Vertical Integration May Save Your Life

Healthcare in the U.S. is expensive.


In both the political and economic landscapes, healthcare has been heavily featured in the public dialogue, often accompanied with high-flown words, from overtones of governmental incapability to excessive cost inefficiencies, fraud and abuse. For an individual not familiar with the healthcare industry and its intricacies, dipping his or her feet into the ocean can be daunting.


What does expensive healthcare mean? How is this gauged? Is higher healthcare spending a problem? What are the implications for the economy? Which steps have already been taken or considered? What are competitive strategies moving forward?


To answer these questions, a framework of the industry must be set with an identifiable problem to be solved.


The healthcare industry is comprised of various interested parties,


These parties include, but are not limited to, healthcare providers, hospitals, suppliers (pharmaceutical and medical device companies), and insurance companies. This framework fits within governmental regulations and provisions. How these key players and other interested parties interact and assign appropriate prices to goods, services and transaction costs contribute to the growing financial obligations that healthcare payers receive and the burden on the economy.


The major drivers of higher healthcare spending in the U.S. are prices of labor and goods, including pharmaceuticals and administrative costs. Highlighted in a recent publication in the Journal of the American Medical Association by Irene Papanicolas, Liana R. Woskie and Ashish K. Jha, higher healthcare spending was previously attributed to higher utilization rates. These rates, however, were found to be of the same magnitude as those of other high-income countries.


Higher healthcare spending in the U.S. has not translated into improved demographic characteristics.


While other comparable, high-income countries typically have their entire population with health insurance coverage (range, 99-100 percent), the U.S. falls short at 90 percent. Health outcomes are also not reflective of higher healthcare spending. The U.S. life expectancy is the lowest among high-income countries at 78.8 years, compared to a mean of 82.0 years. In addition, the JAMA article includes a cross-sectional comparison of high-income countries with regards to spending on health care per capita, health care provider salaries, administrative costs and pharmaceutical costs.


There are signs of inefficiency in U.S. healthcare. The administrative costs associated with planning, regulating and managing health systems and services account for 8 percent of the U.S. healthcare spending, compared to 1-3 percent in the other high-income countries. Pharmaceutical spending per capita was $1443 in the U.S. versus a range of $466 to $939 in other countries. Infant mortality rates were significantly higher at 5.8 deaths per 1,000 live births compared to the overall average of 3.9. Table 1.1 includes additional comparative statistics that serve as indicators of healthcare availability, affordability and quality.


Table 1.1 Comparative Statistics between the U.S. and other high-income countries.

Data as of 2015 or nearest year from the Organisation for Economic Co-operation and Development (OECD). High-income countries considered (10) include the United Kingdom, Canada, Germany, Australia, Japan, Sweden, France, the Netherlands, Switzerland, and Denmark.


Indicator U.S. High-income countries OECD average
Current expenditure on health, % of gross domestic product 17.2 10.74 9.0
Life expectancy, total population at birth 78.8 82.0 80.6
Infant Mortality rate, deaths per 1,000 live births 5.8 3.44 3.9
Out-of-pocket expenditure, per capita, US$ purchasing power parity 1054 796 686
Obese population, measured, % of total population 38.2 20.8 22.6


Inefficiency leads to profit opportunities. Amazon, Berkshire Hathaway, and JPMorgan Chase announced in January a partnership to cut healthcare costs and improve services for their employees. A deal of this magnitude serves as a shock to the healthcare industry and incentivizes innovation to remain competitive. Jeff Bezos, Amazon’s CEO, explained the rationale of undertaking such an initiative, commenting that while the healthcare system is complex, “hard as it may be, reducing healthcare’s burden on the economy while improving outcomes for employees and their families would be worth the effort.”


Vertical integration is a competitive strategy for health care reform.


Vertical integration will lead to competition that necessitates companies at all stages of the healthcare industry to seek competitive pricing through improved cost-efficiency. This competition has both micro and macroeconomics implications as unnecessary costs entailed in healthcare intermediation and administrative costs are driven out of the healthcare industry. Firms forced to offer more affordable and quality care will make budgetary decisions to do so.


In healthcare, there is historical precedence for integration in intermediary markets. In April 2012, the Federal Trade Commission (FTC) approved the merger of Express Scripts and Medco, the two largest Pharmacy Benefits Managers, or PBMs, at the time. Healthcare intermediaries can serve as an economic mechanism to counteract growing market power through aggregating demand and leveraging buying power to negotiate and obtain more favorable pricing for health plans, hospitals, physician practices, patients and employers. Despite these conventional efficiency benefits, however, intermediary consolidation can itself lead to competitive concerns, including exclusionary practices and anticompetitive agreements.


Unnecessary costs associated with intermediation need to be expunged. As institutions, intermediaries benefit the economy by providing opportunities that would not otherwise be available. Mechanisms can span from providing financial liquidity, more equitable information to navigating services. On the other hand, when intermediation can be offered in a more cost-efficient manner or is unnecessary altogether, the costs associated with these services translate into higher prices over time, and are a burden on the economy as a whole.


Vertical integration and portfolio diversification have implications for firms and the larger economy. Though formation of natural monopolies through declining average costs and diseconomies of scale may be of concern in the long run, healthcare firms that capitalize on both economies of scale and scope may lead to external economies including positive externalities that develop the industry and the whole economy. Not only are the individual firms rendered more profitable, but increased entry and resulting efficiency in the market will also alleviate cost burdens on the industry and the U.S. economy.


Major players in the healthcare industry have begun to diversify their portfolios, building off a history of long-term contracting and strategic alliances. The long-term contract between Anthem and Express Scripts, a large PBM, expires in 2019 and will not be renewed after Anthem’s accusations of overcharging by billions of dollars. Moving forward, Anthem has reached a five-year agreement with CVS Health Corp. and will set up its own pharmacy benefits management unit, IngenioRx. Wal-Mart, which has large pharmacy and retail clinic presence, has signaled intentions to acquire Humana, the fifth largest health insurance provider. CVS Health is further along with acquiring Aetna, the third largest health insurance provider, and is currently under antitrust review at the U.S. Department of Justice.


Higher healthcare spending is not necessarily harmful for an economy if warranted by improved health and patient outcomes. Health care spending in the U.S. significantly exceeds that of other high-income OECD countries. This, however, has not translated into improved health as highlighted by indicators of availability, affordability and quality of health care. Vertical integration is a competitive strategy for health care reform and reducing the proportion of the U.S. gross domestic product spent on health care, which is attributed to high administrative costs and the price of labor and goods.