And Now For This Commercial Message

Check out this great new website -- www.newsle.com. The newsle service allows you to track news, the best news, about people. It works on both Facebook friends and on public figures.

This is my son's brainchild, along with his Harvard roommate, hence the full disclosure in this posting's title.

As Axel says, "The goal of Newsle is to make sure you never miss an important story about a friend, professional contact, or public figure you care about."

Go ahead, plug your favorite academic, businessperson, investor, or politician into it and see what news they are making or what is being said about them. Or maybe an ex-boyfriend or girlfriend, or the person who is threatening to sue you. I thought the CEO of BAA (operator of Heathrow airport) would make for an interesting search, which it does.

Key thing is newsle's ability to follow lots of people, with a very wide source of news, automatically for you.

Anyone have any commercialization ideas for this? Applications?

Chaos at Heathrow

Due to "heavy" snow -- about 7 inches, as far as I can tell -- and freezing conditions (15 degrees F tonight) -- the situation at Heathrow airport is chaotic at best. Some poor folks will be spending their their second or even third night at the terminal, with flights having been cancelled since Friday on. No flights left Saturday, and very few today.

What a mess.

Perhaps the chaps who run Heathrow should take a visit to Logan or even better O'Hare. Six to seven inches of snow will not shut them for two days! But, there is the question of optimal investment in snow plows. If these events are rare at Heathrow, they should have less capability. Offsetting this, however, is the very large cost imposed in those rare circumstances. The concept of insurance comes to mind.

And the rarity of the circumstances seems to be changing! Last December Heathrow got belted with snow as well. Some government official was quoted as saying they were consulting with their chief science officer. I would love to hear that discussion.

It does make one wonder how well the climate models do in regard to regional effects.

Where's the Outrage Over the Tax Bill?

When the Democratic Congress was loading the health care bill with sweeteners such as the Nebraska Medicaid exception (the Cornhusker Kickback) and other beauties like money for a new hospital in Connecticut, in order to buy votes, there was a nationwide outrage. Much of the pork, of course, remained, and one of the things I really don't like about the ACA is the amount of pork it spreads around. But there was outrage, especially from Republicans, and it did have some effect.

Now we have a Republican goal, extension of the Bush tax cuts, and the bill that emerges....surprise, surprise, it has a bunch of pork in order to buy support. Not only extension of unemployment benefits, but ethanol subsidies, investment credit, extension of child and marriage benefits....and the huge surprise of a one year reduction in the FICA payroll tax!! Where did that one come from? That I have to say makes no sense to me at all. We do not need more Keynesian stimulus financed by debt, and there is certainly no significant supply-side incentives created by a one year tax break that does not lower the marginal rate for anyone earning above the social security maximum earnings, a bit over $100,000. This one is truly a giveaway.

It really does seem that the Democrats and Republicans together are just trying to one up each other in how much money they can pretend to throw back to the taxpayers. Shameless.

But where is the outrage that we saw with the pork-laden health care bill?

Ah, hypocrisy. If one worries too much about all the hypocrisy in the world, one could work up to a real artery-buster.

If Obama wants to, I think the opportunity is there to show some real leadership by re-shaping the tax system.

Social Security vs. Individual Mandate: Constitutionality?

It is interesting to ask the question of constitutionality about the Social Security system in the United States: Social Security seems on the surface to be a requirement that everyone purchase retirement and survivors' insurance, so how did that pass muster with the Supreme Court?

Well, a little study of history shows that this was a big controversy back in 1937, when the Supreme Court took the case Helvering v. Davis. The Court ruled that Social Security was constitutional under the Tax and Spending Clause, Article I Section 8 of the US Constitution.

The US government, in that case, went to great lengths to argue that Social Security was not an insurance plan. It was just public policy to provide for the general welfare of the country, and it was supported by a tax system not directly related to the specific policy. The Court agreed.

Note the difference with health care insurance today, and the individual mandate. It seems pretty clear that the individual mandate is to buy insurance -- a real contract with a private company, not a "maybe we will give you something when you retire" sort of scheme with the Federal government (again, the government argued that social security was NOT an insurance contract in the general meaning of that phrase). And you could avoid social security by not working and not paying the tax. The penalty of the individual mandate is a funny kind of tax for sure, which you avoid by engaging in the activity.

Remember that the individual mandate exists to avoid folks gaming the system, waiting until they get sick to buy insurance. Such behavior results in pre-exisiting conditions clauses, something most of us find very disturbing. But there are other ways around this problem, as in requiring insurance companies to issue to anyone who has continuous coverage (see my earlier posts). To save the folks who still game the system and end up sick and at our doors begging for mercy, there could be a high risk pool (as there now is) funded by general tax revenues...or even a tax on the insurance that the rest of us buy. Such a plan would seem to be on safer constitutional ground as it does not mandate that anyone do anything.

Such a plan is not without its problems, and would still be subject to gaming unless the high risk pool carried a significant cost, as in substandard coverage. Such a plan also would have would have made the price tag of dealing with those who try to avoid buying insurance real obvious, with the cost to everyone clear in the taxes they paid.

So in order to get the Bill passed (and I think to be able to say that the US has mandatory coverage) the Administration opted for the tactic of making everyone buy insurance, thereby avoiding the price coming to the government and having to be funded by taxes. And we are in the midst of a long protracted legal battle -- with declining support in the public and in Congress for the bill. Again, go back to the Social Security court fight -- there we had increasing public and Congressional support for the legislation.

Individual Mandate Ruled Unconstitutional

Here is but one choice quote from the judge in Virginia (see here for the whole decision: "The use of the term "tax" appears to be a tactic to achieve enlarged regulatory license."

There were a couple main parts of the decision; this quote was a summary of why the penalty for not buying insurance cannot now be construed as a tax, and therefore constitutional under the taxing power.

The main part of the decision lays out the arguments for why inactivity cannot be regulated under the Commerce Clause, and why regulation of inactivity cannot be construed as constitutional under the Necessary and Proper Clause.

All in all, a very intriguing development. It concerns me that so little thought was put into this issue during the legislative process -- recall Nancy Pelosi's comments almost questioning someone's intelligence for even thinking that the law might be unconstitutional. "When CNSNews.com asked House Speaker Nancy Pelosi (D-Calif.) on Thursday where the Constitution authorized Congress to order Americans to buy health insurance--a mandate included in both the House and Senate versions of the health care bill--Pelosi dismissed the question by saying: “Are you serious? Are you serious?”"

Was so little thought also put into other elements of the health care bill, as in the employer mandates?

I think our country, through employers primarily, are in for a major regulatory burden because of this law. And it did not need to be that way.

See posts below on thoughts of avoiding the individual mandate. There are ways to get much of what we need to do in health insurance reform without an individual mandate. We will have to, however, be willing to face the consequence that someone who willingly goes without health insurance will be put into a high risk pool with limited coverage.

Admirers of European socialist-leaning democracies and health care reform zealots will bemoan the lack of Federal power in prescribing behavior of US citizens. I view this decision as a firm reminder that some principles stand above even health care -- as in, our system of a constitutional democracy whereby the Federal government has limited and enumerated powers. As much as we might like the ends here, the means are simply not justified, and that is a more important principle than getting health care for all through an individual mandate.

Thorny Issues of Insurance Availability and Renewability

If the individual mandate gets struck down, as I argue could well happen in my post below, then other mechanisms will be needed to avoid the more egregious problems that tend to occur in health insurance markets.

I highly recommend two articles that address some of the issues in thought-provoking fashion: Cochrane, "Time Consistent Health Insurance," Journal of Political Economy 1995; and Patel and Pauly, "Guaranteed Renewability and the Problem of Risk Variation in Individual Health Insurance Markets," Health Affairs, Aug 28, 2002.

The Cochrane piece casts health insurance as having two components: the insurance of health expenses in a period, and then the insurance against premium increases in the future. His basic argument is for time consistent insurance contracts that get "marked to market" each year. If an insured has gotten sicker during the year, so that their risk-based premium increases for the future, then the "second" insurance contract pays an amount equal to the present value of those premium increases. Presto -- the consumer has the money to pay the increased premiums. The problem of having insurance companies raise premiums when you get sick has disappeared, through the magic of mark to market contracts! (As I note below, symmetry requires the consumer to pay money to the insurer if the consumer's health improves over time, but Cochrane shows that the cash flow implications of this can be easily dealt with.)

The Patel and Pauly article argues for a similar in spirit but practically different arrangement to prevent the problems of premium increases upon illness -- the idea of guaranteed renewability, and at a price that does not reflect any changes in health. So long as you stick with your existing insurer, they must renew you each year, and at prices that do not reflect your benefits history. In fact, as Patel and Pauly show, most states regulatory schemes already required this, and historically much insurance had this long term feature (see below my point on term life insurance).

Both of these papers show that one thorny issue, the prevention of having health insurance premiums skyrocket in price upon becoming sick, can be relatively easily solved, with a minimum of regulation. But in reading these papers, many ideas and concerns come to mind.

Think of your own term life insurance, if you have such insurance. I do, and it is guaranteed renewable for a term of 20 years. The price each year goes up only with my age -- an event that nobody can insure against! So I am protected against my insurer raising my price if they were to discover that I had a heart attack. Am I in some sense "stuck" with my company? Yes, at least if I am no longer healthy, because it would be hard for me to switch insurers at that point. But at least I still have my existing insurance. Is there the possibility that another company will try to induce healthy people away from their existing carriers with policies that reflect their lower risk? One would think so, but I am hardly inundated with such offers. One suspects that perhaps those kind of selection problems are not as serious as the textbooks make them sound.

A concern I have with the Cochrane idea is the ability for consumers and insurers to reap the benefits of specific investments in health. Suppose I do all I can to improve my health -- exercise, diet, all risk factors. Cochrane dismisses the role of behavior on health, but the thinking on that has evolved. Just look at obesity and diabetes. Much of my investments in health will be unobservable to others. As my insurance policy only gets marked to market on the basis of observable risk factors, I am left with no reason to improve my health. In fact, since the contract requires the consumer to pay money to the insurer if they get healthier (remember the consumer gets money from the insurer if they get sicker) I can envision negative incentives to invest in one's health. Of course, existing insurance policies also fail to give me much incentive to increase my health. And if an insurer were to spend money on consumers to improve their health (think employer-based insurance) there is no way for the insurer to recoup those investments if the consumer switches carriers. One yearns for a mechanism to make the new insurance carrier pay the old one for consumer-specific investments in health.

Neither the Cochrane or Patel/Pauly ideas covers the problem of people gaming an insurance system by not buying any insurance until they are sick. Cochrane might respond with, "well, they pay their risk-adjusted price at that time". The problem with that is that society will not tolerate the outcome of sick people facing prohibitively expensive insurance.

If the individual mandate is struck down, and the problem of gaming the system is quantitatively important to the overall insurance market, then there has to be some significant cost to people who wait until they are sick to buy insurance, enough to make such behavior unlikely in the aggregate. And this needs to be done without a mandate to buy insurance enforced via a penalty for not buying it. A reasonable approach might be a low quality Medicaid type insurance policy priced at a significant portion of income for those who have not maintained health insurance, public or private, over their lifetime. Since children are now on their parents' policies until 26, most children will automatically have continuous coverage through that age. All they would need to do at 26 is buy a longterm policy a la Cochrane or Patel/Pauly and maintain it until they hit Medicare age.

The Individual Mandate and Insurance Markets

I believe there is at least an even chance that the Supreme Court will strike down the individual mandate in the new health care bill. Here is a paragraph from the Court's decision in US v. Lopez, the first case in decades that did limit the powers of Congress under the commerce clause of the Constitution:

We pause to consider the implications of the Government's arguments. The Government admits, under its "costs of crime" reasoning, that Congress could regulate not only all violent crime, but all activities that might lead to violent crime, regardless of how tenuously they relate to interstate commerce. See Tr. of Oral Arg. 8-9. Similarly, under the Government's "national productivity" reasoning, Congress could regulate any activity that it found was related to the economic productivity of individual citizens: family law (including marriage, divorce, and child custody), for example. Under the theories that the Government presents in support of § 922(q), it is difficult to perceive any limitation on federal power, even in areas such as criminal law enforcement or education where States historically have been sovereign. Thus, if we were to accept the Government's arguments, we are hard-pressed to posit any activity by an individual that Congress is without power to regulate.

This was the case on the Gun Free School Zones Act, and the Government argued that it had the power to regulate guns in school zones under the commerce clause because: a) guns increase the cost of crime, which affects commerce among the states; and b) guns and crime affect national productivity, which also affects commerce. The Court states quite clearly that these arguments would justify any police power at the Federal level and therefore cannot be right.

In terms of the individual mandate, the parallel argument would be that if inaction -- failure to buy a product -- is considered to be reachable under the commerce clause, then the regulatory power of the Congress would be expanded into a region that would further make the commerce clause infinitely powerful. In Lopez, the Court was willing to draw a line in front of an activity that was not sufficiently related to interstate commerce. I can certainly see another line being drawn, a very bright one it would seem, at the distinction between inactivity and activity.

If the mandate is struck down, then some creativity will be required in insurance markets in order to maintain some of the accomplishments of the health care bill, in particular the avoidance of universally-hated insurance policies such as restrictions on pre-existing conditions and indiscriminate premium increases. My next post will get into some of these issues.

Some Economics of the Employer Mandate

It is exceedingly difficult to figure out from the text of the health bill itself just what are the employer responsibilities under the new health bill. First, which bill does one actually look to? The original House bill, the Senate bill, or the reconciliation bill? I have yet to sort that out...which gives you an idea why people can be justifiably upset about this legislation.

But I trust some lawyers and accountants to sort it out for me. See here for a nice summary piece from the law firm Mintz Levin. I have seen other descriptions that are the same, so I think this is correct.

The basic employer responsibility is two-fold: one, provide "minimum essential coverage" to your employees; and two, make sure it is affordable. Affordable is obviously a key definition. From the Mintz article: "...coverage is deemed "unaffordable" if the premium required to be paid by the employee exceeds 9.5% of the employee's household income." Also, a plan is unaffordable if it covers less than 60% of the total cost of benefits. That 60% rule is actually quite complex, as it involves the actuarial value of the plan with a standard pool of participants. Take a standard pool of participants, simulate them through your health plan -- if the participants pay more than 40% of total costs (through deuctibles and copays) on average, then you do not have an affordable plan.

If the employer does not offer coverage or affordable coverage, it will pay a penalty. The calculation of such penalty -- or is it a tax? -- is itself complicated, depending on the number of employees not being offered coverage and who get a subsidy on insurance they buy on their own (remember there is an individual mandate too). Let us say that it is $3000 per year per employee who does not get offered affordable, minimum essential coverage.

As I write this, I realize just how complex all of this is, and think that perhaps the biggest burden on business is going to be paying the accountants, lawyers and consultants to figure all this out. If the rate of business formation takes a hit, I for one won't be surprised.

But my main focus in this posting are the economic effects of the employer mandate on the labor market.

The basic economics would seem to be the following. Employers must offer employees subsidized insurance in additon to any wage paid. This lowers the demand curve for labor by the cost of the insurance to the employer. Employees get a subsidy, therefore the supply of labor also shifts down by the value of the insurance to the employee. The supply/demand figure shown here illustrates the shifts in the demand and supply for labor.

The key issues are these: (1), Is the cost of the insurance to the employer equal to the value of the insurance to the employee? (2), Can wages freely adjust?

As to point (1), if we took the position that $X of insurance provided by the employer must be valued at $X by the employee, then the way I have the curves depicted would be correct. The demand curve shifts down by $X and the supply curve also shifts down by $X (think of the wage and the insurance all being in annual amounts). Then the new equilibrium is at the same quantity, but at a wage that is reduced by $X. Think of it like this: The government says that employees must be paid 90% in cash and 10% in a dollar-based voucher that can be purchased on a dollar for dollar basis and can be spent on anything. Then the cost of a $1 voucher is $1 and the value to the employee is $1. Clearly this does not affect the equilibrium except that some of the wage is paid in vouchers instead of cold hard dollar bills.

In this case of health care, however, employees do not get vouchers for anything but they get a specific good, health insurance. Economic theory shows that payments in kind are generally worth less than payment in cash. That many employees do not now spend their money on insurance supports this idea. So in this case, the supply curve would shift down less than the demand curve shifts down, and employment will fall.

There is a counterargument, based on the market failure in insurance markets. Suppose that adverse selection is making insurance either unavailable or priced such that some individuals choose not to buy the policies available. Then $X of insurance offered by an employer could not only be valued at $X but even by more than that. In this case, the supply curve of labor would shift down by at least as much as the demand curve falls, and employment could even increase.

Point number (2) from above, can wages freely adjust, is also important to consider. First, wages are notoriously sticky downwards. This is the main reason why labor markets do not clear and we get unemployment. With sticky wages, the adjustments pictured in the graph will not happen, or at least not quickly. Labor demand will drop and labor supply might increase, but the money wage will not fall by the value of the insurance. In this case, labor demand will determine employment, which will be lower than before -- at the point where the old wage intersects the new and lower demand curve. Since more people are willing to work than before, there is observed unemployment.

Another reason for sticky downward wages is the minimum wage. To the extent that the current wage is already above market clearing levels because of government mandate, employment is already being determined by the labor demand curve alone. As that shifts down because of the insurance mandate, employment falls and measured unemployment increases.

The summary of all this? Using my prior beliefs on the differential value of insurance between employer and employed (reasonably higher to the employee) and the very significant downward inflexibility of wages, I predict less employment.

The Democrats' Closing Arguments

Paul Krugman: "So if the elections go as expected next week, here’s my advice: Be afraid. Be very afraid."

Robert Reich:
"Why Business Should Fear the Tea Party"

President Obama: "We're gonna punish our enemies and we're gonna reward our friends who stand with us on issues that are important to us."

The comforting thought of Robert Reich looking out for business interests will keep me smiling all day long.

A Parking Proposal

It always strikes me how unwilling many people are to use prices to solve problems of scarce resources. Parking on college campuses is a prime example, and Dartmouth serves well as a case in point.

The parking lot close to the Tuck School fills up by 8:15am; if you arrive after that, you will have to hike a distance of at least 10-15 minutes. Now I know that may not sound like a catastrophe, and even be good for one's health, but the value of people's time is significant. When it is raining or snowing, or just plain cold (as in below zero) a 15 minute walk across campus is quite unappealing. And of course it is on such days that the parking lot fills up by 8:05 am.

The major cost of not having adequate parking is that faculty will simply choose to not come in to work. On days when not teaching, a professor can just as effectively work from home. Unfortunately, they are then not mingling with others on campus and the lifeblood of the university -- collegial, intellectual interaction -- drains away. For junior faculty, if senior folks are not around, this is a very serious problem. This is not a visible effect, but it is there, and college administrators who ignore it are ill-advised.

This effect also occurs during the day, if an employee has to leave for an off-campus meeting. Not knowing if there will be a spot when they return, many will go home and finish the day there.

Other less important effects are the waste of time spent circling for a free spot (and the gas and carbon) and the time spent trying to be the early bird. I really hate seeing people idling their cars in the parking lot waiting for someone to show up and leave, yet that happens regularly. Where are the green police when you need them?

So what is the answer? Raise the price of parking in the lots closest to campus. Raise the prices until the market clears and the excess demand disappears. "The beatings will continue until the whining stops."

Why the vehement objection to something like this? The usual culprit is that lower-paid employees will not be able to afford the increases, or just that such price increases are a larger part of lower-paid employees' income, so they hurt them more. Yes, that is true, and it is a valid complaint. But the complaint is confusing the incentive effects of higher marginal prices with income effects.

The way to get around this objection is as follows. The rate for on-campus parking right now is $30 per month and $22.50 per month in remote lots. First point: these prices are way too low to have any meaningful incentive effects, and the discrepancy between lots is a joke -- $7.50 per month, $90 per year. Ha!

So the rates should be something like $100 per month for on-campus lots and $20 for remote. Now we are starting to get into an incentive-relevant region. I suspect many people would opt for a remote lot if it meant $960 per year in their pocket.

But here is the real kicker. To put just the price effect into play, without the negative aspects of an income effect, the College can give everyone a cash bonus in their paycheck equal to the increase in rates: $70 per month, or $840 per year. So everyone can keep their current parking and their overall financial situation is unchanged.

But! Anyone can also switch to a remote lot and save $80 per month! Note how this is more of a carrot approach than a stick. Instead of just saying, "parking is more expensive" we are saying, "Parking is more expensive, but we are going to give you additional money to spend how you like. For many of you, spending it on parking is probably not the best use."

Yes, to the extent that people switch to the lower cost lot, the College loses some money. I confidently conjecture that the gains from increased presence on campus and time and fuel savings will far outweigh the loss of revenue. But if that is such a big problem, then I propose this: have the cash bonus paid only to lower-income employees, accomplished through a sliding reduction of the payment. Something like this: the payment is the full $840 per year for anyone earning less than $50,000, and then it phases out linearly between $50K and $100K. This will make the proposal revenue neutral or even revenue positive for the College.

There are a few minor complications that would have to be dealt with, such as the fact that lower income employees actually only pay $12 and $9 for on-campus vs. remote parking right now. See how fairness and equity issues get resolved through pricing of resources -- exactly the last thing you want to do!! For crying out loud, a parking spot is a parking spot; its price has to be the same to everyone so that we all face the same cost of using it! Prices of parking will have to be raised significantly to these lower income folks, but again, they can be given a cash bonus to offset the impact. They will in the end be better off -- as evidenced by their willingness to forego expensive parking for more cash but more walking.

I am going to be pushing this one.

Patient-Based Cost Saving Incentives

There is a lot of talk about new payment schemes for health care providers as possible ways to control health care cost and improve quality. The general principle behind the plans is to create incentives for providers to save cost while maintaining or even increasing quality. Payment systems have to put some risk onto the provider, as through a fixed payment for the care of a population, with residual risk borne by the provider. The theme of "accountable care organizations" includes some form of risk-sharing or savings-sharing, as do payment schemes such as "global payments" or "bundled payments." Of course, Medicare does this to some extent already, by paying providers a fixed fee for a DRG -- diagnostic related group.

What I don't see in any of these discussions is extension of the risk- or savings-sharing to the patient/consumer.

Without bringing the patient to bear on the equation, I fear that we will be trying to make the proverbial horse drink from the stream. We will encounter the problems that HMOs (health management organizations) encountered some years back, when consumers paying good money for health insurance ran up against providers who had incentives to reduce care. Yes, I understand that quality is in the forefront today, but I still think there is a basic conflict with consumers who face a marginal price of zero and a provider who wants to do less. That is a recipe for trouble. We have to somehow reduce the moral hazard problem of consumers demanding care to the point where marginal value is zero (which is typically the marginal price they pay).

One idea one of my colleagues has is for insurance companies to give consumers a lump sum when they are sick -- like your car insurer does when you have a crash. Broken leg? OK, that usually costs $10,00, so here is a check for that amount, do what you want.

The big problem with this is it puts all the risk onto the patient, who is even less able to bear financial risk from cost uncertainty than the provider. There is also the problem that some folks won't get the leg fixed -- we will be a nation of limpers.

But there is another way to do it. How about the insurer says: OK, broken leg, that usually costs $10,000 in our pool. If you can get your leg fixed for less than that, you get to keep 33% of the difference.

Voila!! No risk to the consumer, just upside potential. The insurer will have to price policies a bit higher on average, since they bear all the downside risk and share the upside. But that could be priced easily. As consumers started shopping around and asking providers to cut costs, the whole distribution of cost would shift down. This would unleash tremendous forces to cut cost while keeping quality high. And consumers would not be complaining, for they would be getting paid to save!

I like this idea a lot. It creates tremendously powerful incentives on the patient side, without the problems that other incentive mechanisms have. For example, high deductible policies have the (possible) risk of inducing patients to not take enough preventive care, and both deductibles and copays have to run out at some point if the consumer is not going to bear a tremendous amount of risk. In fact, this is such a good idea that it must be out there somewhere already.

More Fuel for the "Administration is Anti-Business" Fire

The Obama Administration's Justice Department announced an antitrust suit against American Express, after Amex failed to agree to changes to its contracts with retailers. See here.

I have three thoughts on this case. First, I see it as an example of the "economic engineering" philosophy of the Obama administration economics policy. If they see something that they don't think is right, like credit card fees to retailers that seem too high (or health insurance prices), they look for some regulatory scheme to fix it. In this case, the regulatory scheme of choice is antitrust law (which is meant to prevent inefficient exercise of market power, not to simply push down prices that seem too high).

We had a seminar by Ed Leamer of UCLA last week, and in his paper he quoted Frederic Bastiat (1848) as follows: "There is only one difference between a bad economist and a good one: The bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen."

Economic engineering of the sort we are seeing is bad economics. It tries to regulate the visible and ignores the unpleasant fact that economic forces will cause adjustments and outcomes that are even worse. Regulating credit card fees sounds great for consumers, but what if it causes less competition in the credit market, or causes companies like American Express to change their very successful and consumer-friendly business model as a result? Or what if threatening insurance companies causes them to stop issuing policies?

My second thought is on why this is essentially an anti-business policy. At best, this policy is a misguided attempt to help "consumers" without consideration of the impact on companies and their owners (also consumers, but in the form of shareholders). That is antibusiness. Even worse, the policy smacks of pitting large business -- banks and payment networks -- against "small" business -- the retailers (is Gap really a small business though)? Even scarier is the hint that just like Secretary Sebelius in threatening insurers, this case is the follow-through of a threat by Justice against Amex: either change your behavior or we will bring you to court. While such threats are OK in many instances, I get the feeling that this Administration likes to flex its muscles a bit too much, and the flexing is usually aimed at getting prices to change from free market levels.

Third thought is on the antitrust case per se. Amex has about a 25% share of the card payments business, a level that is reasonably high but, I believe, below thresholds normally used in such cases. The overall market is somewhat concentrated, at least on some measures (not at the issuing bank level, but on the network level). These facts I agree make the case interesting. However, Amex has a very good efficiency argument for its policy of not permitting retailers to offer consumers discounts for using non-Amex cards: such behavior is free-riding off the investment that Amex has made in its brand name and what "American Express Accepted Here" means. Consumers are attracted to stores that display the Amex logo, but once in the store, the retailer has incentive to induce them to use other payment means. But Amex only collects revenue if the consumer who was brought into the store by the Amex logo then uses the Amex card. Go back and read the classic article, Howard P. Marvel, Exclusive Dealing, 25 J. L. & Econ. 1 (1982).

If the retailer does not think that the Amex logo on its door is worth the restriction, it is perfectly free to drop Amex as a card and no longer display the logo.

That is a pro-business attitude: freedom of contract.

Does the UK need a tea party?

I would love to see the reaction of the tea partiers if this were proposed in the US!

The UK's tax collection agency is putting forth a proposal that all employers send employee paychecks to the government, after which the government would deduct what it deems as the appropriate tax and pay the employees by bank transfer.

See here for more on the proposal, from CNBC.

I grant that it is not all that different from the withholding that we endure, but something about the cosmetics of "your check got sent to the IRS before you" doesn't seem quite right.

Good for a laugh.

On The Road to Price Controls

A while back I was angry with Kathleen Sebelius, the Secretary for Health and Human Services, for her shameful ranting against insurance companies that raised prices -- see this earlier post, for instance: http://robertghansen.blogspot.com/2010/02/price-increases-on-individual-health.html.

But it now gets even worse. After some insurance companies announced future rate increases for individual plans, the Secretary of HHS wrote a letter to the insurance industry. As reported in the WSJ:

The Health and Human Services secretary wrote that some insurers have been attributing part of their 2011 premium increases to ObamaCare and warned that "there will be zero tolerance for this type of misinformation and unjustified rate increases."

The whole Sebelius letter can be read here.

What would the government do to companies that passed out "misinformation" and had "unjustified" (gasp!) rate increases? One action would be to ban such companies from participating in the insurance exchanges that were mandated in the new health care bill. From the Sebelius letter:

We will also keep track of insurers with a record of unjustified rate increases: those plans may be excluded from health insurance Exchanges in 2014.

And this is even scarier:

Later this fall, we will issue a regulation that will require state or federal review of all potentially unreasonable rate increases filed by health insurers, with the justification for increases posted publicly for consumers and employers.

Potentially unreasonable? Definition, please?? In anything close to a market economy, would one expect to have to justify to the Federal government every price increase? Does the Obama Administration wonder any longer why it is being painted as anti-business?

Guest Post on Net Neutrality

A recent student of mine, Brent Mattis, wrote the following on net neutrality. It makes some good points, especially the one on the heterogeneity of consumers, with some willing to accept lower tiers of service quality for a lower price.


"My friend posted a funny image showing the price structure of a
future ISP if proposed network neutrality regulation fails to pass:

http://i.imgur.com/5RrWm.png

It basically resembles the worst parts of your cellphone and cable
subscriptions. The services are expensive, the offerings are limited,
in short it's awful.

If that truly was the future of high-speed internet access without the
proposed legislation I'd have to debate setting aside my libertarian
sympathies on the issue. Fortunately, for the reasons I'll ellucidate
below I think that is NOT what the future of internet access will be
without network neutrality regulation.

First let's take a trip down memory lane. Back in 1999, my house had
two options for high-speed internet access, ADSL for $60/mo or ISDN
for $150/mo, both provided by the local phone monopoly.

In that a situation I could imagine a company like Bellsouth tampering
with access as envisioned by the artist above. Now however, customers
have significantly more options. To enforce mediocre, high-price,
non-neutral service, ISP's would have to form a cartel.

Fortunately, cartels are only stable in two situations:
1) the resource being offered has very limited natural supply (imagine
there are only two iron ore mines in the world)
2) the government grants cartel-like privileges to the firms (for
example, airlines prior to deregulation).

Because of the relentless march of technology, the former seems pretty
impotent. Between DSL, Cable, Microwave, WiMax, 3G, LTE, 4G, Muni
WiFi, Satellite, Powerline, FiOS, 802.20, WiFi Mesh networking, I
think it would be nigh impossible for BellSouth to provide both bad
services and high prices. If Bellsouth told me they would charge me
$80 dollars/mo for service without access to Usenet or Bittorrent, I'd
tell them, thanks but no thanks. In a competitive market place,
customers are king. Take one example, when Comcast started to throttle
Bittorrent traffic, hellfire and brimstone rained down upon them...
other ISP's certainly took note.

This isn't to say that in a competitive scenario, such as the one I
feel is likely, some ISP's might provide 'content-constrained'
internet service, for a very cheap rate. Many gamers might love to pay
$10/mo for a low latency connection that blocked access to Usenet and
Bittorrent. Other folks might opt for a free service that used a
gatekeeper that set Bing as their permanent homepage. These are
options that benefit the company and the consumer. These are options
that wouldn't exist in a world with government mandated network
neutrality.

We can't say in advance what the market structure will evolve to, but
I would caution that putting the FCC in charge of the ISP industry
will likely have unintended consequences. If the FCC holds the power
to license ISP's, we will be one step closer to the cartelization that
would all but guarantee high prices and shitty service."

The (Difficult) Route to No Tax Rate Increases

How do Republicans arrange for maintaining the Bush tax cuts for everyone when the Democrats want to raise rates for those earning more than $250,000? Impossible feat? Maybe not.

The key is to present the Democrats and the President with only two alternatives: either the Bush cuts are maintained across the board, or everyone sees their taxes go up. No in-between option of "cuts only for the middle class."

I suspect that Democrats would rather take cuts for everyone than the alternative of no cuts at all. Sure, their base of liberals would be furious that the "rich" are getting a tax cut, but the liberals are going to vote Democrat anyway. How many votes will they lose if November comes, the economy is still moribund, and there has been no action on preventing the largest tax increase on record to take effect come 2011?

So how do we get to the point where the Dems have only those two choices? The Republicans have to make Democrats think that they are willing to accept a stalemate -- no tax cuts for anyone. The rational fear of an impasse, given my assumption above that the cost of no tax cut is really high for the Democrats, will make them accept the less desirable alternative of cuts for everyone.

How do Republicans credibly signal to Democrats their willingness to accept a stalemate?

Ironically, I think John Boehner might be off to a good start with these words:

In a pre-taped interview to appear on CBS' "Face the Nation" Sunday, Republican House Minority Leader John Boehner said that, if approving a bill to extend breaks for middle class income Americans were "the only option," he would support it.

To make the threat of opposing "cuts only for the middle class" credible, the Republicans need to establish a public record that they could point to in their defense, if the end result is a logjam and all tax rates go up. This is what Boehner said -- he will not oppose a middle class-only cut. And the White House jumped on his statement, giving it even more publicity and authenticity. So now the Republicans are on record for not opposing a cut only for the middle class. Clearly if we don't get that, it will be the Democrats' fault!

Of course, now the Republicans do have to work for the whole package, cuts for everyone. They need to play chicken, holding off any vote for as long as possible, making the Dems more and more nervous that there will be too little support for cuts only for the middle class. Tell them that there would be enough votes for an across the board maintenance of the Bush cuts, but that the middle class only option looks like it will fail...

Still a long shot, but I can see the road-- well, a small path -- to victory on this one.

The Amazing Keynesian Resurrection

I am dumbfounded at how talk of taxes and spending is focused almost exclusively on the demand-side stimulus effects rather than supply-side incentives.

This is certainly true for the question of maintaining the Bush tax cuts. Almost to a person, the question hinges on whether the "rich" will spend their tax cuts or save it. Funny how saving is seen as a negative! But even worse is the lack of serious argument on the effects of higher marginal rates at higher income levels on labor supply, entrepreneurial effort, and investment. I had to chuckle when one liberal outlet noted that while some of the highest income tax returns are due to small business income, those returns only represent a minor percentage of all small business. How is that relevant? And maybe we should actually be concerned with those small businesses that are actually profitable?

But the frosting on the Keynesian birthday cake came today with Bill Gross' (head of PIMCO, Pacific Investment Management) propoal for Fannie Mae and Freddie Mac to somehow reduce mortgage rates on millions of mortgages. The rationale? Here it is:

"That [action] would obviously benefit the homeowner to the extent of one-third of its future payments,” he said.

“In terms of real dollars, it’s a $50 billion to $60 billion push or stimulus going forward. In my estimation it would lift housing prices by 2 to 5 percent, which is an important policy objective of the administration.”

So let me get this straight. Since the Federal Government has tapped out the public's appetite for borrowing and spending, let's do it by subterfuge: take from bondholders and give to homeowners. Voila! Redistribution and Keynesian stimulus all at once.

Bondholders should be furious at such ideas. If homeowners want to refinance, let them do so on their own. And if they cannot, well, that is the deal that they entered into.

Information Economics and Medical Testing

I have been talking to some colleagues about the issues around medical tests, in particular whether some tests provide such low quality information as to be of negative value. The PSA test for prostate cancer is a case in point, especially for men of my age. Should men around the age of 50 get the PSA test? My understanding of this test is that it reports a number from 0 to infinity, with higher numbers and a positive rate of change being thought to signal the presence of prostate cancer. Critics of the test note a high rate of false positives.

There are many other situations where medical tests are possible, from full body scans to mammograms. None of these tests are perfect. They will fail to detect cancers (false negatives) and they will signal cancer when none is present (false positive).

There is definitely a community of health professionals who advise many patients to not get the tests – and this is not because the tests fail to provide value in excess of their cost, but because the tests are actually thought to be of negative value even without considering their direct cost.

Note that this idea conflicts quite extremely with an idea that many economists would hold, which is that any information is good. As one of my colleagues puts it: The test has been done, and your doctor has emailed it to you. Would you actually pay for an email filter that would prevent you from seeing that message? If the test has negative value, you would pay for a filter. If the test is of even small value, you would open that email!

This is an important question, of both personal and social value. It deserves adequate consideration. I am going to give some initial analysis, using a framework from Bayesian statistical and decision theory, which I think is the optimal approach.

I am going to begin with what I call a Robinson Crusoe world, where the decision maker acts individually and only in consideration of his situation. So third party effects, such as influence by doctors, will be ignored.

The information setup is as follows. Bear with me if you have not done Bayesian analysis for a while, but it is pretty straightforward. This is all standard stuff; if you want to read more I highly recommend an old survey by two of my UCLA professors: Hirshleifer, J & Riley, John G, 1979. "The Analytics of Uncertainty and Information-An Expository Survey," Journal of Economic Literature, American Economic Association, vol. 17(4), pages 1375-1421, December.

In a Bayesian decision setup, we have three kinds of variables: states of the world; messages, and actions. Here, we will have only two states of the world: cancer, or no cancer. Messages are what the test provides. Now the PSA test is a continuous variable, and later I will return to that characteristic. For now, think of the test as returning one of two messages, m1 or m2. Message m1 can be thought of as a low PSA, below a critical value, while message m2 can be thought of as a high PSA, above the critical value.

There are four possible (message, state) outcomes, illustrated by the two-by-two matrix at the top of this post: Two of these have the message being consistent with the state, (m1,s1) and (m2,s2). Then we have two outcomes where the message is in error: a false negative of (m1,s2) and a false positive of (m2,s1). Note in this I am assuming that m1 is the message that we will think of as being the “no cancer” message, i.e., a low PSA.

The key probabilities for decisionmaking will be the posterior probabilities, which are derived from priors and the joint message/state probability density. More precisely:

(1) Pr (s1|m1) = {Pr(m1|s1)Pr(s1)} / Pr (m1)

(2) Pr (s2|m1) = {Pr(m1|s2)Pr(s2)} / Pr (m1)

(3) Pr (s1|m2) = {Pr(m2|s1)Pr(s1)} / Pr (m2)

(4) Pr (s2|m2) = {Pr(m2|s2)Pr(s2)} / Pr (m2)

Note that the message likelihoods – Pr(m2|s2) for example – are a function of the test’s characteristics and quality. For better information quality, we want large differences in the probabilities of a message conditional on different states.

The last two posterior probabilities are the important ones as they are our posteriors after getting the bad message: the probability of not having cancer dependent on getting m2, and the probability of having cancer dependent on getting m2. Note that these two posterior probabilities will differ from their respective prior probabilities, depending on how far the ratios of Pr(m2|s1)/Pr(m2) and Pr(m2|s2)Pr(m2) are from 1. If Pr(m2|s2)/Pr(m2), for example, is much greater than 1, then the posterior probability of having cancer conditional on getting the bad message will be much higher than the decisionmaker’s prior probability. This means that m2 is a highly informative message.

Now we can consider taking actions conditional on a message. I will presume the action to be “treatment,” with the implicit understanding that that might just mean further testing. The decisionmaker wants to take actions that increase their utility, or well-being.

Suppose we take the action of treatment if we get the bad message, m2. Then we can write our expected utility conditional on m2 to be:

(5) E(utility|action,m2) = GAIN*Pr(s2|m2) + LOSS*Pr(s1|m2) - c

where GAIN is our health improvement from treating a real cancer, and LOSS is our health decrement from taking treatment when we do not have cancer (since we got a false positive test). Note that I do include the cost of the test, c, even though I am most interested in whether the before-cost, gross value, of the information can be negative.

Our expected utility conditional on message 1,

(6) E(utility|no action, m1) = -c

since all we do is pay the cost of the test when we get message m1. I could put an additional cost in here, if there were “angst” caused by the test, but I will pass on that idea for now.

The crux of the issue is illustrated by Equation (5), the expected utility conditional on message m2. The value of the test is going to be greater, the greater is the GAIN from treating a detected cancer and the greater is Pr(s2|m2). The value of the test is going to be lower, the greater is the LOSS from undergoing treatment when we do not have cancer, and the greater is Pr(s1|m2) – the probability of a false positive. (Note that false negatives do not enter our analysis directly, but they do indirectly since the probability of a false negative, Pr(m1|s2) equals 1-Pr(m2|s2), so the lower is the probability of a false negative, the higher is the probability of a correct positive.)

One might jump on the fact that the expected utility conditional on message m2 can be negative, even without considering the cost of the test. This is true, if the LOSS and/or the probability of a false positive are large.

However, we need to take a rational decisionmaking viewpoint. If the expected utility conditional on m2 is negative, then we should just never take the treatment! Granted, we will pay the cost of the test, but as I said at the beginning, some people seem to think that tests can be of negative value even without considering the direct cost of the test. From our point of view here, that cannot be true. Of zero value, that is possible, but not negative.

And there is yet another level to the analysis, which will show even more strongly the likelihood of a strictly positive value to any medical test that reports a continuous variable and that has the property that the test becomes more precise as we increase the cutoff. See this report from Johns Hopkins for some discussion, in particular the following:

"In general, a PSA value of 4 ng/mL is considered the cut-off for suspected cancer (although it may vary slightly by age), and levels above 10 ng/mL indicate very high risk. It is values between 4 and 10 ng/mL that are the most ambiguous; men in this range may benefit most from refinements in the PSA test. The risk of cancer based on PSA levels follows:

PSA levels under 4 ng/mL: "normal"
4 to 10 ng/mL: 20 to 30% risk
10 to 20 ng/mL: 50 to 75% risk
Above 20 ng/mL: 90%."

If the expected utility conditional on m2 is negative, then we should increase our cutoff to reduce the probability of false positives and increase the probability of a correct diagnosis (conditional on getting m2). For instance, if a PSA of 8 was our cutoff in the above analysis, then let’s use a cutoff of PSA=50.

In equation 5, increasing the cutoff will clearly increase our expected utility conditional on m2, for Pr(s2|m2) will increase and Pr(s1|m2) will decrease.

Now it is of course true that by increasing our cutoff, we are decreasing the chance of getting a bad message, that is, of getting m2. So we will be less likely to take action, but when we do, we can be pretty sure that we are doing the right thing.

With a low probability of m2, the overall value of the test may be negative, for we are always paying for the test and very rarely taking action. However, my point again is that the test must have value in the gross, before-cost, sense. Or to use the email analogy, if someone already emailed me the results of the test, I definitely do not want to delete that message before seeing it!

I could bring in considerations of angst of getting a test result that is not high enough to take action but enough to make one nervous, or issues of self-control -- an inability to commit oneself to not taking action (or not worrying) if the test result is not extremely high. But that will be for another discussion.

Can Someone Explain Why Net Neutrality Makes Sense?

Google and Verizon have made a proposal to deal with access over the internet.

The proposal says Internet providers should treat all providers of Internet content the same, and should not be able to block them or offer them a paid “fast lane.” It says the Federal Communications Commission should have the authority to stop or fine those who break the rules.

Eric Schmidt, head of Google, justifies their position with this:

Freedom from such discrimination is crucial for consumers and for fostering innovation among Internet entrepreneurs, said Eric E. Schmidt, Google’s chief executive, in a conference call with reporters. “The next two people in a garage really do need an open Internet,” he said.

Yes, and the next two guys in a garage also need free access to a supercomputer, lots of talented college graduates, and venture capital funding at TBill rates.

I suspect strongly that some consumers and some providers of content value the speed of access more highly than others. Economic efficiency calls for them to get that, so long as they pay the cost. Perhaps CEO Schmidt and others assume that their proposal will somehow result in everyone getting the technologically fastest access possible, regardless of cost? More likely, we will all get a mediocre level of service.

The US Postal Service has always given equal service at the same rates for urban and rural customers, even though the costs obviously differ. And Ma Bell (AT&T for youngsters) gave basic access to the phone system at the same prices.

I note that Ma Bell no longer exists in its same form, and the US Postal Service is about to die (only a slight exaggeration).

So I remain unconvinced. If I want to go faster than someone else, or let my customers go faster, why can't I buy a Corvette?

Sound familiar? Mark my words -- the next crisis.

President Obama today launched a call for more Americans to receive a college education:

"That's why I'm absolutely committed to making sure that here, in America, nobody is denied a college education, nobody is denied a chance to pursue their dreams, nobody is denied a chance to make the most in life just because they can't afford it," Obama said. "We are a better county than that, and we need to act like it."

Hmmm....So what were the critical elements of the subprime crisis? A push on the part of the US government to increase home ownership, especially among segments of the population that had traditionally not owned houses or held mortgages. A huge subsidy from the government to those who borrowed to buy a home (through FannieMae and Freddie Mac and through home mortgage interest tax deductibility). An industry of subprime mortgage brokers who, fed by large up-front fees paid for mortgage origination, found millions of willing borrowers -- even though the brokers often knew that the loans were not appropriate and had little chance of being repaid, unless home prices continued their seeming relentless climb.

What do we have with education and student loans? Well, certainly the push for more to attend college (do we remember the studies showing that home ownership leads to all kinds of social good?). We have a subsidy, in the form of student loans -- and with the recent changes in the student loan program (packaged as part of the health reform bill !!), those loans are made and owned by the US government. In the subprime mortgage industry, FannieMae and FreddieMac decided to dramatically increase their purchase and repackaging of subprime mortgages in response to the Federal government's wishes: if your boss wants more home ownership, you better not stand in the way. It is still unclear how the new Federally owned and managed student loan program will work out. In the old days, private banks made student loans. Now it will all go through the Feds, with the taxpayer on the hook through our general taxes. If the Federal government wants more Americans to attend college, how do you expect the political appointees in charge of student loan origination to behave?

Last, we have a growing industry of what I will call subprime educational institutions, or degree mills. These institutions, whether for profit or nonprofit, will benefit from enrolling students, helping them navigate the Federal student loan process, and collecting tuition. The increase in demand for degrees is palpable, and supply will increase to meet the demand. These degree mills will lack significant "skin in the game" just like subprime mortgage brokers -- they will enroll students who have little likelihood of benefitting from the program or even graduating. But tuition is collected up front, and then it will be up to the Feds to collect on the student loans. Even some of the better colleges and educational institutions will be tempted by the increase in demand, and new technology -- online education -- makes it even easier to provide the coursework (for subprime mortgages, the technological innovation was in software to process mortgage applications).

Hell, we even have the equivalent of the credit rating agencies -- let's call them Educational Testing Service and ACT, Inc. What -- there are only two main educational testing services? That is even less than the three main credit rating agencies!

Oh, and the new student loan reform also gives subsidies to those student borrowers who take work in public service, and it caps payments at 10% of income.

All of this reform is promised to save us, the US taxpayers, lots of money.

I have a bridge in Brooklyn you might be interested in.

Multiple Choice: An Airline Pricing Question

It appears as a stylized fact that airlines are getting an increased portion of their revenue through pricing channels other than the "basic ticket." Examples: baggage fees; ticket change fees; food and drink charges; charges for pillows and blankets; optional and priced plans for early check-in; charges for extra leg room. Kevin O'Leary of discount carrier RyanAir has repeatedly suggested charging for the loo, but I don't think that has been implemented yet.

Why the increased reliance on these new revenue channels?

a) Behavioral economics: Consumers don't notice such charges as readily as ticket prices. (I try this with my cat -- hide the pill in her food, but she outsmarts me every time. But don't let me influence your choice; cats might be smarter than people. One of my favorite econ profs used to famously tell his graduate students: You all think you are smarter than dogs, but you aren't -- you're just quicker.)

b) All these things have positive marginal costs, so the airlines are simply learning to price services in line with their costs.

c) Price discrimination. People who travel with lots of bags, for e.g., are more likely to have an inelastic demand for travel, so use baggage charges as a price discrimination scheme. This is similar to IBM in the old days charging their mainframe computer users by the number of "cards" that they consumed. (For youngsters, in the old days, data and even programs were coded onto paper cards and fed into computers. Yes, it was a pain in the butt.)

d) That perennial issue of taxes, and avoidance thereof. According to an IRS ruling in January, the kinds of fees being discussed are not subject to the 7.5% airline transportation tax. See here for details on the ruling, including the IRS private letter.

e) Because they can.

And the answer is.....

On the Proper Role of Government

As reported in CNET:

On Thursday, Sen. Charles Schumer (D-N.Y.), posted an open letter to Apple CEO Steve Jobs, expressing "concern" over the iPhone 4's reported reception problems.

Need we say anything more?

Goldman Coughs Up

So Goldman Sachs wil pay the largest penalty ever assessed on a Wall Street investment bank, $550 million. By settling with the SEC, Goldman avoids going to court with the government. I imagine however that there will now be a slew of private suits, even though investors will get $250 million and the US Treasury the rest. Goldman states in the settlement document,

"It was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure."

This is exactly what I have said all along. Their marketing materials were clearly deceptive. Nobody with good conscience should have prepared those.

Now GS has to follow through with some employee discipline.

Subsidize the Media?

Lee Bollinger, ex-Provost of Dartmouth College and current President of Columbia University, wrote in an editorial in the Wall Street Journal that we should consider public funding of the press.

You cannot be serious.

Sure, I can see the arguments -- we fund research in academia, and that is unbiased. Plus we fund NPR and hey, the British have the rock solid BBC. As an economist, can't I see all the positive externalities coming from the New York Times?

Bollinger states that in regard to public funding of academic research,

...there have been strikingly few instances of government abuse. Indeed, the most problematic funding issues in academic research come from alliances with the corporate sector.

Well, I wonder what evidence he has to support this claim. In my view, government funding of research is great at pushing forward the mainstream, generally accepted vision. Climate science is a great example.

Bollinger's argument shows why you cannot use the standard kind of economic efficiency arguments on everything. If we agree to subsidize everything that gives positive externalities at the margin, where will we stop? There are way too many activities that generate benefits that cannot be appropriated through market transactions. A free market is not going to be perfect in that regard. But holding it to the standard of optimality is not right. We have to compare it to the real alternative, which would be public funding of some activities. Can you imagine what it would look like if we were to start funding the media. (Hint: What would happen to Fox? Or Drudge?)

PS. There once was a time when I used to listen to the BBC on a shortwave radio, they were so good. That time is long past.

iPhone on June 24th

The prices he gave were $199 for a 16gb model, $299 for 32 GB. Decent.

Looks like its new phone time. The FaceTime program is really neat.

And here is a picture that Jobs showed, I took it from macrumorslive.com, where I was following Jobs' address. Note that Tuck's Bridge program is all about the intersection of business and the liberal arts. Maybe Steve needs a third dimension: business, technology, and the liberal arts. Nice.

Video Calling -- How Cool is That?

I'm watching a live blog of Steve Jobs' address to the WWDC in San Francisco.

He saved one of the coolest features of the new iPhone for last -- video calling.

Are we in the 21st century or what?

An Insurance Story

I busted one of the panes in the rear window of my Toyota Tacoma yesterday. I was putting a piece of cedar decking into it, and just nicked the edge of the window -- shattered it.

Called a window replacement service and almost had a heart attack: $1200 for the Toyota OEM replacement window. $1200 for one stupid Finlander moment?

But...I could get a third-party replacement, installed, for $295. A call to a second service confirmed the OEM price but got the third party window down to $220.

Now isn't that amazing. The OEM window costs 5.5 times as much, and we are not talking small change here. There might be some, hopefully minor, quality difference -- on the fit, most likely. I will find out tomorrow when I see the window.

Why the huge price difference? Two things. One, a monopoly position in the OEM window, due to the brand of Toyota. Second, insurance. Most people with comprehensive insurance will just pay the deductible and will therefore go for the more expensive but brand name window. Me, I cannot justify sending that kind of money to Toyota no matter who is paying, so even though I have comprehensive, if that third party window is OK it is going in.

What a lesson in what insurance can do to demand and prices! Do we wonder why medical services cost so much?

One of my colleagues had a very interesting proposal for health insurance that I have not come across. There are proposals to pay health care providers a lump sum -- bundled payment -- for a patient with some diagnosis. Say you need a hip replacement; then your insurer would pay the provider a lump sum of like $12,000. My colleague takes this one step further: he would have the insurer pay the patient the $12,000 and let them get their hip replaced wherever they wish.

That would create some very neat incentives! The problems, and they are important, are several. Foremost is the risk that the lump sum won't be enough to cover some complications. That puts additional risk onto the patient. Second might be the issue that some folks would rather take the money than the new hip. So we would have a nation of limping, but wealthier, elderly.

More on Carried Interest

I received the following comment on my initial post on carried interest:

One way of framing the carried interest question is to find the policy that preserves
the favored tax treatment in the aggregate. If I hold an index fund, my dividends
are taxed at a 15% rate and my realized long-term capital gains are taxed at a
20% rate. Now suppose I hire you to pick my stock for me. However we tax you,
there should be a consistency so that the aggregate dividends and capital gains
are still taxed in a favored manner.

My way of thinking of this would be the following: Suppose a set of friends get together to buy stock. There are five of them and they each put up 20% of the capital. They do well, and decide that one of them who has been bringing the best advice to the group should become the "general partner" and do most of the work. For that, the other four agree to reduce their share of any portfolio gains from 20% to 18%, so that the fifth partner will get 28%.

Since the aggregate capital gains are still the same, the argument above would imply that the manager/GP in my example should get capital gains taxation on his 28% just like the other four "limited partners."

This is a nice analogy, and analogies are nice for framing the issues and perhaps particularly for thinking about horizontal equity issues (are folks in this situation being treated similarly to folks elsewhere doing essentially the same thing?).

But this argument does not trump, for l return to the issue of economic efficiency -- what activities do we want to favor from an "activity level" point of view? By giving our newly minted General Partner the ability to get capital gains treatment on his larger share of the pie, we are enabling division of labor in investment activities. If we made the GP pay ordinary tax rates on any larger share he was given by his partners, we would reduce the incentives the partners would have to take advantage of comparative advantage and specialization.

Do we want to encourage such division of labor? Well, that is the question -- do we want to encourage the supply of specialized labor into management of private equity and venture capital? Perhaps. Capital gains rates are low after all because we want to encourage long term investments over short term.

The Carried Interest Dilemma

A couple colleagues and I were discussing the "carried interest" issue today. In a nutshell, a private equity firm, and other investment vehicles as well, such as venture capital firms, are organized as a partnership, with limited partners (LPs) providing the cash to invest and the general partner (GP) providing the management (and maybe a little bit of cash). The GP is often compensated in two parts, as memorialized in the phrase "2 plus 20": the GP gets 2% of the assets as a management fee, but they also get 20% of any gains when the investment is closed out.

The controversy is over Federal taxation. Now, the 2% is taxed as ordinary income (high rates!) and the 20% is taxed at capital gains rates (lower). Many folks feel that is unfair, letting these rapacious private equity fellows pay such low taxes on huge capital gains.

Before going too far into this, the right question of course is: what will be the different economic outcomes of different tax policies, and what do we think of those outcomes? Fairness is not foremost in my mind -- incentives, behavior, and outcomes loom larger.

It is not hard to think of analogies where similar compensation is paid. The taxation of those situations is instructive. For analogies, how about employees' grants of stock or stock options? Suppose I give stock to an employee, to create incentives for her to increase value. At the time of the stock grant, my understanding is that the value of the shares at that time is income, taxed at ordinary rates. Any capital gain in the stock would be taxed at capital gains rates, assuming the holding period was long enough. If I give the employee options, there is generally no tax due with the option grant, but when exercised, the difference between strike price and market value is ordinary income, unless the stock obtained through exercise is held for a certain period of time.

Another interesting case to consider would be if I lent money to an employee with the requirement that they use it to buy stock. My guess is that what would be taxable at ordinary rates here would be any difference in the interest rate charged the employee versus market rates. If there was a capital gain on the stock, then those would be taxed at capital gains rates.

This latter situation is close to what is happening with private equity. The GPs are being given an interest free loan to buy 20% of the portfolio. They should certainly pay taxes on that interest free loan.

A paper that comes to this conclusion is: Cunningham and Engler, The Carried Interest Controversy: Let's Not Get Carried Away, 61 Tax L. Rev. 121 (2007-2008).

But there is more than just the interest free loan, as the GPS essentially get to buy the shares at a zero price as well.

The more appropriate analogy seems to be the options one. The GPs are being given a call option on 20% of the portfolio, with a strike price of zero. Following the employee stock option tax policy, the grant of the option is not a taxable event. But when the option is exercised, it would be taxed at ordinary income rates, unless the GP somehow maintained their investment position for a period of time after that.

The idea of not taxing the granting of the option but taxing the gain at ordinary rates seems a nice balancing of our desire to stimulate incentives for creating long term value against the creation of excess incentives to enter one specific industry or profession. The tax advantage is essentially one of deferment of taxes -- no tax liability upon grant of the option, but upon exercise.

I think this solution balances nicely the incentives we want to preserve for investments that create value against giving excess incentives for supplying talent to certain industries.

Apple the Second Largest Company by Equity Value

Many stories have reported that Apple today overtook Microsoft in the market value of its equity.

What is more interesting is that Apple is the second-largest company in the US by market value of equity -- second to Exxon Mobil. See here.

Including debt to get total company, or enterprise value, would change the rankings as Apple has no debt and Microsoft has some. And of course other companies may have a lot more.

But it is still very impressive for a company that was almost dead a little over ten years ago.

I still remember the first Apple I bought...an LC 475. It had something like 4mb of ram -- I had to always play around, shutting off some of the built in system components, to get it to run certain programs. That was the first machine I bought for home use, and I have never bought anything other than an Apple since.

Nuke the BP oil leak?

I think BP is in big trouble, as is the Gulf of Mexico. It is a real tragedy for sure -- the only surprising thing so far is the seemingly small amount of actual damage to wetlands, beaches etc. Perhaps I am not paying enough attention, but the internet is not exactly overwhelmed with pictures and evidence of oil everywhere.

But the stories starting to come out on how BP folks made ill-fated decisions that possibly led to the disaster are scary for the company. Larry Kudlow on CNBC has been railing against BP for days on end...he just referred to them as an enemy of the US. Now that is because of something the company is supposedly doing in Iran, but Kudlow mixes Iran and the Gulf in a pretty vitriolic diatribe against the company.

Then there are these stories about how Russia used tactical nukes to stop blowouts back in the USSR days...supposedly did it five times and it worked four out of the five. Hmmmm...what about that fifth time?

Here is the Russian newspaper story that I guess discusses the use of nukes in blowouts. If you cannot read Russian, try this. Where is Red Adair when we need him?

Cyanobacteria in lakes vs. bacteria in pools

The local vigilantes on my beautiful New Hampshire lake have been spotting and reporting cyanobacteria blooms for two years now. Cyanobacteria are naturally occurring bacterial that do at times give off toxins that can cause harm to mammals. Dogs have been known to become sick, although I am unaware of any confirmed cases of human illness. Last summer I got very concerned when some local researchers reported -- in an unpublished paper that nonetheless got much local press-- a statistical correlation between living close to freshwater lakes and onset of ALS, or Lou Gehrig's disease. I don't know where that research now stands, but in my considered opinion it suffered from serious defects. One of these potential defects was the way cases of ALS were reported. I actually got an email from someone on my lake who said that anyone knowing of ALS cases around our lake should report them to the researchers. Hmmmmm....I wonder if a similar email went out to folks who don't live near a lake?

Anyway, the risk from cyanobacteria is incredibly small, especially if one doesn't swim directly in visible blooms (I like to cite a WHO report that said if you are standing in kneedeep water and cannot see your toes, you probably should not go swimming. Hell, even those of us from the UP would figure that one out!)

But finally, the CDC has come out with a report saying that 1 in 8 public swimming pools pose immediate infection risks.

I always told people who asked about cyanobacteria in my beautiful clean Goose Pond: maybe if you are worried you would prefer to go to the pool at Storrs Pond in Hanover and swim in chlorinated water that a bunch of little kid have....well you don't want to know.

Risks are everywhere.

Is Greece Facing a Liquidity Problem or it it Truly Insolvent?

I imagine that the Jean-Claude Trichet has dealt with more pleasant situations than the one over the weekend.

Last week, Mr. Trichet was broadly quoted as saying that the European Central Bank had not even considered the option of buying European government bonds.

Today, the ECB announced that it would indeed be buying government bonds, but that the Bank did not bow to any pressure in coming to this decision -- see here for a sample of one of the hundreds of stories.

OK, no political pressure but certainly a lot of bond market vigilante pressure!

The issue for the US back in 2008-09 was whether banks were insolvent or illiquid. The line there is a gray one to be sure. I support the lender of last resort stepping in during liquidity crises, which in modern banking systems are inevitable, but not to rescue truly insolvent institutions.

The question then is: is Greece insolvent or just illiquid?

This looks to me like massive monetization of European debt, which will not be good for the Euro. And, unlike the US, much if not most of Europe has very little leeway for additional taxation. The US can solve its debt problems, in the worst case scenario, by increasing taxes, most favorably through a VAT. I am certainly not advocating that we do this; I would prefer to see the pressure kept on to cut spending. But if need be, I think the US could raise several percentage points of GDP through a VAT with very little cost to the economy. I don't think that Greece, or many other European countries, could do that.

Seems to me that insolvency is the more likely situation, and bailing out insolvents cannot be good policy. The only offsetting arguments are that the state of the markets do raise liquidity issues for other countries, if Greece were to be let go.

Tough decision for the ECB.

Are Apple's Actions Anticompetitive? Doubtful

As has been widely discussed, it appears that Apple will be preventing iPhone applications developers from using anything other than Apple-approved development tools -- ruling out, among other tools, Adobe's Flash CS5. See here for more of the facts and here for more editorial comment.

Do these kind of restrictions rise to the level of being anticompetitive in the sense of antitrust? Let me sketch some possibilities, none of which I think make for a reasonable business strategy nor do they meet any kind of anticompetitive test. The most likely explanation is a very non-strategic one, simply that Apple wants to make sure that its iPhones and iPads meet the kind of quality test that its vertically integrated Mac platform does. Applications can impact the overall user experience in a variety of ways, and Apple has all the incentive in the world to make sure that they do not impair performance.

It pays to go back and re-study the Microsoft antitrust case. There, the government's claim was that Microsoft was excluding other internet browsers such as Netscape from the original equipment market, mostly by bundling its own browser (Internet Explorer) with its operating system, Windows. The alleged reason for this exclusion was Microsoft's desire to protect its market power in the operating system market. Interesting - the actions were not designed to gain market power in the browser market, but to protect a position in operating systems. Supposedly, Microsoft feared that as other browsers got traction, software developers could write applications that would interface directly with the browser (so called middle-ware) rather than having to interface with the operating system itself. Once applications could be written for browsers, Windows would potentially face more potential entry into the operating system market, since new operating systems would not face the chicken-and-egg problem of not having any applications that could interface with it. That is, the argument was that Windows had a nice network externality working for it, through software developers, and the middleware concept was seen as a threat to the market power that that network externality conveyed.

Now this is not the only possible angle to thinking about Apple and the exclusion of non-approved development tools, but it is an interesting one to consider. That is, could Apple be excluding some development tools to protect its position in a related market?

What market might Apple be trying to protect? Maybe its the Applications Store platform? This is what the post by John Gruber linked to above builds on. Can one build a coherent argument that Apple is restricting development tools so that the Apps Store becomes a standard, for purposes of exploiting market power? This is not unlike some of the earlier antitrust claims, more popular in Europe, that Apple put restrictions on iPods and iTunes so as to lock customers into both platforms.

I think there is one big weakness in any anticompetitive angle to this story, and that involves the inherent lack of power of a standard on an applications store platform. Recall the essential source of market power in the Microsoft story: the software development network externality, whereby the fixed costs of writing for different operating systems gave the operating system with the largest installed base an insurmountable advantage.

I cannot see anything working the same way in the mobile phone applications market. One possibility would be to get all developers writing for the iPhone platform, thereby giving the iPhone and iPad the chicken and egg externality benefit. But the mobile phone market is way too competitive for this story to hold water. The market share of iPhone is around 25%, with very strong competitors. Maybe for the iPad, but that is a whole new market that is too early to even assess for viability. I also do not know how much credence the "fixed cost of development" story should be given here. With Microsoft, I could see that writing something like a whole new spreadsheet package for a new operating system, and overcoming the advantage of installed base of existing products, would be a real challenge. But for mobile apps? Are the fixed development costs really going to prevent apps developers from writing more than one version of a product, if there were two platforms with different requirements? Isn't the gaming market a point against this argument, with popular games being written for the different platforms all the time?

Maybe the Apps Store market itself? Could Apple be trying to protect a dominant position in selling applications? Doubtful. For one, if that were the objective, I fail to see why restricting product would be beneficial -- does Amazon restrict products from its site? Second, it is way too easy for competing applications stores to launch and compete.

I am left with Occam's Razor, having to accept the simplest explanation: Apple wants to approach what it would have with a fully vertically integrated chain from hardware to operating system to applications. That means putting some restrictions on the applications.

There's an Ad for That!: Apple's Amazing Innovation Juggernaut

Apple was on a tear this week. Last Saturday, they had a very successful launch of the iPad, opening up a whole new category for exploration and innovation. Our lives, in short, just got even more interesting and better. Then later in the week, they gave a preview of the new iPhone operating system, which powers not just the iPhones but the iPad as well.

Among the new features was an ability for application developers to include advertisements that run inside of applications. This takes the amazing evolving world of mobile applications to a new revenue-generating level.

The opportunities are going to be pretty incredible. Advertisements will be able to use the GPS capability of the iPhone. So, if you are using an app that looks for restaurants, and you are standing in Marquette, Michigan, well then I would hope that Jean Kays Pasties on Presque Isle Avenue would drop you a nice little note inviting you in to try one of the Upper Peninsula's true delicacies.

Think of how this is a change from Google's search-based advertising. With Google, ads are focused on the search terms that you type in. With Apple, the ads are tailored based on the app you are running (and there are thousands of those) and then the infinitely variable physical location. Plus who knows what else?

The other thing that Apple did was to take another step in the standards war going on over HTML and Adobe's flash. Apple will restrict developers to using programming languages approved by Apple, and that is presumably not going to include Adobe's package that converts Flash based apps to run on the iPhone. I am not quite sure what is going on here, but certainly Apple's control of the entire vertically integrated package of software and hardware has been key to its success so far. I can see obvious potential for some third party programs and languages to impinge on the overall value of a device, from the consumer's perspective. Whether Flash presents those problems, or if something else is going on, that I cannot say.

Stupak to Retire

More fallout from the health care bill. This time, Representative Bart Stupak of Michigan has announced -- or will soon announce, I guess -- his retirement.

Stupak it turns out represents my home territory, the Upper Peninsula of Michigan. I thought I recognized a faint Yooper accent. I saw him on CNN yesterday while he was giving a speech in Bessemer, Michigan.

Well, well. Interesting times for sure. Stupak was the leader of the pro-life argument against the health care bill, and had been leading a bloc of pro-life Democrats against the bill. At the very end, he voted for the bill after getting the promise of an executive order from the President that promised to continue current Federal prohibition against financial support of abortions.

Folks will have different takes on what this means for, well, just about everything. The weekend papers will make for good reading.

An Important Referendum in CA

Steve Chapman writes in the Chicago Tribune about the upcoming ballot initiative in California to legalize possession, growing and sale of small amounts of....marijuana!

Now I think there is the small problem of Federal laws against drugs like marijuana, but I am guessing the cooler heads in the Obama administration might decide that it would be better to let CA give it a shot.

What a noble experiment that would be. Question: what would happen to anyone in prison for possession or sale of amounts that would now be legal?

Lights Out!

A while back I got an email from my neighborhood association that had the bright idea to get rid of our street lights. The thinking behind this brainstorm was twofold, one being to combat global warming and the other being to save money.

I replied with what I thought was a pretty witty piece about taking us back into the Dark Ages. While I would support preserving the night sky for stargazing, I could not see any evidence for significant cost or carbon savings, certainly not enough to offset the disadvantages of dark streets. The idea seems to have died, as the neighborhood is still lit at night.

But I must have been wrong, as now the whole world is turning out the lights. I can't wait for someone to estimate the additional crime and accidents that will occur during that hour.

The Health Care Bill

It should not be all that surprising that we finally got a health care bill passed. Before the Scott Brown victory in Massachusetts, the House and Senate had already passed separate bills; all that remained was to combine the two. The House had the courage to pass the Senate bill with the hope that a reconciliation bill of some kind will remove the most egregious parts of the Senate bill.

The opposition of the populace, as measured by polls and other more informal means, ended up being set aside in favor of the hope that by November all will be forgotten, by a respectable belief on the part of some that the bill is really good for the country, and no doubt by a lot of armtwisting and dealmaking on the part of Pelosi, Reid and the President.

I do believe that the Anthem/Wellpoint increases in individual insurance rates in California, discussed by me in prior posts, played a not-insignificant role. Those increases pointed to the failure of the individual insurance market and defused some of the critics of the bill. The President and others hammered on those increases as evidence of what would happen if the bill did not pass -- and to extent they are correct; the individual markets are in a bit of a death spiral due to adverse selection and other issues.

I would really like to see a news reporter did into that Anthem decision to see if the Anthem folks understodd the gravity of their decisions at that time.

But this is now all water under the bridge.

On the positive side -- always an optimist -- the bill does some good. I have said for some time now that this country passed the point of not wanting to have all citizens have decent health insurance. This bill goes a long way to fixing that basic social safety net issue. Let's not deceive ourselves, however, there will still be a lot of uninsured people, just as there are a lot of folks who do not file their tax returns.

And there is no doubt, as I note above, that the individual and small group health insurance market was headed for disaster. That was making it extremely difficult for self-employed people and for small businesses (if you worked for an employer who did not offer insurance, you had to buy it on your own in a lemons market). That probably induced many people to work for large companies rather than striking out on their own. Removing that wedge between self-employment and working for large companies could be good for entrepreneurship and innovation. I have little doubt that access to health insurance was a large factor in many decisions as to what kind of career to pursue, at least at some point in one's life.

If the new exchanges function well, my hope is that the bill will be altered in the future to allow people in companies that offer plans to buy insurance from the exchanges as well. As the bill stands, that is not allowed (I am not sure why). If that would happen, then the link between place of employment and health insurance will indeed be broken. That in my mind is one of the better things that could happen. Sorry, but I just don't believe that an employer has the ability or incentives to offer me the best kind of insurance. I don't have Dartmouth offer me retirement investment services; they just give me a portion of my salary and let me invest it in my choice of independent, professional investment funds. Health insurance should be handled the same way.

It is too bad that the tax on plans was taken away because of union opposition (well, postponed until some time well in the future). To reduce demand to a more natural level, we need to remove the 25% - 40% subsidy given to purchasers of insurance through the exclusion of health benefits from taxation. I suspect that this tax will get moved up in time as the costs of the new bill become obvious. Get ready, but it actually is a good thing (maybe next they will remove the interest deduction for first and second homes as well?).

I have to look through the bill to see what provisions there are on the supply of doctors. I really worry what is going to happen with another 20 million or so people putting unlimited demands on an already-stretched health care system. This is not the time to be without a physician, for sure -- line one up now. And, I suspect that in the future, because there is going to be more nonprice rationing, WHERE you live will become almost as important as what company you work for, in regard to having access to medical care. I suspect that health care is going to become very similar to public schools, with location being very important and with a two tiered system emerging as well.

So, we are off to a brave new world. At least Americans can now walk through Europe without being thought of as monsters who don't provide health insurance to their neediest of citizens. And there will be some interesting possibilities for innovation and efficiency in this new system.