For-Profit Hospitals Act Generously, New Evidence Shows. Here’s Why

One of the major critiques of free markets is that certain industries, like healthcare, are “too important” to be left to the self-interested forces of the market. Critics of a free market in healthcare argue that for-profit healthcare businesses will tend to ignore patients who have higher costs unless those patients are willing to pay significantly more.

However, a recent working paper from the National Bureau of Economic Research (NBER) provides evidence that this may not be the case. The paper, authored by Donghoon Lee, Anirban Basu, Jerome A. Dugan, and Pinar Karaca-Mandic, explores whether for-profit hospitals engage in a practice called “cream-skimming” more often than non-profit hospitals.

As the paper notes, cream-skimming is, “the behavior of hospitals to select patients, not based on their needs, but by their expected profitability—less ill patients with lower costs are preferred over sicker patients for treatments.”

The paper examines psychiatric patients with different cost profiles. The authors hypothesize that for-profit hospitals will target less costly patients in order to increase profits.

However, they were surprised by their results:

Our main results indicate that FP [for-profit] hospitals do not practice cream skimming. From both general and specialty hospitals, we find that the cost per discharge attributed to differential patient case mix is approximately 200 to 300 dollars higher in FP hospitals compared to NFP [not-for-profit] hospitals.

In other words, for-profit hospitals tend to take on costlier patients than non-profits. Furthermore, contrary to the original hypothesis, the paper documents that for-profit hospitals are better able to contain costs due to superior efficiency.

Readers might be tempted to think the only reason for this is that higher costs mean higher payments, but the authors explain (somewhat technically) that this is not the case. It appears that, compared to non-profit hospitals, for-profits generally are more willing to treat less profitable patients.

What could be causing this paradoxical result?

Well, it isn’t that paradoxical when you realize that healthcare markets are just that—markets. For-profit businesses tend to provide results consistent with human flourishing because of self-interest—not in spite of self-interest.

Profitability is based on two things—revenue and costs. Revenue represents the value that members of society place on the good in question. If 100 people value your service at 200 dollars each, you will be able to earn 20,000 dollars in revenue (100×200).

Cost, on the other hand, represents the dollar value of the inputs a company uses to produce its output. If a doctor’s time is worth 50 dollars per hour, then one eight-hour day of service will cost the hospital 400 dollars.

For-profit companies maximize their profit by doing two things. First, they maximize revenue by providing a good or service that customers are willing to pay a lot for. Second, they minimize costs by improving their efficiency of production.

It should come as no surprise, then, that for-profit hospitals take on a higher number of costly patients. Since the for-profit structure encourages cost minimization, they have an incentive to figure out how to improve efficiency related to more expensive customers in order to sell more services. And since they are relatively more efficient at the expensive-customer enterprise (relative to their not-for-profit counterparts, that is), it shouldn’t be surprising that, on the margin, they take on more of these customers.

The authors provide a similar explanation. They say, “We deduce that FP hospitals are likely to implement more robust cost containment strategies than NFPs to sustain their businesses without incurring financial losses, while preserving their market dominance.”

I can think of another reason why for-profit hospitals may be more likely to cater to higher-cost customers. Generally, healthcare as an industry is heavily scrutinized with respect to selfish behavior that happens to the detriment of patients. If a for-profit hospital gets a reputation for throwing out high-cost patients, this is likely to harm the reputation of the establishment. As a result, for-profit hospitals may be intentionally generous with patients to avoid lower profits caused by a worse reputation.

This is similar to how big retailers tend to be famously over-generous with respect to return policies. Oftentimes companies like Walmart and Amazon will accept returns with no questions asked, even though this system will obviously result in their losing money on individual returns. Why do this? The reputational risk of turning down legitimate returns is high enough that the companies are willing to eat the losses in the name of customer service. Again, the free market drives customer-friendly results.

This all illustrates Adam Smith’s famous point that the self-interest of individuals can generate a system which is beneficial and seemingly altruistic to all. Economists call this the invisible hand of the market.

Every individual… neither intends to promote the public interest, nor knows how much he is promoting it… he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. — Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

So while some claim that healthcare is too important to be left up to market forces, the logic of the invisible hand and the evidence of market-created human flourishing tells me the exact opposite: healthcare is too important to not be subject to market forces.

Editor’s note: This piece originally was published by the Foundation for Economic Education.