Public Grants Awarded to Private Firms: A Mixed Duopoly Analysis

https://doi.org/10.1016/j.qref.2020.05.017Get rights and content

Highlights

  • Public grants to private firms could have adverse socioeconomic effects.

  • Status of competing public firm determines effect of grants to private firm.

  • Mixed duopoly model of healthcare market accommodates healthcare policy.

Abstract

The literature presents conflicting arguments on the social value of public grants awarded to private firms. Some of the prominent examples are those associated with public grants for medical research awarded by the National Institute of Health to private healthcare providers. This study evaluates the social welfare impact of such public grants to private sector in a mixed duopoly model. The results generate equilibrium-based conditions that could be responsible for the enhancing or deteriorating social welfare effect of public grants awarded to private healthcare providers. The status of the competing public healthcare providers turns out to be a crucial factor. The results have policy implications for public granting agencies and for state governments in charge of public healthcare providers.

Introduction

The authors wish to thank Daniel Flores and an anonymous referee for helpful comments.

There are a number of major markets in which the government and the private sector interact extensively on several levels. One of those is the healthcare market in which the government distributes a vast amount of public funds as research grants to private healthcare providers. The National Institute of Health (NIH) is the U.S. primary provider of public grants for research awarded to pharmaceutical firms and healthcare providers, including those awarded to public and private hospitals and clinics. According to the NIH budget data, its annual grants to independent hospitals steadily rose from roughly $1.7 billion in 2009 to $2.5 billion in 20181 . These figures are higher than the NIH grants to each of the categories of research institutes, domestic for-profit organizations, and domestic nonprofit organizations. Private hospitals have utilized these public grants to provide medical care that is perceived to be of higher quality than those offered by public hospitals.2 In a 2014 ranking of most technologically advanced hospitals in the world, the top 15 are private hospitals, of which 7 are in the U.S., including some associated with private universities.3

A concern often arises as to whether the governmental public grants awarded to private hospitals not only accommodate the private hospital's core objective of maximizing its private profits but also raise the society's welfare. Azoulay, Zivin, Li, and Sampat (2019) use the NIH data to evaluate the patent impact of public R&D investment in the private sector. They report that on average a $10 million boost in the NIH funding leads to a net increase of 2.7 patents. They point out that, however, it is difficult to measure the social welfare impact of a medical patent. In a survey review of public investments in R&D of private firms, Zuniga-Vicente, Alonso-Borrego, Forcadell, and Galan (2012) conclude that various aspects of the results of such public investments for the general society are inconclusive and require further analysis on both empirical and theoretical settings. Their findings are highly relevant to the public funding of private research in the healthcare market as well. Li, Azoulay, and Sampat (2017) question, based on their study of 27 years of grant funding by the NIH, whether public investment in private biomedical research generates significant socially valuable outcome. When the social welfare of countries was measured by their GDP, van Elk, ter Weel, van der Wiel, and Wouterse (2019) report that their empirical study of 22 OECD countries showed that publicly sponsored R&D investment often does not foster GDP.

Further concern regarding the social benefits of public investment in medical research by private hospitals is raised by Gravelle, Santos, and Siciliani (2014) and Gaynor, Ho, and Town (2015). They show that there is no consensus on whether the public promotion of private sector in the healthcare market has a positive welfare effect. The trend of privatization over the recent decades has increasingly widened the space for the private sector in the healthcare market. Increasing share of public NIH grants going to private hospitals, as pointed out earlier, is consistent with the underlying privatization trend. The issue of privatization in the healthcare market itself remains controversial. Chang, Wu, and Lin (2018) point out that one of the adverse welfare effects of privatization in the healthcare market is that the public hospitals are increasingly taking the back seat in terms of productivity and innovation.

The objective of this study is, first, to construct a model of the healthcare market consisting of a private hospital and a public hospital who have competitive interactions but pursue different objectives. The setting for our analysis is a mixed duopoly model.4 Our model is distinct in the sense that it combines Stackleberg output interactions with a stochastic demand and quadratic costs. The study then generates a set of equilibrium-based conditions under which public grants to the private hospital enhances the welfare of the society while the absence of one or some of the conditions could reverse the outcome. The results offer an explanation for the existing gap between the camps who have offered opposing views on the social welfare value of public funds funneled as research grants to private hospitals. The results also offer some policy insight to both the governmental granting agencies such as the NIH and the state governments who are the main sponsors of public hospitals.

The rest of the paper is organized as follows. Section 2 specifies the model, Section 3 characterizes its equilibrium, Section 4 evaluates the social welfare effect of a public grant to the private hospital. Concluding remarks and policy implications are presented in Section 5. Appendices 1 and 2 contain the proofs for a lemma and a proposition, and Appendix 3 contains a summary of notation definitions.

Section snippets

The model

We construct a mixed duopoly model consisting of two hospitals, a profit-maximizing private hospital and a social welfare-maximizing public hospital. The private hospital charges a market-driven price for its services based on the market demand it faces. The public hospital relies on state funding of its operations and offers free healthcare services to its patients. The public hospital is viewed as the healthcare provider of last resort and is not in price competition with the private

Equilibrium

A two-player Stackleberg competition is a sequential game where the leader decides its output with the follower's reaction in mind, and then the follower reacts and sets its own output. A solution is obtained by backward induction. As justified earlier, the private hospital is the leader and the public hospital is the follower. In the backward induction, the public hospital first decides its optimal output as a function of the private hospital's unknown output by maximizing the social welfare (W

Welfare effect of grants

We now evaluate the welfare effect of public grants to the private hospital at equilibrium. The equilibrium results in (13) and (14) suggest that, given that the state financing formula for the public hospital (ϕb) remains unchanged, a rise in grants to the private hospital (Gv) increases the medical services offered by the private hospital and reduces the services offered by the public hospital. However, this is not sufficient to make a statement about the impact of grants to the private

Concluding remarks

The healthcare market offers one of the prominent settings in which the social welfare impact of public grants awarded to private firms can be evaluated. The significance of such evaluations arises from both their policy implications and the existing literature that shows conflicting arguments on the social value of public grants awarded to private firms. In our evaluation, we modelled the healthcare market as a mixed duopoly and generated specific equilibrium-based conditions that could be

Conflict of interest

No conflict of interest exists in this study and submission.

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