Chapter 6 The production, costs, and technology of health care 1.Production and the possibility for substitution 2.Economies of scale and scope 3.Technology- allocative inefficient, cost and diffusion

Production and the Possibilities for Substitution Monotechnic View: only one correct way of treating a given illness Substitution: figure 6.1 A. No substitution (ES=0); B. Considerable substitution Physician extender (physician assistant) could substitute for 25 percent to more than 50 percent The elasticity of substitution (ES) measures the responsiveness of a cost-minimizing firm to change in relative input prices Estimates for Hospital care 1. all inputs are substitutes for each other. However, their range is uncertain. 2. The small values are beds with labors (Table 6-1)

Cost in Theory and Practice-economies of scale and scope Cost function (Figure 6-2) and iso-cost (cost-minimization) Scale economies: long-run average cost is declining (Figure 6-3) 1. profit-maximizing 2. consumers 3. the theory of perfect competition 4. does it work for health care industry? Sinjay and Campbell (1965) shows that mergers with the desire of scale economies Economies of scope 1. multi-product nature 2. equation 6.1

Empirical cost-function studies Long-Run versus short-run studies: clear in theory but difficulties in empirical data application: No change in profit implies in the long run since managers have selected the appropriate level of capital to achieve the highest profit Structural versus behavioral cost functions 1.structural cost function derived from economic theory such as iso-cost: Conrad&Strauss (1983) economies of scale Cowing&Holtman (1983) C.R.S Vita (1990) diseconomies of scale 2.behavioral cost function derived from actual data and sometimes omit variables Granneman, Brown, and Pauly (1986) economies of scale

Difficulties faced by all hospital costs studies Case-mix problem 1.Medicare’s Diagnosis Related Group (DRG) identify 506 groups of cases 2. some studies adjust with case mix 3.How to treat quality? A quality-adjusted model: scale economies for low quality nursing home while average quality with constant cost and high-quality with diseconomies of scale 4. Figure 5-6 :Real flat LARC. Points CDE mistake for diseconomies of scale Reliable measure for hospital input prices: registered nurse’s wage ; physician’s input prices

Technical and Allocative Inefficiency Technical inefficient (Figure 6.6 ): 1. Inefficiencies are measured as relative distances from the production frontier with output distance and input distance 2. Some cases are off isoquant curve Allocative Inefficient (Figure 6.7) Each firm minimizing production costs with responding optimally to input prices

Two types of empirical frontier The data envelopment analysis (DEA) approach (Figure 6-8) 1. frontier isoquant for a selected level of output by forming an envelope of the data 2.nonparametric The Stochastic Frontier Analysis (SFA) analysis (Figure 6-9) 1. If each firm is randomly shocked, the firm’s best possible practice (stochastic frontier ) will be randomly shifted 2. parameter assumption where statistical distribution of this inefficiencies 3. no strong parameter assumption in panel data

Technological Changes and costs Technological Change: Cost Increasing or Decreasing (Figure 6-10) Panel A (B) : cost decreasing (increasing) Technological changes

Diffusion of New Health Care Technologies The profit Principle: profit, prestige and well-being of patients The information channel: sociology Information externality (Figure 6-11, equation 6-2): adopting surgeons were more likely to be young, male, board-certificated, US medical school graduates, and urban located Other factors that may affect adoption rate the disadvantage (advantage) of waiting: loss market share (future advance and learn experience) Diffusion of technology and managed care: the result is yes for some technologies and no for others