The Unintended Economist

Patent Law and Economic Growth

2009-09-17T08:58:00.003-04:00

The purpose of the patent system is to "promote the progress of the arts and sciences." In other words, the patent system should promote the development of knowledge. Currently, the U.S. government grants a patent holder a temporary (20 years) monopoly on the patent in exchange for the inventor disclosing to the public how the invention works. The idea is that by granting a temporary monopoly, an inventor has an incentive to invest money in discovering knowledge because the inventor can recoup his investments during the monopoly period. When the monopoly period expires, anyone can make, use, or sell the invention.

Without this monopoly protection, inventors would be reluctant to invest substantial amounts up front. Without it, another party could make and sell the invention after the inventor creates it, but that party would not have to recoup any up front investments. Thus the second party could sell for cheaper, and the inventor would be unable to recoup his investment.

Patents can only be granted on inventions; they cannot be granted on phenomena, principles of nature, and abstract ideas. So mathematical formulas are unpatentable. But the application of a forumla to manufacturing process for making rubber is patentable. The line between an abstract idea and an application of that idea in a particular context can be difficult to draw.

One current issue in patent law is how to treat software patents, and whether software is patentable. Software can often be more like a mathematical formula than an invention. It can be tricky to figure out when software is merely an abstract idea and when it is an application of an idea to solve a problem. Part of this debate over whether software needs patent protection. Progress in the software field moves quickly. By the time a software patent application is processed, the underlying software is often obsolete. Software is more accessible than many other areas of innovation. The investments required to create software are much lower than those to create pharmaceuticals, industrial machines, etc. So patents may not be necessary to encourage innovation because 1) rapid innovation and the first mover advantage obviate the need for a temporary monopoly and 2) inventors do not need to recoup substantial initial investments.

Part of the debate over software patents is over how to best encourage innovation. The patent system applies not just to software, but to chemicals, pharmaceuticals, manufacturing, aerospace engineering, etc. Software inventors do not need to recoup large initial investments. Most other fields, such as the chemical and pharmaceutical industries, are different. Developing chemicals and drugs involves huge up front investments in things like labs, equipment, testing, and regulatory approval. Additionally, the chemical industries are less predictable than software - it is more difficult to invent a new compound for fighting cancer than it is to develop a piece of software that does something new. So the patent system must provide the proper incentive for investment for many industries that are very different.

During the temporary monopoly period, inventors can recoup their investments because others cannot sell the invention. Consequently, the size of the initial investment is dependent upon what the inventor can likely get back during patent term. For software, it seems that protection is often unnecessary to encourage innovation. For pharmaceuticals, however, patent protection is essential to encourage the millions and billions of dollars that companies invest in research and development. Given that much research yields no salable results, companies recoup their investments in many different projects from the few projects that create results.

In a later post, I will discuss how the patent system is relevant to the health care debate. And in another, I will discuss why investment, and not spending, is the driver of economic growth.

Income Distribution

2009-09-17T08:48:00.002-04:00

Eventually I will make another post about how we should expect wealth distribution to change given a change in income distribution. In the meantime, Steve Horowitz notes how the income distribution has changed from 1980 to 2006.

"From 1980 to 2006, the percentage of US households earning $100,000 or more (in constant 2006 dollars) grew from 8.6% to 19.1%. The percentage between $75k and $100K grew from 10.3 to 11.3 percent. At the other end, the percentage under $15K fell from 16.6% to 13.4% and the percentage between $15K and $34K fell from 26.2% to 23.3%.

***

Let me repeat that: over 30% of US households in 2006 earned above $75K compared to under 20% in 1980. Over the same period, the percentage of US households earning under $35K fell from 42.8% to 36.7%. Fewer households are poor, fewer are middle class, and a hunk more are above $75K."

So the income distribution is becoming a bit flatter. Given what we know about various distributions, we should expect this flattening to result in a greater concentration of wealth. But this does not imply less fairness.

My Key Principles of Health Care Reform

2009-08-26T12:55:00.003-04:00

Over at Cafe Hayek, Russ Roberts suggests that we establish the key principles of health care reform. Here is my take.

My Health Care Reform Manifesto:

1. The true cost of a health plan should not be hidden from the individual.

2. Individuals deserve the same tax benefits as corporations when purchasing a health plan - the preferential treatment given to employer sponsored health care reduces employees' choices, causes employee "lock-in", and both reduces the availability and increases the cost of private health plans to individuals.

3. Only the individual can choose the balance of cost and coverage that is appropriate for him or her.

4. Rules should require more transparency regarding a health plan's cost, coverage level, and limitations rather than obfuscating them through labyrinthian regulations.

5. Only the individual can decide whether a treatment is worth its cost.

6. Individuals should have the choice to purchase true health insurance; individuals should not be forced to chose between plans that spread the costs of ordinary health care across all members and no coverage at all.

7. The most effective way to provide assistance to those unable to afford health care is through measurable subsidies or tax credits to those in need rather than through government control over prices or coverage terms.

8. We have an obligation to ensure everyone has access to a minimum, basic level of health care, but not an obligation to provide everyone with the highest quality health care available.

U.S. Wealth Concentration - Part 2

2009-08-25T16:28:00.003-04:00

After re-reading my first post, I realize that I did not clearly delineate my goals for this set of posts. I am hoping that my analysis of income distribution will show two things. First, by looking at the wealth concentrations that result from various income distributions, I hope to show a baseline wealth concentration (essentially a Lorenz Curve) that can be compared to the actual wealth concentration. For any income distribution where all incomes are not the same, the top bands of earners will naturally have a greater concentration of wealth. Whatever your conception of a “fair” distribution, I would like to show what a baseline wealth concentration would look like for you.

Second, by examining the wealth concentrations from various distributions, I hope to show which features of the U.S. income distribution are responsible for the U.S. wealth concentration.

I have created a chart that compares the U.S. income distribution to a variety of statistical distributions. The purpose here is to get a mathematical approximation of the actual distribution.

Here, you can see the 2005 U.S. income distribution in red. The data I have from the Census is in $2500 increments below $100K, in $50K increments up to $250K, and then it has no increments. For my chart, I used an increment of $5K up to $250K, and then added a category for $350K and $500K. For the values over $100K, I just uniformly distributed the Census amounts. So if the Census said 10% of people earned between $100K and $150K, I uniformly distributed that 10% across $5K increments. Consequently, the income line appears stepped above $100K. Because I compressed the increments for $250K-$500K, there appears to be a spike on the right side.

For all the distributions, I used truncated distributions. So the distributions stop at 0, and all the other values are increased correspondingly. The normal distributions both have a mean of 50K. I had to write some VBA to make the skewed normal distribution. The uniform distribution is from $5K to $250K, not $500K, because I used a U(5K, 250K) in my first post. A U(5K, 500K) would be a straight line across 0.01, instead of 0.02. Finally, I am not familiar with the Weibull distribution, but Excel had some built-in functions for it. The results seemed so similar to the actual distribution that I have decided to keep it.

I created two sets of Lorenz curves that show wealth concentration for the above distributions. Excel did not want to cooperate, so I used a tool called Ploticus (http://ploticus.sourceforge.net/doc/welcome.html) to generate these graphs. Its functionality is somewhat limited (though it can do at least one thing that Excel cannot), so I had to create two different charts. The first one is a comparison of some of the distributions above. The x-axis is cumulative distribution and the y-axis is percent of all income.

The second one has actual, normal, uniform, and line of perfect equality:

Although the U.S. income distribution is quite different from the “line of perfect equality,” it is not all that different from a uniform or normal distribution. If income were distributed normally, the U.S. distribution is not far off.

You may note that the variance of the normal distribution is equal to the mean. This is because U.S. income distribution is quite varied. Thus far, I have found that as the standard deviation of income increases, the concentration of wealth at the top seems to increase as well. In my next post, I plan to explore how changes in the standard deviation affect wealth concentration.

U.S. Wealth Concentration

2009-08-24T16:46:00.006-04:00

Income inequality has been a bit of a hot topic recently. The claim is that income inequality in the U.S. is at an all time high, and inequality has been increasing over the past few decades. One recent statistic is that the top 20% of earners take home 50% of the income. This may be true, but that number means nothing in isolation and its presentation is misleading. I will attempt to show why in a series of posts.

To start, let’s look at the actual distribution of income in the U.S. According to the U.S. Census, the following shows the distribution of income across quintiles in 2007.

The top 20% earn about half of all income, which seems like quite a share. This figure is compared to historical data, e.g., 1920 & 2008, 1975-2005, or 1998-2008. These comparisons show how distribution has changed across income bands, but the numbers really do not mean anything in the abstract. For example, is it unusual that the top 20% earned almost 50% of the income? Does this seeming concentration of wealth mean anything statistically?

Although we can compare to the past, we really do not have a baseline figure to compare with the income distribution figures. The mental baseline is likely the line of perfect equality, a term relating to Lorenz Curves and the Gini Coefficient. The line of perfect equality would be the following distribution.

But for this distribution to occur, all incomes must be equal. By equal I mean exactly the same. So the line of perfect equality would only occur in a completely socialist world. Thus, it may not be a good baseline to use.

This post was spurred by an observation I had during one of my prior consulting jobs. Back when I used to analyze revenue and sales data, I noticed that revenue tended to follow a pattern (I have changed the exact numbers to protect any confidentiality). A client, or more precisely annual revenue from a client, fell into one of three categories: small, medium, and large. Typically, 90% of clients provided a small or medium amount of revenue, and maybe 10% provided a large amount of revenue. Although revenue from small and medium clients comprised the bulk of total revenue, the largest 10-20 clients (maybe 1% of all clients) frequently provided over 25% of revenue.

At first, the revenue distribution seemed odd. On second glance, the distribution seemed less odd. (Since I am changing these numbers, I have made them approximate the income distribution in the U.S.) The average annual revenue for small clients was maybe $40,000 and for medium clients maybe $150,000. The largest clients, however, typically provided over $1,000,000 in revenue. If, for example, the firm had 700 clients at $40K, 200 at $150K, and 10 at $1.5M, those 10 clients will make up over 20% of total revenue. The 10 largest clients seem to make up a disproportionate share of revenue, but when you consider that $1.5M is almost 40 times larger than $40K, it starts to seem less odd.

It seems to me that income is distributed in a similar fashion – with most households clustered around some lower values, and a few households out at the extreme. The extreme values may comprise a substantial portion of total income, but looking at them does not tell us anything about what is happening across the rest of the income distribution. Additionally, the concentration of income at the top, like the concentration of revenue, may not be as large an indication of inequality as it appears.

Let’s look at a uniform distribution. For those not statistically oriented, a uniform distribution means that each income band contains the same number of people (or households). I assume that the maximum income is $250,000. I use income bands of $5K, so incomes between $0 and $5K are in the $5K band, $45K to $50K are grouped in the $50K band, etc. In a uniform distribution, the top percentiles earn a greater share of the total income pie than the lower distributions. It also looks more similar to the income distribution in the U.S. than if income were “perfectly equal.”

Here is the Lorenz Curve for this distribution compared to the “line of perfect equality.”

I am not sure how fair a uniform distribution of income would be in the absolute sense, but I think it is fairer than giving everyone the same income. Does a uniform distribution strike people as unfair? If a uniform distribution is not unfair, does the U.S. income distribution look less concentrated at the top now that you have seen this chart? Rather than using the mythical line of perfect equality, it may make more sense to compare income distribution to the uniform distribution.

I am in the process of analyzing a variety of possible income distributions to see what income inequality would look like. I am working on some normal distributions, truncated normal distributions, skewed normal distributions, and Weibull distributions. This process is taking much longer than I thought it would, so this post contains only some very basic, initial findings. Unfortunately I do not have mathematical solutions to what I am trying to show. The calculus involved is ugly, it has been years since I dealt with this kind of math, and we did not do much math in law school. Hopefully I will have something interesting to post soon.

Relief

2009-07-31T15:11:00.001-04:00

Studying for the Virgina Bar Exam was awful, and it sucked up way too much of my summer. It is finally over, at least for now, but hopefully for forever.

I should start posting again soon.

Free Market vs. Strict Regulations

2009-07-02T15:37:00.002-04:00

Free markets give people incentives to innovate and improve inefficiencies. They also encourage technological advancement and increase product diversity. Although highly regulated markets still allow some innovation and some advancement, they are more likely to stagnate growth. A good example of this comes purely from the private sector: the personal computer.

In the 1980s, many computer companies were developing personal computers. For this discussion, the two relevant companies are Apple and IBM. These companies employed two different business models. Apple chose control: it manufactured its hardware, software, and peripherals. Apple did not allow many third parties to make Apple-compatible products. IBM chose open source: it published its specification and allowed any company to make and sell compatible hardware, software, and peripherals. Apple chose strict regulation. IBM chose free markets.

Apple had (and still has) lots of smart, innovative people. They are frequently credited with creating the first graphical user interface. Their products are still innovative and sleek. However, they do not let many third parties make compatible products. Even today, you still have to ship your computer back to Apple if a part has a problem. Dedicated users say their machines have fewer problems and more intuitive. Perhaps this is the case. But at what price?

Anyone could and still can develop a product for the PC. Since the 80s, hundreds and maybe thousands of companies have developed PC compatible hardware and peripherals. The diversity of PC compatible products grew rapidly, much more rapidly than for Apple. Many companies, such as HP, Compaq, and IBM, made PCs. My first computer, a 386, was built by a neighbor who purchased the parts and built it for us. Anyone could service a PC. Replacement parts were cheap and easy to come by. Prices for PCs were and still are significantly lower than Apple's computers.

Microsoft developed Windows, which continued using the free market model. Although Microsoft is very protective of its operating system, it lets anyone develop compatible software. Owners of Apple computers will be very familiar with new products that are only available on the PC. Even today, many companies that develop products for the PC do not support Apple. But the model employed on PCs allows anyone and everyone to innovate.

The result is that the innovative people at Apple were no match for the collective power of the people - the power of the market. PCs dominate the personal computer market. They have cheaper, better, more widely available hardware. More software companies make applications for PCs than for Apple computers. Most peripherals such as digital cameras, printers, mp3 players, and scanners can just be plugged into a PC and they work. Not so with an Apple product.

The contrast between these two products is stark. Apple machines are more expensive, have less hardware variety, less software, and fewer compatible products. They are also less popular.

Some people may complain that PCs are prone to crashes. An Apple machine never gets a Blue Screen of Death. But an Apple machine cannot use the same variety of hardware and software that a PC can. Creating a product for an Apple computer requires more work and is more expensive and results in less sales than creating a product for a PC.

This is the difference between free markets and a strictly regulated economy. Sure, the market will have blips, and sometimes things won't run perfectly smoothly. But markets will create more products, spur faster innovation, and reduce prices through competition. Most importantly, markets let anyone participate. If you have an idea or if you think you can build a better hard drive, you can do it without getting approval from some central agency.

Strict regulation leads to stagnation. Apple has struggled over the past two decades. It is starting to reemerge through non-computer products. But it has stagnated over the past 20 years. Consumers chose lower prices and more diversity over stability. PCs are stable enough. Regulation will lead to the same results. Only those few chosen by the central agency will be able to develop products. Stability will be valued over innovation. Certainty over growth.

Whether they knew it or not, by choosing PCs over Apple computers the American people have shown that they prefer the results of the free market over the results of strict regulation.

The Trade Off Between Quality and Affordability Health Care

2009-06-23T20:05:00.003-04:00

Apparently all of my posts are about health care. I will get to some other topics at some point, but health care is obviously big right now. My posts also seem to be on the long side. I am working on trying to post some shorter material.

Politicians are stating that we must provide both “quality” and “affordable” health care. However, as the terms are commonly interpreted, the two concepts are incongruous.

In health care, "quality" is frequently synonymous with "highest quality" or "new." People want access to the highest quality health care, including the newest treatments. When it comes to your own life, no cost is too high. Or if a drug or a procedure can fix your aching back or foot, you want it. And why shouldn’t your insurance pay for it? Isn’t that why you have it?

You will frequently see the claim that unlike in other fields, health care price has increased as technology has advanced. But this is not true. The problem is that we are not comparing the right values.

Most people do not want average health care. They want the best health care. They want to treat conditions that were previously untreatable. They want their pain alleviated. They want their life extended. And they don’t want to pay for it. People feel entitled to the best because insurance pays for everything.

With personal computers, the situation is different. The average PC can do everything that most people could want. You can use office software, surf the internet, listen to music, and store as much information as you like. According to Gizmodo, the average PC costs $550. Given that technology can do more than most people want, many people will buy the lower quality machines.

While the average price of a personal computer has plummeted, top end machines are still very expensive. Computer games frequently push the limits of the hardware of personal computers, using lots of memory and processing power to render high definition 3D images and complex sounds. Gaming computers usually represent the top of the line for personal computers. Unsurprisingly, these computers are still expensive.

Here are some examples:
This one by alienware starts at $3,599 and the high performance package is $6,599. Neither include the price of a monitor, which could run about $1,500. And some gamers like to run dual monitors.

This one starts at $3545

Mac’s are still expensive. The Mac Pro starts at $2,499, and adding on some typical gaming features (faster processors, dual video cards) the total becomes $6,349. This is before monitors.

Generally, whenever you use the newest, most advanced technology the price tag is large. Today, the price tag for top end personal computers is still very high - maybe not as high as it was 20 years ago, but still very expensive.

In health care, everyone is a computer gamer. Everyone wants access to the most advance technology. Everyone wants to have a Porsche. Therefore it is not appropriate to compare the average cost of health care to the average cost of other technologies. Health care costs are increasing because the payment system is setup so that everyone feels like they can be gamer, that they can have the highest quality care. Therefore, the average cost of health care is going to be much higher than the average cost of a computer.

This is also why administrative costs are high. Insurance companies try to figure out which treatments are cost effective. Figuring out cost effectiveness is something normally done by the price system, but the insurance company adds a layer of obfuscation. Ordinarily prices limit our consumption, but health care prices are not set at the market price. As observed by Bryan Caplan, when insurance does not cover a procedure, it is more likely to be reasonably priced. Price for covered care can be set higher because demand is inelastic – insured people will demand a procedure they think they need without regard for the price. Health care costs will not be brought under control until the public stops feeling entitled to the best care. The number of payers is largely irrelevant.

Additionally, unlike in many other industries, the scope of health care is continually increasing. Computers today still use the same parts as 20 years ago: a motherboard, a processor, memory, hard drives, etc. The number of different ailments that health care can treat is continually expanding. So many treatments do not have a less advanced, inferior (as in inferior good) substitute. The choice is between the newest drug or nothing.

One final point, the high cost of innovative health care is not an accident – it is the product of a reasoned policy choice. Protection of inventions spurs innovation and growth. The price may be high at first, but in the long term, we are all better off if something is invented than if it is not. The problem is that everyone feels entitled to the newest, most expensive care.

The concepts of quality and affordable are incompatible. The most innovative products will always be expensive. We cannot afford to provide everyone with the most expensive health care. Not everyone can drive a Porsche. To make health care viable we must find the appropriate balance between quality and affordability. We cannot have both.

Prices: The Best Known Method of Rationing Scarce Goods

2009-06-23T16:45:00.003-04:00

Ezra Klein states that the health care system uses the “worst form of cost control: rationing by income.” Last time I checked, rationing via the price system was the least bad method of rationing a scarce good. True, prices in some sense “favor” those with a higher income. But in the same sense, the economy “favors” those who can produce more valuable goods or services. The high wages received by those who produce valuable goods and services provides an incentive for other people to begin producing those goods or services.

Most things in a market economy are rationed via the price system. Food, shelter, clothing, the most basic of all necessities, are “rationed by income.” Not everyone can eat filet mignon, not everyone can live in Manhattan, and not everyone can wear Armani. It is elementary that the best known way to ration these scarce goods is by prices. Prices are not always perfect, but they are a more accurate approximation of the value of a good than a person could calculate.

Ezra Klein should have said that the health care system uses “the best known form of cost control: rationing by income.”

Health Care Company Margins

2009-06-16T22:03:00.016-04:00

President Obama has been pushing the idea that a government health care option will “keep insurance companies honest.” Essentially, the argument is that many insurance companies face no competition and make “huge profits.” I have always had a choice of health insurance options, so this did not sound quite right to me. So I looked at some recent annual reports for some of the largest national health insurance companies. Here is what I found.

(Note: list of companies is from here: http://www.athenahealth.com/our-services/PayerView.php)
(Also Note: I did not look at regional providers, so I cannot speak to them)

First, by way of comparison, the net profit margin for the S&P 500 is:
Past 12 months: 8.24%
5-yr Average: 12.29%
(http://www.reuters.com/finance/stocks/ratios?symbol=SPY)

I think the average pretax (so this won't compare directly to net margins) profit margin for U.S. corporations was approximately 8.5% for 1980-2007, but I am not sure if I am reading the chart correctly. (http://contrarianedge.com/2008/02/04/down-to-the-last-drop-of-profit-growth/)

Here is are the net profit margins for the top national health care companies:

I think the numbers speak for themselves.

I found some data about 2006 net profit margins for certain industries and certain companies:

Now here are the data for the same health care companies from 2004-2006:

I ask: are these the profit margins a sign of dishonest health care companies making abnormally large profits?

Health Care Costs Followup

2009-06-16T13:23:00.001-04:00

Ok, so my first post about health care costs was a bit long and perhaps not entirely clear. Let me recap.

The sources of health care cost growth are the following: 1) administrative costs, 2) the consumption and recommendation of inefficient procedures, 3) increased consumption of health care, and 4) the growing number of more expensive procedures.

1) Administrative costs, or the costs of administering health insurance, hospitals, etc., are more or less fixed. This number is not growing. We may spend 30% too much on administrative costs (or whatever percentage) but this is not the source of growth. Also, market competition prevents these costs from exploding - if someone is doing a worse job of providing care than others, they will go out of business.

2) Here I am talking about spending on health care (i.e., procedures, drugs, or tests) that has a very low probability of success or have no positive effect on patient outcome. This includes things like paying for chemotherapy for a 95 year old who has advanced Alzheimer's, or paying $300 per week for allergy medicine for a person who has only mild allergies. A big reason that spending on inefficient procedures occurs is because neither the doctor nor the patient has an incentive to reduce costs. However, the absence of incentives to reduce costs is not a new thing. The current third-party payer structure has been around for over 25 years. Consequently, it seems reasonable to assume that spending on inefficient procedures is at a fixed percentage of all health care spending. Thus, this type of spending is not a source of spending growth.

3) The increased consumption of health care sort of overlaps with categories 2) and 4). This has two components: consumption of unnecessary, inefficient health care (category 2) and consumption of a greater quantity of effective health care. Spending that is not cost effective should be a fixed percentage of total spending. But an increased quantity of consumption is not necessarily something that we want to stop. As technology and science have progressed, we have discovered more conditions that are treatable by health care (Viagra, the medicine for overactive bladder, various prosthetics, lasic, etc.). We consume more health care because more conditions are now treatable. So in addition to whatever spending we had 10 years ago, we now have spending these new technologies. Granted, the price of old technology should go down over time, but what if the rate of innovation is greater now than in the past? This leads to the next category.

4) If the rate of innovation has increased, then the number of new, more expensive procedures will grow. The result is that we will have a larger number of new, expensive health care choices now than we did in the past. In addition to more expensive choices, the range of treatable conditions has increased. Today, people can take drugs to lower cholesterol, to get erections, to treat severe PMS, to treat dementia, to treat AIDS, to treat overactive bladders - a whole range of conditions that were previously unaddressed. These improvements in health care are causing health care spending to grow.

Of all 4 categories of potential sources of cost growth, only the increasing rate of innovation is actually causing spending to grow. The other 3 categories should remain at a relatively fixed percentage of total health care costs.

So the question is how do we reduce cost growth?
Reducing administrative costs or reducing the percentage of inefficient procedures will not reduce cost growth. It may reduce total costs, but it should not affect the growth rate. Innovation will continue, and the range of benefits provided by health care options will increase. Thus the quantity of health care should increase.

The way to reduce growth is to limit the amount we spend on new but expensive health care. As long as a third party is paying the bill, individuals that suffer from an ailment will consume new, expensive health care to treat it. This makes the average spending increase, and it increases the cost of health insurance to everyone.

There are two ways to reduce spending on new, expensive health care. First, the government can decide who gets what treatment, and how much of it. Second, individuals can do their own cost-benefit analysis to decided whether a particular treatment is worth the cost to them. I favor the second option.

The best way to put more responsibility on the patient for cost is to let/force people to research insurance plans and pick the level of coverage that is right for them. Some of these plans should have a higher deductible, forcing the patient to weigh the costs with the benefits.

In my prior post, I suggested a deductible set at a percentage of income instead of a flat rate. I think income percentage deductible might be better applied only when a course of treatment is going to cost more than a certain value. So a plan would have the regular deductible and high-cost treatment deductible. For example, a regular doctor's visit or a course of drugs that costs $500 would come out of the regular deductible. But a course of drugs that costs $20,000 would come out of the high-cost, income percentage deductible. This forces people to carefully weigh the benefits against the costs of an expensive procedure. It ensures that people are weighing similar costs (10% of their income) while still allowing everyone to be insured. A flat rate deductible would fall harder on low income people.

My other suggestion was an insurance plan with a payout at the end. You buy a 10 year plan, that covers up to $100,000 (it should cost less than $100K). Then at the end of 10 years, you get a payout of any unused amount under a certain threshold. So if you spend less than some amount, say $50,000, you get some of that unspent money back. This gives you an incentive to limit the expensive care you get, but to still consume health care that is effective for you.

Alright. So I am not sure if this post is any shorter than my first one. But hopefully it is more clear.

Prohibition Still Doesn't Work: Legalize Drugs

2009-06-15T20:02:00.001-04:00

This is an essay I wrote in 10/2007. But it seems that legalizing drugs is a timeless topic: http://www.nytimes.com/2009/06/14/opinion/14kristof.html?_r=1&ref=opinion.

Destroyed families, decaying communities, international embarrassment—these are just some of the results of one of the least effective, most wasteful campaigns in US history: The War on Drugs. Unlike the pharmaceutical or alcohol industry, the government has relinquished control over the illegal drug market. The current police state provides little control, is expensive in terms of financial cost and human safety, and prevents the government from enacting safety regulations or affecting supply. Just over 20% of the prisoners in state prison are drug offenders, and drug cases are a burden on an already crowded judiciary. In 2000, state and federal spending on the war on drugs totaled approximately $40 billion. Even with such high costs, drugs are still widely available. The old policy does not work; it is time for a new one.

The US’s first foray into prohibition of a drug—alcohol—did not work. Rather than stop drinking, people turned to underground clubs and the black market where the government could not control quality, quantity, or location. The mafia and organized crime reaped huge profits from the prohibition. Illegal drugs like marajuana are modern day the alcohol - it is difficult to meaningfully distinguish most illegal drugs from alcohol. Prohibition of drugs has not worked, and there is no reason to think that it ever will work any better than the prohibition of alcohol.

Rather than continuing to waste money, lives, and liberty, the US should selectively legalize and regulate drugs. By lifting prohibition and enacting regulations, the government can effectively influence drug production, distribution, and sales, and it will even generate a tax revenue stream. The government should legalize and regulate the market for a handful of the least harmful drugs. The government would capture the market for the newly legal drugs, which would grow as other drug users substitute the legal drugs for illegal alternatives. Regulators could control quality, quantity, distribution, and price, and they could effectively target demand reduction and other education programs. In addition, partial legalization will take revenue away from organized crime, gangs, and drug lords, putting many of them out of business.

This policy takes advantage of the principles of marginal deterrence and the substitution effect. Legal penalties already operate to discourage marginal criminal activity by increasing with the severity of the crime. For example, by making the penalty for murder more severe than robbery, many robbers will be marginally deterred from killing their victim. People also substitute legal activities for illegal ones. For example, if gambling on horse races is legal, but gambling on cards is illegal many gamblers will substitute horse races for cards to avoid the risk of punishment. The same principles govern drug users and the drug market.

The first step in enacting this policy is legalizing marijuana. This step will have large and immediate positive effects. First, it will decrease the cost of the current enforcement initiatives as marijuana violations are the most frequent drug crime, composing over 40% of drug arrests in 2005. Second, legalizing and then taxing marijuana will create a revenue stream that can be used to help finance further policy changes. Third, this poses little risk to public health because marijuana is less harmful than alcohol and less addictive than nicotine and caffeine. Forth, some states have already started down this path, making acceptance of the policy more likely. State concerns could be alleviated by allowing states to choose to re-enact prohibition within their borders.

The second step is to study drug habits and then begin to selectively legalize other drugs. By strategic legalization, regulators could harness substitution effects and use marginal deterrence to minimize the size of the illegal market. By legalizing the most commonly used drugs or the safetest drugs, regulators could draw users away from the black market. Such a move could be thought of as anti-competitive behaviour by a monopolist - the government lowers the prices it charges for drugs to just above cost, thereby driving organized crime and drug producers out of business. With this simple move, the government will reduce crime and gain control the drug supply. Revenue streams to organized crime will dry up, and their influence will shrivel away.

Regulators can mitigate some of the negative effects of drug use by setting incentives effectively. Because illegal drug prices include the cost of the producer’s risk of arrest and drug confiscation, among other things, legal drugs will cost much less. Lower costs means that fewer users and addicts would be driven to crime to pay for their habit. Establishing state stores to sell drugs, like how some states currently regulate alcohol sales, will allow regulators to control supply, will give the government an effective outlet for education and prevention programs, and will prevent dealers from "pushing" drugs on children. Although drug use would be legal, public intoxication should still be punished. Society does a decent, though not perfect, job of keeping drunks off of the street and preventing them from driving. Similar policies could prevent drug users from harming the public.

The end result of these policies would be a drastic reduction in the number of drug criminals and the elimination of the resulting underclass of citizens. Burdens on law enforcement, courts, and jails would be significantly reduced. The government would have greater control over the health and safety of its citizens. Admittedly, this plan would not eliminate all drug problems. Society would still have some problem users, and it would still have to spend on education, addiction and abuse counseling, and regulatory enforcement. However, the net costs should be much lower than current drug war spending. Elected officials would have control over the drug market, and if they decide that this policy is ineffective, then they could revert to prohibition. In the meantime, criminal networks, distribution channels, and revenues would be destroyed, crippling organized crime. Considering the ineffectiveness of the current puritanical policy, trying this new course of action is a no lose situation for society.

Bankruptcy for Detroit - An Email From 12/2008

2009-06-15T19:44:00.000-04:00

This is another email from an email exchange related to the one in the previous post. This one is from 12/2008. For any of the webpages I cited, I may have borrowed some wording for the email more closely than I would have for a post like this. Also, I did not check the links to make sure they still work.

What is the difference between bankruptcy and a bailout? Instead of being restructured via bankruptcy, a bailed out company is restructured via the political process. For the automakers, real, substantial, and likely painful reforms must occur in the companies if they are to remain profitable—and profitability is a precondition to employment of workers. Is oversight by Congress or oversight by a bankruptcy court a better way to bring about this change? Judging by Congress’s latest attempt (requiring production of unprofitable green cars and not requiring enough restructuring), a bankruptcy court is a much better place to sort out this mess. It is best to keep the boobs in Congress out of the picture.

--Bankruptcy--

Bankruptcy does not merely obviate a company's debts (although this is a significant part of it). Bankruptcy allows a debtors and creditors to restructure their relationships under court supervision. The company submits a plan to come out of bankruptcy and the court allows the debtor to restructure and prioritize debts with an eye to the debtor remaining in business and maximizing return to the creditors. As part of the process, a company can change its contractual obligations, but only under court supervision. Essentially, creditors who lent the debtor money are forced to recognize the risk associated with lending to a poorly run company. See http://www.ft.com/cms/s/0/1a2e2042-c79f-11dd-b611-000077b07658.html .

For Detroit, making the companies profitable and efficient almost necessarily means closed dealerships, laid off workers, and backing out of pension agreements. This is a necessary evil. It does not make sense to subsidize extra dealerships or higher worker compensation when the company is fundamentally mismanaged. Bankruptcy can help sort out the mess. If a bankruptcy court finds that an automaker is worth more liquidated than it is being in business, then the court liquidates the company's assets to pay creditors. If no restructuring can make a carmaker worth more continuing in business than liquidated, a bailout merely prolongs the inevitable. See http://www.american.com/archive/2008/december-12-08/how-to-help-detroit and see http://online.wsj.com/article/SB122939117718809261.html. It is not a matter of making Detroit as efficient as foreign manufacturers—it is a matter of making them worth more in business than out of business.

--Liquidation--

Even if the Big 3 are liquidated or only some of them are liquidated, Americans and the rest of the world will still demand cars. Someone will produce those cars. For Americans, many of those cars will be produced by foreign automakers' American plants. Jobs will not be eliminated, they will be shifted to companies that have a competitive advantage or to countries that have a comparative advantage in producing automobiles. In anticipation of such demand, some foreign companies or remaining US companies may purchase some of the liquidated assets. In the end, production is shifted to those who can do more efficiently.

"A government bailout of the Big Three keeps huge amounts of productive inputs in firms that can't use them efficiently. Forcing taxpayers to subsidize the continued employment of gargantuan quantities of raw materials, labor and capital goods in unproductive pursuits is a recipe for economic stagnation. The popular and politically convenient myth has matters backwards: The bigger the unprofitable firm, the more vital it is that it be allowed to fail." See http://online.wsj.com/article/SB122895755096596653.html.

--Consumer response to bankruptcy--

Some argue that consumers would not buy a car from a bankrupt manufacturer. This is almost certainly an overly simplistic view. First, how would consumers view a bailed out automaker? I think we can all agree that a bailed out automaker is a bankrupt automaker. If it was not bankrupt, then it would not need bailing out. Maybe some survey out there could shed some light on this question.

Second, the appropriate question is not would a consumer buy a car from a bankrupt automaker, but by how much would a car need to be discounted to make up for the uncertainty in continued warranty coverage. Though we have no answer, we could look to the price of warranties. See http://www.becker-posner-blog.com/archives/2008/12/why_bankruptcy.html. Although I do not have that data, I speculate that such costs are no more than 20% of the purchase price. A steep discount but perhaps one that is maintainable through a bankruptcy proceeding. This might actually increase sales in a deep recession because demand for inferior goods typically rises as income falls.

The final bankruptcy question is whether the act of declaring bankruptcy will have a large negative effect on the economy. I concede that it may, but it is possible that it will not. 55% of Americans oppose taxpayer funded loans to the automakers. Given consumers' preference for bankruptcy over taxpayer loans, the negative effect on consumer expectations and confidence may be minimal (or even positive). I also concede that it is possible that the liquidation of one of the Big 3 would have the opposite effect of a stimulus. However, is the possible benefit provided by "stimulating" the automakers enough to offset the long term damage caused by wasting tax dollars, keeping inefficient firms in business, and creating moral hazard in the auto industry and others industries that are colorable as too large to fail?

--Conclusion--

The allocation of resources to unprofitable industries is a recipe for prolonging an economic downturn and delaying recovery. Bankruptcy is a process that was designed as and has been extensively tested and refined as a means for transforming an illiquid company into a stronger and more profitable company while minimizing the impact on creditors. The potential and uncertain benefits from a Congressional bailout are vastly outweighed by the availability of bankruptcy and the certain harms that will flow from Congressional intervention in the auto market. What is more, is that none of this takes into account the inequities associated with taking tax dollars from companies and citizens in more productive industries to reward companies that made poor business decisions and contracts and to protect creditors who unwisely lent to those institutions.

No Auto Bailout - An Email Exhange from 11/2008

2009-06-15T19:35:00.001-04:00

This is an email exchange in November 2008 that I had while arguing with a friend. I made some small edits, but it is mostly unchanged.

The financial bailout was a bad idea. The government should not become the primary allocator of resources. Politics involves biases, a lack of information, and a lack of expertise. In addition, politicians do not respond to changed circumstances. Without punishment by a market, politicians have no incentive to revise policies. The electorate provides only attenuated and indirect oversight - this is especially true at the federal level. The government also should be careful when changing systemic rules to avoid unintended consequences. But we can't change the financial bailout so we should focus on preventing another ill-advised bailout of the car companies.

I do think consumers would buy cars from a company in bankruptcy. Who would you rather buy a car from: a company hovering at the brink of bankruptcy or a company that has gone bankrupt and come back? A company that requires $25 billion to stay in business? You know you are getting an inferior product for more expensive.

The first reason consumers would buy a car from a bankrupt manufacturer is that, the car likely will be priced lower. Two, American cars can be serviced by anyone – there is already a large, public knowledge base of how American cars work. The only thing consumers would lose is warranty protection. Three, American consumers have dealt with bankrupt companies before and know it is not necessarily the company's end. So the loss of warranty is only a potential risk, not a definite loss. Four, bankruptcy will allow the car companies to cut pension benefits and cut union wages, making them more competitive. Every time someone buys an American car, some not insignificant percentage of the price goes to supporting inflated pension benefits for union members. In a sense, we are still paying for the cars of 20 years ago.

Appropriate marketing should solve consumer concerns about a bankrupt company. Although some surveys indicate that consumers would not buy a car from a bankrupt company, these few surveys are unconvincing.

Not only could the country handle the "collapse" of the US car industry, but the industry must collapse. Allowing existing resources, let alone billions of dollars of new resources, to remain locked up in Detroit causes two losses. First, the resources (i.e., capital) are hogged by inefficient companies and cannot be allocated to efficient producers. Inefficient producers are allowed to continue operating, and efficient producers cannot expand. Second, plenty of car manufacturers produce domestically. If there is some value in the brands or in the factories, those solvent companies will buy them.

And if the problem is that Detroit can't innovate to stay relevant and has not developed any assets that any company would want to buy, why would we want to prop them up? So they can have time to innovate? That could take forever. These companies should be out. Toyota and other companies should be in.

Health Care - No Incentive To Reduce Costs

2009-06-15T18:43:00.000-04:00

Much ado has been made about rising medical spending. We hear that the path of spending growth is unsustainable, that current spending is too high, and that costs need to be cut. For the most part, this analysis recaps much of what has already been said about the causes of spending growth. What I have tried to do, is frame the arguments a little different and categorize the sources of growth. I think that many discussions about costs muddle these categories. By segmenting the sources of growth, I try to explain why almost every time someone says “we need to slow the growth in health care spending,” I hear “we need to slow the rate of medical innovation.” Finally, after analyzing the source of health care spending growth, I briefly present some ideas on how to address the problem.

What causes costs and spending to grow? The sources of growth are the following: 1) administrative costs, 2) inefficient procedures, 3) more expensive procedures, and 4) increased consumption of health care.

Administrative costs should not be too much of a concern. The marketplace is fairly effective at punishing companies that are inefficient. Inefficient firms tend to be overtaken by their more efficient rivals or are otherwise punished. Administrative costs can also be looked at as part of a zero sum game. If a company is charging a sustainable price for its service, and that company can lower its administrative costs, it can increase its profit margin if it lowers its own costs. So why would any company allow significantly bloated administrative costs persist? (The answer is that they are protected by a government granted privilege and do not need to operate efficiently, but that is not relevant to this discussion.)

Inefficient procedures are a cause for concern. By inefficient procedures, I mean things like: diagnostic tests for a condition the patient is extremely unlikely to have; procedures that are unlikely (maybe extremely unlikely) to be successful; and expensive, new medication for a condition that is not serious. When a patient is given a choice between paying nothing to have a test that might detect a health problem and paying nothing to leave a potential health problem undiagnosed, that patient is going to choose the test. Similarly, when given the choice between taking a medication or getting a procedure that might lead to good results, typically the patient only considers the potential gain from the medicine or procedure against the risk of harm. The patient does not consider cost.

When a doctor is faced with recommending a test, medication, or procedure, the doctor would likely weigh: the risk to the patient’s health if a problem exists/persists, the probability the problem exists, the risk to himself of malpractice liability for not recommending the test or procedure, and the financial incentives for ordering more health care. Considering the incentives, the only time a doctor will not order a test is when the test poses a risk of harm to the patient or when the probability the health condition exists is infinitesimally small. Given the other factors, it is in the physician’s interest to recommend more health care.

In some cases, a doctor may have other incentives. For example, a doctor at the Mayo Clinic may be driven by the prestige that comes with providing the very best care. Or a doctor that teaches may be more reluctant to recommend an inefficient procedure because he is trying to be a model for his students. In most cases, however, these incentives are not present.

The problem with inefficient procedures is that the system is setup so that neither the doctor nor the patient gives much consideration to cost. The main mitigating factors are the risk of harm to the patient and perhaps the patient’s desire to avoid a hassle of sitting in a doctor’s office. This leaves cost considerations to the insurance provider. And it also leads to increased consumption of health care by individuals. The insurance provider attempts to limit health care by limiting what it pays for, but limiting care is usually met with some kind of public outrage because someone’s sick mother was denied coverage for a new cancer treatment or the like.

Although the use of inefficient procedures is cause for concern, it is not a new phenomenon. The incentives created by the third party payer system have been in place for some time now (at least 25 years). Thus, the mere fact that some percentage of all health care spending is on inefficient procedures does not seem like a plausible explanation for the growth and projected growth of health care spending. All things being equal, the percentage of health care spending on inefficient or unnecessary procedures will stay constant. Although the putative prevalence of inefficient procedures is part of the problem, it is not cause the growth.

The real culprit of increasing health care spending is innovation. The continual improvements in technology, expansion of medical knowledge, and development of new patents results in an expanding pool of new health care options. These improvements are the result of incentives intentionally provided to innovators – if you invent a new drug, medical device, or method of treatment, you are entitled to a patent, which is a government granted monopoly on your technology. This incentive encourages entities to invest in research and development, and it is not unique to the U.S. – much of the rest of the world grant patents too. So when a company invents, e.g., a new drug, it will not face any competition for the patent’s term (20 years) unless someone else develops another drug that does the same thing. And after the patent term expires, anyone can use the patent free of charge.

Continuing the drug manufacturer example, if a company by developing a new drug can make $1 million per day for 10 years, it has a potential, undiscounted revenue stream of $3.65 billion. That company will be willing to invest a good portion of that potential revenue into research and development with the expectation that it can recoup its losses at some unknown point in the future. The company can make a lot of money when it first gets the patent, but that revenue stream will get smaller as competitors invent similar drugs (if they do) or when the patent term expires and anyone can make the drug. The idea is that innovators are paid handsomely as an incentive, but in 20 years, their invention will be cheap and available to all. For example, acetaminophen was once an expensive, new, patented drug, but now you can buy 100 doses for $10 at your drug store.

So when health care companies innovate, they create health care products that are more expensive. But as just explained, innovative and expensive products are not a bug but a feature. Today, more procedures, tests, and medications are available than in the past. People who, 25 years ago, would be bound to a wheelchair for their entire life, can run marathons. 25 years ago, babies born 3 months early would almost certainly die. Today they have a good chance of surviving. In short, innovation increases not only lifespan, but quality of life as well.

Combining all these factors, patients and doctors do not make decisions based on cost. Companies have an incentive to develop new drugs, tests, medical devices, and treatments. Innovative health care is expensive, at least at first. Unconstrained by cost, consumers and doctors consume new, expensive products. As the rewards for innovation grow, companies spend more to innovate. As the number of new products grows, the number of ailments that can be addressed grows, and spending on all health care products increases. The consumer, who has no incentive to reduce costs, finds out about an expensive new product, and says I must have it. Imagine if you could get a new mp3 player or cell phone or whatever any time you wanted without paying for it. Why not get the newest, best product? This cycle is what is causing health care costs to grow.

Arguably, the growth in spending is beneficial because it increases the growth of innovation. The problem is that as spending grows, spending per patient grows, raising the price of insurance coverage. Consequently, the less fortunate get priced out of the market. The cause of expenditure growth can be addressed in one of two ways. First, the government can limit the growth in spending by rationing care. I will not discuss this option at length, but I will give it mention at the end of this post. Second, the market can limit spending by placing part of the financial burden on patients. I support putting more financial burden on patients. The government should not be in the business of deciding how much care is appropriate.

I have not fully thought out my suggested solutions (which will be the subject of another post), but here is the overview. For the most part, these are solutions thought of by someone else. First, eliminate the tax benefits given to employer provided health care. If consumers are more active in choosing the level of health care that is appropriate for them, they will be more conscious of the costs and benefits of the level of medical care they consume. I happen to have private insurance, and I found the process of pricing out insurance to be rather informative. I also take two prescriptions daily, so I had to consider the price of prescription drug coverage.

Second, is to have a higher deductible on all policies. This also will make consumers more aware of the level of care they consume. However, I have two twists on the deductible concept that I have not heard other people advocate. First, the deductible could be at some percentage of income, maybe 5% or 10%. If a patient thinks that an expensive procedure will yield substantial benefits, this forces each patient to weigh the expense of the procedure in relation to income to the potential benefit. Unlike a fixed deductible, like $5,000, this gives each patient a similar incentive to reduce costs. A $5,000 deductible is a small sum for someone with an income of $150,000, whereas it may be nearly an unaffordable amount for someone with an income of $30,000. If the course of a treatment is going to be $20,000, the high income person will always get it (it only costs them $5K while they get $20K), while the low income person may never get it (the $5K barrier is too large).

Second, is companies may want to offer of some kind of long term, fixed coverage plan. This is modeled after some life insurance plans. This plan has three key features. First, premiums are higher in the first few years, but then drop off to a stable level. Second, these plans have a maximum policy limit. The plan will cover up to, say $100K, and once you hit that limit, you get no more coverage. Third, the plan has a redemption value. If you spend less than you limit (i.e., less than $100K), you get half (or some percentage) of the unspent money back or some kind of refund. This gives you the incentive to use only as much health care as you need.

Finally, I will say that I am not against some minimal level of universal care. Providing everyone with the opportunity to get one physical check up and a few diagnostic tests per year is not going to break the bank. If we spend $1,000 per person on this minimal care, that is $365 million (or so) per year. When we are talking about health plans that are going to cost billions to implement, and then have a going cost of billions per year, $365 million per year is pretty close to zero. Let me be clear however: I am not for universal insurance. Insurance choices should be left to the individual. All I am saying is that we should give everyone the chances to receive basic medical care. This provides health care for everyone and has an ascertainable cost. The cost of universal insurance, especially if you consider the adverse selection consequences, is not ascertainable and will likely contain many hidden costs. Protecting against accidents, unforeseen circumstances, and Mother Nature are best left to the private sector.

The real problem with health care is that so few parties have the incentive to reduce costs. To be certain, excessive administrative spending is not a productive use of resources. Nor is spending on inefficient procedures. But the idea that some outside observer can look at health care and decide when a procedure is effective and when it is ineffective is pure fantasy. As is the idea that the government can set the optimal level of health care spending. Equally plausible is that the government could set the optimal level of bacon consumption, and then look at individual preferences to decide who should get how much bacon. Such a task is nearly impossible. Instead, the health care market should be designed so prices are used to allocate care.

So when people tell you that they want to decrease health care spending growth, beware that what they are proposing is a decrease in health care innovation.

Hello World

2009-06-15T17:42:00.000-04:00

This is my second attempt at setting up a blog. I want to practice articulating my thoughts and arguments, and I also want to create repository of my writings/ramblings. The idea is to blog about whatever interests me, but I seem to return frequently to unintended consequences, incentives, and hidden costs.