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Representation of the trade-off
between quality and quantity. Based onFigure 6–5,
for any given reimbursement rate, a higher quality level can be achieved only
with a lower quantity of output. The curve shows alternative levels of quantity
and quality that can be achieved at a given reimbursement rate.

An alternative theory of resource
allocation and product supply in nonprofit agencies focuses on the behavior of
the executive or administrator of the organization. The underlying assumption
is that the administrator, even though just an agent of the trustees, has
considerable control over the organization’s resources. This seems a plausible
assumption given that trustees of a nonprofit agency typically can devote only
a small portion of their time to trustee-related activities, whereas the
administrator is usually a full-time employee. As part of this approach, a
comparative analysis can be done that examines how the same administrator would
behave if operating the same agency as a profit-seeking enterprise and as a
nonprofit enterprise. The differences in behavior, which are due solely to the
different incentive structures of the two types of organization, create
differences in the use of the agency’s resources and in the agency’s output.

The theory can be viewed as simply an extension of the basic demand
hypothesis presented in Chapter
3. According to this hypothesis, the lower the direct cost of a commodity
or other benefit to an individual, the more the commodity will be demanded. The
extension of the hypothesis involves identifying the commodities that are
desired by the administrator of an agency as well as their relative prices or costs
under varying institutional circumstances. Since we are focusing on the
administrator’s behavior, we will identify two types of benefits that can be
obtained in the context of the job. First, there are the pecuniary benefits,
especially the administrator’s salary. In addition, if the administrator is a
part or full owner of the agency, the pecuniary benefits will encompass the
profits that accrue. Benefits of the second type, sometimes called on-the-job
, are nonpecuniary. These include high-grade office furniture, a
relaxed work atmosphere, “business” trips to exotic places, and so on. Both
types of benefits are wanted by the administrator, but because their supply is
limited, the administrator cannot have everything he or she would like.

Before developing the hypothesis about how much of each type of benefit will
be demanded, we will look at the implications for resource use of obtaining the
two types. First, when a smaller amount of resources is used to obtain a given
output, an opportunity to increase profits is created. Nonpecuniary benefits
also require the commitment of resources. Better office equipment, more liberal
working conditions, and other on-the-job benefits are obtained from the
expansion of the total resource commitment and result in an increase in costs
and a contraction of profits. In a nonprofit enterprise, this reduction in
profits does not detract from the manager’s pecuniary benefits since he or she
will not be rewarded on the basis of the profits the enterprise earns.

The hypothesis as to how the administrator will behave under these
alternative incentive structures is based on the constraints facing the
administrator in the two different environments. In a nonprofit environment,
since the administrator cannot convert profits into take-home pecuniary
benefits, they must be converted into organizational resources if any benefit
is to be obtained. On the other hand, the use of these extra resources in a
for-profit organization will detract from profits and hence from take-home pecuniary
benefits, assuming these are related. The personal costs of on-the-job benefits
are lower for the administrator of the nonprofit agency, and we thus
hypothesize that more will be demanded.

The implications of this hypothesis for nonprofit resource allocation are
considerable. The hypothesis implies that the nonprofit agency will use more
resources to get a given job done, and so its costs will be higher. The absence
of incentives for efficiency has been the target of investigation, including
its effect on nonprofit agency operating costs, particularly in the case of
nonprofit health insurers (Frech 1976),
nursing homes (Borjas et al. 1983;
Frech 1985),
and dialysis units (Lowrie and Hampers 1981).
Similar analyses comparing nonprofit and for-profit hospital behavior have not
been as conclusive for several reasons. First, to compare operating costs
between nonprofit and for-profit hospitals, variables such as case mix, case
severity, and quality must be adjusted for. Assertions have been made that
nonprofit hospitals have a more complex case mix because for-profit hospitals
engage in “cream skimming” by encouraging the admission of low-cost cases.
Evidence on this score seems mixed (Bays 1977a,
Renn et al. 1985;
Schweitzer and Rafferty 1976).
Even more difficult to determine is whether quality differentials exist by
ownership category. Nonprofit managers do have an incentive to produce quality
care (which will show up in higher costs). The role of quality in pushing costs
higher has yet to be fully explored.

Another difference that has been uncovered when comparing nonprofit and
for-profit hospital behavior lies in the pricing area. Charges are the prices
set by the hospital for its services. Two California studies found that
for-profit hospitals had higher charges (relative to costs) for ancillary (lab,
radiology, pharmacy) services (Eskoz and Peddecord 1985;
Pattison and Katz 1983).
Generally, markups (charge-to-cost ratios) for ancillary services were found to
be higher than basic room charges. For-profit hospitals also provided more
(high-profit) ancillary services per patient than nonprofits in the studies and
were more profitable, although cost levels were similar. One possible
explanation of this finding is that nonprofit managers (or trustees) can gain
nonpecuniary benefits from encouraging the use of hospital services by keeping
patient charges low (which may result in lower profits) as well as by providing
more free care to indigents.

However, relying solely on the incentives identified in the administrator as
agent model to explain cost and price differences between for-profit and
nonprofit hospitals would be a mistake. The incentive differences are but one
factor operating to influence costs (and possible cost differences) in the two
types of organization. The reimbursement system is another major influence on
cost and supply behavior. Indeed, the absence of cost differences between
nonprofit and for-profit hospitals that was uncovered by the investigators in
California may have been partly due to the reimbursement system, which, at the
time of the studies, encouraged cost inflation in all types of hospitals. It is
to this factor that we turn to next, in Chapter


following is a cost function for clinic visits in a small inner city clinic:

Quantity of VisitsTotal Cost per Week
  • a.Determine the marginal cost
    for each level of output.
  • b.If the price per visit is
    given to be $25, at what level of visits will the maximum profit position
    be? What are the profits at this level? What is the quantity supplied?
  • c.If the price per visit
    increases to $45, what will be the quantity supplied (assuming maximizing



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