By the time our youngest child, Abbey, appeared on the scene, my wife and I had been parents for 17 years. Abbey was number six. So I had already had nearly two decades of addressing the ubiquitous children’s question: “Why?”
“It’s not good to put rocks in your mouth.”
“The sky is a beautiful purple tonight.”
“We need to gas up the car.”
My (possibly faulty) memory recalls that Abbey had more “whys” than all the others combined. By the time she was four or five, I found myself frequently saying to her, “You know my policy. I don’t do whys.” She would then rephrase the question by asking, “How come?”
“I don’t do ‘how comes’ either. Neither do I do ‘what fors.’”
“Why not, Dad?”
Ah — the coup de grâce! Abbey always won. One has to be wise to do “whys.”
I suppose I have to alter my “why” policy. Last week’s column left us with a very large “why.” Why is the U.S. health-care system so expensive when compared to the rest of the world and yet delivers a substandard product? The high cost of medicine in the U.S. is multifaceted. We begin at the beginning:
All first-year economics courses include a study of the “competitive model,” aka the model of “perfect competition.” Under the assumptions of the model, a competitive market will produce the most efficient results for both producers and consumers. Efficiency means that, given our labor force, capital, resources, and so forth, we can neither produce more by rearranging resources nor can we have greater “utility” (satisfaction) in consumption by changing our spending patterns. In other words, efficiency means we have maxed out.
By nature and culture, most Americans gravitate toward market outcomes and reject public-sector solutions to economic issues. I would guess that this element of our social DNA accounts for why we are the only developed economy on the planet which has yet to adopt a single-payer health-care system for all citizens. We like “free” markets. We have faith in the competitive model. Yet, as we will see, free markets are not necessarily competitive markets.
In my own discussions with many people around the country, most Americans seem to presume that our health-care system is the best of all worlds, that it operates within a competitive environment, and that the industry, as a largely private-sector venture, enjoys the benefits derived from the competitive model. Unfortunately, reality is quite different.
Let us examine the foundational assumptions of the competitive model, including a brief explanation as to why the assumptions are important. Again, I will relax my “why’” policy for a day. But don’t push me too far. It was 35 years before all of those “why” questions had gone off to colleges. Next week, we will examine how closely our health-care industry matches the competitive paradigm.
The economic model of pure competition makes many assumptions, each of which contribute to the outcome of efficiency in production and consumption. The chief assumptions which yield this virtuous outcome include that there exist many buyers and sellers, who: 1) cannot affect prices, 2) are perfectly mobile to relocate, 3) each have perfect information about goods and services produced, and 4) enjoy easy entrance and exit from the markets.
In addition, pure competition assumes 5) well-defined and -enforced property rights, 6) zero transaction costs, 7) no externalities, 8) profit-maximizing producers, 9) homogeneous products, and 10) decreasing returns to scale in production. This will all be on the final exam.
As we go through these points, consider how health care might fit with the model.
Many buyers and sellers ensure that no individual or firm can monopolize pricing.
“Factor mobility” is needed to ensure that production and consumption is efficient. For example, if oil is discovered in a frontier region such as North Dakota, yet few workers are able to get there, we lose efficiency. We are left with more expensive West Texas Intermediate crude.
Perfect information on the part of buyers and sellers ensures that neither party can pull a fast one on an unsuspecting producer or consumer. Free markets often violate this condition.
For example, in 1990, the U.S. Congress passed the Nutrition Labeling and Education Act, requiring food producers to label processed foods with certain nutritional facts. The point was to give consumers as much information as producers, thereby improving efficiency in consumption. This act nudged the free market toward a competitive market.
When either buyers or sellers (producers) of goods and services have difficulty entering or exiting a market, competition is reduced. If, for example, taxis require a medallion to operate, those who would enjoy working as drivers are restricted, and competition is reduced.
However, putting too many cars on the road also creates a negative externality of excess traffic. Sometimes, when free markets violate one aspect of the competitive model, another aspect must be violated to help solve the difficulty. We restrict entry to cab driving to reduce the externality of traffic.
Another example of this involves licensing of tradesmen. Licensing reduces ease of entry to a market. If I want to work as an orthopedic surgeon, I am barred from doing so until I have met the qualifications for a license. Does this not violate the competitive model? Sure it does.
But note assumption 9, homogeneity of products. This means that all widgets are alike. This assumption is violated in almost every market. Often it is trivial. But in some instances, quacks can cause a great deal of damage. To protect consumers from the lack of homogeneity of goods or service, states license surgeons and others who might cause significant harm if unqualified.
Well-defined property rights are often connected to externalities. For example, who owns the air which surrounds one’s house? If the homeowner does, then he or she can keep factory owners from polluting the air, unless they compensate the homeowner. But they would have to negotiate with everyone, which would represent an enormous transaction cost. Note assumptions 5, 6, and 7. They are all violated by a polluting factory, and all interconnected. Governments step in to bring free markets closer to competitive markets by generating emission regulations.
The last assumption of the competitive model is somewhat technical, yet highly important in the real world. It means that the unit cost of production of a good or service does not get cheaper as more and more of the goods are produced. The importance of this assumption may not be obvious. When “more” means cheaper per unit, many smaller firms merge to form a large monopoly since bigger means cheaper for them. But this destroys competition, yielding higher prices for consumers. And this is exactly how free markets operate. Within most developed nations, large mergers must be approved by a regulatory body so as to ensure that competition is not restrained.
As we have rapidly run down the pillars that support the structure of pure competition, how does the health-care industry stack up?
Next week we will examine this, leaving aside the “whys.”
(Marcus Hutchins is a former economist, treasury-bond arbitrage trader, and hedge fund manager. He retired to Southport in 1997, where he resides with his wife, Andrea, and youngest daughter, Abbey. He welcomes feedback at email@example.com.)