Winning a Losing Game, Part VI: The Impact of Price Elasticity

Highly competitive markets have price elasticity; monopolistic markets do not. Transparent markets have price elasticity; opaque markets do not.

Healthcare has long been an opaque market, but as Bob Dylan might say, “the times, they are a-changin.”

Healthcare is so historically opaque that reference pricing is highly lauded by Health Affairs and numerous pundits. However, the experience of CalPERS in using reference pricing reveals how far healthcare is from a consumer driven industry.[1]

In reality, reference pricing is just another example of being a price-taker, and most hospitals have been price-takers for years. With past as prologue, it should be expected that hospitals would prefer reference pricing to price elasticity, because it requires only concession, i.e., being a price-taker, as opposed to competition, i.e., pricing strategically with the goal of maximizing the demand for the health system’s supply of services.

The extent to which health systems are “successful” price-takers is highly correlated with three factors:

  • the level of competition in the payer market;
  • the extent to which a hospital provides a service that is scarce clinically (trauma, burn or pediatrics) or competitively (i.e., regulated by Certificate of Need);
  • the First Law of Real Estate: Location, location, location

While some of these factors may be slow to change, other inherent competitive barriers upon which health systems have historically relied are eroding quickly. Dozens of California-based technology companies are here to help liberate patient health records, making switching physicians easier. The pandemic accelerated the transition to virtual care, and insurance companies are eager to disrupt established referral patterns through captive telehealth platforms, the latest example of which is the acquisition of MDLive by Cigna’s Evernorth division. Health systems should be even more concerned about the commoditization of primary care access by retailers whose scale allows them to operate profitably without relying on ancillary service revenue.

The question for every health system is how long being a price-taker is a sustainable strategy.

Amazon and Walmart are not price takers, and Amazon and Walmart are unparalleled in their understanding of price elasticity. Walmart’s “Smiley the Rollback Man” advertising campaign, which debuted in 1990, flaunts that expertise: 

Historically, price elasticity in healthcare has been rarely discussed, for many legitimate and logical reasons. The looming convergence of a number of different factors suggest that understanding price elasticity will soon be mission-critical, including price transparency initiatives enforced by regulators and embraced by employers, the inexorable rise of deductibles, and the inevitable consequence of competing in a negative-sum game.

Where to begin? First, with the fundamentals.

The formula for price elasticity of demand is this:

Price elasticity of demand = Percentage of change in quantity demanded
                                                             Percentage change in price

What does the formula represent?

“If the actual figure given by the formula is greater than 1, demand is elastic; if it is less than 1, demand is inelastic; if it is equal to 1, demand has unit elasticity. Demand is unitary elastic where the proportionate change in quantity demanded and price are equal.”[2]

Jill Avery, a Senior Lecturer of Business Administration at the Harvard Business School, offers these thoughts about pricing in an interview with Harvard Business Review:

“Setting the right price for your product or service is hard. In fact, determining price is one of the toughest things a marketer has to do, in large part because it has such a big impact on the company’s bottom line. One of the critical elements of pricing is understanding what economists call price elasticity…[which] shows exactly how responsive customer demand is for a product based on its price…

Products and services can be:

  • Perfectly elastic where any very small change in price results in a very large change in the quantity demanded. Products that fall in this category are mostly “pure commodities,” says Avery. “There’s no brand, no product differentiation, and customers have no meaningful attachment to the product.”
  • Relatively elastic where small changes in price cause large changes in quantity demanded (the result of the formula is greater than 1). Beef…is an example of a product that is relatively elastic.
  • Unit elastic where any change in price is matched by an equal change in quantity (where the number is equal to 1).
  • Relatively inelastic where large changes in price cause small changes in demand (the number is less than 1). Gasoline is a good example here because most people need it, so even when prices go up, demand doesn’t change greatly. Also, “products with stronger brands tend to be more inelastic, which makes building brand equity a good investment,” says Avery.
  • Perfectly inelastic where the quantity demanded does not change when the price changes. Products in this category are things consumers absolutely need and there are no other options from which to obtain them. “We tend to see this only in cases where a firm has a monopoly on the demand. Even if I change my price, you still have to buy from me,” explains Avery.”[3]

Viewed objectively, health systems seemingly believe that all healthcare goods are perfectly inelastic. While that notion is historically understandable, it is increasingly unsustainable from a policy standpoint and fatally flawed from economic theory:

“The price elasticity of demand for a good or service will be greater in absolute value if many close substitutes are available for it. If there are lots of substitutes for a particular good or service, then it is easy for consumers to switch to those substitutes when there is a price increase for that good or service. Suppose, for example, that the price of Ford automobiles goes up. There are many close substitutes for Fords—Chevrolets, Chryslers, Toyotas, and so on. The availability of close substitutes tends to make the demand for Fords more price elastic.

If a good has no close substitutes, its demand is likely to be somewhat less price elastic. There are no close substitutes for gasoline, for example. The price elasticity of demand for gasoline in the intermediate term of, say, three–nine months is generally estimated to be about −0.5. Since the absolute value of price elasticity is less than 1, it is price inelastic. We would expect, though, that the demand for a particular brand of gasoline will be much more price elastic than the demand for gasoline in general.”[4]

Healthcare has many more substitute goods than health systems and healthcare providers would like to believe. Between hospitals, imaging centers, and physician clinics, there are more than 15,000 X-ray machines in operation in the United States performing more than 500,000 ankle x-rays where the only clinical requirement is that the patient be still for five seconds while a radiology technician pushes a button. While it is virtually impossible for there to be a clinical difference in the procedure, the commercial reimbursement for CPT code 73600 ranges from $29 to $202.

The fact that the Price Transparency Rule includes 70 CMS-specified "shoppable" services implies that CMS believes that there are at least 70 healthcare services for which there are an abundance of substitute goods.

In 2008, we published the first Hospital Value Index™ in an attempt to measure “outcomes per dollar, or value for money.” The 2009 Hospital Value Index™ defined value this way:

“Value in healthcare is the same thing as value with any other commodity, product or service. Value is the combination of what you receive in exchange for what you paid and the likelihood that you will want it again. The elements of healthcare value include price, quality, efficiency, effectiveness, outcomes, process, experience and on-going perception, to name a few points on our radar. Inherent in value is the cost required to create the good, and the relationship of that cost to its price, demand and availability.”

Price elasticity is effectively a proxy for the “tipping point” of value, as it demonstrates the point at which the consumer’s evaluation of one variable – price – is sufficient to outweigh the other variables of quality, efficiency, convenience, etc.

The measure to which you understand the scope of the problem is the immediacy with which you start to solve the problem. The real problem is that this is an extraordinarily difficult problem.

The business problem is that all health systems underestimate the supply of healthcare services in their markets, which inevitably results in underestimating the total available market for healthcare services. The result? Every health system overestimates their market share.

The technical problem is that merely beginning to understand price elasticity in a $3.2T market requires a real “big data” approach. The challenge is not what you read about in the healthcare press about the volume or variety or velocity of data; the real challenge of “big data” is data engineering, i.e., distributed computing at scale, which is essential for the most important “v” – veracity.

The problem of price elasticity is infinite, which is why Amazon and Walmart constantly change their pricing.

As consumers pay more for healthcare, the more consumers will pay attention to price. And pay more they are, as the Peterson-KFF Health System Tracker reveals: The average deductible for both individual and family coverage more than doubled from 2008 to 2018, while the average annual employee contribution increased by ~60% for individual, employee +1, and family coverage.[5]

The problem of price elasticity is an analytics problem, not a consulting problem, which means it cannot be solved via a consulting engagement with one of the usual suspects.

There are a few firms that can solve the problem, and three of them are your competitors: Optum, Walmart and Amazon. None of them has solved the problem…yet. They will solve the problem, at least better than – and before – the 2,000,000 healthcare providers in the United States. And, when they do, they are unlikely to share the answers, which will make virtually every healthcare provider a price-taker.

Rest assured that the payers will not try to be clever like certain health systems by refusing to post negotiated prices for plan years beginning after January 1, 2022:

"The final rules also require plans and issuers to disclose in-network provider negotiated rates, historical out-of-network allowed amounts, and drug pricing information through three machine-readable files posted on an internet website, thereby allowing the public to have access to health coverage information that can be used to understand health care pricing and potentially dampen the rise in health care spending.”[6]

Payers desperately want to see those prices, especially those Blue Cross Blue Shield rates…and then they will use them against you. Perhaps, then, healthcare providers will finally “get religion” about the importance of consumer choice and price elasticity.

If you don’t believe us, consider our track record. Our 2007 prediction of Walmart’s healthcare approach has aged well, as has our 2008 prediction of the components and weighting of value-based care as compared to what CMS has designed.

In a negative-sum game, the winner is often the party that loses the least. Do you know how much you have to lose? If you want to know, let us know.