The Role of Nonprofits in Health Care

"The very word, 'profit,' is a signal that denies the trust relationship."

--Kenneth J. Arrow

In his essay "Uncertainty and the Welfare Economics of Medical Care," Kenneth Arrow (1963) focuses on asymmetric information as a key feature of the relationship between health care providers and patients, on the need for trust to supplement arm's length market relationships, and on the limits of standard market analysis to describe and explain these relationships. Agency is a central theme of the essay. While the word is not used explicitly in his essay, it is about the potential for exploitation in these relationships.

Arrow's discussion of nonprofit organizations is largely (although not exclusively) focused on the issue of trust and agency. Other aspects of nonprofits--the role of donations in creating and sustaining them, their role in providing community services or public goods--are less developed. The role of community-based nonprofit insurers such as Blue Cross for pooling insurance across risks, for example, and the threat of competition to this arrangement is (presciently) noted, but the market power or institutional structures that created or sustained these arrangements are not discussed.

While Arrow's comments on nonprofit organizations are almost throwaway lines, his insights have become central to an analysis of nonprofits. They form part of the basis of the New Industrial Economics, with its emphasis on information and transaction costs and agency relationships. That framework, adopted and expanded by Henry B. Hansmann especially but also others, has become the standard approach to discussing the economics of nonprofit institutions. Even certain aspects of nonprofits not closely analyzed by Arrow, such as donations, have been recast in these later works into a framework structured by issues of trust and asymmetric information.

In the literature on nonprofits spawned in part from Arrow's initial insights, two related questions are repeatedly raised: (1) Why are nonprofits created and supported? and (2) How do nonprofits behave, and how different is their behavior from profit maximizing for-profits? Implicit in these analyses are questions about whether nonprofit institutions can and should continue to play their historic role in the health care system, and whether public policies on such issues as nonprofit tax exemption, nonprofit to for-profit conversion, and nonprofit antitrust immunity should be geared to preserving and promoting nonprofit health care institutions.

Addressing the question whether, in the absence of changes in public policy, nonprofits can survive without becoming indistinguishable from for-profits requires looking at the changing markets in which nonprofits operate. Answering the question whether policy "should" tilt toward nonprofits must be based on three considerations: (1) whether the conditions calling forth nonprofits continue to exist, (2) whether the costs associated with the benefits of nonprofit ownership have come to outweigh the benefits, and (3) whether the actual behavior of nonprofits sufficiently distinguishes them from for-profits to sustain support for them.

This essay reviews the theory and evidence on the origins and behavior of nonprofits and, at the end, turns to the implications of this analysis for the "should" and "can" questions. It draws principally on the literature and history of nonprofit hospitals, with a limited discussion of nonprofit health plans and insurers. Other health care agents, such as nursing homes and long-term care in which there is a substantial nonprofit presence, are not discussed.

Why Are Nonprofit Organizations in Health Care Created and Supported?

Fostering Trust, Avoiding Exploitation

In his 1963 essay, Arrow puts forward a succinct statement of the problem of agency in the medical sphere: "As a signal to the buyer of his intentions to act as thoroughly in the buyer's behalf as possible, the physician avoids the obvious stigmata of profit-maximizing. Purely arms-length bargaining behavior would be incompatible, not logically, but surely psychologically, with the trust relations. From these special relations come the various forms of ethical behavior discussed above, and...