On the shape of the hospital industry long run average cost curve

Abstract

Empirical studies of the hospital industry have produced conflicting results with respect to the shape of the industry's long run average cost (LRAC) curve. Some of the studies have found a classical U-shaped curve. Others have produced results indicating that the LRAC curve is much closer to being L-shaped. Some theoretical support exists for both sets of findings. While classical theory predicts that the LRAC curve will be U-shaped, Alchian has presented theoretical arguments explaining why such curves would be L-shaped. This paper reconciles the results of these studies. The basis for the reconciliation is recognition of the failure of individual hospitals to produce all their individual product lines at efficient volumes. Such inefficient production is feasible and perhaps common, given the incentive structure which exists under current cost reimbursement systems. The implication of this paper is that large hospitals may have a greater potential for scale economies than has previously been recognized.