Designed to Fail: The Medicare Auction for Durable Medical Equipment

By Cramton, Peter; Ellermeyer, Sean et al. | Economic Inquiry, January 2015 | Go to article overview

Designed to Fail: The Medicare Auction for Durable Medical Equipment


Cramton, Peter, Ellermeyer, Sean, Katzman, Brett, Economic Inquiry


I. INTRODUCTION

The Centers for Medicare and Medicaid Services (CMS) conducted auctions in nine major metropolitan areas in November 2009 to establish reimbursement prices and identify suppliers for durable medical equipment. The impetus for these auctions was the 1997 Balanced Budget Act, which specified that competitive bidding be used as a means of "harnessing market forces" to decrease Medicare costs. The prices that resulted from the 2009 auctions took effect on January 1, 2011 and the program is currently being expanded to 90 other cities.

Medicare's program is unique in that it uses a never before seen median-price auction and does not make winning bids binding. (1) This article examines the theoretical properties of the median-price auction and compares those properties to the well-known clearing-price auction under the independent private values (IPV) paradigm. Our focus is on two important efficiencies that should result from a well-designed auction. Allocation efficiency occurs if the auction always leads to outcomes where winners have lower costs than losers. Quantity efficiency occurs if the auction results in a quantity being supplied at the point where supply meets demand.

From a modeling perspective, allocation efficiency results if a unique, symmetric, increasing equilibrium bid function exists since firms with lower costs always submit lower bids in such an equilibrium. If no such equilibrium exists, an auction can generate an inefficient allocation as some high-cost firms may displace low-cost firms as auction winners. Quantity inefficiency can arise from two sources. First, if the auction rules discourage participation, then too few units might be supplied (this is common when a reserve price is used). Second, if the auction sets the price below any winner's cost, then that winner will likely refuse to supply. (2)

When bids are binding, it is well known that the IPV clearing-price auction elicits the dominant strategy of bidding one's cost. With this strategy, full economic efficiency is achieved as the price is set at the point where supply meets demand and the lowest-cost firms provide the goods for a price that is greater than their costs. Alternatively, we show that the median-price auction suffers both allocation and quantity inefficiencies. Allocation inefficiency arises because symmetric equilibrium bid functions do not exist under realistic assumptions. (3) Quantity inefficiency occurs because the median price is set below some winning bidders' costs and thus the median-price auction is not ex post Individually Rational, leading some demand to go unfulfilled.

The median-price inefficiencies will likely result in supply shortages, diminished quality and service to Medicare beneficiaries, and an increase in long-term total cost as Medicare beneficiaries are forced into more expensive options. Identifying and fixing the auction process are crucial as this program represents an important test case in the broader goal of utilizing market methods for the provision of Medicare supplies and services. Failure of this implementation might well discourage the further application of market methods and prevent future cost savings in other areas.

To better understand the implications of our findings, it is important to understand the CMS auction process. CMS began auction pilots as a means of setting reimbursement prices for Durable Medical Equipment in 1999 in Demonstration Projects in Florida and Texas. In those pilots, and still today, firms place individual bids on a multitude of products within specified categories in an attempt to be named a Medicare provider (nonwinning bidders cannot receive Medicare reimbursements). While reimbursement prices on individual products are set using winning bids on those products, winners are actually chosen based on a "composite" bid that is a weighted average of their individual bids on the different products in a category where the weights indicate the relative importance of the product to the category. …

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