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Economics 186: Health Economics

9 Hospital Production and Behavior A.D. Kraft

Outline

Behavioral models of hospital behavior Hospital production and costs

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Hospital Behavior

Analyze pricing, output and investment decisions for each of the alternative models

Simple profit maximizing models Utility maximizing models Physician control models

Hospital Behavior

Profit maximizing model

Assumes that a non-profit hospital acts as though it were a for profit hospital but returns its profit to the community. A hospital would determine its prices as a profit maximizer, minimize its costs and invest only in projects that offer a profitable return.

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Hospital Behavior

Profit maximizing model

Assume a downward sloping demand To maximize its profits, it would select price on its demand curve where MC intersects its MR curve. The profit maximizing price and output would be P1 and Q1 respectively, and the amount of profit would be difference between price and average costs at this level of output.

Profit maximizing model

Price and cost MC AC

P1

D MR Q1 Q2

Quantity of patient days

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Hospital Behavior

Profit maximizing model

Since the hospital is a multi-product firm with different payers, it can increase its profits by price discriminating according to the price elasticity of demand for each type of patient and type of service. Predicts that hospitals will increase their prices if demand either increases or becomes less price elastic, or if the prices of their inputs increase Hospitals will invest on the basis of which investments offer the highest rate of return,

Hospital Behavior

Profit maximizing model

The performance of the industry would be like that of a monopolistically competitive industry. Hospitals would attempt to differentiate themselves from other hospitals. A nonprofit hospital, would use its profits and contributions from the community to achieve the communitys desires, such as engaging in altruistic activities like charity care for the poor

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Hospital Behavior

Profit maximizing model

Critique of model o o Excludes any important role for the physician According to this model, the hospital competes for physicians (by providing equipment and services) who then refer patients to the hospital. Model assumes that hospital will attempt to keep adding physicians to its staff so that they can in turn increase the number of patients.

Hospital Behavior

Utility maximizing models of hospital behavior

First model: Managers and trustees are decision makers (and beneficiaries). Assumes that managers benefit (in terms of higher salaries) by being the administrator of the largest fullservice hospital in the area. Hospital acts as if they wanted to maximize their output or revenues - increase output to Q2, which would represent the point on the demand curve where AC = P. Short-run maximize their profits and then invest profits in either additional capacity, cost-saving technology or facilities and services that result in the largest increases in output

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Hospital Behavior

Utility maximizing models of hospital behavior Quality-quantity behavioral model: assumes that decision makers have a utility function that includes some measure of the quality of the institution as well as its size. Quality may be defined over facilities and equipment, quality of its medical staff, or the quantity and type of its labor inputs

Hospital Behavior

Utility maximizing models of hospital behavior Hospital will seek to maximize profits in the short-run through its pricing strategy, but will attempt to invest those profits either in increased capacity, cost-saving technology, or in prestige/quality investments. Decision-makers will have to make a trade-off according to the marginal increase in utility resulting from increased quality or quantity

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Quality-quantity model
Price and cost of hospital services D1 P3 AC2 P2 P1 AC1 D2 AC3

Q1

Q3

Q2

Quantity of hospital services

Hospital Behavior

Utility maximizing models of hospital behavior

Adding quality to the objective causes an increase in hospital costs Suppose hospital is operating on AC1, long-run price and output will be P1 and Q1. If the hospital invests in increased quality, the average cost curve rises to AC2 but the increased quality also results in an increase in the hospitals demand, shifting it to D2. The increase in demand may occur as a result of attracting additional physicians to the hospital.

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Hospital Behavior

Utility maximizing models of hospital behavior

After some point, increased expenditures in quality will result in small or negligible increases in demand; Additions to quality beyond that point continue to raise the average cost to AC3 but do not result in further shifts in demand. Since funds that are used to increase quality could be used to increase quantity by adding to capacity, the decision maker has to determine the relative weights to be placed on the quality-quantity tradeoff.

Hospital Behavior

Utility maximizing models of hospital behavior Efficiency consequences

o Price of hospital care will be higher than if quality were not continually increased. Continued increases in quality without increases in demand would shift AC higher, possibly decreasing quantity and raising prices. Hospitals may be producing a higher-quality product than consumers might be willing to pay for.

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Hospital Behavior

Utility maximizing models of hospital behavior

Such a model could be accurate only if

there were either some barriers to entry, such that lower-cost, lower quality hospitals could not enter the market,
consumers had elastic demand with respect to hospital quality price of care were subsidized.

o o

Hospital Behavior

Utility maximizing models of hospital behavior Predictions about behavior o hospitals might make unprofitable investments or maintain unprofitable services as long as these add prestige to the institution. o suggests that a hospital will invest in new technology as soon as it becomes available because of its effect on the perceived image of the hospital. o would be against the entry of for-profit hospitals into the communities. o Non-profit hospitals would be using internal crosssubsidization to pay for prestige services which may be money losers.

Critique: The money-losing services are often duplicative. Further, quality and price of service are not synonymous.

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Hospital Behavior

Utility maximizing models of hospital behavior Modification of the model: inclusion of slack variable in the managers utility function o Hospital administrators are assumed to want to work in pleasant environment, as defined by such amenities as administrative personnel, and higher wages for employees to minimize conflict. o Predict that hospitals will still maximize profits but spend these profits to achieve some combination of quantity, quality and slack. o Prices will be even higher, there would be a great deal of duplication, excess capacity, high costs and rapidly rising prices.

Hospital Behavior

Physician control model of hospital behavior Medical staff controls the hospitals, decisions undertaken by the hospital reflect the objectives of the physicians with staff appointments. Physician is the manager of the patients illness with responsibility for deciding which components to be used in providing treatment. MD is expected to combine the treatment inputs in such a manner so as to increase his own income/productivity.

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Hospital Behavior

Physician control model of hospital behavior Price to consumer = the total amount of the out-of-pocket expenditures for a treatment, relevant price of specific inputs. The MD is able to retain more of the total price the less the patient has to pay for one hospital component. Conversely, the greater the supply price of the inputs, the smaller the return to the producer of a given quantity of the final product.

Hospital Behavior

Physician control model of hospital behavior MD pricing and behavior Amount of profit is P-AC. The higher (lower) the cost of the other inputs, the less (more) profits available to the physician. The difference between the price charged the patient and the amount that goes to pay the hospital (AC at Q1) is available to the physician. Physician acts as the contractor, retaining the amount left over after all the other inputs have been paid. Physician has an incentive to minimize the cost of treatment since higher input costs represent foregone revenue to the physician.

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Profit maximizing model

Price and cost

P1

MC
AC

D MR Q1 Q2

Quantity of patient days

Hospital Behavior

Physician control model of hospital behavior Response to increased demand for services, Favor increases in their hospitals capacity so as to increase their productivity: o the number of interns and residents o additional facilities and services reduce MD waiting time o facilities that are available in the hospital- reduce outside referrals Prefer some hospital slack if it enables them to economize in their own time. Physician control over hospital investment policies result in economic inefficiency.

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MD control model
Quantity of physicians QMC3 QMC4

QMC1

QMC2

QMD0

QH1

QH2

QH3

QH4

Quantity of hospital care

Hospital Behavior

Response to increased demand for services o Suppose the isoquants in the previous figure. It is in the economic interests of the MD for their number to remain the same while quantity of hospital care increased. Since quantity of hospital care produced is greater, the marginal productivity of MDs has increased. Their income is increased as well.

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Hospital Behavior

Physician control model of hospital behavior Effects on hospital pricing behavior o Prior to the widespread availability of insurance, physicians preferred that the hospital assign relatively low prices to services that were complementary to the physicians services; e.g. OR fees for surgeons. o Due to increase in insurance and decrease in out-ofpocket price for hospital services, physicians favored hospital profit maximizing strategies so that the profits can be invested internally according to MD preferences.

Hospital Behavior

Physician control model of hospital behavior

Effects on hospital service mix o Physicians also want hospitals to provide outpatient services and health screening Outpatient departments is convenient way of avoiding financial risk of caring for low income patients and physicians are relieved of providing emergency cases.

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Hospital Behavior

Physician control model of hospital behavior

Effects on hospital staff

Pauly-Redisch model predicts that physicians incomes will be higher under a closed rather than an open staff policy physicians would be willing to add additional members to the staff as long as each additional MD increased the income of the rest ( Marginal Revenue Product > Average Revenue Product Each physician specialty is interested in limiting hospital privileges as too many MDs would decrease the average MDs income

Hospital Production

Hospital output True hospital output consists of: improving or maintaining the patients state of health the capacity to satisfy an option demand on the other.

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Hospital Production

Hospital output Measuring improvement in health is difficult and involves: Measuring the extent of recovery of patients at the beginning and end of hospital treatment Comparing what would have happened if the patient had not been hospitalized- deterioration averted concept Including subjective well-being in the hospital physical and mental well-being while in the hospital Option demand measurement needs to consider not only the patients treated but also the whole population in the catchment area

Hospital Production

Multistage character of hospital production Due to measurement difficulties - resort to output indicators that can be used to operationalize efficient use of hospital resources List various indicators of hospital activity and classify them according to the stage of production A hospitals output can be described as the outcome of a multistage process, with each stage being assigned a specific concept of efficiency.

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Hospital Production

Multistage character of hospital production Indicators most commonly used

Quantities of factors of production (hours worked by MDs/ nurses, supplies, utilities) Quantities of individual medical and nursing services performed (examinations, operations,etc.) Number of patient days differentiated according to intensity of care Number of patients or cases treated - differentiated according to various types of diseases

Hospital Production

Multistage character of hospital production Two alternative ways to describe the different stages of hospital production involving these quantities

Patient days and cases as intermediate inputs Patient days as inputs to treatment process

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Hospital Production

Multistage character of hospital production Common to both ways:

the factors of production - the primary inputs, appear at the bottom level.
Factors produce various medical services which are located at the second level (secondary inputs) Technical efficiency involves minimizing factors of production for producing a given bundle of services

Patient days and cases as intermediate inputs

Recovery Patient days
Nursing efficiency

Cases treated
Internal medical efficiency

Medical services

Technical efficiency

Factors of production

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Hospital Production

Patient days and cases as intermediate inputs

Cases treated and days in the hospital - seen as indicators of different intermediate products at the same stage which enter immediately below the true output recovery. o o o Cases treated reflects medical components Patient days reflects the nursing components Two different types of efficiency the use of the least amount of nursing services possible per day (nursing efficiency), and least amount of medical services possible (internal medical efficiency) for a given improvement in health status

Patient days as input to treatment process

Recovery
External medical efficiency Length of stay efficiency

Cases treated

Patient days Medical services Factors of production

Internal medical efficiency

Technical efficiency

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Hospital Production

Days spent in the hospital are themselves considered inputs into the treatment process.

Therefore, minimizing the length of stay for a given spectrum of diseases constitutes a type of efficiency of its own - length of stay efficiency o Presupposes the existence of binding norms for measuring health status at discharge to prevent sending home quicker but sicker as a strategy to increase length of stay efficiency

Hospital Production

Heterogeneity of output Cases treated do not constitute a homogenous quantity but a heterogeneous one. Various dimensions of treatment case: Principal diagnosis -Type of illness that has called for hospital treatment Severity of the illness and complications arising during treatment Stage of the disease (e.g. in the case of cancer) Concomitant diseases (secondary diagnosis) Patient characteristics reflecting his or her contribution to the production of recovery such as age and sex

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Hospital Production

Patient classification system

Attempts to do justice to the heterogeneity of the hospital output Makes comparisons between hospitals possible. Describe hospital output in some detail, if not with regard to treatment outcomes, but at least with regard to the difficulty of the task.

Hospital Production

Three most common patient classification systems are:

international classification of diseases (ICD) o originally developed for the compilation of mortality statistics and thus solely refers to principal diagnoses Diagnosis related groups (DRGs) objective was to create relatively cost-homogeneous groups o DRG takes into account existence of comorbidities and complications, age of the patient, and type of treatment (conservative or surgical) Patient management categories (PMC) PMC put greater emphasis on concomitant diseases as well as treatment strategies chosen by the hospital

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Hospital Production

Hospital cost functions Apply production theory to hospitals since hospital is a productive unit. Cost function concept is most applicable to hospitals

Why the cost function? Basic behavioral assumption necessary to derive a cost function is that of cost minimization, i.e., that the hospital minimizes the cost of producing any given level of output or service, Q. Cost minimization is a much more general assumption than profit maximization and is consistent with non-profit models. General cost function framework is general enough to accommodate the unique features of hospital cost analysis

Hospital Production

Why the cost function?

It is defined for multi-product firms, assigning minimal costs of production to each output bundle. Cost function is more amenable to econometric estimation. RHS of the cost function; factor prices, output quantities and fixed factors, may be considered exogenous unlike quantities of inputs in production functions that are endogenous

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Hospital Production

Cost function estimates are helpful in answering a number of important economic questions
Economies or diseconomies of scale derived from the shape of the cost function o Help to determine the optimal size of the unit. o Optimal size is important for policy because in some countries, the hospital industry is subject to public regulation regarding the size of the hospital, i.e, number of beds. o Also would indicate tendencies for monopolization

Hospital Production

Economies of scope indicated by interaction terms between outputs o o Useful for seeing whether there are efficiency advantages to producing services jointly hospital departments or output categories that are cheaper to produce jointly should be in one hospital, while those that are more expensive should be offered in separate specialized hospitals

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Hospital Production

Marginal costs of treatment of a patient type results from differentiation of the cost function with respect to the number of patients of a given category Useful for calculating prices in the context of performance based type of payment Relative efficiency of hospitals - derived from the size of the estimated residuals, i.e., the difference between the actual costs and estimated costs of hospitals. May facilitate the monitoring of hospital performance under a payment system based on cost reimbursement.

Hospital Production

Standard vs. behavioral cost functions

Ordinary cost function right hand side variables include: output quantities, factor prices, and amounts of fixed factors of production (for short-term cost functions). Assumes that hospitals are cost minimizing, deviations from cost minimum are random Behavioral cost functions explain costs from actually observed behavior o accommodate hospitals whose motives may not be to maximize profits (and therefore minimize costs)e.g. government owned or community owned.

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Hospital Production

Behavioral cost functions o the function may include determinants such as the type of ownership and organization of the hospital or system of payment for hospital services which should have no influence on minimum costs but help explain systematical deviations from minimum cost.

Hospital Production

Hospital cost functions

Typical behavioral cost function takes the form:

C C ( X 1 ,.... X m ; Y ; Z ;W ; T ; D1 ,....Dn )
o o o o o o X = vector containing the number of cases in the m patient groups distinguished Y = the number of hospital days Z = number of beds W = measure of the factor price level T = type of ownership D = vector of hospital characteristics

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Hospital Production

Hospital cost functions

Including the activity variables , X,Y, Z in linear as well as quadratic form makes it possible to model increasing and decreasing returns to scale. Including interaction terms between the Xs makes it possible to model increasing or decreasing returns to scope

Hospital Production

Hospital cost functions Extent of economies of scale in hospital services

Theoretical relationship between hospital cost and size is U-shaped. Reasons for decreasing costs o A larger facility can have greater specialization of labor o Larger institutions are able to more fully utilize licensed and specialized personnel (since licensing limits certain personnel to certain tasks).

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Hospital Production

Hospital cost functions Extent of economies of scale in hospital services o o Specialized equipment and facilities can also be used to their capacity in larger institutions Take advantage in quantity discounts in procurement

Reasons for increasing costs o Greater proportion of time and effort required to coordinate and control work in large organizations

Hospital Production

Hospital cost functions Extent of economies of scale in hospital services

In estimating cost functions it is important to control for severity of illness of patients and case mix of patients o If larger hospitals are subject to economies of scale but also treat more seriously ill patients, then it may appear that larger hospitals have higher per unit costs.

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AC variations between hospitals

SRAC A SRAC
D C

AC

LRAC

LRAC

Q/T

Hospital Production

Hospital cost functions

Extent of economies of scale in hospital services o The mix of patients in a hospital is an important determinant of hospital costs. Since large hospitals are have a sicker mix of patients, unless case mix is held constant, it would appear that they are subject to diseconomies of scale.

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