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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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    References listed on IDEAS

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    1. Melvyn A. Fuss & Leonard Waverman, 1981. "Regulation and the Multiproduct Firm: The Case of Telecommunications in Canada," NBER Chapters,in: Studies in Public Regulation, pages 277-328 National Bureau of Economic Research, Inc.
    2. Braeutigam, Ronald R & Daughety, Andrew F & Turnquist, Mark A, 1984. "A Firm Specific Analysis of Economies of Density in the U.S. Railroad Industry," Journal of Industrial Economics, Wiley Blackwell, vol. 33(1), pages 3-20, September.
    3. Braeutigam, Ronald R & Daughety, Andrew F & Turnquist, Mark A, 1982. "The Estimation of a Hybrid Cost Function for a Railroad Firm," The Review of Economics and Statistics, MIT Press, vol. 64(3), pages 394-404, August.
    4. Nyman, John A., 1985. "Prospective and `cost-plus' medicaid reimbursement, excess medicaid demand, and the quality of nursing home care," Journal of Health Economics, Elsevier, vol. 4(3), pages 237-259, September.
    5. Lawrence J. White, 1972. "Quality Variation When Prices Are Regulated," Bell Journal of Economics, The RAND Corporation, vol. 3(2), pages 425-436, Autumn.
    6. Richard Schmalensee, 1977. "Comparative Static Properties of Regulated Airline Oligopolies," Bell Journal of Economics, The RAND Corporation, vol. 8(2), pages 565-576, Autumn.
    7. Rosen, Sherwin, 1974. "Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition," Journal of Political Economy, University of Chicago Press, vol. 82(1), pages 34-55, Jan.-Feb..
    8. Brown, James N & Rosen, Harvey S, 1982. "On the Estimation of Structural Hedonic Price Models," Econometrica, Econometric Society, vol. 50(3), pages 765-768, May.
    9. Leffler, Keith B, 1982. "Ambiguous Changes in Product Quality," American Economic Review, American Economic Association, vol. 72(5), pages 956-967, December.
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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. 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.
    3. 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.
    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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