Chapter 5

Health Care Production and Costs

5.1 INTRODUCTION

5.2 PRODUCTION: THE INPUT-OUTPUT RELATION

5.2.1 Basic Relationship

The additional production yielded by the use of one extra unit of variable input is called marginal product. Table 5-1, p. 99.

5.2.2 Shifts in the Relationship

We will examine how changes in some of the underlying conditions affect the production function. The possible changes include a change in the case mix, in the severity of illness of patients, in quality of care, in technology, in amount of capital that –er uses, and in the underlying incentive structure.

1. Change in case mix: physician is confronted with number of rheumatic fever cases in addition to patients with colds →shift production relation downward since more resources are needed for each of these cases.

2. Change in quality of care (greater thoroughness in performing an examination) → shift production relation downward (more resources required for each exam)

3. Change in technology (highly trained specialists and sophisticated equipment) →relation shift downward. Upward if introduction of new piece of equipment can increase output without changing quality.

4. “Management” incentive system. If management (doctor) is rewarded for keeping production costs low, then management will have incentive to use as few resources per unit of output as possible. If it receives a rate of compensation that is positively related to costs, then it will have incentive to use more resources to perform each task.

5.2.3 Substitution among Inputs

Suppose there are 2 variable inputs, physician time (P) and nurse practitioner time (N), in addition to fixed inputs (F). Production function is now: Q = Q (P, N, F). Assuming Q is held constant, we can examine how much nurse practitioner time must be added to the process to offset a unit of physician time. We will call this the marginal rate of substitution of nurse practitioners for physicians. Barriers exist to limit substitution, e.g., licensing laws may limit the degree to which nurse practitioners can substitute for doctors.

5.3 SHORT-RUN COST-OUTPUT RELATIONS

5.3.1 Production and Cost

Fixed costs are costs of fixed factors, including space and equipment rental costs and costs of physician time. The cost curve of a company incorporates the return that the owners could normally get on their assets, including their time, the building they own, etc. This normal return is called normal profit. Any return above normal profit is called economic profit. Variable costs are costs of variable inputs. E.g. cost of nursing hours.

5.3.2 Total Cost

TC = TVC + TFC

TFC = $100

See Fig. 5-1, p. 109.

Behavior of TVC depends on: (1) relation between output and variable inputs, and (2) unit cost of variable resources.

5.3.3 Marginal Cost: additional cost required to move 1 unit higher on output scale = ΔTC/ΔQ

5.3.4 Average Cost

TC/Q

The larger the fixed cost component, the greater the range over which the ATC will fall. Hospitals should experience diminishing ATC over wide range of potential output levels because they have been identified as having large fixed cost components.

In a related phenomenon, called indivisibility, expensive equipment, available in a large dose, cannot be divided into smaller units. It is operated at low levels of output at a high ATC and operated at high levels at a low ATC.

5.4 COST CURVE POSITION

A change in case mix toward more complicated cases and an increase in average severity level will increase the variable resources required per unit of output and will thus increase MC and AC at all output levels. Increase in quality similarly will shift cost curve upward.

Adoption of technology that uses more resources/case will have similar effect. Examples of technological innovations include open-heart surgery, critical care units (CCUs) or intensive care units (ICUs), which are high-cost monitoring and life support units, and magnetic resonance imaging (MRI). Another factor that might cause cost curves to shift is the price the provider pays for hired resources.

A substitution of a less costly for a more costly input can lower the cost curves. But keep in mind that quality of product may become lower as a result of the substitution, and even though output may cost less to produce, it might not be exactly comparable.

5.5 LONG-RUN COST CURVES

Suppose we take a longer perspective and allow enough time for the providing unit to change its “fixed” factors—to expand or contract its physical plant to buy and sell equipment, and hire and fire physicians. For planning periods of sufficient length, such changes are certainly possible. An analysis of relevant issues is called a long-run analysis. The dashed curve in Fig 5-4, p.118 represents the least-cost that can be produced at any given output level (assuming we can choose the size of the facility). This is called the long-run average cost curve.

5.6 ECONOMIES OF SCOPE

Are savings derived from producing different products jointly in the same production unit rather than producing them individually in separate production units (e.g., a clinic could jointly produce given quantities of family planning services and pediatric services more cheaply than the same quantities produced in sharply separated units or departments.

Economies of scope might arise when some of the tasks involved in providing two distinct services are complementary (e.g. if family planning and pediatric services require a common core of testing capabilities, then providing the two types of services in separate units would cause duplication.

Diseconomies of scope occur when 2 types of output are best produced in separate units (e.g., if psychiatric patients are treated with one regimen and home health service patients with another one, combining the two services in a single unit may be more costly than keeping them separate.

5.7 EMPIRICAL ESTIMATION OF COST CURVES

5.7.1 Background

5.7.2 Group practices

5.7.3 Hospital Marginal Costs

5.7.4 Hospital Economies of Scale

5.7.5 Nursing Home Costs

5.7.6 Health Insurance Costs