Uncertainty, Real Options, and Cost Behavior: Evidence from Washington State Hospitals

Variable costs need not be incurred unless a firm wants to produce goods or services; the opportunity to incur variable costs is therefore a real (European) option (McDonald and Siegel 1985). Moreover, fixed investments can usually be postponed; the ability to wait before investing is also a real (American) option (McDonald and Siegel 1986). Decision-makers usually have more accurate information available when choosing to incur subsequent expenditures (variable costs) than when committing to fixed costs for long-term projects. Therefore, decision-makers have greater flexibility to respond to changes in business conditions when upfront (fixed) costs are lower in relation to subsequent expenditures. Because the value of flexibility increases with uncertainty, technologies with high variable and low fixed costs become more attractive as uncertainty increases. We argue that real-options theory therefore implies that the ratio of variable to fixed costs should increase with higher uncertainty.

Hospitals faced an increase in uncertainty when Medicare began reimbursing them using prospectively defined rates in 1983 instead of cost. Empirically we show that the slope coefficient in the regression of log costs on log volume, representing the ratio of variable to total costs, did increase after Medicare introduced the prospective payment system, as predicted by the real options theory. Our sample consists of 831 departments within 59 Washington State hospitals from 1977 through 1994. We also find that departments in hospitals with higher percentages of Medicare revenues exhibit greater increases in the slope coefficient; this increases our confidence in the conclusion that our results are attributable to the Medicare change.

Our research adds to the empirical work on the real-options theory (Quigg 1993; Leahy and Whited 1996; Moel and Tufano 2002). It also adds to the empirical studies of cost behavior which have examined the extent to which costs are fixed and variable, or sticky, and what factors other than volume drive costs. We extend the cost behavior literature by showing that cost behavior is not exogenously specified; rather, changes in uncertainty lead to managerial actions that affect cost behavior.