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We study the strategic relationship between hospital investment in health technologies and provision of service quality. We use a spatial competition framework with altruistic providers and allow for hospital investment and quality provision to be either complements or substitutes in the patient health benefit and provider cost functions. We assume that each hospital commits to a certain investment level before deciding on the provision of service quality. We show that, compared to a simultaneous-move benchmark, providers´lack of ability to commit to a particular quality level generally leads to either under- or overinvestment. Underinvestment arises when the price-cost margin is positive and when quality and investments are strategic complements. In turn, this has implications for the optimal design of hospital payment contracts. We show that, differently from the simultaneous-move case, the first-best solution is generally not attainable by setting the fixed price at the appropriate level, but the regulator must complement the payment contract with at least one more instrument to address under- or overinvestment. We also analyse the welfare effects of different policy options (separate payment for investment, through a higher per-treatment price, or refinement of pricing) to reimburse hospitals for their investments.
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