Question

In the US, the Social Security Administration (SSA) runs a government paid insurance program for retired workers and their spouses called Medicare. In 1983, Medicare changed the way it reimbursed hospitals for treating Medicare patients. Originally, Medicare paid hospitals fees that for each patient covered a portion of the hospital's total cost including both capital (equipment and space) and labor expenses. Under the new Prospective Payment System (PPS), the government reimbursement was made up of a payment computed proportionally to the hospital's capital expenses (equipment and space) and a flat rate based on a patient's diagnosis that did not take into account the hospital's actual use of labor inputs. Effectively, the shift to PPS left hospital's opportunity cost from using equipment and structures the same while significantly increasing the opportunity cost of using labor services. With the aid of an iso-cost-isoquant diagram, explain how the shift to PPS might have affected hospitals' relative use of capital and labor when treating incoming Medicare patients.

Answer 1

The shift to Prospective Payment System (PPS) in Medicare reimbursement affected hospitals' use of capital and labor. The cost of using labor services increased relative to the cost of using capital resources.

Step-by-step explanation:

The shift to Prospective Payment System (PPS) in Medicare reimbursement affected hospitals' relative use of capital and labor. Under PPS, hospitals were reimbursed based on a flat rate computed proportionally to the hospital's capital expenses and a fixed amount based on a patient's diagnosis. This change increased the opportunity cost of using labor services while leaving the cost of using equipment and structures the same.

The impact of this shift can be illustrated using an iso-cost-isoquant diagram. An iso-cost curve shows all the combinations of labor and capital that a hospital can employ for a given total cost, while an isoquant curve represents the different levels of output a hospital can achieve with different inputs. The shift to PPS would result in a steeper iso-cost curve, indicating that hospitals would need to use more labor and less capital to achieve the same level of output. This is because the cost of using labor services increased relative to the cost of using capital resources.