A Theory of Yardstick Competition

TLDR

Typical regulatory schemes give franchised monopolies little incentive to cut costs, a situation mirrored by Medicare’s prospective reimbursement system for hospitals. The article proposes a pricing mechanism that ties a regulated firm’s revenue to the cost levels of comparable firms. The mechanism links regulated firms’ prices to the costs of identical or observable‑difference firms, extending to heterogeneous firms. In equilibrium, firms adopt socially efficient cost‑reduction levels.

Abstract

In the typical regulatory scheme a franchised monopoly has little incentive to reduce costs. This article proposes a mechanism in which the price the regulatedfirm receives depends on the costs of identical firms. In equilibrium each firm chooses a socially efficient level of cost reduction. The mechanism generalizes to cover heterogeneous firms with observable differences. Medicare's prospective reimbursement of hospitals by using diagnostically related groups is a scheme very similar to the one outlined here.