Naked Economics
Page 15
That does not actually happen. Insurance companies usually insure large groups whose individuals are not allowed to select in or out. If Aetna writes policies for all General Motors employees, for example, then there will be no adverse selection. The policy comes with the job, and all workers, healthy and unhealthy, are covered. They have no choice. Aetna can calculate the average cost of care for this large pool of men and women and then charge a premium sufficient to make a profit.
Writing policies for individuals, however, is a much scarier undertaking. Companies rightfully fear that the people who have the most demand for health coverage (or life insurance) are those who need it most. This will be true no matter how much an insurance company charges for its policies. At any given price—even $5,000 a month—the individuals who expect their medical costs to be higher than the cost of the policy will be the most likely to sign up. Of course, the insurance companies have some tricks of their own, such as refusing coverage to individuals who are sick or likely to become sick in the future. This is often viewed as some kind of cruel and unfair practice perpetrated on the public by the insurance industry. On a superficial level, it does seem perverse that sick people have the most trouble getting health insurance. But imagine if insurance companies did not have that legal privilege. A (highly contrived) conversation with your doctor might go something like this:
DOCTOR: I’m afraid I have bad news. Four of your coronary arteries are fully or partially blocked. I would recommend open-heart surgery as soon as possible.
PATIENT: Is it likely to be successful?
DOCTOR: Yes, we have excellent outcomes.
PATIENT: Is the operation expensive?
DOCTOR: Of course it’s expensive. We’re talking about open-heart surgery.
PATIENT: Then I should probably buy some health insurance first.
DOCTOR: Yes, that would be a very good idea.
Insurance companies ask applicants questions about family history, health habits, smoking, dangerous hobbies, and all kinds of other personal things. When I applied for term life insurance, a representative from the company came to my house and drew blood to make sure that I was not HIV-positive. He asked whether my parents were alive, if I scuba dive, if I race cars. (Yes, yes, no.) I peed in a cup; I got on a scale; I answered questions about tobacco and illicit drug use—all of which seemed reasonable given that the company was making a commitment to pay my wife a large sum of money should I die in the near future.
Insurance companies have another subtle tool. They can design policies, or “screening” mechanisms, that elicit information from their potential customers. This insight, which is applicable to all kinds of other markets, earned Joseph Stiglitz, an economist at Columbia University and a former chief economist of the World Bank, a share of the 2001 Nobel Prize. How do firms screen customers in the insurance business? They use a deductible. Customers who consider themselves likely to stay healthy will sign up for policies that have a high deductible. In exchange, they are offered cheaper premiums. Customers who privately know that they are likely to have costly bills will avoid the deductible and pay a higher premium as a result. (The same thing is true when you are shopping for car insurance and you have a sneaking suspicion that your sixteen-year-old son is an even worse driver than most sixteen-year-olds.) In short, the deductible is a tool for teasing out private information; it forces customers to sort themselves.
Any insurance question ultimately begs one explosive question: How much information is too much? I guarantee that this will become one of the most nettlesome policy problems in coming years. Here is a simple exercise. Pluck one hair from your head. (If you are totally bald, take a swab of saliva from your cheek.) That sample contains your entire genetic code. In the right hands (or the wrong hands), it can be used to determine if you are predisposed to heart disease, certain kinds of cancer, depression, and—if the science continues at its current blistering pace—all kinds of other diseases. With one strand of your hair, a researcher (or insurance company) may soon be able to determine if you are at risk for Alzheimer’s disease—twenty-five years before the onset of the disease. This creates a dilemma. If genetic information is shared widely with insurance companies, then it will become difficult, if not impossible, for those most prone to illness to get any kind of coverage. In other words, the people who need health insurance most will be the least likely to get it—not just the night before surgery, but ever. Individuals with a family history of Huntington’s disease, a hereditary degenerative brain disorder that causes premature death, are already finding it hard or impossible to get life insurance. On the other hand, new laws are forbidding insurance companies from gathering such information, leaving them vulnerable to serious adverse selection. Individuals who know that they are at high risk of getting sick in the future will be the ones who load up on generous insurance policies.
An editorial in The Economist noted this looming quandary: “Governments thus face a choice between banning the use of test results and destroying the industry, or allowing their use and creating an underclass of people who are either uninsurable or cannot afford to insure themselves.” The Economist, which is hardly a bastion of left-wing thought, suggested that the private health insurance market may eventually find this problem intractable, leaving government with a much larger role to play. The editorial concluded: “Indeed, genetic testing may become the most potent argument for state-financed universal health care.”4
Any health care reform that seeks to make health insurance both more accessible and more affordable, particularly for those who are sick or likely to get sick, will have devastating adverse selection problems. Think about it: If I promise that you can buy affordable insurance, regardless of whether or not you are already sick, then the optimal time to buy that insurance is in the ambulance on the way to the hospital. The only fix for this inherent problem is to combine guaranteed access to affordable insurance with a requirement that everyone buy insurance—healthy and sick, young and old—a so-called “personal mandate.” The insurance companies will still lose money on the policies that they are forced to sell to bad risks, but those losses can be offset by the profits earned from healthy people who are forced to buy insurance. (Any country with a national health care system effectively has a personal mandate; all citizens are forced to pay taxes, and in return they all get government-funded health care.)
This is the approach that Massachusetts took as part of a state plan to provide universal access to health insurance. State residents who can afford health insurance but don’t buy it are fined on their state tax return. Hillary Clinton supported a personal mandate in the 2008 Democratic presidential primaries; Barack Obama did not, though that arguably had more to do with distinguishing himself from his toughest Democratic opponent than it did with his analysis of adverse selection. Obviously, forcing healthy people to buy something that they would otherwise not buy is a heavy-handed use of government; it’s also the only way to pool risk (which is the purpose of insurance) when the distribution of risk is not random.
Here are the relevant economics: (1) We know who is sick; (2) increasingly we know who will become sick; (3) sick people can be extremely expensive; and (4) private insurance doesn’t work well under these circumstances. That’s all straightforward. The tough part is philosophical/ideological: To what extent do we want to share health care expenses anyway (if at all), and how should we do it? Those were the fundamental questions when Bill Clinton sought to overhaul health care in 1993, and again when the Obama administration took it up in 2009.
This chapter started with the most egregious information-related problems—cases in which missing information cripples markets and causes individuals to behave in ways that have serious social implications. Economists are also intrigued by more mundane examples of how markets react to missing information. We spend our lives shopping for products and services whose quality we cannot easily determine. (You had to pay for this book before you were able to read it.) In the vast majority of c
ases, consumers and firms create their own mechanisms to solve information problems. Indeed, therein lies the genius of McDonald’s that inspired the title of this chapter. The “golden arches” have as much to do with information as they do with hamburgers. Every McDonald’s hamburger tastes the same, whether it is sold in Moscow, Mexico City, or Cincinnati. That is not a mere curiosity; it is at the heart of the company’s success. Suppose you are driving along Interstate 80 outside of Omaha, having never been in the state of Nebraska, when you see a McDonald’s. Immediately you know all kinds of things about the restaurant. You know that it will be clean, safe, and inexpensive. You know that it will have a working bathroom. You know that it will be open seven days a week. You may even know how many pickles are on the double cheeseburger. You know all of these things before you get out of your car in a state you’ve never been in.
Compare that to the billboard advertising Chuck’s Big Burger. Chuck’s may offer one of the best burgers west of the Mississippi. Or it might be a likely spot for the nation’s next large E. coli out-break. How would you know? If you lived in Omaha, then you might be familiar with Chuck’s reputation. But you don’t; you are driving through Nebraska at nine o’clock at night. (What time does Chuck’s close, anyway?) If you are like millions of other people, even those who find fast food relatively unappealing, you will seek out the golden arches because you know what lies beneath them. McDonald’s sells hamburgers, fries, and, most important, predictability.
This idea underlies the concept of “branding,” whereby companies spend enormous sums of money to build an identity for their products. Branding solves a problem for consumers: How do you select products whose quality or safety you can determine only after you use them (and sometimes not even then)? Hamburgers are just one example. The same rule applies in everything from vacations to fashion. Will you have fun on your cruise? Yes, because it is Royal Caribbean—or Celebrity or Viking or Cunard. I have a poor sense of fashion, so I am reassured that when I buy a Tommy Hilfiger shirt I will look reasonably presentable when I leave the house. Michelin tire advertisements feature babies playing inside of Michelin tires with the tag line “Because so much is riding on your tires.” The implicit message is clear enough. Meanwhile, Firestone has most likely destroyed much of the value of its brand as the result of the link between faulty tires and deadly rollovers in Ford Explorers.
Branding has come under assault as a tool by which avaricious multinational corporations persuade us to pay extortionate premiums for goods that we don’t need. Economics tells a different story: Branding helps to provide an element of trust that is necessary for a complex economy to function. Modern business requires that we conduct major transactions with people whom we’ve never met before. I regularly mail off checks to Fidelity even though I do not know a single person at the company. Harried government regulators can only protect me from the most egregious kinds of fraud. They do not protect me from shoddy business practices, many of which are perfectly legal. Businesses routinely advertise their longevity. That sign outside the butcher proclaiming “Since 1927” is a politic way of saying, “We wouldn’t still be here if we ripped off our customers.”
Brands do the same thing. Like reputations, they are built over time. Indeed, sometimes the brand becomes more valuable than the product itself. In 1997, Sara Lee, a company that sells everything from underwear to breakfast sausages, declared that it would begin selling off its manufacturing facilities. No more turkey farms or textile mills. Instead, the company would focus on attaching its prestigious brand names—Champion, Hanes, Coach, Jimmy Dean—to products manufactured by outside firms. One business magazine noted, “Sara Lee believes that its soul is in its brands, and that the best use of its energies is to breathe commercial life into the inert matter supplied by others.”5 The irony is lovely: Sara Lee’s strategy for growth and profits is to produce nothing.
Branding can be a very profitable strategy. In competitive markets, prices are driven relentlessly toward the cost of production. If it costs 10 cents to make a can of soda and I sell it for $1, someone is going to come along and sell it for 50 cents. Soon enough, someone else will be peddling it for a quarter, then 15 cents. Eventually, some ruthlessly efficient corporation will be peddling soda for 11 cents a can. From the consumer’s standpoint, this is the beauty of capitalism. From the producer’s standpoint, it is “commodity hell.” Consider the sorry lot of the American farmer. A soybean is a soybean; as a result, an Iowa farmer cannot charge even one penny above the market price for his crop. Once transportation costs are taken into account, every soybean in the world sells for the same price, which, in most years, is not a whole lot more than it cost to produce.
How does a firm save its profits from the death spiral of competition? By convincing the world (rightfully or not) that its mixture of corn syrup and water is different from everyone else’s mixture of corn syrup and water. Coca-Cola is not soda; it’s Coke. Producers of branded goods create a monopoly for themselves—and price their products accordingly—by persuading consumers that their products are like no other. Nike clothes are not pieces of fabric sewn together by workers in Vietnam; they are Tiger Woods’s clothes. Even farmers have taken this message to heart. At the supermarket, one finds (and pays a premium for) Sunkist oranges, Angus beef, Tyson chickens.
Sometimes we gather information by paying outsiders to certify quality. Roger Ebert’s job is to see lots of bad movies so that I don’t have to. When he sees the occasional gem, he gives it a “thumbs up.” In the meantime, I am spared from seeing the likes of Tomcats, a film that Mr. Ebert awarded zero stars. I pay for this information in the form of my subscription to the Chicago Sun-Times (or by looking at ads that the Sun-Times is paid to display on its free website). Consumer Reports provides the same kind of information on consumer goods; Underwriters Laboratories certifies the safety of electrical appliances; Morningstar evaluates the performance of mutual funds. And then there is Oprah’s book club, which has the capacity to send obscure books rocketing up the best-seller lists.
Meanwhile, firms will do whatever they can to “signal” their own quality to the market. This was the insight of 2001 Nobel laureate Michael Spence, an economist at Stanford University. Suppose that you are choosing an investment adviser after a good stroke of fortune in the Powerball lottery. The first firm you visit has striking wood paneling, a marble lobby, original Impressionist paintings, and executives wearing handmade Italian suits. Do you think: (1) My fees will pay for all this very nice stuff—what a ripoff!; or (2) wow, this firm must be extremely successful and I hope they will take me on as a client. Most people would choose 2. (If you’re not convinced, think about it the other way: How would you feel if your investment adviser worked in a dank office with twenty-year-old government-surplus WANG word processors?)
The trappings of success—the paneling, the marble, the art collection—have no inherent relation to the professional conduct of the firm. Rather, we interpret them as “signals” that reassure us that the firm is top-notch. They are to markets what a peacock’s bright feathers are to a prospective mate: a good sign in a world of imperfect information.
What signals success when you walk into an office in parts of Asia? Ridiculously cold temperatures. The blast of frigid air tells you immediately that this firm can afford lots of air-conditioning. Even when the temperature is more than ninety degrees outside, office temperatures are sometimes so cold that some workers use space heaters. The Wall Street Journal reports, “Frosty air conditioning is a way for businesses and building owners to show that they’re ahead of the curve on comfort. In ostentatious Asian cities, bosses like to send out the message: We are so luxurious, we’re arctic.”6
Here is a related question that economists like to ponder: Harvard graduates do very well in life, but is that because they learned things at Harvard that made them successful, or is it because Harvard finds and admits talented students who would have done extraordinarily well in life anyway? In other words, does
Harvard add great value to its students, or does it simply provide an elaborate “signaling” mechanism that allows bright students to advertise their talents to the world by being admitted to Harvard? Alan Krueger, a Princeton economist, and Stacy Dale, an economist at the Mellon Foundation, have done an interesting study to get at this question.7 They note that graduates of highly selective colleges earn higher salaries later in life than graduates of less selective colleges. For example, the average student who entered Yale, Swarthmore, or the University of Pennsylvania in 1976 earned $92,000 in 1995; the average student who entered a moderately selective college, such as Penn State, Denison, or Tulane, earned $22,000 less. That is not a particularly surprising finding, nor does it get at the question of whether the students at schools like Yale and Princeton would earn more than their peers at less competitive schools even if they played beer pong and watched television for four years.