This paper hypothesizes that the Medicaid reimbursement payment discourages quality nursing home care in markets with excess demand. It further shows that an increase in the propective payment or an increase in the return on capital portion of a retrospective cost-plus payment decreases the quality provided when there is excess demand. Finally, it argues that excess demand destroys a costless signal of quality, namely, the degree of excess capacity in a home, making it more difficult for uninformed consumers to make accurate choices and resulting in markets exhibiting the characteristics of adverse selection. These hypotheses are tested using Wisconsin data.
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