Markets and Health Care

A long time reader directs me to Paul Krugman's column from last Sunday, where he argues that markets for health care are unlikely to work as well as, say, markets for bread or soybeans or Hyundais or even --- yes --- the iPhone.

Krugman's column very much reflects the consensus view of economists (including this one) on health care. Economists have learned a lot about when markets work and when they don't. Markets work well when there are many buyers and sellers, when the buyers and sellers all know exactly what's being transacted, and when it's possible to get the incentives right.

Health care is the perfect storm when it comes to free-market economics. There's the potential for market power and monopoly, there are big problems with asymmetric information, and the fact that everyone's insured means that buyers don't have a strong incentive to carefully weigh cost vs. benefit.

I've written about problems in health care markets before (actually a lot: here, here, here, and here). But this point bears repeating, given the current debate. The consensus of economists is that "trust the market to allocate health care" will not work very well. As Krugman points out, this doesn't mean that the only solution is single-payer, but it does mean that this is probably a setting where government will play a role.

And lest you think think that this is only some liberal, lefty, New-York-Times view, here's a link to a 2006 column from the Wall Street Journal's economics columnist David Wessel, which essentially makes exactly the same point. (Scroll down a few pages to see it.)

How to Make Money Writing an Economics Blog

As I wrote a while ago, I signed up for Google Adsense, and they manage the ads you see on the page. (Proceeds to the Utah Food Bank.)

Adsense pays you based on some function of page views and clicks, and this blog makes a few cents a day, on average. Adsense doesn't send you a check until you accrue $10, and I figured it would take years to hit that hurdle.

But then the new iPhones came out.

I was doing some game theory with the EMBAs at the time, and so I wrote a short blog item describing the developer/user coordination game. The post is nothing terribly deep or insightful; just the basic economics of platform competition.

I think the blog traffic on that one post was bigger than the traffic for all my other posts combined. This blog was making about 50 cents a month, on average, from ads. In June, I made more than $6, and that pushed me up over the $10 mark. I'll be sending some funds to the UFB as soon I get a check from Google.

I'm not saying this to try to boast about how insightful I am. As I said, the iPhone blog post is basic network economics that I learned from Garth Saloner (recently appointed as Stanford GSB dean) way back in 1991.

Rather, I'm saying it to point out how interested people are in the iPhone.

I have an iPhone and I like it, but I don't really see where the fascination is coming from.

The strategy and economics of the iPhone are a bit more interesting than, say, the economics of soybeans. But there are lots of goods and services with interesting economics. I think, for example, that the economics of higher ed are richer, more interesting, and more important than the economics of the iPhone.

But I should just be happy that there is something that draws interest to economics blogs. Probably business professors should drop all examples that don't involve iPhones --- we'd do a better job of holding our students' interest!

Just as an experiment, I'm going to put the word "iPhone" in each of my next three posts, just to see what that does to traffic. I promise to report back.

Hyundai

A while back I prattled on about the economics of asymmetric information. I wrote about how asymmetric information might affect the market for used cars. And about how the World Series of Poker is a great illustration of how to infer, based on someone's actions, what their information must be.

And here's a great NPR story combining the two ideas.

Hyundai, the Korean carmaker, had big quality problems in the late 1980s. Throughout the 1990s, the firm invested heavily in figuring out how to make better cars, and by 1998 Hyundai's cars were plums, not lemons. But perceptions are hard to change. A consumer won't pay a plum price for a car that he or she believes to be a lemon, even if the seller knows that it's a plum.

Hyundai had to figure out how to credibly communicate the "We are selling plums" message.

They did it with an aggressive warranty program. How does that work? Suppose you are a firm and you know that you haven't solved all of your quality problems. Offering a 100,000 mile warranty would be suicide --- because your cars will break down and you'll have massive repair bills. Even if offering the warranty allows your firm to fool consumers into paying plum prices, the time bomb of looming warranty obligations will kill you.

But if you know that you have solved your quality problems, then the warranty offer won't be as costly down the road.

Important point: A warranty program is prohibitively costly for a firm selling lemons. It's not prohibitively costly for a firm selling plums.

This means that only a plum-seller will be willing to offer it.

And this means that consumers --- seeing an aggressive warranty --- will infer that quality problems have been solved, because only a plum seller would be willing to make an aggressive warranty offer. The warranty is therefore a credible signal of product quality.

To tie this back to the earlier poker discussion, Hyundai had to figure out what action it could take that would cause consumers to infer that Hyundai cars were plums. It had to find some action that made economic sense for a plum seller, but didn't make economic sense for lemon seller. And the warranty is just the ticket.

The NPR story describes this as a "marketing move," which it is. But to understand why it's so smart, you need to understand information economics. And this illustrates why economic reasoning is useful across all functions of management.

MBA Oath (Continued Again)

So this is pretty cool --- Max from the MBA Oath commented on my earlier post.

I want to thank Max (and his fellow student organizers) for all their efforts. Whether students across the country agree to sign the Oath or not, it's a great conversation starter and a great learning opportunity. Questions about the appropriate role of private enterprise in our society are really important and really hard. As an educator, I love anything that pushes students to think --- the Oath is a smashing success on that dimension.

(As an aside, are you guys trolling the web for "MBA Oath"? Or is my blog is now required reading at HBS? If the latter, it's about freaking time. They owe me after not offering me a job in 1995.)

Max correctly points out that time is one of the key parameters controlled by policy-makers when it comes to intellectual-property protection. Patents don't last forever --- in the US, patent protection lasts for 20 years.

Why the limit?

Making patent protection last longer would provide stronger incentives for innovation, and that would be good. But making patent protection shorter would limit the ability of patent-holders to exploit market power, and that would also be good. So the patent law is a compromise that reflects these tradeoffs.

Governments write laws that trade off various forms of social value all the time. Max points out some of the ethical dilemmas of Big Pharma (coming mostly again from the patent law), but we can see it in our state and local governments as well.

One example comes from my hometown of Portland, Oregon, which has had an interesting urban planning experiment going for years now. Portland is ringed by an "urban growth boundary." If you own property inside the boundary, you can develop it subject to normal zoning laws. If you're outside the boundary, there are very strict limitations on what you can do with your property. If, say, you own a farm that's just outside the urban growth boundary and you decide that farming isn't very profitable, it's very, very hard to work with a real estate developer to turn your farm into a subdivision or an office park.

This means Portland doesn't have a ring of "exurbs" --- far, far out suburbs --- because the land that would have turned into an exurb can't be developed. It has high population density within the boundary, and little in the way of LA-style sprawl. This might be a good thing.

But it has costs. The limits on development and resulting high density mean that housing prices are probably higher than they otherwise would be. And if you're a homeowner who always dreamed of a really big backyard for kids and dogs to play? You can forget about that. Space is at a premium, so lot sizes tend to be small (or very high priced if they are large.)

Let's tie this back to the Oath: Suppose you're a real estate developer in Portland, and you find some undeveloped property that's within the urban growth boundary. You plan to develop it, but worry that you'll contribute to congestion, smog, and all the problems that development brings. Well, in this case it seems reasonable to me to conclude that local government has weighed the competing interests, and made the choice for you. If a property is inside the boundary, then the social benefit of developing is bigger than the cost. If it's outside, then benefit is smaller than cost.

And this is what I was trying to get at with my initial post offering a competing Oath. The role of the political, legal and regulatory system is to weigh these competing interests, and set the rules of the game. If the political, legal and regulatory processes have set rules based on careful consideration of the facts, then it seems like following the rules is a good guide to making socially productive choices.

But notice how I wrote that last sentence, focusing in particular on the first clause: "If the political, legal and regulatory processes have set rules based on careful consideration of the facts..."

That can be a seriously big "if".

And that's where I think the Oath can come in handy.

With patents, the law has been tested, considered, reconsidered, and reconsidered again. This concern over incentives for innovation as been around so long that the Founding Fathers specifically granted Congress the power to write patent law when they wrote the US Constitution way back in 1787.

With Portland's urban planning, the urban growth boundary has been around for dozens of years. It's been tested and considered, and it's more-or-less what the people of the state have decided.

But the world of private enterprise moves much faster than the world of government. And this means firms can sometimes engage in activities that haven't been considered, tested, and analyzed --- or even understood --- by the political, legal and regulatory systems.

Credit default swaps are an example. This is a new kind of financial transaction that just wasn't around when banking law was written. Bank failures lead to major spillovers to the real economy, so our regulatory process has written rules to force banks not to take excessive risk. The law insures deposits, to reduce the likelihood of a bank run, and forces banks to hold reserves and generally act in a conservative manner. But the law --- some of which dates to the 1930s --- didn't have a lot to say about credit default swaps. In this case, the law wasn't very well established, in part because regulators didn't really understand the social costs and benefits of these transactions.

So my conclusion is this: "Follow the rules" is a good guide for socially productive actions when the political, regulatory and legal process has had sufficient time to understand social costs and benefits and to write good law.

But things are murkier when we're out ahead of the legal process. In situations like this, it might be useful for managers to ask themselves the following: "What I'm doing is legal, but is there a chance it would be illegal or heavily regulated if the government and regulators understood it better?"

That's a heck of a tough question to answer. But it's a good one for business leaders to think about, and I think it's what the MBA Oath folks are trying to encourage.

MBA Oath (Continued)

I posted a while back on the MBA Oath, and promised some additional thoughts. So here are some. (And probably there will be more).

My main criticism of the Oath is that I'm not sure that the authors have thought very hard about what "social value" is. To economists, at least, this term has a precise meaning. And there are many things that firms do --- things that I doubt the authors of the Oath would condemn --- that destroy social value.

Here's a great example from the Wall Street Journal: Toyota Builds Thicket of Patents Around Hybrid To Block Competitors.

Is building a thicket of patents an activity that enhances social value? Well, the way economists think about social value, it most certainly is not.

Why?

When economists think about "social value", they think about whether the potential gains from trade are being turned into actual gains from trade. One of the great things about trade is that it's voluntary, and when two people trade they're both made better off. So, if all the potential gains from trade get turned into actual gains from trade, then we're doing great. If there are potential gains from trade that don't get turned into actual gains from trade, then we're not doing great; we're not maximizing overall social value.

Asymmetric information is one factor that can cause gains from trade to go unrealized, as I've written before.

Market power is another. A seller has market power if that seller has the ability to influence the price at which it sells its product.

Here's an example to show how market power reduces social value. Suppose I have two daisy seeds, and I am the only seller of flowers. There are two potential buyers of daisies. Buyer 1 is willing to pay up to $10 to buy a daisy. Buyer 2 is willing to pay up to $5. My cost of turning a daisy seed into a flower is $3.

What will happen if I am forced (say, by a Soviet-style central planner) to produce two daisies, and sell each for $4? I earn profits of $2. Buyer 1 is willing to pay $10, but is able to buy a daisy for $4 --- this yields "consumer surplus" of $6. Buyer 2 ends up with consumer surplus of $1. If we add up my profit plus the buyers' consumer surplus, we get $9.

What will happen if, instead, I am allowed to charge whatever price I like, with the caveat that I must charge the same price to all buyers? If I'm trying to maximize profits, then the best thing for me is to produce just one daisy, and sell it for $10. This leaves me with profit of $7, and yields zero consumer surplus for both buyers. Again, adding up profit and consumer surplus, we get $7.

The $9 turned into a $7... how? Where did the $2 go?

The $2 represented the lost gains from trade coming from the lost sale to Buyer 2. When I sell to Buyer 2, I incur costs of $3. But Buyer 2 gets something he values at $5, so there are $2 of potential gains from trade. When I have market power, that trade doesn't happen. Social value is destroyed because I refuse to trade with Buyer 2 in order to extract a higher price from Buyer 1.

Ok, fine. But what does this have to do with the MBA Oath?

Toyota is putting up a thicket of patents around its hybrid technology to preserve its market power. Toyota wants to be able to keep competitors from offering similar products, because the existence of similar products will reduce Toyota's ability to charge high prices (and earn big profits) on the Prius. The plain fact is that protecting intellectual property preserves market power, and thus destroys social value --- just as surely as my $10 price on daisies.

Would the MBA Oath folks condemn Toyota for their thicket of patents? I'm guessing not. And the reason why is that they realize that Toyota's intellectual-property-based market-power is granted as a sort of "reward" for innovating in the first place. We grant patents in order to reward inventors by allowing them to charge monopoly prices for some period of time after their invention. We do this because innovation creates social value and unless we allow inventors to capture some of this value, there is little incentive to create value.

So mull this over a bit... In order to get inventors to create value (by innovating) we let them destroy value (by exercising market power). Quite an odd circle...

And this is why blanket statements about promising to create social value are kind of troubling to me. In our modern economy, we want firms to create social value, on net. But our legal system seems to recognize that allowing firms some market power in some cases --- thus destroying social value --- can be a good thing, on net.

While this post is a little critical of the Oath, there are some things I like about it. I'll get to those next time.

Is It Economists' Fault?

I set a new blog record a couple of weeks ago. I got three --- count 'em, three --- e-mails suggesting blog ideas in one day! Two were from family, so I'm not sure how those count. But still... one wasn't.

And so I'll write about the one. A friend --- he's both an accountant and now a Texan, but really he's OK --- sends this article asking why economists didn't do a better job predicting the recent financial collapse.

The author --- Robert Samuelson from Newsweek --- thinks it's because economists just don't spend time thinking about finance, and don't realize how important financial markets are to modern economies.

In my view, this claim is so wrong as to be silly.

Finance is "just" a field of economics, but it's a field that has received a lot of research emphasis in recent years. Every top business school has dozens of researchers working on financial economics problems. And it's not just b-schools... There are top finance researchers in econ departments at Harvard, Stanford, Chicago, and on and on. Why, Princeton started a finance department (within their econ department) and they don't even have a business school! Finance scholars have won multiple Nobel Prizes --- for the CAPM, option pricing, capital structure research, and there'll be more --- and so it's just plain nuts to think that economists don't realize how important finance is.

So what was the problem? Why didn't economic and financial models predict impending doom? Should we shoot the economists?

I think there are two answer to this question, and fortunately both are illustrated by articles that were in the WSJ op/ed section on July 8.

Answer #1 is that, despite all the research, there are still a lot of things that economists still don't understand. I don't think this is because economists are stupid or selfish or lazy or wrong-headed --- I think it's because the problems we study are actually pretty hard. And there's a nice illustration in our first article, Let's Treat Borrowers Like Adults, written by law professor Todd Zywicki. He makes the following point: Buying a dangerous toaster is bad for any consumer who buys it. But a financial transaction is only dangerous if the person who buys it doesn't know what he or she is getting into. And it's very hard for economists to look into the mind of a borrower and figure out what the borrower does or doesn't know about the transaction he or she has just entered into. We're working on understanding human decision-making better, but I think we're not there yet.

So shoot the economists for that if you want. But don't shoot us for not thinking about financial markets. (And please don't actually shoot anyone, economist or not.)

Answer #2 is that even the simple and obvious economics --- the stuff that we're pretty sure we have right --- gets ignored by politicians all the time. And there's a nice illustration of this in our second article, written by, of all people, Gordon Brown and Nicholas Sarkozy. In it, they argue that excessive "speculation" is causing problems in worldwide oil markets.

I don't even know where to begin on this one. Point #1 is that if volatility is really a problem for oil-market participants, the solution is for them to use the futures market to hedge. So it's really pretty easy to use a market-based solution to this problem. Point #2 is that speculation is a good thing --- as long as speculators bear the full costs and reap the full benefits of their actions. (Note that the real estate speculators described in Zywicki's article were able to walk away from their bad housing-market bets, and saddle the banks with the losses.) Speculation is good because it connects present and future prices. The only way to make money speculating is to correctly forecast future price changes. If you think prices will be higher tomorrow than today --- which means that oil will be relatively scarce in the future --- then you can make money speculating by buying today and selling tomorrow. This drives the today price up, and this sends exactly the right price signal to the market. It tells the market to begin conserving oil right now, which is exactly what we all should do if oil is going to be scarce in the future. Read this old Hal Varian NYT column for more.

Why do politicians ignore simple economics? Because they can, at times, care more about getting votes than putting good policy in place. Voters don't necessarily understand that speculation is a good thing, so it can be easy to score political points with articles like this.

And why aren't voters more savvy about basic economics? Well, you can shoot economists for that too.

Associate Dean and Canceled Class

As some of you may have noticed, I've recently been appointed the Associate Dean for Academic Affairs at the David Eccles School of Business.

As others of you have certainly noticed, I've had to cancel Finance 6250 for the Fall Term. This is particularly unfortunate, for a couple of reasons. Reason 1 is that I absolutely love teaching about the economics of organization. Reason 2 is that I made a big song and dance on this blog a while back, trying to get students to take the course.

These two events are, not surprisingly, connected.

Our business school has made great strides over the past few years, but I think we still have significant room for improvement. I've argued before that our state is poised to grow, and, as the state's flagship business school, the DESB needs to be ready to provide the business leadership for that growth. This will require continuing improvements in our faculty, our facilities, and our programs. And it's my job to help Dean Randall figure out how to do it. There's a lot that needs to be done --- and fast.

The reason we canceled Fin 6250 is that I've got to get working on all that other stuff. One of my main objectives will be to improve the quality of our masters' programs, so MBA and PMBA students will still find I'm working on their behalf.

I will still be teaching Fin 6025 and Fin 6026 in the MBA and PMBA programs, but that's mostly because we literally don't have another economist around to staff those core classes. The good news is that we're in the process of stealing a truly outstanding economist away from a top-5 business school --- and the kicker is that he's an incredible teacher too. So look for much expanded econ-related course offerings from the David Eccles School of Business in the near future.

So, my message to students who had been expecting to take Fin 6250 is this: I'm sorry to be unable to teach the class this fall. But I will be investing in the future of your school, and sometimes investments require giving up current consumption.

Fall Term Classes

Seems like it's just this week that the weather finally turned to summer... But already I'm starting to think about Fall Term classes.

We're really excited about our MBA groups for this fall. We have a bumper crop of students, so I'm expecting some really interesting classroom discussions.

This fall I'll be teaching Managerial Econ for the incoming MBA and PMBA classes, and I've already started getting inquiries about textbooks and readings and the like.

I figured I'd direct incoming students here for textbook information in the hope that they'll read some blog entries, get engaged, and get a head start on their MBA.

The recommended textbook is Besanko and Breautigam's Microeconomics (third edition). (This blog is an "Amazon Affiliate", so if you click to Amazon and buy it through this link, then Amazon sends me a check --- which I then donate to the Utah Food Bank.)

The text is NOT required. I will not say things like "Turn to page 442 in the text and work problem 3." I do think it is extremely useful as a reference for students taking this class. In class, I will be working hard to illustrate the applicability of economics to management problems. As a result, I'll sometimes go FAST through some of the more technical details, so I can get to the interesting applications. If you have the text, then you have a resource in case you miss some details. And this will come in handy when working homework problems.

But the text is not required, and I won't be asking you any exam questions that are only discussed in the book.

Yes, I do know that textbooks are frightfully expensive. While I can't pay your textbook bill for you, I promise I will teach you why textbooks are so expensive. (And it's not that the professors who assign the books get a kickback.... I'll get to this the second or third week of class.)

And in the meantime, here's an article about a new business model for textbooks... Tell me... What do you think???

We Rent Movies, So Why Not Textbooks?

If you have more questions about the structure of the course, I'll have the course web page posted by mid August, and students can reach it through WebCT. But in the meantime, I invite incoming students to read this blog and think about economics and how it relates to our everyday lives. I'll be commenting on lots of business and economics news here, and I'd love to get an active conversation going even before fall begins.

Auto Industry Wages

Sorry for the utter lack of blogging recently. I'll get back to both the MBA Oath and some immigration issue shortly.

But for today, another great example from the New York Times Sunday Magazine.

(And as an aside, why is there so much great economics in the NYT Magazine? They're not trying to write about economics, after all... It's because they're writing about really interesting real-world issues --- and economics is just the study of how lots of individuals' real-world decisions add up to the world we live in. The Economist --- great magazine, and I read it every week --- tells you about economics. But the NYT Magazine tells you about life, and that's why it's a better source of economics examples.)

Anyway, the cover story from a week ago was how the auto industry helped create a really vibrant African-American middle class in Detroit, and how the auto industry's troubles are threatening that prosperity.

It's a sad tale. African-Americans still make considerably less than whites (on average), even controlling for education and work history and all that. And unlike other "minority" groups, African-Americans haven't been able to close that gap very well.

But here's how I'm going to use the article in class. For years, union wages in auto firms have been way, way above the going wage for comparable work in other industries. As a result, auto jobs were very, very desirable. Supply far exceeded demand for such jobs.

Now, what does a "normal" firm do when supply exceeds demand? That is, what happens when you list a single job opening and get dozens or hundreds of applications? That's a good sign that maybe the wage you're offering is higher than necessary to attract interest. Profit-maximizing firms will either re-list the job with a lower starting salary, or hire someone at the listed wage, but then limit going-forward wage increases.

Auto firms can't do that. Their wages are negotiated with unions far in advance. If supply exceeds demand, there's no way for them to offer lower wages.

It's a lot like what happens when there is a binding minimum wage. If the government says the lowest wage that firms can pay is $6.50 per hour, but the market-clearing wage (that is, the wage where quantity demanded is equal to quantity supplied) is $5, then any listed job will have excess supply.

One interesting question is how firms decide who to hire. If there are 30 qualified applicants for each opening, then which of them do you select?

The answer in the auto industry? Nepotism. If there are 30 qualified applicants for each opening, then the only way to get hired is to know somebody. Which means the kids of auto workers have a leg up when it comes to getting those jobs. And there's an interesting (but short) discussion of this in the NYT piece.

Is this a good thing or a bad thing? Probably bad. One reason is that we (as a society) want the right people in the right jobs. The price mechanism helps with this (as I've noted before), so messing with prices will mess with the allocation of people to jobs. Another problem is that with any sort of favoritism significant resources can be burned in the attempt to curry favor. I'm just guessing here, but I imagine that a GM auto worker who wants to get his/her son/daughter hired by GM would have to do a lot of work to butter up the right people and grease the wheels. Probably it would be better for everyone if auto workers made autos, rather than spending all day and night trying to kiss up to a supervisor so your kid will get hired.

Anyway, it's a nice example of how resources get allocated when we don't let prices do the job.

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Update: It's a good time to discuss minimum wages --- The Federal Minimum Wage rises to $7.25 on July 24! What will this do to our (already high) unemployment rate?