PRODUCTION FUNCTION

1
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 isnt 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.

2
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?

3
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.

4
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

5
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

6
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)

7
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?)

8
USES OF COSTS II Size and Scope of Firm

• Merger decisions can be driven by average total
  costseconomies of scale. (Horizontal
  integration)
• Outsourcing decisions based on another useful
  cost concept, comparative advantage. (Vertical
  integration)

9
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.

10
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)

11
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.

12
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 tooRAND
  experiment. More coinsurance will make demand
  more elastic.