Pokhara University

Masters in Health care Management,

National Open college (Kathmandu)
course : Health Economics

UNIT V: PRODUCTION IN HEALTH

CARE MARKET

Arjun Thapa Giri, PhD

yogirajarjun@gmail.com
 Presentation outline:

• Meaning of production and production function, concept of

health care products and services of Hospital, Linear production
function and cob-Douglass production function
• Short run production: concepts of Total Product, marginal
production, average production function and law of diminishing
Returns
• Long run production: Concept of ISO-quant, ISO costs, cost
minimization or output maximization.
• Estimation of cost curves from production curves
• Production function of health in the modern day
 Meaning of Production and production function

• Production: production is the process of transforming inputs into

outputs of goods and services. It is an organized activity of
transforming services of factors, inputs, capital (doctor, nurses,
paramedics, infrastructure) into outputs (healthcare services).
• Production function: It is the functional relationship between
physical inputs and physical outputs of hospital/ or health service
or product producing unit.
• Alzebrically it can be expressed as,
• Q = f(health care inputs)
• Linear production function: A production function is said to be
linear if output or production increases by same proportion as the
inputs are increased. In this the production curve is a straight line
or the slope is constant (or marginal product of the factor is
constant).
 Cobb-Dauglas production function
• Estimation of production function also requires
selecting a mathematical function for estimation
purposes.
• In most cases, we use a functional form known as
Cobb-Douglas production function. The function can
be written as:

where X is health expenditure per capita (proxy of

inputs used), E is the education level of population
(proxy for other relevant variables) and u is the error
term.
 Cobb-Douglas production
•  
 We can use Cobb- Douglas production to
illustrate returns to scale
Returns to scale: It is the change in hospital output as all inputs
change by same proportions.
1. Constant returns to scale: a doubling of inputs doubles outputs.
α+β=1
2. Decreasing returns to scale: a doubling of inputs less than
doubles output. α + β < 1
3. Increasing returns to scale: a doubling of inputs more than
double output. α + β > 1
 Concept of Product and services of Hospitals
Based on Feldstein (1967) on hospital cost the most common
measures of output or products are:
• Emissions/ discharge which are registered, when the patient
leaves the hospital, Admissions registered when a patient enters
the hospital,
• Patient days which measures the number of days in which the
patient has been hospitalized,
• Outpatient treatments registrating patients which are treated in
the hospital but leave the same day as they enter.
• QALYs having to do with the effects of treatment, that is the
increase in health related quality of life achieved through the
treatment,
• Patient satisfaction related to inquiries of the users of the hospital
in the form of interviews or questionnaires.
 Hospital Production function
 The physical association between production of products and
services by the hospitals by utilizing available resources can be
termed as hospital production function
 Economists often describe production of output as a function of
labor and capital which can be applied for analyzing the hospital
outputs as:
q = f(n, k)

In the case of health care :

q = hospital services
n = nurses
k = medical equipment, hospital building
 concept of short run and long run
production
• The reference of time period involved in production process is another
concept used in production analysis: short run and long run.
• Short run: a period of time in which the supply and the use of certain
inputs (e.g., plant, building, machinery and so on) is fixed. In it output
can be increased to a limited quantity by increasing the use of only
variable inputs (labor).
• we assume only labor/nurse to be a variable factor, all other factors
assumed to remain constant.
• Laws of production under short run - ‘the laws of variable
proportions’ or ‘law of diminishing marginal returns’.
• Long run: In this input output relations are studied assuming all the
input to be variable.
• A firm’s long run production function is then expressed as Q = f(L,
K). With simultaneous increase in both the inputs (labor and capital),
a firm’s scale of production increases. The input output relationship
under scale of production is known as laws of returns to scale.
Arjun Thapa
 Production in short run

 In Short run : k is fixed, while n is variable

a) At low level of n, k is abundant. Initially increase in nurses when
combined with capital there would be greater increase in services.
- potential synergy effect because nurses can work in teams.
b) Further increase in nurses led to increase in service, but at
decreasing rate - law of diminishing marginal productivity.
c) “Too many “ nurses can cause congestion, communication
problems, led to fall in hospital services
All these phenomenon is called law of variable proportion or
laws of diminishing returns
As labor units (nurses) used in the production processes is
increased, the output initially increases at an increasing rate
(upto X2) then eventually increases at a decreasing rate (X2 to
X3), reaches a maximum and then starts falling (beyond X3).
This phenomenon is called ‘law of diminishing returns’.

TP increases at increases at
increasing rate upto X1
level of output and
increases at decreasing rate
from X1 to X3 level of
output. Beyond X3 output
TP is decreasing and MP is
negative. MP is the slope
of TP so it reaches
maximum at OX1 and AP
declines through but
doesnot touch OX axis.

Arjun Thapa
 Short run: three stages
TP MP AP
Increases, reaches
Stage I its Increases and
Increasing at an maximum and thenreaches
increasing rate declines till MP = its maximum
AP
Stage II
Increases at Is diminishing and
Starts
diminishing becomes equal to
diminishing
rate till it reaches zero
maximum
Continues
Stage III
Becomes negative to decline
Starts declining
but +ive
 Total Product: Total amount of hospital services or
output produced by a given amount of factors per period.
Marginal product: Change in the total product resulting
from an additional unit of factor input.

Total product function: TP = q = f(n,k*)

M
TP TP P
(q)

n1 n n1 n nurses
Nurses (n)
2 2

Marginal product function: MP = Dq / Dn

MP is the slope of the TP curve.
 Average Product: It is the output per unit of
variable factor or average product of factor inputs.

AP = q / n

AP is the slope of a ray from the origin

to the TP curve.
hospital average
services C product B
B
TP
A

n
3
Numerical Example: calculate and fill
# of Amou Total AP of MP of
nurse nt of k outpu n (q/n) n
s (n) t (q) (q/n
)

0 10 0 --- ---

1 10 10

2 10 30

3 10 60
 Cont…
• Total production function : mathematical expression
of relationship between output and factor input.
• Q = f (n, k) where n= nurses, k= capital
• Average production function: alzebric expression of
average output of factor inputs (nurses).
• AP = f(Q, n); AP = TP/n = Q/n
• Marginal production function: Alzebric expression
of marginal product.
• MP = (Q, n); MP = (TPr - TPr-1)/(nr – nr-1)
 Long run: Production concept of Isoquants
• The term ‘isoquant’ has been
derived from a Greek word ‘iso’
Physician Nurse’s
meaning equal and a Latin word services
‘quant’, meaning quantity. hours hours

• The ‘isoquant’ curve is also (Q

known as equal product curve units)
and production indifference I 5 10
curve.
• An isoquant is a locus of points 2 3 10
representing different
combination of the inputs (labor 3 2 10
and capital) yielding the same
output. 4 1 10
 Figure 2 The Consumer’s Preferences
In the long run, all inputs are variable.
Isoquants show combinations of two
inputs (physician hours and nurses
Physician
hours) that can produce the same level
hours of output.
In other words, Production isoquant
shows the various combination of two
inputs that the hospital can use to
produce a specific level of output.
A higher isoquant refers to a larger
output, while a lower isoquant refers to
a smaller output.

Q= 10 units Copyright©2004 South-Western

0 Nurse’s
hours
Cont….Marginal Rate of Technical substitution
• The Marginal Rate of Technical Substitution (MRTS)
- represents the rate at which nurse and physician hours can be
exchanged while still maintaining same output.
 Elasticity of substitution :

r = [D(Input1/Input2)/Input1/Input2] : [D(MP2/MP1)/MP2/MP1]
% change in input ratio, divided by % change in ratio of inputs’ MPs.
 Example: Jensen and Morrisey (1986)
– Sample : 3,450 non-teaching hospitals in 1983.
• q = hospital admissions
• inputs : physicians, nurses, other staff, hospital beds.
• q = a0 + a1physicians + a2nurses + …. + e
• Coefficients in regression are MPs.

19
 Results
Annual Marginal Products for
Admissions
Input MP (at the means)

Physicians 6.05
Nurses 20.30
Other Staff 6.97
Beds 3.04

 Each additional physician generated

6.05 more admits per year.
 Nurses by far the most productive
Iso cost lines: It shows the various combinations of inputs that may be purchased for a
given level of expenditure at given input prices. Let us suppose a manager must pay $25
for each unit of labor services and $50 for each unit of capital employed. The manager
wishes to know what combinations of labor and capital can be purchased for $400 total
expenditure on inputs. Point A on the iso cost curve shows how much capital could be
purchased if no labor is employed, which is 8 units of capital. Simillarly at point B 16 units
of labor can be employed if no capital is hired.
Points B and C also represents
8•A
input combinations that costs
$400.
K = 8- If we continue to denote the
6 B 1/2L quantities of capital and labor
Capital (K)

by K and L, and their respective

prices by r and w, total cost, C,
4 is C = wL + rK. So total cost is
simply the sum of the cost of L
units of labor at w dollars per
2 unit and of K units of capital at
B r dollars per unit:
C = wL + rK
0
• 400 = 25L + 50K
2 4 6 8 1 16
Labor (L) 0 Arjun Thapa K = 8 – 1/2L
 Cost minimization or output maximization

• A hospital manager wishing to maximize profit must first decide

how much output to produce and then how to produce that
amount at the lowest possible cost.
• A manager whose goal is profit maximization are generally
concerned with searching for the least cost combination of inputs
to produce a given output;
• While a manager of non profit motive may have fixed budget or
money available for production to maximize the amount of output
that can be produced

Arjun Thapa
 In the given figure, the manager wants to produce
Cont.. 10,000 units of output at the lowest possible total
cost. All possible combinations of labor and
capital capable of producing this level of output
are shown by isoquant Q. The price of labor (w)
K is $40 per unit, and the price of capital (r) is $ 60
K per unit. Consider the combination of 60L and
1’ A 100K, represented by point A on isoquant Q. At
0K point A, 10,000 units can be produced at a total
0” B cost of $8,400, where the total cost is calculated
Capital (K)

by adding the total expenditure on labor and the

total expenditure on capital: C = wL + rK =
($40x60+$60x100) = $8,400. The manager can
6 E lower this cost by moving down the isoquant and
0 purchasing input combination B, as it lies on
lower isocost line. Since the manager’s objective is to
Q= choose the combination of labor
10,000 and capital on the 10,000 unit
L
L” L isoquant that can be purchased at
0 ’
the lowest possible cost, the
6 9 1 manager will move downward
0 Labor0(L) 5 Arjun Thapa along isoquant until lowest isocost
0 line is reached.
Long 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.
 The Long Run Average Cost Curve

Average
Cost of
Hospital
Services LATC

q q q # of patients
0 1 2
 Long Run Costs of Production
• 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 number of beds (k) was fixed.
– But in the long run, there are no fixed inputs.
 Long Run Costs of Production
• 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.
 Long Run Costs of Production
• Increasing returns to scale
– An 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 Curve

Average
Cost of
Hospital
Services LATC

q q q # of patients
0 1 2
Economies of Diseconomies of
 Long Run Costs of Production
• Decreasing returns to scale
– An 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.
Thanks
 Selected references
• Rexford E. Santere, Stephen P. Neun. Health Economics: Theories, Insights,
and Industry Studies. Irwin Book Team. 1996
• Mills A, Gilson L “Health Economics for developing countries” A survival
kit, EPC publication number 17, summer 1988 (Reprinted August 1992)
• William Jack. Principles of Health Economics for Developing Countries. The
World Bank.1999
• Santerre, Neun SP.: Health Economics-Theory and Practice, 1996
• Health economics, third edition, 2003 by Charles E Phelps
• WHO guide to cost effectiveness analysis, 2003, published by WHO, Geneva
• Handbook for the Economic Analysis of Health Sector Projects, 2000
published by Asian Development Bank, Manila Philippines
• Handbook of Health economics, (2000) edited by Culyer and Newwhouse
(Ed). ELSEVIER, New York
• N. Gregory Mankiw , Microeconomics