Competing on Quality –
Literature Review
March 2014
OFT1531
© Crown copyright 2014
This research has been carried out by OFT economists and independently
reviewed by Professor Mark Armstrong from the University of Oxford and
Professor Kurt R. Brekke from the Norwegian School of Economics. The OFT
would also like to thank Chris Pike from Monitor and Kate Collyer from the
Competition Commission for their helpful comments.
You may reuse this information (not including logos) free of charge in any
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write to the Information Policy Team, The National Archives, Kew, London TW9
4DU, or email: [email protected].
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Office of Fair Trading, Fleetbank House, 2-6 Salisbury Square, London EC4Y
8JX, or email: [email protected].
This publication is also available from our website at: www.oft.gov.uk.
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CONTENTS
Chapter/Annexe
1 Page
Executive Summary
5
General Report
6
Healthcare Report
9
General Report
1 2 3 4 Introduction
12
Purpose of the report
12
Background
12
Quality assessment in OFT work
13
Our approach
15
Key findings
16
Structure of the report
18
Product differentiation and the concept of quality
19
Introduction
19
Basic models of product differentiation
21
Conclusion
30
Assessing quality
31
Introduction
31
Assessing quality in practice
31
Conclusion
39
Competition and quality – Insights from the theoretical literature
41
Introduction
41
Competition and the equilibrium choice of quality and price
42
Competition and the equilibrium choice of quality
when prices are exogenous
66
Conclusion
5 3
Competition and the equilibrium choice of price and quality
Empirical perspectives
67
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Introduction
72
Empirical evidence based on structural models
73
Conclusion
82
Further topics in quality and competition policy
84
Introduction
84
Small but Significant Non-transitory Decrease in Quality (SSNDQ)
84
Quality and merger modelling
87
Quality and post-merger product repositioning
90
Conclusion
95
7 Conclusion
97
8 References
100
6 Healthcare Report
1 Introduction
108
2 The NHS
111
The organisation of the NHS
111
Incentives for competition in the NHS
116
Measures of quality in healthcare
126
Definitions of quality
126
Measuring quality in competition studies
127
Measures of quality available to the public
134
High-level insights into competition on quality
137
Models of competition and quality in healthcare markets
137
Empirical evidence
143
The 'Black Box': linking competition and quality
156
Demand side: patient choice
156
The role of GPs
173
Supply side: hospitals and competition
181
6 Conclusions
187
7 References
190
3 4 5 4
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1 EXECUTIVE SUMMARY
1.1 The UK Merger Assessment Guidelines note that 'Competition is (…) a
process of rivalry between firms seeking to win customers' business over
time by offering them a better deal. Rivalry creates incentives for firms to
cut price, increase output, improve quality, enhance efficiency, or
introduce new and better products (…). '1 This reflects the fact that the
quality of goods and services is of key importance for consumers in many
markets and that often firms compete not only on price but also along
these non-price dimensions. Indeed quality considerations are relevant not
only to the competitive assessment of mergers but also to the competitive
assessment of other business practices, for instance in the context of
cartel, antitrust and market investigations by the competition authorities.
1.2 However, incorporating quality considerations into competition analysis is
not always straightforward in practice. In light of this, our literature review
focuses on the following research questions:
 What are the key challenges in relation to the assessment of quality in competition analysis?  What insights can the theoretical and empirical literature provide into the
impact of competition on quality for the work of competition authorities?
 Are there any discrete areas of competition authorities' work that could
benefit from a fuller appreciation of the relationship between competition
and quality?
1.3 Our work consists of two separate reports: a general literature review
(General Report) and a literature review focusing on the healthcare sector
(Healthcare Report). We decided to make this distinction for the following
reasons:
 In healthcare, quality considerations are particularly important given the crucial implications for patients' life and wellbeing.  Healthcare markets have some characteristics both in general and in the context of the English system which differentiate this sector and which make it particular. Such characteristics include different levels of 1
Merger Assessment Guidelines paragraph 4.1.2 www.oft.gov.uk/shared_oft/mergers/642749/OFT1254.pdf. The
Merger Assessment Guidelines have been adopted by the Competition and Markets Authority (CMA). The CMA will bring
together the Competition Commission (CC) and the competition and certain consumer functions of the OFT in a single
body. The CMA will promote competition, within and outside the UK, for the benefit of consumers. The CMA was
established under the Enterprise and Regulatory Reform Act 2013 (ERRA13) and came into being in October 2013. It
takes on its full powers and responsibilities, such as competition law enforcement, market studies and investigations,
and merger control, on 1 April 2014. Visit the CMA's pages on www.gov.uk/cma for more information.
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understanding between healthcare providers and patients (known as
information asymmetries), the fact that patients do not pay directly for
healthcare (so are not sensitive to its price) and the system of extensive
price regulation. These and other characteristics increase the focus on
competition on quality in the English National Health Service ('NHS').
The reforms of the past decade have meant that NHS hospitals in
England are incentivised to compete on quality for the provision of many
healthcare services through fixed payments that are linked to the number
of patients treated. Since patients can choose where to go, providers
should try to attract them by increasing the quality of their services.
 There is rich healthcare-specific literature which is relevant for our
research questions.
1.4 In the remainder of the Executive Summary, we will give an overview of
our key findings from the literature for the General and Healthcare Reports.
The findings from the two reviews reinforce each other. Both reports
emphasise the challenges around the objective and robust measurement of
quality and both find that the literature can provide only limited insights
into the relationship between competition and quality when suppliers are
free to set both quality and prices. In contrast, when suppliers are not free
to set prices--for example, because prices are regulated--the literature
points toward a positive relationship between increased competition and
improved quality.
General Report
1.5 The General Report aims to address the research questions set out above in
a general, non-industry specific context. Our review looks at theoretical
and empirical papers which focus on the relationship between competition
and quality but we also look at research in specific areas of competition
authorities' work. In addition, we consider some of the UK competition
authorities' past decisions that assessed competition and quality, mainly in
relation to issues of quality measurement.
Key findings
1.6 When considering the challenges that competition authorities face in the
assessment of quality in competition analysis, we identify two key issues:
(i) the challenges around quality measurement; and (ii) limited insights from
the academic literature.
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Practical approaches to measuring quality
1.7 Our review of selected previous cases of the UK competition authorities2
reveals the difficulty in objectively and robustly measuring quality, not least
because of its multidimensional nature. However, our review also identifies
ways in which UK competition authorities have overcome these difficulties.
In cases where they chose to focus on quality considerations (because
prices were either set nationally or did not form part of consumers' choice),
different practical approaches were used, such as making inferences about
expenditure on quality from data on profitability and using consumer
surveys and evidence from third-parties or internal business documents to
assess what quality dimensions drive consumer choice and competition.
1.8 In addition, our review also highlights an innovative approach that the CC
used when assessing the closeness of competition in a case where
competition primarily develops along quality. More specifically, in a merger
between two hospitals, the CC used diversion ratios based on quality
decrease instead of price increase which can be a useful approach in similar
cases in the future.
1.9 Our review indicates that when reliable data is available for the key aspects
of quality, analysis that directly relates these measures of quality to
competition can also be used. As a special case, where sufficient data is
available, statistical methods can be used for this analysis.
Limited insights from the academic literature
1.10 One way to get around difficulties in measuring quality is to seek insights
from the literature regarding the relationship between competition and
quality, and rely more extensively on the predictions of theoretical models.
However, our review finds that the theoretical literature can provide only
limited guidance to practitioners for the assessment of the impact of
competition on quality.
1.11 In particular, it finds that:
 When suppliers choose prices as well as quality levels, the theoretical literature predicts an ambiguous effect of competition on quality. This is because increased competition affects suppliers' incentives to provide 2
In particular, the 2005 Somerfield plc/William Morrison Supermarkets plc merger investigation; the 2008 Groceries
market investigation; the 2005 HMV Group/Ottakar merger investigation and the 2011 Royal Bournemouth and
Christchurch Hospitals NHS Foundation Trust / Poole Hospital NHS Foundation Trust merger investigation of the CC.
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quality in two countervailing ways. On the one hand, it incentivizes
suppliers to increase quality for given prices in order to be more
attractive to customers. On the other hand, competition tends to reduce
suppliers' profitability and may undermine their incentives to invest in
improving quality. The overall impact of increased competition on quality
will depend on the net impact of these two effects.3
 In contrast to the above findings, when prices are regulated or where
suppliers are not free to set prices for other reasons, the theoretical
literature suggests a positive relationship between competition and
quality. This is because where suppliers are not free to set prices, only
the positive direct effect of competition on quality is present: suppliers
will have the incentive to increase quality to win business from their
rivals but increased competition will not reduce prices and profitability
which could undermine the incentive to invest in quality.
 Turning to result from the empirical literature, our review points towards
a positive relationship between competition and quality, even in
situations where suppliers are free to choose price as well as quality.
However, as the empirical literature is recent and still relatively sparse, it
is probably too early to draw any general lessons from this.
Further considerations
1.12 In the General Report, we also discuss some recent developments from the
theoretical and empirical literature on quality assessment in the specific
context of the competition authorities' scrutiny of mergers.
1.13 This strand of the literature highlights potential biases in applying some
quite commonly-used empirical tools for the competitive assessment of
mergers that do not allow for post-merger quality changes in markets
where quality is an important dimension of competition. While we do not
consider that the literature is sufficiently conclusive on the direction of the
possible bias, merger scrutiny in specific industries4 is likely to benefit from
insights provided by the growing body of this literature in the future. In
view of this, we make some suggestions as to the direction of potential
future research.
3
See Table 2 on pages 62 and 78 for the more detailed findings. For example, industries where (i) quality considerations are key, (ii) there are fairly good measures which are likely to drive customers' perception of quality and (iii) there is sufficiently robust evidence on the relationship between competition and quality.
4
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Healthcare Report
1.14 The Healthcare Report addresses our research questions in the context of
the healthcare sector, with a primary focus on competition between
hospitals in the English NHS. Specifically, it:
 Provides a comprehensive, up-to-date description of the economics of
quality competition in healthcare markets, addressing both theoretical
and empirical issues.
 Contributes to the debate around the impact of competition on quality in
the English NHS with a critical review of the available studies on the
topic.
 Highlights some areas where the literature does not offer definitive
conclusions and where more research would be informative.
1.15 In addition, our review also discusses the measurement of quality in the
context of healthcare and, in particular, the advantages and disadvantages
of the most commonly-used quality measures in the literature.
Key findings
1.16 Our review of the literature on the relationship between competition and
quality in healthcare suggests:
 When prices are regulated, as is the case for many services in the
English NHS, most of the theoretical models predict a positive impact of
competition on quality, provided that regulated prices are higher than the
incremental costs of providing the service.
 Empirical studies of the impact of competition in the English NHS are
consistent with the predictions from the theoretical literature and find
that competition has ambiguous effects on one measure of quality when
prices are set by providers but leads to improvements in some measures
of quality when prices are regulated. In particular, the empirical papers
looking at the 1991-97 NHS 'internal market' with unregulated prices
show that competition had a negative impact on heart attack mortality (a
commonly used measure of quality). Conversely in the current NHS
hospital market with regulated prices, studies find that competition leads
to improvements in both heart attack and overall mortality (measures of
quality) and average length of patient stay (a measure of efficiency).
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1.17 Our review of qualitative and quantitative studies of the behaviour of
patients, GPs and providers in the presence of competition in the NHS
suggest that (i) patient choice is now a non-negligible reality in the English
NHS and is influenced at least to some extent by quality considerations,
and (ii) providers take patient choice and competition into consideration
when making strategic decisions.
1.18 That said, our review also points to some gaps in the literature, for
instance, around the impact of the role of GPs as 'informed agents' helping
patients in the process of choice. Moreover, most of the commonly-used
indicators of quality in the literature (such as heart attack mortality,
readmission rates, overall mortality) are subject to criticism. On balance,
however, our review suggests that the mechanisms intended to introduce
quality competition, such as patient choice, appear to be effective. These
findings corroborate the results of the empirical studies looking at the
impact of competition on quality at an aggregate level.
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Competing on Quality –
General Report
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1 INTRODUCTION
Purpose of the report
1.1 The aim of this report is to assess the relationship between competition
and quality from the standpoint of the theoretical and empirical economics
literature. Specifically, recognizing that the quality of goods and services is
of key importance for customers in many markets and that suppliers often
compete not only on price but also on quality, we are interested in:
 Exploring how changes in the level of competition affect suppliers' choice of quality.5
 Identifying areas where quality considerations might play a more important role in the work of competition authorities. 1.2 This research will add to the knowledge of competition authorities and
practitioners with regards to cases where quality can play a key role.
1.3 This report also includes a separate review of the literature on the
relationship between competition and quality in the healthcare sector. In
this sector, the quality of services provided is particularly important given
its implication for patients' wellbeing. In addition, healthcare markets have
some specific features both in general (such as different levels of
understanding between healthcare providers and patients, known as
information asymmetries) and in the context of the English system
(regulated prices for many services, and, therefore increased focus on
quality competition) which differentiate this sector. Partly for these
reasons, there exists a sufficiently large amount of relevant healthcare­
specific literature to warrant a separate review.
Background
1.4 In most markets, suppliers compete not only on price to attract customers
but also seek to distinguish themselves from their competitors by offering
products and services which are different or of better quality. Looking at it
from a different angle: as customers, we favour certain characteristics (for
example, durability) of the products we purchase and - to different degrees
5
The relationship between competition and quality can also work the other way around, in that quality may constitute
an endogenous barriers to entry and, hence, affect market structure. A detailed overview of this aspect of quality
competition is outside the scope of our research. For models addressing this issue, we refer the reader to Sutton (1991)
and Berry and Waldfogel (2010).
12 OFT1531
- we are willing to pay a higher price in return for these characteristics. In that sense, quality is an important dimension along which competition develops in markets. 1.5 To illustrate the above point consider the range of quality and choice that
can exist in markets. For instance, in the smart phone industry a number of
manufacturers compete over several characteristics, with products that
satisfy a wide range of needs and preferences. And even in markets where
customers may be unable to determine the objective quality of a product such as the market for still mineral water - competition ensures that
consumers enjoy a wide range of choices in terms of packaging,
promotions and branding.
1.6 This paper is published at a time of increased national and international
interest in exploring the relationship between competition and quality.
Internationally, the topic of quality - its measurement and its role in
competition analysis - was the subject of a recent OECD roundtable6. In the
UK, policymakers have recently sought advice from the Office of Fair
Trading (OFT) on competition in public markets7, where higher service
quality is an important policy goal. In this context, this paper is well placed
to provide policymakers and practitioners with insights into how quality
considerations can be taken into account in the work of national
competition authorities ('NCAs').
Quality assessment in OFT work
1.7 Quality plays an important role in the legal framework of the UK's
competition regime8; the notion that competition provides not only better
prices to consumers, but also quality, choice and innovation permeates the
UK Competition Agencies' guidelines9 and features prominently in senior
leadership speeches10. In practice, these non-price dimensions of
competition are often closely related. Indeed, innovation is a key for
improvements in product quality and variety. Similarly, choice can mean
that products of different qualities are provided in the market.
1.8 Across the OFT's delivery areas, the consideration of quality –both as a
desired market outcome and as a dimension of competition – features in:
6
www.oecd.org/daf/competition/workinprogress.htm#Quality, OECD (2013). www.oft.gov.uk/shared_oft/speeches/2013/06-13_Competition_in_public1.pdf
8
See for example Enterprise Act 2002section 30(1)(a)(i); section 58(2C)(b); section 134(5)(a); and section 134(8)(a)(1).
9
For example, Merger Assessment Guidelines paragraph 4.1.2
www.oft.gov.uk/shared_oft/mergers/642749/OFT1254.pdf
10
For example,2012 Speech 'Competition law in a modern economy' page three www.oft.gov.uk/news-and­
updates/speeches/2012/0712
7
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 The enforcement of the 1998 Competition Act ('CA98') (Chapter I and Chapter II cases).  The assessment of mergers.
 Market studies.11
Competition enforcement
1.9 In the context of the OFT's competition enforcement work, agreements
that limit the quality and choice of products or services without
countervailing economic benefits may be prohibited under Chapter I of the
CA98. On the other hand, agreements that restrict competition may be
exempted, if they contribute to quality improvements that compensate for
any anti-competitive effect.
1.10 Quality can also play a role in Chapter II cases, for example when an abuse
of dominance takes the form of refusal to supply. In such cases, the OFT
may be required to assess whether the refusal to supply by a dominant firm
could affect the ability of a downstream competitor to provide products or
services of the same quality as the dominant firm.12 Business behaviours by
dominant firms may not be regarded as abusive under CA98 even if they
restrict competition, if an 'objective justification' exists for the behaviour in
question. Such objective justifications may - for example - be efficiencies
relating to product quality.13
Merger assessment
1.11 Quality considerations may also be part of the OFT's merger assessment,
which will typically start with the definition of the relevant market. Here,
quality may play a role in determining the boundaries within which firms or
suppliers compete and how closely they do so (note that the role of quality
in defining the relevant market also applies to competition enforcement and
market studies work). Quality can also play a role in assessing whether the
loss of a competitor will lead to a substantial lessening of competition
(SLC)14 when this involves merging parties degrading the quality of their
products and/or the quality of their competitors' products as a
11
Quality consideration also play an important role in the OFT's consumer enforcement work. However, this area is not
within the scope of this research.
12
See for example, CA98/06/2004 decision relating to the refusal to supply JJ Burgess & Sons Limited with access to
Harwood Park Crematorium.
13
See Van der Vijver (2013) or Guidance on the Commission's enforcement priorities in applying Article 82 of the EC
Treaty to abusive exclusionary conduct by dominant undertakings.
14
For a discussion about what is meant by SLC, see Part 4 of the UK Merger Assessment Guidelines
www.oft.gov.uk/shared_oft/mergers/642749/OFT1254.pdf.
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consequence of the merger. Merging parties may also argue that the
merger would lead to quality improvements, which could outweigh the anticompetitive effect of the merger.15
Market studies
1.12 In market studies, quality consideration can contribute to the OFT's choice
of markets to be investigated. When establishing whether a market is
working well for consumers in a market study, the OFT will evaluate not
only price aspects, but also quality, choice and innovation.16 Finally, in
preparing its recommendations to businesses or to the Government, the
OFT will typically also consider how the changes it proposes will address
(or affect) quality issues found in the market.
1.13 Despite the variety of areas where quality plays (or can potentially play) a
role in the OFT's work, it is important to note that most of the OFT's
decisions regarding, for example, competition enforcement or merger
enforcement are based on expected effects on price, rather than quality.
When evidence on price effects is available, or when theoretical models
can be used to anticipate how a merger or anticompetitive practice affects
price, competition authorities may in practice be more likely to rely on
those rather than on similar analyses of quality.
Our approach
1.14 Having recognized, on the one hand, the importance of quality as a
dimension of competition in well-functioning markets and, on the other
hand, the variety of areas of the OFT's work where the consideration of
quality or choice can play a role, this report aims to illustrate:
 Why the assessment of the effect of competition on quality typically plays a less pronounced role in competition authorities' decisions as compared to the effect of competition on price.  What insights the theoretical and empirical literature can provide into the
impact of competition on quality for the work of competition authorities.
15
Note however this is rarely the case. See, for example, Hutchison 3G/Orange merger at EU level
(http://ec.europa.eu/competition/mergers/cases/decisions/m6497_20121212_20600_3210969_EN.pdf) and
Genzyme/Ilex merger in US ( www.ftc.gov/enforcement/cases-and-proceedings/cases/2005/02/genzyme-corporation­
and-ilex-oncology-inc-matter; approved based on quality efficiencies) .
16
See OFT Market Studies Guidance, paragraph 2.19
www.oft.gov.uk/shared_oft/business_leaflets/enterprise_act/oft519.pdf
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 Whether there are discrete areas of competition authorities' work that
might benefit from a fuller appreciation of the relationship between
competition and quality.
1.15 Our report is primarily informed by theoretical and empirical papers which
focus on the effects of competition on quality. Regarding the theoretical
literature, we selected papers which look at changes in the intensity of
competition, measured either by the number of suppliers or some measure
of substitutability (such as transportation costs), and compare different
market outcomes. Among the empirical studies, we focus on the ones
which specify structural demand models and, therefore, are able to
estimate the effect of competition on consumer welfare. We also identify
papers from the academic literature that can add to the thinking around
competition and quality in discrete areas of competition authorities' work.
Finally, we look at UK competition authorities' past decisions that relied on
an assessment of the relationship between competition and quality.
1.16 Within the topic of competition on quality, there are some areas of the
literature which we decided not to explore or only explore in less detail. For
example, we will not have an extensive review of the rich literature on
minimum quality standards although we refer to a few relevant models in
Chapter 2.
1.17 Moreover, we decided to focus on how the intensity of competition affects
suppliers' unilateral incentives with respect to their choice of quality so
that we do not explore how collusion affects firms' choices of this
parameter. This is motivated by the fact that collusive agreements are
regarded as 'object' restrictions under the CA98. In that sense, there is
limited practical need for characterizing the effect of collusion on firms'
choice of quality and price in these cases.
1.18 Finally, within our analysis of the effect of competition on suppliers' choice
of quality, we focus on horizontal aspects. That is, we do not investigate
how changes in competition in an upstream market affect upstream
suppliers' choice of quality for inputs provided to downstream competitors.
Key findings
1.19 When considering the reasons why quality has played a less pronounced
role in competition agencies' work as compared to price, we find that this
is due to three factors:
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 First, by surveying instances in which UK competition agencies had to
address quality competition, we note that the main difficulty relates to
the objective and robust measurement of quality.
 Second, we note that, in general, the academic literature on the
relationship between competition and quality is indeterminate. When
prices are regulated, the theoretical literature suggests a positive
relationship between competition and quality. In contrast, when firms
choose prices as well as quality levels, the theoretical literature finds an
ambiguous effect of competition on quality although many empirical
papers point towards a positive relationship.17
 Finally, the literature contains limited insights about the consumer
welfare implications of new price/quality equilibria triggered by changes
in competition.18
1.20 When assessing whether practical insights could be helpful to discrete
areas of competition authorities' delivery, we draw on past cases where
quality played a role in the analysis by the CC. In this context, we discuss
the use of quality-concentration analyses and we support the continued use
of this tool going forward in markets where firms compete primarily (or
exclusively) on quality.
1.21 We also discuss the relevance of recent developments from the theoretical
and empirical literature on quality choice in the context of merger control.
We note that this growing strand of the literature highlights potential biases
in applying price pressure tests and merger simulations that do not allow
for post-merger quality changes in markets where quality is an important
dimension of competition. While we do not consider that the literature is
sufficiently conclusive on the direction of the possible bias, merger
assessment in specific industries19 could potentially benefit from insights
provided by the growing body of merger simulations published in academic
journals that allow for firms to alter their post-merger choices of both
quality and price.
17
For a detailed summary of these findings see Table 2 on page 62.
It is clear that if after a change in competition price goes up and quality down, then consumers are harmed. However, if both price and quality increase due to weaker competition, then the impact on consumer welfare is less clear.
19
For example, industries where (i) quality considerations are key; (ii) there are fairly good measures which are likely to drive consumers' perception of quality; and (iii) there is typically enough variation in concentration and characteristics between local markets to provide robust evidence on the relationship between competition and quality.
18
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Structure of the report
1.22 The report is structured as follows; Chapter 2 discusses the concepts of
quality both from the perspective of the academic literature and
competition practice; Chapter 3 describes some of the issues faced by
competition authorities when measuring quality; Chapter 4 explores the
academic literature on the effect of competition on quality, both when
firms also choose price and when prices are exogenous; Chapter 5 looks at
the empirical literature to seek further insights on the impact of competition
on quality when firms set both qualities and prices; Chapter 6 illustrates
three new themes in the literature of competition on quality; and Chapter 7
concludes.
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2 PRODUCT DIFFERENTIATION AND THE CONCEPT OF QUALITY
Introduction
2.1 Before addressing substantive issues on quality measurement and the
relationship between competition and quality, it is worth giving some
consideration to how quality is typically modelled in the academic literature
and how this relates to practice.
2.2 Academic models refer to the quality of a product when there exist some
characteristics along which all consumers agree that one product is more
desirable than the other, all else equal. In other words, there are situations
where ' […] for equal prices, all consumers prefer one over the other
product'20. These situations are reflected in models of 'vertical
differentiation' in the literature.
2.3 This setting may apply either to products on their own, or to single product
characteristics. For example, for given prices a construction firm will prefer
high grade cement to low grade cement. For many products however, the
vertical differentiation framework may apply to individual product
characteristics. For example, a computer's quality develops along many
dimensions; design, brand, size, performance, etc. While we might assume
that all consumers would - all else equal - prefer a fast computer over a
slow one, this assumption would not necessarily apply to other
characteristics. That is, some consumers might prefer brand A over brand B
while others would feel the other way around. It is also likely that different
consumers would prefer, for example, different screen sizes or colours. In
this case, the academic literature would model the product specifications in
a 'horizontal differentiation' framework.
2.4 More precisely, academic models use the horizontal differentiation
framework when ' […] for equal prices, consumers do not agree on which
product is the preferred one'21. In these models, firms would decide about
the variety of the product they offer and not the quality of it as in vertical
differentiation models. Whether a given situation is better reflected by
models of vertical or horizontal differentiation depends on the underlying
consumer preferences. Ultimately, both frameworks help demonstrate the
same point; namely, firms' incentives to differentiate themselves from their
competitors by offering products of different qualities or different varieties.
20
21
Bellaflamme and Peitz (2010), page 112
Ibid.
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2.5 Although academic models make a distinction between horizontal and
vertical differentiation, and refer to quality only in the latter setting, in
practice it is not always easy to draw such a distinction. Indeed, in
practice, many products are defined by multiple characteristics; hence,
they combine these two types of differentiation. Therefore, when
discussing the relationship between competition and quality in Chapter 4,
we will dedicate a separate section to models which look at quality
competition in the context of horizontal differentiation (that is, models with
both horizontal and vertical differentiation). Moreover, from a policy
perspective, the notion of quality may be interpreted more broadly than in
the academic sense. For example, the Background Note of OECD (2013)22
as well as some of the country submissions of the report23 discuss quality
in a broader sense, including not only situations of vertical differentiation
but also horizontal differentiation (that is, product variety).
2.6 Similarly, when discussing the impact of competition on quality in
healthcare markets, Gaynor (2006) looks at economic models of both
horizontal and vertical differentiation and focuses on 'what the models
have to tell us about the ability of markets to deliver products with the
characteristics that people want (regardless whether it is the right "quality"
or the right "variety").'
2.7 In this sense, policymakers are not only interested in whether the socially
optimal level of quality is delivered for given prices in the market but also
care about how closely the product varieties offered in the market match
consumer preferences (that is, whether variation is too large or too small in
the equilibrium) and whether there are too many or too few varieties
offered in the equilibrium from a social welfare point of view. Similarly, an
NCA would not only be concerned about the potential degradation of
product quality as a result, for example, of a merger: the loss of a product
variety, even if it is not unambiguously considered a 'higher quality
product', could also represent significant harm to consumers if sufficient
22
'Economists have come up with a semantic way to distinguish features that all consumers agree are desirable from
features that only some consumers find desirable. The former are grouped under the heading 'vertical product
differentiation' while the latter are categorized as 'horizontal product differentiation'. That is useful terminology, but it
does not change the facts that, to some consumers, a given horizontal product differentiation will count as 'quality'
while to others it will not, and that even among vertical differentiations, consumers sometimes disagree on how
important various features are relative to one another.' www.oecd.org/daf/competition/Quality-in-competition-analysis­
2013.pdf (p 12)
23
See, for example, the submissions from Australia: ''quality is a multifaceted concept with several dimensions,
including product variety, horizontal product differentiation and vertical product differentiation ' (p.43) or the European
Union: 'in some cases, the (perceived) quality correlates with price positioning of a given product or service. (…) Such
vertical differentiation may help to define a group of products which are positioned at a similar level and which compete
against each other, and which customers still regard as substitutes. (…) Apart from vertical differentiation, products may
also be differentiated horizontally, meaning that they simply display different quality features without necessarily being
considered of higher or lower quality. In those cases, the price positioning may not be a good indicator for quality, as
products simply have different characteristics to fit different needs.' (p. 79) in OECD (2013).
20 OFT1531
consumers have a strong preference for the withdrawn product compared
with the remaining products.
2.8 Our report will primarily focus on the impact of competition on the
equilibrium choice of quality in a narrower sense. That is, we are interested
in whether increased competition results in better goods and services in the
market and whether this leads to an increase in social welfare. However, in
order to illustrate more generally why firms want to differentiate their
products from their competitors and to help discuss quality competition
when products are also horizontally differentiated (that is, quality
competition in location models) in Chapter 4, we will briefly present some
basic models of horizontal differentiation alongside models of vertical
differentiation in the next section. These models will serve as building
blocks for some of the consecutive analyses in the report.
Basic models of product differentiation
2.9 In the following we will present basic models of horizontal and vertical
differentiation on which we will draw in later chapters. These models will
help illustrate the considerations behind firms' decisions regarding product
positioning and the choice of product quality, by showing that firms may
have the incentives to differentiate themselves from competitors in order to
enjoy some market power. On the other hand, they also want to offer
products which best meet consumers' preferences. Ultimately, the degree
of product differentiation in a market is determined by the balance of these
two forces.
Horizontal differentiation (product variety)
2.10 In a horizontal differentiation setting, product varieties are represented by
the 'location' of competing firms' products and consumers prefer products
that are located closer to them. Horizontal differentiation models are very
flexible, in that they can accommodate both the physical location of outlets
and the positioning' of brands. For example, all else equal, consumers
would prefer to purchase their groceries in a shop that is physically closest
to them. Conversely, all else equal consumers might also prefer a certain
supermarket chain over another so that one brand is 'closer' to them than
the other. As we will see below, horizontal differentiation models can
capture both scenarios.
2.11 In this subsection we will present the so-called Hotelling model of
horizontal differentiation with firms both choosing location (that is,
endogenous choice of location) and prices based on Belleflamme and Peitz
21 OFT1531
(2010).2425 This model is a good illustration of the considerations behind
firms' decisions regarding product positioning; namely, the trade-off
between differentiating themselves from competitors in order to enjoy
some market power and matching consumer preferences.
2.12 In the simple Hotelling model consumer preferences for particular products
or brands are represented by the consumers' location along a straight line.
In particular, suppose that consumers are evenly distributed on the unit
long interval [0,1] and have a unit mass; that is, we assume an even
distribution and intensity of preferences. The consumer's location describes
her ideal point in the product space or, in a literal interpretation, the actual
location of a consumer in the geographic space so that a consumer of type
x is located at some point x over the unit interval (see Figure 1 below).
2.13 Consumers buy up to one unit from one of the firms (firm i) located
somewhere on the interval [0,1] (at location ݈݅ ). The assumptions that
consumers (i) make a discrete choice among products (and possibly an
outside option) in that they decide which brand or product to buy but do
not mix between different products and (ii) buy zero or one unit of the
product (unit demand) are common in all the theoretical models of product
differentiation reviewed in this report.
2.14 Consumers have a reservation value r for their ideal product and incur a
transportation cost described by the function ‫ݐ‬ሺ|‫ ݔ‬െ ݈݅ |ሻ when buying from
firm i. The existence of transportation costs follows from the fact that
firms are not located at each potential location, primarily because of fixed
costs. In models of product differentiation in general, this transportation
cost can be interpreted as an opportunity cost for a consumer if a product
in the market does not represent her ideal variety.26
2.15 In this setting, we consider a duopoly where firms first simultaneously
choose their location (that is, their product variety) and then compete on
price.
24
See pages 115-120.
In order to model product differentiation along the dimensions of product characteristics, two main research streams
emerged: the class of spatial models in the spirit of Hotelling (1929) and the models of monopolistic competition in the
spirit of Chamberlin (1933), Spence (1976) and Dixit and Stiglitz (1977). The latter strand of literature, however, does
not take strategic interaction between firms into account.
26
For example, each individual is likely to have a most preferred colour (in a particular shade) of a car. However, cars
tend to come in a limited number of colours so one may end up buying a car in a colour which is close to the 'ideal'
shade but does not perfectly coincide with that. In this case, the consumer will have some disutility from buying a
product which is different in its characteristics from the ideal variety.
25
22
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Figure 1: Hotelling model
2.16 The assumption that the choice of location precedes the price competition
stage reflects the idea that prices can often be adjusted faster than product
characteristics. As a consequence, in this model firms choose their
products assuming that their location in the product space will affect the
intensity of price competition. Firms' marginal cost of production is
assumed to be constant (c).
2.17 To find the equilibrium choice of location and price, the game is solved
with backward induction: we first consider the price competition stage with
given locations and then turn to the problem of location choice.
2.18 The existence of a price equilibrium and, therefore the existence of a
subgame perfect equilibrium27 for the whole game depends critically on the
specification of transportation costs: with linear transportation costs, that
is, where ‫ݐ‬ሺ|‫ ݔ‬െ ݈݅ |ሻ ൌ ߬ሺ|‫ ݔ‬െ ݈݅|ሻ, (with ߬ ൐ 0 ) , the model is not
tractable if firms are located inside the interval.28
2.19 On the other hand, if the transportation cost function takes a quadratic
form, it can be shown that a subgame perfect equilibrium exists so that
firms locate at the extremes exerting maximum differentiation.29 In the
following, we will briefly analyse this scenario to illustrate the firms'
decision problem.
2.20 Consider the situation where transportation costs are modelled such that
‫ݐ‬ሺ|‫ ݔ‬െ ݈݅ |ሻ ൌ ߬ሺ‫ ݔ‬െ ݈݅ሻଶ , where ߬ can be interpreted as a measure of
substitutability between products and, hence, a measure of the degree of
price competition. In this setting, the utility of a consumer of type x buying
product i is given by
27
A subgame perfect Nash equilibrium is an equilibrium such that players' strategies constitute a Nash equilibrium in every subgame of the original game. This concept was developed by Selten (1965). 28
Unless we restrict firms not to locate too close to each other in the model. See for example, Economides (1986). 29
This model was developed by d'Aspremont, Gabszewicz and Thisse (1979). 23
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‫ݒ‬௜ ሺ‫ݔ‬ሻ ൌ ‫ ݎ‬െ ߬ሺ‫ ݔ‬െ ݈௜ ሻଶ െ ‫݌‬௜ .
2.21 At the second stage of the game, we consider how firms compete on price
taking their location given. Suppose that the firms are situated such that
݈ଵ ൑ ݈ଶ and that the price difference is small enough so that some
consumer prefer product 1 whereas others prefer product 2.30 Then there
exists a consumer ‫ݔ‬ො ൌ
௟భ ା௟మ
ଶ
െ
௣భ ି௣మ
ଶఛሺ௟మ ି௟భ ሻ
31
who is indifferent between the two
products. The location of the indifferent consumer determines the demand
for each firm so that all consumers located to the left of ‫ݔ‬ො will buy from
Firm 1 and all consumers located to the right will buy from Firm 2. Firm 1
and Firm 2 maximise ߨଵ ൌ ሺ‫݌‬ଵ െ ܿ ሻ‫ݔ‬ොሺ‫݌‬ଵ , ‫݌‬ଶ ሻ and ߨଶ ൌ ሺ‫݌‬ଶ െ ܿ ሻሾ1 െ ‫ݔ‬ො ሺ‫݌‬ଵ , ‫݌‬ଶ ሻሿ
respectively.
2.22 Solving the firms' maximization problem it can be shown that there exists a
unique price equilibrium for each location pair ݈ଵ ൑ ݈ଶ . Considering then the
location choice of the firms, it can also be shown that the subgame perfect
equilibrium of the game is such that firms choose to locate at the extremes
of the interval in the first stage of the game. To understand the intuition
behind this finding, we need to understand what forces are at play when
firms consider where to locate in the product space:
 On the one hand, for given prices, firms would want to 'move towards
the centre' to best meet consumers' preferences and increase their
market shares ('Market Share Effect').
 On the other hand, firms want to differentiate themselves from their
competitors so that they can soften competition and enjoy some market
power ('Strategic Effect').
2.23 Ultimately, the location choice (and successive price choice) of firms will
depend on the relative strength of these two effects: the Market Share
Effect brings firms together while the Strategic Effect drives them apart.
2.24 In the model presented above, the Strategic Effect is strong enough to
countervail the Market Share Effect which results in firms choosing to
differentiate themselves from their rival, to the extent that they choose
maximal differentiation. However, this result follows from the particular
30
If the price difference between the products is too large, all consumers would buy from the same firm in the
equilibrium.
31
This follows from the fact that the indifferent consumer's utility is the same when buying from Firm 1 or Firm 2 so
that ‫ݒ‬ଵ ሺ‫ ݔ‬ሻ ൌ ‫ ݎ‬െ ߬ሺ‫ ݔ‬െ ݈ଵ ሻଶ െ ‫݌‬ଵ ൌ ‫ ݎ‬െ ߬ሺ‫ ݔ‬െ ݈ଶ ሻଶ െ ‫݌‬ଶ ൌ ‫ݒ‬ଶ ሺ‫ ݔ‬ሻ.
24 OFT1531
specification of transportation costs: changing these assumptions could
largely affect this outcome.32
2.25 In addition, as Brenner (2011) points out, the tractability of Hotelling
models decreases with the number of firms which explains why there is
only a limited number of contributions to location models with multiple
firms.
2.26 The most well-known among such models is Salop (1979) which moves
away from the linear model presented above and considers a situation
where (i) firms are located on a circle with circumference one and (ii)
consumers are evenly distributed on this circle.
2.27 The way consumers' decision making is modelled corresponds to the one in
the linear model: consumers' utility depends not only on the prices of the
firms but also on the transportation cost that the consumer incurs when
purchasing from a given firm. Firm i's demand can be derived from the
location of the consumers who are indifferent between buying from firm i
and its two neighbours respectively. More specifically, firm i attracts all
consumers between ‫ݔ‬ො௜ିଵ,௜ and ‫ݔ‬ො௜,௜ାଵ , where ‫ݔ‬ො௜,௜ାଵ is the consumer who is
indifferent between buying from firm i and firm i+1 whereas consumer
‫ݔ‬ො௜ିଵ,௜ is indifferent between firm i and its left neighbour (firm i-1) , as
illustrated by Figure 2.
Figure 2: Salop model - location of indifferent consumers
2.28 It can be shown that, with quadratic transportation costs, firms locate
equidistantly along the circle in the equilibrium to maximise the distance
from their neighbours.33 This result does not change with an increase in the
32
Indeed, the way in which transportation costs are modelled has a strong impact on the existence of equilibrium and on
the degree of differentiation in models of horizontal differentiation. This is because transportation costs influence the
degree of price competition via the number of customers that a firm can attract from its neighbour(s) by decreasing its
price. Economides (1986) demonstrates this by considering a Hotelling setting and using a family of transportation cost
functions: ݂ ሺ݀ሻ ൌ ݀ఈ , where 1 ൑ ߙ ൑ 2. He reiterates the finding that no price equilibrium exists when transportation
costs are linear (or not sufficiently convex). For the cases where an equilibrium exists, on the other hand, he shows that
firms always differentiate their products. This differentiation, however, does not always go to the maximum: the more
convex the transportation cost function (that is, the higher the degree of price competition), the stronger the 'Strategic
Effect' and, hence, the degree of differentiation.
33
Salop (1979) considered the price equilibrium given an equidistant location setting. However, when also considering
location choice, an equilibrium may not exist, similar to the Hotelling model. By introducing quadratic transportation
costs, Economides (1989) circumvents this issue and considers a model where firms choose location before entering into
price competition.
25
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number of firms; hence, in this setting the number of firms and increased
competition does not have an impact on the relative amount of
differentiation. However, since total demand is fixed in this model, the
distance between firms becomes smaller and thus competition more
intense, resulting in lower prices.34
Vertical differentiation (product quality)
2.29 In the previous subsection we looked at a situation where different
consumers preferred different product varieties so that, in the equilibrium,
some consumers would prefer buying one product while other consumers
the other one, even if their prices were the same. However, as discussed
above, there may be situations where all consumers agree that one product
or brand is more desirable than the other at similar prices which is captured
in models of vertical differentiation. In a situation like this, if both products
were priced at the same level, all consumers would buy only one of the
products, namely the one of higher quality.
2.30 Based on Belleflamme and Peitz (2010), we will first present an analysis of
oligopolistic competition under quality differentiation in the spirit of the
model developed by Shaked and Sutton (1982, 1983).35 Then, we will also
briefly discuss an extension of this model and refer to the impact of
changing the strategic choice variable of firms. These models focus on
firms' equilibrium choice of quality levels and prices in a setting where
consumers are perfectly informed about the quality of the good. In Chapter
4, however, we will also discuss some implications of information
asymmetries in situations where quality is not observable.
2.31 Consider a model with discrete choice and unit demand (see paragraph
2.13). Suppose that the quality of a product can be described by some
number s୧ ∈ ሾs, s] where s୧ is a positive real number. Consumers agree that
higher quality is better than lower quality, but value higher quality
differently. To capture this, each consumer is assigned a preference
parameter θ ∈ ሾθ, θሿ where θ is a positive real number. Consumers with a
34
While lower prices and more variety (and, hence, lower transportation costs) are beneficial for consumers, with free
entry the overall welfare in equilibrium is lower than the socially optimal. This is because of the negative effect arising
from the duplication of fixed costs of entry. When firms make their entry decisions, it is irrelevant for them whether their
revenues come from stealing business from their competitors or from generating new business. In contrast, a social
planner would only care about the welfare generated by lower prices and lower transportation costs. Given that stealing
business from competitors only results in a transfer of profits between firms but not in an increase of aggregate welfare,
the dominance of this business stealing effect leads to too many firms entering the market in the equilibrium. On the
other hand, given that total demand is inelastic, lower prices due to entry become welfare-neutral transfers between
firms and consumers. Therefore, if competition authorities give more weight to consumer surplus than to firms' profits,
then entry may not be excessive any more.
35
Other seminal contributions to the vertical differentiation literature include Gabszewicz and Thisse (1979, 1980) who
study price competition in a vertically differentiated industry with exogenous quality levels. In contrast, Shaked and
Sutton (1982, 1983) endogenise the quality choice of firms.
26
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high θ are those who place a greater value on high quality. Consumers are evenly distributed along ሾθ, θሿ so that they amount to M ൌ θ െ θ consumers.
2.32 The conditional indirect utility of consumers from buying one unit of good i
is v୧ ൌ r െ p୧ ൅ θs୧ .36 Firms are assumed to have the same constant (zero)
marginal costs of production independent of quality.
2.33 There are two firms in the market: Firm 1 produces quality sଵ and firm 2
produces quality sଶ . We assume that prices are set such that pଵ , pଶ ൏ ‫ ݎ‬in
equilibrium, so that all consumers buy in the market.
2.34 Assume for the moment that sଵ ൏ sଶ . Then there exists a consumer θ෠ who
is indifferent between product 1 and product 2. The indifferent consumer
୮ ି୮
satisfiesr െ pଵ ൅ θ෠sଵ ൌ r െ pଶ ൅ θ෠sଶ . Solving for θ෠ gives θ෠ ൌ మ భ for
ୱమ ିୱభ
θ෠ ∈ ሾθ, θሿ. That is, the indifferent consumer is determined by the ratio of
price and quality differences. Consumer s of type θ ൐ θ෠ buy the high-quality
product sଶ whereas consumers of type θ ൏ θ෠ buy the low-quality product
sଵ . Note that all consumers prefer higher quality but if high quality implies a
price premium, some consumers will choose the low-quality product.
2.35 Suppose that firms first choose quality simultaneously and then compete
on price. We will characterize the sub game perfect equilibria of this two
stage game.
2.36 We begin by looking at the second stage, when firms compete on price. By
solving the system of first order conditions of profit maximization with
respect to price for given quality, we obtain the optimum prices for any
given quality chosen by both firms.
1
pଵ∗ ൌ ൫θ െ 2θ൯ሺsଶ െ sଵ ሻ
3
1
p∗ଶ ൌ ൫2θ െ θ൯ሺsଶ െ sଵ ሻ
3
2.37 We can now substitute for prices in the profit function and obtain reducedform profit functions which only depend on quality. For sଵ ൏ sଶ , we have:
ଶ
1
π
෦ଵ ሺsଵ , sଶ ሻ ൌ ൫θ െ 2θ൯ ሺsଶ െ sଵ ሻ
9
ଶ
1
π
෦ଶ ሺsଵ , sଶ ሻ ൌ ൫2θ െ θ൯ ሺsଶ െ sଵ ሻ
9
36
The conditional indirect utility function is derived from the direct utility of purchasing a unit of the good and the
budget constraint faced by the consumer. The utility of buying one unit is u୧ ൌ q ଴ ൅ θሺs୧ െ sሻ. If a consumer does not
buy in the market, she only consumes the outside good q ଴ and her utility is assumed to be u଴ ൌ q ଴ െ r െ θs. Each
consumer faces the budget constraint y ൌ r ൅ θs.
27
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2.38 At stage 1, firms set qualities anticipating the resulting equilibrium prices.
Thus, because profits π
෦ଵ and π
෦ଶ increase with the quality difference,
ሺsଵ , sଶ ሻ ൌ ሺs, sሻ or ሺs, sሻ are the equilibrium quality choices of the game in
which firms set qualities simultaneously, that is, one firm will offer a high
quality high price and the other a low quality low price product.37 The main
insight of the vertical differentiation model, then, is that in markets where
products can be vertically differentiated, firms do offer different qualities in
equilibrium which allows them to relax price competition. This result is
particularly powerful considering the assumption that producing higher
quality does not imply higher marginal cost: yet, consumer heterogeneity
results in one of the firms producing lower quality.
2.39 The equations of optimum prices in paragraph 2.36 also have interesting
implications on the number of firms in the equilibrium: for both firms to
have positive demand in equilibrium, the following inequality must hold:
θ ൐ 2θ. If the reverse is true, so that consumers' taste for quality is not
heterogeneous enough, the low-quality firm does not serve any consumers
in the equilibrium even when charging zero prices. If the quality and pricing
decisions are preceded by firms' entry decisions with an arbitrarily small
entry cost, the low-quality firm has no incentive to enter the market. In this
situation, there is no room for more than one firm in the market to operate
profitably, resulting in a natural monopoly situation.
2.40 The above model assumes that, after setting the quality levels, firms
compete on price (Bertrand competition). Motta (1993) departs from this
assumption and analyses how the equilibrium solution would differ
between price and quantity (Cournot) competition at the second stage of
the game. In addition, he also relaxes the assumption on invariable marginal
cost with respect to quality. More specifically, he considers a duopoly
situation with two different assumptions about costs: first, he assumes
that quality improvements are associated with fixed costs (for example,
because quality improvements require R&D); then he analyses the case of
variable costs of quality improvements.
2.41 The main finding of the paper is that firms always choose to offer distinct
qualities at equilibrium, independently of the assumptions on costs and on
the nature of competition (price or quantity competition). However, it is
also shown that the equilibrium qualities under price competition are more
differentiated than those under quantity competition. The intuition behind
this finding is that firms have higher incentives to differentiate their
37
In other words, if firms chose identical qualities, Bertrand competition would imply that prices are driven down to
marginal cost and firms earn zero profits. Therefore, firms have the incentive to set different quality levels.
28
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products and relax competition when competition is more intense at the marketing stage of the game, that is, with Bertrand competition. In this model, consumers are better-off under Bertrand competition than under Cournot competition: in the former case, (i) more consumers are served since the lower quality firm tends to cover a larger segment of the market; (ii) the top quality on offer is higher; and (iii) the firms set lower prices.
However, these results should be interpreted with caution since the model
assumes that the number of firms is fixed. Allowing for free entry could
potentially change the outcome. In Chapter 4 we will analyse models in
which the impact of an increase in the number of firms is also considered.38
2.42 The main insight conveyed by the above vertical differentiation models is
that firms set different qualities of their products in order to relax price
competition among them. Consumers - who value both higher quality and
lower prices - then face a trade-off in that they can either purchase low
price/low quality goods or high price/high quality goods. In Chapter 4, we
will investigate whether increased competition improves the trade-offs
faced by consumers.
2.43 Note that the models we presented in this chapter assume that consumers
can observe the quality of the products they buy. However, in many
situations, consumers buy so-called experience goods with characteristics
that are difficult to observe before purchase. Markets with experience
goods are characterised by asymmetric information in that consumers have
less information about the quality of the products than producers. This may
lead to firms providing too low quality from a social point of view or,
ultimately, a breakdown of quality in the market.39 Firms may find different
ways of overcoming asymmetric information problems, such as using
advertising or prices as signals40 or offering warranties41.
2.44 Providing a comprehensive analysis of the implications of asymmetric
information and the ways to overcome potential issues is outside the scope
of this report. However, in Chapter 4 (in paragraphs 4.38-4.53), we will
analyse one particular setting with asymmetric information. More
specifically, we will look at how competition affects the quality choice of
38
Other interesting extensions of duopoly models with vertical differentiation include Wauthy (1996) or Ronnen (1991)
and Valletti (2000). Wauthy (1996) considers quality and price competition without assuming ex ante that the market is covered and shows that the 'principle of differentiation' holds even with endogenous market coverage. Ronnen (1991)
and Valletti (2000) introduce minimum quality standards (MQS) in a vertically differentiated duopoly setting. Assuming price competition, the former model finds that with the MQS both firms will raise their quality, more consumers will be
active in the market and consumers who were already active will purchase a higher quality product compared to a situation absent MQS. With quality competition, Valletti (2000) also finds that both firms raise their quality as a result of
the MQS. However, there is a fall in the number of active consumers and some consumers switch from the high quality product to the low quality product.
39
This result is modeled in the seminal paper by Akerlof (1970) on the markets for lemons. 40
See for example Milgrom and Roberts (1986).
41
See Spence (1977).
29
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firms when they offer experience goods and use branding and reputation to
overcome issues of asymmetric information in a situation of repeated
interaction with consumers. Moreover, the Healthcare Report also
considers the implications of asymmetric information in the specific context
of the healthcare sector.
Conclusion
2.45 The baseline models of product differentiation presented above are good
illustrations of how firms respond to the diversity of consumer preferences
and why they may end up differentiating themselves from their
competitors. One framework we discussed, that is, vertical differentiation,
helped explain the considerations behind firms' quality decisions in simple
duopolistic models. In the remainder of the paper we will focus on this
angle of product differentiation, that is, firms' quality decisions as a
function of the intensity of competition. Before we do so, however, we will
turn to a fundamental issue in Chapter 3, namely, the assessment of
quality.
30
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3 ASSESSING QUALITY
Introduction
3.1 As the submissions to the OECD roundtable on 'Quality and Competition'
highlight, the main limitation in examining the relationship between
competition and quality is the challenge of measuring quality.42 For most
products, price is a characteristic that is relatively easy to measure and in
most cases it is easily comparable across producers.43 However, for many
products a similarly informative and objective measure of quality does not
exist.44 In addition, the quality of a product often develops along multiple
characteristics.45 These issues around measurement and
multidimensionality can pose a challenge for a competition authority that
wishes to base a decision (such as a merger decision) on a theory of harm
that involves anticipating the effect of the merger on quality. In this
chapter we will demonstrate how UK competition authorities have found
ways to deal with these challenges. More specifically, by using illustrative
examples, we will discuss practical methods that have been employed to
investigate the relationship between the intensity of competition and
quality in three merger cases and a market investigation.
Assessing quality in practice
3.2 In many CA98 cases, market studies and mergers, arguments about quality
are likely to play a secondary role in the assessment of competitive effects
and / or the context of relevant behaviour. While it is understood that a
competitive assessment should analyse the likely effects of the mergers on
quality, choice and innovation as well as price, the assessment often
focuses on price. This is motivated on the one hand by the lack of quality
data which are as informative and comparable as data on price, and on the
other hand by the assumption that price may serve 'as a proxy for other
42
See for example. OECD (2013). 'As quality is often difficult to define and to measure, quality considerations are in
practice often assessed by means of customers' and competitors' views collected during market investigations or
documentary evidence (such as internal analysis or surveys conducted by the firms). The possibility to use more exact
quantitative tools is – contrary to an assessment focused on prices - more limited.' p. 79.
43
Note that this is not the case in all markets. For example, a 2013 review of the UK retail energy market found that
customers find it difficult to compare tariffs of competing energy providers as they may include standing charges,
different per-unit charges, exit fees etc. See Ofgem (2013).
44
For example, while one might easily compare the price charged by different publishers for a given classic literature
book, one version of the book might have a more appealing cover than others. Book covers certainly influence the
preferences of at least some book buyers, but it is unlikely that the difference between the attractiveness of book covers
can be measured with the same ease as the difference in their price.
45
For example, as pointed out in the UK submission of OECD (2013), '[i]n a retailing setting quality may include
considerations of quality of goods on sale, the available range of products, levels of services such as product information
or length of time queuing at the checkout.' (p 104).
31 OFT1531
possible anticompetitive effects, such as a reduction in product quality or
service or a decrease in the pace of innovation.'46 Moreover, as a
generalisation, it is usually quicker to adjust price than quality. Therefore, in
many cases it is assumed that firms compete on price having chosen their
product characteristics, although some aspects of quality may be varied in
the short run.47
3.3 In some circumstances, however, for example in a merger where price is
not a choice variable of a firm, or is less important to consumers, it can be
reasonable to take non-price dimensions, such as quality, into account in
the competitive assessment of the anticipated effects. This is the case in
some 'local competition' mergers, that is, mergers between national
retailers where competition occurs on the local level but prices are set
nationally. In addition, an assessment of the competitive effects with
respect to quality is warranted in cases where prices are regulated and
consumers are assumed to choose suppliers or providers based on quality
alone.
3.4 Below we present three case studies that illustrate the types of measures
of quality relied upon by UK competition agencies in the past. These
examples show practical solutions that may be employed in similar cases in
the future.
Groceries
3.5 The relationship between competition and quality was investigated in a
number of mergers and market studies in the retail grocery sector. In
particular, we discuss how the CC considered quality, range and service in
relation to the 2005 Somerfield plc/William Morrison Supermarkets plc
('Somerfield/Morrison') merger and in the 2008 Groceries market
investigation.
3.6 On 25 October 2004, Somerfield acquired 114 smaller Safeway stores
from Morrisons by way of a sale and purchase agreement. The OFT
referred the merger on 23 March 2005 and subsequently the CC published
its report on the merger on 2 September 2005. On 10 October 2006 the
parties agreed to divest the 12 stores the CC had found to be problematic
in its report.
3.7 The competitive assessment in this case was not solely based on price,
mainly because third parties had indicated that competition in the groceries
46
47
See Kaplov and Shapiro (2007). Footnote 94.
See OECD (2013) page 104.
32 OFT1531
sector developed along quality, range and service as well as price.48 It was
also noted that local Somerfield stores adhered to centrally-set price
bands.49 This suggested that local outlets could have been constrained, to
at least some extent, in exercising market power through price increases in
the local markets which were defined by the distance that customers are
able or prepared to travel to do their shopping.50 In light of these, the
analysis, both in relation to market definition and the assessment of the
competitive effects of the merger focused more broadly on price, quality,
range and service (PQRS), rather than price alone as following the merger,
local stores may increase profits by altering any of the component of the
PQRS retail offer.
3.8 The parties submitted only anecdotal evidence on the relationship between
competition and quality and argued that there would be no attempt to
increase prices or lower quality even in markets characterized by less
intense competition because the PQRS criteria (such as prices) were set
nationally. The CC, on the other hand, noted that local stores did have
some flexibility in pricing; in addition, customer complaints (for example,
about opening hours) confirmed the validity of wider concerns around the
potential deterioration in PQRS (rather than just an increase in price) as a
result of reduced competitive constraints.51 More importantly, the
conclusions on the 'straightforward economic logic' that 'the weaker that
competition, the less the incentive to maintain PQRS'52 was supported by a
margin-concentration analysis. This analysis showed evidence of higher
profit margins in rural markets with less competition, which was a 'result
of higher prices or lower costs possibly associated with a reduction in
range, quality or service.'53
3.9 In another investigation, namely, the 2008 Groceries market investigation
the CC recognised that most large groceries retailers had by then
transitioned toward uniform national pricing strategies.54 In addition to
pricing, other parts of the retail offer, such as product promotions and
product range, were also set nationally for many chains. In that sense, the
CC examined the relationship between the degree of competition and the
non-price elements of the retail offer that might be adjusted at the store
level55, by considering three main sources of evidence: (i) qualitative
evidence from grocery retailers; (ii) evidence on the relationship between
48
Ibid. Paragraph 6.1.; Paragraph 6.25.
Competition Commission (2005). Paragraph 7.51. 50
Ibid. Paragraph 6.7.
51
Ibid. Paragraph 7.52.
52
Ibid. Paragraph 7.29.
53
Ibid. Paragraph 7.52.
54
Competition Commission (2008). Paragraph 6.31. 55
Such as, stock availability, the level of service, the number and type of food counters, the number and type of store amenities, speed of checkout service, cleanliness and opening hours.
49
33 OFT1531
concentration and non-price elements of the retail offer, provided by Tesco
and from a study commissioned by the CC to GfK, a market research firm;
and (iii) margin-concentration analysis.
3.10 The qualitative evidence from retailers suggested that the retail offers
responded to local competitive conditions. Retailers often responded to
entry and changes in local competitive conditions by, for example,
'vouchering', store refurbishments, food counter initiatives or improved
staffing.
3.11 The analysis submitted by Tesco considered the relationship between the
intensity of local competition and various components of the retail offer
including price, range, stock availability and checkout waiting times. This
analysis did not find a statistically significant relationship between
increased local concentration and an inferior retail offer.56 The GfK study
assessed the extent to which 18 individual aspects of the retail offer were
related to concentration. It found that product range was marginally better
in those stores where there was more than one competing retailer.57
3.12 Ultimately, the CC did not give strong weight to either study in its findings.
In relation to the analysis by Tesco, there were 'several methodological
concerns regarding the analysis'58, such as, not controlling for the physical
characteristics of the store or local customer demographics.59 With respect
to the GfK study, it was noted that 'as the study was able to include only a
limited number of products it is difficult to draw strong conclusions
regarding this effect.'60
3.13 Above all, these studies were found inconclusive as '[m]any aspects of the
store-specific retail offer are intangible and have no identifiable metric with
which to measure variation from store to store.'61 In that sense, the studies
were not capable of fully reflecting or measuring all of the elements of the
retail offer.
3.14 Therefore, the CC relied more heavily on a margin-concentration analysis
when analysing the relationship between local market concentration and
the retail offer, noting that in the presence of barriers to entry, a grocery
retailer with few competitors or a high market share will face weaker
56
57
58
59
60
61
Ibid.
Ibid.
Ibid.
Ibid.
Ibid.
Ibid.
34
Paragraph 6.48.
Paragraph 6.49.
Paragraph 6.48.
Page 115, footnote 3.
Paragraph 6.50.
Paragraph 6.51.
OFT1531
competitive constraints and is likely to have an incentive to weaken their retail offer.62 63
3.15 The CC also recognised that 'the margin-concentration analysis does not
involve direct observation of variations in particular aspects of the retail
offer at individual stores; however, a store's profit margin incorporates all
such variations, and as such, it does not raise the measurement issues
inherent in the Tesco and GfK studies.'64 The margin-concentration analysis
in this case showed that 'intense local competition results in lower store
level variable profit margins'65. This led to the conclusion that outlets facing
less competition reduce their retail offer which is reflected in lower costs
and, hence, higher margins.
3.16 Indeed, the argument that in markets where prices are fixed or restricted, a
positive relationship between concentration (that is, a decrease in
competition) and margins is indicative of lower expenses on quality, service
and range is intuitive. Therefore, a margin-concentration analysis can be a
pragmatic and effective tool in a situation where:
 Competition authorities have to expand their competitive assessment to
aspects of quality (as opposed to mainly price), either because individual
firms are constrained in reacting to local competitive conditions through
their pricing (for example, due to national pricing) or because it is clear
that the main drivers of competition are non-price factors.
 It is difficult to measure certain aspects of quality or to capture all the different elements of quality due to multidimensionality. 3.17 However, there are some important points that a competition authority has
to keep in mind in order to reach a robust conclusion when following this
approach which was also recognised in the analysis presented above. In
particular:
62
Ibid. Paragraph 6.2.
In practice, however, the profitability of weakening the retail offer and the incentive to do so is balanced against the
potential costs of varying the retail offer locally. For example, firms may incur administrative costs when changing
quality (for example, by reducing staff, changing cleaning or stocking schedules, reducing opening hours, altering food
counters).This is recognised by the CC when it notes that 'varying the retail offer locally involves administrative and
other costs' (paragraph 6.51). In addition, reputation can also play a role in retailers' quality decisions: while post-merger
some stores might have the ability to reduce quality, range or service to increase profits, they might not have the
incentive of doing so, given that a retail chain might wish to retain a consistent reputation for quality across its stores.
Finally, it may be the case that, when a quality investment has the effect of creating additional sales, a company with
higher market share is more willing to incur fixed investments as it could appropriate the returns of such investment
more fully. For example, if investing in a new fish counter makes people - who would not have bought fresh fish before buy fresh fish, a firm with a higher market share would have a higher incentive to install a fish counter, because it can
spread the fixed costs of the counter over a larger number of additional sales.
64
Ibid. Paragraph 6.51.
65
Ibid. Paragraph 6.53.
63
35 OFT1531
 Endogeneity: In an econometric margin-concentration model, firms' profit
margins are regressed on some function that captures the effect of local
market structure and on other control variables (such as local
demographic variables). It is clear, that market structure and, hence, the
intensity of competition is likely to affect the profit margin of firms.
However, the relationship may also work in the other direction: higher
margins make entry more attractive for firms. If there are some
unobserved effects which affect profit margins, in markets where there
is a high realisation of these effects, there will be more entry as profits
are higher. To mitigate this issue, the CC used an instrumental variable
approach.66
 Choice of cost elements: The relationship between profit margins and concentration are sensitive to whether certain costs are assumed to be fixed or variable. A competition authority, therefore, needs to consider carefully what costs to include in the profit margin. 67
3.18 Finally, we note that there may be other approaches that could potentially
be used to deal with the fact that not all aspects of quality can be
measured (and hence related to concentration). For example, if we can
assume that a tangible measure and a non-measurable aspect of quality are
correlated, the former may be used to proxy for the latter; this argument is
explored by Mordoh (2011) in relation to quality measures in health
economics as discussed in Chapter 3 of the Healthcare Report.
3.19 We also note that when reliable data is available for all the important
aspects of quality, studies that relate measures of quality to local market
concentration may be a more direct way of addressing the issue of whether
a merger, for example, will reduce quality in the market.
The HMV Group/Ottakar merger
3.20 On 8 September 2005, HMV announced its intention of making a public
offer for the entire issued share capital of Ottakar's. The transaction was
notified to the OFT on 9 September 2005.The OFT referred the merger to
the CC on 6 December 2005 and the CC cleared the merger
unconditionally on 12 May 2006.
66
For a detailed review of endogeneity in margin-concentration studies see Competition Commission (2008). Appendix 4.4, page 9.
67
Ibid. Page 4.
36 OFT1531
3.21 As in Somerfield/Morrisons merger, both competition authorities recognised
that in 'brick and mortar' bookselling competition took place mainly on the
local level and that local stores could not alter prices, which were set
nationally by the chains. In that sense, the CC found that '[c]ompetition in
book retailing at the local level between existing stores is concentrated on
two non-price factors, range of titles in stock and quality of in-store
service.'68
3.22 Unlike in the Somerfield/Morrisons, the clearance decision rested almost
exclusively on evidence relating various measures of quality to the intensity
of local competition and, therefore, addressed whether the merger would
be likely to lead to a change in these measures more directly. Specifically,
the CC looked at 'the number of staff; the level of staff experience; book
signing; store opening hours; and the number and timing of refurbishments
relative to competitor store openings.'69 The analysis found measurable
differences between overlapping and non-overlapping stores only in book
signings and refurbishments.
3.23 The CC's approach also differed from the Somerfields/Morrisons decision
(and the Groceries market study) in that it used consumer survey data to
evaluate the contribution of book signing and refurbishment to overall
quality. Survey data showed that consumers considered neither book
signings nor refurbishments 'to be a particularly important feature of book
stores'. Moreover, the analysis found 'no evidence of any difference in
customer satisfaction between overlap and non-overlap areas.'70 This led to
the conclusion that there was 'no evidence that competition at the local
level had a significant effect on service quality [and] that the proposed
merger would not result in an SLC at the local level.'71
NHS hospital merger
3.24 On 29 November 2011, the Royal Bournemouth and Christchurch Hospitals
NHS Foundation Trust (RBCH) and the Poole Hospital NHS Foundation
Trust (PHFT) announced their intention to merge (the 'Bournemouth/Pool
merger'). The OFT referred the merger on 8 January 2011 and on 21
October 2013 the CC prohibited the merger.
68
69
70
71
Competition Commission (2006). Paragraph 5.35. Ibid. Paragraph 5.45.
Ibid. Paragraph 5.51.
Ibid. Paragraph 5.97.
37
OFT1531
3.25 NHS Foundation hospitals are typically reimbursed with a fixed lump sum
per treatment for elective services (the focus of our analysis). This led to
the conclusion that '[a]s there is a fixed price for each elective treatment
[…] foundation trusts have an incentive to compete on quality to attract
patients to their profitable elective services.'72
3.26 In the Somerfield/Morrisons and HMV Group/Ottakar decisions, the CC
based its assessment of SLC on whether post-merger competition on
quality would decrease. To do so, it assessed whether more concentrated
local markets scored lower on available measures of quality. A key issue
there, then, was to identify appropriate measures of quality.
3.27 In contrast, in the Bournemouth/Pool merger, a large number of quality
indicators were available, including clinical factors (such as infection rates
or mortality rates) and non-clinical factors (for example, waiting times).73
However, it was also important to address whether available measures of
quality did in fact influence patients' or GPs' choice of healthcare provider
and whether patient choice served as a sufficient incentive for hospitals to
compete along quality and increase their quality performance.
3.28 Neither of these issues was trivial because competition had only recently
become a feature of the public healthcare sector in the UK. Moreover, in a
market for credence or experience goods as healthcare, 'quality does not
necessarily or entirely take the form of qualities that can be measured or
observed […].'74 The CC reasoned that in order to establish whether a
lessening of competition could arise post-merger, the following conditions
had to be analysed:
 Whether patients and/or GPs have and exercise choice of provider.
 Whether quality75 influences that choice.
 Whether the parties would have an incentive to compete to attract patients absent the merger.  Whether the parties are close competitors.76
3.29 Evidence showed that patients and GPs did exercise their choice of
providers based on hospital's quality measures. The CC also found that
hospitals would have an incentive to compete on quality. To inform this
72
Competition Commission (2013). Paragraph 38.
Ibid. Paragraph 6.73.
74
Ibid. Paragraph 6.75.
75
See Chapter 3 of the Healthcare Report for a detailed description of measures of quality used in the Heath Economics literature.
76
Ibid. Paragraph 6.69.
73
38 OFT1531
finding, it was not possible to rely on comparative analyses as seen in the
two mergers above, because the merger did not involve multiple locations
with varying degrees of concentration. Instead, the conclusion was based
on the academic literature (part of which will be reviewed in the Healthcare
Report) and on other sources of evidence, such as an analysis of GP
referral patterns as well as internal documents and third party views which
indicated that hospitals do compete on quality. Having established that the
merging parties were each other's closest competitors, the CC concluded
that the merger would lead to unilateral effects (in terms of quality
degradation) in 20 elective inpatient services and 36 outpatient services.
3.30 Further to the sources of evidence mentioned in the previous paragraph,
the CC also carried out a survey among patients and GPs, which helped
establish whether patients and GPs use quality indicators to choose health
service providers. The survey also contained questions that helped assess
the closeness of competition of the merging parties. In this merger,
assessing parties' closeness of competition could not have been done
through traditional price-based diversion ratios. That is, in order to calculate
diversion ratios for marginal consumers the CC could not have asked
which alternative provider a patient would have used, had prices increased
by 5-10 per cent.
3.31 Instead, the survey asked - among other things – whether patients of each
Trust would have switched providers had waiting times at the chosen Trust
been 10 per cent higher. The results showed that for most patients each
merging party was the other's next best alternative. This supported the
conclusion that the two providers were indeed their respective closest
competitor.
3.32 In sum, the Bournemouth/Poole merger is a good example of a situation
where price was not a choice variable of providers and did not affect
patients' choice but, unlike in other sectors, measures of quality were
available. In this case, an innovative feature of the analysis was the use of
a survey which contained a 'quality based' test for diversion ratios.
Diversion ratios calculated in this way may be useful in markets where
measures of quality are available and where competition agencies assess
competition on quality in the future.
Conclusion
3.33 As country submissions to the recent OECD roundtable on Competition and
Quality demonstrate, the measurement of quality is the main factor
39
OFT1531
impeding a fuller appreciation of the effects of competition on quality in
agencies' competition enforcement and merger control work.
3.34 In this chapter we presented three merger cases and a market investigation
to illustrate how UK competition agencies assessed whether a merger
would lead to an SLC in terms of a deterioration of quality or the
relationship between market concentration and the quality of offers more
generally. We note that agencies chose to focus on quality as opposed to
price in markets where it was reasonable to assume that competition took
place mainly on non-price dimensions, either because prices were set
nationally or because they did not form part of consumers' choice of
supplier/provider. These cases illustrate practical approaches for measuring
quality that may be employed in similar cases in the future.
3.35 We noted that in cases where issues around the measurement and
multidimensionality of quality were found to be particularly strong, a
margin-concentration analysis can be used to infer that in more
concentrated markets expenditure on quality is lower. In cases where the
CC could complement measures of quality with consumer surveys, for
example to assess how consumers value single drivers of quality, the CC
assessed the effect of competition directly on available measures of
quality. Finally, we noted how in a merger between two hospitals, the CC
employed diversion ratios based on quality decrease as opposed to price
increases.
3.36 These practical approaches are good examples of how competition
authorities take quality considerations into account in markets where
quality is the main driver of competition, despite the difficulties with the
measurement and multidimensionality of quality. In Chapter 5, however,
we will discuss that where more data is available econometric models can
also be used to estimate the loss of consumer welfare implied by a merger
in markets where firms compete along multiple dimensions of quality.
40
OFT1531
4 COMPETITION AND QUALITY – INSIGHTS FROM THE
THEORETICAL LITERATURE
Introduction
4.1 In the previous chapter we discussed that one of the reasons why quality
considerations may play a limited role in competition analysis is the
challenge of measuring quality. One way of getting around these difficulties
would be to seek insights from the literature regarding the relationship
between competition and the equilibrium level of quality and rely more
extensively on the predictions of theoretical models. However, as also
noted for example, in OECD (2013), economic theory cannot always
predict how the changes in the intensity of competition affect quality. More
specifically, when firms set both price and quality, the conclusions of the
theoretical literature on the relationship between competition and quality
are ambiguous. In contrast, when prices are exogenous (for example,
because they are regulated), economic theory predicts a positive
relationship between competition and quality. The purpose of this chapter
is to further explore this point by reviewing the theoretical literature and
drawing out the main findings of the most relevant papers in a comparable
manner.
4.2 To this end, we will first look at the situation where both price and quality
levels are set by competing firms and will explore how the changes in the
intensity of competition affect the equilibrium choice of qualities and prices
and, in turn, overall welfare. The literature on the relationship between
competition and quality consist of two key strands: one consists of papers
which apply a vertical differentiation framework either with observable
qualities or with asymmetric information whereas the other looks at quality
competition in a horizontal differentiation framework. These latter models
reflect the point we discussed in Chapter 2, namely, that in practice many
markets show elements of both horizontal and vertical differentiation.
4.3 In the second part of this chapter, we will consider how the predictions of
the theoretical literature change when firms are free to set quality levels
but prices are exogenous. Most of the papers analysing this issue focus on
the healthcare sector. Therefore, we will give more weight to this
literature in the Healthcare Report, while this chapter will only briefly
highlight some general considerations.
41 OFT1531
4.4 To conclude the chapter before moving on to explore the relevant empirical
literature in Chapter 5, we will summarise the key conclusions of the
reviewed theoretical papers, highlighting any potential differences in their
key assumptions.
4.5 Our review confirms that the theoretical literature can provide only limited
guidance for assessing the relationship between competition and quality.
This is because the conclusions of theoretical models are greatly sensitive
to the assumptions on, for example, the timing of the game or the
convexity of the utility functions. The only exception is the case of
exogenous prices; for example, when prices are set by a regulator or prices
are set by firms nationally despite differences in the intensity of local
competition. In this case, theory predicts a positive relationship between
the intensity of competition and quality levels. However, regulating prices
and, therefore, potentially limiting the available range of price-quality offers
may not always be desirable from a social welfare viewpoint. In particular,
consumers may prefer the choice between high-quality/high-price and low­
quality/low-price offers compared to a more restricted range of quality-price
offers. In addition, designing the optimal regulatory policy which results in
the socially optimal price-quality offers is likely to be challenging. The
assessment of where price regulation can play a role and how the optimal
regulatory framework should be designed, however, is not in the scope of
our research.
Competition and the equilibrium choice of quality and price
4.6 In Chapter 2, we showed that when two firms compete with each other
they may have the incentives to differentiate their products by offering
products of different qualities in order to relax competition. These models,
however, did not consider how a change in the intensity of competition
may alter or affect these results. However, understanding the impact of
competition on firms' quality decisions and, potentially, on consumer
welfare in markets where quality considerations play a key role is highly
relevant from a policy perspective. Therefore, we will now turn to
theoretical models which provide a framework for considering these
questions.
4.7 As mentioned in the introduction of this chapter, the theoretical literature
suggests that the relationship between competition and quality differs
fundamentally between the situation where firms also choose price and the
one where prices are regulated. In the former case, the impact of
competition on quality is ambiguous. As Bar-Isaac (2005) points out: 'on
42 OFT1531
the ambiguous role of competition on quality provision and efficiency, there
is a considerable body of literature which, though focusing on different
mechanisms, suggest that economic research is not always in agreement
with the conventional wisdom on the benefits and effect of competition'.
That is, market forces cannot always be relied upon to supply the socially
efficient quality level.
4.8 One source of this inefficiency is the potential divergence between
consumers' marginal and average valuation as shown in the seminal paper
by Spence (1975). A profit-maximising firm will choose a quality level
where the marginal cost of quality equals the marginal revenue of quality,
which is the marginal valuation of quality by the marginal consumer
multiplied by the quantity. In contrast, the social welfare maximising quality
level would equate the marginal cost of quality with the total valuation of
quality by all consumers. In other words, the social planner would consider
the effect of an increase of quality on all consumers, whereas the profit­
maximising firm considers only the effect on the marginal consumer.77
Depending on the difference between the marginal valuations of the
average and marginal consumers, the supply may be lower, higher or equal
than the social optimum. Although Spence's analysis was conducted in a
monopoly setting, Ma and Burgess (1993) highlight that these results are
also robust with other market structures.
4.9 However, there is another possible source of inefficiency in the provision of
quality when firms compete for market shares which will be in the focus of
our analysis in this chapter. The key intuition is that increased competition
affects firms' incentives to provide quality in two broad ways: on the one
hand, it has the direct effect of incentivizing firms to increase quality in
order to be more attractive to consumers when competing more intensely
with other firms; on the other hand, it has a (negative) impact on firms'
margins and, hence, may potentially undermine firms' incentives to invest
in quality (indirect effect). Before turning to specific models, it is worth
illustrating this trade-off by considering the following general profit function
of a firm:
ߨ ൌ ‫ܦ݌‬ሺ‫݌‬, ‫ݖ‬ሻ െ ‫ܥ‬ሺ‫ ܦ‬ሺ‫݌‬, ‫ݖ‬ሻ, ‫ݖ‬ሻ
77
More formally, let's consider a firm's maximisation problem with the inverse demand p=P(p,z), where p is price, q is
quantity and z is quality, and the cost function TC=C(q,z). The firm's problem is then max௤,௭ ߨ ൌ ܲሺ‫ݍ‬, ‫ݖ‬ሻ‫ ݍ‬െ ‫ ܥ‬ሺ‫ ݍ‬, ‫ݖ‬ሻ and
the first-order condition with respect to quality is ‫ݍ‬
ப୔ሺ.ሻ
ப୸
െ
பେሺ.ሻ
ப୸
ൌ 0. On the other hand, the social planner would maximise
௤
social welfare (that is, the difference between consumer surplus and cost): max௤,௭ ܹሺ‫ ݍ‬, ‫ݖ‬ሻ ൌ ‫׬‬଴ ܲሺ‫ݔ‬, ‫ݖ‬ሻ݀‫ ݔ‬െ ‫ܥ‬ሺ‫ ݍ‬, ‫ݖ‬ሻ . The
௤ ப௉ሺ௫,௭ሻ
‫׬‬଴ ப௭ ݀‫ݔ‬
ப஼ሺ.ሻ
firs-order condition with respect to quality in this case is
െ
ൌ 0. Dividing the first terms in both first-order
ப௭
conditions by q, it becomes clear that, even though the incentive to provide quality is related to the marginal willingness
to pay for quality in both cases, the social planner is concerned with the average marginal valuation of quality whereas
the firm is concerned with the marginal valuation of the marginal consumer.
43 OFT1531
where p is price and z is quality. The first-order condition with respect to
quality is then
ቆ‫ ݌‬െ
∂Cሺ. ሻ ∂Dሺ. ሻ ∂Cሺ. ሻ
ቇ
െ
ൌ0
∂D
∂z
∂z
4.10 From this, it is clear that the incentive for offering higher quality is
positively related to the profit margin of the firm and increased competition
may affect the first-order condition in two ways. First, the demand
பୈሺ.ሻ
sensitivity to quality (
ப୸
) increases with competition: in a more
competitive environment, consumers have more choice and are thus more
reactive to changes in quality. This strengthens the incentives to increase
quality for given prices (direct effect). Second, lower prices due to
increased competition reduce the profit margin and, thus, weaken the
incentive to provide high quality (indirect effect). The overall effect of
competition on quality will depend on the relative strength of these two
opposing forces.
4.11 With exogenous prices (for example, because of regulation) only the first
(direct) effect is present; therefore, there is a positive relationship between
competition and quality. Note, however, that this is only the case if prices
are set high enough that firms can make positive profits.
4.12 After these general considerations, we will now turn to the specific models
focusing on the relationship between competition and quality when firms
are free to set their prices. First, we will look at papers which use the
framework of vertical differentiation and will discuss models both with
observable and unobservable quality. Then we will turn to papers which
combine horizontal and vertical differentiation.
Models of vertical differentiation only
4.13 In the following we will focus on quality choices under oligopolistic
competition when firms compete in vertically differentiated products. In
particular, we will analyse how a change in the intensity of competition
affects the equilibrium choice of quality (and price) of firms and, ultimately,
welfare.
4.14 The model we discussed in paragraphs 2.29 –2.39 in the spirit of Shaked
and Sutton (1982, 1983) does not allow for comparative statics with
respect to the degree of competition and firms' quality choice, since, in
their model of Bertrand competition, only two firms can survive in the
equilibrium. We showed that these two firms have the incentive to develop
44
OFT1531
different quality levels and segment the market in order to relax price competition. Although Motta (1993) extended the analysis to a Cournot setting where potentially more firms could exist in the market, he did not
carry out comparative statics with respect to the number of firms. The models we will present below, in contrast, will consider the impact of increased competition on firms' quality choices. 4.15 First, we will turn to models of perfect information where quality is
observable to consumers. We will then review papers which can provide
insights on the relationship between competition and quality when
consumers cannot observe quality before purchasing the good.
Models with observable quality
4.16 The literature which focuses on competition and firms' endogenous choice
of quality in a vertical differentiation framework with observable quality
consists of papers which assume firms that offer a range of products with
different qualities. Indeed, all the models we will analyse below consider a
situation with multi-product firms that provide a range of products of
different qualities sold at different prices.78 The key finding of these models
is that increased competition may incentivise firms to lower the quality of
their low-end offers in order to discriminate more strongly between
consumers with low and high valuation of quality and extract more surplus
from the latter group. As a consequence, increased competition may allow
more consumers to purchase the product but lead to a reduction in the
average quality.
4.17 We will start with Gal-Or (1983) who considers an oligopoly model and
explores how the change in the number of firms, as a measure of the
intensity of competition, affects firms' equilibrium choice of price and
quality. In that sense, her model is a generalisation of the model developed
by Mussa and Rosen (1978) who explore the product line decisions of a
monopolist that is able to offer a range of products of different qualities.
The main insight from Mussa and Rosen (1978) is that a firm may offer
inefficiently low qualities (for consumers with lower valuation for quality) in
order to reduce substitution possibilities of consumers with higher valuation
for quality and to extract more surplus. Gal-Or (1983) explores how the
incentives for such a downward distortion are affected by competition.
4.18 In particular, she analyses an industry consisting of n>1 firms, where each
firm may offer more than one type of product, in that firms can produce
78
For example, manufacturers of cameras typically provide a range of devices of different qualities and prices in order to
match consumer preferences.
45
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products of different qualities with the same production facility. This is in
contrast with Shaked and Sutton (1982, 1983) who assume that products
of different qualities require different production facilities, the construction
of which is costly. In their model, therefore, a single firm does not diversify
its product mix.
4.19 Gal-Or (1983) assumes that the marginal cost of production is constant
and rises with the quality of the product whereas the fixed costs of entry
are assumed to be zero. It is also assumed that firms do not incur any
additional fixed cost when diversifying products. The quality level that
firms can set is bounded from below and is normalized at zero. This lower
bound is either determined by a minimum quality standard or the
production process.
4.20 In the model, each consumer is characterized by the taste parameter x
which determines the utility and marginal utility a consumer derives from
the quality of the product. Consumers are evenly distributed over the
interval [0,X].79 The quality of the product is restricted to a single
dimension which implies that any two consumers will agree on which of
two products they prefer, since they always prefer more quality to less at a
given price.
4.21 Consumers' willingness to pay for the product of quality m are measured
by the utility function U(m,x). Income effects in the model are assumed to
be constant.80 Therefore, the net utility of purchasing some product may be
measured by the difference between the willingness to pay expressed by U
and the price of the product which is p(m) for a product of quality m.
Hence, consumers will maximize
V(m,x)≡U(m,x)-p(m)
when choosing the quality of the product to purchase (or choose not to
buy at all).
4.22 Gal-Or derives the equilibrium in a Cournot setting, that is, assuming that
the strategic variable of firms is the quantity, conditioned on quality levels.
She shows that in equilibrium :
 Consumers of type ൏ ‫ݔ‬ො , that is, those with the lowest valuation for quality do not buy the product at all. 79
80
The even distribution of the taste parameter is needed to guarantee the uniqueness of the symmetric equilibrium.
This assumption is relaxed in Brekke et al (2010), as discussed paragraphs 4.74 -4.83.
46 OFT1531
 Consumers of type ‫ݔ‬ො ൑ ‫ ݔ‬൏ ‫ ∗ ݔ‬buy a product of zero (that is, the lowest
available) quality level.
 Consumers of type ‫ ∗ ݔ‬൑ ‫ ݔ‬buy products of positive quality levels.
4.23 These cut-off points also determine the product mix, that is, the proportion
of products of different quality levels, produced by each firm. The
motivation for firms to offer products of various qualities is to segment the
market and employ partial price discrimination in order to increase profits.81
4.24 By conducting a comparative statics analysis with respect to the degree of
competition (measured by the number of firms), Gal-Or demonstrates that
as a result of additional entry:
 ‫ݔ‬ො declines if the market is not completely covered and, therefore, more consumers find it possible to participate in the market.  More consumers find it optimal to purchase the product of the lowest quality, since x* rises.  The consumers that purchase products of positive quality (that is, high-
quality products) choose products with the same characteristics both before and after entry. 4.25 In other words, with more intense competition each firm chooses its
product mix to consist of a bigger percentage of low quality products. The
intuition behind this finding is that when additional firms enter into the
industry, the ability of a single firm to segment the market and to extract
surplus from consumers declines as a consequence of more intense
competition. Therefore, each firm has to produce a greater percentage of
lower quality goods to discriminate more effectively among consumers who
value the product more highly. In other words, in order to get the
consumers who value quality more choose the high quality/high prices
product, the firms need to set the quality of the low quality product low
enough that it is not a good substitute to the consumers who have a higher
valuation for quality.
4.26 Ultimately, entry leads to the increased production of products of the
lowest quality level. This implies a reduction in the average quality provided
in the market and may also result in a reduction of welfare. In particular,
the above analysis suggests that entry may have two contradictory effects
on social welfare. On the one hand, aggregate production rises and
81
In contrast, in models of imperfect information the motivation to provide high quality products is to build-up
reputation, as discussed in paragraphs 4.34 - 4.53 .
47 OFT1531
increases the participation of consumers in the market. On the other hand,
the average quality that is provided to consumers declines. The coexistence
of these two effects implies that, in this model, the overall impact of
increased competition on welfare is ambiguous.
4.27 Similar to Gal-Or (1983), De Fraja (1996) studies the competition between
multiproduct firms, each of which can supply a group of vertically
differentiated products, in a Cournot setting82 with simultaneous choice of
quality and quantity.83 The two papers come to similar results in that they
both derive an equilibrium in which the firms match each other's product
line. However, contrary to Gal-Or (1983), in de Fraja (1996) firms do not
provide all the theoretically possible varieties (that is, they leave 'holes' in
their product line) in the equilibrium, even in the absence of fixed cost of
production.
4.28 Another fundamental difference between the two models is that in de Fraja
(1996) the marginal cost of production is not assumed to increase with
quality. That is, the concept of quality in the model is defined according to
consumer preferences and not according to some technological measure.
4.29 In this setting, de Fraja shows that when the number of firms increases,
the average quality provided in the market might decrease because of an
increase in the production of lower quality products due to market
expansion. This argument, namely, that consumers who were previously
out of the market will buy the low quality product, is in line with the
findings of Gal-Or presented above. However, in De Fraja's model the
reduction of the average quality with an increase in the number of firms
does not continue indefinitely: with a sufficiently large number of firms only
the highest quality product would be supplied. This is because, as the
number of firm increases, prices get closer to the marginal cost. In the
extreme case, if a good is produced in positive quantity, then its price will
equal the marginal cost. Given vertical differentiation in the model, which
implies that for equal prices all consumers would agree that one product is
better than another, only the product of the highest quality would be
supplied in this case. This result is in contrast with Gal-Or's (1983) where
the average quality decreases unambiguously with entry.
4.30 The above reasoning also implies that the number of varieties eventually
decreases with entry and, therefore, the welfare implication of the
increased number of firms is ambiguous. The welfare of consumers who
82
De Fraja justifies the choice of Cournot competition to proxy situations where oligopoly competition is less severe than price competition with perfect substitutes.
83
The assumption on simultaneous choice of quality and quantity implies that the analysis of the paper is most relevant for industries where changes in specifications are relatively cheap to make, once 'line' set up costs have been incurred. 48
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buy a variety which is available before and after entry increases with entry
as prices go down. On the other hand, some consumers may be made
worse off if the variety they were purchasing ceases to be available after
entry so that they are forced to choose between a lower quality at a lower
price or a better quality of a higher price (or decide not to purchase at
all).However, at the limit when only the highest quality is produced and is
prices at marginal cost, consumers would be unambiguously better-off.
However, this result is a consequence of the assumption that the marginal
cost of producing a high-quality product is the same as that of a lowquality product; quality, in this sense, is closer to the concept of 'perceived
quality' in this model.
4.31 The two previous models assume that competing firms are able to produce
and offer the same qualities. Johnson and Myatt (2003), in contrast,
consider a more general situation where one firm potentially is limited in
the qualities it can offer. Although they only look at a situation where a
monopolist faces competition from an entrant and, hence do not carry out
the same comparative statics with respect to the number of firms as the
two papers above, their model provides interesting insights on how
incumbent firms may adjust their product lines (that is, quality offers) in
response to competition. Another interesting aspect of their paper is the
modelling choice of using an 'upgrades approach'. That is, they do not
work with actual products but instead with upgrades from one quality to
the next. For example, they consider that selling separate low and highquality products is conceptually equivalent to selling a low-quality 'baseline'
product alongside with a theoretical 'upgrade' from low to high quality. A
high-quality product is then obtained by combining the baseline product
with an upgrade.
4.32 For the formal model we refer the reader to the paper. Here we will only
give a brief summary of the key findings and the underlying intuition. The
model presumes that entry by a single firm occurs in a market originally
dominated by a monopolist. The duopolists compete in quantities, each
potentially offering a range of quality-differentiated products. Whether the
incumbent chooses to extend or contract its product line depends
fundamentally on the shape of the marginal revenue curves in the market:
 When marginal revenue is everywhere decreasing, the incumbent never
responds to the entry by expanding its product line. In these cases, entry
will result in the pruning of the lower-quality products from the
incumbent's product line. This is because with decreasing marginal
revenue, firms face the typical Cournot incentives to reduce their own
output as the output of a rival increases. For example, if the incumbent
49 OFT1531
originally marketed both a low- and a high-quality product and the
entrant is able to offer only a low-quality good then, when confronted
with positive output by the entrant, the incumbent restricts output in the
low-quality market. Furthermore, since the total production in the lowquality market also adversely effects the price of the high-quality good
(due to some degree of substitution between low and high-quality
products), the incumbent faces additional pressure to lower its own
output in the low-quality market. If the entrant finds it optimal to
produce beyond a certain level, the response for the incumbent is to
leave that market to the entrant in an effort to preserve margins on the
high-quality good. That is, it will prune its product line in order to focus
on quality.
 On the other hand, when marginal revenue is increasing in some regions,
for example, in a situation where demand reflects distinct 'market
segments' such as 'household' and 'business' customers, a sufficiently
large intrusion by a competitor may lead an incumbent to expand its
supply. However, such pressure only applies at the quality level offered
by the entrant, since that is the only market in which the entrant is
active. This means that the incumbent will introduce a lower-quality
product (a fighting brand) that allows its total output to increase while
still exercising market power through the restriction of supply of the
high-quality good. In other words, as a monopolist the firm might
choose not to serve the low-end market segment in order to limit
substitution possibilities and maintain high prices for high-end products.
Once a competitor enters on a large enough scale, however, the possible
increase in marginal revenue may encourage the incumbent to expand
into that segment along with the entrant. This situation tends to emerge
when the entrant offers only low-end products, that is, when there is
some asymmetry between the technological capabilities of the
incumbent and the entrant. The model also finds that when the
incumbent introduces a fighting brand, it will be of quality comparable to
the lowest quality good of the entrant's. However, an increase in the
maximum quality that an entrant can offer makes it more likely that the
incumbent will choose to exit the lower-quality markets.
4.33 As mentioned, the above model focuses on an incumbent's reaction to
entry and on the choice of the product line without assessing the impact of
a further increase in the number of firms or analysing welfare implications.
Using a similar upgrades approach, Johnson and Myatt (2006) present a
50 OFT1531
more general analysis of oligopolistic competition in quantities between
firms offering multiple quality-differentiated products. Among others, they
carry out a comparative statics with respect to the number of firms in a
situation where symmetric firms compete incurring only marginal costs,
using a similar upgrades approach as Johnson and Myatt (2003). In a
situation where firms set quality and quantity simultaneously, they show
that in the unique multiproduct Cournot equilibrium of a symmetric
industry, an increase in the number of firms results in an expansion in the
supply of each upgrade, and hence a reduction in each of their prices. With
respect to complete products, which are the sum of component upgrades,
it can be shown that the price of complete products falls with entry. At the
same time, entry pushes upward the distribution of qualities sold, that is,
the output of high-quality products increases. On the other hand, in some
situations, the output of the lowest quality product may decrease.
Models with asymmetric information
4.34 In the previous subsection we considered models of quality competition
where quality was observable to consumers. In these models, the rationale
behind providing products of different qualities is to discriminate between
consumers and relax price competition. We will now turn to a
fundamentally different framework where firms and consumers interact
repeatedly and quality is only observable after purchasing the product. In
these situations, producing high quality can be a means for the firms to
establish brand and reputation. In the following we will explore how
competition between firms is likely to affect quality in such a setting. The
main finding of the reviewed papers is that intense competition may
undermine firms' incentive to provide high-quality via the erosion of
margins. In other words, some models suggest that not even repeated
interaction between firms and consumers can ensure that firms produce
high-quality to build up brand and reputation.
4.35 The seminal papers by Klein and Leffler (1981), Shapiro (1983); Allen
(1984) about the effects of reputation and branding on quality provision
argue that repeated interaction between firms and consumers can help
ensure that high-quality products are provided in the market even when
quality is not observable. In these models, consumers use firms' past
behaviour as a guide for future behaviour and decide whether to purchase
from a firm based on its 'reputation' (that is, the past quality decisions).
This means that when consumers can observe quality after the purchase
and, therefore, are informed about firms' past quality decisions, they can
act as disciplinary body by punishing firms that 'cheat', that is, produce
low quality.
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4.36 The models find that in the equilibrium there is a quality-assuring price
which gives firms enough positive profits from producing high-quality
goods and maintaining reputation so that it is not in their interest to reduce
quality and earn only a one-period gain.
4.37 This literature, however, does not take the strategic interaction between
firms into account which leads to the result that industrial structure does
not have an impact on firms' incentives to produce high-quality: consumers
can always 'discipline' firms. Indeed, in Klein and Leffler (1981) and
Shapiro (1983) firms face a perfectly elastic demand at the quality-assuring
price while in Allen (1984) consumers choose randomly among firms
charging the lowest price, provided that it weakly exceeds the qualityassuring price. Therefore, consumers would never buy from an entrant
which charges a price below the quality-assuring price. By introducing
strategic competition for market shares between firms, Kranton (2003)
shows that a consumer-enforced reputation mechanism is not always
sufficient to sustain high-quality production. The intuition behind this
finding is that intense competition may eliminate the margin needed to
induce firms to maintain a reputation for high-quality production.
4.38 More formally, Kranton develops a model where I >2 firms interact with
consumers in an infinitely repeated game.84 A consumer values a highquality good at ‫ݒ‬ு and a low-quality good at ‫ݒ‬௅ , where ‫ݒ‬ு ൐ ‫ݒ‬௅ ൐ 0. A
firm's marginal cost of producing high-quality goods (ܿு ) is higher than the
marginal cost of producing low-quality goods (ܿ௅ ). It is also assumed that
‫ݒ‬ு െ ܿு ൐ ‫ݒ‬௅ െ ܿ௅ ൐ 0, so that it is socially desirable to produce high-quality
goods.
4.39 In each period the interaction between firms and consumers proceeds as
follows:
 Firms set their prices simultaneously.
 Each consumer then chooses a firm or chooses not to buy at all.
 Firms then choose to produce high-quality or low-quality goods.
4.40 At the end of each period, all consumers learn of firms' quality choices and
can use this information in subsequent periods when selecting a firm.
Kranton argues that the timing of the game corresponds to 'made-to-order'
purchases when consumers need to pay for a good prior to production.
However, this framework could also be applicable to the provision of
certain services or situations where some ancillary service is provided with
84
As in all previous models presented in this report, Kranton (2003) assumes discrete choice and unit demand.
52
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the good, for example, the maintenance of a product or the delivery of a
product purchased online. In such cases, the consumer would first buy or
place the order for the product based on the product price but could only
evaluate the overall quality of the service when the product has been
serviced or delivered.
4.41 The model assumes that a firm's market share in period t depends on (i) its
and its rivals' prices in period t; (ii) firms' past market shares; and (iii)
firms' past quality choices. Past prices only affect firms' market shares to
the extent that they affect past market shares: this means that consumers
do not 'punish' firms for providing high-quality products at discounted
prices in certain periods.
4.42 In each period, firms maximize their continuation profits: that is, the payoff
in the current period and the expected discounted stream of future payoffs,
taking into account how their rivals will react in the future to their current
moves. Given that in this model firms can compete on price for market
share, the key consideration behind a firm's decision about prices and
quality levels is whether it can increase and consolidate its market share
over time by attracting new consumers with a price cut in a given period:
 If a firm can permanently increase its market share by attracting new
consumers, it will have an incentive to produce high-quality goods even
with a price cut (that is, a firm's offer of high-quality goods will be
credible, despite the lower current-period price). In this case, the profit
from selling to a larger set of consumers in the future is greater than the
one-shot gain from producing low quality.
 On the other hand, if the firm does not enjoy a sufficiently large
permanent increase in market share, it has an incentive to produce low
quality in a given period, taking advantage of the temporary increase in
the number of consumers.
4.43 In this framework, Kranton analyses whether producing high-quality
products at the 'quality-assuring' price can always be equilibrium. She
shows that, with intense competition, an individual firm can have the
incentive to cut its price in order to gain market share (as described in the
previous paragraph). Given that all of the firms would have the same
incentive, the 'quality-assuring' equilibrium may not be sustainable. The
key insight behind this result is that a firm's price in a given period does
not necessarily affect its incentives to produce high-quality products in that
particular period: firms can credibly promise to sell high-quality goods at a
low price in order to induce consumers to switch and gain market share.
53 OFT1531
This price competition, however, can eliminate the profits necessary to
induce firms to produce high-quality goods which may result in high-quality
products not being produced in the market.
4.44 Contrary to Kranton (2003), who does not allow for any positive effects of
increased competition on the ability to sustain high-quality equilibria, BarIsaac (2005) argues that the relationship between competition and an
industry's ability to maintain a high-quality equilibrium is ambiguous:
competition can both aid and hinder reputational commitments for quality.
4.45 Akin to the previous model, whether reputational considerations will
motivate a firm to produce high quality, depends on the trade-off between
the short-term gain of not producing high-quality and the long-term
negative effects of beginning the consecutive period with a relatively low
reputation. Without formalization, this trade-off can be summarized by the
following simple inequality which ensures that the firm produces high
quality:
Short‐term cost of producing high rather than low quality
≤
Discounted value of high reputation
-
Discounted value of low reputation
4.46 Bar-Isaac points out that increased competition can affect all of these
terms at different rates. Therefore, the overall effect of competition on
reputation incentives (and quality) is ambiguous and may not be
monotonic. In particular, he considers a model with n+1 identical firm
who simultaneously choose quantity85 and quality in every period. The
marginal cost of production increases with quality. Given that quality is not
observable to the consumers, Firm i's demand depends on consumers'
anticipation of the quality of its product and on those of its rivals.
Specifically, demand is given by the following inverse demand function:
‫݌‬௜௧ ൌ 1 െ
‫ݔ‬௝௧
2‫ݔ‬௜௧ 2ߪ
െ
෍
ଶ
‫ݑ‬௜௧
‫ݑ‬௝௧
‫ݑ‬௜௧
௝ஷ௜
where ‫ݔ‬௜௧ denotes the quantity of the good produced by Firm i in period t;
‫ݑ‬௜௧ ∈ ሼ݈, ݄ሽ denotes its anticipated quality, which may be either low or high;
and σ denotes the degree of substitution between different firms' outputs.
85
Note that in Kranton (2003) firms choose prices. 54
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This inverse demand function implies that goods are imperfect substitutes
when σ < 1 and that customers are willing to pay more when they
anticipate high quality goods. Bar-Isaac assumes that the consumers' and
rivals' expectations of firm i's quality and future behaviour is not affected
by quantity decisions.
4.47 Firms compete in quantity and maximize future profits with a per-period
discount factor �. Bar-Isaac shows that competition, measured by either n
(the number of firms) or σ (degree of substitution) can have ambiguous,
and in particular, non-monotonic effect on the possibility of the equilibrium
in which high-quality is produced. For the formal analysis, we refer the
reader to the paper. Here we will only present the intuition behind this
result with reference to the inequality presented in paragraph 4.45:
 With increased competition, prices are driven down. Since firms can
always exit the market and earn zero profits, increased competition
reduces the discounted value of high reputation with no effect on the
discounted value of low reputation (which is zero). In this case,
competition reduces the 'punishment' for diverging from producing high
quality and therefore makes it more difficult to satisfy the inequality.
 On the other hand, a firm in a more competitive environment faces the
prospect of a more severe fall in market share as well as a price drop on
losing its reputation in the case where the discounted value of low
reputation is non-zero and so the punishment for not producing highquality increases with competition, making it easier to satisfy the
inequality.
4.48 In other words, it is intuitive that, a firm which does not face the threat of
competition might do little to develop reputation given that it would lose no
buyers to rivals. In the above model, this discipline of competition, coupled
with its erosion of the reputational price premia, can lead competition to
have non-monotonic effects on the strength of reputational concerns.
4.49 An interesting extension of the literature on intertemporal branding and
reputation is Hörner (2002). Similar to the aforementioned models by
Kranton (2003), Bar-Isaac (2005) and Dana and Fong (2011), this paper
considers the impact of competition on quality when quality is not
observable. However, in contrast with the previous models, Hörner (2002)
also assumes that firms cannot perfectly control the quality of their
products. That is, a firm that exerts effort can only reduce the probability
of a bad (low-quality) outcome.
55 OFT1531
4.50 In this situation, Hörner shows that a monopolistic firm would not have an
incentive to provide high-quality whereas competition may help overcome
this issue. Suppose that there are two types of firm: apt and inapt. In each
period when consumers interact with the firms, they pay upfront for a good
the expected quality of which increases with the effort exerted by the firm.
Consumers cannot distinguish inapt firms from the apt ones and they
cannot observe effort levels, either. On the other hand, they do observe the
price and customer base of a firm as well as the quality of the good
obtained after the purchase.
4.51 Hörner first considers a monopoly situation and analyses whether an
equlibrium in which the apt firm always exerts high effort exists. He shows
that if consumers become convinced that the firm in the market is apt and
believe that is always exerts high-effort, their expectations (and hence the
revenues of the firm) become inelastic to a bad outcome. In these
circumstances, low-quality outcomes will simply be attributed to bad luck.
As a consequence, the firm will have an incentive to 'slack off' and the
proposed equilibrium with high effort unravels.
4.52 With competition, in contrast, consumers can exert effective discipline over
the firms and induce them to produce high quality. This is because any
consumer can break off the relationship with a firm and decide to purchase
from another one: it does not matter how good a certain firm is thought to
be; rather what matters is whether it is thought to be better than its
competitors. Firms which cannot keep loyal customers or cannot attract
new customers exit the market. Note that because a bad outcome may
occur even with an apt firm exerting high effort and because consumers
punish firms with bad quality and switch away from them, even some apt
firms will exit the market. In the long run, however, the share of apt firm
will increase in the market, since bad outcomes are more likely to occur if a
firm is inapt. This model, therefore, suggests that competition will result in
a higher proportion of apt firms and an increase in quality.
4.53 The models reviewed above show that in the presence of asymmetric
information, competition may have an adverse effect on quality, mainly
because it may incentivise firms to price below the quality assuring price
and, therefore, eliminate the margins necessary to maintain high-quality.
This implies that, in industries where quality considerations play a crucial
role but quality levels are not observable, regulation (for example, price
regulation or the introduction of minimum quality standards) may increase
quality levels and overall welfare under certain circumstances. On the other
hand, in some situations, competition may also incentivise firms to exert
higher effort and provide high-quality in order to achieve a relatively good
56
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reputation compared to their rivals and maintain or increase their customer
base.
Models with both horizontal and vertical differentiation
4.54 So far we have looked at the impact of competition on quality in models of
vertical differentiation only. In this subsection we will present models
which combine horizontal and vertical differentiation. This literature can
provide particularly interesting insights on the relationship between
competition and quality in industries where both product quality and variety
matters or the nature of competition is best described in a spatial
competition framework.
4.55 Similar to the papers focussing on horizontal differentiation more generally,
these models use two different measures for the intensity of competition:
the number and density of firms and/or transportation costs. All three
papers we will review below assume that quality is observable before
purchase; therefore, we will not consider issues of asymmetric information
in this framework. The reviewed models come to mixed conclusions on the
relationship between competition and quality: depending on model
specifications, such as assumptions about the utility or cost function,
competition may have a negative, neutral or positive impact on firms'
choice of quality.
4.56 Ma and Burgess (1993) consider a model of symmetric duopoly where the
location of the firms is determined first (exogenously), then firms either (i)
choose quality and price simultaneously or (ii) choose quality and then price
sequentially. Given that locations are exogenous, this model does not allow
for analysing issues of product positioning. However, it can still provide
interesting insights on the implications of competition on quality in spatial
settings.
4.57 The intensity of competition in this model is measured by transportation
costs: lower transportation costs imply more competition. The total cost of
production of firms consists of a fixed cost and unit cost, so that producing
a higher quality product requires a higher marginal cost and a higher start­
up or fixed cost. More formally, the cost of producing a quantity Q of
quality T is ߠሺܶሻܳ ൅ ߔሺܶሻ, where ߠሺܶሻ is the unit cost and ߔሺܶሻ is the fixed
cost of quality.
4.58 There is a continuum of consumers with each consumer valuing the good
sufficiently highly to buy one unit from a firm. Consumers have preference
over two dimensions of product characteristics: a consumer always prefers
57
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a higher quality and, besides the quality (T) of the good, each consumer
also prefers some other 'ideal' product characteristic as in the standard
Hotelling model described in paragraphs 2.11-2.24. More specifically,
consumers are evenly distributed on a 'line' of length � with the firms being
located at each end of the line (as mentioned above, the choice of location
of the firms is exogenous).
4.59 A consumer's utility positively depends on the quality of the good from a
firm and negatively on the distance between the consumer and the firm
(where the distance represents the deviation of the firm's product
characteristic from the consumer's ideal): a consumer with index x (where
0 ≤ x ≤ �) will have the utility ܶ஺ െ ܿ‫ ݔ‬െ ܲ஺ if she buys from firm A and
ܶ஻ െ ܿ ሺℓ െ ‫ݔ‬ሻ െ ܲ஻ if from firm B, where c>0 is the unit cost of
transportation. A consumer buys from the firm that offers her the higher
utility. Demand and profit functions are derived in the usual 'Hotelling
way', as discussed in paragraphs 2.20 - 2.22.
4.60 Ma and Burgess first determine the equilibrium choice of quality and prices
in the sequential game by backward induction. The unique equilibrium
prices are obtained by solving the following reaction functions:
ܲ஺ ሺܶ஺ , ܶ஻ ሻ ൌ ܿℓ
ܶ஺ െ ܶ஻ 2ߠሺܶ஺ ሻ ൅ ߠሺܶ஻ ሻ
൅
3
3
ܲ஻ ሺܶ஺ , ܶ஻ ሻ ൌ ܿℓ
ܶ୆ െ ܶ୅ 2ߠሺܶ୆ ሻ ൅ ߠሺܶ஺ ሻ
൅
3
3
4.61 These equilibrium price strategies describe two key effects:
 When setting prices in the last stage of the game, either firm with a
quality disadvantage (relative to its competitors) would react by setting a
lower price in order to gain market share. The strategic effect that
qualities have on price competition tends to reduce the returns to quality
investment. Therefore, a firm is deterred from adopting a higher quality
level at the first stage for fear of more intense competition from the rival
in the second stage.86 ('Price undercutting effect'.)
 On the other hand, at the price competition stage, a firm with higher
marginal cost of producing quality will compete at a disadvantage which
86
If TA<TB so that Firm A has invested less in quality than Firm B, then Firm A will set a lower price than Firm B to
make up for its lower quality by reducing price. Even though Firm B has a higher quality product and should gain a larger
market share, this will be counteracted by Firm A's lower price.
58 OFT1531
means that it can expect its rival to set a higher price (or rather, not to
compete so fiercely).87 ('Increased marginal cost effect'.)
4.62 The overall price reaction is a combination of the above two effects and
depends crucially on the types of costs associated with higher quality. This
ultimately determines the impact of intense price competition and firms'
incentives to provide high-quality. When products with higher quality can
be produced with higher fixed costs (regardless of whether higher quality
requires higher marginal cost) the price undercutting effect dominates the
increased marginal cost effect and, therefore, the equilibrium quality level is
below the social optimum. On the other hand, when higher quality products
require higher marginal production costs (but not higher fixed costs), the
two effects cancel each other out, that is, firms' incentive to invest in
quality is not undermined at the first stage of the game by the prospect of
more intense price competition once quality levels has been set. As a
consequence, when producing higher quality only entails higher marginal
costs but no fixed costs, the equilibrium quality level becomes efficient.
4.63 Ma and Burgess argue that the sequential choice of quality and prices is a
suitable assumption for most situations since quality choices usually
involve technological decisions. Therefore, it is reasonable to assume that
quality is less flexible and less frequently changed than price. However,
they also look at the setting in which firms choose quality and prices
simultaneously. They show that in this case firms set the socially optimal
quality level in equilibrium because firms can neither use quality choices to
influence pricing decisions nor use price decisions to react against quality
choices of rivals.
4.64 The above results are independent of transportations costs: that is,
changes in the intensity of competition would not alter the equilibrium level
of quality (and price). That is, the 'direct' incentives of firms to increase
quality to be more attractive to consumers when competing more intensely
with other firms, and the 'indirect' effects of increased competition on
quality through lower margins cancel each other out. However, this is a
result of the specific demand structure of the model: in a more general
setting, it is possible that one of the two effects dominates, as we will see
in Brekke et al. (2010).
4.65 In contrast with the Hotelling setting of Ma and Burgess (1993),
Economides (1993) considers a circular (Salop) model88 of differentiated
87
The equilibrium price strategies show that, with TA<TB, the higher is Firm B's marginal cost of producing the better
quality product, the higher Firm A sets its equilibrium price, that is, with higher marginal cost of producing the highquality product Firm B's advantage over Firm A is reduced. Therefore, Firm A's need to cut the price to make up for loss
of market share is mitigated.
59
OFT1531
products where each product is defined by one feature of variety and one
feature of quality. The model, therefore, allows for exploring the basic
substitutability between variety and quality in terms of a means to relax
competition and defining the equilibrium variety-quality mix as a result of
the strategic interactions among firms.
4.66 More formally, a product is defined as a pair ሺ‫ݔ‬௝ , ܽ௝ ሻ where ‫ݔ‬௝ and ܽ௝ denote
the position of the product in the variety and quality spaces respectively. In
line with the Salop setting, ‫ݔ‬௝ lies on a circumference of length one
(denoted by C) whereas quality level aj is chosen from the interval [0, ܽത].
Hence, the space of product characteristics is the cylinder C ൈ [0, ܽത].
4.67 Similarly, each consumer can be defined by two parameters: z (lying on C)
describes her most preferred variety while ߠ߳ሾ0,1ሿ denotes the relative
intensity of her preference for quality. The space of consumers'
characteristics (z, ߠሻ is the cylinder C ൈ [0,1].
4.68 The utility that a consumer (z, ߠሻ derives from buying one unit of product
ሺ‫ݔ‬௝ , ܽ௝ ሻ sold at price p௝ is
ܸ൫‫ݖ‬, ߠ, ‫ݔ‬௝ , ܽ௝ , ‫݌‬௝ ൯ ൌ ݇ ൅ ߠܽ௝ െ ‫݌‬௝ െ ห‫ ݖ‬െ ‫ݔ‬௝ ห
4.69 The separability of quality and variety in the above utility function implies
that consumers with the same intensity of preference towards quality value
an increase in the level of quality equally, irrespective of their preference in
terms of variety.89
4.70 The marginal cost of production is independent of the quality feature of the
product90 and is assumed to be zero. On the other hand, the marginal cost
of quality is increasing with the level of quality and firms also incur a fixed
cost (F).
4.71 The timing of the choice of variety (that is, location), quality and price has
an important effect on the equilibrium outcome. Therefore, Economides
analyses the following game structures:
 A three-stage game with no pre-commitment in quality ('the no pre-
commitment three-stage game'):
88
As described in paragraphs 2.26-2.27. Note also that the transportation cost is normalised at one the model.
90
An example of this would be when improvements in quality come from better design or increased advertising which do not affect the production cost.
89
60 OFT1531
Stage 3
Stage 1
Stage 2
Entry choice
Choice of location
Choice of quality and price
 A four-stage game with pre-commitment in quality ('the pre-commitment
four-stage game') :
Stage 1
Entry choice
Stage 2
Stage 3
Choice of location
Choice of quality
Stage 4
Choice of price
 A game with no pre-commitment in location ('the no pre-commitment in
location game'):
Stage 1
Entry choice
Stage 2
Choice of location and quality
Stage 3
Choice of price
4.72 These settings account for the fact that in the short run, only prices and
perhaps some features of quality are flexible and, therefore, available as
strategic variables. In the long run, however, product specification
(location) is also flexible, and in the very long run firms can also enter and
exit. One key feature of the models is whether the quality choice precedes
the price choice; if there is pre-commitment in quality, the firms can use
quality as an aggressive strategic variable to secure extra revenue.91
4.73 For the details of how the equilibrium is derived in each scenario, we refer
the reader to the paper. Here we will only give a high-level overview of the
results and the underlying intuition. The key findings of the paper are the
following:
 Pre-commitment in quality in the 'pre-commitment four-stage game'
allows firms to support the same prices as in the 'no pre-commitment
three-stage game' with lower quality levels and expenditure. This is
because, by committing to a certain quality level before choosing prices,
firms can reveal how aggressively they are willing to compete. That is,
communication accentuates the value of quality as a strategic variable.
For the same number of firms, therefore, the 'pre-commitment four-stage
91
Note that, similar to previous models, Economides (1993) assume fixed total demand. Therefore, firms' use of quality
as an aggressive strategic variable is largely motivated by securing their market share of this fixed demand.
61 OFT1531
game' would result in the same prices but lower quality and higher
profits than the 'no pre-commitment three stage game'. Increased profits
in the long-run, however, will induce entry. Therefore, ultimately there
will be a larger number of brands, which will result in lower prices and
further decrease in quality in the 'pre-commitment four-stage game'
compared to the 'no pre-commitment three-stage game' at the free entry
equilibrium.
 The equilibrium outcome is the same in the 'pre-commitment four-stage
game' and the 'no pre-commitment in location game', implying that there
is no strategic advantage of pre-commitment in the product variety when
varieties are chosen simultaneously.
 There is an inverse relationship between the level of quality and the
number of varieties at the equilibrium. This follows from two
considerations. First, the distance between neighbouring firms is
proportionate to the potential demand for each firm. Second, quality, an
aggressive strategic variable, is used in proportion with the potential
gains. As a consequence, the optimal quality level of firms is increasing
in the distance between firms (1/n). In other words, as the number of
firms increases, the potential market to capture by each firm falls which
reduces the incentive to provide high quality levels. This implies that
increased competition (in terms of more firms) leads to a decrease in the
equilibrium level of quality.
 Overall, compared to a market without competition in quality, the
equlibria with quality competition may result in lower total surplus. More
specifically, both the 'pre-commitment four-stage game' and the 'no precommitment three-stage game' result in higher diversity and underprovision of quality compared to the optimal outcome, with bigger
divergence observed in the 'pre-commitment four-stage game'.92
Economides argues that, as a result of this, introducing minimum quality
standards can reduce the number of varieties and increase total surplus.
In contrast, opening competition in the dimension of quality may not be
welfare-improving.
92
As discussed in footnote 32, there would be excessive variety even in a pure horizontal differentiation setting as
profits from introducing a new variety are generated from stealing demand from competitors and not from expanding
demand. This effect is exacerbated by vertical differentiation, in that quality can be used as an aggressive strategic
variable to facilitate attracting consumers from competitors.
62 OFT1531
4.74 Brekke et al. (2010) build on the previous models but generalize their
findings by assuming (i) utility functions that are non-linear in income and
(ii) cost functions that are non-separable in output and quality.
4.75 Similar to Economides (1993), Brekke et al. consider a Salop model where
firms and consumers are located on a circumference of length 1. The utility
of consumers is given by the function
ܷ௜ ሺ‫ݍ‬௜ , ݀௜ , ‫ݕ‬ሻ ൌ ‫ ݒ‬൅ ܾሺ‫ݍ‬௜ ሻ െ ‫݃ݐ‬ሺ݀௜ ሻ ൅ ‫ݑ‬ሺ‫ݕ‬ሻ
with
‫ ݕ‬ൌ ܻ െ ‫݌‬௜ െ ݄߬ሺ݄௜ ሻ
where ‫ݍ‬௜ the quality of the product sold by firm i, ݀௜ is the distance
between the consumer and firm i, ‫ ݕ‬is a composite numeraire good, ܻ is
gross income whereas ‫ ݐ‬and ߬ are the non-monetary and monetary
transportation costs respectively.
4.76 In contrast to Economides (1993), where firms' cost functions are
separable in output and quality, in Brekke et al. (2010) firms' cost
functions take a general form that allows for both cost complementarity
and cost substitutability between quality and output.93 With cost
substitutability, a higher quality level results in an increase of the marginal
cost of production whereas with cost complementarity this is not the case.
4.77 Synthesising the approach of Ma and Burgess (1993) and Economides
(1993) with respect to the measurement of competition, Brekke et al.
(2010) use two different proxies for the intensity of competition: lower
transportations costs (meaning an increase of the degree of substitutability
between the products offered by different firms) and the number of firms.
They analyse the price and quality effects of competition in each
framework.
4.78 Another interesting feature of the model is that transportation costs are
decomposed into monetary and non-monetary costs: non-monetary costs
affect utility directly whereas monetary transportation costs add to the
consumption expenditures and affect utility through the budget constraint.
The distinction allows for a more flexible interpretation, depending on
whether competition takes place in the geographical or product space.
93
In particular, the cost function ‫ܥ‬ሺܺ௜ ሺ. ሻ, ‫ݍ‬௜ ሻ, where ܺ௜ is the output and ‫ݍ‬௜ js quality, is such that ‫ܥ‬ଡ଼ଡ଼ >0, ‫ܥ‬௑௑ ൒ 0, ‫ܥ‬୯ ൐ 0,
‫ܥ‬୯୯ ൐ 0 while ‫ܥ‬ଡ଼୯ ൏ 0 with cost complementarity and ‫ܥ‬ଡ଼୯ ൐ with cost substitutability.
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OFT1531
4.79 The main results of the model based on different assumptions in a setting
where firms choose prices and qualities simultaneously are summarized in
Table 1 below.
Table 1: Summary of findings from Brekke et al. (2010)
Measure of competition
No (utility
is linear in
income)
Income
effects
Increased number of firms
Decreased transportation
costs
Lower prices but ambiguous
effect on quality:
Lower prices but no effect
on quality.95
Lower quality when cost
independence between
production and quality.94
Higher quality with
sufficiently strong cost
substitutability between
output and quality.
Yes (utility Ambiguous effect on prices
is strictly
and quality.
concave in
income)
Higher quality at the
equilibrium, irrespective of
the nature of the
transportation cost or the
timing of the game.
Prices fall with lower nonmonetary transportation
costs but may increase with
lower monetary
transportation costs if there
is sufficiently strong cost
substitutability between
quality and output.96
4.80 As shown in the table, the results differ from previous literature on
competition and product quality in a horizontal differentiation setting: the
negative or neutral relationship between competition and quality is reversed
under certain assumptions. In particular, Brekke et al. (2010) show that:
94
This result is similar to Economides (1993).
As in Ma and Burgess (1993), the direct and indirect effects of increased competition on quality cancel each other out and the equilibrium quality level is independent of the transportation cost. 96
The intuition behind this finding is that in this scenario, higher quality level increases the marginal cost of production which puts upward pressure on prices. 95
64
OFT1531
 When allowing for income effects (by assuming that utility is strictly
concave in income), lower transportation costs, as a measure of more
intense competition, always lead to higher quality. This is because the
indirect effect of increased competition on quality via price-cost margins
as described in paragraph 4.10 is smaller with income effects in Brekke
et al. (2010) than without income effects in the model of Ma and
Burgess (1993). Therefore, the direct effect of increased competition to
increase quality and win business from rivals dominates.
 The presence of income effects may also result in a positive relationship
between the number of firms, used as the other measure of more intense
competition, and equilibrium quality. For given prices and qualities, a
higher density of firms means that the marginal consumers net income
increases due to lower monetary transportation costs. With strictly
concave utility in income, marginal utility of income decreases, which
reduces the demand responsiveness to prices. This will place an upward
pressure on prices. If the income effect is sufficiently large, this upward
pressure may outweigh the downward pressure from increased
competition.
 In addition, the positive relationship between the number of firms and
quality levels may hold even without income effects if there is sufficient
cost substitutability between output and quality. With a higher number
of firms, each firm faces less demand and incurs lower marginal cost of
production. With cost substitutability between quality and output, this
will make quality improvements less costly. If this effect is sufficiently
strong, the relationship between the number of firms and quality may
turn out to be positive.
4.81 In terms of welfare, however, Brekke et al. (2010) find that equilibrium
quality provision is always less than socially optimal in the presence of
income effects whereas quality coincides with the socially optimal level
when there are no income effects (that is, utility is linear in income).
4.82 Brekke et al. (2010) also test whether the sequential choice of quality and
price changes the above results. They show that the results regarding the
relationship between competition and quality (see Table 1) are qualitatively
unaffected by whether quality and prices are chosen simultaneously or
sequentially. However, they also find that in the sequential model the
equilibrium choice of quality is lower than in the simultaneous model even
with income effects. This demonstrates that the results of Ma and Burgess
65 OFT1531
(1993) in relation to the strategic use of quality and the equilibrium quality
level are robust to the assumption of decreasing marginal utility of income.
4.83 Given the assumptions on income effects and on discrete choice with unit
demand (similar to all the previous models in this chapter), the model we
have just presented may have particular relevance for markets where
consumers typically buy one unit of a relatively expensive good from their
preferred dealer so that the purchase expenditure is a significant proportion
of the consumer's income. This would likely to be the case, for example,
with cars, expensive electronic appliances or furniture.
Competition and the equilibrium choice of quality when prices are
exogenous
4.84 In the previous section we showed that when firms compete along both
quality and price, economic theory has ambiguous predictions with respect
to the relationship between the intensity of competition and the equilibrium
level of quality. The intuition behind this conclusion is simple: competition
has a direct effect of increasing the incentives to provide high quality for
given prices to gain market shares but it also results in lower margins
which undermines the incentives to invest in quality (indirect effect). The
net of these two effects and, therefore, the overall impact of competition
on quality, will depend on the specific assumptions of a particular model.
4.85 In contrast, when prices are exogenous (for example, because they are
regulated), the theoretical literature gives clear predictions about the
relationship between competition and quality.
4.86 We note that the theoretical literature with regulated prices is very much
focussed on healthcare markets. Hence, Chapter 4 of the Healthcare
Report gives a more detailed overview of this literature and of Gaynor
(2006) and Gaynor and Town (2012) in particular. Here we will only briefly
refer to Ma and Burgess (1993) already presented in paragraphs 4.56 4.64 and to Brekke et al. (2006).
4.87 Ma and Burgess (1993) show that, when firms choose qualities and prices,
quality decisions can have strategic effects: firms react to quality
disadvantages by price reductions. As a consequence, firms' incentives to
invest in quality can be undermined by the prospect of triggering fierce
price competition rivals. However, when regulated prices are imposed,
firms will lack the incentives to use quality to influence the outcome of
price competition. In other words, the elimination of price competition can
66
OFT1531
help correct the distorting effect of quality competition. More generally, it
is intuitively clear that, when prices are fixed by a regulator, firms can
choose only quality to attract consumers while the potential margin
reducing effect of competition is not present, as we showed in paragraphs
4.9-4.11.
4.88 In a slightly different setting (that is, with endogenous location choice)
Brekke et al. (2006) examine the interaction between location and quality
choices made by competing firms facing a fixed product price. The paper
shows that compared to a situation of price competition, regulated prices
will yield a higher supply of quality and will also generally lead to improved
locational efficiency.
4.89 Intuition and the literature, hence, suggest that price regulation can help
overcome distortions and incentivize firms to provide the optimal level of
quality in markets where quality plays an important role but is difficult to
observe and assess. Without regulation, competition would be likely to
develop mainly on price which can lead to a race to the bottom and too
low levels of quality from a social viewpoint. Price regulation may provide
a solution to this problem although setting the 'right' level of prices is like
to be a finely balanced exercise. Considerations on the optimal design of
regulation, however, are outside the scope of this paper.
Conclusion
4.90 To conclude this chapter, we will summarise the main findings of the
reviewed models with respect to the impact of competition on quality.
Given that the findings from the literature are less clear cut when prices are
endogenous, we will focus on these models in the table: in order to
compare the results in a systematic way, we will present the findings
together with the key assumptions of each model in Table 2 below. The
key findings can be summarised as follows:
 Models looking at the product line decisions of multiproduct firms which
offer products of different qualities show that with an increase in the
number of competitors, firms may have the incentive to lower the quality
of their low-end offers. This is because with lower margins as a result of
increased competition, firms want to discriminate more strongly between
consumers of low and high valuation for quality and extract more surplus
from the latter group. Whether consumers are better or worse off in this
situation depends on their relative valuation between lower prices and
lower quality. On the other hand, when the provision of high quality
67 OFT1531
does not imply higher marginal cost, with a very large number of firms
competing in the market only the highest quality would be provided. In
this case, consumers would be unambigously better off. Another
framework, in which firms' quality choice is simultaneous with their
output decision, suggests that an increase in the number of firms would
not only result in lower prices but also in higher average quality in the
market.
 Models focusing on quality decisions of firms when consumers cannot
observe quality before the purchase suggest that intense competition
may undermine quality provision. In these situations, not even repeated
interaction between consumers and firms can guarantee that firms have
the incentive to build up brand and reputation through providing high
quality. However, whether this is really the case depends on whether a
firm can credibly offer high quality at a lower price in order to induce
consumer switching. If this is the case, all the firms may have the
incentive to undercut each other's price and this intense competition can
eliminate the margins necessary for providing high quality. This negative
impact of competition, however, seems less clear when firms compete in
quantities instead of prices in which case competition can both increase
and decrease the incentives to provide high quality.
 Models in which firms can differentiate their products both horizontally
(that is, offering different product varieties) and vertically (offering
different qualities), come to mixed conclusion on the relationship
between competition and quality. The intensity of competition in this
framework is measured either by the number (density) of firms or
transportation costs. Increased competition in these models only lead to
higher quality when (i) there are income effects and more intense
competition means lower transportation costs or (ii) when lower marginal
production costs would make quality improvements less costly and allow
for improvements in quality with an increase in the number of firms.
68 OFT1531
Table 2: Summary of findings from the theoretical literature when both prices and qualities are endogenous
Paper
Gal-Or (1983)
Type of
product
differentiation
Vertical
Is quality
observable
ex-ante?
Yes
Strategic
variable:
price or
quantity
Timing of the
game
Quantity
Sequential:
(1)quality;
Single
product
or multiproduct
firms
Assumptions on production
costs
Measure of
competition
Effect of
competition
on the level of
quality
Fixed cost
Marginal cost
Multi­
product
No fixed
cost
Increasing in
quality
Number of firms
Decrease in
the average
level of
quality (but
increased
differentiation
)
(2) quantity
De Fraja
(1996)
Vertical
Yes
Quantity
Simultaneous
Multi­
product
No fixed
cost
Independent
of quality
Number of firms
Ambiguous:
U-shaped
relationship
between
competition
and average
quality
Johnson and
Myatt (2003)
Vertical
Yes
Quantity
Simultaneous
Multi­
product
No fixed
cost
Increasing in
quality but
there might
be an
additional
Entry by a
competitor (in an
originally
monopolistic
market)
Ambiguous
69
OFT1531
cost element
which is
independent
of quality
Johnson and
Myatt (2006)
Vertical
Yes
Quantity
Simultaneous
Multiproduct
No fixed
costs in
the base
model
Arbitrary
firms-specific
marginal costs
Number of firms
Increase in
average
quality
Kranton
(2003)
Vertical
No
Price
Sequential:
Single
product
No fixed
cost
Increasing in
quality
Number of firms
Competition
can
undermine the
provision of
high quality
Bar-Isaac
(2005)
Vertical
No
Quantity
Simultaneous
Single
product
No fixed
cost
Increasing in
quality
Number of firms;
or Degree of
substitution
Ambiguous
Ma and
Burgess
(1993)
Vertical and
horizontal
Yes
Price
Sequential:
Single
Increasing
in quality
Increasing in
quality
Transportation
costs
Neutral
Single
Constant
Independent
of quality but
Number (density)
of firms
Decrease in
quality
(1) price,
(2)quality
(1) quality,
(2) price
Simultaneous
Economides
(1993)
70
Vertical and
horizontal
Yes
Price
Sequential:
OFT1531
there is
additional
marginal cost
which
increases with
quality
(1) quality,
(2) price
Simultaneous
Brekke et al.
(2010)
Vertical and
horizontal
Yes
Price
Simultaneous
Sequential:
Single
No fixed
cost
May increase
with quality
Transportation
costs
(1) quality,
(2) price
71
Number (density)
of firms; or
OFT1531
Ambiguous
(see Table 1)
5 COMPETITION AND THE EQUILIBRIUM CHOICE OF PRICE
AND QUALITY - EMPIRICAL PERSPECTIVES
Introduction
5.1 As seen in the previous section, the theoretical literature suggests that
changes of competition affect firms' incentives to provide quality in
two opposing ways when firms also set prices: competition has a
direct effect of increasing the incentives to provide high quality for
given prices to gain market shares but it also results in lower margins
which undermines the incentives to invest in quality (indirect effect).
In this context, this section reviews the empirical evidence on the
relationship between competition and quality, in markets where firms
also choose price. Our aim is to identify whether the empirical
literature is able to provide insights for practitioners over and above
the arguments explored by theoretical literature.
5.2 The empirical literature on the relationship between competition and
the endogenous choice of quality and price is relatively sparse.97
Evidence from a number of recent quality-concentration analyses
indicates that there is a positive relationship between competition and
quality, in markets where firms also compete on price. For example,
Matsa (2011) analyses the effect of competition on supermarkets'
incentive to provide quality. He finds that '[c]ompetition from WalMart – the most significant shock to industry market structure in half a
century – decreased [inventory] shortfalls by up to 24 per cent.'98
Greenfield (2012) examines the relationship between concentration
and airline service quality by regressing on-time performance on
market structure. Controlling for endogeneity of merger decisions with
respect to service quality, he finds that 'routes that experienced a
relative increase (decrease) in concentration experienced a relative
increase (decrease) in delays'99 and 'the effect of competition on
airline delays is three times stronger than previous studies
suggests'.100 Finally, Akgunduz et al. (2013) examine how competition
affects child care centres' quality in the Netherlands and show that
97
See for example, Greenfield (2012). Page 2.
Matsa (2009). Page 1.
99
Greenfield (2012). Page 21.
100
Ibid. Page 1.
98
'high density of child care centres in an area improves scores in quality
assessment measures'.101
5.3 It is important to note that these papers do not quantify the effect of
competition-induced changes in quality on consumer welfare.102 This is
significant, because – in markets where firms compete on both price
and quality - observing a change in quality on its own is insufficient to
establish whether a change in competition has made consumer better
or worse off. In light of this, in this section we focus on three
empirical studies that specify structural demand models, which
identify consumers' price elasticity of demand and valuations of
quality. With estimates on these parameters, structural models are
then able to anticipate the effect of a change in competition on
consumer welfare and are as such most relevant for assisting decision
making in markets where quality is an important dimension of
competition.
Empirical evidence based on structural models
The effect of satellite TV entry on cable TV quality and price
5.4 Chu (2010) examines the effect of entry in the US subscription TV
market by satellite TV providers in the mid-1990s. Using the number
of channels contained in a subscription package as a measure of
quality, he investigates how cable TV providers changed the quality
and price of their offering following entry of satellite TV providers
'offering more channels and better reception than the typical cable
service'.103 He finds that in most markets, satellite providers respond
to entry by increasing quality and lowering price. However, he finds
that not all consumers benefit from entry, as cable providers face
distorted incentives to provide 'too much quality from a standpoint of
consumer welfare.'104
101
Akgunduz et al. (2013). Page1.
To appreciate the significance of studies that relate competition to consumer welfare, through its price and quality drivers, consider the effect of 1978 deregulation on the US airline industry; prices fell sharply and the once proverbial quality standards plummeted (see for example, Borenstein and Rose 2007 for a review). To
understand, however, if deregulation was desirable, one needs to establish if consumers value lower prices more than they value higher quality.
103
Chu (2010). Page 739.
104
Ibid. Page 732.
102
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5.5 The US subscription TV market seems to lend itself well for estimating
a structural model that traces the effect of entry on the endogenous
choice of quality. Cable systems generally hold local monopolies on
terms negotiated with the city franchising authority105 and cable
menus are set individually for each market, meaning that the dataset
used in the study exhibits substantial variation both in prices and
quality. Moreover, the vertical quality of a subscription package can –
perhaps satisfyingly - be proxied by the number of channels it
contains.106
5.6 The starting point for Chu's analysis is a rich set of market-level data
covering the years 1992 to 2002 and 210 local markets and
comprising information on prices, product characteristics, observed
demand, and demographic covariates. The author constructs a
vertically differentiated model of supply and demand for cable and
satellite TV, which allows for the supply response to entry to depend
on local demand conditions, cost shocks, and brand effects. The
parameter estimates from the model allow the author to identify which
response cable TV provider opted for in response to satellite entry;
competing head-to-head (raising prices and qualities), fighting entry
(lowering prices and raising quality) or differentiating downward
(lowering quality and price). It also allows him to estimate the effect of
satellite TV entry on cable TV prices and qualities in each market, as
well as the associated effects on consumer welfare.
5.7 With regards to the first point, Chu finds that in 87.2 per cent of
market-years, incumbent cable operators responded to entry by
lowering price and raising quality. In 14.1 per cent of cases the
incumbent competed 'head to head' by raising both price quality while
in the remaining 3.2 per cent of cases the incumbents differentiated
downward.107 Downward differentiation occurs in markets where
'consumers are relatively heterogeneous in their willingness to pay for
quality', thus affording 'more opportunity for profitable product
differentiation when firms differentiate downward'108. On the other
hand, firms increase both price and quality in markets where
'consumer preferences for content are relatively homogeneous and
105
Ibid. Page 733.
Chu controls for the improved reception of Satellite TV using fixed effects in this empirical model. See page
740.
107
Ibid. Page 732.
108
Ibid. Page 732.
106
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demand is therefore sensitive to small changes in menu characteristics.'109
5.8 Chu also examines the effect of Satellite TV entry on consumer
welfare. While, unsurprisingly, the average effect of entry is positive,
he notes that 'with endogenous quality adjustment, the intuition that
competition at least weakly benefits all consumers no longer holds.'110
In markets were the incumbent responds by increasing both prices and
quality (14.1 per cent of market-years) 'consumers with weak
preferences for quality may become worse off under head-to-head
competition, when cable firms change their offerings to make them
less differentiated from the new good'.111 Also, in markets where the
incumbent increases quality and reduces prices, from the perspective
of buyers with weaker preferences for quality, 'the chosen mix of
price reduction and quality enhancement too heavily favours quality
enhancement'112 by incumbents' response to entry. The intuition
behind this finding is that the cable operator's response is shaped by
the preferences of 'marginal' consumers, that is, consumers that are
indifferent between choosing between cable and satellite. However,
these marginal consumers are likely to have a higher valuation for
quality than average cable consumers; cable TV's response, being
tailored to marginal consumers, creates incentives to provide 'too
much' 113 quality.
5.9 It is important to note that a defining aspect of entry in this market is
that satellite TV providers - unlike cable TV providers - were not able
to adjust quality to demand conditions in local markets, as they
broadcast the same number of channels nationwide. In that sense, at
the local level only one market participant (cable TV providers) faces a
choice in terms of quality while for the entrant quality is exogenous.
As this is a characteristic is quite specific to the subscription TV
market, it is not clear whether Chu's insights would apply to industries
where both entrants and incumbents can choose quality
endogenously.
5.10 In summary, Chu (2010) shows that, following the entry of satellite
TV providers, cable TV providers in the majority of local markets
109
Ibid. Page 763.
Ibid. Page 732
111
Ibid. Page 732
112
Ibid. Page 762.
113
Ibid. Page 732.
110
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responded by decreasing prices and increasing quality. While the effect
of Cable TV providers' response increases consumer welfare overall,
the balance of price reduction and quality increase is biased to favour
consumers with a high valuation for quality. In markets where Cable
TV providers' response was to increase both quality and price,
consumers with weak preferences for quality might actually have been
made worse off by Satellite TV entry. This finding contradicts the
intuition that competition at least weakly benefits all consumers with
endogenous quality adjustment. However, it is important to note that
Chu's result may be driven by the technological constraints faced by
Satellite TV providers which prevent them from providing a product
that is tailored to local demand conditions.
Ownership consolidation and product quality in the US daily newspapers
market.
5.11 Fan (2013) examines how changes in competition affect the
endogenous choice of quality in the U.S. daily newspaper market.
Using three separate measures of quality, the author estimates a
structural model of the US daily newspaper market, that 'describes
demand for newspapers, the demand for advertising and publishers
[quality and price] decisions.'114 She then uses the model parameters
to simulate a merger between two Minneapolis newspapers (Star
Tribune and St. Paul Pioneer) blocked by the US Department of Justice
(DoJ). Fan finds 'if the merger had occurred, both newspapers would
have decreased the news content quality, the local news ratio and the
content variety' and the merger would have led to 'a rise in both
newspapers' subscription price'.115 Importantly, she also finds that
ignoring adjustments of product characteristics in the merger
simulation leads to an underestimation of consumer welfare loss and
producer surplus.116
5.12 The US daily newspaper market seems well suited for an empirical
study on competition and the endogenous choice of quality in that
individual newspapers often circulate in local117 markets unlike other
industries (for example, the automobile industry) which provide a
114
Fan(2013). Page 1599. Ibid. Page 1600. 116
Ibid. Page 1600. 117
Fan's model does account for competition from national newspapers; however she assumes that 'the
characteristics and prices of the three national newspapers (Wall Street Journal, New York Times and USA Today) are taken as given in the model' as 'it is unreasonable to think that national newspapers compete with all small newspapers [at the local level]'.See Fan (2013). Page 1605.
115
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common set of products for the entire country. Moreover, 'there is
substantial variation in demographics and ownership structure',118
which helps identify the model parameters. Finally, being newspapers
a differentiated product, the quality characteristics of newspapers are
important for assessing welfare.
5.13 As measures of quality, Fan uses:
 A content quality index, which is constructed as a linear function of
non-advertising space; the number of staff for opinion sections and
the number of reporters.
 Local news ratio, which captures a newspaper's emphasis on local
news and is proxied by the percentage of local-news staff over the
total number of staff.
 A measure of variety, which measures to what extent a
newspapers' coverage is balanced across major sections.119
5.14 The starting point for Fan's analysis is panel data covering years from
1997 to 2005 and containing data on county-level circulation,
advertising demand, subscription prices, advertising rates and
newspaper characteristics for each publication, as well as county level
demographics. Using this dataset she estimates newspaper demand,
advertising demand and the first order conditions with respect to
advertising rate, subscription price and newspaper characteristics. This
allows her to identify equilibrium choices of price, advertising rates
and the above quality characteristics in a sequential choice game
where 'publishers choose the characteristics of their newspapers in
the first stage and newspaper prices and advertising rates in the
second stage'.120
5.15 Fan then uses these estimates to simulate the welfare effects of a
blocked mergers between two newspapers in two separate areas
(Minneapolis and St. Paul metropolitan areas), where the model allows
for changes in price, advertising rates and quality characteristics post­
118
Ibid. Page 1599
Fan computes the share of staff for each of the following sections: business & financial, computers &
technology, editorial/opinion page, entertainment & art, features & lifestyle, local news, national & international
news, science & medicine and sports. She then uses these shares are used to measure 'variety' as 100ሾ1 െ
Σ୧ ሺshare ofstaffinsection iሻଶ ]. This measure implies that the more a newspaper is concentrated on a particular
section, the lower is its 'variety' measure. See Fan (2013). Page 1613.
120
Ibid. Page 1605.
119
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merger. She finds that the merger between the Star Tribune and St.
Paul Pioneer Press would have led the merged entity to raise
subscription prices by 1.5 per cent for Star Tribune - the larger
newspaper - and by 4.3 per cent for the smaller Pioneer.121 Content
quality, share of local news and variety would also have decreased; in
all cases, the quality decreases for the smaller Pioneer would have
been larger than the decreases for the Star. This result is consistent
with the fact the publisher can charge higher advertising rates for the
newspaper with the larger circulation; the merged publisher 'has an
incentive to shift circulation from its small to its large newspaper.'122
5.16 Fan also compares the welfare changes for readers, advertisers and
publishers in her endogenous-quality model with the changes that
would result from a model where only (advertising and subscription)
prices are allowed to change post-merger. Consistent with theoretical
models explored in Chapter 6 below, she finds that there exists a bias
from ignoring post-merger endogenous quality choices. Specifically,
she finds that changes in newspaper characteristics 'account for 40
per cent of the post-merger change in consumer welfare' so that
'ignoring characteristic adjustment leads to an underestimate of the
welfare loss for readers by 1.05 million dollars, the welfare loss for
advertisers by 1.86 per cent, and the increase in publisher surplus by
0.10 million dollars.'123
5.17 It is important to note that, while the model allows for publishers to
alter their choices along three drivers of quality, Fan assumes that
location choices are exogenous and that the merged publisher will not
discontinue servicing any country where both newspapers were
competing in before the merger. She motivates this choice by arguing
that 'location decisions are typically of a longer horizon than both
quality and price decisions'124. While this modelling choice may be
justified by specificities of the newspaper industry, it is plausible that
in other settings firms may also consider withdrawing one brand from
markets knowing that sales will be diverted to the remaining brand.125
121
Ibid. Page 1613
Ibid. Page 1613
123
Ibid. Page 1624
124
Ibid. Page 1615.
125
For example, the OFT recently referred the Completed acquisition by Optimax Clinics Unlimited of Ultralase
Limited to the CC. In its report, the OFT referred the merger when the merging parties had already initiated the
'closure of a number of clinics/consultation centres where the merger parties were located in close geographic
proximity to each other' OFT (2013). Page 2.
122
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This may have effects on consumer welfare that Fan's model would
not accommodate.126
5.18 In summary, having estimated a structural model that subscription
prices, advertising rates and newspaper quality characteristics, Fan
conducts a simulation of a merger between two newspapers in the
Minneapolis area. She finds that the effect of the merger on consumer
welfare is negative (via changes in quality and increases in price for
both newspapers). She also shows that ignoring post-merger quality
adjustments produces biased estimates of post-merger changes to
prices and consumer welfare. In that sense, her research lends further
weight to the theoretical argument (further examined in Chapter 6)
that merger simulations or price pressure analyses should – where
possible – consider the quality effects of proposed mergers in
industries where quality is an important dimension of competition.
Evidence on competition and quality from the airline industry
5.19 Chen and Gayle (2013) examine the effect of the mergers between
Delta and Northwest (DL/NW) and Continental and United (CO/UA) on
product quality. Specifically, the authors test the hypotheses that (a)
post-merger changes in quality depend on the level of pre-merger
competition, and (b) that the relation between pre-merger competition
and post-merger quality is not monotonous. The measure of quality
employed by the authors is 'routing quality'; the 'percentage ratio of
nonstop flight distance to the product's itinerary flight distance used
to get passenger from their origin to destination'.127 Consistent with
their predictions, the authors find that 'each merger increased routing
quality […] in markets where the merging firms did not compete prior
to their merger'. Conversely, 'each merger decreased routing quality of
the merging firms' products in markets where they competed prior to
their merger'128 and the magnitude of the quality reductions depended
'(non-monotonically, in the case of the CO/UA merger) on their
competition intensity prior to the merger.'129
126
Moreover, Fan's study focuses on a two-sided market; the relationship between the advertising market and the consumer market generates additional strategic effects (for example, a merger may lead to higher prices for advertising but lower subscription prices). In that sense, Fan's results may be attenuated as compared to
industries where this additional strategic effects does not exist. 127
Chen and Gayle (2013). Page 10. 128
Ibid. Page 29.
129
Ibid. Page 2.
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5.20 The airline industry lends itself well to study the changes in
competition; there exists publically available measures of service
quality (for example, flight delays, number of stop-overs or routing
quality) that seem intuitively representative of what drives consumers
perception for airline service quality. Moreover, airline markets are
typically defined on a route level130 and there exists considerable
variation in concentration and characteristics for each route. This helps
identify the effect subsequent rounds of consolidation had on airlines'
endogenous choice of quality.
5.21 The starting point of Chen and Gayle's analysis is the recognition that
two forces affect firm's post-merger provision of quality. On the one
hand there is the 'coordination effect' whereby 'a merger allows two
firms to share technology information and coordinate production,
which can positively affect the quality of their product'131. On the
other hand, there is the 'incentive effect', whereby the merger
'eliminates the competitive pressure on firms to provide high
quality'132; the authors postulate that 'the magnitude of the incentive
effect depends on how intense the two firms competed before the
merger'133. They argue that, if the firms competed weakly pre-merger,
the incentive effect may be weak. If pre-merger competition was at
some intermediate level, the effect may be strong. If pre-merger
competition was so strong to erode profits and compromise the
provision of quality, the incentive effect may again be weak. In
essence, Chen and Gayle propose a U-shaped relationship between
pre-merger competition and post-merger changes in quality, which is
'reminiscent of the inverted-U relationship between innovation and
competition suggested by Aghion et al. (2005)'.134
5.22 To test their theoretical hypothesis, the authors begin by estimating a
structural demand and supply model for airline travel to identify
merging parties' pre-merger cross price elasticities. They do so using a
quarterly sample representing 10 per cent of airline tickets collected by
the US Bureau of Transport Statistics. The time span covered is from
2005 to 2011 and the data comprises '(i) the identity of airline(s)
associated with the itinerary; (ii) airfare; (iii) number of passengers that
130
See for example the market definition in the European Commission's Ryanair/Aer Lingus decision. European
Commission (2007).
131
Chen and Gayle (2013). Page 2.
132
Ibid. Page 2.
133
Ibid. Page 29.
134
Ibid. Footnote 3.
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purchase the specific itinerary; (iv) miles flown in getting the
passenger from the origin to destination; and (v) the identity of origin,
destination and intermediate stop(s) airports.'135
5.23 The authors extract pre-merger cross price elasticities for the merging
parties from the structural model described above; these cross-price
elasticities 'serve as a useful indicator of [pre-merger] competition
intensity'.136 The authors then regress post-merger routing quality on a
set of variables that includes pre-merger cross price elastiticties to
establish whether the level of pre-merger competition determines postmerger quality outcomes. Consistent with their predictions they find
that 'each merger is associated with an increase in routing quality in
markets where the merging firms did not compete with each other
prior to the merger, but with a decline in routing quality in markets
where they did. Furthermore, in the case of the CO/UA merger, the
change in product quality appears to exhibit a U-shaped relationship
with the two firms' pre-merger competition intensity.'137
5.24 It is important to note that although Chen and Gayle employ a
structural model to estimate consumer valuations of routing quality
and cross-price elasticities, unlike the papers by Chu (2010) and Fan
(2013), the authors do not quantity price effects of the mergers and
hence do not compound the overall welfare effects of price and quality
changes. Moreover, while the authors argue that 'routing quality is one
of the better measurable quality dimensions of air travel service that is
more directly related to optimal choices [in terms of incentive and
coordination effects] of the merger', routing quality may be only one
aspect of service quality that consumers value. If other drivers of
airline service quality (for example, legroom or in-flight amenities) are
less responsive to incentive and coordination effects, the effect of the
merger found by Chen and Gayle on routing quality would be diluted
over a wider set of drivers of quality unaffected by the merger. Finally,
while one of the authors' main assumptions is that incentive effect is
dependent upon pre-merger competition, they model the coordination
effect exogenously. However, it is not clear why coordination effects
should be independent of the extent of pre-merger competition; it
seems equally plausible that merging parties would be better placed to
135
136
137
Ibid. Page 12.
Ibid. Page 3.
Ibid. Page 4.
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'share technology information and coordinate production'138 in markets
where they compete more closely with each other.
5.25 In summary Chen and Gayle present an elaborate empirical study on
two US airline mergers; they find that each merger is associated with
a quality increase in routes where the merging firms did not compete
(that is, they did not both serve the route) pre-merger, but with a
quality decrease in markets where they did and that the quality change
can be a U-shaped function of the pre-merger competition intensity.
While further research could address some of the limitations of the
study described above, one of the paper's key messages is that, in
general, competition agencies should give less weight to qualityrelated efficiencies if the merger is between close competitors. This is
not only because price effects are more likely to outweigh any postmerger quality improvements if the parties are close competitors (as
mentioned above, the authors do not investigate the price effects of
the two airline mergers); more subtly, the authors' argument is that –
when close competitors merge – any potential efficiencies in quality
provisions may be trumped by the removal of incentives to achieve
those efficiencies. Chen and Gayle's paper implies that competition
agencies should take a favourable view on quality-related efficiencies
only if merging parties are not close competitors or pre-merger
competition was so intense as to erode profits and undermine
incentives to provide quality.
Conclusion
5.26 Our review of the theoretical literature on the endogenous choice of
quality had found that 'the effect of reduced competition on quality
[…] is theoretically ambiguous when firms choose both quality and
price'.139 In that sense, in this section we aimed at outlining any
insights that the empirical literature on the endogenous choice of
quality could provide. We noted that while a number of econometric
studies confirm that a positive relation exists between competition and
quality, these are insufficient to inform policy making that has
consumer welfare – not quality on its own – as an objective. For this
reason, in this section we reviewed empirical studies that employed
structural models that explicitly measured the impact on consumer
138
139
Ibid. Page 2.
Romano and Balan (2011). Page 46.
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welfare of changes in competition, allowing for firms to choose both
price and quality endogenously. A paper by Chu (2010) found that
entry at the top end of the subscription TV market led incumbents to
respond by increasing both quality and prices, but that not all
consumers benefitted equally from entry under endogenous quality. A
paper by Fan (2013) found that a blocked merger between two
Minneapolis daily newspapers would have reduced consumer welfare
through changes in quality and increases in subscription prices;
ignoring quality changes underestimates consumer harm. A paper by
Chen and Gayle (2013) focusing on two US airline mergers found that
service quality increased on routes where the merging parties were not
previously competing; service quality decreased – non-monotonically
for one merger – on routes where firms where previously competing.
5.27 As the empirical literature is recent and still relatively sparse, it is too
early to draw any lessons for practitioners from any of the structural
models reviewed above (or simpler regression analyses) investigating
the effect of competition on quality when firms also choose price.
Moreover, the results of empirical studies are likely to be driven by
industry-specific characteristics and – as highlighted previously –
empirical papers can only investigate the relationship between
competition and quality in industries where reasonable measures of
quality exist.
5.28 Despite these limitations, the papers reviewed in this section highlight
that firms endogenous choice of quality are affected by changes in
competition and that the post-merger choice of quality can have
important effects on consumer welfare. Moreover, as explored further
in Chapter 6, ignoring endogenous quality can bias predictions about
post-merger changes in prices and consumer welfare. Further empirical
research employing structural models to investigate the effect of
mergers on the endogenous choice of quality would be welcome. In
particular – taking example from Chen and Gayle's study on the
relationship between pre-merger competition and the directionality of
post-merger quality changes - future research could investigate what
prior market characteristics can help decision makers anticipate the
likely effect of mergers on quality and consumer welfare.
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6 FURTHER TOPICS IN QUALITY AND COMPETITION POLICY
Introduction
6.1 In this chapter, we summarize insights from the nascent literature on
competition and quality in the context of competition enforcement and
merger140 control. We identified three developing themes that might
become more important in practical considerations where quality is an
important dimension of competition. These themes are:
 Market definition when firms compete on quality.
 Modelling the effect of mergers when firms compete on price and
quality.
 Anticipating merger effects with post-merger brand repositioning.
6.2 With the exception of the first theme above, the concepts and
examples presented in this chapter relate mainly to the merger control
function exercised by competition authorities. While the literature
themes we review here are still in their infancy, the objective of this
chapter is to inform competition practitioners', by illustrating the
insights and intuitions that the papers presented below postulate.
Small but Significant Non-transitory Decrease in Quality (SSNDQ)
6.3 As the Guidelines set out, a typical merger assessment would begin
with 'the identification of the market or markets for the goods or
services concerned'.141 Similarly, defining the market is an important
step in many CA98 investigations. The conceptual tool with which
competition agencies take on this task is the small but significant and
non-transitory increase in price (SSNIP) test. This test asks whether it
would be hypothetically profitable for a monopolist to raise prices by
five-10 per cent (from competitive levels) in a candidate market; if it
would not be profitable, other products or geographies are added to
140
It is important to note that while a merger clearly changes the number of competitors in the market, it is not
immediately equivalent to a 'change in competition' whose effects on firms' endogenous choice of quality we
studied in detail in the preceding sections. This is because we implicitly assumed changes in competition to be
exogenous, while a merger may be an endogenous choice by firms. This is explored for example, in Greenfield
(2012).
141
See OFT and CC (2010), paragrapgh 5.1.1.
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the market until it is defined widely enough to allow a hypothetical
monopolist to pass the SSNIP test.
6.4 Once a market is defined, the second step is the 'assessment of the
competitive effects of the merger in the market(s)'.142 The Guidelines
recognize that competitive effects may manifest themselves on 'price
or non-price aspects such as quantity sold, service quality, product
range, product quality and innovation.'143 This raises the question
whether there exists a non-price based test with which a market can
be defined; this would be particularly sensible in markets where a
competition agency expects the competitive constraints are mainly
determined by quality factors.
6.5 This issue was addressed by Hartmann et al. (1993) in the context of
the US Department of Justice's challenge to the sale of EMI (a British
manufacturer of computer tomography (CT) scanners) to General
Electric.144 The case hinged on whether CT scanners constituted a
separate product market, or if they belonged to a wider market for
medical diagnostic instruments, which would have included X-rays,
nuclear imaging, diagnostic ultrasound and CT scans. The question
was difficult, because the introduction of CT scanners had spurred
performance improvements in older imaging techniques, as well as
price changes in all technologies.
6.6 Using the Medical Diagnostic Devices (MDD) industry as an example,
Hartman et al. argue that in markets where firms compete on prices as
well as performance attributes,145 a price based SSNIP test is
inadequate. In the medical imaging example, 'an increase or decrease
of five per cent in the price of CT instruments would have had no
effect on sales of nuclear imaging equipment'.146 In fact, the authors
note that after the introduction of CT devices their price rose fivefold
without prompting renewed reliance on X-ray or nuclear devices.147
However, to conclude that these technologies constitute separate
markets would be incorrect; the competitive response by X-ray or
nuclear device manufacturers was vigorous, as they reacted to the
142
Ibid. Paragraph 4.2.3. Ibid. Paragraph 4.2.3. 144
Department of Justice (1980).
145
In the case of medical imaging devices these are areas of application, image clarity, invasiveness and tissue-
specificity. Hartmann et al. (1993). Page 329.
146
Ibid. Page 334.
147
Ibid. Page 334.
143
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introduction of CT scanners by greatly improving the performance and
capabilities of their respective technologies.
6.7 In markets subject to rapid technological change, where demand is
driven by price and measurable performance attributes, Hartman et al.
then propose modifying the SSNIP test in the following way; instead
of a test based on a five-10 per cent increase in price, they propose
asking whether a hypothetical monopolist could profitably reduce
quality of a key performance attribute by up to 25 per cent,148 keeping
all else constant. The SSNIP test would then be replaced by a 'Small
but Significant Non-transitory Decrease in Quality' (SSNDQ) test.
6.8 Note that by suggesting applying a 25 per cent decrease in the
performance on a single attribute, the authors bypass the issue of
multidimensionality in the quality of medical diagnostic imaging
devices. While their suggested approach renders the application of the
SSNDQ test conceptually easier to apply, consumers value different
drivers of quality differently. In that sense, while a survey of imaging
specialists might find that a hypothetical monopolist would 'pass' the
SSNDQ test following a 25 per cent decrease in image resolution of
MDDs, a decrease in non-invasiveness larger than 25 per cent may be
needed to for a hypothetical monopolist to pass the test as patients
may value image clarity more than non-invasiveness.
6.9 The use of the SSNDQ was discussed at the recent OECD roundtable
on quality and competition. Noting that 'Google did not topple Yahoo
in the internet search market [...] because of price competition'149, the
OECD Background Note highlights that Hartmann et al.'s argument
may also extend to digital industries. However, the OECD Note also
points out that qualitative data gathered through interviews with third
parties and through the examination of corporate documents may be a
more realistic approach to defining high technology markets than a
formal test as proposed by Hartman et al. The SSNDQ test might
'therefore probably [be] more useful as a loose conceptual guide than
as a precise tool that courts and competition authorities should
actually attempt to apply'.150
148
149
150
Ibid. Page 340.
See OECD (2013). Paragraph 19.
See OECD (2013). Paragraph 19.
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6.10 As seen in Chapter 3 UK competition authorities have duly taken nonprice competition into consideration when defining the relevant market
or assessing the degree of substitution between merging parties, in
markets where prices were invariant. However, a formal market
definition test for non-price competition does not form part of the tools
typically used by UK competition authorities in markets where price is
at least one choice variable by firms. Moreover, the practical scope for
and likelihood of extending the application of the SSNDQ test for
competition authorities is unclear.
Quality and merger modelling
6.11 The inclusion of the 'upward pricing pressure' ('UPP') tool in the 2010
US Horizontal Merger Guidelines intensified the already keen academic
interest in this method, first proposed by Werden (1996). First used in
practice by UK competition authorities, the UPP is an analytical tool
through which competition agencies can anticipate to what extent
unilateral incentives to raise price will increase post-merger. Its main
attractiveness is that it requires a limited amount of data and
assumptions to deliver its result.151 However, this comes at the
expense of precision; because of its limiting assumptions, the UPP is
intended to provide practitioners with an understanding of the upward
pressure on prices, as opposed to estimates of the anticipated price
rise itself.
6.12 Numerous papers have investigated how the predictive power of the
UPP can be augmented while preserving its simplicity. An essential
feature of the UPP is that it focuses on prices and ignores other
strategic variables of a firm, for example, capacity, promotions and
quality. However, the effect of a merger on the UPP, when firms
choose quality and price was recently investigated by Willig (2011)
and by Sorana (2013). The two papers, which we illustrate below,
highlight that UPP may overstate merger effects when firms' choice of
quality is considered.
151
The UPP test typically requires only knowing the margins, diversion ratios and pre-merger prices of the
merging firms.
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UPP and exogenous quality changes
6.13 Willig (2011) provides a simple comparison between the standard
UPP/GUPPI formula and a UPP formula that accounts for (vertical)
quality differences between merging parties' products. His model
contemplates a two-to-one merger where the choice of quality is
exogenous; nevertheless his comparative statics illustrate how an
improvement in consumer's valuation of the merging parties' product
could translate into a less than-proportionate increase in price.
6.14 The starting point for Willig's comparison is the standard UPP formula,
which is derived from pre and post-merger profit functions for two
merging firms, producing goods 1 and 2:
Π ௜ ൌ ሺܲ௜ െ ܿ௜଴ ሻ‫ܦ‬௜ ሺܲଵ , ܲଶ ሻ
Pre-merger:
Post-merger: Π ୫ ൌ ሺPଵ െ cଵ ሻDଵ ሺPଵ , Pଶ ሻ ൅ ሺPଶ െ cଶ ሻDଶ ሺPଵ , Pଶ ሻ
(1)
(2)
where ‫ܦ‬௜ ሺܲଵ , ܲଶ ሻ is the demand of product ݅ ൌ 1,2 for given prices ܲଵ , ܲଶ .
Π ୧ , and ܿ௜଴ are the profits and pre-merger marginal costs of the two
merging firms ݅ ൌ 1,2 respectively. Π ௠ is the post-merger monopoly
profit of the merged firm and ܿ௜ are the marginal costs of production
from using the assets previously belonging to firms ݅ ൌ 1,2.
6.15 As usual, there is an upward pricing pressure if the gain in market
power from the merger is not offset by reductions in marginal costs
(efficiencies). Formally, there is an incentive for the merged firm to
raise the price of firm 1's good – assuming no changes affecting firm
2's product - if :
൫௉మబ ି௖మబ ൯ఋభమ
௉భబ
൐
ሺ௖భబ ି௖భ ሻ
௉భబ
(3)
where ߜଵଶ - the diversion ratio between products 1 and 2 – is the
fraction of the sales of good 1 lost as a consequence of a price rise in
good 1, that are diverted to good 2.152 The left hand side of the
formula above establishes that the higher profit margins are on the
152
Note however, that in practice, diversion ratios are often assessed based on questions asking about consumer
behaviour in case one of the goods or suppliers is not available, instead of price changes. See, for example, page
32 of the document 'Good practice in the design and presentation of consumer survey evidence in merger
inquiries' (www.oft.gov.uk/shared_oft/consultations/merger-inquiries/Good-practice-guide.pdf).
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acquired good and the higher the diversion ratio is between the two
products, the higher will be the pressure to increase price post-merger.
If the upward pressure on price is not matched by marginal cost
savings the firm expects to accrue from the merger (the right hand
side of the equation above) the net effect will be an increase in postmerger prices.
6.16 Willig then proposes a simple demand system where 'the impact on
consumers' demand of a change in the characteristics of a product is
equivalent to an addition to the product's price (from lowering of
quality), or a subtraction from the products' price (from raising
quality).'153 Formally, the demands for goods 1 and 2 are:
‫ܦ‬ଵ ሺܲଵ െ ‫ݒ‬ଵ , ܲଶ െ ‫ݒ‬ଶ ሻ ≡ ‫ܦ‬ଵ ሺ‫ܪ‬ଵ , ‫ܪ‬ଶ ሻ (4)
‫ܦ‬ଶ ሺܲଵ െ ‫ݒ‬ଵ , ܲଶ െ ‫ݒ‬ଶ ሻ ≡ ‫ܦ‬ଶ ሺ‫ܪ‬ଵ , ‫ܪ‬ଶ ሻ (5)
where '‫ܪ‬௜ ൌ ܲ௜ െ ‫ݒ‬௜ are the 'hedonic', or quality-adjusted prices for the
products after the merger and ‫ݒ‬௜ is the value of the improvement in
the quality of product ݅ , per unit, for each consumer, brought about by
the merger'154.
6.17 The resulting pre- and post-merger profit functions are hence as
follows:
Pre-merger:
Π ௜ ൌ ሺܲ௜ െ ܿ௜଴ ሻ‫ܦ‬௜ ሺܲଵ , ܲଶ ሻ(6)
Post-merger:
Π ୫ ൌ ሺHଵ ൅ vଵ െ cଵ ሻDଵ ሺHଵ , Hଶ ሻ ൅ ሺHଶ ൅ vଶ െ cଶ ሻDଶ ሺHଵ , Hଶ ሻ
(7)
6.18 Note from equations (6) and (7) above that the model does not
investigate how the choice of quality level is altered by the merger;
instead, it assumes that the merging parties will successfully achieve
improving the quality of the product post-merger, via the additional
quality improvement ‫ݒ‬௜ which did not feature in (6).
6.19 The UPP condition derived from the model above now becomes:
൫௉మబ ି௖మబ ൯ఋభమ
௉భబ
153
154
൐
ሺ௩భ ା௖భబ ି௖భ ሻ
௉భబ
(8)
Willig (2011). Page 27.
Ibid. Page 27.
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6.20 Comparing the condition above with equation (3) we note that as long
as the quality improvement ‫ݒ‬ଵ is positive, all else equal, the threshold
above which the net price effect of the merger is positive becomes
higher. As compared to a model that ignores quality improvements, it
is hence less likely that a merged firm 'fails' the UPP test, that is, will
raise (quality adjusted) prices post-merger.
6.21 While Willig's model is limited by the assumption that the level of
post-merger quality is exogenous, it does offer a formal model for
merging parties' arguments in mergers where 'it may be more
pertinent […] to presume efficiencies from the merger […] apply to
product quality rather than marginal costs.'155 In that sense, Willig's
paper adds to the small but growing literature on the role of fixed
costs efficiencies in merger control156. Such arguments might be
relevant 'in markets for differentiated products where fixed costs of
product R&D and design are particularly important' and 'merger
efficiencies are less likely quantitatively to apply to marginal
production costs and are more likely to apply to consumers' valuations
of the qualtities of the involved products.'157
Conclusion and relevance
6.22 In summary, a recent paper on the UPP test – which has been
employed by the OFT since the mid-2000s and has risen to
prominence in the US more recently – highlights that the UPP can be
extended to capture quality effects of a merger, in markets where
firms compete both on price and product quality. While it is unlikely
that other 'augmented' UPP formulas will replace the test employed so
far, the aforementioned paper highlight that in markets where firms
compete on quality as well as price the UPP test may be biased, in
that it does not take potential changes in product quality into account.
Quality and post-merger product repositioning
6.23 Aside from altering firms' choices of quality and price, a merger might
also change horizontal aspects of product differentiation. In markets
155
156
157
Ibid. Page 27.
See for example, Rubinovitz (2009).
Willig (2011). Page 27.
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for horizontally differentiated products, the UPP test and merger
simulations assume that post-merger, merging parties and competitors
leave their product positioning unaltered.
6.24 In this context, this section explores an insightful paper by Gandhi,
Froeb, Tschantz and Werden (2008) illustrating how firms' would
change the location of their brands post-merger. Noting that 'the
current understanding of unilateral effects is based almost entirely on
the analysis of models of competition in a single dimension [price]',
Gandhi et al. propose a model that relaxes the assumption that firms
compete only on price, and consider the effects of a merger when
sellers of differentiated products compete both on price and product
positioning. They compare the consumer welfare effects of a merger in
their price-location model to those in a model where each product has
a fixed location and firms compete only on price.
6.25 To construct their comparisons, the authors consider a Hotelling
model158 of four stores located along a line segment. Firms
simultaneously choose both prices and location, recognizing that
consumers' preferences for a store increases the closer the store is
located to the consumer. In that sense, firms face a trade-off; 'on the
one hand, firms want to differentiate themselves from competitors to
enjoy market power and on the other hand, firms want to locate where
they can best meet consumers' preferences.'159 Each store is initially
owned by a separate firm, and then two of the firms merge. For both
merging and non-merging firms, the merger changes not only the
equilibrium price; it also changes firms' preferred location.
6.26 The authors provide an intuitive graphic analysis for the location
effects of the merger, which we present here (for a more detailed
mathematical analysis, we refer the reader to Gandhi et al.'s paper).
Holding other parameters of their model constant, the authors plot the
equilibrium locations of the four firms along the vertical axis
(representing a line of length 10) against values of the travel cost
parameter on the horizontal axis.
Figure 3: Pre-Merger Store Locations as a Function of Travel Cost.
158
159
See previous discussion in paragraphs 2.11-2.23.
Belleflamme Peitz (2010). Page 111.
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Source: Gandhi et al., page 8. Subject to the originator's copyright.
6.27 Figure 3 illustrates that with sufficiently high travel costs, the four
stores are fully separated in equilibrium. As travel costs decline, there
is less opportunity to gain market power by separating from other
stores and thus a greater incentive to locate in the manner that best
serves the greatest number of customers. For that reason, as travel
costs approach zero, stores' equilibrium locations overlap in the centre
of the location line.
6.28 The pattern of separation (relative to travel costs) changes when two
of the firms merge. Gandhi et al. find that for all travel costs,
separation is higher after the merger. This is because 'the merged firm
moves its products apart to reduce cannibalization, while the nonmerging firms move their products to positions between the merging
firms' products. This can be seen in Figure 4 below; only with
maximum travel costs do equilibrium locations before and after the
merger overlap.
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Figure 4: Pre- and Post-Merger Store Locations
Source: Gandhi et al., page 9. Subject to the originator's copyright.
The dashed line represents the pre-merger locations whereas the full line represents the
post-merger locations.
6.29 The authors show 'post-merger product repositioning […] confers
consumer benefits not observed in the standard price only model.
Variety increases, which has a direct welfare-enhancing effect, and
the post-merger price increases with post-merger product repositioning
are significantly less'. The latter effect occurs because with fixed
locations the incentive to raise prices is highest, the closer the initial
location of the merging brands. Consumers lost through a price rise in
one merging brand will be captured by the other merging brand,
making a price rise profitable. In contrast, with brand repositioning, the
fact that the merged entity spreads its brands out to reduce
cannibalization decreases the incentive to raise prices. This leads to
both an increase in product variety and comparatively smaller
incentives to raise prices for the merged firm.
6.30 Gandhi et al.'s findings suggest that ignoring the possibility of brand
repositioning may lead to competition overstating the unilateral effects
of a merger under certain circumstances. When evidence shows that
market participants routinely undertake brand repositioning (as in the
US Wild Oats/Whole foods merger, or in the commercial radio industry
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example below), the authors suggest that a more lenient approach
should be taken towards mergers involving two closely overlapping
products.
6.31 The issue of brand repositioning has been addressed in some UK160
and US161 merger cases, but so far mostly in the context of potential
entry; the argument is that should merging producers of overlapping
brands raise prices of their products, existing competitors would move
their products closer to the merging parties' location. It is important to
note though that Gandhi's argument goes beyond that, in that it
postulates that the parties themselves would not continue occupying
their original (overlapping) space, but rather would move their
respective brands away from each other to reduce cannibalization.
Brand repositioning as a type of potential entry is a 'second order'
effect, where competitors' action (entry) is conditional on merging
firms' exploiting the market power gained through the merger. Brand
repositioning by the merged parties, on the other hand, is a direct
response triggered by the change in incentives caused by the merger.
As it directly affects parties' closeness of competition, the above
paper suggests, brand repositioning by merging parties can potentially
have a greater impact on merger assessment than arguments about
brand repositioning by competitors.162
Conclusion and relevance
6.32 In sum, the paper by Gandhi et al. above illustrates that when merging
parties that produce closely competing brands can offer convincing
evidence about their ability and intention to separate overlapping
brands post-merger, this may mitigate competition agencies' concerns
on unilateral price effects. In practice, in either case competition
authorities' acceptance of any own-brand repositioning case will hinge
on evidence of repositioning having happened in the market, or being
likely to happen in the future. Gandhi et al.'s model assumed no
repositioning costs and it is likely that the attenuating effect of brand
repositioning is lower, the higher are repositioning costs. However, as
a recent paper by Sweeting (2010) on the US commercial radio
stations market illustrates, repositioning costs that may be as high as
160
Unilever, GMC Radio
For example, Whole Foods/Wild Oats. Oracle/PeopleSoft; KimberlyClark/Heinz
162
Note, however, that Gandhi et al. do not allow for ceasing to provide a brand (that is, a decrease in the
number of brands which may be a likely scenario in practice.
161
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one year's revenue163, are not sufficient to prevent radio markets
adapting quite quickly to demand shocks'.164 This may imply that as
the academic literature on the effect of mergers on price and location
develops, arguments on repositioning could become more relevant in
certain markets.165
6.33 On a final note, Gandhi et al.'s model is concerned with the effect of a
merger on horizontal differentiation; it investigates the effect of
competition not on quality (through vertical differentiation) but rather
on varieties. It is however conceivable that Gandhi et al's framework
of analysis may apply to mergers where merging parties' products are
of similar quality initially, and where post- merger the merged entity
may find it profitable to differentiate the two products vertically.
Further research formally asserting this equivalence would be
interesting, as examples of vertical repositioning were presented in the
OECD Roundtable on Quality and Competition. For instance, following
the merger between P&O Princess Cruises and Carnival Corporation,
the Cunard Line was repositioned as a premium brand.166 Also, a
recent Japanese evaluation of a merger in the market for seasoning
spices found that 'the combined firm reorganized its product
positioning strategy so as to sell X's products as high-end ones and
Y's as low-end ones.'167
Conclusion
6.34 In this final chapter we reviewed three strands from the nascent
literature on competition and quality in the context of competition
enforcement and – especially - merger control. These strands relate to
market definition in industries where firms compete more vigorously on
non-price dimensions, such as quality, than on price; possible biases in
the UPP test when firms compete on quality and price; and
anticipating merger effects with post-merger brand repositioning.
6.35 The papers presented above highlight that some of the tools used by
competition authorities in merger assessments might have some biases
in markets where quality is an important dimension of competition.
163
164
165
166
167
Sweeting (2007). Page 3.
Ibid. Page 40.
Ibid. Page 3.
Ibid. Page 17.
OECD (2013). Page 90.
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However, we do not consider that the literature presented above
invalidates the use of SSNIP tests, UPP test or merger simulations in
such industries. This is because, on the one hand, it is not clear that
the proposed alternatives (the SSNDQ test, the DHP test or merger
simulations with endogenised product location) will be practically
applicable, given the difficulties in measuring and assessing quality. On
the other hand, none of the merger control tools challenged by the
papers above are decisive on their own in a typical merger
assessment. Rather, they are part of a larger exercise and they
complement information gathered via third party feedback and through
the analysis of internal documents.
6.36 In that sense, the significance of the three strands reviewed above is
that they help merger practitioners understand the sources of bias that
may affect analytical tools such as the SSNIP, the UPP test or merger
simulations in markets where firms compete on price and quality.
Since these papers in certain circumstances (that is, under certain
assumptions) identify the directionality of the bias implied by ignoring
quality competition, competition authorities could address this issue
with targeted qualitative evidence. For example, in markets for
differentiated goods where merging parties and competitors may
reposition their brands post-merger, competition authorities may ask
merging parties to point out examples of past repositioning to assess
the robustness of standard tools for competitive assessment. In sum,
in markets where competition develops along multiple dimensions the
relevance of existing tools for merger control may be preserved by
complementing them with targeted qualitative evidence, as informed,
for example, by the papers reviewed above.
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7 CONCLUSION
7.1 This report has sought to improve our understanding of the
relationship between competition and quality. To this end, we have
reviewed the relevant theoretical and empirical literature and have also
studied selected previous decisions of UK competition authorities, with
particular focus on bringing out practical insights.
7.2 We found that, in general, competition authorities face multiple
challenges when incorporating quality assessment into their analysis.
The most fundamental issue is the difficulty around the objective and
robust measurement of quality, which may be further complicated by
the multidimensionality of quality in many cases.
7.3 In Chapter 3, we looked at ways in which UK competition authorities
tried to overcome these difficulties. To do this, we reviewed examples
where UK competition agencies chose to focus on quality
considerations because prices were either set nationally or did not
form part of consumers' choice (for example, in the context of the
healthcare sector). In these examples, we identified different practical
approaches that UK competition authorities used, such as (i) making
inferences about the expenditure on quality from margin-concentration
analysis where difficult to measure or assess because of
multidimensionality; (ii) using consumer surveys and evidence from
third-parties or internal company documents to complement analysis
when assessing the effect of competition directly on available
measures of quality; and (iii) using consumer surveys where quality
develops along more than one dimension to assess how consumers
value single drivers of quality. In addition, our review of past cases
also identified an innovative approach that the CC used when
assessing the closeness of competition in a case where competition
primarily develops along quality. More specifically, in a merger
between two hospitals, the CC used diversion ratios based on quality
decrease instead of price increase which could be a useful approach in
other cases where measures of quality are available in the future.
7.4 We also noted that, when reliable data is available, studies that relate
these measures of quality to local market concentration can also be
used; these analyses address the issue of whether the merger will
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reduce quality more directly. We also suggested that, where more data
is available, econometric models could also be used to estimate the
loss of consumer welfare implied by a merger in markets where firms
compete along multiple dimensions of quality.
7.5 After having discussed issues around the measurement of quality, we
turned to seek insights from the academic literature on the relationship
between competition and quality in Chapter 4 and 5.
7.6 We concluded that the theoretical literature can provide only limited
guidance to practitioners for the assessment of competition on quality.
In particular, we found the following:
 When firms choose prices as well as quality levels, the reviewed
theoretical literature finds an ambiguous effect of competition on
quality. The key intuition behind this finding is that increased
competition affects firms' incentives to provide quality in two broad
ways. On the one hand, it has the 'direct effect' of incentivizing
firms to increase quality in order to be more attractive to consumers
when competing more intensely with other firms. On the other
hand, competition has a (negative) impact on firms' margins and,
hence, may potentially undermine firms' incentives to invest in
quality ('indirect effect'). The overall impact of increased
competition on quality will ultimately depend on the relative
strength of these two opposing forces, which is highly sensitive to
model specifications.
 In contrast, when prices are regulated or are exogenously given for
firms for another reason, the theoretical literature suggests a
positive relationship between competition and quality. This is
because with exogenous prices, only the direct effect of
competition on quality is present.
7.7 On the other hand, our review of the empirical literature points
towards finding a positive relationship between competition and some
metrics of quality even in situations where firms choose both quality
and price. However, as the empirical literature is recent and still
sparse, it is too early to draw any general lessons for practitioners
from this.
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7.8 In the last chapter of the report we discussed some recent
developments from the theoretical and empirical literature on quality
assessment in the specific context of merger control. This strand of
the literature highlights potential biases in applying price pressure tests
and merger simulations that do not allow for post-merger quality
changes in markets where quality is an important dimension of
competition. While we do not consider that the literature is sufficiently
conclusive on the direction of the possible bias, merger assessment in
specific industries where quality considerations play a key role is likely
to benefit from insights provided by the growing body of merger
simulation literature that allow for firms to alter their post-merger
choices of both quality and price in the future.
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Competing on Quality –
Healthcare Report
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1 INTRODUCTION
1.1 In the healthcare sector, the quality of services provided is particularly
important, given its crucial implications for patients' wellbeing and,
potentially, life. For this reason, competition and health economists
have often studied the relationship between competition in healthcare
markets and quality. In the English National Health Service (NHS), the
topic is particularly relevant, since prices for many healthcare services
are regulated, and competition is thus mostly on quality. Therefore, in
the context of the OFT research about competition on quality, we
devote specific attention to healthcare markets, in order to understand
how competition between healthcare providers affects the quality of
their services.
1.2 The aims of this study are manifold. First, we intend to provide a
comprehensive, up-to-date description of the economics of quality
competition in healthcare markets, addressing both theoretical and
empirical issues. Second, we mean to contribute to the debate around
the impact of competition on quality in the English NHS, critically
reviewing the available studies on the topic. Third, we aim to highlight
some areas where the literature does not offer definitive conclusions,
and more research would be informative. Finally, we intend to produce
a theoretical basis for the economic evaluation of competition issues in
healthcare by the OFT and, from April 2014, by the CMA. Throughout
the paper, we mainly concentrate on competition between hospitals,
though we also analyse competition in the market for GP services in
paragraphs 5.51-5.63.
1.3 In Chapter 2, we outline the organisation of the English NHS, in
particular with regard to providers and commissioners. We then
describe the principal mechanisms introduced by the NHS reforms over
the last 10 years to incentivise competition, namely Payment by
Results (PbR),168 patient choice, Any Qualified Provider (AQP) and the
expansion of the independent sector treatment centres (ISTCs). PbR
links payments to volumes treated through a system of fixed tariff
prices, which should incentivise hospitals to compete on quality. If
patients can choose where to be treated, and they choose higher
quality providers, then payments should favour these providers. AQP
168
In Chapter 2, we devote particular attention to the topic of price regulation, and to PbR in particular .
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and the expansion of the ISTCs allow patients to choose from more
providers, both public and private.
1.4 In order to assess the impact of competition on quality, it is in the first
place necessary to choose how to measure quality. Healthcare quality
is made of different and interlinked dimensions, and it is not easy to
measure. A number of different quality metrics have been used in the
literature, but virtually all of them have shortcomings. We review
advantages and disadvantages of the most important ones in Chapter
3.
1.5 In the central part of the paper, we present some theoretical models of
competition on quality in healthcare, and review in detail the studies
which analyse empirically the impact of competition in the English
NHS. The prediction from theory is that competition has ambiguous
effects on quality when prices are set by providers, and leads to
quality improvements when prices are regulated. Interestingly, the
results of the empirical papers reviewed confirm this forecast: in a
context of unregulated prices and block contracts, Propper, Burgess,
Green (2004) and Propper, Burgess and Gossage (2008) show that
competition had a slightly negative impact on quality, measured by
heart attack (AMI) mortality. In the current NHS hospital market, with
fixed prices, Bloom et al. (2010), Gaynor, Moreno-Serra, Propper
(2013), Cooper et al. (2011) and Cooper et al. (2012) find that
competition leads to improvements in (respectively) managerial quality;
AMI and overall mortality; AMI mortality; and length of stay (a
measure of efficiency).
1.6 Despite the use of advanced econometric techniques, the latter four
papers have received some criticisms, especially because they do not
model explicitly the relation between the process of competition and
the measures of quality employed.169 In Chapter 5, we try to shed light
on this relation, reviewing a series of studies, both qualitative and
quantitative, about the behaviour of patients, GPs and providers in
presence of competition in the NHS. Their results show that patient
choice is now a non-negligible reality in the English NHS, that it
depends at least to some extent on quality considerations, and that
providers tend to take patient choice and competition into
consideration when making strategic decisions. In turn, this helps to
169
This is particularly relevant when the indicator of quality refers to emergency procedures, since it is less
straightforward to see how competition for elective services affects quality for emergency services.
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corroborate the findings of the country-level studies by Bloom et al.
(2010), Gaynor, Moreno-Serra, Propper (2013) and Cooper et al.
(2011, 2012).
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2 THE NHS
The organisation of the NHS
2.1 The National Health Service (NHS) was founded on 5 July 1948. As
Rivett explains,170 the idea underpinning its creation was to provide
care free at the point of delivery for everybody, financing it almost
entirely by central taxation. 66 years later, these precepts are still
valid; in fact, the first two principles of the NHS Constitution (2013)
state that
 the NHS provides a comprehensive service, available to all, and
 access to NHS services is based on clinical need, not an individual's
ability to pay.171
2.2 The NHS provides different types of healthcare services, the most
important being primary care, secondary care, tertiary care, mental
health and community health services:172
 Primary care services are those offered by General Practitioner (GP)
practices, dentists, pharmacists and opticians. NHS walk-in-centres
and services such as NHS Direct telephone can be considered part
of primary care too.
 Secondary care refers to services provided by specialists (such as
dermatologists, cardiologists, gynecologists), usually in hospitals.
Patients are referred to them by their primary care provider, usually
their GP.
 Tertiary care consists of specialised health care, usually provided on
referral from GPs or secondary health professionals. Tertiary care
services (such as cancer management, neurosurgery and plastic
surgery) tend to be complex and costly, and to be offered in highly
specialised centres.
170
Rivett G. C. 'National Health Service History'. Last accessed on 29 August 2013 from www.nhshistory.net
Although NHS service is still mainly free at the point of use for patients, some charges have been introduced
over the years. For instance, prescription charges in England stood in 2009/10 at £7.20 per item, generating
around 0.5 per cent of the NHS resource budget.
172
Competition Commission (2013, page 40).
171
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 Mental health services concern the treatment of mental health
conditions and of other conditions such as autistic spectrum
disorders, dementia, recovery from a stroke and drug and alcohol
dependency.173 They are provided in both hospital and community
settings.
 Community health services are health and social care services
provided in residential and community settings, sometimes for
public health interest. They include school nursing, district nursing,
nutrition and dietetics, diabetes care, health visiting, mental health
services.
2.3 Primary care plays a fundamental role in the NHS, since the GP is
generally the first medical professional to interact with patients,
suggesting them a course of action. This could consist, for instance, in
the prescription of a medication, or in a referral to a specialist.174 Most
GPs are independent contractors working as part of a multi-disciplined
practice, but an increasing number of them are becoming salaried.175
2.4 GP practices in England have on average 4.2 GPs and about 6,600
patients.176 They are paid mainly according to two types of contracts,
the General Medical Services (GMS) and the Primary Medical Services
(PMS).177 The GMS contract covers about 52 per cent of practices,
which are paid a mixture of lump sums, capitation, quality incentive
payments, and items of services.178 The practices with the PMS
contract receive a lump sum which covers the amount they would
have received under GMS, plus payment for additional services they
are required to provide.179
2.5 Secondary, tertiary and community care in England are managed by
NHS trusts, by foundation trusts and by independent and third sector
providers. Trusts are obliged to provide quality care, to stay within
their budget and to meet some targets for the speed of treatment.
173
www.nhs.uk/nhsengland/aboutnhsservices/mentalhealthservices/Pages/Overview.aspx (Last accessed on 29
November 2013). 174
The role of GPs as patients' advisers and its implications for hospital competition are discussed in detail in paragraphs 5.43-5.50. In paragraphs 5.51-5.63, we describe issues related to competition in the market for primary care services.
175
Rivett G. C. 'National Health Service History'. Last accessed on 29 August 2013 from www.nhshistory.net
176
Santos, Gravelle, Propper (2013, page 5).
177
Other contracts are the Alternative Provider Medical Services (APMS) ones.
178
Santos, Gravelle, Propper (2013, page 6).
179
Ibid. 112
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They can merge, either with similar types of trust or with different
ones.180 Hospital trusts, also called acute trusts, are the NHS trusts
which run hospitals (that is, those providing secondary or tertiary
care), controlling their development and their expenses. Some hospital
trusts are centres for more specialised care, or are linked to
universities and provide training to health professionals.181
2.6 In order to gain increased autonomy at hospital level and greater
flexibility in responding to local healthcare needs, trusts may, since a
number of years, apply to the healthcare sector regulator, Monitor, to
become NHS foundation trusts. Many NHS trusts have successfully
attained foundation trust status and there are currently 147 NHS
foundation trusts. Foundation trusts are legally independent entities,
and have substantial managerial and financial freedom. They are
accountable to the community and to local partnership organisations,
for instance because they have to consult and involve in their strategic
planning a board of governors which includes patients, staff, members
of the public, and partner organisations.182 Trusts are allowed to
become foundation trusts if they can prove to be well governed,
financially viable and legally constituted, and if they respect certain
quality standards set by the Care Quality Commission (CQC).183 In the
near future, all NHS trusts are expected to become foundation
trusts.184
2.7 Foundation trusts can retain their surpluses and raise capital from both
the public and private sectors (within borrowing limits determined by
projected cash flows) to invest in new and improved services for
patients and service users.185 They are therefore incentivised to
increase their income,186 and the current payment system ensures that
this objective can be pursued by attracting more patients (at the
expense of other providers).187 Foundation trusts are inspected by the
180
Rivett G. C. 'National Health Service History'. Last accessed on 29 August 2013 from www.nhshistory.net
www.nhs.uk/NHSEngland/thenhs/about/Pages/authoritiesandtrusts.aspx (last accessed on 29 August 2013).
182
Ibid.
183
www.monitor-nhsft.gov.uk/becoming-nhs-foundation-trust/how-the-assessment-process-works/monitors­
assessment-process (last accessed on 29 August 2013)
184
At the moment, there is no formal deadline for trusts to achieve foundation trust status, though this process is
informally expected to be completed by April 2016 (see http://bma.org.uk/working-for-change/the-changing­
nhs/reconfiguration-and-integration/reconfiguration/the-foundation-trust-pipeline). Trusts can become foundation
trusts independently, or through a merger or acquisition involving an existing foundation trust. The process is
made easier by the Trust Development Authority, whose key functions include 'supporting the transition of NHS
Trusts to Foundation Trust status' (www.ntda.nhs.uk/about/).
185
www.nhs.uk/NHSEngland/thenhs/about/Pages/authoritiesandtrusts.aspx (last accessed on 29 August 2013).
186
Competition Commission (2013, page 50).
187
The payment mechanisms providing a link between the number of services provided and the revenues are
described in paragraphs 2.20-2.29 below.
181
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CQC and overseen by Monitor, which is accountable directly to
Parliament. Monitor assesses foundation trusts' financial risk and
quality governance, and can put failing trusts into special
administration.188
2.8 The Health and Social Care Act (HSCA) 2012 introduced significant
changes to the structure and the regulation of the NHS, which came
into force on 1 April 2013; these changes included new arrangements
for the funding of healthcare services. Most NHS services are currently
commissioned by Clinical Commissioning Groups (CCGs), new
authorities which replaced the Primary Care Trusts (PCTs). There are
currently 211 CCGs in England, and all GP practices in the country
belong to a CCG.189 Of a total NHS budget of almost £110 billion,190
CCGs receive £65 billion to commission services which include
emergency care, community care, elective hospital care, mental health
services and learning disability services.191
Figure 1. Funding arrangements from April 2013 onwards
188
The role of a Trust Special Administrator is 'to take control of the provider's affairs and work with
commissioners to ensure that patients continue to have access to the services they need' (www.monitor­
nhsft.gov.uk/sites/default/files/publications/ToPublishFinalTSAGuidanceApril2013.pdf).
189
www.nhs.uk/NHSEngland/thenhs/about/Pages/authoritiesandtrusts.aspx (last accessed on 29 August 2013).
190
www.gov.uk/government/uploads/system/uploads/attachment_data/file/223600/public_expenditure_statistical_an
alyses_2013.pdf
191
Competition Commission (2013, page 52).
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Source: OFT based on a diagram from 'The new NHS in England: structure and
accountabilities' (Nuffield Trust 2013, page 5) and subject to the originator's copyright.
2.9 Most of the remaining NHS services are commissioned by NHS
England, previously known as the NHS Commissioning Board. NHS
England was established in October 2012, and took on its full
functions on 1 April 2013; it is composed of eight directorates, with
four regional operations directorates and 27 Local Area Teams
(LATs).192 NHS England's main functions are overseeing the CCGs and
directly commissioning those services not covered by the CCGs; all the
27 LATs are responsible for commissioning of GP services, dental
services, pharmacy, and certain aspects of optical services, while 10
of them lead on commissioning of specialised services193 across
England. A smaller number of LATs carry out the direct commissioning
of other services, such as military and prison health.194
Figure 2. NHS commissioning bodies - April 2013 onwards
Department of Health
NHS England
4 NHS England regional
commissioning offices
17 commissioning support units
27 Local Area
Teams (LATs)
211 clinical commissioning
groups
Health services: NHS trusts and primary
care services
Source: OFT based on a diagram from 'The new NHS in England: structure and
accountabilities' (Nuffield Trust 2013, page 4) and subject to the originator's copyright.
192
Competition Commission (2013, page 55). Specialised services are those 'provided in relatively few hospitals, accessed by comparatively small numbers of patients but with catchment populations of more than one million' (www.england.nhs.uk/ourwork/d-com/spec­
serv/). 194
www.nhs.uk/NHSEngland/thenhs/about/Pages/authoritiesandtrusts.aspx (last accessed on 29 August 2013)
193
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Incentives for competition in the NHS
2.10 Over the last decade, governments have implemented policies to
extend competition in the NHS. As explained by Mays and Tan (2012),
the current incentives for competition in the provision of hospital
services have been shaped by a series of reforms put into action
between 2002 and 2008. The changes recently introduced by the
HSCA 2012 were built on that structure.
2.11 In the English healthcare system, there exist forms of both competition
in the market and competition for the market. The former occurs when
providers compete for patients who can choose where to be treated.
Competition in the market pertains, for instance, to routine elective
services and maternity services, commonly paid according to fixed
tariffs.195 In other cases, there is competition for the right to be the
sole provider of certain services within an area, through competitive
designation processes managed by the relevant commissioning
entities. This competition for the market occurs usually for community
services, mental health services and some non-elective services; the
winner of the competitive process receives a contract to provide these
services for a number of years, according to a certain standard. In the
rest of our study we will focus mostly on competition in the market,
which has received greater attention in the literature.
2.12 In paragraphs 2.17-2.34, we describe in detail the mechanisms
introduced by the NHS reforms over the last 10 years to incentivise
competition. The most relevant ones were Payment by Results (PbR),
patient choice, Any Qualified Provider (AQP) and the expansion of the
independent sector treatment centres (ISTCs). PbR links payments to
volumes treated through a system of fixed tariff prices, which should
incentivise hospitals to compete on quality. If patients can choose
where to be treated, and they choose higher quality providers, then
payments should favour these providers.196 AQP and the expansion of
the ISTCs allow patients to choose from more providers, both public
and private.
195
Competition in the market also concerns GPs, AQP community services and some AQP mental services (for example, IAPT).
196
This is because patients are expected to base their choice of provider on quality factors, at least in part. High
quality providers should thus treat more elective patients, and then receive more payments.
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2.13 In 2007, these arrangements were reinforced when the Department of
Health issued 10 (non-statutory) 'Principles and Rules for Cooperation
and Competition' (the Principles and Rules), which included conditions
on commissioners, cooperation and agreements, conduct of individual
organisations, mergers and vertical integration.197 The task of ensuring
understanding of and compliance with the Principles and Rules was
assigned to the Cooperation and Competition Panel (CCP), which
issued guidelines explaining how it would assess complaints.
2.14 Following the HSCA 2012, the CCP is now part of Monitor as the
Cooperation and Competition Directorate, and the substance of the
Principles and Rules has become statutory. The rules regarding
commissioners' duties are stated in The National Health Service
(Procurement, Patient Choice and Competition) (No.2) Regulations
2013198. The rules regarding providers are built in Monitor's new NHS
provider licence199, whose condition C2 states that:
'The Licensee shall not: (a) enter into or maintain any agreement or
other arrangement which has the object or which has (or would be
likely to have) the effect of preventing, restricting or distorting
competition in the provision of health care services for the purposes of
the NHS, or (b) engage in any other conduct which has (or would be
likely to have) the effect of preventing, restricting or distorting
competition in the provision of health care services for the purposes of
the NHS, to the extent that it is against the interests of people who
use health care services'200
2.15 Monitor has produced a number of guidelines explaining the
functioning of the new system and its implications for commissioners
and providers, and will publish other documents in the future.201
197
Department of Health (2009)
Regulation 10(1) states that 'when commissioning health care services for the purposes of the NHS, a relevant
body
must not engage in anti-competitive behaviour, unless to do so is in the interests of people who use health care
services for the purposes of the NHS which may include (a) by the services being provided in an integrated way
[…] (b) by cooperation between the persons who provide the services in order to improve the quality of the
services'
199
The licence (which contains conditions on pricing, choice and competition, integrated care, continuity of
services and NHS foundation trusts) has already been issued to foundation trusts; most of the other providers will
need a licence from April 2014 (www.monitor.gov.uk/licence).
200
Particularly relevant for competition is also condition C1, which 'protects patients' rights to choose between
providers by obliging providers to make information available and act in a fair way where patients have a choice
of provider' (www.monitor-nhsft.gov.uk/sites/default/files/publications/ToPublishLicenceDoc14February.pdf).
201
See www.monitor-nhsft.gov.uk/regulating-health-care-providers-commissioners/cooperation-and­
competition/our-cooperation-and-compe for Monitor's publications about cooperation and competition.
198
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Together with the previous publications from the CCP,202 they are
intended to increase the general awareness of the rules regarding
competition in the NHS, and to explain to commissioners and providers
how to comply with them. Moreover, from 1 April 2013 Monitor has
concurrent powers with the OFT to enforce provisions of the
Competition Act 1998 and the Treaty on the Functioning of the
European Union in relation to the provision of healthcare services in
England.203
2.16 With regard to hospital mergers, the legislation provides that the OFT
will review the relevant mergers between NHS foundation trusts, and
between NHS foundation trusts and other enterprises.204 The OFT
published a set of frequently asked questions documents (the FAQs),
which clarifies that it considers NHS trusts to fall within the definition
of 'enterprise' and as such can be reviewed by the OFT under the
merger control provisions of the Enterprise Act 2002 (EA02).
However, the FAQs clarify that mergers involving only NHS trusts
would not constitute a relevant merger situation, as the trusts would
remain under the common control of the Secretary of State for
Health.205,206 However, Monitor may review such arrangements, and
advise the NHS Trust Development Authority on their competition
implications. Under the HSCA 2012, Monitor is also required to
provide advice to the OFT on relevant customer benefits for mergers
under review involving foundation trusts.207 At an earlier stage,
moreover, it can offer informal advice to trusts on how to assess
prospective patient benefits and competition implications of mergers.
This is part of the regulatory framework which the OFT, CC and
Monitor are responsible for, intended (among the other things) to
'reduce the number of mergers requiring notification', to 'minimize the
202
See www.monitor-nhsft.gov.uk/regulating-health-care-providers-commissioners/cooperation-and­
competition/archive-co-operation-and--1 for an archive of guidelines regarding the Principles and Rules, and
www.monitor-nhsft.gov.uk/regulating-health-care-providers-commissioners/cooperation-and-competition/our­
cooperation-and-compe for a series of documents on the implications of competition rules under the HSCA 2012
203
www.monitor-nhsft.gov.uk/sites/default/files/publications/ToPublishCCPGuidanceonCA98March13.pdf.
204
The OFT's role in reviewing NHS mergers - Frequently Asked Questions (paragraph 25). Following the
enactment of the Enterprise and Regulatory Reform Act 2013, from 1 April 2014 these mergers will be reviewed
by the Competition and Markets Authority.
205
The OFT's role in reviewing NHS mergers - Frequently Asked Questions (paragraphs 24-25)
206
Section 26 of the EA02 states that for the purposes of UK merger control, 'any two enterprises cease to be
distinct enterprises if they are brought under common ownership or common control'. To the extent that
enterprises are already under common ownership or common control, a merger between them would therefore
not satisfy this criterion such that they would not 'cease to be distinct'.
207
The OFT'S role in reviewing NHS mergers - Frequently Asked Questions (paragraph 26-27). See also
www.monitor-nhsft.gov.uk/regulating-health-care-providers-commissioners/cooperation-and­
competition/principles-and-rules-coop
118
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risk of lengthy merger review', and to 'enable mergers that will have a
positive overall effect for patients to proceed'.208
Payment by Results
The case for price regulation
2.17 It is widely acknowledged that healthcare markets are far from
satisfying most of the requirements characterising perfectly
competitive markets.209 As pointed out by Dranove and Satterthwaite
(2000), two of the most prominent market failures present in
healthcare systems are the asymmetries of information between
patients and providers (as we will discuss in Chapter 5 in more detail)
and the high costs of search for patients. Given these features,
competition on both prices and quality in healthcare markets may not
deliver a socially optimal combination of these two variables. For
instance, Gaynor (2006) presents a number of theoretical models
which show that competition with market-determined prices may
result in the optimal equilibrium level of quality, but may as well
produce quality too high or too low from a social welfare perspective.
2.18 A possible, second best solution to this problem consists in forms of
price regulation for healthcare services, as that currently implemented
in the English NHS through the Payment by Result (PbR) payment
scheme.
2.19 As we will see in paragraphs 4.1-4.15, theoretical models generally
predict a positive effect of competition on quality when prices are
fixed. Regulated healthcare prices might thus stimulate improvements
in quality.210 A key message from the literature, however, is that the
sign of this effect actually depends on the price level set by the
regulator:211 if the tariff is lower than marginal cost, providers are
208
Joint statement from the Office of Fair Trading, the Competition Commission and Monitor, 17 October 2013 (available at www.oft.gov.uk/shared_oft/press_release_attachments/OFT-CC-Monitor.pdf).
209
Hurley (2000), Dranove and Satterhwaite (2000).
210
In addition, price regulation can also be a means to stimulate improvements in cost-efficiency. The rationale for the implementation of fixed prices based on average costs is explained by the model of 'yardstick competition' presented in the seminal paper by Shleifer (1985). In a yardstick competition setting, the 'regulator uses the costs of comparable firms to infer a firm's attainable cost level'. In his baseline model, Shleifer (1985) describes the case of competition between identical firms serving different markets. Each firm is assigned a 'shadow cost' equal to the mean marginal cost of all other firms. The presence of this cost 'yardstick' forces firms to compete and stimulates cost efficiency. Indeed, firms are incentivised to be more efficient than the average in order to obtain a higher margin, while firms less efficient than the average may incur losses. 211
See paragraphs 4.5-4.15.
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expected to reduce the quality of their services in response to
increases in competition. If, on the contrary, tariffs are too high, the
level of quality provided may be excessive from a social perspective.
Setting the 'right' level of tariff, therefore, is likely to be a finely
balanced exercise. In the following paragraphs, we will describe how
tariffs are set in the English NHS at the moment. Then, we will discuss
strengths, limitations and possible future modifications of the current
payment system.
Price regulation in practice: Payment by Results
2.20 PbR is an activity-based funding system, consisting in the payment of
a fixed tariff for each patient a provider treats, based on the national
average cost of the particular service received by the patient. This
mechanism is similar to the Prospective Payment System (PPS)
introduced in the U.S. for Medicare in 1983, which pays a fixed sum
per patient on the basis of the diagnosis related group (DRG) to which
the patient is assigned.212
2.21 The PbR regime links the work a provider does and the money it
receives, thus offering incentives for trusts to compete with each
other for patients.213 Since prices are fixed, competition for PbR
services is intended to be on quality.
2.22 PbR was introduced in 2003/04, initially only for some hospital
services. Over time, the number of procedures paid by a tariff has
gradually increased; as quantified by Appleby et al. (2012), in
2011/12 it represented nearly 60 per cent of an average hospital's
activity, and included almost all elective and emergency services.
Hospital services are divided in units, the healthcare resource groups
(HRGs), and a different tariff is calculated for each HRG. The tariff is
based on the national average cost of the HRG, adjusted for a market
forces factor (MFF) which takes account of local differences in costs
(for instance, the costs of land and labour).214
2.23 The PbR tariffs can be adapted in several ways, in order to provide
more effective incentives. For instance, all tariffs are reduced by four
212
Chalkley and Malcomson (2000).
There are also other forms of payment decided at local level, such as local tariffs (similar to PbR, but locally set) or block contracts, which remunerate providers irrespective of the number of patients treated.
214
Appleby et al. (2012, page 8).
213
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to five per cent every year, with the aim of fostering a constant and
general improvement in efficiency.215 Moreover, the presence of a
'marginal rate emergency tariff' makes emergency non-elective
treatments potentially less profitable,216 in order to incentivise
commissioners and providers to 'support the shift of care out of
hospital settings and keep the number of emergency admissions to a
minimum'.217
2.24 There exist a number of additional pricing mechanisms, which provide
incentives for trusts to achieve particularly high levels of quality. First,
hospitals suffer a financial loss if one so-called 'never event' occurs,218
second, a limited number of services are associated to best practice
tariffs, designed to reimburse for the cost of high quality care; third,
the Commissioning for Quality and Innovation (CQUIN) payment
framework makes a proportion of providers' income conditional on
locally agreed goals around quality and innovation.219
2.25 The HSCA 2012 assigned to Monitor and NHS England the
responsibility for the national tariff from 1 April 2014. Monitor's role
will consist in developing the methodology for price setting; calculating
prices; regulating and approving local modifications; enforcing the
pricing regime.220 This last task, in particular, is important for the
correct functioning of the pro-competitive incentives. For instance, the
CCP review of the operation of 'any willing provider'221 found that
some PCTs were imposing restrictions on the number of patients a
provider can treat or will be paid for treating, using for example block
and capped contracts and implicit threats of non-payment.222 These
kinds of arrangements would remove the incentives for NHS trusts to
215
Appleby et al. (2012, page 8) and Competition Commission (2013, page 78).
Under this framework, only 30 per cent of the normal PbR tariff is paid on all services resulting from
emergency admissions once the total value of all these services in a given year exceeds the value in 2008/09
(adjusted to current year prices).
217
Department of Health (2013b, page 26).
218
'Never events' are serious safety incidents like wrong site surgery or retained instruments post-operation.
219
Appleby et al. (2012, page 11) and Competition Commission (2013, page 78).
220
With regard to the development of the pricing methodology, the HSCA also assigned a role to the Competition
Commission. Indeed, if more than 51 per cent of 'relevant providers' or 51 per cent of CCGs object the method of
determining the prices proposed by Monitor, the method could be referred to the CC, to which objectors would
then have the opportunity to make representations (see
www.monitor.gov.uk/sites/default/files/publications/2014%2015%20National%20Tariff%20Payment%20System
%20A%20Consultation%20Notice%20-%201810.pdf).
221
CCP (2011, paragraphs 92-108)
222
After the publication of the review, the Department of Health intervened in the debate about block and capped
contracts. In November 2011, as noted in Competition Commission (2013, page 81), the Secretary of State for
Health responded to the CCP's report, banning PCTs from putting in place caps on operations which do not take
account of needs of patients.
216
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compete to attract additional patients, and would therefore weaken
their incentives to improve hospital quality.
2.26 However, Monitor is aware of these risks. In the context of
Competition Commission's assessment of the Bournemouth and Poole
merger, Monitor provided the CC with a submission stating that:
 'The use of rigid caps and floors on activity is inconsistent with the
fundamental principle of PbR that payment should be based on the
number and complexity of cases treated.'
 'To the extent that block contracts may restrict choice or
competition, Monitor may seek to take enforcement action under
the Health and Social Care Act 2012, the Procurement, Patient
Choice and Competition Regulations, or the provider license.'223
PbR: strengths, weaknesses and future evolution
2.27 As we discussed above, PbR plays a key role in the development of
competition in the NHS, since it ensures that payments follow the
patients, and hospitals are rewarded for their volume of activity. In this
way, financially sensitive providers are supposed to compete to attract
patients; given that prices are fixed, competition is expected to be on
quality. In Chapter 4 , in fact, we will show that the empirical
evidence on competition in the new NHS market seems to suggest
that the mechanisms introducing competition (including PbR) have
been successful in fostering quality improvements.224
2.28 Over the past years, however, a series of studies have highlighted
some weaknesses of the payment system currently in place in the
English NHS.225 In its role of being responsible for the national tariffs,
Monitor is also aware of these issues: in a recent discussion paper,226
223
See Competition Commission (2013), pages 81-82.
Interestingly, in paragraphs 4.39-4.40 we will also review a study that finds, in presence of fixed PbR prices, a
positive impact of competition on a measure of cost efficiency, the average length of stay of patients.
225
See for instance Appleby et al. (2012), already discussed in paragraph 2.22 above; other examples are:
Patient Level Costing: Can it yield efficiency results? (www.nuffieldtrust.org.uk/publications/patient-level-costing­
can-it-yield-efficiency-savings); An evaluation of the reimbursement system for NHS-funded care - A Report for
Monitor (www.monitornhsft.gov.uk/home/news-events-publications/our-publications/monitors-new­
role/evaluation-the-reimbursementsystem-0); Accountability Hearing with Monitor
(www.publications.parliament.uk/pa/cm201213/cmselect/cmhealth/652/652.pdf). See also Competition
Commission (2013), which mentions some complaints of providers about the payment system.
226
How can the NHS payment system do more for patients? (www.monitor­
nhsft.gov.uk/sites/default/files/publications/How%20can%20the%20NHS%20payment%20system%20do%20m
ore%20for%20patients_0.pdf).
224
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it acknowledges that the new payment system should reflect
outcomes more than activities; create incentives for integrated care;
be based on more accurate information on costs and quality; allow
flexibility, but only under clear rules; have a long-term perspective,
that fosters innovation from providers.
2.29 Outlining its approach to costing, Monitor has also explained that its
long-term vision is to change the main source of cost data on which
regulated prices are based, moving towards using the cost of treating
each patient rather than the average cost.227 At the moment, indeed,
tariffs depend on the average national cost of single healthcare
resource groups (HRGs);228 in the future, Monitor's intention is to use
data on cost at patient-level to calculate the regulated prices for the
various providers.229 It is worth noting, however, that these prices
would remain per-unit, thus ensuring that 'money follows the patients'
and in turn stimulating quality competition.
Patient choice, AQP and ISTCs
2.30 At the present time, users of healthcare services in England are
entitled to numerous opportunities of choice. As the 2013/14 Choice
Framework states230, patients have the right to choose (up to a certain
extent) their GP practice, their provider of a specialised test, and both
the provider and the specific consultant for their first consultant-led
outpatient appointment for elective care.231
2.31 The introduction of forms of patient choice of provider for primary and
secondary care was the biggest change implemented in the NHS in the
2000s; indeed, the reforms occurred in those years are sometimes
collectively labelled as 'patient choice reforms'. From 2006 to 2008,
patients were offered a choice of at least four hospitals, and a choice
of a date and time for their appointment. Since 2008, all patients
227
Costing Patient Care: Monitor's approach to costing and cost collection for price setting (www.monitor­
nhsft.gov.uk/sites/default/files/Costing%20Patient%20Care%20201112%20%20FINAL_0.pdf)
228
See paragraph 2.22.
229
It is interesting to note that this approach is backed by theoretical studies too. Indeed, Shleifer (1985) also
argues that yardstick competition is not the optimal way of regulating prices when firms are heterogeneous and
the regulator observes the characteristics that make firms differ. If this is the case, the author shows that the
optimal approach involves estimating a regression of costs on the observed characteristics that determine
diversity.
230
Department of Health (2013)
231
At the moment, the NHS Constitution states that patients have the right to choose the organisation that
provides their NHS care when they are referred for their first outpatient appointment with a service led by a
consultant. Even if it is not a right, choice of maternity provider exists in practice. Choice in mental health will be
added to the NHS constitution in April 2014.
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needing routine elective care in England have been able to choose
between any NHS or independent sector provider which respect the
CQC quality standards and are willing to provide services at the PbR
tariff.232 This policy, previously known as Any Willing Provider (AWP),
is now called Any Qualified Provider (AQP).
2.32 Patients' right of choice is enshrined in the NHS Constitution since
2009,233 during the years, a series of tools which should make it easier
for patients to exercise their right has been developed. The Choose
and Book system, for instance, is supposed to give patients and GPs
the opportunity to easily book an appointment with the selected
provider; websites such as NHS Choices and Dr Foster collect
comparative data on healthcare providers, GP practices and
consultants, allowing patient to make more informed choices.
2.33 Advocates of patient choice claim that it can lead to an increase in the
quality of healthcare services for patients.234 Given the PbR scheme,
providers should be incentivised to attract more patients in order to
earn additional revenues. If patients can choose where to receive
treatment, or where GPs choose on their behalf, providers should try
to attract them offering the services needed. Since prices are fixed,
they would have an incentive to invest time and resource to provide
patients a higher level of quality. Several studies have tested
empirically the validity of this hypothesis which we will discuss
extensively in Chapter 4.
2.34 Over the past decade, a number of government policies have
encouraged healthcare commissioners to consider different types of
provider organisations, including both not-for-profit and for-profit
independent providers, when commissioning healthcare services. The
most relevant intervention to promote independent sector provision is
represented by the Independent Sector Treatment Centre (ISTC)
programme, implemented through two waves, started in 2003 and in
2007.235,236 ISTCs are privately owned structures, but under contract
to provide services only to NHS patients, with prices (loosely) based
on the NHS tariff. As pointed out by Naylor and Gregory (2009),
232
See www.cqc.org.uk/organisations-we-regulate/registering-first-time/essential-standards for information about the essential standards for providers.
233
Department of Health (2009b).
234
Dixon et al. (2010, page 2) and Blair (2003, cited by Appleby et al. (2003)).
235
Kelly and Tetlow (2012). 236
Recently, private hospitals with standard acute contracts are having an impact as well.
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ISTCs were created in 2003 to provide extra capacity and help the
NHS reduce waiting times, while their expansion, in 2007, was
intended also as an additional means to stimulate patient choice and
competition. Indeed, the latter policy had objectives which included
'providing patients with a greater choice of providers' and 'introducing
competition with the intention of stimulating NHS providers to improve
their own services'.237 ISTCs currently provide a small but growing
proportion of NHS elective care services, mostly concentrated in
orthopedics, gastroenterology and ophthalmology.238 Recent evidence
on the impact of the ISTC programme in relation to patient choice is
reviewed in Chapter 5 .
237
238
Department of Health (2006a), House of Commons Health Committee (2006)
Naylor and Gregory (2009), Kelly and Tetlow (2012).
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3 MEASURES OF QUALITY IN HEALTHCARE
Definitions of quality
3.1 There is a lack of consensus around the definition of quality in
healthcare. The quality of healthcare systems and services is a
multidimensional concept, but there is little agreement on which its
dimensions are; in fact, patients, medical professionals and policy
makers may have different preferences for some aspect of quality over
others. With regard to healthcare systems, Donabedian (2003) argues
that quality can be characterised by a number of attributes which
include efficacy, effectiveness, efficiency, optimality, acceptability,
legitimacy and equity. The World Health Organisation (2006) lists
effectiveness, efficiency, accessibility, centrality of patients, equity
and safety as components of quality which could and should be
improved.
3.2 A report by Lord Darzi (2008) produced a working definition of quality
in healthcare for the NHS, which includes the following three
dimensions:
 Patient safety. 'The first dimension of quality must be that we do
no harm to patients. This means ensuring the environment is safe
and clean, reducing avoidable harm such as excessive drug errors or
rates of healthcare associated infections.'239
 Patient experience. 'Quality of care includes quality of caring. This
means how personal care is – the compassion, dignity and respect
with which patients are treated. It can only be improved by
analysing and understanding patient satisfaction with their own
experiences.'240
 Effectiveness of care. 'This means understanding success rates
from different treatments for different conditions. Assessing this
will include clinical measures such as mortality or survival rates,
complication rates and measures of clinical improvement. Just as
important is the effectiveness of care from the patient's own
239
240
Lord Darzi (2008), page 47.
Ibid.
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perspective which will be measured through patient-reported
outcomes measures (PROMs). Examples include improvement in
pain free movement after a joint replacement, or returning to work
after treatment for depression. Clinical effectiveness may also
extend to people's well-being and ability to live independent
lives.'241
Measuring quality in competition studies
3.3 In studies which assess the impact of healthcare competition on
quality, the choice of the quality measure often plays a fundamental
role. The relevant literature has generally favoured measures of
effectiveness of care, in particular mortality rates. Following Mordoh
(2011), we outline the issues arising in competition studies with
regard to quality measures, and to mortality rates in particular. We
then analyse advantages and disadvantages of the most used measure
of quality, the acute myocardial infarction (AMI) mortality rate. We
conclude this section suggesting measures of quality which could be
used more frequently in competition studies.
The choice of quality measures
3.4 The first condition a meaningful quality measure should fulfill is that it
reflects as much as possible the quality of care provided. This might
seem tautological, but arguably some indicators are better than others
in capturing the quality of healthcare services. Indeed, all healthcare
outcomes have a relevant random component, and depend only to a
certain extent on what healthcare providers do. The outcome of some
measures, however, is under hospitals' control to a more substantial
extent, and therefore these measures can be expected to better
capture a provider's quality.
3.5 Mordoh (2011) claims that, in order to provide meaningful results, the
quality measure chosen in studies on competition and quality should
also depend on the competitive pressure affecting providers, at least
to some extent. That is, there should be some causal mechanisms
which can link the process of competition and the quality indicator. As
we will see in more detail below, this is a controversial point for most
241
Ibid.
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of the available studies on competition and quality, which use
mortality rates for non-elective procedures as dependent variables, and
do not themselves model explicitly how they are affected by
competition for elective services.
3.6 As we noted in paragraphs 3.1-3.2, healthcare quality is a
multifaceted concept, and indeed Rosenthal (1997) and Romano and
Mutter (2004) argue that providers can perform well in some
dimensions and badly in other ones. Some authors take into account
this problem, and consider quality measures relative to multiple
dimensions; for instance, Beckert, Christensen and Collyer (2012) use
both mortality rates and the number of methicilin-resistant
staphylococcus aureus (MRSA) infections. Other papers, however,
focus only on one condition or surgical procedure, even though they
usually analyse it with respect to different outcomes, such as mortality
rates, readmission rates and complication rates. Examples of this
second type of study are Kessler and McClellan (2000) and Cooper et
al. (2011), which use only the outcomes for patients treated for an
AMI.242
3.7 Raw quality indicators should usually be adjusted in order to take into
account the different hospitals' case mixes; otherwise, divergences in
outcomes could reflect not only the differences in the quality of care,
but also those in patients' grade of illness and co-morbidities. As
explained in Romano and Mutter (2004), the risk adjustment can be
done in various ways.243 When providers have the opportunity to
choose patients, or when sicker patients may choose to be treated in
the best hospitals, selection bias might be particularly relevant. This is
one of the reasons why researchers usually prefer mortality rates for
A&E procedures as indicators of quality, since most of the time
hospitals cannot choose their emergency patients, and vice versa.244
3.8 When choosing a measure of hospital quality, it is important to select
the appropriate time period over which it is calculated. Using short
time periods does not account for the long term effects of treatment;
longer periods allow taking them into consideration, but might
introduce more noise, since factors other than a provider's quality may
242
However, it must be noted that Cooper et al. (2012) uses the same methodology as in Cooper et al. (2011) to study the effect of competition on a measure of hospital efficiency, the average length of stay.
243
It may involve, for example, the adjustment of the dependent variable, or the use of patient-level controls.
244
The location of the hospital, however, would still be relevant.
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affect the outcomes. Researchers often use 30-day mortality rates,
which can be either 'in-hospital' or 'post-admission'. In-hospital rates
are based on the number of deaths within 30 days of the admission
which occurred in the hospital, while post-admission (or case-fatality)
rates take into consideration also the patients discharged from the
hospital. The choice between them is often based on the availability of
data, but can become a source of controversy, as in the debate
between Pollock et al. (2011) and Bloom et al. (2011).245
3.9 Ideally, a quality measure selected for empirical studies should be
based on a significant number of occurrences, because statistical
problems may arise when calculations are derived from few
observations. Measurement errors are further statistical complications
which should be addressed. Virtually all the procedures in hospitals are
inherently vulnerable to mistakes in the recording process, but some of
them may also be vulnerable to gaming or manipulation.
3.10 In the previous paragraphs, we followed Mordoh (2011), and saw
which conditions should be fulfilled by a measure of quality used in
studies concerning competition and quality. Ideally, good quality
indicators should reflect the actual quality of care provided; be linked
to the process of competition; take into account the
multidimensionality of hospital quality; be risk adjusted to control for
selection bias; have the right time specification; be linked to highvolume clinical procedures; be measured without errors. In the next
paragraphs, we consider how many of these conditions are met by the
quality indicators used in the literature, in particular by the AMI
mortality.
The AMI mortality rate
3.11 Acute myocardial infarction (AMI) is the medical term for the event
commonly known as heart attack. The AMI death rate is the most
commonly used measure of quality in the analysis of the effects of
competition on hospital quality. It appears in 19 out of the 28 studies
245
Indeed, Pollock et al. (2011) criticise Cooper et al. (2011) for the use of in-hospital heart attack mortality for
all-age patients, but do not acknowledge that Gaynor, Moreno-Serra and Propper (2013) come to results very
similar to those of Cooper et al. (2011) employing heart attack mortality within 30 days in any location, for
patients aged between 35 and 74.
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reviewed by Mordoh (2011), and in five out of the six studies which
use NHS data and are reviewed in Chapter 4.246
3.12 The scholars supporting the use of AMI mortality claim that it has
many of the characteristics necessary for a good indicator of hospital
quality. Indeed, Gaynor, Moreno-Serra and Propper (2013) and Cooper
et al. (2011) argue that:
 In AMI procedures, there is a link between timely and high-quality
intervention and patients' survival, especially because AMI patients
are highly influenced by quality of hospital care.
 AMI mortality can be used as a mono-dimensional measure of
hospital quality, because it is correlated with other indicators, such
as length of stay and waiting times of knee and hip replacement,
and overall hospital mortality rate.247
 AMI is an emergency procedure, so all patients with symptoms of
AMI are admitted. This implies that there is less scope for selection
bias.
 Since AMIs are relatively common, and death is unfortunately a
fairly frequent outcome, hospitals deal with a substantial number of
occurrences; the variability of rates is thus less of an issue than for
other treatments.
 Unlike many measures relative to elective procedures, AMI rates are
not subject to gaming and manipulation.
 The endogeneity between market structure and hospital quality is
attenuated by using a measure of quality for non-elective
procedures (such as AMI) rather than one for elective treatments.248
3.13 However, the use of AMI mortality as a measure of quality has been
the object of considerable debate. Pollock et al. (2011) strongly
criticise the work of Cooper et al. (2011), pointing out problems which
arise from their selection of the quality variable. For instance, they
claim that AMI mortality rates should not be considered a good marker
246
The remaining paper, by Cooper et al. (2012), focuses only on a measure of hospital efficiency, the length of stay for four elective procedures. 247
On this point, Propper, Burgess and Gossage (2008) also add that the infrastructure used for the treatment of AMI is common to other hospital services.
248
For a mathematical explanation on this point, see Cooper et al. (2011, Appendix A).
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of general hospital quality, since they would be at best 'a measure of
clinical care in cardiology'. Cooper et al. (2011) present correlations
between AMI mortality and indicators which could represent other
dimensions of quality. These correlations are positive, but their
magnitude is never overwhelming.249 It is therefore not easy to
evaluate the clinical significance of this relationship, and to conclude
that AMI death rate is a good proxy of overall quality.
3.14 As anticipated in paragraph 3.5, another criticism of the studies using
AMI mortality rates as indicator of quality concerns the lack of clarity
about the causal link between competition and the outcomes of
emergency procedures. This makes it difficult to demonstrate the
causality of a relationship between competition and AMI mortality,
especially if the correlation between the latter and the outcomes of
elective treatments is not demonstrated. We examine this issue in
detail in the second part of Chapter 4 .
Other measures of quality
3.15 In paragraphs 3.4-3.9, we outlined criteria which should be followed
to choose the dependent variable in studies of the impact of
competition on quality. In paragraphs 3.13-3.14, however, we have
seen that the indicator most commonly used for this purpose is
unlikely to satisfy all of them. However, other options have been
proposed in the literature, and some of them could arguably be used
more extensively instead of - or as complement to - AMI mortality.
3.16 One possibility consists in the use of mortality rates for other
procedures, either elective or non-elective. The former can present a
stronger causal link to the process of competition, but the latter allow
avoiding endogeneity issues arising from selection bias. Dimick et al.
(2004) list a series of operations for which quality of care is strongly
reflected in mortality after surgery: Coronary Artery Bypass Graft
(CABG) surgery, Repair of Abdominal Aortic Aneurysm, Pancreatic
Resection, Esophageal Resection, Pediatric Heart Surgery, Craniotomy
and Hip Replacement. However, according to the authors only CABG
surgery is performed frequently enough to have a number of
249
In the sample of Cooper et al. (2011), raw AMI mortality has a correlation of r=0.33 with hip and knee
replacement waiting times, and a correlation of r=0.11 and r=0.22 with the length of stay for hip and knee
replacement, respectively. Cooper et al. (2011) also present a result from Dr, Foster Health, which found a
correlation r=0.33 between AMI and overall mortality in 2009/10.
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occurrences sufficient for identification purposes; therefore, only
CABG mortality should be used in empirical studies.250
3.17 Employing one indicator of overall hospital mortality can also raise
several concerns. First, scholars like Bamezai, Mukamel and Zwazinger
(2002) argue that all-cause hospital mortality rates may be biased
towards zero, because hospitals perform differently in different areas,
so low mortality rates in some sectors could balance high mortality
rates in other ones. Second, hospital data have to be risk adjusted in
order to provide a single mortality rate. The risk adjusted measures
most frequently used are the hospital standardised mortality ratios
(HSMRs), which compare the observed numbers of deaths in a given
hospital with the expected number of deaths based on national data,
after adjustment for factors that affect the risk for in-hospital death,
such as age, diagnosis and route of admission.251,252
3.18 HSMRs are widely used, and remain one of the key quality measures
in the NHS. However, they might be subject to a number of flaws. As
explained in Papanicolas and McGuire (2011), many authors have
concerns around the reliability of these indicators, since they are based
on techniques of risk adjustment on which there is little consensus,
and which could actually increase the bias they are intended to
reduce. Black (2013) argues that HSMRs are dependent on nonhospital care, flawed by data inaccuracy, based on a mistaken concept
and on an inadequate case-mix adjustment, and not validated.
3.19 The skepticism around HSMRs is also due to the presumption that
mortality, in general, may not always be a valid measure of quality.
For instance, Gravelle et al. (2012) find that (risk adjusted) mortality
for high risk conditions has very low correlations with indicators of
quality for elective procedures, and with measures of patient
experience. Pitches, Mohammed and Lilford (2007) review 36 studies,
and find a positive association between risk adjusted mortality and
quality of care only in half of the cases examined.253 Bevan and
Skellern (2011) show that no significant relation exists between
250
Indeed, it has been used by Gaynor, Propper, Seiler (2012).
Shojania and Forster (2008)
252
Another measure increasingly used together with HSMRs is the Summary Hospital-level Mortality Indicator (SHMI), which is 'the ratio between the actual number of patients who die following treatment at the trust and
the number that would be expected to die on the basis of average England figures, given the characteristics of
the patients treated there' (www.hscic.gov.uk/SHMI) 253
Indicators of quality are obtained 'from patient case-notes and/or clinical databases ("explicit review") or expert panels which judged quality of care typically in the form of inspection reports ("implicit review")'.
251
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hospitals' HSMRs and measures of quality for hernia repair and hip
replacement,254 and state that 'mortality rates in any form do not […]
provide a good measure of elective surgery'.
3.20 Virtually all empirically used quality metrics can be criticised:
readmission rates, for instance, have been employed quite often in the
literature, but are not exempt from problems. Papanicolas and McGuire
(2011) point out that they cannot always be attributed to the quality
of care provided. Indeed, high readmission rates can be due not only
to poor hospital quality, but also to poor quality of other parts of the
health systems, or to poor adherence of patients to doctors'
recommendations. They could even be a result of good quality of care,
if improved hospital technology allows more severely ill patients to
survive, but with worsened mobility and subsequent need of hospital
readmission.
3.21 In order to overcome most of the issues related to mortality rates,
other measures which are specific to non-emergency surgery could be
more widely used in the future competition studies. The most
important are the Patient Reported Outcome Measures (PROMs),
which have been collected by all providers of NHS-funded care since
April 2009 (even if they were only experimental data until summer
2011). PROMs assess the quality of care from the patient perspective,
through questionnaires administered to patients undergoing four
elective procedures: hip replacement, knee replacement, groin hernia
and varicose veins. Patients are asked the same questions before and
after treatment in order to assess the health gain from the procedure.
3.22 As mentioned above, PROMs have become available only recently, and
researchers are likely to start using them in the near future. Since
PROMs data before the introduction of the patient choice reforms do
not exist, identification strategies like those used by Cooper et al.
(2011) and Gaynor, Moreno-Serra and Propper (2013) cannot be
implemented. However, Bevan and Skellern (2011) suggest that the
impact of patient choice and competition on PROMs in the English
NHS could be evaluated exploiting the differences with the other UK
countries.
254
These are Patient Reported Outcome Measures (PROMs) for hernia repair and hip replacement (see paragraphs
3.21-3.22 below).
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Measures of quality available to the public
3.23 Reliable measures of healthcare quality are needed not only by
researchers to investigate the effects of hospital competition, but also
by patients, GPs, providers, commissioners, regulators and
competition authorities, to correctly assess the quality of services
provided. In particular, the availability of significant indicators could
help choice by patients and other users of healthcare services,
stimulate competition and increase the performance of providers.
3.24 As we mentioned in paragraph 2.32Error! Reference source not
found., indeed, patient choice reforms were accompanied by an
increase in the publication of data on quality, which was expected to
improve information with beneficial effects on quality itself. The
availability of information is generally expected to make quality
comparisons between hospitals easier for GPs and patients, increasing
the responsiveness of demand and therefore also the marginal
incentive to increase quality. Indeed, both Sisk (1998) and Love, Paita,
Custer (2001) stress the importance of data publication and
dissemination strategies for fostering competition in healthcare.255
3.25 It is worth noting, however, that the existence of information available
to the public could lead to quality increases by itself, even without the
presence of patient choice. Indeed, the publication of information
about their quality could motivate providers and clinicians to improve
their performance because of concerns about their public image and
reputation, and not only because of the threat of losing patients and
revenue. This is suggested for instance by Hibbard, Stockard, Tusler
(2003), who use data for Wisconsin, and find that making information
about healthcare performance public fostered quality improvement.256
In a NHS context, Bridgewater et al. (2007) find that the publications
of surgeons' survival rates stimulated performance improvements (and
no apparent selection of patients by surgeons); as suggested by
Coulter (2010), this effect appears to have been driven by the impact
255
However, Gravelle and Sivey (2010) come to a different conclusion modeling hospital competition between
two hospitals with large quality differences. In that situation, better information about quality can lead to lower
quality. Furthermore, Katz (2013) models three situations in which 'providing more precise signals of provider
quality can lead to lower equilibrium quality'.
256
In this setting, patient had the possibility of choosing where to be treated. However, providers seemed to
react to the publication of information because of concerns about reputation, rather than market shares.
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of publication on clinical teams, rather than by the use of the
information by patients.257
3.26 For all these reasons, it seems important to understand which
measures are available to the public, because one would expect
providers to focus on performance improvements on those metrics.
Indeed, one of the conclusions of the paper by Propper, Burgess and
Gossage (2008), which studies the impact of hospital competition in
the 1991-97 NHS 'internal market', is that ' hospitals in competitive
markets reduced unmeasured and unobserved quality in order to
improve measured and observed waiting times'.258 This implies that
the choice of quality indicators to be published is likely to be an
important decision itself.
3.27 In the NHS, a growing number of indicators are available to patients
and GPs, for instance through NHS Choices, Dr Foster and the CQC.259
NHS Choices allows users to compare public and private hospitals with
respect to adjusted mortality rate, MRSA infection rate, responses to
patient safety alerts, staff and user recommendations, compliance
with CQC standards, and user ratings. The latter are based on
cleanliness, staff cooperation, dignity and respect, involvement in
decisions and same-sex accommodations, evaluated on a scale from
one to five.260
3.28 Dr Foster provides various data about hospital performance, not only
at trust level, but also for single procedures and consultants. However,
the piece of information most easily accessible to the public is the
relative position of a hospital against its competitors, with respect to
mortality (measured by the HSMR) and efficiency (measured
combining 13 indicators, such as readmissions within a week and 28
days, procedures with limited clinical effectiveness, short-stay
admissions without a diagnosis).
257
Indeed, the study by Bridgewater et al. (2007) uses data for April 1997 - March 2005, when patient choice
was absent. However, it cannot be excluded that the availability of information to referring clinicians played a role in the performance improvements.
258
See paragraphs 4.20-4.25 for a more detailed review of the studies on competition in the internal market, which include Propper, Burgess and Gossage (2008).
259
Other information is available, for exampke, on patientopinion.org.uk; iwantgreatcare.org; findthebest.co.uk ;
qualitywatch.org.uk.
260
Concerns and opportunities regarding the existence of online reviews of healthcare services are discussed by Trigg (2011), who examines 'the role of patients as judges of healthcare quality; the motivation behind patients
posting reviews; and patients' use of such information'.
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3.29 The CQC assesses the compliance of providers with a series of
essential standards of quality, and publishes on its website reports on
the results of its inspections. At a high level, they are based on five
areas (standards of treating people with respect and involving them in
their care; of providing care, treatment and support that meet people's
needs; of caring for people safely and protecting them from harm; of
staffing; of quality and suitability of management) which include a
number of factors such as number and qualification of staff,
responsiveness to patient requests, protection from infections.261
3.30 Although these websites provide useful advice for the choice of
providers, it is not clear which combination of the available indicators,
if any, could represent a valid and reliable measure of hospital quality.
Indeed, Nuffield Trust (2013) points out that 'one aggregate,
comprehensive rating of providers may provide more clarity and
simplicity for the public', but at the same time explains that 'there is
currently no independent comprehensive assessment of quality across
all providers'.262 Simultaneously, the research into individual metrics is
ongoing, even though the validity of certain metrics currently
employed (such as the HSMR and the SHMI) is still debated.263
261
For an example, see www.cqc.org.uk/directory/r1h13 . Nuffield Trust (2013). Ratings providers for quality: a policy worth pursuing?
263
For example, Sir Bruce Keogh's report (2013) explains that the interpretation of HSMR and SHMI as measures
of avoidable deaths is 'clinically meaningless and academically reckless', and announces that Nick Black and Lord
Ara Darzi will conduct a study into the relationship between these 'excess mortality rates' and 'actual avoidable
deaths', with the aim of introducing a new national indicator of avoidable deaths in hospitals.
262
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4 HIGH-LEVEL INSIGHTS INTO COMPETITION ON QUALITY
Models of competition and quality in healthcare markets
4.1 Competition and health economists have developed a number of
theoretical models which can describe the impact of competitive
forces in the healthcare sector. Most of the existing literature focuses
on competition for hospital services, although over the last years some
attention has been devoted to the effects of competition in other
markets, such as those for health insurance and for physician
services.264 In hospital markets, theoretical results are usually different
depending on whether prices are modelled as regulated or not. As
shown in Gaynor (2006, sections 3.2, 3.4), when prices are set by
providers (that is, are not regulated) theory does not offer clear
predictions on hospitals' quality level in equilibrium. Since the results
vary with the particular specifications of the models, the impact of
competition on quality and on consumer and social welfare is
ambiguous.
4.2 In our analysis, we focus exclusively on models of hospital competition
in presence of regulated prices, which better describe the situation in
the English NHS under the PbR system. But for one case, the models
illustrated present providers who are only vertically differentiated with
respect to quality.265 We first describe models with profit-maximising
hospitals and only elective patients. Afterwards, we introduce the
presence of both elective and non-elective patients. Finally, we
consider the case of semi-altruistic hospitals, which are not only
interested in profits, but also directly care about the level of quality
provided. The prediction of the theoretical literature is quite clear:
except for some notable cases we will point out in paragraphs 4.6, 4.9
and 4.15, quality is expected to increase in the degree of competition
when prices are regulated.
Models with regulated prices
264
See Sections 5 and 6 in Gaynor and Town (2012) for a review.
Gaynor (2006, sections 3.2.2 and 3,4) describes the results of a series of models which allow for horizontal differentiation, though usually in a setting with market-determined prices.
265
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4.3 A good baseline for our analysis is the model outlined in Gaynor
(2006, page 9) and Gaynor and Town (2012, page 49), in which
prices are regulated, and hospitals choose the level of quality they
provide in order to maximise their profit. Quality includes any non-price
output characteristics and is mono-dimensional, so providers are
vertically differentiated.266
4.4 The degree of competition is represented by the number of providers
in the market, and the demand faced by hospital i is
q୧ ൌ s୧ ሺz୧ , zି୧ ሻDሺpො, z୧ , zି୧ ሻ
where s୧ is hospital i's market share, z୧ is its quality, zି୧ is a vector of
all other hospitals' qualities, D is market demand and pො is the
administratively set price. s୧ is assumed to be increasing in z୧ and
decreasing in the number of providers; the responsiveness of hospital
i's market share to its own quality,
பୱ౟
ப୸౟
, is assumed increasing in the
number of hospitals.267 Each provider has costs modeled by
c୧ ൌ cሺq୧ , z୧ ሻ ൅ F
where c(·) is the variable cost and F is the fixed cost of entry. Free
entry and exit are assumed too, so in equilibrium profits π୧ are zero for
every hospital i.268
4.5 Given these specifications, maximization over quality and assumption
of Nash behaviour lead to the following equilibrium conditions:
∂π୧
∂Dሺ൉ሻ
∂c୧
∂c୧ ∂s୧
ቋെ
ൌ ൤pො െ
൨ ቊ Dሺ൉ሻ ൅ s୧
ൌ 0
∂z୧
∂z୧
∂q୧ ∂z୧
∂z୧
and
π୧ ൌ pො ൉ q୧ െ c୧ ൌ 0
266
See Chapter 3 of the General Report.
The intuition is that in more competitive environments patients have more alternatives, and are thus more
reactive to changes in quality.
268
Obviously, the assumption of free entry and exit may be accurate when the market under consideration is that for a single hospital specialty or procedure (see Propper, Burgess, Green (2004, page 1250)), but is more questionable when the units of analysis are the whole hospitals.
267
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Since
பୱ౟
ப୸౟
is positive by assumption, the term in curly brackets is larger
with competition than with monopoly. Given that
பୱ౟
ப୸౟
is also increasing
in the number of hospitals, the main conclusion of the model is that,
conditional on price above marginal cost, more competition leads to
higher quality.269 The hospital's equilibrium level of quality also
increases in the quality elasticity of demand, in the market share and
in the total demand, and decreases in the marginal costs of quantity
and quality.
4.6 However, it is important to highlight that the predicted effect of
competition on quality depends on the sign of ቀpො െ
பୡ౟
ப୯౟
ቁ, the marginal
profit of hospital i, in equilibrium. If the regulated price is greater than
the marginal cost of additional patients, a hospital has financial
incentives to increase quality when there are a larger number of
providers. The higher is the price set by the regulator, the higher are
these incentives, and the stronger will be the impact of competition on
the level of quality provided in equilibrium. When marginal profits are
negative, however, the hospital is incentivised to attract fewer
patients, and to reach this goal it will reduce its quality. The effect of
competition on quality in this case is expected to be negative.
4.7 Gravelle et al. (2012, page 2) apply these considerations about the
level of fixed prices to the English hospital market. Since the PbR tariff
is linked to the average cost of service provision, they note that the
profit margin will be larger for procedures with large fixed costs and
low marginal costs; for hospitals operating at volumes where their
marginal cost is not increasing; for services where the prospective
price computation includes investment or capital costs. In all of these
cases, therefore, theory predicts that competition will provide greater
incentives to increase quality.
4.8 Gaynor (2006) and Gaynor and Town (2012) stress that their model
predicts an increase of quality and of consumer welfare when
competition is greater, but that it has less clear normative implications.
Indeed, competition could lead to excessive quality levels, and
269
Using the zero profit conditions, firms will in equilibrium offer quality until the average costs equals the
regulated price. This implies, in particular, that the profit margin is only positive if average costs are strictly higher
than marginal costs. In this specification, therefore, hospitals only offer positive quality levels if there are
increasing returns to scale.
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therefore to a decrease in social welfare. This can happen because
hospitals do not consider the effect of demand stealing, and so they
could be too numerous in equilibrium. In fact, since every provider
pays a fixed cost of entry, the increase in the number of hospitals
causes an increase in costs, which could outweigh the consumer
benefits from increased quality (especially if there is diminishing
marginal utility from quality and diminishing returns in quality
production). In the same way, a too high regulated price can determine
excessive levels of quality. Of course, quality is less likely to be
excessive if it pertains to highly effective treatments; in these cases, it
implies a greater consumer surplus, which is more likely to outweigh
costs.
4.9 The model by Gaynor (2006) and Gaynor and Town (2012) presented
in the previous paragraphs is considered the standard one when
describing hospital competition with regulated prices, only elective
patients and non-altruistic providers. A model with these same
characteristics is also outlined in a very recent paper by Katz (2013),
who comes to somewhat different results.
4.10 In Katz (2013) hospital quality is shown to be increasing in the
elasticity of demand with respect to quality, so competition leads to
improvements in quality every time it has a positive effect on quality
elasticity. Interestingly, the predicted impact of an increase in
competition depends on the source of the increase itself. When more
competition derives from the elimination of forms of market division, in
fact, Katz (2013) shows that there might exist distributions of
consumer valuation of providers for which quality is decreasing in
competition.270
4.11 The author argues that the in the pre-2006 NHS market there was de
facto a situation of market division, since patients were mostly
assigned to providers on the basis of location. However, the empirical
evidence we will review in this chapter and in the next suggests that
in the 2006 NHS the distribution of consumer valuation was arguably
such as to entail positive effects of the elimination of market division.
270
This happens because a monopolist only competes against the outside good, so it is interested in any changes
that lead to positive valuation by consumers, while competing providers are interested in achieving valuations
higher than those of their rivals. Therefore, if an increase in quality would result in a shift of valuation from a
negative value to a small positive one, a monopolist would surely be interested in achieving the higher level
quality, while a duopolist would be less likely to have this incentive. In such a case, higher quality would be
probably reached in the less competitive scenario.
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For instance, Gaynor, Propper, Seiler (2012) find that the introduction
of choice increased the quality elasticity of the demand for Coronary
Artery Bypass Graft (CABG) surgery,271 and in the model by Katz
(2013) increased elasticity unambiguously translates in higher
quality.272
4.12 Interestingly, Katz (2013) also finds that a reduction of hospital
competition has an unambiguous and negative impact on quality when
it derives from a merger. Indeed, his model shows that, 'absent
efficiencies, a fall in the number of providers due to a merger generally
results in lower equilibrium quality at any given price'.
Extensions: spillovers and altruism
4.13 Gaynor and Town (2012, page 51) extend their model to consider
what happens when there are two different types of patients, one
which can choose provider (for example, patients of elective services)
and one which cannot (for example, emergency patients). Hospitals
still maximize their profits with respect to the quality provided, but
emergency patients do not have any impact on the choice of
equilibrium quality. The model shows that an increase in the number of
hospitals (which compete only for elective patients) still incentivizes
providers to increase their quality. Under the key assumption that
hospitals set only one quality level for both patient types, the effects
of competition spill over into higher quality also for patients of non­
elective services.273 Quality is predicted to increase in the regulated
price for elective patients too, whether this is assumed identical to
that for emergency patients or not.
4.14 It may be argued that modeling providers as firms maximizing
exclusively profits is not accurate. In fact, most hospitals are non­
profit or public; even in purely for profit contexts, one can imagine
that doctors are concerned with patients' health, and may balance
with their altruism the income-maximizing objectives of hospital
management.274 Gaynor and Town (2012, page 53) modify the model
described in paragraphs 4.3-4.6 to take into account these
271
272
273
274
See paragraphs 5.39-5.42.
Interestingly, indeed, Gaynor, Propper, Seiler (2012) also find a positive impact of competition on quality.
This is a strong assumption, and we will discuss it in more detail in paragraph 4.52.
Gravelle et al. (2012). 141
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considerations. Hospitals are semi-altruistic firms, whose utility
function
U୧ ൌ uሺz୧ , π୧ ሻ ൌ vሺz୧ ሻ ൅ π୧
is increasing both in quality z୧ and profit π୧ . The equilibrium conditions
are
∂c୧ ∂s୧
∂Dሺ൉ሻ
∂c୧ ∂v୧
∂U୧
ൌ ൤pො െ
൨ ቊ Dሺ൉ሻ ൅ s୧
ቋെ
൅
ൌ0
∂z୧
∂q୧ ∂z୧
∂z୧
∂z୧ ∂z୧
and
U୧ ൌ vሺz୧ ሻ ൅ π୧ ൌ 0
The only difference with the conditions for the baseline model is the
presence of the term
ப୴౟
ப୸౟
, which is greater than zero. This means that,
for each level of competition, the value that providers put in quality
has an effect similar to that of a reduction in their marginal cost of
producing it. The resulting equilibrium quality is thus higher than that
provided by hospitals maximizing only profits.275
4.15 However, the results of other authors who take into consideration
altruism are not necessarily the same. In Brekke, Siciliani, Straume
(2011) hospitals are still semi-altruistic firms choosing the utilitymaximizing level of quality276,277, but the effect of competition on
quality cannot be predicted a priori. Indeed, the combination of
altruism and increasing marginal costs of quantity makes the sign of
marginal profits ambiguous in equilibrium.278 For certain hospital cost
structures, a sufficient degree of altruism may lead providers to
choose a level of quality higher than the profit-maximising one, such
that the marginal cost of an additional patient is larger than the
regulated price. When this is the case, an increase in competition
makes the marginal profit even more negative. The optimal response
275
Gaynor, Moreno-Serra, and Propper (2010, section III.B) model simultaneously spillovers and altruism, with
specifications broadly similar to those described in paragraphs 4.4-4.5. 276
The (fixed) location of providers is modeled too, so a dimension of horizontal differentiation is present.
277
Hospitals are modeled as semi-altruistic because their objective function is assumed increasing in both profits and utility of patients.
278
This happens because the utility of altruistic providers might increase even treating patients which imply a financial loss.
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of hospitals is thus to reduce their quality, in order to reduce financial
losses. Interestingly, Brekke, Siciliani, Straume (2008) use a very
similar model and predict an unambiguously negative impact of
competition between semi-altruistic providers on waiting times (that is,
competition is supposed to have a beneficial effect for patients). This
happens because increasing quality has a direct and an indirect cost
for the hospital, while reducing waiting times only has an indirect cost.
Empirical evidence
4.16 There are a number of empirical studies which test at a country level
the relationship between competition and quality in hospital markets.
For many years, only papers using US data were available. They
studied both markets with administered prices and markets with prices
set by providers, finding mixed results.279 Over the last decade, a
series of studies have analysed the impact of two waves of procompetitive policies in the English NHS. The first one, occurred
between 1991 and 1997, created hospital markets where providers
competed both on price and quality. The second one started in 2006
and has shaped the current market for hospital services in England, in
which prices can be considered as fixed. Our focus will be on the six
available studies using NHS data.280 Interestingly, they come to
unanimous result: competition caused a slight decrease in quality
when prices were set by the providers, and led to an increase of
quality in a context of regulated prices such as that of the current
English NHS.
4.17 The econometric approach followed in these six studies is based on
the Structure-Conduct-Performance (S-C-P) framework, which is
commonly used in the literature on competition and quality. The idea
behind the S-C-P paradigm is that market structure is causally linked to
firm conduct, which in turn determines industry performance. In
practice, performance is often omitted in healthcare studies, which
279
For instance, in contexts of regulated prices Kessler and McClellan (2000) find a positive impact of
competition on quality, Gowrisankaran and Town (2003) find a negative impact, and Mukamel et al. (2001) find
no effect. With market-determined prices, Gowrisankaran and Town (2003) find a positive impact of competition
on quality, Volpp et al. (2003) find a negative impact, and Ho and Hamilton (2000) find no effect of competition
on mortality.
280
For a comprehensive review including the US studies, see Gaynor and Town (2011, pages 60-76).
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focus on modeling the relationship between structure and conduct.281
The generic equation estimated in these cases is thus
z୧ ൌ β଴ ൅ βଵ MS୧ ൅ βᇱଶ controls ൅ ε୧
where z୧ and MS୧ are measures of quality and market structure for
hospital i, respectively.
4.18 The indicator of market structure most commonly used in the literature
is the Herfindahl-Hirschman Index (HHI) of market concentration.282
Sometimes other measures, such as the number of hospital
competitors, are used. As Mordoh (2011, page 20) notes, however,
the number of competitors may not measure competition as accurately
as the HHI, since it does not take into account asymmetries of market
shares.283
4.19 As explained by Gaynor and Town (2012, page 57), a drawback of
the S-C-P approach is that market structure can usually be considered
endogenous in S-C-P models. Indeed, there could be unmeasured
variations in demand and cost factors affecting both quality and
market structure. Reverse causality is an issue as well, since hospitals
could have higher market shares because of their higher quality.
Techniques commonly employed in the S-C-P studies to deal with the
endogeneity problem include the use of instrumental variables and
'predicted' HHIs. In the next sections, we will point out which
measures of market structure have been used in the English literature,
and which methods, if any, have been employed in the specific cases
to address the risk of endogeneity.
The 1991-97 'internal market'
4.20 The first attempt to introduce competition in the NHS consisted in the
creation, during the period 1991-1997, of an 'internal market' for
hospital services. The organisation of NHS in those years is described
in Propper, Burgess, Green (2004, paragraph 2.1), Propper, Burgess
281
Gaynor and Town (2012, page 56). In this definition, conduct refers to the actions taken by firms (for example, pricing, quality), while performance refers to what is related to welfare (for example, social welfare,
profits, consumer surplus) and is ultimately affected by firms' actions.
282
The Herfindahl-Hirschman Index is the sum of the squares of all firms' market shares.
283
It must be noted, however, that estimation of S-C-P models require a reasonably well defined market in both product and geographic dimensions, and that when market definition has some risk of being wrong, using the
counts of competitors within distance bands might be less problematic than using HHIs. Moreover, the justification for HHI is clear with Cournot competition, but not so clear with quality competition.
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and Gossage (2008, paragraph 2.1) and Bevan and Skellern (2011,
page 1). Competition was stimulated by separating the roles of
providers and purchasers. Public hospitals, previously managed by the
relevant health authorities, became NHS trusts, and were encouraged
to compete with each other and with private hospitals to secure
contracts with the purchasers for the provision of services. Most
contracts were annual and for blocks of services. Two different types
of purchasers were created, District Health Authorities (DHAs) and
General Practice Fund-Holders (GPFHs). DHAs were responsible for
purchasing hospital services for all the population in a certain area,
except for the patients of those GP practices which opted to become
part of GPFHs.
4.21 Purchasers had incentives to obtain good prices for healthcare
services. GPFHs, in particular, could (under some conditions) retain
their surpluses, thus had a strong interest in 'shopping around'
between providers. Since also the quality of the services offered was
supposed to affect the decisions of purchasers, each hospital faced a
downward sloping demand curve depending on price and quality, in a
form of payer-driven competition. In practice, however, no official
measures of quality for the various trusts were available, though other
indicators, like waiting times, were instead observable. There was little
scope for patient choice too, since only GPs belonging to GPFHs could
choose where to refer their patients, and individuals had limited choice
of GP.
4.22 Two papers by Propper et al. study empirically the impact that
competition in the NHS internal market had on hospital quality. The
identification method of Propper, Burgess, Green (2004) consists of
several OLS regressions of quality on competition, with the inclusion
of various controls such as local morbidity and whether the trust was
a teaching hospital. They use pooled data for the years 1995/6­
1997/8, for 202 trusts. The main measure of quality is the three-year
weighted average of the 30-days in-hospital AMI mortality for patients
aged 50 and over. This choice is justified not only for the reasons
listed in paragraph 3.12, but also because 30-days in-hospital deaths
were one of the few quality data available on the internal market
period. The main measure of competition is the number of trusts in the
catchment area of a hospital, normalised by the population of the area.
The empirical finding is that hospital competition had a negative and
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statistically significant impact on quality, although very small in
absolute value.284
4.23 Propper, Burgess and Gossage (2008) conduct a similar study, though
using a more sophisticated estimation technique. They use panel data
on 145 trusts for the financial years 1991/2-1999/2000, and perform
a difference-in-differences (DiD) analysis. They do it exploiting the fact
that, because of two policy changes, competition was encouraged
between 1991 and 1997, and discouraged immediately before and
after that period. Formally, hospitals in uncompetitive markets are the
control group, hospitals in competitive markets are the treatment
group, and the period of institutional support to competition is the
treatment. A local market is considered competitive or uncompetitive
according to four different indicators. They are binary variables based
on the number of competitors in one hospital's catchment area and on
the extent to which the population of the catchment area can choose
between different hospitals. The measure of quality is an annual
hospital-level average of the 30-days in-hospital AMI mortality for
patients aged 50 and over.
4.24 Results show that competition had a negative effect on clinical quality:
when competition was actively promoted, death rates in competitive
areas were higher than in areas not subject to competition. In the
same years, however, hospitals subject to competitive forces had
significantly shorter average waits for elective treatment. The authors'
explanation is that hospitals responded to payer-driven competition
focusing on efforts that could have observable results, such as shorter
waiting times, and neglecting clinical quality, which was poorly
observable.
4.25 Propper, Burgess, Green (2004) and Propper, Burgess and Gossage
(2008) describe a market in which hospitals compete both on quality
and on the price attached to block contracts, and find that in such a
context more intense competition does not lead to higher quality. This
is consistent with the available theory on competition and quality,
which (as noted in paragraph 4.1) does not predict a beneficial impact
of hospital competition in markets where prices are set by providers.
The new NHS hospital market
284
An increase in competition from the 25th to the 75th percentile of the distribution of the competition measure
is found to increase death rates only by 0.01 (approximately 20 per cent of the standard error of AMI mortality).
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4.26 In Chapter 3 we described the institutional settings implemented over
the last 10 years to develop a competitive regime for the English
hospital market. The new system was designed to make providers
compete on quality and not on price, at least for the services covered
by PbR. As seen in paragraphs 4.2-4.15, theory predicts that in such
a context competition is generally positively correlated with hospital
quality. Indeed, patient choice was introduced in 2006 by the
government as a way of intensify the level of competition, with the
precise expectation that this would have favoured an increase of
quality.285
4.27 There exist four papers which investigate at a country level the impact
of competition on quality in the hospital market with regulated prices
created in the middle of the past decade. In the following paragraphs,
we review these studies and list their findings. In the next section, we
discuss the controversies aroused by their results.
4.28 The main objective of the paper by Bloom et al. (2010) is to study the
relationship between hospital competition and management quality,
using cross-sectional data for 2006. Managerial quality is measured by
the results of a survey conducted interviewing clinicians and managers
of cardiology and orthopedics departments, for 100 hospital trusts.286
The authors show that their indicator of management quality is
positively correlated with measures of clinical quality, access, staff
satisfaction and financial performance.287 The main measure of
competition faced by a given hospital is the number of public hospitals
within a 30km radius from it. This variable is likely to be endogenous,
because for instance there could be omitted variables impacting on
both number of trusts and managerial quality.288 In order to provide a
source of exogenous variation, the authors use the political
contestability in an area as an instrument for the number of hospitals
in the same zone in 2005.289 More precisely, the baseline measure of
political contestability is the lagged (1997) share of Labour marginal
constituencies within a 45km radius of a given hospital.290
285
Mays and Tan (2012, page 1).
For details on the survey see Bloom et al. (2010, section II.A and appendix A).
287
See Bloom et al. (2010, page 11).
288
For example, the number of hospitals could be larger in areas with older and poorer patients, and at the same
time better managers could try avoid working in those areas (Bloom et al. 2010, page 17).
289
The rationale behind this choice is that hospital closures are unpopular, so politicians in areas with stronger electoral uncertainty tend to avoid them. In those areas, thus, there will be a larger number of hospitals.
290
Marginal constituencies are those where Labour won or lagged behind by less than five percentage points.
286
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4.29 Bloom and colleagues find a positive and significant impact of
competition on managerial quality: the addition of a rival provider
increases management quality by 0.4 standard deviations. They use a
2SLS technique also to regress the AMI mortality rate on competition,
and find that adding a hospital increases heart attack survival rates in
its rivals by 8.8 per cent. The authors allude to similar results from
OLS regressions of other measures of hospital performance on
competition, though they do not mention corresponding 2SLS
regressions.291
4.30 The identification strategy followed by the other three papers is similar
to that of Propper, Burgess and Gossage (2008). Indeed, Cooper et al.
(2011, 2012) and Gaynor, Moreno-Serra, Propper (2013) all use DiD­
style estimations to isolate the causal effect of competition on quality.
They exploit the 2006 policy change, and regard the establishment of
the patient choice reforms as the event which introduced the
'treatment', that is hospital competition. Since the NHS reforms
involved all the zones of England, there was not a distinct treatment
group composed by hospitals never affected by the pro-competitive
policies. However, the authors argue that hospitals in more
concentrated markets, where there was smaller scope for choice,
faced less exposure to the policy change. Therefore, they use a
continuous variable of treatment intensity, the degree of concentration
in the market, and estimate the impact of competition comparing the
evolution of quality outcomes in hospitals located in more or less
concentrated environments.292
4.31 Gaynor, Moreno-Serra, Propper (2013) use data from a pre-reform
financial year (2003/4) and a post-reform one (2007/8). The DiD
regression they estimate is
z୧୲ ൌ β଴ ൅ βଵ Iሺt ൌ 2007ሻ ൅ βଶ Iሺt ൌ 2007ሻ ൉ HHI୧,ଶ଴଴ଷ ൅ βଷ X୧୲ ൅ μ୧ ൅ ξ୧୲
where z୧୲ is the outcome variable at hospital i at time t; I is the
indicator for the post-reform period; HHI୧,ଶ଴଴ଷ is the pre-policy HHI, the
measure of market structure; X୧୲ is a vector of observed hospital
characteristics varying over time; μ୧ is an unobserved fixed effect; ξ୧୲ is
291
292
Bloom et al. (2010, page 19)
Continuous treatment variables have been used for DiD estimations by Card (1992), for instance.
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random noise. t takes two values, 2003 for the financial year 2003/4
and 2007 for the financial year 2007/8. βଶ is the DiD coefficient,
which indicates how the impact of market structure changes after the
reform.
4.32 As we pointed out in paragraph 4.19, the use of concentration
measures on the right-hand side of such equations can generate
endogeneity. To address this issue, the authors follow Kessler and
McClellan (2000) and Gowrisankaran and Town (2003) and substitute
the actual HHI with a 'predicted' one, which is supposed to be
unrelated to quality and unobserved patient heterogeneity.293 The first
step in the construction of this adjusted HHI index is the estimation of
a probabilistic hospital choice model based only on exogenous patient
and hospital characteristics (such as patients' age and gender, size and
teaching status of hospitals). The predicted HHI is then calculated
using each hospital's predicted patient choice probabilities.294
4.33 As dependent variables, the authors use both clinical and non-clinical
outcomes. The former include 30-day AMI mortality rate (for patients
aged 35-74), 28-day all-cause mortality rate and 28-day all-cause
mortality rate excluding AMI deaths. The latter include the mean
length-of-stay (LOS) of admitted patients, the number of total and
elective admissions, the share of elective admissions, total
expenditure, and a measure of (lower) productivity, expenditure per
admission.
4.34 Results suggest that competition has a positive impact on clinical
quality, though not big in absolute value. A 10 per cent fall in the HHI
leads, for instance, to a fall in the 30-day AMI mortality by 2.91 per
cent. This translates to a little more than eight avoided AMI deaths per
hospital every year, or about 1,000 fewer total deaths per year over all
the hospitals in the sample. At the same time, competition seems to
have a positive effect on efficiency as measured by LOS (a 10 per
cent fall in a hospital's HHI is associated with a 2.3 per cent fall in
length-of-stay), but no statistically significant effect on number and
composition of admissions, on hospital expenditure and on expenditure
293
In this sense, the predicted HHI can be seen as an instrumental variable for the actual HHI.
In Gaynor, Moreno-Serra, Propper (2013) the construction of the predicted HHI is described in section IVB and in detail in the online Appendix.
294
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per admission.295 Given these results, the authors conclude that 'the
effect of competition is to save lives without raising costs'.
4.35 Cooper et al. (2011) also use a DiD-style approach which exploits the
policy change of 2006 to estimate the impact of competition on
quality. The main difference between their model and that of Gaynor,
Moreno-Serra, Propper (2013) is that they use data not only for two
years, but for all the quarters between the beginning of 2002 and the
end of 2008. They choose to do this in order to take into
consideration the differences in quality trends, and to estimate the
effect of interest from a break in the time trend for quality after the
introduction of patient choice.
4.36 Cooper et al. (2011) use a large number of measures of market
structures, usually consisting in the natural logarithm of particular
HHIs. The markets considered in the computation of these indexes are
centred on GP practices, rather than on hospitals.296 For the authors'
favoured measure, the market consists in the hospitals within a radius
representing the 95th percentile of the distances travelled by one GP
practice's patients. Even though most of the HHIs the authors use are
generated through actual patient flows, they also create a predicted
HHI. An additional robustness check is represented by the use of an
instrument for market structure. This instrument is the standard
deviation of distances from GPs to their nearest four hospitals,
conditional on the distance to the patient's nearest hospital. The
authors' argument in support of its validity is that the relative positions
of NHS hospitals and GPs are unrelated to hospital quality, since
hospitals locations in England are largely a historical artefact.
4.37 The only measure of hospital quality employed in Cooper et al. (2011)
is the 30-day in-hospital AMI mortality rate.
4.38 The DiD estimation of Cooper and his colleagues shows that the
introduction of a competitive regime increased hospital quality. After
2006, AMI mortality fell about 0.31 percentage points per year faster
in hospitals that had a value of the market structure index higher by
295
Other quality indicators not affected by the policy change, such as the MRSA rate, are listed in Gaynor, Moreno-Serra, Propper (2013, footnote 16 )
296
According to the authors, this better reflects the structure of NHS markets after 2005, and allows avoiding the possible interference between health status and market structure, if patient characteristics are correlated with
unobserved determinants of choice.
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one standard deviation.297 This means that the shift from a hospital
market with two providers of equal size to one with four providers of
equal size would have led to a 0.39 percentage point faster reduction
in heart attack mortality per year after the introduction of choice.
Given these figures, the authors calculate that the reforms resulted in
about 300 fewer deaths per year.
4.39 Cooper et al. (2012) employ methodologies very similar to those of
Cooper et al. (2011), and investigate the effect of competition from
public and private hospitals on the efficiency of NHS trusts. Efficiency
is measured through hospitals’ average length of stay (LOS) for four
elective procedures, and even more precisely using the pre-surgery
LOS. The DiD estimation suggests that the 2006 reform had a positive
effect on hospital efficiency. Hospitals in markets that were one
standard deviation more competitive before 2006 shortened their presurgery LOS by about nine per cent and their overall LOS by five per
cent relative to the mean after the introduction of choice. Moreover,
the authors find no evidence that NHS hospitals located in less
concentrated areas were cherry-picking patients likely to be less
expensive to treat.
4.40 Cooper et al. (2012) perform an additional DiD analysis of the impact
of the 2007 reform which expanded the number of ISTCs, in order to
assess the impact of the competition from private hospitals.
Interestingly, their results suggest that the introduction of more
relevant private competition was not associated with an increase in
the efficiency of incumbent public hospitals. In fact, NHS providers
located in less concentrated markets actually saw their LOS increase
after 2008, when the ISTC reform come fully into effect.
Discussion and controversies
4.41 The results of the studies by Propper, Burgess, Green (2004) and
Propper, Burgess and Gossage (2008) have received little criticism by
academic and medical communities. According to Bevan and Skellern
(2011) this happened because they are consistent with the theoretical
expectations for markets with prices set by providers, and are
corroborated by other evidence on the impact of the internal market.298
297
The indexes of market structure created by Cooper et al. (2011) assign higher values to more competitive areas.
298
Le Grand, Mays, Mulligan (1998), Brereton and Vasoodaven (2010).
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4.42 As discussed above, the findings of the econometric studies on the
NHS market with regulated prices are consistent with the predictions
from theory as well. However, several criticisms have been levelled
against them, most notably in an article in Lancet by Pollock et al.
(2011), followed by a reply by Bloom et al. (2011).299 Pollock et al.
(2011) focus on Cooper et al. (2011), but many of their criticisms can
be extended to Cooper et al. (2012), Gaynor, Moreno-Serra and
Propper (2013) and Bloom et al. (2010).300 These are discussed below.
Choice of the dependent variable
4.43 The first point of debate (also described in Chapter ·) is the
appropriateness of the use of a single measure of quality, especially
AMI mortality, as a proxy of general hospital quality. Indeed, Pollock et
al. state that AMI mortality rates are at best 'a measure of clinical care
in cardiology', and Bevan and Skellern (2011) argue (probably
exaggerating) that 'mortality rates in any form do not […] provide a
good measure of elective surgery'. As we saw in paragraph 3.13,
Cooper et al. (2011) show correlations between AMI death rates and
some indicators of quality in support of their point, but it is difficult to
conclude that AMI mortality is a marker of overall hospital quality.
Econometric estimation
4.44 One of the criticisms of the studies of Cooper, Gaynor, Bloom and
colleagues is that they fail to identify a causal effect of competition on
quality, and only show correlation.301 Usually, both econometric and
theoretical issues are mentioned as reasons of identification problems.
In the next paragraphs, we highlight the main issues related to the
empirical estimations performed in the aforementioned papers. In the
following section, we deal with the theoretical problems related to a
causal interpretation of their findings.
4.45 The technical criticisms to the paper by Bloom et al. concern both the
dependent variable and the instrument. Pollock et al. (2011) and
Mordoh (2011, page 29) level generic accusations against the survey
299
An extended point-to-point response is available online at http://cep.lse.ac.uk/textonly/_new/research/productivity/lancet_LONGrep.pdf. 300
The criticisms of the work of Gaynor and coauthors refer to the working version of their paper, Gaynor, Moreno-Serra and Propper (2010).
301
Pollock et al. (2011). 152
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which is used to quantify managerial quality. However, the
methodology through which the survey is conducted seems
particularly robust, and likely to provide a reliable indicator for
management quality, at least in cardiology and orthopaedics
departments.
4.46 The choice of the instrument for market structure in Bloom et al.
(2010) appears quite thoughtful as well, but it is not exempt from
potential flaws. Indeed, Bevan and Skellern (2011) suggest that the
instrumental variable may be related to the dependent ones. For
instance, eliminating the threat of hospital closure in marginal
constituencies could provide greater institutional stability, and thus
lead to improved clinical or managerial quality.302
4.47 Even though Gaynor, Moreno-Serra and Propper (2013) and Cooper et
al. (2011, 2012) all use sophisticated measures of market structures,
it is not clear whether they manage to correctly resolve the problem of
endogeneity or not. For example, the predicted HHI has been often
seen in the literature as an indicator of market structures exogenous to
hospital quality, but the consensus on this claim seems not to be
unanimous. Indeed, Cooper et al. (2010) argue that the validity of
predicted HHIs relies on the validity of the underlying patient flows
model, and that the idea of considering patient demographics
exogenous to patient health outcomes is also debatable. With regard
to the instrument for market structure used by Cooper et al. (2011),
any judgement on its quality hinges on the acceptance of the
hypothesis that the distances from GPs to their nearest hospitals are
not related to the quality of the hospitals. Interestingly enough,
however, we found no papers criticising this assumption, or the
validity of the instrument in general.
4.48 As we have seen, many of the studies reviewed isolate the causal
effect of interest through DiD estimations, which are nowadays
routinely used in policy evaluation work.303 As pointed out by Bevan
and Skellern (2011), in order to assess the validity of a DiD approach
it is necessary to control for a) pre-existing differences in trends
302
An additional issue related to Bloom et al. (2010) is that the measure of market structure used in the study is the number of competitors of a given hospital. As we noted in paragraph 4.18Error! Reference source not found., indeed, some could argue that the number of hospitals might not represent accurately the competitive forces acting in a market.
303
Angrist and Pischke (2008, 2010).
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between treatment and control groups; b) changes occurring
contemporaneously with the introduction of treatment, which can
have affected the outcome variables.
4.49 Cooper et al. (2011) and Gaynor, Moreno-Serra and Propper (2013)
control for the pre-reform differences in trends between hospitals in
more and less competitive areas, but the second point is more
problematic. Indeed, Bevan and Skellern (2011) explain for instance
that the policies of the 2000 national service framework for coronary
heart disease were credited with major reductions in AMI mortality.
However, they suggest that this is not a big problem for the
aforementioned studies, since Gaynor, Moreno-Serra and Propper
(2013) find a positive impact of competition on quality also when the
latter is measured by in-hospital mortality for all causes but AMI, an
indicator which cannot be substantially influenced by the national
service framework.
4.50 However, Pollock et al. (2011) argue that effect of competition on
AMI mortality found by Cooper et al. (2011) and Gaynor, MorenoSerra and Propper (2013) is due to the beneficial introduction of
angioplasty in response to the national service framework, since
angioplasty is mainly performed in urban (and then less concentrated)
areas. Gaynor, Moreno-Serra and Propper (2013) show that this is not
the case, by controlling for a wide range of cardiac treatment
measures, including angioplasty and thrombolytic treatment. In fact,
introducing these controls increases the estimated positive impact of
competition on AMI mortality, because the use of thrombolytics is
associated to fewer AMI deaths, and at the same time mostly occurred
in rural, more concentrated areas.304
Theoretical interpretation
4.51 Despite the econometric issues described above, the most
controversial problem regarding the causal interpretation of the S-C-P
studies consists in the difficulty in providing a robust theoretical
relationship between market structure and hospital outcomes. For the
studies on the English NHS, for example, it is not clear how
competition for elective services affects quality for emergency
304
This point is, again, also acknowledged by Bevan and Skellern (2011).
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services. As noted by Propper (2012), there is a 'black box' regarding
the actual reactions of patients and providers to competition.
4.52 We saw in paragraph 4.13 that one of the theoretical specifications
from Gaynor and Town (2012) models the presence of both
emergency and elective patients. It predicts that competition provides
incentives for hospitals to increase the quality of elective services, and
that this increased quality spills over into higher quality also for
emergency procedures.305 However, these results depend on the
strong assumption that providers set a unique level of quality for all
the patients. This is debatable, because competition for elective
services could as well be expected to cause a diversion of
management effort resulting in lower quality for emergency
procedures, as pointed out by Bevan and Skellern (2011). Moreover,
the econometric studies reviewed above do not usually clarify whether
patients actually exercise choice in the NHS, and then whether the
presence of patient choice actually translates in stronger competition.
Cooper et al. (2011) try to bypass these shortcomings referring to the
results of Bloom et al. (2010). They claim that the findings of this
study suggest that the link between competition and AMI mortality is
represented by managerial quality, since this is shown to be dependent
on market structure, and correlated to emergency mortality. However,
we have seen in paragraph 4.46 above that the validity of the results
from Bloom et al. (2010) has been itself criticised.
4.53 These considerations suggest that the studies using NHS data might
be deemed unable to fully demonstrate that competition causes quality
to increase. However, they provide at least a strong indication of such
an effect: they use advanced econometric techniques in a convincing
way, and all come to similar results. However, in order to robustly
assess the existence and strength of a causal link between
competition and healthcare outcomes, more evidence was needed
about the practical implementation of patient choice and about the
actual reaction of healthcare providers to competitive forces. In the
next chapter, we will review evidence on the behaviour of patients,
GPs and providers, in presence of competition in the NHS, in order to
gain additional insights into the link between competition and
healthcare quality.
305
This may happen, for instance, if competition fosters investments in facilities and medical equipment used for
both elective and emergency surgery.
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5 THE 'BLACK BOX': LINKING COMPETITION AND QUALITY
Demand side: patient choice
5.1 As we previously outlined, patient choice plays a key role in the
functioning of competition in the NHS. If patients did not have the
opportunity to choose, there would be little incentive for healthcare
providers to compete, and to increase quality in order to attract them.
The empirical studies reviewed in the previous chapter, indeed, regard
the establishment of patient choice in 2006 as the 'treatment'
introducing competition, and as the first determinant of potential
improvements in hospital quality.
5.2 A process of patient choice leading to quality improvements is one
where patients are willing to choose, aware of their right to choice,
and offered alternatives among a range of options. Moreover, patients
(and their GPs) are intended to give strong consideration to quality
when choosing provider, and to have access to enough information
about quality to help their decision. If these conditions are met in
practice, then patient choice and demand forces offer the potential for
fostering quality improvements.
5.3 It is important to note, however, that GPs have a key role in advising
patients, and in choosing on their behalf when they do not exercise
choice. For this reason, GP choice may drive quality competition as
well (and might be better informed than patient choice).306
5.4 In the next sections, we analyse in more details the necessary
conditions for the effectiveness of patient choice, and present the
available evidence on actual patients' behaviour in the English NHS.
First, we review the findings of a series of studies, from the
Department of Health, The King's Fund and GfK (on behalf of the
Competition Commission).307 We also present evidence on changes in
demand patterns after the introduction of patient choice. Finally, we
review recent empirical studies investigating the determinants of
patients' demand with econometric techniques.
306
We study GP's role in the choice process in paragraphs 5.43-5.50, and the competition in the market for primary care services in paragraphs 5.51-5.63. 307
Department of Health (2006b, 2009c, 2010), Dixon et al. (2010) and GfK (2013), respectively. 157
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Evidence on patient choice
Awareness and availability of choice
5.5 In order to be effective, the opportunity of choosing provider has, first
of all, to be known by patients. Ideally, they should be aware of
choice before meeting their GP, or at least be offered a choice among
providers (usually by the GPs themselves). If this were the case for a
proportion of NHS users great enough to pose a threat to hospitals'
finances, providers should then take into consideration patient choice
as a relevant variable when making strategic decisions. It is important
to stress, however, that it might not need many patients to be
sensitive to quality for providers to take it seriously, and to plan
performance improvements. For some hospitals, indeed, even small
shifts in elective patients could constitute an incentive to compete on
quality, given the implications for income.308
5.6 From May 2006 to March 2009, after the introduction of patient
choice, the Department of Health ran a series of bi-monthly 'National
Patient Choice Surveys' to monitor the implementation of the policy.309
An additional follow-up survey was then commissioned in February
2010, with about 69,000 respondents.310 Many of the questions
asked to patients regarded awareness and offer of choice, and found
that:
 In February 2010, 54 per cent of patients were aware before
visiting their GP that they had a choice of hospitals for the first
outpatient appointment, up from 50 per cent in March 2009 and 29
per cent in the first survey.
 The percentage of patients recalling being offered a choice of
hospital for their first outpatient appointment was 30 per cent in
May/June 2006. It increased substantially until the beginning of
2007, then it remained quite stable. In March 2009 and February
2010 this percentage was 47 per cent and 49 per cent,
respectively.
 Both in March 2009 and February 2010, around 63 per cent of
patients who were aware of choice recalled being offered the
308
309
310
This is shown, for example, by the survey evidence collected by Dixon et al. (2010, pages xvIII, 158) See for instance Department of Health (2006b, 2009c).
Department of Health (2010).
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opportunity to decide, whereas only 32 per cent of those not aware
of choice remember being given it.
 Both in March 2009 and February 2010, 67 per cent of respondents
had the possibility to go to the hospital they wanted. Interestingly,
the patients who could choose were more likely to be referred to
their favoured hospital, thus fully benefitting from the policy reform.
Indeed, in February 2010 88 per cent of the patients who were
given choice were able to go to their preferred provider (five per
cent had no preference). On the other hand, only 47 per cent of the
patients not offered choice could go to the hospital they wanted. It
must be noted, however, that another 40 per cent of those patients
had no preference, so in the end only 13 per cent of patients were
not able to go to their preferred provider.311
Figure 3. Percentage of patients aware of choice, offered choice and able to go to the
hospital they wanted, May 2006-February 2010
80%
70%
60%
50%
Aware of choice
40%
Offered choice
30%
Able to go where wanted
20%
10%
Feb‐10
Nov‐09
Aug‐09
Feb‐09
May‐09
Nov‐08
Aug‐08
May‐08
Feb‐08
Nov‐07
Aug‐07
May‐07
Feb‐07
Nov‐06
Aug‐06
May‐06
0%
Source: Department of Health (2010)
311
As suggested by Dixon et al. (2010, page 61), this kind of figures might reflect the fact that patients having
preferences on hospitals may be more likely to be offered a choice, or that those who are not given a possibility
to decide may have been more willing to go with the GP's suggestions.
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5.7 The study from Dixon et al. (2010) examines comprehensively the
implementation of patient choice in four English local health
economies, with data collected between August 2008 and September
2009. The four areas under examination were chosen in order to be
representative of different levels of potential for choice and its
penetration.312 The study involves a survey of 2,181 patients and
interviews with patients, GPs and providers.
5.8 With regard to the way in which patients experience the choice
process, the authors find that:
 45 per cent of patients were aware of their ability to choose before
visiting their GP, a percentage slightly smaller than in the National
Patient Choice Survey for March 2009. However, there were
differences in the awareness of patients between the different local
health economies, with 61 per cent of respondents being conscious
of choice in an area and only 39 per cent in another.
 Patients appear to value choice in itself. Indeed, 75 per cent of
respondents said that patient choice was either 'very important' or
'important' for them.
 Consistently with the figures from the National Patient Choice
Surveys, 49 per cent of respondents recalled being given a choice
of provider. Choice was more likely to be presented to patients who
were aware of it before visiting their GP, and to those referred to an
ISTC. Again, there were large differences between areas, since 71
per cent of patients were offered choice in one of the four regions
and 41 per cent in another.313
 Only 19 per cent of patients knew of the possibility to receive NHS
treatment in a privately run hospital, and even fewer (eight per cent
of those offered a choice) remembered being given this option. This
might partially due to the fact that ISTCs can use the NHS brand, so
patients could be unaware that those structures are privately run,
even when they are offered to be treated there.
312
Potential for choice and penetration of choice are measured by the number of hospitals in a 60-minute drive-
time and by the proportion of patients that were offered a choice by their GP according to the November 2007 National Patient Choice Survey, respectively.
313
These two areas are the same in which patients were most and least aware of choice, respectively. 160
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 As in the National Patient Choice Surveys, the data suggested that
patients offered a choice were much more likely to attend the
provider they wanted (91 per cent against 52 per cent). Even in this
case, however, a substantial fraction of the patients who were not
offered a choice declared to have no preferred hospital.
5.9 A recent source of evidence on the approach of patients and GPs to
the process of choice is represented by GfK (2013), a market research
undertaken for the Competition Commission in the context of the
investigation on the merger between the Royal Bournemouth and
Christchurch Hospital and Poole Hospital (Bournemouth and Poole).314
The research consists in 456 interviews to patients referred to the two
hospitals involved in the merger, and 36 GP interviews.
5.10 The results of the patient interviews show that around 45 per cent of
respondents were conscious of choice before their visit to the GP.
Only a quarter of patients were told by the GP that they have the right
to decide, and most of this 25 per cent of respondents were already
aware of choice. The overall percentage of patients who knew they
had alternatives was about 50 per cent. Patients were also asked how
important was choice to them, and around half of them responded that
it was 'essential' or 'very important'.315
5.11 The findings of the National Patient Choice Surveys and of Dixon et al.
(2010) describe well the state of implementation of the patient choice
policy at the beginning of 2010. Even if there was evidence of
improvements in the awareness and offer of choice with respect to
2006, the situation in 2010 was still ambiguous. The diffused
appreciation of the intrinsic value of choice was comforting, but it
might be argued that the figures on awareness and offer of choice did
not suggest a full realization of the objectives of the policy.
5.12 However, more recent evidence would be needed, in order to better
understand how the availability of choice for NHS patients evolved in
the last years, and to have a good picture of the current state of
314
Competition Commission (2013). “The Royal Bournemouth and Christchurch Hospitals NHS Foundation Trust/
Poole Hospital NHS Foundation Trust Merger Inquiry”. Provisional findings report. Document available at
www.competition-commission.org.uk/our-work/directory-of-all-inquiries/royal-bournemouth-and-christchurch-poole
315
Please note that the options for this question are different from those for the similar one in Dixon et al. (2010).
In fact, in that case patients could select among 'Important or very important', 'somewhat important' and 'of little
importance or unimportant'.
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affairs. As showed in figure 3 above, for instance, the awareness of
choice increased steadily between 2006 and 2010; if it had
maintained that growth rate in the past three years, it would be now
at very high levels. The results of GfK (2013) do not suggest an
improvement in the awareness of choice, nor in the likelihood of being
offered choice; however, they only refer to a single health economy
and cannot be generalised to the situation in England.316
Table 1. Main results of the surveys from Department of Health (2006, 2010), Dixon et al.
(2010) and GfK (2013).
DH (May
2006)
DH (Feb
2010)
Dixon et al.
(2010)
GfK(2013)
% Aware
of choice
29
54
45
45
% Offered
choice
30
49
49
50
% Able to
go where
they
wanted
NA
67 (88 if
91 if offered
offered
choice, 52 if
choice, 47 if not
not)
NA
% Thinking
choice is
important
NA
NA
50 (essential
or very
important)
75 (very
important or
important)
5.13 Another aspect to be evaluated is whether the findings of the
aforementioned studies indicate a degree of availability of choice
sufficient to stimulate a response from providers. Indeed, Pollock et al.
(2011) quote some results from National Patient Choice Surveys and
from Dixon et al. (2010), suggesting that they prove the unavailability
of patient choice in practice. Similarly, The Foundation Trust Network
argues that the low proportion of patients who were offered choice in
2010 is a signal that 'other parts of the machinery of choice are not
yet functioning adequately across the board'.317 However, the figures
cited in the previous paragraphs (and summarised in Table 1) are not
316
For instance, we saw in paragraph 5.8 that results for awareness and offer of choice tend to be very different
between regions. 317
Third party submission to the Competition Commission in the context of the Bournemouth and Poole merger (Competition Commission 2013, Appendix G).
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inconsistent with a substantial share of patients exerting choice, and is
likely to be sufficient to present a substantial revenue risk to unpopular
hospitals.318
5.14 In the next paragraphs, we present additional evidence on the
effectiveness of patient choice. We assess the role played by quality in
driving the choice of provider, reviewing the available studies, both
qualitative and quantitative, of the factors influencing the demand for
healthcare services. In addition, we investigate whether the actual
choices of patients changed after the introduction of the policy.
Drivers of patient choice
5.15 A key condition for the proper functioning of the incentives introduced
with the patient choice reforms is that patients (and GPs) base their
decisions not only on the distance from hospitals, but also on factors
which are under more direct control of providers. If that is the case,
indeed, theory predicts that suppliers of healthcare services will react
to the signals from the demand, improving in those aspects which
matter to patients and GPs. It is important to note that these elements
may include the various dimensions of healthcare quality cited in
Chapter 3, but are probably not limited to them. It is possible that
patients care about factors which cannot fall into a narrow definition
of quality (for example, the quantity of parking facilities in a hospital);
however, as far as providers improve their performance in these
aspects to win referrals, this could still increase consumer welfare.
5.16 In the February 2010 National Patient Choice Survey, patients offered
choice were asked to select the single most important factor in
choosing a hospital.319 Of those surveyed, 38 per cent indicated the
distance from house or work as the most influential characteristic; 12
per cent of patients selected a personal experience with the hospital;
10 per cent waiting times; six per cent a good previous experience;
and only five per cent indicated quality of care.320 These results are
not materially different from the opinions of GPs and providers
collected in Dixon et al. (2010), suggesting that the main drivers of
patient choice are location and convenience of hospitals, experience
318
For example, see www.bbc.co.uk/news/uk-england-stoke-staffordshire-21381795, and paragraph 5.5 above.
Department of Health (2010).
320
Another element related to quality, 'cleanliness or low levels of infection', was selected only by two per cent of patients.
319
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and waiting times. Likewise, in the May/June 2006 National Patient
Choice Survey321 location and convenience were the most common
factors mentioned by patients as influences on their decision.322
5.17 However, the results from patient surveys change significantly when
patients are asked to select from a list as many factors as they feel are
most important when choosing their hospital. In most of the National
Patient Choice Surveys between 2006 and 2009, for instance,
'hospital cleanliness and low infection rates' was indicated most often
as a relevant factor, followed by 'quality of care'.323 'Cleanliness' and
'quality of care' were the most selected answers also in a similar
question in Dixon et al. (2010, page 70), followed by 'standard of
facilities'. In a similar fashion, for the patients surveyed in GfK (2013)
the most important factor in assessing a hospital is the 'clinical
expertise of consultants and other healthcare professionals'; clinical
outcomes and other aspects of quality also are very relevant, while
waiting times and convenience of the hospital are relatively less
important.
5.18 Dixon et al. (2010, page 79) suggest that one possible explanation of
the discrepancy in the surveys' results is that patients provide
different answers to prompted and unprompted questions. When
asked the latter, or during the interviews, patients tend to indicate
location as the most relevant factor of choice. However, the analyses
subsequently performed (Dixon et al. 2010, pages 80-85) seem to
confirm that quality aspects are relevant drivers of patient choice.
First, the study of revealed preferences shows that patients choose
providers with better quality of hospital environment (according to
patient ratings), lower 'Clostridium difficile' infection rates, and higher
ratings of other performance indicators. Second, the authors analyse
patients' response to hypothetical choices between hospitals with
different characteristics. The results indicate that patients are prepared
to attend more distant hospitals in order to receive better quality.324
The most important factors for choice are the hospital infection rates,
a measure of improvement in health (similar to PROMs) and patients'
321
Department of Health (2006b).
In this survey, patients who were offered a choice of hospital were invited to give (in their own words) up to
three important factors when choosing a hospital. 323
In the March 2009 report, for instance, the former was indicated as important by 74 per cent of patients, the latter by 64 per cent (Department of Health 2009c, page 8).
324
It must be noted, however, that 25 per cent of the respondents decided to go to the local provider in all the choice scenarios offered, regardless of the options presented to them. This could indicate a lack of engagement with the survey questions, or an extreme loyalty to the local provider. 322
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own experience of the provider. Interestingly, the negative weight due
to previous bad experience with a provider is more relevant than the
positive one due to previous good episodes.
5.19 The interpretation of the previous findings suggests that quality
factors matter for the choice of hospital. However, a full
implementation of patient choice also requires that patients are offered
enough information about healthcare quality to help their decision. This
way, in theory, they would be more likely to select the best providers,
which would thus be rewarded for their highest quality. In the
February 2010 National Patient Choice Survey, those patients who
had been offered choice were asked to select the most important
source of information used to select their hospital. 43 per cent
indicated their GP and 29 per cent their own experience or that of
family and friends. The answers to a similar question in Dixon et al.
(2010) show that the most used sources of information were patients'
own experience (41 per cent of respondents), GP (36 per cent) and
friends and family (18 per cent). The information on comparative
hospital performance appeared to have a very limited role for patient
choice: in both surveys, only six per cent of respondents selected a
booklet or leaflet about choices as a source of information, and only
four per cent indicated the NHS Choices website.
5.20 Dixon et al. (2010) also find that the major sources of advice for
patients were the GP and their family and friends, while the opinion
about the local hospital was formed primarily through the experience
of family, friends and patients themselves, and second through local
media, newspapers and gossip. The lack of official information and
support could be seen as an obstacle to the effectiveness of patients'
decision making. The providers interviewed for the study, indeed,
thought that patients did not have enough information to base their
choice on quality. However, only 14 per cent of patients who were
offered choice declared they would have liked more information.
Similarly, in the February 2010 National Patient Choice Survey 83 per
cent of the respondents told they had enough information to help them
choose.
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Evolution of demand: treatment location and GPs' referral patterns
5.21 Before the introduction of choice, the default option presented to
patients was usually to attend their nearest hospital.325 After the
reform, if distance were not the only determinant of patient choice, we
would expect to see patients change, at least in part, their location of
treatment. The proportion of people going to their closest provider may
thus indicate the extent to which patients base their choice of hospital
only on proximity and not on other factors, such as quality.
5.22 The results of the survey in Dixon et al. (2010) show that 69 per cent
of respondents who were offered choice, and 76 per cent of those
who were not, attended their 'local' hospital/treatment centre. Using
postcode data, the authors also calculate that 53 per cent of patients
who were given choice, and 39 per cent of those who were not, did
not go to the hospital nearest to their home. It is not clear whether the
authors take into consideration the possibility that at the time of the
survey the local hospital (or that closest to the place of residence) did
not provide the treatment needed by some patients. If that were the
case, those patients would be coded as attending a provider which is
not their closest one, even when they would in fact travel to the
nearest available hospital for their clinical need. In this scenario, the
figures cited above would overestimate the proportion of patients for
which distance is not a fundamental driver of choice.
5.23 In the investigation on the Bournemouth and Poole merger, the
Competition Commission has calculated, for a series of specialties, the
share of patients going to the nearest hospital that actually provides
the treatment they need.326 On average, 81 per cent of elective
patients attend their closest provider (86 per cent if a more
conservative measure of proximity to hospitals is used). However,
there are some specialties (such as pediatric medical oncology,
nephrology, pediatric surgery) whose patients seem to give less
importance to proximity, and to travel more often beyond their nearest
provider.
5.24 These results indicate that, for most of the specialties under
examination, distance is a fundamental driver of choice; however, they
325
Kelly, Tetlow (2012, page 4).
Competition Commission (2013, Appendix G). The data refers to the area relevant for the Bornemouth and Poole merger.
326
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also suggest that other factors, such as quality, play a role in the
process of hospital selection. Indeed, if quality is similar across
providers, many patients could take it into consideration in their
decision, but then still opt for the local hospital. Following the same
line of reasoning, the specialties for which distance seems less
decisive could be those which present larger quality difference
between providers.
5.25 The study by Kelly and Tetlow (2012) examines in detail the changes
in treatment location since 2006, in order to investigate the impact of
two reforms, the introduction of patient choice and the expansion of
ISTCs (which treat NHS-funded patients). The first part of the report
studies the evolution of patients' choices from 2006/07 to 2010/11
for three outpatient specialties (orthopaedics and trauma,
gastroenterology and opthalmology). In the whole period, patients who
received care from their nearest NHS trust remained the majority, but
their proportion declined between 2006/07 and 2010/11.327 During the
same years, there was no significant rise in the number of patients
attending a NHS provider which was not their nearest one, but there
was an increase in the proportion of patients going to ISTCs.328
.Obviously, the stable proportion of patients going to a NHS provider
which was not their closest one reflects aggregate data, so does not
exclude switching by a significant number of individual patients: for
instance, many patients might have switched between non-nearest
NHS providers; similarly, many others might have started to attend
non-local providers instead of their nearest one, but their impact on
the aggregate data might have been balanced by a similar number of
patients switching from non-local to local hospitals. Indeed, we will
see in paragraphs 5.29-5.31 below that in the second half of the past
decade there were signs of change in patients' treatment locations,
even considering only NHS providers.
5.26 The analysis performed for outpatient specialties is then repeated for
three inpatient procedures (hip replacement, cholecystectomy and
elective inguinal hernia), for which there exist reliable data for the prereform years. Even in this case, the examination of attendances
reveals a shift away from the nearest NHS hospitals to ISTC providers.
327
In 2006/07, 68 per cent of orthopaedics and trauma patients, 74 per cent of gastroenterology patients and 67
per cent of opthalmology patients attended their nearest provider. By 2010/11, these percentages had fallen to
59 per cent, 66 per cent and 66 per cent, respectively.
328
In 2010/2011, eight per cent of orthopaedics and trauma attendances, 4.8 per cent of gastroenterology
attendances and 2.3 per cent of opthalmology ones took place in ISTCs.
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The proportion of patients attending their closest NHS provider fell
after 2006/07 (that is, after the reforms) for all the procedures
considered.329 At the same time, there was a statistically significant
increase in the proportion of patients admitted to ISTCs, and no
change in the share of those attending other NHS trusts. By 2010/11,
ISTCs accounted for 17 per cent of hip replacements, six per cent of
cholecystectomies and 17 per cent of elective hernia repairs funded by
the NHS.
5.27 The authors perform a series of robustness tests to support their
findings. First, they repeat the analysis for three emergency
procedures which are comparable to hip replacement, cholecystectomy
and elective hernia, but are not performed by ISTCs. Results show
very little change in the proportion of patients treated at the nearest
NHS trust or at another NHS provider over the period under
examination. According to the authors, this suggests that between
2006/07 and 2010/11 the impact of the reorganisation of NHS
services on the pattern of patients' attendances was small, and thus
cannot account for the switch towards ISTCs showed by the data.
5.28 Subsequently, the authors take into consideration the fact that, after
their expansion in number and capacity, ISTCs might be the nearest
provider for some patients. For instance, 23 per cent of the patients
who had hip replacements in 2004/05 would have had an ISTC as the
nearest treatment centre, had they had the same operation in
2010/11. In order to check that the growth in ISTCs utilisation
showed by the data was not simply due to switches to new nearest
providers, the authors perform separated analysis for three types of
areas, differentiated with respect to the location of their nearest ISTC
in 2009/10. Results show that the shift towards ISTCs in 2010/11
was higher in those areas where they constituted the nearest provider,
but it was not limited to them. According to the authors, indeed,
ISCTs still treated a significant proportion of patients where they were
more than 15 km further than the nearest NHS provider, especially for
hip replacements procedures.
5.29 In addition to the changes in treatment location, Kelly and Tetlow
(2012) also analyse the dynamics of GPs' referral patterns between
329
In 2003/04, 69 per cent of hip replacements, 76 per cent of cholecystectomies and 77 per cent of hernia
operations were performed at the patient's nearest provider. By 2010/11, these percentages had fallen to 54 per
cent, 69 per cent and 61 per cent, respectively.
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2006/07 and 2010/11. On average, GP practices referred patients to
12 providers in 2006/07 and to 18 providers in 2010/11. The average
increase in number of providers used was accompanied by annual
increments at all points along the distribution. As the overall number of
hospitals employed rose in each subsequent year, so did the statistical
dispersion of this variable across GP practices, indicating that
practices reacted to the presence of patient choice in very different
ways. In the same years, the concentration of referral across providers
fell too. The mean GP practice-level HHI decreased from 0.71 in
2006/07 to 0.61 in 2010/11. Further analysis of the cumulative
distribution function of HHI reveals that between 2006/07 and
2008/09 referrals became less concentrated at all points of the
distribution.
5.30 The authors calculate that a large part of the changes in the referral
patterns is explained by the expansion of ISTCs. For instance, the
entry of ISTCs between 2006/07 and 2010/11 accounts for half of
the increase in the average number of providers used in the same
period. However, the data shows that the diversification of GP
referrals was not due only to the presence of new private providers.
Even when ISTCs are excluded from the analysis, indeed, there is
evidence of an increase in the number of NHS trusts used by GPs, and
of a decrease in the concentration of referrals. This is consistent with
the results of Gaynor, Moreno-Serra, Propper (2013, page 149), who
show that between 2003/04 and 2007/08 better hospitals (with
regard to AMI mortality and waiting times) were chosen by more
elective patients relative to worse providers. Over the same period, the
proportion of patients travelling further than their nearest provider
increased for better hospitals, while it clearly decreased for worse
ones.330
5.31 A similar approach to that of Kelly and Tetlow (2012) is used in
Competition Commission (2013, Appendix G), which analyses the
referral patterns of GP practices equidistant between the hospitals
involved in the merger under investigation.331 Since closeness to
providers is not a factor for patients of these practices when choosing
between the two hospitals, changes in their shares at a GP level could
reveal a role played by other aspects, such as the relative quality of
330
The sample of providers used for these analyses include only NHS acute trusts.
The two hospitals are the Royal Bournemouth and Christchurch Hospitals Nhs Foundation Trust, and the Poole Hospital Nhs Foundation Trust [Bournemouth and Poole].
331
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the providers. The analysis employs data for a series of inpatient and
outpatient elective services, relative to the period April 2010­
September 2012. For some of the specialties under consideration, the
results show changes in the referral patterns that are likely to be
caused by a 'business winning' effect, which in turn may depend on
providers' relative quality.
5.32 In conclusion, the evidence reviewed in the previous paragraphs
suggests that, in the second half of the past decade, non-marginal
changes in the location of treatment for NHS-funded patients did take
place. However, it is not straightforward to conclude that the results
from Kelly and Tetlow (2012) prove that patient choice was effective
and caused the variation in referral patterns shown by the data, as
claimed by Zack Cooper.332 Most of the impact highlighted by the
study, indeed, might be determined by the entry of the ISTCs.
According to the authors, 'it is not possible to isolate the effect of the
two policies - increasing patient choice and the expansion of ISTCs'.333
In particular, they explain that the pattern in the data could be due
both to patients choosing to attend ISTCs, and to ISTCs creating
capacity which was then filled by GPs and commissioners.334
5.33 The findings reviewed in paragraphs 5.30 and 5.31, however, suggest
that switches of providers occurred also within the market of NHS
hospitals, at least to a certain extent, and that might have been
determined by quality considerations. Further research on this topic
could prove particularly useful, since other evidence of changes in
treatment location in response to differences in hospital quality would
represent a relevant additional confirmation of the effectiveness of
patient choice.
Patients' response to quality: econometric studies
5.34 In addition to the studies based on surveys and interviews, a number
of econometric papers have examined the determinants of demand for
healthcare services in the English NHS. A good starting point is
represented by Sivey (2010), who analyses the choice of hospitals for
332
www.nuffieldtrust.org.uk/blog/opening-black-box-links-between-competition-and-quality (last accessed on 6 October 2013),
333
Kelly and Tetlow (2012). 334
Evidence in favour of the latter hypothesis is constituted by the results of interviews with providers reported in
Dixon et al. (2010, page 110), which show that 'the independent sector was not perceived as much of a threat
but has been used as a key partner in providing much-needed extra capacity to get waiting times down'.
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cataract operation in the NHS for three pre-reform years, from
2001/02 to 2003/04. Applying a latent-class multinomial logit model,
the author finds that travel time has a stronger impact on the
probability of hospital choice than waiting time, but the latter does
play a role in influencing demand. The estimated waiting times
elasticities are consistent with the previous literature, with a
magnitude around -0.1. Since the data refer to a pre-reform period, the
demand side is represented by the GPs choosing for their patients.
Interestingly, the analysis performed in the paper highlights the
existence of two different types of GPs, one very responsive to
waiting times, and one whose choice of hospital for the patients was
not influenced at all by this indicator of hospital performance. This
highlights the fact that, before the introduction of patient choice, the
patients of the latter class of GPs had limited possibility to benefit
from performance improvements of providers (at least with regard to
waiting times).
5.35 Beckert, Christensen, Collyer (2012) examine the choice of hospital for
hip replacements in England in a post-reform year, using data on
39,060 patients and 216 NHS hospitals for 2008/2009. The hospital
demand is represented by a classical conditional logit model, where
the utility that a patient obtains from choosing a certain provider (and
then the probability of selecting it) depends on characteristics of the
patient and the hospital, and on the distance between them.335
Interactions between distance and patient characteristics, distance and
hospital characteristics and patient and hospital characteristics are
added, in order to model possible differences in the assessment of
hospitals for patients with different socio-demographic characteristics.
The measure for waiting times is the average of waiting times for hip
replacements in the hospital. It is included in the model because it is
likely to affect demand and might be correlated with clinical quality
(both observable and unobservable). As pointed out by Gravelle et al.
(2012), however, the authors choose not to address the possible
endogeneity of waiting times (as done instead by Gaynor, Propper,
Seiler (2012)), thus implicitly assuming that they are not correlated
with unobserved hospital quality measures which affect demand.
5.36 The results show that distance negatively influences the likelihood of
selecting a provider, especially for older patients, those living in rural
335
As a sensitivity check, the authors also re-estimate their model as a mixed multinomial logit, which does not
rely on the assumptions of independence from irrelevant alternatives (IIA).
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areas and those living in more income-deprived areas. Hospital quality
and performance matter too, since the lower the mortality rate and the
shorter the waiting times, the more likely a patient is to choose a
hospital. Similarly, the probability of choosing a provider increase in its
CQC rate and decrease in its number of MRSA infections. Finally, the
higher the referral frequency of a GP to a particular hospital, the more
likely are her patients to go to that hospital.336
5.37 These findings show that hospital location is not the only driver of the
demand for hip replacement, and that various measures of quality play
a role in it. Moreover, the results are consistent to those listed in
paragraphs 5.17-5.18, since the survey findings already showed
infection rates and various measures of quality of care to be relevant
for patient choice. The GP also emerged as an important source of
advice and information for patients, so it is not surprising that their
histories of referrals influence the choice of their patients.
5.38 In the second part of the article, Beckert, Christensen, Collyer (2012)
first use the results from the demand model to calculate elasticities of
demand with respect to a proxy for quality, the HSMR. The actual
hospital market shares are calculated on the basis of the estimates of
the logit model, then the elasticities are obtained after the simulation
of a 10 per cent increase in the HSMR (that is, a 10 per cent decrease
in quality), when the market shares in the new scenario are computed.
The elasticities of demand to quality found in this way are thus
indicators of hospitals' market power. They are subsequently used by
the authors to simulate the effect of mergers between two hospitals
on their capability to reduce quality unilaterally. Applying the
procedure described above to the hospitals involved in the merger, the
authors calculate both pre- and after-merger elasticities (when the two
providers are considered as a single one). If the demand of the two
hospitals is significantly less elastic after the merger, it means that the
parties were close substitutes, and that once the merger occurs they
will have greater market power, and confront less competition.
5.39 Gaynor, Propper, Seiler (2012) investigate the impact of the patient
choice reforms on the change in individual-level and hospital-level
elasticities of demand, using data on 13,500 elective CABG performed
336
At the hospital level, the estimated average marginal effects indicate, for instance, that a 6-km increase in the
distance would cause a loss of 43.8 per cent of demand, while an increase in the CQC rate by one unit would
result in 15.4 per cent more patients for the hospital.
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in 29 hospitals in 2004/05 and 2007/08. In order to employ a
correctly risk-adjusted indicator of quality, the authors introduce a
measure of quality obtained through a 'production function of patient
survival'. They specify a linear probability model of patient mortality,
regressing indicators for whether patients died after the surgery
(conditional on visiting a certain hospital) on patient characteristics and
hospital-time period fixed effects. To solve the endogeneity of the
process of hospital selection, they use the distance from each provider
as an instrument for hospital choice. In this way, they recover the
causal impact of being treated in a certain hospital on patients'
chances of survival, and use this set of estimated fixed effects (called
'case-mix adjusted mortality rates') as an indicator of hospitals' quality
of care.
5.40 Afterwards, the authors employ this measure of quality to estimate a
complex structural model of patients' demand, using separate hospital
fixed effect for every quarter in order to address the possible
endogeneity of waiting times. They code the five quarters between
January 2004 and March 2005 as the pre-reform period, and the five
quarters between January 2007 and March 2008 as the post-reform
period. Results show that patients became more responsive to hospital
quality: an increase in mortality by one standard deviation results in an
approximately seven per cent drop in the probability of the average
patient to choose the hospital after the reform, while it led to an
approximately three per cent decrease before the reform. Interestingly,
the change in responsiveness to quality was larger for sicker and
better informed patients. On the other hand, the average
responsiveness to waiting times does not seem to have changed.
5.41 At the hospital level, the main finding of the study is that an increase
in the mortality rate by one standard deviation results in a 4.9 per cent
decrease in market share for the average hospital after the reform,
compared to a decrease of 0.36 per cent in the pre-reform period. The
elasticity at the average hospital was 0.02 before the reforms, and
became -0.12 afterwards. In spite of a big heterogeneity in the effects
across hospitals, the results suggest that introduction of choice
'increased hospitals' incentives to improve quality'.
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5.42 In the last part of the paper337, the authors perform some basic
analyses of the impact of competition on quality, estimating that the
pro-competitive reforms saved 10 lives per year,338 and led to a 7.68
per cent increase in patient welfare. Regarding the competitive
environment faced by hospitals, they analyse how market shares
before the reform would have been different if patient had chosen
provider on the basis of the estimated parameters for the post-reform
period. Results show heterogeneity, but one provider would have lost
8.7 per cent of its market share and another would have gained 14.7
per cent.
The role of GPs
GPs' role in the choice process
5.43 As we mentioned in the previous sections, the extent to which
competition in the NHS may lead to improvements in the quality of
services depends on the presence of active and informed patients. Like
many other public services markets, however, healthcare markets are
naturally characterised by the existence of asymmetric information
between consumers and providers. Indeed, patients may experience
difficulties in understanding what type of care is appropriate for their
condition, and are likely to be less informed than healthcare
professionals about quality and other relevant characteristics of
treatments. In the healthcare context, moreover, the negative
consequences of asymmetric information are particularly relevant,
given the potential serious effects for patients of making bad choices.
5.44 OFT (2010, page 39) explains that patients may experience a
particular lack of information when faced with one-off healthcare
decisions; however, information asymmetry is often present also with
regard to procedures repeated over time. This happens because
healthcare services are not always experience goods, whose
characteristics are difficult to be detected before consumption, but can
be ascertained afterwards. In many cases, indeed, they are more
similar to credence goods, whose quality cannot be determined even
after having consumed them.339
337
Gaynor, Propper, Seiler (2012, sections 8.1-8.3).
This is a 3.1 per cent decrease in the CABG mortality rate.
339
As explained in OECD (2012, page 43), examples of credence goods are also found in the provision of taxi services, legal and financial advice, and in many repair professions.
338
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5.45 As Pike (2010, page 14) and OECD (2012, page 234) point out, a
number of structures are in place in the NHS to address the problems
caused by asymmetric information. First, the evaluation of providers
according to the CQC standards guarantees that at least a basic level
of quality is offered by each hospital, so that unsafe providers cannot
exploit the presence of information asymmetry and remain in the
market.340 Second, the Department of Health makes available a series
of quality indicators on providers, for instance through the NHS
Choices website and the Dr Foster Hospital Report. This information is
intended to reduce the information gap between consumers and
suppliers of healthcare services, helping patients to make informed
decisions. GPs, as independent clinical experts, have a similar role to
play, and are expected to increase the amount of information available
to patients, facilitating the process of choice. For this reason, the role
of GPs in the NHS is not only to provide primary care services, but
also to act as 'informed agents' on the side of patients.341
5.46 Patients tend to rely more on GPs than on other official sources (like
NHS Choices) to get information about hospitals.342 For this reason,
the help received from GPs might be considered a crucial factor to
attenuate the asymmetry of information between patients and
providers, and to make hospital markets work better. OFT (2010, page
43) and OECD (2012, page 234), indeed, argue that a key element for
the correct functioning of competition in the NHS is that GPs have
interests aligned to those of their patients, and are supportive of
patient choice. Dixon et al. (2010, page 7) explain that the
development of effective competition in the NHS would be facilitated
by GPs who give importance to choice; who offer it to all patients,
involving them in decision making; who have access to information
about provider quality and communicate it to patients; who have time
and resources to support patient informed choice. As pointed out in
paragraph 5.3, moreover, GPs may also drive quality competition by
themselves, choosing providers (arguably on the basis of quality) on
behalf of patients when they do not exercise choice.
5.47 However, when Dixon et al. (2010) analyse the evidence collected
through interviews with 25 GPs in the four local health economies
340
341
342
For individual medical practitioners, a similar task is carried out by the General Medical Council.
OECD (2012, page 243). See paragraphs 5.19-5.20above.
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described in their study, they find that the conditions listed in the
previous paragraph are only partially met in their sample. For instance,
the support of GPs to patient choice was not strong, and GPs were
generally less positive than providers about choice. Some of them had
concerns about its implications for equity and for the efficient use of
resources, but in the view of Dixon et al. (2010) the negative opinions
were often due to the difficulties encountered in the use of Choose
and Book, the new appointment booking system.
5.48 The data reported in paragraph 5.8 showed that three quarters of
patients thought choice was important, and slightly less than half of
them were conscious of their right to choose provider. In contrast to
these figures, GPs appeared to believe that most people were not
aware of choice, and that demand for choice was limited. They tended
to think that in reality patients wanted to delegate the decision to
them, and often simply chose the local hospital. In a similar way, all
the GPs interviewed said they offered a choice to their patients, but
the results of the patient survey showed that only 49 per cent of
respondents recalled being offered it. However, the authors of the
study explain that this discrepancy could be in part due to bad
memory from patients, or to differences in the meaning of the
expression 'offer of choice' between patients and practitioners.
5.49 We saw in paragraphs 5.17-5.18 that the factors patients deemed
most important for the choice of provider were cleanliness, quality of
care and standard of facilities. We also noticed that these results were
consistent with actual patients' decisions, so were likely to be due not
only to the phrasing of the survey questions. However, the GPs
viewed location and convenience as the principal determinants of
patient choice of providers. Apart from a few exceptions, they did not
believe that patients were evaluating hospitals on the basis of
measures of quality. Maybe for this reason, GPs hardly ever presented
comparative performance data on hospitals to their patients, and they
themselves distrusted this source of information.343 In general, GPs
were conscious of their role as informed agents, but tended to advise
patients using a mix of personal knowledge about hospitals and single
consultants and of feedback from previously referred patients. The
authors conclude that this 'soft intelligence' used by GPs may prove
useful for providing informed advice on local hospitals, but might
343
This might explain why in the surveys by Dixon et al. (2010) and by the Department of Health (2010) very
few respondents said they had recurred to booklets about choice or to NHS Choices.
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provide limited help to those patients who consider to attend non-local
structures, and would need to know more about them.
5.50 The findings of Dixon et al. (2010) raise some doubts about the
effectiveness of GPs as informed agents who can foster quality
improvements, helping patients to choose or choosing on their behalf.
Indeed, the data suggests that in some cases patients were not
offered choice, and GPs decided for them. When this happened, it is
not clear whether they took their decisions on the basis of factors
which mattered to patients, including quality. The evidence provided
by Dixon et al. (2010) shows that GPs' opinion on what is important
to patients seemed to differ from the actual view of patients, and that
providers tended to see GP's referral patterns as fairly stable, and
paying little attention to quality. However, this might be simply due to
different views of quality (if, for instance, GPs prefer one dimension of
quality and patients favour a different one), or to dissimilar risk
preferences between GPs and patients. In addition, it must be noted
that all the interview data collected by Dixon et al. (2010) refers to
2008/09; in absence of more recent evidence, it is not easy to
conclude that these considerations about the role of GPs are still valid.
Extension: competition on quality in the primary care market
5.51 Within the current Choice Framework for the NHS,344 patients are
entitled to choose not only their hospital, but also their GP practice.345
As for hospitals, patient choice for GPs is intended to foster quality
improvements from practices.346 Indeed, for both types of GP
contracts currently in use,347 'payments follow the patient,'348 so
practices are in theory incentivised to attract more patients. Since
prices are absent in this market too, GPs should compete with each
other only on the basis of quality, which is then expected to increase.
5.52 In order to facilitate patient choice, a number of indicators of the
quality of services at GP practices have been made available to NHS
patients. Data accessible on NHS Choices includes the number of
registered patients, the overall score of a national patient survey,349 a
344
Department of Health (2013)
In theory, patients have the right to register with any GP practice in England. However, we will see in paragraph 5.55 below that there exist some limitations to this right. 346
Santos, Gravelle, Propper (2013).
347
The General Medical Services (GMS) and the Primary Medical Services (PMS) contract (see paragraph 2.4).
348
Pike (2010, page 7) 349
See paragraph 5.56 and footnote 354 below.
345
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series of practical information about the practice and the services
offered, and the users rating. These rates are assigned with respect to
telephone access, appointments, dignity and respect, involvement in
decisions and accuracy of information.
5.53 The possible benefits from competition between GPs are not limited to
improvements in the quality of primary care services, but include also
potential increases in the extent of hospital competition, which in turn
may boost quality of secondary care services. As Pike (2010, page 13)
explains, indeed, in absence of competition GPs suffer no financial
consequences for referrals to a poor quality hospital. Without patient
choice of primary care provider, indeed, patients could not leave the
GP practice, even if they blamed the GP for the poor quality of the
secondary care services received.350
5.54 If patient choice and competition are effective, on the other hand, the
financial threat of patients switching practice in consequence of wrong
referrals is present. This should constitute an additional incentive for
GPs to align their interests to those of patients. GPs should take extra
care in appraising the quality of hospitals, in order to suggest the best
option to their patients. Being evaluated more carefully by medical
experts, hospitals could in turn be incentivised to further improve their
quality.
5.55 There are some restrictions on competition in the market for GP
services. First, the presence of catchment areas reduces the possibility
for certain patients of being registered with a given GP practice.
Indeed, every practice is only obliged to accept residents in a specific
catchment area as patients, and is allowed to reject the request of
people living outside the area.351 In a similar fashion, there could be
difficulties for the entry of new practices or for the expansion of
existing ones, and patients may experience difficulties in switching
practice. In fact, the ability of patient to access GP services and the
impact of the rules for setting up and/or expanding a practice are
among the aspects of the provision and commissioning of GP services
which are listed in a recent call for evidence from Monitor.352
350
For example, if the hospital care was not well integrated with follow on care.
The Department of Health has put into practice some mechanisms to relax this restriction (www.nhs.uk/NHSEngland/AboutNHSservices/doctors/Pages/patient-choice-GP-practices.aspx), though very limited and on the fringes.
352
www.monitor.gov.uk/gpservices. 351
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5.56 The vast majority of studies analysing the relationship between
competition and quality focus on hospital services. Pike (2010)
investigate instead the effect of competition between GP practices on
GPs' quality. Primary care quality is measured through an indicator of
clinical quality and one of patient observed quality. The former is the
number of referrals to secondary care for Ambulatory Care Sensitive
(ACS) conditions, which are treatable within primary care,353 the latter
is represented by the patient satisfaction scores obtained from the
national GP Patient Survey.354
5.57 In 2004, the Quality Outcomes Framework (QOF) was introduced as
part of the contract for GPs. Almost all the GP practices in the UK
participate in the QOF scheme, which allows practices to earn
additional income through the accumulation of QOF points, designed
to reward the quality of primary care. The QOF score could thus be
deemed a good indicator of GP quality for competition studies, but the
author explains that some of its characteristics are unsuitable for this
purpose. Indeed, the relative QOF achievements are not completely
related to the quality offered to patients; improvements of QOF scores
are not incentivised by an increase in GP competition; QOF results are
arguably subject to gaming; there is very little variation in QOF scores.
5.58 In his empirical analysis, the author uses data on all English GP
practices in 2009. For each practice, he calculates the number of
competitors within different distance bands, and uses it as a proxy of
the degree of competition faced by the practice within each band.
Regressing his favoured measures of quality on the number of
competitors and on practice and population characteristics,355 he finds
that competition in a radius of 500 metres is positively correlated with
quality. Adding one additional rival within 500 metres from a practice,
indeed, is significantly associated with 0.7 less ACS total referral per
year, 0.0895 less ACS referrals per patient per year and 0.1 per cent
higher patient satisfaction with the practice.356 To give an idea of the
magnitude of this impact, the author explains that the same decrease
in ACS referrals per patient would be achieved through 1,000 fewer
353
That is, better quality is represented by a lower number of ACS referrals.
The scores of the practices in the national GP patient surveys are available on the NHS Choices website (www.nhs.uk/Pages/HomePage.aspx) and in more detail on www.gp-patient.co.uk/info/ . 355
When the dependent variable is the satisfaction in the patient survey, characteristics of participants in the
survey are added as regressors.
356
But for one case, the number of competitors further than 500 metres is never related to practice's quality in a statistically significant way. This suggests that practices react almost only to the competitive pressure from
nearby rivals, and that competition for GP services is likely to be local.
354
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births in practice's local area, and the same increase in patient
satisfaction would be attained through an extra 1/3 of a GP working at
the practice, or through 500 fewer patients on the practice's list size.
5.59 In paragraphs 5.35 -5.42 we reviewed the empirical studies by
Beckert, Christensen, Collyer (2012) and Gaynor, Propper, Seiler
(2012), which investigate whether the demand for hospital services is
responsive to quality. In a very recent paper, Santos, Gravelle, Propper
(2013) address the same research question with regard to the market
for GP services. As in the case of hospitals, indeed, the sensitivity of
demand to variation of quality is a prerequisite for competition to have
a positive effect on quality. The authors construct a dataset on 3.372
million patients and almost 1000 practices in East Midlands' 2875
Lower Super Output Areas (LSOAs) for 2009/10,357 and use the
lagged QOF total points in 2006/07 as the main measure of practice
quality.358 They acknowledge that the QOF score is unlikely to
represent accurately the quality of a practice, but argue that it can be
seen as a determinant of demand of GP services. This is because the
scores are available to the public online, so patients can use them as a
basis for their choice of GP practice.359
5.60 Patients' choice of practice is estimated through a series of conditional
logit models. In the baseline model, all the individuals in the same
LSOA are assumed to have identical preferences over practice
characteristics, and then also the same probability of choosing a given
practice. Moreover, the choice set for patients is restricted to the
practices within 10 km of their LSOA centroid. For each LSOA and GP
practice, the authors calculate the marginal effects of practice
characteristics (including quality) and (cubed) distance on the
probability that a practice is selected, and then report the average
marginal effects.
5.61 The results of Santos, Gravelle and Propper (2013) show that patients
are more likely to select practices with younger GPs, with a higher
proportion of female GPs, with a lower proportion of non-European
357
LSOAs are small homogeneous English areas, administratively defined.
However, a number of alternative quality variables are used for sensitivity checks, including the QOF scores
for 2009/10, the annual emergency admission rate for ACS conditions and three patient satisfaction measures
from the GP Patient Survey. Still, the authors conclude that 2006/07 total QOF points is the best single overall
measure of practice quality to predict patient choice.
359
A summary of QOF scores is showed on NHS Choices
(www.nhs.uk/Services/GP/Performance/DefaultView.aspx?id=36680), though not in a central position. The
extensive QOF results are published on www.qof.ic.nhs.uk/index.asp.
358
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qualified GPs, and practices that have opted out of out-of-hours cover
and have PMS contracts. More importantly, patients prefer less distant
GPs, and are responsive to practice quality, since an increase of QOF
points by 1/10th standard deviation increases the likelihood of
choosing a practice by 0.00082. Although this effect is small in
magnitude, the number of patients gained by a practice through an
increase in quality is not, since it depends also on the number of
practice's potential patients. According to the estimates of the
authors, an increase of QOF points by 1/10th standard deviation
translates into 103.6 more patients for the practice. It must be noted,
however, that the patients gained through an identical increase in the
proportion of GPs who are female or trained inside the EU are 486 and
1342, respectively.
5.62 The authors perform a number of sensitivity checks to corroborate
their results. For instance, they allow for observed patient
heterogeneity within a LSOA, and find that young men are the least
sensitive to quality, that more deprived LSOAs have a lower ratio of
importance of quality to importance of distance and that rural areas
are less responsive to both distance and quality. They also control for
unobserved heterogeneity estimating a mixed logit model, finding that
the mean estimates are similar to those of the conditional logit, and
only the standard deviation of distance and quality are significantly
different from zero. Subsequently, they control that data does not
depend on practice choices, checking that restrictions in patients'
choice set (due, for instance, to the presence of catchment areas)
increase the average marginal effects of distance and quality, but do
not alter their ratio. Finally, the authors control for the presence of
endogeneity and measurement error, instrumenting the quality of a
practice by the average quality of neighbouring practices.360 Estimating
a two stage residual inclusion (2SRI) model,361 they find that the noninstrumented quality measures are likely to be endogenous, but
calculate that the average marginal effects of quality obtained with the
2SRI estimation are larger than the baseline ones.
5.63 In conclusion, the papers by Santos, Gravelle, Propper (2013) and Pike
(2010) suggest that demand for GPs is influenced by their quality, and
360
According to the authors, if there are not unobservable determinants of demand which are correlated across neighbouring practices and affect practice quality, this instrument is likely to be valid, since the quality of nearby
competitiors is probably a good predictor of practice quality.
361
Terza, Basu, Rathouz (2008).
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that primary care competition is positively associated with quality of
GP practices, though their results are not of an overwhelming
magnitude. It is worth noting, however, that these findings hold
notwithstanding the restrictions to competition and patient choice
described in paragraph 5.55 above, and subject of the Monitor call for
evidence on GPs.362 Absent those conditions, the association between
competition and quality in the market for GP services might thus be
expected to increase.
Supply side: hospitals and competition
5.64 In the previous two sections, we analysed the available evidence
about the impact of patient choice on the demand side of healthcare
markets. Our aim was to understand whether NHS patients are in the
position to choose provider, whether they base their decisions on
quality considerations, and whether GPs help them in the process of
choice. The findings reviewed suggest that patients are aware of their
right to choice, at least to some extent, that they take into account
provider quality when they make their decisions, and that changes in
treatment location did occur since choice was made available.
5.65 From a theoretical point of view, the results reported above should
stimulate quality competition on the supply side of hospital markets.
Indeed, they imply that the demand faced by a particular hospital can
change in consequence of variations of the quality the hospital
provides. Quality improvements, either real or perceived, can thus
translate into an increase in the number of patients treated, while a
decrease in quality may be followed by a loss of market share. Since
the PbR framework implies that payments follow the patients (at least
for most elective services), increments and decrements of market
shares are associated with financial gains and losses, respectively. In
presence of providers interested in earning revenue (or at least in not
losing it), as in the English NHS, patient choice should then incentivise
providers to compete on quality.
5.66 In the next paragraphs, we try to evaluate whether this hypothesis is
likely to hold in the English hospital market. We investigate whether
providers respond to the competitive pressure triggered by patient
362
See footnote 352.
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choice competing on the basis of quality. First, we discuss the findings
of the qualitative studies by Dixon et al. (2010), and Pike (2012), also
referring to the evidence collected by the Competition Commission in
the context of the Bournemouth and Poole merger investigation.363
Second, we review the paper by Gravelle, Santos, Siciliani (2013),
who study empirically the response of providers to changes in
competitors' quality.
5.67 The study from Dixon et al. (2010) includes semi-structured interviews
with 49 senior staff in 15 NHS and independent sector providers,
conducted between November 2008 and April 2009. The data
obtained from the interviews is used by Frosini, Dixon, Robertson
(2012) too. The two studies find that hospitals appeared to compete
with each other to some extent, but that incentives for competition
were lower for those providers which were operating at or over
capacity, for those with high and rising number of referrals, and for
those whose activity was constituted for a large part by emergency
care. In general, however, hospitals subject to competitive pressure
focused on retaining patients and not on actively looking for new
ones. When competition occurred, it involved neighbouring providers,
and was directed mainly to the marginal patients equidistant from
them. This could be explained by the fact that providers seemed to
compete for GP referrals rather than directly for patients, and at the
same time felt that GPs' referral patterns depended more on location
than on quality of hospitals, and were fairly stable.
5.68 Generally, providers were interested in monitoring their volume of
referrals, and in some cases were taking measures to understand the
causes of low volumes. When service improvements occurred,
however, these were generally not directly influenced by the presence
of patient choice. Still, providers were aware of the implications of
choice, which often was one of the motivations behind quality
improvements. For instance, when quality increases were planned with
the aim to gain a good reputation (or to retain an already good one),
providers were conscious that this could also secure them more
referrals, because of patients returning to the hospital or
recommending it to other people.364
363
Competition Commission (2013).
It is worth noting that this view is consistent with the evidence from patient surveys, which suggested that
patients based their decisions mainly on personal experience and on the opinions of family and friends.
364
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5.69 The analysis of the interview data suggests that collaboration and
cooperation between providers were relevant phenomena in the areas
studied by Dixon et al. (2010). Indeed, there were numerous examples
of NHS hospitals which collaborated with other providers (both public
and private) and with commissioners to better face a number of
common local problems. However, Frosini, Dixon, Robertson (2012)
state that in many cases the behaviour emerging from the interviews
carried out by Dixon et al. (2010) could be deemed anti-competitive.
For instance, they refer to examples of agreements and historical
relationships between hospitals and GP practices which, according to
their paper, implied that the referrals from the practice were directed
mostly to that hospital, irrespective of quality considerations. At the
same time, Frosini, Dixon, Robertson (2012) also refer to more or less
formal agreements between providers to not compete on existing
services, to not enter into direct competition, and to split the market
for elective services according to specialties.
5.70 In a Cooperation and Competition Panel (CCP) working paper, Pike
(2012) studies the response of providers to competitive pressure, in
order to understand whether they reacted to the presence of
competition planning quality improvements to attract more patients.
He uses information found by the CCP during its investigations into
eight hospital mergers between May 2011 and May 2012, and
concludes that in each of these cases both of the merging trusts
competed with one provider or more to win referrals.
5.71 The evidence collected by the CCP shows that there were cases in
which this competition was targeted directly to patients, through
improvement of quality in aspects which mattered to them. Providers
did this because they believed that patients were informed about
hospitals' outcomes and reputation, through both word of mouth and
official sources of information. At the same time, however, trusts
invested in initiatives designed to improve dimensions of hospital
quality which mattered to GPs,365 who were likely to play an important
role in influencing patient choice. There was also evidence of trusts
competing for tertiary patients, trying to gain referrals for further
specialist care from consultants at other hospitals. In addition to cases
of competition in the market, Pike (2012) also describes examples of
365
For instance, through better and faster discharge summaries that improve the degree to which healthcare
services are integrated.
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competition for the market, with providers investing in order to be
selected for contracts by commissioners.
5.72 Pike (2012, Attachments A-D) lists the actions undertaken by trusts in
reaction to competition from other providers. They usually involved
investments in quality improvements, and the communication of the
results achieved to patients, GPs, consultants and commissioners.
Hospitals' investments affected four areas: integration and cooperation
(for example, locating staff in GP practices to reduce waiting times);
inputs or processes (for example, increasing infection control to attract
referrals); access to service (for example, introducing shuttle buses
between sites); market research and communication (for example,
conducting customer surveys).
5.73 The approach of Pike (2012) has been recently adopted by the
Competition Commission, within the analysis of the competition
between Bournemouth and Poole hospitals.366 Reviewing the parties'
marketing strategies and internal documents, the Competition
Commission found evidence suggesting that they had competed on
quality in the past. For instance, both parties appeared to have
marketed the quality of their services, especially to GPs, and one party
actively monitored GPs referrals, and seemed to believe that it had the
ability to retain patient referrals.
5.74 The studies reviewed in the previous paragraphs can give an idea of
the extent to which provider actually compete for patients, but does
not measure empirically the impact of the presence of competition on
hospitals' behaviour. This analysis is conducted by Gravelle, Santos,
Siciliani (2013), who investigate whether a provider responds to an
increase in quality from competitors by improving its own quality, that
is whether hospital qualities are strategic complements. The authors
set out a theoretical model of hospital quality competition with fixed
prices, whose prediction is that one provider's quality responds to the
quality of its rivals if the marginal cost of treatment is increasing, or
the responsiveness of demand to quality is increasing in competitors'
quality.
366
Competition Commission (2013, Appendix G).
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5.75 The authors use data for 147 NHS hospital trusts in 2009/10, and
consider 16 different measures of hospital quality;367 six of them are
based on standardised mortality rates, seven are standardised
readmission, revision and redo rates, three derive from surveys of
patients’ experiences.368 The identification strategy consists in the
estimation, by maximum likelihood, of the effect of a ‘weighted
average quality of the rivals’ on one hospital’s quality. Weights are
inversely related to the distance between providers, and a weight
equal to zero is assigned to the quality of rival hospitals not falling
within a catchment area of 30 minutes travel time.369 The estimation
outcomes suggest that hospital quality responds positively to the
quality of rival providers for seven out of the sixteen indicators, and
does not respond for the others.370 Results are especially significant for
the measures related to patients’ experiences. When an effect is
present, an increase in rivals’ quality by 10 per cent increases quality
by 1.7-2.9 per cent.
5.76 A similar analysis is performed in the paper by Gaynor, Propper and
Seiler that we reviewed in paragraphs 5.39-5.42.371 In order to
evaluate the supply-side response to the introduction of choice, the
authors regress the change in their risk-adjusted measure of mortality
on the change in the aggregate elasticity of demand to quality,
previously estimated through their choice model. They find a negative
and significant effect of the change in elasticity on the change in
mortality, suggesting that providers reacted to the presence of choice,
since 'hospitals whose demand became more responsive to quality
improved quality disproportionately more than elsewhere'.372
5.77 The findings outlined in the previous two sections showed that patient
choice is now a non-negligible reality in the English NHS, and that it
depends at least to some extent on quality considerations.
Consistently, the available studies of providers' reactions to quality
seem to indicate that providers are aware of the presence of patient
choice and competition, and tend to take them into consideration
when making strategic decisions. More importantly, they suggest that
367
For a description of the quality indicators, see Gravelle, Santos, Siciliani (2013, Appendix)
Correlations among the quality measures are shown in Tables 2-3 of Gravelle, Santos, Siciliani (2013).
369
As a sensitivity check, the authors also repeat the analysis with catchment areas of 60 and 98 minutes.
370
Effects are detected for overall mortality rates, in-hospital stroke mortality, knee replacement readmissions,
stroke readmission within 28 days, and three indicators on patients’ experience. 371
Gaynor, Propper, Seiler (2012, pages 27-28).
372
In a U.S. context, an interesting study of the strategic reaction of hospitals to the behaviour of competitors is Dafny (2009),which shows that providers increase price following a rival's merger. 368
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the existence of a competitive pressure has incentivised providers to
improve the quality of their services.
5.78 The evidence provided in this chapter allows to better understand the
practical functioning of patient choice and competition in the NHS, and
to highlight strengths and potential weaknesses of the current system.
Although this may not be sufficient, in isolation, to show the existence
of a causal link between competition and quality, it helps to
corroborate the findings of the country level studies reviewed in
Chapter 4 , suggesting that they are largely consistent with the
reactions of patients and providers to the introduction of competition.
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6 CONCLUSIONS
6.1 After the reforms of the past decade, NHS hospitals are incentivised to
compete on quality for the provision of many healthcare services.
Indeed, prices are fixed, and payments are linked to the number of
patients treated. Since patients can choose where to go, providers
should try to attract them, and do this by increasing the quality of
their services.
6.2 In such a context of regulated prices, the theoretical models described
in paragraphs 4.3-4.15 generally predict a positive impact of
competition on quality, provided that fixed tariffs are higher than
marginal costs of additional patients. There exist, however, models in
which the effect of competition is more ambiguous, and according to
some specifications may be negative.
6.3 Studying the 1991-97 'internal market' (where competition was both
on price for block contracts and quality), Propper, Burgess, Green
(2004) and Propper, Burgess and Gossage (2008) show that
competition caused a slight decrease of quality, measured by AMI
mortality. On the other hand, the studies of the new NHS hospital
market in England all confirm the prediction from theory in presence of
regulated prices. Bloom et al. (2010), Gaynor, Moreno-Serra, Propper
(2013), Cooper et al. (2011), Cooper et al. (2012) find a positive
effect of competition on (respectively) managerial quality, AMI and
overall mortality, AMI mortality and a measure of efficiency, the length
of stay.
6.4 The papers by Gaynor, Moreno-Serra, Propper (2013) and Cooper et
al. (2011) have received a number of criticisms (especially from
Pollock et al. (2011)), in many cases not fully deserved. On the
analytical side, indeed, they use econometric techniques widely
employed in the recent empirical literature, and control for endogeneity
of market structures and for confounding factors in a reasonably
convincing way.
6.5 However, the use of AMI mortality rate as the principal measure of
quality gives rise to some problems. First, it is not straightforward to
conclude that AMI mortality is a good proxy of overall hospital quality.
Second, it is not easy to assess the existence of a causal link between
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competition for elective services and a measure of quality for
emergency procedures like AMI, especially because the
aforementioned studies do not model explicitly the relation between
competition and quality.
6.6 The evidence presented in Chapter 5 is meant to address the latter
problem, shedding light on the reactions of patients and providers to
competition in order to see whether they are consistent with the
findings of the country-level empirical papers. The studies reviewed in
this chapter suggest that a substantial share of patients are exerting
choice (which is likely to be sufficient to present a substantial revenue
risk to unpopular hospitals); that there were changes in treatment
location after the introduction of competition; that patient choice
depends at least to some extent on providers' quality; that providers
are aware of the presence of patient choice and competition, and tend
to take them into consideration when making strategic decisions.
6.7 Not all of the evidence at our disposal, however, reflects behaviours
consistent with an effective implementation of patient choice and
competitive mechanisms; GPs, for instance, do not seem to fully
adhere to the role of 'informed agents' helping patients in the process
of choice.373 On balance, however, the mechanisms intended to
introduce quality competition appear to be effective. This, in turn,
helps to validate the findings of the country-level studies by Bloom et
al. (2010), Gaynor, Moreno-Serra, Propper (2013), Cooper et al.
(2011, 2012).
6.8 The review carried out in our paper has highlighted some areas where
there is a dearth of conclusive evidence, and more research would be
informative. In the context of quality measurement, for instance, we
saw that most of the indicators commonly used (such as AMI
mortality, readmission rates, risk-adjusted overall mortality) can be
criticised. However, there is an ongoing research on quality metrics,
for instance on PROMs and new indicators of avoidable deaths,374 and
more reliable measures could be available in the near future.
6.9 In Chapter 5, we reviewed several studies investigating from different
angles the behaviour of demand and supply forces in the NHS
373
As already pointed out in paragraph 5.50, however, the evidence on the role of GPs in the choice process is not particularly up-to-date.
374
See paragraphs 3.21-3.22 and footnote 263, respectively.
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markets. In this field, however, some areas of research should be
further explored, since more recent evidence could be particularly
useful. This is the case, for instance, of studies of changes in
treatment location; of qualitative and quantitative studies of providers'
reaction to competition; of studies of GPs' role in the process of
choice. The latter topic, in particular, is still relatively unexplored, and
up-to-date research could investigate to what extent GP choice is
based on quality considerations, or whether interests of GPs are fully
aligned to those of patients.
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7
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