Economies of Scale

Hospitals

Economies of scale are most likely to be found in industries with large fixed costs in production. Fixed costs are those costs that must be incurred even if production were to drop to zero. In the extreme case, high fixed costs could lead to a natural monopoly situation, in which the most efficient (least costly) market structure would be to have only one firm providing a particular kind of good or service. In the long run, economists expect only one firm to “naturally” survive even in the absence of legal regulations. Yet, in a world where the rate of technological change is extremely high, one cannot rule out a situation in which multiple firms are providing the good or service; even this would be less efficient than a single firm providing the good or service. This is part of the rationale behind states' certificate of need (CON) laws, designed to contain costs by avoiding extensive duplication of services and redundant hospital capacity.

Studies investigating the possible existence of economies of scale in hospitals find mixed results. In part, this could be related to the large variety of services offered by individual hospitals or to demand conditions, such as transportation costs, that limit the economies of scale that can be realized. However, studies that focus on individual services characterized by high fixed costs, such as open-heart surgery facilities, CT scanner units, and therapeutic radiology facilities, often find evidence of economies of scale.

Scale economies are not limited solely to providers. Payers face long-run average costs, which incorporate capital, and other fixed set-up costs. High start-up costs in the insurance industry require many subscribers to cover those costs. The flip side is, of course, that high set-up costs represent barriers to entry, which inhibit competition. Firms in industries exhibiting economies of scale therefore tend to have market power.

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