The Impact of Changes in Regulation on Cost Behavior

This study examines whether introduction of fixed-price regulation influences firms to increase the elasticity of their cost structures and to reduce the asymmetric behavior of cost in response to changes in volume. It also examines variations in the extent of such responses arising from differences in institutional constraints on the flexibility to make adjustments. We posit that introduction of fixed-price regulation results in cost pressures and a concomitant increase in the operating risk faced by firms. In response, firms will attempt to influence their cost structures by increasing their cost elasticity (i.e., the response of cost to changes in volume) and by reducing their cost asymmetry (i.e., the differential response of cost to decreases in volume relative to increases in volume). We empirically test these predictions using 16,186 hospital-year observations from the German hospital industry for the years 1993-2008. Our results indicate that fixed-price regulation increases cost elasticity and decreases cost asymmetry. Consistent with the tenets of institutional theory, the strength of response to regulation is stronger in for-profit hospitals, which have greater flexibility to make adjustments to their cost structures, compared to nonprofit or government hospitals. These results hold after controlling for economic and hospital-specific factors. Thus, economic as well as sociological aspects influence cost structure responses to regulatory changes.