317_L29, March 26, 2008, J. Schaafsma 1 Review of the Last Lecture Began a discussion of 3 generations of models of the practitioner firm Almost finished our discussion of the first generation models => these stress monopoly power (due to restricted entry), exog dem, profit max implication => technical efficiency given Q, allocative inefficiency noted two problems with these models => i) demand exogenous (unrealistic), and ii) the P-F is generally not technically efficient today look at 2 pieces of evidence that the P-F is not technically efficient: i) suboptimal use of auxiliaries ii) HMO practice style is more efficient. Also note that sub-optimal firm size (economies of scale not used) thus not at min ave cost then look at the second generation of models: utility maximization

Two pieces of evidence that the PF firm is not technically efficient, Given its output 317_L29, March 26, 2008, J. Schaafsma 2 1. Under-utilization of Para-professionals and HC auxiliaries 2. HMO healthcare costs lower

317_L29, March 26, 2008, J. Schaafsma 3 Empirical Evidence that the P-F is Not Technically Efficient at Q: Suboptimal Use of Para-professionals 1.Under-utilization of Para-professionals and HC auxiliaries generally agreed that Drs. could deliver same quantity and quality of care at lower cost by using lesser trained HC workers for more of the simpler HC tasks  thus not minimizing costs  why not? In Canada  partial explanation  Medicare prohibits practitioners from billing for services provided solely by employees Can delegate part but not all of the task However see the same underutilization in the U.S. ///

317_L29, March 26, 2008, J. Schaafsma 4 Possible Reasons for Underutilization of HC Auxiliaries Cartel practice of reducing Q to achieve higher P? Possibly. taste for practice style  many Drs. enjoy providing all aspect of HC and do not wish to be primarily managers/supervisors of HC delivered by lesser trained, but fully qualified, auxiliaries  can indulge this style since protected from competitive pressures owner-practitioner supplies most of the labour  if lower cost auxiliaries substituted for own labour  own earnings  (unless still working full time)  this could be a reason for under-utilizing auxiliaries  find that where the DOC/POP ratio is high fewer auxiliaries used than where the DOC/POP ratio low. ///

317_L29, March 26, 2008, J. Schaafsma 5 Empirical Evidence that the P-F is Not Technically Efficient: HMO HC Costs 2. Health Maintenance Organization (HMO) evidence HMOs combine insurance and HC delivery into one firm Person pays the firm an annual fee (premium) and the firm supplies all the required HC needs for that year Analysis shows that HMOs deliver care at a lower cost  they substitute auxiliaries for peak professionals where feasible & their size allows them to reap economies of scale In HMOs  HC provider preferences for practice style receive less weight ///

317_L29, March 26, 2008, J. Schaafsma 6 Empirical Evidence that the P-F is Not Technically Efficient: Suboptimal Practice Scale Not only is the P-F inefficient at its output level, but it is also not at the bottom of its average total cost curve P-F too small to achieve economies of scale Group practice can use lumpy forms of capital and auxiliaries more efficiently Licensure restricts entry  allows this inefficiency to exist since no competitive pressure to reduce costs by adopting a more efficient organizational structure. ///

317_L29, March 26, 2008, J. Schaafsma 7 Summary of the Relevance of Monopoly Power Based Models monopoly power based models of the P-F capture some important elements of the P-F e.g., restricted entry, lack of competition, product differentiation however, the models we have looked at assume profit maximization:  substantial evidence that the P-F is not a profit maximizer  furthermore, profit maximization is inconsistent with the agency role the monopoly models also assume demand is exogenous  inconsistent with the agency role and licensure  agency role not needed if the consumer is fully informed (no asymmetry of information) ///

317_L29, March 26, 2008, J. Schaafsma 8 Second Generation Models of the P-F: Utility Maximization second generation models of the P-F  continue to assume monopoly power and an exogenous demand curve however, also build in the fact that: - the owner/operator (the physician) supplies a large amount of the labour - the firm is not a profit maximizer. - instead => the P-F is a utility maximizer

317_L29, March 26, 2008, J. Schaafsma 9 The Utility Maximization Model objective of the P-F in the utility maximization model is to choose the combination of Y (income), L (Leisure time) and S (practice style) that maximizes utility: i.e. max U = U(Y, L; S) subject to three constraints (next slide) S is an index for practice style (e.g., 10 different practice styles; select one) HC provider must trade-off Y, L, and S against each other to max Utility

317_L29, March 26, 2008, J. Schaafsma 10 The Three Constraints on Utility Maximization 1.downward sloping demand curve  if the firm’s output   P   determines gross revenues, PQ, for any output level (diagram) 2. production function, factor input prices, and practice style  determine the cost for any given output level #1 and #2 together define net income Y, for a given output level and practice style: Y = Total Revenue – Total Cost = PQ – TC(Q, S) 3.Time worked and leisure time must add to 24 hours. ///

317_L29, March 26, 2008, J. Schaafsma 11 Illustration of a Key Aspect of the Utility Maximization Model The utility max’n model has three endogenous variables (Y, L, S) => solving the model requires math => beyond this course. Instead consider a key aspect of the model => assume a given output Q, thus revenue (PQ) is given (P determined by Q and the downward sloping demand curve) & net income (Y) depends on practice style: Y = PQ – TC(Q, S) Can draw an isoquant and the isocost line representing the minimum cost of producing that output from society’s point of view (given the hourly rate for Drs and for nurses). A higher isocost line is selected by the Dr. (preferred practice style) => yields a higher net income for the Dr. (more billing for own time) and more hands-on care from physician as opposed to a nurse.

317_L29, March 26, 2008, J. Schaafsma 12 Efficiency Implications if the P-F is a Utility Maximizer allocative inefficiency: (monopoly power still included in this model => insufficient output) technical inefficiency: factor inputs not used where they are most productive => i) above the LATC curve at any given output level (due to practice style and the disincentive to substitute nursing time for billable hours of own time) and ii) not at the minimum LATC (due to small firm size and monopoly power)

317_L29, March 26, 2008, J. Schaafsma 13 Policy Response if the Practitioner Firm is a Utility Maximizer policy responses (same as for the monopoly models): 1.Increase supply of licensed intermediate level HC professionals  breaks monopoly power and creates pool of lower cost substitutes => addresses allocative inefficiency and technical inefficiency 2.Allow non-professionals to own and manage for-profit HC firms  will suppress provider preferences in how healthcare is delivered  least-cost production  (addresses technical inefficiency) => problem is “what about agency role??!” ///

317_L29, March 26, 2008, J. Schaafsma 14 Agency Role not an Issue if Demand Exogenous if demand exogenous  agency role not an issue (consumer fully informed)  can allow for-profit HC no need to worry about profit motive over-riding patient’s best interest since fully informed patient cannot be exploited. ///