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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

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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,

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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

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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

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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

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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

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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

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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 ~

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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

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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

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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

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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

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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. REFERENCES Aday, LuAnn, Ronald Anderson, and Gretchen V. Fleming (1980) Health Care in the U.S.: Equitablefor Whom? Beverly Hills, Calif.: Sage. American Hospital Association (1985) 1984 Hospital Cost and Utilization Trends. Econo7ruc Trends l(Spnog). American Medical Association (1985) Medicare As- signment: 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.: Bowman and Allanheld. Bunker, John (1970) Surgical Manpower: A Com- parison of Operations and Surgeons in the United States and in England and Wales. The Nets England Journal of Medicine 282:135-144. 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):141~1489. 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.

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18 Easley, David, and Maureen O'Hara (1983) The Eco- nomic Role of the Nonprofit Firm. Bed Journal of Eco- nomics 14(Autumn):531-538. Ginzberg, Eli (1984) The Monetarization of Medical Care. The New England Journal of Medicine 310(May 3~:1162-1165. Hansmann, Henry B. (1980) The Role of Nonprofit Enterprise. Yale Law~ournal 89(April):835 901. Health Affairs (1984) Special issue on "Variations in Medical Practice." 3(Summer). Hirsch, Fred (1976) Social Limits to Growth. Carn- bridge, 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 Non- profit Health Care Institutions. Pp. 17-34 in Bradford H. Gray (ed.) The New Health Care for Profit. Wash- ington, D.C.: National Academy Press. Jonsen, Albert (1983) Watching the Doctor. The New England Journal of Medicine 3080une 23~:1531-1535. Lult, Harold S. (1981) Health Maintenance Orga- nizations: Dirnens~ns of Performance. New York: Wiley. Majones, Giandomenico (1984) Professionalism and Nonprofit Organizations. Journal of Health Politics, Policy and Law 8(Winter):639-659. Modern Healthcare (1985) 15Qune 7~. Pauly, Mark (1980) Doctors and Their Workshops. Chicago, Ill.: University of Chicago Press. Pauly, Mark, and Michael Redisch (1973~1he Not- for-Profit Hospital as a Physicians' Cooperative. Amer- ican Economic Review 63(March):87-99. Relman, Arnold S. (1980) The New Medical-Indus- trial Complex. The New England Journal of Medicine 303~0ctober 23~:963-969. Relman, Arnold S., and Uwe Reinhardt (1986) An Exchange on For-Profit Health Care. This volume. Roe, Benson B. (1981~1be UCR Boondoggle: A Dead Knell for Private Practice? The New England Journal of Medicine 305July 2~:4145. Schroeder, Steven A., and Jonathan A. Showstack (1978) Financial Incentives to Perform Medical Pros cedures and Laboratory Tests. Medical Care 12 (Au- gust):709-713. FOR-PROFIT ENTERPRISE lN HEALTH CARE 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 (ea. ~ 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 (ed.), Health Care Policy. Starr, Paul (1982) The Social Transformation of American Medicine New York: Basic Books. Steinwald, Bruce, and Duncan Neuhauser (1970~1he Role of the Proprietary Hospital. Law and Contem- porary Problems 35(Autumn):817-838. Stevens, Rosemary (1982) A Poor Sort of Memory: Voluntary Hospitals and Government Before the Depression. Mil~ank Metric Fund Quarterly 60:551- 584. Stevens, Rosemary (1985) The Historical Perspective [on lbe New Entrepreneurialism in Health Care]. Bul- letin of the Nets York Academy of Medicine 61Janu - - February):54-59. Tietelman, Robert (1985) Selective Surgery. Forbes (April 22~:75-76. U. S. Small Business Administration (1983) Unfair Competition by Nonprofit Organizations with Small Business: An Issue for the 1980s. Washington, D.C.: U.S. Small Business Administration. Veatch, Robert M. (1983) Ethical Dilemmas of For- Profit Enterprise in Health Care. Pp. 125 152 in Brad- ford H. Gray (ed.), The New Health Care for Profit. Washington, D.C.: National Academy Press. Vladeck, Bruce (1976) Why Nonprofits Go Broke. Tile Public Interest 42(Winter3:8~101. Weisbrod, Burton A. (1981) We Limitations of Com- petiffon: A Skeptical View. Pp. 40-51 in Competition- Regulation and the HMO: Impact on Hospitals and Physicians, 23rd Annual George Bugbee Symposium on HospitalA~airs. Chicago, Ill.: University ofChicago Graduate School of Business. Williamson, Oliver E. (1981) The Modern Corpo ration: Origins, Evolution, Attributes. Journal of Eco- nomic Literature 19(December):1537-1568.

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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

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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.

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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

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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

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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

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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 nomic Role of the Nonprofit Firm. The Bed Journal of Economics 14~2~:531-538. Hansmann, Henry B. (1980) We Role of Nonprofit Enterprise. The Yale law Journal 89~5~:83~901. James, Estelle (1982) Production, Consumption and Cross-Subsidization in Non-profit Organizations. Working Paper No. 30. Program on Non-profit Orga- nizabons, Yale University. 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.

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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- pitil. American Economic Review 60~1~:64-74. 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- ican Economic Beview 63~1~:87-99. 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 He Hospital Industry. In H. E. Frech III (ed.), Health Care Policy. Weisbrod, Burton A. (1977) The Voluntary Non- profit sector An Economic Analysis. Lexington, Mass.: Lexington Books. Weisbrod, Burton A. (1980) Private Goods, Collec- tive Goods: The Role of the Nonprofit Sector. Pp. 139- 177 in Kenneth W. Clarkson and Donald L. Martin (eds.) The Economics of Nonproprietary Organi~a- tions. Greenwich, Conn.: JAI Press. Williamson, Oliver E. (1981) The Modern Corpo- ration: Origins, Evolution, Attributes. Journal of Eco- nomic Literature l9(December):1537-1568.