Nonprofit Firms

Dr. Katherine Sauer Metropolitan State College of Denver Health Economics

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 nations hospital patients.

Distinctions between for-profit and nonprofit firms: Nonprofits: - nondistribution constraint - no one has a claim on the residual - exempt from corporate income taxes - often sales tax and property tax, too - donations to nonprofits receive favorable tax treatment

I. Why Nonprofit Firms Exist A. market failure Externalities: - free markets underproduce goods/services with external benefits Public Goods: - non-excludable and non-rival - free rider problem

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. $

Marginal Tax

D(A)

D(B)

D(C)

D(D)

D(E)

QA

QB QC QD Quantity of the Public Good

QE

If the government opts for level QA of the good: - 4 voters would have preferred more - 1 voter is happy If the government opts for level QB of the good: - 3 voters would have preferred more - 1 voter would have preferred less - 1 voter is happy If the government opts for level QC of the good: - 2 voters would have preferred more - 2 voters would have preferred less - 1 voter is happy

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 (esp. 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 q - higher quality means a higher demand curve

There is an average cost curve corresponding to each level of quality. - higher quality means higher costs The hospitals budget constraint requires that the hospital produce the level of output where AR = AC.

AC(q3)

AC(q2)

AC(q1)

D(q1) Q1 Q2 Q3

D(q2)

D(q3)

Quantity

For each level of quality, the firm chooses the quantity where AR=AC. If we plot each quality-quantity point, we can see the Quality-Quantity Frontier.
quality

Quality

The tangency between the QQF and the indifference curve yields the optimal combination of quality and quantity for the firm.

quality

U (firm prefers quality)

U (firm prefers quantity)

Quantity

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 physicians cooperative (Pauly and Redisch) This view focuses on the full 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

From the physicians standpoint, M* is the optimal number. From the hospitals standpoint, Mo is Physician the optimal number. income
$

Supply of physicians

Net average revenue

M*

Mo

Number of physicians

D. Comparison of Q-Q model and Physicians Coop. model Hospital Residual (HR) = R(K, L, Mo) - wL - rK +D +G R(.) is all revenues D is donations G is government subsidies

quality

Optimal for a utility maximizing firm U

HR=3 HR=2 HR=1

HRmax Optimal for a Physician Cooperative HR=0 Quantity

E. The Evidence Sloan and colleagues (1998) conclude that there is not a difference. They base their conclusion on studies of quality, cost, and efficiency of hospitals by ownership type. Ballou (2008) finds public hospitals are first to serve areas of poverty.

McClellan and Staiger (1999) find higher mortality rates for the elderly in for-profit hospitals overall, but the small difference on average masked substantial variation with a number of markets showing quality superiority in the for-profit hospitals. Grabowski and Hirth (2003) find that competition from nonprofits tends to provide spillover effects so as to improve the quality of the forprofits .

Norton and Staiger (1994) found that hospitals in the same market area tend to serve the same number of uninsured. Ballou and Weisbrod (2003) find substantial differences among religious, secular nonprofit, and government hospitals in patterns of CEO compensation. Brickley and van Horn (2002) find for a large sample of nonprofit hospitals that compensation incentives for CEOs are significantly related to financial performance.

Hansmann et al. (2002) found the for-profit to be quicker in adjusting to market demand changes. Chakvarty et al. (2005) find the for-profits to be more nimble in adjusting to new economic conditions.

F. The Hospital as Two Firms (Harris) Harris proposes that the hospitals 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. expect that hospital preferences for new technology will be driven by the physician demanders - quality enhancing 2. any hospital regulation aimed at the trustees or administration may have little effect 3. re-organizing hospitals along product lines may make them more efficient - ex: cardiology department

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

Wealth-Benefits Frontier Profit maximizing firms will try to achieve the highest utility that the WB frontier allows.
Uprofit

Non-pecuniary benefits

wealth

Nonprofits often have limits (L) on the level of wealth.

Uprofit

U non-profit

Non-pecuniary benefits

wealth

Even if firms have similar preferences between wealth and non-pecuniary benefits, the nonprofit will choose a higher level of non-pecuniary benefits.
Uprofit

U non-profit

Non-pecuniary benefits

B. Evidence Nonfrontier studies (matched hospitals pair-wise or compared selected groups of hospitals) usually found little, if any, cost efficiency differences between the nonprofits and the for-profits. Kessler and McClellan (2001) find the for-profit hospitals could treat elderly heart attack patients at somewhat less expense (2.4 percent less) without reduction in quality of care.

Wilson and Jadlow (1982) compared nuclear medicine services in nonprofit and for-profit hospitals and found for-profits more efficient. Ozcan et al. (1992) used DEA and found small differences Burgess and Wilson (1998) conclude that no significant difference in efficiency can be found between nonprofit and for-profit hospitals.

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 profitmotivated 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 physicians 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?