Katie Sauer Health Economics

Nonprofit Firms Chapter 13 Overview: Overview: I. Why Nonprofit Firms Exist II. Models of Nonprofit Hospital Behavior III. Efficiency of Nonprofit vs For Profit Firms ____________________________________________________________________ Nonprofit firms account for only 5 percent of GDP, but they make up a significant portion of the health care sector. The 60 percent of community hospitals that are nonprofit provide nearly 70 percent of the beds and treat a similar proportion of the nation¶s hospital patients. Three distinctions between for-profit and nonprofit firms: Nonprofits: 1. 2. 3. I. Why Nonprofit Firms Exist A. market failure Externalities:

Public Goods:

B. Weisbrod Model (nonprofits arise because government fails to provide the level of the good desired by the people) Suppose there are 5 voters (A, B, C, D, and E) with different marginal benefits associated with a particular public good. The government must choose how much of the public good to provide.

All voters will pay the same marginal tax for the provision of the good. Given the same marginal tax, but different marginal benefits, each voter will have a different optimal level of the public good. Indicate each voters preferred quantity on the graph (label them QA, QB, etc).

If the government opts for level QA of the good, how do the voters feel?

If the government opts for level QB of the good, how do the voters feel?

If the government opts for level QC of the good, how do the voters feel?

The preferences of the median voter will prevail. Half the voters will feel that the good is underprovided. - establish nonprofit firms to provide the good The Weisbrod Analysis applies to any goods/services that have external benefits to the community. C. Contract Failure (Hansmann) Nonprofits arise in situations where it is hard to verify that the contract has been fulfilled. (especially when quality is hard to observe). - nursing homes often have contract failure - physicians help abate contract failure in hospitals

II. Models of nonprofit hospital behavior A. Quality-Quantity Theory (Newhouse) Think of the hospital as a utility maximizer. - max the utility of decision makers - board of trustees - administrator/CEO - physician staff The hospital has preferences over quality and quantity. - quantity is # of cases (treat as one type) - assume one measure of quality The hospital has a budget constraint. - must pay its bills (no negative net revenue) - nondistribution constraint (no positive net revenue) Let all the revenue sources be summarized in the average revenue curve (demand curve). - depends on level of quality ³q´ - higher quality means a higher demand curve There is an average cost curve corresponding to each level of quality (q). - higher quality means higher costs The hospital¶s budget constraint requires that the hospital produce the level of output where AR = AC. For each level of quality (q1, q2, q3), indicate the firm¶s quantity on the graph below (label them Q1, Q2, Q3).

If we plot each quality-quantity point, we can see the Quality-Quantity Frontier.

The tangency between the QQF and the indifference curve yields the optimal combination of quality and quantity for the firm. On the graph above, draw two indifference curves: One showing the firm has a strong preference for quality, one showing a strong preference for quality. B. The Profit-Deviating Nonprofit Hospital (Lakdawalla and Philipson ) This model views a nonprofit as a mix of altruism and profit motives. This model explores the entry and exit responses of nonprofits to changes in market conditions and government regulation. A nonprofit has an advantage over pure for-profit firms because it can receive donations. The operating constraint of for-profit firms: profits must be > zero The operating constraint of nonprofit firms: profits + donations must be > zero C. The hospital as a physician¶s cooperative (Pauly and Redisch) This view focuses on the ³full price´ of the hospital care. - hospital charges - physician charges The hospital maximizes pecuniary gains for the decision makers. Physicians run the hospital to maximize their incomes. The hospital maximizes net revenues (NR) per physician (M): NR /M NR = all revenues - payments for other labor - payments for capital

On the graph, illustrate the optimal number of physicians from the physicians¶ point of view. On the graph, illustrate the optimal number of physicians from the hospital¶s point of view.

D. Comparison of Q-Q model and Physician¶s Coop. model Hospital Residual (HR) = R(K, L, Mo) - wL - rK +D +G R(.) is all revenues D is donations G is government subsidies On the graph, illustrate the optimal for a utility maximizing firm. On the graph, illustrate the optimal for a physician cooperative.

E. The Evidence Sloan and colleagues (1998)

Ballou (2008)

McClellan and Staiger (1999)

Grabowski and Hirth (2003)

Norton and Staiger (1994)

Ballou and Weisbrod (2003)

Brickley and van Horn (2002)

Hansmann et al. (2002)

Chakvarty et al. (2005)

Overall summary of above evidence:

F. The Hospital as Two Firms (Harris) Harris proposes that the hospital¶s internal organization is really two separate firms interacting in a complex way. -conflict within the organization - trustee/admin = supply inputs - physician staff = demanders The provision of health care requires a complicated, uncertain sequence of events. - repeated marginal decisions about life and death - non-price related decision rules Implications: 1.



III. Efficiency of nonprofit firms vs for profit firms A. Property Rights Theory An essential economic problem comes about because of the non-distribution constraint. - non-pecuniary benefits become more important Employees in for-profit and nonprofit firms both face a tradeoff between monetary wealth and non-pecuniary benefits. Wealth-Benefits Frontier Profit maximizing firms will try to achieve the highest utility that the WB frontier allows.

Nonprofits often have limits (L) on the level of wealth. Even if firms have similar preferences between wealth and non-pecuniary benefits, the nonprofit will choose a higher level of non-pecuniary benefits. Illustrate this on the graph above. B. Evidence Nonfrontier studies

Kessler and McClellan (2001)

Wilson and Jadlow (1982)

Ozcan et al. (1992)

Burgess and Wilson (1998) ___________________________________________________________________ Concluding Thoughts: Nonprofit firms exist in health care for two possible reasons: provide public goods that are neglected by the private markets and the government reduce or eliminate a contract failure that arises because consumers may not trust the profit-motivated firm Three analytical models of nonprofit hospital behavior: The Newhouse hospital model is motivated by the desire to provide service to the community. The Lakdawalla-Philipson model exploits a middle ground to explain the entry and exit behaviors of nonprofits. The Pauly-Redisch hospital model is really under the physicians¶ control, who use it to maximize the average physician¶s income. The data from recent efficiency studies offer little support regarding hospitals, which have shown little, if any, difference between the ownership types. ____________________________________________________________________ Discussion Questions: 1. If the delivery and quality of health care could be cheaply and accurately monitored by an agency, would there be any contract failure in health care remaining? Would there be any need for nonprofits?

2. Under which of the models of hospital behavior does the tax-exempt status of nonprofit hospitals make the most sense? The least sense?

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