Vertical Differentiation, Quality Competition and Second-Best Hospital Price Regulation

We analyze quality competition between hospitals under vertical health care services differentiation and price regulation. We show that a regulator can set a price to achieve the first-best level of quality for any market structure. However, under free entry, the number of entering hospitals at a Nash equilibrium will be greater than the socially optimal number of hospitals when the regulator uses the only credible price policy. Consequently, though Cournot competition achieves the goal of rent extraction, it leads to excessive fixed costs. When the regulator cannot use another instrument to deter entry, he cannot achieve the first-best level of welfare. He must therefore design a second-best pricing policy to compromise between allocative efficiency and optimal market structure. We show that this policy results in a lower level of health care services quality, a greater number of hospitals and a lower price than those obtained in the first best.