Low quality care has been a central nursing home issue since the Senate's 1975 report which estimated that almost half of America's nursing homes were substandard. The present study reviews the explanations suggested thus far and argues that this market failure is best explained by the effect of excess demand on quality.

Excess demand lowers quality in two ways. First, its presence converts the incentive to increase quality in order to gain additional Medicaid patient reimbursement payments into an incentive to lower quality. That is, when the number of potential patients exceeds the available beds, private patients are first served because the private price exceeds the Medicaid rate. Therefore, if excess demand exists, it is excess Medicaid demand. Under excess Medicaid demand, the firm's only incentive to increase quality is the payment from the additional private patients attracted. Since, however, the private patient attracted displaces a Medicaid patient, the Medicaid reimbursement rate now becomes a cost of increasing quality. Second, when costs of information on quality are high, consumers may rely on costless signals of quality such as price or the number of units sold. Excess demand in this market eliminates the number of units sold as a signal of quality since all beds are always filled. Under these circumstances, homes may take advantage of uniformed consumers by increasing prices and lowering quality. This strategy may be optimal since patients are typically reluctant to transfer homes.

To test these hypotheses, a five-equation model of the nursing home market is developed and estimated both simultaneously and equation-by-equation using data from Wisconsin. Two quality measures are used: the number of Medicaid certification violations weighted according to severity and a comprehensive experimental measure developed by Wisconsin to streamline the enforcement of Medicaid standards.

In general, the estimates confirm that excess demand creates an important disincentive to provide quality care and that patients who are able to choose among homes make less accurate judgments of a home's quality under excess demand. It was further determined that price is a poor signal for quality, suggesting the presence of adverse selection behavior.