights make it worthwhile to undertake socially productive activity. . . . Three landmarks in the historical reduction of transaction costs were: the institutions [economic and political] that made possible impersonal exchange; the assumption by the state to protect and enforce property rights; and the realization of the gains made from the modem revolution in science. . . . Broadly speaking, the economic institutions have been those that have permitted the growth of markets or improvements in, or the introduction, of new technology. The political institutions have been those that improved the security o f property rights and the enforcement o f contracts. In fact the two institutional sources have been inextricably intertwined.^^ 92 The case of the dowry to secure the contract of marriage in olden times is an example of such property. Later, prior to monetary systems, property rights to land were important in securing a contract Differentiating fixed and chattel property was also important A fixed property could not be carried away and therefore served as a metUum for barter. Chattel property, on the other hand, was not fixed but could be redeployed (as was the case of women as chattel). Since the development of monetary systems, money is the traditional venue that secures the contract However, through time, precious metals and minerals have, and continue, to be valuable items in contract security (e.g.. the “gold at Fort Knox” and “the diamond engagement ring” are metaphors for the centuries-old concept of securing an agreement with valuable minerals and jewels). 93 North, Douglass C., “Transaction Costs Through Time,” IVorking Paper: Economic History (N) 9411006 (Washingtott DC: Department of Economics, Washington University, 1994). 69 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The subject of assets as property to secure a contract has received extensive attention in recent literature. Milgrom and Roberts write on asset specificity: “One important dimension on which transactions differ is the nature of the investments that the parties to the transaction must make.”^ The most notable works on the use and deployment of assets in contractual relationships can be found in Williamson: “Williamson’s writings have played a major role in developing transaction costs from the work of Coase. His writing in 1985 identifies asset specificity, frequency, and uncertainty as the key to dimensions o f transactions which also accents the limits of human rationality.”^ ^ Some of Oliver Williamson’s most recent work uses market transactions to explain organizational form in relation to the market. He adds a contractual component to this theory of the firm (introducing the cognitive map o f contract in 1985)^^ Coming under criticism for not including an intermediate form of organization between the market and the firm, he explores a hybrid structure based upon semi-strong contractual relationships. In his 1991 writing, he consolidates much o f the theory of institutional economics, the environment and governance. In this complex work, he examines unilateral and bilateral market contracting, market- firm-hierarchical dependency as a result of contracting type, and market disturbances 94 Milgrom and Roberts, Economics, Organizations and Management (N.Y.: Prentice Hall, 1992), 30. 95 Ibid., 51. Williamson, Oliver, The Economic Institutions o f Capitalism (New York, N.Y.: Tlie Free Press, 1985). 70 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. to the contractual relationship that will, in a Darwinian sense, select for the favorable form based upon environment and organizational structure.^^ (Williamson’s claim regarding the importance o f organizational evolution and the boundary of the firm has been a topic of much discussion in recent literature and will be discussed in greater detail in the next section). Thus far, the ex-ante problems of contracting have been discussed. Ex-post problems also exist. Williamson describes an ex-post hold-up; Holdup is the general business problem in which each party to a contract worries about being forced to accept disadvantageous terms later, after both parties have an investment which may be devalued by the actions of others. . . . The party that is forced to accept a worsening of the effective terms o f a relationship is being held up. . . . It is the specificity of assets together with imperfect contracting that lies at the core of the hold-up problem. The hold-up problem is an example of post-contractual opportunism.^* The neoclassic model predicts that individuals and firms enter into contractual relationships for mutual profit maximization, perquisites, firm growth rates, and risk sharing because o f uncertainty. Within this contractual relationship, goals emerge, organizational slack (shirking) occurs and dynamic choices are modeled within the ex-post-contractual relationships. Measurement costs are a 97 Williamson, Oliver, “Comparative Economic Organization: The Analysis of Discrete Structural M\su)a\ivQs" Administrative Science Quarterly, 36(June 1991): 269-296. 9S Milgrom and Roberts,. 136-140. 71 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. larger class o f transaction costs that include monitoring costs/^ ex-post uncertainty and friction that stem from information asymmetries about agent performance. Large measurement costs are encountered in measuring organizational performance. These expenditures are necessary to value the shift in distribution of bargaining gains both individually as well as organizationally. Reputation effect is another feature of ex-post contractual relationships. In relational contracting, where there is an issue of which party should have the discretion to direct activities in unforeseen events, it should be the one with the most to lose from a damaged reputation. This is the one with the longer horizon, the more visibility, the greater size, and the greater frequency of transactions. Contractual knowledge and learning from long-term relationships reduces contractual transaction costs. Langlois and Robertson point out that the differences in transaction costs in the short run depend on specific property rights, and 99 Jensen, Micluel C., and William. Meckling, "Tlieory of tlie Firm : Managerial behavior, agency costs, and ownership structure,”/ourwa/ o f Financial Economics, 3 (October), 1976, pp. 305-360. Sappington, David, E. M ., “Incentives in Principal-Agent Relationslups,” Journal o f Economic Perspectives, 5 (Spring, 1991): 45-66. Myerson, Roger, and M ark Satterwaite, Efficient Mcclianisms for Bilateral Trading,” Journal o f Economic Theory, 23 (1983): 265-281. Williamson covers ex-post contracting problems in great detail in liis 1991 article, “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives.” Milgrom and Roberts, 140. 72 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. transaction costs in the long run depend on residual property rights. Residual rights to property determine asset ownership. In the short run, there may be bargaining over the residual rights between parties that incur transaction costs. In the long run, because knowledge of the contractual relationship will provide for better specific rights ex-ante, organizational learning will occur and contractual transaction costs will be reduced. Ex-post, greater coordination of administrative structures, and higher individual productivity through routine will reduce internal and external contractual transaction costs. Toshihiro Nishiguchi contends that the emphasis on synergistic problem solving (ex-post contracting) rather than antagonistic bargaining (ex-ante contracting) between organizations is one important reason for the competitiveness of Japanese manufacturers. He presents research to support his claim that the major advantages of Japanese-style contracting lie chiefly in the economic benefits derived from inter-firm problem-solving mechanisms that ensure continuous 104 Langlois, Richard, and Paul Robertson, Firms, M arkets and Economic Cliange: A Dynamic Theory of Business Institutions (New York, NY; Rutledge, 1995). Langlois and Robertson argue iliat in tlie sliort term specific property riglits are contained in the contract, and residual rights are riglits to control tlie unforeseen circumstances. It is the residual property riglits of tliat asset, wliich determine ownership (28). Langlois and Robertson build tlieir long-run arguments from Marsliall’s ‘ Teaming-and-organization” view. They argue (using Shumpeter’s definition) tliat ‘ 'the long run is tlie period over which enough learning has taken place that adjustments are small and come only in response to foreseeable clianges in exogenous conditions” (27). Tliey furtlier argue tliat in the long run transaction costs miglit be expected to approach zero as activities become more routine, wliich in turn reduces the cost of contracting (33). Nishiguchi, Toshihiro, Strategic Industrial Sourcing: The Japanese Adx’ antage (New York, NY: Oxford University Press, 1994). 73 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. production of high-quality, low-cost pro d u cts.A t the empiric level, Nishiguchi develops a collaborative contracting model. This collaborative model and his theories of obligational and relationship contracting are explored in this dissertation. His research is supported by case examples as he develops new strategies of organizational structure for contracting. It is unclear that the Japanese contractual advantages outlined by Nishiguchi remain effective in light of the recent economic failings of the Japanese industrial and banking markets. Nishiguchi finds that by shifting from discrete subcontracting of parts to complete and subsystem assemblies, system pricing can not be derived from market prices alone. Prime contractors and subcontractors collaboratively look at reducing costs through joint problem-solving, to the extent that subcontractors provide detailed cost data. Over time, unilateral price determination by customers has been replaced by bilateral agreements. Tlie research is framed by four tlicoiies of subcontracting: dualism (inequalities between the segmented labor market), obligational contracting (tlie dichotomous formalization of markets and hietarcliies to minimize transaction costs tlirougli deepening asset specificity, goodwill and benevolence relationship conuacting) and flexible specialization (a derivative of the craft mode of production). Nishiguclii, 9-16. A major theme for Nishiguclii is that Japanese customer-contmctor rclationsliips shifted from exploitive to collaborative. 108 Large Japanese manufacturers began to invest seriously in their subcontractors from the late 1950s onward. Tliis investment ranged from creating 100% owned subsidiaries to creating partially oivned related firms to simply providing loans or loan guarantees. The purpose was clear—to increase the manufacturers’ control over some of their major subcontractors through capital and managerial assistance. Nishiguchi, 113. 74 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A shift toward greater responsibilities for subcontractors was in large part supported by the large Japanese manufacturers’ strategic financial and managerial support, but also by specific government policies. The support came fi-om government intervention in the market that did three things; (1) prohibited unfair contracting practices, (2) promoted subcontracting cooperatives, and (3) provided small business financing. These policies provided a fi-amework dedicated to small firms which strengthened the subcontracting relationship so that contemporary firms cooperate to produce high quality, low price products.The emergence of contract assembly and subsystems manufacturing tended to stabilize contractual relations because of the greater asset specificity.***^ This allowed the subcontractor assemblers to foresee, to the extent made possible by the customers strategy, the future trends of their business and, thus, the subcontractor could prepare in advance. Contracting in Japanese manufacturing is traced to a distinctive producer strategy to try to manage the demands o f increasing product proliferation from rapid market expansion and competition among many producers in overlapping market 109 Such contracting arrangements had many advantages such as more stable contractual relations, more opportunities for technological learning and improved growth prospects. Nishiguchi, 70-86. * * * * Tlie reason was because the assembly lines went from customer to subconuactor. Because the assembled components could not be made in-house, it made little economic sense to discharge the subconuactor in a recession. Second, it was in tlie customers’ best interest tliat their products assembled by tlie subcontractors did not lose competitiveness tlirough poor manufacturing operations. Third, by becoming an essential part of the large Omis’ production forces and demonstrating more composite skills, this new breed of assembly subcontractor could expect reasonably long-term growth through continuing contracts and could better allocate their resources for the future. Nishiguchi, 162-168. 75 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. segments, by outsourcing to contractors a substantial number of functions.**’ This arrangement allowed the primary producers to focus their internal resources on strategic activities, including state-of-the-art product development and process innovation. The delegation of actual production activities to external organizations shortened overall lead times and product cycles while allowing the product line to expand. Through a contractual clustered control contracting structure, the firms at the top buy from a specified contractual base. This section has presented streams of thought, topics and definitions that will be used for modeling in the theory chapter (Chapter 4).**^ The discussion of contractual relations has been concerned with the theory of transaction costs, contracts and behavior. The next section examines the theory of the firm as a coordinating and mediating structure for transactions. Theories related to the limits and boundaries of the firm are also explored. Here, again, Williamson’s arguments are kept to a minimum as his contributions are explored in great depth in Chapter 4. O'er time, many of these contractors were converted from single discrete process specialists to contract assemblers and sj'stems components manufacturers who increasingly assumed responsibilities for designing, testing, and procuring parts of certain mature products. Nishiguchi, 137. * *^ Thus far, a general description of components of contractual relationships lias been provided. Williamson’s woH c between 1985 and 1991, incorporates all of these topics and each, as he defines them, is explored in great depth as liis work is expanded and a new model of tlie “hybrid” firm is dc\ eloped. 76 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.4. Organizations as Structures for Economie Exchange North writes, “An economic definition of transaction costs are the costs of measuring what is being exchanged and enforcing agreement. In the larger context of societal evolution they are the costs involved in human interaction over time.”^ * ^ Discussed in the previous section was the usefulness o f the firm as a market- coordinating economic mechanism. Explored here is the theory of the firm as a coordinating and mediating mechanism for transaction costs, technology and human endeavor. Administrative mechanisms for coordination and control, hierarchy and governance structures are explored. Adam Smith is credited with first recognizing the need for economic coordination and specialization of function to increase productivity and create economic growth. Division o f labor and specialization are often cited as reasons for the need for organizations. Coase provided an additional argument with his theory of the firm which (he concluded) is organized to reduce market transaction costs. Much of the modem theory of the firm dates to the work o f Alchian and Demsetz who viewed the firm as a “nexus of contracts.” As discussed in the previous section, the organization as a set of contracting parties requires administrative coordination. Property rights proponents see the organization as mediating the use of specific property and the coordination and/or control of residual property rights, including 77 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. control and use o f assets. Langlois and Robertson point out the narrow approach of the Smith and Coase views of organizations; From the perspective o f real-world behavior and the boundaries of the firm, these assumptions ignore some of the most important factors that determine firm organization and underpin the relationship between firms and markets. They essentially relegate to second place, or even assume away altogether, the activities that people working for the firm are actually engaged in.^^"* Milgrom and Roberts state that the key role o f management in organizations is to ensure coordination. The success o f the organization is dependent on achieving effective coordination and the actions o f the many individuals and subgroups, making sure the focus o f activities is on organizational goals. Chandler connects the importance o f science and technology as a driving force in the transformation o f organization and structure in production and distribution. New organizations were organized when people found that market outcomes were inefficient. Also, where markets do not lead to efficient outcomes, other institutions or individuals, either public or private, may emerge. Market failure explains nonmarket economic activities. Barzel emphasizes organization design ^ North, “Transaction Costs Through Time,” 1 . 114 Langlois and Robertson, 11. ^ Milgrom and Roberts, 114. Chandler, Alfred, The Visible Hand: The Managerial Revolution in American Business (Cambridge, MA: Harvard University Press, 1977). 78 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. connected to measurement costs. He argued that an authoritarian organizational structure tied to knowledge, technology and repetitive routine in large-scale production and distribution process lends itself readily to measurement. This is especially true for monitoring, documenting, accounting trails and employee supervision. North draws upon this measurement and enforcement theme to relate both to the transaction sector and technology.^** North writes, “...the exchange process embodied in contracts has to be extended over long periods o f time, which entails uncertainty about prices and costs and the possibility o f opportunistic behavior on the part of one of the parties to the exchange.”' * ^ A number of organizational problems emerge from these characteristics associated with transaction costs associated with technology; (1) increased resources are necessary to measure quality o f output; (2) team production permits economies o f scale; (3) there is an increase in potential gains from opportunistic behavior that lead to both intra- and inter-firm strategic behavior; (4) the development of large Barzel, Yoram, “Tlie Entrepreneur’s R.ewwd for Self-Policing,” Economic Inquiry, 25 (1987); 103-116. 118 North, “Transaction Costs Tlirough Time,” (7). North states: “Necessary to be able to realize the gains of a world of specialization are control over qualit>' in the lengtliening production chain and a solution to the problems of increasingly costly principal/agent rclationsliips. Much technology indeed is designed to reduce transaction costs by substituting capital for labor or by reducing tlie degrees of freedom of tlie worker in the production process and by automatically measiuing the quality of intermediate goods. An underlying problem is tliat of measuring inputs and outputs so that one can ascertain tlie contribution of individual factors and tlie output at successive stages of production,” (7). Ibid. 79 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hierarchies produces the familiar problems of bureaucracy; and (5) the external effects of unknown costs place a cost burden on third parties. Much literature has been devoted to the design and size of the firm and the developmental direction that it takes. Williamson builds much of his transaction cost organizational theory from Coase's works, but he incorporates into his theory of the firm concepts of contractual relationships and asset specificity. The direction of Williamson’s research is that minimization of transaction costs will limit the boundaries of the firm. In his 1991 works he attributes market disturbance to the contractual form as selecting, in a Darwinian sense, the design and survivability of the organization. Later, in 1993, Williamson returns to this theme, but he further emphasizes the comparative efficiency on the basis of contractual relationships and the limits that it places on the • 122 organization. These concepts of organizational theory face opposing arguments. Langlois and Robertson argue that Ibid., 8. Coase asked the question of why all transactions arc not carried out in the market If the firm is more efficiency over the market then why isn’t tliere one giant firm. Recognizing that neither would be efficient Coase writes that all changes, which improve managerial tecluiique, will tend to increase tlie size of the firm (46). 122 Williamson, Oliver, “Contested Excliange Versus the governance of Conuactual Relations,” The Journal o f Economic Perspectives, 7 (January, 1993): 103-108, Williamson expands on liis theme of organizational form being selected from the competitive market in a Darwinian sense and be comparatively efficient on tlie basis of m arket disturbances which shape the contractual relationship (104). 80 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. [mjost theories of the boundaries o f the firm are static in an important sense. They take the circumstances of production as given and investigate comparatively the properties o f market-contract arrangements, internal organization, and sometimes other modes of organization. What happens, however, when the technologies o f production— and perhaps other environmental factors—are changing rapidly? Williamson’s assumptions of natural selection are challenged by Freedman who points out that organizational history and prior choices also impose limitations on organizational development. He does acknowledge that the organizational shape that firms develop must reflect the type of transactions required, but he believes that natural selection as a process of an efficient market has inherent difficulties. Freedman takes Williamson to task for a too simplistic approach to organizational design and development without considering the limits placed on the organization, and incentives from sources other that transaction costs and market efficiency.'^ Further criticisms o f Williamson’s evolutionary organizational development theme are articulated by Bowles and Gintis: “The inference that survival entails efficiency is unwarranted, for it ignores the path dependent nature of evolution and the possibility of multiple equilibria . . . . [W]here you end up depends on where you’ve 123 Freedman, Craig, “Williamson’s Back Door — Transaction Costs and tlie Efficient Firm,” Discussion Paper, the University of New South Wales, October 1993. Freedman cites organizational ffexibility as a survival mechanism tliat is at least equally, if not more, important (5). 81 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. been. . . Stiglitz is also critical of Williamson’s approach, citing evolution as being pathway-dependent and not truly reflective of the realities o f organizational development and survival. Stiglitz argues against Williamson’s assertion that institutions emerging from the competitive process will be comparatively efficient. He writes, “A voluntary signed contract improves the lot of both parties, but that does not demonstrate that the general equilibrium of the economy is Pareto efficient.” The “evolution” argument is a direction o f research in the boundaries and limits of organizations. It is part of an ongoing series of discussions in organizational innovation, developmental pathways, and complementarity. These themes are explored next as they relate to vertical integration. 3.5. Vertical Integration When nearly perfect competitive markets for inputs are present, there is little reason for a firm to be vertically integrated (i.e., supplying its own inputs). The decision to vertically integrate is often referred to as the “make or buy” decision of the firm. The decision to internalize inputs, rather than buy from the market, stems 124 Bowles, Samuel, and Herbert Gintis, “Tlie Revenge of Homo Economicus: Contested Exchange and tlie Revival of Political Econoinv,” The Journal o f Economic Perspectives, 7 (January, 1993): 97. Stiglitz, Jolm , “Post Walrasian and Post Marxian Economics,” The Journal o f Economic Perspectives,! (January, 1993): 109-114. 82 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. from a wide range of considerations: (1) how well the outside market is functioning in supplying the inputs, (2) determining whether the transaction should be within the firm or take place across the firm’s boundaries on the basis of cost and revenue, (3) the existence o f increasing returns to scale over a relevant range of production levels, (4) the ability to bargain with suppliers in an outside market through the bidding process, (5) evaluation of transaction costs associated with internal coordination and control, (6) transaction costs associated with monitoring an outside contracted supply source, (7) lack of expertise in the market for a specific product or service. This list is meant to be illustrative, not exhaustive. Economies of scale and scope in production are often the reasons cited for vertical integration. Economies of scale (usually at high volume production) allow a firm to reduce its per unit production costs relative to small scale production. This in turn allows a reduction in price, a better competitive advantage, and an increase in quantity demanded. Economy of scope refers to the ability to produce several products together at less cost than at the sum of the costs of a group of single product firms within a dynamic environment. Related to both concepts of scale economy and scope is that of firm core competency (i.e., a firm's capacity to introduce new products and produce them efficiently). Complementarity of design provides for related products to be produced as a result of firm knowledge and capacity, which allows for innovation. 83 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Research themes on vertical integration topics are numerous. A sampling includes; vertical integration and coordination of stages of production,*^® vertical integration as facilitating mass production, vertical integration for firm growth and scale economies to achieve innovation,*^*’ * ^ ^ vertical integration to facilitate and Teece, David, Vertical Integration and Vertical Divestiture in the U.S. Oil Industry: Analysis and Policy Implications (Palo Alto, CA; Stanford University Press, 1976). Teece views vertical integration as a result of a liigh degree of interdependence among successive stages of production. Vertical integration provides coordination for independent operations. Dihlculties in interdependence arise if program execution depends on contingencies that can not be predicted in advance. Although Teece does not identify contractual relationships specifically, uncertainty in contractual relationships can lead to vertical integration as a metliod to coordinate and control inputs. See also, Teece’s work: “Towards an Economic Tlieory of tlie Multiproduct Firm,” Journal o f Economic Behavior and Organization, 3 (1982); 39-63. 127 Piore, Miciiael J., and Cliarles Sahel, who argue tliat adoption of mass production, represent the triiunph of idea ratlier titan economic necessity. The Second Industrial Divide (New York, NY: Basic Books, 1984). The tliread of this argument is carried forward by Chandler who writes that the success of large organizations is linked to liigli tlirougliput production and mass distribution tliat implies integration of function. Cliandler, A, Scale and Scope: The Dynamics of Industrial Capitalism (Cambridge, MA; Harvard University Press, 1990). See also. Chandler, A., “Organizational Capabilities and tlte Tlicory of tlie Firm,” Journal o f Economic Perspectives, 6 (1992): 79-100. 128 Lazonick, William, “Competition. Specialization, and Industrial Decline,” Journal o f Economic History, 41 (1981): 31-38. Lazonick is a proponent of tlte large firm over tlte market as tlte coordiitating structure. In Itis early w orics he argues that tlte growth of tlte firm depends on tlte ability to combine economy of scale and irmovatica 129 See Teece’s work in 1986 in which he identifies bottlenecks in the irmovation process tftat cause traitsaction costs because they pose tlte tlueat of strategic expropriation of rents. This leads to a hold-up problem when tlte bottleneck owner realizes his strategic importance to irmovation and threaterts to withltold. Tltis in turn raises the price. From, “Profiting from Technological Innovation: Implications for Integration, Collaboration, Licensing and Public Policy,” Research Policy, 15 (1986): 285-305. 84 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. coordinate basic research, and vertical integration to produce fewer domestic competitors for global competition/^' 3.6. Pricing Theory The section presents information on pricing theory. Brief definitions of market pricing are offered that relate to competitive, monopolistic and oligopolistic markets. The focus o f this dissertation is on the contractual relationships that exist between firms and markets and intermediate forms. Where pricing is concerned, the type of market (as determined by the pricing and organizational mechanism) affects both firm and government behavior. A discussion of the competitive bidding and bargaining process would not be complete without a discussion of how prices are determined. A market is said to be perfectly competitive if there are many sellers and buyers so that the actions of an individual cannot affect the price of a commodity. Within this market, the products of all firms in the market are considered homogeneous; there is mobility of resources, and there is freedom of firm entry and Florida, Richard, and Martin Kenney, "Venture Capital-Financed Innovation and Teclmological Change in the USA” Research Policy, 17 (1988): 119-137. In Lazonic’s later works, one of which is cited here, he argues for large, vertically integrated oligopolies and even monopolies in order for corporate giants to compete in global markets. Lazonick, William, “Industry Clusters versus Global W ebs: Organizational Capabilities in the kaxtnaaEcQmmy." Industrial and Corporate Change, 1 (1993): 1-24. 85 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. exit. Additionally, all buyers and sellers have perfect information regarding current price, there is no collusion by sellers in setting prices, and the sale and purchase o f a firm is insignificant relative to the aggregate of the market. All buyers maximize utility, and sellers maximize profits. The equilibrium output of the firm is the output at which total profits are maximized. In the short run, i^ at optimum level of output, price equals marginal cost, the firm is maximizing total profits at an output. If price equal to marginal cost is less than average variable costs, the firm is minimizing total losses. In the long run, all factors of production and all costs are variable. Therefore, a firm will remain in business in the long run only if total revenues equal or exceed total costs. The point where price or marginal revenue equals long-run marginal cost gives the optimum output for a perfectly competitive firm. If at this level of output the firm is making a profit, more firms will enter this perfectly competitive industry until all profits are squeezed out.^^^ Entry occurs where there are profits to be made. Exit occurs where negative profits occur (average revenue is less than average costs). With free entry, where there are constant average costs and return to scale technology, the number of firms 132 MIT Dictionary o f Modem Economics, ed., David Pearce (New York: The Macmillan Press, Ltd., 1989). In pure competition, there are a large munber of independent sellers of some uniform product When each firm sets the price at which it sells its output it will have to take into accoimt the behaviors of both the consumer and the other producers (323) 86 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. will be variable. Market equilibrium depends on quantity, demand and supply prices. In some markets, such as that of monopoly, barriers to entry may exist In a monopoly market there is a single supplier of a homogeneous product. The objective of the monopolist is to maximize profits by setting marginal cost equal to marginal revenue while cutting output quantity and raising price. A lack of competitors allows the monopolist to behave in this way. Decision-making for the monopolist is how much output and at what price to sell the o u t p u t . T h e price charged by the monopolist is a markup over marginal cost, with the level of markup being given as the function o f the price elasticity o f demand. In pure monopoly, the monopolist is Pareto inefficient. However, the discriminating monopolist can be Pareto efficient. After the monopolist sells the units of output at monopoly price and takes the profit, then the monopolist can offer added output to the public. The public pays the monopoly price but are better off because they can purchase the extra output. The monopolist is better off in selling the extra unit. This will continue as long as consumers are willing to pay. 133 Apgar, William, and Harold Brown, Microeconomics and Public Policy (New York: Scott, Foresman and Company, 1987). Tlicy identify some of tlte most common barriers to entiy wliich include: (1) Decreasing average cost of production of existing firms so tliat entering firms don’t have enougli capital to invest in tlie assets to compete; (2) institutional restrictions such as licensing or zoning; (3) product dififerentiation; and (4) spatial impact where tlte market only supports a producer of an efficient size. 134 If the marginal revenue exceeds tlte marginal cost of production, tlte monopolist will expand output. The expansion stops when marginal revenues are equal to marginal costs. 87 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Competitive monopoly markets can exist. This is where several monopolists “compete” in setting their prices and output levels. In this instance price must equal average cost for each firm, and each firm must be operating at a maximal profit point on its demand curve. The monopolistic competitive equilibrium reveals excess capacity. The monopolistic competition model represents a case between competition and monopoly. Now, suppose that there are monopoly firms but that the goods produced are all very close substitutes so that the demand curve facing each firm is fiat. In the long run, the monopolistic competitive equilibrium is near the competitive equilibrium. With a fiat demand curve facing each firm, the competitive solution is reached. When the boundaries of the market are considered, a location monopoly can exist. A new firm enters and begins to produce a product tliat is a close substitute for tlie product of Firm I. Firm I finds tlie demand for its product clianges and tliat at each price it would not be able to sell as much as it did before; tlierefore, price and output drop. If tliere is only one firm in the industry and there is some sort of barrier to entry, then the monopoly equilibrium results (286). The MIT Dictionary o f Modern Economics, cd., David Pearce (New York: Tlie Macmillan Press, Ltd., 1989). Varian, )ia l. Microeconomic Analysis (New York, NY: W.W. Norton & Company, Inc., 1978). Varian says to consider the model where identical consumers reside along a circle. Assume that each consumer wants to buy one and only one unit of some output, considering a maximum the consumer is willing to pay. Firms are located discretely along tlie circle. Tlie consumer will consider the distance between each firm and tlie cost to travel to tlie firm as part of tlie per-unit purchasing decision (68-69). 88 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Oligopoly exists when there are a few firms in the industry so that each one constitutes a fairly substantial share of the market. A duopolostic industry contains only two sellers. If there is no perceptible influence of one seller’s decision (quantity or profit) upon the other, then some other market condition may be in operation. If changes in quantity, profit, or price are noticeable on an order o f magnitude, it is duopolistic or oligopolistic. The price-quantity combination and profit of a duopolist or oligopolist depend upon the actions of all members of the market. The Cournot collusion and Stackelberg solutions are developed for markets with homogeneous products but can be extended to differentiated markets. * * * ° An action-reaction occurs with each duopolist adjusting quantity and price to counter the behavior of the other or others. Collusion occurs if the duopolists or oligopolists 138 Assume S)Tnmcuical long-nm competitive monopoly equilibria with all firms charging average price. Each firm operates somewhere on its average cost curve making zero profits. Tlu-ce possible outcomes are possible: (1) A pure monopoly can exist so tliat each firm operates at a point inside its own market area. Consumers living between market areas of tlie firm are not served. (2) Market areas of the firm just meet. In tltis case each firm as essentially a monopoly on its own customers, but all customers are served. (3) Market areas overlap so that each firm has to compete for some of its customers. See Varian, Microeconomic Analysis (69-71). 139 Henderson, James M., and Richard E. Quandt, Microeconomic Theory (New York, NY: McGraw- Hill Book Company, 1958), 175-180. An oligopolistic industry contains a munber sufficiently small so that tlie actions of any individual seller liave a perceptible influence upon tlie rivals. Tlie essential distinguishing feature is the interdependence of the various sellers’ actions. If tlie influence is imperceptible, tlie industry satisfies tlie basic requirement for either perfect competition or die many-sellers' case of monopolistic competition. 140 The basic behavior assumption of the Cournot solution is Üiat each duopolist maximizes his profit on the assumption diat die quantity produced by tlie rival is fixed. One sets an output and the other adjusts, or one becomes tlie price leader, and die oilier follows (88). The MIT Dictionary o f Modern Economics, 1989. 89 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. recognize their mutual interdependence and agree to act in unison in order to maximize the total profit o f the industry. Stackelberg’s solution is to observe the action-reaction function.*” * * Stable equilibrium will be achieved as in the Cournot model except that the sophisticated duopolist will have higher profits than the naive duopolist. If both firms become sophisticated, then disequilibrium will result with the necessity for collusion. A price war would be damaging to the profits of each duopolist and is to be avoided. Price leadership occurs when one firm takes the initiative in making price changes and others follow. Monopsony is a classification for the market of factors of production. If firms take the factor price as given, then there is a competitive factor market. Monopsony occurs when there is a sole buyer of a factor of production who takes the 141 Stackelberg's solution incorporates tlte notion of a “sophisticated” duopolist who recognizes tliat the competitor acts on the Cournot assumptions wliich is tliat each firm maximizes profits, assuming the competitor’s output remains constant. Tlie sopliisticated duopolist will act like a monopolist, incorporating tlie rival’s predicted decisions into liis considerations and becoming in effect a price leader, and choosing the price which maximizes profits subject to the known reaction of the rival firm. MIT Dictionary o f Modern Economics, 1989. 142 There are three forms of price leadersliip: (1) Dominant firm price leadersliip where one dominant firm sets the price, and fringe firms must accept tlie price; (2) Barometric price leadership which is distinguished by change in tlie identity of tlie leader, and (3) Collusive price leadersliip. Tliis occurs in oligopolistic markets where few established firms have similar market share as well as demand and cost conditions. Price initiatives by any one firm will be reflected in the wishes other the otliers. MIT Dictionary o f Modern Economics, 1989. See Also Walters, Stephen J.K., Enterprise, Government and the Public (New York, NY: McGraw-Hill, Inc., 1993) 175. 90 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. supply behavior of its supplier into account. Under this condition, a monopsonistic factor market exists. Bargaining is a complex process that is central to economic life. “Such hard- to-describe features as bargaining strength, credibility, guile, patience, and strategic insight, would combine with initial conditions to determine the outcome. . . . The value maximization principle means that the value-creating aspects of the agreement are determinate. Only the monetary transfers would be determined by bargaining strength.”* * * ^ Information asymmetries can lead to the potential that bargainers will misrepresent value to get a better price. To prevent misrepresentation, each party to the bargain must attempt to behave in a straightforward fashion. If both sides to a trade named the actual value to each, trade would be immediate. In actuality, trade occurs if the buyer’s valuation exceeds the sellers. 143 As e (elasticity of supply) approaches tliat of infinity, monopsonistic beliavior approaches tliat of a competitive market Varian, however, establishes tliat externalities and common pool resources are still important considerations, AZ/croeconowi/c.-l/m/yris, 1978, 74-75. 144 Milgrom and Roberts, 1992, 140. 145 Milgrom, Paul, and John Roberts, 'Timit Pricing and Entry Under Incomplete Information: An Equilibrium Analysis,” Econometrica, 50 (1982): 443-459. Milgrom and Roberts contribute their insigiits to bargaining and price behavior in tlieir treatment of signaling as deterrence to entry. “Building on tlie ideas of Philip Nelson, we also developed tlie model of prices and uninformative advertising as signals of product qualit),” Milgrom and Roberts, 1992, 162. 146 This leads to a typical pattern identified by Milgrom and Roberts: "\Vlien incentive constraints arc important in bilateral bargaining, trade takes place only if the gains from trade arc sufficiently large...In many exchanges, some important characteristic or quality of tlie good being traded is imknown to the buyer and seller,” Milgrom and Roberts, 1992, 144-147. 91 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.7. The Use of the Industrial Organizational Model of Health Care Delivery The structure of the hospital market has changed over time. Hospitals have been predominantly nonprofit, independent institutions, generally competing in local markets and providing inpatient services. The trend for hospitals to be part of a larger organization, a multihospital, and to become vertically integrated, that is, to provide an entire range of services, such as ambulatory care clinics, inpatient care, outpatient surgery, home care and nursing home care, has been demonstrated in the last fifteen years. As a result, the hospital industry is more concentrated. The reasons cited for vertical integration and mergers include scale economies, lower interest costs, greater access to capital markets, and improved cash management. Hospitals facing declining occupancy rates, more stringent reimbursement policies, and declining profitability are more willing to give up their autonomy to survive. These systems are comprised of investor-owned secular nonprofit, religious and public hospitals. According to Fuchs, managed care may be responsible for the mergers occurring in the health care industry. He holds the concept of managed care, as an organizational mechanism to lower health care costs which rose twice as fast as the rest of the economy until 1990, responsible for the vertical integration of hospitals into health systems. In the process, he feels the physician-patient relationship has Feidstein. 230-232. 92 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. been damaged, and the most detrimental mergers are those that increase market share or inflate stock prices. Fuchs is skeptical that consolidation has become a more efficient method o f delivering care, stating that large consolidations are usually followed by deconsolidation, as firms become too large and inefficient.**** Much o f the literature on health care vertical integration and oligopoly draws conclusions through the use of case studies. Vertical integration and managed care are viewed as alternatives to competition that forced physicians and hospitals to specialize to boost profits.***^ On the other hand, hospitals vertically integrate to increase market share and control premium dollars distributed to providers. The measure of success for an integrated delivery system is the extent to which it sustains market power. Price competition has changed the way health care services are delivered and paid. Through selective contracting, managed care plans curb expenditures and limit covered services. Vertical integration produces large hospitals, physician groups, and insurance companies to secure contracts for medical care, squeezing out the smaller providers who must either drop out or merge. Statistically, the numbers that have already done so evidences the tendency for * * * * Fuchs. Victor, “Managed Care and Merger Mania (Commentary),” The Journal o f the American Medical Association, 111. no. 11 (March 19, 1997); 920-921. 149 Anderson, Howard. “Hospitals Seek New Ways to Integrate Healthcare,” Hospitals, 66, no. 7 (April 3, 1992): 26-36. Kaufman, Nathan, “Power Notebook (Managed Care Integration Strategy),” Hospitals & Health Networks. 69, no.3 (Feb 5, 1995): 58-61. Bodenlieimer, Thomas, and Kevin Gmmbach, “The Reconfiguration of U.S. Medicine,” Journal of the American Medical Association, 274, no. 1 (July 5, 1995): 85-91. 93 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospitals to vertically integrate. Between 1979 and 1991, community hospitals affiliating or merging increased from 30% to 50%; forty-eight HMO mergers, sales and acquisitions took place in 1992. Many geographic areas have three to four networks covering most of the p o p u latio n .B y 1993, ten insurance firms controlled 70% of the HMO market and two. Metropolitan Life and Travellers, have merged. Empirical work focusing on hospital consolidation, competition, regulation, and governance structure differences was conducted by Graham and Cowing (1997). They examined a number of variables related to hospital reserve margin, which is defined as the number and percentage of unused beds. They conclude that consolidation should be encouraged because large hospitals hold smaller relative amounts of unused beds and can provide a diverse array of procedures. Hospitals with less market power and those with high inpatient prices have lower reserve margins. They are not as capable of substituting inpatient beds from different wards to meet demand. They also find that the hypothesis that for-profit hospitals are more efficient than not-for profit hospitals is not true.'^^ Ibid., 87. Woolliander, Stcffie, and David V. Himmelstcin, “Giant HMO ‘A’ or Giant HMO ‘B’ Galloping toward Oligopoly,” Nation, Vol. 259 (Sep. 19, 1994): 265-268. 154 Graham, Glenn, and Tliomas Cowing, “Hospital Reser\’ e Margins - SUnctural Determinants and Policy Implications Using Cross-Section Data,” Southern Economic Journal, 63, no. 3 (Jan 1997); 692-710. 94 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.8. Political Economy Markets have been studied extensively in public policy as a means of identifying points o f governmental intervention if the market fails. The three traditional reasons for market failure are transaction costs, information asymmetries, and the existence o f public goods. Markets in perfect equilibrium have zero transaction costs and perfect information. Market disequilibrium, which leads to market failure, violates the basic assumptions of the competitive economy. This disequilibrium interferes with efficiency in production or consumption and leads to the following: market failure, the government identification and provision o f public goods, and externalities with social and/or transaction costs. The most common rationale for government regulation of an industry is the need to limit monopoly and the monopolist’s natural incentives to restrict output and charge too high a price, leading to misallocation o f resources. Four pieces of legislation in anti-trust were passed in the early part of the century: The Sherman Anti-Trust Act of 1890 prohibited monopolies; the Clayton Antitrust Act in 1914 outlawed specific practices such as price discrimination and contracting collusion; the Robinson-Patman Act of 1936 outlawed quantity discounts not justified by cost differentials; and the Allen Anti-Merger Act of 1950 forbade companies from acquiring the assets of competitors when the effect is to reduce competition. It is market failure that is often offered as the rationale for public provision of private, quasi-private, or public goods. Market failure is cited as the need for the 95 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. regulation of markets by government agencies. Public policy initiatives can range from those formulated in the political realm to those formulated by microeconomic experts. The scope of this dissertation was to examine the traditional microeconomic theory as developed for industrial organizations and identify those areas where linkages can be made to the health care sector. 96 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 4 THEORETICAL CONTRIBUTION TO THE HYBRID USING TRANSACTION COST ECONOMICS, ASSET SPECIFICITY AND THEORY OF CONTRACTS 4.1. Introduction This chapter integrates Oliver Williamson’s theoretical work in contracts and governance between period 1985, when he published his book. The Economic Institutions o f Capitalism,^^^ and his 1991 article in Administrative Science Quarterly entitled “Comparative Economic Organization: The Analysis of Discrete Structural Alternatives.Because both works are integrally important to the development o f a theoretical model o f optimal pricing in the hybrid firm, assumptions from both the book and the article are articulated in this chapter. Then, a general equilibrium pricing model o f the market-hybrid-hierarchy (with emphasis on the hybrid) is advanced. Toshihiro Nishiguchi’s work on asset specificity, clustered control relationships, and differences between western and eastern Williamson, Oliver, The Economic Institutions o f Capitalism (New York, N.Y.: Tlie Free Press. 1985). ' W iU iaj Administrative Science Quarterly, 36 (June, 1991): 269-296. Williamson, Oliver, “Comparative Economic Organization: Tlie Analysis of Discrete Structural 97 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. contractual relationships is used to illustrate why the hybrid optimal pricing efficiency gains are met/^^ Oliver Williamson’s 1985 book and consolidated theory in his 1991 article are important to integrating economic organizational concepts of contract and governance. Such an integrative approach allows extension o f this theory to a new contractual model of the hybrid firm (i.e., one that describes the intersection of the market and the hierarchy, with the hybrid as an intermediate form, and the optimal pricing, asset specificity and contractual safeguards that result). This dissertation makes arguments from the models and assumptions of economic theory developed by the cited authors. The modeling in this dissertation integrates, refines, and expands Williamson’s theories between 1985 and 1991. The author uses Bart Kosko’s fuzzy set theory*^* to develop an economic model of the market-hybrid-hierarchy forms of organization. The model and arguments ultimately advanced here are the author’s contribution to analysis of hybrid forms of health care organization. This phase of the research seeks to provide an integrative cognitive map of Williamson’s analysis of discrete structural alternatives and the development of an optimal pricing and contractual general equilibrium model o f the hybrid. In Williamson's 1991 work, markets and hierarchies are polar modes, with the hybrid Nishiguclii, Toshihiro, Strategic Industrial Sourcing: The Japanese Advantage (New York, NY: Oxford University Press, 1994). 158 Kosko, Bart, Fuzzy Thinking: The New Science o f Fuzzy Logic (New York, NY: Hjperion, 1993). 98 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. mode defined at the interface. The hybrid mode is characterized in contractual terms by semi-strong incentives/an intermediate degree of administrative apparatus, semi-strong market adaptations of both market and hierarchy, and a semi-legalistic contract law regime. As the condition of bilateral dependency builds the hybrid, asset specificity deepens. A general equilibrium optimal price model for the hybrid is developed on the basis of optimum asset specificity and safeguards. This is then compared to Nishiguchi's findings and his work on asset specificity, bilateral contracting, and clustered control organizational forms. 4.2. The Firm and the Market Oliver Williamson writes. Firms, markets and relational contracting are important economic institutions. They are also the evolutionary product of a fascinating series of organizational innovations . As 159 Williamson defines tlie market as providing strong incentives and liierarcliies providing weak incentives. The hybrid provides semi-strong incentives; i.e., not as strong as tlie market, but not as weak as tlie liierarchy. “Comparative Economic Organization; Tlie Analysis of Discrete Structural Alternatives,” 280. Asset specificity refers to tlie degree in wliich an asset can be redeployed to alternative uses and by alternative users witliout sacrifice of productive values. Disturbances for which coordinated responses are required become more numerous and consequential as investments in asset specific ity deepen. As compared to the m arket, tlie hybrid sacrifices incentives in favor of superior coordination among tlie parts. As compared witli tlie hierarchy, tlie hybrid sacrifices cooperativeness in favor of greater incentive intensity. Francliising awards greater autonomy than hierarchy but places fhmcliisees under added rules and surveillance as compared with markets. Williamson, The Economic Institutions o f CapUalism, 15. 99 R e p r o d u c e d with permission of the copyright owner. Further reproduction prohibited without permission. compared with other approaches to the study of economic organization, transaction economics (I) is more microanalytic,*^^ (2) is more self conscious about its behavioral assumptions, (3) introduces and develops the economic importance of asset specificity, (4) relies more on comparative institutional analysis, (5) regards the business firm as a governance structure rather than a production function and (6) places greater weight on ex-post institutions of contract with special emphasis on private ordering^^ (as compared with court ordering). The transaction is the basic unit of analysis and (the theory) insists that organizational form matters. Governance structures exist to minimize transaction costs, which are the costs of running an economic system. These costs are distinguished from production costs. Transaction costs are the economic equivalent o f friction in physical systems.Empirical research on transaction costs almost never attempts to measure such costs directly. Instead, the question is whether The term microanatytic is used here to distinguish tlie unit of analysis as tlie transaction ratlier than tlie production function. Williamson, “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” 287. In tlie equilibrium distribution of transactions, tlie institutional environment, as a set of parameters, clianges in respect to tlie comparative cost of governance. Tlie comparative governance cost setup needs to cliaracicrize parameter clianges as improvements (or not). 164 Private ordering refers to tlie contractual relationship of direct participation in tlie market ratlier tlian tliat which is a court-ordered empioyer-cmployee contractual relationsliip. Williamson, The Economic Institutions o f Capitalism, 17-18. Williamson uses Keimeth Arrow’s definition of Utuisaction costs in: ICennetli Arrow, “Tlie Organization of Economic Activity: Issues Pertinent to tlie Choice of Market versus Nonmarket Allocation.” In The Analysis and Evaluation of Public Expenditure: The PPB System, vol. 1, U.S. Joint Economic Committee, 91“ Congress, 1 “ Session, 1969, Wasliington, D C., U.S. Government Printing Office, 48. 100 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. internal or external organizational relations (contracting practices; governance structures) are consistent with the attributes of transaction cost reasoning. 4.3. Cognitive Map of Contract Figure 4-1 is a replication o f Williamson’s “Cognitive Map of Contract.”^ * * * Williamson describes the departure points of the organizational monopoly and efficiency branches, and describes the further divisions of the efficiency branch. The efficiency branch minimizes transaction costs by assigning transactions (which differ in their attributes) to governance structures which are the organizational frameworks within which the integrity of a contractual relation is decided. Transaction cost economics adds the proposition that the ex-post support institutions of contract matter. Williamson, The Economic Institutions o f Capitalism, 22-24. Williamson’s “Cognitive Map of Contract,” labeled Figure 1-1 on p. 24, The Economic Institutions o f Capitalism, describes the dcpanure points of the organizational monopoly and efliciency branches. Both arc concerned willi ilie puzzle of when industrial organizations supplant market exchange. He furtlicr divides tlte incentive branch in two. One concerns property riglits, the other agency. Within tlte agency branclt, he identifies tlte logical positivists’ direction in wltich the organizational fonn is naturally selected witlt Darwinian efficacy. Tlte otlter direction of agency is that of the principal-agent tlteorists and tlte complications with subordinates that arise from iitformation asymmetries. 101 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Leverage C ustom er Price D iscrim ination Entry Barriers PF PF Rival Strategic Behavior M onopoly Property Rights Efficiency Incentives Agency G overnance T ransaction Cost M easurem ent F ig u re 4-1 Williamson's C ognitive M ap o f Contract 1 0 2 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Transaction cost economics further maintains that the most critical dimension for describing transactions is the condition o f asset specificity. Parties engaged in a trade that is supported by nontrivial investments in transaction-specific assets are effectively operating in a bilateral trading relation with one another. Harmonizing the contractual interface that joins the parties, thereby to effect adaptability and promote continuity, becomes the source of real economic v alue.Table 4-1 is a summary of characteristics of the different branches of the map. Williamson’s 1985 work The Economic Institutions o f Capitalism is primarily concerned with llie governance branch of transaction cost economics as he distinguishes contractual trading attributes of the market and tlie firm. His later w ork “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” focuses on asset specificity specifically as he defines an intermediate form of governance (the hybrid) based on organizational economic and contract theory. Ibid., 25-29 103 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-1 Characteristics of Williamson’s Cognitive Map of Contract Monopoly EfTiclency Neoclassic framework of firm as production function — Price in relation to buyers — Practices in relation to rivals Natural boundary of firm defined by tlie production function Antitrust laws applied tluough price tlieory Production function separate from strategic conception of contract Distinguishes incentive alignments from those of transaction costs Boundary defined by contracts and governance Incentive Alignment focused on ex-ante side of contracts Transaction cost analysis lies outside of production function______________________ Property Rights Branch Ownership matters and rights accrue to the assets Transaction cost tlieor}- builds from that of private ordering Complex contracting is used to master organization and inefficiency_______________ Agency Branch Principals contract with agents to execute contracts Principals are aware of the hazards ex-ante Agency tlieory is divided into two parts: — Positivist: Efficacious organization form naturally selected — Principal-agent: Complications of information as\Tnmcin' Governance Branch Adopts tlie science of contract Joins tlie arbitrator with an institutional design specialist Agents are boundcdly rational and given to opportunism Transaction cost atuibutcs arc assigned to governance structures Governance Structures provide framework for contracts Measurement Branch Transaction cost attributes are associated with economic supply 104 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.4. Simple Contracting Schema Figure 4-2 is a replica of Williamson’s Figure 1-2.’^ * The underlying assumptions for this contracting schema follow: Assumption I: General purpose or special purpose technology supplies a good or service. Special purpose technology requires greater investment in transaction specific assets. Assumption 2: k is the measure of the good or asset specificity; k = 0 denotes general purpose technology. In this case, a free market governance suffices; guarantees are obtained through competition. Assumption 3: Parties to a contract have an incentive to devise safeguards to protect the assets of the k > 0 kind; s denotes the magnitude of safeguards. When s = 0, no contractual safeguards are provided. When s > 0, contractual safeguards are provided. Williamson, The Economic Institutions o f Capitalism, 33. 172 Assumptions I through 6 arc abstracted from The Economic Institutions of Capitalism, Chapter I. 105 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. k> 0 P > p Figure 4-2 W illiamson's "A Simple Contracting Schema Assumption 4\ Comparative institutional analysis emphasizes that technology (k), contractual governance/safeguards (s) and price (p) (output p ric e)are fully interactive and are determined simultaneously. Price is defined as the relative market supply price of a good or service. 173 In Williamson’s contracting schema tlirce values of price are given; p is tlte m aricet price, p is tlte contractually unsafeguarded price and p is tlte contractually safeguarded price. The Economic Institutions of Capitalism, 33. 106 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Assumption 5: Nodes A, B, and C set out in the contractual schema have the following properties: At Node A, assets are general purpose along the branch where k = 0. Price (p), which is market derived, enjoys no contractual safeguards and traders can remain anonymous. Transactions that involve significant investments o f a transaction specific kind k > 0 are ones for which parties are effectively engaged in bilateral trade. Asset ownership matters and traders cannot remain anonymous. Transactions at Node B enjoy no contractual safeguards, s = 0 but there is some asset specificity. This renders Node B unstable with an effect on the projected supply price such that:^^*^ p > p These transactions are apt to be unstable contractually; they may revert to node A or be relocated to node C with the introduction of contractual safeguards (s > 0) that would encourage the use of k > 0 technology. While it might appear that marginal cost increases with the introduction of contractual safeguards, which should increase 174 Tlie price at Node B is greater than die price al node C because tlie buyer is not contractually bound to the seller (i.e., tlie buyer wants tlie lower price that the contract safeguards, but is ofiering no guarantee to tlie seller tliat repeat business is in tlie oiling on a continual or intermittent basis). Tlie seller in a Node B transaction must ask for tlie higher price because of the transaction costs of dedicating assets for tlie job. Fitting a job into the job queue, with no guarantees tliat tlie customer will retiun, runs tlie risk of alienating tlie other repeat customer’s business; this is especially true for the customer who has committed to a contractual relationship. 107 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. price, price actually decreases because the buyer guarantees the purchase which allows dedication of assets to the trade. Transactions at Node C incorporate safeguards (s > 0) resulting in p . These transactions are protected against expropriation hazards, subject to property rights. Contractual safeguards are the greatest, and asset specificity is the deepest at Node C. Assumption 6\ Since price and governance are linked, parties to a contract should not expect to have their cake (low transaction cost price) and eat it too (no safeguards). It is important to study contracting in its entirety. Both the ex-ante terms and the manner in which contracts are thereafter executed ex-post vary with the investment characteristics and the associated governance structures in which transactions are embedded. Any problem that can be posed directly or indirectly as a contracting problem is usefully investigated in transaction cost minimizing terms. Williamson’s “Cognitive Map o f Contract,” and “Simple Contracting Schema” serves as useful devices in advancing his argument. Figure 4-3 incor porates these six assumptions and their characteristics into a “Pricing Theory of Contract.” 108 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. K =0 Leverage Unassisted Market Governance Customer Price Discrimination PF Entry Barriers Rival K. =0 Strategic Conception of Contract Strategic Behavior Monopoly Property Rights cx-antc side of contract ex-post side of contract Efficiency S = 0 Incentives Agency K>0 Governance Transaction Costs M easurement Figure 4-3 Pricing Theory of Contract 109 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Assumption 7: Monopoly supply is productive-efficient where economies of scale are large in relation to the size of the market. Monopoly transactions are located at Node A, and it is monopoly market safeguards, not contractual safeguards, that ensure the higher price p. 4.5. Pricing Theory of Contract This model integrates Williamson’s concepts of contracts and further defines price in relation to different governing structures located at the three nodes. Price p at node A lies along the side where assets are general purpose and asset specificity does not exist (K = 0)*^^. Safeguards to the trade are competitive market safeguards rather than contractual safeguards, and market governance prevails. The boundary of the production function (PF) contains Node A and the area defining the market. According to Williamson, this area is concerned with second-order economizing. The focus of this dissertation is the strategic conception of contract and the transaction cost economics that lie outside of the production function boundary. O f particular interest is what happens to price between unstable Nodes B and C. At Node B the seller must either remain as an autonomous market trader or develop a coordinating structure (market - hybrid). Node C is where asset specificity is deep. For dissenation modeling purposes, Williamson’s use of lower case k for asset specificity and s for contractual safeguard are converted to tiic upper case in discussions of Nodes A, B, and C and in the branches of tlie “Cognitive Map of Contract” Lower case k and s are used when set tlieory is introduced later in tliis cliapter. 110 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. contractual safeguards are great, and coordinating governance structures are implemented. The hybrid to hierarchy shift lies between these two Nodes. A line between property, agency and governance structure divides the concepts o f ex-ante and ex-post contractual relationships as a conceptual mapping point for the behavior of price under the conditions of specialized assets (K > 0) and un safeguarded and safeguarded contractual conditions. This line is at the point K > 0 because once assets are dedicated, an agency relationship is established because the trade is no longer anonymous, but specific and dedicated. It is already noted that price p is higher at Node B than the price p at Node C because of the uncertainty of the unsafeguarded trade when assets are special purpose and represent a significant investment by the seller (safeguarded price is less that price under conditions of uncertainty). Property rights secure the asset for the seller, but the seller seeks the higher price ex-ante when the buyer does not offer safeguards to the trade. With contractual safeguards ex-ante, the seller can lower the price in anticipation o f a continued trading relationship. Agency is placed on the ex post side of contract as principal-agent theory emphasizes that principals and agents have ex-post contractual relationships (within inherent risk in ex-post performance), and contractual safeguards are placed within the contract with written or implied contractual controls implemented within the principal-agent relationship ex-post. It is the uncertainty o f the bilateral contractual relationship that keeps price higher in the direction of Node B. I l l Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Contractual oversight requires a coordinated governance structure for contractual monitoring and to prevent shirking; thus, the ex-post side of contract includes a greater coordinated governance structure. Knowledge and reputation effect between the two contracting parties is gained ex-post the contracting relationship which allows a negotiation of the price in the direction of greater coordination. Eventually, the cost of a coordinated governance structure (such as monitoring and shirking) can exceed the benefits gained from specialized assets and safeguarded contracts. Williamson’s 1991 work examines this concept specifically as he develops the model of “discrete structural alternatives” and the transaction costs associated with the relationship of asset specificity, contractual safeguards and mediating governance structures. 4.6. Firms, Hybrids and Hierarchy Williamson’s contemporary work continues the study of economic organization from a comparative institutional point o f view in which transaction cost economizing is featured. In his 1991 article, Williamson argues that hierarchy is not merely a contractual act, but also a contractual instrument and a continuation of market relations by other means of market exchange. His paper combines institutional economics, aspects of contract law, and organization theory to distinguish three generic forms of economic organization— the market, hybrid and 112 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hierarchy. However, he states that the “[cjomparative economic organization never examines organization forms separately, but always in relation to alternatives.”* ^ ® Williamson’s argument o f discrete structural analysis asserts that (I) firms are not merely extensions of markets but employ different means, (2) discrete contract law differences provide crucial support for and serve to define each generic form of governance, and (3) marginal analysis is typically concerned with second-order refinements to the neglect of first-order . . 177 economizing. According to Williamson, first order economizing affects adaptation and eliminates waste. His interpretation of Frank Knight and Oskar Lange is that economics has been too preoccupied with issues of allocative efficiency (first order economics), in which marginal analysis is featured, to the neglect of organization efficiency (second order economics) in which discrete structural alternatives are brought under scrutiny. Even more basic is the propensity to focus exclusively on market mechanisms to the neglect of discrete structural alternatives.*^*' The discriminating alignment hypothesis to which transaction-cost economics owes much of its predictive content holds that transactions which differ in their attributes are aligned with governance structures which differ in their costs and competencies in a discriminating (mainly, transaction-cost-economizing) way. But whereas the dimensionalization of transactions received early and explicit Williamson, “Comparative Economic Organization: Tlie Analysis of Discrete Slructural Alternatives,” 269. 177 Tliis is a continued theme from Williamson’s 1985 work. 178 Williamson, “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” 276-277. 113 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. attention, the dimensionalization of governance structures has been relatively slighted. . . . Market, hybrid, and hierarchy differ in contract law respects, . . .but there is more to governance than contract law. Crucial differences in adaptability and in the use of incentive and control instruments are also germane. The challenge to comparative contractual analysis is to discern and explicate the different means of contracting relationships. Each viable form of governance— market, hybrid, and hierarchy—is defined by a syndrome of attributes that bears a supporting relation to one another. These attributes are described in Table 4-2;’^° Table 4-2 summarizes the seven attribute characteristics by governance type. Williamson’s underlying hypothesis is that each governance type is supported by a type of contract law. Parties to a trade are contractually bound differently based upon the type o f governance structure. Contract disturbance type, contract resolutions, control mechanisms, method of contract realignment (adaptation) and incentive to contract will be different because the laws supporting each type of contract differ as follows: 179 Ibid., 277. Tills is a summary of Williamson’s governance attributes described in ’ ’Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” 269-296. He focuses on tlie hybrid in response to criticism tliat institutional economics focuses on polar forms of market and firm to tlie neglect of an intermediate or hybrid form. 114 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-2 Governance Syndrome of Attributes Attributes Market Hybrid Hierarchy Contract Type Classic law, unilateral Neoclassic law, bilateral Forbearance law, fiat, employment contract Disturbance Type Highly consequential Consequential Inconsequerrtial Disturbance Resolution Court standing litigation Arbitration Internal organizational structure Market Adaptation to Environment Through price Bilateral long-term dependency Through internal coordinating mechanisms Control Buyers and sellers reposition autonomously Some hierarchy, contractual safeguards, administrative apparatus Hierarchy and administrative controls Incentives Strong, driven by market Semi-strong, some incentives sacrificed for superior coordination Weak, direct market incentives, bureaucratic costs Asset Specificity Light Semi-strong Deep 115 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.6.1. Market Attributes Market trading is supported by classic contract law in which parties to the trade are anonymous. A good or service is offered at a price and is subject to price competition for the same or substitute goods and services. This is the nature of a unilateral contract (i.e., the seller sets the price, and the buyer agrees and pays the price or reneges and walks away). In this type o f unilateral contract (the offer is made and either accepted or rejected), buyer and seller remain anonymous and bear no dependency relationship. Each party can go his own way with negligible transaction costs. If there is a disturbance to this unilateral contract in the form of a trade dispute, resolution is through the courts where both parties have standing. In most instances of market trading, disputes are minimal, transaction costs are low, and incentives to trade via the price system are high subject to competition. Competitive efficiency results and is market driven. 4.6.2. Hybrid Attributes Bilateral trade agreements characterize the hybrid governance structure. The parties can no longer remain anonymous, and neoclassic contract law prevails as negotiations require both parties to engage in the contract. Trading is bilateral. Middle range or consequential disturbances are ones to which neoclassical law applies. . . . By contrast with a classic contract, this contract (1) anticipates disturbances for which adaptation is needed, (2) provides a tolerance zone. . . within which misalignments will be absorbed, (3) requires 116 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. information disclosure and substantiation if adaptation is proposed and (4) provides for arbitration in the event voluntary agreement fails/** Dispute resolution is through arbitration rather than the courts. This leads to a trade-off o f transaction costs as follows: The partners trade anonymity for reputation seeking a lower price for the buyer and a greater trade guarantee for the seller. Unilateral market trade advantage is subrogated to coordination through hierarchy. As a result transaction costs are lowered in dispute resolution as private ordering arises in importance and arbitration is used over litigation. However, Adaptability withstanding, neoclassical contracts are not indefinitely inelastic. As disturbances [to the contract] become highly consequential, neoclassical contracts experience real strain, because the autonomous ownership continuously poses an incentive to defect. . . . From an economic point of view, the tradeoff that needs to be faced in excusing contract performance is between stronger incentives [to contract] and reduced opportunism.**^ 4.6.3. Hybrid Organizations How do hybrids compare with respect to adaptability (Nodes A and C), incentive intensity, and administrative control? The hybrid mode displays intermediate values in all three features. It preserves ownership autonomy that elicits strong incentives and encourages adaptation to Node A. Because there is bilateral dependency, however, long-term contracts are supported by added contractual safeguards and administrative apparatus, (information disclosure, dispute- * * * Ibid., 272. * *^ Ibid., 273. 117 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. settlement machinery) These facilitate adaptations of Node C but come at the cost of incentive attenuation. Williamson’s model provides further insights into the economic reason why firms emerge, and markets are not just a collection of entrepreneurs or autonomous contractors. Adaptability to contractual disturbance occurs through governance. The incentive and control techniques brought by contract type make it possible for differing governance structures to successfully respond to varying types and levels of disturbance to a significant degree. The ability to adapt successfully to a market disturbance is dependent upon governance supported by a specific type of contract. Thus, equilibrium within the hybrid results. 4.6.4. Hierarchical Attributes The firm can be described as a nexus of contracts. But, to regard the corporation only as a nexus of contracts misses much of what is truly distinctive about this mode of governance to regard. . . . Bilateral adaptation effected through fiat is a distinguishing feature of internal organization. . . . If hierarchy enjoys an advantage with respect to fiat, why can’t the market replicate this?. . . . One explanation is that fiat has it origins in the employment contract. . . . A separate and complementary explanation is that implicit contract law of internal organization is that of forbearance. . . . Courts routinely grant standing to firms should there be disputes over prices, the damages to be ascribed to delays, failures of quality, and the division and 183 Williamson cites tlie works of Alcliian and Dcinsctz, 1972; Jensen and Mcckling, 1976; and Fama, 1980 “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” (274) to suggest tliat the firm is no différent from tlie market in contractual respects. What differs is contract law and governance t>pe. 118 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the like. Courts will refuse to hear disputes between one internal division and another over identical technical issues. Access to the courts being denied, the parties must resolve their differences internally. Accordingly, hierarchy is its own court of ultimate appeal. To review alleged mistakes o f judgment or to adjudicate internal disputes would sorely test the competence of courts and would undermine the efficacy of hierarchy. Forbearance law supports hierarchical organization. The underlying rationale for forbearance law is twofold: (1) parties to an internal dispute have deep knowledge—both about the circumstances surrounding a dispute as well as the efficiency properties of alternative solutions— that can be communicated to the court only at great cost, and (2) permitting internal disputes to be appealed to the court would undermine the efficacy and integrity o f hierarchy. If fiat were merely advisory, in that internal disputes over net receipts could be pursued in the courts, the firm would be little more than an ‘inside contracting' system.’*^ 4.7. Expansion of the Pricing Model of Contract The pricing model of contract is now expanded to include the economic concepts of the hybrid and to incorporate the governance syndrome o f attributes listed in Table 4-2.**^ Ibid., 274-275. Ibid., 276. Assumptions 7 tlirough 13 are derived from “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives.” Tliese assumptions link characteristics of adaptation between differing governance structures, asset specificity and market disturbances. 119 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Assumption 8: Adaptation (A); Node A denotes autonomy in market bargaining. Consumers and producers respond to individual parametric price changes to maximize utility and profits respectively; contracting is unilateral; the identities of parties are not important. Node A includes the monopolistic market concepts. Assumption 9: Coordination (C); Node C denotes coordination through hierarchy. Adaptive internal coordinating mechanisms are crafted; autonomy is supplanted by hierarchy; the authority relation (fiat) has adaptive advantages over autonomy for transactions of a bilaterally dependent kind; hierarchy is buttressed by the differential efficacy of administrative controls within firms as compared to firms. Assumption 10: At unstable Node B, there will arise an intermediate contracting relationship (the adaptive hybrid) which is located between the two polar modes of market and hierarchy. Hybrid (X). The neoclassical contract law of hybrid governance differs from the classical contract law of markets and the forbearance contract law of hierarchies. It is more elastic than the former and more legalistic than the latter; parties develop a long-term to bilateral dependency relationship as a result of deepening asset specificity; identities of the parties matter. Assumption 11: Buyers and sellers will reposition autonomously in a dis turbance where price serves as a sufficient statistic. Each party has a strong incentive to reduce costs and adapt efficiently. In a bilaterally dependent relationship, party- to-contract gains are made through hierarchy. Adaptive advantage is gained through 120 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. organization as bilateral dependency progressively builds. Market incentives are traded for the superior coordination of administrative functions. Assumption 12: Internal organization degrades market incentive intensity, and added bureaucratic costs result. The advantage of hierarchy is that adaptations to consequential market disturbances are less costly to firms because proposals to adapt internally require less documentation; internal disputes are resolved by fiat rather than arbitration (as in the hybrid) resources are saved and timely adaptation is facilitated through forbearance. In responding to a market disturbance, information can be more easily and accurately assessed internally rather than externally which should make external information asymmetries more costly than internal information asymmetries. Internal dispute resolution enjoys the support o f information organization, and internal organization has access to additional incentive instruments such as career reward and profit sharing. Hierarchy has the advantage over the hybrid of internal coordination and control. The firm’s ability to respond to external market disturbances through internal control and coordination is advantaged by hierarchy. These advantages of hierarchy over hybrid in adaptation C are not realized without cost. Weaker market incentive intensity and greater bureaucratic costs attend the move from hybrid to hierarchy. Transaction costs are operationally important. Critical dimensions include the frequency with which transactions recur, the uncertainty to which transactions are subject and the type and degree of asset specificity involved in supplying the good or service in question. 121 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Assumption 13: Governance costs are expressed as a function of asset specificity. “Asset specificity has reference to the degree to which an asset can be redeployed to alternative uses and by alternative users without sacrifice o f productive value.. . . Asset specificity creates bilateral dependency and poses added contracting hazards. . . . The analysis here focuses entirely on transaction costs: neither the revenue consequences nor the production-cost savings that result from asset specialization are included. “Although asset specificity can take a variety of forms, the common consequence is this: a condition of bilateral dependency builds up (via the hybrid) as asset specificity deepens.” Although asset specificity can take a variety of forms, the common consequence is this: a condition o f bilateral contractual dependency builds up as asset specificity deepens. The identities of buyers and sellers are irrelevant when asset specificity is zero. Identity matters as investments in transaction specific assets increase, since such specialized assets lose productive value when redeployed to best alternative uses and by best alternative users. When bilaterally dependent parties are unable to respond quickly and easily, because of disagreements and self-interested 187 Williamson identifies six t)'pes of asset specificity: (1) Site specificity, (2) physical asset specificity, (3) human asset specificity, (4) brand name capital, (5) dedicated assets and (6) temporal specificity in “Comparative Economic Organization; Tlie Analysis of Discrete Structural Alternatives,” 281. The distinctions between diflcring tjpes of asset specificity are mentioned here as Tosliihiro Nishiguchi specifically identifies which arc tlie most important to target pricing. Ibid., 281-282 Ibid., 282. 122 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. bargaining, maladaptation costs result. Transfer of transactions from market to hierarchy creates added bureaucratic costs, but those costs may be more than offset by bilateral adaptation gains. Arguments are now established to define a new model of contracts and pricing theory o f the hybrid and to build a general equilibrium theory of price on the basis of optimal asset specificity and safeguards.Figure 4-4 “Strategic Conception of Asset Specificity,” begins the model development of the strategic conception of the hybrid. Argument 1: For this dissertation model, the characteristics of Market Adaptation (A) and Hierarchical Coordination (C) correspond to the points at Nodes A and C of the “Pricing Model of Contracting.” For the purposes of expanding this model, let the Hybrid (X) form begin at point B since it is mix of A and C nodes. Argument 2: Let the range of K as set k, extend from 0 (no asset specificity of market governance) to I (deep asset specificity for hierarchy). At Node A, asset specificity K = 0 and at node C, asset specificity K = The deepening of asset specificity for k, can be described as an asset specificity vector between the furthest points of the map axes, and between Nodes A (market autonomy) and C (coordinated hierarchy). 190 Arguments represent the underlying assiunptions for tlie models developed in tliis dissertation. Assumptions continue to represent those of the autliors cited. 191 Argument 2 sets a range of asset specificity asK = 0->K = 1 . Within this range of K, is set k, with k, k n . In this dissertation, k is limited to ko, ki, k ^ , and Nodes A, B, and C are discrete. 123 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. k : = 0 Leverage U nassisted Market G overnance C ustom er Price D iscrim ination PF Entry Barriers Rival Strategic Conception o f Contract Strategic B ehavior Monopoly Properly Rights e x -a n te side of c o n tra c ts K > e x -p o st side o f c o n tra c ts Efficiency Incentives Agency K >0 S > 0 G overnance Transaction C osts M easurement Figure 4-4 Strategic Conception of Asset Specificity 124 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.8. Interfacing the Market-Hybrid-Hierarchy Areum ent 3: Expansion o f Williamson’s concept of contract and discrete structural alternatives is based upon the premise that the market-hybrid-hierarchy nodes are not just points on a line but represent a range of intermediate activities. Areum ent 4: Transaction cost economics is concerned with economic organization outside of the organizational production function frontier. Therefore, the strategic conception of contract and the inherent organizational contractual strategies upon which Williamson’s theories are based can serve as a boundary for the interfaces of defining deepening asset specificity between market-hybrid- hierarchy. A second vector (lying outside of the production function) is used to define these intermediate forms. As one mode changes to another, a line is drawn parallel to the asset specificity vector to identify mixed intermediate structural forms between the two polar modes of Market and Hierarchy. Assumption 14: Let M represent adaptation through the market (and transaction costs). Let H represent adaptation through coordination, (and H ® transaction costs), then and the bureaucratic costs of internal organization exceed those of the market because the latter is superior in adaptation.Asset specificity is close to 0 at and close to 1 at t f . The inequality reflects the inability 192 Hierarchy refers to internal coordination of m arket transactions witli all of tlie attributes given in Table 4-2. 125 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. o f markets to adapt as compared to hierarchies as asset specificity becomes more consequential. 4.9. The Economic Model of Governance Cost as a Function of Adaptation Transactions, for which the requisite adaptations to disturbances are neither predominantly autonomous nor coordinated but require a mixture o f each, are candidates to be organized under the hybrid mode. Over some intermediate range of asset specificity K, there will be a mixed adaptation somewhere between A and C that is the hybrid. Let M = Adaptation through Market, X = Hybrid and H = Adaptation through Hierarchy. Assumption IS: Governance cost is a function o f asset specificity. “Efficient supply requires operating on the envelope, whence, if k* is the optimal value of k|, the rule for efficient supply is as follows: ki is semi-strong asset specificity and kz is very strong asset specificity” (as defined by Williamson). Williamson argues the efficacy o f the hybrid as being the best organizational form in adapting to consequential market disturbances. The hybrid is better than the market and the hierarchy (i.e., the market requires ideal transactions in law and 193 Williamson, “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” 283-284 126 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. economics to be efficacious; the hierarchy excels in coordination and control, but at a higher cost— the cost of bureaucracy— than for that of the hybrid). The hybrid has semi-strong asset specificity and bilateral contractual safeguards, whereas the market is non-asset specific without contractual safeguards and the hierarchy is deeply asset- specific with many contractual safeguards. In both instances, the hybrid is favored over the other two form s.*®'* A reum ent 5: Two vectors are drawn, vector A-C where K = 0 at Node A and K = I at Node C, and vector D-F which represents the k, intermediate range of activities that arise outside of the production function. Vector D-F begins with the customer at the production function barrier and includes that branch for entry barriers, the branch denoting strategic behavior and the branch for transaction costs. The shaded area in Figure 4-5 reflects the “tail end” of the market boundary as it extends into the hybrid. Agency is identified as the end point because it is the point at which principals contract with agents to execute their contracts. There is bilateral dependency in environmental adaptation, and contractual safeguards are introduced. Ibid., 284. 127 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. K . = 0 A K>0 EfTiciency X. Incentives K > 0 Transaction Costs S > 0 Price Discrimination Leverage Unassisted Market Governance Customer Entry Barriers S =0 Rival Strategic Conception o f Contract Strategic Behavior Monopoly Property Rights ex-ante side u f contracts ex-post side o f contracts S = 0 Agencv Governance Measurement Figure 4-5 Location of Asset Specificity and the Market 128 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The shaded area in Figure 4-6 reflects the “front end” of hierarchy as it K = 0 Leverage unassisted Market Governance Customer Price Discrimination < Entry Barriers Rival S =0 Strategic Conception o f Contract Strategic Behavior Monopoly Property Rights ex>ante side of contracts K>0 ex-post side of contracts S = 0 Efficiency Incentives Agency K>0 S > 0 Governance Transaction Costs S > 0 Measurement Figure 4-6 Location of Asset Specificity and the Hierarchy 129 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. extends into the hybrid along the parallel vectors of deepening asset specificity. The beginning of the hybrid from the market and end of the hybrid as it becomes hierarchical is identified. Monopoly and efficiency branches o f the map of contract intersect where K > 0 and S = 0. The point at which contractual safeguards are introduced (S > 0) is where property rights and contractual safeguards intersect on the Efficiency branch. Agency is also the point at which hierarchy forms. Complications of information asymmetry require a monitoring function; hierarchy exists to provide an administrative apparatus for this relationship. The hybrid forms on the ex-ante side of the contract line where price is set in relation to buyers and incentives are aligned. This is the germinal point where anonymous trade gives way to bilateral contract dependency. The beginning of the hybrid has more market characteristics than hierarchical characteristics. The strong market incentives are sacrificed for coordination. The agency relationship establishes a bilateral contracting dependency and the need for an administrative structure. This leads to the development of internal coordinating mechanisms and a measure of hierarchical control. As the hybrid gains hierarchical attributes, market disturbances become less consequential. However, market incentives are weaker. The hybrid has traded off the market incentives for administrative control. The hybrid is then represented as the area between the two extremes of market and hierarchy as in the shaded entire area in Figure 4-7. 130 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Monopoly K > 0 Efficiency K>0 Transaction Costs Leverage Price Discrimination Entry Barriers K =0 Unassisted Market Governance Customer Rival Strategic Conception of Contract Strategic Behavior Property ex-ante side of contracts Rights ex-post side of contracts S =0 Incentives Agency S > 0 S > 0 Governance Measurement Figure 4-7 Location of Asset Specificity and the Hybrid 131 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The point at which there are no safeguards (S = 0) is bounded by Property Rights, Incentives and the Efficiency branch. It should be noted that there is asset specificity without contractual safeguards, thus the increased importance of property rights. Contractual safeguard incentives are introduced on the Efficiency branch where S > 0. In Williamson’s model K and S are equal to or greater than 0 along the sides o f the axes, but he does not set K and S > 0 at the intersections. This distinction becomes important when developing a general equilibrium model using asset specificity, contractual safeguards and transaction costs and in extending this model with fuzzy set theory. This model is further extended below. Assumption 16: Equilibrium distributions of transactions change in response to disturbances in the institutional environment.’^^ Changes in a set o f parameters elicit shifts in the comparative cost of governance. A much larger parameter change is required to induce a shift from market to hierarchy (or the reverse) than is required to induce a shift from market to hybrid or from hybrid to hierarchy. The critical predictive action is that which is located in the neighborhood of ki (M to X) and kz (X to H). Areument 6: There are two important points in the set k, (Vector D-F): ki where the market shifts to the hybrid and k^ where the hybrid shifts to the hierarchy. Perpendicular line w-v is drawn between unstable Node B and the Monopoly branch. In the cognitive map, an area defining k, and kz can be drawn by extending line w-v 195 Distuitances in the environment that result in transaction costs to the trade will lead to transaction cost equilibrium through a change in mediating structure, 287. Williamson, “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives.” 132 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. as a vector from Property Rights to the Monopoly branch where K > 0, and extending a line from point u between unstable Node B and the intersection o f the Monopoly and Efficiency branches. This bounded shaded area represents the market to hybrid shift ki (M to X). By extending a perpendicular line from point z on the Governance branch to the transaction cost branch, and extending a line from line x-y to the transaction cost branch, one can describe a bounded shaded area representing the hybrid to hierarchy shift kj (X to H) in Figure 4-8. The shaded areas represent the range of changing trade relationships of the firm as the shift occurs from market to hybrid and hybrid to hierarchy. Within the horizontal shaded area at k % bilateral trading is no longer autonomous and anonymous. Asset specificity to secure the trade is important, but contractual safeguards are not yet part of the trade (K > 0, S = 0). In the shaded area at kz, both asset specificity and contractual safeguards are important as mediating governance structures are present and asset specificity is deep (K > 0, S > 0). The shaded vertical area represents the gradations of asset specificity from “semi-strong to deep” and the presence of contractual safeguards that range from “nonexistent to many.” Concurrently, price changes in response to the interaction of asset specificity and contractual safeguards on the basis of transaction costs. It is this shaded area that defines the location of the hybrid. 133 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. K = 0 S = 0 Leverage Unassisted Market Governance Customer Price Discrimination PF Entry Barriers ^ Rival Strategic Conception of Contract Strategic Behavior Monopoly Property Rights ki (MtoX) ex-ante side of contracts K>0 ex-post side of contracts Efficiency Incentives A g en cy K > 0 S > 0 Governance ki (X to H) Transaction Costs M easurem ent C ; K = 1 S = I Figure 4-8 Location of ki and k % 134 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Triangles uvw and xyz represent the hybrid's retention of incentive structures from the market, and the adoption of a more greatly coordinated governance structure which is less than the hierarchy and ki and kz shifts are introduced. Figure 4-8 displays these model extensions. Williamson describes the fluidity with which trading occurs along the vertical area bounded by Vectors A-C and D-F. The hybrid shifts upward or downward in response to environmental changes. Assume it is possible to identify a community of traders in which reputation effects work better (or worse). . . . The hazards of opportunism in interfirm trading are greatest for hybrid transactions. . . . Improvement in interfirm reputation effects will reduce the cost of hybrid contracting. . . . Hybrid contracting will therefore increase, in relation to hierarchy. . . . Reputation effects are pertinent within firms as well. If internal reputation effects improve, then managerial opportunism will be reduced and the cost of hierarchical governance will fall. Assumption 17—Reputation Effect as a Parameter: Market disturbances will produce changes in the trading relationship. In the community o f traders, continued trade relies heavily on the trading partners’ reputation. The more opportunistic the behavior of the traders, the greater the transaction costs. The hybrid is especially strong in reducing these transaction costs through arbitration's mediating structure at the ki location. The cost of hierarchy at k % is reduced because 196 Williamson, “Comparative Economic Organization: Tlie Analysis of Discrete Structural Alternatives,” 291. 135 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of the inter- and intrafirm cooperative reputations that develop over time. This cooperative bilateral relationship shifts the hybrid upward in the direction of strategic behavior (along Vector A-C). Alternatively, adverse reputation, both within the firm and within the market, increase transaction costs and alternatively shift the trade in the direction of hierarchy and governance. Argument 7: The reputation effect is based upon the knowledge the parties to the contract have about each other both before and after the trading relationship is established. A good reputation results in lowered transaction costs for pre- contractual investigations, and post-contractual monitoring for both parties. The reputation effect over time allows for the increase of dedicated assets, moderate contractual safeguards, and a reduction in transaction costs for the trade. The result of this type of reputation effect is the reduction o f governance costs and a lowering of price (as a result of reduced transaction costs). Adverse reputations, on the other hand, can lead to the opposite: increased pre- and post-contractual investigation and monitoring, unwillingness to dedicate assets, increased governance and transaction costs. Assumption 18— Uncertainty as a Parameter: As environmental disturbances to the trade increase, a coordinated response (in the form of a mediating structure) is required. The hybrid mode is the most susceptible to frequent disturbances to the equilibrium o f the contractual relationship. This is because the hybrid adaptations can’t be made unilaterally (as with market governance) or by fiat (as with hierarchy) but require mutual consent. An increase in the frequency of 136 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. environmental disturbances will be associated with an increase in market and hierarchy modes and a decrease in the hybrid. Areum ent 8: Greater market disturbance shifts the hybrid in the direction of greater coordination. Opportunities in the market arise because information is not perfect between trading partners (information asymmetries). One partner to the trade may possess more information than the other leading to opportunism and the need for the lesser party to adapt. Areum ent 9: Trading arrangements depend on asset specificity and contractual safeguards (K,S). The extended two-dimensional model of the hybrid pictured in Figure 4-8 is not adequate to explain the relationship of asset specificity (K), contractual safeguards (S) and transaction costs (TC) to output price. This is because the only values of S and K considered are ( K = 0, S = 0), (K = 1 , S= 1), (K > 0, S = 0), and (K > 0, S > 0). Gradation of relationships between K and S, which are not captured within Williamson’s model, can be captured within this model. They include points where (K = 0, S > 0), (K = I, S = 0), (K = 0, S = 1), and intermediate ranges in the set k, and s,. Areum ent 10: The three variables of asset specificity, contractual safeguards and transaction cost can be placed on an X-Y-Z axis where X = K, Y = S, and Z = TC, as in Figure 4-9. 137 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. i Figure 4-9 X-Y-Z Axes o f K, S, and TC The relationship of transaction costs to asset specificity and contractual safeguards on the three axes add a third dimension to Williamson’s model. Fuzzy set theory is useful in expanding a two-dimensional model of the hybrid into a three- dimensional model that will satisfy all values of P C , S and TC, (respectively, X, Y and Z variables). 138 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.10. Fuzzy Systems As conceived by Lotfi Zadeh, its inventor, fuzzy logic provides a method of reducing and explaining system complexity. Zadeh was concerned with the rapid decline in information afforded by traditional mathematical models as the complexity of the target system increased. Much of this complexity, he realized, came from the way in which the variables o f the system were represented and manipulated. Since these variables could only represent the state of a phenomenon as either existing, or not existing, the mathematics necessary to evaluate operations at various boundary states becomes increasingly complex. At some point this complexity overwhelmed the information content of the model itself, leaving only a morass of equations and little knowledge about the underlying process. In modeling fuzzy sets, the mechanics are linguistic rather than mathematical expressions. Zadeh makes a case that humans reason in fuzzy, rather than mathematically precise, symbolic terms. These fuzzy terms define general categories that are not rigid or fixed. The transition from one category— concept idea, or problem state—to the next is gradual with some states of variables having greater or less membership in the one set than a n o th e r.T h e use of fuzzy sets 197 Cox, Earl, The Fuzzy Systems Handbook (Cambridge, Massachusetts; Academic Press Professional, 1994). Ibid., 1-2. 139 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. provides a mechanism for exploring the gradations o f change from market to hybrid to hierarchy. Fuzzy sets are functions that map a value that might be a member of the set to a number between zero and one which indicates the degree of membership. A degree of zero means that the value is not in the set; a degree of one means that the value is completely representative of the set. This produces a curve across the members of the set.^^^ A linguistic variable is the name of a fuzzy set. A linguistic variable holds the properties o f approximate or imprecise concepts in a systematic and computationally useful way. It reduces the apparent complexity of describing a system by matching a semantic tag to the underlying concept. Williamson unintentionally creates a fuzzy set when he assigns asset specificity the adjectives “light, semi-strong, and deep.” Fuzzy logic provides the underpinnings for designing and writing flizzy models. Fuzzy set theory, and the broader area of fuzzy logic itself, is not a specific method for any particular application. The theory o f fuzzy sets supports a more general theory of fuzzy logic which, in turn, supports the logical constructs used to create and manipulate approximate reasoning.^°° Ibid., 2-3 Ibid., 4-5 140 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Fuzzy logic builds from the “Heisenberg Uncertainty Principle”. In 1927, Walter Heisenberg derived the “Uncertainty Principle” by observing and writing about a phenomenon characteristic o f quantum mechanics. The quantum theory and the theory of relativity are both based on a close analysis of the act of observation. . . . Thus we find that we cannot determine the position of a particle without altering its momentum. . . . Thus the attempt to determine the position o f a particle introduces an uncertainty into its momentum. There is, in fact, a connection between the two: the more closely we determine the position, the greater the uncertainty in momentum.^°* Heisenberg found many relationships between conjugate variables that met his uncertainty criteria: between energy and time, and electric and magnetic field strengths. Thus, there is always uncertainty when studying the relationship of two variables. Bart Kosko argues that uncertainty relations arise from a math quirk created by the Uncertainty Principle and that many other fields use the same math which creates their own uncertainty relations. This math is imprecise, and it is such imprecision demonstrated by the Uncertainty Principle that makes fuzzy logic and fuzzy set theory possible.^°^ Kosko argues that the Uncertainty Principle was used to explain a gray physical world in bivalent black-and-white mathematical terms. Kosko further Allen, Tliomas L., and Raymond M. Keefer, Chemistry: Experiment and Theory (San Francisco. CA: Harper & Row Publishers, 1978). Kosko, 106. 141 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. argues that the Uncertainty Principle can also be used to explain a black-and-white physical world in bivalent gray mathematical terms through the use of fuzzy sets and linguistics rather than symbolic variables.^®^ Kosko uses the right triangle as the geometric symbol for Heisenberg’s uncertainty principle. It is the tool that optimizes the best possible solution to the relationship of two variables.^®^ Assumption 19: The right triangle represents the so-called “ 'normal equations' of least-squares curve fitting.” A generalization of the Pythagorean theorem gives the subsethood theorem of fuzziness.^°^ Kosko demonstrates his model of fuzzy subsethood using a bit cube.^°^ In the Kosko bit cube the cube comers are Aristotelian black and white and have zero fuzzy entropy because Aristotle’s law of sets holds 100% as A or not A. Within Kesko’s bit cube, “Fuzzy entropy shows that the closer to the midpoint, the fuzzier the set and the closer to the comer, the less fuzzy. Kosko’s bit cube results: black Kosko writes, (106) “Fuzzy logic means reasoning with fiizzy numbers and fiizzy sets. In practice it means making computers reason with fuzzy numbers in the form of if-then statements or rules of thumb.. . . The fuzzy Entropy Theorem gives the entropy E(A) of fiizzy set A as the ratio of the coimted overlap or intersection A n A to the coimted underlap or A w A. A " denotes the complement of A or the set not-A. W ith nonflizzy sets the overlap is empty and so the numerator equals zero. With fiizzy sets there is overlap and the numerator is always greater than zero.” (Heisenberg and Planck’s constant supported.) 204 Kosko, 114 (footnote) “The Cauchy-Schwartz inequality relates the lengths U and 1 b of the A and B arrows to the absolute value of the “inner product” or correlation between A and B. 1 a X 1 b ^ |A • B| All uncertainty principles have this form.” Ibid., 114. The principles of the bit cube are illustrated in Appendix B. 142 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and white corners, gray interior described by a linguistic series of adjectives that range from none to all (0 to 1).” Assumption 20: To build a fuzzy system requires three steps. First, select the nouns or “variables.” Call these X and Y. X is the input to the system. Y is the output. Second, select the fuzzy sets. Fuzzy sets are adjectives within the range of X,Y nouns. Third, develop an inter-related system that links the (noun) variables X- Y to the fuzzy (adjective) sets. Argument II: The three axes in Figure 4-9 can be used to explore the behavior of price and a model of price which will incorporate the principles of market incentives property rights, agency and governance. Four boundaries of variable relationships are established as a new map of contract. They are Strategic Behavior (1> K> 0, S = 0), Governance (l> K> 0, S = 1), Efficiency (1 >S > 0, K = 1) and Monopoly (K = 0, 1 > S> 0). Unstable point Bi is where (1 > K > 0, S = 0); that is strategic behavior. Unstable point Bz is where (K = 0, 1 > S > 0); that is monopoly. The hybrid shift (M-X) lies in the area of information asymmetries and market uncertainty at the ex-ante side of contract. This shift is influenced by property rights and market incentives. The Kosko uses Heisenberg’s Uncertainty Principle to support tlie paradox tiiat no matter how small a number is in moving closer to zero on a number line it will become infinitely small, but never reach zero. Tlie numerator will always be positive and tlie tlieory of bivalent sets A or not-A holds. Heisenberg discovered tliat in studying two interrelated variables such as velocity and position, if one reached 0, tlie value of the other reached tlie magnitude of infinity. Kosko’s fuzzy set model then ranges from 0 to 1 witli tlie numerator in his fuzzy set theorem being equal to 0 so that A-and not-A holds. 143 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hybrid to hierarchy shift (X to H) lies in the area of reputation on the ex-post side of contract with influences from administrative controls and organizational incentives. Fuzzy set theory can be used to develop a model of the hybrid based on asset specificity, contractual safeguards and transaction costs. This model can be used to explore the behavior of output price. Further, fuzzy set theory allows approximates to be made where uncertainty leads to mathematical imprecision, especially as it pertains to the relationships o f asset specificity and safeguards to transaction costs. Fuzzy set theory allows this new model of the hybrid to incorporate the principles of market incentives, property rights, agency and governance. As a result of this overall three-dimensional modeling, greater intricacies o f the relationship of the market, hybrid and the hierarchy structure and pricing modes are elucidated. 4.11. Fuzzy Theory and the Hybrid Model The modeling developed to this point has two major boundaries: Monopoly and Efficiency. If the Monopoly-Efficiency boundaries are folded outward to the right, a diamond shape results, but leaves the two left sides unidentified. For this model, the upper boundary on the left is identified as Strategic Behavior and the lower boundary on the left is identified as Governance to result in a four-sided diamond. The ki (M to X) and kj (X to H) shifts are extended across the face of the diamond. The ex-ante and ex-post contracting line runs horizontally through the middle. Vector A-C runs through the center of the diamond. Vector D-F is parallel 144 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A-C but outside of the production function. Vector D-F represents the intermediate range of k,. The diamond shape now allows a second vector to be established parallel to vector A-C and equal to vector D-F. This new vector E-G represents the intermediate range of s,. It should be noted that unstable point B now has two locations, B 1 and B2. Figure 4-10 is a diagram of the “Diamond Cognitive Map of Contract.” All internal linguistic variables have been removed and will be reassigned within this new structure. This geometric design provides the opportunity to explore gradations of contract from market to hybrid to hierarchy in an equilibrium model. The new location of S > 0 is made equivalent to that of K > 0 to reflect this general equilibrium. It should be noted that ki includes the Triangle u-v-w and k % includes the Triangle x-y-z which represent the trade-off o f market incentives to mediating structures through hierarchy. This diamond is constructed with four faces: Monopoly, Strategic Behavior, Efficiency and Governance?^^ Left and right side ex-ante and ex-post linguistic variables are identified at differing levels o f asset specificity and contractual safeguards: 208 Governance is taken out of the “Cognitive M ap of Contract” and used to identify tlie lower left side of the diamond. This is because as it adopts tlie science of contract and transaction costs, attributes are assigned to governance structures. Tlie term liierarchy is placed in the location where governance would be normally located within tlie diamond because it is a better description of the mediating structme that is produced as a result of dedicating assets and contractual safeguards to trade relationsliips. 145 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A K = 0 S = 0 Leverage Price Enuy Barriers Strategic Behavior Monopoly f c o n tra c ex-ante si Uicra chy Measu ement Governance Efficiency K = 1 S = 1 K = 0 82 S = 1 C F igure 4-10 D iam ond M ap of C o n tract 146 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-3 Contracting Variables Ex-Ante Contracting Variables Asset Specific (K) Safeguard Specific (S) Entry Rival Strategic conception of contract Unilateral market safeguards Property rights Market incentives Ex-Post Contracting Variables Asset Specific (K) Safeguard Specific (S) Agency Franchise bids Adaptation through coordination Adaptation through price Administrative controls Organizational incentives Fiat Forbearance The bit cube linguistic variable locations in Table 4-3 are supported by Assumptions 8 through 13 and their locations within the new model are illustrated in Figure 4-11. 147 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A K - 0 S - 0 Strategic Behavior Monopoly Bl K-1 S -0 E amen Strategic Cooceptioa of Contract Unitoteral MufcetSafi EYopeity Eliglits Franchue Bidding C oordi nat i on Adaptation ex-ante < fC-0 ex-poit Price daptation Adnuoistrative Contrôla Organizational IncentTvta Hierai : 1>S>0 EfCciency Figure 4-11 Market-Hybrid-Hierarchy Map of Contract 148 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The two-dimensional model o f the hybrid identified in the Figure 4-12 shows a right triangular tradeoff of Auvw market incentives for Axyz coordinating structures. Areument 12: The Axyz represents the hybrid tradeoff of a greater coordinating structure in favor of the lesser returns from market incentives, as an ability to respond to this range of disturbances. The area of Axyz represents the range of adaptation to more consequential disturbances which shift the hybrid in favor of the hierarchy. Since Axyz equals in tradeoffs Auvw, the area of this triangle equals the uncertainties, based on information asymmetries, in the market, that lead to the option for reduced incentives by forming mediating structures. Therefore, the knowledge-reputation line x-y equals the reduced opportunism line v-w. The areas of both triangles define the uncertainty of contractual relationship where there are minimal safeguards. The shift towards greater coordination is a shift towards greater safeguards and a deepening of asset specificity in the direction o f the ex-post side of contracts. These areas identify the location where market uncertainty is traded off for reputation effect. The reputation effect is a consequence of increased administrative controls and organizational incentives. Vector D-F represents the deepening of asset specificity (K) from 0 to I, as safeguards increase outside of the production function. Vector E-G represents the increase of contractual safeguards (S) from 0 to I as asset specificity increases. The location of ki, the shift of the market to the hybrid, is identified in Figure 4-11 and lies where asset 149 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. specificity and safeguards range fi'om 0 to 1/2. (This is consistent with a K and S > 0). Driving the ki shift is uncertainty because o f information asymmetries as follows: As the hybrid form emerges from the market, assets change from general purpose to specialized assets. Market anonymity to trade gives way to implied contractual mutual consent. Yet, market incentives (in the form of opportunism) may be part of the trade. Information asymmetry may weight the contractual outcome in favor o f one party over the other. In order for the parties to protect their assets in a semi-strong mode in an uncertain market world, contractual guarantees are sought. These guarantees may be as informal as knowledge and reputation a priori, or as formal as a written contract. The latter allows a greater role for market incentives; the former requires a greater amount of coordinating or mediating structures. The tradeoff for a market price is a higher level of predictability and outcome control. Running through the fuzzy center of the cube are the fuzzy linguistic variables— information asymmetries, uncertainty, knowledge, and reputation. This produces an expanded version of the “Diamond Cognitive Map of Contract” in Figure 4-10. The locations o f ki and kz are identified as the shaded areas across the diamond (Figure 4-12). 150 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Bl K . = 0 S = 0 S = 0 K>0 Strategic Behavior . /Leverage P rice \ Mnnnnnlv y' E ntr E nt \Bai y % ier^ E \ Rival^V ySUategi^v /Conception oK. y' C ontract \ /Infon / Asym oatioiK netry \ /Unilateral \ . /M arket Safeguard^ ; Property y / ' / Rights / /Coordination. / /Adaptation N / Une \ la ex-anrc^ itainty/ ir fu e of con 'fitoket IncentivgOs. N . /'Franchise :ract > / Bidding \. ^\^A gencyy/^ cx-ppA / K n ov iiiktof con ledge \ ract y / ' y . Price y' / ^ i&daptatioy' 'V Administrative^ \Controls / 1 > If > n \ ^ K eput tiom ' V Organizational 'incentives / \ I > S > 0 \ ^ i a t / H i. \Forb( rarch y \ / K =1 irancy' 0 / Governance V ,y Efficiency K . = 1 S = 1 K . = 0 S > 0 B2 Figure 4-12 M arket-H ybrid-H ierarchy Map of C o n tract k, and k % Areument 13: The vector for deepening asset specificity DF lies between the Strategy and Governance branches parallel to the AC vector and represents the intermediate activities o f points (K > 0, S = 0) and (K > 0, S = 1). The vector DF lies 151 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. outside of the production function frontier, which is consistent with Williamson’s assumptions regarding transaction costs. A second Vector EG is drawn between the Monopoly and Efficiency branches and represents the range of intermediate activities between points (K = 0, S > 0) and (K = 1, S >0). The Vector EG lies outside of the production function frontier. By introducing the points at which asset specificity and safeguards become greater than or equal to 0, the lower end of the parameter shift ki is defined as the point at which K is greater to or equal to zero, and the ex-post side of contracts in relation to incentives is defined as the point at which S is greater to or equal to zero as an equilibrium model. Areum ent 14: There will be a range of asset specificity k; and contractual safeguards s. from the point at which there are no safeguards S = 0 and maximum safeguards S = 1. This corresponds to the range of asset specificity K(0,1) such that; Markets use S o <s* <si kq < k* < k. Hybrids use St < s* < s; ki <k* <kj Hierarchies use S z > s* kz > k* The bit cube ordinals can now be assigned. Figure 4-13, the “Diamond Bit Map Model of Market-Hybrid-Hierarchy Model of Contract,” places the linguistic variables in their bit-map locations. 152 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. K = ü S =0 A Strategic Behavior ( 1/4. n> Price 1 > K > 0 s = 0 (1/2. ou Entry (3 /4 ,0} / Contract Strate g i c \ Conception Bld. k l / \ Property^ Coordination Adaptation ( t . 1/4) \ Administrative, yCon trois kz I > S > 0 K = I (1. l / 2 ) \ - Entry ex-ante \ Monopoly Bam ’crsy X O . 1/4) 1 > s > 0 Rival K = 0 ---------r. (0. 1 /2 ) Informatiortv Asymmetry rtamty / U nilateral \ /M a rk e t S aE eeuard^ (0, 3/4) \ M ^ e t Incentives té o f contiract ^ SI Franchise' Bidding ex-posC^side of contract Kno *ledge\ Price . Adaptation^ •(0. I)B2 Fiat nation \ Organizational/ Incentives / y sz (1/4. 1) 1 > K > 0 7^ (1/2. 1) s = l Efficiency Forebearancc, i : ' I ' j F / ' Hiemrchy |g ,- Governance j -----------(3/4. i) \ Measurcment' " '■ I ' c K = 1 S = 1 Figure 4-13 Diamond Bit Map of Market-Hybrid-Hierarchy Model o f Contract I Areum ent IS: Let the bit cube with points A-BI-C-B2 represent the market- hybrid-hierarchy theory of contract. Ordinal numbers that are fractions between 0 and 1 are used to identify the location of linguistic variables within the diamond in anticipation of constructing a fuzzy set bit cube. The following observations can now be made: 153 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1. There is a range of binary points from 0 to 1 with point A— Autonomy and market adaptation labeled (0,0) and point C—Hierarchical Coordination labeled (1,1). 2. Unstable point B is represented by Bl labeled (1,0) (the instability is from lack o f safeguards where S = 0) and B2 labeled (0,1). (The instability is from a lack of asset specificity where K = 0). 3. The four sides of the cube face represent a range from 0 to 1 of asset specificity (K) and contractual safeguards (S). 4. The Production Function (PF) is bounded by points (0, 0), (1/4, 0) (0, 1/4) and (1/4, 1/4). In Williamson’s model. Point B is contractually unstable due to the lack of contractual safeguards, therefore price p > p . However, there exists within the hybrid the point at which p = p = p* on the basis of optimal safeguard s*, optimal asset specificity k*, and optimal transaction cost to*. It would be expected to be found at the interface of the ex-ante and ex-post side of contracts where knowledge and reputation effect equally replace information asymmetries and uncertainty. 154 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.12. The Three-Dimensional Theory of the Market- Hybrid-Hierarchy The bit-map in Figure 4-14 is constructed as a rendering of a three- dimensional model of the theory of contract based on asset specificity, contractual safeguards and transaction costs. This two-dimensional view illustrates the expansion of the theory of the market-hybrid-hierarchy. A cube is drawn using fuzzy set coordinates to identify the locations of range lqo-,2) and S(o_2) in set k\ and si. The linguistic variables can be placed on an X-Y-Z grid and assigned K, S, and TC ranges as intermediate values between 0 and 1 . Holding transaction costs constant, variables of asset specificity and contractual safeguards in the range ki, si, are assigned ordinal locations as follows: ko = (0,0) to ( 1/4, 1/4) S o = (0,0) to (1/4, 1/4) ki = (1/4, 1/4) to (1/2, 1/2 S i = (1/4, 1/4), to (1/2, 1/2) k* = (1/2, 1/2), to (1, 1/4) s* = (1/2, 1/2) to (1/4, 1) k2 = (l, 1/4 to 1), (1) S2 = (1/4, l ) t o ( l . I) Areument 16: The designation of the four corners and their binary properties as stated above result in, and can be mapped as a series of linguistic variables. In the range ko_>2 asset specificity adjectives are identified as None (O)-Slight (l/4)-Semi-strong (l/2)-Strong (3/4)-Deep (I). In the range so->2, contractual safeguard adjectives are identified as Zero(Q)-Mmimal (l/4)-0ptimal (1/2)- A lot 155 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (3/4)~Too many (I). The outer, less fuzzy conjugate variables, are then mapped on the basis of their bit locations. The fuzzier interior, which includes uncertainty- information, knowledge-reputation, are also mapped. The hybrid shift (M to X) is found in the interior of the cube and is fuzzier than the hybrid to hierarchy shift (X to H) which is found towards the outer areas (less fuzz). This modeling is supported by Assumptions 16, 17 and 18. Of interest is the location of optimal asset specificity k* and optimal contractual safeguards s* within the hybrid. Both of the values are found at the center of the diamond at point u and will be found at the center of the cube. Optimal asset specificity and contractual safeguards are attained at optimal transaction costs, tc*. As asset specificity and contractual safeguards deepen within the cube, coordinating and mediating structures also deepen. Williamson uses economic theory to show that “[t]he hybrid mode is almost as good as the market for strictly autonomous adaptations. ...” As long as the bilateral trading agency relationship is based upon symmetrical information, and “[i]t is better than the market in all other adaptive categories” (as long as there are consensual contract safeguards based upon franchise bidding and complete knowledge). A three-dimensional cube can be constructed incorporating the conjugate variables (Figure 4-14). This three-dimensional cube is constructed based upon the two-dimensional diamond-shaped cube and the map. (See Figure 4-13 which identifies the variable locations). 156 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A (0, 0, 0) Monopoly B2 (0, 0, I) (0. 1, 1) [0. 1,0 1C C om Contn : epuon Propeny Right Coordination ^A^ptarion Agency Administrative Controls IVeasuren ( 1. 1 ,0) (1,0,0) Bl Efficiency (I, 1. 1) C Figure 4-14 Three-Dim ensional M odel o f Diamond Bit Map M odel o f Contract 157 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The hybrid is located at the center of the cube. Optimal contractual safeguards s* and optimal asset specificity k* are located in the interior of the cube with optimal transaction costs tc* held constant. Likewise, the production function and hierarchy are located in opposite directions but also at equilateral and opposing poles (points A and C). The conjugate variables are placed within the cube based upon map locations. Note the location of ko-so, ki-si, k*-s*, and k^-sz. Now that the location of k* and s* is defined in three dimensions, an exploration of the relationship of asset specificity, safeguards and transaction costs to an optimal price p* in a three dimensional general equilibrium model is warranted. 4.13. A General Equilibrium Optimal Pricing Model of the Hybrid Fuzzy set theory was used to construct a three-dimensional bit cube that related the economics of organizational variables to each other on the basis o f deepening asset specificity (K), contractual safeguard (S), and holding transaction costs (TC) constant across the boundaries of the market, the hybrid, and the hierarchy. A general equilibrium model of pricing will be developed that mathematically models the contracting behavior of trading parties who bilaterally bargain prices on the basis of asset specificity and contractual safeguards. Optimal pricing is reached when asset specificity (k*), contractual safeguards (s*) and transaction costs (tc*) are optimal. 158 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Argument 17: Price is a function of asset specificity, contractual safeguards and transaction costs or p(k,s,tc). As the hybrid emerges fi'om the market, a price adaptation results in response to transaction costs of the trade. The change in price, Ap, is equal to the price after a transaction disturbance minus the price before the transaction disturbance. The change in price, Ap, can be expressed as u = p(k,s,tc). The change in price Ap as the hybrid emerges has the characteristics of p > p > p*. Optimal price p* is found where optimal asset specificity (k*), contractual safeguards (s*) and optimal transaction costs (tc*) converge along the XYZ axes at the center of the cube. At the center of the cube tc* is positive and equal to s* and k*. Argument 18: Customers and suppliers barter for a price on the basis of dedicated assets and contractual safeguards. A general equilibrium model o f asset specificity, contractual safeguard and resulting pricing behavior is now developed after the McKenzie Model.^°^ This model examines optimal asset specificity with optimal pricing (k*, p*) and optimal contractual safeguards with optimal pricing in a general equilibrium model (s*, p*) with optimal transaction costs tc* held constant. 4.13.1. General Equilibrium Pricing Model of Optimal Asset Specificity Let p = customer demand price for asset specificity without safeguards. 209 Described in McKenzie, Lionel, “Theory for a Competitive Market,” Eœnometrica, 27 (1959): 54-71. 159 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Let p = suppliers supply price of asset specificity without safeguards. Let kd = customers demand for greater asset specificity at M— >X. Let ks = suppliers supply of lesser asset specificity at M— >X. Arsum ent 19: The customer wants greater asset specificity kd for lower price p (special purpose assets). Without safeguards the supplier demands a higher p for the provision of less specificity kg. Therefore, asset specificity is a function of output price. The economic assumptions are sets of inequalities which assert that production is proportional to demand using no more than available resources. This model assumes perfect competition and economic profits are 0. Assume the demand of asset specificity quantity is a continuous function of the demand for lower price, then (1) kd = Dem(p) (Customer). Assume the suppliers-offered quantity of asset specificity is a continuous function of the supply price. Then (2) ks = Sup(^ (Supplier). The objective is to show that the economy is in general equilibrium and that there is a value p* = p = p such that Sup(p*) = Dcni(p*). Solve ks = Sup(p) for p to obtain, 160 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (3) p = G(ks). This leads to two equations: (4) kd=Dem(p) and p = G (k s). In a continuous function model, there are values of kj and ks that coincide and kd = ks; therefore, (5) G[Dem(p)] = p . Since G[Dem(p)] = p is continuous, the appropriate fixed-point theorem guarantees a value p* such that G[Dem(P*)] = p*. At this price the demand, supply and no economic profit conditions are satisfied; therefore, an equilibrium of p* and k* is attained. 4.13.2. General Equilibrium Pricing Model o f Optimal Safeguards Let p = customer demand price subject to safeguards. Let p = supplier supply price subject to safeguards. Let S (i = customer demand safeguards (M ^X ). Let S s = suppliers supply o f safeguards (M->X). A rsum ent 20: The supplier will provide a good or service at the higher price p at a level o f contractual safeguards S g . The customer wants the lower price p for 161 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. special purpose assets at a level of safeguard sj. The production is proportional to demand using no more than the available resources at contract safeguard s > 0. In perfect competition profits are 0, and demand safeguards si are a continuous function of price p. Assume the demand quantity is a continuous function of the demand price. Then (1) S d = Dem(p). Assume the supply quantity is a continuous function of the supply price. Then ( 2 ) Ss = S u p ( p ) . Assume demand quantity is a continuous function of demand price. The objective is to show the economy is in general equilibrium and that there is a value p = p =p* such that Sup(p*) = Dem(p*). Solve S s = Sup® for p to obtain (3) p = G(Ss). This leads to the following equations: (4 ) Sd = Dem(p) P = G(Ss). There are values of S d and S s that coincide and S d = S s; therefore, (5) G[De,n(p)]=P 162 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Since G[Dem(^l = p is continuous, the appropriate fixed-point theorem guarantees a value p* such that G[Dem(P*)] = p*; therefore, an equilibrium of safeguards s* and p* is attained. Arsum ent 21: Combining the function terms yields the following equations: 0 ) kü = Dcm(P) (2) k,= S„p(p) Solve k, = Syp (p) for p for a continuous function (3) p = G(k,) Tliis leads to two equations (4) kj = (p) P = G(kJ (5) The model guarantees that kj and k, coincide, therefore kj = k ^ (6) cm (Î)] = p* ( > ) S d = D „ „ (p ) (2) S3=S„p(p) Solve Sj = S„p(p)forp for a continuous function (3) p = G(sJ This leads to two equations (4 ) Sd = D ,,„ (pj P = G(sJ (5) The model guarantees that $ d and S j coincide, therefore Sj = s, I (6) (p)] = p* The location of parameter shift ki(M to X) is identified where asset specificity K > 0 and the range of contractual safeguards lies between so = 0 and si requiring p. Information asymmetries and unsafeguarded contracts account for the higher price. The location of parameter shift k2(X to H) is where contractual safeguards equal s % and asset specificity is deep allowing price p. 163 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In a continuous function model, there is a fixed point at which p* coincides with optimal safeguard s* and optimal asset specificity k*. The optimal price p* is less than p because o f market uncertainties that warrant the higher price from the supplier. Optimal price p* is also less than price p. While price p is lower than p because of reputation effect and knowledge, price p is greater than p* because of bureaucracy. The following relationships between contractual safeguards, asset specificity and optimal price state: ki < k* < ki Si < s* < S 2 P>P >P* The arguments for optimal pricing of the hybrid was modeled based upon bilateral contracting supported by flexibility in deploying assets (semi-strong asset specificity) with optimal contractual safeguards and a reduction in transaction costs. In summary, the theoretical arguments presented in this chapter not only support Williamson’s theory of the hybrid, but conceptually expand the hybrid model. While optimality is gained through the hybrid, the hybrid model characteristics are difficult to retain because of the instability o f pricing behavior in the vicinity o f BI and B2 (short-term transaction cost phenomena). This instability results fi'om external market forces and internal adaptive forces on asset specificity, contractual safeguards and transaction costs, the sum of which drives coordination in 164 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the direction o f the firm (hierarchy) and governance (long-term transaction cost phenomena) along Vector A-C. As a result, the optimal price p* gains in the short term may give way to the higher price p in the long run as survivability requires mediating structures, unless a new organizational design model can be found to retain the optimality of asset specificity, contractual safeguards and transaction costs in the vicinity o f price p*. Organizational design that captures the characteristics o f optimal k*, s*, tc* and p* cannot be derived from the market or the firm alone. Contractual uncertainty ex-ante is traded for knowledge and reputation ex-post and intertemporal asset specificity (i.e., the flexibility in deploying the assets with retention of market incentives within the coordinating structure). Langlois and Robertson^*^ find a reduction of transaction costs over time when examining transaction costs in the short and long run;^*^ Langlois, Ricliard, and Paul Robertson, Firms, Markets and Economic Change: A Dynamic Theory o f Business Institutions York, NY; Roullcdge Pub., 1995). Langlois and Robertson write, “ ‘Production costs alone matter only when enough time lias elapsed tliat transient ‘frictions’ do not matter. As a resulL a tlieory from production costs alone tells us much about the organization of tlie economy, but it also tells us less tlian we want to know about the boiuidaries of the firm, tliat is, about tlie ownership of the various stages of production and the nature of tlie contractual relationships among diem. Tlie flip side to tliis analogy, of course, is that the Coasean theory of the boundaries of tlie firm is necessarily a short-run tlieory. Transaction costs are essentially short-nm phenomena. Tliis does not by any means make such costs unimportant. One carm ot explain ownership and conuacting suucturcs witliout tliem.” (25). 165 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Our contention is that transaction costs lose their importance in this kind of long run. To the extent that transaction costs are “frictions”—a term one often hears applied— then such costs are bound to diminish over time with learning, all other things being equal. . . . Our argument is the converse: as change diminishes [in the long run], economic problems recede. Specifically, as learning takes çlace within a stable environment, transaction costs diminish."*^ The phenomenon that Langlois and Robertson write about is identified as the knowledge and reputation found in the interior of the cube where transaction costs are low and in the location of optimality. 4.14. Argument Summary and Test of Theorem 1 The following table summarizes the model arguments as a test of Theorem I. Table 4-4 Hybrid Model Arguments Arguments 1. Market to firm hybridization begins at unstable Node B since it is a mix of A- C modes.______________________________________________________________ 2. At Node A asset specificity K=0 and at node C asset specificity K = I. There is a range k, that extends from K = 0 to K = 1 . Continued 212 Langlois and Robertson, 1995, 27-29. 166 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-4 Hybrid Model Arguments (Continued) 3. Market-Hybrid-Hierarchy Nodes represent a range of intermediate activities of asset specificity and contractual safeguards._________________ 4. The strategic conception of contract serves as a boundary for the interfacing of deepening asset specificity between the market, hybrid, and hierarchy. Mixed intermediate structural forms lie along a vector k, in first order economizing (i.e., that part of the vector outside of the production function)._______ 5. The beginning and ending of the hybrid location is found along Vectors AC (K = 0, K = 1) and DF (k,) at the intersections of the Efficiency and Monopoly branches where K > 0 and S = 0. The point at which contractual safeguards are introduced (SsO) is where property rights and contracts intersect on the Efficiency Branch. 6. Lines perpendicular to Vector AC identify where the market-to-hybrid shift (M to X) and hybrid-to-hierarchy (X to H) occurs. The market-to-hybrid shift is bounded by the Monopoly branch, the intersection of the Monopoly and Efficiency branches where K>0, unstable point B and property rights. The hybrid-to hierarchy shift is bounded by the Governance and Transaction Cost branches and the point where S>0. ____ _____ 7. A positive reputation effect over time allows for the increase in dedicated assets and moderate contractual safeguards and a decrease in transaction costs. This leads to lower prices. Adverse reputations lead to the opposite effect. Continued 167 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-4 Hybrid Model Arguments (Continued) 8. Market disturbances shift the hybrid in the direction of greater coordination. Hybrid-to-market shifts can occur more easily than hierarchy-to-hybrid shifts. Market opportunities arise because information is not perfect. Partners to the trade have varying degrees of information. 9. Trading arrangements depend on asset specificity K and S. Varying interactions of K and S are given as (K = 0, S = 0), (K = I, S = I), (K > 0, S = 0), (K > 0, S = I) (K = 1, S > 0) (K > 0, S > 0), (K = 0, S > 0), (K = 1, S = 0), (K = 0, S = 1) and intermediate ranges._______________ ___________________ 10. The three variables o f asset specificity, contractual safeguards and transaction cost can be placed on an X-Y-Z axis where X = K, Y = S, and Z = TC. 11. Asset specificity, contractual safeguards and transaction costs can be placed on three axes. Asset specificity K is placed on the X axis, contractual safeguards on the Y axis and transaction costs on the Z axis. The range o f the XYZ axes is 0 to 1. The three axes can be used to explore the behavior of price and incorporates the principels of market incentives, property rights, agency and governance.______ Continued 168 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-4 Hybrid Model Arguments (Continued) 12. Four branches are established as a new map of contract which has a diamond structure. They are Strategic Behavior (K > 0, S = 0), Governance (K > 0, S = 1), Efficiency (K = I, S > 0) and Monopoly (K = 0, S > 0). There are two unstable points: HI (K > 0, S = 0), and B2 (K > 0, S = I). The market-to-hybrid shift k % lies in the areas of information asymmetries and market uncertainty on the ex-ante side of contract with influences from property rights and market incentives. The hybrid-to hierarchy shift kj lies in the area of reputation on the ex-post side of contract with influences from administrative controls and organizational incentives._____________ 13. Vector DF runs through the diamond structure between the Strategic Behavior and Governance branches and represents the intermediate activities of (K > 0, S = 0), (K > 0, S = 1). Vector EG runs between the Monopoly and Efficiency branches and represents (K = 0, S > 0), (K = 1, S > 0) and their intermediate activities. 14. Vectors DF and EG bound the interior of the diamond in which is found Axyz which represents the range of adaptation to more consequential disturbances which shift the hybrid in favor of hierarchy ex-ante. The Auvw represents the tradeoffs of market uncertainties, information asymmetries and market disturbances that lead to forming hierarchical mediating structures. The areas of both triangles define the uncertainty of contractual relationships where there are minimal safeguards. The shift toward greater coordination is a shift towards greater contractual safeguards and a deepening of asset specificity in the direction o f the ex-post side of contracts. Continued 169 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-4 Hybrid Model Arguments (Continued) 15. The intermediate ranges of k, and sj are such that so <s*<si at ko<k*<ki for markets si<s*<S2 at k[<k*<ki for hybrids and S 2>s* at k%>k* for hierarchies._____ 16. Using fuzzy set theory, there are a range of binary points from 0 to I as follows; Node A (0,0) and Node C (1,1), B 1(1,0), and 82(0,1) The production function triangle is identified as (0,1/4). The four branches are identified as Strategic Behavior Branch A-Bl at K (l/4,1) S(0), Monopoly Branch A-B2 at K(0) S( 1/4,1), Governance Branch Bl-C at K(l) S( 1/4,1) and the Efficiency Branch B 2 -C atK (l/4 ,l)S (l). 17. A series of linguistic variables can be mapped in the range ko-* 2 and so-> 2 - Asset specificity adjectives in the k range are none-slight-semi-strong-strong- deep. Contractual safeguards in the s range are zero-minimal-optimal-a lot-too many. The conjugate variables of production function, unilateral market safeguards, market incentives, franchise bidding, strategic conception of contract, property rights, agency, price adaptation, organizational incentives, forbearance, adaptation through coordination, administrative controls, and fiat are mapped in a grid corresponding to the linguistic variables. The interior fuzzy conjugate variables are identified as information asymmetries, uncertainty, knowledge and reputation. This mapping produces a cuboidal structure with k* and s* located at the center with transaction costs held constant. 18. A general pricing equilibrium model based on McKenzie theory for a competitive market identifies optimal asset specificity and price (k*,p*) and optimal contractual safeguards and price (s*,p*). ______ Continued 170 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4-4 Hybrid Model Arguments (Continued) 19. A customer wants greater asset specificity at lower price p. Without safeguards, the supplier demands higher p for the provision of less asset specificity kg; ki < ki. 20. The customer wants the lower price p for contractual safeguards at Sj. The supplier provides a good or service at the higher price p for unsafeguarded contracts at S g ; s % < si- 21. In a continuous function general equilibrium model, kj, kg, S d, S g coincide and G[Dem p ] = p*. The appropriate fixed point theorem guarantees these values. Optimal price p* will coincide with optimal asset specificity k* and optimal contractual safeguards s*. Theorem 1 states: There is an optimal price p* that can be found within the hybrid that results from the interactions of optimal asset specificity k*, optimal contractual safeguards s* and optimal transaction costs tc*. 171 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 5 STRUCTURAL ORGANIZATION OF HEALTH CARE DELIVERY SYSTEMS AND A THEORETICAL TEST OF THE HYBRID MODEL 5.1. Introduction This chapter examines the reorganization and restructuring o f the acute inpatient hospitals and providers into integrated health systems and uses the cubed model of the hybrid to explain this transformation. Oliver Williamson found three key factors that are fimdamentally responsible for the success of the Japanese firm—employment, subcontracting and banking. The work of Toshihiro Nishiguchi in examining asset specificity, pricing and organizational design in the success of the Japanese firm provides theoretical evidence to support Williamson’s assumptions and the model for the theory of the hybrid. 213 Williamson, Oliver, “Comparative Economic Organization: The Analysis of Discrete Structural Administrative Science Quarterly, 36 (June. 1991), 295-296. 172 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. He found an evolutionary transformation o f contracting relations produced a symbiotic relationship benefiting both customers and suppliers. This relationship is developed through an organizational clustered control mechanism.^^** 5.2. Clustered Control Organization Clustered control functions are systematically concentrated in a smaller number of first-tier subcontractors that control lower-tier subcontractors. Figure 5-1 shows how the Fuji Electric Plant of Tokyo reordered its relationship with its subcontractors."*^ According to Nishiguchi, this organized contractual structure relieves those at the top of the hierarchy of the increasingly complex controlling functions typical o f expanding external manufacturing organizations. Nishiguchi asserts that by converting subcontracting relations from exploitative to collaborative ones, both purchasers and suppliers benefit from the synergistic effects that accrue from joint problem solving and continuous improvement in price, product quality, delivery, design, and engineering. 214 Nishiguchi, Toshihiro, Strategic Industrial Sourcing: The Japanese Advantage (New York, NY: Oxford University Press, 1994), 122. The core firms at the top of the cluster buy from a concentrated base (i.e., they buy completed assemblies from first-tier subcontractors who buy specialized parts from a cluster of second-tier contractors who buy discrete parts or labor from third-tier contracts). Figure 5-1 is reproduced from Nishiguchi, 123. 173 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Individual Relationships Past Fuji Electric Present Individual Relationships Fuji Electric F irs t-T ie r S u b c o n trm c to rs S e c o n d -T ie r S u b c o n tra c to rs Figure 5-1 Cluster Control: H ierarchical N etw orking Reduction in D irect C ontacts. First Tiers Control Second Tiers 174 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5.3. Asset Specificity The Figure 5-1 shows that movement from exploitative to collaborative contracting in manufacturing entails changing asset-specific contractual relations. There is also a contractual hierarchical relationship. The longer the term o f the contract or trading relationship is, the more likely the subcontractor will acquire customer specific expertise (i.e., an increase in asset specificity). Asset specificity is higher in Japan than in comparative western countries; however, contracting patterns can be different even within the same firm where different manufacturing strategies are pursued. 5.4. Structural Alternatives and the Theory of the Hybrid The following set of Nishiguchi assumptions and propositions integrate his findings into the theory of the “hybrid.” Of particular importance are his thoughts on contractual relationships and pricing. Assumption 21: Japanese businesses and government intentionally implemented measures to alter the contractor-subcontractor relationship from an adversarial (which continues to be found in the West) to a cooperative one. Japanese 175 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. firms have fewer customers and favor long-term contractual relationships compared to the West?^^ Proposition l: Collaborative contracting changes the nature of bargaining. Contractual safeguards are offered in the form o f assurances through long-term relationships. Information disclosure ex-ante reduces uncertainty and information asymmetries and provides ex-ante as well as ex-post knowledge. Reputation effect is assured through smaller numbers of contracting parties in the tiered system. However, this type of relationship requires a different type of pricing mechanism than that o f the market alone. Also it requires a level of contractor-subcontractor rules and control not often found in western countries. Assumption 22\ Nishiguchi asserts that rather than negotiating price downstream, firms and contractors alike look at the possibility o f reducing costs at the source by means of joint problem solving. There is a tendency toward long-term contractual relations which help them cooperate. Firms are able to demand of subcontractors continuous contributions to price reductions and produce quality improvement in exchange for long-term contractual relations which help them to cooperate. Purchaser-seller profit sharing rules are developed on the basis of objective analytic value measures. A logical continuum o f this shift is the contractors’ participation in bilateral cost reduction efforts through improved design. The combined costs are reduced step by step toward the target cost while keeping Nishiguchi, 122-123. 176 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. constant the required specification and consumer needs. Black box design concept occurs; the customer provides basic ideas and specification o f size and performance, and the supplier attends to the details o f the design, fully utilizing the customer’s expertise in specialized services.^ Assumption 23: Williamson writes that highly idiosyncratic transactions are ones where the human and physical assets required for production are extensively specialized, so there are no obvious scale economies to be realized through interfirm trading that the buyer (or seller) is unable to realize himself (through vertical integration). In the case, however, o f mixed transactions, the degree of asset specialization is less complete. Accordingly, outside procurement for those components may be favored by scale economy considerations.^'* Proposition 2: Collaborative contracting and the cluster controlled tiered system reflect the required specific asset specificity (physical and dedicated). The resulting bilateral contracting relationship that results is reflective of the hybrid as it precludes the need for a heavy bureaucratic apparatus and deep human and site asset specificity. Through this contracting mechanism, optimal price p* can be found as that which is not defined by the market alone, but through optimal asset specificity that is deep with respect to physical and dedicated assets while shallow in human and In the product development phase it is common for m ajor contractors to send several resident design and/or product engineers to their customers for two to three years before Job I. They are made aprt of the customer’s project team. They collaborate to solve various design problems and to attain target costs. Experimentation takes place in the field after implementation. 5 1 Q WiUiamson. Oliver, 1985, 75-76. 177 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. site asset specificity. The caveat is that in order to attain price-minus target pricing, optimal safeguards of full information disclosure on business practices, costs, prices and bilateral disclosure in the form of an “open shop” are required. Nishiguchi's model provides structural evidence of the hybrid. It provides a backdrop to compare and contrast the theory of hybrid organizations. 5.5. Characteristics of the Hybrid The hybrid organization is neither a large bureaucratic organization, nor a small or large stand-alone company competing in the market. The hybrid organization is a network of independent companies contractually bound in a long term relationship. This modular network brings together companies with core competencies and expertise in a variety of niche markets. This hybrid organization is highly dependent on information systems connectivity. The benefit of this modular network is independence and incentive for the core firms to produce higher product quality, better pricing for the customer and greater efficiencies. The hybrid differs from a vertically integrated organization on the basis of ownership (Table 4-2 Governance Syndrome of Attributes). In the hybrid, the contract type is that of neoclassic law with bilateral contracting relationships. In the vertically integrated organizations, the contract type is that of forbearance law, and contractual relationships are internalized (e.g., employment contracts). 178 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The flaw in the hybrid is that it requires a flexible labor force. As Nishiguchi points out, dedicated and physical asset specificity is more important than human asset specificity. Through subcontracting mechanisms and dedicated long-term bilateral cooperative contracts this flaw can be surmounted, but to succeed, this organizational design requires collaborative, rather than adversarial contracting over the long term. In Chapter 4 the hybrid model was developed. A network, or modular organizational design format described by Langlois and Robertson,^^^ is consistent with the optimal pricing model of the hybrid model, as well as the relationship of transaction costs, asset specificity and contractual safeguards. The importance of this network model is that it allows for standardization of practice in the private, non profit, or public sectors that can lead to substitutability of services. Organizations are interconnected through neoclassic contracts at each organizational level in order to manage capacity and gain pricing and cost efficiencies. The model o f the organizational hybrid is particularly important to the integrated health care delivery system in which different organizations are interconnected through contract at each organizational level. Since the development of integrated delivery systems started with horizontal integration of hospitals, the first phase of hybrid development is a multiorganizational system. Taking this system's design one step further, the network model allows a multiorganizational 219 Langlois and Robertson. 74. 179 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. system to add component organizations to work for discrete client bases and to access niche expertise or markets without having to add a new division or tool up for diversification activities. This leads to the hypothesis that the hybrid structure is an alternative to internalizing health care delivery organizational capacity, and that integrated health care networks do not behave like oligopolies or monopolies. Narrowing profit margins, constraints on reimbursement and organizational survival strategies have led to the managed care systems described in Chapter 2. In many ways, this restructuring or reorganization of relationships in the United States health care industry is analogous to the Nishiguchi model in which multiple competing contractors and subcontractors provide services to multiple clients. Table 5-1 shows Nishiguchi's comparison of contemporary Japanese contracting relationships to those of Western countries. 180 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-1 Comparison of Japanese and Western Contracting Japanese Collaborative Contracting Western Bargaining Contracting Contractors are assigned integrated tasks, including research and development. Strategy requires long term commitment between contractor and organization. Contracts issued on a short-term basis and are not expected to do more than the customer ordered. Job content is integrated between customer and contractor. Job content is piecework. Dependence is on a single customer for inputs. Far more customers per organization. Trade relations cannot be short-term, as continuous mutual commitments are required. Once basic terms are fixed, trading continues until one or both parties find reasons to discontinue. This can lead to short-term commitments. The customer assumes contractors will automatically and continuously improve quality and reduce costs. If they don’t, the customer tries to discover the reason for problems and push contractors to solve problems at the source. It is unusual for a customer to fire or switch without such monitoring. Cost increases are assumed over time as natural and unavoidable. Problems arising fi’ om contractors, such as input price increases, are interpreted as antagonistic power relations. If a contractor proposes a price increase or there are other problems with performance, the customer usually bargains for a smaller increase or other concessions while threatening to switch contractors. Relations are planned and coordinated. No effort at joint problem-solving at the source. 181 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As the Japanese grew in economic power to develop its world-class automotive and electronics industry, the use of contracting intensified. A full product line strategy emerged. An important outcome of this structural change was the emergence of multi-skilled contractors who took advantage of the increasing multifunctional technological expertise to serve their customers. Along with the price-minus and target-cost method of new product development that emerged in Japan came profit-sharing rules for purchaser and supplier. This rule-setting was a significant departure from the traditional practice in which the contractor’s incentives for improvement were frequently negated by the customer’s attempts to try to monopolize the benefits of its contractor’s new ideas. The new arrangements inspired contractor entrepreneurship and led to a circle of customer-contractor competition and cooperation. The result was contractor-driven innovations. Substantial cost reduction and a larger capability for design changes were not achieved through a single-minded devotion to economies of scale or downstream negotiations to reduce price; rather, they came from the contractors’ proposals at the source. This would also be expected from the hybrid model in Chapter 4. 182 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5.6. Transformation of the Health Care Delivery Infrastructure Organizational and structural changes are rapidly taking place as HMOs and managed care organizations integrate as contracting networks. It is important to examine contracting relationships within the health care delivery system and compare the resultant organizational design advantages with those proposed by Williamson, Nishiguchi and Langlois and Robertson. In many ways this restructuring and reorganization of organizational relationships in the U.S. health care industry is analogous to the Nishiguchi model in which multiple competing contractors and subcontractors have provided services to multiple competing companies prior to government market intervention as follows. The traditional health care delivery model was one of multiple independent contracting relationships between insurance companies, hospitals, doctors, independent lab and x-ray services and pharmacies (all with inherent transaction costs that resulted in higher prices). Structurally, the contracting relationships are similar to those that existed in Japan prior to the development of clustered-control contracting relationships. Figure 5-2 demonstrates the unclustered control relationships o f medical delivery in the 1960s and 1970s. 183 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. HOSPITALS MED GROUPS ANCILLARY i Individual Physicians ^ ------ Individual Contract Relationships Figure 5-2 Unclustered Control Contractual Relationships 1970s to M id-1980s In the unclustered control relationships that existed in the medical delivery system from the mid-1960s to the early 1980s, contractual relationships were 184 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. individual and linked to multiple primary firms. According to the Nishiguchi model, in a rapidly expanding economy (which health care was during this time), the contractual relationships should have been market-based competitive models that resulted in continuously lowered prices between all participants in an adversarial bargaining relationship; yet, during this time, the opposite was true. Medical care delivery between physicians, hospitals, insurance companies, and other suppliers was collegial and cooperative. Through the medical insurance mechanisms, both consumers and suppliers were insulated from competitive market forces that would have rendered the Nishiguchi model true. The unidirectional flow o f the arrows illustrates the passive role of the insurance companies as third-party fiscal intermediaries (i.e., retrospectively paying the bills submitted by the providers in the absence of cost-constraining mechanisms). In the 1980s the federal government intervened in the medical care market through a series of regulations designed to introduce competition in health care delivery. This was an effort to constrain medical care costs because a greater percentage of payments o f medical care costs were made through public funds. Table 5-2 lists the legislation that led to the structural transformation o f the delivery system from 1965 to 1989.^^° 220 As will be demonstrated later, the key legislation identified directly resulted in the organizational redesign of stand-alone entities to contracting networks. 185 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-2 Key Federal Legislation 1965-1966 Social Security Act amended to add Medicare and Medicaid. 1973 Health Maintenance Organization Act is passed 1983 April 20, 1983 Title VI of P.L. 98- 21, the Social Security Amendments of 1983 Established Prospective Payment System (PPS) and introduced Diagnostic Related Groups (DRG) as prospective payment mechanism. Provided that national DRG payment rates would be phased in over a five-year transition period. 1986 President’s proposed budget included several provisions affecting PPS Including a freeze on payment rates. 1985-1986 Consolidated Omnibus Budget Reconciliation Act (COBRA) of 1985 and P.L. 99-177 Balanced Budget and Emergency Deficit Control Act of 1985 Reduced Medicare payments to hospitals by 1%. P.L. 98-21 Required the Health and Human Services Secretary (HHS) to adjust the DRG classification and weighting factors in FY 1986 and at least every four years thereafter to reflect changes in treatment patterns, technology and other factors which may change the relative use o f hospital resources. Continued 186 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-2 Key Federal Legislation (Continued) P.L. 99-509 Omnibus Budget Reconciliation Act (OBRA) Required the (HHS) Secretary to adjust the DRG classification and weighting factors beginning in FY 1988. P.L. 99-272 (COBRA) Provided that additional payments will be made from May 1, 1986 to October 1, 1988 to hospitals that serve a disproportionate share of low-income patients 1989 Introduction of Resource Based Relative Value Scale (RBRVS). Congress phases in a fixed fee schedule for Medicare physician payments based on RBRVS beginning in 1992. Physicians are forced to accept as final the amount paid for Medicare (without charging the remainder to the patient), targets for physician spending are established, and congress authorizes research on medical effectiveness studies. Since the most expensive component of care was acute inpatient care, alternative organizational forms arose such as outpatient surgery, urgent and acute ambulatory care centers. Figure 5-3 demonstrates the changed contractual relationships between direct caregivers (physicians) and the organizations they serve (inpatient and outpatient organizations). Independent contractual arrangements continued, but they were constrained by formal contracts issued by insurance companies regarding what services would be paid for. 187 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. HOSPITAL SYSTEM INSURANCE I OP SURG MBS I i ANCILLARY MBS GROUP MBS URGENT CARE MBS I ! FOUNDATION I I I I I Individual Physicians Contracting Organization Relationships Figure 5-3 Transitional Cluster Contracting Mid 1980s to Mid 1990s 188 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Attempts at health care cost reduction and greater monitoring of all providers by the insurance companies occurred as the insurance companies sought to reduce their costs and constrain premium charges. One of the characteristics of the clustered-control model is that of monitoring of the contractor by the primary firm. In the unclustered control model, there is no primary firm. As the unclustered independent contractual model of the 1970s was transformed to the semi-clustered contractual model o f the 1980s, cost-plus pricing (retrospective reimbursement) changed to price-minus pricing (prospective reimbursement). That is, in order for health care delivery organizations to contract with insurance companies, formal contract discount rates were established. This provided for a niche market for preferred provider organization (PPOs) brokers, intermediaries who negotiated the contracts. These price-minus rates were not derived in the collaborative sense, but more in an adversarial manner (As the Nishiguchi model would predict). Additionally, the insurance companies began monitoring the hospitals as first-tier contractors, who then monitored the physicians as second-tier contractors. From the mid 1990s, full cluster-control mechanisms have been in place (Figure 5-4). 189 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. INTEGRATED CORPORATE HEALTH CARE SYSTEM / ' \ INSURANCE HOSPITAL A ! I HOSPITAL B à -------- INTEGRATED HOSPITAL C A - A — A 1 1 PHYSICIAN SERVICES ! ' 1 f i ! f f : V Foundation j Foundation ; ; F oundation Foundation ' ' A 1 ! 1 ; A2 : Cl C 2 ! : : L ' : 1 1 A i ; 1 ! i : 1 L) ( J L Figure 5-4 Clustered Control Contracting Mid-1990s to 21st Century 190 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Proposition 3: The organizational response has been reformation o f formal individual contractual relationships to formal firm contractual relationships, reducing the number and type of contracting organizations. Physicians are organized as independent practice associations (IPA) or what is also known as the foundation model. Through the IP A or foundations, physician services are contracted to the hospitals. In order for physicians to have patients, they must belong to a contracting “panel.” They see only patients who have selected a specific insurance company with which they (the physicians) are part of the provider panels. In effect, the insurance companies and health care corporations have become the primary firms. The first-tier contractors are the hospitals, the second-tier contractors are the IP As or foundations, and the third-tier contractors are the physicians. The price-minus contracting methods of the 1980s have given rise to capitated rate setting, in which full inpatient and outpatient services (including ancillary and pharmacy) are purchased for a flat rate. This “managed care model” allows health service delivery systems to enroll “covered lives” in which premium payments are collected from the insurance companies whether or not the patient utilizes the services. In fact, the incentive for the health care delivery system is that patients “not” use services. The diagnosis-related grouping system, which formed the basis for prospective reimbursement in the 1980s, has been converted to product lines under a capitated reimbursement system. Monitoring of this clustered-control arrangement has been made possible through the use of management information systems. Is this an adversarial system? 191 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Right now the answer is yes, as it pits the delivery system against the reimbursement system and independent doctor practices against insurance companies. If Nishiguchi’s model is right, then economic gains (through the pricing mechanism) are not made through adversarial bargaining between insurance company and physician, insurance company and hospital, and so on, but by developing long-term collaborative relationships and implementing systems that identify problems at the source. The organizations that now comprise the health maintenance organization (physicians, hospitals and insurance companies) restructured from individual firms to contractually linked networks between 1970 and the present. The next section of this chapter examines the structural changes of the individual “firms” that comprise the restructure to HMOs and managed style delivery of care. 5.7. Structural Changes in the Physician Market The structure of the physician services market is determined by barriers to entry and by the extent of economies of scale to be gained by practicing in medical groups. . . . Entry barriers have also influenced the types o f firms able to deliver physician services. Restrictions on HMOs have inhibited their ability to compete in the physician services market. Hospitals have similarly been unable to deliver physician services. Restrictions on the corporate practice of medicine have made it difficult for non-physicians to hire physicians and compete with other physicians. . . . The structure of the physician services market could have been characterized as competitive, except for various restrictions, such as limits on both physician advertising and insurance companies’ ability to negotiate discount prices among physicians. With the applicability of the antitrust laws to the health field in the early 1980s, physician 192 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. imposed restrictions on advertising and price competition were eliminated. As competitive restrictions were removed, the structure of the industry began to change.^^^ When the structure of the physician services market is discussed, it is generally with respect to the number of physicians in solo and group practice. For more than 100 years prior to the 1970s, the predominant form of medical practice was solo practice with insurance-sponsored fee for service reimbursement.^^ Explanations for the shift from solo to group practices include (I) Scale economies and lower costs: The findings on economies of scale in physician practices appear to be confirmed by the recent data indicating that more physicians are joining group practices; in 1979 21.7 percent of physicians were in group practice; by 1980, this had increased to 32.8 percent and by 1988 to 44.5 percent. The fastest-growing form of group practice during the 1980s was the single specialty form o f practice, increasing from 10.9 to 20.5 percent of physicians between 1980 and 1988. It is interesting to note that while single specialty groups outnumber multispecialty groups almost three to one, multispecialty groups are much larger in size, 24.2 versus 6.2. The increase in the number of physicians in group practice and the increasing in size of each group suggests that group practice is a more efficient form o f organization and that the optimal size of the group is likely to be larger than the average size. ^ Feidstein. Paul, Health Care Economics (Albany, NY: Delmar Publishers, 1993), 176-177. ^ Ibid.. 176. ^ Ibid., 177-178. 193 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Sharing benefits decreases incentives for these physicians to be as productive as physicians who practice in small groups or in solo practice/^"* (2) As the group size increases, individual incentive to monitor the group behavior decreases. Monitoring is a group benefit, but the cost of monitoring is borne by the individual. (3) Management and the formation of committees make decisions for the group rather than the individual practitioners. One study shows that when compensation is based on group productivity, individual physician output increases offsetting the disincentive effect o f revenue sharing.(4) Disputes among members are likely to occur particularly regarding payment incentives to maintain productivity. Additional explanations of the rise o f the medical group include: (5) Lack of patient information, which explains medical group formation. Physicians are better able than patients to evaluate other physicians. Being a member o f a medical group conveys information to patients regarding the quality of the members; (6) 224 Ibid.. 177, “If physicians in a large group share the costs of inputs, each physician has an incentive to increase their use of inputs if the benefit they receive from the additional input use exceeds their share of the additional costs.” 225 Ibid., 177, Sharing of revenues can produce declines in productivity. In solo practice, the physician is the sole beneficiary of productivity. Feidstein cites the study by Martin Gaynor and Mark V. Pauly, “Compensation and Productive Efficiency in Partnerships: Evidence from Medical Group Practice,” Journal o f Political Economy, 98 (3), Jimc 1990, 544-573. 227 Feidstein, 176. Tire output—physician services—consists of examinations, treatment, tests, history taking as well as health education, record keeping, and patient billing. Information on the quantity and mix of each of the services provided in a physician’s office is generally unavailable. Empirical studies must therefore use proxy measmes for physician services. Such measures include annual gross patient billings and/or weekly number of office visits (which reflect difrerent practice patterns and/or different levels of acuity for which adjustments caimot be made). 194 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reputation effect in which information economies of scale are realized. A new physician entering the market takes time to establish a reputation among patients and to build a practice. (This implies building trust). When a physician joins a group, the group’s reputation is immediately transferred to the individual and the new physician is able to receive patients from other, busier, physicians in the group. This allows a substitution effect that does not produce a competitive one. (7) Multispecialty effect; multispecialty groups offer greater Informational economies, designing fair compensation and monitoring physicians’ quality and productivity. (8) The last explanation is shared risk. The desire by physicians to reduce uncertainty 228 and share risk is important. Physicians in solo practice are likely to experience greater variation in workload and income than are members of a group practice who share the work to the extent that physicians are risk averse. They are willing to trade off the greater incentives of solo practice, where they receive the full income from work effort and do not have to share revenues to become part of the group. Proposition 4: The history of the physician market was described as one of a monopoly or cartel, whether physicians were in solo or group practice. If one accepts that this was the case of the physician market in the 1970s into the early 1980s, then this places the physician market in the comer of the bit cube at point A 228 Ibid., 177-178. Feidstein notes, "Large medical groups provide a greater variet>' of outputs than do small groups or solo practices. Larger groups are also more likely to own laboratories and .x - ray facilities and participate in HMOs and insurance plans, which require additional administrative personnel. Unless outputs and inputs are measiued accurately and adjustments made for differences in outputs the results of studies may incorrectly conclude that large groups have higher costs and are therefore less efficient" 195 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. market autonomy, oriented to the face of the monopoly side of the cube. Yet, at this location, market trading is supposed to be anonymous. Thus, physicians participated in the market as autonomous traders, but were not anonymous because of the principal-agent relationship, an implied contract between physician and patient. Therefore, the anonymity concept of competitive autonomous market trading at point A is violated. This orients the physician market toward the strategic behavior side of the cube in which agency, property rights, uncertainty and the strategic conception of contract are also included. Figure 5-5 (both shaded and unshaded) demonstrates that portion of the cube that describes the physician market in the 1970s and early 1980s. The franchise bidding portion is included as it represents those few physicians who were participants in the early development of HMOs. Let Figure 5-5 represent the three-dimensional bit-cube theory of contract from Chapter 4. The production function, monopoly face and strategic conception of contract characterize the location of the physician production function input and outputs and strategic behavior under monopoly conditions. Market price p at Node A will be the greatest. Any pricing behavior in the direction of B2 (0,1) is unstable as there is no asset specificity. All of the pricing behavior will be in the direction of agency and greater human and physical asset specificity for the physician. Insurance companies traditionally paid the higher price which included insuring against uncertainty and risk. Retrospective reimbursement provided the incentive for the strategic conception of contract (i.e., the physician determined the inputs prior to billing the insurance company). The insurance company was then obligated to pay 196 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the bill after the fact. Note that asset specificity ki is reached, but contractual safeguards are at so. Franchise bidding was nominal at this time so a level of safeguards at si has not been attained. Proposition 5: Let the area called unilateral market safeguards in Figure 5- 5 represent the location of the insurance sector of the health care market prior to government intervention efforts. There are no contractual safeguards for the third Monopoly (0, 0, 0) PF Rival Entry C o lic ^ on Strategic ontract Vf Prc petty Rid Coordinatioi Agency (3/4, 1/4, 1/4) Figure 5-5 1970s Structure o f the Physician Market Using the Cube Model 197 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. party payers (insurance company and government) (so = 0) with retrospective reimbursement. The way to move the physician market away from the profit- maximizing agency strategic conception of contract is through the franchise bidding process in the direction of contractual safeguards (S = 1) but where there is no designated asset specificity (K = 0). Both points BI and B2 are unstable. Therefore, those who control the money in the form of reimbursement (the supplier-payer) must contractually negotiate with those who control the patient-customer (the demander- physician). Prospective reimbursement mechanisms with a contract broker, in the form of a preferred provider organization), accomplished just that. The push-pull contractual relationships between employer, third-party payer and the delivery system, moved both asset specificity and contractual safeguards in the direction of the center of the cube to produce lower prices. Prices are lowered as the transaction costs of uncontrolled and unilateral physician trading was converted to one of bilateral physician-insurance contractual trading and lower transaction costs. This is consistent with the Nishiguchi model. Proposition 6: Dependency is o f a bilateral nature so that market efficiencies are not traded for organizational or bureaucratic inefficiencies. In effect, under conditions of the optimal pricing model, a restructured physician market, which is one of bilateral contractual relationships will be more efficient than the market (classic contract law) and more efficient than a hierarchical structure with deep asset specificity and contractual safeguards. Thus, the assumption that buyers and sellers will reposition autonomously in a disturbance where price serves as a 198 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. sufficient statistic is correct. Each party has a strong incentive to reduce costs and adapt efficiently. Adaptability is gained through emergence of governance structures and incentive and control techniques brought about through contract type and the level of disturbance. Proposition 7: There is a bilateral relationship between governance structures and asset specificity. As governance structures emerge between the insurance and physician markets in the form of the preferred provider organization broker, asset specificity deepens as the contractual relationship strengthens. A parameter shift ki occurs from M to X as a predictive action and a hybrid form will emerge. The hybrid form that emerges as a result of this parameter shift is the physician-payer-PPO triumvirate. Organizationally, the physicians join groups in greater numbers to obtain greater bargaining power and the contractual relationship becomes one of independent contractor rather than autonomous market participants. As the parameter shift ki moves in the direction of this hybrid, the property rights of both parties secure the deepening asset relationship that is produced by the contractual safeguards to the trade. Market incentives (or disincentives) are traded for greater coordination through hybrid governance. Price p is lowered toward p as a result. As payers shift from retrospective to prospective methods o f payment, the predictive action that was expected from the providers was that of lower price and cost. The literature supports the model showing that these gains have been made. 199 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The model is further supported in that the emergence of PPOs and IP As as a hybrid shift occurred in the mid 1980s coincidental to the introduction of regulations that converted physician (and hospital) retrospective payments to prospective payments as the federal government became responsible for a larger percentage of these health care costs and insurance companies could no longer extract higher premium payments from employers. The bit cube in Figure 5-6 displays the organizational characteristics that include all of these considerations. 200 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B2 (0, 0, 1 ) Monopoly (0, 0, 0) I PF I w Leverage Rival ! I (0, Entry I Strategic Cl itract Pro jcrty Rii hts Agency Admin — C û i (1, 0, 0) Efficiency 9 < o 3 § O o BI Figure 5-6 1990s Physician Organization ko to ki Shift Using the Cube Model 201 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Proposition 8: Organizational redesign evidence i s found which supports Propositions 1 through 6 as follows: Organizational models that moved physicians from the autonomy market relationship in the direction of a clustered control relationship include contract employee, medical group, faculty practice, independent practice associations and nonprofit foundation models. These models deviate from traditional employer- employee relationships (select neoclassic law over forbearance and fiat), depart from independent practitioner entities to medical group provider entities and institute economic incentives and rewards for cost-effective organizational delivery o f health and medical services. Two types of model applications that serve to integrate physicians with the hospitals and other organizations they serve are the “Foundation Model” and the “Small/Rural Model.”^^ In the foundation model (Figure 5-7), the foundation contracts with physicians for their professional services on an annual basis. The parent corporation can own, lease or contract with hospitals, freestanding centers, home health, and long-term care organizations. The physical facilities are organized into separate corporate entities. The professional services corporation has 229 Philbin, Patrick, “From the Ground Up: Planting the Seeds of Network Development, Hospitals and Health Networks {June, 1993): 46-52. 202 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. physicians, nurses, and professional and allied care-givers on salary or contract. This system can network with public health and voluntary health agencies.^^° Licensed Facility Foundation Medical Group Independent Practitioner -Bilateral Contractual Relationships Figure 5-7 Foundation Model of Health Care Delivery Organization 230 Ibid., 49. 203 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The nonprofit foundation model pictured above typically evolves from a health care delivery environment in which a multispecialty medical group existed as a for-profit entity and has a history or interest in philanthropic pursuit of public service health, education and/or research, recognizing the benefits of tax-exempt financing available to nonprofit foundations. The ownership and management of assets is transferred to the foundation and the practitioners subcontract with the foundation to provide services. The foundation model provides a significant advantage o f reduced capital afforded via its access to the tax-exempt bond market.^* The small-rural model focuses on integration of the delivery of health care services with the community. A coordinating council is designed to meet routinely to develop a seamless case management system and retain the primary care services and their delivery in the county. The public health system is also reorganizing to take advantage of the private sector restructuring (Figure 5-8). Jack, Max, and Robert Phillips, ‘ ‘Public-Private Partnership Organizations in Health Care: Cooperative Strategies and Models.” Hospitals and Health Services Administration. 38 (3) (Fall. 1993): 387-400. Philbin, 50. 204 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. C o o rd in atin g C o u n cil R egional S y stem s B o ard Schools Courts Police Providers Welfare Government Business/Industry Nursing Homes Programs Public Health Health Professionals Mental Health Voluntary Agencies Other Hotel/M otel Prevention Hospitals Physicians Preferred Health Organizations F ig u r e 5 -8 Sm all H osp ital R ural Health Care D elivery M odel Reorganization o f the public service delivery infrastructure could create economic incentives for private medical provider participation in becoming a high-quality, low-cost provider of service. This restructuring begins with redefining the relationship between the public health care institution and the private medical 205 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. community. This public-private partnership is intended to create incentives that link the public health delivery system to medical provider performance. Physician autonomy has been greatly eroded as these networks have developed. This erosion was brought about by (1) deregulation o f the health care industry in the 1980s coincidental to government regulation that reimbursed government-funded patients on a prospective rather than a retrospective payment schedule and (2) the implementation of a capitated insurance reimbursement rate leading to the need by physicians to participate in groups for risk-sharing. Both provided market mechanism incentives (i.e., reduced income) for physicians to joint multipractice groups and to participate in health maintenance organizations. Through both incentives and organizational structure, greater physician practice monitoring can occur—one from an internal organizational standpoint, the other from an insurance and government-regulated reimbursement perspective. Large medical groups have the greatest market power because a greater portion of the community’s specialists are part of the same group. This results in less competition, a more concentrated market, and groups more likely to increase their prices. Physicians in large groups are more likely to be associated with HMOs and PPOs than solo physicians or small groups. Large medical groups are better able to market their services directly to insurers, employers, and hospitals. Ibid., 50 206 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Proposition 9: Let physician relationships, as they move from solo to group practice, to large group practice or independent practice association be represented by Figure 5-6 as a relational contracting, bilateral, recurrent mixed to idiosyncratic type. Property rights and principal-agent relationships (between physician, patient and delivery system) deepen. Assets are more greatly specialized to the needs of the parties to the transaction. Market incentives are traded for contractual governance structures and reduction of information asymmetry, which accrues to the insurance companies paying the bill. Reputation effect (knowledge and reduced uncertainty) accrues to physician groups. As a result, efficiency gains are met-as higher price market p is lowered. According to the model, asset specificity deepens between the mixed and idiosyncratic type leading to ki > ko and si » so. Price p is achieved, but p* conditions have not yet been met. Note that p* is not obtained as k*, s*, and tc* are not obtained as the model requires. Through the development of IP As, adaptation through price is achieved as the market price p is lowered to the franchise bid p. It should be noted that in the process, the higher price still reflects asymmetrical information and lack o f certainty (a market pricing phenomenon). On the other hand, contractual safeguards, deepening asset specificity, organizational incentives, adaptation through coordination and reputation effect strengthen the relationships of buyer (insurance company or broker [PPG]) and seller (physician group), allowing for reduced prices,, 207 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. depending on what each party to the contract negotiation is willing to disclose in the bargaining process. 5.8. Structural Changes in the Hospital Market As the cost of health care delivery has continued to increase, increasingly hospitals and physicians have integrated their services. The hospital is no longer the focal point of delivery as it has been in the past. This evolution started as hospitals merged to form multihospital systems in the 1980s and developed a corporate structure for oversight of them. In the 1990s, the corporate health care system is comprised of hospitals, clinics, urgent care centers, ancillary services, long-term care services, home health and emergency services. Figure 5-9 is the “Health Care Delivery Network Model.” In Figure 5-9, the direct patient delivery services are supported by organizational support services (denoted by the double-headed arrows converging to the center line). It is the patient delivery system which has responsibility for quality of care and outcomes. 208 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hospitals Clinics Direct Care Clinicians Administrative Systems Patient 4 — i- Long Terai I Care Urgent Care i Emergency Care Ancillary Services Support Services Svstem Finance Svstem I Insiuance L Reimbursement ^ System Legal System Receptors Quality of Care Effects 4 " and Impact Problem Analysis and Outcomes F ig u re 5-9 H ea lth C are D elivery N etw o rk M od el 209 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As price competition has intensified, insurance companies have tried to reduce uncertainty over their provider relationships and establish greater control of their determination of costs, namely hospitals and physicians. Changes in the organization of production and the organizational structure of the firm delivering medical services have been effected by the pursuit of economies of scale and scope, regulations affecting entry into a market, payment systems, the applicability o f the antitrust laws, and the nature of transaction costs. Increased interdependence among the various providers, suppliers, and insurers has resulted in attempts to lower the transaction costs of these relationships. The development of sophisticated data systems that integrate clinical and financial information on each patient by specific providers has improved the ability of hospitals and insurers to evaluate different providers. Together with the need for greater certainty in relationships, control o f costs, and referral of patients, this information has enabled hospitals and insurers to select providers with whom they prefer to have closer relationships, which may occur through ownership or exclusive arrangements. The consequence has been an increase in vertical integration in the financing and delivery o f medical services. Outpatient services, such as laboratory and radiology diagnostics, pharmacies, surgeries, examination and treatment, contributed heavily to hospital profitability in the late 1980s, although the profitability of these services was also declining. The increase in hospital outpatient services occurred for two reasons. Third-party payers have attempted to decrease the use of the most costly component 210 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of care—the hospital— by expanding insurance coverage to the outpatient setting, and insurers have instituted utilization review mechanisms to ensure outpatient procedures are favored over inpatient procedures. This change has been facilitated by technology changes that permit more procedures to be shifted from the hospital to the outpatient setting. Changes in the reimbursement system are moving hospitals into complementary product lines which means specialization of services by individual hospitals in a hospital system. Under a fixed-price reimbursement system, hospitals now have the incentive to discharge patients sooner to other institutional settings such as nursing homes and home health care agencies. This allows the hospital which owns those entities to receive additional reimbursement for care. By vertically integrating into related products, the multihospital system is then able to approach employers and offer a complete product line with broad geographic coverage. 5.9. Hospital Network Evolution The evolution and integration of stand-alone hospitals into hospital networks is consistent with regulatory changes that are described in Table 5-3. The introduction of significant legislation in 1983, 1985-1986 and 1989 led to three generations of organizational networked systems. A timeline of legislation and the three levels of integration are provided: 211 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-3 Level of Hospital Integration and Corresponding Federal Legislation 1983 1985-1986 1989 PPS and DRGs established Freeze on payment rates Decreased Medicare to hospitals RBRVS Level I vertical integration Level H vertical integration Level in vertical integration Proposition 10: The reorganization of hospitals into vertically integrated hospital systems coincides with significant pieces of Federal legislation. Hospital realignments range from weak affiliation agreements to a merger of one facility into a larger organization where the smaller institution loses its identity. The reasons for these agreements include economies of scale, lower interest costs, greater access to capital markets, improved cash management, and lower malpractice premiums. Hospitals facing declining occupancy rates, more stringent reimbursement policies, and declining profitability are more willing to give up their autonomy in order to 2 1 2 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. survive. First generation models (Level I) which arose in the mid-1980s include shared purchasing, rural consortia, and merged hospitals (Figure 5-10).^"* O rganizational Network First G eneration M odel P rim ary i L evel o f H ospital Care Secondary Level o f H ospital Care T ertiary | Level of j H ospital i Care I ; ! 1 . i ' ! Î Medical ! Staff i L , i ! 1 j Medical j 1 Staff 1 ! 1 ! 1 Medical : Staff 1 j 1 Shared \ Services Shared Support Services Laundry Purchasing Managed Care Referral Figure 5-10 Level I Hospital Integration 234 Ibid., 51. 213 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In this model, the hospitals and medical staff operate independently, but the hospitals determine that they can share services in an attempt to lower their individual costs. This interhospital sharing o f the costs of support services such as laundry, purchasing and managed care referrals, are the first attempts o f independent hospitals to constrain and share costs by working together. Second-generation models (Level II) which arose in the late 1980s provide for a network coordinating board. With the acquisition of independent hospitals and merging of independent hospitals into multihospital systems, the coordinating board is directly responsible for hospital network performance. This board is usually made of administration and medical staff with the possible addition of business, industry and other appropriate organizations. The medical staff still maintains autonomy through individual and group practice. This model moves the network into overall systems planning and managed-care products, where the clinical integration might include selection of specific delivery sites for certain services. This clinical integration has the advantage of higher volume activity at one site, reducing cost and duplication of equipment and staffing (Figure 5-11).^^ Philbin, 51. 214 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. O rg a n iz a tio n a l N etw ork S econd-G eneration M odel - L a te 1980s Network Coordination Board Board - Administration - Medical Staff Primary Level of Hospital Care Secondary ! Level of i Hospital ! Care Tertiary { ! Level of | ! Hospital ! Care Additional Integration Medical Medical Medical ; Staff Staff Staff Overall System Planning Managed Care Products Selected Delivery Sites Product Lines Figure 5-11 Level II Hospital Integration In the Organizational Network Third-Generation Model (Figure 5-12) developed in the early 1990s, physicians, ambulatory centers and other providers are 215 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Organizational Network Third Generation Model Hospital Network Corporate Board Primary Hospitals Secondary Hospitals Tertiary Hospitals Physician Integration Ambulator^’ Centers Additional Integration Integrated Management/Finance Advanced Managed Care Products Integrated Delivery Figure 5-12 Level III Hospital Integration 216 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. incorporated into the overall network with integration of clinical services, integrated management, advanced managed-care products, and seamless health care delivery.^^ This organizational restructuring has tended to make the hospital industry more concentrated. Let Figure 5-13 represent the three-dimensional bit cube theory of contract from Chapter 4 as representative of the hospital structure in the late 1970s and early 1980s. As stand-alone organizations, hospitals have heavily dedicated physical and human assets, with deep contractual safeguards, to the independent production of inpatient care. Ibid., 52. 217 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Agency Admirustrative Controls M easi irem ent' ( 1, 1 , 1) I, 0,0 Figure 5-13 Model of Hospital Organizational and Contractual Relations, Early 1980s, Using the Cube Model Proposition 11: The Efficiency and Governance faces of the cube characterize the location of the solo hospitals in the late 1970s and early 1980s. 218 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hierarchical price at Node C includes bureaucratic internal and external oversight costs, and internal contracting relationships by fiat and forbearance. If Feldstein’s argument is accepted that hospitals were noncompetitive and inefficient because of retrospective reimbursement, then pricing behavior at Node C is protected by too many contractual safeguards, S = 1 at kz. Also, physical, dedicated and human asset specificity is deep K = 1 at sz. At that time, kz > k* > k i and sz > s* > S i in an unclustered control relationship. Hospital reputation is important for the physician privileging process. Organizational incentives are to put patients in beds. Price adaptation is through the retrospective reimbursement mechanism with contractual guarantees via insurance and government payment mechanisms. At this time, unilateral market safeguards for insurance companies were at So = 0 (in probability terms, insurance companies can somewhat predict the future with regard to cost, but without effective controls); guaranteed payments for hospitals ensured that contractual safeguards were at the level o f sz = 1 . Adaption through price was one of expansion of physical, dedicated, and human assets leading to annual cost and price increases that exceeded inflation. Therefore, organizational incentives were for continued growth in dedicated human and physical assets because the contractual safeguards ensured that price increases would be met through the insurance reimbursement system. 219 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Proposition 12: The way to move the hospital market and solo organizations in the direction of clustered-control with resulting lower contractual safeguards, asset specificity and greater organizational efficiencies was to trade off hierarchical bureaucratic costs for greater market incentives. Through the development of shared services, independent hospitals' dedication o f assets decreased and the hospital had greater flexibility in deploying shared assets. Contractual safeguards were lessened as insurance companies paid on a prospective rather than retrospective basis, and internal organizational safeguards were converted to inter-hospital shared-services contractual safeguards (which were less predictable). The result was a lessening overall of both dedicated assets and contractual safeguards. As Williamson points out, much larger parameter changes are required to induce a shift from market to hierarchy (or the reverse) than are required to induce a shift from market to hybrid or from hybrid to hierarchy. An apparent contradiction occurs. Hospitals as stand-alone institutions operating under retrospective reimbursement (Level I integration) had deeper asset specificity than when they became part of networks (Level II integration). They had greater contractual safeguards under retrospective reimbursement (Level I integration) than under prospective reimbursement which coincides with Level II integration. What appears to be a greater hierarchical structure as independent hospitals become part of networks is, in actuality, a lessening of hierarchical structure as redundant administrative, support services, and clinical systems are reduced or eliminated. 220 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Within this integrative restructuring, bilateral contractual relationships are maintained between clinicians, hospitals and insurance companies and these organizations, while networked, still operate as independent entities. Hierarchy is lessened because the relationships remain external and contractually bound (neoclassic contract law), rather than being internalized within one organizational structure (forbearance law); thus, asset specificity, contractual safeguards and transaction costs decrease as hospital networks form. This shift from hierarchy in the direction of the hybrid is forced through both government market intervention and changes in methods of reimbursement. Proposition 13: To gain a better pricing structure in a Hierarchy-to-Hybrid Shift (H to X), the mechanism by which the hospitals and their markets moved to a more competitive process through selective contracting (franchise bidding) needed to occur. Franchising awards greater autonomy than hierarchy but places franchisees under added rules and surveillance as compared with markets.^^^ As solo hospitals have diversified through urgent care, ambulatory surgery centers, and implemented selective contracting with physician groups, the organizational redesign has evolved from the semi-cluster control hospital system of the 1980s to the full cluster control health care system of the 1990s with the concomitant H to X shift is because of the increase and scope of hospital contracting with entities outside the organization. 237 Williamson, “Comparative Economic Organization: The Analysis of Discrete Structmal Alternatives,” 1991.283. 221 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Proposition 14: This system redesign has occurred as a result of selective contracting by the government and insurance companies franchising with hospitals and physician groups. As a result of systems integration, health maintenance organizations and managed care are the results of these contractual relationships. This evolutionary process has resulted in both horizontal and vertical systems integration as demonstrated by the structural changes identified in previous sections of this chapter. The simultaneous introduction of selective contracting (franchising) has introduced uncertainty into the contractual relationship as the kz and s % guarantees for hospitals (retrospective reimbursement) move in the direction of ki and Si. Prospective reimbursement, with lesser dedicated assets and uncertain contractual safeguards (due to uncertain transaction costs) results in lower ex-ante prices. On the other hand, the insurance companies and government agencies which pay the hospital costs have greater contractual safeguards in the form of prospective reimbursement and capitated payments. Subsequently, for the insurance companies. S o = 0 moves in the direction of si = 0 > S > 1 under the prospective reimbursement system and S z = 1 under the capitation system. For the integrated hospital system, asset specificity kz shifts in the direction o f ki as hospitals are required to contract with physician groups, and assets can be redeployed through contract changes. Property rights and agency relationships develop between physician groups and hospitals as a result of these contractual relationships. 222 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The shift from hierarchy to hybrid, however, provides the opportunity for these newly integrated systems to attempt to achieve optimal price p* under conditions of optimal asset specificity k* and optimal contractual relationships s*. Rights Property ; Agency Admiiiistrative -faC ^ t rels--- i Fiat B1 (1, 0, 0) ( 1, 1, 1) Figure 5-14 Hospital Organizational Model and Contractual Relationships, 1990s, Using the Cube Model 223 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. These changes are reflected in the three-dimensional bit-cube for hospital restructure illustrated in Figure 5-14. It should be noted that under the selective contracting mechanism, the contractual asset specificity and contractual safeguards for the insurance companies shifts to k % and sz as hospitals and physician groups move in the direction of si, Ici. This shift for the insurance companies occurs because of information asymmetries. As inpatient, outpatient, and physician groups integrate services through contractual relationships, they all submit claims for payments to the insurance companies and government fiscal intermediaries. Thus an insurance company has proprietary price and cost information on doctors and hospitals that gives them an information advantage. In addition, insurance companies have economic information on patients that their contracting partners, the physicians, do not have, giving the insurance companies an economic advantage in the contractual relationship. The development of vertically integrated health care systems is consistent with the Langlois-Robertson view o f the evolution of organization (i.e., the technologies of production and the environment are rapidly changing which lead to complimentarity of design and not path dependency).^* On the other hand, it appears that both the Gintis-Stiglitz view of organization redesign and Williamson’s view of Darwinian selection are compatible.^^^ First, organizations will do what 238 Langlois and Robertson, 30. 239 Bowles, and Gintis, “The Revenge of Homo Economicus; Contested Exchange and the Revival of Political Economy,” 83-102 224 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. it takes to develop and survive; developmental history is also part of this survival strategy (Gintis and Stiglitz supported). Second, Williamson’s theory on the market as a Darwinian selection process is also supported. Darwinism is about survival of the fittest. In the sense of the smaller hospitals versus the larger hospitals, the small ones were absorbed, first by affiliation agreements, then by mergers and acquisitions (contact relationships supported by deepening asset specificity). It was the larger hospitals that pursued the bond market, raised the capital to buy the smaller hospitals, developed the outpatient services, and drove the formation o f hospital systems.^**^ The theories of vertical integration are explored in the context of restructuring of hospital systems into health care systems. 5.10. Vertical Integration of Health Care Systems As discussed in Chapter 3, when nearly perfect competitive markets for inputs are present, there is little reason for a firm to be vertically integrated. The advantage of vertical integration is that adaptations can be made in a sequential way without the need to consult, complete or revise interfirm agreements. Where a single ownership entity spans both sides of the transaction, a presumption of 240 Stiglitz, “Post Walrasian and Post Marxian Economics,” 109-114. 225 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. joint profit maximization is warranted. Thus, price adjustments in vertically integrated enterprises will be more complete than in interfirm trading. And, assuming that internal incentives are not misaligned, quantity adjustments will be implemented at whatever frequency serves to maximize the joint gain to the 242 transaction. An alternative view expressed by Langlois and Robertson is that the boundaries of the organization are determined by the extent to which ancillary capabilities will be internalized or bought through the market. This depends on the strength of the organization’s own capabilities relative to those that can be purchased (on relative transaction costs) and on the respective transaction and the governance costs involved in making or buying the capabilities. Both the intrinsic core and ancillary capabilities that comprise an organization and the prevailing levels of transaction costs may be expected to change over time because they are underpinned by knowledge. Thus, in the long run, the boundaries of the firm may alter as the organizational itself, and other organizations, learn in ways that change the relative values of ancillary capabilities and the levels o f transaction and governance costs. When the market cannot provide the right ancillary capabilities at the right time. 241 An indication of the changing role of the hospital is the rapid increase in hospital outpatient services. The structure of the hospital market has changed over time. Hospitals have been predominantly independent institutions, generally competing in local m arkets and providing inpatient services. The trend now is for hospitals to be part of a larger entity, a multiorganization system, and to become vertically integrated—that is, provide an entire range of services, such as ambulatory care clinics, inpatient care, outpatient stngery, home care, and nursing home care. 242 Williamson, Oliver, 1985, 78. 226 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. vertical integration may result; and when the firm lacks the right ancillary capabilities at the right time, vertical specialization may occur. Is rapid economic change likely to make market contracting more or less costly relative to internal organization? “Almost without exception writers who have asked this question have concluded that in such circumstances internal organization is clearly superior to arms-length contracting on transaction cost grounds. Large centralized firms offer advantages in the implementation of new technologies. Large firms have a better chance than smaller ones of appropriating the benefits arising from innovation because they can often internally supply the complementary inputs required and market new products successfully. Large and diverse organizations may be able to accelerate the spread of change by making faster connections between an innovation and its various uses than would occur in a network of smaller less diversified firms that pick of their information through undirected market channels. The law and economics of vertical integration have been subject to controversy. The monopoly dispute is whether vertical integration is an instrument o f price discrimination designed to check marginalization or set up entry barriers.^"*^ 243 Langlois and Robertson, 7. Ibid.. 35. Ibid., 86. 227 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Assumption 24: Williamson’s model of asset specificity asserts that market procurement has advantages in both scale economy and governance respects where asset specificity is slight [ko > ki » k*] and contractual safeguards are not present (So = 0). The firm will never integrate for production cost reasons alone. It is only when contracting difficulties related to asset specificity and contractual safeguards intrude into the market that the firm and market support vertical integration, and then only for values o f k’ * ' that exceed ki. In the case o f hospitals, asset specificity is not slight and there are many contractual safeguards. Hospitals are vertically integrating in response to market disturbances in the form of reduced payments from payers. 5.11. Health Information and Clustered Control Undergirding the structural changes of the health care delivery system and contracting relationships is patient personal health and cost information that is compiled in the patient record. This includes such information as personal and insurance information, the documentation and monitoring o f clinical events, abstracted information for billing purposes, clinical outcomes, and archived information for longitudinal care. Computer systems are already in use to integrate the billing and coding of inpatient and outpatient clinical and ancillary events for managed care reimbursement. Clustered control relationships would not be possible without the patient record. Inputs into the record include all o f the clinical data involved in patient care, 228 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. administrative data regarding personal information, insurance coverage, ancillary service data, and a variety o f summary reports by physicians, nurses, and allied health practitioners documenting patient care. A very important aspect o f electronic data interchange use in medical/health care involves the multitude o f transactions that comprise the patient health record. The patient record not only serves as the source document for care, but it also serves as a resource for diagnostic coding and statistical abstracts which are used for such diverse purposes as reimbursement from the insurance company, research data for clinical trials and outcomes assessments. This record also contains labor, capital resource and supply consumption data. Sophisticated hardware and software computer packages now allow components of the record to be automated and integrated to capture data by the amount of labor, capital and supply resources consumed, severity o f illness by diagnostic code, and resources consumed based upon whether there were morbid and nonmorbid events. Such information provides indicators regarding severity of illness of the patients cared for, level of quality of care delivered by clinical personnel, patient risk management assessments, and financial information concerning the cost of patient care and the amount of reimbursement expected for each patient by diagnostic category. The patient records system is diagrammed in Figure 5-15. 229 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Delivery System Efficiency Through Autom ated Patient Records P roduce and M onitor C lin ical , O utcom es Q uality Indicators { C linical E vents System I |L Efficiency, | y Q uality C are, j I Reduced C ost j d u m b e r o f R eco rd s Served by S ystem E lectronic R ecord ^A dm inistration/ F inance Bill I A ncillary E vents | Tracking, Reduced Services D uplication i L ongitudinal j Care I I Figure 5-15 Inputs and O utputs of a C onsolidated P a tie n t Record System Electronic integration within the health care delivery system includes inter- and intra- telecommunications networks that link subsystem organizations. Electronic systems integration can achieve multiple objectives: (1) increase reporting efficiencies through the reduction of redundant flow of information and elimination of duplicative services, (2) provide integrated information databases for clinical and administrative decision support (including providers), (3) provide mechanisms for monitoring individual and organizational behavior, (4) provide 230 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. clinical outcomes on the efficacy of treatment protocols and (5) nationally standardize aspects of clinical and administrative delivery processes across organizational forms and assign cost risk to individual patients. Internal computerization and telecommunications systems are being implemented that will integrate the patient record, the billing system, administrative fonctions, and clinical delivery information to increase systems efficiency. 5.12. Electronic Integration of Health Care Delivery Networks As health care systems integrate organizationally, they strive to electronically integrate interorganizationally (i.e., develop integrated multimedia technology that will support patient care across time, multiple locations, and in a form that allows information to be structured into data elements so that those elements can be accessed, analyzed, and displayed). The intraorganizational computerization and telecommunications system will integrate the patient record, the billing system, administrative fonctions, and clinical delivery information. These are mechanisms used to increase systems efficiency through reduction of transaction costs. Integration of a continuum of care o f patient services includes seamless delivery from outpatient, to acute inpatient, through chronic inpatient care, to in transit and transient services. To coordinate an electronic patient record that covers all transaction events requires a multimedia electronic record that is syntactically- linked across all organizational forms and record-keeping fonctions. Software 231 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. interfacing requires linkages between differing diagnostic coding systems to produce DRG codes for outcomes and morbidity level for the system, and for converting information further to product lines for capitated reimbursement. At the same time, information can be archived for longitudinal care and clustered-service performance monitoring by the health system and insurance company to analyze the cost effectiveness of inpatient and outpatient service provision. It is important to visualize health and medical care records documentation from a system framework because the computer-based patient record is an integrated record-keeping system of all the transactions, and the associated costs, involved in patient care within the delivery system. As multihospital, multifunctional health care systems have developed, intraorganizational and interorganizational telecommunications connectivity continues to be required. Health information distribution requires multiplex networks, advanced switching capabilities, uniformity of hardware and software design, multimedia information file transfer capabilities, closed-to-open architecture interfacing capabilities, and software-to-software interfacing capabilities. What the future holds through this level of telecommunications integration is an organizational system that can be electronically monitored and that component of the system that can archive and analyze the most information will be the economic winner. Embedding health care delivery scientific knowledge, practice standards, practitioner experience with diagnoses, procedural and diagnostic coding mechanisms, diagnostics, treatment, modalities and health care processes into a 232 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. standardized data base has the potential to produce an extensive decision tree. The benefits o f such an integrated database is made possible by standards-setting bodies, artificial intelligence, and greater computer speed and storage capacity. The integrated health care delivery networks are made possible by this computing capability. P r o p o sitio n 15: Knowledge and information are at the heart of the bit- cube. That knowledge is now defined as “database knowledge” and the health care information is defined as that which must be publicly disclosed in the bilateral trading relationship between the health plan (insurance company or government third-party) and the delivery system (doctors and hospitals). 5.13. Internal and External Pricing within Acute Care Hospitals In Chapter 2, economic pricing was discussed as that where marginal revenue equals marginal cost; the firm is maximizing profits in the short term and remain in business. In the long run, total revenues must exceed total costs. If marginal revenue falls below average costs, the firm is not making a profit but operating at a loss. A competitive market requires unlimited entry where profits are to be made and there are constant average cost and return to scale technologies. Traditionally, the health care delivery system has violated the competitive market in several respects: there are entry barriers, transaction costs, information asymmetries, incomplete contracting, monopoly specialization and lack of 233 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. substitutability, and over-regulation resulting in a general lack of competition. Through the model of the hybrid it was demonstrated that vertically integrated systems that appear to be oligopolies (by virtue of structure) are competitive contractual networks (by virtue of price competition). Also, the terminology associated with transaction costs and competitive markets that were discussed in the 3-D bit-cube can exist as linguistic gradations rather than absolutes. However, the physician and hospital’s ability to cost shift, and the willingness of insurance payers to pay for the cost shifting, obscured for some time the operating cartel with what appeared to be a competitive market with multiple competing firms. In vertically integrated health care systems with market power and price competition, cost- shifting can be eliminated. Thus, the competitive arena for health care delivery systems has been price competition through integrated health systems, health maintenance organizations and managed care. However, this delivery infrastructure serves both physicians (individuals) and hospitals (firms) and both health care delivery and medical care delivery operate simultaneously within the same infrastructure. To change the cartelized market to one of a price and cost competitive market requires incentives and risks by all contracting parties that will change physician and hospital behavior. The role of the fiscal intermediary (government and insurance companies) was the mechanism by which these incentives and risks are introduced. This has resulted in (1) a bounding of the system through HMO contracting relationships, (2) implementation of managed care (the management of physician 234 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. behavior), (3) reductions in premiums to employers, and (4) a shift in economic power to the health beneficiaries. The results are; vertically and horizontally integrated health care delivery systems, the grouping of physicians into organizational structures, hospitals becoming cost rather than revenue centers, health plans converting from not-for-profit status to profit status with public offerings, and health plans with monopoly power. Nishiguchi argues price-minus target-pricing within the collaborative relationship is more efficient and reduces costs at the source.^**^ Accordingly, this pricing method is superior to the cost-plus, value-added method of pricing within an adversarial relationship that is characteristic of western business practice. Langlois and Robertson argue that modular organizational design is price and cost efficient.^'^^ In fact, Langlois and Robertson’s organizational design based on organizational network modularity can be used to model the health care systems integration and the contracting relationships that exist between insurance companies, hospitals, physicians and health plans. Figure 5-16 is an adaptation of their organizational network design to the health care delivery system. 246 Nishiguclii, 136-138. 247 Langlois and Robertson, 73. 235 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Networked Insurance System Networked Hospital System Hospital I Hospital 2 Hospital 3 Networked Health Plans — i HP2 7 Networked i Subcontractor I C linicians j Figure 5-16 Networked Managed Care Systems 236 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The optimal pricing hybrid model requires a level o f trust between contracting parties that has not been a tradition in Western bargaining and contracting culture (i.e., bilateral contracting requires cooperation and trust between contracting parties with information disclosure, efforts by both parties to reduce cost at the course, “open books,” “open shops,” and long-run collaboration). The list price for inpatient services is set because management knows that no group of payers will pay that price as it can be bargained downward by all categories of patients; thus cost shifting has been integral to health care delivery services. As the ability to cost shift goes away through vertical integration, real price competition now exists because of the bargaining positions of powerful health plan organizations. Bargaining relationships still exist because there is no monopoly health plan contract, but as multiorganizational relationships become multiorganizational networks, this may not continue to be the case. Figure 5-16 identifies the networked relationships between the payers and health care providers which have developed. The insurance and government payer sources are at the top and the subcontracting physicians are at the bottom. This figure identifies the two major opposing forces with the power to shape the future (i.e., physicians and payers). Proposition 16: The full cluster-control structure o f the health care delivery system provides evidence o f reduced cost and inhibition o f price increases because o f a more efficient organizational format that utilizes semi-strong asset specificity and decreased contractual safeguards between payers and hospitals, payers and 237 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. physicians, and physicians and hospitals. The insurance companies have converted to for-profit entities; the government as a payer is still attempting to provide a social indemnity service through Medicaid and Medicare. Without cost shifting hospitals can no longer rely on one payer agreeing to pay more than others. When the organizational design work of Williamson, Nishiguchi, and Langlois and Robertson is integrated and applied to health care organizations, several tentative conclusions can be advanced about the organizational design and pricing strategies found within the hybrid as follows: 1. Hybrid organizations are component organizations with a modular format. This modularity allows for greater pricing efficiency gains. 2. Hybrid organizations are different organizations with different sets of skills and bound by contract to offer a set of goods or services to a target client population. 3. A hybrid organization contains companies that organize around identifiable segments of a market, create products and deliver services that meet the needs of clients in that segment. 4. The hybrid organization delivers services directly to a targeted client population. The hybrid organization also contracts services to other organizations that serve that particular client population, but do not have the requisite expertise. 238 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5. Hybrid organizations are part of networks of organizations that have a decentralized governance. 6. Within the network of the hybrid organization, the needs of the population segment are recognized, then managers are charged with meeting the needs of customers within that segment. 7. Hybrid organizational relationships are maintained through contractual means. Both parties stand to gain or are placed at financial risk as part of the contractual relationship. 8. A hybrid network provides aggregated market power for participants through coalitions and alliances. 9. Hybrid organizations are not “conglomerates” because the companies retain control o f how they will deliver goods and services, and governance is decentralized. Collaborative contracting within the hybrid requires that both parties to the contract share the risks and benefits. 10. Hybrids that appear to be oligopolies or monopolies may actually be competitive monopsonies when franchise bidding by component organizations (which produces competition) and decentralization of governance occur both within the hybrid and between organizations in the market. 239 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. P ro p o sitio n 17: HMOs and Managed Care Companies are modular contracting networks, rather than single large organizational entities or conglomerates. 5.14. Proposition Summary and Test of Theorem 2 A summary o f the propositions and a test of Theorem 2 is undertaken. Table 5-4 Summary o f Propositions Propositions I. Collaborative contracting changes the nature of bargaining. Information disclosure ex-ante reduces uncertainty and information asymmetries and provides ex-ante as well as ex-post knowledge. Successful contracting depends upon the reputation of both parties. 2. Bilateral collaborative contracting precludes the need for a heavy bureaucratic apparatus and deep human and site asset specificity. Optimal price p* can be found which is not defined by the market alone. To attain this price-minus target pricing, optimal safeguards of bilateral full information disclosure on business practices, costs, prices in the form of an “open shop” are required. Continued 240 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-4 Summary of Propositions (Continued) 3. Through Federal legislation, unclustered to clustered control market mechanisms were introduced. In the 1970s, there were unclustered relationships between physicians, hospitals and insurance companies with cost-plus pricing. By the 1980s, semi-clustered control mechanisms were in place and contracting occurred through preferred provider organizations with price-minus pricing. In the 1990s, full clustered control relationships are in place with insurance payers as the primary firm, first-tier organizations as the contracting organizations, second-tier contractors as the hospitals and third-tier contractors the physicians with capitated rate setting. Monitoring of these clustered relationships is through management information systems. 4. Physician monopoly markets operated at higher price p. As autonomous traders the anonymity concept of a competitive autonomous market trade at Node A is violated because of the principal-agent relationship. Physician market behavior in the hybrid model lies in the direction of strategic behavior in which agency, property rights, uncertainty and the strategic concept of contract variables are located. Franchise bidding through PPOs has moved physician pricing in the direction of p. Continued 241 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-4 Summary of Propositions (Continued) 5. Under retrospective reimbursement, insurance companies had no contractual safeguards (so = 0) in their contracting relationship with physicians.. Franchise bidding moves the physician profit-maximiîdng agency strategic conception of contract in the direction of (S = 1), but at a location where there are no dedicated assets (K = 0) at unstable point BI. Through the foundation model of physician organization, franchise bidding and prospective reimbursement, assets are dedicated and contracts are safeguarded. Establishing foundations and contracting through PPOs under conditions of prospective reimbursement have moved the physician market to (k,, s,) with a resulting lower price p. 6. Dependency of asset specificity and contractual safeguards is of a bilateral nature so that market efficiencies are not traded for organizational or bureaucratic inefficiencies. The restructured physician maricet through contracting is more efficient than the market, and more efficient than a hierarchical structure with deep asset specificity. In the contracting relationship for physicians k(14) and s(%) exist because physicians hold the assets. In the contracting relationship for insurance payers, the opposite occurs and k(%) and sC/2) exist because the insurance payers are contractually safeguarded through the collection of premiums. However, optimal price p* is not attained because of information asymmetries between contracting parties. Through claims processing information systems, the insurance payers have more information than the physician groups. Continued 242 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-4 Summary o f Propositions (Continued) 7. As the governance structure between insurance payers and physicians emerges, asset specificity deepens and the contractual relationship strengthens. A parameter shift from ko to k, occurs through the insurance payer-PPO-physician triumvirate. Physicians become contractors through large groups to obtain greater bargaining power and the contractual relationship is one of independent contractor. Market incentives (or disincentives in the form of lost patients) are traded for greater coordination through hybrid governance. Physician incentives become organizational incentives, and market adaptation is through coordination. 8. The hybrid structure of the physician reorganization produces clustered-control relationships that include contract employee, medical group contractors, feculty practices, independent practice associations and physician non-profit foundation models. These models deviate from traditional employer-employee relationships, and neoclassic law is selected over forbearance and fiat. Economic incentives and rewards are introduced for cost-effective delivery of health and medical services. 9. The bilateral relational contracting relationship between physician foundations and insurance payers is of the mixed to idiosyncratic type. Asset specificity deepens and contractual safeguards are put in place (k,>ko and s,>So). Assets are more specialized to the needs of the parties to the transaction. The benefit of information asymmetries accrues to the insurance companies paying the bill. Reputation effect accrues to the physician groups. As a result, market efficiency gains are met and price is lowered, but the contracting relationship is not ideal. Continued 243 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-4 Summary of Propositions (Continued) 10. The reorganization of hospitals into vertically integrated systems coincides with the introduction of Federal legislation in 1983, 1985-1986 and 1989. Level 1 vertical integration (hospital networks) coincides with 1993 legislation that established prospective pricing on the basis of diagnostic related groups (DRGs). Level n vertical integration (organizational networks) coincides with 1985-1986 legislation which froze payment rates and decreased Medicare payments to hospitals. Level III vertical integration (health care networks) coincides with Federal legislation which introduced the Resource Based Relative Value Scale (RBRVS). 11. The Efficiency and Governance feces of the hybrid characterize the location of hospital and insurance companies during the 1970s. Hierarchical price and Node C include bureaucratic internal and external oversight costs and internal contracting relationships by fiat and forbearance. Pricing behavior at Node C is protected by too many contractual safeguards, S = 1 at kz. Also physical, dedicated and human asset specificity is K = 1 at Sz Unilateral market safeguards for insurance companies were at So=0 under retrospective reimbursement, and guaranteed payments for hospitals ensured that contractual safeguards for hospitals were at a level of s% = 1 . Continued 244 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-4 Summary of Propositions (Continued) 12. The introduction of Federal legislation between 1983 and 1989 moved the hospital market in the direction of clustered-control contractual relationships resulting in lower contractual safeguards for hospitals and greater contractual safeguards for insurance companies. The goal was to trade off higher bureaucratic costs for greater market incentives (a hierarchy to hybrid shift) at k2. 13. To obtain the hierarchy-hybrid shift, franchise bidding in the form of selective contracting is introduced. Selective contracting by insurance payers provides franchises to physician groups and hospitals but introduces uncertainty in the contractual relationship. Hospitals lose their dedicated asset and contractual (k;, S z) guarantees and are forced into an unstable (kz, s,) posture of heavily dedicated assets without contractual safeguards. Through franchise bidding, they are forced to price discount to get and keep contracts. This reduces price overall. Insurance payers gain a significant advantage (so=0 shifts to sz =1) with capitated rates. To survive, hospitals have shifted assets and contracting risks through selective contracting (k,, Si) with physicians and other health care delivery groups. 14. As a result of clustered control, franchise bidding and the development of large structural oligopolistic health care delivery networks, insurance payers gain dedicated assets and contractual guarantees at the level of kz, Sz. An insurance payer has proprietary price and cost information on all parties in the health care delivery network giving them an information advantage in the contracting relationship. Continued 245 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5-4 Summary of Propositions (Continued) 15. ECnowledge and information lie at the heart of the hybrid cube model in the form of electronic databases. The party to the trade with the most information has the trading advantage. Insurance payers have a trading advantage over hospitals and physicians because of pricing and utilization information they gain from both parties. 16. The optimal pricing model requires a level of cooperation and trust between contracting parties through information disclosure, efforts for both parties to reduce cost at the source, and long-run collaboration. The list price for hospital services is set because no group of insurance payers will pay that price but bargain it downward. In this way hospitals attempt to mitigate their information disadvantage. Price competition exists between competing hospitals because of the bargaining strength of the insurance payers. 17. Health care networks called health maintenance organizations and managed care companies are modular networks rather than single conglomerates. Pricing efficiency gains have been made through this structure, but pricing optimality has not vet been reached. Theorem 2; Organizational redesign o f physicians, acute care hospitals, and insurance plans into integrated health maintenance organizations and bilateral contract arrangements provide a means o f reducing the health care delivery price. 246 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As demonstrated by the theoretical arguments and application of the cube model to the health care delivery system, reorganization of physicians, hospitals, and insurance plans into health maintenance organizations has led to price reductions on a theoretical level, but pricing is not optimized. Through integration o f health care delivery networks and selective contracting, heavily dedicated assets and contractual safeguards have accrued to the insurance companies. The result is a deepening of hierarchy and bureaucracy for the insurance payer as a result of the required monitoring and administrative controls put in place to manage the integrated health networks. Further, pricing gains can be made if the insurance payers are put at a greater risk in the market which will decrease the dedicated assets and contractual safeguards for the insurance payer. This can be accomplished through an insurance competitive payer market mechanism 5.15. Chapter Summary and Conclusions Three strategies are offered for achieving optimal pricing by lowering transaction costs, developing semi-strong asset specificity (i.e., the flexibility to deploy the assets based upon demand) and seeking optimal contracts in health care delivery: 1. Hospitals and physicians need to rebalance the unilateral contracting relationships (to make them bilateral) that have developed between insurance companies and employers with the 247 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospitals, foundations, and physicians from which they purchase services. With insurance companies threatening to drop doctors from panels and discontinue contracts with hospitals, they demonstrate the typical Western contracting adversarial behavior. Bilateral agreements with cost-sharing and profit-sharing on both sides might benefit all in a collaborative contracting arrangement, as both sides work backward from a price-minus posture, through value-added engineering mechanisms to reduce transaction costs along the way and identify problems at the source. 2. All trading partners need to rethink contractual relationships within the clustered-control setting in which they work seeking to reduce costs, improve quality through bilateral contractual relationships and provide incentive monitoring functions for all firms in the exchange through long-term commitment. Telecommunications technology and open information sources to multiple contracting parties should preclude the health-plan’s ability to “discharge at will” the contract physician after that individual has invested many thousands of dollars in professional and career development. 248 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To get the cost reductions that they need without sacrificing quality, all parties need to think in terms of collaborative contracting arrangements rather than adversarial ones. Within this collaborative process, individuals and firms might find that the contractual relationship can provide design strategies and innovative solutions. 3. Cost-sharing, risk-sharing, and profit-sharing should be components of any bilateral arrangement in a clustered-control contracting model. Electronic health care information integration will facilitate all information transferal needs. 249 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 6 SUMMARY AND CONCLUSIONS Chapter 1 raised a series of answerable questions. 6.1. Current Transaction Cost Theory of Industrial Organizations Oliver Williamson’s comparative organizational theory is based upon the industrial organizational model of the private sector. The theoretical arguments in this dissertation demonstrate that with further model development and refinement, the transaction cost approach can be applied to organizations within the non-profit and service sectors of the economy. This dissertation developed a theoretical model of the hybrid that explained the metamorphosis of market transactions to pre-firm and firm hybrids as a nexus of contracts linked by transactions and asset specificity. This metamorphosis leads to the need for a coordinating structure called the firm. As the firm adapts to consequential market disturbances, it adapts through deeper coordinating structures called hierarchy. 250 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The model of the hybrid developed in this dissertation examines in detail the development of firms as they emerge from the market to the hybrid stage (M-X shift), but it also examines the hybrid as a developmental stage as it transitions to hierarchy (X-H shift). This flow is not unilateral, but bilateral, although it is easier to shift hybrid to market than it is to shift hierarchy to hybrid. However, in the case of hospitals, as part of health networks, a hierarchy to hybrid shift has occurred as a result of government intervention into the health care market. Though hospitals are institutionalized bureaucracies and meet the criterion of hierarchy with deeply dedicated assets, the loss of contractual safeguards has forced them to link as a component of a health care delivery network. The network is the hybrid, and the hospital, as part of the network, becomes hybridized. Hybrids form around unstable nodes BI and 32 in the cube model. The instabilities at these nodes are created because there is misalignment of asset specificity and contractual safeguards leading to increased transaction costs. The misalignment plus transaction costs lead to the hybrid moving to a survival mode of pure market participation or hierarchy. To remain a stable firm when operating at these unstable points, hybrids must have the flexibility to deploy assets upon increased and decreased demand related to trading and near-perfect contracting. This level o f operation requires near-perfect information. In the absence of information, pricing mechanisms must be sophisticated enough to determine the perfect price for the contractual relationship at hand with just the right amount of dedicated assets. To achieve this not only requires internal and external information 251 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. systems, but also data in an analyzed form that is quickly accessible and easily interpreted. The theory and model o f the hybrid is useful in explaining organizational restructuring, regardless of governance structure, and provides a mechanism for analyzing pricing behavior that is not derived solely from the market. Optimality of pricing and the ability to deploy assets in relation to any type o f contract is characteristic o f all organizations. The skill is the ability to find the perfect price for a given combination of asset specificity, contractual safeguards, and transaction costs. This ability is especially crucial when there is a significant market disturbance. Williamson introduced the hybrid model and discusses its attributes on the basis of a two-dimensional model o f asset specificity. The expansion of the hybrid model in this dissertation takes the hybrid theory to the next dimension as a series of interactions of asset specificity, contractual safeguards, and transaction costs within a three-dimensional model to identify predictable pricing behavior by the firm. This provides a richer model design for explaining the firm and conceptually broadens the range of firm behavior, expectations, and adaptation that can’t be captured by two- dimensional models of industrial organization alone. This also allows applicability of the model to health care organizations which are predominately non-profit firms. Therefore, based upon Williamson’s work between 1985 and 1991, this model is useful in defining and predicting further changes in the organization of health care delivery. 252 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6.2. Acute Inpatient Health Care Organizational Market Restructure The U.S. economy is an information-based service economy, yet models of industrial organization from the turn of the century persist as the operational norm. Developed for health care organizations, the comparative institutional system level of analysis identifies organizational restructuring in response to market changes that correspond to the contractual-govemance model. The pricing model developed demonstrated that the competitive market of the 1980s has led to greater organizational pricing efficiency through organizational integration. Hospitals, as part of health care networks, have reorganized along the model of industrial organizations (i.e., consolidating and developing product lines as if they are manufacturing firms). This reorganization has occurred in response to Federal legislation that has produced contractually bound organizations that are called health systems, which have produced a more efficient pricing structure between all contractually bound parties. However, this level of integration has produced the appearance of health care system oligopoly that invites scrutiny and possibly more regulation. At best, hospitals within health systems are competitive monopsonies. To be a true oligopoly would require that health care systems achieve more than market share. In addition to market share, it would require a health system to have the power to exclusively contract with the majority of physicians and insurance companies who also have dominant market share. There are too many and varying 253 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. levels of contracting (most still nonexclusionary) to produce a true health care network or hospital system oligopoly. It appears that integrated health care delivery systems are following the industrial organizational model to become as powerful a bargaining partner as the insurance companies and the Federal government who pay their bills. The folly of this strategy is that while insurance companies are profit maximizing industrial organizations and will behave accordingly, health care organizations may look and act like an industrial organization, but without the same economic behavior; therefore, the bargaining goals are misaligned. Insurance companies want to make money and pay dividends to shareholders. Health care networks want to deliver quality patient care at an affordable price. Information is at the heart of perfect bargaining, perfect asset specificity, and perfect pricing. As pointed out, insurance companies have proprietary information on all caregivers. They can gain financial and operational information on hospitals from public agencies. In the market trade, the trader with the most information wins the economic bargaining game. Large and small hospitals alike can not remain open if they are operating below marginal costs. Rather than providing a broad range of services across all DRGs, hospitals might pay more attention to those that are profitable and those that are not and realign the unprofitable services with other services that can offer a cross-subsidy if the hospital wants to retain that unprofitable service. Hospital corporations need to look at how assets are deployed and develop specialty centers. 254 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Why attempt to be all things to all consumers? Physicians need to mobilize their market power as partners with the hospitals to balance the market power of the insurance companies. The Federal government needs to look at how reimbursement is distributed across DRG. If additional regulation is needed, it is regulation that will spur competition amongst carriers of health insurance (insurance companies) similar to the competition amongst hospitals that occurred in the 1980s. 6.3. Objectives The objectives of this dissertation were achieved. The discriminating alignment hypothesis proposed by Williamson was extended and a general equilibrium organization and pricing model based upon the hybrid was developed. This new model was linked to the health care sector through Nishiguchi's work in cluster-control organizations and contracts (where price is not determined by the market alone). The theoretical arguments and propositions developed provide a bridge between the economic theories of transaction cost economics and private sector industrial organization to theories of service sector organizations and networks. The model developed has been successfully applied to explain changes in the organization and structure of health care networks. 255 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. BIBLIOGRAPHY Akerlof, George. “The Market for Lemons; Qualitative Uncertainty and the Market Mechanism.” Q uarterly Journal o f Economics 84 (1970): 488-500. Alchian, Armen, and Harold Demsetz. “Production, Information Costs and Economic OvÿamzaX.ion.''' American Economic Review 67 (1972): 777-795. Allen, Thomas L., and Raymond M. Keefer. Chemistry: Experim ent and Theory (San Francisco: Harper & Row Publishers, 1978. Anderson, Howard, “Hospitals Seek New Ways to Integrate Healthcare,” Hospitals 66, no. 7 (April 5, 1992): 26-36. Apgar, William, and Harold Brown. M icroeconomics and Public Policy. New York: Scott, Foresman and Company, 1987. Arrow, Kenneth, “Uncertainty and the Welfare Economics o f Medical Care,” American Econom ics Review, 53(1963), 941-973. Reprinted in Issues in Health Economics, ed. Roice Luke and Jeffrey L. Bauer. Aspen Publications, 1982. ________ . T^e Z/o t /Y j q/'Orgia77/rûr//on. New York: Norton Publishing, 1974. ________ . Essays in the Theory o f R isk Bearing. Chicago. Markham Pub., 1970. . “The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Nonmarket Allocation.” In The Analysis and Evaluation o f Public Expenditure: The PPB System, vol. 1, U.S. Joint Economic Committee, 91^ Congress, 1” * Session, 1969, Washington, D C , U.S. Government Printing Office, 59-73. . “Uncertainty and the Welfare Economics of Medical Care.” American Economic Review 53 (1963): 941-973. 256 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Barr, Nicholas. “Economic Theory and Welfare State: A Survey and Interpretation.” Journal o f Economic Literature 30 (June, 1992), 741-803. Barzel, Yoram. “The Entrepreneur’s Reward for Self-Policing.” Economic Inquiry, 25 (1987): 103-116. Bodenheimer, Thomas, and Kevin Grumbach. “The Reconfiguration of U.S. Medicine.” Journal o f the American M edical Association 274, no. 1 (July 5, 1995): 85-91. Bowles, Samuel, and Herbert Gintis. “The Revenge of Homo Economicus: Contested Exchange and the Revival of Political Economy.” The Journal o f Economic Perspectives 1 (January 1993): 97. Chandler, A. Scale and Scope: The Dynamics o f Industrial Capitalism. Cambridge, MA: Harvard University Press, 1990. Chandler, Alfred. “Organizational Capabilities and the Theory of the Firm.” Journal o f Economic Perspectives 6 (1992): 79-100. ________ . The Visible Hand: The M anagerial Revolution in American Business. Cambridge, MA: Harvard University Press, 1977. Coase, Ronald H. The Firm the M arket an d the Law. Chicago: The University of Chicago Press, 1989. Commons, John R. “Institutional Economics.” American Economic Review 21 (1931): 648-57. Cox, Earl. The Fuzzy Systems Handbook. Cambridge, MA: Academic Press Professional, 1994. Demski, Joel, and David Sappington. “Optimal Incentive Contracts with Multiple A.e,QXïis." Journal o f Economic Theory (1984): 152-171. Dranove, David. “Demand Inducement and the Physician/Patient Relationship.” Economic Inquiry 26, no. 2 (April 1988): 281-298. Dranove, David, and William White. “Agency and the Organization of Health Care Delivery.” Inquiry 24 (1987): 405-415. 257 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Fama, Eugene F. “Agency Problems and the Theory o f the Firm.” Journal o f Political Economy, 88 (April, 1980): 288-307. Feidstein, Paul. Health Care Economics. 4th ed. Albany, New York: Delmar Publishers, 1993. Florida, Richard, and Martin Kenney. “Venture Capital-Financed Innovation and Technological Change in the USA.” Research Policy 17 (1988): 119-137. Freedman, Craig. “Williamson’s Back Door — Transaction Costs and the Efficient Firm.” Discussion Paper, The University of New South Wales, October 1993. Fuchs, Victor. “Managed Care and Merger Mania (Commentary).” The Journal o f the American M edical Association 211, no. 11 (March 19, 1997): 920-921. Gaynor, Martin, and Mark V. Pauly. “Compensation and Productive Efficiency in Partnerships: Evidence from Medical Group Practice.” Journal o f Political Economy, 98 (3) (June 1990): 544-573. Glaser, William A. “How Expenditure Caps and Expenditure Targets Really Work.” The M ilbank Quarterly, 71, no. 1 (1993): 97-127. Graham, Glenn, and Thomas Cowing. “Hospital Reserve Margins: Structural Determinants and Policy Implications Using Cross-Section Data.” Southern Economic Journal 63, no. 3 (January, 1997): 692-710. Grossman, Sanford and Oliver Hart. “An Analysis of the Principal-Agent Problem.” Econometrica 51 (1983): 7-45. Hayek, Frederick. “The Use of Knowledge in Society.” Am erican Economic Review 35 (1945): 519-30. Henderson, James M., and Richard E. Quandt. M icroeconomic Theory. New York: McGraw-Hill Book Company, 1958. Hillman, Alan. “Managing the Physician: Rules versus Incentives.” Health Affairs, (Winter, 1991): 138-146. Holahan, John, and Stephen Zuckerman. “Medicare Mandatory Assignment: An Unnecessary Risk?” Health A ffairs no. 1 (Spring, 1989): 65-79. 258 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Jack, Max, and Robert Phillips. “Public-Private Partnership Organizations in Health Care: Cooperative Strategies and Models.” H ospitals and Health Services Adm inistration 38, no. 3 (Fall, 1993), 387-400. Jensen, Michael C., and William Meckling. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal o f Financial Economics 3 (October, 1976): 305-360. Kaufman, Nathan. “Power Notebook (Managed Care Integration Strategy).” Hospitals & H ealth Networks 69, no. 3 (February 5, 1995): 58-61. Knight, Frank H. Risk, Uncertainty and Profit. London: London School of Economics, 1921. Kosko, Bart. Fuzzy Thinking: The Nerw Science o f Fuzzy Logic. New York: Hyperion, 1993. Kreps, Donald. N otes On the Theory o f Choice. Boulder, CO: Westview Press, 1988. Laffont, Jean-Jacques, and Jean Tirole. “The Dynamics o f Incentive Contracts.” Econometrica 56 (1986): 1153-1175. Langlois, Richard, and Paul Robertson. Firms, M arkets arid Economic Change: A Dynamic Theory o f Business Institutions. New York: Rutledge, 1995. Lazonick, William. “Industry Clusters versus Global Webs: Organizational Capabilities in the American Economy.” Industrial and Corporate Change 1 (1993): 1-24. ________ . “Competition, Specialization, and Industrial Decline.” Journal o f Economic H istory 41 (1981): 31-38. McCubbins, Michael D., Roger G. Noll and Brian R. Weingast. “Administrative Procedures as Instruments of Political Control.” Journal o f Law, Economics and Organization 3 (Fall, 1987): 243-277. McKenzie, Lionel. “Theory for a Competitive Market.” Econometrica 27 (1959):54- 71. Meier, Kenneth J. The Political Economy o f Regulation: The Case o f Insurance, Peter Colby, ed. Albany, NY: State University o f New York Press, 1988. 259 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Melnick, Glenn A., and Jack Zwanziger. “Competition and Regulation, 1980 through 1991.” Am erican Journal o f Public Health 55 no. 10 (October, 1995): 1391- 1396. ________ . “The Effects of Hospital Competition and the Medicare PPS Program on Hospital Cost Behavior in California.” Journal o f H ealth Econom ics 7, no. 4 (December, 1988): 301-20. . “Hospital Behavior Under Competition and Cost-Containment Policies.” Journal o f the American M edical Association 260, no. 18 (November 11, 1988): 2669-75. Melnick, Glenn A., and Jack Zwanziger, Anil Bamezai, and Robert Pattison. “ The Effects of Market Structure and Bargaining Position on Hospital Prices.” Journal o f H ealth Economics 11, no. 3 (October, 1992): 217-33. Milgrom, Paul, and John Roberts. “Limit Pricing and Entry Under Incomplete Information: an Equilibrium Analysis.” Econometrica 50 (1982): 443-459. ________ . Economics, Organizations and Management. New York: Prentice Hall, 1992. Miller, Robert H., and Harold S. Luft. “Managed Care Plan Performance Since 1980, a Literature Analysis.” Journal o f the American M edical Association 271, no. 19 (May 18, 1994): 1512-1519. Mitchell, Janet B., Gerard Wedig, and Jerry Cromwell. “The Medicare Physician Free Freeze: What Really Happened?” Health Affairs (Spring, 1989): 21-33. Moe, Terry. “The New Economics o f Organizations.” Am erican Journal o f Political Science 28 (November, 1984): 744-746. Morrissey, Michael A. Cost Shifting in Health Care: Separating Evidence From Rhetoric. Washington, DC: The AEI Press, 1994. Myerson, Roger, and Mark Satterwaite. “Efficient Mechanisms for Bilateral Trading.” Journal o f Economic Theory 23 (1983): 265-281. Newhouse, Joseph, “An Iconoclastic View of Health Cost Containment.” Health Affairs 12 (1993 Supplement): 152-171. 260 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Nishiguchi, Toshihiro. Strategic Industrial Sourcing: The Japanese Advantage. New York; Oxford University Press, 1994. North, Douglass C. “Transaction Costs through Time.” Working Paper: Economic History .Washington, DC: Department of Economics, Washington University, 1994. Pearce, David, ed. M IT Dictionary o f M odem Economics. New York: The Macmillan Press, Ltd., 1989. Philbin, Patrick. “From the Ground Up: Planting the Seeds of Network Development.” Hospitals and Health Networks (June, 1993): 46-52. Piore, Michael J., and Charles Sabel. The Second Industrial Divide. New York: Basic Books, 1984. Pope, Gregory C. “Physician Inputs, Outputs, and Productivity, 1976-1986.” Inquiry (Summer, 1990): 151-160. Rafferty, John. “Enfranchisement and Rationing Effects of Medicare on Discretionary Hospital Use.” Health Services Research (Spring 1975): 51-63. Reiman, Arnold S., and Uwe Rheinhardt. “Debating For-Profit Health Care and the Ethics of Physicians.” Health Affairs 5 (Summer, 1986): 5-31. Sappington, DEM. “Incentives in Principal-Agent Relationships.” Journal o f Economic Perspectives S (Spring, 1991): 45-66. Savage, Deborah Ann. “Change and Response: An Economic Theory of Professions with an Application to Pharmacy.” Unpublished Dissertation, University o f Connecticut, 1993. Shavell, Stephen. “Risk-Sharing and Incentives in the Principal and Agent Relationship.” B ell Journal o f Economics 10 (1979): 55-73. Simon, Herbert. M odels o f Man. New York: John Wiley and Sons, 1956. Spence, A. Michael, and Richard Zeckhauser. “Insurance, Information and Individual KcXvouT American Economic Review 61 (1971): 380-387. 261 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Starr, Paul. The Social Transformation o f Am erican M edicine. New York: Basic Books, Inc., 1982. Stiglitz, John. “Post Walrasian and Post Marxian Economics.” The Journal o f Economic P erspectives! (faxaxaxy, 1993): 109-114. ‘Incentives, Risk and Information: Notes Toward a Theory of Hierarchy.” B ell Journal o f Law, Economics and Organization 6 (1975): 552- 579. Stiglitz, John E., and Aaron Weiss. “Credit Rationing in Markets with Imperfect Information.” American Economic Review 71 (1981): 393-409. Teece, David. “Profiting fi’ om Technological Innovation: Implications for Integration, Collaboration, Licensing and Public Policy.” Research Policy, 15 (1986): 285-305. ‘Towards an Economic Theory of the Multiproduct Firm.” Journal o f Economic Behavior and Organization 3 (1982): 39-63. ________ . Vertical Integration and Vertical Divestiture in the U.S. O il Industry: Analysis and Policy Implications. Palo Alto, CA: Stanford University Press, 1976. Tirole, Jean. The Theory o f Industrial Organization. Cambridge, MA: MIT Press, 1988. U.S. Government Printing Office. CRSBriefs. Washington, D C., 1989. Varian, Hal. M icroeconomic Analysis. New York: W.W. Norton & Company, Inc., 1978. Walters, Stephen J. K. Enterprise, Government and the Public. New York: McGraw- Hill, Inc., 1993. Wiesbrod, Burton A “The Health Care Quadrilemma: An Essay on Technological Change, Insurance, Quality o f Care, and Cost Containment.” Journal o f Economic Literature (fnne, 1991): 523-552. Williamson, Oliver. “Contested Exchange Versus the Governance of Contractual Relations.” The Journal o f Economic P erspectives! (Izsvmxy, 1993): 103-108. 262 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. . “Comparative Economie Organization: The Analysis of Discrete Structural Alternatives.” Administrative Science Quarterly 36 (June, 1991): 269- 296. . The Econom ic Institutions o f Capitalism. New York: The Free Press, 1985. Woolhander, Steffie, and David V. Himmelstein. “Giant HMO ‘A’ or Giant HMO ‘B ’ Galloping toward Oligopoly.” Nation 259 (September 19, 1994): 265-268. 263 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Appendixes A: Health Care Organization Definitions B: Fuzzy Logic and the Bit Cube C: Definition of Economic Terms Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 264 APPENDIX A Health Care Organization Definitions CAPITATION : A method of reimbursement where a contracted health care provider receives a fixed per-member-per-month (pmpm) premium. In the case of a contracted facility, such as a hospital, the health plan would pay the pmpm premium counting all lives covered under the plan. Employers contract with HMOs to provide all health care to enrolled recipients (enrollees) for a fixed amount per person per month (covered life). Recipients enrolled in the HMO receive all services, except in emergencies, from providers employed or affiliated with the HMO. The HMO is at financial risk for the services provided to enrolled recipients and may pass on financial incentives to its participating providers to reduce unnecessary services or receive discounted prices from providers. Provider choice is limited to selected providers. CAPITATED BASIS: A fixed per-member-per-month payment or percentage of premium paid to a provider who assumes the fiill risk o f the cost of contracted services without regard to the type, value, or frequency o f services provided. This is in contrast to Fee-For-Service. CASE M IX: A measure of the mix of cases being treated by a particular health care provider that reflects different levels of need for resources among different patient groups. Case mix is generally established by estimating the relative rate of frequency that various types of patients are seen by the provider in question during a given time period and may be measured by factors such as diagnosis, severity of illness, utilization o f services and provider characteristics. COST SHlF ilN G : Charging different prices to different groups. The presence of price differences (for a good or service) is price differentiation (static cost shifting). In the static cost shifting view, the provider is worse off for providing care to a group paying a lower price. In the price discrimination view, the provider is better off providing care to both groups rather than to only one. Cost shifting occurs when providers raise prices to one group of payers because another group of payers is now 265 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. paying less (dynamic cost shifting). On the other hand, lowering a price to one payer leads the firm to lower the price to other payers. For health care delivery cost shifting to continue to be effective, market power is necessary. Vertical integration and oligopoly provide an environment in which cost shifting can continue to be successful under conditions of price discounting that occurs faster than cost reduction. CONTINUUM OF CARE; A way of looking at the level and type of care provided to individuals from the most acute and intensive to the least acute and least intensive. The concept of continuum is important because integrated health networks of the future are going to be expected to provide the entire range of services contained on the continuum. COPAYMENT : The portion of a specific claim or medical expense that an HMO member or insured person (patient) must pay out of pocket to the rendering provider. This is usually a fixed amount and is justified as an incentive to discourage overuse o f health services. COVERED LIVES: When employers sign up for an exclusive contract, fUll-risk capitated health plan, their employee beneficiaries are called covered lives. The health plan receives a certain dollar amount per enrollee, or covered life, whether or not the enrollee uses health care services. The health plan then selectively contracts with the providers. Numbers of covered lives in a geographic area can be used to determine the number of physicians and inpatient beds needed in a geographic region. DIAGNOSIS RELATED GROUP (DRG): A patient classification system that relates demographic, diagnostic, and therapeutic characteristics of patients to length of inpatient stay and amount o f resources consumed. While initially devised to be a utilization (not reimbursement) measure. Congress adopted this mechanism as a framework for specifying hospital case mix. DRGs identify classifications of diagnosis for which Medicare payment is made under a prospective pricing system (PPS). PPS determines reimbursement for Medicare patients by multiplying the hospital's base rate (established for each individual hospital by a specific blending formula), and the relative weight for the DRG (an estimate of that particular DRG’s resource intensity in relation to the average DRG; a DRG with a relative weight of 2 would be roughly twice as resource intensive as the average DRG, which has a weight of 1). FORMULA; DRG relative weight x hospital’s base rate = Medicare Payment. Medicare, based on the above calculation regardless o f actual patient charges, would reimburse the hospital. Minimal extra reimbursement does exist in the form of “outlier payment” if the length of stay or charges exceed a very high, defined threshold. 266 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. FEE FOR SERVICE (FFS): A traditional form of reimbursement in health care where payment is made on the basis of services rendered to the patient. The provider’s fee is usually discounted by the insurance plan that maintains its own reimbursement schedule. This schedule is usually the predetermined dollar amount conversion factor times the unit value of a diagnostic coding system or a formula o f usual and customary charge based upon actuarial analysis. DYNAMIC COST SHIFTIN G : When a provider lowers (or raises) the price charged to one payer and in turn charges other payers more (or less). Dynamic cost shifting requires a hospital to have not only market power, but unexploited market power, that is the ability to charge one category o f payers a higher price (consistent with higher profits). Unexploited market power has two necessary conditions. The hospital decision makers must value something other than profits exclusively and (2) one of the things it values must be the group that is cost shifted against (i.e., the privately insured patients because they pay their bills). GEOGRAPHIC MANAGED CARE (GMC): A fiill-risk capitation Medicaid program being piloted in California. GMC is modeled after the private insurance sector full-risk capitation model. Providers contract with the State, through competitive bidding, to provide full service HMO benefits to Medi-Cal (Medi-Caid of California) recipients. HEALTH BENEFIT INTERMEDIARY: A health benefit intermediary contracts with employer or government sponsors to offer its health plans to potential enrollees. A health benefit intermediary can be an HMO, insurance carrier, or an independent provider organization that contracts directly with employers. Five types of HMO plans are distinguished by the organizations that provide services and the exclusivity of the relationship between the intermediary and large medical groups. These are Prepaid Group Practice (PGP), Network HMO, Staff HMO, IP A HMO, and Mixed- Model HMO. HEALTH MAINTENANCE ORGANIZATION (HM O): A contractual relationship, either selective or nonselective, that exists between physicians, physician groups, hospitals, and insurance carriers in the delivery o f medical and health care. This organization is responsible for providing or arranging the provision of comprehensive health care services on a prepayment basis to voluntarily enrolled persons within a designated population. Some HMOs emphasize prevention and wellness models of primary care to maintain the health of their enrolled customers. HEALTH PLAN: Health insurance coverage that is either offered as a tax-exempt employment benefit, provided by the government through the Medicaid and Medicare Programs, or individually purchased fi-om an insurance company. Health 267 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. plan coverage and cost ranges from traditional fee-for-service plans to fiill risk capitated HMO plans. HORIZONTAL INTEGRATION; Ownership o f like-stages o f production. This is an affiliation or merger in which multiple organizations delivering the same product output are organized. An example is multiple hospitals within one health care delivery system, (also known as a multihospital system). Multihospital systems were prevalent in the early to mid-1980s. As physician groups and outpatient services were incorporated into these systems through contracts and affiliation agreements, vertical integration occurred producing integrated delivery networks. INDEPENDENT PRACTICE ASSOCIATION (IPA): A network o f independent physicians which forms in order to contract with hospitals, insurance companies, and the government in an HMO arrangement. An IPA is a partnership, corporation, association, or legal entity that provides prepaid health care services or subscribers of a health plan. This arrangement connects a health plan with a group of licensed physicians, dentists, or other health care personnel and outlines the provision of services and established method of provider compensation. INTEGRATED DELIVERY NETW ORK: A multi-organizational network that includes multiple hospitals, outpatient services, home health, and long-term care organizations, and a health plan that is either an internal or external indemnity system. Organizational arrangements within an integrated delivery network are either contractual (affiliation agreements) or corporate owner-operated (mergers and acquisitions). This entity is fiscally and clinically accountable for the health status of the population. The integrated delivery network receives all revenues for the delivery of services. IPA HMO: The intermediary either contracts with an IPA (that it may or may not own or control) that in turn contracts with solo or small group practices. MANAGED CARE; The management of physician practice through selective contracting with physician networks. Managed care plans differ greatly in physician practice management features, such as provider selection, retention, information feedback techniques, utilization management procedures, provider reimbursement and risk-sharing methods, and physician organization. MANAGED CARE ORGANIZATION (MCO): An organization that delivers inpatient and outpatient care by managing physician utilization of organizational services. 268 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. MDŒD-MODEL H M O : The intermediary has various relationships with providers. For example, the intermediary may contract exclusively with medical groups and nonexclusively with solo practice physicians in the same area. NATIONAL COM M ITTEE ON QUALITY ASSURANCE (NCQA): An independent, not-for-profit organization that accredits managed care plans. NETW ORK HMO; The health benefit intermediary relationship with medical groups is nonexclusive. POINT O F SERVICE (POS): Requires enrollment of beneficiaries and often uses primary care physicians as gatekeepers. These plans allow enrollees or their physicians to refer outside the network for care at an increased cost to the patient. POS plans generate savings fi*om the provider discounts by changing enrollee’s service utilization patterns. Many POS plans resemble a hybrid between an HMO and a PPO. PREFERRED PROVIDER ORGANIZATION (PPO): Companies that negotiate selective contracts between insurance companies and/or employers, and hospital and physician groups to provide full coverage inpatient and outpatient services for a given price. PPO plans contract with these selected providers who furnish services at lower than usual prices. Providers are willing to offer discounts because they get an increased volume o f patients. PREPAID GROUP PRA C TICE (PGP): In this type of HMO, the health benefit intermediary has an exclusive relationship with one or more large medical groups. PRIMARY CARE CASE MANAGEMENT (PCCM): A contract with a primary care physician to manage the care of the recipient who enrolls with a particular provider. Contracted primary care physicians are typically paid a case management fee for this service and on a fee-for-service basis for all medical services rendered. Recipients must choose or are assigned a primary care provider as a case manager. The case manager is usually a primary care physician, but may be a clinic or an HMO. PCCMs represent partial-risk capitation and are used for government-funded programs. PCCMs are unique to Medicaid. PROFIT M AXIM IZATION; Shifting capacity to other markets and selling the service at a lower not higher price. (The usual economic assumptions do not lead to dynamic cost shifting as it is typically defined in the health policy literature). PROVIDER: An individual, group, or organization that provides direct health care delivery services such as physicians and hospitals. 269 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. PROVIDER SPONSORED NETW ORKS (PSN): Physician groups that contract directly with the payer, without the indemnity component, in a managed care arrangement. Example: Medicare reform may allow the provider to form networks that contract directly with the Health Care Financing Administration (HCFA) with capitation. STAFF H M O: The health benefit intermediary directly employs physicians. STATIC CO ST SHIFTING: The provider’s ability to charge different prices to different payers. VERTICAL INTEGRATION: Ownership of differing stages of production that includes the inputs (such as raw materials), the process, and the outputs. In health care, vertically integrated organizations own or are affiliated with either physician groups, or health plans as suppliers of the inputs (patients or covered lives). The capacity of the health care delivery system includes a variety of inpatient and outpatient services, both acute and long-term care. Ownership of capacity (hospital beds) is no longer the most efficient way to deliver services in a full-risk capitated HMO model. 270 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. APPENDIX B Fuzzy Logic and the Bit Cube Kosko uses the analogy o f the clay trap as Aristotelian logic where two traps are let and the shooter either hits or misses both traps. In the two-trap case, the shooter either scores a miss-miss (0,0), a hit-miss (1,0), a miss-hit (0,1) or a hit-hit (1,1). The set is all or nothing, A or not-A. Now suppose a judge scores hits in a trap case between clays 1 and 2 as miss, nick, partial, most, and hit, or 0, %, 1 6 , %, and 1, respectively. This gives 25 (5^ possible scores and a denser fuzzy lattice. Kosko measures fuzzy entropy with two strings. Using the bit cube in the trap case he finds the score of (^/s, V i) where the first clay is almost powdered, but the second is only nicked. This score is fuzzy set A as a point in the cube below: With a red string tied from point A to the nearest comer, the string keeps track o f how close to the comer and how far from the midpoint lies Point A. If A moves away from the nearest comer, it moves closer to the farthest comer and vice versa. With a blue string tied from A to the farthest comer, the percent measure of fuzzy entropy can be measured as the length of the red divided by the length o f the 271 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. blue. This gives a number between 0 and 1 describing the vagueness of Point A. The bigger the number, the more the vagueness or fuzziness. At the midpoint, all four points are equal and fuzzy entropy is maximized. 248 Kosko, Bart, Fuzzy Thinking: The New Science o f Fuzzy Logic (New York: Hyperion, 1993), 131- 132. 272 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. APPENDIX C Definition of Economic Terms ASSET SPECIFICITY: Asset specificity refers to the degree to which an asset can be deployed to alternate uses and by alternative users without sacrificing production. There are six kinds of asset specificity: (1) site specific (2) physical (3) human (4) brand name (5) dedicated and (6) temporal (time specific). General purpose assets are characteristic of anonymous market trading. Special purpose asset specificity creates bilateral trading dependency and contractual hazards. CLASSIC CONTRACT LAW : Contingent and comprehensive contracting where all relevant future contingencies pertaining to the supply of a good or service are described with respect to both likelihood and future behavior of the contracting parties. Dispute resolution is through the courts. CONTRACTUAL DISPUTES: Disputes require access to a legal forum external to the original setting of the dispute. Remedies are provided as prescribed in the law of contracts and through the court system. Disputes that could be brought to the court may be settled by other means such as arbitration, self-help, or avoidance. CONTRACTUAL SAFEGUARDS: Contractual safeguards are fashioned to obtain credible commitments from parties to a transaction and instill integrity into transactions. Safeguards take the form o f common ownership. Ex-ante and ex-post costs of contracting are interdependent. Ex-ante and ex-post contractual safeguards must be addressed simultaneously. EX-ANTE CONTRACTING AND TRANSACTION COSTS: The costs of drafting, negotiating, and safeguarding an agreement before it is enacted. EX-POST CONTRACTING AND TRANSACTION COSTS: The setup and running costs associated with governance structures to administer contracts and the bonding costs of effecting secure commitments. Ex-post contracting also includes the maladaptation costs incurred when transactions drift out of contractual alignment and haggling costs incurred if bilateral efforts are made to correct ex-post misalignments. 273 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. KlKM: Transaction cost economics maintains that the firm is usefully regarded as a governance structure. Organizational variety arises primarily to service and economizing transaction costs. FORBEARANCE LAW: The law of corporate judgment in which firm management is not normally liable for mistakes of judgment whether classified as mistakes of fact or law unless there is bad faith or corrupt motives. Forbearance doctrine is applied to the firm management. The use o f courts to review alleged mistakes of judgment or to adjudicate internal firm disputes would undermine hierarchy. GOVERNANCE STRUCTURE: A means by which efficient transactions are organized. Governance structures are of three types: market, hybrid, and hierarchy. HIERARCHY: The organizational structure put into place when a transaction is transferred out of the market and placed under unified ownership. A hierarchy appears as a support structure to maintain the integrity o f the internal exchange relationship. The degree o f hierarchy is usually assessed in decision-making respects. Where the responsibility for affecting price or contracting adaptations is concentrated on one or a few agents, hierarchy is relatively great. If individual agents negotiate a price or contract, the hierarchy is slight. HIERARCh A e S a n d CONTRACTS: The firm is a nexus o f contracts. Employment contracting is through fiat, and forbearance is the implicit contract law of internal organization. HlERARCtiAES AND PRICIN G : Hierarchical structures provide coordination and control of contractual relationships within the firm. Controlling, coordinating and monitoring systems increase transaction costs which increases output price. HYBRIDS AND CONTRACTS: Parties are not anonymous, and bilateral trade agreements exist. Negotiation requires both parties to engage in the contract. The contract contemplates unanticipated disturbances for which adaptation is needed. HYBRIDS AND PRICING: The buyer and seller are not anonymous, there is bilateral dependency, assets are specific to the trade, and pricing is set according to contracting hazards. Minimizing transaction costs associated with the trade decreases output price. MARKETS AND CONTRACTS: Market trading is supported by classic contract law in which parties to the trade are anonymous and dispute resolution is through the courts. A good or service is offered at a price in the form o f unilateral contract. The 274 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. seller sets the price and the buyer pays it or walks away. There is no dependency relationship. MARKETS AND PRICING: The buyer and seller are anonymous. A good or service is offered at a price subject to price competition for the same or substitute good or service. In most market trading, disputes are minimal and transaction costs are low. Pricing is subject to competition and a market-driven, competitive efficiency results. NEOCLASSIC CONTRACT LAW; Incomplete contracting in which not all future contingencies for which adaptations are required can’t be anticipated at the outset and the adaptation will not be evident until the circumstance materializes. Such gaps in planning require a more flexible means of dispute resolution, which can be achieved through a third party such as arbitration. The alternative is to remove the transaction from the market and internalize them organizationally. Adaptive, sequential decision-making would then be implemented under unified ownership. TRANSACTION COSTS: The cost o f running economic systems. Transaction costs are the economic equivalent of friction in physical systems. These costs are distinguished from production costs. 275 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. IMAGE EVALUATION TEST TARGET (Q A -3 ) / % 1 . 0 ! f m i.i 1.25 i±° 1.4 23 2.2 2.0 1 . 8 1 . 6 150mm 6 " V V ^ 7 , V / / o / /y /A P P L IE D ^ IIVMGE . In c 1653 East Main Street Rochester, NY 14609 USA Phone: 716/482-0300 ------- Fax: 716/288-5989 O 1993, /VpplieO Image, Inc., Ail Rights Reserved Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

Linked assets

University of Southern California Dissertations and Theses

Conceptually similar

PDF

Managing change, market and value: Reengineering cardiac care in a tertiary care academic medical center

PDF

An analysis of health risk selection and quality of care under Medicare fee -for -service and Medicare managed care health care systems

PDF

The effect of rate regulation and price competition on labor efficiency in ancillary and nursing service areas of hospitals in California, 1983-1991

PDF

A coalignment theory of executive political transitions

PDF

Alternate models of women's health care policy in the United States

PDF

Balancing community benefit and economic survival in nonprofit hospitals: A comparative perspective on charitability and tax-exemption policies in competitive health care markets in Pennsylvania ...

PDF

Statistical analysis of health care expenditure and health status in the well-elderly study

PDF

Evidence of age-based rationing of health care to the elderly: The effect of age and death on the use of health care services by elderly enrollees in an HMO

PDF

Political theories of public policy making: A test of the ability of political theories to predict the features of the policy process

PDF

Patient life in a nursing home: an experiential study

PDF

Clinical capital equipment acquisition: A study of executive decision-making

PDF

Evaluating differences in patient satisfaction with inpatient hospital care categorized by diagnostic related groups

PDF

Technological advances in long-term care: Barriers to implementation.

PDF

Regionalization of fire protection and emergency medical aid services: A comparative case study analysis of economic and socio-political impacts

PDF

Toward a theory of networks and network effectiveness: An analytical framework for the study of multilevel networks in health care service delivery

PDF

Religious-based managed care: A Wesleyan paradigm for reforming health care

PDF

Performance management in health care in Iceland

PDF

The impact of state abortion policy on selective abortion ratios in the United States

PDF

The principles behind institutionalized crisis responses: Applying interorganizational theory to the unique demands of crisis response networks

PDF

Nongovernmental organizations in public /private partnerships: Applications to new institutional economics

Asset Metadata

Creator Donneson, Mary Kathleen (author)

Core Title The use of transaction cost economics, fuzzy set and systems theories in the development of a three-dimensional pricing model of asset specificity and contracts, and applied to health care

Degree Doctor of Public Administration

Degree Program Public Administration

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, General,health sciences, health care management,OAI-PMH Harvest,Political Science, public administration

Language English

Contributor Digitized by ProQuest (provenance)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c17-337139

Unique identifier UC11353736

Identifier 9835179.pdf (filename),usctheses-c17-337139 (legacy record id)

Legacy Identifier 9835179.pdf

Dmrecord 337139

Document Type Dissertation

Rights Donneson, Mary Kathleen

Type texts

Source University of Southern California (contributing entity), University of Southern California Dissertations and Theses (collection)

Access Conditions The author retains rights to his/her dissertation, thesis or other graduate work according to U.S. copyright law. Electronic access is being provided by the USC Libraries in agreement with the au...

Repository Name University of Southern California Digital Library

Repository Location USC Digital Library, University of Southern California, University Park Campus, Los Angeles, California 90089, USA