HEALTH ECONOMICS Health Econ. 8: 151–164 (1999) PRODUCTION FUNCTIONS INTERNAL MARKETS AND HEALTH CARE EFFICIENCY: A MULTIPLE-OUTPUT STOCHASTIC FRONTIER ANALYSIS U.-G. GERDTHAM a, *, M. LO  THGREN b , M. TAMBOUR a AND C. REHNBERG a a Centre for Health Economics, Stockholm School of Economics, Stockholm, Sweden b Department of Economic Statistics, Stockholm School of Economics, Stockholm, Sweden SUMMARY This paper has two purposes. The first purpose is methodological and aims to extend previous work on efficiency analysis by implementing a multiple-output stochastic ray frontier production function model. This model generalizes the single-output stochastic frontier model to multiple-input, multiple-output technologies and allows simultaneous estimation of technical efficiency and analysis of influential variables on efficiency. The second, empirical, purpose is to test for existence and magnitude of the effect of purchaser/provider split combined with new reimbursement schemes on technical efficiency in the Swedish public hospital system. The analysis is carried out with a panel data set covering the total population of 26 Swedish County Councils from 1989 to 1995. Our empirical results support the frontier model specification and indicate that output-based reimbursement improves technical efficiency. The potential saving in costs due to a switch from budget-based allocation to output-based allocation is estimated to be almost 10%. Copyright © 1999 John Wiley & Sons, Ltd. KEY WORDS — internal markets; stochastic ray frontier model; technical efficiency; panel data INTRODUCTION The Swedish health care system is publicly man- aged. The financing and delivery of health care services are supplied by 26 politically, economi- cally and administratively ‘independent’ County Councils (including some independent municipali- ties) in a monopolistic integrated system in which most facilities are owned as well as managed by the public County Councils. The system has been exposed to several reforms in recent years. One major reform is a purchaser/provider split within some of the County Councils. A common princi- ple in the reform has been to induce politicians to concentrate on the interest of citizens by separat- ing the consumer/purchaser and provider roles within the County Councils. The providers in these counties remain under public ownership, but politicians have decided not to be represented on the boards of hospitals and health centres. They, therefore, have lesser decision-making power at the operational level. In these organizations politi- cians are represented in collective purchasing units who are contracting with autonomous providers. The collective purchasing units usually receive their resources on the basis of population and need characteristics (number of inhabitants, age, etc.), which are used for purchasing health services from providers within the County Coun- cil, but purchases from external providers are also allowed. The implementation has mainly changed the way providers are reimbursed, and to a lesser extent the competitive environment for the hospi- * Correspondence to: Centre for Health Economics, Stockholm School of Economics, Box 6501, S-113 83 Stockholm, Sweden. Tel.: +46 8 7369283. Fax: +46 8 302115. E-mail: heug@hhs.se CCC 1057–9230/99/020151 – 14$17.50 Copyright © 1999 John Wiley & Sons, Ltd. Receied 20 April 1998 Accepted 26 October 1998