lecture 5

Medical Care Production and Medical Care Production and CostsCosts

Health EconomicsHealth EconomicsFall 2009Fall 2009

Professor Vivian HoProfessor Vivian Ho

OutlineOutline

Motivation Productivity Measures Cost Measures

Mergers are transforming the Mergers are transforming the industryindustry

2000 – NE Georgia Health system proposed to – NE Georgia Health system proposed to buy Lanier Park Hospital in Gainesvillebuy Lanier Park Hospital in Gainesville estimated cost savings of $2 million annually.estimated cost savings of $2 million annually.

• would lead to $100 million cut in operating costs would lead to $100 million cut in operating costs in first year alone.in first year alone.

2005 – United Health Group (insurance) – United Health Group (insurance) proposed to merge with PacifiCare Health proposed to merge with PacifiCare Health Systems (also an insurer)Systems (also an insurer)• 26 million customers.26 million customers.

Mergers are transforming the Mergers are transforming the industry (cont.)industry (cont.)

But will mergers help to contain costs and/or But will mergers help to contain costs and/or improve productivity in the industry?improve productivity in the industry?

• Depends upon production and costs in the Depends upon production and costs in the health care sector.health care sector.

Assessing the Productivity of Assessing the Productivity of Medical FirmsMedical Firms

Economists often describe production of output Economists often describe production of output as a function of labor and capital :as a function of labor and capital :

q = f(n,k)q = f(n,k)

• In the case of health care :In the case of health care :

qq = hospital services = hospital servicesnn = nurses = nursesk k = medical equipment, hospital building = medical equipment, hospital building

Assessing the Productivity of Assessing the Productivity of Medical Firms (cont.)Medical Firms (cont.)

Short run : Short run : kk is fixed, while is fixed, while nn is variable is variable

a) At low level of At low level of n, kn, k is abundant. Each in nurses is abundant. Each in nurses when combined with capital greater in services.when combined with capital greater in services.- potential synergy effect because nurses can - potential synergy effect because nurses can work in teams.work in teams.

b) Further in nurses service, but a decreasing Further in nurses service, but a decreasing rate - law of diminishing marginal productivity. rate - law of diminishing marginal productivity.

c) “Too many “ nurses can cause congestion, com- “Too many “ nurses can cause congestion, communication problems, hospital servicesmunication problems, hospital services

Substitutability in Production of Substitutability in Production of Medical CareMedical Care

There may be more than one way to produce a given level of health care.There may be more than one way to produce a given level of health care. Licenced practical nurses (LPNs) vs Registered Nurses (RNs) in hospitals.Licenced practical nurses (LPNs) vs Registered Nurses (RNs) in hospitals.

LPNs have less training.LPNs have less training. Maybe not as productive, but not as costly.Maybe not as productive, but not as costly.

Physician assistants vs physicians at ambulatory Physician assistants vs physicians at ambulatory clinics.clinics. But physician assistants can’t prescribe meds in most statesBut physician assistants can’t prescribe meds in most states. .

Substitutability in Production of Substitutability in Production of Medical Care (cont.)Medical Care (cont.)

= 0 = 0 no substitutabilityno substitutability.. = = perfect substitutability.perfect substitutability.

88

Potential for substitutability If price of 1 input Potential for substitutability If price of 1 input

increases, can minimize impact on total costs by increases, can minimize impact on total costs by

substituting away.substituting away. Elasticity of substitution :Elasticity of substitution :

= [= [(I(I11/I/I22))//II11/I/I22] : [] : [(MP(MP22/MP/MP11))//MPMP22/MP/MP11]]

% change in input ratio, divided by % change in ratio of inputs’ MPs.% change in input ratio, divided by % change in ratio of inputs’ MPs.

Production Function for Hospital Production Function for Hospital AdmissionsAdmissions

Jensen and Morrisey (1986)Jensen and Morrisey (1986) Sample : 3,450 non-teaching hospitals in 1983.Sample : 3,450 non-teaching hospitals in 1983.

qq = hospital admissions = hospital admissions

inputs : physicians, nurses, other staff, hospital bedsphysicians, nurses, other staff, hospital beds.

qq = = 00 + + 11physicians +physicians +22nurses + …. + nurses + …. +

Coefficients in regression are MPs.Coefficients in regression are MPs.

ResultsResults

• Each additional physician generated 6.05 more Each additional physician generated 6.05 more admits per year.admits per year.

• Nurses by far the most productiveNurses by far the most productive

Annual Marginal Products for AdmissionsAnnual Marginal Products for Admissions

Physicians 6.05Physicians 6.05Nurses 20.30Nurses 20.30Other Staff 6.97Other Staff 6.97Beds 3.04Beds 3.04

Input Input MP (at the means)MP (at the means)

Results (cont.)Results (cont.)

• Each inputs is a substitute for other in production Each inputs is a substitute for other in production process.process.

• If wages of nurses rise, can substitute away by If wages of nurses rise, can substitute away by having more hospital beds.having more hospital beds.

Elasticity of Substitution between InputsElasticity of Substitution between Inputs

Physicians with nurses 0.547Physicians with nurses 0.547Physicians with beds 0.175Physicians with beds 0.175Nurses with beds 0.124Nurses with beds 0.124

Input pairInput pair

Except for when Except for when = 0 = 0

Medical Care CostMedical Care Cost

Explicit costs of doing business.Explicit costs of doing business.

• e.g. staff payroll, utility bills, medical supply costs.e.g. staff payroll, utility bills, medical supply costs.

Necessary for :Necessary for :• Comparing performance evaluation across Comparing performance evaluation across

providers/depts.providers/depts.• TaxesTaxes• Government reimbursement/rate settingGovernment reimbursement/rate setting

Accounting CostsAccounting Costs

Medical Care Cost (cost.)Medical Care Cost (cost.)

i.e. opportunity costs.i.e. opportunity costs.

• e.g. opportunity cost of a facility being used as an e.g. opportunity cost of a facility being used as an

outpatient clinic = rent it could earn otherwise.outpatient clinic = rent it could earn otherwise.

Necessary for :Necessary for :• optimal business planning.optimal business planning.• allows one to consider highest returns to assets allows one to consider highest returns to assets

anywhere, anywhere, not just vs. direct competitors, or w/in not just vs. direct competitors, or w/in health care industry.health care industry.

Economic Costs Economic Costs = Accounting Costs = Accounting Costs

Short-Run Total CostShort-Run Total Cost

costcost

hospital servicehospital service

STC( STC( q q )) = = w n + r k*w n + r k*

w w = wage rate for nurses = wage rate for nurses r r = rental price of capital= rental price of capitalshort runshort run k fixedk fixed w n = w n = variable costvariable cost

r k = r k = fixed cost . fixed cost .

q0

STCSTC

w n

r k

Short-Run Total Cost Short-Run Total Cost (cont.)(cont.)

STC( STC( q q )) = = w n + r k*w n + r k*

• In the short run, k is fixed.

rk* is the same, regardless of the amount of hospital services (q) produced.

•As q rises, increases in STC are only due to increases in the number of nurses needed (n).

Marginal and Average CostsMarginal and Average Costs

SMC = STC

q

= (wn + rk*)/q

= w(n/q) = w(1/MPn)

= w/MPn

The short run marginal cost of nurses depends on their marginal productivity.

Marginal and Average Costs Marginal and Average Costs (cont).(cont).

SAVC = STVC

q

= (wn)/q

= w(1/APn)

= w/APn

The short run average variable cost of nurses depends on their average productivity.

Graphing Marginal and Average CostsGraphing Marginal and Average Costs

Costs

q0 q0

SMC

SATC

SAVC

SAVC0

SATC0

SMC0

Graphing Marginal and Average CostsGraphing Marginal and Average Costs

SATC and SAVC are u-shaped curves.Increasing returns to scale followed by

decreasing returns to scale. SMC passes through the minimum of

both SATC and SAVC.If marginal cost is greater than average

cost, then the cost of one additional unit of output must cause the average to rise.

Average and Marginal Costs (cont.)Average and Marginal Costs (cont.)

IRTS followed by DRTS in production leads to U IRTS followed by DRTS in production leads to U shaped AC curve. shaped AC curve.

Hospital Hospital doesn’tdoesn’t necessarily produce at q* (min. necessarily produce at q* (min. cost).cost).

Depends on hospital’s objectives.Depends on hospital’s objectives.

Even so, will attempt to stay Even so, will attempt to stay onon the cost curve the cost curve (not above it).(not above it).

Average and Marginal Costs (cont.)Average and Marginal Costs (cont.)

Why do all of these cost curves matter?

Many hospitals operate at a loss (profits<0) in some years. If a hospital seeks to maximize profits, and

it knows it’s going to lose money in a given year, why should it treat any patients?

In the SR, a hospital will still stay open if treating patients will cover its fixed costs and part of its variable costs.

The hospital will receive a price P from insurers for each patient treated. To max profits, choose q* where MR=MC.

q*

P=MR

Price per Patient

Patients0

MC

ATC

AVC

At output q*, the hospital’s revenues are PAq*0.

The hospital’s total costs are CBq*0. The hospital earns negative profits CBAP.

Price per Patient

Patients0

MC

ATC

AVC

q*

P=MCA

C

P

B

The hospital’s FC are (ATC-AVC)q*, or CBDE. If the hospital shuts down, it must still pay for FC. Since CBDE>CBAP, the hospital will lose less if it

remains open.

Price per Patient

Patients0

MC

ATC

AVC

B

A

C

P

q*

DE

In the SR, FC are critical for determining whether a hospital should stay open for business.

So, in general, how large are FC?

Study of Cook County Hospital in Chicago (Roberts, JAMA 1999)Urban public teaching hospital, 1993

Fixed Costs: Capital

Worker salaries & benefits

Building maintenance

Utilities

Variable Costs: Worker supplies

(e.g. gloves)

Patient care supplies

Paper

Food

Lab supplies

Medications

Why are salary & benefits a FC?Workers often have long-term contracts. Many workers won’t take jobs w/ frequent

layoffs.

For Cook, the budget was 84% FC, 16% VC.

Often makes sense for Cook to operate at a loss, not reduce patient load.

Cutting the # of patients you serve won’t save a lot if you can’t cut FC simultaneously.

If you serve 5% fewer patients, you may still need to:Pay for a CT scanner & technicianPay for upkeep of the ER & ORPay annual licensing fees to city & state

Determinants of Short-run Costs Determinants of Short-run Costs (cont.)(cont.)

5 different measures of q 5 different measures of q inputsinputs

ER careER care nursing labornursing labor medical/surgical caremedical/surgical care auxiliary laborauxiliary labor pediatric carepediatric care professional professional

laborlabor maternity carematernity care administrative administrative

laborlabor other inpatient care other inpatient care general laborgeneral labor materials and suppliesmaterials and supplies

Cowing and Holtmann 1983

FindingsFindings

Found short run economies of scaleFound short run economies of scale Hospitals operate to left of min. on AVC curve.Hospitals operate to left of min. on AVC curve.

i.e Larger hospitals producing at lower costs i.e Larger hospitals producing at lower costs than smaller hospitals. than smaller hospitals.

Best way to reduce aggregate hospital costs?Best way to reduce aggregate hospital costs? Reduce # of hospital beds by a fixed % in all Reduce # of hospital beds by a fixed % in all

hospitals.hospitals.

Close the smallest hospitals in each region.Close the smallest hospitals in each region.

Findings (cont.)Findings (cont.)

Definition : Economies of scopeDefinition : Economies of scope

Cost of producing 2 outputs < sum of cost of Cost of producing 2 outputs < sum of cost of producing 2 goods separately. producing 2 goods separately.

Found Found DisDiseconomies of scope with respect to economies of scope with respect to ER and other services.ER and other services. Larger ER’s may bring in more complex mix of Larger ER’s may bring in more complex mix of

patients to the hospital. ORpatients to the hospital. OR

Larger ER’s generate operating challenges for Larger ER’s generate operating challenges for other services (e.g. communication, staffing other services (e.g. communication, staffing scheduling).scheduling).

Sources of Economies of Scope Sources of Economies of Scope

Economies of scope can arise at any point in the production process.

Acquisition and use of raw materialsDistributionMarketing

Sources of Economies of ScopeSources of Economies of Scope

Specialty Hospitals versus General Hospitals.Specialty Hospitals

Texas Heart Institute in Houston. Shouldice Hospital in Ontario performs only

hernia repair. University General Hospital in Houston,

bariatric surgery.

General Hospitals Methodist, St. Luke’s, Memorial Hermann


General hospitals can spread the fixed costs of operating rooms and intensive care units over multiple different operations.Operate at full capacity by treating all types

of patients.

However, specialty hospitals argue that they can lower marginal costs by specializing.


Know-how can be spread over products sharing similar technology.Medical device companies frequently

produce multiple different products.Ethicon Endo-Surgery.Makes multiple different devices for

minimally invasive surgery. Factories often require similar technology,

and the marketing strategies are similar too.


Spreading advertising costs.Methodist hospital can pay for one ad

advertising its top rankings in multiple services.


Research and development.Pharmaceutical companies can spend

hundreds of millions of $’s to develop a drug.

Once drug is developed, they sometimes find alternative beneficial applications.

Gleevec for leukemia, and gastrointestinal tumors.

Costs of production and sales can be spread over many different drugs.

Long Run Costs of ProductionLong Run Costs of Production

In the long run, all inputs are variable. k is no longer fixed. e.g. A hospital can build a new facility or

add extra floors to increase bedsize in the long run.

If all inputs are variable, what does the long run average cost curve look like?

The Long Run Average Cost CurveThe Long Run Average Cost Curve

Average Cost of Hospital Services

# of patients

LATC

q0 q1 q2


Just like the short run cost curve, the long run cost curve for a firm is also u-shaped.However, the short run cost curve is due to

IRTS, then DRTS relative to a fixed input.e.g. In the short run, the only way to

increase the number of patients treated was to hire more nurses; but the # of beds (k) was fixed.

But in the long run, there are no fixed inputs.


The u-shaped long run average cost curve is due to economies of scale and diseconomies of scale.

Economies of scale Average cost per unit of output falls as the

firm increases output.Due to specialization of labor and capital.


Example of specialization and the resulting economies of scale.A large hospital can purchase a

sophisticated computer system to manage its inpatient pharmaceutical needs.

Although the total cost of this system is more than a small hospital could afford, these costs can be spread over a larger number of patients.

The average cost per patient of dispensing drugs can be lower for the larger facility.


Increasing returns to scaleAn increase in all inputs results in a more

than proportionate increase in output.e.g. If a hospital doubles its number of

nurses and beds, it may be able to triple the number of patients it cares for.

However, most economists believe that economies of scale are exhausted, and diseconomies of scale set in at some point.


Diseconomies of scale arise when a firm becomes too large.e.g. bureaucratic red tape, or breakdown in

communication flows.At this point, the average cost per unit of

output rises, and the LATC takes on an upward slope.

Diseconomies of scale (in costs) imply decreasing returns to scale in production.

The Long Run Average Cost CurveThe Long Run Average Cost Curve


# of patients

LATC

q0 q1 q2

Economies of scale Diseconomies of scale


Decreasing returns to scaleAn increase in all inputs results in a less

than proportionate increase in output.e.g. Doubling the number of patients cared

for in a hospital may require 3 times as many beds and nurses.

In some cases, the production process exhibits constant returns to scale.A doubling of inputs results in a doubling of

output.

The Long Run Average Cost Curve The Long Run Average Cost Curve under Constant Returns to Scaleunder Constant Returns to Scale


# of patients


Like the short run cost curve, a number of factors can cause the short run cost curve to shift up or down.Input prices.Quality.Patient casemix.

e.g. If the hourly wage of nurses increases, the average cost of caring for each patient will also rise.The average cost curve will shift _____


Empirical evidence on HMOs and costs. See handout.

lecture 5

Documents

average costs costs

marginal costs

medical care cost cost

total cost q

fixed cost

average costs satc

average costs smc

hospital services q