Yardstick competition in healthcare financing

Yardstick competition

Briefly
Hospital is reimbursed with the industry average marginal cost, which forces hospitals that have above average marginal costs to introduce cost saving efforts in order to break even.

Why we need it?
Hospitals have some monopoly power due to:
- people's ability to shop around medical services is limited when they sick
- information about the quality of medical services is limited or complicated, so people tend to rely on their past experience
- outcomes are unpredictable, cannot judge the quality
- you don't really know the price until you get the bill
- it is often the case that there is only one specialised hospital in the area that offers the service
and on, and on, and on...

So, the fact is, the hospital is a half monopolist, which is usually called monopolistic competition. And as a half monopolist, hospital's production behavior is somewhere between a perfect competitor and a monopolist. Thus, it is not efficient and there is some welfare loss involved. Also, less competition means less effort to be efficient. Yardstick competition financing is used to shift the production efficiency closer to perfect competition and away from monopoly.

(Note. Perfect competition equilibrium is at P=AC=MC=AR=Demand. Monopolist equilibrium is at MC=MR but P=AC at that quantity)

Lets look at the picture below. If there was a perfect competition, the equilibrium point would be at A, with price Pp and quantity Qp. The price equals marginal cost at this points, so the hospital does zero economic profit.

However, monopolist maximizes profits by setting price Pm and producing Qm quantity. The result is welfare loss that equals the area of the triangle limited by the area below A-B and MC lines.

So, due to high monopoly power, hospitals tend to produce at price and quantity closer to point B on the picture. Yardstick competition forces them to produce closer to point A, which is a perfectly competitive market outcome that maximizes welfare.

How it works?
So, how we can get closer to the perfect competition case? First, we can reimburse hospitals at their marignal cost level, which is price Pp on the picture above. This will force them to produce quantity Qp. This is slightly better.

But, in a perfect market, firms look for ways to reduce their costs to get more profit. Those, who fail to become more efficient leave the market. That does not work quite well with hospitals.

So, to force hospitals become more efficient, instead of financing each hospital at its marginal cost, lets reimburse with an average of all hospitals' marginal costs (MCav on the picture below). Now, around half of the hospitals will end up not receiving enough reimbursement to cover their marginal costs, i.e. face potential bankrupcy (loss equals rectangular area AC-MCav-Qav-Yaxis). They will have average cost (AC-curved line) that is higher than the reimursement price.

But the generous guys from the government now offer them a lump sum to purchase cost reducing technologies, so they can break even or make some profits. So, costs are reduced (lets say down to MCnew), hospital made profit (rectangular area MCnew-MCav-Qav-Yaxis), everyone is happy. Well, only until the end of the year, when generous guys from the government recalculate average marginal cost and again, make half of the hospitals face potential bankrupcy, unless they reduce their marginal costs. So, the yardstick is being recalculated each year, until there is not more room for improving efficiency.

Further notes
Hospital's own marginal cost is excluded from calculation of industry average marginal cost, so the hopsital cannot influence it.