Physician Market Power—Evidence From the Allocation of Malpractice Premiums

NORMAN K. THURSTON [*] Based on evidence from variations in malpractice premiums, physicians have local market power, at least in some dimensions. It is observed that higher-cost physicians pass on a significant portion of idiosyncratic costs to patients as higher prices. I test two hypothesized sources of this market power: barriers to entry from specialization and relatively inelastic firm-level demand for certain services. Examining the relationship of physician-specific malpractice premiums to fees, I find no observable difference in the ability of surgeons and nonsurgeons to pass on these costs; however, both types of physicians pass them on more to surgical than to nonsurgical patients. (JEL L11, I11) I. INTRODUCTION Two of the most interesting unanswered questions with regard to markets for physician services are whether physicians enjoy market power that affects their price-setting behaviors and, if so, what the source of such market power might be. One frequent hypothesis is that asymmetric information regarding quality gives physicians market power that varies depending on the type of services sought by patients--markets for common services (office visits) are thought to be more competitive than less frequently sought services (surgeries). Another possibility is that supply restrictions in medical education, coupled with the specialization and certification process, creates barriers to entry, giving specialists a greater degree of market power than generalists. I perform tests of these hypotheses by looking at how physicians allocate fixed costs to prices. Economic theory suggests that the ability to pass on higher-than-average fixed costs to customers in the form of higher prices is directly related to the existence of local market power. For physicians, malpractice premiums provide a unique opportunity to examine this problem. I utilize individual-specific variation in malpractice premiums to test whether this market power is observable due to either specialization or patient type. I find empirical evidence of market power based on patient heterogeneity but not based on specialization. Malpractice insurance premiums represent a substantial portion of physicians' costs. [1] Malpractice insurance protects doctors from liability settlements arising out of patients' claims that they failed to follow acceptable procedures. (Tort law requires physicians to use skills commensurate with their class of practitioner. [U.S. House of Representatives, 1990, 89].) Because collected premiums must cover insurers' costs, rising malpractice premiums are simply reflections of the rising costs of providing this service. Premiums are set by the insurer, subject to approval by state insurance regulatory agencies. A base fee is set for the physician's geographical location, usually the state, then adjustments are made to account for specific geographic areas, such as major metropolitan areas versus rural areas. [2] The riskiness of the type of practice is also assessed-specialty classes are assigned multipliers-yielding the approximate annual premium, which is fairly constant within markets and specialty classes . One of the most striking features of the structure of malpractice premiums is that after controlling for important factors that determine base premiums for physician risk categories, there is still substantial variation in premiums paid. The choice of coverage that a policy will carry (the maximum amounts payable for one case and total payment) is an important consideration. Other adjustments are made if a physician performs high-risk procedures or if the insurer has responded to claims against the physician in the past (U.S. House of Representatives, 1990, 31-41); however, formal experience rating is not common. Given the nature of the institutions, a small set of information describing a practice's structure, history, and location is sufficient to separate the malpractice premium into the common base fee and the individual-specific component. …