PRODUCTION FUNCTION
• Output is a function of inputs
• Standard physical production function: Q = f(L,K)
• Marginal Product of an input: change in output in
response to a one-unit increase in that input. This isn’t
always what it looks like on its face!
• All marginal products are not the same: the MP of an
input can change with the amount used or with the
amount of other inputs used.
PROPERTIES OF THE
PERDUCTION FUNCTION
• Diminishing Returns: when increasing a “variable
factor” while holding other “fixed factors”
constant.
• Substitutes and complements (across inputs):
compare MP of one input with more/less of the
other input.
• Economies of Scale: if double all inputs, does
output double?
• Intertemporal substitutes and complements (for a
given input across time): compare MP of an input
at one point in time when more/less of the input
has been used previously. Examples?
OPTIMALITY
• Equi-marginal principle. Consider reducing L by
$1 and increasing K by $1…
• Economies of scale and firm size
• How input mix responds to change in input prices
• Demand for inputs. Changes in desired output
level, output prices, input prices, etc. will lead to
changes in the amount of inputs desired.
• Diminishing returns influence the output decision,
which will be discussed in the next unit.
COST CONCEPTS I
• Implicit and Explicit Costs
• Forward Looking and Backward Looking
(Sunk) Costs
• Accounting and Economic Costs
• Economic Costs (also called Opportunity
Costs) are forward looking, implicit and
explicit costs
COST CONCEPTS II
•
•
•
•
Fixed and Variable Costs
Short Run and Long Run Costs
Total, Average, Marginal
The reason we make these distinctions is
because different kinds of costs are relevant
in different circumstances
PROPERTIES OF COSTS
• Short Run ATC equals or exceeds Long Run ATC
for any level of output (equi-marginal principle)
• Marginal Costs increase beyond some level of
output (diminishing returns)
• Average Short Run Costs are smaller than Average
Total Costs
• Average Costs equal Marginal Costs at the level of
output for which Average Costs are lowest (this
relates to economies of scale)
USES OF COSTS I: Health
Interventions
• Cost-effectiveness analysis: minimize the
cost of producing a given level of output
• Cost-benefit analysis: determining whether
the benefit exceeds the cost
• These concepts can apply in a managerial
framework or in a policy framework (should
WHO adopt a particular policy intervention?)
USES OF COSTS II: Size and
Scope of Firm
• Merger decisions can be driven by average
total costs—economies of scale.
(Horizontal integration)
• Outsourcing decisions based on another
useful cost concept, “comparative
advantage.” (Vertical integration)
USES OF COSTS III: Supply
Decisions
• Short run output decisions in profit maximizing,
competitive firm determined by price and
marginal costs. Long run output decisions, which
include entry and exit, by profit maximizing firm
determined by price and average costs.
• Market short run supply, of perfectly competitive
profit maximizing firms, comes from marginal
costs (aggregated across firms). Market long run
supply comes from average costs, the logic is a
little complicated. Long run supply is more elastic
than short run supply.
HEALTH CARE IS AN INPUT!
• Production of Health: Health = f(HC, other
inputs). What are those other inputs?
• Are there diminishing returns to HC? Yes, another
term for it is …..
• Are there substitutes for HC? Complements?
• So the demand for health care depends on out of
pocket price, the overall value of health (scale
effect), the ability to substitute other inputs for HC
in health production (substitution effect)
EVIDENCE ON HEALTH
PRODUCTION
• Other important inputs: lifestyle,
environment, education, income, nutrition.
These impact health directly, and through
good hygiene/health habits.
• Health care probably not the most important
input, even at the margin. Still, tremendous
value placed on life/health means that
health care is highly valuable! VSL in $mil.
EVIDENCE ON HEALTH
CARE DEMAND
• RAND experiment and many others: HC demand
price inelastic, meaning not very sensitive to price.
• HC Demand income inelastic (within US studies)
or income elastic (cross-country studies)
• HC Demand responsive to insurance too—RAND
experiment. More coinsurance will make demand
more elastic.