In February 2011, the Department of Justice settled its case alleging that United Regional Health Care System had engaged in predatory bundled discounting with certain managed care plans that prevented the smaller Kell West Regional Hospital from becoming a full-service competitor. DOJ’s analysis relies on a novel variant of the “discount attribution” approach used in two prior cases: Ortho and PeaceHealth. That variant, however, is incompatible with DOJ’s own theory of competitive dynamics. Critically, DOJ also fails to present an analysis of the economic rationality of below-cost pricing.
DOJ alleges that United Regional’s managed care contracts with non-Blue Cross plans harmed competition by excluding Kell West from the payors’ networks in exchange for increased discounts on all services at United Regional. Had these insurance networks included Kell West, DOJ argues, Kell West’s increased profits would have enabled it to expand into United Regional’s “monopoly services.” Kell West ostensibly would have added “additional intensive-care capabilities, cardiology services, and obstetrics services.” Since DOJ does not allege that United Regional’s scheme would have forced Kell West to close, its theory implies that United Regional must maintain this scheme into perpetuity to continue excluding Kell West from the “monopoly services.”
To test its predatory pricing theory, DOJ applied a modified form of the Ortho and PeaceHealth “discount attribution” approach. In general, the discount attribution approach assigns the entire discount for the bundle of services to the sales of the competitive service alone. The modification used by DOJ involves dividing United Regional’s patients under exclusive contracts into (1) those receiving services not available at Kell West, (2) those receiving services available at Kell West but who prefer United Regional (“preferred services patients”) and (3) those receiving services available at Kell West who would switch to Kell West but for the exclusive contracts. The third group, termed “contestable” patients by DOJ, constitutes what DOJ believes are the competitive sales. DOJ estimates that only 10% of United Regional’s non-Blue Cross commercially insured patients are contestable. After attributing the discount on the whole bundle of services entirely to the 10% of patients, DOJ concludes that United Regional’s prices for the services supplied to the contestable patients are well below its costs, resulting in competitively harmful predatory pricing.
To better understand the implications of DOJ’s theory, consider a stylized example used in Ortho (and cited by the Ninth Circuit in PeaceHealth) of bundled discounting of shampoo and conditioner. A slight variation of that example features one firm that produces both shampoo and conditioner and a second firm attempting to enter the shampoo market. The incumbent monopolist offers the two-product bundle at a discount below the products’ combined stand-alone prices. The discount attribution approach weighs the entire bundled discount against the stand-alone price of the shampoo, the product in which entry threatens. This attribution captures the intent to block competition in the shampoo market without affecting the monopoly conditioner market.
United Regional’s alleged attempt to thwart Kell West’s entry into the monopoly services market is analogous to the hair-products monopolist’s preventing entry into the shampoo market, but there are some important differences. In the Orthoexample, the discount affects competition in the market for the competitive product, leaving the monopoly product untouched. United Regional, however, has virtually no service line that is free from Kell West’s threatened entry, under DOJ’s assumptions. That difference is important because identifying the markets ultimately affected by the alleged anticompetitive conduct is the key to determining proper attribution. In the hair products example, the entire discount is attributed to shampoo because that is the market with the competitive impact. In United Regional, DOJ theorizes that the bundled discount prevents Kell West from entering the monopoly services markets and becoming a full-service hospital, thus preventing it from attracting monopoly services patients. Presumably, not being full-service also prevents Kell West from attracting the preferred services patients. The effect of the alleged anticompetitive conduct thus is not restricted to the contestable 10% of patients. They are simply the mechanism to harm competition by preventing Kell West’s expansion. The bundled discount affects United Regional’s competition for all patients, and it should be attributed to all of them. As DOJ’s Competitive Impact Statement states, “the entire discount should be attributed…to the patients that United Regional would actually be at risk of losing,” and it risks losing all patients to an expanded Kell West.
Moreover, DOJ ignored the question of recouping forgone profits. Recoupment is a central feature of any analysis of predatory pricing because no economically rational firm will price below cost with no prospect of recovering forgone profits. A straightforward way to consider recoupment is to assess United Regional’s pricing options. One option would be to avoid the restrictive contracts altogether. In this no-exclusives, no-discounts scenario, United Regional would price its monopoly services at the monopoly level until Kell West expanded into a full-service hospital, and then it would lower those prices to competitive levels. Alternatively, United Regional might enter into exclusive contracts in which health plans forgo a broad hospital network in exchange for greater discounts. In doing so, it may construct discounts to the health plans that are sufficient to compensate the plans for accepting a narrow hospital network, but nevertheless result in prices above cost. Finally, United Regional might offer health plans a discount that results in its price being below cost, as DOJ alleges. That is the only scenario in which United Regional would be engaged in the alleged predatory strategy. Insofar as DOJ alleges that United Regional’s strategy actually involved pricing below cost to keep Kell West out of the market for monopoly services, it must also explain why it is economically rational for United Regional to engage in an apparent money-losing strategy. DOJ does not explain how the below-cost pricing losses are to be recovered by United Regional or how the pricing strategy may otherwise be profit-maximizing.
Perhaps DOJ ignored recoupment because it made the same mistake as the Ninth Circuit, which stated in PeaceHealththat a seller of bundled products need not meet the recoupment standard as long as it makes positive profits on bundled sales. In fact, any pricing below a single-period profit maximizing price involves forgone profits that must be recovered. Alternatively, DOJ may have avoided discussing recoupment because it recognized that by necessity, United Regional never can both meet the below-cost requirement of predatory pricing and still recover the forgone profits attributable to this alleged predation strategy.
Thus DOJ’s analysis of United Regional’s alleged predatory pricing is deficient in two key respects. DOJ’s logic of attributing the full bundled discount to the “contestable” patients is faulty. Moreover, DOJ’s inexplicable silence on recoupment leaves a critical gap that cannot be ignored.