Hospital Competition with Soft Budgets

• Published date: 01 July 2015
• Author: Kurt R. Brekke,Luigi Siciliani,Odd Rune Straume
• DOI: http://doi.org/10.1111/sjoe.12111
• Date: 01 July 2015

Scand. J. of Economics 117(3), 1019–1048, 2015

DOI: 10.1111/sjoe.12111

Hospital Competition with Soft Budgets∗

Kurt R. Brekke

Norwegian School of Economics, NO-5045 Bergen, Norway

kurt.brekke@nhh.no

Luigi Siciliani†

University of York, York, YO10 5DD, UK

ls24@york.ac.uk

Odd Rune Straume††

University of Minho, 4710-057 Braga, Portugal

o.r.straume@eeg.uminho.pt

We study the incentives for quality provision and cost efficiency for hospitals with soft

budgets, where the payer can cover deficits or confiscate surpluses. While a higher bailout

probability reduces cost efficiency, the effect on quality is ambiguous. Profit confiscation

reduces both quality and cost efficiency. First-best is achieved by a strict no-bailout and

no-profit-confiscation policy when the regulated price is optimally set. However, for subop-

timal prices, a more lenient bailout policy can be welfare-improving. When we allow for

heterogeneity in costs and qualities, we also show that a softer budget can raise quality for

high-cost patients.

Keywords: Cost efficiency; hospital competition; quality; soft budgets

JEL classification:I11; I18; L13; L32

I. Introduction

Hospital deficits and government-sponsored bailouts are frequently ob-

served in many countries. Recently, the English newspaper The Telegraph

wrote (15 September 2011):

Taxpayers will face a £5 billion bill to bail out failing NHS hospitals over

the next few years unless radical action is taken.

This headline was based on a report co-authored by a former health

adviser (Professor Paul Corrigan) to Tony Blair.1According to this report,

†Also affiliated with CEPR.

††Also affiliated with NIPE and University of Bergen.

∗We thank two anonymous referees for very helpful suggestions. Comments from participants

at the 2012 EARIE Conference are also gratefully appreciated.

1The report “The hospital is dead, long live the hospital” by P. Corrigan and C. Mitchell

was published by the UK think tank Reform in September 2011.

CThe editors of The Scandinavian Journal of Economics 2015.

1020 Hospital competition with soft budgets

more than 40 UK hospitals are facing financial problems, and the National

Health Service (NHS) must deliver £20 billion of efficiency savings to

balance the budgets. This situation is not specific to the UK. In Norway,

for instance, hospitals have been running deficits over a long period. In

2002, the government introduced a reform to harden the hospitals’ budget

constraint by transforming the public hospitals into state-owned enterprises.

However, Hagen and Kaarbøe (2006) show that the hospitals continued to

report deficits and to receive supplementary funding from the government

after the reform. Hospital deficits and bailouts are also present in healthcare

systems with a larger private sector, as in the US. According to Shen and

Eggleston (2009), the share of general acute US hospitals reporting negative

income grew from 21 percent in 1995 to 29 percent in 2004.

In a recent paper, Kornai (2009) discusses what he calls the soft budget

syndrome in the hospital sector.2Here, he points out that, despite being a

widespread phenomenon, the research on soft budgets in the hospital sector

is very limited.3With this paper, we aim to bridge this gap by studying

the impact of soft budgets on the provision of hospital care. We ask two

key questions. (i) What are the incentives for hospitals to be cost efficient

and to invest in quality when facing soft budgets? (ii) Is there a scope for

soft budgets to be welfare-improving in the hospital sector?

To analyze these questions, we consider a model with two competing

hospitals that differ in location (following Hotelling) and face demand

uncertainty. The hospitals invest in quality and expend effort on cost re-

ductions before the state of demand is revealed.4We consider the Nash

equilibrium where the hospitals earn negative profits in the high-demand

state and positive profits in the low-demand state. There are two reasons

why hospitals run deficits (surpluses) when demand is high (low).5First,

we assume that prices are regulated, implying that hospitals cannot profit on

high demand by increasing their prices. This is in line with most hospital

financing mechanisms across OECD countries that are based on diagnoses

related groups (DRGs). Hospitals receive a tariff for each patient treated,

2Kornai is considered to be the father of the concept of soft budget constraints. For a general

review of this literature, see Kornai et al. (2003) and Kornai (2001).

3There are a few (mainly) empirical papers on soft budgets in the hospital market (e.g.,

Duggan, 2000; Shen and Eggleston, 2009; Eggleston and Shen, 2011). We describe the

related literature in more detail later.

4Therefore, we consider dimensions of quality and cost efficiency that are more long term

and cannot be easily adjusted according to demand fluctuations. This can be investments

in machinery, medical equipment, training programs for medical staff, treatment protocols,

management procedures, etc.

5There is also some indicative evidence that high demand is the “bad state” in the hospital

sector. For instance, Hagen and Kaarbøe (2006) find that hospital deficits in Norway tend

to be higher when the hospitals treat more patients than expected (planned). They argue that

this is the key source of hospital deficits.

CThe editors of The Scandinavian Journal of Economics 2015.