Economies of Scale, Efficiency and Optimal Size of the Hospital

Abstract

Hospitals are being expanded all over the world. Hospitals are becoming larger (i.e., increasing patient admissions each year) and more complex (i.e., offering a wider range of services to patients with more diverse medical care needs). In the hospital sector and other branches of the economy, economies of scale are important, according to which the volume of medical services can be increased by reducing average costs and increasing quality. However, measuring this relationship between the volume of medical services and costs is difficult because hospitals differ substantially in terms of specialization, patient composition, and other parameters that affect the volume of costs. The paper discusses the features of economies of scale in the healthcare sector and the dependence of the volume of medical services on costs and quality.

Studies confirm that the influence of various factors on the costs and quality of medical services depends on the environment and the system of incentives in which hospitals operate. Relationships between patients and healthcare providers based solely on price negotiations do not ensure adequate healthcare quality. Due to informational asymmetry with respect to the real cost of hospital services and quality of treatment, medical service buyers cannot influence cost reductions and increase the quality of treatment, which increases hospital power. Thus, when evaluating the impact of hospital competition on costs and quality of care, we must remember that market mechanisms in health care do not always increase public welfare.

Keywords: Economies of Scale, Quality of Medical Services, Cost of Medical Services, Hospital, Healthcare Market

Introduction

Regardless of economic development, modern hospitals are affected by demographic changes, the complications of the structure of diseases, and the development of new medical technologies. The hospital’s operation results depend on various links of the healthcare system: providers of medical services, customers, competitors, and other entities of the healthcare system.

The theory of economies of scale is used to explain efficiency in production systems. Economies of scale argue that unit cost decreases as the volume of output increases. Several mechanisms, including the effect of volume on fixed costs, resource specialization, and market positions vis-à-vis suppliers, can explain this relationship between cost and volume. On the other hand, economies of scale are usually related to the phenomenon in which a service’s unit cost decreases when the production volume increases (Bernet & Singh, 2015) [1]. Economies of scale refer to when producing various services in one large unit is profitable rather than in several specialized production units.

In the hospital sector and other branches of the economy, economies of scale are important, according to which the volume of medical services can be increased by reducing average costs and increasing quality. The results of many studies conducted in the health sector support the existence of the phenomenon of economies of scale (Giancotti et al., 2017) [2]. Still, applying the concepts of economies of scale in the health sector is becoming more difficult. The fact is that measuring the relationship between the volume of medical services and costs is difficult because hospitals differ substantially in terms of the level of specialization, composition of patients and other parameters that affect the volume of costs. The article discusses the peculiarities of economies of scale in the healthcare sector and the complexity of the dependence of the volume of medical services on the incurred costs and quality.

Hospital Efficiency

Quantitative and qualitative parameters determine the evaluation of the effectiveness of hospital results. Three aspects of quality are distinguished: 1. Quality of resources - investment and human resources, including the level of competencies of medical personnel. 2. Quality of the process of providing services - medical technologies, compliance with medical standards, intensity of treatment, level of service to patients. 3. The level of clinical result - the outcome of the patient’s treatment.

Two main aspects of efficiency are considered when studying the functioning of hospitals in the medical market. Technical (local) efficiency - the ratio between resources and the produced product, for example, the ratio of personnel to the volume of services rendered (the number and structure of treatment cases in the hospital). The volume of the hospital influences technical efficiency, the medical technologies used, and the motivation of the organization and each worker. Allocative efficiency - the ratio between different directions of resource allocation, which determines the rationality of the cost structure, taking into account alternative costs. Different trends in technical and allocative efficiency are possible. For example, an increase in the technical efficiency of hospital activity that does not require hospitalization may be accompanied by a decrease in allocative efficiency - a significant concentration of resources in hospital services.

The organization of medical services differs significantly from country to country. However, it is possible to distinguish the main trends in the formation of hospitals:

• Transformation of a large part of hospitals into large complexes where complex and expensive medical technologies are used;
• Transfer of some types of inpatient services to the ambulatory level;
• Increasing the intensity of treatment and, as a result, reducing the delay of patients in the hospital;
• Reducing the demand for beds and increasing the concentration of resources on the treatment of complex diseases in hospitals;
• Rapid increase in resource saturation per hospitalization case.

Despite the general tendency to reduce the number of beds, the share of hospital sector costs in the total health care costs in developed countries has been quite stable for the last 20 years and amounts to 20-35%. For comparison, in Georgia, it exceeds 60%, resulting from high levels of hospitalization and long-term treatment.

Another general trend is the reduction in the duration of hospital treatment. Hospitalization rates per 10,000 population vary by country. In some countries, it is decreasing (in 1990-2005 in Canada it decreased by 32%, in Sweden - by 10%), while in other countries it is increasing (in the same period in Great Britain it increased by 41%, in Spain - by 14%, in Norway - by 20%). (OECD, 2007) [3]. The number of medical personnel per bed increased in European countries in 1990-2005 (the minimum was in Germany - 6%, the maximum in Great Britain - 2.6% (OECD, 2007) [4].

These trends are due to the special nature of technical progress in the hospital sector: new medical technologies rarely lead to an economy of labour resources. Often, they require the recruitment of a new category of medical workers, which increases the saturation of resources for each case of hospitalization. One day of hospitalization in Great Britain is about $ 500; in some hospitals in the USA, it exceeds $2000.

Economic Status of the Hospital

According to economic status, hospitals are divided into three groups: public, private non-profit and private commercial. In the countries with a budgetary health care system (Great Britain, Scandinavian countries, Ireland, Italy, Spain, and Portugal), the share of public hospitals is 70-95%. In countries with a compulsory medical insurance system, this share is relatively small, although it still has a larger share; for example, in France, 65% of beds are located in state hospitals; in Germany - 55%; in Belgium - 60%. In countries where private health insurance is more developed, for example, in the USA, the share of private hospitals (commercial and non-commercial) is relatively large - up to 70-80% (Cutler, 2002) [5].

In the late 1990s, the World Bank proposed another typology, according to which medical organizations are divided into budgetary, autonomous and corporate types (Preker & Harding, 2003) [6].In an autonomous organization, managers have full decision-making authority. The global budget provides financing. Medical organizations have the full right to dispose of property. An autonomous organization is mainly formed by transforming a traditional budgetary organization into another organizational-legal form - trusts (Great Britain, Italy), non-profit organizations (Spain), and public state organizations (Lithuania).

Corporate organizations appear as independent entities - corporation operating according to the general rules of entrepreneurship. The state owns the corporation’s property and manages its activities as its representative in the governing body. The organization assumes full economic responsibility for its obligations. In essence, it is a model of a state enterprise. Compared to an autonomous organization, there are more rights to use the income and more responsibility for obligations. The state acts as the corporation’s owner and tries to maintain strategic control over the activities of the medical organization while leaving the medical organization free to make current business decisions. The most famous examples of corporations are the state corporations of Sweden, Denmark, New Zealand, and Israel in the hospital sector.

Many countries in the 1990s tried to give public hospitals more autonomy by converting them into other public organizations. The most famous form is the transformation of state organizations into trusts. For example, in Great Britain in the early 1990s, all public hospitals were converted into NHS trusts. Trusts have established contractual relationships with purchasers of medical services, in particular with public authorities and large general medical practices.

Another form of autonomization is the transformation of budgetary medical organizations into public healthcare organizations, such a transformation was carried out in Lithuania. Lithuania first adopted the Law on Public Organizations (1996), which established the main features of such organizations: income is generated based on contracts with customers. Profit is not the goal of the activity; it does not bring to the founder but is directed to the development of medical activity. In 1997, the Law on Public Reorganization of Budgetary Organizations was adopted.

In many countries, there is a diversity of ownership and organizational-economic forms of hospitals. Given the medical market’s peculiarities, many countries face a difficult choice of the optimal ratio of private and public hospitals. On the one hand, private commercial hospitals can respond promptly to market changes because their goal is to make a profit. When the necessary incentives are created to influence private commercial hospital decisions regarding the volume and quality of services, then the service delivery function can be transferred to the private commercial sector. On the other hand, the existence of information asymmetry allows commercial hospitals to increase the volume or price of the service, as well as to reduce the quality. Low-income countries prefer private, non-profit hospitals, even if they are technically less efficient.

It is important to consider that the development of one or another form of hospital organization is conditioned by the historically formed representations of the role of a commercial hospital in different countries. For example, in the US, market relations in health care were dominated by commercial hospitals from the beginning. Historically, the main role in Europe belonged to state organizations. Since the 1980s and 1990s, many European countries have turned to autonomous organizational forms.

Hospital Expences

In the short term, hospital costs - the number of beds (hospital capacity), supplies, and equipment - are mostly fixed. A decrease in the number of patients leads to a decrease in average costs. In the long run, all costs are variable. Hospital administration may hire more doctors and invest in additional beds or expensive equipment. By predicting patient flow, a hospital can minimize average costs. When a daily intake of 150 patients is expected, a medium-sized hospital and a large hospital for 300 patients are required. Thus, at each expected level of demand, the administration can determine the capacity (capacity) of the hospital, as well as the number of medical personnel, minimizing average costs.

A U-shaped curve theoretically represents the dependence of hospital volume on costs. As the volume of the hospital increases, average costs decrease to a certain minimum, after which they increase again. With the increase in the volume of medical services, it is possible to increase the number of doctors who specialize in warfare and increase access to high-tech equipment. Hospitals can also purchase large volumes of equipment at a reduced cost. However, as the size of the hospital increases, so do the costs of organizational coordination and management control.

Thus, it may be economically prudent to expand the size and scope of the hospital to better utilize existing expertise, infrastructure, and equipment. However, at some point, the hospital moves away from the optimal efficiency level and begins to exhibit diseconomies of scale. Also, small hospitals can be inefficient because fixed infrastructure and administrative costs are spread over a very small number of cases, increasing the average hospital visit cost. In this regard, studies show that negative effects of scale diseconomies are expected below 200 beds and above 600 beds (Roh et al. 2010) [7].

The existence of economies of scale is one of the factors determining the intensity of competition. When economies exist, the limits of competition are limited. Therefore, it is important to identify the limits of this economy for the health sector. At this point, we need to understand whether the market structure of medical service providers is a natural monopoly, where only large hospitals can achieve an efficient volume of services, or whether the market structure is more diverse, where many smaller hospitals can exist.

However, it is important to understand that this ratio of volume and costs is ambiguous, as is the conclusion about the existence of economies of scale. Studies confirm that there is an economy of scale in health care, but it is significantly lower (11-14%) than in other sectors of the economy (60-95%) (Eastaugh, 2004) [8].

Hospitals are not uniform in terms of the composition of treated patients, the complexity of the services provided, and the amount of scientific research spent on the training of doctors (some hospitals perform the functions of both teaching and research centres simultaneously).

Let’s compare two hospitals: hospital B has more beds than hospital A, but patients in hospital B have a more complex disease structure. It can be assumed that the average costs in this hospital will be higher, making it less efficient. But in this case, such a conclusion does not correspond to the truth. Many parameters are used to evaluate the impact of hospital volume on costs: hospital volume, the structure of diseases, quality of treatment process, severity of disease, differences between doctors’ salaries, and costs of doctors’ training. Empirical studies in this direction are associated with certain limitations from the data, adequate indicators, and the technical side. It can be said that many studies in the USA confirm the existence of economies of scale, although not very significant, for hospitals with a capacity of 200-300 beds. An insignificant average percentage of savings justifies the presence of competition in the supplier market.

At first glance, hospital A, which provides a few medical services, has lower average costs than hospital B and is, therefore, more efficient. But if we take into account the many factors that affect the long-run costs of a hospital, that is, if we compare short-run and long-run costs, we can see that hospital B is more efficient because it provides services with the lowest long-run average costs.

Thus, lower average costs are not an indicator of higher hospital efficiency. Other factors also affect the efficiency of the hospital. Therefore, it is necessary to empirically assess the existence of economies of scale in each hospital operating in the local market, taking into account the peculiarities of the case structure. This refers to economies of scale not only for costs but also for the quality of services. It is important to consider that the quality of medical services is often determined by increasing the level of specialization of hospitals. The greater the volume of types of medical services, the greater the results of treatment. It is also necessary to consider the possibility of economies of scale in relatively small medical organizations and individual sub-departments. For example, a large hospital with a large set of specialities may not provide economies of scale, while an individual sub-department may be able to provide such economies through the power of replication of well-utilized medical technologies. It is also necessary to consider the different effects of scale (increase in the volume of services) on the quality of treatment for different specializations and types of services. For example, an increase in the volume of services significantly increases the quality of open heart operations but practically does not change the quality of cholecystectomy.

Behavior of commercial and non-commercial hospitals in the medical market

The status of the hospital is determined by the objective function, which in turn is related to the status of the hospital. A commercial hospital maximizes profits, while a non-profit hospital may include other factors in its function, such as serving socially vulnerable citizens, providing services that have public benefits, and conducting research in commercially unprofitable areas.

The number of beds determines the capacity of the hospital. The number of hospitalizations is determined in proportion to the number of beds. The optimal number of beds for a commercial hospital-monopolist is lower than for a commercial hospital in a monopolistically competitive market, which in turn is lower than the optimal capacity of a non-profit hospital. The price set by a non-profit hospital is lower than that of a commercial hospital.

Theoretical models of hospital competition

The relationship between providers of medical services takes place within the framework of the existing and changing market structure. The market structure is determined by the degree of differentiation of economies of scale services, the presence of hospital service providers, and market entry and exit barriers. The wider the market boundaries, the more hospitals can compete. And conversely, in the absence of hospitals within the geographical reach, the hospital gains market power.

Studies confirm the importance of the geographic accessibility factor of the hospital in the market structure. According to one study, a 10% reduction in the distance to a hospital increases the demand for its services by 13-14% (Henderson, 2005) [9]. However, the market for certain specialized services may extend beyond local boundaries as patients are willing to travel significant distances to receive a specific type of treatment.

According to neoclassical economic theory, competition leads to efficient economic results. The services of healthcare providers are very different from other services. Due to informational asymmetry and uncertainty in the origin of demand, competition opportunities and outcomes in health care may differ from those in other areas of the economy.

Hospitals can compete on two levels:

• Competition for individual users of services;
• Competition on the collective buyer of services - insurance companies.

Competition between hospitals can be carried out according to prices and the quality of medical supplies. The main condition for ensuring the positive effects of hospital competition is the availability of information for all interested parties of the system according to two parameters:

• Effective use of resources;
• Quality of provided services.

When the object of hospital competition is the collective buyer of services, competition helps hospitals allocate and use resources more efficiently. In this case, the buyer of services, due to its size (for example, a large insurance company), has a relatively high (compared to individual buyers) power and, as a result, has a stronger influence on costs and non-price parameters of services.

The effectiveness of competition depends on the organization of the insurance system - the market structure of hospitals and insurance services free contracting with selected hospitals. Increasing the volume of hospitals (by merging them), which leads to economies of scale and provides relatively high indicators of the quality of treatment, can strengthen the market position. At the same time, the ability of the hospital to impose its conditions on the insurance company regarding the prices of hospital services is expanded. When many hospitals operate in a local market, their ability to impose their terms on a powerful insurance company is substantially reduced.

Methods of reimbursement for hospital services also influence the effectiveness of competition.

Hospital reimbursement can be based on two approaches. Retrospective compensation is based on the actual volume of services rendered, where the role of the financier is minimal. However, the buyer can control hospital cases. The second approach involves reimbursing medical services using the prospective method based on the pre-agreed volume of services provided.

Factors of effectiveness of competition in the medical market

Based on the theoretical aspects of competition, it is possible to systematize the factors that influence the results of hospital competition.

Institutional environment factors. The availability of information on the quality of treatment (mortality, re-hospitalization rates) and effective use of resources are the most important factors in making a rational decision by the buyer and user of medical services. The scarcity of information is reflected in the imperfection of contracts and leads to high transaction costs, which reduces competition. State regulation in such areas as licensing, establishment of quality standards, and provision of information on hospital activities contributes to the increase of quality in the conditions of competition.

Peculiarities of local markets. The existence of empirically justified economies of scale limits the possibilities of competition. When the large size of the hospital, i.e. market concentration, allows for lower costs of services, increasing the number of hospitals is inefficient. In addition, the larger the hospital, the greater the volume of services provided, and the quality of many types of treatment depends on the experience of doctors and the number of procedures performed. In this case, expanding the number of hospitals is not justified from the point of view of quality improvement. When there is a need to expand hospitals to meet growing demand - a situation where demand exceeds supply - the opportunity to compete on quality and price increases.

Attitudes of hospitals to purchasers of medical services. An interested, well-informed buyer of medical services is a key factor influencing decisions made by a hospital on the volume and quality of services. The higher the buyer power, the stronger the buyer’s influence on service quality and costs. Another way to influence the buyer’s hospital is through reimbursement. Pre-negotiated, prospective funding creates additional incentives to contain costs, hospitals compete on price, while retrospective reimbursement methods do not create incentives to increase efficiency. In addition to the collective buyer, the hospital’s activity is influenced by the individual user of medical services, who makes a rational choice of the hospital based on price and quality. In the case of compulsory insurance, the price elasticity of demand is zero. At this time, the hospital may increase the cost of its services. When the consumer pays for some of the services themselves, the price elasticity of demand increases, and the hospital’s price competition becomes more effective because it attracts many patients.

The hospital’s response to changes in external conditions. Hospital behaviour is driven by internal motivations that depend on economic status. When a hospital has large decision-making powers, competition encourages the search for ways to increase operational efficiency. A for-profit hospital will focus more on cost containment, while a not-for-profit hospital will focus more on increasing quality.

Empirical Assessment of Hospital Performance

Volume of medical services and quality of treatment

It is known that special importance is attached to the experience and skills of doctors in clinical practice in medicine. For example, open-heart surgeries are allowed only in hospitals that can perform a set minimum of such surgeries. Large hospitals can easily meet this minimum. Better clinical outcomes can be achieved in more concentrated hospitals, where large hospitals dominate (in less competitive markets) and volume drives quality. Studies confirm that the cumulative number of cardiac operations (its increase in a given period) significantly impacts outcome indicators (lethality and complications). Also, the impact of volume on quality is confirmed by studies, according to which, in hospitals where the number of operations is large, mortality is significantly lower (Welke et al., 2008; [10] Lee et al., 2015 [11]).

Hospital competition and production costs

Some studies confirm that when hospitals are financed by a retrospective method (actual costs), competition leads to an increase in the volume of services, costs and prices (Krabbe-Alkemade, et al., 2017; [12] Fournier & Mitchell, 1992 [13]). However, there are studies according to which competition reduces costs and prices (Connor et al., 1998; [14] Dranove et al., 1993; [15] Proppe & Söderlund, 1998; [16] Dranove & Satterthwaite 2016 [17]). In addition, competition increases the widespread adoption and use of expensive technologies (Deng & Pan, 2019) [18].

The most common indicators of competition among medical service providers are:

• The Herfindahl-Hirschman Index is calculated based on hospital volume (number of beds, level of capital expenditures) within a country or region. In the US, the Federal Trade Commission has defined the following criteria for the degree of market concentration: HHI < 1000 - unconcentrated market, 1000 < HHI < 1800 - medium concentration, and HHI > 1800 - high concentration. The highest index of 10,000 corresponds to a monopoly;
• number of doctors per hospital in the country/region;
• Share of hospitalizations by hospital in the country/region.

Hospital competition is determined by the market structure, which is determined by the boundaries and characteristics of that market’s population. Therefore, the measurement of competition makes sense only during the correct analysis and assessment of local market boundaries.

As a result of the introduction of statutory methods of financing hospitals and the definition of agreed volumes of hospital services, competition in the early 1990s in the USA was associated with relatively low costs and prices. (Fulton, 2017) [19].

Hospital competition, treatment costs and quality

Studies confirm that in the conditions of competition of hospitals in terms of quality, there is an intensification of expensive services, which leads to an increase in costs and prices (Strumann et al., 2022) [20]. In the US, this kind of competition in the medical market, which causes cost inflation, is called a “medical arms race”. However, excessive duplication and intensification of services can reduce the effectiveness of patient care because hospitals cannot afford to invest in research into more effective treatment methods.

Studies evaluating the impact of hospital competition on costs and quality of care have produced mixed results. High competition in the US until the 1990s was ineffective because it increased hospital costs while not significantly affecting treatment outcomes (for example, the fatality rate of myocardial infarction did not decrease).

In the 1990s, the competitive landscape in the US changed substantially due to the emergence of managed health insurance schemes. During this period, prospective reimbursement methods of financing hospitals were introduced, which means financing medical services not according to actual costs but according to predetermined prices. At the same time, stricter requirements were established for using expensive resources. After the 1990s, high competition led to cost reduction and quality improvement. Consequently, competition has become a useful mechanism for influencing hospital performance.

In Great Britain, the reform of the National Health Service, which began in 1991, was aimed at stimulating competition among hospitals. Studies confirm that the price of hospital services was lower in regions with high competition among hospitals; However, the higher the volume of the medical organization, the lower the price (Joynt et al., 2011) [21]. According to other studies, competition between hospitals reduced the quality of patient treatment (Lyon, 1999) [22]. Thus, American researchers note the impact of competition on quality, and according to British researchers, competition strengthens the price signal. In Britain, healthcare purchasers (local governing bodies) focused more on price reduction than quality when negotiating with healthcare providers. When analyzing the impact of competition on quality, researchers took more into account the size and status of the hospital.

Conclusion

Empirical studies confirm that the influence of various factors on the quality of treatment depends on the environment and system of incentives in which hospitals operate. Relationships between buyers and providers of medical services, which are based only on price negotiations, do not lead to the provision of adequate quality medical services. Due to informational asymmetry with respect to the real cost of hospital services and quality of treatment, medical service buyers cannot influence cost reductions and increase the quality of treatment, which increases hospital power. Thus, when evaluating the impact of hospital competition on costs and quality of care, we must keep in mind that market mechanisms in health care do not always increase public welfare.

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