Yardstick Competition when Quality is Endogenous: The Case of Hospital Regulation

In many countries hospital regulation undergoes fundamental change. In reaction to steadily increasing costs, authorities switch from cost of service regulation to prospective payment systems (PPS). While it seems clear that this new scheme sets strong cost saving incentives, this is not so clear for quality provision. As a matter of fact, everything hinges on the prices the regulator sets. Figuring out optimal prices is, however, a difficult task, be- cause the regulator faces serious informational limitations. The literature largely ignores this problem and points to Shleifer's (1985) yardstick compe- tition for a solution. Yardstick competition, however, ignores quality issues. This paper fills this gap in the literature and shows that endogenizing qual- ity changes the results of yardstick competition substantially. Quality will be zero and cost reduction efforts can be heavily distorted. In general, a simpler version of yardstick competition average cost pricing turns out to be more favorable, though not perfect.