economics 186 9 hospital production and behavior rev

8/3/2019 Economics 186 9 Hospital Production and Behavior Rev

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9 Hospital Production and BehaviorA.D. Kraft

Economics 186: Health Economics

Outline

Behavioral models of hospital behaviorHospital production and costs


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Hospital Behavior

Analyze pricing, output and investment decisionsfor each of the alternative models

Simple profit maximizing modelsUtility maximizing modelsPhysician control models

Hospital Behavior

Profit maximizing model

Assumes that a non-profit hospital acts as though it were afor 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 aprofitable return.


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Hospital Behavior


Assume a downward sloping demand

To maximize its profits, it would select price on itsdemand curve where MC intersects its MR curve. Theprofit maximizing price and output would be P1 andQ1 respectively, and the amount of profit would be

difference between price and average costs at this levelof output.


Quantity of patient days

Price andcost

D

MR

MC

AC

Q1 Q2

P1


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Hospital Behavior


Since the hospital is a multi-product firm with differentpayers, it can increase its profits by price discriminatingaccording to the price elasticity of demand for each typeof patient and type of service.

Predicts that hospitals will increase their prices if demandeither increases or becomes less price elastic, or if the

prices of their inputs increase

Hospitals will invest on the basis of which investmentsoffer the highest rate of return,

Hospital BehaviorProfit maximizing model

The performance of the industry would be like thatof a monopolistically competitive industry.Hospitals would attempt to differentiate themselvesfrom other hospitals.

A nonprofit hospital, would use its profits andcontributions from the community to achieve thecommunitys desires, such as engaging in altruisticactivities like charity care for the poor


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Hospital Behavior

Profit maximizing modelCritique of model

o Excludes any important role for the physician

o According to this model, the hospital competes forphysicians (by providing equipment and services) whothen refer patients to the hospital.

o Model assumes that hospital will attempt to keepadding physicians to its staff so that they can in turnincrease the number of patients.

Hospital BehaviorUtility maximizing models of hospital behavior

First model: Managers and trustees are decision makers(and beneficiaries).

Assumes that managers benefit (in terms of highersalaries) by being the administrator of the largest full-service hospital in the area.

Hospital acts as if they wanted to maximize their outputor revenues - increase output to Q2, which wouldrepresent the point on the demand curve where AC = P.

Short-run maximize their profits and then investprofits in either additional capacity, cost-savingtechnology or facilities and services that result in thelargest increases in output


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Hospital Behavior

Utility maximizing models of hospital behavior

Quality-quantity behavioral model: assumes that decisionmakers 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-runthrough its pricing strategy, but will attempt to investthose profits either in increased capacity, cost-saving

technology, or in prestige/quality investments.

Decision-makers will have to make a trade-off accordingto the marginal increase in utility resulting from increasedquality or quantity


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Quality-quantity model

Quantity of hospital services

Price and costof hospitalservices

D1

D2

AC1

AC2

AC3

Q1 Q2Q3

P3

P2

P1


Adding quality to the objective causes an increase inhospital 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 costcurve rises to AC2 but the increased quality also results inan increase in the hospital s demand, shifting it to D2. Theincrease in demand may occur as a result of attractingadditional physicians to the hospital.


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After some point, increased expenditures in quality willresult in small or negligible increases in demand;

Additions to quality beyond that point continue to raisethe average cost to AC3 but do not result in further shiftsin demand.

Since funds that are used to increase quality could beused to increase quantity by adding to capacity, thedecision maker has to determine the relative weights to be placed on the quality-quantity tradeoff.


Efficiency consequences

o Price of hospital care will be higher than if quality werenot continually increased.

o Continued increases in quality without increases indemand would shift AC higher, possibly decreasingquantity and raising prices.

o Hospitals may be producing a higher-quality productthan consumers might be willing to pay for.


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Such a model could be accurate only if

o there were either some barriers to entry, such thatlower-cost, lower quality hospitals could not enter themarket,

o consumers had elastic demand with respect to hospital

quality

o price of care were subsidized.


Predictions about behavioro hospitals might make unprofitable investments or

maintain unprofitable services as long as these addprestige to the institution.

o suggests that a hospital will invest in new technologyas soon as it becomes available because of its effect onthe perceived image of the hospital.

o would be against the entry of for-profit hospitals intothe communities.

o Non-profit hospitals would be using internal cross-subsidization to pay for prestige services which may bemoney losers.

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


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Hospital BehaviorUtility maximizing models of hospital behaviorModification of the model: inclusion of slack variable in the

manager s utility functiono Hospital administrators are assumed to want to work

in pleasant environment, as defined by suchamenities as administrative personnel, and higherwages for employees to minimize conflict.

o Predict that hospitals will still maximize profits butspend these profits to achieve some combination of

quantity, quality and slack.o Prices will be even higher, there would be a greatdeal of duplication, excess capacity, high costs andrapidly rising prices.

Hospital BehaviorPhysician control model of hospital behavior

Medical staff controls the hospitals, decisions undertaken bythe hospital reflect the objectives of the physicians with staff appointments.

Physicianis the manager of the patient s illness withresponsibility for deciding which components to be used inproviding treatment.

MD is expected to combine the treatment inputs in such amanner 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-pocketexpenditures for a treatment, relevant price of specificinputs.

The MD is able to retain more of the total price the less thepatient has to pay for one hospital component. Conversely,

the greater the supply price of the inputs, the smaller thereturn to the producer of a given quantity of the finalproduct.

Hospital Behavior

Physician control model of hospital behaviorMD pricing and behavior

Amount of profit is P-AC. The higher (lower) the cost of the other inputs, the less (more) profits available to thephysician. The difference between the price charged thepatient and the amount that goes to pay the hospital (ACat Q1) is available to the physician.Physician acts as the contractor, retaining the amount leftover after all the other inputs have been paid.Physician has an incentive to minimize the cost of treatment since higher input costs represent foregonerevenue to the physician.


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Quantity of patient days

Price andcost

D

MR

MC

AC

Q1 Q2

P1

Hospital Behavior

Physician control model of hospital behaviorResponse to increased demand for services,

Favorincreases in their hospital s capacity so as to increasetheir productivity:o the number of interns and residentso additional facilities and services reduce MD waiting

timeo facilities that are available in the hospital- reduce

outside referralsPrefer some hospital slack if it enables them to economizein their own time.Physician control over hospital investment policies result ineconomic inefficiency.


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MD control model

Quantity of hospital care

Quantity of physicians

QMC1QMC2

QMC3QMC4

QMD0

QH1 QH2 QH3 QH4

Hospital Behavior

Response to increased demand for services

o Suppose the isoquants in the previous figure. It is inthe economic interests of the MD for their numberto remain the same while quantity of hospital care

increased.

o 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 behaviorEffects on hospital pricing behavioro Prior to the widespread availability of insurance,

physicians preferred that the hospital assignrelatively low prices to services that werecomplementary to the physician s services; e.g. ORfees for surgeons.

o Due to increase in insurance and decrease in out-of-pocket price for hospital services, physicians favoredhospital profit maximizing strategies so that the

profits can be invested internally according to MDpreferences.

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

o Outpatient departments is convenient way of avoiding financial risk of caring for low incomepatients and physicians are relieved of providingemergency cases.


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Hospital BehaviorPhysician control model of hospital behaviorEffects on hospital staff

o Pauly-Redischmodel predicts that physiciansincomes will be higher under a closed rather than anopen staff policy

o physicians would be willing to add additionalmembers to the staff as long as each additional MDincreased the income of the rest ( Marginal RevenueProduct > Average Revenue Product

o Each physician specialty is interested in limitinghospital privileges as too many MDs would decreasethe average MD s income

Hospital Production

Hospital output

True hospital output consists of:

improvingor maintaining the patient s state of

healththe capacity to satisfy an option demand on theother.


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Hospital ProductionHospital output

Measuring improvement in health is difficult and involves:Measuring the extent of recovery of patients at the beginning and end of hospital treatmentComparing what would have happened if the patient hadnot been hospitalized-deterioration averted conceptIncluding subjective well-being in the hospital physicaland mental well-being while in the hospital

Option demand measurement needs to consider not only thepatients treated but also the whole population in thecatchment area

Hospital Production

Multistage character of hospital production

Due to measurement difficulties - resort to outputindicators that can be used to operationalize efficient use of hospital resources

List various indicators of hospital activity and classify themaccording to the stage of productionA hospital s output can be described as the outcome of amultistage process, with each stage being assigned aspecific concept of efficiency.


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Hospital ProductionMultistage character of hospital production

Indicators most commonly used

Quantities of factors of production (hours worked byMDs/ nurses, supplies, utilities)

Quantities of individual medical and nursing servicesperformed (examinations, operations,etc.)

Number of patient days differentiated according to

intensity of care

Number of patients or cases treated - differentiatedaccording 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 productionCommon to both ways:

the factors of production - the primary inputs, appear atthe bottom level.

Factors produce various medical services which arelocated 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 intermediateinputs

Factors of production

Medical services

Technical efficiency

Patient days Cases treated

Recovery

Internal medicalefficiency

Nursing efficiency


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Hospital Production

Patient days and cases as intermediate inputsCases treated and days in the hospital - seen as indicatorsof different intermediate products at the same stage whichenter immediately below the true output recovery.

o Cases treated reflects medical components

o Patient days reflects the nursing components

o Two different types of efficiency the use of the leastamount of nursing services possible per day (nursingefficiency), and least amount of medical servicespossible (internal medical efficiency) for a givenimprovement in health status

Patient days as input to treatmentprocess

Factors of production

Medicalservices

Technical efficiency

Patient days

Cases treated

Recovery

Internal medicalefficiency

Length of stayefficiency

External medicalefficiency


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Hospital Production

Days spent in the hospital are themselves consideredinputs into the treatment process.

Therefore, minimizing the length of stay for a givenspectrum of diseases constitutes a type of efficiency of itsown - length of stay efficiency

o Presupposes the existence of binding norms for

measuring health status at discharge to preventsending home quicker but sicker as a strategy toincrease length of stay efficiency

Hospital Production

Heterogeneity of outputCases treated do not constitute a homogenous quantity but aheterogeneous one.Various dimensions of treatment case:

Principal diagnosis -Type of illness that has called forhospital treatmentSeverity of the illness and complications arising duringtreatmentStage of the disease (e.g. in the case of cancer)Concomitant diseases (secondary diagnosis)Patient characteristics reflecting his or her contributionto 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 thehospital output

Makes comparisons between hospitals possible.

Describe hospital output in some detail, if not withregard to treatment outcomes, but at least with regard tothe difficulty of the task.

Hospital ProductionThree 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 createrelatively cost-homogeneous groupso DRG takes into account existence of comorbiditiesand complications, age of the patient, and type of

treatment (conservative or surgical)

Patient management categories (PMC) PMC put greateremphasis on concomitant diseases as well as treatmentstrategies chosen by the hospital


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Hospital Production

Hospital cost functionsApply production theory to hospitals since hospital is aproductive unit. Cost function concept is most applicable tohospitals

Why the cost function?Basic behavioral assumption necessary to derive a costfunction is that of cost minimization, i.e., that thehospital minimizes the cost of producing any given levelof output or service, Q. Cost minimization is a much

more general assumption than profit maximization and isconsistent with non-profit models. General cost functionframework is general enough to accommodate theunique features of hospital cost analysis

Hospital ProductionWhy the cost function?

It is defined for multi-product firms, assigning minimalcosts of production to each output bundle.

Cost function is more amenable to econometricestimation.

RHS of the cost function; factor prices, output quantitiesand fixed factors, may be considered exogenous unlikequantities of inputs in production functions that areendogenous


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Hospital Production

Cost function estimates are helpful in answering anumber of important economic questions

Economies or diseconomies of scale derived from theshape of the cost functiono 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 publicregulation 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 Useful for seeing whether there are efficiencyadvantages to producing services jointly

o hospital departments or output categories thatare cheaper to produce jointly should be in onehospital, while those that are more expensiveshould be offered in separate specializedhospitals


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Hospital ProductionMarginal costs of treatment of a patient type results fromdifferentiation of the cost function with respect to thenumber 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 theactual costs and estimated costs of hospitals.

May facilitate the monitoring of hospital performanceunder a payment system based on cost reimbursement.

Hospital ProductionStandard vs. behavioral cost functions

Ordinary cost function right hand side variables include:output quantities, factor prices, and amounts of fixedfactors of production (for short-term cost functions).Assumes that hospitals are cost minimizing, deviationsfrom cost minimum are random

Behavioral cost functions explain costs from actuallyobserved behavioro 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 thetype of ownership and organization of the hospitalor system of payment for hospital services whichshould have no influence on minimum costs but helpexplain systematical deviations from minimum cost.

Hospital ProductionHospital cost functions

Typical behavioral cost function takes the form:

o X = vector containing the number of cases in

the m patient groups distinguishedo Y = the number of hospital dayso Z = number of bedso W = measure of the factor price levelo T = type of ownershipo D = vector of hospital characteristics

),....;;;;;,....( 11 nm D DT W Z Y X X C C


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Hospital Production

Hospital cost functions

Including the activity variables , X, Y, Z in linear as well asquadratic form makes it possible to model increasing anddecreasing returns to scale.

Includinginteraction terms between the X s makes itpossible to model increasing or decreasing returns to scope


Extent of economies of scale in hospital services

Theoretical relationship between hospital cost and size isU-shaped.Reasons for decreasing costso A larger facility can have greater specialization of

laboro Larger institutions are able to more fully utilize

licensed and specialized personnel (since licensinglimits certain personnel to certain tasks).


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o Specialized equipment and facilities can also beused to their capacity in larger institutions

o Take advantage in quantity discounts inprocurement

Reasons for increasing costso Greater proportion of time and effort required to

coordinate and control work in large organizations



In estimating cost functions it is important to control forseverity 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 mayappear that larger hospitals have higher per unitcosts.


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AC variations between hospitals

Q/T

AC

A

SRAC LRAC

C

DSRAC

LRAC



o The mix of patients in a hospital is an importantdeterminant of hospital costs. Since largehospitals are have a sicker mix of patients, unlesscase mix is held constant, it would appear thatthey are subject to diseconomies of scale.

economics 186 9 hospital production and behavior rev

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