A pretty good economist

I have been reading webbed articles by Austan Goolsbee, widely described as Barack Obama's economic advisor. Most of them are pretty good; he's obviously a real economist in the Chicago style, someone who sees economics as a powerful and exciting tool for explaining the world. And he generally favors markets, incentives, and the like.

On the other hand ... . Take a look at his Slate piece on the American health care system. It takes the form of a critique of Michael Moore's proposals but includes Goolsbee's own views of what is wrong and what should be done about it. He writes:

Economists call this "adverse selection" and when there is too much adverse selection—when the health of the people in the uninsured pool is extremely different from the average person in the country—the market may fail completely. Insurance companies may just deny people coverage entirely.

This is a problem at the core of our health care woes. Moore finds scores of examples—people with tumors, heart problems, lost limbs and digits, you name it. And in each case the insurance company finds a way to deny paying for people's illness even though the people actually have health insurance. He also shows people who simply cannot get insurance because they have pre-existing conditions, are too heavy, are too light, and on and on.

Without any rules against cream-skimming, the insurance companies have every incentive to keep dumping the sick people—often retroactively, after they become sick.

This confuses several different issues. One is the failure to enforce insurance contracts, with the result that the insurer who has lost his bet fails to pay off. That may be a serious problem but it has nothing to do with adverse selection or cream skimming.

That case aside, the argument is simply wrong. Insurance companies free to set the price of what they sell have no incentive to avoid insuring people who are bad risks. They can make money insuring good risks at good risk prices and bad risks at bad risk prices.

Adverse selection, as Goolsbee surely knows, requires asymmetric information—a situation where one party to a transaction has information the other does not. If the customer knows more about his health than the insurance company then the decision to buy insurance will be taken as a signal that the purchaser is a worse than average risk, insurance companies will price accordingly, and people who know they are good risks but cannot prove it will be unwilling to buy good risk insurance at a bad risk price. That is the standard problem of adverse selection in insurance and it is the precise opposite of cream skimming. The bad risks end up insured—at a bad risk price—and the good risks uninsured. In Ackerlof's famous sketch of the problem, set in the used car market, lemons sell, cream puffs don't.

All of this assumes that insurers are free to set their prices. Suppose instead that they are required to charge the same price to everyone, or at least restricted in ways that prevent them from charging bad risks the true cost of insuring them. In that situation it will indeed be in the interest of the insurance companies to try to avoid insuring bad risks—to skim the cream off the top. But the problem there is produced not by the market but by price control. The solution is to eliminate the restriction.

What does Goolsbee propose?

Addressing cream-skimming is at the heart of every responsible program for U.S. health-care reform .... These plans take aim at "pooling," for example, by allowing insurance companies to insure an entire state or region as a whole in exchange for serving everyone in that pool—no dropping, no denials, no shenanigans.

For the requirement that the insurance company serve everyone in the pool to have any teeth, it must include restrictions on the prices insurance companies can charge to those they serve. So Goolsbee's solution to a problem created by price control is—unless I badly misread him—price control.

There is, of course, another problem in the background—but one that has nothing to do with adverse selection. Someone with bad health will, on a free market, end up paying more for health care, directly or through insurance, than someone with good health. Many people, quite possibly including Goolsbee, see that as a bad thing that we should do something about. But it is not a problem that insurance can be expected to solve. Once the dice—for bad health or anything else—have been rolled, it is too late to bet on them.

Unless I am missing something, the analysis in that particular piece is simply bad economics, including the misuse of a technical term that the author surely understands. Nonetheless, my reading of Goolsbee's work leaves me more, not less, favorably inclined to Obama. His economic advisor may get some things wrong, but overall he is an economist and one inclined to favor the market.

Rather like Alfred Kahn, another Democratic economist, to whom we owe airline deregulation.

[Readers interested in a more detailed explanation of adverse selection may want to go to the relevant chapter of my webbed Law's Order and search for "adverse selection."]

Executive Compensation and the Economics of Insurance

One of the things legal rules do is to allocate risk, so one of the subjects covered in teaching the economic analysis of law is the economics of risk allocation, conventionally put in terms of the economics of insurance. Designing optimal rules in this context is hard, because there are three different objectives and no reason to expect the rule that is best for achieving one to be best for the others.

The first objective is risk spreading—for familiar reasons, many people prefer a certain income of (say) $50,000 a year to a coin flip between $10,000 and $90,000, even though the average outcomes are the same. Insurance provides a way of converting the riskier outcome into the less risky.

The second objective is optimum incentives for controlling risk. Often, although not always, the same person who starts out bearing the risk is the one in the best position to take precautions against it. From this standpoint insurance is the problem, not the solution. Once I have insured my house or factory for its full value, the incentive to me to take costly precautions to make it less likely to burn down is low. In the extreme case, where an insurance company has been so imprudent as to insure something for more than its full value, the chance of a fire may become very large indeed. This is the problem described in the literature as moral hazard, not because taking risks is immoral but because “moral” in this context has an older meaning close to “psychological.” The hazard is due to the incentives of the actors, the moral not the physical characteristics of the situation.

The third objective has to do with the fact that the choices we make signal—imperfectly—information about our private information. That I want to buy lots of life insurance today is evidence that I know something the insurer doesn’t about my chances of living to tomorrow. That is a reason for him not to sell it to me, or only at a high price. The same argument applies, although less strongly, to anyone who wants to buy insurance against any risk that he has better information about than the seller. Wanting to buy is evidence that the risk is higher than average, a fact which the seller will take into account in pricing the insurance.

That is a problem if you face an average or below average risk but still, because of risk aversion, want to insure against it, provided you can do so at a price not much greater than the actuarial value of the insurance, a problem known in the literature as “adverse selection.” The classic example is the market for lemons. Sellers of used cars know more about them than buyers, so the fact that I want to sell my car signals that it is likely to be a lemon, so I get offered a lemon price, which makes it even less likely that I will sell it if it isn’t a lemon.

The same set of problems applies to executive compensation. One obvious way of better aligning the interests of executives with those of stockholders is to require the executives to be stockholders. To align the interests in the long term as well as the short, one could require executives not only to hold a sizable fraction of their personal wealth as stock in the company they work for but also to hold it under rules that prevent them from selling the stock or hedging it for some substantial period of time.

Arguably, this would be a good way of controlling not only moral hazard but adverse selection as well. An executive whose private information implied that hiring him would be bad for the company—perhaps because he planned to keep the job only until a better offer, expected shortly, came through, or because he planned to supplement his income at the expense of the stockholders—would have a good reason not to take the job on those terms, which is a second reason to insist on those terms when offering it.

On the other hand, requiring executives to invest a large fraction of their wealth in the stock of the company they worked for would be a very bad way of spreading risk. If the company did well, both the executive’s salary and his stock portfolio would go up. If it did badly, both would go down. Better, from that standpoint, to spread the risk by owning stock in some company, practically any company, other than the one he works for.

In some contexts, some employees are paid with stock options that can only be exercised after a set period of time; I do not know if there are any precautions to prevent the employee from hedging his bet by selling the stock short before the time has expired. I also do not know to what extent the tactic described above is, or can be, implemented for executive compensation more generally. Clearly there are reasons both for doing it and against.

Comments welcome, especially from anyone who knows more than I do about the actual terms of the usual employment contracts for top executives.

Genetic Testing and Insurance: One Datum

Reductions in the cost of genetic testing and improvements in what we know about what it tells us produce obvious benefits; if you know you are  likely to have some particular medical problem, you may be able to take precautions against it. But they also have at least one potential downside. The more is known about the chance of bad things happening to us, the less able we will be to insure against them.

A solution to this problem that is sometimes proposed is to permit individuals to have their genes tested but forbid insurance companies to require testing as a condition of insurance or to use the information it produces. The problem with that is adverse selection. If the customer knows his risk and the insurance company doesn't, high risk and low risk customers are charged the same price, making insurance a good deal for the former and a bad deal for the latter. Insurance companies, realizing that most of those who choose to buy their insurance are bad risks, will charge accordingly, driving more of the low or average risk customers out of the market. In the limiting case, insurance is bought only by high risk customers, at a high risk price. A famous description of the problem is Akerlof's article "The Market for Lemons."

If we allow both insurance companies and their customers to make use of genetic information, then both high risk and low risk customers can buy insurance, but at different prices. The risk of having genetic variants that make you more likely to suffer some expensive medical problem is uninsurable, although you can still insure against the risk that, given those genes, the problem will actually appear.

The theoretical analysis of the problem is straightforward; interested readers can find one version in Chapter 6 of my Law's Order. But the theory does not tell us how large the problem is. That depends on empirical facts, in particular on how much the information provided by genetic testing affects the expected cost of insuring someone.

As it happens, I recently came across a datum relevant to that question, as a result of having my own genes tested by 23andMe, a company that does mail order genetic testing. It turned out that I had a genetic variant that implied a moderately increased risk of meningioma, the second most common type of brain tumor.

The information came a little late to be useful. Last summer, while I was part of a group on World of Warfare, one of the other players noticed that I had stopped responding. He called the house. My son took the call, came into my office, and found me half conscious on the floor. The diagnosis at the local hospital was meningioma, a benign (i.e. non-cancerous) tumor inside my skull but fortunately outside my brain. It was large enough to put pressure on my brain, so required surgery. I got surgery, all went well, and I am now fully recovered, aside from a visible scar and a tendency of my scalp to itch.

According to 23andMe, 35,000 Americans a year are diagnosed with meningioma, and in most cases the tumor is small enough not to require surgery. Assume that 10,000 of those, like my case, do, making the annual probability for a random American 1/30,000. Further assume that the average cost is $100,000. That's the right order of magnitude—I saw the figures for what it cost my insurance company, but don't have them ready to hand at the moment. The average cost to the insurance company of that particular risk is then about $3.

Finally, assume that my "moderately increased risk" means twice the average risk, which seems if anything a high guess. It follows that in a world where insurance companies had and used that data, my medical insurance would cost me, or my employer, three dollars a year more than in a world where the data was not available.

There are, of course, lots of other risks that my health insurance insures against. For some my genetics are presumably favorable, for some unfavorable. It would require much more information than I have to estimate how much the cost of insurance would vary from one person to another if all of that information was available and used. But at least the single datum I happen to have suggests that the effects might be small.

Following Arguments Where They Lead

In my recent exchange with Robert Frank, I suggested that his view of schooling has important implications for government policy. If, as he argues, schooling is largely or entirely a positional good, something where what matters to the individual is not how good his education is in absolute terms but how it compares with other people's education, one implication is that we are spending far too much on it. The benefit I get from attending Harvard comes mostly, on this view, at the expense of other people who don't attend Harvard and as a result lose out to me in the later competition for jobs, mates, and status.

It follows that the social benefit—individual benefit summed over everyone—of my attending Harvard is much less than the private benefit, hence that individuals will be willing to spend much more on schooling than it is really worth. Putting it differently, it implies that each person's expenditure on schooling imposes negative externalities on other people. Frank appears to believe that this is true not only of money spent on going to Harvard but on the money spent by well off suburban taxpayers on the public schools that their children attend.

The usual view of economists is that acts imposing negative externalities ought to be discouraged, perhaps by taxing them. Schooling, however, is subsidized on an enormous scale, at both the K-12 level and above. So I asked Frank whether, on the basis of his expressed views, he would favor abolishing subsidies to schooling and taxing it instead. He never answered the question, perhaps because he viewed it as a digression from our central argument.

His failure to answer it raises a more general issue, not limited to Robert Frank or even to economists who share his political views. To what extent are they—I really mean we—willing to follow out the implications of our arguments when they lead to political conclusion we don't like?

Nuclear power is the one source of electric power that does not put carbon dioxide into the atmosphere and can be expanded more or less without limit—at a cost not wildly above the cost of power from fossil fuel. That ought to make it very attractive to those who believe that we face a threat of catastrophic proportions from global warming. Some environmentalists agree—most, at least so far as I can judge, do not. Similarly for the idea of geoengineering, holding the earth's temperature down by large scale projects to reduce the amount of sunlight the earth absorbs or to increase absorption of carbon dioxide, perhaps by fertilizing aquatic algae. In each case, there are undoubtedly arguments against as well as arguments for. But the arguments for do not seem to get much attention from those who, on the basis of their expressed views, ought to find them of great interest.

For libertarians, especially libertarian economists, a similar problem is raised by the issues grouped under the label of market failure—situations where individual rationality fails to lead to group rationality. Standard examples include public goods, externalities, adverse selection and private monopoly. In each case, good economic arguments can be made for the claim that interventions by government can lead to an improved outcome. Just as in the environmental case, the arguments are not conclusive; one can accept their validity while offering reasons to reject the conclusion (links to two different talks). But that approach is very different from the attempt to deny or evade the straightforward economic arguments in favor of intervention—as I believe some libertarian economists do. Libertarians who are not economists face a similar set of problems in justifying existing property holdings, many of which were not obtained by the means that libertarian political philosophy, going back to Locke, regards as legitimate.

Readers are invited to submit other examples—ideally ones associated with political positions they are sympathetic to.