Medicare is the U.S. government-paid medical insurance system for the elderly and disabled. In 2011, Medicare paid healthcare providers (hospitals and physicians) $550 billion for services provided to Medicare beneficiaries.

Medicare works through a reimbursement plan.Hospitals and doctors treat patients, and then Medicare reimburses the hospitals and doctors according to a specific criterion.

Before 1983, Medicare used the following approach to reimburse hospitals and doctors.Hospitals and doctors would determine (1) their total costs for the year and (2) the percentage of total patient-days (the total number of days that all patients spent in the hospital) that came from Medicare patients.So, under this system, providers would spend money on labor and capital, and Medicare would reimburse them the percentage of these total costs that was equal to the percentage of their patients who were Medicare patients.

In 1983, the system for reimbursements was changed when the Perspective Payment System (PPS) was passed.Under PPS, capital expenditures - building additions, renovations, and purchases of medical technologies - were rebated as before.So a healthcare provider would get reimbursed a percentage of their capital expenditures that equaled the percentage of their patients who were on Medicare.Under PPS, however, the system for reimbursing labor expenditures was different.PPS paid providers a flat rate based on the patient's diagnosis, regardless of the actual labor expenditures. So, for example, a heart surgery would entitle the hospital to a pre-specified payment regardless of whether the hospital spent more or less on the labor inputs necessary to complete the task.

a.Intuitively, what effect would you think that PPS would have on the way that healthcare providers allocate their spending between capital and labor? Explain your reasoning.

b.Suppose that providers treat a yearly amount of patients that stays relatively stable across the years. (This implies that you can assume that a provider's level of output stays at some Q*.) Using isoquants and isocost lines, show the effect that you would expect PPS to have on healthcare providers' labor and capital expenditures.

c.Consider a hypothetical case of someone coming to the hospital with a minor head injury.How did PPS change the incentives that healthcare providers faced? What course of treatment would seem to be typical before PPS? How would you expect this to change following PPS?

d.Suppose that a researcher has data for many hospitals' labor expenditures and capital expenditures both before and after 1983.What would the data show if the data matched the prediction of economic theory?

e.Suppose that, in addition to the data described in (d), the researcher also knows the percentage of each hospital's patients who were on Medicare each year. Would you expect the result that you describe in (d) to be influenced by whether a hospital has a large percentage of its patients on Medicare or a small percentage of its patients on Medicare? Briefly explain your reasoning.