Shleifer: The theory of yardstick competition
Franchised monopolies in the United States are typically subject to "cost-of-service"
regulation => the regulator adjusts the firm's prices to equal the costs it incurs
Regulation avoids welfare losses from monopoly pricing, but also permits high enough
prices to induce the firm to supply. BUT if prices track costs, the firm has no profit
incentive to minimize costs.
Need of: cost control, prevent waste, and promote cost-reducing innovation, cost-of-service
regulation must be modified.
One approach to this problem is lagged price adjustment, which allows firms to reap the
benefits from reducing their costs for some time until the price is brought down.
First, there is the welfare loss from divergence of marginal cost from price, which
accumulates between cost reviews. Second, if firms recognize that prices ultimately follow
costs, they may well not reduce costs to efficient levels. What the regulator needs is some
relatively simple benchmark, against which to evaluate the firm's potential => can decide
what the firm's costs ought to be => can set the price
One obvious available benchmark is a state-owned firm engaged in the same line of
business as the regulated firm.
It is possible to compare similar regulated firms, where the regulator uses the costs of
comparable firms to infer a firm's attainable cost level. Borrowing the term that
describes comparison of private and state-controlled firms, we call this regulatory
scheme "yardstick competition."
Medicare's prospective reimbursement system compensates hospitals on the basis of
average costs incurred by comparable hospitals in treating patients in the same DRG.
The efficacy of using costs of comparable firms as indicators of a firm's potential is best
illustrated for "identical" firms, which the regulator can expect to be able to reduce costs at
the same rate. By relating the utility's price to the costs of firms identical to it, the regulator
can force firms serving different markets effectively to compete. If a firm reduces costs when
its twin firms do not, it profits; if it fails to reduce costs when other firms do, it incurs a loss.
In the case of heterogeneous firms, yardstick competition is likely to compare favorably with
cost-of-service regulation, and it actually attains the social optimum if heterogeneity is
accounted for correctly.
Prospective reimbursement using diagnostically related groups (DRG)
The experience with DRG reimbursement by Medicare illustrates the strengths and
weaknesses of yardstick competition.
Medicare divides all possible patient types into 500 diagnostically related groups. Each
patient is assigned to a group on the basis of his physician's diagnosis, and Medicare pays
hospitals a fixed fee for treating a patient, given his DRG.
Fee = the average costs of treating patient in the same DRG taken across comparable hospitals
over the previous year + plus inflation adjusting
If a hospital can treat its patients for below what it costs others to treat similar patients,
it pockets the excess of its fee over its cost; if it cannot keep costs below fees, it suffers a
loss.
With 40% of an average hospital's revenue coming from Medicare payments, one expects
hospitals to try to minimize costs. Evidence from early Medicare results shows progress in
cost control.
Half-year after the beginning of Medicare's program, the average stay per Medicare patient
has dropped, arguably bc payments, unlike costs, do not rise with the length of the stay. In
contrast, in states that introduced incentive payments based on per diem rates, lengths of stay
seem to rise.
Though Medicare currently adjusts its payments by a geographic cost-of-labor index, and
gives extra money to teaching hospitals, it disregards other sources of variation. Most
conspicuously, it does not adjust the payment for the severity of illness.
The reasons for this policy are obvious: the moral hazard associated with reporting severity
is great, and different hospitals probably get equally sick patients. If, some hospitals get a
disproportionate share of very sick patients, they will suffer. This issue seems to be perceived
as a serious flaw in the current system, and cheat-proof corrections for severity are a large
research topic in this area.
Difficulties of devising a perfect reimbursement program point to the importance of
moral hazard.
Doctors can:
• injudiciously reduce patients' length of stay in the hospital to contain costs
• they can discharge patients and then readmit them "with complications" or under a
different DRG
• They can forego implementation of new and better procedures bc Medicare does not
adequately pay for them.
Medicare should apply the same approach the same like to other endogenous variables. So,
hospitals that have more than the average number of readmissions might not be compensated
for them; hospitals that discharge patients within a DRG much faster than do other hospitals
should perhaps be penalized...
More complication than what they will save in cost.
The rewards of a given firm depend on its vis-à –vis a shadow firm, in this case the outcome
is efficient.
Yardstick comp is likely to outperform cost-of-service regulation. The reason is that welfare
losses from unobservable firm differences are small till these differences are small.
In contrast, welfare under cost-of-service regulation can fall far short of the optimum. An
important potential limitation of yardstick competition is its susceptibility to collusive
manipulation by participating firms. At issue is whether firms can slow down cost reduction
without losing money or even make money.
