Certificate-of-need regulation and entry: evidence from the dialysis industry.

• Author: Ford, Jon M.

1. Introduction

   Certificate-of-need (CON) regulation is widely used in the health care industry.(1) The primary alleged purpose of this regulatory tool is to reduce industry costs by preventing "unnecessary duplication of facilities."(2) While specific CON regulations vary from state to state, virtually all require new firms planning to enter the industry and incumbent firms planning an expansion of productive capacity to submit an application in which the applicant must demonstrate: (1) a market demand (or "need") for the incremental output, investment, or new service being proposed, and (2) the inability or unwillingness of existing firms to meet that demand with facilities already in place. Moreover, incumbent firms are offered the opportunity to formally intervene during the CON review process to express their opposition to the proposed entry or expansion plans.

   Economists have long been skeptical of this form of regulation. At least three fundamental reasons underlie this skepticism. First, private investors are likely to have vastly superior information to that held by regulators on the need for new capacity. These investors are much more familiar with industry conditions than regulators, and they are placing their own money at risk by entering and/or expanding. Second, given the obvious incentive of existing firms to oppose virtually any entry, expansion of capacity, or introduction of new services by competitors and the fact that this policy provides an open forum for such opposition, the likelihood that CON regulation actually serves the interests of consumers by fostering lower industry costs is remote. And third, to the extent that CON regulation is effective in reducing net investment in the industry, the economic effect is to shift the supply curve of the affected service back to the left. Since most medical services are thought to exhibit inelastic demand (due to the general unavailability of substitutes and the high frequency of third-party payments), the effect of such supply shifts is to raise both equilibrium price and total expenditures on the affected service, which is precisely opposite of the stated objective.(3) Despite these criticisms, however, CON regulation remains a pervasive force in the health care industry.

   The economic criticisms outlined above assume that CON regulation represents a binding constraint on capacity expansion decisions. There has been some recent debate in the literature, however, about whether CON regulation is, in fact, effective in reducing net new investment in the industry.(4) Some authors have argued that the CON review process does not prevent new firms from entering or existing firms from expanding but merely requires these firms to justify their capacity expansion plans to regulators. Any investments warranted by market conditions, they argue, are generally approved. Thus, there is some doubt as to whether CON regulation represents a binding constraint on investment in the affected industry.

   In this paper, we investigate this issue by examining the impact of CON regulation on entry into the dialysis industry over the decade of the 1980s.(5) This industry grew substantially during this period of time. On December 31, 1980, there were 1,041 dialysis clinics with 12,329 stations in the U.S. By December 31, 1989, there were 1,830 clinics with 23,654 stations |20~. In part, this growth is attributable to a 1972 amendment to the Social Security Act which authorizes the federal government to pay 80 percent of the cost of treatment (by either dialysis or kidney transplantation) of all citizens suffering from renal failure. The End Stage Renal Disease (ESRD) program, which is operated under Medicare, has grown from $229 million in its initial year (serving 11,000 patients) |7~ to $3.7 billion in 1988 (serving 110,000 patients) |23~. Such increases in funding have provided strong incentives for entry into this industry. And the presence of these incentives, in conjunction with changes in CON regulation, provides an ideal experimental situation in which to measure the impact of such regulation on observed entry.

   An attractive feature of our study is that we are able to utilize two alternative measures of entry. Consequently, our results are important not only for policy decisions regarding CON regulation in this and other health-related industries but also for evaluating the empirical performance of the different entry measures used. Given the recent re-emergence of the perceived role of entry (or potential competition) as an important disciplining force affecting market behavior,(6) our findings should be of widespread interest.

   The paper is organized as follows. First, we describe two alternative measures of entry used in this study. These measures are made possible by the very detailed accounting of both firms and capacity reported in the dialysis industry. Second, we specify a simple empirical model of the determinants of observed entry into this industry. Next, we describe our data and present our empirical results. These results indicate that CON regulation has significantly retarded new firm entry and total capacity expansion in this industry, thereby restricting supply and fostering increased levels of industry concentration. Finally, we summarize our findings and conclude the paper.

2. Measures of Entry

   Most prior empirical studies of the entry process have measured entry by the net change in the number of firms in the industry over some specified period of time |3; 5; 15~. This measure, however, is widely recognized as being deficient in two important respects. First, it does not account for the size of the new firms that have entered the industry nor the size or any incumbent firms that have exited. And second, a simple count of the net change in the number of firms also fails to reflect expansion or contraction of capacity by incumbent firms already in the market. For both reasons, this traditional entry measure falls short of the general concept of entry as an overall expansion of productive capacity in an industry.

   Here, we utilize two different measures of entry into the dialysis industry. First, we employ the traditional measure--the annual net change in the number of dialysis clinics in each state in each year in our sample (1982 through 1989). This measure (|E1.sub.it~) is included in order to compare the results obtained with our alternative entry measure.

   Second, we employ the annual net change in the total number of dialysis stations (i.e., machines) in each state in each year. This measure (|E2.sub.it~) reflects both new firm entry (including size of firms and number of firms) and incumbent firm capacity expansion. Thus, it represents a broader measure of entry than the...