Why measure costs?

The main purposes for costing services are:-

Cost Analysis &
Techniques
• To identify resource use

• A basis for price setting

Steve Parrott
Centre for Health Economics

[email protected]

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 OUTPUT

specifies the maximum output that can be produced from

any given amount of inputs.
Why Costs?
Economists have attempted to estimate the production
functions for health care
• important for management and budgeting when
operating a service. Technical progress occurs when a given output can be
produced with fewer inputs,

• manager will want to know the outgoings of the service

when accounting for past expenses and forward
Output As workers are added
planning the service. to the fixed factor (e.g.,
land), output initially
increases. However,
there comes a point
where output will
increase at a
• important input to an economic evaluation diminishing rate.

Eventually output may

0 1 2 3 4 5 6 7 8 decrease as workers
Number of Workers are added. This may
be because workers
get in each others’ way
and the production
facility is too crowded.

The shape of a production function will depend upon the industry in

question, and the type of production facility currently used.

3 4
Summarising the Production Function OUTPUTS

SHORT RUN = The period in which the firm can only

make partial adjustment of its inputs to changes in
conditions.

Q = q (L, K)
Output b

Total output

Output is a function of labour and capital

a

Labour and capital are factors of

Labour
production
Average
and
marginal
product

a
c
Average product of input

Marginal product of input

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TOTAL PRODUCT - Rises and then falls COSTS

Increasing returns to a factor

Fixed costs do not vary with output.
Up to point "a" - the production function is increasing at an
increasing rate
Variable costs vary directly as output changes.

Diminishing returns to a factor

Semi variable costs are costs which vary with output but
After point "a" - production function increases at a not directly as with variable costs.
decreasing rate

When total product increases, marginal product is positive

Cost Total cost • Fixed costs do not vary with
£ output. Plotting fixed costs
against output will give a
When total product is at a maximum, marginal product is horizontal line
ZERO (point "b") Variable cost
• Variable costs increase as
F output increases. Plotting
variable costs against
With increasing returns, marginal product is positive Fixed cost output will give an upward
sloping line.
0 Output
With decreasing returns, marginal product is negative

AVERAGE PRODUCT is rising if MP > AP

AVERAGE PRODUCT is falling if MP < AP

7 8
 Average Costs

Total Cost = Fixed Cost + Variable cost

Average cost: AC = Total Fixed Cost + Total Variable Cost
Output

C(q) = F + v (q)
Example:
Fixed cost Variable Total cost Average
cost cost
0 £100 0 £100 -
1 £100 £10 £110 £110.0
2 £100 £20 £120 £60.0
3 £100 £30 £130 £43.3
4 £100 £40 £140 £35.0
5 £100 £50 £150 £30.0
6 £100 £60 £160 £26.7

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 Marginal costs

cost of producing one extra unit of output

Plotting the average cost against output:

A.C.
£110
Marginal cost: = Change in Total Cost
£100
£90 Change in Output
£80
£70
£60
£50
£40 Cost
£30
c2 C (q)
£20
£10 .
c1
0 1 2 3 4 5 6

0 q1 q2 Output

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Cost functions can exhibit very different properties. 2. Marginal cost falls as output increases

1. Marginal cost increases as output increases

Cost
C (q)

c2
Cost
. c2 C (q)
c1

c1

0 q1 q2 Output

0 q1 q2 Output
This may be the case, for example, if an input is in
short supply and as output increases, local supplies
are used up and the input must be brought from
further away, thus increasing transport costs.
Marginal costs may fall as output increases.

For example, workers may become quicker as

they repeat a job more often, or the firm may be

able to reduce costs, for example bulk

transportation of goods.

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 Marginal Costs and Average Costs An Example of Marginal Costs

Heating, Nursing Materials, Total Average Marginal

lighting, staff drugs, food, cost cost cost
maintenance laundry
ATC, MC 0 50 0 0 50 - -
1 50 20 5 75 75 75
2 50 20 10 80 40 5
Marginal
3 50 20 15 85 28.3 5
Cost
4 50 20 20 90 22.5 5
5 50 20 25 95 19 5
6 50 40 30 120 20 25
7 50 40 35 125 17.9 5
8 50 40 40 130 16.3 5
9 50 40 45 135 15 5
10 50 40 50 140 14 5
Average
11 50 60 55 165 15 25
Cost
12 50 60 60 170 14.2 5
13 50 60 65 175 13.5 5
14 50 60 70 180 12.9 5
15 50 60 75 185 12.3 5
16 50 80 80 210 13.1 25
17 50 80 85 215 12.6 5
0 18 50 80 90 220 12.2 5
OUTPUT 19 50 80 95 225 11.8 5
20 50 80 100 230 11.5 5

Marginal cost intersects average cost at the lowest point of Costs of Programme
AC

If cost of additional unit exceeds AC, AC will rise 250

If cost of an additional unit is less than AC, AC will fall 200

150

£
100

50

0
Output

Total cost Average cost Marginal cost

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 The LONG RUN

120 The period in which the firm can adjust all of its inputs to a
100 change in conditions – if all inputs can be changed then all
80 costs are variable.
60

40

Example:
20

Output Total Cost Average cost

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
0 0 -
Fixed cost Staffing costs Material costs
1 30 30

2 54 27

3 74 24.7

4 91 22.7

5 107 21.4

6 126 21

7 149 21.3

8 176 22

9 207 23

10 243 24

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 Economies of Scale

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There are three main reasons for economies of scale:

1 Indivisibilities
20

Also known as fixed costs –

10 2 Specialisation

A sole worker must undertake all of the task himself.

As output increases more workers can be taken on

0 1 2 3 4 5 6 7 8 9 10
and by concentrating on a single task can act more
efficiently.

If long run average costs fall as output increases, the 3 Better machinery
producer is said to gain economies of scale
As output increases, larger and better technology can
be applied.
If long run average costs rise as output increases, the
producer is experiencing diseconomies of scale. eg, oil transportation, the volume of a tanker rises in
greater proportion than the amount of steel required to
construct the tanker.

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Diseconomies of Scale
The overall shape of the AC curve depends on

a) How long economies of scale persist

• If output increases beyond a certain level, the average
b) How long diseconomies of scale occur
cost can increase as output increases.

The part of the AC curve that is horizontal is the point of

• main reason - as a productive facility gets larger it
minimum efficient scale.
becomes more difficult to manage and co-ordinate.

• In addition, the first factory location may be the most

Industries which are capital intensive and use advanced
efficient in terms of geographical locality.
technology tend to have rapidly falling AC curves and

therefore large potential to gain economies of scale as

• If a second factory is built, there may be higher costs
output increases.
involved in transporting raw materials.

• In mining, deeper coal seams may have to be dug out.

This is the case with hospitals and health care providers.

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MINIMUM EFFICIENT SCALE

Why are there few aircraft manufacturers and lots of

concrete plants ?
Small MES = local concrete plants

Large MES = aircraft assembly and production

Efficient operation only needs a few workers

Market is roughly 50km radius from plant

Huge economies of scale to be enjoyed

Market is the whole globe

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DETERMINING THE LEVEL OF OUTPUT

When deciding on the level of output to produce, a firm must look

at the relationship between costs and revenue.

A competitive firm Competitive Firm MR

Firm can sell as much as it wants at the prevailing market price AR

Output Price Total MR Total Cost MC
Revenue
0 50 0 0
1 50 50 50 30 30
2 50 100 50 70 40
3 50 150 50 120 50
4 50 200 50 180 60
5 50 250 50 250 70

AR
MR
• Marginal revenue is the change in revenue when output
changes.

• Faced with the above costs, a firm will not produce when MR is 0
Output
negative.

• The firm will also not produce where MC is greater than MR

Faced with the above costs, a firm will not produce when MR is
negative.
• This would imply that profit (revenue minus cost) is being
reduced by expanding output
The firm will also not produce where MC is greater than MR

This would imply that profit (revenue minus cost) is being

MONOPOLIST Price falls as output increases
reduced by expanding output
Total Total
Output Price Revenue MR Cost MC
0 80 0 - 30 -
1 70 70 70 34 4
2 60 120 50 40 6 The profit maximising rule is therefore to set output
3 50 150 30 48 8 where
4 40 160 10 58 10
5 30 150 -10 70 12 MARGINAL COST equals MARGINAL REVENUE

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 Technical efficiency

• a point where it is not possible to increase health gain given the

available resources.
MC
• Supply factors look at whether health care is being produced at
MR
Price its most efficient level.
Cost AC
P • does not consider the prices of inputs

Production function

AR

Output

MR
q = f (L)
B
Q
Output A
C
D

Labour input

• A and B are technically efficient

• C and D are technically inefficient

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DETERMINING THE LEVEL OF PRODUCTION
ISOQUANTS
Can buy K and L at factor prices, one unit K costs £10, one unit L costs £20

Units K Exp on K Units L Exp. On L Total

expenditure
0 £0 5 £100 £100
2 £20 4 £80 £100 CAPITAL
4 £40 3 £60 £100
6 £60 2 £40 £100
8 £80 1 £20 £100
10 £100 0 £0 £100

8
LABOUR
6

2
0 1 2 3 4 5 L

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CHOOSING A LEVEL OF PRODUCTION
FIXED PROPORTIONS TECHNOLOGY

CAPITAL
CAPITAL

0 LABOUR

L LABOUR

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Allocative Efficiency
Determining the output from the health care sector.

• requires that inputs are chosen optimally given the prevailing • For most marketable goods and services there is a clear
product of known quality to which consumers can attach
input prices, hence output is produced at the lowest cost some value

• Output is where demand and supply are in equilibrium

Capital
Q = 1000
• For health care the output, ignoring any process utility, is
the impact on health status.
Z

Isocost = £55,000 • How is the product measured?

Are medical procedures all the same?

Isocost = £50,000
Unlikely
0
Labour

• empirical evidence would suggest the quality and impact

Firm Z is technically efficient but allocatively inefficient on health outcomes vary considerably.

Firm X is both allocatively and technically efficient

• patient =====> seen as one of the “inputs” to the

process and they also vary in “quality” or severity of
condition and capacity to benefit.

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Difficulty of measuring outcomes Economics of scale and scope and their impact in health care

Combinations of inputs which yield the same output given the

• physical
technology are represented on isoquants

• psychological
degree of substitution between the different inputs of health care is
an important question.

• economic

The production function shows the combination of inputs needed

to produce different levels of outputs.

The alternative way of considering these relationships is to convert

the physical units to costs.

needs to be considered if the efficiency of a firm is to be

considered.

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Economies of scale

Example

• implications for the size and type of organisations and hence av av

cost cost
whether there is potential for supply side failure.

average
cost ac1 ac1

AC AC

AC

0 q1 0 q1
ac2

HOSPITAL 1 HOSPITAL 2

0 q2

HOSPITAL 3 average
cost

• econs of scale where AC is falling

AC

• need for a certain size of output for costs to be minimised

ac2

• firms become larger and fewer in any market.

0 q2
• if firms need to be big and require large start-up costs this HOSPITAL 3
creates a barrier to the entry of new firms

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Economies of scope

• occurs in multi-product firm when it is cheaper to produce two or

more outputs jointly than separately.

• e.g. hospital output - large capital equipment and operating

theatres etc can be shared across a number of different medical Example

care interventions.

• suppose two hospitals in one town, one producing only geriatric Economies of scope: where the total cost of producing Q1=100

care and other paediatric care and Q2=150 jointly is less than producing them separately

• would costs be lower if provided in one hospital ?

TC (Q1=100, Q2=150) < TC (Q1=100, Q2=0) + TC (Q1=0, Q2=150)

• the two types of car go well together -

1. inputs similar

2. things learnt in one could be used in the other

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Conclusions

• Costs are central to economics

• Many reasons to carefully measure costs

• Important to both profit and non-profit making

organisations

• Producers examine costs and revenues when

determining output

• Marginal costs are crucial to business decisions

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