Introduction
Recent reforms of European health care systems have led to numerous changes in organizational structures. The separation of responsibility for purchasing health care services from the responsibility for providing them, and the sub-sequent development of the purchaser function, constitute a vivid example of this trend. In this chapter we look at some of the theories that have informed and bolstered these changes. We show how economic ideas have played a central role in underpinning many reforms. In the world of practical policy making, however, the theory drawn upon has often been fairly superficial. Basic text-book models of demand, supply and the benefits of competition have fre-quently been the sole theoretical foundation for change. In contrast, the recent academic literature has been characterized by an outpouring of work that takes a considerably more in-depth and sophisticated view of the performance of alternative organizational structures. This literature is generally referred to as the new institutional economics (NIE) or economics of organization (EO).
New institutional economics is a wide and fast growing area of intellectual inquiry. It has the potential to make a major contribution to our understanding of why different organizational forms emerge and how they can be expected to perform. It also provides the basis for some prescriptive recommendations, that is, how activity should be organized in order to meet predetermined objectives.
The purpose of this chapter is to draw on some of the main elements of this literature in order to provide some deeper insights into the purchasing function in health care.
The chapter is divided into three sections. The first section sets out some of the conceptual building blocks that have been developed within the economics of organization literature. The next section takes one important area of the theory – that relating to transactions – and considers the dimensions of this process in more detail. Finally, the third section offers some reflections on the relevance of these theoretical developments for the development of purchasing.
Economic organization – conceptual building blocks
Organization is the central concept in this chapter. At the outset, it is worth posing the question of why, in modern economies, not just in health care, we have economic organizations. Economic organizations are ‘created entities within and through which people interact to reach individual and collective goals’ (Milgrom & Roberts, 1992: 19). But why do they exist? A fundamental observation about the economic world is that people can produce more, and realize economic gains, if they specialize in activities to produce goods and services, transacting with one another to acquire inputs and also final products and services. Specialization leads to organizations. However, whereas these gains to specialization can be massive, they can only be realized if, first, people’s actions and decisions are coordinated so that one person’s contribution is com-patible and consistent with another’s, and second, people are motivated to make the appropriate contribution.
Coordination and motivation
Modern health care systems have a high degree of organizational specialization.
The development of distinct purchaser organizations is one of these. This division of functions gives rise to problems of coordination and motivation. Effect-ive coordination requires the organization to decide what tasks need to be undertaken, how they should be accomplished and who should do what. For example, what health care services should be provided; how should they be produced and delivered to users; and who should do the commissioning and providing? An effective system of motivation requires appropriate incentives to be put in place to ensure that individuals and organizations behave in an effi-cient manner. As other chapters in this book explain, incentives can take many forms. They can be built into contracts between purchasers and providers; they can be pursued through payment systems; and they can be operated through government carrying out its stewardship function. The design of an efficient set of incentives will lead to appropriate behaviours and effective coordination.
Transactions and contracts
Specialization leads to the need for transactions. These are the core of EO the-ory. Through transactions, individuals and organizations plan and implement activities, and agree the terms on which resources will be exchanged. Contracts are the mechanism through which agreements between individuals and organ-izations are coordinated. Contracts can be far broader than formal legal agree-ments in the corporate world. They can be informal, verbal, not enforceable or even verifiable by a third party. They do, however, specify each party’s actions and rewards for a range of circumstances or contingencies. Contracting is a continual process, with new agreements being reached as new contingencies arise.
Bounded rationality
The economics of organization differs from neoclassical economics in recognizing that individuals are subject to bounded rationality (Simon, 1951, 1955, 1957, 1961). This means that individuals are limited in their scope to act fully rationally because of limitations relating to both information at their disposal and their computational skills. This makes the writing of complete contracts impossible – hypothetically such contracts perfectly solve the coordination and motivation problems.1 Put another way, in the real world, contracts are incomplete, being costly to create and implement, and imperfect in solving the coordination and motivation problems. These limitations mean that new contracts are being continually determined and old ones adapted.
The principal–agent framework
Another conceptual building block of organization economics is the classification of people or parties involved in transactions. Transactions can be characterized by an imbalance of information, so there is likely to be a depend-ency relationship between the parties involved. In particular, one party to the transaction often has either more information and/or better bargaining power than the other. On this basis the theory identifies two types of parties to a transaction. The principal is a party who wishes to secure provision of some good or service but does not have the necessary specialized knowledge, skills or assets.
The principal employs an agent to undertake this task and in the process delegates some control to that party (Grossman & Hart, 1983).
The problem faced by the principal is to secure some service benefit from the agent while not knowing the true value of those benefits, or being forced to accept those benefits the agent wishes to supply. Either way the information imbalance can make it difficult for the principal to be sure that the agent is acting in the principal’s true interests. Even when the course of action that the principal wishes the agent to undertake has been established to a satisfactory extent, a motivation problem remains. The principal needs to put in place an incentive structure that motivates the agent to act appropriately.
Principal–agent relationships abound in health care because of specialization and information imbalances. Indeed this book has chosen to analyse the purchaser function in terms of a triple principal–agent relationship. In the first relationship, purchasers are the agents for patients, securing health care services on their behalf. The second relationship has the health care provider in the agent role with the purchaser now as the principal. In this relationship, the purchaser carries out a procurement function. This task involves securing services from providers, which means negotiating with or directing providers as to the characteristics of services to be provided and the terms of the transaction.
In the third agency relationship the purchaser acts as agent for the state when ensuring that purchasing decisions reflect national health priorities.
Governance structures
Governance structures have been defined as the matrix of rules, regulations, protocols and conventions that relate to the transaction (Williamson, 1979, 1994; North, 1990).
The idea of governance structure is relatively simple, but actually defining such a structure is much less so. The literature has attempted to draw out several relevant dimensions. These include: ownership, control and agency (brokerage and devolution) (Williamson, 1975, 1985; Jensen & Meckling, 1976; Grossman
& Hart, 1983, 1986; Coleman, 1990); contract form and reimbursement incen-tives (MacNeil, 1985; Milgrom, 1990; Laffont & Tirole, 1993; Hart, 1995; Forder, 1997; Lyons & Mehta, 1997); regulation (Stigler, 1971; Vickers & Yarrow, 1988;
Spulber, 1989); and social environment (Hannan & Freeman, 1984; Feenstra, 1995; Granovetter, 1995).
The first dimension concerns the degree of integration of purchasing and providing roles, and ownership of the associated infrastructure. In this connec-tion, it is useful to distinguish between ownership and control (Coleman, 1994).
What is the distribution of ownership of the apparatus and assets of the purchas-ing and providpurchas-ing function? Are both purchaspurchas-ing and providpurchas-ing apparatus owned by the same (set of) stakeholders – such as the state – or are they separ-ately owned? Whatever the distribution of ownership, it does not necessarily dictate the distribution of control between stakeholders over various functions.
An organization with unified ownership may, for example, internally separate purchasing and providing. Or the owner of one set of assets may voluntarily pass or cede control to the owner of another set. In fact, the locus of real control (that is, how much authority is really shifted away from that vested originally by ownership) is perhaps the key factor in explaining strategic performance.
Reimbursement incentives have a fundamental bearing on the operation of economic systems in general (Laffont & Tirole, 1993), and health care systems are no exception (Frank & Gaynor, 1991; Ma, 1994; Propper, 1995; Forder, 1997). Oliver Williamson distinguishes types of incentives as either high or low powered (Williamson, 1985). Incentives are high powered when indi-viduals can keep all the profits resulting from their efforts. Low-powered incen-tives feature some dilution of the relationship between profits/surpluses and efforts. Salaries are examples of low-powered incentives. Individuals receive income that is only indirectly related to their efforts. As Williamson notes, the power of incentives depends on whether providers have control over their own actions and efforts and have the right to appropriate net income, either as a result of ownership or because this right was ceded contractually.
The problem of regulation is to configure the health care system so that individual actors making decisions in their own best interests actually operate in the wider social interest. This is a key aspect of the evolving stewardship role of government (see Chapter 8). Regulatory activities normally relate to three main areas, namely the regulation of capacity, prices and quality. In each of these areas, government (or one of its agencies) sets standards that individual organizations are required to meet.
The social environment within which it takes place can exert a strong influence on the behaviour of health system actors. For example, Granovetter and others
describe how actions that arise in specific transactions are embedded in conventions that exist in an individual’s social sphere (Hannan and Freeman, 1984; Granovetter, 1985; Hamilton & Feenstra, 1995). These conventions may work against narrow economic considerations. For example, parties to transac-tions in societies that value personal honour may be less likely to exploit their position – to cheat – than parties in societies with more ‘pragmatic’ values (Granovetter, 1985; Hodgson, 1988; Sako, 1992).
Even restricting our attention to the above dimensions creates a multitude of possible governance structures. However, in practice, choices along particular dimensions tend to be correlated and can be grouped to reduce the number of alternative governance structures to just three main types, as follows.
Markets have separately owned and controlled organizations (or individuals) responsible for purchasing and providing goods and services. Contracts are determined in voluntary (bilateral) exchanges and contract adaptations are negotiated and resolved by both parties. Payment incentives are often high powered because ownership usually confers the right to appropriate residuals (profits). It is, however, possible for lower or mixed reimbursement incentives to be used if parties cede some of the rights to income in the contract.
Hierarchies are characterized by a decision-making authority that is vested with one party to a contract (the hierarchical superior – for example, managers), with this authority being ceded to them by the other party (the subordinate – for example, employees) accept the instructions of managers. Hierarchical subordinates are usually paid on a salary or equivalent low-powered incentive basis. Hierarchies commonly feature unified ownership although that is not always the case. Employees can always leave if they wish.
Networks share some features of both markets and hierarchies. Ownership is dispersed – as in markets – but control is often voluntarily ceded by one party and predominantly held by the other party, as in hierarchies. However, whereas hierarchies are characterized by authority and markets by arm’s-length relation-ships, networks are characterized by cooperation and trust.2 Purchasers, for example, are willing to give providers freedom to operate a service because they trust providers to not exploit this situation. Grant payment is very common. This arrangement mixes incentives regarding individual transactions. Although pro-viders receive a lump-sum award and can keep the residual, this is usually spread over many transactions so allowing cost cross-subsidization. Moreover, there are often circumstances that allow retrospective adjustments to the payment.
These three governance structures are summarized in Table 4.1.
Governance structures: new public management
One area in which the components of EO theory have come together is in relation to the new public management (NPM). This has developed as a categorization of the broad set of reforms of the public sector described by commentators across the OECD countries. Despite a number of important inter-country differences, some of the main features of NPM can be identified as follows (Pollitt, 2001):
•
a shift in the focus of management effort from inputs and processes to outputs and outcomes;•
a shift towards more measurement, leading to an emphasis on performance indicators and standards;•
a preference for more specialized, ‘lean’, ‘flat’ and autonomous organizational forms rather than large, multi-purpose, hierarchical bureaucracies;•
a widespread substitution of contract, or contract-like, relationships for hierarchical bureaucracies;•
use of market or market-like mechanisms for the delivery of public services, including privatization, contracting out, the development of internal markets, and so forth;•
a blurring of the line between the public and private sectors (growth of public–private partnerships and hybrid organizations) (Osborne & Gaebler, 1992);
Table 4.1 Governance purchasing options
Devolution Strategic (central) Tactical Tactical (local) Contract type Specification Minimal, informal Minimal, informal Detailed, formal Length (duration) Short, frequent Short, frequent Long,
infrequent
•
a shift away from universalism, equity, security and resilience towards efficiency and individualism;•
growing consumerism.The rhetorical basis for NPM can be traced to neoliberal and New Right ideologies.
For example, in the United Kingdom, Mrs Thatcher’s radical economic indi-vidualism drove her determination in 1979 to ‘roll back the state’. Similar aims can be detected in the Dekker proposals and subsequent developments in the Netherlands. Even more dramatically, moves towards market-based systems in the former communist countries of Central and Eastern Europe are based on an embodiment of these principles.
In this way, NPM represents a move away from a hierarchical to a market form of governance. This involves a separation of ownership and control, arm’s-length contracting, performance measurement and compliance monitoring. EO theory provides some normative underpinnings for NPM, although EO theory is far more restrictive about the conditions in which marketization would work (indeed, NPM precedes current version of EO theory).
Dimensions of transactions
One of the key components of the new institutional economics or economics of organization is the subject of transactions. This is the process whereby actors within an economic system interact with each other. The choice of governance structure and its outcomes are crucially mediated by the features of transactions.
In this section, we take a closer look at the features or dimensions of transac-tions. These cover: measurement, bargaining and monitoring costs; costs arising from rent seeking and shirking; contract completeness; frequency, duration and reputation in carrying out transactions; complexity and uncertainty;
competition and contestability; the role of the social context.
Above we noted the importance of complexity, contestability and frequency/
duration of transactions. Complexity covers information problems relating to both uncertainty about the characteristics relevant to the transaction, for example population health needs, and asymmetric distributions of informa-tion, for example doctors knowing more about health care than patients, or hospitals knowing more than insurance funds. Contestability likewise breaks down into barriers to entry/exit (that is, levels of competition) and asset specificity – for example, medical technology that has only one purpose, that is, cannot be adapted for other uses without significant cost. To this list we would add the social environmental context of the transaction. These are distin-guished from elements of the governance structure in that they are either given – outside the control of stakeholders – or at least immutable in the short run.
Measurement, bargaining and monitoring costs
Transactions typically give rise to measurement, bargaining and monitoring costs. Measurement costs arise because, in order to determine appropriate courses of action, the parties to a transaction need information on relevant
characteristics – for example, the service in question, its quality, people using it, cost and so forth. In some circumstances there is wasteful duplication of effort as both parties (principal and agent) need to gather intelligence to negotiate from an informed position (Milgrom & Roberts, 1990). With suitable safeguards it would be much less costly overall for only one party to collect this information, sharing it with the other party without misrepresentation.
Bargaining costs are incurred in negotiating the terms of the contract. When both parties to the transaction have a significant contribution in determining how the benefits of the transaction are distributed, this bargaining can be quite protracted and costly.
Monitoring costs are incurred both ex ante and ex post. They are incurred in determining relevant characteristics that are pre-existing and private to a trans-action, for example about other parties’ preferences. Such ex ante information contrasts with information about characteristics relating to the process and out-come of the transaction, for example quality of service or efforts of providers.
Contracts determined without ex ante information cannot generally induce parties to divulge such information voluntarily (Baron, 1989; Laffont & Tirole, 1993; Forder, 1997). Yet, this information is needed for the transaction to work smoothly and efficiently, making gathering at least some of it – thus incurring monitoring costs – worthwhile. It should also be noted that there is often an inverse relationship between ex ante and ex post costs, so that if, for example, a purchaser invests time and money in developing more complete contracts, the costs of monitoring are likely to be reduced.
A major advantage of hierarchies and networks over markets as a system of governance is the low level of measurement and bargaining costs they entail.
Where control is ceded to a higher authority or network partner, duplication of measurement is avoided. In addition, because one party is given authority voluntarily, protracted bargaining is unlikely.
Rent seeking, poor incentives and coordination problems
Rent seeking occurs when stakeholders expend effort in an attempt to gain a greater share of the total surplus (profit) of a transaction and in doing so actually reduce the total surplus generated (Milgrom & Roberts, 1990). Such behaviour can take many forms. It may be characterized by providers exploiting low con-testability to restrict supply and push up prices (that is, monopoly markets).
Another form involves principals renegotiating contracts with agents after
Another form involves principals renegotiating contracts with agents after