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OCR for page 3
1 Profit and Realm Care:
1 An In~uc:tion to He 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. 2 Although pro-
prietary 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 arid diversification they have be-
come 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 esti-
mated 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 Hu-
mana, Inc.) that own or operate hundreds
of hospitals, nursing homes, and other fa-
cilities 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 com-
panics concentrate on a particular type of
facility or service, such as hospitals, nursing
3
homes, psychiatric hospitals, health main-
tenance 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 ad-
dition, several large companies whose pri-
marylines of business are not in the delivery
of health services have established or ac-
quired 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 capi-
taTistic society, there has Tong been concern
about the possible adverse or pernicious ef-
fects of profit motivations in health care
(Veatch, 1983; Steinwald and Neuhauser,
1970:830-834; see also Shaw, 19111. Con-
flicting opinions about for-profit health care
mirror common views of the profit motive
and market-driven behavior. Thus, various
positive benefits of Me investor-owned model
are often citecl: that it provides new impetus
for innovation, more responsiveness to the
needs and desires of patients and physi-
cians, sounder approaches to management,
and an important source of new capital for
OCR for page 4
4
health services. On the other hand, some
observers see for-profit health care organi-
zations as antithetical to the traditional mis-
sion and values of health care institutions,
as a threat to the autonomy and ideals of the
medical profession, and as destructive of im-
plicit 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 sup-
ported. Others are skeptical about these fears
or are dubious about the extent to which
health care institutions and professionals ac-
tually embody the ideals that they enunci-
ate. 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 butin terms of(l) inflationary eco-
nomic 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 in-
surance coverage and who are not eligible
for public programs. Thus, the debate about
for-profit health care touches upon most is-
sues 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 insti-
tutions on the costs and quality of health
care, on access to care for those who are
unable to pay, and on the funding and con-
duct of medical education and research? In
other words, does the for-profit form's sup
FOR-PROFIT ENTERPRISE IN HEALTH CARE
posed 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 com-
munities, the efficiency 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 implica-
tions 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 reli-
gious not-for-profit, and public institutions,
some of which are independent and some
of which are a part of multi-institutional sys-
tems. Different types of ownership typify
different types of institutions. Nursing homes
have Tong been predominantly propnetary,
for-profit institutions. Acute care general
hospitals are typically private, not-for-profit
institutions. Among certain specialized types
of institutions (e.g., psychiatric and tuber-
cuTosis hospitals) governmental ownership
was typical, because of the public health and
safety concerns that led to their creation.
(Charging pasterns of ownership and control
of different types of institutions are de-
scribed in Chapter 2.)
Increasingly, institutions of different
ownership types and with ostensibly differ-
ent rationales and missions now operate side
by side. In a sharpening competitive envi-
ronment, some observers see decreasing
ownership-related differences in institu-
tional behavior. Still, certain values, beliefs,
OCR for page 5
AN INTRODUCTION TO THE ISSUES
and labels remain associated with govern-
mental (last resort, inefficient but equita-
ble), not-for-profit (voluntarism, charity,
community), and for-profit (efficient, inno-
vative 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 Tong surrounded
questions of ownership in health care and
the proper role of government. Were have
always been advocates of a Dubliciv con-
trolled 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 pre-
vailed, with private ownership preclominat-
ing. 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 gov-
ernment, 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 phy-
sicians (and other health professionals) and
private institutions (both for-profit and not-
for-profit) for services rendered to individ-
ual beneficiaries of public programs and not
for appropriations to governmental institu-
tions. 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
5
relative virtues of two types of private in-
stitutions 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 pre-
dominant. The first hospitals served exclu-
sively as charitable or public organizations
for the sick and destitute who had nowhere
else to go, but today's not-for-profit hospi-
tals have diverse origins in the missions of
both religious and secular charitable orga-
nizations and the actions of civic-minded cit-
izens seeking to improve their communities.
For-profit (or investor-owned) institu-
tions leave 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 hy-
potheses in the empirical literature (exam-
ined later in this report) on the comparative
behavior of for-profit and not-for-profit in-
stitutions.
Theory for predicting the behavior of not-
for-profit institutions is still in a relatively
undeveloped state (Weisbrod, 1981; Hans-
mann, 1980; Easley and O'Hara, 1983), and
divergent theories exist about for-profit or-
ganizations (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 be-
liefs 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 organiza-
tions can be expected to behave quite dif-
ferently from each other. (People who hold
this view differ in which type of organization
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6
FOR-PROFIT ENTERPRISE IN HEALTH CARE
TABLE 1.1 Common Distinctions Between For-profit and Not-for-profit Organizations
For-profit
Not-fior-profit
Corporations owned by investors
Can distribute some proportion of profits (net
revenues less expenses) to owners
Pay property, sales, income taxes
Sources of capital include
a. Equity capital from investors
b. Debt
c. Retained earnings (including depreciation and
deferred taxes)
d. Return-on-equity payments from third-party
payers (e.g., Medicare)
Management ultimately accountable to stockholders
Purpose: Has legal obligation to enhance the wealth
of shareholders within the boundaries of law; does
so by providing services
Revenues derived from sale of services
Mission: Usually stated in terms of growth,
efficiency, and quality
Mission and structure can result in more streamlined
decision malting and implementation of major
decisions
Corporations without owners or owned by
"members"
Cannot distribute surplus (net revenues less
expenses) to those who control the organization
Generally exempt from taxes
Sources of capital include
a. Charitable contributions
b. Debt
c. Retained earnings (including depreciation)
d. Govermental grants
Management accountable to voluntary, often self-
perpetuating boards
Purpose: Has legal obligation to fulfill a stated
mission (provide services, teaching, research, etch
must maintain economic viability to do so
Revenues derived from sale of services and Dom
charitable contributions
Mission: Often stated in terms of charity, quality,
and community service, but may also pursue
growth
Mission and diverse constituencies often complicate
decision making and implementation
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 op-
posed 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 nec-
essary to accept this hospital-as-physician-
carte! 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 compar-
ative behavior offor-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 be-
havioral tendencies of for-profit and not-for-
profit health care organizations.
Investor Ownership
The purpose of investor-owned corpora-
tions in general is to make money for inves
OCR for page 7
AN INTRODUCTION TO THE ISSUES
tors to preserve and enhance the economic
value of the invested capital. This purpose
is built into the corporate governance struc-
ture. An investor-owned corporation is ul-
timately governed by its owners
(stockholders), who elect the board of di-
rectors. 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 fiends, financial institutions, pen-
sion funds, labor union trust funds) and are
thus controlled by individuals who them-
seives are accountable for their investment
decisions, who closely monitor companies'
performance, and whose decisions to sell
can affect a stock's price (transactions in-
volving 10,000 or more shares are not un-
usual 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 cor-
poration not only serve on the board but
also have significant holdings of the corpo-
ration'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 pre-
sent for management, other profitability in-
centives also exist. First, many companies
explicitly tie large incentives for manage-
ment to the company's economic perfor-
mance; for top executives, such incentives
(in cash, stock, or other forms) often run into
the hundreds of thousands or even many
millions of doliars.5 Second, and more im-
portant, 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
7
companies devote careful attention to the
Wall Street analysts whose recommenda-
tions 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 prof-
its 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 de-
termine how a company defines its social
responsibilities; for example, many compa-
nies, including some health care corpora-
tions, have established departments or
foundations to make charitable contribu-
tions. This is not behavior that bespeaks sin-
gle-minded commitment to short-term profit
maximization, although in the Tong term it
can be presumed that hard economic cri-
teria ordinarily guide American business be-
havior.
Since Adam Smith, the fulcrum of eco-
nomic theory about for-profit organizations
is the objective of profit maximization. More
recent alternative theories of the corpora-
tion recognize the role of managers (as dis-
tinct from owners), whose primary objective
may pertain to status or security, for ex-
ample, rather than maximizing profits. Sim-
ilar goals may animate management in not-
for-profit organizations. Some theorists sug-
gest 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 corpo-
ration is barred by its charter from "distrib-
uting its net earnings, if any, to individuals
OCR for page 8
8
who exercise control over it, such as mem-
bers, officers, directors, or trustees" (Hans-
mann, 1980:838~.6 This key characteristic is
referred to as the "nondistribution require-
ment," and a variety of managerial and or-
ganizational behaviors are thought to follow
from it. On the one hand it is seen as pro-
viding 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 or-
ganizations are a response to contract failure
in circumstances that make contracts be-
tween 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, ex-
cept where resources are tight.
Despite their label, not-for-profit orga-
nizations are not prohibited from earning
profits (usually called "surpluses') from their
operations; however, these surpluses gen-
erally must be devoted to the further fi-
nancing 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 Administra-
tion, 1983), but We 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 in-
come taxes (under Section 501(c)~3) of the
Internal Revenue Code) and from state and
load income, property, and sales taxes. Since
many not-for-profit organizations own val-
uable property and earn healthy surpluses,
these are significant advantages.
Not-for-profit organizations can be distin-
guished from each other by two attributes:
their control and their financing. "Mem-
bership" or "mutual" not-for-profit organi
FOR-PROFIT ENTERPRISE IN HEALTH CARE
zations (such as country clubs or professional
associations) are controlled by the organi-
zation's patrons or members, who elect the
board of directors (Hansmann, 1980:841;
Horty and Mu~holiand, 1983:201. "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 de-
gree to which they derive their income from
donations or from charges for the services
they provide.7 The not-for-profit organiza-
tion that derives its income primarily from
charges for services is largely a creature of
the post-WorId War II period, when the
growth of private and public third-party
payment programs effectively monetized
health care (Ginzberg, 19841.
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 re-
sponsive to community health care needs,
they should be responsible and efficient cus-
todians of the resources entrusted to them,
they should provide service to all who need
it without regard to ability to pay, and so
fob. Over the years certain criticisms have
been recurrent that administrators and
trustees (1) are insufficiently critical of phy-
sicians' requests for new equipment and fa-
cilities, (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 man-
agement, in part because the nondistnbu-
tion requirement prevents their sharing any
surplus that might be created and because
association with independent hospitals tends
to tie administrators to a particular com-
munity rather than to put them on the ca-
reer ladder of a larger organization.
Trustees have tended to come from the
economic and professional elites of the com-
munity, not from among people for whom
OCR for page 9
AN INTRODUCTION TO THE ISSUES
inability to pay was commonplace. These
factors are alleged by some to have led trust-
ees and ambitious administrators to concen-
trate surpluses on salaries and staff(thereby
making not-for-profit organizations inher-
ently inefficient, according to a common
criticism) and on new services, facilities, and
equipment, regardless of whether an objec-
tive community need existed. Incleed, some
observers have seen not-for-profit hospitals'
tendency toward excessive investment in
unneeded facilities and equipment as jeop-
ardizing their economic soundness (VIa-
deck, 19761. 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 provid-
ers is muddied by several factors. First, dif-
ferences in sources of capital have sharply
diminished, as is discussed in Chapter 3.
Historically, charitable donations and gov-
ernmental grants were the major sources of
capital and important sources of revenue for
not-for-profit hospitals. However, the rev-
enues of not-for-profit hospitals have in-
creasingly 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 require-
ments to be met mostly from retained earn-
ings 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 be
9
havior of for-profit and not-for-profit hos-
pitals. Both types have been forming multi-
institutional arrangements in the hopes of
gaining economies of scale and greater ac-
cess to capital, aggressively marketing and
vertically integrating (e.g., through the ac-
quisition of primary care centers and long-
term-care facilities) to increase control of pa-
tient Dow anc} market share, and paying more
heed to the vigor of the bottom line by
heightening cost control and limiting un-
compensatec] care.
Third, not-for-profit org~ni7~tions 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, 19851. The
ability of any organization to survive re-
quires 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 reno-
vations 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 or-
ganization, providing services becomes the
purpose of their work, rather than making
money for stockholders. Conversely, within
a not-for-profit organization there are offi-
cials whose responsibilities are primarily fi-
nancial and who evaluate organizational
options, strategies, and policies primarily in
terms of their effect on the organization's
boKom line.
Fifth, it is simplistic to conclucle that be-
cause 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
OCR for page 10
10
its long-term profitability. The extent to
which companies provide uncompensated
care to patients who are unable to pay, en-
gage in educational and training activities
and devote resources to research and de-
velopment 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 in-
clude (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
ofthe entire institution or for providing spe-
cific services (e.g., coverage of the emer-
gency room); (c) joint ventures for a wide
variety of purposes between not-for-profit
hospitals and members of their staffs. be-
tween not-for-profit hospitals and for-profit
hospitals (or hospital companies), and be-
tween for-profit multihospital systems and
not-for-profit multihospital systems; and (~)
for-profit alliances (such as Voluntary Hos-
pitals of America, American Healthcare Sys-
tems, SunHealth) that are owned by, and
provide services to, not-for-profit hospitals
or multihospital systems. Such hybridiza-
tion is descnbed 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 chari-
table contributions, particularly from for-
mer 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 univer-
sities, art galleries, and other cultural cen-
ters) 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 sub-
stantial gifts of company stock.
Seventh, the requirements for incorpo
FOR-PROFIT ENTERPRISE IN HEALTH CARE
ration as a not-for-profit organization are not
stringent in many states. In some states a
not-for-profit organization can be estab-
lished "for any lawfill purpose" (Elorty and
Mulholiand, 19831. Among certain types of
health care providers, such as home health
care agencies, owner-operated, not-for-profit
organizations are sometimes difficult to dis-
tinguish from their for-profit competitors by
any criterion other than the former's ex-
emptions from paying corporate taxes.
Eighth, even the not-for-profit's prohi-
bition against distribution of profits has be-
gun to break down as legal ways are
discovered whereby not-for-profit organi-
zations 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 or-
ganizations. Under certain circumstances for-
profit companies can gain access to tax-ex-
empt debt financing through industrial rev-
enue bonds and through construction and
lease-back arrangements.
Finally, it must be recognized that a va-
riety of other factors can affect the behavior
of health care organizations and may atten-
uate 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 pro-
grams, governance and medical staff re-
sponsibilities, liability for negligence,
restrictions on the "corporate practice of
medicine," and so form. The larger eco-
nomic 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 pa-
tients, or offer specialized services. Also, a
major constraint on many institutions is that
their~ability to attract patients depends on
OCR for page 11
AN INTRODUCTION TO THE ISSUES
physicians, who have traditionally been rel-
atively independent of the institution and
whose first ethical responsibility is to the
patient. This factor is discussed in more de-
tai] 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 insti-
tutions 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 discus-
sions 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 relation-
ship between professionals and patients, and
about whether it is legitimate to make prof-
its from the misfortunes of the ill.
The value questions about health care can
be discussec! 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
11
that distinguish medical care from commer-
cial 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 correspon-
dence between committee members Uwe
Reinhardt and Arnold Relman in Part II of
this volume.)
Health Care as Economic Good
The view, oversimplified here, that per-
sonal 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 ben-
eficial. Furthermore, because there is evi-
dence that medical institutions and physicians
respond to economic incentives (as every-
one else does), it seems realistic to view
health care in these terms. This view cloes
not deny that government plays an essential
role in making these market forces work.
Indeed, because of the cost, unpredictabil-
ity 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 pro-
duce the anticipated beneficial results. Gov-
ernmental involvement does not deny that
other market factors and competitive forces
should be allowed to operate, although the
form of that involvement determines the ex-
tentofthe competition. For example, if ben-
eficiaries 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 pro
.] . . . 1 · ~
OCR for page 12
12
ducing the best outcome for all a system
that is responsive to consumers, in which
the producer of inferior services will be pun-
ished and the hard test of the bottom line
will restrain capital expenditures for equip-
ment and facilities if demand is lacing. Such
a system should lead to maximum efficiency
in the production of services, except in per-
verse 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 par-
ticipation 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 incligent) and (2) to pay and regulate
in ways that will foster competition and, per-
haps, appropriate care. Some forms of reg-
ulation, including some aspects of professional
and institutional self-regulation, are op-
posed as being antithetical to competition;
other forms may be necessary to maintain
fair competition.
As with markets generally, the best out-
come 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 ser-
vices 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 de-
cide 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 em-
phasizes the purchaser's role (and the in-
centives created by purchasers) in disciplining
or shaping the system. Thus, providers will
focus their attention on factors that can be
judged by patients (availability, accessibil-
ity, amenities, courtesy) and by physicians
(because they make so many of the key de-
cisions). As payers become more aggressive,
FOR-PROFIT ENTERPRISE IN HEALTH CARE
attention will increasingly be focused on fac-
tors that payers can monitor (cost, conve-
nience, patterns of care, and quality-related
measures of outcomes, such as readmission
or mortality rates). Patients (or payers) that
uncritically assume that health care provid-
ers will subordinate their own interests to
the patient's interests are vulnerable to ex-
ploitation, no matter what ideals the pro-
vider may state. In this view, entrepreneur-
ism 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 Me idea
that health care is properly seen as an eco-
nomic 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 prof-
itable to do so. Although the proper pursuit
of such goals may oRen produce behavior
that the market will reward, the behavior is
not so motivated. This view holds that heady
care should be seen as a "social good," a
conception that was more obviously appli-
cable when infectious disease made an in-
clividual's misfortune a threat to his or her
neighbors (Stevens, 1985) and in an era when
many people were depenclent 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 re-
sided. The response to disease and disability
should stem not from the fact that a market
is created from peoples' misfortunes but Dom
a humane response to their needs. The ideal
OCR for page 13
AN INTRODUCTION TO THE ISS UES
is that the needs of the sick ant] unfortunate
should be met by persons who, as a philos-
opher expressed it, are acting out of love
rather than out of the expectation of gain
(Braybrooke, 19831.
The idea that everyone's interest would
ultimately be best served if everyone pur-
sued self-interest is alien to this view, which
holds that health professionals and institu-
tior~s should put patients' interests ahead of
self-interest (although it may be "good busi-
ness" to behave thusly). In this view it is
quite appropriate to expect health care in-
stitutions 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 sup-
port, the institution's role is to provide
needed service and to make up the resulting
deficits however it can, including cross-sub-
sidization from paying patients. Prices should
be set to enable institutions to remain fi-
nancially 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 provid-
ers will come to fee} no shame in refusing
to serve those who cannot pay, in declining
to offer or provide needed services that can-
not generate an acceptable economic re-
turn, 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).Z° 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
13
many key elements of health care. These
elements include the great knowledge im-
balance 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 re-
quired of the physician; the necessity of third-
party payment because of the unpredicta-
bility and cost of medical expenses, but which
substantially reduces the patient's price sen-
sitivity and attenuates market restraints on
prices; the importance of a community-wide
perspective on the need for services, par-
ticularly of high-cost, low-utilization ser-
vices such as 24-hour emergency room
coverage, burn treatment units, and neo-
natal 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 en c! tend to be in-
versely related to ability to pay.
Aclherents 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 ea-
gerness to duplicate services without re-
spect for community "need" if doing so serves
competitive advantages; its alleged will-
ingness 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 Me equivalent
of packaging in other areas of merchandis
ng. Arcs 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 consum-
er's dollars away from the necessities and
tempting the provider to substitute the im-
provement 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
1
OCR for page 15
AN INTRODUCTION TO THE ISSUES
organizations should shape the configura-
tion 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 cer-
tainly underlie the debate about for-profit
or corporate trends in health care. Recog-
nition of the value issues may offer cIarifi-
cation 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 in-
centives be designee! 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 doDars on inef-
ficiency or unnecessary care)? Or is such
perfection of incentives an unrealistic coals
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? Mat
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 ex-
amination of the relationship between phy-
sicians and organizations rests on two
premises. First, the committee believes that
physicians have substantial fiduciary re-
sponsibilities toward their patients, mean-
ing 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 consid-
ered in light of the physician's fiduciary re-
sponsibilities.
The question of the physician's fiduciary
responsibilities inevitably leads to questions
15
of the economic arrangements in medical
practice and of the compatibility of profes-
sional responsibilities and the not-for-profit
organization. This is the subject of Chapter
8. Fears that physicians might exploit the
vuinerabilities of patients for pecuniary gain
are not new. Indeed, a conflict of interest
of sorts is present and manifest in any sit-
uation 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 oh must be a mo-
tivating force in stimulating the use of these
technologies, along with a desire to close
the income gap with high-income special-
ists. Ibus, there has long been concern about
physicians creating a conflict of interest by
establishing organizations (pharmacies, di-
agnostic centers, hospitals) external to their
practice and then making patient-care de-
cisions that can affect the economic weD-
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 phy-
sicians appear to be increasing and have cre-
ated special concerns about conflict of interest
and its impact on trust in the doctor-patient
relationship.
Second, the committee believes that phy-
sicians' responsibilities to patients require
that they play a role in monitoring and as-
suring the quality of care in medical orga-
nizations to which they refer or admit
patients. Although this role Frequently has
been inadequately realized and although in
OCR for page 16
16
stitutions (and their boards and administra-
tion) share this responsibility, the committee
has focused on the physician's role in this
regard, because of the concern with fidu-
ciary responsibilities and because organi-
zational 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 re-
duce the physician's voice on dec~sion-mak-
ing bodies. Many current developments-
the growth of HMOs, preferred provider
arrangements, and joint ventures, not to
mention the growing supply of physici~ns-
could reduce physicians' Eeedom to shift
patients away from an institution that the
physician finds unsatisfactory. And trends
such as the growth of multi-institu~onal ar-
rangements and the growth of for-pro~t or-
ganiza~ons could alter physicians' roles in
institutional management and governance.
These issues are examined in Chapter 9.
NOTES
1 The terms "for-profit," "investor-owned," and "pro-
prietary" are all used in this report to refer to orga-
nizations that are owned by individuals and corporations
(such as institutional investors) to whom profits are
distributed. Such organizations stand in contrast to or-
ganizations that are incorporated under state laws as
nonprofit or not-for-profit organizations. (The defining
characteristics of both types of organizations are dis-
cussed later in this chapter.) Terms within each set are
not used in a consistent fashion in the literature. Never-
theless, the committee sees some differences in con-
notation among the terms and has attempted to use
terminology appropriately and consistently as follows.
The term "proprietary" is used to connote the tra-
ditional 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 sub-
stantial number of stockholders. The term "for-profit"
encompasses both. (A drawback ofthe term "for-profit"
is that it seems to define organizations in teas of as-
sumed behavior that is, that such organizations will
seek to maximize profit, because by definition that is
their purpose. However, the committee sees organi
FOR-PROFIT ENTERPRISE IN HEALTH CARE
national 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 be-
cause the term "not-for-profit" conveys a direct contrast
with the term "for-profit" and because the term "non-
profit" 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" owner-
ship. 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 institu-
tions should not be misconstrued as a debate about
public versus private ownership. Except where explic-
itly noted, the public or government-owned institu-
tions referred to in this report are owned by state or
local governments, not the federal government.
2For example, the merging health care supply com-
panies, 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 hos-
pitals; W. R. Grace and Co. has acquired National
Medical Care, the hemodialysis company, and McDon-
nell Douglas owns more than half interest in an HMO
company called Sanus.
3The term "efficiency" appears in the report because
for-profit orations are commonly alleged to be more
efficient than public or not-for-profit organizations.
However it should be recognized that because "effi-
ciency" 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 differ-
ences in the service being produced is, unfortunately,
generally conjectural.
40f course, in addition to such boards and top man-
agement, centrally managed multi-institutional sys-
tems, whether for-profit or not-for-profit, typically also
have separate boards and management at the local in-
stitutional level. Ibe amount of local authority over
institutional affairs is variable.
5Stock 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
OCR for page 17
AN INTRODUCTION TO THE ISSUES
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.
6Public 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 trea-
sury), 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 in-
directly under control of elected officials; a significant
portion of their operating budgets and capital needs
often comes in the form of direct governmental appro-
priations; and their responsibilities often explicitly in-
clude providing care to patients without insurance or
the ability to pay for care.
7Hansmann has labeled these two types as donative
and commercial not-for-profits, respectively.
8The concerns and arguments about the appropri-
ateness 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 val-
ues such as trust are generated or eroded by the in-
centives and practices of the market. Thinkers such as
David Hume and Adarn Smith saw the growth of com-
mercialism as enhancing such virtues as "industrious-
ness 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).
9Multiple 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
17
existed within institutions (See Duliand Hollingshead,
1968), although this has been diminished substantially
by governmental funding programs, particularly Med-
icare and Medicaid.
into illustrate this ethos, Forbes Magazine noted
with approval Republic Health's strategies for maxi-
mizing 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 mar-
keting 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 oc-
cupancy, 1,800 more patients were treated at the hos-
pital in 1984 than in 1983. "Result: the hospital made
$3 million pretax in 1984" (Tietelman, 1985~.
22Willingness 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 proven
and the growth of surplus beds) clearly shows. Com-
petitive impulses of a slightly different nature (e.g., for
prestige) were undoubtedly in part responsible.
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OCR for page 19
APPENDIX TO CHAPTER 1
Economic Theories of For-Prolit and
Not~for-Profit Organ~zadons
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 ser-
vices. It describes the different objectives that
economic theory suggests are pursued by or-
ganizations in each sector and considers the
implications for the behavior of health care
providers primarily hospitals of these ob-
jectives. Because it is the nature of theory to
abstract from the complexities of everyday
reality, the emphasis here is on the basic ele-
ments that theoretically distinguish the three
sectors. ~
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 deci-
sions, 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 conse-
quence, resources are used in a way that sac-
rifices the least amount of alternative
production. In addition to directing resources
19
into their most productive uses, the compet-
itive market model has the result that consum-
ers attain their highest possible levels of
economic satisfaction, given their preferences
and incomes.
Why, then, does an economy include gov-
ernmental production or not-for-profit, private
production? What are the comparative advan-
tages of these sectors, and what variables de-
termine which services are produced by which
sector?
According to economic theory, the govern-
ment 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,
1967:46~63; Musgrave and Musgrave, 1973:5~.
National defense, law and order, fire protec-
tion, administration of justice and of contracts,
parks, and basic research are services that ben-
efit the community. However, since people
can receive the benefits of such services with-
out paying for them, they are unlikely to be
produced by profit-making fiens. Too, the pri-
vate, 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 vac-
cination against measles also protects his
schoolmates. There is neither a means to ex-
clude the neighbors or schoolmates from the
benefits nor to charge them for their share.
Governments also may produce some ser-
vices for people who, if they had to pay a pri-
vate provider, would go without. Ibus, another
important rationale for governmental produc-
tion 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 Chil-
dren) are one form of redistribution; direct
OCR for page 20
20
provision of services such as health and edu-
cation 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 Mat benefit consumers collectively
rather Wan individually (another excellent ex-
ample 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 wel-
fare and the government provides compen-
sation when the market fails? A not-for-profit
organization gives up "the right to accu-
mulate a monetary residual which then can
be distributed to its owners for personal con-
sumption. Instead, ~} not-for-profit orga-
nizations' resources must be used internal-
ly . . ." 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 fiends through
compulsory taxation, but must depend on
some combination of (1) selling their prod-
uct 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-Drofit or~aniza-
tions 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 re-
ceives favored status under most federal leg-
islation. The principles on which this special
treatment is founded are not clearly for-
mulated (Hansmann, 1980~; however, since
not-for-profit organizations existed before
these government~onferred advantages, this
favored status would not appear to be caus-
ative.
A number of theories attempt to explain
the existence of not-for-pro~St organizations.
One is that the not-for-profit organization is
optimal when information regarding the
quality or quantity of service is asymmetric
FOR-PROFIT ENTERPRISE IN HEALTH CARE
in favor of the seller (Hansmann, 1980; Eas-
ley and O'1Iara, 1983; Bays 19831. When
consumers are at an informational disadvan-
tage, 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 con-
sumers 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, be-
cause they are prohibited from sharing in
any excess profits.
Complex persona] services such as heath
care are especially at issue:
Often the complexity of these services, their non-
standard 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 in-
centive to seek some constraints on the organiza-
tions' 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 mon-
itor, because the preferences of consumers for
the ostensible protection of the not-for-profit
forIn would make it difficult or impossible for
for-proIRt producers to remain in the market.
However, we observe the continued existence
of both forms in the nursing home and day-
care industries, where presumably informa-
tion asymmetry exists and where transferring
to a different provider is difficult dames and
Rose-Ackerman, Forthcoming). Other goods
arid services for which quality is difficult to
ascertain are produced almost entirely by for-
profit Grins; 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 predom-
inates, 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 or-
ganizations.
OCR for page 21
AN INTRODUCTION TO THE ISSUES
An alternative theory is proposed by Ben-
Ner (1983), who theorizes that the not-for-profit
organization emerges in response to consum-
ers' 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 ex-
ample. The not-for-profit firm (e.g., the con-
sumer-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 avail-
able to consumers, which is to form coalitions
to reduce or remove information asymmetry
by sharing information, seeking expert advice,
or conducting research.)
Weisbrod (1971, 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 pub-
lic 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 ex-
ample, can be a means for citizens to meet
their demand for higher quality or to meet
their special religious, linguistic, or other pref-
erences. Thus, this model suggests that not-
for-profit organizations arise to meet the het-
erogeneous demands of consumers for public
and quasi-public services that are not Filly 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). Accord-
ing 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 pro-
curement practices that raise production costs
for the government. Not-for-profit organiza-
tions also offer the potential for receiving do-
nations of money and in-kind services that is
21
not offered by for-prof~t firms. "Contracting
out," as well as more subtle forms of delegation
therefore give the government a degree of flex-
ibility, 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 bu-
reaucratically unable to do so except by sub-
sidizing private organizations.
Thus, economic theory offers several expla-
nations for why some goods and services are
produced by not-for-profit firms. The theory
suggests that not-for-profit production may ex-
ist as a response to consumers' need for pro-
tection 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 standardizecl
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 char-
acterize 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 re-
viewed in the following section.
hIODELS OF THE BEHAVIOR OF FOR
PROlIT AND NOT-FOR-PROFIT
ORGANI2;AIIONS
Traditional economic theory treats the man-
agement structure and decision-making pro-
cess as a black box. The filial is characterized
by an objective fimction that represents either
a single decision maker or the result of inter-
actions (and the resolution of any conflicts)
among stockholders, trustees, and managers.
The basic model hypothesizes that, irrespec-
tive of how decisions are made, the firm's ob-
jective is to maximize profits. More recent
theories of the for-profit firm, discussed be-
low, take greater cognizance of the role of man-
agers and the possibility Mat profit maximization
OCR for page 22
22
may not be their sole or even their primary
objective.
Economic theories of the behavior of not-
for-prof~t firms generally ascribe to them ob-
jectives other than profit (i.e., net revenue)
maximization (Davis, 1972; lames and Rose-
Ackerman, Forthcoming). In the simplest not-
for-proht model the objective is to maximize
output. If the not-for-profit organization pro-
duces a single product, such as day care, re-
ceives 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 prod-
uct 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 pop-
ulated by profit-maximizing producers.
This picture becomes more complicated,
however, in the more relevant case in which
a not-for-profit firm receives unrestricted do-
nations and produces more than one product.
Whether the not-for-profit firm's long-run out-
put 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-pro~t
managers and their donors desire to produce
higher levels of some or all of their outputs
(serving greater numbers of people, for ex-
ample), these levels will be obtained at the
expense of efficiency in comparison with the
profit-maximizing firm in a competitive in-
dustry. As discussed below, however, the hos-
pital industry has substantial entry barriers and
other characteristics that cause it to differ from
the purely competitive model.
Ike fact that a not-for-profit firms managers
do not share in any surplus resulting from ef-
ficiency 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 stock-
holders can exercise control of managers offor-
profit firms, or, in extreme cases, takeovers
via the capital market can perform the role of
FOR-PROFIT ENTERPRISE IN HEALTH CARE
selecting managers who maximize profits
through efficient production, such mecha-
nisms are not available in the not-for-proISt
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 in-
puts, and production of a nonoptimal mix of
outputs dames and Rose-Ackerman, For~-
coming; 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 Man is
optimal from an efficiency standpoint).4 In the
latter case, the not-for-profit firm will op-
erate well short of maximum efficiency in
the short run. Lee's (1971) mode! 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 ex-
tension, 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 mar-
ket and drive down the price through com-
petition, but the availability of donations can
cushion the not-for-profit manager from the
pressures of competition.
Models of not-for-profit organizations of-
ten include the objective of maximizing
quality (Newhouse, 1970~; however, the ef-
feet 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 cap
infer quality from the fees, and those con-
sumers 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 meth-
ods will be utilized, such as waiting lists in
the case of high-quality not-for-profit nurs-
ing 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 ed
OCR for page 23
AN INTRODUCTION TO THE ISSUES
ucation and research), the not-for-profit or-
ganization is hypothesized to engage in cross-
subsidization. The profit-maximizing firm
theoretically will not do so, because its op-
timal 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-quaTity or esoteric
medical care as suggested by Newhouse) by
producing other outputs that he does not
particularly value but that generate a sur-
plus. The surplus then can be used to sub-
sidize the valued outputs. The sale of gifts
and T-shirts to subsidize the exhibits and
research activities of the Metropolitan Mu-
seum 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 man-
agers 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 subsi-
dies. Thus, not-for-profits' continued dis-
cretion over the production of desired outputs
over time requires barriers to entry, dona-
tions, or both. This discretionary behavior
by managers does not necessarily coincide
with the preferences of donors or with max-
imum social welfare.
The presence of entry barriers and asym-
metric information suggests that profit-max-
imizing firms may not operate efficiently in
industries such as hospital care and educa-
tion. 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. Baumo} (1967), for example, de-
velops a model that characterizes the firm
as maximizing tote] revenues, subject to the
constraint that stockholders receive a suffi-
cient 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 fib. Also simi-
larly, this type of behavior can be sustained
23
only if there are entry barriers.
Another model, from Williamson (1981),
suggests that managers of for-profit firms
prefer certain expenditures to others be-
cause they contribute to the managers' sta-
tus and security. This mode} is analogous to
the input-preference mode] of not-for-profit
behavior discussed previously. However, as
distinct from Baumol's model, Williamson's
mode} gives a greater weight to profits, be-
cause they permit the firm to expand, which
also provides prestige to the manager. Both
models predict that the firm will favor cer-
tain factors of production and will produce
some outputs beyond profit-maximizing lev-
els, behaviors that also are attributed to the
not-for-profit firm and that imply nonefh-
cient 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 cir-
cumstances: profit maximization as the over-
riding 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 ob-
jectives that differ from profit maximization,
including the enhancement of their organiza-
tion's prestige; the provision of specific ser-
vices that further this or other goals; the
provision of charitable care, teaching, or re-
search; 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 Grins to enter the hos-
pital 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 pres-
ent for many hospital services. However, the
issue of information asymmetry depends cru
OCR for page 24
24
cially on the role of the physician. If, as Hans-
mann 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 pro-
duce 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 sat-
isfies the preferences of physicians rather than
the preferences of consumers or managers.
The nature of hospital services and the char-
acteristics 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 non-
profit organization appears to compare unfa-
vorably with the competitive ideal, this standard
of comparison probably is inappropriate in the
hospital industry. For-prof~t hospitals, be-
cause of entry barriers, information asymme-
try, 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 hospi-
tals do not behave in socially optimal ways.
Even though managers of not-for-profits can-
not receive directly a share of any monetary
surplus, the presence of donations and entry
barriers and the absence of stocl~older pres-
sures may allow them considerable leeway to
use resources and to produce services accord-
ing to their own preferences. These prefer-
ences may or may not be consistent with those
of society.
This discussion has not addressed the cru-
cial issue of how services are to be distributed.
According to standard economic theory, the
profit-maximizing firm in a competitive econ-
omy sells its product at the market price to
anyone who wants to buy at that price and
who can afford it. Thus, the competitive mar-
ket distributes goods and services in accord
with the existing income distribution. If so-
ciety prefers that hospital services be distrib
FOR-PROFIT ENTERPRISE IN HEALTH CARE
uted more equitably, and if managers of not-
for-profit hospitals share society's preferences,
then these hospitals may be superior to for-
pro~t hospitals when judged in terms of so-
cietal well-being.
NOTES
1A 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.
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 (19751.
fin the case of certain not-for-profits- religious, ed-
ucational, health, scientific, cultural, and social service
organizations" donor contributions also are tax de-
ductible. Others, chiefly membership groups such as
social clubs, fiaternal organizations, and labor unions,
are tax-exempt but donations are not (Rudney, 1981~.
4The legal requirement that a nonprofit organiza-
tion's costs must be reasonable is intended to deter
such behavior.
REFERENCES
Baumol, W. J. (1967) Business Behavior, Value and
Growth. New York: Harcourt, Brace, and World.
Bays, Carson W. (1983) Why Most Private Hospitals
Are Nonprofit. Journal of Policy Analysis aru] Man-
agernent 2~3~:36~385.
Ben-Ner, Avuer (1983) Nonprofit Organizations: Hey
Do They Exist in Market Economies? Working Paper
No. 51. Program on Non-profit Organizations, Yale
University.
Davis, Karen (1972) Economic Theories of Behavior
in Nonprofit, Private Hospitals. Journal of Economics
and Business 24~2~:1-13.
Easley, David, and Maureen O'Hara (1983~1he Ecm
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Economics 14~2~:531-538.
Hansmann, Henry B. (1980) We Role of Nonprofit
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James, Estelle (1982) Production, Consumption and
Cross-Subsidization in Non-profit Organizations.
Working Paper No. 30. Program on Non-profit Orga-
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James, Estelle, and Susan Rose-Ackelll~an (Forth-
coming) lye Nonprofit Enterpnse in Market Econ-
omies. In M. Montias and J. Kornai (eds.) Economic
Systems.
OCR for page 25
AN INTRODUCTION TO THE ISSUES
Lee, Maw Lin (1971) A Conspicuous Production
Theory of Hospital Behavior. Southern EconomicJour-
nal 28(1):48-58.
Gustave, Richard A., and Peggy B. Musgrave (1973)
Public Finance in Theory and Practice. New York:
McGraw-Hill.
Newhouse, Joseph P. (1970) Toward a Theory of
Nonprofit Institutions: An Economic Model of a Hos-
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Okun, Arthur M . (1975) Equality and Efficiency: The
Big Tradeoff. Washington, D.C.: The Brookings In-
stitution.
Pauly, Mark, and Michael Redisch (1973) The Not-
for-Profit Hospital as a Physicians' Cooperative. Amer-
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Rudney, Gabriel (1981) A Quantitative Profile of the
Nonprofit Sector. Working Paper No. 40. Program on
Non-pro~t Organizations, Yale University.
25
Samuelson, Paul A. (1967) Economics. 7th ed. New
York: McGraw-Hill.
Sloan, Frank A. (Forthcoming) Property Rights in
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Care Policy.
Weisbrod, Burton A. (1977) The Voluntary Non-
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Weisbrod, Burton A. (1980) Private Goods, Collec-
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177 in Kenneth W. Clarkson and Donald L. Martin
(eds.) The Economics of Nonproprietary Organi~a-
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Williamson, Oliver E. (1981) The Modern Corpo-
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nomic Literature l9(December):1537-1568.
Representative terms from entire chapter:
care institutions
