Applied Economics, 1995, 27, 286-296 Resolving the impasse on hospital scale economies: a new approach H.E. FRECH III and LEE RIVERS MOBLEY University of California, Santa Barbara 93106 and Oakland University, Rochester, Michigan 48309, USA The existence of scale economies in hospitals is important for both public and managerial policy, yet production and cost functioti studies have found conflicting evidence. More recently, more sophisticated studies have typically found scale dis- economies, which is inconsistent with the views of industry participants and observers. In the early 1980s, California deregulated both private and public health insurance (MediCal), which provides a natural laboratory for examining hospital efficiency. Using Stigler's original and multivariate survivor analysis, we resolve the conflict in favour of scale economies, and reconcile the controversy. The survivorship method- ology is simple to apply, and a useful tool in conjunction with statistical cost and production studies. I. INTRODUCTION The existence of scale economies in the hospital industry has long been both a policy and a scientific concern. Empirical cost and production function estimates conflict: some flnd economies of scale and some, especially newer, more sophis- ticated ones, do not. This paper uses survivor analysis to resolve the quandary (in favour of scale economies) and suggests an explanation for why many statistical studies go awry. Also, the multivariate extension of the technique, following Keeler (1989) enables us to address one of the problems associated with classical, univariate survivor analysis, described by Shepherd (1967). Because the tech- nique captures the effects of all factors in addition to effi- ciency which enhance growth, it is important to control for these other factors statistically. We examine the eflect of chain affiliation, adverse selection, and local market condi- tions on survivorship, and we test the robustness ofthe basic results on scale economies. We use California data for 1983-89 because the state substantially deregulated health insurance in 1982 and because more detailed data are avail- able for these hospitals. California data California hospital markets in the 1980s provide an excel- lent setting for a survivor analysis because competition has recently increased due to policy changes. Important changes in insurance and insurance markets were enhanced, and Preferred Provider Organizations (PPOs) and Health Maintenance Organizations (HMOs), which had achieved modest market shares by 1980, grew phenomenally with the favourable legislation.' The survivor principle states that as competition in- creases, the firms which survive in an industry will be at least of minimum efficient scale. As a result of the increased competition noted above, California hospitals appear to be moving towards a new, more efficient size distribution. This parallels the trucking industry's response to deregulation, studied by Keeler (1989). II. CONFLICTING LITERATURE The topic of hospital scale economies has long been of concern to policy makers, as larger hospitals were seen as 'The 1982 Galifomia Medicaid Reform Bill allows selective contracting between MediGal or private insurers and hospitals. The MediGal contracts are forfixeddaily rates, regardless of diagnosis, while the private ones may be on any basis. Individual hospitals offer low rates in exchange for higher volume ofpatients (Bergthold, 1984). 286 0003-6846 © 1995 Chapman & Hall