2
ONLY USE THE READING PROVIDED
Include the two questions that you selected to discuss at the top of your initial posting.
· What are the characteristics of a perfectly competitive market?
· What is the difference between variable and fixed costs, how do they change in short-run vs. long-run? Provide an example in healthcare.
· What does increasing returns mean in the short-run? Provide an example of increasing returns?
· From an economic perspective, at what point does a firm decide to shut-down? Explain.
· When a market is perfectly competitive what does this imply about the supply curve and the price charged for a particular good?
· What is the level of profits in the long-run in a perfectly competitive market? Explain why.
· What is the difference between an economic and accounting profit?
· What is the principle of diminishing marginal return?
APA Requirements -Include Scholarly Evidence: Include at least TWO APA formatted references with correlating in-text citations.
CHAPTER
137
9FORECASTING
Learning Objectives
After reading this chapter, students will be able to
• articulate the importance of a good sales forecast,
• describe the attributes of a good sales forecast,
• apply demand theory to forecasts, and
• use simple forecasting tools appropriately.
Key Concepts
• Making and interpreting forecasts are important jobs for managers.
• Forecasts are planning tools, not rigid goals.
• Sales and revenue forecasts are applications of demand theory.
• Changes in demand conditions usually change forecasts.
• Good forecasts should be easy to understand, easy to modify, accurate,
transparent, and precise.
• Forecasts combine history and judgment.
• Assessing external factors is vital to forecasting.
9.1 Introduction
Making and interpreting forecasts are important jobs for managers. Sales
forecasts are especially important because many decisions hinge on what the
organization expects to sell. Pricing decisions, staffing decisions, product
launch decisions, and other crucial decisions are based on the organization’s
revenue and sales forecasts.
Inaccurate or misunderstood forecasts can hurt businesses. The orga-
nization can hire too many workers or too few. It can set prices too high or
too low. It can add too much equipment or too little. At best, these sorts of
forecasting problems will cut into profits; at worst, they may drive an orga-
nization out of business.
Lee.indd 137 1/2/19 3:15 PM
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Economics for Healthcare Managers138
The consequences of bad or misapplied forecasts are particularly seri-
ous in healthcare. For example, underestimating the level of demand in the
short term may result in stock shortages at a pharmacy or too few nurses
on duty at a hospital. In both cases, the healthcare organization will suffer
financially and, more important, put patients at risk. It will suffer because the
costs of meeting unexpected demand are high and because the long-term
consequences of failing to meet patients’ needs are significant. The best out-
come in this case will be unhappy patients; the worst outcome will be that
physicians stop referring patients to the organization.
Overestimating sales can also have serious long-term effects. A hospital
may add too many beds because its census forecast was too high. This surplus
will depress profits for some time because the facility will have hired staff and
added equipment to meet its overestimated forecast, and the costs of hir-
ing and paying new employees and buying new equipment will substantially
exceed actual sales profits. In extreme cases, bad forecasts may drive a firm
out of business. A facility that borrows heavily in anticipation of higher sales
that do not materialize may be unable to repay those debts. Bankruptcy may
be the only option.
Sales and revenue forecasts are applications of demand theory. The fac-
tors that change sales and revenues also change demand. The most important
influences on demand are the price of the product, rivals’ prices for the prod-
uct, prices for complements and substitutes, and demographics. Recognizing
these influences can simplify forecasting considerably because it focuses our
attention on tracking what has changed.
9.2 What Is a Sales Forecast?
A sales forecast is a projection of the number of units (e.g., bed days, visits,
doses) an organization expects to sell. The forecast must specify the time
frame, marketing plan, and expected market conditions for which it is valid.
A forecast is a planning tool, not a rigid goal. Conditions may change.
If they do, the organization’s plan needs to be reassessed. Good management
usually involves responding effectively to changes in the environment, not
forging ahead as though nothing has shifted. In addition, fixed sales goals
create incentives to behave opportunistically (that is, for employees to try
to meet their goals instead of the organization’s goals). For example, sales
staff may harm the organization by making overblown claims of a product’s
effectiveness to meet their sales goals, even though their actions will harm the
company in the long run. Alternatively, sales managers may bid on unprofit-
able managed care contracts just to meet goals.
Whenever possible, a sales forecast should estimate the number of
units expected to be sold, not revenues. The number of units to be sold
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Chapter 9: Forecast ing 139
determines staffing, materials, working capital, and other needs. In addition,
costs often vary unevenly with volume. A small reduction in volume may save
an entire shift’s worth of wages (thereby avoiding considerable cost), or an
increase in sales may incur a small cost increase if it requires no additional
staff or equipment.
The dollar volume of sales can vary in response to factors that do not
affect the resources needed to produce, market, or service the sales. Dis-
counts and price increases are examples of such factors. Revenues can vary
even though neither volume nor costs change. Finally, managers can easily
forecast revenue given a volume forecast. In general, managers should build
their revenue estimates on sales volume estimates.
Good forecasts have five attributes. They should be
1. easy to understand,
2. easy to modify,
3. accurate (i.e., they contain the most probable actual values),
4. transparent about how variable they are, and
5. precise (i.e., they give the analyst as little wiggle room as possible).
These attributes often conflict. Managers may need to underplay how impre-
cise simple forecasts are because their audience is not prepared to consider
variation. As Aven (2013) points out, many decision makers are more com-
fortable working with a single, precise estimate, even though it may be inac-
curate. Precision and accuracy always conflict because a more precise forecast
(80 to 85 visits per day) will always be less accurate than a less precise forecast
(70 to 95 visits per day). Offering decision makers several precise scenarios is
usually a good compromise. For example, busy decision makers generally can
use a forecast such as “Our baseline forecast is 82 visits per day for the next
three months, our low forecast is 75 visits per day, and our high forecast is
89 visits per day.”
Forecasting Supply Use
More and more healthcare institutions seek to
reduce costs while increasing the quality of care.
Accurate forecasts of the use of medical supplies represent an important
element of this effort. Overordering supplies drives up costs, and under-
ordering supplies also can drive up costs and compromise care.
Case 9.1
(continued)
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Economics for Healthcare Managers140
9.3 Forecasting
All forecasts combine history and judgment. History is the only real source
of data. For example, sales can be forecasted only on the basis of data on past
sales of a product, past sales of similar products, past sales by rivals, or past
The stakes can be high. Caldwell Memorial Hos-
pital, a 110-bed hospital in North Carolina, saved
$2.62 million in less than six months by consolidat-
ing and eliminating excess supplies (Belliveau 2016). The hospital used
a Lean approach to inventory management, which involves streamlining
and simplifying the inventory and ordering systems.
In addition, a number of hospitals have expanded their use of just-
in-time inventory management (Green 2015). This method reduces, but
does not eliminate, the need for forecasting accuracy. Some supplies
are highly specialized and are used intermittently, so they must be
ordered well in advance. The savings can be substantial. Mercy Hos-
pital in Chicago was able to reduce its inventory by 50 percent using
just-in-time inventory management (Green 2015).
Discussion Questions
• What share of hospital costs do supplies represent?
• Why would overordering supplies drive up costs?
• Why would underordering supplies drive up costs?
• Can you offer examples of Lean inventory management? Does it
work well?
• Can you offer examples of just-in-time inventory management?
Does it work well?
• Can you offer examples of supplies that have to be available at all
times?
• What are the main challenges to making accurate forecasts of
supply use in hospitals?
• How would you forecast supply use in the emergency department?
Why?
• How would you forecast supply use in hospital clinics? Why?
• Would you use judgment in making these forecasts? Why?
• Would you use statistical models in making these forecasts? Why?
• How are supply chain forecasts different for hospitals than for
retail? For manufacturing?
Case 9.1
(continued)
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Chapter 9: Forecast ing 141
sales in other markets. History is an imperfect guide to the future, but it is
an essential starting point.
Judgment is also essential. It provides a basis for deciding what data
to use, how to use the data, and what statistical techniques, if any, to use.
In many cases (e.g., introductions of new products or new competitive situ-
ations), managers who have insufficient data will have to base their forecasts
mainly on judgment.
As mentioned in section 9.2, a forecast must specify the time frame,
marketing plan, and expected market conditions for which it is valid. Changes
in any of these factors will change the forecast.
A forecast applies to a given period. Extrapolating to a longer or
shorter period is risky; conditions may change. The time frame varies accord-
ing to the forecast’s use. For example, a staffing plan may need a forecast
for only the next few weeks. Additional staff can be hired over a longer time
horizon. In contrast, budget plans usually need a forecast for the coming
year. Organizations usually set their budgets a year in advance on the basis
of projected sales. Strategic plans usually need a forecast for the next several
years. Longer forecasts are generally less detailed and less reliable, but manag-
ers know to take these factors into account when they develop and use them.
Forecasts should be as short term as possible. A forecast for next
month’s sales will usually be more accurate than forecasts for the distant
future, which are likely to be less accurate because important facts will have
changed. Your competitors today are likely to be your competitors in a month.
Your competitors in two years are likely to be different from your competitors
today, so a forecast based on current market conditions will be poor.
Marketing plan changes will influence the forecast. A clinic that
increases its advertising expects visits to increase. A forecast that does not
consider this increase will usually be inaccurate. Increasing discounts to phar-
macy benefits managers should result in increased sales for a pharmaceutical
firm. Again, a forecast that does not account for additional discounts will usu-
ally be deficient. Any major changes in an organization’s marketing efforts
should change forecasts. If they do not, the organization should reassess the
usefulness of its marketing initiatives.
Changes in market conditions also influence forecasts. For example, a
major plant closing would probably reduce a local plastic surgeon’s volume.
Plant employees who had intended to undergo plastic surgery may opt to
delay this elective procedure, and prospective patients who work for similar
plants may defer discretionary spending in fear that they too may lose their
jobs. Alternatively, a hospital closure will probably cause a competing hospital
to forecast more inpatient days. Historical data have limited value in project-
ing such an effect if a similar closure has not occurred in the past. Approval
of a new drug by the Food and Drug Administration should cause a phar-
maceutical firm to forecast a decrease in sales for its competing product. This
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Economics for Healthcare Managers142
sort of change in market conditions is familiar, and the firm’s marketing staff
will probably draw on experience to predict the loss.
Analysts routinely use three forecasting methods: percentage adjust-
ment, moving averages, and seasonalized regression analysis. If the
data are adequate and the market has not changed too much, seasonalized
regression analysis is the preferred method. However, whether the data are
adequate and whether the market has changed too much are judgment calls.
Percentage adjustment increases or decreases the last period’s sales
volume by a percentage the analyst deems sensible. For example, if a hospi-
tal had an average daily census of 100 the previous quarter, and an analyst
expects the census to fall an average of 1 percent per quarter, a reasonable
forecast would be a census of 99. Because of its simplicity, managers often
use percentage adjustment; however, this simplicity is also a shortcoming.
In principle, a manager could choose an arbitrary percentage adjustment.
Without some requirement that percentage adjustments be well justified,
this approach may not yield accurate forecasts. For example, a manager
might justify a request for a new position based on a forecast that average
daily census will increase by 5 percent, even though the average daily census
had been falling for the last 14 quarters. In addition, percentage adjustment
does not allow for seasonal effects. (Seasonal effects are systematic tenden-
cies for particular days, weeks, months, or quarters to have above- or below-
average volume.)
Demand theory can be used to add rigor to percentage adjustments.
For example, if the price of a product has changed, an estimate of the per-
centage change in sales can be calculated by multiplying the percentage
change in price by the price elasticity of demand. So, if an organization has
chosen to raise prices by 3 percent and faces a price elasticity of demand of
−4, sales will drop by 12 percent. Similar calculations can be used if the price
of a substitute, the price of a complement, or consumer income has changed.
The moving-average method uses the average of data from recent
periods to forecast sales. This method works well for short-term forecasts,
although it tends to hide emerging trends and seasonal effects. Exhibit 9.1
shows census data and a one-year moving average for a sample hospital.
Exhibit 9.1 also illustrates the calculation of a seasonalized regression
format. Excel was used to estimate a regression model with a trend (a vari-
able that increases in value as time passes) and three quarter indicators. The
variable Q1 has a value of 1 if the data are from the first quarter; otherwise,
its value is 0. Q2 equals 1 if the data are from the second quarter, and Q3
equals 1 if the data are from the third quarter. For technical reasons, the aver-
age response in the fourth quarter is represented by the constant. A negative
regression coefficient for trend indicates that the census is in a downward
trend. The results also show that the typical third-quarter census is smaller
percentage
adjustment
An adjustment
that increases
or decreases the
average of the
past n periods.
(The adjustment
is essentially a
best guess of what
is expected to
happen in the next
year.)
moving average
The unweighted
mean of the
previous n data
points.
seasonalized
regression
analysis
A least squares
regression that
includes variables
to identify
subperiods (e.g.,
weeks) that
historically have
had above- or
below-trend sales.
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Chapter 9: Forecast ing 143
Quarter Census Moving Average First Second Third Trend
1 99 1 0 0 1
2 109 0 1 0 2
3 101 0 0 1 3
4 107 0 0 0 4
5 104 104.0 1 0 0 5
6 116 105.3 0 1 0 6
7 100 107.0 0 0 1 7
8 106 106.8 0 0 0 8
9 103 106.5 1 0 0 9
10 107 106.3 0 1 0 10
11 90 104.0 0 0 1 11
12 105 101.5 0 0 0 12
13 102 101.3 1 0 0 13
14 94 101.0 0 1 0 14
15 98 97.8 0 0 1 15
16 104 99.8 0 0 0 16
17 99 99.5 1 0 0 17
18 105 98.8 0 1 0 18
19 94 101.5 0 0 1 19
20 102 100.5 0 0 0 20
21 100 100.0 1 0 0 21
22 100.3
Seasonalized Regression Model
Coefficient t-statistic
Intercept 108.811 40.90 R2 = 0.55
First quarter −3.968 −1.53 F(4,20) = 4.98
Second quarter 0.732 0.27 p = 0.01
Third quarter −8.534 −3.16
Trend −0.334 −2.16
EXHIBIT 9.1
Census Data
for a Sample
Hospital
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Economics for Healthcare Managers144
than average because the coefficient for Q3 is large, negative, and statistically
significant.
The forecast based on seasonalized regression analysis is calculated as
follows: 108.811 + (−0.334 × 22) + 0.732. Here, 108.811 is the estimate of
the constant, −0.334 is the estimate of the trend coefficient, 22 is the quarter
to which the forecast applies, and 0.732 is the estimate of the Q2 coefficient.
Therefore, the seasonalized forecast is 102.2, slightly higher than the forecast
based on the moving average. Overall the seasonalized forecast is a little more
accurate than the one-year moving average. The mean absolute deviation
for the regression is 2.3 for periods 5 through 21, and the mean absolute
deviation for the moving average is 4.0.
Exhibit 9.2 shows an overview of the forecasting process. The main
message of this exhibit is that a forecast is one part of the overall product
management process. In addition, the forecast will change as managers’
mean absolute
deviation
The average
absolute
difference between
a forecast and the
actual value. (It is
absolute because
it converts both 9
and −9 to 9. The
Excel function
=ABS( ) performs
this conversion.)
Assess internal and external factors.
Develop an initial forecast.
Develop an initial marketing strategy and then modify the forecast
and marketing strategy until they are consistent.
Monitor sales, internal factors, external factors,
and the marketing strategy.
Modify the forecast and marketing strategies as needed.
EXHIBIT 9.2
An Overview of
the Forecasting
Process
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Chapter 9: Forecast ing 145
assessments of relevant internal factors (e.g., cost and quality), external fac-
tors (e.g., the competitive environment and payment levels), and the market-
ing plan change.
A naïve forecast uses the value for the last period as the forecast for
the next period—in other words, a 0 percent adjustment forecast. Exhibit
9.3 shows an example of a naïve forecast. A moving-average forecast uses the
average of the last n values, where n is the number of preceding values used in
the forecast. For example, the first entry in the Two-Period Moving-Average
Forecast column in exhibit 9.3 equals (189 + 217) ÷ 2, or 203.
To compare forecasting techniques, analysts sometimes use the mean
absolute deviation, which is the average of the forecast’s absolute deviations
from the actual value. (When using the absolute deviation, it does not mat-
ter if a value is higher or lower than the actual value; all the deviations are
positive numbers.) For April through July, the naïve forecast in exhibit 9.3
has a mean absolute deviation of 12.0, and the two-period moving-average
forecast has a mean absolute deviation of 12.1. From this perspective, the
naïve forecast performs a little better.
These (and other) mechanistic forecasting methods do not allow man-
agers to explore how changes in the environment are likely to affect sales.
How would changes in insurance coverage change sales? Naïve forecasts and
moving-average forecasts are little help in such situations.
9.4 What Matters?
Assessment of external factors (i.e., factors beyond the organization’s con-
trol) is vital to forecasting. General economic conditions are a prime example.
Expected inflation and interest rates are good indicators of the state of the
Month Sales
Naïve
Forecast
Two-Period Moving-
Average Forecast
February 189
March 217 189
April 211 217 203
May 239 211 214
June 234 239 225
July 243 234 236.5
EXHIBIT 9.3
Simple
Forecasting
Techniques:
Naïve and
Moving-Average
Forecasts
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Economics for Healthcare Managers146
economy. Local market conditions, such as business rents and local wages,
also play an important role.
Government actions also can have a major impact on healthcare firms.
For example, changes in Medicare rates affect most healthcare firms. Alter-
natively, regulations can have a significant effect on costs. Expansion of Med-
icaid eligibility can have major effects on some hospitals and minor effects
on others. Keep in mind that these sorts of changes will also affect most of
your competitors, but forecasters would be ill advised to ignore changes in
government policy.
The plans of key competitors must also be considered. Closure of a
competing clinic or hospital can increase volume significantly and quickly.
Introduction of a generic drug can have a dramatic effect on a pharmaceuti-
cal manufacturer. Changes in competitors’ pricing policies can have a major
impact on sales.
Technological change is always an important issue. If a rival gains a
technological advantage, your sales can drop sharply. For example, if a rival
introduces minimally invasive coronary artery bypass graft surgery, admis-
sions to your cardiac unit will probably drop significantly until you adopt
similar technology. In other cases, your own advances may affect sales of
substitute products. For example, introduction of highly reliable magnetic
resonance imaging may sharply reduce the demand for conventional colo-
noscopy. Keep in mind, however, that if you do not introduce technologies
that add value for your customers, someone else will. A decision not to
introduce an attractive product because it will cannibalize sales is usually
a mistake.
Finally, although markets usually change slowly, differences in general
market characteristics (e.g., median income and percentage with insurance
coverage) may be important in forecasting sales of a new product.
Assessment of internal factors (i.e., factors within an organization’s
control) is also vital to forecasting. For example, existing production may
limit sales, or production may have limited sales in the past. If so, changes in
capacity or productivity need to be considered. Changes in the availability of
resources and personnel can also have a powerful effect on sales. For many
healthcare organizations, the entry or exit of a key physician can dramatically
shape volume. In addition, changes in the size, support, composition, and
organization of the sales staff can affect sales dramatically. For instance, a
small drug firm may experience a large increase in sales if one of its products
is marketed by a larger firm’s sales staff.
Failures or improvements in key systems can also have dramatic effects
on sales. Breakdowns in a clinic’s phone or scheduling system may drive away
potential customers. Fixing the phone system, in contrast, might be the most
effective marketing campaign the clinic ever launched.
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Chapter 9: Forecast ing 147
Mistakes to Avoid When Making
Forecasts
Business plans require a sales forecast. Scott Fishman, the CEO of
Envisage, sees three common mistakes in business plans (Fishman
2015):
• They forecast “hockey stick” revenue growth.
• They forecast smoothly rising trend lines.
• They lack convincing evidence of market size.
A “hockey stick” forecast—a revenue graph shaped like a hockey
stick—involves limited revenues initially followed by explosive growth.
It is a potentially effective sales technique to use in discussions with
executives and investors because it suggests that the business oppor-
tunity might be extremely valuable.
In contrast, smoothly rising trend lines do not seem plausible from
an economic standpoint. The number of customers and their consump-
tion of any product is typically finite. Furthermore, any true blockbuster
product will attract competition.
Every new product faces a complex environment: features and
benefits, competitive environment, regulatory conditions, payment
models, distribution, pricing, market positioning, and so forth. A genu-
inely new product will have multiple unknowns in its market. If there
are no unknowns, it is not really a new product. A convincing forecast
demands market research, an honest recognition of what is not known,
and a strategy for resolving some of the unknowns.
Discussion Questions
• What is problematic about a “hockey stick” forecast?
• Can you find an example of a product that displayed “hockey stick”
revenue growth?
• What is problematic about a forecast with a smoothly rising trend
line?
• Can you find an example of a product that displayed smoothly rising
revenue growth?
• From an economic point of view, what is implausible about
smoothly rising trend lines?
Case 9.2
(continued)
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Economics for Healthcare Managers148
9.5 Conclusion
Making and interpreting forecasts are important tasks for healthcare manag-
ers. Not only are most crucial decisions based on sales forecasts, but also the
consequences of overestimating or underestimating demand can be cata-
strophic. Overestimating demand can put the financial future of an organiza-
tion at risk, whereas underestimating demand can compromise the care of
patients and harm the organization’s reputation.
Analysts should apply demand theory to their sales forecasts to better
recognize changes. Demand theory limits what analysts need to consider: the
price of the product, the price of substitutes, and the price of complements.
The key idea of demand theory is that the out-of-pocket price drives most
consumer demand. The amount the consumer has to pay depends largely
on the terms of the insurance contract. Is the product covered? What is the
required copayment? Changes in the answers to these two questions can shift
sales sharply. The same concerns affect the prices of substitutes. The most
important substitutes are similar products offered by rivals, but other prod-
ucts that meet some of the same needs should also be considered.
Demographic factors are important. Population size, income per
capita, the age distribution of the population, the ethnic makeup of the
population, and the insurance coverage of the population are some examples.
Although vital, demographic factors tend to be stable in the short term.
Demographics are much more important in long-range forecasts.
“Prediction is very difficult, especially if it’s about the future.” This
saying, noted in chapter 4, reveals a core truth about forecasting: You often
will be wrong. Knowing that, a shrewd manager will make decisions that can
be modified as conditions change. The shrewd manager will also know which
• Can you find an example of a product that
wildly underperformed early forecasts?
• Can you find an example of a product that
wildly overperformed early forecasts?
• What external factors might cause below-forecast sales? Above-
forecast sales?
• What internal factors might cause below-forecast revenues? Above-
forecast revenues?
• What are examples of new products with uncertain prospects in
healthcare?
Case 9.2
(continued)
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Chapter 9: Forecast ing 149
data are likely to be the most problematic or most variable and will monitor
those data carefully.
Management decisions require sales forecasts. Off-the-cuff forecasts
often fail to consider key factors and can lead to risky decisions. Imper-
fect forecasts can be used to make decisions as long as you recognize that
your predictions will sometimes be wrong and you structure your decisions
accordingly.
Exercises
9.1 The table lists visits for each of the four clinics operated by your
system. You anticipate that volumes will increase by 4 percent next
year. Forecast the number of visits for each clinic, and explain what
assumptions underlie your forecasts. For example, are you sure that
all the clinics can serve additional clients?
Period Clinic 1 Clinic 2 Clinic 3 Clinic 4 Total
This year 16,640 41,600 24,960 33,280 116,480
Next year ? ? ? ? 121,139
9.2 Your data for the clinics in exercise 9.1 suggest that clinic 2 is
operating at capacity and is highly efficient. Its output is unlikely to
increase. Furthermore, clinic 4 has unused capacity but is unlikely
to attract additional patients. How would these facts change your
answer to the question in exercise 9.1? Continue to assume that
overall volume will rise to 121,139.
9.3 You estimate that the price elasticity of demand for clinic visits
is −0.25. You anticipate that a major insurer will increase the
copayment from $20 to $25. This insurer covers 40,000 of your
patients, and those patients average 2.5 visits per year. What is your
forecast of the change in the number of visits?
9.4 A major employer has just added health insurance coverage for its
employees. Consequently, 5,000 of your patients will pay a $30
copayment rather than the list price of $100 per visit. These patients
average 2.2 visits per year. You believe the price elasticity of demand
is between −0.15 and −0.35. What is your forecast of the change in
the number of visits?
9.5 The following table shows data on asthma-related visits. Is there
evidence that these visits vary by quarter? Can you detect a trend?
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Economics for Healthcare Managers150
A powerful test would be to run a multiple regression in Excel. (To
do this, you will need the free Analysis ToolPak for your version of
Excel. Microsoft [2018] offers guidance on how to load and use the
Analysis ToolPak.) To test for quarterly differences, create a variable
called Q1 that equals 1 if the data are for the first quarter and 0
otherwise, a variable called Q2 that equals 1 if the data are for the
second quarter and 0 otherwise, and a variable called Q4 that equals
1 if the data are for the fourth quarter and 0 otherwise. (Because
you will accept the default, which is to have a constant term in your
regression equation, do not include an indicator variable for Quarter
3.) Also create a variable called Trend that increases by 1 each
quarter.
Year Q1 Q2 Q3 Q4
2014 1,513 1,060
2015 1,431 1,123 994 679
2016 1,485 886 1,256 975
2017 1,256 1,156 1,163 1,062
2018 1,200 1,072 1,563 531
2019 1,022 1,169
9.6 Your marketing department estimates that Medicare urology visits
equal 5 − (1.0 × C) + (−6.5 × TO) + (5 × TR) + (0.01 × Y). Here,
C denotes the Medicare copayment (now $20), TO is waiting
time in your clinic (now 30 minutes), TR is waiting time in your
competitor’s clinic (now 40 minutes), and Y is per capita income
(now $40,000).
a. How many visits do you anticipate?
b. Medicare’s allowed fee is $120. What revenue do you anticipate?
c. What might change your forecast of visits and revenue?
9.7 Because of fluctuations in insurance coverage, the average price paid
out of pocket (P) by patients of an urgent care center varied, as the
table shows. The number of visits per month (Q) also varied, and
an analyst believes the two are related. The analyst also thinks the
data show a trend. Run a regression of Q on P and Period to test
these hypotheses. Then use the estimated parameters a, b, and c
and the values of Month and P to predict Q (number of visits). The
prediction equation is Q = a + (b × Month) + (c × P).
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Chapter 9: Forecast ing 151
Month 1 2 3 4 5 6 7 8 9 10 11 12
P $21 $18 $15 $24 $18 $21 $18 $15 $20 $19 $24 $20
Q 193 197 256 179 231 214 247 273 223 225 198 211
9.8 Use the data in exercise 9.7 to answer these questions:
a. Calculate the naïve estimator, which is Qt = Qt − 1.
b. Calculate the two-period moving-average forecast.
c. Calculate the mean absolute deviation for the regression forecast,
the naïve forecast, and the two-period moving-average forecast.
d. Which forecast seems to perform the best? Why?
9.9 Sales data are displayed in the table.
Month Sales Month Sales
February 224 January 260
March 217 February 284
April 211 March 280
May 239 April 271
June 234 May 302
July 243 June 286
August 238 July 297
September 243 August 301
October 251 September 309
November 259 October 314
December 270
a. Calculate the naïve estimator, which is Salest = Salest − 1.
b. Calculate the two-period and three-period moving averages.
c. Calculate the mean absolute deviation for each of the forecasting
methods.
9.10 A pharmaceutical company produces a sinus medicine. Monthly sales
(in thousands of doses) for the past three years are shown in the
table on the next page.
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Economics for Healthcare Managers152
a. Develop a regression model that allows for trend and seasonal
components. Obtain the Excel output for this model.
b. Calculate a two-period moving-average forecast.
c. Compare the mean absolute deviations for these approaches.
d. Use one of these models to forecast sales for each month of
year 3.
References
Aven, T. 2013. “On How to Deal with Deep Uncertainties in a Risk Assessment and
Management Context.” Risk Analysis 33 (12): 2082–91.
Belliveau, J. 2016. “How a Small Hospital Developed Lean Supply Chain Manage ment.”
RevCycle Intelligence. Published September 6. https://revcycle intelligence .com
/news/how-a-small-hospital-developed-lean-supply-chain-management.
Fishman, S. 2015. “3 Mistakes to Avoid When Forecasting the Market for Your
Medical Device.” Med Device Online. Published September 21. www.med
deviceonline.com/doc/mistakes-to-avoid-when-forecasting-the-market-for
-your-medical-device-0001.
Green, C. 2015. “Hospitals Turn to Just-in-Time Buying to Control Supply Chain
Costs.” Healthcare Finance. Published May 6. www.healthcarefinancenews
.com/news/hospitals-turn-just-time-buying-control-supply-chain-costs.
Microsoft. 2018. “Use the Analysis ToolPak to Perform Complex Data Analysis.”
Accessed September 18. https://support.office.com/en-us/article/use-the
-analysis-toolpak-to-perform-complex-data-analysis-6c67ccf0-f4a9-487c-8dec
-bdb5a2cefab6.
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
6,788 8,020 1,848 410 586 2,260 2,232 8,018 9,384 6,916 5,698 6,940
9,136 7,420 3,350 1,998 1,972 3,572 4,506 10,474 13,358 8,232 8,218 10,248
9,628 7,826 3,528 2,126 2,070 3,762 4,754 11,010 14,040 8,646 8,634 10,782
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CHAPTER
485
SHOULD PROFITS IN HEALTHCARE BE
PROHIBITED?
Statements such as the following are often made as reasons for prohibiting
the profit motive in healthcare.
It is fundamentally wrong to make a profit on somebody’s illness.
Patients’ healthcare decisions should not be based on making money. Profit
maximization might be an appropriate goal for other areas of the economy,
such as cars and housing, but not where people’s health is concerned. Should
people make a profit from others’ need for life-saving treatments? Profit incen-
tivizes people to provide unnecessary care, decrease quality, raise prices, and
reduce care to the sick.
The policy prescription that usually follows from such comments is a
single-payer healthcare system or government price controls; in both scenarios,
the government determines the allocation of capital.
Trade-offs always exist. Eliminating profits must be weighed against the
“costs” of doing so. Under which approach would enrollees and patients be
better off? Would substituting altruism for the incentive to earn profits achieve
greater efficiency, lower healthcare costs, improved care coordination, higher
quality, and more rapid innovation? Does empirical evidence exist to show that
government bureaucrats are wiser than entrepreneurs in their allocation of
capital and in deciding which innovations should be funded? Which approach
would be subject to less interference from politicians?
Definition of Profits
Accounting Definition of Profits
What is the appropriate definition of profits? Accountants define profit as the
difference between revenues (net of discounts) and the amount that is spent to
earn those revenues. In addition to the direct costs of production, costs include
administration, depreciation of capital, marketing, interest expense on loans,
and taxes. These are “explicit” costs. Earnings and net income are sometimes
used as substitute terms for profits.
Net profit margin is an indicator of a company’s profitability and is cal-
culated by dividing net profit by net revenue, converting that number into a
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AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition
Account: s4264928.main.eds
Health Pol icy Issues: An Economic Perspect ive486
percentage, and multiplying it by 100. The result is a measure of the net income
(profit) generated from each dollar of revenue. For example, if a firm has $100,000
in revenue and its net profit is $10,000, then its profit margin is 10 percent. Profit
margins are often used to compare profitability between firms in an industry.
According to the accounting definition of profit, any firm with positive
net income is profitable.
Economic Definition of Profits
Economists, however, disagree with this definition. A firm might be making a
positive profit, yet economists would conclude the firm is losing money. Unless
the firm can increase its profit, it may go out of business.
How can a profitable firm, according to generally accepted accounting
principles, be losing money according to economists? More important, whose
definition of profit is a more accurate predictor of whether the firm will be
able to attract more capital and expand or perhaps be forced to merge with
stronger competitors if it is to survive?
To get started in business, a firm needs capital to build a facility, hire
employees, buy supplies and equipment, and so forth.1 To raise the necessary
capital, the firm’s management must attract investors by promising them a
return on their money. Investors are only willing to provide the firm with
money if they can earn a greater return than that in comparable investments.
Investors can earn a return on their capital in various ways; they can invest
in other businesses, either directly or through the stock exchanges, as well as
buy government bonds. Because investing in a business is riskier than buying
government bonds, investors would require a greater return on their capital
than the interest on government bonds. The return to investors must be com-
mensurate with the risk involved.2
The return to stockholders in the form of dividends is not a business
expense that is deducted from revenues. The amount of money remaining after
all of the firm’s expenses are deducted from the firm’s revenues, which accoun-
tants consider to be profit, is used to pay dividends to the firm’s shareholders.3
Thus, if the firm earns some profit, but not enough to pay the dividends
expected by investors, the accounting statement will still show that the firm
has earned a profit. However, unless these “implicit” (as well as explicit) costs
are covered, capital will leave the firm and seek a higher return elsewhere. The
firm will not have covered all its costs and will be unable to secure the necessary
capital to enable it to grow and compete with more profitable firms.
The rate of return to investors is considered to be the cost of capital;
it is a cost and is not, according to economists, part of the firm’s profit. It is
the rate of return on what the firm’s capital could have earned if it had been
invested in its next best use, after adjustment for risk. (This is referred to as
the opportunity cost of capital.)4
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 487
A firm that makes a positive accounting profit that is insufficient to pay
an adequate return to its investors is considered to be losing money.
When a firm earns enough money to cover all its costs, including its
cost of capital, economists consider the firm to be making zero economic profit.
(For simplicity, this term can be referred to as a normal profit.) Revenue will
equal the firm’s explicit and implicit costs, thereby earning a normal profit.
There would be no reason for capital to leave the firm or for investors to want
to invest more funds in the firm. The firm is in equilibrium.
Firms require a normal profit to remain in business. Each of the firm’s
resources is paid what they are worth in their next best use. If they do not receive
that return, those resources will move to where they can earn it, likely a differ-
ent firm or industry. Normal profits typically occur in competitive industries
in which no firm has a comparative advantage over other firms in the industry.
Excess Profits (Economic Profit)
Firms may earn more than a normal profit, more than is necessary to pay its cost
of capital. The firm is then earning “economic profit,” or simply “excess profits.”
If a firm earns excess profits, is it greedy and should those excess profits
be taken away?
Healthcare providers are able to earn excess profits for one of three rea-
sons; the first is beneficial for consumers and should be encouraged, whereas
the other two are disadvantageous to patients and taxpayers.
Excess Profits Based on Differentiation and Innovation
When the iPhone was invented, it was unique; nothing like it existed. A new
product was made available to consumers that they were willing to buy because
they valued it highly. Apple earned excess profits. Similarly, purchasers are will-
ing to pay higher prices for innovative blockbuster drugs that treat previously
untreatable diseases because the benefit they receive is worth the higher cost.
Some hospitals are able to attract a greater volume of patients (and
charge insurers higher rates) because insured enrollees value those hospitals
more highly than others; they have a better perceived reputation, they may offer
services their competitors do not, or their location may be more convenient.
These attributes differentiate them from their competitors. The same is true
for some physicians. They may earn excess profits because of their reputation,
their professional manner, and so on.
Hospitals, physicians, other healthcare providers, and insurers who are
able to differentiate themselves in a positive manner from their competitors
may be able to earn excess profits. The additional value provided to consumers
justifies these excess profits.
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Health Pol icy Issues: An Economic Perspect ive488
Excess profits, earned as a result of innovation or differentiation, are
temporary. Competitors begin to emulate those who earn excess profits. Over
time, the differentiation between firms decreases. As imitators enter the market,
prices are driven down, as are excess profits. Under competition, firms must
continually strive to differentiate themselves to earn excess profits. Patients
benefit when firms continually strive to develop better services to earn excess
profits.
Excess Profits Based on Anticompetitive Actions
Excess profits have adverse effects on consumers when they are generated by
anticompetitive behavior. For example, if two hospitals, each with large mar-
ket shares in a community, merge, thereby decreasing the number of hospital
competitors, the merged hospitals will be able to raise their prices and make
excess profits. As generally occurs with hospital mergers, the merged hospitals
have not improved services or provided a higher-quality product, although
that is often the reason given by hospital executives for the merger. With fewer
hospital competitors in the market, health insurers have less negotiating power
and must pay higher prices to the merged hospitals.
Consumers have not benefited from the merger and, in fact, are worse
off because they must pay higher insurance premiums and have fewer choices
for their care. Even if hospital prices are fixed by Medicare, mergers provide
hospitals with greater market power. The merged hospitals have less incentive
to innovate, improve quality and care coordination, or be responsive to their
patient population. Patients have fewer choices with respect to the providers
from whom they can seek care.
Similarly, merged health insurers that achieve market power are likely to
charge higher premiums. Medical groups, or other healthcare provider orga-
nizations, that merge do so to become dominant in their market and increase
their profits. Merged organizations do not necessarily improve their services;
instead, consumers are made worse off by having to pay higher prices from
fewer providers.
Only when organizations have to compete are they more responsive to
their purchasers. The higher the degree of monopoly power, achieved through
anticompetitive actions, the less responsive the firm will be toward those it
serves.
The federal antitrust agencies, the Federal Trade Commission, and the
Department of Justice investigate mergers and other potential anticompetitive
actions to determine whether consumers are harmed. These government agen-
cies have investigated and brought to trial numerous cases, such as mergers
between not-for-profit hospitals to gain monopoly power, boycotts by medical
and dental societies against health insurers, and attempts by medical societies
to engage in price fixing.
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 489
Not-for-profit healthcare organizations generally have not behaved any
differently from for-profit counterparts in their search for excess profits through
anticompetitive actions.
Excess Profits Based on Third-Party Payment and Lack of Patient
Incentives
Another reason why healthcare providers can make excess profits is health insur-
ance. For example, a person enrolled in Medicaid or a Medicare patient with
Supplement Part B coverage pays little out of pocket when seeking medical
care. When an insured person bears little of the cost of care, he has less incen-
tive to be concerned about use of medical services, to search for lower-priced
providers, or to check whether the provider has billed accurately for the services
received. In these situations, providers do not need to have a better reputation,
provide higher-quality care, or be the only provider to make excess profits.
Fraud is particularly rampant in Medicare and Medicaid because govern-
ment oversight is less vigorous than oversight by private health insurers. The
US Government Accountability Office (2015) estimates that in 2015 Medicare
made improper and fraudulent payments of approximately $60 billion, 10
percent of Medicare’s annual provider payments.
Excess profits generated through lack of patient and/or purchaser incen-
tives to pay attention to the cost of care or inadequate monitoring of provider
billings by the government have negative effects on rising medical costs, qual-
ity of care, and taxpayers, who pay for government-funded programs such as
Medicare and Medicaid.
Do Not-for-Profit Hospitals and Insurers Generate
“Profits”?
All firms require capital to get started. Not-for-profit hospitals relied heavily on
charitable capital donations from members of the community to finance their
development. These charitable donors did not seek a financial return on their
donation. Instead, their “return” was to ensure that their community would
have a hospital that improved the health of those it served. (The “return” to
some donors, similar to donors in the fields of arts and education, is a degree
of immortality by having their names inscribed on a specific capital project.)
Not-for-profit Blue Cross plans were begun by not-for-profit hospitals
in their region that provided the initial capital. These hospitals controlled Blue
Cross plans until the 1980s. In return for their capital, Blue Cross plans sold a
type of hospital insurance designed to advance the self-interest of those hospitals.5
A not-for-profit company is supposed to provide services for the benefit
of the general public, and it has restrictions on how surpluses (net income or
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Health Pol icy Issues: An Economic Perspect ive490
earnings) can be distributed. Further, a not-for-profit company does not have
stockholders, and its primary motive is not to increase its profit.
Legal distinctions between for-profit and not-for-profit firms are less
important than any behavioral differences between the two types of orga-
nizations. Currently, many not-for-profit hospitals and insurers exist. They
have expanded in size, developed new services, bought physician practices,
and gained excellent reputations. How have they been able to achieve all this
without earning profits? Where did the capital originate for these investments?
In reality, healthcare not-for-profits earn (or try to earn) a profit. How-
ever, the excess of their revenues over cost is not called profit; net margin or
margin is used to refer to the difference between revenues and expenses.
If healthcare profit were eliminated, would that also include the net
margins of not-for-profit hospitals and “reserves” for insurers? A statement
heard repeatedly from not-for-profits is this: “no margin, no mission.” Thus,
even not-for-profit hospitals must earn more money than their costs if they are
to expand, innovate, develop new services, buy physician practices, and even
survive in a competitive environment.6
Even if the funds were donated to a not-for-profit healthcare provider,
those funds have a “cost.” That cost, however, is not included on the pro-
vider’s income and expense statements. The real cost of those subsidies is their
“opportunity cost,” which is the value the subsidies could have produced if
they were spent on another government project, such as infant nutrition or
preventive health programs. Government subsidies should have a yardstick by
which to judge the value of the expenditures.
The financial return to private capital is a measure of what that private
capital could have earned if invested elsewhere. Donations to not-for-profits
should include a market return on the subsidy as a cost on their income and
expense statements. Failing to include that return understates the true cost of
the not-for-profit hospital’s efficiency in producing healthcare.
Not-for-profit institutions also raise capital by borrowing. Debt markets
and banks try to ensure that their loans can be repaid. To demonstrate their
creditworthiness, the borrower has to show that its earnings are several times
greater than the interest payments on the debt. The additional earnings—above
what is required to pay interest on the debt—would be considered profit or
net margin.
Some not-for-profit healthcare organizations report substantial “prof-
its.” For example, not-for-profit Kaiser Foundation Health Plan and Hospitals
reported a six-month net income of $1.2 billion in 2016.7 Similarly, Blue
Shield of California was reported as having a reserve or profit of $4.2 billion
in 2015. Not-for-profit health insurers can use their profits in several ways, one
of which is to increase the size of the reserves. Insurers’ reserves are essential if
they are to pay medical claims when expenses exceed premium revenues. (State
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 491
insurance regulators are often concerned regarding whether those reserves are
excessive, and premiums should instead be reduced.8)
Generally, little difference exists between for-profit and not-for-profit
healthcare providers in their pricing strategies, which are based on what the
market will bear.9 Both types of hospitals generally set their prices to maximize
profits. For example, purchasers, such as health maintenance organizations
(HMOs), who are more willing than other insurers to shift their patients to
competing hospitals, receive greater not-for-profit hospital discounts than
insurers who are less able to shift their use of the hospital. Automobile insur-
ance companies typically do not have prenegotiated contracts with hospitals
for insured enrollees who are hurt in auto accidents. Hospitals will charge
these insurers much higher rates than insurers who have negotiated contracts.
The main cost advantage that not-for-profits have over for-profits is
not that they don’t earn profits, but that they are exempt from federal and
state income taxes and state sales taxes. One might expect that this competi-
tive advantage would enable them to charge lower prices than their for-profit
competitors and drive them from the market. Yet, this has not occurred.
What Are the Consequences of Eliminating “Profit” from
Healthcare?
If healthcare profits were prohibited, would healthcare costs and premiums
be lower and healthcare more affordable? The history of not-for-profit firms
provides some indication of what would likely occur if all healthcare orga-
nizations had to be not-for-profit and government were responsible for the
allocation of capital.
Goals and Behavior of Not-for-Profits in Noncompetitive Markets
The difference between for-profit and not-for-profit ownership lies in what each
type of hospital (or insurer) does with its profits. When only normal profits
are earned, each type of institution must use such profits to pay the full costs
of the enterprise, including a return to capital and debt.
When excess profits are earned, either in the short or long run, share-
holders in for-profit firms receive a greater return after taxes are paid. Not-
for-profit hospitals may spend their excess profits in several ways. They may
invest in new facilities and services (some of which may not be profitable but
may increase the hospital’s prestige); they may subsidize certain unprofitable
services; or they may increase employee benefits and salaries.
What the not-for-profit hospital or insurer does with its excess profits
depends on management and its board of directors’ objectives. When not-
for-profit hospitals are not subject to competitive pressures, their actions have
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Health Pol icy Issues: An Economic Perspect ive492
greatly varied. Some not-for-profits have used their “profits” to benefit their
communities. Others have used their “profits” for ends that are less noble.10
Once hospitals no longer have to compete, and they cannot distribute their
profits to stakeholders, their production costs will rise faster than they would
otherwise.
Lack of Incentives to Respond to Purchasers
Prohibiting, or even limiting, profits in healthcare will similarly reduce the
public benefits that profits provide. The public, and patients, benefit from the
profit motive among healthcare providers and insurers in the following ways.
Profits are the incentive for firms to be responsive to the desires of
purchasers. Firms try to gain a competitive advantage by providing better
amenities, achieving a better reputation, improving the quality of care, provid-
ing better patient services and improved access to care, and achieving greater
efficiencies. Firms that are more successful in meeting the needs of purchas-
ers are able to increase their market share. Patients, enrollees, and purchasers
(with an incentive and information to make appropriate choices) will switch
to firms that are better able to meet their needs. Firms that do not adapt are
driven out of business.
Only firms that have gained monopoly power through anticompetitive
actions, such as monopolization of the market through mergers, price fixing,
legal barriers to entry, or lack of consumer information, can continue to earn
a profit while neglecting the preferences of buyers. Patient satisfaction and
quality of care are lower when patients cannot choose and are unable to shift
to other healthcare providers and payers.
Lack of Incentives for Innovation
Patents on blockbuster drugs result in monopolies, but pharmaceutical com-
pany profits are the incentive for developing innovative drugs. Without the
opportunity to earn excess profits, firms would have no incentive to devote the
huge amounts of capital and incur the large risk involved to develop innovative
drugs that the public values and is willing to buy.
The search for profits has led to innovations in the delivery and financing
of health services. Until the late 1940s, not-for-profit Blue Cross plans were the
dominant insurers, offering only one type of health plan. Commercial insurers
entered the health insurance market by offering greater choice of insurance
plans, using deductibles and copayments to lower premiums. These for-profit
insurers also based their premiums on the actuarial risk group of the enrollee
(experience rating), rather than on the average risk of all insured enrollees
(community rating). Blue Cross had to adapt to remain competitive.
In the 1980s and 1990s, entrepreneurs saw a great opportunity to
profit if they could reduce rising healthcare costs. Hospitals were inefficient
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 493
and costly, and patients were being hospitalized who could be treated in less
costly settings. The pursuit of profits led to major changes in the delivery
and payment of care. For-profit entrepreneurs innovated in the use of lower-
cost (and patient preferred) outpatient surgery centers, forcing not-for-profit
hospitals and (hospital-controlled) Blue Cross to similarly expand their use of
outpatient surgery.
The growth of HMOs and the managed care revolution continue today.
Utilization was reduced and hospitals were forced to compete to join HMO
networks. Hospitals had to become efficient to survive, and many went out of
business. Lower HMO premiums forced existing insurers to adopt the same
managed care techniques to survive. Consumers benefited through lower
premiums (see exhibit 20.3).
High-deductible health plans, health savings accounts, retail medical
clinics, reference pricing, clinical apps for smartphones, virtual and digital
access to physicians, and large data analyses are among the many examples
of ongoing private sector innovations that are lowering costs and increasing
patient access to care.
The prospect of excess profits continues to change the healthcare financ-
ing and delivery system. Patients are being moved to less costly and patient-
preferred settings. They have an increased choice of health plans, lower pre-
miums than would otherwise be the case, and greater access to care through
the use of digital technology.
The profit motive has led to the entry of innovative firms that were
able to lower medical costs and be more responsive to the public’s interests.
Without the profit incentive, why would firms be willing to risk their capital to
try and innovate to the benefit of purchasers? How would the medical sector
be able to attract high-quality medical personnel and healthcare executives?
If profit were prohibited, who would perform the functions of for-profit and
not-for-profit firms?
Other mechanisms have been tried, such as command and control sys-
tems, price regulation, and government control and allocation of capital. How-
ever, historically, these alternative approaches have not been nearly as successful
in improving consumer welfare as has the profit incentive.
Inefficient Allocation of Capital
Government regulators are unable to allocate capital better than the private
market. Without profits as a measure of success in meeting the public’s demand,
where would government regulators get the information necessary to allocate
capital to healthcare projects and to healthcare organizations? Profits (and
expected profits) are necessary information to guide the allocation of resources.
What incentive do regulators have to take on risk and innovate? They
cannot legally earn more money, and if they take any risk in allocating capital
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Health Pol icy Issues: An Economic Perspect ive494
and their project fails, they might get fired or demoted. Government regula-
tors’ incentive is to play it safe and not undertake risky innovations or upset
politically powerful organizations. Politics often takes precedence in regula-
tory policy and in the allocation of federal capital subsidies. The following are
examples of how government has allocated capital.
Certificate of Need: In 1974, Congress enacted a law, referred to as Certificate
of Need (CON), to limit rising medical expenditures by controlling hospital
capital expenditures. Government regional planning agencies were established
to review all hospital capital expenditures exceeding $100,000. Not only did
CON fail to limit hospital expenditure increases, but existing hospitals “cap-
tured” the CON planning agency and used the controls on capital investment
to limit competition by preventing new hospitals from entering their market
(Mitchell 2016, 22–24). The law, and hospitals’ self-interest, was used to prevent
competitive free-standing outpatient surgery centers from being established.
Although the federal law was repealed in 1979, many states still have a CON
agency, which is used to benefit existing healthcare firms by serving as an entry
barrier to competitive healthcare firms.
Medicare Demonstration Project: A government demonstration project
showed that Medicare could lower the cost of acquiring durable medical equip-
ment (DME), but the program was not implemented. The DME providers,
who would have lost revenues, objected to their legislators, and the program
was cancelled (Newman et al. 2017).
Solyndra: Solyndra was a solar-panel start-up that failed, leaving taxpayers
liable for $535 million in federal guarantees. Despite studies expressing doubt
about the potential for success, administration officials allocated large sums
of capital to Solyndra and other similar companies based on a political agenda
(Leonnig and Stephens 2012).
Consumer Operated and Oriented Plans (CO-OPs)
The ACA provided loans to 23 not-for-profit health insurance CO-OPs ($2.4
billion was eventually spent). The justification for establishing the CO-OPs was
based on the faulty premise that the CO-OPs, being not-for-profit, would have
lower costs and could charge lower premiums, thereby promoting competition
on the health insurance exchanges. The CO-OPs received subsidized loans.
Although the government expected that one-third of the CO-OPs would fail,
the interest rate charged to the CO-OPs did not reflect the very high risk of
failure. Government is less concerned about risk when taxpayer funds are used
than are private investors using their own funds.
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 495
Not-for-profit health plans, such as Blue Cross and Blue Shield, and
for-profit insurers were already competing on the health insurance exchanges.
These plans had achieved economies of scale. How were the newly established
CO-OPs expected to compete against these large Blue plans?
Of the 23 CO-OPs, only 4 were expected to offer plans in 2018. The
other CO-OPs failed because of large financial losses and operational prob-
lems (Norris 2017). CO-OPs exist and can even prosper in many areas of the
economy, but they have grown very slowly and require sufficient capital to do
so. Typically, CO-OPs accumulate reserves (profits) to finance their growth
and to offset losses until they can achieve economic efficiency. The health
insurance CO-OPs made many mistakes, such as hiring unqualified managers
and pricing their premiums too low relative to the risk level of their enrollees;
in addition, they tried to expand too rapidly (Harrington 2016). As occurs
in many new businesses, their projections were inaccurate, they suffered large
losses, and they required more capital but didn’t have investors who could
provide additional risk capital.
An important role of private investors (for which they require a profit
commensurate with their investment risk) is to evaluate the quality of the
management of a start-up business. Private investors will also provide sufficient
capital to sustain the start-up when it incurs losses. When hospitals started Blue
Cross plans, they provided the capital to ensure that these plans succeeded.
The CO-OPs are cooperatives, owned by their enrollees. They had no
backup source of capital. Consequently, once they started to incur losses, they
failed. Evergreen, a Maryland co-op, stated on its website, “For far too long,
health insurance carriers have put profits ahead of people. We were founded
by healthcare leaders who believe there’s a better way forward—for the health
of Maryland and for future of healthcare in America.” Subsequently, as its
losses mounted and to prevent bankruptcy, Evergreen changed to a for-profit
company to attract private investors who provided the risk capital needed to
keep the co-op in business (Goldstein 2016).
Summary
Agreeing on an appropriate definition of “profit” is necessary to understand
the consequences of eliminating profit from healthcare. The accounting defi-
nition of profit is the difference between revenues and explicit costs, as com-
monly used in financial statements. The economists’ definition differs in that
it considers the rate of return on capital as a cost to the firm. It is an implicit
cost, not a profit, because if capital does not earn its return, it will leave and
be invested elsewhere.
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Health Pol icy Issues: An Economic Perspect ive496
The economic definition of profit leads to better predictions of the
firm’s behavior. If the firm’s revenues cover all of the firm’s costs, including
the rate of return on capital (adjusted for the riskiness of the investment), then
the firm is making a “normal” profit. The consequence of earning less than
normal profits is that the firm has not covered its cost of capital. Capital will
leave and the firm will eventually go out of business.
Not-for-profit healthcare providers and insurers must also generate a
profit or margin (the excess of revenues minus explicit costs); otherwise, they
would not have the necessary capital to expand, invest in new equipment and
technology, purchase physicians’ practices, hire staff, or even survive.
Eliminating a firm’s accounting “profit” or “margin” will cause for-
profit firms to exit the healthcare industry and limit the ability of not-for-profit
providers and insurers to innovate or provide additional services to patients.
Patients will be worse off under such a policy.
Allowing healthcare firms to earn “excess” profits is also essential to
incentivize them to innovate, improve services, reduce costs, and be responsive
to patient preferences. Patients benefit when firms compete on the basis of
service and quality. When a firm achieves excess profits through anticompetitive
mergers or through lack of patient information or incentives to choose among
less costly and higher-quality providers, these concerns should be addressed
separately through antitrust actions and changing patient incentives so that
cost of care is considered as well as benefits.
Access to capital is essential for innovations to occur, for firms to grow,
and for patients to benefit from medical research. Without investors’ expectation
of profit, capital would shift to other sectors of the economy, and healthcare
would remain as it was 50 years ago.
The alternative to relying on profit (or private donations) to allocate
capital is to rely on government and its regulators to decide which firms are
more deserving, who should expand, what services should be provided, by which
type of provider, and what innovations should be financed. When for-profit
firms fail, investors lose money, not taxpayers. Government is less able than
private investors (using their own funds) to properly evaluate the investment
prospects and management ability of healthcare firms. Government allocation
of capital is often based on politics rather than on potential economic perfor-
mance. Examples of misallocation of capital are numerous in the healthcare
field and other areas, such as the failed ACA CO-OPs and the Solyndra scandal.
Patients’ best interests are not served by removing profit from healthcare.
The fact that a firm is not-for-profit does not guarantee that its costs are lower,
its quality is higher, or it will act more in the interests of its patients than will
for-profit firms. The Federal Trade Commission has successfully sued not-for-
profit hospitals that have merged to gain market power and then raised their
prices. Medical schools have failed to innovate in their curricula, despite many
efforts to do so (Nutter and Whitcomb 2005).
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 497
The Department of Veterans Affairs healthcare system acquired a notori-
ous reputation for falsifying waiting lists and denying care to veterans, result-
ing in the deaths of many patients (Slack 2017). Not-for-profit firms without
competition will act no differently from for-profit monopolies.
The best guarantor of efficiency and responsiveness to the consumer is
price-competitive markets with informed purchasers, regardless of whether provid-
ers are for-profit or not-for-profit firms.11 The role of government in a profit-driven
system is to remove the impediments to competition, eliminate barriers to entry
that are meant to protect incumbents, promote dissemination of information so
purchasers can be informed, and subsidize those with low incomes so they have
the same choices among competitive healthcare firms as everyone else.
Discussion Questions
1. What is the difference between the accounting and economic
definitions of profit?
2. What is the difference between normal and excess profit?
3. Under what circumstances does excess profit benefit consumers?
4. Under what circumstances does excess profit harm consumers?
5. What remedies are available when excess profits occur because of
anticompetitive actions, lack of patient information, or comprehensive
insurance coverage (because patients have little incentive to be
concerned with prices)?
6. What functions do profits serve in healthcare?
Notes
1. Firms cannot start, grow, and survive on only loans. Banks and the
debt markets lend money based on the risk that the loan will be repaid
with interest. A firm without any assets is an extremely poor risk. As
the firm has greater amounts of invested capital and improved earnings
prospects, loans become less risky. Once a firm has incurred too much
debt (in relation to its capital), loans again become very risky.
2. Physicians, and other healthcare professionals, also must earn a profit
based on their large investment in the cost of their medical education.
The capital outlay for their investment includes, in addition to
tuition, cost of books, and other supplies, the opportunity cost of not
earning an income comparable to other college graduates during their
additional years of training. Their higher income represents the return
on their education investment and their fewer working years. Physicians
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Health Pol icy Issues: An Economic Perspect ive498
in some specialties earn excess profits because entry into those residency
programs is limited.
3. Instead of paying dividends, firms may reinvest their dividends and
provide a return to investors in the form of a higher stock price. The
tax consequences of dividends and capital gains on a higher stock price
differ.
4. When a firm has both debt and investor capital (equity), then the
expected cost of debt and return to equity, adjusted for risk, must be
calculated to determine the firm’s overall cost of capital.
5. For example, Blue Cross sold only inpatient hospital insurance. A
Blue Cross patient was entitled to a 30-day hospital stay and was not
responsible for any out-of-pocket payments. Because patients did not
have to pay a deductible or copays, hospitals did not have to compete
on price for such patients. A Blue Cross insurer had to sign up at least
75 percent of the hospitals in its market; therefore, hospitals did not
have to compete to be included in the Blue Cross provider network.
Also, when outpatient surgery centers opened, Blue Cross, controlled
by hospitals, refused to cover care in centers unaffiliated with existing
hospitals. It was more expensive for a Blue Cross patient to go to
an unaffiliated surgery center than to go to a hospital for surgery.
Hospitals’ self-interest was an important reason why Blue Cross
insurance was more costly than commercial insurance, which offered
broader coverage and included patient copays and deductibles. Blue
Cross plans eventually had to break away from hospital control to
survive in a price-competitive insurance market.
6. Relying on 2013 Medicare Cost Reports and Final Rule Data from the
Centers for Medicare & Medicaid Services, Bai and Anderson (2016)
used the measure of net income from patient care services per adjusted
discharge to calculate the profitability of acute care hospitals. They
determined that seven of the ten most profitable hospitals were not-for-
profit, and each of those hospitals earned more than $163 million in
total profits from patient care services.
7. For the six months ending June 30, 2016, Kaiser Foundation Health
Plan Inc., Kaiser Foundation Hospitals, and their respective subsidiaries
reported net income of $1.2 billion, compared with $2.1 billion
for the same period in 2015 (Kaiser Permanente 2016). Kaiser also
reported that year-to-date capital spending was $1.28 billion, which
reflects continued investments in facilities and technology to support
care delivery. These investments in facilities are to ensure that Kaiser
Permanente can meet the needs of its growing membership and
communities.
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Chapter 30: Should Prof i ts in Healthcare Be Prohibited? 499
8. The California Franchise Tax Board removed the tax exemption of
Blue Shield of California in 2015 (Cohen 2015). Blue Shield has
appealed that decision. One reason given for the state’s action is that
Blue Shield maintains a reserve of $4.2 billion, which critics claim is
four times greater than the amount Blue Shield requires for potential
future claims. Given the large reserve, greater than the amount that
Blue Shield claimed it needed to meet losses and future claims, critics
wondered why Blue Shield needed the rate increases it requested.
9. Little difference also exists between for-profit and not-for-profit
healthcare providers in how much charity care is provided, although
not-for-profit teaching hospitals provide a greater degree of charity
care. (See chapter 15, “Do Nonprofit Hospitals Behave Differently
Than For-Profit Hospitals?”) Congress revoked Blue Cross’s federal tax
exemption in 1986. The General Accounting Office concluded that the
difference between Blue Cross and Blue Shield and for-profit insurers
was not sufficient to justify the Blues’ federal tax-exempt status (New
York Times 1986).
10. When Medicare began, hospitals were reimbursed according to their
costs of caring for the aged. Cost-based payment resulted in hospitals
paying higher wages to their executives and staff. Cost reimbursement
enabled hospitals to invest in the latest technology, facilities, and
services. Costs increased and quality of care declined in many of these
hospitals. Studies found that hospital open-heart surgery units that
performed few surgeries cost more and had worse outcomes than units
that performed a large number of surgeries (Robinson and Luft 1987).
11. In 1776, Adam Smith wrote, “It is not from the benevolence of the
butcher, the brewer, or the baker that we can expect our dinner, but
from their regard to their own interest.”
References
Bai, G., and G. Anderson. 2016. “A More Detailed Understanding of Factors Associ-
ated with Hospital Profitability.” Health Affairs 35 (5): 889–97.
Cohen, R. 2015. “CA Pulls Tax-Exempt Status of Blue Shield of California.” Nonprofit
Quarterly. Published March 19. https://nonprofitquarterly.org/2015/03/19/
ca-pulls-tax-exempt-status-of-nonprofit-blue-shield-of-california/.
Goldstein, A. 2016. “Maryland’s ACA Health Co-op Will Switch to For-Profit
to Save Itself.” Washington Post. Published October 3. www.washingtonpost.
com/news/health-science/wp/2016/10/03/marylands-aca-health-co-
op-will-switch-to-for-profit-to-save-itself/.
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Health Pol icy Issues: An Economic Perspect ive500
Harrington, S. 2016. “Review of the Affordable Care Act Health Insurance CO-OP
Program.” Statement Before the Permanent Subcommittee on Investigations,
Committee on Homeland Security and Government Affairs, US Senate,
March 10, 2016. www.hsgac.senate.gov/download/harrington-testimony_-
psi-2016-03-10.
Kaiser Permanente. 2016. “Kaiser Foundation Health Plan and Hospitals Report
Second Quarter 2016 Financial Results.” Posted August 5. https://share.
kaiserpermanente.org/article/kaiser-foundation-health-plan-hospitals-report-
second-quarter-2016-financial-results/.
Leonnig, C. D., and J. Stephens. 2012. “Energy Dept. E-mails on Solyndra Provide
New Details on White House Involvement.” Washington Post. Published August
9. www.washingtonpost.com/politics/energy-dept-e-mails-on-solyndra-provide-
new-details-on-white-house-involvement/2012/08/08/668dc042-e162-11e1-
a25e-15067bb31849_story.html.
Mitchell, M. D. 2016. “Do Certificate-of-Need Laws Limit Spending?” Mercatus work-
ing paper. Published September. www.mercatus.org/system/files/mercatus-
mitchell-con-healthcare-spending-v1a .
Newman, D., E. Barrette, and K. McGraves-Lloyd. 2017. “Medicare Competitive
Bidding Program Realized Price Savings for Durable Medical Equipment Pur-
chases.” Health Affairs 36 (8): 1367–75.
New York Times. 1986. “Blue Cross Tax Status Is Challenged.” Published July 4.
www.nytimes.com/1986/07/04/us/blue-cross-tax-status-is-challenged.html.
Norris, L. 2017. “CO-OP Health Plans: Patients’ Interests First.” Healthinsurance.org.
Published August 27. www.healthinsurance.org/obamacare/co-op-health-
plans-put-patients-interests-first/.
Nutter, D., and M. Whitcomb. 2005. “The AAMC Project on the Clinical Education
of Medical Students.” Association of American Medical Colleges. Accessed
May 2018. www.aamc.org/download/68522/data/clinicalskillsnutter .
Robinson, J., and H. Luft. 1987. “Competition and the Cost of Hospital Care, 1972–
1982.” Journal of the American Medical Association 257 (23): 3241–45.
Slack, D. 2017. “VA Still in Critical Condition, Secretary David Shulkin Says.” USA Today.
Published May 31. www.usatoday.com/story/news/politics/2017/05/31/
veterans-affairs-secretary-david-shulkin-state-of-va/102333422/.
Smith, A. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. Edited
by E. Cannan (London: Methuen, 1904). Accessed May 2018. http://oll.
libertyfund.org/titles/smith-an-inquiry-into-the-nature-and-causes-of-the-
wealth-of-nations-cannan-ed-vol-1.
US Government Accountability Office. 2015. Medicare Program: Additional Actions
Needed to Improve Eligibility Verification of Providers and Suppliers. Published
June. www.gao.gov/assets/680/671021 .
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CHAPTER
185
12PRICING
Learning Objectives
After reading this chapter, students will be able to
• apply the standard marginal cost pricing model,
• explain why price discrimination can increase profits,
• explain the link between pricing and profits, and
• discuss the importance of price setting.
Key Concepts
• Pricing is important.
• Marginal cost pricing maximizes profits in most cases.
• The consequences of setting prices incorrectly can be substantial.
• Price discrimination is common in healthcare and other industries.
• Price discrimination can substantially increase profits.
• Contracting demands the same information as pricing.
12.1 Introduction
Pricing is important. Prices set too low or too high will drag down profits.
The trick is to set prices so that your organization captures profitable busi-
ness and discourages unprofitable business. To maximize profits, marginal
revenue should just equal marginal cost (assuming the product line is profit-
able). To maximize other objectives, organizations should start with profit-
maximizing prices.
Pricing is a continuing challenge for healthcare organizations for three
reasons. First, many managers do not have a clear pricing strategy. They lack
the necessary data to make good decisions and may be mispricing their prod-
ucts or selling the wrong product lines. Second, many managers lack skills
and experience in setting prices and negotiating contracts. Third, the pricing
strategy that is best for the organization may not be the pricing strategy that
Lee.indd 185 1/2/19 3:15 PM
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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
Account: s4264928.main.eds
Economics for Healthcare Managers186
certain departments or clinics prefer. Managers of these units may have incen-
tives to price products too high or too low. In the absence of a clear strategy
and good data, how prices are actually set will be up for grabs.
12.2 The Economic Model of Pricing
The economic model of pricing, marginal cost pricing, clearly identifies a
pricing strategy that will maximize profits. This strategy also identifies the
information needed to set prices.
The economic model of pricing is simple. First, find out what your
incremental costs are. (Remember, incremental costs are the same as marginal
costs.) Second, estimate the price elasticity of demand facing your organiza-
tion’s product. (Demand for the products of your organization will usually
be much more elastic than the overall demand for the product. See chapter
8 for more information about elasticity.) Third, calculate the appropriate
markup, which will equal ε/(1 + ε). (Here, ε represents the price elasticity of
demand for your organization’s product.) Multiplying this markup by your
organization’s incremental cost gives you the profit-maximizing price. The
profit-maximizing price will equal [ε/(1 + ε)] × MC, where MC represents
the incremental cost. So, if the price elasticity of demand is −2.5 and the
incremental cost is $3.00, the profit-maximizing price would be [−2.5/(1 −
2.5)] × 3.00, or $5.00.
By now you may have noted that the pricing rule is just a restatement
of the profit maximization rule from chapter 11, which states that marginal
revenue equals marginal cost. The formula for marginal revenue is Price × (1
+ ε)/ε, so MC = Price × (1 + ε)/ε. Solve this formula for Price by dividing
both sides by (1 + ε)/ε, and you end up with Price = MC/[(1 + ε)/ε], which
is the same as [ε/(1 + ε)] × MC.
Data on incremental costs are important for a wide range of manage-
ment decisions. Pricing is one more reason to estimate incremental costs.
Estimating the right price elasticity of demand can be more of a challenge.
Three strategies can provide you with this information. One would be to hire
a marketing consultant. Depending on how much your organization is will-
ing to spend, the consultant can provide you with a rough or fairly detailed
estimate. Another strategy would be to combine information on overall
market price elasticities of demand with information on your market share
for this product line. (Chapter 8 lists a number of market price elasticities.)
Dividing the overall price elasticity of demand by your market share gives an
estimate of the price elasticity your organization faces. For example, if the
overall price elasticity is −0.3 and your organization commands an eighth of
marginal cost
pricing
Using information
about incremental
costs and the
price elasticity
of demand to set
profit-maximizing
prices. The profit-
maximizing price
will equal [ε/(1 + ε)]
× incremental cost,
with ε representing
the price elasticity
of demand.
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Chapter 12: Pr ic ing 187
the market, you would estimate that your organization faces a price elasticity
of demand of −0.3/0.125, or −2.4. The third strategy would be to experi-
ment. For example, raise a product’s price by 5 percent and see how much
demand falls. Because the price elasticity of demand equals the percentage
change in quantity sold divided by the percentage change in price, this cal-
culation is straightforward.
Exhibit 12.1 illustrates how different profit-maximizing markups can
be. An organization facing a price elasticity of demand of −2.5 and an incre-
mental cost of $10.00 should have a markup of $6.67. In contrast, a similar
organization facing a price elasticity of demand of −5.5 should set a markup
of $2.22. Each of these choices maximizes profits, given the market envi-
ronment each firm faces. Clearly, organizations that face less elastic demand
enjoy larger markups. The payoffs of differentiating your products can be
substantial because these products face less elastic demand.
12.3 Pricing and Profits
What should you do if the rate of return from a line of business is inadequate?
The obvious solution is to raise prices. Unfortunately, like many obvious
strategies, this one will often be wrong. If a product line yields an inadequate
return on investment, four strategies should be explored.
1. Make sure your price is not too high or too low. Return to the
maximum pricing formula and see if you calculated incorrectly, or
whether your estimate of the price elasticity of demand was inaccurate.
Elasticity Price
−1.5 $30.00
−2.5 $16.67
−3.5 $14.00
−4.5 $12.86
−5.5 $12.22
−6.5 $11.82
−7.5 $11.54
−8.5 $11.33
−9.5 $11.18
EXHIBIT 12.1
Profit-
Maximizing
Prices When
Incremental
Costs Equal $10
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Economics for Healthcare Managers188
2. Reassess your estimate of incremental costs. If it is too high, your
prices will also be too high, and vice versa.
3. See how much you can cut your costs. Most healthcare firms should be
able to reduce costs substantially. To see whether yours can be brought
down, take a look at costs and business practices in firms you think are
efficient.
4. If all else fails, exit the line of business.
The consequences of setting price incorrectly can be substantial. In
exhibit 12.2 the profit-maximizing price should be $15.00. Setting a price
much lower or much higher than $15.00 reduces profits significantly. Note,
though, that being a bit too high or a bit too low is not disastrous. Being a
little off in your estimates of incremental cost or the price elasticity of demand
will usually mean your profits will be a little smaller than they could have been.
Pricing is an important component of marketing. How is the marginal
cost pricing model too simple? The main concern is that it does not account
for strategy. For example, demand for an innovative product will typically
be inelastic. The resulting high margins, unfortunately, will attract a host
of rivals. Your organization may want to forgo some immediate profits to
discourage entry by competitors. Alternatively, aggressive price cutting in
mature markets is likely to encourage price cutting by your competitors.
In markets with relatively few competitors, not rocking the boat by cutting
prices may allow everyone to enjoy stable, high prices and high profits. These
factors demand careful study, but even if you do not follow the marginal cost
pricing scenario, it should be your starting point.
Price Profits
$5.00 ($881,059)
$7.50 ($130,527)
$10.00 $0
$12.50 $28,194
$15.00 $32,632
$17.50 $30,824
$20.00 $27,533
$22.50 $24,172
$25.00 $21,145
EXHIBIT 12.2
Profits When
Incremental
and Average
Costs Equal $10
and the Price
Elasticity of
Demand Equals
−3.0
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Chapter 12: Pr ic ing 189
12.4 Price Discrimination
Price discrimination is common in healthcare, as it is in other industries.
Price discrimination refers to charging different customers different prices
for the same product. Price discrimination makes sense if different custom-
ers have different price elasticities of demand and if resale of the product by
customers is not possible. Most healthcare providers and their products meet
these criteria. Healthcare providers contract with an array of individuals and
insurance plans. The price sensitivities of those purchasers differ widely, and
services can seldom be resold. So, profit-maximizing healthcare firms will
want to explore opportunities for price discrimination (or more politely, dif-
ferent discounts for different customers).
Price discrimination can increase profits. Suppose half your customers
(group A) have price elasticities of −3.00 and half (group B) have price elas-
ticities of −6.00. The demand curve for group A is 16,000 − 800 × Price, and
the demand curve for group B is 16,000 − 1,045 × Price. (You can verify that
the group A elasticity is −3.00 at a price of $15.00 and the group B elasticity
is −6.00 at a price of $12.00.) Your average and incremental costs are $10.
In setting prices you could use the average price elasticity of demand (−4.50)
and charge everyone $12.86. Or you could charge group A $12.00 and
charge group B $15.00 (which is what the marginal cost pricing model tells
us to do). As exhibit 12.3 illustrates, not using price discrimination leaves a
substantial amount on the table.
So, aside from managers (who are eager to learn new ways to improve
profits) and consumers (who are eager to learn new ways to get discounts),
why should price discrimination matter to anyone? Some observers think the
different prices reflect cost shifting, not price discrimination. According to
the cost shifting hypothesis, price reductions negotiated by PPOs or imposed
by Medicaid will raise costs for everybody else. The cost shifting hypothesis
is widely believed. For example, Morrison (2017) argued that employers and
consumers were paying billions more each year because Medicare and Med-
icaid payments were too low.
price
discrimination
Selling similar
products to
different buyers at
different prices.
cost shifting
The hypothesis
that price
differences are
due to efforts by
providers to make
up for losses
in some lines
of business by
charging higher
prices in other
lines of business.
Without Price Discrimination With Price Discrimination
Group Price Quantity Profit Price Quantity Profit
A $12.86 5,712 $16,336 $15.00 4,000 $20,000
B $12.86 2,561 $7,324 $12.00 3,460 $6,920
8,273 $23,660 7,460 $26,920
EXHIBIT 12.3
Profits With and
Without Price
Discrimination
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Economics for Healthcare Managers190
The cost shifting hypothesis might be true but probably is not. Most of
the empirical evidence from the contemporary marketplace is inconsistent with
the cost shifting hypothesis (White 2013). Why does the hypothesis persist?
There are three possibilities. First, the cost shifting hypothesis may be a ratio-
nalization for widespread discounting. No customer likes getting the smallest
discount, so perhaps healthcare firms lead the customer to believe a small dis-
count is due to cost shifting (“We could give you a better price if it weren’t for
the big discount we’re forced to give Medicare!”). This scenario is the most
likely. Second, cost shifting might be real, reflecting poor management on the
part of profit-seeking organizations. If a firm raised prices for some customers
because other customers negotiated a discount, either prices were too low to
begin with or the firm was acting imprudently in raising prices. Third, cost
shifting might be real, reflecting responses of not-for-profit firms that had set
prices lower than a well-managed, for-profit firm would have. However, pres-
sure on the bottom lines of healthcare organizations—profit and nonprofit—
means that, if it existed, cost shifting is probably a thing of the past.
Similar price differences are common in other industries with similar
characteristics. Have you ever wondered why it makes sense for one passenger
to have paid $340 for a flight and another passenger in the same row to have
paid $99? Why does it make sense for a matinee to cost half as much as the
same movie shown two hours later?
When the incremental cost of production is small, when buyers can
be separated into groups that have different price elasticities of demand, and
when resale is not possible, price discrimination is usually profitable. Most
healthcare firms, both not-for-profit and for-profit, fit this profile, so their
managers need to know how to price discriminate. With no margin, there is
no mission. Price discrimination helps increase margins.
Price Discrimination in Practice
What do American Airlines, Home Depot, Staples,
Stanford University, AT&T, the Mayo Clinic, and
Safeway have in common? They all price discriminate (Howe 2017). They
charge different customers different amounts for the same product.
Pharmaceutical discounts are the clearest examples of healthcare
price discrimination because the products are identical. Only the prices
differ. A cash customer (e.g., someone without insurance coverage)
may pay the highest price, the list price. However, in some instances,
Case 12.1
(continued)
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Chapter 12: Pr ic ing 191
insured customers may pay more because insurers
have not passed on discounts to their beneficia-
ries (Ornstein and Thomas 2017).
Most customers pay much less than list prices. Insurers negotiate
discounts with manufacturers and pharmacies. These discounts are
typically about 30 percent (Goldberg 2017). Some hospitals and HMOs
have their own pharmacies and can negotiate even better deals with
manufacturers. These organizations sometimes pay as little as 40 per-
cent of list prices. Most discounts come in the form of rebates, mean-
ing that a purchaser pays the list price up front but gets a payment
from the seller later. This makes resale more difficult and limits price
transparency (Morgan, Daw, and Thomson 2013).
The federal government has multiple discount programs. The larg-
est is the Medicaid rebate program, which requires manufacturers to
pay a rebate that varies by the type of drug. Prices, formularies, and
copayments vary from state to state, so it is not clear that the Medic-
aid rebate program covers the most effective medications or gets the
best prices (Luthra 2017). Many federally funded clinics and hospitals
are eligible for the Medicaid discount. However, these agencies can
often negotiate better deals because they can buy wholesale and
because they can choose drugs for their formularies.
Tribal and territorial governments can use the prices on the Federal
Supply Schedule, which federal agencies use to buy common supplies
and services. The Department of Defense, the Department of Veter-
ans Affairs (VA), the Public Health Service, and the Coast Guard may
get prices that are slightly lower than Federal Supply Schedule prices
because of a provision called the federal ceiling price. This provision
caps the price using a formula based on private-sector transactions.
Finally, these agencies can try to negotiate prices below the federal ceil-
ing price. The VA, which uses a national formulary, has used its bargain-
ing power to get substantially better prices. Good, Emmendorfer, and
Valentino (2017) report that the VA gets the steepest discounts in the
country, with prices as much as 44 percent lower than Medicare prices.
Discussion Questions
• Why do drug firms give discounts voluntarily?
• Do other healthcare providers routinely give discounts to some
customers?
• Why do the uninsured typically pay the highest prices?
Case 12.1
(continued)
(continued)
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Economics for Healthcare Managers192
12.5 Multipart Pricing
Thus far we have focused on simple pricing models. In fact, a wide range
of pricing models may be applicable. One is the multipart pricing model,
in which customers pay a fee to be eligible to use a service and pay separate
additional fees as they use the services. An obvious example would be a man-
aged care plan. The trade-off is that a low entry fee (premium) yields more
customers. High copayments reduce costs (either increasing profit margins
or reducing premiums), but at some point high copayments will drive away
customers. The right combination is always a balancing act. A related pricing
strategy is tying. Tying links the prices of multiple products. Again, the goal
is to balance multiple prices so as to maximize profits.
EXHIBIT 12.4
Marketing
Forecast
What Should You Charge?
Suppose that exhibit 12.4 is your practice’s mar-
keting forecast.
Case 12.2
(continued)
Price
Low-Income
Clients
High-Income
Clients Total
$35.75 2,125 14,250 16,375
$35.25 2,375 14,750 17,125
$34.75 2,625 15,250 17,875
$34.25 2,875 15,750 18,625
• Why is the cash price sometimes lower than the
insurance price?
• Why would a hospital usually get a better price
for a drug than an insurance company?
• Why does the VA get such low prices?
• Suppose a law was enacted that required drug manufacturers to
give state Medicaid agencies the same price they negotiated with
the VA. How would Medicaid and VA prices change?
• Should Medicare adopt the VA formulary?
Case 12.1
(continued)
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Chapter 12: Pr ic ing 193
Discussion Questions
• By law, you must charge everyone the same price. What do you
charge?
• Your costs equal $100,000 plus $20 per visit. What are your
revenues, costs, and profits?
• If you could charge the two groups different prices, what prices
would you charge each group?
• What would your revenues, costs, and profits be?
• Would this scenario be ethical?
• How could you identify the two groups? (You cannot do income
surveys of your patients.)
Case 12.2
(continued)
Price
Low-Income
Clients
High-Income
Clients Total
$33.75 3,125 16,250 19,375
$33.25 3,375 16,750 20,125
$32.75 3,625 17,250 20,875
$32.25 3,875 17,750 21,625
$31.75 4,125 18,250 22,375
$31.25 4,375 18,750 23,125
$30.75 4,625 19,250 23,875
$30.25 4,875 19,750 24,625
$29.75 5,125 20,250 25,375
$29.25 5,375 20,750 26,125
$28.75 5,625 21,250 26,875
$28.25 5,875 21,750 27,625
$27.75 6,125 22,250 28,375
$27.25 6,375 22,750 29,125
EXHIBIT 12.4
Marketing
Forecast
(continued)
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Economics for Healthcare Managers194
12.6 Pricing and Managed Care
Are these issues relevant in markets dominated by managed care? Yes. One
needs the same information to set a price or to evaluate a contract. Accept-
ing a contract in which marginal revenue is less than incremental cost almost
never makes sense because such a situation reduces profits. Such contracts
make sense only when these losses are really marketing expenses, and even
in these cases the money probably could be better spent elsewhere. Similarly,
giving a large discount to a buyer who is not sensitive to price almost never
makes sense. For example, a managed care plan that needs your organiza-
tion’s participation to offer a competitive network is not in a good bargaining
position and should not get the best discount.
The flip side of the pricing problem, contracting, is even tougher. Eco-
nomic models of pricing tell us that managers need to know what their incre-
mental costs are, what markup over incremental costs they should expect, and
what their rivals will bid. Each of these will be uncertain to some degree, and
many healthcare firms have only sketchy cost data. This fact is especially true
for incremental costs, which many firms are not prepared to track. Without
good data on incremental costs, managers will be flying blind and may be
tempted to base their bids on average costs. This reaction usually costs some
profitable business opportunities.
Should My Firm Accept This
Contract?
You are the manager of a 20-physician cardiology practice. You are
getting ready to advise your board about a proposal for capitated spe-
cialty care from a local HMO. Data from your fee-for-service practice
show billings per member per month of $100 for visits, $80 for cath-
eterizations, and $115 for lab services. The practice owns the labs, and
the profits are shared among the partners. Your estimate is that costs
(aside from physician income) equal 25 percent of charges.
The proposal from the HMO is for a rate of $275 per member per
month. Your immediate reaction is to reject it. Your chief financial
officer makes two comments that give you pause: “Our overhead will
drop significantly if we accept this proposal and convert 25 percent of
Case 12.3
(continued)
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Chapter 12: Pr ic ing 195
12.7 Conclusion
Pricing is important, but many healthcare firms lack direction. Without a
clear model of pricing, managers are unable to realize their firm’s goals. They
do not know what their incremental costs are or what sort of price elasticity
of demand their organization faces. As a result, they do not know what prices
to charge. This lack of knowledge reduces profits in two ways. The organiza-
tion may set its prices too high or too low. Alternatively, the organization may
participate in the wrong markets. It may accept contracts it should refuse or
refuse contracts it should accept.
The economic model of pricing tells managers what they should
do. Its implications apply to both pricing and contracting, so it remains an
important part of every healthcare manager’s tool kit. Actually applying this
model will not always be easy, but not knowing what to do is harder still.
Price discrimination is everywhere in healthcare, and many organiza-
tions rely on it to remain profitable. Profitable price discrimination requires a
little more information than setting a single price, so effective price discrimi-
nation is challenging. In addition, many healthcare managers are mesmerized
by tales of cost shifting. Cost shifting is unlikely to be responsible for differ-
ences in price. If managers genuinely believe cost shifting is occurring, the
belief steers them in the wrong direction.
our business to capitation. In addition, we should
anticipate that our rates for visits, catheterizations,
and tests will drop significantly once we convert.”
In this case the town has only two other cardiology groups. You
are not sure whether they have been asked to bid or not. Your legal
counsel has warned you that direct discussions with your rivals might
leave you open to an antitrust suit.
Discussion Questions
• Why is your initial response to reject the offer?
• Why might overhead go down if you accept the contract?
• Why might utilization rates go down?
• What are the risks of accepting or refusing?
• What should you do next? Should you accept the proposal? Should
you make a counteroffer?
Case 12.3
(continued)
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Economics for Healthcare Managers196
Exercises
12.1 The marginal cost pricing model calculates a markup over marginal
costs using estimates of the price elasticity of demand. Will any
other pricing strategy result in higher profits?
12.2 If cost shifting is just a useful public relations ploy, why does it get
so much attention?
12.3 Will raising prices increase the rate of return from a line of business?
12.4 Can you think of a healthcare firm that does not price discriminate
(i.e., charge different customers different amounts for the same
product)?
12.5 Price discrimination requires the ability to distinguish customers
who are the most price sensitive and the ability to prevent arbitrage
(resale of your products by customers who buy at low prices). What
attributes of healthcare products make these tasks easy to do?
12.6 Your pharmacy provides services to Medicare and PPO patients.
You estimate a price elasticity of demand of −2.2 for Medicare
patients and −5.3 for PPO patients. Your marginal and average cost
for dispensing a prescription is $2. What is the profit-maximizing
dispensing fee for Medicare and PPO patients? Why might the price
elasticities of demand differ?
12.7 Your dental clinic provides 3,000 exams for private pay patients and
1,000 exams for members of a union. Your fixed costs are $50,000
and your incremental cost is $40.
a. Private pay patients have a price elasticity of demand of −3. What
do you charge them?
b. The union has negotiated a fee of $50. Is it profitable to treat
members of the union?
c. What would happen to your profits if you stopped treating
members of the union?
d. If the union negotiated a fee of $45 instead, what would you
charge private pay patients?
e. What does this tell you about cost shifting versus price
discrimination?
12.8 You provide therapeutic massage services, focusing on stress
reduction services that are not covered by insurance. Your monthly
overhead is $2,000. You value your time at $20 per half hour (how
long a therapeutic massage takes). Supplies per massage cost $4.
You currently charge $75 per massage and have a volume of 100
clients per month. Your trade journal says that a 5 percent reduction
in prices typically results in a 7.5 percent increase in volume. What
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Chapter 12: Pr ic ing 197
would happen to your volume, revenues, and profits if you cut your
price to $70? If you raised your price to $80?
12.9 The table shows case-mix-adjusted price and volume data for Dunes
Hospital. Calculate its marginal cost, marginal revenue, and profits
at each level of output. What price should it choose?
12.10 Your firm spent $100 million developing a new drug. It has now
been approved for sale, and each pill costs $1 to manufacture. Your
market research suggests that the price elasticity of demand in the
general public is −1.1.
a. What price do you charge the public?
b. What would happen to profits if you charged twice as much?
c. What role does the $100 million in development costs play in
your pricing decision?
d. The Medicaid agency has made a take-it-or-leave-it offer of $2
per pill. Do you accept? Why or why not?
12.11 Why are most healthcare providers able to charge different groups
of purchasers different prices for the same products?
12.12 A clinic has incremental costs per case of $10 and overhead costs of
$100,000. It faces a price elasticity of demand of −2.
a. What is the clinic’s profit-maximizing price?
b. How would the profit-maximizing price change if overhead costs
doubled?
c. With excess capacity, would serving Medicaid customers for a fee
of $16 make sense?
d. How would the profit-maximizing price change if Medicaid raised
its fee to $18?
12.13 You manage a not-for-profit hospital in a competitive market.
Suppose you decide to charge less than the profit-maximizing price
to your customers.
a. What effect would that decision have on profits?
b. What effect would that decision have on you and your career?
12.14 Assume the price elasticity of demand for physicians’ services is −0.2.
If your marginal cost per visit is $20, what is your profit-maximizing
Admissions 6,552 9,048 9,672 9,984 10,296
Revenue $52,416,000 $70,574,400 $73,507,200 $73,881,600 $74,131,200
Cost $42,588,000 $59,264,400 $63,835,200 $66,393,600 $68,983,200
Price $8,000 $7,800 $7,600 $7,400 $7,200
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Economics for Healthcare Managers198
price if you control 5 percent of the market? What is your profit-
maximizing price if you control 15 percent of the market? What
lessons do you draw from this information?
12.15 A busy urgent care clinic has average costs of $40 and incremental
costs of $60.
a. How could incremental costs be higher than average costs?
b. The clinic charges $80 for a visit. What price elasticity of demand
does this information imply?
c. Volume is currently 200 visits per week. What are the clinic’s
profits?
d. An HMO guarantees at least ten patients per week. It proposes a
fee of $55. Should the clinic accept the contract?
e. What happens to profits if it accepts the contract?
References
Goldberg, R. 2017. “Reduce Drug Prices by Eliminating PBM Rebates.” The Hill.
Published February 14. http://thehill.com/blogs/congress-blog/healthcare
/319479-reduce-drug-prices-by-eliminating-pbm-rebates.
Good, C. B., T. Emmendorfer, and M. Valentino. 2017. “VA Responds to Concerns
About Collaboration with ICER.” Health Affairs Blog. Published October
25. www.healthaffairs.org/do/10.1377/hblog20171024.745943/full/.
Howe, N. 2017. “A Special Price Just for You.” Forbes. Published November 17. www
.forbes.com/sites/neilhowe/2017/11/17/a-special-price-just-for-you/.
Luthra, S. 2017. “Massachusetts Grabs Spotlight by Proposing New Twist on Medic-
aid Drug Coverage.” Kaiser Health News. Published November 21. https://
khn.org/news/massachusetts-grabs-spotlight-by-proposing-new-twist-on
-medicaid-drug-coverage/.
Morgan, S., J. Daw, and P. Thomson. 2013. “International Best Practices for Nego-
tiating ‘Reimbursement Contracts’ with Price Rebates from Pharmaceutical
Companies.” Health Affairs 32 (4): 771–77.
Morrison, I. 2017. “Spotlight on Healthcare Costs.” Leader’s Edge. Published Nov-
ember. http://ianmorrison.com/spotlight-on-healthcare-costs.
Ornstein, C., and K. Thomas. 2017. “Prescription Drugs May Cost More with
Insurance Than Without It.” New York Times. Published December 9. www.
nytimes.com/2017/12/09/health/drug-prices-generics-insurance.html.
White, C. 2013. “Contrary to Cost-Shift Theory, Lower Medicare Hospital Pay-
ment Rates for Inpatient Care Lead to Lower Private Payment Rates.” Health
Affairs 32 (5): 935–43.
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CHAPTER
169
11MAXIMIZING PROFITS
Learning Objectives
After reading this chapter, students will be able to
• define measures of profitability,
• describe two strategies for increasing profits,
• explain how to respond if marginal revenue exceeds marginal cost,
• identify the profit-maximizing level of output, and
• discuss differences between for-profit and not-for-profit providers.
Key Concepts
• All healthcare managers need to understand how to maximize profits.
• Most healthcare organizations are inefficient, so cost reductions can
increase profits.
• To maximize profits, firms should expand as long as marginal revenue
exceeds marginal cost.
• Marginal cost is the change in total cost associated with a change in
output.
• Marginal revenue is the change in total revenue associated with a
change in output.
• Managers need to distinguish incremental cost from average cost.
• An agency problem arises because the goals of stakeholders may not
coincide.
11.1 Introduction
Substantial numbers of healthcare managers serve firms that seek to maxi-
mize profits. For example, for-profit hospitals, most insurance firms, most
physician groups, and a broad range of other organizations explicitly seek
profits
Total revenue
minus total cost.
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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
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Economics for Healthcare Managers170
maximum profits. In addition, recognizing that “with no margin, there is
no mission,” many not-for-profit healthcare organizations act like profit-
maximizing firms. And even organizations that are not exclusively focused
on the bottom line must balance financial and other goals. Bankrupt orga-
nizations accomplish nothing. As a result, even healthcare managers with
objectives other than maximizing profits need to understand how to maxi-
mize profits. A manager who does not understand the opportunity cost (in
terms of forgone profits) of a strategic decision cannot lead effectively. All
healthcare managers need to understand how to maximize profits. Finally,
as markets become more competitive, the differences between for-profit and
not-for-profit firms are likely to narrow.
Profits are the difference between total revenue and total cost. To
maximize profits, you must identify the strategy that makes this difference
the largest. In other words, identify the product price (or quantity) and char-
acteristics that maximize profits.
11.2 Cutting Costs to Increase
Profits
An obvious way to increase profits is to cut costs. Most healthcare organiza-
tions are inefficient, meaning that they could produce the same output at
less cost or produce higher-quality output (that sells for a higher price) for
the same cost. The inference that healthcare organizations are inefficient is
based on two types of evidence. First, studies by quality management and
reengineering teams have identified that costs can be cut by increasing the
quality of care. For example, a transportation project at CareMore Health
System (that used Lyft) reduced wait times, reduced cost, and increased
patient satisfaction (Eapen and Jain 2017). The second type of evidence
results from statistical studies. For example, a sophisticated study of hospital
efficiency concluded that inefficiency represented more than 15 percent of
costs (Zhivan and Diana 2012). Some improvement appears to have been
made in recent years, but inefficiency remains substantial (Khushalani and
Ozcan 2017).
As exhibit 11.1 illustrates, the payoff from cost reductions can be sub-
stantial. The organization in the exhibit earns $40,000 on revenue of $2.4
million. This operating margin (profits divided by revenue) of 1.7 percent
suggests that the organization is not greatly profitable. Reducing costs by
only 2 percent changes this picture entirely. As long as the cost cuts represent
more efficient operations (not cuts in quality or customer service), all the cost
reductions will increase profits, in this case by 118 percent.
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Chapter 11: Maximizing Prof i ts 171
11.2.1 Cost Reduction Through Improved Clinical Management
Cost reductions often require improvements in clinical management because
differences in costs are primarily driven by differences in resource use, not
differences in the cost per unit of resource. (An organization cannot maxi-
mize profits if it overpays for the resources it uses.) In turn, differences in
resource use are driven by differences in how clinical plans are designed and
executed. Improvements in clinical management require physician coopera-
tion and, more typically, physician involvement. Even though many health-
care professionals make clinical decisions, physicians in most settings have a
primary role in decision making.
Having recognized the importance of physicians in increasing effi-
ciency, managers need to ask whether the interests of the organization and
its physicians are aligned. In other words, will changes that benefit the orga-
nization also benefit its physicians? If not, physicians cannot be expected to
be enthusiastic participants in these activities, especially if the advantages for
patients are not clear.
Managers are responsible for ensuring that the interests of individual
physicians are aligned with the organization or for changing the environment.
For example, physicians usually benefit from changes in clinical processes that
improve the quality of care or make care more attractive to patients. If man-
agers present the change proposal in this fashion, physicians may understand
how they will benefit. In other cases, however, physicians cannot be expected
to participate in quality improvement activities without compensation. For
independent physicians, explicit payments for participation may be required.
The same may be true for employee physicians, or participation may be a part
of their contractual obligations. In both cases, managers must be aware of the
high opportunity cost of time spent away from clinical practice.
Where feasible, physicians’ compensation can incorporate bonuses
based on how well they meet or exceed clinical expectations. This system
helps align the incentives of the organization and its physicians and provides
a continuing reminder to improve clinical management.
Status Quo 2% Cost Reduction
Quantity 24,000 24,000
Revenue $2,400,000 $2,400,000
Cost $2,360,000 $2,312,800
Profit $40,000 $87,200
EXHIBIT 11.1
The Effects of
Cost Reductions
on Profits
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Economics for Healthcare Managers172
Profiting from Clinical Improvement
Surgical complications reduce patients’ quality of
life and survival. As exhibit 11.2 shows, surgical
complications also increase hospital length of stay, readmission rates,
and costs. Such complications can significantly reduce profitability,
especially in bundled payment, capitated, or other value-based pay-
ment environments.
Hospitals are sometimes paid more when patients experience
complications (although Medicare has ended reimbursement for some
clinical shortcomings). Because incremental revenues are highly vis-
ible and incremental costs due to complications are not, hospital
administrators may think that clinical shortcomings are not eroding
margins. Michard and colleagues (2015) conclude that implementing
goal-directed fluid therapy (which significantly reduces complications)
would return $2.50 to $4.00 for each dollar invested. In this case,
improving quality is highly profitable.
Poor quality reduces hospital profits, even if it substantially
increases payments by insurers. And poor quality is a terrible strategy
in both the short run and the long run. For example, Gutacker and col-
leagues (2016) conclude that the elasticity of hospital demand with
respect to a typical health gain (measured by the Oxford Hip Score) is
1.4, and the demand elasticities for readmission and mortality rates are
−0.02 and −0.004. Poor quality leads to market share losses, and this
effect is likely to become larger as insurers increasingly use cost and
quality data to try to steer patients to efficient, effective, safe providers
(Avalere Health 2017).
Length of Stay Readmission Rate Cost
With Without With Without With Without
Gastrectomy 4 2 12.7 5.2 $27,794 $12,641
Vascular bypass 6 3 21.3 14.1 $31,979 $16,849
Esophagectomy 13 9 18.5 15.4 $67,924 $37,382
Source: Michard et al. (2015).
EXHIBIT 11.2
Surgeries With
and Without
Complications
Case 11.1
(continued)
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Chapter 11: Maximizing Prof i ts 173
11.2.2 Reengineering
Reengineering and quality improvement initiatives can increase profits, but
this does not mean that they will or that they will do so easily. Nothing guar-
antees that costs will fall, and nothing guarantees that revenues will not fall
faster than costs. Especially in hospitals, improvement initiatives often coin-
cide with downsizing efforts, making the staff wary (and sometimes causing
the organization to lose the employees it most wants to keep).
Skilled leadership does not guarantee success but is essential to
improvement initiatives. Many projects fail, but alignment of the board,
management, and clinicians appears to increase the odds of success (Pannick,
Sevdalis, and Athanasiou 2016). Reengineering and quality management
initiatives demand the time and attention of everyone in the organization,
meaning that other things are left undone or are done less well. If not done
skillfully, reengineering and quality management initiatives can make things
worse.
11.3 Maximizing Profits
Organizations can also increase profits by expanding or contracting output.
The basic rules of profit maximization are to expand as long as marginal
revenue (or incremental revenue) exceeds marginal cost (or incremental
marginal or
incremental
revenue
The revenue
from selling an
additional unit of
output.
marginal or
incremental cost
The cost of
producing an
additional unit of
output.
Discussion Questions
• Is there other evidence that providers profit
from improving quality?
• What is Medicare currently doing to measure quality? Safety?
Efficiency?
• What are private health plans currently doing to measure quality?
Safety? Efficiency?
• What are Medicaid plans currently doing to measure quality?
Safety? Efficiency?
• How large are the potential effects on hospital profits of Medicare’s
value-based payments?
• How large are the potential effects on physician profits of
Medicare’s value-based payments?
• How will value-based payments from private insurers affect profits?
• How could better quality not cost more?
• What is inefficiency in healthcare? How common is it?
Case 11.1
(continued)
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Economics for Healthcare Managers174
cost), to shrink as long as marginal cost exceeds marginal revenue, and to
shut down if the return on investment is not adequate. If increasing output
increases revenue more than costs, profits rise. If reducing output reduces
costs more than it reduces revenue, profits rise.
Marginal cost (or incremental cost) is the change in total cost associ-
ated with a change in output. Marginal revenue (or incremental revenue) is
the change in total revenue associated with a change in output. The chal-
lenges lie in forecasting revenues and estimating costs.
As shown in exhibit 11.3, increasing output from 100 to 120 increases
profits because the marginal revenue is greater than the marginal cost. Rev-
enue increases from $2,000 to $2,400 as sales increase from 100 to 120
units, so marginal revenue equals $20 ($400 ÷ 20). Costs increase from
$1,500 to $1,600, so marginal cost equals $5 ($100 ÷ 20). The same is true
for the expansion from 120 to 140. Marginal revenue falls because the firm
has to cut prices to increase sales, and marginal cost rises because the firm
is approaching capacity. Even though marginal revenue is nearly equal to
marginal cost, profits still rise. Expanding from 140 to 160 reduces profits.
Further price cuts push marginal revenue below marginal cost.
Managers need to understand what their costs are and must not con-
fuse incremental costs with average costs. Average costs may be higher or
lower than incremental costs. As long as the organization operates well below
capacity, average costs usually will exceed incremental costs because of fixed
costs. As the firm approaches capacity, however, incremental costs can rise
quickly. If the firm needs to add personnel, acquire new equipment, or lease
new offices to serve additional customers, incremental costs may well exceed
average costs.
The following example illustrates why managers need to understand
marginal costs and compare them to marginal revenues. A clinic is operating
near capacity when a small PPO (preferred provider organization) approaches
it. The PPO wants to bring 100 additional patient visits to the clinic and pay
$50 per visit. The manager accepts the deal, even though $50 is less than
the clinic’s average cost or average revenue. Shortly thereafter, another PPO
approaches the clinic. It too wants to bring 100 additional patient visits to
Quantity Revenue Cost Profit
Marginal
Revenue
Marginal
Cost
100 $2,000 $1,500 $500
120 $2,400 $1,600 $800 $20 $5
140 $2,660 $1,840 $820 $13 $12
160 $2,880 $2,120 $760 $11 $14
EXHIBIT 11.3
Marginal
Cost, Marginal
Revenue, and
Profits
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Chapter 11: Maximizing Prof i ts 175
the clinic and pay $50 per visit. The manager turns down the offer. When
criticized for this apparent inconsistency, the manager defends the decision,
explaining that the clinic had excess capacity when the first PPO contacted it.
The marginal cost for those additional visits was only $10 (see exhibit 11.4).
Signing the first contract increased profits by $4,000 because the marginal
revenue was $50 for those visits. When the second PPO contacted the clinic,
it no longer had excess capacity and would have had to add staff to handle the
additional visits. As a result, marginal costs for the second set of visits would
have been $510, and profits would have plummeted.
11.4 Return on Investment
When examining an entire organization rather than a well-defined project,
most analysts focus on return on equity rather than return on investment.
Equity is an organization’s total assets minus outside claims on those assets.
Equity also can be defined as the initial investments of stakeholders (donors
or investors) plus the organization’s retained earnings.
What is an adequate return on investment? The answer to this ques-
tion depends primarily on three factors: what low-risk investments (e.g.,
short-term US Treasury securities) are yielding, the riskiness of the enter-
prise, and the objectives of the organization.
All business investments entail some risk. Those risks may be high, as
they are for a pharmaceutical company considering allocating research and
development funds to a new drug, or they may be low, as they are for a pri-
mary care physician purchasing an established practice in a small town. In any
case, a profit-seeking investor will be reluctant to commit funds to a project
return on equity
Profits divided
by shareholder
equity.
Status Quo
Adding the
First PPO
Adding the
Second PPO
Quantity 24,000 24,100 24,200
Revenue $2,400,000 $2,405,000 $2,410,000
Average revenue $100.00 $99.79 $99.59
Marginal revenue $50.00 $50.00
Cost $2,040,000 $2,041,000 $2,092,000
Average cost $85.00 $84.69 $86.45
Marginal cost $10.00 $510.00
Profit $360,000 $364,000 $318,000
EXHIBIT 11.4
Marginal Cost
and Profits
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Economics for Healthcare Managers176
that promises a rate of return similar to the yield of low-risk securities. Conse-
quently, when rates of return on low-risk investments are high, investors will
demand high yields on higher-risk investments. The size of this risk premium
will usually depend on a project’s perceived risk. An investor may be content
with the prospect of a 9 percent return on investment from a relatively low-
risk enterprise but will not find this yield adequate for a high-risk venture.
Because managers must be responsive to the organization’s stake-
holders, they must also avoid high-risk investments that do not offer at
least a chance of high rates of return. What constitutes a high rate of return
depends on the goals of the organization and the nonfinancial attributes of
an investment. In some cases, an organization that is genuinely committed to
nonprofit objectives will be willing to accept a low return (or even a negative
return) on a project that furthers those goals.
11.5 Producing to Stock or to Order
Organizations can produce to stock or produce to order. One that pro-
duces to stock forecasts its demand and cost and produces output to store
in inventory. Medical supply manufacturers are an example of this sort of
organization. More commonly in the healthcare sector, firms produce to
order. They also forecast demand and cost, but they do not produce any-
thing up front. Instead, they set prices designed to maximize profits and
wait to see how many customers they attract. Hospitals are an example of
this type of organization. This distinction is important because discussions
of profit maximization are usually framed in terms of choosing quantities or
choosing prices.
Thus far, the content of this chapter has been largely framed in terms
of firms that produce to stock; however, its implications apply to healthcare
organizations that produce to order. Only by setting prices based on their
expectations about demand and cost do they discover whether they have set
prices too high or too low. An organization has set prices too high if its mar-
ginal revenue is greater than its marginal cost, because that means additional
profitable sales at a lower price were missed. An organization has set prices
too low if its marginal revenue is less than its marginal cost. Organizations
that produce to order must also make the same decisions about rates of
return on equity discussed earlier. Is a 5 percent return on investment large
enough to justify operating an organ transplant unit? How important is the
unit to the organization’s educational goals? What are the alternatives?
When organizations contract with insurers or employers, estimates of
marginal revenue should be easy to develop. To estimate marginal revenue
for a new contract, calculate projected revenue under the new contract,
producing to stock
Producing output
and then adjusting
prices to sell
what has been
produced.
producing to order
Setting prices
and then filling
customers’ orders.
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Chapter 11: Maximizing Prof i ts 177
subtract revenue under the old contract, and divide by the change in volume.
For sales to the general public, economics gives managers a tool: Marginal
revenue equals p × (1 + 1/ε), where p is the product price and ε is the price
elasticity of demand. (See chapter 8 for more information about elasticity.)
Most healthcare organizations face price elasticities in the range of −3.00 to
−6.00, so marginal revenue can be much less than the price. For example,
if a product sells for $1,000 and the price elasticity of demand is −3.00, its
marginal revenue will equal $1,000 × (1 − 1/3.00), or $667. In contrast, if
the price elasticity of demand is −6.00, its marginal revenue will equal $1,000
× (1 − 1/6.00), or $833. As demand becomes more elastic, marginal revenue
and price become more alike. Unless the elasticity becomes infinite, though,
marginal revenue will be less than price.
11.6 Not-for-Profit Organizations
The strategies of not-for-profit organizations may differ from those of for-
profit organizations because of more severe agency problems, differences in
goals, and differences in costs. These forces have multiple effects.
11.6.1 Agency Problems
All organizations have agency problems. Agency problems are conflicts
between the interests of managers (the agents) and the goals of other stake-
holders. For example, a higher salary benefits a manager, but it benefits
stakeholders only if it enhances performance or keeps the manager from
leaving (when a comparable replacement could not be attracted for less).
Not-for-profit firms face three added challenges. They cannot turn manag-
ers into owners by requiring them to own company stock (which helps to
align the interests of managers and other owners). In addition, no one owns
the organization, so no one may be policing the behavior of its managers
to ensure that they are serving stakeholders well. Furthermore, assessing
the performance of managers in not-for-profit organizations is a challenge.
A not-for-profit organization may earn less than a for-profit competitor for
many reasons. Is it earning less because of its focus on other goals, because
of management’s incompetence, or because the firm’s managers are using the
firm’s resources to live well? Often the cause is difficult to pinpoint.
11.6.2 Differences in Goals
Goals other than profits can influence an organization’s behavior, though they
need not. Not-for-profit firms gain benefits from the pursuit of goals other
than profit. Managers should consider how their decisions affect the benefits
derived from these other goals. To best realize its goals, a not-for-profit
agency
An arrangement in
which one person
(the agent) takes
actions on behalf
of another (the
principal).
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Economics for Healthcare Managers178
organization should strive to make marginal revenue plus marginal benefit
equal to marginal cost. Marginal benefit is the net nonfinancial gain to the
firm from expanding a line of business. Three cases are possible:
1. If the marginal benefit is greater than 0, the not-for-profit will produce
more than a for-profit.
2. If the marginal benefit equals 0, the not-for-profit will produce as
much as a for-profit.
3. If the marginal benefit is less than 0, the not-for-profit will produce
less than a for-profit.
A further complication is that the marginal benefit may depend on other
income. A struggling not-for-profit may act like a for-profit, but a highly
profitable not-for-profit may not.
11.6.3 Differences in Costs
Not-for-profit organizations’ costs also may differ. First, the not-for-profit
may not have to pay taxes (especially property taxes), which tends to make
the not-for-profit’s average costs lower. On the other hand, the not-for-profit
firm’s greater agency problems may result in less efficiency and higher aver-
age and marginal costs.
The fundamental problem is that we cannot predict how not-for-profit
organizations will differ from for-profit firms. This lack of forecast is frustrat-
ing for analysts and raises a question for policymakers: If we do not know
how not-for-profit organizations benefit the community, why are they given
tax breaks?
Tax Exemptions for Not-for-Profit
Hospitals
Not-for-profit hospitals enjoy federal, state, and local tax exemptions,
but they face challenges from governments in both courtrooms and
statehouses (Santos 2016). Contemporary hospitals differ markedly
from those that existed at the turn of the twentieth century, which
were truly charitable institutions. They were supported almost entirely
by donations and largely staffed by volunteers. Thus, it can be argued
that tax exemption for not-for-profit hospitals is a historical relic. When
the income tax started in 1894, there was no Medicare, no Medicaid,
Case 11.2
(continued)
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Chapter 11: Maximizing Prof i ts 179
and no insurance. Most people with money got
care at home. The role of hospitals was to care for
the poor.
These days, hospitals serve paying customers, and for-profits,
which pay income and property taxes, provide about as much uncom-
pensated care as not-for-profits (Valdovinos, Le, and Hsia 2015). (Not-
for-profits do appear to offer more charity care—1.9 percent of total
expenses—than for-profits, at 1.4 percent.) Not surprisingly, not-for-
profits’ de facto tax-exempt status has come into question.
The case of Provena Covenant Medical Center illustrates this. After
a lengthy court battle, in 2010 the Supreme Court of Illinois upheld the
Illinois Department of Revenue’s denial of an application for exemp-
tion in 2002, finding that Provena was not a charitable institution and
the property was not used for charitable purposes (Santos 2016). Two
factors influenced the decision. First, of the hospital’s $118 million in
total revenue, more than 96 percent came from patient and insurer
payments, and less than $10,000 came from charitable donations.
Second, Provena Covenant Medical Center did not actively promote its
charity care program. The hospital routinely billed indigent patients
and forced them to apply for discounts under the terms of the financial
assistance program. In short, Provena Covenant Medical Center did not
appear to be a charity.
In recent years, increasing numbers of localities have asked not-
for-profits to make payments in lieu of taxes. For example, Boston
received $32.4 million of these payments in 2017 (City of Boston
2018). Such arrangements are becoming more common as localities
seek to cover the cost of services. Furthermore, many health systems
look no more like charities than Provena Covenant Medical Center did.
One response to this situation was the changes in the community
benefit standard specified by the Affordable Care Act (ACA). First,
hospitals must prepare a community health needs assessment every
three years. This report identifies the major health challenges fac-
ing that community and lays out a plan for the hospital to address
them in the coming years. Second, hospitals must create a financial
assistance plan that explains the criteria for offering financial assis-
tance and must make the plan freely accessible to the public. Third,
hospitals cannot charge patients that qualify for assistance more than
they charge insured patients. Fourth, hospitals must make reasonable
Case 11.2
(continued)
(continued)
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Economics for Healthcare Managers180
11.7 Conclusion
Even managers of not-for-profit organizations need to know how to maxi-
mize profits. They must identify appropriate product lines, price and promote
those product lines to realize an adequate return on investment, and produce
those product lines efficiently. Most healthcare organizations are less profit-
able than they could be because they are less efficient than they could be.
Leadership must be effective for efficiency to increase. Cost reductions and
quality improvements are easier to talk about than to realize, especially where
clinical plans (i.e., physician practices) must change to improve efficiency.
efforts to establish that a patient is not eligible for
assistance before initiating extraordinary collec-
tion actions. However, the ACA did not specify the
terms of financial assistance plans.
This issue is not likely to go away. In states that expanded Medic-
aid after 2014, uncompensated care fell from 3.9 percent to 2.3 percent
(Dranove, Garthwaite, and Ody 2017). It fell only 0.12 percent in states
that did not expand Medicaid. As more and more people gain health
insurance, the case for tax-exempt status gets harder to make.
Discussion Questions
• How much community benefit do not-for-profit hospitals provide?
• How much community benefit do for-profit hospitals provide?
• Why does using list prices tend to inflate estimates of community
benefit?
• Are there other important differences between not-for-profit and
for-profit hospitals?
• Would local governments be better off if they taxed hospitals and
paid for charity care?
• Is tax exemption a good way to encourage private organizations to
serve the public interest?
• Can you find examples of controversies about hospitals’ tax-exempt
status?
• Can you find examples of payments in lieu of taxes?
• Does tax exemption for not-for-profit hospitals still make sense?
• Can you propose an alternative to tax exemption?
Case 11.2
(continued)
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Chapter 11: Maximizing Prof i ts 181
Decisions to expand or contract should be based on incremental costs
and revenues. Few healthcare managers know what their costs are, so they
often have difficulty forecasting revenues and estimating costs to be able to
make these decisions.
Not-for-profit organizations may or may not resemble for-profit orga-
nizations. In some cases, their goals and performance are similar. Managers
need to understand why the goals of not-for-profit organizations are worthy
of tax preferences and be able to make that case to donors and regulators.
Exercises
11.1 A clinic has $1 million in revenues and $950,000 in costs. What is
its operating margin?
11.2 The owners of the clinic in exercise 11.1 invested $400,000. What is
the return on investment? Is it adequate?
11.3 A laboratory has $4.2 million in revenues and $3.85 million in
costs. What is its operating margin?
11.4 The owners of the laboratory in exercise 11.3 invested $6 million.
What is the return on investment?
11.5 View selected interest rates on the website of the Board of
Governors of the Federal Reserve System (www.federalreserve.
gov/releases/h15/). What is the current annual yield for one-year
Treasury securities?
11.6 Go to the Yahoo! Finance website (finance.yahoo.com), and look up
the operating margin and return on equity for Community Health
Systems (symbol CYH). How does it compare to Pfizer (PFE),
Amgen (AMGN), Laboratory Corporation of America (LH), and
Tenet Healthcare Corporation (THC)?
11.7 A not-for-profit hospital realizes a 3 percent return on its $200,000
investment in its home health unit. Its current revenue after
discounts and allowances is $382,000. Administrative costs are
$119,000, clinical personnel costs are $210,000, and supply costs
are $47,000. Providing home health care is not a core goal of the
hospital, and it will sell the home health unit if it cannot realize
a return of at least 12 percent. A process improvement team has
recommended changes to the home health unit’s billing processes.
The team has concluded that these changes could reduce costs by
$20,000 and increase revenues by $5,000. Analyze the data that
follow and assess whether the changes would make the home health
unit profitable enough to keep.
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Economics for Healthcare Managers182
Old New
Revenue $382,000 $387,000
Cost $376,000 $356,000
Profit $6,000 $31,000
Return on investment 3% 16%
11.8 The table shows cost and revenue data for a clinic. Calculate the
clinic’s marginal cost, marginal revenue, and profits at each volume.
Which price maximizes its profits?
Surgeries 250 300 350 400 450
Price $2,000 $1,920 $1,800 $1,675 $1,550
Revenue $500,000 $576,000 $630,000 $670,000 $697,500
Cost $516,000 $538,500 $563,500 $591,000 $621,000
11.9 The table shows cost and revenue data for a clinic. Calculate the
clinic’s marginal cost, marginal revenue, and profits at each volume.
Which price maximizes its profits?
Surgeries 250 300 350 400 450
Price $200 $210 $220 $230 $240
Revenue $50,000 $63,000 $77,000 $92,000 $108,000
Cost $49,000 $61,000 $74,750 $90,500 $108,250
11.10 The price–quantity relationship has been estimated for a new
prostate cancer blood test: Q = 4,000 − (20 × P). Use a spreadsheet
to calculate the quantity demanded and total spending for prices
ranging from $200 to $0, using $50 increments. For each $50 drop
in price, calculate the change in revenue, the change in volume, and
the additional revenue per unit. (Call the additional revenue per unit
marginal revenue.)
11.11 The table shows output and cost data. Calculate the average total
cost, average fixed cost, average variable cost, and marginal cost
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Chapter 11: Maximizing Prof i ts 183
schedules. If the market price were $500, should the firm shut
down in the short run? In the long run?
11.12 A clinic’s average and marginal cost per case is $400. It charges
$600 per case and serves 1,000 customers. Its marketing team
predicts that it will expand its sales to 1,250 customers if it cuts
its price to $550. How do profits change if it cuts prices? What is
the firm’s marginal revenue? Why is marginal revenue not equal to
$550?
11.13 A clinic’s average and marginal cost per case is $400. It charges
$600 per case and serves 1,000 customers. Its marketing team
predicts that it will expand its sales to 1,250 if it signs a contract for
a price of $550 with a local health maintenance organization. How
do profits change if it signs the contract? What is the firm’s marginal
revenue? Why is its marginal revenue different from the marginal
revenue in the previous exercise?
11.14 Why would a for-profit organization that incurs losses choose to
operate?
11.15 Why would a profitable for-profit organization choose to exit a line
of business?
References
Avalere Health. 2017. Health Plan Use of Patient Data: From the Routine to the Trans-
formational. Published April. http://go.avalere.com/acton/attachment
/12909/f-0466/1/-/-/-/-/NPC%20Avalere%20Issue%20Brief .
City of Boston. 2018. “Payment in Lieu of Tax (PILOT) Program.” Updated July 31.
www.boston.gov/departments/assessing/payment-lieu-tax-pilot-program
#fiscal-year-2017-pilot-results.
Dranove, D., C. Garthwaite, and C. Ody. 2017. “The Impact of the ACA’s Medi-
caid Expansion on Hospitals’ Uncompensated Care Burden and the
Potential Effects of Repeal.” Commonwealth Fund. Published May. www
.commonwealthfund.org/~/media/files/publications/issue-brief/2017
/may/dranove_aca_medicaid_expansion_hospital_uncomp_care_ib .
Eapen, Z. J., and S. H. Jain. 2017. “Redesigning Care for High-Cost, High-Risk
Patients.” Harvard Business Review. Published February 7. https://hbr
.org/2017/02/redesigning-care-for-high-cost-high-risk-patients.
Quantity 0 5 10 15 20 25 30 35
Total cost $20,000 $20,500 $20,975 $21,425 $21,850 $22,300 $22,775 $23,275
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Economics for Healthcare Managers184
Gutacker, N., L. Siciliani, G. Moscelli, and H. Gravelle. 2016. “Choice of Hospital:
Which Type of Quality Matters?” Journal of Health Economics 50: 230–46.
Khushalani, J., and Y. A. Ozcan. 2017. “Are Hospitals Producing Quality Care
Efficiently? An Analysis Using Dynamic Network Data Envelopment Analysis
(DEA).” Socio-Economic Planning Sciences 60: 15–23.
Michard, F., W. K. Mountford, M. R. Krukas, F. R. Ernst, and S. L. Fogel. 2015.
“Potential Return on Investment for Implementation of Perioperative Goal-
Directed Fluid Therapy in Major Surgery: A Nationwide Database Study.”
Perioperative Medicine. Published October 19. https://doi.org/10.1186/
s13741-015-0021-0.
Pannick, S., N. Sevdalis, and T. Athanasiou. 2016. “Beyond Clinical Engagement: A
Pragmatic Model for Quality Improvement Interventions, Aligning Clinical
and Managerial Priorities.” BMJ Quality & Safety 25 (9): 716.
Santos, E. J. 2016. “Property Tax Exemptions for Hospitals: A Blunt Instrument
Where a Scalpel Is Needed.” Columbia Journal of Tax Law 8 (1): 113–39.
Valdovinos, E., S. Le, and R. Y. Hsia. 2015. “In California, Not-for-Profit Hospitals
Spent More Operating Expenses on Charity Care Than For-Profit Hospitals
Spent.” Health Affairs 34 (8): 1296–303.
Zhivan, N. A., and M. L. Diana. 2012. “U.S. Hospital Efficiency and Adoption of
Health Information Technology.” Health Care Management Science 15 (1):
37–47.
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CHAPTER
73
5UNDERSTANDING COSTS
Learning Objectives
After reading this chapter, students will be able to
• calculate average and marginal costs,
• articulate why increasing efficiency is important,
• identify opportunity costs, and
• forecast how changes in technology and prices will change costs.
Key Concepts
• Costs can be hard to measure and depend on perspective.
• Incremental cost equals the change in cost resulting from a change in
output.
• Average cost equals the total cost of a process divided by the total
output of a process.
• Large firms have a cost advantage if there are economies of scale.
• Multiproduct firms have a cost advantage if there are economies of scope.
• Costs depend on outputs, technology, input prices, and efficiency.
• Opportunity cost is the value of a resource in its best alternative use.
• Sunk costs, which are costs you cannot change, should be ignored.
5.1 Understanding Costs
Understanding and managing costs are core managerial tasks. Whatever the
mission of the organization, cost control must be a priority. An organization
with costs that are too high, given the quality of its product, will be hard-
pressed to succeed.
An efficient producer of a good or service has a competitive advan-
tage. For example, a pharmacy that can accurately dispense a product more
cheaply than its competitors has an advantage. The efficient producer can
efficient
Producing the
most valuable
output possible,
given the inputs
used. (Viewed
differently,
an efficient
organization
uses the least
expensive inputs
possible, given
the quantity and
quality of output it
produces.)
competitive
advantage
Offering products
of the same quality
at lower cost than
rivals, offering
products of higher
quality at the same
cost as rivals, or
offering products
that customers are
willing to pay more
for.
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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
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Economics for Healthcare Managers74
win more contracts, enjoy higher profit margins, and more easily weather
a slump. In healthcare, the bar has been raised: Increased attention to the
outcomes of care challenges us to think about health, not just medical care.
Healthcare organizations are being challenged to work with customers to
produce health efficiently, not just to produce goods and services efficiently.
The pressure to become more efficient has grown. As the next chapter
details, public and private insurers have taken steps to steer patients to pro-
viders with lower costs. If your organization is a high-cost producer, it will
soon need to become more efficient.
This chapter focuses on what is necessary to turn an organization
into an efficient producer. The starting point is to understand costs, which
requires a combination of two definitions. First, the goods or services an
organization uses in producing its outputs are called inputs. Second, oppor-
tunity cost equals the value of an input in its best alternative use. From this
production-oriented perspective, costs equal the opportunity cost per unit
of input multiplied by the volume of inputs. Reducing the cost per unit that
the organization pays for inputs reduces total costs, but real savings result
from reducing the volume of inputs the organization uses. To reduce input
volume, managers must lead efficiency improvement efforts or outsource the
production of goods and services.
5.2 Cost Perspectives
Costs are complex because they may be difficult to measure and depend on
the perspective of the beholder. For example, consumers will characterize
the cost of a prescription in terms of their out-of-pocket spending and ancil-
lary costs, such as the value of time spent filling a prescription. Pharmacists
will focus on the spending required to obtain, store, and dispense the drug.
Insurers will focus on their payments to the pharmacist for the prescription
and their spending on claim management. Each of these perspectives on costs
is valid. Exhibit 5.1 illustrates costs from three perspectives.
In exhibit 5.1, a pharmacist acquires a drug for $10 and incurs $5 in
processing, storing, and billing costs. The pharmacist should recognize that
reasonable returns on her time and on her investment in the pharmacy rep-
resent opportunity costs because both could be used in other ways. The con-
sumer is uninterested in the pharmacist’s costs. What matters to him are his
out-of-pocket costs and the $4 in travel expense he incurs when he drives to the
pharmacy. When the consumer does not have insurance, as shown in exhibit
5.1, the consumer’s perspective on costs mirrors society’s perspective. Both
will say that the drug costs $20, although the two calculations are different.
The consumer will focus on the price he pays and his travel costs. Society will
output
A good or service
produced by an
organization.
input
A good or
service used in
production.
opportunity cost
The value of what
one cannot do as a
result of making a
choice.
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Chapter 5: Understanding Costs 75
ignore the price the consumer pays and focus on the underlying resource use
by the pharmacist and the consumer. The payment is an accounting entry, not
a real use of resources (because it equals the amount the pharmacist receives).
Exhibit 5.1 illustrates two important concepts. First, what one party
views as a cost, the other views as revenue. Reducing costs sounds wonderful
from the perspective of the buyer, but not from the perspective of the seller.
Second, it is often convenient to use the price of a product as a proxy for the
cost of producing it.
Exhibit 5.2 lists cost perspectives when the prescription is covered by
insurance. Although the cost looks the same from the pharmacist’s perspective,
three things change as a result of coverage. First, the additional perspective of
the insurer must be considered. Second, the insurer incurs expense by processing
the claim. Third, the consumer’s perspective on costs now differs from society’s.
The insurer focuses on its share of the retail price and its cost of paying
the bill. Again, the insurer should factor in the opportunity cost of using its
investment to provide pharmacy insurance benefits but will probably express
this figure in terms of a required return on investment. From the perspec-
tive of the insurer, covering the prescription adds $21 in costs. From the
perspective of the consumer, insurance coverage reduces costs by $11. Note
Pharmacy Consumer Society
Wholesale price $10 $0 $10
Travel $0 $4 $4
Processing $5 $0 $5
Capital $1 $0 $1
Retail price ($16) $16 $0
Total $0 $20 $20
EXHIBIT 5.1
Prescription
Costs from
Three
Perspectives
Without
Insurance
Pharmacy Consumer Insurance Society
Wholesale price $10 $0 $0 $10
Travel $0 $4 $0 $4
Processing $5 $0 $9 $14
Capital $1 $0 $1 $2
Retail price ($16) $5 $11 $0
Total $0 $9 $21 $30
EXHIBIT 5.2
Cost
Perspectives
with Insurance
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Economics for Healthcare Managers76
also that society’s perspective on costs differs from the perspective of any of
the participants when insurance plays a role. Society adds the processing and
asset costs that the insurer incurs, making the total $30.
The concept of cost cannot be fully understood without stating a cost
perspective. The part of cost that matters depends on your point of view. Your
revenues are someone else’s costs, and your costs are someone else’s revenues.
Most people want to focus on costs from the perspective of the orga-
nization in which they work, but shifting costs to customers or suppliers
seldom represents a good business strategy. Long-term business success rests
on selling products that offer your customers excellent value and offer your
suppliers adequate profits.
As stated earlier, the difficulty of measuring cost components also
complicates the concept of costs. For example, opportunity costs are some-
times hard to measure. Managers sometimes become confused when cal-
culating the opportunity cost of resources that have changed in value. For
example, land that your organization bought a few years ago may be more
valuable if rents in the area have risen or less valuable if rents have fallen. In
most cases, though, an input’s opportunity cost is simply its market price.
Linking the use of a resource to the organization’s output also poses
problems. A focus on incremental costs (i.e., the cost of the additional
resources you use when you increase output by a small amount) often simpli-
fies this task. “How much more of a hospital’s information system does its
intensive care unit use when it cares for an additional patient?” is an example
of a way to reframe the relationship between resource use and output and
facilitate its measurement.
Cost Reductions at Baptist Health
System
Baptist Health System, a clinically integrated network of five hospi-
tals in Texas, has taken part in Medicare’s knee replacement bundled
payment programs since 2008. Medicare began bundled payments in
the hope that its costs (the amount it pays doctors, hospitals, nursing
homes, and rehabilitation centers) would go down. Baptist Health Sys-
tem also sought to improve quality and reduce costs, thereby gaining a
competitive advantage (Navigant 2016).
It seems that both parties got what they wanted. Average Medi-
care payments per knee replacement without complications declined
bundled payment
Payment of a fixed
amount for an
episode of care.
The payment
might cover just
hospital care or
might include
the physician,
hospital, and
rehabilitation.
Case 5.1
(continued)
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Chapter 5: Understanding Costs 77
5.3 Vocabulary
To talk sensibly about costs, we need a clear vocabulary. At the core of that
vocabulary are the concepts of average cost and incremental cost. Average
cost equals the total cost of a process divided by the total output of a process.
In exhibit 5.3, when total cost equals $10,500 and output equals 300, aver-
age cost equals $35. Incremental cost, also called marginal cost, equals the
change in a process’s total cost that is associated with a change in the pro-
cess’s total output. In exhibit 5.3, total cost rises from $8,000 to $10,500 as
output rises from 200 to 300, so incremental cost equals ($10,500 − $8,000)
÷ (300 − 200), or $25 per unit of output.
In exhibit 5.3, average cost is significantly larger than incremental cost.
This difference is common because many processes require resources (e.g.,
average cost
Total cost divided
by total output.
marginal or
incremental cost
The cost of
producing an
additional unit of
output.
by 21 percent between 2008 and 2015 (Navathe
et al. 2017). However, Baptist Health System’s
cost per case declined by 25 percent, primarily
because of reductions in implant and rehabilitation costs (Navathe
et al. 2017). In addition, outcomes appeared to improve. Episodes
with readmissions decreased from 6.4 percent to 5.0 percent, epi-
sodes with emergency department visits decreased from 7.4 percent
to 6.5 percent, and episodes with prolonged stays decreased from
22.4 percent to 7.3 percent (Navathe et al. 2017). Overall, Medicare
spent less, Baptist earned a higher profit margin, and patients got
better care.
Discussion Questions
• This case includes two perspectives on costs. Which is correct?
• How did participating in the bundled payment change Baptist’s
perspective on costs?
• Did Baptist reduce both marginal and average costs?
• Did Baptist gain a competitive advantage as a result of these
changes?
• Baptist reduced implant costs by 29 percent. How could it do this?
• Baptist reduced rehabilitation costs by 27 percent. How could it do
this?
• Was Baptist Health System efficient in 2007?
• Whose revenues fell as a result of the changes that Baptist made?
Case 5.1
(continued)
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Economics for Healthcare Managers78
equipment or key personnel) that do not change as output varies. For example,
to open a pharmacy, a pharmacist has to rent a building. If sales fall short of
expectations, the rent will not change. Rent is an example of a fixed cost, a
component of total cost. In contrast, some labor costs and the cost of restock-
ing the pharmacy will vary with sales. Average cost includes fixed and variable
costs, but incremental cost includes only variable costs. The fact that average
cost often exceeds incremental cost is important because management deci-
sions often hinge on knowing how much increasing or decreasing production
of a good or service will cost. Your willingness to negotiate with an insurer that
offers $300 per service is likely to depend on whether you believe an additional
service will cost you $440 (the average cost) or $120 (the incremental cost).
Most management decisions concern incremental changes. Should we
increase hours in the pediatric clinic? Should we reduce evening pharmacy
staff? Should we accept patients needing skilled nursing care? These decisions
demand data on incremental costs.
In addition to being the most relevant concept for managers, incre-
mental costs are easier to calculate than average cost. Average cost calculations
always involve difficult questions (e.g., How much of the cost incurred by
the chief financial officer should we allocate to the pediatrics department?).
In contrast, incremental cost calculations involve more straightforward ques-
tions and can be performed by most clinicians and frontline managers (e.g.,
What additional resources will we need to keep the pediatric clinic open on
Wednesday evenings, and what are the opportunity costs of those resources?).
To decide whether to start or stop a service, a manager needs to compare
average revenue and average cost. For example, a telemedicine program that
has average revenue of $84 and average cost of $98 is unprofitable. To decide
whether to expand or contract a service, a manager needs to compare how
revenue and costs will change. To make this comparison, information about
incremental costs is essential. Usually confusion about cost arises because one
person is talking about average cost and another is talking about incremental
cost (or because one person is talking about costs to society and the other is
talking about costs to the organization).
fixed cost
A cost that does
not vary when
output changes.
variable cost
A cost that
changes when
output changes.
Output Total Cost Average Cost Incremental Cost
0 $3,000
100 $5,500 $55 $25
200 $8,000 $40 $25
300 $10,500 $10,500/300 = $35 ($10,500 − $8,000)/
(300 − 200) = $25
EXHIBIT 5.3
Total, Average,
and Incremental
Costs
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Chapter 5: Understanding Costs 79
5.4 Factors That Influence Costs
Producer costs depend on what is produced (the outputs), the prices of
inputs, how outputs are produced (the technology), and how efficiently
inputs are used. We will explore each of these factors.
5.4.1 Outputs
Differences in outputs can profoundly affect costs. Firms that produce large
volumes of a good or service may have lower costs than firms that produce
small volumes. Large firms that have a cost advantage have economies of
scale. Firms that produce several different kinds of goods or services may
have lower costs than firms that produce just one. Multiproduct firms that
have a cost advantage have economies of scope. Economies of scale and
scope result from sharing resources.
An example of economies of scale might be a large pharmacy’s use of
automated dispensing equipment. In a larger pharmacy the fixed costs of the
equipment could be shared by a larger number of prescriptions, so the cost
per prescription could be lower. An example of economies of scope might
be a nursing home that expands to offer skilled care as well as intermediate
care. Fixed costs (e.g., the cost of the director of nursing) would be shared
by additional patients, so average costs for intermediate care could be lower.
Differences in the quality of outputs can affect costs as well. For an
efficient firm, higher-quality products cost more. For an inefficient firm,
higher-quality products may not.
What is higher quality? Economists define quality from the per-
spective of consumers, not from the clinical perspective common in
healthcare. In economics, a good or service is of higher quality when
it is more valuable to a well-informed customer than comparable goods
or services. Consumers usually find greater value in goods or services
that produce better clinical outcomes, so the clinical perspective is not
wrong. Economists also define quality in terms of nonclinical factors.
Well-informed consumers may attribute higher quality to a product that is
easier to use, a service for which the wait is shorter, an insurance plan with
less confusing referral requirements, a provider who bills more accurately,
or a more cordial staff.
If higher quality does not cost more, failure to provide it demon-
strates inefficiency. The many opportunities available to improve quality in
healthcare without increasing costs reflect how inefficient most healthcare
organizations are. Once an organization has become efficient, higher qual-
ity (better service, improved reliability, greater accuracy, less pain, and other
enhancements) will cost more to produce.
economies of
scale
When larger
organizations have
lower average
costs.
economies of
scope
When multiproduct
organizations have
lower average
costs.
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Economics for Healthcare Managers80
Improving Performance in Primary
Care
Lean is a performance improvement strategy that emphasizes reducing
waste, with waste defined as activity that adds less value than it costs.
Examples of waste include patients’ waiting time (which adds no value
from their perspective), staff looking for supplies, staff who are not
using all their skills, and unnecessary paperwork.
The Lean approach stresses increasing efficiency and redesigning
products so that they meet customers’ goals better. Does Lean reduce
costs in primary care? Does it improve customer satisfaction? Does it
improve staff satisfaction? Does it improve clinical quality? California’s
Palo Alto Medical Foundation for Health Care, Research and Education
(which has more than 1,400 physicians and more than 5,000 other
employees) systematically evaluated its systemwide Lean initiative to
find out (Hung et al. 2017).
This initiative standardized the equipment, supplies, and educa-
tion materials in exam rooms; set up shared work spaces for physi-
cians and staff; and redesigned multiple workflows. For example,
teams started daily morning huddles to review schedules, expanded
the roles of medical assistants, and established metrics to track clini-
cal quality, costs, patient satisfaction, staff satisfaction, and physi-
cian satisfaction. Most measures of clinical quality did not change,
although diabetes care improved. Costs dropped, patient satisfaction
increased, staff satisfaction increased, and physician satisfaction did
not change (Hung et al. 2017).
Discussion Questions
• What are other examples of waste?
• How would standardizing equipment, supplies, and education
materials increase efficiency?
• Why would expanding the roles of medical assistants increase
efficiency?
• Cost per visit fell by 12.5 percent. How would this affect profits?
• How might huddles reduce costs? Increase quality?
• Would the changes described in this case reduce costs from a
patient’s perspective?
Case 5.2
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Chapter 5: Understanding Costs 81
5.4.2 Input Costs
Higher input prices mean higher costs. Shifting to a different combination
of inputs will only partially offset the effects of higher input prices. However,
this rule does not hold when a firm is inefficient or when a perfect, lower-
priced substitute for the higher-priced input is available. An inefficient firm
might be able to limit the effects of a cost increase by shifting to a more
efficient production process. For example, even if the wages of pharmacy
technicians increase, the cost of dispensing a prescription might not increase
if the pharmacy switches to the automated system it should have been using
before the wage increase. A firm also can avoid higher costs by switching
to a perfect substitute. For example, if an Internet access provider tried to
raise its monthly rates, firms could switch to rival Internet access providers,
and costs would not go up. Unfortunately, firms are unlikely to find such a
replacement in most cases.
5.4.3 Technology
Advances in technology always reduce the cost of an activity, but volumes
may increase enough to increase spending. Adopting a new technology
would be pointless if it increased the costs of a process (unless it increased
the quality of the process). For example, installing an automated laboratory
system would be absurd if it increased the cost per analysis. An automated
laboratory system that reduces the cost per analysis, however, does not
guarantee that laboratory costs will go down. Lower costs per analysis may
prompt physicians to request more analyses, and the greater volume could
cancel the cost savings and might even drive up costs.
5.4.4 Efficiency
Increases in efficiency always reduce the cost of an activity. Production of
almost every healthcare good or service can be made more efficient. Few
production processes in healthcare have been examined carefully, and most
healthcare workers have little or no training in process improvement. Con-
sequently, mistakes, delays, coordination failures, unwise input choices, and
excess capacity are far too common. More and more, though, healthcare
organizations are responding to financial and quality challenges by trying to
increase efficiency (Rotter et al. 2017).
Even though greater efficiency reduces costs, not everyone is in favor
of it. Greater efficiency often means that fewer workers will be needed.
Workers whose jobs are in jeopardy may not want to help improve efficiency.
(Commitment to a policy of no layoffs is usually one of the core terms of effi-
ciency improvements.) Others have limited incentive to participate in efforts
to improve efficiency. Physicians must help change clinical processes, yet many
physicians have little to gain from these efforts. The gains produced by the
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Economics for Healthcare Managers82
changes will accrue to the healthcare organization, but the resulting billing
reductions will be problematic for physicians and other healthcare workers
not employed by the organization. A major challenge lies in devising incen-
tives that will encourage workers and contractors to help improve efficiency.
5.5 Variable and Fixed Costs
Managing costs requires an understanding of opportunity costs and triggers
that change costs. As stated earlier, opportunity costs usually are easy to
assess. The opportunity cost of using $220 in supplies is $220. The opportu-
nity cost of using an hour of legal time billed at $150 per hour is $150. Other
cases demand more study. For example, the opportunity cost of a vacant wing
of a hospital depends on its future use. If the wing will be reopened for acute
care in response to a rising hospital census, the opportunity cost of the wing
will depend on its value as an acute care unit. If the wing will be reopened
because the hospital needs a skilled nursing unit, the opportunity cost of the
wing will be determined by its value in that role.
Sunk costs should be ignored. A sunk cost is a cost you cannot
change. A computer’s purchase price is a sunk cost, as is money spent to train
employees to operate the computer. If your current needs do not require the
use of a computer, you should not fret about its initial cost. The opportunity
cost of the computer will depend on its value in some other use (including
its resale value).
In the long run, all costs are variable. Buildings and equipment can
be changed or built. The way work is done can be changed. Additional per-
sonnel can be hired. The entire organization could shut down, and its assets
could be sold. However, in the short run, some costs are fixed. An existing
lease may not be negotiable, even if the building or equipment no longer
suits your needs. Ignore fixed costs in the short run. They are sunk costs.
When fixed costs are substantial, average costs typically fall as output
increases because the fixed costs are spread over a growing volume of output.
As long as the average variable cost (AVC) is stable, this drop in the average
fixed cost (AFC) will cause a reduction in average total costs. Average total
costs equal AFC plus AVC. As exhibit 5.4 illustrates, AFC drops from $30 to
$15 as output rises from 100 to 200. If variable costs rise quickly enough,
average total costs may rise despite the fall in AFC. In exhibit 5.4, variable
costs rise by $10,000 as output increases from 200 to 300. As a result, aver-
age total cost rises to $60 even though AFC continues to fall.
Fixed and variable costs are important concepts for day-to-day manage-
ment of healthcare organizations. For example, an advantage of growth is that
fixed costs can be spread over a larger volume of output. The idea is that lower
sunk cost
A cost that has
been incurred
and cannot be
recouped.
average variable
cost (AVC)
Variable costs
divided by total
volume.
average fixed cost
(AFC)
Fixed costs divided
by total volume.
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Chapter 5: Understanding Costs 83
AFC can result in lower average total costs, so profit margins can be larger.
As exhibit 5.4 illustrates, growth should not result in increases in AVC large
enough to offset any reduction in AFC. Otherwise, growth will be unprofitable.
Misclassifying costs can create odd incentives. For example, fixed over-
head costs are often allocated on the basis of some measure of output, which
can understate the profits from growth because the overhead costs allocated
to a unit would increase as the unit grows. So that unit managers are not dis-
couraged from expanding, allocated fixed costs should not vary with output.
EXHIBIT 5.4
Fixed and Variable Costs
Output
Total
Cost
Fixed
Cost Average Total Cost
Average
Fixed Cost
Average
Variable Cost
0 $3,000 $3,000
100 $5,500 $3,000 $55 $30 $25
200 $8,000 $3,000 $40 $15 $25
300 $18,000 $3,000 $18,000/300 = $60 $3,000/300 = $10 $15,000/300 = $50
Costs of Care in the Emergency
Department
A Colorado woman took her daughters to what she thought was an
urgent care clinic in a shopping mall (Olinger 2015). Both were treated
for respiratory problems, and the visit went well. “I thought it was a
fine experience,” she commented, “until I got the bill.” She had gotten
care from a free-standing emergency department, not an urgent care
clinic, and her out-of-pocket obligation for the visits was nearly $5,000.
This represents an unusually high price, but care is expensive in
emergency departments. Ho and colleagues (2017) found that treating
respiratory infections in a hospital’s emergency department averaged
$1,074, and treating respiratory infections in a free-standing emer-
gency department averaged $1,351. In contrast, treating respiratory
infections in an urgent care center averaged $165. (These are average
prices paid, not charges.) Prices in emergency departments are typi-
cally more than ten times those in urgent care clinics.
Case 5.3
(continued)
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Economics for Healthcare Managers84
These high prices explain why many health-
care reform plans seek to steer patients away
from using emergency departments. For example,
Oregon moved most Medicaid enrollees into coordinated care orga-
nizations, with the explicit goal of reducing emergency department
use (McConnell 2016). (Because they have difficulty accessing other
sources of outpatient care and because they face low out-of-pocket
costs, Medicaid enrollees tend to use emergency departments at high
rates.) In Oregon, use of emergency departments fell by 8 percent
(McConnell 2016).
About a third of emergency department visits are not emergen-
cies, and there is an ongoing controversy about how much such a visit
costs (Galarraga and Pines 2016). Perspective differences cause part
of the controversy. Insurers and patients talk about the prices that
they pay, and providers talk about how much it costs to produce such
visits. Yet another perspective notes that patients who use emergency
departments as usual sources of care have high rates of preventable
hospitalizations. Galarraga and Pines (2016) estimate that the average
payment for a visit that is not an emergency is $883 but the average
payment for a preventable hospitalization is $9,515.
Discussion Questions
• Why do patients who are not critically ill go to emergency
departments?
• Why are prices so high in emergency departments?
• Are production costs also high in emergency departments?
• What is an example of a fixed cost in an emergency department? A
variable cost?
• If an emergency department’s volumes fell, how would its costs
change?
• Should insurers try to reduce emergency department use?
• How might insurers reduce emergency department use?
Case 5.3
(continued)
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Chapter 5: Understanding Costs 85
5.6 Conclusion
Cost management has become vital because organizations that are more
efficient have a competitive advantage. Increasingly, managers are challenged
to reduce costs while improving clinical quality and customer service. This
pressure has intensified as purchasers have realized that high costs do not
guarantee high quality and that high quality may not be more expensive.
Healthcare organizations are beginning to adopt cost-reducing technol-
ogy, substitute low-cost production techniques for high-cost ones, purchase
goods and services more conservatively, and rethink what they produce. In
addition, providers and insurers are being challenged to improve the health
of target populations in ways that are cost-effective—a task that is more dif-
ficult than the efficient production of healthcare products.
Exercises
5.1 Why is it important to distinguish between fixed and variable costs?
5.2 Explain how a decrease in input prices or an increase in efficiency
would affect costs.
5.3 You spent $500,000 on coding training last year. Is this a sunk cost?
Should it be considered in making a decision whether to switch
coding software?
5.4 You bought two acres of land for $200,000 ten years ago. Although
it is zoned for commercial use, it currently holds eight small, single-
family houses. A property management firm that wants to continue
leasing the eight houses has offered you $400,000 for the property. A
developer wants to build a 12-story apartment building on the site and
has offered $600,000. What value should you assign to the property?
5.5 A clinic’s cost and visit data are as follows. Calculate its average and
marginal costs. Note that you can only calculate marginal cost as
visits increase from 100 to 110.
Visits Total Cost Average Cost Marginal Cost
100 $2,000
110 $2,100
5.6 A community health center has assembled the following data
on cost and volume. Calculate its average and marginal costs for
volumes ranging from 25 to 40. What patterns do you see?
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Economics for Healthcare Managers86
Visits Total Cost
20 $2,200
25 $2,250
30 $2,300
35 $2,350
40 $2,400
5.7 Sweetwater Nursing Home has 150 beds. Its cost and volume data
are as follows. Calculate its average and marginal costs for volumes
ranging from 100 to 140. What patterns do you see?
Residents Costs
80 $10,000
100 $11,000
120 $12,000
140 $13,200
5.8 A phlebotomist takes 15 minutes to complete a blood draw. The
supplies for each draw cost $4, and the phlebotomist earns $20
per hour. The phlebotomy lab is designed to accommodate 20,000
draws per year. Its rent is $80,000 per year. What are the average
and incremental costs of a blood draw when the volume is 20,000?
10,000? What principle does your calculation illustrate?
5.9 Use the data in exercise 5.8. How would the average and marginal
costs change if the phlebotomist’s wage rose to $24 per hour? What
principle does your calculation illustrate?
5.10 A new computer lets a phlebotomist complete a blood draw
in 10 minutes. The supplies for each draw cost $4, and the
phlebotomist earns $20 per hour. The phlebotomy lab is designed
to accommodate 20,000 draws per year. Its rent is $80,000 per year.
What is the marginal cost of a blood draw? What principle does your
calculation illustrate?
5.11 Use the data in exercise 5.8. How would the average and marginal
costs change if the rent rose to $100,000? What principle does your
calculation illustrate?
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Chapter 5: Understanding Costs 87
5.12 A patient visits a clinic. She incurs $10 in travel costs and has a
copayment of $20. The clinic’s total charge is $60. The clinic
spends $9 to bill the insurance company for the visit and uses
resources worth $51 to produce the visit. The insurance company
pays the clinic $40 and spends $11 to process the claim. Describe
the cost of the visit from the perspective of the patient, the clinic,
the insurer, and society.
5.13 A practice uses $40 worth of a dentist’s time, $30 worth of a
hygienist’s time, $10 worth of supplies, and $15 worth of a billing
clerk’s time to produce a visit. The practice charges a patient
$25 and charges the patient’s insurer $70. The insurer spends an
additional $4 to process the claim. The patient incurs travel costs of
$20. What are the costs of the visit from the perspective of society,
the patient, the practice, and the insurer?
5.14 Kim and Pat underwrite insurance. Each underwrites 50 accounts
per month. Each account takes four hours to underwrite. The value
of their time is $40 per hour. Monthly costs for each are $1,500
for an office, $2,000 for a receptionist, and $2,400 for a secretary.
Calculate the average and incremental cost per case for Kim and
Pat.
5.15 If Kim and Pat from exercise 5.14 merge their operations, they
would need only one receptionist, and their rent for the joint
office would be $2,800 per month. All other values stay the same.
Calculate the average and incremental cost per case for the merged
office. Do they have economies of scale at 100 accounts per month?
Should Kim and Pat merge their offices?
References
Galarraga, J. E., and J. M. Pines. 2016. “Costs of ED Episodes of Care in the United
States.” American Journal of Emergency Medicine 34 (3): 357–65.
Ho, V., L. Metcalfe, C. Dark, L. Vu, E. Weber, G. Shelton Jr., and H. R. Under-
wood. 2017. “Comparing Utilization and Costs of Care in Freestanding
Emergency Departments, Hospital Emergency Departments, and Urgent
Care Centers.” Annals of Emergency Medicine 70 (6): 846–57.
Hung, D. Y., M. I. Harrison, M. C. Martinez, and H. S. Luft. 2017. “Scaling Lean in
Primary Care: Impacts on System Performance.” American Journal of Man-
aged Care 23 (3): 161–68.
McConnell, K. J. 2016. “Oregon’s Medicaid Coordinated Care Organizations.”
JAMA 315 (9): 869–70.
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Economics for Healthcare Managers88
Navathe, A. S., A. B. Troxel, J. M. Liao, N. Nan, J. Zhu, W. Zhong, and E. J.
Emanuel. 2017. “Cost of Joint Replacement Using Bundled Payment Mod-
els.” JAMA Internal Medicine 177 (2): 214–22.
Navigant. 2016. “Improving Quality and Reducing Cost with Bundled Pay-
ments.” Published April 4. www.navigant.com/-/media/www/site/insights
/healthcare/2016/baptist-health-case-study .
Olinger, D. 2015. “Confusion About Free-Standing ER Brings Colorado Mom $5,000
Bill.” Denver Post. Published October 30. www.denverpost.com/2015/10/30
/confusion-about-free-standing-er-brings-colorado-mom-5000-bill/.
Rotter, T., C. Plishka, L. Adegboyega, M. Fiander, E. Harrison, R. Flynn, J. Chan,
and L. Kinsman. 2017. “Lean Management in Health Care: Effects on
Patient Outcomes, Professional Practice, and Healthcare Systems.” Cochrane
Database of Systematic Reviews 11: CD012831.
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