21875 THE ECONOMICS OF PUBLIC AND PRIVATE ROLES IN HEALTH CARE: INSIQHTS FROM INSTITUTIONAL ECONOMICS AND ORCANIZATIONAL THEORY by Alexander S. Preker and April Harding June 2000 THE W OR L D B AN K The Economics of Public and Private Roles in Health Care: Insights from Institutional Economics and Organizational Theory Alexander S. Preker Lead Economist The World Bank April Harding Private Sector Economist The World Bank THE ECONOMICS OF PUBLIC AND PRIVATE ROLES IN HEALTH CARE: INSIGHTS FROM INSTITUTIONAL ECONOMICS AND ORGANIZATIONAL THEORY A. A HISTORICAL SNAPSHOT through purchasing or budget transfers to service providers. The resource-generation function includes the Advances in health during the past few decades production, import, export, distribution, and retail of are impressive. The increase in life expectancy and the human resources, knowledge, pharmaceuticals, medical decrease in fertility throughout the world have been equipment, other consumables, and capital. The service- greater in the past 40 years than during the previous delivery function includes both population-base and 4,000 years (Figure 1). Life expectancy is almost 25 personal clinical services provided by the public sector years longer today than at similar income levels in 1900. and private sector (nonprofit and for-profit) Unparalleled mprovemnts X_ qThese core functions are influenced by governments through their stewardship function and by Life Expectancy and Fertility Rates the population through demand and markets. The 80 .60 combined effects of these five factors lead to either good P 70 | iS.S or poor performance in health outcomes, financial 65 7L Expectancy S0 protection, and responsiveness to consumer expectations ._ 60 4.5 (Figure 2).1 X0 / X Health systems are dysfunctional sometimes Ul 45B 30 Jr because of uneven development among the core g 40 ftiTotal Fertility Rates functions and sometimes because of poor coordination -J 35 , , , , F , | ~ > 2.5 and complimentarity between the public and private 3020 ~9ZO $0 ~ 2.0 sector. 1SS0 60 70 80 90 200010 20 30 40 2050cor Figure 1 Core Functional Components and These gains in health are partly the result of Perfomiance Measures improvements in income and education, with n . accompanying improvements in nutrition, access to contraceptives, hygiene, housing, water supplies, and StewardsAp sanitation. Asis described by the World Health V _ j outo Organization (WHO) in its 2000 World Health Report, i O|. I o .*I the achievements in health during the twentieth century __ __ * 4 F Pratection are also a result of new knowledge about the causes, - - 1 = prevention, and treatment of disease, and policies that cs * |rQuaftd make known interventions more accessible. _ - - Demnd and Msctot International experience indicates that the Figure 2 underlying cause of most threats to good health are well known today, and affordable drugs, surgeries and other interventions are often available, even in low-income We argue in favor of greater private sector countries. But, because of weakness in one or more of participation in generating inputs and providing health three core functions of health systems-financing, services and a strong government engagement in generation of inputs, and provision of services- securing equitable and sustainable financing as well as potentially effective policies and programs often fail to executing the "stewardship function." In too many reach the poor. countries, these roles are reversed, with adverse effects on equity and efficiency. The financing function includes the collection and pooling of revenues and the use of these revenues, I From Centuries of Minimalism ... But one does not have to resort to moral principles or arguments about the welfare state to Ideological views on the roles of the state and warrant collective intervention in health. The past the private sector belong to a long list of false antitheses century is rich in examples of how the privates sector in the field of medicine and health care.2 Since the and market forces alone failed to secure efficiency and beginning of written history, the pendulum has swung equity in the health sector. back and forth between minimalist and heavy-handed state involvement in the health sector. Economic theory provides ample justification for such an engagement on both theoretical and practical During antiquity, people used home remedies grounds to secure: and private healers when they were ill. Yet, as early as the second millennium B.C., the papyri give fascinating * efficiency-since significant market failure exists in evidence that Imhotep, archetypal physician, priest, and the health sector (information asymmetries; public court official in ancient Egypt, introduced a system of goods; positive and negative externalities; distorting publicly provided health care with healers who were or monopolistic market power of many providers paid by the community.3 and producers; absence of functioning markets in some areas; and frequent occurrence of high This early experiment in organized health care transaction costs)7 did not survive the test of time. The Code of Hammurabi (1792-50 B.C.) laid down a system of * equity-since individuals and families often fail to direct fee-for-service payment, based on the nature of protect themselves adequately against the risks of services rendered and the patient's ability to pay.4 For illness and disability on a voluntary basis due to the next three thousand years, the state's involvement in short-sightedness (free-riding) and characteristic health care revolved mainly around enforcing the rules shortcomings of private health insurance (moral of compensation for personal injury and protection of hazard and adverse selection).8 the self-governing medical guild.5 Largely inspired by western welfare state At best, financing, organization, and provision experiences such as the British National Health Service of health care was limited to the royal courts of kings, (NHS) and the problems of market failure, during the emperors, and other nobility who might have a physician past 50 years, many low- and middle-income countries for their personal use and for their troops at the time of established state-funded health care systems with battle. The masses got by with local healers, midwives, services produced by a vertically integrated public natural remedies, apothecaries, and quacks. bureaucracy. ... To Heavy-Handed State Involvement ... Back to Neoliberalism of the 1990s Unlike this early private participation in health During the 1980s and 1990s, the pendulum care, during the twentieth century, governments of most began to swing back in the opposite direction. During countries have become central to health policy, often the Reagan and Thatcher Era,9 the world witnessed a both financing and delivering a wide range of care. growing willingness to experiment with market Today, most industrial countries have achieved universal approaches in the social sectors (health, education, and access to health care through a mix of public and private social protection). This was true even in countries such financing arrangements and providers.6 as Great Britain, New Zealand, and Australia-historical bastions of the welfare state. Proponents of such public sector involvement in health care have argued their case on both philosophical As in the ascendancy of state involvement, the and technical grounds. In most societies, care for the recent cooling toward state involvement in health care sick and disabled is considered an expression of and enthusiasm for private solutions has been motivated humanitarian and philosophical aspirations. by both ideological and technical arguments. 2 The political imperative that has accompanied In many countries, for reasons of both liberalization in many former socialist states and the ideological views and weak public capacity to deal with economic shocks in East Asia and Latin America information asymmetry, contracting, and regulatory certainly contributed to a global sense of urgency to problems, governments often try to do too much- reform inefficient and bloated bureaucracies and to especially in terms of in-house service delivery-with establish smaller governments with greater too few resources and little capability. accountability.10 Parallel to such public production, the same Yet, it would be too easy to blame ideology and well-intending governments often fail to: economic crisis for the recent surge in attempts to reform health care systems by exposing public services * develop effective policies and make available to competitive market forces, downsizing the public information about personal hygiene, healthy sector, and increasing private sector participation.11 lifestyles, and appropriate use of health care regulate and contract with available private In reality, the welfare-state approach failed to sector providers address many of the health needs of populations across * ensure that adequate financing arrangements are the world.12 Hence, the dilemma of policymakers available for the whole population worldwide: although state involvement in the health * secure access to public goods with large sector is clearly needed, it is typically beset by public externalities for the whole population. sector production failure. 13 The next section will present a discussion of the Toward a New Stewardship Role of the State .........most significant sources of government production failure to which market-based solutions are being Today, governments everywhere are reassessing applied and the market imperfections that must be when, where, how, and how much to intervene or addressed to optimize complementarity between the two whether to leave things to the market forces of patients' sectors. demand. B. THE NATURE OF GOVERNMENT FAILURE The growing consensus is that to address this problem requires a better match between the roles of the Many attempts have been made in recent years state and the private sector, and their respective to reinvigorate the public sector through "best-practice" capabilities-getting the fundamentals rights. In most management techniques. Borrowed from the private countries, this means rebalancing an already complex sector and organizational reforms, these tools attempt to mix of public and private roles in the health sector.14 replicate the private incentive environment. 15 To improve efficiency or equity, governments These reforms have included efforts to can choose from an extensive range of actions-from strengthen the managerial expertise of health sector least to most intrusive. These include: staff, both through training and recruitment policies. Frequently, attempts are also made to use business * providing information to encourage behavioral process reengineering, patient-focused care, and quality- changes needed to improve health outcomes improvement techniques. Such efforts have also * developing and enforcing policies and included setting up clinical directorates, introducing regulations to influence public and private sector improved information systems to facilitate effective activities decision making, and performance benchmarking.16 * issuing mandates or purchasing services from public and private providers Why has the public sector been so impervious to * providing subsidies to pay for services directly these types of management and organizational or indirectly reforms?17 A review of theories regarding * producing (in-house) preventive and curative governments' performance of their multiple functions is services. needed to shed light on the profound nature of the 3 structural problems involved. This review complements social values, a political agenda that reflects such values, the well-developed theories of market failure provided and vested bureaucratic interests (Figure 3, left box).22 by health economists.18 Below we explore the problems For example, there may be general social agreement that of poor public accountability, information asymmetry, the population has to be protected against the financial abuse of monopoly power, failure to provide public consequences of illness through some sort of health goods, and loss in strategic policy formulation that have insurance system. When the policies of the political parallels in market failure. party in power are consistent with such values and bureaucrats have the capacity to implement them, the Problems Relating to Public Accountability intersection will be large. The first set of problems relates to the difficult The Authorizing Environment Needed task of translating individuals' preferences into public X polity and getting that policy implemented. As we know, for God Public Sector Accountability all public interventions involve transfers of benefits to Ideal Real some people and costs to others, leaving both winners and losers.19 Accountability means that government action accords with the will of the people it represents. Scial litia Socal Po A Yet, since people's values are never perfectly Values AgendA ValuVs Agenda homogeneous in any society, accountability will always be based on some imperfect rule about the aggregation \Buurat Bu/rat of individual values or respect for minority interests.20 This raises several intractable procedural issues Figure 3 relating to accountability in the electoral process, _____ taxation policies, content of public spending programs, and vested bureaucratic interests. In the health sector, a further tension eyists between the authorizing environment needed for good Ballots are blunt instruments that cannot capture public accountability and most individuals' desire for the full range of issues that may be bundled together at some sovereignty over their own health care. This leads election time. The intensity of views on any one issue to difficult dilemmas during the rationing of care or cannot be reflected. And, election promises are often not design of compulsory programs, based on the kept. So at best, public spending policies are an application of some sort of majority rule that infringes imprecise reflection of social values. on either perceived minority group rights or individual survival.23 Normal rational individuals who may share Majority rule in itself can be a form of tyranny if social values about the need to ration health care applied strictly without constraints. Most democratic resources often lose their commitment to such values societies safeguard minority interests to some extent, but when confronted by resource constraints in the face of even with good intentions there are limits to both serious illness or death. practicality and desirability in this respect. Information Asymmetry in the Public Sector Finally, public servants may have strong conflicts between their own interests and their assigned Information asymmetry can occur in three miajor responsibilities to execute the collective will of the ways in the health sector-between patient (public) and society they represent. And, their political overseers may health care professional; between patient and also have strong vested interests that are different from administrator or health care system; and between health those of the society that they represent.21 care professional and administrator or health care system. In an ideal setting, good public accountability would be secured through a large intersection Patients know more about their symptoms than (authorizing environment) between fairly homogeneous doctors but may-unwittingly or deliberately-not 4 articulate this clearly. Doctors know more about the receive clear signals about the agency cost of such causes, prognosis, and effectiveness of available informnation asymmetry. treatmnents but may not communicate this clearly to the patient. Or, the patient may not understand the Not surprisingly, many public health care implications of what he/she is being told. For facilities in low- and middle-income countries do not paternalistic reasons, the doctor may deliberately keep detailed patient records, do not know through-put conceal information, based on a judgement that the statistics, and do not know the unit costs of the patient will not be able to cope with the full knowledge procedures they are using or illnesses they treat. of his/or her ailment (e.g., terminal cancer). Through Hospitals are often not doing what policymakers or self-selection, these problems are typically worse in the administrators would like, or what they think they public sector, which has to deal with large volumes of should be doing. And, doctors working in such public poorer and less educated patients. hospitals maintain an information advantage that gives them a great deal of latitude to pursue their own When it comes to interactions between patients interests. Paradoxically, since public systems often give (public) and health care administrators, patients may try their beneficiaries less leverage than private systems to avoid being excluded or paying higher health care give their clients, patients may be less able to use the premiums by choosing to conceal pre-existing information they do possess to influence their own conditions. Similarly, there is often have a lack of treatment. information and understanding of available public programs. The benefit of gathering useful data about Potentialfor Corruption such programs is usually undervalued compared with its cost. Some of these programs may be too complex to Worse than this "ignorance by default," due to fully understand even if information were available. information asymmetry, are the information problems Frequently, the lack of transparency in the rationing of deliberately engineered by politicians, bureaucrats, scarce resources is deliberate. organizations, and health care providers entrusted with public accountability. Finally, some serious information asymmetries exist between health care providers and the Although deliberate deception and fiscal fraud is administrators for whom they work (or between usually sanctioned severely, it is much harder to hold the administrators and owners). Health care providers-as public sector accountable for petty abuses, avoidance, advocates for patients-have a much better and obfuscation. Such deception may take the form of understanding of legitimate needs or demands. hidden costs, subsidies, cost shifting, or inflation. Or it Administrators have a much better understanding about may occur as an amplification of benefits, exaggeration supply and cost of available resources but know little of the consequences of alternatives, or claiming credit about a selected intervention's appropriateness or for activities that originate elsewhere. effectiveness. The doctor's well-know information advantage over the patient is not solved by the existence Given the complex nature of health care, it is not of a public employer or administrator who knows even hard to imagine the considerable scope for misleading or less about interactions between patients and providers. defrauding patients and the public in the health sector. Associated Higher Transaction Costs Abuses of Public Monopoly Power Such information asymmetries add to agency Monopoly power occurs for four reasons when costs in terms of structuring, monitoring, and bonding the public sector gets involved in producing health contracts among agents and principals with conflicting services. This may be due to: (a) legal restrictions on interests.24 Private firms, concerned about profits, have competition; (b) access to subsidized capital and a strong incentive to limit agency costs related to revenues, creating an uneven "playing field"; (c) below- information asymmetry.25 Public agencies that are not cost distribution of goods and services to achieve equity held to a clear "bottom line" due to unspecified social goals; or (d) production of public goods or goods where functions and many complex sources of subsidies do not markets are not viable. 5 When-in addition to the above accountability Failure of Critical Policy Formulation and information problems-the public sector enjoys monopoly power, people who work for it are given wide The most frequently cited reason for greater scope for abusing this power through the extraction of government involvement in the health sector is that, rents, internal distribution of "slack" to employees, and when left to competitive forces and prices alone., in lowering of quality. several other critical areas the market does not lead to welfare-enhancing production and allocation of a Public monopolies exhibit the usual negative number of health care goods and services. These features. First, monopoly suppliers often reduce output include: and quality, while raising prices. The excess in prices over and above what the market would normally bear- * public goods (policymaking and information) rents-leads to allocative inefficiency or a net * goods with large externalities (disease prevention) deadweight welfare loss to consumers who have to forgo . goods with intractable market failure (insurance). the consumption of other goods. It is therefore surprising that governments in the A manifestation of such rents is the informal health sector often neglect the exact same three areas user charges that are commonly levied on patients and while they are busy producing curative services that the their families in public health facilities. In many private sector could easily provide. Furthermore, when countries, these rents are not limited to doctors most public funds are spent on poorly targeted public accepting bribes or peddling influence (allowing production, few or no resources are left for strategic privileged patients to circumvent the usual rules on prchasing f rervices ar the for from resource allocation, to receive preferential treatment, and punongoof services for the poor from to cut waiting time). It also includes charges levied by nongovermental providers. other salaried workers for items ranging from toilet The next section presents a discussion of some paper and clean linen to food, drugs, and medical of the key theoretical underpinnings for a new approach supplies. to optimize complementarity between the public and In a recent study on corruption around the private sector. world, such abuses in publicly run health services C. THEORETICAL UNDERPINNINGS ranked number one in terms of the burden placed on households.26 Patients who can afford to pay formal The current trend worldwide is to use three charges in the private sector often prefer it to paying types of approaches to address the public sector failures such rents in the public sector. Taxpayers charged twice in service delivery described above in descending order for low-quality services and such abuses have little of importance. They include increased:27 recourse but the blunt and often ineffective instrument of voting power. * exit possibilities (market consumer choice) * *~~~~~ voice (client participation) Second, monopoly suppliers have strong * voice (cienartication) incentives to lower expenditures through decreased * loyalty (hierarchical sense of responsibility). output when staff members benefit from the financial residuals. Although public organizations cannot legally When possible, one would always use exit, distribute such residuals outside the organization to unless forced to use the weaker variants because the shareholders, they can be internally consumed in several goods and services involved are not "marketable." ways. First, executives often receive generous social benefits and travel allowances (perks). Second, time- We will focus mainly on the first option--the keeping is often not enforced rigorously (doctors often exit option. This approach relies on greater private work short hours in public institutions). Third, some of sector participation, allowing clients and patients a the residual may be used to pursue personal agendas choice or alternative to publicly provided services. Such (discretionary spending on special projects and exit options can be implemented in parallel with other research). public sector management reforms that increase voice and loyalty. 6 From Neoclassical Economics ... consumed by other patients. At will, patients can choose not to be vaccinated. And, vaccination programs can, in One of the central tenets of neoclassical principle, compete with each other for market share. economics is that, in an optimally functioning market, competitive forces will lead to a more efficient Box 1. Private, Mixed, and Public Goods allocation of resources-Pareto-optimal competitive The neoclassical model classifies goods and service as equilibrium-than nonmarket solutions. private, mixed, or public. Private goods exhibit excludability (consumption by one individual prevents consumption by another- According to the neoclassical model, when there no positive or negative extemalities); rivalry (there is competition are many firms and consumers-and prices are allowed among goods based on price); and rejectability (individuals can to respond to the forces of supply and demand- choose to forgo consumption). True public goods have significant competition will result in . an equilibrium situation where elements of nonexcludability. nonrivalry, and nonrejectability. Mixed goods have some but not all of the characteristics of private it is impossible to make someone better off without goods (see Figure 4). making someone else worse off. This will result in a welfare-maximizing situation. The Nature of Goods Based on Neo-Classical Economics The perfectly competitive Walrasian model, as it is sometimes called, requires a number of assumptions Nature of Economic Good to be met. These include: Properties Public Mixed Prrvate * The goods involved behave like private goods (i.e., Excludability - + + rivalry, excludability, and rejectability (Box 1). Rivalry - + + * Rights can be perfectly delineated. Rejectability - + + * Transaction costs are zero. Consumer Protecion Consumption Goods Poicymakdng Medical Clinics According to neoclassical theory, a breakdown Regulations Hospitals Seffing Standards Medical Suppliersi occurs in both efficiency and equity when public goods Figue e4 tCong Sta ndarmaetical S or services with significant externalities are allocated through competitive markets. Likewise, as described earlier, significant problems occur in efficiency and Likewise, even expensive diagnostic and equity when private goods are produced or provided by therapeutic care-though often provided in publicly a public sector monopoly. owned inpatient facilities at highly subsidized rates-is really private goods and hence marketable. The same is Unfotunaely mos heath are oodsand true for ambulatory and community-based care. Even services do not behave like perfect private or public tu o muaoyadcmuiybsdcr.Ee goodserv doanot behave like perfectly privudatle orbub when governments try to fully control the market for goods. Many are not perfectly excludable but are associated with complex externalities. Rights are often such services, preventing their sale in the informal difficult to delineate, leaving residual claimants. And economy is often difficult. transaction costs are often high. Therefore, though in a Pareto-optimal state, it would be impossible to make invokedThereforeal eoclss theory is on someone better off without making someone else worse Ivkdby mainstream cConomists to justify public and private roles in the health sector, consumption off, few situations meet such criteria in the health sector. characteristics alone almost never indicate anything about the specific production processes needed to secure O. oe. hand,altho many publ hal technical efficiency and equity. Neoclassical theory activitie (e.g., sanitation servies,controcontributes little to the understanding of optimal prevention of communicable diseases, and health organizational arrangements for service production. It is promotion) generate significant externalities, they are essentially "institution free."28 Other theories are not pure public goods. All have some element of needed to fill this vacuum in understanding production excludability, rejectability, and rivalry. For example, a characteristics. vaccine given to one patient cannot simultaneously be 7 ... to the Economics of Organizations seeking, cheating, breach of contract, incomplete disclosure). Principals will try to maximize their benefit Recently, much progress has been made in to the extent that the relationship could become unviable identifying the key factors causing wide variations in for the agent. organizations' performance. The developments most relevant for understanding the advantages and The extent of such opportunism varies disadvantages of different arrangements for service drastically from country to country and from one (delivery come from principal-agent theory, transaction cultural setting to another. In some settings, such as cost economics, property rights, and public choice monopolistic national health services, opportunism may theory. These fields are often grouped together under the be less apparent than in other settings where providers title "institutional economics." Institutional economics are more accustomed to competing with each other (lirectly addresses the issue of how best to structure Although opportunism may appear to be greater ir organizations that consist of individuals pursuing countries such as Chile, India, and the United States multiple and often conflicting interests.29 there is good evidence that principal-agent relationships within national health services such as Costa Rica, New ,Agency Theory Zealand, Scandinavia, Sri Lanka, and the United Kingdom are also vulnerable to opportunistic behavior. This framework highlights that social and political objectives may be more readily achieved This theory sheds most light on firm boundaries through a series of explicit and transparent "contracts" and the conditions under which activities are best: l'or labor/services between an "agent" that undertakes to arranged within a hierarchy instead of through market: perform various tasks in an acceptable way on behalf of interactions with suppliers or other contractors. More a "principal" in exchange for a mutually agreed award. generally, vertically integrated organizations, simple lJsually, the principal needs the agent's efforts and "spot" contracts, franchises, or joint ventures are expertise but has only limited ability to monitor the interpreted as discrete structural alternatives-each agent's actions or evaluate whether the final outcome is offering different advantages and disadvantages for satisfactory. effective governance.32 Governance arrangements are evaluated by comparing the patterns of costs generatecl The agency literature surveys the range of for planning, adapting, and monitoring production ancl contracts (e.g., payment and monitoring arrangements) exchange.33 observed in the economy as attempts to align incentives and reward cooperation between self-interested but Unlike public organizations, private firms havt interdependent individuals.30 Several studies have the flexibility (indeed the requirement) to adjust their generalized the agency insight from the employment governance structure to changes in the markel: context to the full range of relationships that make up environment-making them fruitful sources of "bette- Ihe firm-now conceptualized as a nexus of many practices" for governance arrangements. Public agencies contracts.31 The need for incentive alignment is that have tried to adjust public organizations to changes pervasive in the health sector: relations between patient in market environment (e.g., formation of NHS Trusts in and physician or governments and contracting agencies the United Kingdom, establishment of the Hospital are classical examples of principal-agent structure. Authority in Hong Kong, and corporatization of publicly owned hospitals in New Zealand) have often run into 'Transaction Cost Economics problems with the underlying structure of incentives and its sustainability. Major policy reversals occurred Transaction cost economics emphasizes the recently in both the United Kingdom and New Zealand, limitations of contracts and the need for flexible means adding weight to the argument of some critics of the of coordinating activities. Principals and agents are both original reforms that they would have been better off to opportunistic. Agents will seek to minimize the privatize instead of settling for the imperfect middle aggregate production and transaction costs and ground of public sector corporatization. maximize the benefits (unless closely monitored, agents might be unreliable, engaging in behavior such as rent 8 For example, vertically integrated (within firm) are spread throughout the organization. Despite its focus organizations arise as a response to problems with on the contracting problems that motivate internal market contracting. The firm substitutes low-powered organization, transaction cost economics views vertical incentives, like salaried employment, for the markets' integration as the governance mechanism of last resort. high-powered incentives of profit and loss. Vertical Even in the many instances where policy objectives integration permits the details of future relations imply that spot market transactions are not desirable, between suppliers (including employees), producers, and contractual networks, virtual integration, franchising, or distributors to remain unspecified; differences can be concessions will outperform unified ownership adjudicated as events unfold. Vertical integration (or arrangements. unified ownership) pools the risks and rewards of the organization's activities and can facilitate the sharing of Box 3: High-Powered Incentives of Ownership information, the pursuit of innovation, and a culture of cooperation. Suppose a transaction involves several people supplying labor, physical inputs, and so on. If all but one party have contracted Box 2: Influence Activities to receive fixed amounts, there is only one residual claimant. In that case, maximizing the value received by the residual An important issue related to moral hazard and the structure of claimant is the same as maximizing the total value received by organizations is influence activities and the associated costs known all parties. If the residual claimant also has residual control, as influence costs.34 analysis has shed much light on the propensity just by pursuing his own interests and maximizing his own of publicly owned service delivery organizations to capture returns the claimant will be led to make efricient decisions. inordinate portions of the sector budget as well as on their abili to The combination of residual control and residual claims influence sector policy to their benefit-often at the expense of the provides strong incentives and capacity for an owner to public interest maintain and increase an asset's value. Firmns often attempt to In the health sector, provider organizations expend effort to reproduce these high-powered incentives by allocating affea decisions regrding the distribution of resources or other residual claims in the formn of bonuses or shares to key benerits amnong providers to their benefit. These influence activities decisionmakers in their firm. occur in all organizations, but countervailing forces are particularly weak in public service delivery structures-and influence costs are Misalignment of residual rights and returns causes one of the most imponant costs of centralized control. Evidence of serious problems. The residual claimant to the retums from a influence activities is seen in public utilities where monopolies are state-owned enterprise is the public purse, but the residual often maintained to protect low productivity of state-owned decisionmakers are effecively the enterprise manager, the enterprises from competition from more efficient producers. In the workers, and the bureaucrats in the supervising ministry. None health sector, the tendency to allocate resources to tertiary and of curative care at the expense of primary, preventatve, and public of these has any great personal stake in the value of the health is evidence of similar capture. enterprise. The resulting low productivity is well documented. Another example of misalignment comes from the U.S. The cost of these activities includes both the losses Savings and Loan (S&L) industry. Those who had the right to associated with poor resource-allocation decisions as well as the loss control the S&L's investment also had the right to keep any associated with efforts to capture rents. These costs can be reduced profits earned but were not obligated to make good on losses. when no decisionmaker has the authority to make decisions that That combination of rights and obligations created an service providers can easily influence. This condition can sometimes incentive for risk taking and fraud that was not effectively be brought about by creating legal or other boundaries between te ncentive for ris cetak ing a ud t wa t ot efecivl policymaker, the funder, and the service provider unit. Many counteredbyotherdevicesdurngmostofthe 1980s. organizational reforms have attempted to diminish these activities. Examples include reforms separating the policymaker from the payer These fields of analysis have led to better from the provider in public service delivery as well as privatization understanding of the institutional sources of government of utilities. failure. The framework has been used to design organizational reforms that seek to allocate to the holders of critical Despite these positiv features,vinformation the authority to make relevant decisions and the Despite these positive features, vertical financial incentive to do so (in the form of residual claims on integration suffers from characteristic weaknesses as a the outcome of the decision). mechanism of governance. The two most prominent are the weakening of incentives for productivity and the proliferation of influence activities (Box 2). The weak incentives come as individuals capture less and less of the gains of their own efforts as rewards and their losses 9 Property Rights Theory two different and often ignored goods characteristics- contestability and measurability.39 Property rights theory looks at the same incentive issues from a slightly different perspective. A market can be said to be perfectly contestable Since private ownership appears to have strong positive if firms can enter it freely (without any resistance frorn incentives for efficiency, property rights theorists have existing firms) and then exit without losing any of their attempted to find out why (Box 3). Explanations have investments, while having equal access to technology focused on two issues: the possession of residual (no asset specificity).40 Contestability allows decision rights and the allocation of residual returns.36 competitionfor the market to substitute for competition Residual rights of control are the rights to make any in the market. decisions regarding an asset's use not explicitly contracted by law or assigned to another by contract. Contestable goods are characterized by low The owner of an asset usually holds these rights barriers to entry and exit from the market, whereas non- although they may be allocated to others.37 contestable goods have high barriers such as sunk cost, monopoly market power, geographic advantages, and The notion of ownership as residual control is asset specificity. Investments in specific assets represent relatively clear for a simple asset like a car. It gets much a "sunk cost" since its value cannot be recovered more complicated when applied to an organization such elsewhere.41 Two specific assets that are especially as a firm. Large organizations bundle together many relevant in the health sector are expertise and reputation. 3ssets, and who has which decision rights may be Once incumbents have invested in activities that result in ambiguous. In addition to residual decision rights, an expertise or generate trust, they enjoy a significant owner holds the rights to residual revenue flows from barrier to entry for other potential suppliers, thereby his assets. That is, the owner has the right to whatever lowering the degree of contestability. Opportunism, on revenue remains after all funds have been collected, and the other hand, will lower such trust or barriers to entry. all debts, expenses, and other contractual obligations The degree of such opportunism will vary from one have been paid out. country to another and in different cultural settings. Political Choice Theory Measurability in the health sector, as in other sectors, is the precision with which inputs, processes This field focuses on the self-interested behavior outputs, and outcomes of a good or service can be of politicians, interest groups, and bureaucrats, and measured. By definition, it is difficult to measure with studies its implications for effective government and the precision the output and outcome of health services size of government. Individuals are viewed as rational characterized by a high degree of information utility maximizers. Bureaucrats, attempting to maximize asymmetry. Information asymmetry is the extent tc their budgets, will acquire an increasing share of which information about the performance of an activity rnational income. As a result, the state will grow much is available to users, beneficiaries, and contracting bigger than necessary to deliver core functions. Powerful purchasing agencies (see discussion above under "The i .terest groups will capture increasing portions of Nature of Government Failure"). resources. Institutional rigidities develop, reducing economic growth.38 This analysis has led public choice These theoretical underpinnings are used in the tAeorists to support conservative political agendas following section to understand some recent reforms in (minimizing the role of the state). the public sector. Production Characteristics of Goods and Services ... D. TRENDS IN PUBLIC SECTOR REFORMS The principles of institutional economics lead to Rarely does technical or systemic analysis alone a much more refined and useful understanding of the influence the extent of public and private involvement in different kinds of institutional arrangements required for the health sector. In actuality, service delivery efficient and effective production of goods and services. arrangements are the product of complex economic, A model along these lines can be developed, based on institutional, and political factors. 10 Extensive reforms of public sector organizations Many reforms throughout the world have sought and state-owned enterprises, implemented over the past to move delivery away from the center of the circle to 15 years, addressed the same problems encountered in more arn's-length contracts with public and private delivering public health services. In the realization that organizations. However, the nature of the outputs and these organizational problems were structural in nature, the existence of mechanisms for public sector using the analytical tools of organizational economics, management of their delivery constrains moving these reforms have focused on altering the institutional delivery outward. arrangements for service. These developments shed light on similar problems in delivering public health services. Increased autonomy or corporatization-moving from the center of the circle to the outer limits-requires One way to understand organizational reforms accountability mechanisms not tied to direct control. in service delivery is to view the different incentive These controls (e.g., contracts) take considerable environments within which government's tasks can be capacity to write and enforce, especially for health performed (Figure 5).42 The civil or core public service services where outputs and outcomes are difficult to lies at the center (usually constitutional control bodies, specify. line ministries), and the activities of the staff are highly determined. Job tenure is also strong. Budgetary units How far countries may go in pushing activities (government departments), autonomous units, to incentive environments in the outer circles depends on corporatized units, and privatized units are four common the nature of the outputs (the services involved) and organizational modalities that straddle these incentive their capacity to create accountability for public environments in the health sector.43 objectives through indirect mechanisms such as regulation and contracting. Incentive Environments E. APPLICATION TO HEALTH SECTOR Looking at the health sector across the world, all health care goods and services can be categorized on a Broader Pubik Sector 2 continuum from high-contestability and high- measurability services to low-contestability and low- measurability services, and significant information A.09 if .?asymmetry. Factor markets and product markets will be discussed separately, since each has unique Figure 5 characteristics. Although the following discussion refers ___;_________________i:________i;____________ mainly to curative and public health services, the analysis could be extended to some of the broader The broader public sector is distinguished by the intersectoral determinants of good health such as water, relative flexibility of the financial management regime sanitation, education, healthy lifestyle policies, and good and by managerial freedom in recruitment and nutrition. promotion. This sector may include special purpose agencies, autonomous agencies and, on the outer limits, Production Characteristics of Factor Markets state-owned enterprises. Beyond the public sector lies the domain of the market and civil society. Services may For the production of inputs, this contestability be delivered by for-profit, nonprofit, or community and measurability matrix would look as follows (Figure organizations. The incentives for efficient production are 6). higher moving toward the periphery, where service delivery is often better. 11 Production Characteristics of Inputs differentiation (specialized medical equipment) and Figure 6 (^CW ) ; 0 0 0 00000 0 t00 copyright protection (brand-name drugs). Furthermore, - High (Factor Markets) because of the benefits conferred through economies of HighContestibilily Medium Contestbibty LowContestibilty scope and scale, over time a significant global > Typel Typell Typelil 1 concentration of pharmaceutical and high-technology * Production of Consumables Production of Equipment * Production h I Retail of VWholesale Pharmaceubcals industries has occurred, giving them considerable X . Drugs & Equipment * Drugs & Equipment * High Technology m :} . Other Consumables Other Consumables * Large Capital Stock monopoly power. * Unskilled Labor Small Capital Stock Z Type IV Type V Type VI E * Basic Training Research For all the activities in the first row (Type I Skilled Labor * Knowvedge Higher Educabon through III), measurability of outputs remains high. 3 High Skilled _ There is little information asymmetry. l Type VII Type VIII Type IX As we move to the second row, measurement of l_______________________________________ : . the outputs and outcomes become more problematic. Outputs and outcomes can be measured, but it is more The production of consumable items and the difficult than in the case of activities in the first row. retail of drugs, medical supplies, and other consumables would be the best example of highly contestable goods Various barriers to entry reduce contestability. where outputs are also easy to measure (Type I). Many Training is almost always associated with special companies usually jostle for a share of the market, and licensing and long lead times (Type V). The specialized barriers to entry are few (the initial investment capital is labor market is usually associate with many professional modest and there are few requirements for specialized barriers as well as subsequent restrictions in scope of licensing or skills). Unskilled labor also belongs in this practice and labor mobility. Contestability is even lower category. in the Type-VI-?why parens here) category. Most research and other knowledge-generating activities As we move across the first row, a number of would fall under this category. So does the training of factors begin to contribute to raising the barriers to highly specialized staff in universities and other higher entry, thereby reducing the contestability of the goods or education centers. services in question (Type I). Investment cost (sunk cost) and increasing technical specifications create There are no good examples of inputs for the moderate barriers to entry in the manufacture of health sector that would fit into the last row, with specialized equipment and supplies. Wholesale trade in significant information asymmetry in addition to drugs, medical supplies, and medical equipment has measurement problems. some entry barriers because of the larger investmenit requirements and more limited supply and distribution Production Characteristics of Product Markets chains. The specialization and licensing of pharmacists contribute to these entry barriers. In the case of small Interventions and services can also be capital stock (e.g., clinics and diagnostic centers), entry categorized along a similar continuum from high barriers are created mainly though certification and contestability and high measurability through to licensing. interventions and other outputs with low contestability, low measurability, and significant information Finally, as we move across to Type III activities, asymmetry (Figure 7). Whereas reduced contestability entry barriers are much higher, as in the manufacture of due to market concentration is one of the main problems pharmaceuticals and high-technology medical encountered in factor markets (production of inputs), a equipment, due to large up-front investment costs that key problem with interventions and other outputs cannot be recovered later during sale of the assets (sunk- (product markets) has to do with difficulties in costs). These production activities are also associated specifying and measuring outputs and outcomes. with costly and long lead-time for research, development, and registration of new products. Other barriers to entry under this category include product 12 Production Characteristics of Outputs For these reasons, ambulatory clinical care Figure 7 (Product Markets) would fall under the Type VI category (relatively low _igw. (Product Markets) barriers to entry other than professional High Contestblity Medumi Contesebility Low Contestibilty qualifications/certification of staff) but high information D Type I Type 11 Type 111 asymmetry and difficulties measuring outputs and r2X . . . outcomes. As we move across the third row, _____________ contestability diminishes due to specialization and cost, it Type IV Type V Type VI in addition to measurement problems. For these reasons, E n2 Non Clincl Activities Clinical Intervenbons public health interventions, intersectoral action Management Suportp High Tech Diagnostics a Laundry & Caterng programs, and inpatient clinical care belong toType VII Roudne Diagnostics i activities. . TypeVlypeype Vll Type IX Ambiatory Care * Public Healh Interentons Poicyrnaiing l, *Madcal * nterseorlAcn * MomtoringEvaluabon I Mc.Nursing In-Pal Action M This leaves a few clear-cut activities such as Denal policymaking, monitoring, and evaluation under the Type IX category. The contestability and measurability As we move to the second row (Type IV to of these activities is extremely low. These activities are Type VI), measurement of the outputs and outcomes therefore usually retained as a core part of an integrated becomes more problematic. Although routine bureaucracy. diagnostics such as laboratory tests may be highly contestable (many players in a competitive market with F. "MAKE OR Buy" DECISION GRID few barriers to entry), monitoring their performance in terms of effectiveness and quality of the activities Set Priorities First undertaken is much harder (Type IV). The same is true for various nonclinical hospital activities. In many countries "make or buy" decision are made before policymakers and providers have gone As we move across to the Type V category, through an explicit priority-setting process. Priorities contestability is reduced by various barriers to entry. specified should include the range of interventions to High-tech diagnostics usually requires specialization, finance through public resources (including preventive licensing, and large sunk costs, giving established services) and should ensure that public subsidies are players a marked advantage over new entrants. A further appropriately targeted (e.g., to the poor and other barrier to entry for these activities would be government vulnerable groups).44 Countries often rush into "make policies that control or restrict the introduction of some or buy" decisions before setting priorities for needed and new technologies (CAT or NMR scanners). Clinical affordable interventions. Such prioritization is interventions are usually outsourced only to certified complicated by the fact that the cost of treating different providers. In each of these cases, outputs and outcomes illnesses varies greatly and often bears little relation to can be measured, but it is more difficult that in the case the effectiveness of available interventions.45 of activities in the first row. Furthermore, for a whole rage of activities, information disclosure and coordination through a strong In addition to difficulties in measuring output stewardship function may be sufficient. and outcomes, most clinical interventions are characterized by an additional constraint of information ... Then Decide Who Can Produce What asymmetry. At times, information may be readily apparent to patients (e.g., the quality of "hotel services" Based on the above discussion, it is now easy to such as courtesy of clinical staff, the length of waiting map the goods and services that can be bought, those periods, the cleanliness of linens, the palatability of where coordination is enough, and those that are better food, and privacy. Without survey techniques, however, produced in-house by the public sector itself (Figure 8). such information may not be readily available to the The size of the "make" in-house production triangle will contracting policymakers or administrative staff. depend largely on the effectiveness of policy instruments to deal with contestability and measurability problems. See section G for discussion.. 13 needs at multiple locations, and relational contract "Makeo or B Dcislin SGrid. for difficult-to-monitor purchases).46 ,gh HncOntesbbiwi Medium Contibility Low Conteiity Once a buying decision has been made, all potential producers must be treated alike by creat.ng a a ~~~~~~~level playing field. This includes ensuring that there are no hidden competitive advantages such as tax concessions or access to subsidized capital. And it means ensuring that no unfair competitive advantage is e< < 0 given to any producer through privileged access to information. Figure 8 G. POLICY LEVERs AVAILABLE TO GOVERNMEN'TS From the previous discussion, we can see that ... Finally Decide From Whom to Buy and How . ......most goods and services have some degree of market imperfection in terms of reduced contestability and Once "make or buy" options have been settled, measurability. Governments have at their disposal a the next questions relate to: (b) whom to buy from; and variety of instruments that they can use to address these (c) how to structure the purchase. problems. A few of these instruments-from least to most intrusive-include requiring information Whom to buny from disclosure, introducing regulations, contracting for services, providing subsidies or direct financing, and e Consider all possible producers (public, beginning public production. In this section we discuss nongovernmental and private-for-profit; domestic, these instruments as they relate to "make or buy" and international). decisions. * Base purchase decision on best product at the lowest price responsive to specific needs-type of good, Standard Policy Instruments price, quantity, after acquisition support, timeliness, and so forth (consider international competitive Factor markets. For some inputs--the bidding when possible). production of consumables, unskilled labor, and the * If there is currently no market, consider stimulating retail of drugs, medical equipment, and consumables- demand rather than in-house production. there are few serious market imperfections such as * If contestability is low and there is no competitive reduced contestability and low measurability (Figure 9, market, consider using benchmark purchasing upper left corner of matrix). With minimal government (based, on estimated reference costs) so that intervention such as good information disclosure and suppliers have to compete for rather than in the some quality or safety standards, competitive markets market. are best at producing these inputs. Public production of * If there is a market, but it is dysfunctional, consider these inputs usually leads to low quality, lack of improving its function through appropriate innovation, and inefficient production modalities. incentives (strategic subsidies) or regulations (antitrust). And how to buy * Choose the contractual arrangement most suitable for a given purchase (spot market for unpredictable items, medium-term supply contract for predictable items, franchise arrangements for standardized 14 Policies to Deal with Reduced "scontracted out" (purchased) and do not in principle Contestibility and Measurability have to be produced in-house. High ContesbbiIty MediumContestibelity LowConteshbiity In practice, decisions about which interventions 1t ,, ,- >' / ...... S to make in-house and which to contract out are i--. I - t complicated by a number of factors. First, for some * .a outputs (e.g., clinical interventions) what is to be a7 4 G°v#@delivered is much harder to specify than the inputs. This 2ne 2 so makes it difficult to manage the resulting contracts and prevent opportunistic behavior by providers (private health insurance is especially vulnerable to opportunistic h! rbehavior). Second, contestability is often reduced for the L] Figure 9 reasons described earlier in our discussion on inputs. Finally, complex health problems often require strategic coordination among different interventions and other The other extreme-training very specialized outputs (integrated care, continuity of care, appropriate labor and generating knowledge about rare health and timely referrals, and the like). conditions and their treatment-is characterized by considerable market imperfections due to reduced In the case of outputs, policymakers need to contestability and low measurability. A mix of strong examine two critical questions in addition to the degree regulation and in-house production is often needed to of contestability and measurability before arriving at ensure adequate generation of these inputs. good "make or buy" decisions. Is a strategic coordinated response needed? To what degree do the goods and Most other inputs can be bought. However, services benefit from ongoing innovation and markets often give the wrong signal about the level adaptability? (surpluses and shortages), mix, and distribution of these inputs. This is especially true of human resources and For example, nonclinical activities such as the production of pharmaceuticals and medical custodial services, catering, laundry, and management equipment with a long development or training phase. do not require special strategic coordination. They can Skilled use of regulations and contracting mechanisms is usually be "unbundled" and "contracted out" as a therefore needed when purchasing inputs that have standard service to firms that specialize in these moderate contestability and measurability problems. activities without too much customization. In contrast, clinical and public health interventions often do need to Large producers may try to severely reduce be coordinated and tailored to the individuals and contestability by erecting strong barriers to entry through populations receiving them and the organizations protective policies (patents and licensing requirements), providing them. Experience has shown that benchmarking (manufacturing standards), large sunk "unbundling" these activities often leads to many cost requirements, collusion, and a high degree of problems such as cost shifting, discontinuity of care, and specialization (R&D). For these inputs, stronger policy poor quality.48 measures may be needed such as monopsony purchasing power and long term contracts. Other Often Forgotten Policy Levers Despite this complex landscape in goods The contestability and measurability of goods and characteristics, in many areas of reduced contestability services is not static but influenced by elements of the and measurability, governments could achieve most systemic environment. Government policies directly equity, efficiency, and quality objectives through influence this environment and the "nature of the good," regulations and contracting.47 yielding alternative levers to take them closer to (or farther away from) the ability to use the indirect tools of Product markets. As in the case of inputs, the contracting and regulation. These alternative levers production of interventions and other outputs can be include: 15 * Governance: relationship between owner procedures) (modification in governance and (governments) and health care organizations payment system) * Market environment: competition in or for goods * shifting from difficult-to-define, long-term and services markets relationships (employment or service arrangements) * Purchasing mechanisms: funding or payments to shorter term, more specific contractual arrangements for the goods or services. arrangements (modification in payment system) * using quantifiable monetary incentives instead of These three factors exert a powerful influence more difficult to track nonmonetary incentixe on the "nature of the goods" and hence on the ability to payments such as ethics, ethos, and statt.s ensure delivery through indirect mechanisms. In the next (modification in payment system) three sections, we will see how these factors combine to * tightening reporting, monitoring, and accountabiliry determine the level of contestability in the market or mechanisms (modification in governance and measurability of a good. This will include a discussion payment system). of which instruments are effective in dealing with the related market and government failures. For example, by removing restricti- e government monopolies from vaccination services Governance and Internal Incentive Regime (governance/market), such programs could be shifted into a Type II or even Type I position. It is easy to Changes made in governance-the relationship measure the number of children vaccinated, who between government and organizations- influence the contracts a given disease, and entry barriers for firms goods characteristics of the health care goods and that want to provide vaccination services on behalf of ser-vices in question. This relationship can be modified the government. Similar action applied to other services substantially in five different dimensions: (a) the could shift many away from the lower right corner of the decision rights given managers; (b) the residual grid toward the upper left corner (Figure 10). claimant status; (c) the degree of market exposure; (d) accountability arrangements; and (e) adequacy of The Nature of Health Care Goods subsidies to cover social functions.49 Based on Organizational Economics C(ontestability may be enhanced by: Hig Contestibility Medium Contestibility Low Contestibility | X Type I Type 11 Type III C _ > unbundling large bureaucratic structures - a (rmodification in governance) lar E E ,____ _' * ocutsourcing other functions to specialized providers TypeIV Type V Type VI (modification in payment system) * leveling the playing field by exposing all the actors > to the same potential benefits and losses due to W TypeVII TypeVIII lx nmarket exposure (modification payment system) *decreasing barriers to entry due to political _ Ambulatory Care Figure 10 interference or unwarranted trust in public i - production (modification in market structure) * explicitly separating contestable commercial Likewise, tertiary and quaterary care provided functions and noncommercial social objectives in university hospitals could be shiFted from a low- (inodification in governance and stewardship). contestability/measurability grid to a medium- contestability/measurability position through better Measurability may be enhanced by. information on outcome, policies that favor clearly defined contracts, performance benchmarks, and a & relying on quantifiable results (output or outcome tightening of reporting, monitoring, and accountability asues) for accountabilit and performance mechanisms. The same would be true for public health tasurgetsrathr thanroc (inuts and breacrmaice services and activities such as vaccination that are often targets rahrhnrces(iptsaduepart of the responsibilities of ambulatory care providers. 16 Several factors may also alter the goods Policies that influence the competitive characteristics of pharmaceuticals, medical equipment, environment through regulations or contracting can and consumable supplies. As recently as 10 years ago significantly alter the contestability of health care goods development costs, patent protection, and a small market and services. Similarly, information asymmetry can be share may have made highly specialized medical reduced by policies that increase the availability of good equipment or drugs (Type III goods) very expensive. information on health services, enhance health care Today, they may behave like ordinary goods (Type II or providers' institutional capacity to deal with such I). Examples include the quick production of generic information, and improve patients' understanding about drugs by many companies once patent protection expires health problems. or the rapid increase in use of sigmoidoscopes and transcutaneous surgical instruments once the technology Such policies not only address some of the was no longer new and prices dropped. underlying contestability and measurability problems, but they also shift both the contestability/measurability This shift in goods characteristics is not a one- grid and the boundaries of needed government way street. The goods properties can also become less intervention to ensure favorable outcomes (Figure 11). contestable and more difficult to measure. Organizational reforms do not always lead to increased Shifting the Contestability/Measurability decision rights, residual claimant status, market Grid and Needed Public Policies exposure, accountability arrangements, and explicit High M dium LOW subsidies to cover social functions. In fact, during the Contestibility Contestbiljty Contessbilty past 50 years, many national health systems deliberately shifted goods and services in the opposite direction by nationalizing ownership and production. m And market imperfections may contribute to entry barriers instead of lowering them. Doctors, |0 dentists, and pharmacists can and do collude to restrict entry by potential competitors. Hospitals have a natural monopoly for their services for patients living nearby t Figure 11 and can create monopoly power through relations with _ other hospitals and referring doctors. Medical equipment distributors with licensing agreements for the top Conversely, in a less competitive environment international companies can easily monopolize a with weak policies and data to overcome information domestic market. Pharrnaceutical retailers can control asymmetry, the grid for services that fall into the upper their mark-up by forming professional cartels. The left corner (Type I, II, and IV) may contract, with the public and nongovernmental sectors have a competitive grid in the lower right corner (VI, VIII, and IX) advantage over the private sector due to their access to expanding. subsidized or free capital from domestic and foreign donors. Market Imperfections in Service Delivery Market Environment There are two related problems in the market structure of service delivery in most segments of the A central argument in favor of exposing providers health sector. First, little or no competition may to market forces is that, in a functioning market, emerge-reducing the pressures on the provider to competitive forces will lead to a more efficient deliver "value for money" to maximize profits. allocation of resources than a command economy or Alternatively (or in addition), competition may emerge, nonmarket solutions. The structure of the market to but it may be dysfunctional. Both cases are discussed in which organizations are exposed, therefore, has a critical this section. influence on their behavior. It may directly determine what strategies make sense to generate more revenue. 17 Some health services, especially tertiary and products; and (c) control a large share of the relevant quaternary, exhibit scale economies in production. This market. relieves incumbent hospitals from pressure from new entrants. Geographic monopoly over certain services Information asymmetry in the health sector may leave buyers very little leverage to negotiate with exacerbates these problems. For example, medical service providers. There are many examples of strong treatment is largely a "bundled" good where the seller collusion among medical doctors that creates a virtual (doctor) guides patients' consumption decisions-which monopoly, thereby shifting the grid for ambulatory hospital to go to for surgery, which lab to use for medical care toward the left-and strengthening the diagnostic services, and so on. Thus, providers can need for direct provision or other policy intervention. parley their information advantage into control over a Public monopolies and policies that prevent public funds rigid and lucrative referral chain. Doctors may "forward from being used to contract services from the private integrate" into diagnostic labs or pharmacies and steer sector have the same negative effect on contestability. their patients toward consumption where they have a financial stake. Hospitals may "backward integrate" by Even for services where monopoly power is not an creating strong links with doctors, thereby cornering part issue, providers may still capture market share or of the market where they experience little or ro maximize profits through various forms of distortionary competitive pressure. Medical professionals are behavior (Figure 12). frequently able to create cartels, limiting competitive pressures that strengthen the influence of patients and In a competitive market, firms seek to maximize purchasers. their profits-and by using any method that makes sense in that environment. In a healthy market environment, Since patients and payers know less than they will try to capture market share from their providers about the true value or cost of health service;, competitors by better pleasing customers, maximize providers can cream-skim, selecting patients who cost profits by reducing costs through efficiency gains, and less to treat than other patients. Thus, providers can expand their product lines through imitation or increase their profits, not by delivering better service lo innovation. Wherever possible, however, they will seek capture market share or cutting costs but by choosing to exploit or construct advantages. Where this is more profitable patients. possible, the pressures for efficiency and quality generated by the market may be weak. Most of these market imperfections in service delivery can be corrected through appropriatr Market Forces That Influence regulations and contracting arrangements. Compefftion: A few examples will illustrate this point. Equal access to capital and antitrust legislation, limiting the power of VNewI professional cartels, can significantly decrease the entry barriers for some segments of the health care market, The II^z;;ndustry ^ ~ especially for clinical services that fall in the middle POw"r Joskentimo Pwr Of band of the contestability/measurability grid. The same Suwpiers Among Curu would be true for contracting practices that are open to both public and private providers and which leave open possibilities for choosing alternative providers or &bsiruwe exercising "exit" strategies. Figure 12 * "Podu"rgsor r Sxvices " ~~~~~~~~~~~~~~~~In other instances, supplier cartels, combined with low quality-control standards, shift activities such Such distortionary features of health service as retail sale and distribution of pharmaceuticals and markets often enable providers to: (a) counter the medical equipment into the lower right corner, even bargaining power of suppliers, patients, or purchasers; though such activities belong in the upper left area of (b) ward off threats posed by new entrants and imitation high contestability and measurability. 18 Market Imperfections of Private Health Insurance Singapore, and nionopsonistic purchasing in the United Kingdom. Even if private health insurance is contestable, due to severe information asymmetry, such services are Although reforms in governance may endow an often deliberately crowded out for strategic reasons by organization with formal claims to residual revenue in restrictive policies and public financing. This topic is different categories, the structure of the payments beyond the scope of discussion in this paper but is system will directly determine whether this claim has discussed in detail elsewhere and briefly in Box 4.50 any real meaning or incentive effect. If, for example, services must be delivered at prices below cost, there Box 4. The Intractable Market Imperfectins will be no residual to claim. Thus, the relation of costs to of Private Healh Insurante the price-setting and capital-charging formula in the P volunty kaitl insurance is .on s *la payments system is a critical determinant of the prone to market imperfections, many of them related to o incentives of the model. The crucial factor is whether asymmetries. marginal cost-saving efforts by the provider can generate revenue flows that the provider can keep lnsurance may succeed in proteaing some people against without deterioration in quality or effectiveness. selected risks, but it usually fikls to cover everyone who wants to subscribe to insurance plans and often excluds individuals who need health insuwnc the most or who are at gratest risk, of ifew Thls ~ When reforms in organizations such as hospitals happens because insurem have a strong incentive to enrol only entail a shift in revenue earning by delivering services healthy or low-cost clients (risk selection or cream-skimming). "in a market," what kind of market emerges becomes a Private insurers also have incentives to exclude costly odiions or crucial issue. Often, government is the largest or only to minimize their financial risk by using benefit caps and exclusions This limits protection aginst expensive/ catastrophic i . buyer. In this case, the process and terms on which the government purchaser engages the provider may well Becaus of these facts, individuals who know y ame at determine the degree of pressure on the provider to risk of illness have a strong incentive to concel their undertying "deliver the goods." medical condition (adverse selectdon). Individuals who are-or think they are-healthy will often try to pay as low prmiums as possibe. This prevents insurs from raising the funds needed to icov the To gain maximum benefits from reforms that expenses incurred by sicker or riskier membe. Wors the healthy expose the public sector to competition with the private may even delibcrately undennsure themselves, in fte hope thatfe sector, it is crucial that adequate steps are taken to or highly subsidized care will be available when they become ill secure competitive neutrality. (free-riding). When third-party insurers pay, both patients and providers have less incentive to be conerned about costs, and some may become careless about maintaining good heflt. This leads not Two sets of policies must be built into provider only to more care being used (the reason for insce). bt aso to payment systems to achieve competitive neutrality: less effeive care, or care that would not be needed if people maintained good health (moral hazard) o* moneterization of social functions such as explicit Purchasing Mechanisms subsidies that cover the cost plus a reasonable margin in delivering services to nonpaying or uninsured patients Finally, provider payment systems also influence goods properties by interacting with three of * leveling of the playing field through a the five key elements of the internal incentive regime of standardization of the fee structure and cost of health care organizations: distribution of residual claims, capital for both the public and private sector. market exposure, and provision for social functions. Service providers, in particular, respond differently to H. GETTINGFROMHERETOTHERE alternative funding and payment mechanisms. For example, collective purchasing by a strategic social We have presented a strong argument for a health insurance fund in Germany sends a different set contiued and even an enhanced role for the state in of signals to providers than regulated competition in the providing strong sectoral stewardship and securing United States, consumer-driven demand through out-of- equitable and sustainable financing for the health sector. pocket payments in India, medical savings accounts in But it challenges the principles and nature of public 19 intervention pursued by many governments, especially A R in the area of the public production of health services. Many countries today have large inefficient , public sectors producing goods and services that could AN be bought from nongovernmental providers. Moving t .. . _ from one system to another will not easy (Figure 13). It ...... will take time and must be accompanied by capacity building in areas such as contracting, regulation, and Uebabnced - noved ioernment -actdie coordination of nongovernmental providers. excessivel inwlvei 60e9rment activities 'Rowing Function' - conenrtrfted an 'Stecrirgj 6cncration of Inwts ord Functionis' - StcAdsip : Provision of Services. end Finaicing A three-step process can be used to move gradually from one balance to another in the public- private mix in service delivery. First, when there is I:9W 13 already a large private sector, the public sector can begin by recognizing its existence and slowly increase use of these resources through better coordination, contracts, and a positive regulatory environment. Once some learning has taken place in coordinating and contracting with existing providers, the positive lessons from this experience can be transferred to other priority areas where nongovernmental providers may not yet be active. Finally, in some cases where the public sector is clearly engaged in inefficient activities such as public production of many inputs, these can be converted through outright privatization and subsequently bought from the private sector.51 At the same time, the public sector may not be involved in areas of strategic importance such as securing financial protection against the cost of illness and failing to provide critical sectoral oversight in terms of its stewardship function. Parallel to moving out of the area of production of goods and services, a strong argument can be made for a more integrated approach and greater public sector involvement in health care financing, sectoral coordination, regulation, monitoring, and evaluation. 20 ENDNOTES (Houston: National Center for Policy Analysis, January World Health Organization (WHO), World Health Report 1986); and J.S. Vickers and G.K. Yarrow, Privatization: An 2000: Health Systems Performance (Geneva: WHO, 2000). Economic Analysis (Cambridge, Mass.: MIT Press, 1992). 2 D. Black, An Anthology of False Antitheses (London: 10 N. Barr (ed.), Labor Markets and Social Policy in Central Nuffield Provincial Hospital Trust, 1984). Flexibility and and Eastern Europe (Oxford: World Bank/Oxford rigidity; access and privacy; animal experiment an animal University Press, 1994); and World Bank, "Investing in welfare; medicine and alternative medicine; science and People and Growth," 1996 World Development Report: compassion; acute and chronic sector; hospital or From Plan to Market, ch. 8 (New York: Oxford University community; treatment or prevention; science or Press, 1996) pp. 123-32 compassion; access and privacy. " One of the first proposals for this approach was published 3 Papyri are ancient Egyptian clay tablets. J. K. Mason and R. by A. Enthoven, "Consumer Choice Health Plan," New A. McCall Smith, Law and Medical Ethics, 2d ed., England Journal of Medicine 298:12 (1978): 650-58 and (London: Butterworths, 1987), p. 4, quoting A. Castiglioni, 298:13 (1978): 709-20; A. Enthoven, Theory and Practice A History of Medicine, translated and edited by E.B. of Managed Competition in Health Care Finance (New Krunbhaar, 2d ed. 1947). York: North-Holland, 1988). ' In this famous cuneiform legal code of the first Babylonian 12 World Health Organization, 1999 World Health Report Dynasty, has 9 of its 282 statutes relate to the services of (Geneva: WHO, 1999); WHO, European Health Care healers. Statutes 215-17 and 221-23 deal with laws Reforms: Analysis of Current Strategies, Series No. 72, governing the fees to be received for certain services; (Copenhagen: WHO Regional Office for Europe, 1996); Statutes 218-20 deal with penalties to be inflicted on the World Bank, 1993 World Development Report: Investing in healer in the case of unsatisfactory therapeutic results and Health (New York: Oxford University Press, 1993); World death. Careleton B. Chapman, Physicians, Law, and Ethics Bank, Sector Strategy: Health, Nutrition, and Population (New York: New York University Press, 1984), pp. 4-5. (Washington: World Bank, 1997); and UNICEF, State of 5 ~~~~~~~~~~~~~~~the World's Children (New York: UNICEF, 1999). C Control of membership and secrecy, reflected in the Hippocratic Oath was characteristic of all trades. British 13 For a review of the health care problems in the former Medical Association (BMA), Handbook of Medical Ethics socialist states see A.S. Preker and R.G.A. Feachem, Market (London: BMA, 1984), p. 6. Mechanisms and the Health Sector in Central and Eastern Europe, Technical Paper Series No. 293 (Washington: Today, the United States, Mexico, and Turkey are three World Bank, 1996); (translated into Czech, Hungarian, exceptions in the Organization for Economic Cooperation Polish, Romanian, and Russian). and Development (OECD) where universal access has not yet been secured. For a review of the introduction of 4 Most health economists-even those favoring a more universality in the OECD, see A.S. Preker, The Introduction competitive marketplace-recognize that government needs of Universality in Health Care (London: IIHS, 1989). to play a significant role in the health sector. For an excellent recent review on this topic see T. Rice, The For a comprehensive discussion see R.G. Evans, Strained Economics of Health Reconsidered (Chicago: Health Mercy (Toronto: Butterworth, 1984). The classics include: Administration Press, 1998). For a more detailed discussion F. Bator, "The Anatomy of Market Failure," Quarterly on the theory and empirical evidence of public and private Journal of Economics 72:3 (1958): 351-79; A.B. Atkinson, roles in health care financing, see P. Musgrove, Public and and J.E. Stiglitz, Lectures on Public Economics Private Roles in Health: Theory and Financing Patterns (Maidenhead: McGraw-Hill, 1980); and R.A. Musgrave and (Washington: World Bank, 1996); and G. Schieber (ed), P.B. Musgrave, Public Finance in Theory and Practice, 4th Innovations in Health Financing (Washington: World Bank, ed. (New York: McGraw-Hill, 1984). 1996). For a more comprehensive discussion see Barer, L. Morris, '5 See D. Osborne and T. Gaebler, Reinventing Government Thomas E. Getzen, and Greg L. Stoddart (eds.), Health, (New York: Plume, 1993). Health Care and Health Economics: Perspectives on Distribution (Chichester, West Sussex, England: John 16 See R. Saltman and J. Figueras (eds.), European Health Wiley & Sons, 1998); and E. van Doorslaer, A. Wagstaff, Care Reform: Analysis of Current Strategies (Copenhagen: and F. Rutten (eds.), Equity in the Finance and Delivery of WHO, 1997), pp. 213-14. Health Care: An International Perspective, (Oxford: 17 See J.Q. Wilson, Bureaucracy (New York: Basic Books, Oxford Medical Publications, 1993). The classical reference 1989); J.D. Donahue, The Privatization Decision: Public is K.W. Arrow, "Uncertainty and the Welfare Economics of Ends, Private Means (New York: Basic Books, 1989); and Medical Care," American Economic Review 53:5 (1963): World Bank, World Development Report: The State in a 940-73. Changing World (New York: Oxford University Press, For a comprehensive review, see P. Young, Privatization 1997). Around the Globe: Lessons from the Reagan Administration 21 s C.J. Wolf, "A Theory of Non-Market Failure, " Journal of Harvard University Press, 1970; World Bank, Sector Law and Economics 22:1 (1979): 107-39; A. Peacock, "On Strategy: Health, Nutrition, and Population. the Anatomy of Collective Failure," Public Finance 35:1 2 See J. Robinson, "Physician-Hospital Integration and (1980): 33-43; D.L. Weimer and A.R. Vining Policy Economic Theory of the Firmn," Medical Care Research Analysis: Concept and Practice (Englewood Cliffs, NJ: andoReview 54:1 (March 1997): 3-24 Prentice Hall, 1989); A.R. Vining and D.L. Weimer, "Government Supply and Government Production Failure: 29 OECD, Regulatory Reform, Privatisation and Competiticn A Framework Based on Contestability," Journal of Public Policy (Paris: OECD, 1992), p. 17. Policy 10: 1(1990): 1-22. 30 D.E. Sappington, "Incentives in Principal-Agent '9 Much of this discussion is not new but firmly rooted in Relationships," Journal of Economic Perspectives 5:2 political and moral philosophy. See K. Arrow, Arrow's (1991): 45-66. Theorem: The Paradox of Social Choice (New Haven: Yale 3 E.F. Fama, "Agency Problems and the Theory of the Firm," University Press, 1980.) Journal of Political Economy 88:2 (1980) 288-307; M.C. 20 Although there are no technical limits, few countries like Jensen and W.H. Meckling, "Theory of the Firm: Switzerland use plebiscites, and only for major issues of Managerial Behavior, Agency Costs and Ownership national interest. Even then, it is an imperfect instrument Structure," Journal of Financial Economics 3 (1976): 305- due to low voter turnout. 60. 21 Four interrelated causes have been identified that explain 32 See 0. Williamson, "Comparative Economic Organization: this observation (A.R. Vining and D.L. Weimer, The Analysis of Discrete Structural Alternatives," "Government Supply and Government Production Failure: Administrative Science Quarterly 36 (June 1991): 69-296. A Framework Based on Contestability," Journal of Public " Two useful references include: 0. Williamson, The Policy 10:1 (1990): 15). First, direct democracy usually prevents the overseer from knowing the preferences of Economic Institutions of Capitalism: Firms, Markets and society. Second, overseers (representatives) typically pay Relational Contracting (New York: Free Press, 1985); and more attention to constituencies and sensational issues that 0. Williamson, "Transaction Cost Economics," ch. 3 in RP are most likely to be influential in their reelection. Third, Schmalensee and R. Willig (eds.), Handbook of Industrial public officials usually have more than one overseer, often Organization (New York: North-Holland, 1989). leading to conflicting and unstable political demands. See P. Milgrom and J. Roberts, "Bargaining Costs, Finally, since overseers do not fully benefit themselves from Influence Costs, and the Organization of Economic the effectiveness of their oversight, they often devote Activity," in J. Alt and K. Shepsle, (eds.), Perspectives on inadequate time and effort to this task, leaving bureaucrats Positive Political Economy (New York, Cambridge with a large range of independence. University Press, 1990), pp. 57-89. 22 This conceptual framework was developed by M. Moore, 35 P. Milgrom and J. Roberts, Economics of Organization ard Creating Public Value (Boston: Harvard University Press, Management (Englewood Cliffs, NJ: Prentice-Hall, 1992) p. 291 - 1995). 292. 23 We will discuss this further in a later section under agency 36 Milgrom and Roberts, Economics of Organization and problems. T.L. Beauchamp, and J.F. Childress, Principles of Management, ch. 9. Biomedical Ethics, 2d ed. (Oxford: Oxford University Press, 1983), p. 4; and E.J. Lemmon, E.J., "Moral Dilemmas," 3' For example, a person may own a house but not have the Philosophical Review 71 (1962): 139-52. right to occupy it if he has leased it out. He may own a car but not have the right to transfer it freely if he has a loan 24 See theoretical section for a more complete discussion of secured by the car. the principal-agent concepts. S. Bennett, B. McPake,and A. Mills (eds.), Private Health Providers in Developing M. Olson, The Rise and Decline of Nations: Economic Countries: Serving the Public Interest? (London: Zed Growth, Stagflation and Social Rigidities (New Haveni: Books, 1997). Yale University Press, 1982). 25 E.F.Fama and M.C. Jensen, "Agency Problems and 39N. Girishankar, " Reforming Institutions for Service Residual Claims," Journal of Law and Economics 26:2 Delivery: A Framework for Development Assistance with (1983): 327-49. an Application to the HNP Portfolio," World Bank Policy Research Working Paper 2039 (Washington: World Bank, 26 D. Kaufmann and R. Ryterman, "Global Corruption 1999). Survey," World Bank Working Paper (Washington: World 40 Bank, 1998). 40W.J. Baumol, J.C. Panzar, and R.D. Willing, Contestabhle Bank, 1998). Markets and the Theory of Industrial Structure (New York: 27 A. Hirschman, Exit, Voice, and Loyalty: Responses to Harcourt Brace Jovanovich, 1982); and W.J. Baumol, Decline in Firms, Organizations, and States (Boston, Mass.: "Towards a Theory of Public Enterprise, " Atlantic Economic Journal 12:1 (1984): 3-20. For a critique of this 22 theory, see W.G. Shepherd, " Contestability vs. Competition-Once More," Land Economics 71:3 (August 1995): 299-309; and W.G. Shepherd, "Contestability vs. Competition," American Economic Review 74:4 (1984): 572-87. 41 An asset is specific if it makes a much larger contribution to the production of a good than its value in alternative uses. See B. Klein, R.G. Crawford, and A.A Alchian, "Vertical Integration, Appropriable Rents and the Competitive Contracting Process," Journal of Law and Economics 21:2 (1978): 297-326. 42 Adapted from N. Manning, "Unbundling the State: Autonomous Agencies and Service Delivery," Draft World Bank Discussion Paper, 1998. 43 See A.S. Preker and A. Harding (eds.), Innovations in Health Service Delivery: Corporatization in the Hospital Sector (Baltimore: Johns Hopkins University Press, 2000); forthcoming. In other parts of the public sector, such autonomous and corporatized units are also variously referred to as public or executive agencies, independent public organizations (IPOs), quasi-autonomous nongovernmental organizations (QANGOs), and state- owned enterprises (SOEs). There is no standard functional distinction between these different organizational modalities. 44 C. Ham, "Priority Setting in Health Care: Learning From International Experience," Health Policy 42:1 (1997): 49- 66. 45 Musgrove, P, "Public Spending on Health Care: How Are Different Criteria Related?" Health Policy 47 (1999): 207- 23. 46 See A. Harding and A.S. Preker (eds.), Private Participation Toolkit (Washington: World Bank, 2000); forthcoming. 47 R. Herzlinger, Market Driven Health Care: Who Wins, Who Loses in the Transformation of America's Largest Service Industry (Reading, Mass.: Perseus Books, 1997). 48 N. Manning, "Unbundling the State: Autonomous Agencies and Service Delivery"; and Bennett, McPake, and Mills, Private Health Providers in Developing Countries. See Preker and Harding, Private Participation Toolkit. 50 See Musgrove, Public and Private Roles in Health. 51 See Harding and Preker, Private Participation Toolkit. 23 HEALTH, NUTRITION, AND POPULATION NP .H W O R LD B A N K HUMAN DEVELOPMENT NETWORK THE WORLD BANK Abou~t Ibis seis. ap9eirs gin thfis series arenot formal; publicatcions of the World: lanlk. The present preliminary and 0i unpolished rEesults of analtysis that -areg circulated to ecurage gliscussion 0antd icomment;f ci'tatiion and th use of such fapaersho takacotoipro vinac ater.Thfinings, nrt on a tfand conclusions lexpressed -in this poaper -are entirely hose of gthei author(s) and shDoulds noty be attriibutec in a;0Xny mabannjer tto the Worlid Btank,itoitgs affiliatead organtizations otr to; memers of itsy Board of tExecutive: Direcor org Diothe coutrlisthy repreent. For free cpies ofthtis paper, Eplease icontact the Health, Poptl utlatiton Avsory Srvlice, Th Wrld B-ank, 1l$El818H Street Nl0Wj Rom GBi - 38, Washaington, D^C 2 0433-0002::3301. Telephtone: (20'2) 473--2'256, Fax:e (202) 61i4-0657,f E-tmtal:l hlealthpop@worldbank.orgg oi 00ja00visit the HeaElth, Nutrition, tand Population ebsitat ww.warldbangkzorghnp.0000000000jit 000t0t> t 00 t0 i ; 00 00Authors fintersed Ein submittiang text foJr thUis series s:hould gcontact 0Alex Preker- 0 i 0 E-mail: Apreker@?worldmahank}g.org 0 i CS 3 S a S S ( C i ( ; X t j E j j j E S fj S S d E(h