Economics

How Big Is Too Big?

Screen Shot 2016-05-20 at 8.38.33 AMWith healthcare mergers now announced seemingly every week, I’ve been giving some thought to scale:  How big can/ should health systems be?

Anecdotally, I’m struck that the most impressive healthcare companies in America are super- regional players:  Geissinger, Cleveland Clinic, UPMC, etc.  They seem to get a lot more attention than the national players with hundreds of facilities.

Leaving aside questions like strategy (e.g. is integration of payers/doctors/hospitals the key to these successes), I’ve wondered whether regional systems are simply the right size to thrive.  My suspicion is that even clever organizational structure (a topic which I wrote about last year) can’t overcome barriers that prevent large healthcare companies from innovating and thriving, particularly as companies move to risk and the business of healthcare becomes more complex. Like cellular organisms, large companies can outgrow their life support. (Interestingly, it’s actually the ratio of body volume to surface area [gas exchange, digestion, etc] that served as a constraint to organism size…)

I recently ran across a superb paper-  a doctoral thesis written by Staffan Canback.  Canback (who now leads the Economist Intelligence/ Canback predictive analytics consulting firm in Boston) wrote his thesis, called Limits of Firm Size: An Inquiry into Diseconomies of Scale in 2000, while a student in London. Canback argues, convincingly, that companies do become more efficient with scale, but reach a point where “diseconomies” begin to mitigate performance.  This may seem intuitive: (as Canback notes, if efficiency only improved with scale then we would buy everything from one company that produces everything with great levels of efficiency).  We don’t.

I’m dabbling in this complex field, but here are my takeaways:

Classic economic theory proposes that there is increasing efficiency (decreasing unit cost) with scale but that at a certain point diseconomies of scale begin to increase unit cost.

Screenshot 2016-03-05 09.21.36

The problem with this curve is that it can’t explain why there tend to be multiple companies of various sizes competing successfully in a given industry.  The answer, according to Canback, is that there is a large “sweet spot” in most industries where the benefits of scale are reached and before structural inefficiencies develop.  There is then an inflection point, limited to large companies, where diseconomies of scale emerge.  The curve looks more like this:

Screenshot 2016-03-05 09.22.32

What are the diseconomies of scale that Canback writes about? The ones that begin to increase unit cost at point M2?  They are ultimately bureaucratic concerns. Canback quotes the economist Herbert Simon:

“the central problem is not how to organize to produce efficiently (although this will always remain an important consideration), but how to organize to make decisions.”

The first part of this statement essentially refers to the negative derivative of the cost curve, while the second part refers to the upward slope as diseconomies of scale set in.

Here are the four main categories of scale diseconomies:

1. Communication distortion due to bounded rationality
It is impossible to expand a firm without adding hierarchical layers. As information is passed between layers it is necessarily distorted. This reduces the ability of high level executives to make decisions based on facts

2. Bureaucratic insularity
As firms increase in size the senior managers are less accountable to the lower ranks of the organisation and to the shareholders. They thus become insulated and will, given opportunism, strive to maximise their personal benefits rather than the corporate goal

3. Atmospheric consequences due to specialisation
As firms expand there will be increased specialisation, but also less moral involvement of the employees.

4. Incentive limits
Firms can not compensate their employees perfectly.
Here is the relationship between these four limiting factors and undesirable outcomes in large firms.

 

Screenshot 2016-03-05 09.45.51

In a complex, heavily customized relationship-based industry like healthcare, I’d suspect that these difficulties would be amplified.

It would be fascinating to plot the progressive performance of the country’s largest healthcare companies as they grew over time (including not just fiscal performance, but also measures of quality and innovation).  I’d be curious to see if it they look like Canback’s charts: doing fine until the magic inflection point at M2…

Marc-David Munk, MD is a doctor and healthcare executive living in Boston. He is a fellow of the American College of Healthcare Executives and the American College of Emergency Physicians.

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William Palmer MDMichel AccadPaul @ Pivot ConsultingLLCmarc-davidmunkEdgardo Tenreiro Recent comment authors
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William Palmer MD
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William Palmer MD

You don’t want providers or buyers to have market power. This means the ability to affect prices. You want them to “take” prices. This means they are established by lots of buyers and sellers. If they have to take prices they will have maximum motivation to become as efficient as possible. If things work out, prices will be just a wee bit over marginal costs of production.

Michel Accad
Member

Good post. You bring to mind the book by Kirkpatrick Sale titled Human Scale, published in the early 1980’s. http://www.amazon.com/Human-Scale-Kirkpatrick-Sale/dp/1897408064#productDescription_secondary_view_div_1463956280553

Also, if I’m correct, Aristotle also believed there was a optimum size range for a city. Too small and it was not self sufficient. Too large and it became inefficient to govern, for reasons similar to what you list.

marc-davidmunk
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marc-davidmunk

Thanks for the thought Michael. It’s an insightful comment. I actually wrote about human scale in medicine a while back. Check it out:
https://mdmunk.com/2015/05/31/humanizing-the-healthcare-machine-on-not-getting-lost-in-the-warehouse/

Paul @ Pivot ConsultingLLC
Member

Analysis of the economic structure of health care is very uncommon and is useful. In my opinion a more important element than size is the prevalence of near monopoly (oligopoly) health service firms which are insulated from pressures to operate efficiently….and often protected by certificate of need laws….and are further protected by state regulations……..and are further protected by the dominant insurer (in my region it was a non profit with over 60% market share) who goes along for a variety of reasons (as well portrayed in a THCB blog by ex insurance executive Jim Purcell)…and thereby fail to drive health… Read more »

Edgardo Tenreiro
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Edgardo Tenreiro

The most difficult, indeed impossible constraint for size of firm to overcome is its decreasing ability to develop free market prices to guide allocation of scarce resources 8labor, supliese capital) because by definition prices can only be the outcome of free exchange between individual members of a free market. The larger the size of the firm, the hardest it is to use prices for those allocations. This is especially true in healthcare where free market prices are mostly absent. The end result is a miss allocation of scarce resources resulting in cueing, shortages, malivestment, rationing, etc.

marc-davidmunk
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marc-davidmunk

It’s a interesting point. The challenge, of course, is that healthcare is plagued by mysterious and obscured pricing: it’s in no way a free market. If I understand your point about size being a barrier to intelligent pricing, I may push back a bit and suggest that regional dominance seems to be very advantageous to large regional systems. They are In a strong negotiation position with Insurers and not to concerned about being priced affordably. One could potentially make the point that more diffuse (national) companies are in a less favorable position since their big foortprint means that they don’t… Read more »

jjrichar
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jjrichar

Won’t any organization face the same crisis when operating in a stagnant manner. The difference is in the various scope and size of challenges faced. The solution is in the innovations implemented – not your everyday changes, but the real, high flying, disruptive, change the way you think, breath life into your organization, innovations…

marc-davidmunk
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marc-davidmunk

You’re right. The real “M2” inflection point will be when your business model becomes obsolete, We’re already seeing a lot of “new” healthcare companies challenging the way we deliver care.

BobbyGvegas
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Increasing fragmentation, “shards” of healthcare delivery as a function of M&A consolidation growth?

http://regionalextensioncenter.blogspot.com/2015/06/the-us-healthcare-system-in-one-word.html

Keith McCallin
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Keith McCallin

As I am all about the health care product and secondarily about the profits from the product, I am disinclined to dabble too much in this complexity. I was glad, though, to read this very early in the article referenced in BobbyGvegas’s reply: “…our medical industry is not really a “system,” nor is it predominantly about “health care.” It is more aptly described as a patchwork post hoc disease and injury management and remediation enterprise, one that is more or less “systematic” in any true sense only at the clinical level. Beyond that it comprises a confounding perplex of endlessly… Read more »

marc-davidmunk
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marc-davidmunk

Great quote!

Keith McCallin
Member
Keith McCallin

Let me ask: How so, great quote?

BobbyGvegas
Member

The full context, from my original May 2009 post: http://bgladd.blogspot.com/2009/05/us-health-care-policy-morass.html