The Incidental Economist

The following entertaining passage by Steve Landsburg is worth a read, as is the entire post from which it is excerpted.

[E]fficiency analysis strikes down political smokescreens. Like this: …

Economist: Your program [to subsidize health care for the poor] costs a billion dollars and delivers half a billion dollars worth of benefits. That’s inefficient. … [Y]ou could take that billion dollars and deliver a full billion dollars worth of benefits instead if you spent it a little differently. Why not just hand the cash out to poor people?

Politician: Because I don’t want to help all poor people. I only want to help sick poor people — and this is the only way I can think of to do that.

Economist: Ah. So your goal here is not to make the health care system work better after all. Instead it’s to transfer resources to sick poor people.

Politician: I guess so.

Economist: That’s fine. Now we can have a healthy debate about whether that’s what we want to do.

And now, you see, thanks to the economist’s insistence on thinking about efficiency, we end up having an honest debate about the politician’s real goal instead of a dishonest debate about the politician’s feigned goal. However the debate turns out, that’s a useful exercise.

I agree that thinking about efficiency is completely worthwhile. I’ve said so in blog posts and done so in my work. Making the not-too-risky inference from the above quote that Landsburg would consider the ACA a transfer program (since it subsidizes health care insurance for lower-income individuals an families), I agree with him on that too.

However, I disagree that the politician’s goal in his hypothetical is necessarily to redistribute wealth. In fact, I think the politician was duped by the economist. This reminds me of Greg Mankiw’s claim that the ACA is an merely an excuse to redistribute income. Here’s what I wrote in response:

There is a perfectly good reason why the ACA must be redistributive. By now we know how avoidance of adverse selection requires that a mandate accompany outlawing pre-existing condition exclusions. And low-income subsidies must accompany a mandate (if necessary, see Krugman for a review of the logic). If an individual can’t afford health insurance without a subsidy, it’s not helpful to provide one and to adjust the tax system to make the overall package distribution neutral. That’s like saying, “Can’t afford insurance? Let me help with the cost. Now pay me back.”

Putting this differently, there are externalities at work that justify redistribution. The goal is to address the externalities. Redistribution is just the necessary means.

In what feels like (but may not be) his final NY Times Economix post relating to Arrow’s 1963 paper and his own 2001 article, Uwe Reinhardt offers a solemn warning,

[R]ead carefully the columns written by eminent economists in the major news media and their Congressional testimony. Count how many times the authors justify their recommendations with appeal to efficiency. …

Virtually all modern textbooks in economics … [do not acknowledge] the ethical dimensions of the concept. I use these texts in my economics courses as, I suppose, do most my colleagues around the world. But I explicitly alert my students to the ethical pitfalls in normative welfare economics. …

My advice to students and readers is: When you hear us economists wax eloquent on the virtue of greater efficiency — beware!

You’ll have to read the rest to get a better idea of what Reinhardt means by all this. Trust me, it’s worth a look. Personally encouraged by Reinhardt, I examined Arrow’s and his paper myself last year and offered my own warning,

My own sense is that it is asking far too much of welfare economics to point to a unique solution that optimizes a universally accepted criterion. Indeed, one ought to be suspicious of any claims of unique optimality. It is plausible that any such result is preordained by the form of the optimand, even if not explicitly stated. Extra-utility welfare analysis (also called extra-welfarism) can very likely recommend “optimal” policies distinct from “optimal” ones suggested by utility-based (welfarist) approaches.

But no approach has a unique claim to legitimacy. An unassailable argument does not exist for any one solution, whether public or private, to any problem, not even health care. Is this curse of nonuniqueness the death knell of welfare economics? Certainly not. The value of welfare economics in particular and economics in general is the clarity of thought it enforces. A welfare analysis of almost any type will lead the analyst to consider particulars and consequences that are opaque to casual thought. While it is relevant that health care is not a perfectly competitive market one misses the point of economics entirely to suggest that this renders it inaccessible to welfare analysis. Such a thought would be a grave mistake, especially since it appears as if private provision of health care and health insurance is here to stay.

The responsibility of the economist is to understand the assumptions and limitations of his tools. This is the great virtue of Reinhardt’s contribution. By expanding and clarifying Arrow’s words, … he makes those facets of neo-classical welfare analysis plain, not just to the economist, but likely to any clear thinker motivated to read it.

Uwe Reinhardt has been unpacking some of the content of Arrow’s seminal 1963 paper that defined health economics. I promised this blog’s readers that I would continue to announce his posts as they appeared. Today is the third post (links to first and second posts). This third one includes content that inspired my own post last year. It is largely based on Reinhardt’s 2001 paper that goes into greater depth on Arrow’s.

Uwe Reinhardt’s second post on Arrow’s 1963 paper that launched health economics as a discipline is up at Economix. As I said before, this series is as close to required reading as can exist for followers of this blog. Do I have to threaten a quiz?

Here’s a quote:

[I]nformation on both the diagnosis of and the likely consequences of treatment are asymmetrically allocated between the sell-side (providers) and the buy-side (patients) of the health-care market. The very reason that patients seek advice and treatment from physicians in the first place is that they expect physicians to have vastly superior knowledge about the proper diagnosis and efficacy of treatment. That makes the market for medical care deviate significantly from the benchmark of perfect competition, in which buyers and sellers would be equally well informed.

There’s much more.

I don’t make declarations like this often: Uwe Reinhardt’s Economix post today is a must read for readers of this blog. It’s the beginning of a straight-forward summary of Arrow’s seminal 1963 paper on health care. Reinhardt promises a follow up that I’ll declare a must read before I even see it (I’ll announce it anyway).

In case you don’t know, Arrow is a Nobel-prize winning economist. His 1963 paper arguably launched or defined the field of health economics. It’s not an easy paper to read. The ideas are so densely packed scholars have been discussing them since. I’ve written about that paper and Arrow before. And so has Reinhardt. In a 2001 paper, which I’ve summarized, Reinhardt masterfully unpacked some of the content of Arrow’s paper. Reinhardt’s paper is, by comparison to Arrow’s, quite readable.

So is his post:

It is easy to see why Professor Arrow’s paper fired the imagination of generations of economists around the world in their argument that public health policy should confine itself strictly to making the market of health care perfectly competitive and then to redistribute income — perhaps by means of tax-financed vouchers to help subsidize the purchase by poorer people of needed health care — in order to achieve whatever distributive ethic society wishes to impose on health care. That free-market approach would automatically take care of whatever moral aspect society wishes to impute to health care.

Having established this normative benchmark, Professor Arrow explored in the rest of his paper how close the market for health care actually comes to the characteristics of a perfectly competitive norm.

I encourage you to read Reinhardt’s post for reasons given above and also because his message gets to the heart of a question I’ll ponder further next week. Have health economists played a meaningful role in shaping our current health care system? That is, do we have a private, market-based system for the non-elderly because health economists advocated and justified exactly that? I’ll give you my opinion on these questions next week.

The vast majority of employers only offer one health insurance choice. If/when insurance exchanges become available, individuals will have easy access to more insurance plans. Of course the employer-sponsored insurance tax subsidy will keep many employer plans more attractive than exchange based plans* for individuals who do not qualify for premium credits toward purchase of exchange plans. Still, it is worth asking, what is the social cost of the relatively lower degree of choice among employer plans?

That’s the question posed and answered in a recent NBER paper by Dafny, Ho, and Varela. The authors exploit a proprietary dataset on employer offers and employee enrollment between 1998 and 2006 for over 800 large employers with over 10 million employees, collectively. They imagine a world in which employees receive a voucher equal to their employer’s current contribution toward health insurance and then use the voucher to purchase any plan in an exchange-like setting. Their statistical model of consumer choice permits the calculation of the net gain in consumer surplus resulting from increased choice (the extra amount consumers would be willing to pay for the additional choice).

We find choice is worth quite a bit for most individuals: in our most conservative hypothetical scenario the median employee would enjoy a surplus gain of roughly 20% of combined employer and employee premium contributions. In year 2000 dollars, this gain is approximately $2,025 for a family of four. Combining these figures with data on employer subsidies, we find the median employee would be willing to forego 27 percent of her employer subsidy simply for the right to use what remains toward a plan of her choosing. (© 2010 by Leemore Dafny, Katherine Ho, and Mauricio Varela.)

There are plenty of reasons to support exchanges and a transition away from employer based insurance. In addition to the other distortions of the labor market due to an employer based system (job lock, for one), Dafny, Ho, and Varela point to a substantial loss of economic welfare.

Their paper provides one other tremendous service: a more complete literature review on insurer loading fees (LF, which relates to premium as premium = (1+LF)*medical costs) than any I’ve seen (pages 28-31). They cite literature that reports loading fees that range from 7% for large insurers to 30% for the non-group market and an overall average of 12.8%. They write that the Lewin Group has predicted a loading fee of 10.7% for an exchange for which all workers are eligible to participate. Note that these loading fees (LFs) can be converted to loss ratios (LRs) via LR = 1/(1+LF). The implied range of loss ratios is consistent with what I wrote in an earlier post (phew!).

* Small businesses will be permitted to offer exchange based plans as their employer plan. So workers in such firms will be able to enroll in exchange plans and receive the tax subsidy.

I’m on a blog break this week so all posts are reruns until the new year. This post originally appeared on 19 May 2009 on The Finance Buff. If you wish to leave comments, please do so on the original post.

What follows is an illustrative sketch of a classical economic welfare analysis using Google Reader as an example. It is intended for an audience with no economics background. At the risk of disappointing readers, I confess that, due to lack of data, I make up all the numbers. However, anyone with better estimates of the components could improve the calculation by following the steps outlined. Those familiar with Google Reader may wish to skip the next paragraph.

One way to read blogs is to visit each one’s website. Wouldn’t it be better if each could send new posts to one consolidated place for you? Well, nearly all can; the way to take advantage of this efficiency is using an aggregator like Google Reader. Blog sites, like The Finance Buff, advertise this service with icons that say “subscribe,” “RSS,” or “Atom,” or with a symbol like this. By clicking on these icons, you can add blog “feeds” to Google Reader (or another aggregator). The result is akin to a receive-only e-mail experience in which blog posts are listed in your reader and updated automatically.

Google Reader has enhanced my life, changing how I work and spend leisure time. I would not easily keep up with blogs of interest without Google Reader or something like it. (The blogs to which I subscribe are listed in this spreadsheet.) Google Reader is free, but it provides more than zero dollars worth of value to me. If it were not free I would pay something for the service.

For the sake of argument, let’s say I’d be willing to pay $100 per year for Google Reader. This represents the gross value of Google Reader to me. Since I actually pay $0, then the net value I receive from Google Reader is $100 – $0 = $100 per year. This is just like $100 in my pocket because I’d have paid that amount more for Google Reader than I had to. That $100 represents my individual annual consumer surplus.

I don’t know how many Google Reader users there are, but let’s say there are 10 million. Suppose the average individual user is like me, with a consumer surplus of $100 per year. Then the annual total consumer surplus of Google Reader is $100 x 10 million = $1 billion per year. That’s a lot of value. Of course, I made the numbers up.

There is also value that Google receives beyond its costs of producing Google Reader. Google does not receive revenue directly from its Reader right now. Let’s assume it attributes revenue to its Reader because it draws users to other (ad-based) revenue-producing Google products. Ad revenue earned by Google subsidizes the price consumers would otherwise pay for its services in general and the Reader in particular. A market in which producers use revenue from one group (e.g., advertisers) to subsidize another (e.g., viewers, readers) is called a two-sided market. Broadcast TV is another example of a two-sided market.

Let’s pretend that ad-based revenue Google imputes to its Reader is, on average, $11 per user per year. Let’s also assume that the average marginal cost of providing Google Reader to each of the 10 million users is $1 per user per year. So, Google nets $11 – $1 = $10 per year for an average user and, therefore, $100 million per year for all users. This $100 million is the annual total producer surplus associated with Google Reader.

Total surplus is the sum of consumer and producer surplus, and is an economic measure of welfare. In our example total surplus is $1.1 billion, $1 billion for consumers and $100 million for the producer.

Typically an economic welfare analysis of a market includes comparisons of surplus values for different market configurations. Doing so leads to conclusions about which group, consumers or producers, is made better or worse off in one setting versus another. It is possible for both producers and consumers to be made better off (or both worse off) via a structural change in the market. Total surplus is maximized in the circumstance of perfect competition, an ideal situation which is actually quite rare.

As an example, we could consider the RSS aggregator market with and without the participation of Google Reader. The analysis above is almost complete for the market with Google Reader. What it lacks is the consumer (producer) surplus associated with RSS aggregator users (producers) who do not use (supply) Google Reader that can be attributed to its presence in the market. It is plausible that its presence in the market causes other aggregators to be less expensive or of higher quality. Thus, users of other aggregators receive consumer surplus and their producers lose producer surplus due to lower prices and higher marginal cost of higher quality.

A separate analysis is required to compute the surplus of consumers and producers in the RSS aggregator market in the absence of Google Reader. To conduct this analysis, one would need a model that predicts what current Google Reader users would do in this case. If Google Reader left the market, how would aggregator market shares adjust? How many Reader users would forego aggregator use altogether? I’ll leave suggestions of ways of making such predictions to a future post.

One thing the above explicitly illustrates is that both producers and consumers are made economically better off through market transaction. It isn’t just that producers get revenue and consumers get products. Producers earn profit and consumers receive value beyond the sticker price. Since most of us are in the role of consumer frequently but seller hardly ever we tend to begrudge the firm its profit and pay little notice to the additional value beyond price we receive in return. Google Reader is not the only bargain. Given the enjoyment and convenience obtained by the multitude of products we use it’s a wonder how little of that full value we actually pay. The rest is consumer surplus.

This post originally appeared on The Finance Buff.

This post reviews some academic literature relevant to a discussion about health reform referenced previously. The focus is Uwe Reinhardt’s paper “Can Efficiency in Health Care Be Left to the Market?” (2001, Journal of Health Politics, Policy and Law), for which I will use the shorthand “EHC” for “Efficiency in Health Care.” I highly recommend EHC to anyone wishing to understand welfare economics, even those without an economics background. It is quite accessible, more so than my own words below, selected in large part for space efficiency. (Duke University Press honored my request to provide a few months of unrestricted access to EHC.)

EHC is a review of certain themes in the seminal paper in health economics by Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care” (1963, American Economic Review). In particular EHC’s focus is Arrow’s analysis of the application of foundational concepts of welfare economics to health care. Arrow himself made his argument so efficiently that, to quote Reinhardt, “nothing less than the academic analogue of talmudic scholarship” is required to extract its full value.

A central concept of neo-classical welfare analysis is that of Pareto efficiency, a “first do no harm” welfare criterion. A Pareto efficient distribution of a good (like health care) is one for which any change would make at least one individual worse off. Only a change that would make everyone better off is Pareto efficiency improving. A limitation of the criterion is nonuniqueness: every distribution for which there is no change that makes everybody better off is Pareto optimal, including those judged inequitable by other criteria. A redistribution of just one penny’s worth of care from a prince to a pauper does not increase Pareto efficiency, no matter how well off the prince or in desperate need the pauper.

The nonuniqueness of the Pareto criterion is often side-stepped through appeals to the first and second fundamental theorems of welfare economics. The first is that a perfectly competitive market achieves Pareto efficiency. The second is that any Pareto efficient distribution of resources (e.g. health care) can be achieved as a competitive equilibrium arising from a particular distribution of wealth. Thus, if the conditions of these theorems are met, any Pareto efficient distribution of health care resources could be brought about by a set of suitable initial endowments of wealth (e.g. achieved through the tax code). In Arrow’s words,

“by successive approximations a most preferred social state can be achieved, with resource allocation being handled by the market and public policy confined to the redistribution of money income.”

However, it is (or should be) uncontroversial that the market for health care is not perfectly competitive. Thus, it does not satisfy the conditions of the first and second fundamental theorems. In fact, this is one of the main themes of Arrow’s paper.

EHC’s critique is deeper, however. It is unlikely that any one initial distribution of wealth would achieve the desired distribution of health care and the desired distributions of all other goods and services. The maximization of utility by the recipient of wealth transfer may include the “right” amount of health care but also “undesirable” amounts of other goods (e.g. too much gin, not enough education). The first and second fundamental theorems are of no help at all in “optimizing” distributions over multiple goods simultaneously.

The public policy solution to such an undesirable outcome is distribution not of wealth but of in-kind benefits. In health care this has become commonplace: think Medicare and Medicaid. Is this sufficient justification for a public health plan available to all non-elderly Americans? EHC poses the question thus, “How are we to judge the merits of social health care policies?” Having seen that the nonuniqueness of the Pareto criterion makes it a particularly blunt tool, EHC turns to another pillar of welfare economics: Kaldor-Hicks efficiency.

Under the Kaldor-Hicks criterion, optimality is achieved when no voluntary exchange of compensation would motivate a change in distribution. If a unit of health care is more highly valued by the prince than the pauper Kaldor-Hicks efficiency justifies a shift of health services from the latter to the former. This is a direct appeal to individual utilities and therefore is subject to the same critique as levied against policy via wealth distribution: an “undesirable” distribution of a particular good may result. This is essentially the argument made in EHC. Other objections to the Kaldor-Hicks efficiency criterion are raised elsewhere.

My own sense is that it is asking far too much of welfare economics to point to a unique solution that optimizes a universally accepted criterion. Indeed, one ought to be suspicious of any claims of unique optimality. It is plausible that any such result is preordained by the form of the optimand, even if not explicitly stated. Extra-utility welfare analysis (also called extra-welfarism) can very likely recommend “optimal” policies distinct from “optimal” ones suggested by utility-based (welfarist) approaches.

But no approach has a unique claim to legitimacy. An unassailable argument does not exist for any one solution, whether public or private, to any problem, not even health care. Is this curse of nonuniqueness the death knell of welfare economics? Certainly not. The value of welfare economics in particular and economics in general is the clarity of thought it enforces. A welfare analysis of almost any type will lead the analyst to consider particulars and consequences that are opaque to casual thought. While it is relevant that health care is not a perfectly competitive market one misses the point of economics entirely to suggest that this renders it inaccessible to welfare analysis. Such a thought would be a grave mistake, especially since it appears as if private provision of health care and health insurance is here to stay.

The responsibility of the economist is to understand the assumptions and limitations of his tools. This is the great virtue of Reinhardt’s contribution. By expanding and clarifying Arrow’s words, in EHC he makes those facets of neo-classical welfare analysis plain, not just to the economist, but likely to any clear thinker motivated to read it.

This post originally appeared on The Finance Buff and was cited by The Carnival of Personal Finance #206.

What follows is an illustrative sketch of a classical economic welfare analysis using Google Reader as an example. It is intended for an audience with no economics background. At the risk of disappointing readers, I confess that, due to lack of data, I make up all the numbers. However, anyone with better estimates of the components could improve the calculation by following the steps outlined. Those familiar with Google Reader may wish to skip the next paragraph.

One way to read blogs is to visit each one’s website. Wouldn’t it be better if each could send new posts to one consolidated place for you? Well, nearly all can; the way to take advantage of this efficiency is using an aggregator like Google Reader. Blog sites, like The Finance Buff, advertise this service with icons that say “subscribe,” “RSS,” or “Atom,” or with a symbol like this. By clicking on these icons, you can add blog “feeds” to Google Reader (or another aggregator). The result is akin to a receive-only e-mail experience in which blog posts are listed in your reader and updated automatically.

Google Reader has enhanced my life, changing how I work and spend leisure time. I would not easily keep up with blogs of interest without Google Reader or something like it. (The blogs to which I subscribe are listed in this spreadsheet.) Google Reader is free, but it provides more than zero dollars worth of value to me. If it were not free I would pay something for the service.

For the sake of argument, let’s say I’d be willing to pay $100 per year for Google Reader. This represents the gross value of Google Reader to me. Since I actually pay $0, then the net value I receive from Google Reader is $100 – $0 = $100 per year. This is just like $100 in my pocket because I’d have paid that amount more for Google Reader than I had to. That $100 represents my individual annual consumer surplus.

I don’t know how many Google Reader users there are, but let’s say there are 10 million. Suppose the average individual user is like me, with a consumer surplus of $100 per year. Then the annual total consumer surplus of Google Reader is $100 x 10 million = $1 billion per year. That’s a lot of value. Of course, I made the numbers up.

There is also value that Google receives beyond its costs of producing Google Reader. Google does not receive revenue directly from its Reader right now. Let’s assume it attributes revenue to its Reader because it draws users to other (ad-based) revenue-producing Google products. Ad revenue earned by Google subsidizes the price consumers would otherwise pay for its services in general and the Reader in particular. A market in which producers use revenue from one group (e.g., advertisers) to subsidize another (e.g., viewers, readers) is called a two-sided market. Broadcast TV is another example of a two-sided market.

Let’s pretend that ad-based revenue Google imputes to its Reader is, on average, $11 per user per year. Let’s also assume that the average marginal cost of providing Google Reader to each of the 10 million users is $1 per user per year. So, Google nets $11 – $1 = $10 per year for an average user and, therefore, $100 million per year for all users. This $100 million is the annual total producer surplus associated with Google Reader.

Total surplus is the sum of consumer and producer surplus, and is an economic measure of welfare. In our example total surplus is $1.1 billion, $1 billion for consumers and $100 million for the producer.

Typically an economic welfare analysis of a market includes comparisons of surplus values for different market configurations. Doing so leads to conclusions about which group, consumers or producers, is made better or worse off in one setting versus another. It is possible for both producers and consumers to be made better off (or both worse off) via a structural change in the market. Total surplus is maximized in the circumstance of perfect competition, an ideal situation which is actually quite rare.

As an example, we could consider the RSS aggregator market with and without the participation of Google Reader. The analysis above is almost complete for the market with Google Reader. What it lacks is the consumer (producer) surplus associated with RSS aggregator users (producers) who do not use (supply) Google Reader that can be attributed to its presence in the market. It is plausible that its presence in the market causes other aggregators to be less expensive or of higher quality. Thus, users of other aggregators receive consumer surplus and their producers lose producer surplus due to lower prices and higher marginal cost of higher quality.

A separate analysis is required to compute the surplus of consumers and producers in the RSS aggregator market in the absence of Google Reader. To conduct this analysis, one would need a model that predicts what current Google Reader users would do in this case. If Google Reader left the market, how would aggregator market shares adjust? How many Reader users would forego aggregator use altogether? I’ll leave suggestions of ways of making such predictions to a future post.

One thing the above explicitly illustrates is that both producers and consumers are made economically better off through market transaction. It isn’t just that producers get revenue and consumers get products. Producers earn profit and consumers receive value beyond the sticker price. Since most of us are in the role of consumer frequently but seller hardly ever we tend to begrudge the firm its profit and pay little notice to the additional value beyond price we receive in return. Google Reader is not the only bargain. Given the enjoyment and convenience obtained by the multitude of products we use it’s a wonder how little of that full value we actually pay. The rest is consumer surplus.