A theory of yardstick competition

1. A theory of yardstick competition Andrei Shleifer Presented by Kabi Malla

2. Introduction • Different approaches to cost-reduction and pricing regulation • “Cost-of-service” • Firm’s prices equal to the cost it incurs • “Lagged price adjustment” • Firm’s prices still follow cost but it doesn’t change for some time. • These approaches fail to achieve efficient cost reduction. • “Yardstick Competition” • Comparing similar regulated firms with each other • Regulator uses the costs of comparable firms • Regulator can force firms serving different markets to compete • Regulators do not need to know the cost reduction technology • Comparatively favorable even in the case of heterogeneous firms

3. The Model • Assumptions • One period model • N > 2 identical risk-neutral firms ( without uncertainty ) • Faces a downward –sloping demand curve • Profit equation for the firm: • Where p = price, c = marginal cost , q = output, T = lump-sum transfer to the firm* , R(c) = investment in cost reduction • R(C0 ) = 0 , R`(c) < 0, R``(c) > 0 [higher the investment in cost reduction, lower the final unit cost*]

4. The Model Contd… • Regulators pick c, p and T to maximize: subject to breakeven constraint : V ≥ 0 (3) • The integral in (2) is consumers’ surplus and (3) specifies that T covers losses. • The max. problem yields the social optimum solution: • The costs and benefits of marginal change in c must be equal, at the optimum.

5. The Model Contd…. • The second order conditions from (2) shows: Assume that -R’(C0)<q(C0), that – R’(0)>q(0) and that –q’(c) - R”(c) < 0 (cost reduction gets progressively costlier). The optimum is unique. • Prices and lump sum are the two instruments available to the regulators . • Regulators rely on firm’s profit motive to reduce cost • Firms do not have the option to refuse to produce and exit if it does not like the price.

6. Yardstick Comp. among identical firms • Each firm iis assigned its own “shadow firm” (benchmark) with the following cost and cost-reduction expenditure. • (9) and (10)

7. Yardstick Comp. among identical firms • The firm’s maximizing strategies are unique. Second order condition implies: If Ci > C* then Ci≥ pi ( since pi is the average of unit costs lower than Ci ) Firm ilowers Ciby ∆Ci , it gains q(pi)∆Ci at the cost of –R`( Ci)∆Ci But the firm prefers to lower its cost as q(pi)∆Ci > –R`( Ci)∆Ci Likewise, if Ci < C*firm i would want to raise its unit cost • It does not let an inefficient cost choice by a firm influence the price and the transfers it receives. (as long price is equal to c*).

8. Alternative Environments • Average cost pricing (lump sum transfers isn’t available) • When T = 0 • Replacing in (16) we can solve for the price for firm i. • The average cost pricing version of YC gives a symmetric equilibrium where firms pick the second best unit cost levels.

9. Alternative Environments • “Reduced-form” regulation (heterogeneous firms) • Observe for characteristics that makes firm differ and run regression of costs on these characteristics.

10. Alternative Environments • Estimate (25) by using data on costs and firm specific charateristics • Use the estimated coefficients to obtain: • The cost-reduction expenditure is predicted through Taylor expansion of R(c,ɵ) from (24). The lump sum transfer Ti(ɵi) would be equal to Ri • Difficulties with the approach: • Omitted variable bias • Inclusion on endogenous characteristics • (Obtain consistent predictions of costs)

11. Medicare –Yardstick Competition • Reimbursement system is remarkably close to Yardstick competition • Divides patients into 500 diagnostically related groups. • Pays a fixed fee for the patients treatment, given his/her group and related average costs for treatment. • Hospitals either keeps a profit or incurs a loss given the excess of the fee over its costs. • Medicare results shows progress towards cost control • Still there are serious flaws in the system • Doesn’t take into account the severity of illness. • Could lead to injudicious practices. • Suggested modifications (is it feasible?)

12. Conclusion • Equilibrium outcome is efficient (both for identical and heterogeneous firms). • Even if diversity is not accounted for properly, this approach outperforms cost-of-service regulation. • Potential limitation – susceptibility to collusive manipulation • However, the scope of collusion is limited by: • Regulator can disallow certain strategies / limit permissible actions for the firms. • Very large number of firms would make collusive strategies unsustainable.

13. THANK YOU