Factor Substitution and Unobserved Factor Quality in Nursing Homes

This paper studies factor substitution in one important sector: the nursing home industry. Specifically, we measure the extent to which nursing homes substitute materials for labor when labor becomes relatively more expensive. From a policy perspective, factor substitution in this market is important because materials-intensive methods of care are associated with greater risks of morbidity and mortality among nursing home residents. Studying longitudinal data from 1991-1998 on nearly every nursing home in the United States, we use the method of instrumental variables (IV) to address the potential endogeneity of nursing home wages. The results from the IV models are consistent with the theory of factor substitution: higher nursing home wages are associated with lower staffing, greater use of materials (specifically, physical restraints), and a higher proportion of residents with pressure ulcers. A comparison of OLS and IV results suggests that empirical studies of factor substitution should take into account unobserved heterogeneity in factor quality.