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Medical Care Production and
Costs
Part 1
Health Economics
Fall 2007
Professor Vivian Ho
Outline
Motivation
 Productivity Measures
 Cost Measures

Mergers are transforming the
industry
 2000 – NE Georgia Health system proposed to
buy Lanier Park Hospital in Gainesville
estimated cost savings of $2 million annually.

 2002 – Anthem (insurance) proposed to acquire
Trigon Health Care (also an insurer)
• $9 billion in assets, $13 billion in revenues, 10 million
members.
•
would lead to $75 million in pretax savings in
2004.
Mergers are transforming the
industry (cont.)
 But will mergers help to contain costs and/or
improve productivity in the industry?
• Depends upon production and costs in the
health care sector.
Assessing the Productivity of
Medical Firms
 Economists often describe production of output
as a function of labor and capital :
q = f(n,k)
• In the case of health care :
q = hospital services
n = nurses
k = medical equipment, hospital building
Assessing the Productivity of
Medical Firms (cont.)
 Short run : k is fixed, while n is variable
a) At low level of n, k is abundant. Each in nurses
when combined with capital greater in services.
- potential synergy effect because nurses can
work in teams.
b) Further in nurses
service, but a decreasing
rate - law of diminishing marginal productivity.
c) “Too many “ nurses can cause congestion, communication problems,
hospital services
Graphical Representation
Total product = q = f(n,k*)
hospital
services
(q)
TP
n1
marginal
product
n1
n2 Nurses (n)
n2
nurses
MP = Dq / Dn
 MP is the slope of the TP curve.
Graphical Representation
AP = q / n
 AP is the slope of a ray from the origin to the TP
curve.
hospital
services
average
product
C
B
B
TP
A
n3
Practice Question
People living in Boston are hospitalized about 1.5
times as often as those living in New Haven,
However, the health outcomes of patients in
these 2 cities appear to be identical. Does this
mean that hospital care has no ability to improve
health?
health
outcomes
hospitalizations
Substitutability in Production of
Medical 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.
LPNs have less training.
 Maybe not as productive, but not as costly.


Physician assistants vs physicians at
ambulatory clinics.

But physician assistants can’t prescribe meds in
most states.
Substitutability in Production of
Medical Care (cont.)
 Potential
for substitutability
If price of 1 input
increases, can minimize impact on total costs by
substituting away.
 Elasticity
of substitution :
r = [D(I1/I2)/I1/I2] : [D(MP2/MP1)/MP2/MP1]
% change in input ratio, divided by % change in
ratio of inputs’ MPs.

r=0
r=
8

no substitutability.
perfect substitutability.
Production Function for Hospital
Admissions
 Jensen and Morrisey (1986)
 Sample : 3,450 non-teaching hospitals in 1983.
q = hospital admissions
inputs : physicians, nurses, other staff, hospital beds.
q = a0 + a1physicians + a2nurses + …. + e
 Coefficients in regression are MPs.
Results
Annual Marginal Products for Admissions
Input
Physicians
Nurses
Other Staff
Beds
•
•
MP (at the means)
6.05
20.30
6.97
3.04
Each additional physician generated 6.05 more
admits per year.
Nurses by far the most productive
Results (cont.)
Elasticity of Substitution between Inputs
Input pair
Physicians with nurses
Physicians with beds
Nurses with beds
•
s
0.547
0.175
0.124
Each inputs is a substitute for other in production
process.
• If wages of nurses rise, can substitute away by
having more hospital beds.
Except for when s = 0
Medical Care Cost
Accounting Costs
 Explicit costs of doing business.
• e.g. staff payroll, utility bills, medical supply costs.
 Necessary for :
•
•
•
Comparing performance evaluation across
providers/depts.
Taxes
Government reimbursement/rate setting
Medical Care Cost (cost.)
Economic Costs
= Accounting Costs
 i.e. opportunity costs.
• e.g. opportunity cost of a facility being used as an
outpatient clinic = rent it could earn otherwise.
 Necessary for :
•
•
optimal business planning.
allows one to consider highest returns to assets
anywhere, not just vs. direct competitors, or w/in
health care industry.
Recall

Given a production function :
q = f (n,k)
q = hospital services
n = labor = nurse = n
k = capital = medical equipment, hospital
building
Short-Run Total Cost
STC( q ) = w n + r k*
w = wage rate for nurses
short run
k fixed
r = rental price of capital
w n = variable cost
r k = fixed cost .
cost
STC
STC
wn
rk
q0
hospital service
Short-Run Total Cost (cont.)
STC( q ) = 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).
Short-Run Total Cost (cont.)
 Recall : Production function initially exhibits IRTS
 Total costs rise at decreasing rate up to q0
cost
STC
STC
wn
rk
q0

After q0, DTRS in production
increasing rate
hospital service
costs rise at
Marginal and Average Costs
DSTC
SMC =
Dq
= D(wn + rk*)/Dq
= w(Dn/Dq) = w(1/MPn)
= w/MPn
The short run marginal cost of nurses depends
on their marginal productivity.
Marginal and Average Costs (cont).
STVC
SAVC =
q
= (wn)/q
= w(1/APn)
= w/APn
The short run average variable cost of nurses
depends on their average productivity.
Numerical Example

See handout.
Graphing Marginal and Average Costs
SMC
Costs
SMC0
SATC
SAVC
SATC0
SAVC0
0
q0
q
Graphing 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.
Relating Product and Cost Curves
MPn
Cost
SMC
APn
SAVC
APn
MPn
0
n1
n3
n
q1
q3
q
Average and Marginal Costs (cont.)
 IRTS followed by DRTS in production leads to U
shaped AC curve.
 Hospital doesn’t necessarily produce at q* (min.
cost).
 Depends on hospital’s objectives.
 Even so, will attempt to stay on the cost curve
(not above it).
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.
MC
Price per
Patient
ATC
P=MR
AVC
0

q*
Patients
The hospital will receive a price P from
insurers for each patient treated.
 To
max profits, choose q* where MR=MC.
Price per
Patient
MC
ATC
C
P
0
B
A
q*
P=MC
AVC
Patients
At output q*, the hospital’s revenues are
PAq*0.
 The hospital’s total costs are CBq*0.
 The hospital earns negative profits CBAP.

MC
Price per
Patient
ATC
C
P
B
A
AVC
E
0



D
q*
Patients
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.

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
Variable Costs:
 Worker supplies (e.g.
gloves)
Worker salaries &
benefits

Patient care supplies

Building maintenance

Paper

Utilities

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 & technician
 Pay for upkeep of the ER & OR
 Pay annual licensing fees to city & state