Economic Analysis of the Demand for a Product/Service in Healthcare Sector

UMUC HMGT 435

Week 4: The Supply Side: Importance of Costs

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Understand difference between accounting vs. economic costs

Understand characteristics of cost in short-run vs. long-run and impact on:

Average vs. marginal

Input specialization

Diminishing returns

Understand what costs matter for a firm’s pricing decision

Breakeven vs. shut-down prices

Understand what factors constitute a “perfectly competitive” market

Key Learning Objectives Week 4

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Economic costs include the “opportunity” cost of inputs used in the production process

Economic Cost = Explicit cost + Implicit Cost

Accounting Cost = Explicit cost

Explicit cost : actual monetary payments for inputs

Implicit cost: opportunity cost of inputs that do not require a monetary payment

Applies to Profit Equation as Well

Economic Profit = Total Revenue minus Costs (Explicit + Implicit)

Accounting Profit = TR minus C (Explicit only)

Accounting vs. Economic Costs and Profits

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From Week 1 introduced the concept of factors of production also called input into the production process

Labor- Doctors, nurses, administrative staff, etc.

Physical capital – Hospitals, doctor’s offices, medical technology, etc.

Natural Resources and Raw Materials – land for the capital to be built, energy sources (oil and gas), raw materials for pharmaceuticals

Entrepreneurship – scientists who develop cures for cancer, drug companies who develop new drugs.

Production Function: Relationship between Inputs (e.g. labor, capital) to and Outputs (e.g. patient care) from the production process

Factors of Production in Healthcare

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Production Function and Time

Short-run: period of time in which firms are able to vary one of the inputs to production

Long-run: period of time in which firms can vary all inputs to production

All inputs are variable in long-run, you can hire and fire labor, you can build more physicians offices and hospitals

Thus, the production function is largely a short-run decision

Within the Short-Run timeframe, firms do face different stages of production based on how much output (and marginal product) they can get from a given input (e.g. labor).

The Production Function and Time

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Increasing returns (Marginal Product (MP) > Average Product (AP)

Each additional worker contributes more to their output.

Example: New physician office with a number of exam rooms and one physician and one admin staff. Adding another physician and admin staff can allow the office to see more patients in a day.

Diminishing returns (MP = AP)

As firm increases workers, output increases but at a diminishing rate.

Example: Too many physicians for same amount of office space means that they will start bumping into each other and rate of growth in patient care will decline

Negative (or decreasing) returns (MP < AP)

As firms add workers, output declines

Example: waiting room and exam rooms at full capacity, so cannot see any more partients even if add physicians, only solution is a long-run option to expand office space.

The Stages of Production

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Total Costs = Fixed Costs + Variable Costs

Fixed costs do not vary with quantity produced

Variable costs vary with quantity produced

In the long-run, all costs are variable

Distinguish between Average and Marginal Costs

Average Costs = Total Costs/Quantity

Marginal Costs = Change in Total Costs resulting from a one-unit increase in output

Principle of Diminishing Returns

As more variable inputs are added, in the SR, MC must eventually be increasing

Example: Crowded hospital waiting room

Short-Run Costs

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Characteristics of a perfectly competitive market:

Many sellers (large number of firms) and buyers

Homogeneous product (identical and no branding)

No barriers to entry

Firms in Perfectly Competitive Market must determine:

What price to charge?

How much to produce?

Supply Curve of A Perfectly Competitive Firm

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