Hospital and Ramsey Pricing: The Cost Shifting Issue

A discussion I had the other evening with a hospital executive centered around issues of hospital pricing, costs, Medicaid, and market power. My comments along the lines of, "Hospitals face inelastic demands and little effective competition, and they price accordingly" got the executive justifiably agitated. It was a lively evening.

Let me present a violently simplified picture of hospital pricing. I will assume we are dealing with a nonprofit hospital, which essentially faces a "balanced budget" constraint.

Suppose that the state government cuts its Medicaid reimbursements to this hospital in response to state budgetary problems. So instead of getting the list price of $10,000 for a gall bladder surgery, and for which the hospital used to receive $2500 from Medicaid, the hospital will now receive only $2,000. All reimbursements are cut in this fashion.

Faced with a balanced budget constraint, what is our hospital to do? Well, about 60% of the hospital's patients use private insurance, typically through an employer. This is a very inelastic demand. As a hospital increases its prices to private insurers, about the worst that can happen is that one or more of those insurers will cut the hospital out of their preferred supplier network. This is a relatively unlikely occurrence, but of course it depends on the current level of prices, the amount of the increase, and the competition among insurers.

In fact, what provoked my evening discussion was my work on this case in New Hampshire between Anthem BCBS and Exeter Hospital. Anthem threatened to cut Exeter Hospital out of its supplier network, claiming that Exeter had higher prices than other suppliers.

Such events do happen, but they do not present enough of a reason to reject my assumption of inelastic demand for private insurers' patients.

So what is our budget-constrained hospital to do, faced with cuts in government reimbursements. Raise prices to the private insurance market, of course! This is the infamous "cost-shifting" phenomenon in health care.

However, this turns out to be exactly what a central planner concerned with welfare maximization would do -- or, shall we say, it is exactly what the doctor would order!

There is a well-known idea in economics, Ramsey pricing. The classic problem is exactly our setup from above: How should an organization price its products or services, if it has to balance its budget (zero profit) and it wants to maximize welfare of society? The answer is to price in inverse relation to demand elasticity: the most elastic products get the lowest prices and the least elastic products get the highest prices (prices are actually relative to marginal cost of production). The sense of this is as follows. For maximum welfare, you want to create the least distortion in consumer behavior from what is optimal. What would be optimal would be for consumers to buy the product right up to where their value equalled marginal cost of production. That would take a price equal to marginal cost, and will not be feasible with the budget constraint. So we price higher to the inelastic demands, knowing that consumers will not cut back much on their purchases -- hence we will get a lot of revenue.
for the elastic demands, we keep prices closer to marginal cost, for if we raised prices there, we would get a large cutback in consumption which is inefficient.

So cost shifting to the private insurance market is just Ramsey pricing.

And in fact, take an even broader view of what is going on. We have something that the public has deemed to be good -- provision of medical care to the poor. But how to pay for this? We could use broad income taxes, but those are hard to raise, and in fact, cause inefficient distortion for production throughout the economy. So let's just force hospitals to take really low prices for services provided to the poor, knowing very well that the impact will be to raise health care prices to the privately insured. Turns out to be an efficient implicit tax scheme.

There is another angle I could pursue as well, which is a bit of what I was doing with the health care exec. This one paints nonprofit hospitals in not such a benign fashion. Faced with an inelastic demand curve, what else might we expect hospitals to do? Since they are nonprofit, they cannot make money for shareholders. But, they can certainly make life nice for anyone who works there. They can make sure that docs have all the resources they want, far beyond what a pure cost/benefit analysis would justify. They can, if faced with rising costs for whatever reason, take the easy road and raise prices rather than take the hard road of pushing back on the cost increases. If a typical for-profit business in a competitive marketplace faces rising costs, it cannot just raise prices to make it up. Hospitals often do not face that kind of competition, for a variety of reasons.

Broccoli, Schmoccoli: A Mandate for Education

As an argument against the individual mandate to buy health insurance, one often hears something like this: "If the government can force us to buy health insurance, they could also force us to buy GM cars or even broccoli!"

Those are rather lame analogies -- unrealistic and not truly parallel to health insurance. While forcing us to buy cars has probably already crossed some civil servant's mind, the auto market just does not have the features of health insurance to make it even a remote candidate for an individual mandate-type rule. And broccoli...come on.

Here is a better one. Let's look forward to the year 2025, and read an editorial in the New York Times supporting the College Responsibility and Accountability Program.

What is more important than education, as a means for upward mobility in society? What better than education to break the generational cycle of ignorance, poverty, and dependence? The statistical evidence confirms that there is no better investment than investment in oneself, through a great post-secondary, college education. Education is truly a "special" economic commodity. It deserves special social and legal consideration.

Yet the United States is failing in providing a reasonably priced college education for all those who could benefit from it. In fact, the United States spends considerably more of its GDP on education, but its citizens consistently perform worse than other countries on any measures of intellectual ability, be it verbal or quantitative. The rate of increase in tuition at American universities exceeds by a large margin the general rate of inflation, and it has done so for decades.

The reasons for this high-cost, low-quality education market are numerous, and the forces of change work at glacial speed in the education industry. We still teach in the same way that Socrates did thousands of years ago. Some professors still use a blackboard! Technology advances abound, yet their rate of adoption is tortoise-like. Variations in costs and outcomes across colleges are huge: the total cost of an MBA at a private university exceeds $140,000, yet the graduates of elite schools can calculate an NPV no better than graduates of state universities with costs significantly less.

High costs force high prices, and many students and their parents are deep in educational loan debt.

And of course, the main problem is that we have a huge uneducated portion of the population -- those who are essentially closed out of the educational market. Without a college education, the chances of these young people making it into the middle class are very low. Their children will be in an even worse situation. While luck sometimes will lift a family out of ignorance and poverty, we cannot rely on hope alone. Something has to be done.

Exacerbating the situation is ruinous, death-spiral inducing competition in the education market. The best private and public colleges, rich with donations from wealthy alumni and blessed with grand reputations and brand names, attract only the very brightest students with the most potential. The less qualified (at least as measured by test scores and high school records) end up at colleges with...less qualified professors, fewer resources, and worse opportunities. The best companies go to the best colleges to recruit those students, leaving graduates of lesser schools in the ranks of the unemployed. As opportunities at lower tier schools deteriorate, prospective students wisely choose to not attend. This is the lemons market of education.

The College Responsibility and Accountability Program promises a remedy. In today's world, we have to recognize that a college education is a right. We must provide all young Americans an excellent college education. To do so, an individual mandate for everyone to purchase a four-year college education is both necessary and proper. Without an individual mandate, too many young people will choose to not attend college, and many universities will be unable to adequately provide the necessary resources for those foresighted students who do attend.

There are those who say that the US Constitution does not give Congress the power to regulate the education market, or to regulate an inaction on the part of its citizens. Yet the education market is clearly an interstate market, with students freely flowing across state lines, making application of the interstate commerce clause a trivial exercise. And as for the argument that Congress lacks the power to regulate an inaction: What more significant action can there be than the failure to attend college? To characterize the decision to not attend college as the lack of a decision or the lack of an action is to fail to see the other side of a coin. Deciding to not attend college is a decision to free ride off the rest of society; it is a decision to save one's own money now with the guarantee that the rest of society will protect one later on. The aggregate effect of a large portion of our young population to not attend college will prevent efficient functioning of an interstate higher education market; the regulation of these decisions is therefore a necessary and proper exercise of Congress' enumerated Constitutional power to regulate interstate commerce.

The College Responsibility and Accountability Program has many other provisions besides the individual mandate. There are provisions for employer-based tuition credits; enhanced subsidies and tax credits for lower income students; and the establishment of pilot programs to bend the value curve in education. There is an innovative new system of state-level educational exchanges to permit students to pick the college education that best fits their needs -- with choices of bronze, silver, gold and platinum packages. Pricing of the options is tightly regulated, with pricing differentials allowed only for the length of the program and the degree offered.

But the individual mandate to buy post-secondary education from a Federally-accredited institution is an absolutely necessary part of the overall package. If the pool of students remains at only 60% of the potential, as it is now, this country will never achieve the high quality educational industry that we need to be competitive. Requiring the purchase of a college education, with generous subsidies for those in need, is not only constitutionally permitted but absolutely necessary.

More on Wisconsin

An excellent article by Tim Carney gets, I think, to the heart of the issue about "stripping away" collective bargaining rights over non-wage aspects of government union workers.

Carney cites these statistics:

Four of the top six Wisconsin contributors to the 2010 elections were labor unions, with the state's teachers union giving $119,342 and the Wisconsin chapter of the American Federation of State, County, and Municipal Employees spending $83,888. The teachers union gave 96 percent of its money to Democrats, while Wisconsin AFSCME gave Democrats every penny.

Government unions spent $573,868 on Wisconsin's 2010 elections -- almost all of it going to Democrats -- while government employees spent another half million, with most going to Democrats.

I trust the broad thrust of these numbers -- the public unions whose collective bargaining rights are being stripped overwhelmingly support the Democratic Party.

Now put yourself in a taxpayer's situation. Public officials bargain with the unions. The unions support them, financially. Taxpayers have to monitor the relationship to make sure it does not get too cozy. The more complicated the bargaining -- the more dimensions for politicians to reward a focused group of supporters -- the more difficult it is for taxpayers to monitor the relationship.

If we are concerned about the classic problem of politics - the ability of politicians to focus benefits on a small group while imposing a small cost on a large diffuse set of taxpayers - I think we could make a strong case for making any bargaining between politicians and public unions (or any other group that fits the above description) as clear and transparent as possible. Having multiple dimensions of a contract up for grabs makes the task of monitoring difficult. In principle, if the union were truly bargaining with the principal (rather than the agent of the principal) then it could extract all that is possible via just one instrument, the cash compensation.

A downside to the Wisconsin solution might be that politicians can set the benefits at any level they want. So if a new regime comes in, it would seem that they would have even more ability to give out largesse to the public employees.

One also does have to admit the view that this is simply reneging on an earlier contract. I am not overly sympathetic to that view, as even in the private sector the contributions to health care and pensions are constantly changing. The idea that the nonwage components of compensation are sacrosanct certainly went out the window, even in academia, with the last financial crisis.

Antitrust Inquiry for Apple?

Numerous reports on a potential FTC inquiry over Apple's policies on media subscriptions sold through its AppStore and billed through iTunes: see here for example.

What law is being violated here?

I have been waiting for Apple and publishers to get their collective act together and start offering some decent content, at a reasonable price, that I can access on my phone (preferred for now) or my iPad (birthday present coming up).

The complaint seems to be that Apple's 30% take is too large.

I ask again: What law is being broken here?

Fascinating Events in Wisconsin!

How many people really understand just what "collective bargaining rights" the Wisconsin governor's (Republican Scott Walker) proposal "strips away?" ("Strips away" seems to be the favorite media phrase for it.)

If you want to design a health care plan for public sector employees that makes economic sense (as measured by maximizing the total net value) might it be the case that you don't want to bargain over deductibles, copays, and network coverage while you are also bargaining over wages?

And doesn't bargaining over wages give sufficient leverage for the union? If other parameters of the job are set, the residual falls onto the wage, and that is what can be collectively bargained over.

Two final thoughts. In regard to the Democrat legislators leaving the State to prevent a vote from being taken, I find this pretty humorous:

The Wisconsin Constitution prohibits police from arresting legislators while they're in session.

What, are you kidding -- the WI constitution has that kind of detail? Quote is from this MSNBC story.

Second, this will be I think a watershed event. Let's see who blinks.

UPDATE: A reader has pointed out my naivety. His explanation of the constitutional prohibition against arresting legislators is sensible -- supposedly arresting your opponents was common practice in olden times. And I thought it was just another perk of elected office. Even our NH constitution provides for this: "No member of the house of representatives, or senate shall be arrested, or held to bail, on mesne process, during his going to, returning from, or attendance upon, the court."

The Individual Mandate, The Coase Theorem, and the Takings Clause

There is nothing improper in the means that Obamacare deploys. Laws may properly regulate both actions and inactions...

If Congress can tax me, and can use my tax dollars to buy a health insurance policy for me, why can't it tell me to get a policy myself (or pay extra taxes)?

These are two quotes from Prof. Akhil Amar's opinion piece in the LA Times, "Constitutional Showdown."

Is there really no substantive, principle-based distinction between regulating action vs. inaction? Or similarly, is it really the same to tax me and use the proceeds to buy insurance for me vs. telling me to buy a policy or pay a tax (penalty)?

I think there are very large differences, substantive differences based on very important principles, that would seem to have constitutional implications as well.

The differences relate to a famous theorem in economics, the Coase Theorem, and they also relate to the Takings Clause of the Constitution ("nor shall private property be taken for public use, without just compensation").

The Coase Theorem states that the final allocation of property rights is independent of the initial allocation, in the absence of transaction costs and income effects. It is a remarkable yet simple theorem (the best kind). I like to illustrate it with pollution. If firms have the legal right to pollute the air, one might think that we will get a lot of pollution. Yet in such a world, those affected by pollution could pay the firms to stop. Whether the bargain works will depend on the cost of stopping the pollution versus the costs of the pollution. Another legal regime would give the citizens the right to clean air. In that case, we might think that we would get perfectly clean air, but of course that is wrong: firms may buy the right to pollute from the ciitzens. Indeed, they will do so if the cost of not polluting exceeds the cost of the pollution to the citizens, hence the Coase Theorem: pollution levels will be the same, no matter the initial allocation of legal/property rights.

Of course, in a world with transaction costs and income effects, the initial allocation of rights does matter. If citizens have to buy the right to clean air, they will likely buy less than the amount they would keep in a regime where they had the right to clean air to begin with -- the main reason being an income effect. Having to buy the right to clean air reduces citizens' wealth, and that in turn affects how much clean air they want. Transaction costs reinforce this: such costs make trading of rights difficult, so the initial allocation of rights is sticky.

If polluters have the initial right to pollute, it is reasonable to believe that we will have more pollution than if citizens initially have the right to clean air.

Of course, the Coase Theorem does not deny that the allocation of wealth is (strongly) affected by the initial allocation of rights. Citizens are better off if they start with the rights.

The individual mandate can be seen as an initial allocation of rights in favor of the government -- I don't have the right to decide whether to buy or not, the government can mandate it. The transaction costs of buying that right back are low, however, as all I need to do to buy my freedom of choice back is pay the penalty.

Without a mandate, citizens have the legal right to choose insurance or not, and if the government wanted them to buy insurance, they would have to pay them to do so (subsidize the insurance). This means that the government will have to raise tax revenue, and the transaction costs of that are large.

Following Coasian logic, I conclude that there will be less insurance purchased in a regime without the individual mandate. My main rationale is that the government will find it hard to raise sufficient tax revenue to get to the same outcome they would achieve with the individual mandate. This is indeed the heart of the mandate: it is a cheap (to the government) way to get everyone insured.

Now let's think about the takings clause in the Constitution. I have not seen anyone raise it in light of the individual mandate, yet it seems to me to hold some relevance. What is more "private property" than one's own wealth/money? Isn't the government essentially "taking" our money and using it for public purpose when they say that we must buy insurance?

The takings clause is very important in our society. It restricts how much public policy the government can implement, by giving citizens the initial right to their property. In Coasian terms, the takings clause forces the government to buy our property if they want to use it for public purpose. The takings clause forces government to go to taxpayers to finance policy, and that is a difficult task. Following my Coasian arguments above, the takings clause results in less public policy. Think of how much environmental policy could be implemented if only government could appropriate any private land, without just compensation, to hold in its natural state for conservation reasons!

Many commentators are arguing that the individual mandate is constitutional because it is a "necessary and proper" way to implement a constitutionally acceptable regulation of interstate (health care) commerce.

"Proper" in this sense has always been interpreted to mean not inconsistent with any part of the Constitution. In the words of Justice Marshall, "let it be within the scope of the constitution, and all means which are appropriate, which are plainly adapted to that end, which are not prohibited, but consistent with the letter and spirit of the constitution, are constitutional."

The individual mandate seems to me to be inconsistent with the takings clause, at least in spirit. The takings clause makes the government bear the cost of its good intentions, in the sense that it must raise taxes on the citizenry. Doing good by taking private property is not allowed. I ask again: what is more private than my own wealth? Isn't it a "taking" for the government to tell me what I have to spend my money on? Doesn't the individual mandate represent the clearest taking of all?

PS. I could entertain the idea that just compensation is given, in that the individual receives insurance. But this is a hard story to tell, given the main reason for the mandate: to force a whole class of individuals into a transaction that a rational individual would not undertake.

The Stubborn Charade of the Individual Mandate

Why the stubborn insistence that the individual mandate is absolutely necessary to effective reform of our health care system? I am somewhat baffled.

The individual mandate is combined with a penalty for not buying government approved insurance, and with subsidies for buying such insurance, where the subsidy depends on your income level. By 2016 the penalty will be the greater of 2.5% of income or $695. Coupled with the penalty will be a subsidized insurance policy available. Let's say just for argument that the subsidized price of insurance for such a person would be $3,000. Thus, the purely economic calculus is that the net cost of insurance is $2,305 -- the difference between the cost of insurance and the penalty. Presumably if the insurance is worth more than $2,305, such a person would buy it and avoid the penalty.

Of course it is extremely simple to achieve the same outcome purely with a larger subsidy. Just make the cost of the insurance $2,305. The economics of the situation are virtually identical (virtually in that the person's situation is improved by $695 in the second scenario, whether they buy insurance or not). The key point is that the difference in wealth between having insurance vs. not having insurance is $2305 in both scenarios, i.e., the real price of insurance is the same.

So why do folks insist on the mandate/penalty combination instead of the free choice/subsidy combination?

Well, the larger subsidy costs more tax revenues. That probably would not have passed even the 2010 Congress. Essentially the mandate is a way to shift the cost of the program from general tax revenues to individuals who are forced to buy a product they don't want to.

There are other ways to achieve larger participation in the health insurance market as well, such as open enrollment periods at certain times only, and imposing a real cost for noncontinuous coverage.

Strike Two Against the Individual Mandate

A US District Court in Florida (R. Vinson, judge) issued summary judgment in support of 26 states who had brought suit against the Patient Protection and Affordable Care Act. The judge in the case considers two routes to a constitutional basis, flowing directly from the Commerce Clause and secondarily, resting on the Necessary and Proper Clause. As to the Commerce Clause, the telling summary is as follows:

Because I find both the “uniqueness” and “economic decision” arguments unpersuasive, I conclude that the individual mandate seeks to regulate economic inactivity, which is the very opposite of economic activity. And because activity is required under the Commerce Clause, the individual mandate exceeds Congress’ commerce power, as it is understood, defined, and applied in the existing Supreme Court case law.

As expected, the key point is that the Act requires action from an otherwise passive citizen, and this is not what the Commerce Clause permits, as defined in all previous Supreme Court decisions or by the Founders.

The Court secondarily turns to justifying the individual mandate on the basis of the Necessary and Proper Clause:

To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers, and all other Powers vested by this Constitution in the Government of the United States, or in any Department or Officer thereof.

The argument here is a bit more convoluted in my humble opinion, but the judge's decision is clear:

The Necessary and Proper Clause cannot be utilized to “pass laws for the accomplishment of objects” that are not within Congress’ enumerated powers. As the previous analysis of the defendants’ Commerce Clause argument reveals, the individual mandate is neither within the letter nor the spirit of the Constitution. To uphold that provision via application of the Necessary and Proper Clause would authorize Congress to reach and regulate far beyond the currently established “outer limits” of the Commerce Clause and effectively remove all limits on federal power.

Again in my humble opinion, the Necessary and Proper Clause issue is an important one, and I do not find Judge Vinson convincing. It is a hard one -- if regulation of the insurance industry is the desired and constitutional end (justified via Commerce Clause) then isn't the individual mandate a necessary and proper means to that end?
It seems to me that one line of argument raised by Judge Vinson but not adequately argued is the difference between means and ends. I don't quite view the individual mandate as a means, but more of an end in itself. The language of the Clause is what I point to -- authorizing laws necessary for "carrying into execution." I can see the Constitutional basis of requirements for keeping records, or for creating criminal statutes for enforcing laws based on Constitutional powers. But is the individual mandate really a law necessary for "carrying into execution" the rest of the PPAC Act? Or is it an integral part of the Act itself, part of the ends that are being desired?

Another possible line of inquiry is that the individual mandate steps into territory that is normally reserved by the States -- a sure limiting factor to application of the Necessary and Proper Clause. The fact that Massachusetts already instituted a state level individual mandate would support this line of thinking.

Certain of Judge Vinson's words are being picked up by liberals, especially this part:

It is difficult to imagine that a nation which began, at least in part, as the result of opposition to a British mandate giving the East India Company a monopoly and imposing a nominal tax on all tea sold in America would have set out to create a government with the power to force people to buy tea in the first place. If Congress can penalize a passive individual for failing to engage in commerce, the enumeration of powers in the Constitution would have been in vain for it would be “difficult to perceive any limitation on federal power” [Lopez, supra, 514 U.S. at 564], and we would have a Constitution in name only. Surely this is not what the Founding Fathers could have intended.

Do you see Tea Party written all over that? Time for a Rorschach Test!

Beware Comma-Shaped Low Pressure Systems

One picture says it all; this will be a fun storm.

ps. that little bit of blue in the Northeast dumped 4-6 inches today, as the opening act.

Dueling Financial Crisis Commission Reports

The Financial Crisis Inquiry Commission released its massive report today, with a majority group taking the bulk of the report and then two dissents (by Republican members).

Lots of interesting facts, conjectures, and conclusions.

One of the main issues argued between the majority and the dissent is the role of the GSEs, Fannie Mae and Freddie Mac.

The majority downplays their role, accepting that they played a part but not being a primary cause. I guess I would tend to agree with that, but not to the extent of the majority. The majority report notes that

Importantly, GSE mortgage securities essentially maintained their value
throughout the crisis and did not contribute to the significant financial firm losses
that were central to the financial crisis. (page xxvi)

Peter Wallison, in his dissent, argues that the GSEs played a larger role. His Table 1 on page 456 is definitely of interest, showing that the two main GSEs held 39% of the total subprime mortgage principal as of 2008 (definitions of the Table are not precise, but the Pinto document referenced does help).

In thinking about the role of the GSEs, who bought a lot of subprime originations and held them, I thought of mortgage backed securities as a big set of joint products. The GSEs wanted the AAA tranches, and sure enough, as the majority points out, those securities and the similar whole loans the GSEs bought did not have significant actual losses. None of the AAA securities did. But: suppose a set of consumers has a large increase in demand for beef. That will result in an increase supply of cow hides, pushing down the price of hides -- and someone is going to buy the hides. So the GSEs wanted a lot of AAA securities, with the byproduct being a lot of mezzanine B rated paper. That paper had to go somewhere, even at lower prices/higher yields. At high enough yields, it was bought, and it seemed quite profitable to the investment banks who held it (maybe after it was repackaged in CDOs).

Another analogy would be the war on drugs. Isn't it the buyer of drugs who are the real problem? They create the demand, and the suppliers just respond.

So without the GSEs we might not have had so much supply of lower rated MBSs.

I don't want to go so far as to make the GSEs a primary cause of the crisis, but they played a pretty significant part.

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.