Applying Economic Principles to Health Care

, , Centers for Disease Control and Prevention, Atlanta, Georgia, USA; , Emory University, School of Medicine, Atlanta, Georgia, USA.


Emerging Infectious Diseases. 2001;7(2) 

In This Article

Resource Allocation in Health Care

Examination of resource allocation in the health-care industry is complicated because the market characteristics differ from those in a perfectly competitive market. The market for health-care services is considered an imperfect market because -- 1)Health care is a heterogeneous product, as the patient can experience a range of outcomes; 2) Patients who are insured have third-party payers covering their direct medical expenses; and 3) A "market price" is lacking, i.e., no feedback mechanism exists that reflects the value of the resources used in health care.

While the perspectives of consumers, producers, and society converge in a perfectly competitive market, hospital patient costs in the health-care market are different for patients (consumers), health-care providers (suppliers), insurance companies (third-party payers), and society. The economic impacts of pain and suffering are of concern to the patient and society, but may not be relevant to a purely economic analysis of costs from the perspective of health-care providers or third-party payers[2].

Regardless of perspective, economic thinking provides one common goal: efficiency, or getting the most from available resources. A hospital administrator, for example, is faced with the challenge of organizing resources to meet the organization's goals. The relationship between the range of productive inputs utilized and outputs produced can be characterized by a production function, which shows the maximum amount of product that can be obtained from any specific combination of resources (or inputs) used in producing a product (or output). By identifying the relationship between output and inputs, one can find the combination of inputs and output that maximizes economic return.

The classic production function from economic theory follows a standard curve (Figure 2) that demonstrates the relation between one input and one output[3]. This curve involves a variable input as opposed to a fixed input. Changes in the quantity of variable inputs will cause variation in the quantity of output produced (e.g., varying application of a fertilizer to a crop). Fixed inputs are those that must be in place before production can begin and do not vary with output levels (e.g., buildings). This curve embodies the notion of diminishing marginal returns. As one increases an input, a point is reached at which the additional output produced by adding another unit of input begins to get smaller and smaller, ultimately leading to a decline in the total output produced. The fixed input becomes overextended by the expanded production. For example, adding too much fertilizer to a crop can compromise soil quality and lead to a decline in output.

Figure 2. Standard curve of production function, demonstrating the relation between one input and one output.

This is a technical relationship that does not yet include dollars. If the organizational goal is to maximize output, a producer would employ IB units of input to produce OB units of output. This approach would make sense if inputs were free. However, inputs are usually not free. This is where an economist steps in. At some point before the maximum, the value of the additional output created by an additional unit of input is less than the cost of this additional input (e.g., spending $10 in additional input costs may yield only $8 in additional output value). The decision rule is to produce only as long as the value of additional output is just equal to the cost of the additional input.1

For this figure, the region where it is "economic" to produce is somewhere between input quantities IA and IB. The information needed to identify these productive relationships in a hospital must come from hospital epidemiologists as well as from hospital accountants. Epidemiology, being the principal measurement tool for population health status, provides measures of health-care outcomes (outputs). Measures of resource use (inputs) in a hospital should be based on hospital purchasing and cost accounting records (as opposed to hospital patient charges that do not accurately reflect actual resource use).

1 A complicating factor omitted from the discussion is time. In a longer view of time, all fixed inputs are considered variable and can be redeployed to some other productive process. Therefore, fixed costs must be covered in the long run. Since fixed costs are 'sunk" costs (spent before production even begins), it makes sense to keep operating for short time periods (as opposed to shutting down all production) if variable costs are covered.


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