Equilibrium Provider Networks: Bargaining and Exclusion in Health Care Markets

December 2016
Kate Ho and Robin S. Lee

Why do insurers choose to exclude medical providers, and when would this be socially desirable? We examine network design from the perspective of a profit maximizing insurer and a social planner in order to evaluate the effects of narrow networks and restrictions on their use—a form of quality regulation. An insurer may wish to exclude hospitals in order to steer patients to less expensive providers, cream-skim enrollees, and negotiate lower reimbursement rates. In addition to the standard quality distortion arising from market power, there is a pecuniary distortion introduced when insurers commit to restricted networks in order to negotiate lower rates. We introduce a new bargaining solution concept for bilateral oligopoly, Nash-in-Nash with Threat of Replacement, that captures such bargaining incentives and rationalizes observed network exclusion. Pairing our framework with hospital and insurance demand estimates from Ho and Lee (forthcominga), we compare social, consumer, and insurer optimal networks for the largest non-integrated HMO carrier in California across 14 geographic markets. Both the insurer and consumers prefer narrower networks than the social planner in most markets: the insurer benefits from lower reimbursement rates (almost 50% in some markets), and passes a portion of the savings along in the form of lower premiums. However, the social planner may prefer a fuller network if it encourages the utilization of more efficient insurers and providers. We argue that the appropriateness of network regulation is context specific, and will depend on premium setting constraints and the generosity and efficiency of alternative insurance products.