As finals week approach, I scrutinize the papers more closely looking for inspiration for examination questions. My eye was recently caught by an article in the NYT about most favored nation clauses and a suit brought against Blue Cross & Blue Shield (BCBS) in Michigan. The gist of the matter is this. BCBS asked hospitals it contracted with to serve their policy holders to give it most favored nation (MFN) status. There are two kinds of MFN. Regular MFN where the supplier promises the buyer it will always get a price no higher than lowest price the supplier offers to any other buyer. And, MFN+, where the supplier promises the buyer their price will be some % lower than the lowest price offered to any other buyer. BCBS apparently had MFN promises from 45 hospitals (all with < 100 beds) and MFN+ promises from >25 others which required BCBS to receive at least a 23% discount compared to other insurance providers. A full list of the relevant hospitals can be found here.

The benefits to a buyer  from MFN status are well known. My colleague Sandeep Baliga has articulated them on his blog. It raises prices for BCBS’s competitors. Hospitals should also  benefit, because it reduces their incentives to cut prices to fill beds. Why? A price to cut to another insurance provider in order to gain their business, requires a price to cut to BCBS as well. If BCBS fills a lot of beds, that might be sizable. It is, since BCBS is the largest provider in the region covering 60% of Michigan’s commercially insured residents. Indeed, BCBS should be willing to increase payments to hospitals to get a MFN. Thus, the effect of the MFN is to raise prices to all insurance providers, but raises the prices of BCBS’s competitors even more!

If you buy this, then hospitals should jump at the chance to offer BCBS MFN or MFN+ status. However, in order to get the 45 small hospitals I noted above to sign on, BCBS threatened to slash payments to them by 16% if they did not offer MFN status. We come now to the interesting issue that the newspapers have missed.  When exactly does it make sense to demand an MFN and to offer one?

Let us look at the choice that faces an individual hospital. To simplify, suppose that 70%  of the hospitals capacity is filled by by BCBS policy holders and the other 30% by policy holders of another provider, say RCRS. Suppose BCBS comes to the hospital and offers to increase the payment it makes in return for the hospital raising the price to RCRS even more. Should the hospital accept?

Case 1: RCRS can go elsewhere.

If the hospital accepts BCBS’s offer, RCRS sees a price increase. If it can find another hospital with capacity and low price, it leaves. In which case, the hospital is left with 30% unused capacity. Thus BCBS’s price must be large enough to compensate for the lost profits from RCRS’s departure. However, from BCBS’s point of view, RCRS’s costs are as they were before, and BCBS has just raised its costs!

Case 2: RCRS cannot go elsewhere.

Then, neither can BCBS. In which case the hospital is in the drivers seat when bargaining with BCBS and RCRS. It could raise prices anyway on both.

Lets try another tack. Could BCBS’s size and its threat to reduce payments (I presume by shrinking volume) persuade a hospital to offer it MFN status? Suppose, as one of the hospitals, I decline BCBS’s offer. It reduces the # of its policy holders that come to me. These policy holders have to go somewhere. Perhaps they go to a hospital that accepted BCBS’s offer. In which case RCRS will be looking to shift their policy holders from that hospital to mine perhaps, because I have a lower price. Again, if the numbers work out I have no reason to say yes to BCBS.

Perhaps, what is missing from the discussion are the policy holders. What if policy holders care about the hospital they will be sent to. So, if RCRS is turfed out of a hospital, its policy holders `stay behind’ as it were by switching to BCBS. This again puts bargaining power in the hands of the hospital, because insurance companies need  the right mix of hospitals to attract policy holders.

So, why did the hospitals accept the MFN clauses.