Working papers // The Levy Economics Institute 353
The incentive contracts that managed care organizations write with physicians have generated considerable controversy. Critics fear that if informational asymmetries inhibit patients from directly assessing the quality of care provided by their physician, competition will lead to a race to the bottom in which managed care plans induce physicians to offer only minimal levels of care. To analyze this issue we propose a model of competition between managed care organizations. The model serves for both physician incentive contracts and HMO product market strategies in an environment of extreme information asymmetry - physicians perceive quality of care perfectly, and patients don't perceive it at all. We find that even in this stark setting, managed care organizations need not race to the bottom. Rather, the combination of product differentiation and physician practice norms causes managed care organizations to race to differing market niches, with some providing high levels of care as a means of assembling large physician networks. We also find that relative physician practice norms, defined endogenously by the standards of medical care prevailing in a market, exert a pull to the top that raises the quality of care provided by all managed care organizations in the market. We conclude by considering the implications of our model for public policies designed to limit the influence of HMO incentive systems.