Multitasking, quality and pay for performance

We present a model of optimal contracting between a purchaser and a provider of health services when quality has two dimensions. We assume that one dimension of quality is contractible (dimension 1) and one dimension is not contractible (dimension 2). We show that the optimal incentive scheme for the contractible dimension depends critically on the extent to which quality 1 increases or decreases the marginal cost and marginal bene?t of quality 2 (i.e. substitutability or complementarity). If the two quality dimensions are substitutes, three possible solutions arise: a) the optimal incentive scheme is high powered: the incentive is equal to the marginal bene?t of quality dimension 1 and the optimal quality in dimension 2 is zero; b) the optimal incentive scheme is low powered: both quality dimensions are positive; the incentive is below the marginal bene?t of quality dimension 1; c) it is not optimal to introduce pay for performance as the gain of welfare from an increase in quality dimension 1 is lower than the loss of welfare from an increase in quality dimension 2. If the two quality dimensions are complements the incentive scheme is always high powered: the incentive is above the marginal bene?t of dimension 1 and both quality dimensions are positive.