Excess Demand and Cost Relationships among Kentucky Nursing Homes

By Davis, Mark A.; Freeman, James W. | Health Care Financing Review, Summer 1994 | Go to article overview
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Excess Demand and Cost Relationships among Kentucky Nursing Homes

Davis, Mark A., Freeman, James W., Health Care Financing Review


In a previous survey of nursing home cost studies, Bishop (1980) discussed the influence of several key variables commonly linked to nursing home expenditures, including occupancy rate, ownership and provider type, location, and level of care. While the evidence for some cost factors was persuasive, Bishop concluded that existing studies provided a limited view of the determinants of nursing home costs. Among the limitations cited by Bishop were the failure to assess the impact of market variables (e.g., competition and consumer demand) and the lack of adequate quality and case-mix measures.

Subsequent to Bishop's review, a spate of studies estimating nursing home cost functions were conducted (e.g., Birnbaum, et al., 1981; Caswell and Cleverly, 1983; Koetting, 1980; Lee and Birnbaum, 1983; Meiners, 1982; Nyman, 1988a,b; Palm and Nelson, 1984; Schlenker, 1986; Schlenker and Shaughnessy, 1984; Smith and Fottler, 1981; Smith, Fottler, and Saxberd, 1985; Tuckman and Chang, 1988; Ullmann, 1984, 1985). Although these studies certainly broadened our understanding of nursing home cost factors, the majority effectively ignored market influences.

Nyman's (1988a) comparison of underbedded and overbedded nursing home markets in Wisconsin is a striking exception to previous cost function studies. Using a proxy for excess demand or tight bed supplies, his analysis revealed lower patient-care expenditures in nursing homes located in underbedded markets. Given a pervasive shortage of beds in many nursing home markets, Nyman's findings invite specific policy responses designed to eliminate the problem of excess demand (e.g., relaxing certificate-of-need regulations).

Our investigation was prompted by the dearth of studies incorporating market variables in previous cost function estimates, as well as Nyman's distinctive research on excess demand. The policy implications stemming from an excess demand argument and the significant variability in nursing home markets warrant additional study. Accordingly, this study tests excess demand hypotheses using 1989 data from a sample of Kentucky nursing homes.

In addition, many, but not all, nursing home cost function estimates employ average operating costs, rather than average total costs, as the dependent measure. Because average total costs include property costs (e.g., interest and depreciation), which are not directly tied to patient care, the factors associated with average operating costs may differ from those related to average total costs. As such, operating costs are probably more sensitive to the cost reduction efforts of nursing homes. Therefore, our analysis incorporates both average total costs and average operating costs.


Many researchers and policymakers acknowledge that bed shortages are characteristic of the nursing home industry in the United States (Harrington, Swan, and Grant, 1988; Scanlon, 1980; Vladeck, 1980). One estimate suggests a national shortage of 250,000 beds (Richardson, 1990). In part, the excess demand for beds may result from certificate-of-need legislation and construction moratoria aimed at controlling Medicaid expenditures, as well as policies that do not encourage alternatives to nursing homes, such as home care or enhanced community services. This shortage of beds is the basis for Nyman's (1988a) excess demand argument, which is offered as a fundamental cause of the quality problems plaguing the industry.

The basic premises of the excess demand argument are derived from economic theory. In the nursing home industry, as in other industries, the dictates of profit maximization foster an emphasis on cost minimization. Although the possibility of raising prices to maximize profits is always an option, a primary source of revenue for nursing homes, the government, does not pay market price but rather reimburses on a cost-oriented basis. Although many partially regulated industries often make up revenue shortfalls by raising rates on private-pay patients (e.

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Excess Demand and Cost Relationships among Kentucky Nursing Homes


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