Elsevier

Social Science & Medicine

Volume 55, Issue 6, September 2002, Pages 895-906
Social Science & Medicine

Cost characteristics of hospitals

https://doi.org/10.1016/S0277-9536(01)00237-4Get rights and content

Abstract

Modern hospitals are complex multi-product organisations. The analysis of a hospital's production and/or cost structure should therefore use the appropriate techniques. Flexible functional forms based on the neo-classical theory of the firm seem to be most suitable. Using neo-classical cost functions implicitly assumes minimisation of (variable) costs given that input prices and outputs are exogenous. Local and global properties of flexible functional forms and short-run versus long-run equilibrium are further issues that require thorough investigation. In order to put the results based on econometric estimations of cost functions in the right perspective, it is important to keep these considerations in mind when using flexible functional forms. The more recent studies seem to agree that hospitals generally do not operate in their long-run equilibrium (they tend to over-invest in capital (capacity and equipment)) and that it is therefore appropriate to estimate a short-run variable cost function. However, few studies explicitly take into account the implicit assumptions and restrictions embedded in the models they use. An alternative method to explain differences in costs uses management accounting techniques to identify the cost drivers of overhead costs. Related issues such as cost-shifting and cost-adjusting behaviour of hospitals and the influence of market structure on competition, prices and costs are also discussed shortly.

Introduction

In this paper we try to gain an insight into the literature on the cost structure of hospitals. The aim is not to give a complete overview of the existing empirical literature, the focus is rather on the theoretical and methodological aspects involved. Modern hospitals are complex multi-product organisations that should be analysed using the appropriate techniques. The more recent studies derive flexible hospital cost functions which are consistent with neo-classical production theory. Using multi-product cost functions and regressing total costs on various output levels and input prices allows the degree of economies of scale and scope to be calculated. However, before estimating a cost function, it is necessary to keep in mind some important considerations and complications. Can hospitals be considered as truly cost-minimising firms? Do they operate in their short- or long-run equilibrium? What are the local and the global properties of flexible functional forms?

The paper is structured as follows: first some methodological aspects of cost functions are discussed. More specifically, the two main categories of hospital cost function studies will be introduced, concentrating however on the more recent technique of using flexible functional forms derived from the microeconomic neo-classical theory of production. Complications resulting from the use of these flexible functional forms are also dealt with in this section. In the second part of the paper some specific hospital cost function studies are discussed to give the reader an example of the issues tackled in the methodological part. An alternative approach as well as some relevant related topics are also shortly discussed in the last section.

Section snippets

Hospital cost function estimation

The theory on economies of scale was originally developed for and applied to single-product outputs in industry. Later on the concepts of ray average cost, multi-product scale economies and economies of scope were introduced to relax the restrictive assumption of producing a single output. Originating from the theory of firms producing multiple-product outputs, this method can also be used to derive economies of scale and scope for (non-profit) organisations such as hospitals.

Breyer (1987)

Cost minimisation

The neo-classical cost function assumes that hospitals minimise (variable) costs, given that input prices and outputs are exogenous. Therefore, applying flexible functional forms such as the quadratic, translog or generalised translog cost function implies cost-minimising behaviour of hospitals. Cost minimisation has been questioned: given the not-for-profit status of most hospitals and the cost-based reimbursement system in many countries, this assumption may be violated. However, Pauly (1987)

Specific hospital cost function studies

This section does not intend to give a complete overview of the existing empirical research (e.g. NHS Centre for Reviews and Dissemination (1996) is a comprehensive survey). Instead, some specific (often cited) hospital cost function studies will be discussed to give the reader an example of the issues tackled in the previous methodological part. For every article we will specify which of these methodological aspects were actually adopted or discussed (e.g. the specification of the model, the

Concluding comments

We have tried to gain an insight into the literature on the cost structure of hospitals, which nowadays are complex multi-product organisations. The most appropriate technique to analyse hospital cost structure is to estimate a flexible functional form of a cost function which is derived from the neo-classical theory of the firm. This approach assumes that hospitals minimise (variable) costs, given that input prices and outputs are exogenous. Therefore, applying flexible functional forms such

Acknowledgements

The author would like to thank the referees of this journal for their useful comments.

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