An application of the principal-agent theory: Not-for-profit hospitals

This dissertation explores the application of the principal-agent theory to not-for-profit hospitals. Economic theory of the agency predicts efficiency losses and sub-optimal production due to principals' weak control over agents' behavior. This is largely attributable to information asymmetry between principals and agents. From a public policy perspective, if there is evidence indicating economic inefficiencies associated with not-for-profit firms, economic justification of the tax benefits provided to not-for-profit hospitals could be questioned. The objective of this dissertation is to discover whether such economic inefficiencies exist.;Review of the not-for-profit literature and the associated empirical studies show little discernable difference between not-for-profit and for-profit hospitals in pricing, product mix, resource allocation and other economic decisions. Further, both types of hospitals appear to be providing the similar levels of the community health benefits such as free or discounted care for the indigent population. Conventional wisdom is that not-for-profit hospitals are community oriented but studies do not provide significant evidence for that. Furthermore, the non-profit form may heighten the effects of the principal-agent problem, i.e., the contradictory interests of the principal and its agent. Given the characteristics and incentives of the principal (hospital board of trustees and local community), and the agent (hospital management), the principal's control over the agent in the not-for-profit environment may be more hindered in comparison to for-profit hospitals.;This dissertation develops a positive model based on the principle-agent theory, explaining how the rational ignorance behavior by principals and the rent-seeking by managers result in weak oversight over the management. Two predictions of the theory, which are over-production and above the market monetary and non-pecuniary rewards for the management, are tested on a representative sample of California hospitals. Regression analysis shows that the not-for-profit hospital managers on average receive greater compensation and have lower turnover rates on the job, i.e. greater job stability in comparison to the for-profit California hospitals in the sample. In addition, the difference of means test over the fourteen-year study period indicates a not-for-profit hospital tendency to use more labor inputs in the production of the similar outputs. Implication is that non-profit hospitals may structurally be disposed to perform economically less efficiently than for-profit hospitals. To address these findings, I show that the managerial rewards could be structured in such a way as to reduce the negative effects of the moral hazard due to the principal-agent problem and provide positive incentives for the greater economic efficiency. As a result, the scope of this work has a practical and timely bearing on the current debate about the health care reform.;Later in the dissertation I deal with the public policy implications of the model. Particular attention is paid to the various not-for-profit institutional reform proposals aimed at addressing the principal-agent problem. There is room for various self-regulatory approaches on the part of hospitals. In fact, a number of institutional reforms inspired primarily by the Sarbanes-Oxley Act are being embraced voluntarily by the not-for-profit hospitals. Taken together with a managerial compensation system that rewards efficiency, these measures could alleviate the principal---agent problem and information asymmetries.