Is Physicians’ Office Testing Evolving Toward an Oligopoly?

Commercial Lab Consolidation is The Culprit

CEO SUMMARY: One of the most unpopular industries with consumers is the airline industry. At the national level, it is an oligopoly—dominated by seven carriers. But in many cities, it is a monopoly, with one airline flying 80% of the seats in and out of town. Ongoing consolidation of regional commercial labs by the Two Blood Brothers is creating a parallel situation in the lab industry segment serving physicians’ offices. Nationally, that market segment is now an oligopoly. But in many cities, it is already a monopoly, dominated by one national lab company. Consequences of this trend will soon be obvious.

IS THE LABORATORY TESTING INDUSTRY in the United States becoming an oligopoly, a market typically dominated by two or three companies?

Economists familiar with the details of the lab testing industry would increasingly answer “yes”—specifically for the physicians’ office testing segment of the market. This has been the primary source of specimens and revenues for independent commercial laboratories during the last two decades.

But more provocatively, I would posit that, on a city-by-city analysis, it can be argued that the physicians’ office testing segment of the laboratory industry is already a monopoly. Consequences of this duality—oligopoly at the national level, monopoly at the regional level—have yet to play out in the marketplace. Thus, most lab executives and pathologists are not yet alarmed at the negative dynamics that often result from markets characterized by monopolistic and oligopolistic characteristics.

By way of illustration, I believe the American airline industry provides a good example of the duality of a nation- al oligopoly supported by regional monopolies. Most laboratorians have first-hand experience with the consumer-unfriendly service and prices offered by airlines. Over time, similar service and pricing practices can be expected to emerge in the commercial laboratory segment of our industry as this oligopolistic and monopolistic duality becomes more entrenched.

Two-Lab Oligopoly In U.S.

Ongoing consolidation of the commercial laboratory segment of the industry is creating a two-company oligopoly, comprised of Quest Diagnostics Incorporated and Laboratory Corporation of America. During 2002, the two companies will do an estimated $4.3 billion and $2.6 billion, respectively.

But their dominance of the national market becomes evident when looking at the third biggest public lab company that remains. That is Bio-Reference Laboratories, Inc. (BRLI), with projected revenues of $90 million in 2002. LabOne, Inc., at $234 million, shouldn’t be overlooked. However, the lion’s share of its testing volume does not come from physician’s offices, but from life insurance testing.

This year, acquisitions of Unilab, Inc. ($390 million in 2001) and American Medical Laboratories, Inc. (AML–$300 million in 2001) not only made Quest Diagnostics bigger, but removed two of its three largest laboratory competitors from the marketplace. (See TDR, April 22, 2001.) Last week LabCorp announced that it would acquire Dynacare, Inc., with estimated 2002 revenues of $410 million from its lab operations in the United States and Canada. It has been the ongoing acquisitions of independent commercial labs such as these that concentrated testing from physicians’ offices into the hands of just two national laboratory companies.

Customers Pay More

Most laboratorians are familiar with the concept of a business monopoly—dominance of a market by one company. Such dominance allows a company to manipulate supply in order to artificially raise prices. Because customers pay more than they would otherwise, monopolies have long been considered “bad,” thus making them valid targets for government antitrust action. Innovation and service generally suffer because the monopoly company doesn’t have to improve its products and services, since its customers have no alternative choice. (Think “airlines.”)

In our nation’s history, examples of “bad” monopolies were John D. Rockfeller’s Standard Oil Trust and Andrew Carnegie’s United States Steel Trust. At the turn of the century, federal “trustbusters” took decisive action to break up such monopolies.

In so doing, government regulators developed the basic principles of antitrust law which are still in use. One prominent recent example is the government’s antitrust case against Microsoft Corporation. Federal regulators charged that Microsoft Windows has a monopoly share of the market for PC operating systems and that Microsoft has engaged in anticompetitive behavior to protect this monopoly.

But an oligopoly has important differences from a monopoly. Because there are at least two competitors, efforts to truly control supply and artificially raise prices requires, at worst, outright collusion and, at best, careful synchronization between the oligopolists to implement “uncoordinated and unplanned” moves that constrict supply and increase prices.

In the United States today, probably the best example of an oligopoly market is air travel. At the national level, seven airline companies control inter-city air travel in the United States. At this level, their control of the supply of seats between cities, and the prices of those seats, is a “competitive” process that is carefully manipulated.

However, at a regional level, these same airlines become monopolies. This is a result of the hub-and-spoke business model that developed during the 1980s. For example, Northwest Airlines controls more than 80% of the flights going in and out of Detroit’s McCarran Airport, giving it monopoly pricing power in that regional market. In North Carolina, USAir has a similar market share at Charlotte/Douglas International Airport, which was recently judged to have the highest airfares of any airport in the United States.

From this perspective, the oligopolistic business practices of the nation’s seven airlines can offer instructive insights into the business practices of the two blood brothers, Quest Diagnostics and LabCorp.

Monopolies At Local Level

My contention is that laboratory testing offered to physicians’ offices by commercial laboratories is becoming an oligopolistic market at the national level—and is already monopolistic in specific regional markets.

Thus, if the national market for physicians’ office testing segment is becoming a true oligopoly, does this portend a better or worse future for career laboratorians. And how will this dichotomy of oligopolistic/monopolistic characteristics at the national and local level affect the customers served by labs, including physicians, patients and payers?

I pose this question for a good reason. I believe, in particular, that the back-to-back acquisition of Unilab and AML by Quest Diagnostics, assuming that antitrust enforcers approve the Unilab deal, is a sentinel event in the American laboratory services marketplace. That is to say, in calculating market share to determine whether proposed lab mergers and acquisitions would be anti-competitive, regulators are willing to lump all classes of testing into one pot and then calculate the post-merger impact against that pot.

1970s OPEC Oligopoly Yielded to Competition

DURING THE 1970s, OPEC’s oil cartel represented an oligopoly in the crude oil markets. Through overt collusion, member-countries were able to restrict supplies of oil, causing prices to artificially double and triple between 1973 and 1981.

Early in the 1980s, OPEC lost its oligopolistic-derived power to keep oil prices artificially high as non-OPEC countries brought increased supplies of crude oil into the world market. The arrival of new suppliers eroded the oligopoly’s effectiveness and restored a degree of competitive balance.

For the lab industry, the OPEC example demonstrates that having multiple competitors offering lab testing in the same market is one effective way to break an oligopoly. But because healthcare is local, the key is to have multiple lab competitors in a region, each capable of providing comparable lab testing services to physicians’ offices in that region.

Market Share Threshold

Generally, one element that triggers antitrust concerns is whether, post-merger, the combined enterprise will hold more than 30% market share of the area served. As many laboratorians recognize, the combination of Unilab and Quest Diagnostics in California would certainly exceed that threshold by a sizeable factor—if the testing segment served is measured as the share of physicians’ office send-out testing within the Golden State. If it includes all lab testing, including hospital inpatient/out- patient and POL (physician’s office laboratory), then it probably doesn’t.

That is why, if antitrust concerns are not triggered by the Unilab/Quest Diagnostics merger in the California regional market, it will be a sign that antitrust concerns will apparently not be triggered by the continued acquisition of local independent commercial lab companies by the Two Blood Brothers. That implies further consolidation of the dwindling number of viable independent lab companies in the United States that are organized to primarily serve the send-out testing needs of physicians’ offices.

Are hospital laboratory testing outreach programs a viable and competitive factor in this analysis? That depends. In certain cities, one can find flourishing and viable hospital lab testing outreach programs. However, across the nation, there is a depressingly low number of successful hospital outreach testing programs operated by the nation’s 4,800 hospitals and the 600+ integrated delivery networks.

In fact, in the nation’s biggest cities, such as New York, Los Angeles, and San Francisco, there are less than a handful of hospital outreach programs. Most of these serve “captive” business—physicians’ offices owned or managed by the hospital or health system itself. In those cities, lab outreach programs which are viable competitors against the Two Blood Brothers are difficult to find.

In contrast, Detroit, Seattle, and several large Florida cities have highly-competitive lab testing markets. Hospital lab outreach programs are every bit as competitive as the national labs in fighting for lab testing business that originates from physicians’ offices. They have professional managed care contracting capability and their contracts are usually serviced by a regional laboratory network.

Regional Lab Networks

THE DARK REPORT has written about Detroit’s Joint Venture Hospital Laboratories (JVHL), the Florida Reference Laboratory Network (FRLN), and Washington State’s PacLab Network. Since healthcare is a regional business, it is not surprising that there are some regional successes. However, in many communities across the United States, no hospital lab outreach program exists, leaving those regional markets wide open for the Two Blood Brothers.

It should not be overlooked that the ranks of independent commercial lab companies have been dramatically reduced through mergers and acquisitions. On page 14, a table of the largest, non-hospital-owned independent laboratory companies is presented. Estimates of the annual revenues of these private lab companies show that only a couple exceed $50 million per year in annual revenues.

Defacto, and independent of subsequent federal antitrust policy, there now exists a duality of national oligopoly and regional monopolies in the market segment of send-out lab testing for physicians’ offices.

Impact On Small Labs

Assuming that to be true, it becomes important for those regional lab competitors which are still in business to think strategically about how this oligopolistic/monopolistic duality impacts their business.

After all, oligopolies create interesting and complex challenges, both for the tiny competitors trying to survive on the fringes of the market, and for government regulators. Again, the airline industry is instructive. Any time a start-up airline emerges, the oligopoly of the seven major airlines works in concert to squeeze it before it gets financial traction. They do this by adding flights and seats on the same routes and discounting ticket prices.

A great example of this was in Dallas, hub for American Airlines. In the last 18 months, an upstart airline began flying regional jets from Dallas Love field, non-stop, to major markets. American immediately put comparable jets into Love Field (although it had never scheduled service there since the opening of Dallas-Fort Worth Airport in the 1970s). American matched the upstart’s flights and discount fares. When the discount airline failed, American ceased flying from Dallas Love Field.

No AntiTrust Enforcement

Antitrust behavior by a regional monopolist and a national oligopolist? Certainly most individuals with common sense would think so, but federal antitrust regulators decided not to bring a case. This scenario happens regularly to start-up airline companies and preserves the basic oligopoly for existing airline companies.

Could the collective number of hospital lab outreach programs and small independent commercial labs that still operate in the United States somehow act as a counterweight to many business practices of the Two Blood Brothers?

Probably not. Take managed care contracting, for example. Size gives the Two Blood Brothers clout, both at the national level and the local level. Not surprisingly, in most urban markets, the Two Blood Brothers hold almost all the major managed care contracts.

Clout In MC Contracting

That’s because, on one hand, the national insurance companies like the simplicity of “cutting one contract” with one lab company to serve all their local plans. On the other hand, the two national labs are willing to provide testing at prices which are uneconomically-low for local lab providers serving local markets. Yet, these same managed care companies will com- plain about the poor service levels of the Two Blood Brothers, while denying local labs, with recognizably better infrastructure and service, the opportunity to serve those beneficiaries.

It is important for the laboratory industry to recognize the reality of this national oligopoly and regional monopoly in the physicians’ office testing segment. It has changed the competitive dynamics of the lab industry.

Furthermore, ongoing consolidation of anatomic pathology groups could bring about a similar situation in future years. This would be particularly true if the Two Blood Brothers decided to also begin acquiring local pathology group practices.

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