Medical Care Production and Costs Part 2 Health Economics Fall 2007 Professor Vivian Ho

Medical Care Production and Medical Care Production and CostsCosts

Part 2Part 2

Health EconomicsHealth EconomicsFall 2007Fall 2007

Professor Vivian HoProfessor Vivian Ho

OutlineOutline

Cost measures (cont.) Cost and quality. Long run costs of production. Computing profits.

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.

Cost-minimizing input choiceCost-minimizing input choice

Example Example

- - Health care providers’ choice of nursing staff mix. Health care providers’ choice of nursing staff mix.

RN’s care for 6 patients per hour; hourly wage = $20RN’s care for 6 patients per hour; hourly wage = $20

LPN’s care for 4 patients per hour; hourly wage = $10LPN’s care for 4 patients per hour; hourly wage = $10

TC(TC(qq00)=20)=20RNRN + 10 + 10LPNLPN

If a hospital needs to hire nurses to care for If a hospital needs to hire nurses to care for growing patient volume, which should be hired? growing patient volume, which should be hired?

Cost Minimizing Input ChoiceCost Minimizing Input Choice Costs are minimized when:

Suppose that instead:

Then the last dollar spent on an LPN generates more output than the last dollar spent on a registered nurse.

MPRN

wRN

=

MPLPN

wLPN

MPRN

wRN

<

MPLPN

wLPN

Are physicians “costly” to Are physicians “costly” to hospitals? hospitals?

Physicians bill insurers or their patients for care.Physicians bill insurers or their patients for care.

In most cases, physician not paid a wage by a In most cases, physician not paid a wage by a hospital. hospital.

However, physicians generate other hospital However, physicians generate other hospital costs.costs.

Review and process physician’s application.Review and process physician’s application. Monitor physician’s performance.Monitor physician’s performance. Examining rooms and other supplies. Examining rooms and other supplies.

MPMPdocdoc MP MPnn

wwdocdoc wwnn

Are physicians “costly” to Are physicians “costly” to hospitals? (cont.)hospitals? (cont.)

Can solve for “shadow price” of doctors, if other Can solve for “shadow price” of doctors, if other variables known.variables known.

wwdocdoc = $7,012 per year. = $7,012 per year.

Does Higher Quality Higher Costs?Does Higher Quality Higher Costs?

Reducing costs without sacrificing quality. Reducing costs without sacrificing quality.

Improved production line.Improved production line.

bedside access to computerized treatment bedside access to computerized treatment guidelines.guidelines.computerized patient charts.computerized patient charts.

Motivated work force.Motivated work force.

involving nurses in case managementinvolving nurses in case management

reimburse physicians based on performance reimburse physicians based on performance evaluationsevaluations

Does Higher Quality Higher Costs?Does Higher Quality Higher Costs?

“ “ In an increasingly competitive environment, In an increasingly competitive environment, hospitals must take a critical look at their hospitals must take a critical look at their product lines… Many institutions must decide product lines… Many institutions must decide between eliminating or investing in unprofitable between eliminating or investing in unprofitable product lines” product lines”

Juran ReportJuran Report e.g. Hospital may have profitable, high quality e.g. Hospital may have profitable, high quality

heart surgery, but kidney surgery may be losing $, heart surgery, but kidney surgery may be losing $, lower quality.lower quality.

Business opportunities in costsBusiness opportunities in costs

Companies which can synthesize complex data Companies which can synthesize complex data to improve quality and restrain cost will survive.to improve quality and restrain cost will survive.

Express Scripts - Express Scripts - Pharmacy Benefit Manager (PBM) Pharmacy Benefit Manager (PBM)

Manages prescription claims on behalf of Manages prescription claims on behalf of HMO’s, insurance companies, unions, etc.HMO’s, insurance companies, unions, etc.

Obtains drug cost savings through drug Obtains drug cost savings through drug utilization review, generic substitution, mail-utilization review, generic substitution, mail-order pharmacy, volume discounts from retail order pharmacy, volume discounts from retail pharmacy.pharmacy.


Express ScriptsExpress Scripts-- Practice Pattern Science (PPS) Practice Pattern Science (PPS)

An information service company.An information service company. Offers practice variation analysis and disease Offers practice variation analysis and disease

management support service linking healthcare data management support service linking healthcare data from all points of care.from all points of care.

Complements PBM servicesComplements PBM services Be a leader in the development of disease Be a leader in the development of disease

management, provider profiling and outcomes management, provider profiling and outcomes assessment technologies.assessment technologies.


Express ScriptsExpress Scripts-- Practice Pattern Science (PPS) (cont.)Practice Pattern Science (PPS) (cont.)

Diagnostic ClusterDiagnostic ClusterSMSM Methodology : Methodology : links to a “global” pattern treatment through its patient links to a “global” pattern treatment through its patient treatment episodes (PTEtreatment episodes (PTETMTM))

Provider Profiling :Provider Profiling : reduce providers practice pattern variationreduce providers practice pattern variation

Diseases Management Support Service :Diseases Management Support Service : Gatekeeper of patient case mix.Gatekeeper of patient case mix. Scorekeeper for patterns of treatment.Scorekeeper for patterns of treatment.

Pharmaceutical Information :Pharmaceutical Information : Benchmark prescription drug patternsBenchmark prescription drug patterns Track the composition of prescription drugsTrack the composition of prescription drugs Report the mean and median global treatment costReport the mean and median global treatment cost

Business opportunities in costs Business opportunities in costs (cont.)(cont.)

Practice Pattern Science (PPS) subsidiary. Practice Pattern Science (PPS) subsidiary. Computerized patient profile database.Computerized patient profile database. Bars claims if potential dangerous interactions Bars claims if potential dangerous interactions

identified.identified. Identifies people over-utilizing drugs by visiting Identifies people over-utilizing drugs by visiting

multiple doctors.multiple doctors.

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.


Economies of scale arise due to specialization of labor and/or capital.That is, the long run relationship between

average costs and output reflects the nature of the production process.

This is why economies of scale (in costs) are can also be referred to as increasing returns to scale (in production).


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.

QUIZQUIZ

The average size of U.S. hospitals in 2003 was 167 beds per hospital. A recent study determined that there are economies of scale for hospitals up to around:

A. 126 beds

B. 173 beds

C. 224 beds

D. 280 beds

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Medical Care Production and Costs Part 2 Health Economics Fall 2007 Professor Vivian Ho