Wednesday, November 25, 2009

Humpty Dumpty Health Care

“And all the King’s Horses and all the King’s men couldn’t put Humpty together again.”

This children’s nursery rhyme makes a fitting warning. Sometimes, after a sequence of events, there is no going back. Such is the situation with the passage of governmental health care. When the government passes the so-called “public option,” there will be no going back. Why? In economics, we say that we have fallen into a transitional gains trap. A transitional gains trap is one in which it would be better if we had entirely avoided it, but once we are in the trap, there are so many vested interests, there is no escape.

When governmental health care becomes available, new incentives will be created and economic actors (consumers, suppliers, politicians, bureaucrats, special interest groups, etc.) will respond to them. Let’s take a look at each group in turn.


Consumers are always comparing benefits and costs at the margin, and we usually don’t even know that we are doing it. When we go to a store was look for deals and specials and decide whether the purchase is “worth it.” By making this appraisement, we are not only signaling our wants and desires, we are also placing a limit on how much of which items we are willing to purchase for these prices. Suppliers react to this information and search for the least cost methods to provide these items and thereby make money.

In a world, where there is a third-party payer, these checks-and-balances disappear. The consumer is no longer constrained by the amount of purchasing power available to himself. He is no longer “writing the check.” Someone else is paying. So the discernment over price, quality and quantity vanishes. The result is a dramatic overconsumption of health care and skyrocketing prices. Once someone else is paying the bill, a resistance to even the idea of paying for these services yourself builds until no one can even remember what it was like to not have a third-party payer. This group is now stuck in the trap.

Suppliers are constantly striving to earn profits. They do so by raising their revenues and by cutting their costs. Raising a company’s revenue is not the easiest thing to do. A company can certainly raise prices, but the consequence to this choice is the reaction made by customers. They will make fewer purchases as the price goes up. There is a limit to the height of prices before revenues diminish. Economists call this relationship “the price elasticity of demand.”

The alternative choice that companies can make is to cut costs. The cutting of costs is a difficult and sometimes painful process. It may require the purchasing of machines that displace workers. Trying to increase internal efficiencies and cutting internal costs requires tenacious dedication and penny pinching. The virtue that comes from this is that resources are seldom wasted. When waste does occur, there is an incentive to correct it and raise profit levels.

When the government enters into the picture, they are not subject to market conditions. Companies are allowed charge “cost-plus-mark-up.” We see this approach in many highly regulated sectors of the economy like water and electric utilities. Under a single payer system, companies that supply medical care will always be able to cover their costs. The incentive to vigilantly cut waste evaporates. In fact, the reverse occurs. There is now an incentive to pad one’s costs. The result is that the financial burden of the health care market multiplies. The companies like not having to compete and hold down costs. They are now stuck in the trap.


Economics differs from other fields such as political science when it comes to the basic assumption about the motivation of individuals. Political scientists traditionally ask about “the good, “the just” or “equity” and then assume that the actor in their scenario pursues these goals. The economist assumes that individuals are rationally self-interested. They set their own goals and pursue them in the way that maximizes benefits and minimizes costs. The economist applies this outlook to politicians. We suppose that politicians are no different than the rest of us and pursue their own personal goals. Chief among these goals is the goal of staying in power. I do not think that this is an unreasonable assumption to make about politicians.

The politician stays in power by getting people to vote for him or, at least, by voting against the other guy. If a governmental take over of health care occurs, the politicians in favor of the system will campaign on the platform of expanded the benefits to all who vote for him. At the same time, he will demonize his rival by stating that his opponent will “take away your health care.” The implication of this campaign is that only those who are in favor of a governmentally run system are compassionate and just, while those who are against it want to see people dying in the street. Thus, the political class will have an incentive to maintain and expand the system—even those who were initially opposed to it.

A large bureaucracy will be needed to run governmental health care. Those employed by the government obviously have an interest in perpetuating the system, but the incentives are much worse. Bureaucrats are paid by the seriousness of the problem. The larger the problem they are tasked to solve, the more money and resources they command. That translates into nicer offices, more lavish conference locations, etc. They even have a disincentive to actually solve the problem. We see this occurring in the public school system. Failing businesses are liquidated and resources are transferred to more efficient users. In contrast, failing schools get larger budgets and more resources to “fix the problem.”

On a departmental level, we know that budgets are assigned by “need.” “Need” in a bureaucracy is determined by how much it spent the previous year. Thus, there is a strong incentive to spend all of the money in the budget as rapidly as possible so as to increase the future budget. As a result, health care costs spiral and service declines. The bureaucrats are strongly entrenched in the trap.

Special Interest Groups
There is currently an army of special interest groups on Capitol Hill and there is nothing that indicates that the situation will change with the passage of governmental health care. In fact with more power and more money flowing through Washington, we should expect to see an increase in lobbying efforts. We should not be surprised to see lobbying efforts to expand Program X and efforts to include Group A and efforts to cut the out of pocket expenses for Group B. New special interest groups will spring up. And why not? When it is easier to gain by the majority vote of 535 people than by any other means, people will follow the path of least resistance and lobby 535 people. These special interest groups will raise money for those politicians that support them. They will increase the costs to the system. They will actively help perpetuate the trap.

After Humpty Dumpty Falls

The transitional gaps trap is a nasty place to be. There is no easy way out. Once we are in it, the combination of these groups, acting in their own self-interest—basically responding to the incentives before them, diminishes the whole. Unfortunately, the direct cost of getting out of the trap is higher and so we will sink further and further into the trap until the entire system implodes.

It is for these reasons that we must fight as hard as we can to stay out of the trap, because once Humpty Dumpty falls, no one will be able to put him back together again.


P. Law said...

Great title! Individuals always act in their own self-interest. Unfortunately, this new piece of legislation being drafted, "free" healthcare for all, will change the Incentives of each group, as you rightly pointed out. ... and if this passes, we are headed down a slippery slope. ... will be tough to put Humpty Dumpty back together again!
A note - FREE doesn't mean that things are available at no cost. ie. Perhaps the dollar price is zero, but there are transactional costs associated with receiving "free" healthcare ... like longer wait times at doctor's office, etc.

P F Cwik said...

Thanks, Pia. Nice comment.

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