Health Economics- Lecture Ch06

8/3/2019 Health Economics- Lecture Ch06

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The Production, Cost, and

Technology of Health Care

Dr. Katherine Sauer

Metropolitan State College of Denver

Health Economics


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Recall from chapter 5 that health is the output goal.

Much attention is paid to the intermediate output,

health care.

Outline:

I. Degree of Substitutability in the Production Process

II. Costs

III. Efficiency

IV. Technology


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I. Degree of Substitutability in the Production Process

Health practitioners often argue that there is basically one

way to treat a given illness. (monotechnic view).

Economists often note that there is more than one way to

skin a cat.


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Suppose that when treating one case, it is not possible to

substitute any nurse hours for any physician hours:

Q=1

nurse hours

physicianhours

n1

p1

n2

Inputs are needed

in a fixed

combination of

p1/n1.


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Suppose that there is some degree of substitutability for

nurse hours and physician hours when treating one case.

Q=1

nurse hours

physicianhours

n1

p1

n2

The rate of substitution

changes as we move

along the curve.

Even though

substitution is possible,

nurses and doctors are

not equivalent.p2

AB


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What degree of substitution is possible?

The work done by economists suggests that substitution

possibilities could be substantial.

Depending on the number of physician hours employed,

one physician extender could substitute for 25 percent to

more than 50 percent of a physicians services.

(Brown,1988; Deb and Holmes, 1998; Liang and

Ogur, 1987; Okunade and Suraratdecha, 1998)


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- look at elasticity of substitution (s )

- measures the responsiveness of a (cost-

minimizing) firm to changes in relative input prices

iceRatioFactor

tRatioFactorInpus

Pr%

%

(

(!I

The larger the value of , the greater the substitutability.

If a firm is a cost-minimizer, then it would respond to

changes in input prices. It would tend to shift from thecostlier input to the relatively cheaper one.


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Example:- Suppose in order to treat 75 cases, a hospital employs

100 nurses and 100 physicians.

-The annual salary for a physician is $200,000 and is

$40,000 for a nurse.- Suppose that the elasticity of substitution is 0.6.

If each physicians salary increases by $20,000, how willthe hospital respond?


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Q=75

nurses

physicians

100

100

n2

p2A

B

Intuitively we know that this hospitalwill substitute away from physicians

and use more nurses.


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To find the new number of nurses and doctors, we need

to calculate the %Factor Input Ratio.

We know = 0.60.

We can calculate the % Factor Price Ratio because we

have salary data.

initial factor price ratio = 200,000 / 40,000 = 5

new factor price ratio = 220,000 / 40,000 = 5.5

% factor price ratio = 5.5 5 x 100 = 10%5


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0.60 = % factor input ratio

10%

6% = % factor input ratio

The initial factor input ratio = 100/100 = 1

The new factor input ratio = 1 (1)(0.06) = 0.94

So the ratio of physicians to nurses now = 0.94. If the

hospital uses one less doctor, what does that mean?

0.94 = 99

#N #N = 105


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So, in response to the increase in physicians salaries, the

hospital can use 5 nurses to substitute for one physician.

Change in cost to the hospital from the substitution:save $220,000 from not paying 1 physician

costs ($40,000 )(5) = $200,000 for the new nurses

net savings of $20,000


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Q=75

nurses

physicians

100

100

105

99A

B


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Empirical Evidence for Input Substitution in Hospitals


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II. Costs

production function: relates inputs to output

cost function: relates costs to output

Theoretically speaking, the cost function is only validfor cost-minimizing firms.

Do non-profits minimize costs?

Recall that the firms problem is to produce a certain

level of output at the minimum cost.


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The expansion path C-F-G

shows the cost-minimizing

combinations of capital

and labor that can be usedto produce 100, 150 and

200 physician office visits,

respectively.


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Suppose we are given the input prices

r = $1,200 and w = $1,000

The cost of producing 100, 150 and 200 physician visits

would be:

100: 20(1000) + 25(1200) =$50,000

150: 30(1000) + 40(1200) =

$78,000

150: 45(1000) + 50(1200) =

$105,000


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This total cost curve leads to an average cost curve

like this one.


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Economies of Scale: exist over the range of output

where a firms long run average costs are falling

(as a firm gets larger / produces more output, its averagecosts fall)

LRAC

AC

($)

Q

AC1

AC3

AC2

Q1 Q2 Q3

How does

this relateto health

care?


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Economies of Scope: exist when the joint production of twogoods costs less than producing each good separately

- only possible for multi-product firms

ex: pediatric care and geriatric careQp = 100 Qg = 150

If the following is true, then economies of scope exist:

TC( Qp=100, Qg=150) < TC(Qp=100, Qg=0) + TC(Qp=0, Qg=150)


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Issues in Hospital Cost Studies

a. Long Run vs Short Run

- clear in theory, what about in practice?

b. Structural vs Behavioral cost functions

- Structural functions are derived from economic theory.

(isoquant, isocost)

- Behavioral functions are an analysis of patterns in actual

cost data.


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c. difficulties in all hospital studies

- What do hospitals produce?

(face very different case mixes)

LRAC for H3(very complicated)

LRAC for H2(somewhat complicated)

LRAC for H1(not complicated)

Q

AC

($)E

D

C

Estimated LRAC


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- How to treat quality?

- Lacking in reliable measures of hospital input prices.

- Physician input prices are omitted.


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Research Findings:

The most recent research supports claims thateconomies of scale exist in hospitals.

Preya and Pink (2006) studied costs of Canadian

hospitals prior to a massive consolidation, findinglarge scale unexploited gains to strategic

consolidation in the hospital sector.

Dranove and Lindrooth (2003) studied a large numberof hospital consolidations, they found significant,

robust, and persistent savings for mergers, 2, 3, and 4

years after consolidation.


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III. Efficiency

Technical Inefficiency: a producer is not achieving the

maximum output for a given input combination.

-production within a certain firm


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Allocative Efficiency: requires the efficient allocation ofinputs between firms, and between outputs.

Economic theory says that allocative efficiency will result

when:

- inputs are purchased in competitive markets

- firms are minimizing production cost

Each firm must respond optimally to changes in input

prices.


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Empirical Techniques for evaluating efficiency:frontier and non-frontier

Frontier: actual output or costs are compared to the best

possible situation

Non-Frontier: actual output or costs for two or more

groups of firms are compared, controlling for other

variables

We will focus only on frontier.


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Frontier: Data Envelopment Analysis (DEA)

- the frontier for production is initially unknown

- it is revealed as firms are observed- linear programming is used to construct the

outer shell of data points

Technicalinefficiency is

measured as the

distance from the

frontier.


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Notable drawback: assumes all firms that are not on

the frontier are inefficient

Notable feature: do not need to make any assumptions

about the underlying distribution of inefficiency

non-parametric


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Frontier: Stochastic Frontier Analysis (SFA)

- each firm is treated uniquely

- assume each firm will be affected by a shock

to its ability to provide care

- when a firm is randomly shocked (to alter its

production and cost), its best possible practice

(frontier) is randomly shifted

- when a frontier function is partially random,

it is a stochastic process


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Notable drawback: need to guess in advance the

distribution of inefficiency

Notable feature: treats each firm uniquely

DEA andSFA areoftenusedascomplementarytools.


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Results of Hospital Efficiency Studies:

Reported overall efficiency has been quite high.

The earliest DEA study (Valdmanis, 1990) reported

technical efficiency levels of about 90 percent, while

Magnussons DEA (1996) study reached similarly highlevels.

SFA studies have tended toward similar levels; early

SFA studies (Zuckerman, Hadley, and Iezzoni, 1994;and Folland and Hofler, 2001) found the sum of

technical and allocative inefficiency to be only a little

more than 10 percent.


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For-Profit vs Non-Profit Hospitals

In nearly all recent studies, nonprofit and for-profit

hospitals appear approximately equal in efficiency.

While the earliest studies (Valdmanis, 1990; and Ozcan

et al., 1992) found differences between samples of

public and for-profit hospitals, studies since then found

no significant differences (Sloan et al., 2001).

Burgess and Wilson (1998) concluded: We find no

evidence that differences in ownership affect technical

efficiency after controlling for other factors.


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Inefficiency and Quality

Deily and McKay (2006) explain that hospitalinefficiency may reduce the quality of care. -

inefficiency measure was a highly significant and

positive contributor to a measure of hospital

mortality rates.

Laine and colleagues (2005) attempted similar tests for

long-term care.

- no inefficiency effect on clinical quality,- inefficiency contributes to the prevalence of

pressure ulcers, indicating poor quality of care

was associated with technical inefficiency.


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IV. Technology

A. Technology and CostsDoes technological change increase or decrease costs?

- if productivity is raised, then costs are lower

- if quality is improved, then costs can be higher

Holding quality constant, technological change means it

is less costly to produce a given level of output.

However, technology may change the mix of products or

services available, which may increase or decrease the

cost of treating a patient.


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Measuring the cost of treatment can be difficult.

- treatments change over time

- effectiveness of treatment changes- quality changes


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B. Who adopts new technology and why?

1. Profit principle: adopt if revenues are expected to

increase

2. Information channels: emphasizes the role of friends/

colleagues/journals/etc in decision making

3. Theory of innovation: adopt when PV of future profits

is greater than zero

- wait too long, miss out

- wait somewhat, gain from others experience

4. Managed care: flattening of incentives can decrease

interest in switching technologies


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Classic Pattern of Adoption

(logistic function)


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Summary:

The production function, which summarizes the

relationship of inputs and outputs, also embodies the

technology.

Technology that permits substitution between inputs

provides better flexibility to the manager.

Cost estimation describes the cost curves, which identify

the economies of scale and scope.

Health firms may differ in technology because the

adoption of new technologies differs among firms and is

never instantaneous

Health Economics- Lecture Ch06

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