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Quality Adjusted Cost Functions

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  • Paul J. Gertler
  • Donald M. Waldman

Abstract

We propose a simple method for estimating cost functions in the presence of endogenous and unobserved quality. The theory of production, the equilibrium conditions implied by optimizing behavior, and exogenous influences on product demand are used to identify the model. An important advantage of the method is that the data requirements, above those necessary for standard cost function estimation, are minimal and the data are usually readily available. Specifically, exogenous information that influences the demand for the firm's product is required. We apply this method to estimate quality-adjusted cost functions in the nursing home industry. Estimation of a translog cost function that ignores quality yields seriously misleading estimates of marginal cost and economies of scale. In particular, while estimation of a quality-exogenous cost function reports economies of scale, estimation of a quality adjusted cost function reveals diseconomies of scale for high quality homes, constant returns to scale for average quality homes, and economies of scale for low quality homes.

Suggested Citation

  • Paul J. Gertler & Donald M. Waldman, 1990. "Quality Adjusted Cost Functions," NBER Working Papers 3567, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:3567
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    Cited by:

    1. Joseph P. Hughes & Loretta J. Mester, "undated". "Evidence on the Objectives of Bank Managers," Rodney L. White Center for Financial Research Working Papers 4-94, Wharton School Rodney L. White Center for Financial Research.
    2. David C. Grabowski & Jonathan Gruber & Joseph J. Angelelli, 2006. "Nursing Home Quality as a Public Good," NBER Working Papers 12361, National Bureau of Economic Research, Inc.
    3. Dan Friesner & Robert Rosenman, 2004. "Non-profit cost-adjusting with quality as a private good," Applied Economics, Taylor & Francis Journals, vol. 36(5), pages 511-523.
    4. Ralph Bradley, 1994. "Growth Of U.S. Health Care Spending," Contemporary Economic Policy, Western Economic Association International, vol. 12(4), pages 45-56, October.
    5. Darius Lakdawalla & Tomas Philipson, 1998. "Nonprofit Production and Competition," NBER Working Papers 6377, National Bureau of Economic Research, Inc.

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