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Firms in markets such as health care and education are often profit constrained due to regulation or their non-profit status, and they are often viewed as being altruistic towards consumers. We use a spatial competition framework to study incentives for cost containment and quality provision by altruistic firms facing profit constraints. If prices are regulated, profit constraints lead to lower cost containment efforts, but higher quality if and only if firms are sufficiently altruistic. Under price competition, profit constraints reduce quality and cost containment efforts, but lead to lower prices if and only if firms are sufficiently altruistic. Profit constrained firms’ cost containment efforts are below the first-best, while their quality might be too high or too low. If prices are regulated, profit constraints can improve welfare and be a complement or substitute to a higher regulated price, depending on the degree of altruism.

In many markets, goods or services are provided by firms that face constraints on profit distribution, either because they have non-profit status or because they are subject to regulation which limits the amount of profits that can be distributed to the owners of the firm. In these cases, profits must be (wholly or partially) reinvested in the firm or spent on ‘perquisites’. In this paper we analyse theoretically how profit constraints affect firms’ choices regarding quality, price, and cost containment. The main applications of our analysis are regulated markets such as health care, child care, long-term care and education, and we are particularly interested in analysing whether profit-constrained firms in such markets are likely to offer higher or lower quality than firms that do not face any constraints on profit distribution. This goes to the heart of the question of whether owners of private firms that receive public funding should be allowed to distribute profits, which is often a hotly contested policy issue with regulatory practices that vary across countries. To give a motivating example from education markets, in 1992, Sweden embarked on a radical education reform programme, which has recently become the subject of intense debate in the UK.1 The Swedish reform introduced free school choice and liberalised entry by removing school ownership restrictions, including the ban on private for-profit schools. Private schools receive public funding corresponding to the average cost per student for each student from the municipality in which the school is located, but are not allowed to charge any top-up fees or ‘cherry pick’ pupils according to background. The Conservatives claim that the Swedish experiment has been successful and consider introducing school choice and removing the ban on for-profit schools in the UK. Labour, in contrast, claim that the Swedish reform has failed, and in April 2010, Ed Balls (then Secretary of State for Education) wrote a letter to Michael Gove (the current Secretary of State for Education), stating the following: ‘Parents and taxpayers across the country will be rightly shocked that you are willing to allow taxpayers’ money to be diverted from its intended purpose – the education of our children – to the profits of the private companies you want to prove it, even more so because the evidence from Sweden is that this very policy caused educational standards across the country to fall.’2 In this paper we directly address the concern expressed in the above statement by analysing how firms’ incentives for quality provision (for example, the ‘educational standards’ of schools) depend on their ability to distribute profits. We analyse this question within a theoretical framework that is commonly used for studying competition in markets such as health care and education, namely a spatial competition model where consumers make their purchasing decisions based on travelling distance, quality and price. In the main version of the model, we assume that prices are regulated and that firms compete only on quality. Subsequently, we extend the model to allow for price competition. We also allow the firms to become more cost efficient by investing in cost containment effort. Quality is taken to be observable, but non-contractible, as is commonly assumed in the literature,3 and we assume that there are both monetary and non-monetary costs associated with quality provision. Furthermore, we assume that firms are altruistic in the sense that they care about profits and (to some extent) consumers’ benefit. Finally, we model profit constraints as being equivalent to a tax on profits,4 the basic underlying assumption being that owners prefer compensation in cash over alternative modes of compensation, such as perquisites.5 Taken together, these model ingredients are particularly suited to describe provider behaviour in markets such as education, health care, long-term care and child care. In all these markets, quality is an important competition variable, whereas prices might be regulated or not. Travelling costs also play a potentially important role in determining demand, e.g., distance to nearest school, hospital, kindergarten, nursing home, etc.6 Furthermore, altruistic provider preferences are generally acknowledged to be a relevant characteristic of such markets.7 Finally, in many countries, a significant share of education, health care, long-term care and child care services is provided either by non-profit institutions or by for-profit ones that are subject to some form of profit regulation.8 In contrast to the main bulk of the literature on non-profit firms,9 constraints on profit distribution are taken to be exogenous in our analysis. The main reason for this is that we do not confine our study to non-profit firms, but to profit-constrained firms more broadly. Indeed, many firms are profit-constrained not by choice but by regulation. For instance, most European countries do not allow for-profit schools to operate in their publicly funded educational system, as highlighted by our example from the UK. Another interesting example is Norway, where regulatory practices regarding profit distribution differ enormously between two otherwise similar markets: education and child care.10 Whereas owners of private government-dependent schools are not allowed to distribute any profits, owners of private government-dependent kindergartens have so far not been subject to any profit constraints, although the government has recently aired the idea of introducing profit caps that limit the amount of profits that can be distributed in the child care market. Similar regulatory restrictions often apply to hospitals and nursing homes. An interesting example is provided by the English National Health Service. Before 2003 all publicly-funded hospitals had the status of Acute Trusts with severe restrictions on how to spend surpluses. By 2014 all NHS Trusts will have a new status known as Foundation Trusts. Foundation status implies greater financial flexibility: hospitals can retain financial surpluses, they do not have to break even, can invest in new services and reward staff with higher salaries (Marini et al., 2008; between 2003 and now the new status was voluntary and hospitals had to apply for obtaining the different status). Thus, with the above-mentioned examples in mind, we focus on the impact and not the source of profit constraints, and we therefore set up a modelling framework that captures important features of markets where profit constraints are highly relevant. The results from our analysis show that, while a constraint on profit distribution always leads to less cost efficiency, the effect on quality and (if not regulated) prices are more ambiguous. If prices are regulated (as for most publicly-funded hospitals and schools in Europe) and firms compete only on quality, profit-constrained firms provide higher (lower) quality in equilibrium if the degree of altruism is sufficiently high (low). The reason is that altruistic providers choose a quality level that exceeds the profit-maximising level. A profit constraint will then reduce the negative marginal profits and thus induce a higher quality level given that the providers are sufficiently altruistic. In the case of quality-and-price competition (as for example in the child-care and nursing-homes markets), the imposition of a profit constraint always leads to lower quality, while prices will decrease if firms have sufficiently altruistic preferences and increase otherwise. The reason for the negative effect on quality is that prices and thus profit margins are reduced for high levels of altruism, which in turn reduces the profit incentive for investing in quality. However, we show in an extension that if the altruistic firms only care about the quality and not about the price consumers have to pay, then a profit constraint increases quality under price competition if and only if firms are sufficiently altruistic. We also perform a welfare analysis where we show that cost efficiency is too low for profit-constrained firms, while quality may be over- or underprovided in the market equilibrium. If prices are set by the firms, quality is always underprovided if there are constraints on profit distribution. However, if prices are set by a regulator, but not necessarily at the first-best optimal level, profit constraints may improve welfare for low or intermediate degrees of altruism, depending on the price level. If price regulation is optimal, we show that price and profit constraints can be either complements or substitutes, depending on the degree of altruism. For example, markets with non-profit (as opposed to for-profit) firms should optimally face a lower (higher) price if the degree of altruism is sufficiently high (low). The remainder of the paper is organised as follows. In Section 2 we offer a more detailed discussion of related literature, before presenting the model in Section 3. The model is then analysed for the cases of price regulation (Section 4) and price competition (Section 5). Welfare issues are analysed and discussed in Section 6, before Section 7 closes the paper with some concluding remarks.

In this paper we have analysed the impact of profit constraints on altruistic firms’ incentives to invest in quality and cost efficiency. Using a spatial competition approach, where consumers choose providers based on travelling distance, quality and price, we have derived the market equilibrium under quality competition with regulated prices and under quality-price competition. We have also analysed the welfare effects of price regulation and profit constraints. Our analysis has offered two sets of insights. In terms of market outcomes, we have showed that a constraint on profit distribution always leads to less cost efficiency, whereas the effect on quality and prices are more ambiguous. If prices are regulated, profit constraints lead to increased quality provision only if the firms are sufficiently altruistic. Otherwise, for low (or zero) levels of altruism, profit-constrained firms offer lower quality than firms that are not profit-constrained. On the other hand, if firms are allowed to compete on both quality and price, profit constraints always have a negative effect on quality provision, while the effect on prices is ambiguous; profit constraints lead to lower (higher) prices if the degree of altruism is sufficiently high (low). In terms of welfare outcomes, we have showed that profit constraints lead to too low levels of cost efficiency, while quality may be over- or underprovided in the market equilibrium, depending on the degree of altruism, if prices are regulated. Consequently, profit constraints might improve welfare if the regulated price is not set at the optimal level. Under optimal price regulation, profit constraints increase (reduce) the regulated price if altruism is sufficiently low (high), implying that price and profit constraints are either complements or substitutes. For example, markets with non-profit (as opposed to for-profit) firms should optimally face a lower (higher) price if the degree of altruism is sufficiently high (low). On the other hand, if prices are set by the firms, the imposition of profit constraints always reduce welfare due to underprovision of quality and insufficient cost containment. Before concluding the paper, let us briefly mention some possible extensions and limitations of our study. We have considered an oligopoly model with competition between a fixed number firms. The number of firms could have been endogenised, for instance, by deriving the free-entry equilibrium.21 This is likely to generate different results with respect to the effects of profit constraints, but would require a different set up, and is thus beyond the scope of our study. The kind of markets where profit-constrained firms are frequently observed, such as health care, long-term care and education typically have restrictions on entry. Our analysis of oligopolistic competition between a fixed number of (profit-constrained) firms should therefore be highly relevant. Another possible extension is to allow firms to select the location in addition to the quality and price. By placing the firms at the endpoints of the Hotelling line, we implicitly assume that firms would choose maximum (horizontal) product differentiation. However, this assumption is consistent with existing literature that show that firms will locate at maximum distance in order to dampen quality (and price) competition (e.g., Economides, 1989 and Brekke et al., 2006). Thus, endogenising location choices is not likely to provide any additional insight from the analysis.