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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 q0
Quality also variable
• Higher quality shifts up both curves
• New equilibrium can be larger or smaller than q0
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)
AC
AR
MC
MR
q
qN
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-forprofit 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 pi and qi 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(p2)<0 so the  term must be positive. Again because q΄2(p2)<0 this
means MC>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, u2, is not a function of price and costs increase at an
increasing rate with u2. 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