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Institute of Medicine (US) Committee on Implications of For-Profit Enterprise in Health Care; Gray BH, editor. For-Profit Enterprise in Health Care. Washington (DC): National Academies Press (US); 1986.

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For-Profit Enterprise in Health Care.

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1Profits and Health Care: An Introduction to the Issues

Few changes in the organization of health care in the United States have stimulated more interest and alarm than the rise of a new form of entrepreneurism—investor-owned, for-profit organizations that provide health services as a business.1 Although proprietary health care organizations are not new, publicly traded health care companies that own multiple facilities have appeared only in the past 20 years. With their rapid growth and diversification they have become increasingly visible and influential. In many ways they represent a challenge to established interests, practices, values, and ideals.

The revenues of businesses that provide health services for profit have been estimated at 20 to 25 percent of the nation's expenditures on personal health services (Relman, 1980), which would amount to $70 to $90 billion dollars today. Investor-owned health service businesses range from large companies (such as Hospital Corporation of America, Beverly Enterprises, and Humana, Inc.) that own or operate hundreds of hospitals, nursing homes, and other facilities to independent institutions owned by local investors. In mid-1985 the stock of 34 investor-owned companies that provide health care was publicly traded (Modern Healthcare, 1985:173). Some of these companies concentrate on a particular type of facility or service, such as hospitals, nursing homes, psychiatric hospitals, health maintenance organizations (HMOs), alcoholism and drug abuse treatment, rehabilitation, home health care, urgent care, or medical offices. Others are diversified into a variety of health care and related services. In addition, several large companies whose primary lines of business are not in the delivery of health services have established or acquired health services subsidiaries.2 Many other proprietary or for-profit health care organizations are not publicly traded. Some of these are subsidiaries of not-for-profit hospitals and hospital chains; others are owned by local investors, many of whom, anecdotes suggest, are physicians. (Growth trends among health care organizations are examined in detail in Chapter 2.)

Although ours is a predominantly capitalistic society, there has long been concern about the possible adverse or pernicious effects of profit motivations in health care (Veatch, 1983; Steinwald and Neuhauser, 1970:830-834; see also Shaw, 1911). Conflicting opinions about for-profit health care mirror common views of the profit motive and market-driven behavior. Thus, various positive benefits of the investor-owned model are often cited: that it provides new impetus for innovation, more responsiveness to the needs and desires of patients and physicians, sounder approaches to management, and an important source of new capital for health services. On the other hand, some observers see for-profit health care organizations as antithetical to the traditional mission and values of health care institutions, as a threat to the autonomy and ideals of the medical profession, and as destructive of implicit social arrangements by which medical care has often been provided to people who could not pay for it and by which teaching and research have been indirectly supported. Others are skeptical about these fears or are dubious about the extent to which health care institutions and professionals actually embody the ideals that they enunciate. Some view physicians as a type of businessperson and see nothing wrong in making money from health care. Others identify the problems not in the behavior of providers but in terms of (1) inflationary economic incentives in the way that health care is paid for (a factor that has been undergoing rapid change), (2) the lack of competition among health care providers (also rapidly changing), and (3) failures of public policy, particularly regarding people who lack insurance coverage and who are not eligible for public programs. Thus, the debate about for-profit health care touches upon most issues of health care policy in the United States.

Questions Examined in this Report

In preparing this report the committee focused on the following major questions in seeking to illuminate for-profit health care and the issues associated with it:

1.

How extensive is the trend toward for-profit health care and what factors underlie it?

2.

What are the implications of the growth of investor ownership of health care institutions on the costs and quality of health care, on access to care for those who are unable to pay, and on the funding and conduct of medical education and research? In other words, does the for-profit form's supposed greater responsiveness to economic incentives lead to systematic differences from not-for-profit and governmental institutions in the kinds of patients that are served, the kinds of services that are offered to communities, the efficiency3 with which services are provided, the prices that are charged for services, or the quality of services?

3.

Are changes taking place in physicians' relationships with health care institutions that will alter the traditional fiduciary aspects of the profession and the public trust that has been vested in it?

4.

What are the public policy implications of the committee's analysis of these questions?

The Diverse Ownership of American Health Care Organizations

In our highly decentralized and pluralistic health care system, health care is provided by a mixture of for-profit, secular and religious not-for-profit, and public institutions, some of which are independent and some of which are a part of multi-institutional systems. Different types of ownership typify different types of institutions. Nursing homes have long been predominantly proprietary, for-profit institutions. Acute care general hospitals are typically private, not-for-profit institutions. Among certain specialized types of institutions (e.g., psychiatric and tuberculosis hospitals) governmental ownership was typical, because of the public health and safety concerns that led to their creation. (Changing patterns of ownership and control of different types of institutions are described in Chapter 2.)

Increasingly, institutions of different ownership types and with ostensibly different rationales and missions now operate side by side. In a sharpening competitive environment, some observers see decreasing ownership-related differences in institutional behavior. Still, certain values, beliefs, and labels remain associated with governmental (last resort, inefficient but equitable), not-for-profit (voluntarism, charity, community), and for-profit (efficient, innovative but self-interested) organizations. However much these may be historical myths, they are very powerful ideas in American society (Stevens, 1982). Their reality transcends their history, although they have roots in history as well as in economic theory.

Deeply felt issues have long surrounded questions of ownership in health care and the proper role of government. There have always been advocates of a publicly controlled health care system, who argue that health care is a basic service or public good that should be provided for by government. Almost all industrialized countries have adopted some such approach. In the United States, however, a mixture of private and public insurance and control has always prevailed, with private ownership predominating. This pattern is rooted in history, the development and subsequent importance of local institutions, the generally high level of public satisfaction with a mostly private health care system, American distrust of big government, and the widespread perception that public institutions produce ''bureaucratic arrogance, high costs, and inefficiency" (Drucker, 1984:21). Public institutions have frequently, if not always willingly, been cast in the role of provider of last resort, even though many of these institutions have been aggressively seeking a broader clientele.

Today, most governmental spending on health care is for payments to private physicians (and other health professionals) and private institutions (both for-profit and not-for-profit) for services rendered to individual beneficiaries of public programs and not for appropriations to governmental institutions. As a result of history and past public policy, then, the debate about for-profit health care is not about private versus public control of medical institutions but is instead largely about the differences between (and relative virtues of) two types of private institutions-not-for-profit and for-profit.

The For-Profit/Not-For-Profit Distinction

Among general hospitals the not-for-profit, voluntary institutions have long been predominant. The first hospitals served exclusively as charitable or public organizations for the sick and destitute who had nowhere else to go, but today's not-for-profit hospitals have diverse origins in the missions of both religious and secular charitable organizations and the actions of civic-minded citizens seeking to improve their communities.

For-profit (or investor-owned) institutions have been distinguished from not-for-profit institutions on a variety of aspects, many of which are summarized in Table 1.1. These distinctions suggest why differences in institutional behavior are often assumed to exist and whence are derived the hypotheses in the empirical literature (examined later in this report) on the comparative behavior of for-profit and not-for-profit institutions.

TABLE 1.1. Common Distinctions Between For-profit and Not-for-profit Organizations.

TABLE 1.1

Common Distinctions Between For-profit and Not-for-profit Organizations.

Theory for predicting the behavior of not-for-profit institutions is still in a relatively undeveloped state (Weisbrod, 1981; Hansmann, 1980; Easley and O'Hara, 1983), and divergent theories exist about for-profit organizations (see, for example, Williamson, 1981). Economic theories of for-profit and not-for-profit organizations are summarized in an appendix to this chapter. It should be noted, however, that two contradictory beliefs are frequently heard regarding the comparative behavior of for-profit and not-for-profit health care organizations.

One belief is that the economic incentives faced by those who control the organization are so different in for-profit and not-for-profit institutions that the two types of organizations can be expected to behave quite differently from each other. (People who hold this view differ in which type of organization they see as appropriate in health care.) The other belief is that for-profit and not-for-profit organizations are not necessarily very different from each other. Some economic theorists suggest that many not-for-profit hospitals, particularly the community (as opposed to the university) variety, are through one device or another, essentially run to further the economic interests of physicians (Pauly, 1980; Pauly and Redisch,, 1973; Clark, 1980). As Sloan (forthcoming) notes, "to the extent this is so, the voluntary hospital is only a profit-seeking hospital in disguise, and there is no reason to expect it to behave much differently." However, it is not necessary to accept this hospital-as-physician-cartel view to argue that for-profit and not-for-profit organizations that exist in a similar economic and competitive environment will behave similarly in many respects. Many observers point to examples to support the argument that there is little, if anything, that "the for-profits" are doing that cannot also be found among "the not-for-profits." The argument then turns to whether the behavior in question is more common in one or the other sector and to whether not-for-profit organizations are being forced by competition to behave in ways that are in some sense aberrant to the not-for-profit form.

Much empirical evidence on the comparative behavior of for-profit and not-for-profit health care organizations is examined in this report. This chapter examines historical and organizational differences, as well as some factors that may attenuate the different behavioral tendencies of for-profit and not-for-profit health care organizations.

Investor Ownership

The purpose of investor-owned corporations in general is to make money for investors—to preserve and enhance the economic value of the invested capital. This purpose is built into the corporate governance structure. An investor-owned corporation is ultimately governed by its owners (stockholders), who elect the board of directors. The stockholders accepted the risk of purchasing stock in the expectation of gaining an economic return that is larger than would be available through nonequity forms of investment, such as the purchase of bonds. Profits for stockholders come in the form of dividends and appreciation in the value of their investment. Large blocks of stock are owned by institutional investors (mutual funds, financial institutions, pension funds, labor union trust funds) and are thus controlled by individuals who themselves are accountable for their investment decisions, who closely monitor companies' performance, and whose decisions to sell can affect a stock's price (transactions involving 10,000 or more shares are not unusual institutional trades) (Blumstein, 1984).

The board of directors makes broad policy decisions and employs the top management (the officers) of the corporation.4 In health care and other fields, top officials of the corporation not only serve on the board but also have significant holdings of the corporation's stock. The dividends that they and other stockholders receive and the value of their holdings depend on the corporation's earnings. In addition to the accountability and incentives that investor ownership present for management, other profitability incentives also exist. First, many companies explicitly tie large incentives for management to the company's economic performance; for top executives, such incentives (in cash, stock, or other forms) often run into the hundreds of thousands or even many millions of dollars.5 Second, and more important, for a publicly traded company the value of its stock and, hence, its ability to raise additional capital is a function of the company's past and projected earnings (see Chapter 3). Thus, it is understandable that companies devote careful attention to the Wall Street analysts whose recommendations influence the market's valuation of their stock (Siegrist, 1983).

None of these characteristics determine what strategies a company might pursue (whether it is interested in short-term profits or long-term growth; whether it wants specialization or diversification; whether and how much it centralizes decision making; whether it seeks to base its reputation on unsurpassed quality or on providing good value for the money, etc.). Nor do they determine how a company defines its social responsibilities; for example, many companies, including some health care corporations, have established departments or foundations to make charitable contributions. This is not behavior that bespeaks single-minded commitment to short-term profit maximization, although in the long term it can be presumed that hard economic criteria ordinarily guide American business behavior.

Since Adam Smith, the fulcrum of economic theory about for-profit organizations is the objective of profit maximization. More recent alternative theories of the corporation recognize the role of managers (as distinct from owners), whose primary objective may pertain to status or security, for example, rather than maximizing profits. Similar goals may animate management in not-for-profit organizations. Some theorists suggest that whereas the status of management in for-profit organizations rests substantially on profitability, managerial prestige in the not-for-profit organization rests much more on the size and reputation (e. g., for quality) of the institution.

Not-For-Profit Organizations

Although state laws under which not-for-profit organizations are incorporated vary in their requirements, a not-for-profit corporation is barred by its charter from "distributing its net earnings, if any, to individuals who exercise control over it, such as members, officers, directors, or trustees" (Hansmann, 1980:838).6 This key characteristic is referred to as the "nondistribution requirement," and a variety of managerial and organizational behaviors are thought to follow from it. On the one hand it is seen as providing some assurance of quality and proper performance to consumers who lack the knowledge or information with which to monitor performance adequately. Thus, Hansmann suggests that not-for-profit organizations are a response to contract failure in circumstances that make contracts between consumers and suppliers impractical to write or too costly to monitor. On the other hand the nondistribution constraint is sometimes alleged to cause indifference to consumers and inattention to efficiency, except where resources are tight.

Despite their label, not-for-profit organizations are not prohibited from earning profits (usually caned "surpluses") from their operations; however, these surpluses generally must be devoted to the further financing and production of the services that the organization was formed to provide. There is debate about whether not-for-profit organizations should be restricted to certain traditional charitable purposes (Hansmann, 1980:839; U.S. Small Business Administration, 1983), but the provision of medical care and the conduct of teaching and research, are clearly qualifying purposes.

Related to, but distinct from, the question of not-for-profit status is the availability to not-for-profit organizations, under certain conditions, of exemptions from federal income taxes (under Section 501(c)(3) of the Internal Revenue Code) and from state and local income, property, and sales taxes. Since many not-for-profit organizations own valuable property and earn healthy surpluses, these are significant advantages.

Not-for-profit organizations can be distinguished from each other by two attributes: their control and their financing. "Membership" or "mutual" not-for-profit organizations (such as country clubs or professional associations) are controlled by the organization's patrons or members, who elect the board of directors (Hansmann, 1980:841; Horty and Mulholland, 1983:20). "Non-membership" not-for-profit organizations are controlled by a self-perpetuating board, which is a common pattern among not-for-profit nursing homes and hospitals. On the financing side, not-for-profit organizations can be distinguished according to the degree to which they derive their income from donations or from charges for the services they provide.7 The not-for-profit organization that derives its income primarily from charges for services is largely a creature of the post-World War II period, when the growth of private and public third-party payment programs effectively monetized health care (Ginzberg, 1984).

Many statements have been made over the years about the goals and ideals that not-for-profit health care organizations (and their boards) should pursue—they should be responsive to community health care needs, they should be responsible and efficient custodians of the resources entrusted to them, they should provide service to all who need it without regard to ability to pay, and so forth. Over the years certain criticisms have been recurrent—that administrators and trustees (1) are insufficiently critical of physicians' requests for new equipment and facilities, (2) are motivated not by trying to meet all of the community's medical needs but by a growth imperative stemming from the desire for prestige and power, and (3) are not interested enough in sound management, in part because the nondistribution requirement prevents their sharing any surplus that might be created and because association with independent hospitals tends to tie administrators to a particular community rather than to put them on the career ladder of a larger organization.

Trustees have tended to come from the economic and professional elites of the community, not from among people for whom inability to pay was commonplace. These factors are alleged by some to have led trustees and ambitious administrators to concentrate surpluses on salaries and staff (thereby making not-for-profit organizations inherently inefficient, according to a common criticism) and on new services, facilities, and equipment, regardless of whether an objective community need existed. Indeed, some observers have seen not-for-profit hospitals' tendency toward excessive investment in unneeded facilities and equipment as jeopardizing their economic soundness (Vladeck, 1976). The purpose here is not to assess the validity of old criticisms or the extent to which not-for-profit organizations conform to some set of ideals, but only to emphasize the lack of agreement in the field about their motivating principle.

Problems with the For-Profit/Not-For-Profit Distinction

The clarity of the distinction between for-profit and not-for-profit health care providers is muddied by several factors. First, differences in sources of capital have sharply diminished, as is discussed in Chapter 3. Historically, charitable donations and governmental grants were the major sources of capital and important sources of revenue for not-for-profit hospitals. However, the revenues of not-for-profit hospitals have increasingly come from billing for the services they provide and now, with the rising capital intensity of health care, the relative decline of charity, the rapid inflation in the 1960s and 1970s, and the end of the government's Hill-Burton program, leave capital requirements to be met mostly from retained earnings and debt. These also are the primary sources of capital for for-profit institutions.

Second, although investor-equity capital puts constant economic pressure on the managers of investor-owned enterprises, economic pressure is not peculiar to the for-profit sector. Thus, it is not surprising that many observers see similarities in the behavior of for-profit and not-for-profit hospitals. Both types have been forming multi-institutional arrangements in the hopes of gaining economies of scale and greater access to capital, aggressively marketing and vertically integrating (e.g., through the acquisition of primary care centers and long-term-care facilities) to increase control of patient flow and market share, and paying more heed to the vigor of the bottom line by heightening cost control and limiting uncompensated care.

Third, not-for-profit organizations can and do make profits (usually termed a "surplus") in the customary accounting sense of the term. Indeed, in 1984 the average total net margin (the percent of revenues retained after expenses) of U.S. hospitals, most of which are not-for-profit, was 6.2 percent (American Hospital Association, 1985). The ability of any organization to survive requires that it generate revenues beyond those necessary to cover operating expenses, not only because of the need for working capital but also because the equipment and renovations needed to keep an institution up-to-date and acceptable to doctors and patients require new infusions of capital.

Fourth, ends and means can displace each other at various levels of any organization. Providing services might be the way that the for-profit health care organization makes money; but for many people in such an organization, providing services becomes the purpose of their work, rather than making money for stockholders. Conversely, within a not-for-profit organization there are officials whose responsibilities are primarily financial and who evaluate organizational options, strategies, and policies primarily in terms of their effect on the organization's bottom line.

Fifth, it is simplistic to conclude that because the for-profit company's purpose is to make profits it will strive for short-term profit maximization at every opportunity, if only because of the likely impact on its public image and the importance of that image for its long-term profitability. The extent to which companies provide uncompensated care to patients who are unable to pay, engage in educational and training activities, and devote resources to research and development are all empirical questions, not matters of definition.

Sixth, various forms of not-for-profit/for-profit hybrids have become widespread among hospitals in recent years. These include (a) for-profit subsidiaries set up for a variety of purposes by many not-for-profit institutions; (b) not-for-profit (and public) hospitals that have entered into contracts with for-profit companies for management of the entire institution or for providing specific services (e.g., coverage of the emergency room); (c) joint ventures for a wide variety of purposes between not-for-profit hospitals and members of their staffs, between not-for-profit hospitals and for-profit hospitals (or hospital companies), and between for-profit multihospital systems and not-for-profit multihospital systems; and (d) for-profit alliances (such as Voluntary Hospitals of America, American Healthcare Systems, SunHealth) that are owned by, and provide services to, not-for-profit hospitals or multihospital systems. Such hybridization is described in more detail in Chapter 2. Although the amount of hybridization that has come from the other direction is smaller, some for-profit health care organizations have set up foundations that receive and dispense donated monies. Some of these are set up at the local hospital level to receive charitable contributions, particularly from former patients and their families, that are used for such purposes as building a chapel. Investor-owned companies make charitable contributions (e.g., to colleges and universities, art galleries, and other cultural centers) that are typical of the giving programs of other corporations in the United States, and some health care companies have set up foundations for this purpose with substantial gifts of company stock.

Seventh, the requirements for incorporation as a not-for-profit organization are not stringent in many states. In some states a not-for-profit organization can be established "for any lawful purpose" (Horty and Mulholland, 1983). Among certain types of health care providers, such as home health care agencies, owner-operated, not-for-profit organizations are sometimes difficult to distinguish from their for-profit competitors by any criterion other than the former's exemptions from paying corporate taxes.

Eighth, even the not-for-profit's prohibition against distribution of profits has begun to break down as legal ways are discovered whereby not-for-profit organizations can develop incentive compensation arrangements for management and staff that are essentially profit-sharing plans.

Ninth, access to tax-exempt financing is not the sole province of not-for-profit organizations. Under certain circumstances for-profit companies can gain access to tax-exempt debt financing through industrial revenue bonds and through construction and lease-back arrangements.

Finally, it must be recognized that a variety of other factors can affect the behavior of health care organizations and may attenuate ownership-related differences. Strong values are associated with health care, and certain types of institutional behavior can result in strong negative publicity. Health care institutions all operate within a web of statutory and case law and regulations. These laws and regulations determine whether an institution may open, who may practice medicine, eligibility for governmental programs, governance and medical staff responsibilities, liability for negligence, restrictions on the "corporate practice of medicine," and so forth. The larger economic or marketplace environment also places constraints on institutions and affects their ability to do many things, such as raise prices, cross-subsidize care of uninsured patients, or offer specialized services. Also, a major constraint on many institutions is that their ability to attract patients depends on physicians, who have traditionally been relatively independent of the institution and whose first ethical responsibility is to the patient. This factor is discussed in more detail later in this chapter.

Notwithstanding the many factors that can be cited that blur the borders between for-profit (or investor-owned) and not-for-profit health care organizations, most distinctions in Table 1.1 between institutions owned by an investor-owned company and institutions owned by not-for-profit corporations still hold. The question that remains is whether the type of ownership and control of institutions makes a difference. That question is the subject of much of this report.

The Value Question

Although a large portion of this report is devoted to comparisons and contrasts in the behavior of institutions with different types of ownership, the argument about for-profit health care is as much about values as it is about facts. A deep division about values underlies and inevitably affects all discussions of the behavior and implications of the growth of investor-owned health care.8

The depth of feeling about this topic is only partly a reaction to perceived threats to the institutions that people believe in or attacks on the legitimacy of enterprises to which people have devoted their energies. Another cause has to do with value conflicts and beliefs about the nature of health care itself, the place of health care in society, the role of health care providers; the relationship between professionals and patients, and about whether it is legitimate to make profits from the misfortunes of the ill.

The value questions about health care can be discussed under two broad categories—health care as an economic good and health care as a social good. One view emphasizes the attributes that health care shares with other goods and services that are offered and purchased in the marketplace. The second identifies and emphasizes the characteristics that distinguish medical care from commercial services. In the next sections these two views, which emphasize different aspects of the same set of activities that we know as health care, are described in more detail. They are stated as polar extremes, although most observers probably accept the validity of some aspects of both sets. (An interesting set of contrasting views held by members of the committee can be seen in correspondence between committee members Uwe Reinhardt and Arnold Relman in Part II of this volume.)

Health Care as Economic Good

The view, oversimplified here, that personal health care (in contrast to public health measures) is much like other consumer goods also implies that marketplace forces and the operation-for-profit motive are largely beneficial. Furthermore, because there is evidence that medical institutions and physicians respond to economic incentives (as everyone else does), it seems realistic to view health care in these terms. This view does not deny that government plays an essential role in making these market forces work. Indeed, because of the cost, unpredictability of individual need, and importance of health care, many adherents of this view believe government should fund care for those who cannot otherwise obtain it. The breadth of coverage of governmental, as well as private, insurance programs determines the extent to which market forces can produce the anticipated beneficial results. Governmental involvement does not deny that other market factors and competitive forces should be allowed to operate, although the form of that involvement determines the extent of the competition. For example, if beneficiaries of governmental programs could receive care only at governmental hospitals, the role of market forces would be minimal.

In this view, competition and market forces (rather than central planning or "command and control regulation") are seen as producing the best outcome for all—a system that is responsive to consumers, in which the producer of inferior services will be punished and the hard test of the bottom line will restrain capital expenditures for equipment and facilities if demand is lacking. Such a system should lead to maximum efficiency in the production of services, except in perverse circumstances where revenues are based on reimbursement for costs, thereby creating incentives to increase expenses rather than to control them. In this view government's roles are (1) to facilitate participation in the market by people whose resources would otherwise preclude their doing so (i.e., to pay for all or part of services for the indigent) and (2) to pay and regulate in ways that will foster competition and, perhaps, appropriate care. Some forms of regulation, including some aspects of professional and institutional self-regulation, are opposed as being antithetical to competition; other forms may be necessary to maintain fair competition.

As with markets generally, the best outcome from this viewpoint is expected if the players, making free and independent choices, all pursue their own interests. The market will shape the configuration of services that are made available. If some payers are willing or able to pay for more amenities or services than are other payers, a multi-tier system will result. Similarly, the market (not "regulators" or "planners") should decide whether institutions should attempt to provide all services to all segments of the community. or should specialize or pursue a particular segment of the market for health services.

In extolling the market, this view emphasizes the purchaser's role (and the incentives created by purchasers) in disciplining or shaping the system. Thus, providers will focus their attention on factors that can be judged by patients (availability, accessibility, amenities, courtesy) and by physicians (because they make so many of the key decisions). As payers become more aggressive, attention will increasingly be focused on factors that payers can monitor (cost, convenience, patterns of care, and quality-related measures of outcomes, such as readmission or mortality rates). Patients (or payers) that uncritically assume that health care providers will subordinate their own interests to the patient's interests are vulnerable to exploitation, no matter what ideals the provider may state. In this view, entrepreneurism and competition are essential and proven elements in our free enterprise system, and the burden of argument lies with those who contend that they are inappropriate in health care.

Health Care as Social Good

A contrasting set of views opposes the idea that health care is properly seen as an economic good that is appropriately bought, sold, and disciplined by competitive forces in a marketplace. This view holds that health professionals and institutions should pursue the goals or ideals of applying biomedical science on behalf of patients and to meet community needs, whether or not it is profitable to do so. Although the proper pursuit of such goals may often produce behavior that the market will reward, the behavior is not so motivated. This view holds that health care should be seen as a "social good," a conception that was more obviously applicable when infectious disease made an individual's misfortune a threat to his or her neighbors (Stevens, 1985) and in an era when many people were dependent either on charity or public facilities (in distinction to public programs) for their medical care.

In this view, health care is a community service to which words such as caring and compassion and charity should apply—words that connote the family and the church, where the functions of caring for the sick once resided. The response to disease and disability should stem not from the fact that a market is created from peoples' misfortunes but from a humane response to their needs. The ideal is that the needs of the sick and unfortunate should be met by persons who, as a philosopher expressed it, are acting out of love rather than out of the expectation of gain (Braybrooke, 1983).

The idea that everyone's interest would ultimately be best served if everyone pursued self-interest is alien to this view, which holds that health professionals and institutions should put patients' interests ahead of self-interest (although it may be "good business" to behave thusly). In this view it is quite appropriate to expect health care institutions and professionals to provide care to patients who are unable to pay. Ideally, perhaps, the funds required for such care should be raised by government through taxes; however, in the absence of such support, the institution's role is to provide needed service and to make up the resulting deficits however it can, including cross-subsidization from paying patients. Prices should be set to enable institutions to remain financially viable, not at whatever level the market might sustain.

The business orientation that is seen as a concomitant of for-profit health care also is regarded as a threat to the very ethos of health care. Among the fears that health care will become a business are that a multi-tier system will become more inescapable and more socially acceptable,9 and that providers will come to feel no shame in refusing to serve those who cannot pay, in declining to offer or provide needed services that cannot generate an acceptable economic return, in setting prices as high as the market will allow and doing whatever is necessary to maximize income, and in aggressively marketing services that may be unrelated to basic health needs but that generate profits (e.g., cosmetic surgery).10 It is thus feared that the move toward for-profit health care will affect the moral or ethical climate of health care.

This view also emphasizes the limitations of competition and market forces, arguing that such forces do not properly adjust for many key elements of health care. These elements include the great knowledge imbalance between providers and recipients of medical services; the inability of the patient to judge much more than superficial aspects of quality; the essential fiduciary role required of the physician; the necessity of third-party payment because of the unpredictability and cost of medical expenses, but which substantially reduces the patient's price sensitivity and attenuates market restraints on prices; the importance of a community-wide perspective on the need for services, particularly of high-cost, low-utilization services such as 24-hour emergency room coverage, burn treatment units, and neonatal intensive care units; the fact that there are people who need care who cannot afford it; and the fact that individuals' needs for care are unpredictable and tend to be inversely related to ability to pay.

Adherents of the "social good" view also frequently point to some perverse effects of the marketplace—its stimulus to provide unnecessary services; its tendency to offer only those services from which, and to serve only those patients from whom, money can be made either directly or indirectly; its eagerness to duplicate services without respect for community "need" if doing so serves competitive advantages;11 its alleged willingness to shade on aspects of quality when detection by customers is unlikely, as can happen in medical care; its emphasis on amenities, which are seen as the equivalent of packaging in other areas of merchandising. Critics see amenities as unrelated to quality in a basic functional sense, but as having the potential to become the basis of competition, thereby drawing the consumer's dollars away from the necessities and tempting the provider to substitute the improvement of amenities for more expensive and genuine improvements in the quality of services.

A source of concern about the rise of investor-owned health facilities is the belief that they behave differently from not-for-profit organizations. As Douglas (1983) writes, "while the nonprofit producer, like its for-profit counterpart, may have the capacity to raise prices and cut quality, it has nowhere the same incentive since those in charge are barred from taking home the profit." (The theoretical conceptions that underlie predictions of different behavior by for-profit and not-for-profit organizations are discussed in more detail in the Appendix at the end of this chapter.)

Although the two views of health care acknowledge the key role of the physician in the operation of the system, the social view emphasizes the fiduciary aspects of that role rather than the physician as entrepreneur or as customer, the object of the hospital's marketing efforts. The physician is seen as the translator of biomedical knowledge into practice, as the patient's agent, as motivated to identify needs and to do what is required, not to identify demand and satisfy it. It is felt that these key aspects of the physician's role can best be pursued in settings where profit is not the primary goal. A largely unexamined sense of compatibility has existed between the ideals of professionalism and the not-for-profit form for health care organizations such as hospitals (Steinwald and Neuhauser, 1970; Majones, 1984). As Starr (1982:23) put the argument,

The contradiction between professionalism and the rule of the market is long-standing and unavoidable. Medicine and other professions have historically distinguished themselves from business and trade by claiming to be above the market and pure commercialism. In justifying the public's trust, professionals have set higher standards of conduct for themselves than the minimal rules governing the marketplace and maintained that they can be judged under those standards by each other, not by laymen.... [The] shift from clients to colleagues in the orientation of work, which professionalism demands, represents a clear departure from the normal role of the market.

In discussions of ideals that run counter to economic incentives, the question inevitably arises of the extent to which the behavior of physicians or health care institutions has actually conformed to ideals of altruism, service, and science (Relman and Reinhardt, 1986). Skeptics point to several facts: the rise in physician fees and income that followed the shift from their depending for income on the means of their patients to their drawing on funds from third-party payers who reimbursed under the "usual, customary, and reasonable" approach (Roe, 1981); widespread and long-standing variations in medical care (Health Affairs, 1984); the tendency of volume of services to increase when they are covered by insurance (Aday et al., 1980); low levels of hospitalization and surgery when fee-for-service incentives are not present (Luff, 1981; Bunker 1970); patterns of acquisition and use of laboratory and diagnostic testing equipment in physicians' offices (Schroeder and Showstack, 1978); widespread physician unwillingness to accept Medicare as full payment for their services (AMA, 1985); and the struggles of legal services attorneys to force not-for-profit hospitals to care for more indigent patients (see Clearinghouse Review , 1969-present). Clearly, the highest ideals of medicine are not always fully realized in any sector of the health care system. Jonsen (1983) has noted that medical practice always involves a tension between altruism and self-interest. Ideals, even if imperfectly realized, may affect where the balance is struck, as may the way care is organized and paid for.

Economic Good Versus Social Good

The contrasting views of health care as economic good and as social good involve a complex mix of values, assumptions, beliefs, and assertions. They underlie debates about many questions of health policy, such as community rating versus experience rating in health insurance and whether bad debts and charity care should be treated as allowable costs under cost-based reimbursement, whether market forces or health planning organizations should shape the configuration of available services, whether hospitals that care for a disproportionate share of the poor should be especially rewarded, and whether hospital rates and revenues should be regulated. These contrasting views certainly underlie the debate about for-profit or corporate trends in health care. Recognition of the value issues may offer clarification when differences of opinion arise; it also may help to temper expectations about the amount of agreement that can be reached in the examination of the ''facts" about a controversial topic.

In health research and policy, relatively little attention has been given to means by which altruism rather than self-interest is stimulated in health professionals. Can incentives be designed to reward providers for pursuing self-interest in a way that also is in the best interests of patients (and that does not waste health care dollars on inefficiency or unnecessary care)? Or is such perfection of incentives an unrealistic goal, making it essential to the ideals of health care that providers respond to values of charity and altruism, as well as to anxiety about peer approval and legal liability? That is still another form of the issue posed by the growth of for-profit health care.

Relationship of Physicians to Health Care Organizations

The framework for the committee's examination of the relationship between physicians and organizations rests on two premises. First, the committee believes that physicians have substantial fiduciary responsibilities toward their patients, meaning that the physician has an ethical and often a legal obligation to act in the patient's best interests. The arrangements between physicians and institutions must be considered in light of the physician's fiduciary responsibilities.

The question of the physician's fiduciary responsibilities inevitably leads to questions of the economic arrangements in medical practice and of the compatibility of professional responsibilities and the not-for-profit organization. This is the subject of Chapter 8. Fears that physicians might exploit the vulnerabilities of patients for pecuniary gain are not new. Indeed, a conflict of interest of sorts is present and manifest in any situation in which the potential provider of a service is asked to define whether it is needed. The problem of conflict of interest becomes more difficult to control when it is not understood by the recipient of services, and when the economic return for providing the advice is relatively small in proportion to the return for providing the service that is recommended.

Conflict of interest is also created when physicians make substantial capital outlays for high-cost technologies; the need to have such an investment pay off must be a motivating force in stimulating the use of these technologies, along with a desire to close the income gap with high-income specialists. Thus, there has long been concern about physicians creating a conflict of interest by establishing organizations (pharmacies, diagnostic centers, hospitals) external to their practice and then making patient-care decisions that can affect the economic well-being of the organization, a concern that can be extended to the doctor's office when tests are ordered using the doctor's own X-ray, laboratory, electrocardiograph, or other equipment. Notwithstanding that multiple conflicts of interest can be identified in health care, proprietary activities involving physicians appear to be increasing and have created special concerns about conflict of interest and its impact on trust in the doctor-patient relationship.

Second, the committee believes that physicians' responsibilities to patients require that they play a role in monitoring and assuring the quality of care in medical organizations to which they refer or admit patients. Although this role frequently has been inadequately realized and although institutions (and their boards and administration) share this responsibility,, the committee has focused on the physician's role in this regard, because of the concern with fiduciary responsibilities and because organizational changes are taking place that could alter significantly the balance of power and influence within medical institutions. Changes that reduce the physician's ability to shift patients to other institutions could have that effect, as could changes that reduce the physician's voice on decision-making bodies. Many current developments—the growth of HMOs, preferred provider arrangements, and joint ventures, not to mention the growing supply of physicians—could reduce physicians' freedom to shift patients away from an institution that the physician finds unsatisfactory. And trends such as the growth of multi-institutional arrangements and the growth of for-profit organizations could alter physicians' roles in institutional management and governance. These issues are examined in Chapter 9.

References

  • Aday, LuAnn, Ronald Anderson, and Gretchen V. Fleming (1980) Health Care in the U.S.: Equitable for Whom? Beverly Hills, Calif.: Sage.
  • American Hospital Association (1985) 1984 Hospital Cost and Utilization Trends. Economic Trends 1(Spring).
  • American Medical Association (1985) Medicare Assignment: Recent Trends and Participation Rates. SMS Report 4(February).
  • Blumstein, Michael (1984) How Institutions Rule the Market. New York Times (November 25) : Section 3.
  • Braybrooke, David (1983) Ethics in the World of Business. Totowa, N.J.: Rowman and Allanheld.
  • Bunker, John (1970) Surgical Manpower: A Comparison of Operations and Surgeons in the United States and in England and Wales. The New England Journal of Medicine 282:135-144. [PubMed: 5409538]
  • Business Week (1985) Executive Pay: Who Made the Most (May 6):78-79.
  • Clark, Robert C. (1980) Does the Nonprofit Form Fit the Hospital Industry? Harvard Law Review 93(May):1416-1489. [PubMed: 10246691]
  • Clearinghouse Review (1969-present) Chicago, Ill.: National Clearinghouse for Legal Services.
  • Douglas, James (1983) Why Charity? The Case for a Third Sector. Beverly Hills, Calif.: Sage.
  • Drucker, Peter F. (1984) Beyond the Bell Breakup. The Public Interest 77(Fall):3-27.
  • Duff, Raymond S., and A. B. Hollingshead (1968) Sickness and Society. New York: Harper and Row.
  • Easley, David, and Maureen O'Hara (1983) The Economic Role of the Nonprofit Firm. Bell Journal of Economics 14(Autumn):531-538.
  • Ginzberg, Eli (1984) The Monetarization of Medical Care. The New England Journal of Medicine 310(May 3):1162-1165. [PubMed: 6424015]
  • Hansmann, Henry B. (1980) The Role of Nonprofit Enterprise. Yale Law Journal 89(April):835-901.
  • Health Affairs (1984) Special issue on "Variations in Medical Practice." 3(Summer).
  • Hirsch, Fred (1976) Social Limits to Growth. Cambridge, Mass.: Harvard University, Press.
  • Hirschman, Albert O. (1982) Rival Interpretations of Market Society: Civilizing, Destructive, or Feeble? Journal of Economic Literature 20(December):1463-1484.
  • Horty, John F., and Daniel Mulholland III (1983) Legal Differences Between Investor-Owned and Nonprofit Health Care Institutions. Pp. 17-34 in Bradford H. Gray, editor. (ed.) The New Health Care for Profit. Washington, D.C.: National Academy Press.
  • Jonsen, Albert (1983) Watching the Doctor. The New England Journal of Medicine 308(June 23):1531-1535. [PubMed: 6855827]
  • Luft, Harold S. (1981) Health Maintenance Organizations: Dimensions of Performance. New York: Wfiey.
  • Majones, Giandomenico (1984) Professionalism and Nonprofit Organizations. Journal of Health Politics, Policy and Law 8(Winter):639-659. [PubMed: 6699386]
  • Modern Healthcare (1985) 15(June 7).
  • Pauly, Mark (1980) Doctors and Their Workshops. Chicago, Ill.: University of Chicago Press.
  • Pauly, Mark, and Michael Redisch (1973) The Not-for-Profit Hospital as a Physicians' Cooperative. American Economic Review 63(March):87-99.
  • Relman, Arnold S. (1980) The New Medical-Indus-trial Complex. The New England Journal of Medicine 303(October 23):963-969.
  • Relman, Arnold S., and Uwe Reinhardt (1986) An Exchange on For-Profit Health Care. This volume.
  • Roe, Benson B. (1981) The UCR Boondoggie: A Death Knell for Private Practice? The New England Journal of Medicine 305(.July 2):41-45. [PubMed: 6785650]
  • Schroeder, Steven A., and Jonathan A. Showstack (1978) Financial Incentives to Perform Medical Procedures and Laboratory Tests. Medical Care 12 (August):709-713. [PubMed: 651395]
  • Shaw, Bernard (1911) The Doctor's Dilemma. New York: Brentano's.
  • Siegrist, Richard B., Jr. (1983) Wall Street and the For-Profit Hospital Management Companies. Pp. 35-50 in Bradford H. Gray, editor. (ed.) The New Health Care for Profit. Washington, D.C.: National Academy Press.
  • Sloan, Frank A. (Forthcoming) Property Rights in the Hospital Industry. In H. E. Frech III, editor. (ed.), Health Care Policy.
  • Starr, Paul (1982) The Social Transformation of American Medicine New York: Basic Books.
  • Steinwald, Bruce, and Duncan Neuhauser (1970) The Role of the Proprietary Hospital. Law and Contemporary Problems 35(Autumn):817-838.
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  • Veatch, Robert M. (1983) Ethical Dilemmas of For-Profit Enterprise in Health Care. Pp. 125-152 in Bradford H. Gray, editor. (ed.), The New Health Care for Profit. Washington, D.C.: National Academy Press.
  • Viadeck, Bruce (1976) Why Nonprofits Go Broke. The Public Interest 42(Winter):86-101.
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  • Williamson, Oliver E. (1981)The Modern Corporation: Origins, Evolution, Attributes. Journal of Economic Literature 19(December):1537-1568.

Appendix to Chapter 1. Economic Theories of For-Profit and Not-For-Profit Organizations

Sunny G. Yoder

This appendix considers, from a theoretical perspective, the rationale for the existence of private, for-profit; private, not-for-profit; and governmental production of goods and services. It describes the different objectives that economic theory. suggests are pursued by organizations in each sector and considers the implications for the behavior of health care providers—primarily hospitals—of these objectives. Because it is the nature of theory. to abstract from the complexities of everyday reality, the emphasis here is on the basic elements that theoretically distinguish the three sectors.1

Economic Rationale for the Three Sectors

The standard for comparison among models of economic production and distribution is the private, for-profit firm in a market economy. The simple competitive model is based on the presence in an industry of many firms acting to maximize their profits and many individual consumers acting to maximize their welfare (utility). If there are a sufficient number of firms in the industry so that no one firm can affect the market price, if firms can enter and exit the industry. readily, and if consumers have enough information to make informed decisions, then prices serve as accurate signals of firms' willingness to produce and consumers' willingness to buy. In the equilibrium state the prices are such that the quantity and mix of goods and services being produced are just the quantity, and mix that consumers want to buy. Because new firms can enter the industry and compete away excess profits, production is carried out in the least costly manner, given feasible production technology. As a consequence, resources are used in a way that sacrifices the least amount of alternative production. In addition to directing resources into their most productive uses, the competitive market model has the result that consumers attain their highest possible levels of economic satisfaction, given their preferences and incomes.

Why, then, does an economy include governmental production or not-for-profit, private production? What are the comparative advantages of these sectors, and what variables determine which services are produced by which sector?

According to economic theory, the government produces services (and sometimes goods) that the private, for-profit sector either does not produce or that it produces in smaller quantities than society desires (Samuelson, 1967:46-463; Musgrave and Musgrave, 1973:5). National defense, law and order, fire protection, administration of justice and of contracts, parks, and basic research are services that benefit the community. However, since people can receive the benefits of such services without paying for them, they are unlikely to be produced by profit-making firms. Too, the private, for-profit market will tend to under-produce goods and services for which one person's consumption also benefits another. One person's fire protection, for example, also protects his neighbors' houses; one child's vaccination against measles also protects his schoolmates. There is neither a means to exclude the neighbors or schoolmates from the benefits nor to charge them for their share.

Governments also may produce some services for people who, if they had to pay a private provider, would go without. Thus, another important rationale for governmental production is redistribution of income in instances when society judges that the distribution of income and wealth resulting from the private market alone is unsatisfactory. Direct transfers (e.g., Aid to Families with Dependent Children) are one form of redistribution; direct provision of services such as health and education is another. Government also can finance the private production of such services or can purchase them on behalf of some members of society.

The theoretical rationale for governmental production, in summary, stems from two sources: the failure of the profit-maximizing private market to supply goods that society values, but that benefit consumers collectively rather than individually (another excellent example from Samuelson is lighthouses); and the need to assure that all citizens have access to certain basic goods and services.2

What is the rationale for not-for-profit production, then, if the for-profit market generally achieves a high level of social welfare and the government provides compensation when the market fails? A not-for-profit organization gives up "the right to accumulate a monetary residual which then can be distributed to its owners for personal consumption. Instead, all not-for-profit organizations' resources must be used internally ..." (James, 1982:1). In this respect they differ from for-profit firms. On the other hand, not-for-profit organizations do not have the government's right to raise funds through compulsory taxation, but must depend on some combination of (1) selling their product or products at price levels sufficient to cover their costs and (2) obtaining revenues from voluntary donations of money, goods, and services. Many not-for-profit organizations do both.

Provided that an organization agrees to the nondistribution constraint (and, in most states, has "reasonable" operating costs), state and federal laws accord it special status. It is generally exempt from taxes3 and also receives favored status under most federal legislation. The principles on which this special treatment is founded are not clearly formulated (Hansmann, 1980); however, since not-for-profit organizations existed before these government-conferred advantages, this favored status would not appear to be causative.

A number of theories attempt to explain the existence of not-for-profit organizations. One is that the not-for-profit organization is optimal when information regarding the quality or quantity of service is asymmetric in favor of the seller (Hansmann, 1980; Easley and O'Hara, 1983; Bays 1983). When consumers are at an informational disadvantage, the market may not provide sufficient discipline to prevent a for-profit producer from marketing inferior services at excessive prices—a welfare loss for consumers and, by extension, for society. In such a case consumers are better served by a not-for-profit producer. Although it, too, could cut quality or raise prices, according to this theory its managers have little incentive to do so, because they are prohibited from sharing in any excess profits.

Complex personal services such as health care are especially at issue:

Often the complexity of these services, their nonstandard character, and the circumstances under which they are provided make it difficult for the consumer to determine whether the services are performed adequately. Thus, the patron has an incentive to seek some constraints on the organizations' behavior beyond those he is able to impose by direct, private contract. (Hansmann, 1980:862)

According to this theory, then, not-for-profit firms would be dominant in markets in which the quality of the product is difficult to monitor, because the preferences of consumers for the ostensible protection of the not-for-profit form would make it difficult or impossible for for-profit producers to remain in the market. However, we observe the continued existence of both forms in the nursing home and clay-care industries, where presumably information asymmetry exists and where transferring to a different provider is difficult (James and Rose-Ackerman, Forthcoming). Other goods and services for which quality is difficult to ascertain are produced almost entirely by for-profit firms; examples are legal and medical services, personal computers, and used cars (Ben-Ner, 1983; James and Rose-Ackerman, Forthcoming). In higher education, where public and not-for-profit production predominates, considerable information is available about the "selectivity, student/faculty ratios, faculty credentials, and alumni of colleges and universities..." (James and Rose-Ackerman, Forthcoming). On empirical grounds, then, it appears that information asymmetry alone does not explain the presence of not-for-profit organizations.

An alternative theory is proposed by Ben-Ner (1983), who theorizes that the not-for-profit organization emerges in response to consumers' desire for control. According to his model, consumers may choose to establish their own organization in preference to taking their chances in the marketplace. A group of parents might start its own day-care center, for example. The not-for-profit firm (e.g., the consumer-run, not-for-profit cooperative) is theorized to dominate when the consumers' principal objective is to maintain high quality. The nondistribution constraint reduces the tendency by managers of such organizations to misrepresent or produce lower quality. (Ben-Ner does not discuss another alternative available to consumers, which is to form coalitions to reduce or remove information asymmetry by sharing information, seeking expert advice, or conducting research.)

Weisbrod (1977, 1980) characterizes not-for-profit organizations as responses to failures by government rather than failures by the private market. According to this theory, government responds to society's average demand for public services, conveyed through its collective-choice mechanisms. This average, however, underrepresents those members of society who have a very high demand for governmental services, as well as those whose tastes differ from the average. A private school, for example, can be a means for citizens to meet their demand for higher quality or to meet their special religious, linguistic, or other preferences. Thus, this model suggests that not-for-profit organizations arise to meet the heterogeneous demands of consumers for public and quasi-public services that are not fully met by the government's standardized output.

A somewhat different model proposes that the government delegate the production of certain public or quasi-public goods to not-for-profits rather than producing them itself (James and Rose-Ackerman, Forthcoming). According to this model, private production may offer the advantage of lower costs, because private firms can charge fees to cover some of their costs (e.g., tuition, hospital charges) and can avoid legally imposed wage rates and procurement practices that raise production costs for the government. Not-for-profit organizations also offer the potential for receiving donations of money and in-kind services that is not offered by for-profit firms. "Contracting out," as well as more subtle forms of delegation therefore give the government a degree of flexibility, as well as the possibility of reduced cost. The subsidy or grant to a not-for-profit organization is often used by government when it desires to purchase intangible services for which it is difficult to measure the quid pro quo. Too, policymakers may wish to provide more differentiated services, but may be bureaucratically unable to do so except by subsidizing private organizations.

Thus, economic theory offers several explanations for why some goods and services are produced by not-for-profit firms. The theory suggests that not-for-profit production may exist as a response to consumers' need for protection when the good or service cannot be observed or its quality accurately evaluated, as a response to differential demand for public or quasi-public goods when government has difficulty providing other than standardized output, as a means for government's achieving lower-cost production of certain public goods, or for a combination of these reasons. The rationale for the existence of not-for-profit firms, however, does not answer other important questions such as, what decision rules characterize the use of economic resources by these firms? In particular, how do their decisions about what to produce, and in what quantities, differ from the decisions of for-profit firms? Theories addressing these questions are reviewed in the following section.

Models of the Behavior of For-Profit and Not-For-Profit Organizations

Traditional economic theory treats the management structure and decision-making process as a black box. The firm is characterized by an objective function that represents either a single decision maker or the result of interactions (and the resolution of any conflicts) among stockholders, trustees, and managers. The basic model hypothesizes that, irrespective of how decisions are made, the firm's objective is to maximize profits. More recent theories of the for-profit firm, discussed below, take greater cognizance of the role of managers and the possibility that profit maximization may not be their sole or even their primary objective.

Economic theories of the behavior of not-for-profit firms generally ascribe to them objectives other than profit (i.e., net revenue) maximization (Davis, 1972; James and Rose-Ackerman, Forthcoming). In the simplest not-for-profit model the objective is to maximize output. If the not-for-profit organization produces a single product, such as day care, receives all its revenues from the sale of that product, and has the same cost structure as a for-profit producer, in the short run the not-for-profit firm will produce more of the product than the profit-maximizing firm, but at a higher cost. However, if there are no barriers to prevent new firms (either not-for-profit or for-profit) from entering the industry, over the long run their entry will cause the industry, to become as efficient as if it were entirely populated by profit-maximizing producers.

This picture becomes more complicated, however, in the more relevant case in which a not-for-profit firm receives unrestricted donations and produces more than one product. Whether the not-for-profit firm's long-run output is greater or lesser than that of the for-profit firm under these conditions—which are characteristic of not-for-profit hospitals and private educational institutions—will depend on the objectives of managers. If not-for-profit managers and their donors desire to produce higher levels of some or all of their outputs (serving greater numbers of people, for example), these levels will be obtained at the expense of efficiency in comparison with the profit-maximizing firm in a competitive industry. As discussed below, however, the hospital industry has substantial entry barriers and other characteristics that cause it to differ from the purely competitive model.

The fact that a not-for-profit firm's managers do not share in any surplus resulting from efficiency and the fact that they usually have access to donated revenues not tied to specific production are offered as positive reasons for the existence of not-for-profit organizations. These characteristics also may have potential negative effects. For instance, whereas stockholders can exercise control of managers of for-profit firms, or, in extreme cases, takeovers via the capital market can perform the role of selecting managers who maximize profits through efficient production, such mechanisms are not available in the not-for-profit arena. The attenuation of "property rights" (managers' rights to any residual earnings or capital gains) in the case of not-for-profits can encourage "shirking," choice of inefficient inputs, and production of a nonoptimal mix of outputs (James and Rose-Ackerman, Forthcoming; Sloan, Forthcoming). Managers of not-for-profit organizations may accord themselves high salaries, "perks" such as plush offices, or lavish expense accounts; they also may choose an inefficient production technology, (e.g., greater use of high-technology capital than is optimal from an efficiency standpoint).4 In the latter case, the not-for-profit firm will operate well short of maximum efficiency in the short run. Lee's (1971) model of the not-for-profit hospital, for example, suggests that it will acquire sophisticated equipment and highly trained personnel beyond the point required for production in order to enhance the prestige of the organization and, by extension, its managers. The ability of a not-for-profit hospital to continue to operate in this manner should be limited by the extent to which for-profit firms can enter the market and drive down the price through competition, but the availability of donations can cushion the not-for-profit manager from the pressures of competition.

Models of not-for-profit organizations often include the objective of maximizing quality (Newhouse, 1970); however, the effect of this objective on consumer welfare is ambiguous. If not-for-profits produce higher quality and charge higher fees (prices) to cover the added costs, then consumers can infer quality from the fees, and those consumers who desire higher quality and are willing to pay the additional cost can choose to do so. If, however, the higher quality is paid for out of donations, fees may be the same for both high-quality and low-quality providers. In this case other sorting methods will be utilized, such as waiting lists in the case of high-quality not-for-profit nursing homes or day-care centers.

In the case of not-for-profit organizations that have multiple outputs (e.g., the various clinical services of a hospital, as well as education and research), the not-for-profit organization is hypothesized to engage in cross-subsidization. The profit-maximizing firm theoretically will not do so, because its optimal strategy is to produce each product line to the point where marginal costs and marginal revenues are equal. The manager of a not-for-profit organization, however, may pursue the goal of producing outputs that he values (e.g., high-quality or esoteric medical care as suggested by Newhouse) by producing other outputs that he does not particularly value but that generate a surplus. The surplus then can be used to subsidize the valued outputs. The sale of gifts and T-shirts to subsidize the exhibits and research activities of the Metropolitan Museum and the Smithsonian Institution is one example. The provision of well-reimbursed ancillary services to subsidize a coronary care unit is another. As with preferred inputs, however, the ability of not-for-profit managers to engage in cross-subsidization over time is limited to the extent that new firms may enter and compete away the profits on the products that are providing the subsidies. Thus, not-for-profits' continued discretion over the production of desired outputs over time requires barriers to entry, donations, or both. This discretionary behavior by managers does not necessarily coincide with the preferences of donors or with maximum social welfare.

The presence of entry barriers and asymmetric information suggests that profit-maximizing firms may not operate efficiently in industries such as hospital care and education. However, there also is a question of whether pure profit maximization is the sole objective of private firms in this (or indeed any) industry. Alternative models have been suggested that give greater weight than does the traditional model to the preferences of managers. Baumol (1967), for example, develops a model that characterizes the firm as maximizing total revenues, subject to the constraint that stockholders receive a sufficient return to make the firm's securities attractive in the capital market. Such a firm will behave, according to the theory, very similarly to a not-for-profit firm. Also similarly, this type of behavior can be sustained only if there are entry barriers.

Another model, from Williamson (1981), suggests that managers of for-profit firms prefer certain expenditures to others because they contribute to the managers' status and security. This model is analogous to the input-preference model of not-for-profit behavior discussed previously. However, as distinct from Baumol's model, Williamson's model gives a greater weight to profits, because they permit the firm to expand, which also provides prestige to the manager. Both models predict that the firm will favor certain factors of production and will produce some outputs beyond profit-maximizing levels, behaviors that also are attributed to the not-for-profit firm and that imply nonefficient production.

Why For-Profit Hospitals May be Inefficient

This review of the theoretical literature comparing the behavior of not-for-profit with for-profit enterprises suggests that for-profit organization results in greater efficiency (i.e., least-cost production) under very, specific circumstances: profit maximization as the overriding objective, no substantial barriers to entry, observable output. These circumstances do not appear to typify the hospital industry. Hospital managers may well have preferences and objectives that differ from profit maximization, including the enhancement of their organization's prestige; the provision of specific services that further this or other goals; the provision of charitable care, teaching, or research; and the improvement of their own professional status. Also, this is an industry in which there are substantial entry barriers. The capital requirements to start a hospital are large. Too, certificate-of-need regulations greatly constrain the ability of firms to enter the hospital industry. Hospital services are extremely complex, and most consumers have little or no direct experience for evaluating them, nor do they always have the opportunity to obtain information from others before seeking these services. Thus, information asymmetry with its potential market failure is likely to be present for many hospital services. However, the issue of information asymmetry depends crucially on the role of the physician. If, as Hansmann suggests, the physician acts as the patient's knowledgeable agent with respect to assessing the quality of hospital services, the hospital is faced with a powerful constraint on its ability either to cheat on quality or to produce services on which consumers and their physicians place little value. If, on the other hand, physicians dominate hospital decision making and direct it toward maximizing their own incomes, as Pauly and Redisch (1973) and others have suggested, the quantity and mix of services produced would be that which satisfies the preferences of physicians rather than the preferences of consumers or managers.

The nature of hospital services and the characteristics of the hospital industry, pose the question of whether for-profit production will achieve the optimal levels of efficiency and consumer satisfaction that the competitive market model predicts. Thus, while the nonprofit organization appears to compare unfavorably with the competitive ideal, this standard of comparison probably is inappropriate in the hospital industry. For-profit hospitals, because of entry barriers, information asymmetry, and the ambiguity of the physician's role as the consumer's agent, may not be presumed to produce the quantity and quality of services desired by society at an efficient price. At the same time, economic theory, suggests that there also may be reasons why not-for-profit hospitals do not behave in socially optimal ways. Even though managers of not-for-profits cannot receive directly a share of any monetary surplus, the presence of donations and entry barriers and the absence of stockholder pressures may allow them considerable leeway to use resources and to produce services according to their own preferences. These preferences may or may not be consistent with those of society.

This discussion has not addressed the crucial issue of how services are to be distributed. According to standard economic theory, the profit-maximizing firm in a competitive economy sells its product at the market price to anyone who wants to buy at that price and who can afford it. Thus, the competitive market distributes goods and services in accord with the existing income distribution. If society prefers that hospital services be distributed more equitably, and if managers of not-for-profit hospitals share society's preferences, then these hospitals may be superior to for-profit hospitals when judged in terms of societal well-being.

References

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Footnotes

1. The terms "for-profit," "investor-owned," and "proprietary" are all used in this report to refer to organizations that are owned by individuals and corporations (such as institutional investors) to whom profits are distributed. Such organizations stand in contrast to organizations that are incorporated under state laws as nonprofit or not-for-profit organizations. (The defining characteristics of both types of organizations are discussed later in this chapter.) Terms within each set are not used in a consistent fashion in the literature. Nevertheless, the committee sees some differences in connotation among the terms and has attempted to use terminology appropriately and consistently as follows.

The term "proprietary" is used to connote the traditional independent owner-operated institution (for example, hospital, nursing home, or home health agency). The term "investor-owned" is used to connote companies (rather than institutions) that have a substantial number of stockholders. The term "for-profit" encompasses both. (A drawback of the term "for-profit'' is that it seems to define organizations in terms of assumed behavior—that is, that such organizations will seek to maximize profit, because by definition that is their purpose. However, the committee sees organizational behavior not as a matter for definition but as a topic to be investigated empirically.)

On the other side, the committee prefers the term "not-for-profit" over the term "nonprofit," both because the term "not-for-profit" conveys a direct contrast with the term "for-profit" and because the term "nonprofit" often is incorrectly interpreted to mean that the organization has (or should have) no surplus of revenues over expenses. That is again an empirical question, not a matter of definition.

Both for-profit and not-for-profit types of ownership stand in contrast to "public" or "government" ownership. Most health care institutions in the United States are private, not public, and the debate about for-profit versus not-for-profit ownership of health care institutions should not be misconstrued as a debate about public versus private ownership. Except where explicitly noted, the public or government-owned institutions referred to in this report are owned by state or local governments, not the federal government.

2. For example, the merging health care supply companies, Baxter Travenol and American Hospital Supply Corporation, both have home care subsidiaries; several insurance companies (e.g., Prudential, John Hancock, Aetna, CIGNA) have HMO subsidiaries; the Owens-Illinois glass company bought nursing homes and hospitals; W. R. Grace and Co. has acquired National Medical Care, the hemodialysis company, and McDonnell Douglas owns more than half interest in an HMO company called Sanus.

3. The term "efficiency" appears in the report because for-profit organizations are commonly alleged to be more efficient than public or not-for-profit organizations. However it should be recognized that because "efficiency" refers to the comparative cost at which a given good or service is produced, it can be properly studied only when there is a high degree of standardization of the good or service being produced. This condition seldom holds in studies of health care costs. Data tend to be available only on such measures as expenses per day or per case. Whether differences in such measures indicate differences in efficiency or are due to differences in the service being produced is, unfortunately, generally conjectural.

4. Of course, in addition to such boards and top management, centrally managed multi-institutional systems, whether for-profit or not-for-profit, typically also have separate boards and management at the local institutional level. The amount of local authority over institutional affairs is variable.

5. Stock options are a form of long-term compensation characteristic of growth-oriented companies, because they are a method of rewarding employees (usually executives) for company growth and they sometimes substitute for higher salaries, thereby increasing the amount of corporate earnings that can be devoted to growth. The price at which the option to purchase a given amount of the stock is offered to an employee is often only slightly below the current market value. The option, which is typically for a period of years, becomes valuable when the value of the stock increases. Old stock options with a growth company such as Humana are extremely valuable when exercised, since "a share of stock bought for $4 in 1974 is now worth $403.20" according to Business Week (1985:79), which explains how the 1984 compensation of Humana, Inc. board chairman David Jones included $17,394 million in stock options.

6. Public institutions share some of the characteristics of not-for-profits (most important, the restrictions on distributing surpluses to the individuals controlling the organization, although in the case of public institutions, surpluses commonly are returned to the public treasury), but have several key differences: They are owned not by a state-chartered corporation but by government itself (federal, state, or local); they are directly or indirectly under control of elected officials; a significant portion of their operating budgets and capital needs often comes in the form of direct governmental appropriations; and their responsibilities often explicitly in-elude providing care to patients without insurance or the ability. to pay for care.

7. Hansmann has labeled these two types as donative and commercial not-for-profits, respectively.

8. The concerns and arguments about the appropriateness of markets as the mode of distribution of health services parallel more general arguments about market societies that go back more than two centuries. As Hirschman (1982) has shown, there is a very. old debate about whether self-interest can replace love and charity as the basis of a well-ordered society and whether values such as trust are generated or eroded by the incentives and practices of the market. Thinkers such as David Hume and Adam Smith saw the growth of commercialism as enhancing such virtues as "industriousness and assiduity (the opposite of indolence), frugality, punctuality, and, most important perhaps for a market society, probity,," and would create as a by-product "a more 'polished' human type—more honest, reliable, orderly and disciplined, as well as more friendly and helpful, ever ready to find solutions to conflicts and a middle ground for opposed opinions" (Hirschman, 1982:1465). The opposing thesis, among both Marxist and conservative thinkers, was that the emergence of a capitalist society fundamentally undermined the proper moral foundations of society—that religiously based virtues (truth, trust, acceptance, restraint, obligation, and cooperation) would be threatened or destroyed by market society's pursuit of individual self-interest rather than the general interest (Hirschman, 1982; Hirsch, 1976).

9. Multiple tiers in health care are, of course, not new and are particularly exemplified by the split between public and private institutions. Multiple tiers also have existed within institutions (See Duff and Hollingshead, 1968), although this has been diminished substantially by governmental funding programs, particularly Medicare and Medicaid.

10. To illustrate this ethos, Forbes Magazine noted with approval Republic Health's strategies for maximizing profits by identifying surgical procedures that can be "done quickly, often in a few hours, without lots of nurses, tests, meals or general care" and marketing them to the public "just as hotels market cut rate weekends." The article noted that in one of this company's hospitals, with a 25 percent occupancy rate, sales on elective surgery were offered. The hospital accepted whatever Medicare was willing to pay and charged the patient no deductible. Without raising occupancy, 1,800 more patients were treated at the hospital in 1984 than in 1983. "Result: the hospital made $3 million pretax in 1984'' (Tietelman, 1985).

11. Willingness to duplicate services without respect to need is, of course, in no way peculiar to the for-profit sector, as the experience of the past 20 years (including the history of the health planning program and the growth of surplus beds) clearly shows. Competitive impulses of a slightly different nature (e.g., for prestige) were undoubtedly in part responsible.

1. A fourth sector, households, principally engages in selling its labor services to one of the other sectors and using its earnings to purchase goods and services. Household production for the most part consists of home maintenance and repair, care of children and infirm adults, food preparation, and the like, activities that are not generally monetized.

2. Defining the standards of such access and devising mechanisms to ensure it are central problems in all societies, of course. The efficiency-equity dilemma has been explored by Okun (1975).

3. In the case of certain not-for-profits—religious, educational, health, scientific, cultural, and social service organizations—donor contributions also are tax deductible. Others, chiefly membership groups such as social clubs, fraternal organizations, and labor unions, are tax-exempt but donations are not (Rudney, 1981).

4. The legal requirement that a nonprofit organization's costs must be reasonable is intended to deter such behavior.

Copyright © 1986 by the National Academy of Sciences.
Bookshelf ID: NBK217897

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