Posts Tagged ‘efficiency’

health-freemarket

The dystopia of the American healthcare system certainly invites a utopian response—a ruthless criticism as well as a vision of an alternative.

As I showed last week, the left-wing response involves a critique of the conditions and consequences of the capitalist organization of U.S. healthcare and the fashioning of a radical alternative. Single-payer, which uses tax revenues to finance the purchase of adequate healthcare services for everyone, is one possibility. On top of that, it is necessary to expand the diversity of healthcare providers, which would include more democratic, cooperative or worker-owned healthcare enterprises.

That’s how activists, educators, and policymakers informed by heterodox economics can begin to rethink the U.S. healthcare system. What about mainstream economics?

Given the persistent attacks on and attempts to replace Obamacare by Republican legislators—against a “government takeover” of healthcare in the name of “free markets”—one would expect mainstream economists to provide a theoretical justification based on their usual utopianism—of an efficient allocation of scarce resources in an economy characterized by private property and individual decisions in unregulated markets.

However, as it turns out, they can’t. And that’s all because of Kenneth Arrow.

Consider, for example, the 2017 New York Times column by Greg Mankiw.

In Econ 101, students learn that market economies allocate scarce resources based on the forces of supply and demand. In most markets, producers decide how much to offer for sale as they try to maximize profit, and consumers decide how much to buy as they try to achieve the best standard of living they can. Prices adjust to bring supply and demand into balance. Things often work out well, with little role left for government. Hence, Adam Smith’s vaunted “invisible hand.”

Yet the magic of the free market sometimes fails us when it comes to health care.

Mankiw, who is known to celebrate free markets in everything, is forced to allow for an exception when it comes to healthcare. (Fellow mainstream economist John Cochrane, in a sharp riposte, argued that “For once, I think Greg got it wrong.”)

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The reason is because, back in 1963, future Nobel Laureate Arrow published “Uncertainty and the Welfare Economics of Medical Care.” Mankiw’s column (and the longer treatment for his textbook [pdf]) is basically a restatement of the issues raised by Arrow over a half century ago.

According to Arrow, healthcare is characterized by a set of “special features,” all of which stem from the “prevalence of uncertainty.” These include the following:

  • an irregular, unpredictable demand for medical care
  • an element of trust in the relationship between patient and provider
  • considerable uncertainty as to the quality of the healthcare provided as well as asymmetry of knowledge concerning that quality
  • a restricted supply (e.g., because of licensing)
  • a combination of price discrimination (e.g., between the insured and uninsured) and price-fixing

In consequence, the healthcare industry cannot be expected to operate along the lines of, or to deliver the same results as, the canonical neoclassical model of perfect competition.

Thus, Arrow concludes,

It is the general social consensus, clearly, that the laissez-faire solution for medicine is intolerable. . .

The logic and limitations of ideal competitive behavior under uncertainty force us to recognize the incomplete description of reality supplied by the impersonal price system.

Neither Arrow nor Mankiw suggests what the alternative is. But it’s clear that, from the perspective of mainstream economics, healthcare cannot be shoehorned into the neoclassical model of perfect competition they use to analyze all other commodities and markets. What we can say is their theory of the economics of healthcare leaves open the possibility of considerable extra-market intervention and regulation.

Healthcare is where the utopianism of neoclassical economics fails.

But then we can ask, where does that utopianism not fail? Why should it hold any better when it comes to other capitalist commodities, such as labor power, money, and land? And, if it does not, then neither the modes of analysis nor the policy conclusions that are central to mainstream economics retain any validity.

In my opinion, that’s why the issue of utopia and healthcare is so important.

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Special mention

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Technically, there is no Nobel Prize in economics. What it is, instead, is the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, which members of the Nobel family and a previous winner (Friedrich von Hayek) have criticized.

So, where did the prize come from? As Avner Offer explains,

The Nobel prize came out of a longstanding social conflict. On one side, central banks and the better-off striving to keep property intact and prices stable; on the other, everyone else’s quest for economic security. The Swedish social democratic government clipped the wings of the central bank – Sveriges Riksbank – in pursuit of more housing and jobs. In compensation, the government allowed the central bank to keep some funds, which the bank used in 1968 to endow the Nobel prize in economics as a vanity project to mark its tercentenary.

This year’s Nobel Prize in Neoclassical Economics (as I dubbed it 5 years ago) was awarded jointly to Oliver Hart and Bengt Holmstrom. Officially, the 2016 prize recognized “their contributions to contract theory.” Unofficially, as I understand their work, it was all about attempting to solve a longstanding problem in neoclassical economic theory: the theory of the firm.

Historically, neoclassical economists (and, for that matter, not a few heterodox economists) simply assumed capitalist firms maximize profits. But, in the context of a market system, there’s no particular reason a non-market institution like “the firm” should exist (instead of, for example, everyone—workers, managers, suppliers, buyers, and so on—entering into market exchanges in parking lots or coffee shops each morning).* And yet corporations, many of them employing hundreds of thousands of workers and making record profits, have become central to the way capitalist economies are currently organized. Moreover, once you look inside that “black box,” a great deal more is going on. Workers are hired to perform necessary and surplus labor in the course of producing commodities by managers, who run the enterprise on a daily basis and receive a cut of the surplus from the board of directors, who themselves need to be elected by shareholders (who, together with money-lenders, merchants, government officials, and many others, inside and outside the enterprise, receive their own portions of the surplus). Corporations, as it turns out, are pretty complicated—political, cultural, and economic—institutions.

But when neoclassical economists like Hart and Holmstrom look inside the firm what they see is a single issue—a relationship between a “principal” and “agents.” Principals (e.g., capitalists) are presumed to enter into agreements—voluntary contracts—with agents (e.g., workers) to advance a goal (e.g., of maximizing profits). As they see it, contracts are risky because, first, principals and agents often have conflicting interests (e.g., principals want maximum effort while agents are presumed to engage in risk-averse, shirking behavior) and, second, measuring fulfillment of the goal is imperfect (that is, not all the actions of the agents can be perfectly observed). The whole point of contract theory, then, is to devise a relationship such that—through a combination of incentives and monitoring—agents can be made to work hard to fulfill the goal set by the principal.

In one of his most famous and influential papers, “Moral Hazard in Teams” (pdf, a link to the working-paper version), Holmstrom’s starting point is the idea that there’s a problem of “inducing agents to supply proper amounts of productive inputs when their actions cannot be observed and contracted upon directly” (in other words, moral hazard), especially when they work in teams. He then sets up a model in which he demonstrates that “separating ownership from production”—which also provides the incentive for limited monitoring by the owners (i.e., stockholders)—solves the problem of moral hazard and restores efficiency.**

In other words, the Nobel Prize-winning approach to contract theory is used to demonstrate what neoclassical economists had long presumed: that capitalist firms (and not, e.g., worker-owned enterprises) represent the most efficient way to organize production.

That’s why, from a neoclassical perspective, it is only natural that capital hires labor.

 

*In fact, Paul Samuelson (in 1957, in “Wages and Interest: A Modern Dissection of Marxian Economic Models,”American Economic Review) once argued that “In a perfectly competitive market, it really doesn’t matter who hires whom: so have labor hire ‘capital’.”

**Hart, for his part (in a paper with John Moore [pdf]), looked at the issue of property rights in relation to firms by distinguishing between owning a firm and contracting for services from another firm. Their model shows, once again in true neoclassical fashion, that the owner of an enterprise—who exercises “control,” not only over assets, but also over the workers tied to those assets—will have more control, leading to higher efficiency, if they directly employ the workers than if they have an arm’s-length contract with another employer of the workers. That’s because, under single ownership, the employer can “selectively fire the workers of the firm” if they dislike the workers’ performance, whereas under contracted services they can “fire” only the entire firm.

 

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Everyone knows Wall Street is just a racket, soaking up large portions of the surplus and stuffing the pockets of wealthy bankers. That’s especially true since the spectacular crash of 2007-08, when millions lost their jobs and homes.

But many people also harbor the illusion, based on the relentless campaign from mainstream economists and financial journalists, that perhaps Wall Street bankers, even if they’re not doing God’s work, are at least doing something—anything—that is useful for the wider society. Why else would they have been bailed out with taxpayer money and, then as now, be paid such a fortune?

The defense of Wall Street rests on three major arguments, and Lynn Stout (Distinguished Professor of Corporate and Business Law at Cornell Law School) convincingly gives the lie to all of them.

Argument #1: Wall Street helps companies raise capital

If we look at the numbers, it’s obvious that raising capital for companies is only a sideline for most banks, and a minor one at that. Corporations raise capital in the so-called “primary” markets where they sell newly-issued stocks and bonds to investors. However, the vast majority of bankers’ time and effort is devoted to (and most bank profits come from) dealing, trading, and advising investors in the so-called “secondary” market where investors buy and sell existing securities with each other. In 2009, for example, less than 10 percent of the securities industry’s profits came from underwriting new stocks and bonds; the majority came instead from trading commissions and trading profits (Table 1219). This figure reflects the imbalance between the primary issuing market (which is relatively small) and the secondary trading market (which is enormous). In 2010, corporations issued only $131 billion in new stock (Table 1202). That same year, the World Bank reports, more than $15 trillion in stocks were traded in the U.S. secondary marketmore than the nation’s GDP. Yet secondary market trading is fundamentally a zero sum game—if I make money by buying low and selling high, it’s money you lost by buying high and selling low.

Argument #2: Wall Street provides liquidity (e.g., the ability for investors to sell their investments relatively quickly)

The problem with this line of argument is that Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Argument #3: Wall Street trading helps allocate society’s resources more efficiently (by ensuring securities are priced accurately)

This argument is based on the notion of “price discovery”–the idea that the promise of speculative profits motivates traders to do research that uncovers socially useful information. The classic example is a wheat futures trader who researches weather patterns. If the trader accurately predicts a drought, the trader buys wheat futures, driving up wheat prices, causing farmers to plant more wheat, helping alleviate the effects of the drought. Thus (the argument goes) the trader’s profits from speculating in wheat futures are just compensation for providing socially valuable “price discovery.” Once again, however, this cheerful banker “just-so story” turns out to be unsupported by any significant evidence. Let’s start with the questionable premise that the average trader earns profits from doing good research. The well-established fact that very few actively-managed mutual funds routinely outperform the market undermines the claim that most trading is driven by truly superior information.

But even more significantly, the fact that a trader with superior information can move prices in the “correct” direction does not necessarily mean that society will benefit. It’s all a question of timing.  As famous economist Jack Hirshleifer pointed out many years ago, trading that makes prices more accurate when it’s too late to do anything about it is privately profitable but not socially beneficial. Most Wall Street trading in stocks, bonds, and derivatives moves information into prices only days–sometimes only microseconds–before it would arrive anyway. No real resources are reallocated in such a short time span. 

So, if Wall Street doesn’t help raise capital, provide liquidity, or help allocate resources efficiently, what does it do that benefits society?

Doctors and nurses make patients healthier.  Firefighters and EMTs save lives. Telecommunications companies and smart phone manufacturers permit people to communicate with each other at a distance. Automobile executives and airline pilots help people close that distance. Teachers and professors help students learn. Wall Street bankers help—mostly just themselves.

1percent grand compromise

Ray Fisman and Daniel Markovits suggest that we’re seeing right now, with the insurgent campaigns of Donald Trump and Bernie Sanders and elite hopes that they will just fade away, are “early skirmishes in a coming class war.”

Why? Because their research (along with coauthors Pamela Jakiela and Shachar Kariv, just published in Science) revealed stark differences between attitudes toward economic justice between ordinary Americans and those at the top. Basically, the elites (both intermediate and extreme) are much more likely to be selfish as their compatriots in general. What’s more, elite Americans show a far greater commitment to efficiency over equality than ordinary Americans.

Our results thus shine a revealing light on American politics and policy. They suggest that the policy response to rising economic inequality lags so far behind the preferences of ordinary Americans for the simple reason that the elites who make policy—regardless of political party—just don’t care much about equality. Hemingway’s illusory but widely shared view that the only thing that separates the rich from the rest is their money thus disguises a central pathology of American public life. When American government undemocratically underdelivers economic equality, the cause is less party than caste.

So, even though the United States has exhibited growing and increasingly grotesque economic disparities between a small group at the top and everyone else for almost five decades, little has been done to address the problem of economic inequality. The tendency, as I have argued, has been to pathologize the poor.

What Fisman et al. do is to turn their attention to the pathologies of the rich and the fact that “elite Americans are not just middle-class people with more money.”

They display distinctive attitudes on basic moral and political questions concerning economic justice. Simply put, the rich place a much lower value on equality than the rest. What’s more, this lack of concern about inequality among the elite is not a partisan matter. Even when they self-identify as progressive Democrats, elite Americans value equality less highly than their middle-class compatriots.

The question going forward is who will control public policy: the small elite who aren’t much concerned with issues of inequality or the majority of the population who place a much higher value on equality.

The fact is, one side in the class war has been winning since the mid-1970s. Now is the time to turn it around, so that ordinary Americans will get the policies they want and deserve.

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Back in 1974, Stephen Marglin published an important essay, “What Do Bosses Do? The Origins and Functions of Hierarchy in Capitalist Production” (pdf).

Marglin was responding to the tradition within mainstream economic theory, from Adam Smith to neoclassical economics, that hierarchy and specialization were indispensable for increasing productivity and achieving efficiency. He countered that “capitalist hierarchy has little to do with efficiency” but, instead, was designed to guarantee “to the entrepreneur an essential role in the production process” and “to provide for the accumulation of capital.”

Smith’s ideas are receiving renewed attention, in relation to the other side of the capitalist relationship: workers.

According to Barry Schwartz, most workers are unhappy with the work they’re doing—and that’s at least partly due to Smith.

the ideas of Adam Smith have become a kind of self-fulfilling prophecy: They gave rise to a world of work in which his gloomy assumptions about human beings became true. When you take all opportunities for meaning and engagement out of the work that people do, why would they work, except for the wage? What Smith and his descendants failed to realize is that rather than exploiting a fact about human nature, they were creating a fact about human nature.

The transformation I have in mind goes something like this: You enter an occupation with a variety of aspirations aside from receiving your pay. But then you discover that your work is structured so that most of those aspirations will be unmet. Maybe you’re a call center employee who wants to help customers solve their problems — but you find out that all that matters is how quickly you terminate each call. Or you’re a teacher who wants to educate kids — but you discover that only their test scores matter. Or you’re a corporate lawyer who wants to serve his client with care and professionalism — but you learn that racking up billable hours is all that really counts.

Pretty soon, you lose your lofty aspirations. And over time, later generations don’t even develop the lofty aspirations in the first place. Compensation becomes the measure of all that is possible from work. When employees negotiate, they negotiate for improved compensation, since nothing else is on the table. And when this goes on long enough, we become just the kind of creatures that Adam Smith thought we always were. (Even Smith, in one passage, seemed to acknowledge this possibility, noting that mindless, routinized work typically made people “stupid and ignorant.”)

Schwartz makes it out to be a tension between our lofty aspirations and the drudgery of the jobs we actually do. (And he uses the example of the “dancing janitors”—who help out with patient care without additional compensation—to illustrate the idea that we’re looking for something more than wages.)

I’ll admit, I do think there’s a tremendous amount of dissatisfaction on the job. And I like the idea that economic theory is “performative” (that is, it both captures something going on in the real world and creates that world).

But he buries the real issue elsewhere in his piece:

This, again, is what Adam Smith thought. In his famous example of the pin factory, he extolled the virtues of the division of labor: “One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head.” Our work experience might be poorer, but we — or at least our bosses — would be richer.

So, we’re back to where we started, with the bosses. Whether or not hierarchy and the division of labor are efficient, it’s the bosses who are becoming richer as a result of the work employees do. And employees are forced to have the freedom to work for the bosses in order to purchase the commodities and pay off the debts they need to reproduce themselves and their families. Workers get wages and salaries, bosses get profits.

That’s what workers do—unless and until we create another kind of enterprise, in which workers make the important decisions about the work they do and what will be done with the value they create.

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I remember my dismay, when I first began teaching economics, how enthralled my colleagues (at least the liberal ones) were with Arthur Okun’s notion of the fundamental tradeoff between equality and efficiency (which they supplemented with John Rawls’s theory of justice). No critique of capitalism, no critique of political economy. They believed the democratic process would find the appropriate balance between market efficiencies and nonmarket interventions to create greater equality.

I was never happy with the idea of such a tradeoff (or, for that matter, with the veil of ignorance), because it was based on denying the fundamental injustice embedded in a capitalist economy—the appropriation and distribution of a surplus produced by the majority for the benefit of a tiny minority at the top. And no amount of celebrating the supposed efficiencies of capitalist markets (which, for the most part, were simply assumed) or tinkering with the distribution of income (with tax-based redistribution) was going to fix that.

But what strikes me now is ultimately how disastrous was the framework developed by Okun (and by Rawls), given what has happened to the distribution of income and wealth in the United States since then (since 1975, when Okun first published Equality and Efficiency: The Big Tradeoff and when the first revision of Rawls’s A Theory of Justice appeared).

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Consider, for example, the distribution of income. In 1975, the top 1 percent managed to capture almost 9 percent of national income; by 2013, its share had risen to over 20 percent.

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A similarly dramatic change has occurred with the pay of top corporate executives. The CEO-to-worker compensation ratio has risen from 28 when Okun wrote to 296 today.

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And, of course, the distribution of wealth—which has always been more unequal than the distribution of income—has also worsened: according to Emmanuel Saez and Gabriel Zucman [pdf], the share of the top 0.1 percent rose from 7.6 percent in 1975 to 22 percent in 2012.

I have every reason, then, to be even more critical of Okun (and, for that matter, Rawls) today than I was then. The idea that there was a tradeoff between equality and efficiency (or, in Rawls’s case, the notion that those at the bottom might benefit from inequality), and that we shouldn’t veer too far in creating more equal economic outcomes in the name of efficiency (and of justice), steered us away from imagining and implementing policies and institutions that would have prevented the return to a more and more unequal distribution of income and wealth. As a society, we could have taken such measures but we didn’t.

In retrospect, Okun’s approach (and that of Rawls) was the problem, not the solution.