William P. Rogerson
Under prospective pricing, payers for health care essentially use price regulation of hospitals as a way of indirectly regulating the provision of treatment intensity. This paper presents a theory of how a nonprofit hospital selects treatment intensities for its products given the payer’s choice of prices and then determines how the payer should select prices in light of this theory. The main result is that, in equilibrium, the ratio of price to marginal cost will vary across products inversely with the elasticity of demand with respect to treatment intensity. This means that, generally, the hospital will earn positive (negative) accounting profit on products with low-(high-) intensity elasticities of demand.