It’s easy to forget the humble beginnings of America’s health maintenance organizations (HMOs). Conceived as an experiment in providing care to a small number of members for a set monthly fee, they are now among the most potent forces in US healthcare. One in five Americans belongs to an HMO. Compound annual growth has averaged 12 percent during the past decade. And the industry has spawned several profitable publicly traded companies.

What accounts for this remarkable success? The simple story is that HMOs offered the right product at the right time. Employers were looking for ways to contain the escalating cost of insuring their employees. HMOs were offering comprehensive coverage for a fixed fee—often more than 30 percent below indemnity prices. They soon found they could use their growing patient flows to squeeze healthcare providers (chiefly hospitals and physicians) on costs, winning savings that they were able to pass on to customers or keep for themselves.

Healthcare markets across the United States have followed a consistent pattern. At first, providers do little or nothing as HMOs begin gaining share. As penetration increases, they enter a price war to preserve share—and...