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Competition and Market Power in Option Demand Markets
Capps, C., Dranove, D. and M. Satterthwaite

Abstract: Some important markets feature intermediaries who offer a network of upstream suppliers to downstream consumers. Often, consumers may select their intermediary prior to knowing their specific needs. Insurance markets are an important example. We call these "option demand", or OD markets. This paper studies supplier market power in OD markets. We first develop a measure of market power based on the logit model of demand. We assume that the intermediary, at the time it forms a network of suppliers, knows the distribution of consumer preferences and the distribution of possible states of the world, but not the upcoming realizations. Consumers then evaluate the different networks and commit to the intermediary that provides the greatest expected utility. Finally, consumers realize their demands and select their preferred supplier from the network. To fit our model to insurance networks we assume that, once sellers are included in a network, consumers pay the same price regardless of which network seller they select. Thus the selection of sellers depends on non-price attributes only. Because intermediaries know the ex ante distribution of consumers' preferences, they can aggregate over all consumers and compute the ex ante value of adding a particular seller to the network.

We evaluate this framework using data from the market for inpatient hospital services in San Diego. We estimate a multinomial hospital choice model to identify the parameters of patients' logit demand functions. Based on these estimates, we compute the value that each hospital adds to a hypothetical managed care network. Given that the San Diego hospital market is not perfectly competitive and that hospitals and managed care organization (MCOs) negotiate the prices at which services are provided, we use a simple bargaining model to specify what proportion of its added value each hospital captures. We then regress our estimates of added value on each hospital's actual profits from daily hospital services. We find that hospital profits from managed care patients are highly correlated with the ex ante added values they bring to the network: at the sample mean, the elasticity of profits with respect to ex ante added value is approximately one. This implies that when hospitals' bargaining position is strengthened, via a merger for example, they are able to extract higher premiums from MCOs.

Competition and Market Power in Option Demand Markets (PDF 952 KB)

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