De-regulate health care?

I generally enjoy The Economist’s blog, but I think they’ve taken their free-market philosophy a little far with their post on the “de facto monopoly of the American Medical Association in the distribution of licences to practice medicine.” Their claim is that the AMA extracts large rents from their monopoly and unfairly prevents other from practicing medicine. I don’t know what sort of rents doctors get from their education so I can’t comment on that. A more interesting question is whether it would be efficient to allow a deregulated market in medical practice.

Every time you go to the doctor you are, effectively, contracting for medical services. A well-known problem in contracting theory is lack of verifiability. The problem is that it is very costly to you to find out whether the doctor is providing you with high quality medical services. If you are not yourself trained as a doctor then you have to seek the opinion of someone who is in order to verify the quality of service you received. Even then, there is a question mark over the third party’s credibility: they may want to either protect the reputation of medical practitioners or, alternatively, destroy the reputation of competitors. Even the knowledge that you recovered from illness is not enough since this is a very noisy signal of medical quality. Without specialist knowledge it is impossible to know what the outcome would have been in the absence of treatment. The suggestion that consumers ought to have “choices over traditions of training and styles of care” suffers from the same problem. In the absence of highly specialised knowledge there is no way for consumers to verify the quality of each style of care.

There are two possible remedies to the problem of verifiability: information and regulation. Consumers can be informed by the AMA about the choices they face in a deregulated market or the market can be regulated. Unfortunately, it is simply not possible to become an expert on medical care by reading a couple of pamphlets. Placing the burden on consumers to choose wisely is unlikely to result in an efficient health care outcome. By contrast, regulation puts the burden of choice on experts in the field for whom it is far less costly to evaluate performance. It is quite possible that the rents that the AMA extracts from consumers are far lower than the costs to society of deregulation.

The marginal revenue of movies

I was reading the Dilbert blog the other day, and Scott Adams was trying to talk about a Dilbert movie. Before starting to ask the blogging community whether they thought it would be a hit, he linked to this article, and asked why movie producers keep making so many R rated films, when G rated films gave larger returns. He puts it down to the directors incentives not being aligned with those of the investors. So instead of making a film that will maximise profit, directors make films that maximise the chance of winning awards. This is all very good, and I’m sure that there is an agency problem in film making. However, the agency problem will be ex-post the decision on what type of film to make. It seems to me that if investors felt they would make the most money of G-rated films, they would make contracts with directors to force them to make G-rated film, thereby solving (most) of the agency problem.

Scott Adams has an extremely good understanding of economics (he did do a degree in it), however, in this case I feel that he has confused average and marginal revenue. Now the article states that the average revenue from a G-rated film is greater than the average revenue from a R-rated film. However, when an investor puts money into a film being made, they are interested in the marginal revenue of that film type that is available from the market. The investor is putting money into a project that creates 1 more of that type of film in the market place. In that case the marginal revenue of a film type is what the investor is after.

Now it is possible that the average revenue of R-rated films may be lower, while the marginal revenue of an R-rated film is the same as a G-rated film. All we need for this to happen is the initial returns from the first G-rated film on the market to be higher than the R-rated film, but for marginal revenue to then fall much faster for the G-rated film type than the R-rated film type. I think this is a good description of demand for movies. Families have a high value for taking their kids along to the first great animated film of the year, however once we get to the 3rd animated film for the month the family will stop going. However, R-rated films tend to get a specific crowd that is interested in that type of film. This crowd is willing to pay to see more movies, but may not be as large as the crowd that goes to the first animated film. Furthermore if there is more range among R-rated films than G-rated films, the set of products we are discussing is catering to a differentiated market. If this is the case, the release of an R-rated film would have less of an impact on the marginal revenue of another R-rated film than would be the case with G-rated films.

However, there are a number of other explanations for the difference in average revenue:

  1. R-rated films are less prone to failure (so the marginal profit can be lower)
  2. R-rated films are cheaper to make (so although marginal revenue is lower, marginal profits are equal)
  3. There is some bias among investors towards R-rated films
  4. There are too few directors and too many investors, and so directors they have some market power. As a result, directors can change the composition of movies

Personally, I think all these things come into play in some way. However, I’m confident that movie investors are often trying to maximise their profit, just like people who invest in companies or houses.

Airlines and competition

I’ve been thinking about the fact that AirNZ is going to shut down Freedom Air in March 2008. With Freedom Air, Air NZ was able to serve the budget end of the market and the higher quality end by selling a differentiated product. However, the company could have simply offered different services in different compartments of the plane, it seems a touch over the top to create a whole separate brand just to get the advantage of price discrimination (at least in this case).

The true purpose of Freedom air was to prevent competition. By paying a whole lot of money to run a cut price airline, Air NZ was able to make it uneconomical for other potential entrants from coming into the market, as their marginal cost was greater than the price they could set when competing with Freedom. The investment in Freedom air acted as a form of commitment. As the investment in capital, goodwill etc for Freedom air was costly to reverse, Air NZ could credibly commit to fighting a new competitor on the Trans-Tasman route through the low prices Freedom charged, rather than just allowing them entry.

However, Air NZ has dropped Freedom right when Virgin was getting in on the act. I expect this is because the costly commitment to fight the new competitor was not sufficient to prevent the new competitor entering. As a result, Air NZ has decided to dump Freedom Air and just accept that there is a new competitor. I guess this is fair enough, as Virgin has some very deep pockets, and if Air NZ decided to fight them they may well be on the losing end. As a result, Freedom Air was a useful mechanism to reduce small scale competition in the market place, but it was not effective at preventing the arrival of one of the big boys.

In the future, I’m sure the case of Freedom Air will be a useful case study in how an incumbent can use costly commitment to prevent the entry of a new competitor. How do you think the commitment game functions in this case?

Fortnight in numbers

This time instead of being lazy I’ve actually been a bit busy, so here are some numbers from the last fortnight.

  1. Net annual arrivals fell to 8,730 in August
  2. Tourist arrivals rose 5.8%pa in August
  3. CA deficit came in at 8.2% of GDP in June
  4. Electronic sales rose 9.2%pa in August
  5. Core retail sales rose 5.0%pa in July
  6. House sales fell 9.8% (SA) between July and August
  7. TOT rose 0.6%
  8. Manufacturing output rose 3.2% (seasonally adjusted) over the June quarter.
  9. RBNZ didn’t change the OCR
  10. The exchange rate went between 0.686US and 0.746US busy times.

Where have all the socialists gone?

Over at Cato Unbound the health care debate rages on. David Cutler and Dana Goldman reply to Robin Hanson’s original article by almost agreeing with him. They both begin by acknowledging that much of our current health care spending is wasted. The gist of their criticism is that when you reduce health care consumption then you reduce necessary as well as ‘wasted’ health care. Consequently they call for increases in the effectiveness of spending rather than cuts to it. Note that Hanson never claims that the spending that does happen shouldn’t be controlled by doctors to ensure that necessary procedures still get performed.

Moreover, the criticism really seems to be an attempt to avoid the problem by simply wishing it away. Nobody denies that it would be nice if no health spending were wasted and it were all highly effective for treatment purposes: the fact is that it’s not and it probably never has been. As Hanson asks in his reply, “why must this distant possibility [of better health care] stop us from publicizing and acting now on our consensus that we expect little net health harm from crude cuts?”

Ezra Klein claims that some of the spending might be justified in order to raise peoples’ quality of life showing that we care. This might be a valid point, but I question whether that money couldn’t have a greater impact on peoples’ quality of life if it were spent elsewhere in the government’s budget. I have never been one to call for slashing social spending indiscriminately, but I’m surprised by how weak the replies to Hanson’s rather radical essay have been. The overwhelming response seems to be a knee-jerk rejection of such extreme spending cuts without a real refutation of the reasoning behind them.

Carbon taxes again…

It looks like Matt’s not the only brilliant economist campaigning for Pigovian taxation of carbon emissions. Now Greg Mankiw’s weighed in on the side of taxation. To those who claim a carbon tax is regressive because poor people are forced to live in the suburbs and drive more than the wealthy, Mankiw says

Gilbert Metcalf, a professor of economics at Tufts, has shown how revenue from a carbon tax could be used to reduce payroll taxes in a way that would leave the distribution of total tax burden approximately unchanged.

In addition, the Economist points out that

…it’s possible that a carbon tax might sharply reduce carbon output without any fall in oil consumption, so long as consumers of other fuels affected by the tax reduce their use of such pollutants and their consequent emissions,

although this seems like a bit of a long shot.
In NZ, the government has preferred a cap-and-trade system to carbon taxes. Mankiw mentions that this is equivalent to a carbon tax only if the permits are auctioned off. If they are allocated for free based on previous emissions, as I believe the case will be in NZ (please correct me here if I’m completely mistaken), then “…the prices of energy products would rise as they would under a carbon tax, but the government would collect no revenue to reduce other taxes and compensate consumers.” In other words, a cap-and-trade with grandfathered permits IS regressive and it’s expensive to redress the burden on the poor.