Toward a theory of Nonprofit institutions: An economic theory of a hospital Joseph Newhouse AER 1970

Nonprofit Institutions Up to that point pretty much ignored by economists Nonprofits pretty much irrelevant except for hospital sector –By 1966, $15 billion spent on hospital care –In 1963, employed 1.5 million people (more than many economic sectors) Paper explores how nonprofit institutions affect the allocation of resources

Model of a nonprofit hospital Implications from a simple model Focus on nonprofit status and economic efficiency Simplifying assumption – no third party payment –Ignores an important aspect of hospital industry –Allows model to be applied more generally to other sectors

Managerial Objective Quantity of output –Consistent with laws granting nonprofit status –Consistent with philanthropic notion of health care as a right –Given a downward sloping demand curve, incentive is to keep price low and may involve price discrimination Quality of output –Enhances prestige –Consistent with other goals like attracting physicians and serving society Supported in the hospital trade literature

Maximizing Quantity and Quality Can’t maximize both unconstrained Institution faces a budget constraint; deficit can’t exceed a reasonable amount Indicates a problem of constrained optimization –Maximize some function of quantity and quality subject to a budget constraint –Accreditation requires some minimum threshold of quality

Problems of measurement Quantity seemingly easy, except must account for multiproduct of different types of care (see below) Quality less concrete –Should not be construed as input based (personnel per patient, for example) as doing so ignores input substitution –Consider it to be a vector of characteristics discernable by patients and other customers

Demand and Cost A function of both price and quality –Physicians prefer higher quality, thus attracts a larger medical staff –When two quality vectors have the same cost, we assume that the hospital decision maker chooses that quality vector which maximizes quantity bought at a given price. –The implication is that an increase in quantity demanded at each price which is brought about by an increase in quality can only be accomplished at an increased cost. There is a tradeoff between quantity and quality holding cost constant

More on cost and quality Look only at quality vectors that maximize quantity at any given price –Associates each quality vector with a particular cost –Implication is that cost itself becomes an indicator of quality Without price discrimination implies that price equals average cost –Also assumes no deficit (i.e., negative profit)

More on quantity Hospitals treat many different diseases, each with own needs Simplify by thinking of quantity as “patient days” –Aggregation problem based on diseases treated and needs of society –Thus quantity too is an abstraction

Firm equilibrium For a given quality, say the minimum allowable for accreditation, there is a specific average cost function Given the quality, there is also a demand curve dependent on price To maximize quality, with  =0, AR=AC, firm is at q 0

Quality also variable Higher quality shifts up both curves New equilibrium can be larger or smaller than q 0

Locus of equilibria Bends back as patients desire for quality and willingness to pay for it is satiated Probably not convex Managers maximize U(quantity, quality) subject to this tradeoff

Additional issues Ability to run a deficit – does it change anything? Funding a deficit through fund raising –What is the incentive for fund raising? –How much will the managers devote to fund raising?

Implications for efficiency Get least cost production for the given output –Not globally least cost production –And, for any given quality, a greater output than a profit maximizer with market power (despite what Feldstein says) AR AC MCMR qq qNqN

Other differences For profit will produce a wider variety of quality, i.e., would produce all quality levels that are profitable. Not for profit has a bias towards quality (from the objective function) hence will not produce some quality even if profitable. –Lower quality allows greater quantity, but lowers maximand. –Bias towards “Cadillac only” care –Predicts duplication and redundancy of equipment and services Has become a big issue in the literature: Do for profit hospitals produce lower quality care? –Back in 1965 evidence was yes, based on accreditation, staffing, etc. –More recent evidence much more ambiguous

Social outcome Duplication of equipment and services –Quality goal and prestige of high intensity services –Possible lower cost and fund raising incentives Choice on quality-quantity tradeoff is management optimizing not socially optimizing –Biased by philanthropy (evidence, Rosenman and Li, HCMS, 2002, showed grants increased quality, donations increased quantity at not-for-profit clinics in California) Nonprofit status works as a barrier to entry, since no clear motivation for entry –Only potential write-off for donors, but no incentive for new facilities –Growth of for-profit hospitals has likely improved efficiency in the hospital sector –Actual and potential for-profit entry forces not-for-profit to be more efficient Insurance lowers the price incentive

The Effect of the Nonprofit Motive on Hospital Competitive Behavior Harrison and Lybecker BEP Economic Analysis and Policy 2005

Analysis Post Feldstein Harrison and Lybecker put more emphasis on the role of not-for-profit objective to demonstrate the goals of the not-for-profit have important impacts on market outcome Find competitive behavior and market outcome depends on what the not-for- profit wants to achieve

Changes in the Hospital Marketplace Changes in reimbursement have forced hospitals to change behavior Little cost-plus reimbursement Growth of capitation-based reimbursement Growth of for-profit competition This paper explores how different not-for-profit objectives affect competitive behavior and outcomes for both types of firms.

General construct Objectives of the two types of firms: where p i and q i are the price and quantity, respectively, for firm i, c(i) is the total cost function, and  is weighting a parameter. V is the nonprofit motive.

Model 1: Quantity Quantity depends on the price of each hospital First-order conditions (3) is just MR-MC=0 for the for-profit hospital. The last term in (4) is negative since q΄ 2 (p 2 ) MR. Hence the firm sets price lower to get more quantity (and utility from the increased quantity). Moreover we see and so the more important profit the higher prices are for both hospitals.

Model 2: Charity Nonprofit wants to emphasize nonreimbursed care. Assume the nonreimbursed care, u 2, is not a function of price and costs increase at an increasing rate with u 2. Objectives are and first order conditions are

Model 2: Charity (continued) Some simple math gives us that Both prices and uncompensated care decrease as profits become more important to the not-for-profit firm. Results show the nonprofit setting a higher price for paying customers to cover the nonpaying customers (called “cost shifting”). As the emphasis on charity care decreases (  increases), so will cost shifting and prices become more competitive. Prices fall, total quantity increases, and the number of uninsured served declines.

Model 3: Quality Consumers value quality, and higher quality increases demand. Quality is costly First order conditions

Model 3: Quality (continued) Basic assumptions about convexity and symmetry between firms gives us that The nonprofit motive provides the firm an additional source of marginal benefit; hence it produces a higher quality than the for-profit firm, but also higher prices (to cover the cost) of quality. When profit becomes more important, the nonprofit lowers both price and quality.

Summary of results

Criticism Pretty good paper, interesting results No stunning conclusion Should have had quality in all models, with quantity attracted to quality (both for quantity model and charity model). –With nested models, would have had clearer implications, allowing empirical testing