Month: August 2021

We are just about finished with the August economics marathon.

In my earlier post Economics 202: Artificial Limits on Supply – Housing, I argued that one factor leading to the ever-increasing cost of housing was government actions, such as zoning restrictions, that tend to limit supply. Another government program, the mortgage interest deduction,((just in case the reader is not certain what the mortgage interest deduction is: in general, a taxpayer who itemizes deductions may deduct from adjusted gross income the interest paid on money borrowed to buy or improve the taxpayer’s residence, so long as the loan is secured by a mortgage on the property.)) acts as a demand-side subsidy((The mortgage interest deduction is what is sometimes called a “tax expenditure,” which means that the government does not actually incur an expense but foregoes revenue, which has the same effect.)) and contributes to the increase in housing costs.

“Wait,” you may say, “I thought the mortgage interest deduction benefits homebuyers and makes buying a house more affordable.” I long thought so myself and supported the mortgage interest deduction as a way to encourage home-ownership. However, I have recently concluded, consistent with the earlier examples of the effects of demand-side subsidies, that it does not really work that way. When a homebuyer (and her lender) is calculating the mortgage amount she can afford (which, when added to the down payment, is, less closing costs, the maximum she can pay for a house) she is looking at the monthly payment. The deductibility of mortgage interest means that the mortgage payment can be that much higher, increasing the gross amount that can be paid in debt service and therefore the amount that can be borrowed. In a seller’s market, the buyer will be forced to the upper edge of her affordability envelope (if she does not choose to go there, one of the other potential buyers certainly will). Thus, the true beneficiary of the mortgage interest deduction is the home seller.

Because I do not believe that there is any general social benefit to using a tax expenditure to keep housing costs as high as they are, I have concluded that the mortgage interest deduction should be discontinued. Because, however, millions of homeowners took the deductibility of mortgage interest into account in determining how much to borrow, it could be catastrophic (and certainly would be unfair) to take the deduction away all at once. I would like to see it ratably reduced over a span of 25 or 30 years.((Under the 25-year plan, in year 1 96% of mortgage interest (including new mortgages) would be deductible, in year 2 92% and so on until zero deductibility is achieved in year 25.))

Jay Bohn
August 30, 2021

As I have said several times, I do not claim to have originated the concept that demand-side subsidies increase the price of the subsidized commodity. In the area of higher education I can confidently point to someone who still may not be first, but certainly got here ahead of me: former U.S. Secretary of Education William Bennett. His 1987 New York Times op-ed articulated what became known as the Bennett Hypothesis: “increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions.”

In 2016 Grey Gordon and  Aaron Hedlund published a working paper “Accounting for the Rise in College Tuition” which summarizes some research on this question and proposes a model that indicates that “demand shocks—which consist mostly of changes in financial aid—account for the lion’s share of the higher tuition.”((Another collection of studies appears here, and provides this alarming statistic: “Between 1978 (the first year in which college tuition had its own CPI category) and the third quarter of 2017, the price of tuition and fees increased by 1,335 percent. This rate of growth exceeded that of medical costs (704 percent), new home construction (511 percent) and the Consumer Price Index for all items (293 percent). [footnotes omitted]”)) What would happen if the government (meaning taxpayers) provided free tuition as Bernie Sanders and other “progressives” propose?

As with any other vendor, the college wants to maximize its revenue (for only the best of motives of course). Colleges compete for students in more ways than academic prestige; I would bet student living is significantly more comfortable than in the past. The cost of tuition is less an immediate consideration. Indeed, higher tuition may be a status symbol and a surrogate for the quality of the education.

Here, as in other sectors, there exists a group of students who (or perhaps more accurately, whose parents) can afford and are willing to pay without subsidy. Others must receive financial aid (financed in part no doubt by those paying full freight). It has become impossible to save or work one’s way through college.

Jay Bohn
August 26, 2021

This is the first of a three-post arc discussing the impact of demand-side subsidies upon particular areas of the economy that will bring the August economics marathon to an end.

In the post Economics 151: Insurance Basics and the Affordable Care Act, I noted that health insurance has grown in the scope of benefits offered; it is no longer just protection against the cost of a catastrophic illness or injury but pays for a significant portion of routine medical care including office visits, physical examinations and prescriptions. It has long been my premise that the availability of a source of ready payment for such services means that the cost of the services will increase to absorb available funds. The insured rarely shop for healthcare based on price because the deductible/co-payment will either be a fixed amount or relatively insignificant and somebody else is paying for the balance. Health insurance itself acts as a demand-side subsidy.

The substitute for the price-conscious consumer is the insurance company itself which will ration care and/or dictate what healthcare providers are paid. Insurance companies are not the fan-favorite in this competition. As with many other areas where demand-side subsidies are offered, the policy emphasis is on the consumer’s “need.” This process will lead to government mandates that certain benefits be provided (meaning that insurance companies will have to look to patients with less “popular” conditions for savings). There are also problems where the service is provided by a healthcare practitioner not contractually tied the the insurance company’s reimbursement rates but where the government protects the patient from full responsibility for the cost of care from the non-participating practitioner.((See here for an early explanation of New Jersey’s then-new law on the subject.))

Jay Bohn
August 23, 2021

This is the post I have been planning since the first on economics in the beginning of May. I will start by repeating that I am not an economist and that I do not claim credit for “discovering” the principle I am asserting.((Not being an economist, I also do not feel obligated to do research to trace the history of this idea.))

One of the basic building blocks of economics is the “law” of supply and demand that I wrote about some months ago as one of the basic premises for my ideas. My last two posts((Economics 201: Artificial Limits on Supply and Economics 202: Artificial Limits on Supply – Housing)) considered this from the supply side, particularly the effect of artificial supply limits (government regulations) on prices.

Now I am looking at it from the demand side. In my supply and demand post I asserted that “demand” includes, but means more than, mere “want” or “desire” for an item.  The consumer must be able to pay for the item, an ability I called “wherewithal.”

Where a particular economic commodity is important, but unattainable for many due to price, it is common for politicians to propose to subsidize its purchase by those who cannot afford it. A couple of examples will suffice: college education and housing.

If you have been paying attention (and accept my thesis about desire and wherewithal constituting “demand”), you see where this is leading: broad-based demand-side subsidies tend to cause the price of the subsidized commodity to increase. Further support for this proposition comes from what I described as the SEP Problem: the fact that “someone” else is paying for something can have the effect of increasing the cost that thing, especially where “someone” is someone of whom the consumer is willing to take advantage (the government or insurance companies, for example).

This principle does not necessarily mean that broad-based demand-side subsidies are inherently wrong, just that they are inefficient. The price for the good is a moving target, just as the “observer effect” in physics posits that the act of measuring can change the state of the thing measured. A government program that seeks to make automobiles more affordable may decide that giving potential buyers $400 to use to purchase a new (or newer) car, say in exchange for a “clunker” of no real value, will allow a reasonable number of households to acquire safe, fuel-efficient and ecological appropriate automobiles (or at least better than the clunkers traded in). However, automobile prices are nothing if not elastic, and there is no guarantee that the “base price” of the car that the consumer is seeking to purchase was not recently raised to absorb the benefit of all or most of the $400 subsidy.

Eligibility for the subsidy may be means-tested to assure that those who can afford the item are not subsidized, but just as it will reduce the government’s cost for providing the subsidy, it will also result in actual higher prices for those whose purchase of the commodity is not subsidized.

My next several posts will provide examples of this principle at work, in healthcare, higher education and housing.

Jay Bohn
August 19, 2021

In my last post I commented on the effect of artificial limits on supply (mostly government regulations) as a cause of higher prices. In this post I will deal with one example, the effect of government regulation on the cost of housing.

It is quite common to blame builders for the increasing cost of housing. While I do not doubt that builders seek to make as much profit as possible from every housing unit they construct,((Indeed, go back to the thesis of my very first economics post: “My thesis is that as a general rule people will tend to act in what they perceive to be their (economic, political, social) best interest.”)) there are other forces at work.

One of these factors is demand. As the population increases, the number of households seeking housing increases as well. We are in the midst of a remarkable sellers’ market with housing selling for a significant premium over the (presumably already inflated) asking price.((Demand is also influenced by the availability of financing and low interest rates, but I am anticipating just a little bit; stay tuned.))

Another factor, however, is the limits that government (chiefly local government) puts on their ability to build large amounts of housing.

In the early part of the twentieth century, municipal zoning became widespread. The earliest forms may have simply attempted to segregate residential, commercial and industrial uses from each other, but municipalities soon learned that they could use the zoning power to exclude the poor and minorities (who are over-represented in the lower income levels) by, among other things, prohibiting or severely limiting multi-family housing and requiring relatively large lot sizes.

Decades ago builders could provide housing affordable to working families without subsidies and set-asides (think Levittown).((A single house on a large lot may yield a profit, but as the number of houses on the same size tract increases, I am certain that the aggregate profit increases as well (at least to a point), even though the price of each home will be less and therefore affordable to a larger portion of society.)) But as the easily developed land was used up, it became harder for the free market, even where permitted to do so by appropriate zoning, to provide such housing. Exclusionary zoners, at least in New Jersey, have done a pretty good job of running out the clock on the ability of market forces to provide affordable (in the generic sense) housing for households of modest incomes.

But for every government-created problem, there is likely a government-proposed solution, with a significant premium in transaction costs and control.

In 1975 the New Jersey Supreme Court found in the State constitution a limit on municipal ability to use the zoning power to exclude poorer households. In fact, it determined that municipalities had an affirmative obligation to use their zoning power to provide a realistic opportunity for their fair share of housing affordable to lower income households. This ruling did not prohibit the use of the zoning power to exclude the poor by increasing housing prices, it just limited it. Over the ensuing 45+ years there has been much litigation over the details.

It is not my intention here to discuss the myriad failings along the way, I just want to point out that “affordable” has become a term of art and, like so much else, those not wealthy or not poor enough to qualify for the government benefit are squeezed out.

Jay Bohn
August 16, 20201

In one of my first economics posts, I discussed the classic law of supply and demand. In this post I am going to comment on the effect of artificial limits on supply as a cause of higher prices.

Some limits on supply are natural; there are just so many (or is just so much) of the good or service in the world. gold and diamonds are naturally rare, therefore valuable.

But there are other limits on supply that are artificial, usually a a result of a limitation imposed by the government.

The government-imposed limitation may be directly intended to reduce supply, such as liquor licenses or taxicab medallions, which in themselves become valuable economic goods. Historically, agricultural prices have been supported by requiring a specific allotment to grow certain crops (such as tobacco) or actually paying some farmers not to grow certain crops.

Intellectual property protections, like copyrights and patents, are intended to encourage “science and the useful arts” by assuring the author or inventor a time-limited monopoly. Such limits do, and in part are intended, to result in higher prices than if such protections did not exist.

The limitations may be for another purpose, such as quality assurance; for example, professional licenses usually require particular educational achievements and/or passing a licensing exam. Even where the limit serves such a quality-assurance purpose, the particular requirements might be adjusted to serve a price support purpose.

Jay Bohn
August 12, 2021

My last two posts((Economics 111: Insurance Basics I – Types of Insurance and Economics 112: Insurance Basics II – Premiums and All That)) covered types of insurance, premiums, and risk. I will now discuss some features of the Affordable Care Act, a.k.a. Obamacare, in light of these concepts.

Health insurance is a form of casualty insurance originally created to mitigate the risk of the costs of hospitalization and major medical expenses. During World War II, when employers were legally prevented from raising wages to attract employees, they began to offer health insurance as a recruiting incentive, leading to the situation today when employer-paid (or part paid) health insurance is a common, but not universal, fringe benefit.

Health insurance has grown, not just in the number of insured but in the scope of its benefits. It is no longer just for major expenses (although all medical expenses are now beyond what a typical patient could afford to pay out of pocket), but it covers office visits, physical examinations and prescriptions.

Another factor in the high cost of medical care is the legal obligation of hospitals to treat all comers, whether they can pay or not. Some of this “charity care” is reimbursed through government programs (that may simply shift the costs somewhat from urban hospitals primarily serving the poor to other hospitals fortunate to have a greater proportion of insured patients), but I expect that a great deal is paid by the insurance companies covering insured patients in the form of higher prices.

There are three basic cornerstones of the Affordable Care Act.

One is community rating, which greatly limits the ability of the insurance company to set premiums based upon a fine degree of precision risk calculation. This means that better risks (the young) will often pay higher premiums so that higher-risk customers (the old) can pay less.((I say “pay” although in many if not most cases the premiums are paid, at least in part, by the employer or the government.))

A second is the requirement that insurance companies pay benefits for pre-existing conditions. One particular risk the uninsured used to face were policy terms that denied coverage for pre-existing conditions. Just as you cannot retroactively buy car insurance after an accident, once you had a particular health condition, you could not get coverage for it. That would be like making a bet on roulette after the ball has stopped. This feature is very popular.

The third building block was intended to keep those disadvantaged by community rating in the insurance market, especially as the requirement for coverage of pre-existing conditions would eliminate that risk for being voluntarily uninsured. An insurance company cannot long pay out in benefits more than it takes in in premiums. Even people fortunate enough to have partially paid insurance as a job benefit may find that their share is more than they can afford. Some of these people may conclude, accurately or not, that the cost of the premiums is higher than the risk of being uninsured. These people are likely to be younger and believe that they can enter the insurance market when they are more likely to need healthcare. Younger people are typically better risks for health insurance companies, and so their premiums are lower. Older people become terrible risks, and if their premiums are commensurate with the risk, they become astronomical. (Remember, insurance is a bet and everyone wants to win.) To keep these people in the premium-paying pool so that they subsidize the higher-risk insured, the Affordable Care Act includes an individual mandate which requires them to have health insurance and imposes a tax penalty if they do not. The individual mandate was decidedly unpopular.((The two existential challenges to the Affordable Care Act to reach the Supreme Court, National Federation of Independent Business v. Sebelius, 567 U. S. 519, 530 (2012), and California v. Texas, ___ U.S. ___ (2021), involved the individual mandate.)) While it is still part of the Affordable Care Act, the penalty amount was reduced to $0.((See Tax Cuts and Jobs Act of 2017, Pub. L. 115–97, §11081, 131 Stat. 2092 (codified in 26 U. S. C. §5000A(c)).))

Jay Bohn
August 9, 2021

In my last post I discussed various types of insurance and likened the decision to buy insurance to placing a bet with the insurance company as a sort of casino. Just like a casino must balance the odds to assure its profitability, an insurance company must understand the likely cost of each risk in terms of the benefits it will have to pay and set its premiums accordingly, not too little that it goes out of business but not too much that it gets no business.

There is a perception that insurance companies have a lot of money, and this may well be true. Most of them are businesses with stockholders, and after payment of benefits, operating costs, and taxes have to make a profit to survive. While meaningful price comparison may be difficult, they do compete with other insurance companies and to some extent business will flow to the insurance company offering the coverage that customers are convinced they want for the lowest price.((What coverage is actually needed can be a far different question and one well beyond not only this post but any that I currently contemplate.))

There are other tools that insurance companies can use to control their risks. For many types of insurance the insured is responsible for a “deductible,” usually a fixed dollar amount of each claim (or aggregate of claims for the policy period) and/or a “co-payment,” whereby the insurance company will only pay a specified percentage of a covered loss.((Because higher deductibles and co-payments should mean lower premiums, they are also a way that the insured can fine tune the balance between costs and coverage to match her own risk tolerance.)) An insurance company can also obtain its own insurance policy for part of its risk; this is called “re-insurance.”((As some policy holders of the failed Mutual Benefit Company learned, reinsurance policies benefit the company (and its policy holders generally when it is insolvent) and not the holders of any of the polices that are reinsured.))

Insurance is also a highly regulated industry, and the government will often require policies to provide a certain level of benefits. Such requirements will likely either increase the premium or lead the insurance company to reduce benefits elsewhere. Although such requirements do certainly limit consumer choice, the insurance company can take them into account when setting its premium rates. Sometimes, however (always in the public interest, of course), the regulator will mandate the payment of benefits beyond those for which the policy provides during a policy term. I believe that health insurance companies were required to provide extra benefits in connection with COVID-19 and following Hurricane Sandy New Jersey prohibited insurance companies from charging a higher “hurricane” deductible for which their policies provided.

Insurance companies rely upon actuaries to calculate the risk of various perils in order to determine the appropriate premium. Changes in the regulatory environment during the term of a policy can lead to a situation where the risk in increased beyond that which had been computed and therefore the premiums (which the insurance company cannot change during the policy period) are insufficient to the risk, impairing the insurance company’s financial position to a greater or lesser extent. Every dollar in increased benefits requires an offsetting dollar of reduced expense or increased revenue somewhere.

The pricing of premiums relies upon the ability to predict accurately the expected payout for the aggregate of the risk the insurance company assumes. Actuaries may determine what characteristics of an insured make a particular peril more or less likely to occur, or more or less expensive if it does, but they do not, at least generally, predict risk at the policy holder level. The risk of a payout on a health insurance policy is, on average, less with a younger insured than an older. An insurance company that ignored the actual risk in order to price health insurance premiums lower for older policy holders would end up charging younger policy holders more than their actuarial fair share and lose them to a competitor. Such a company would likely attract a greater share of older policy holders.

While some knowledge of the risk being transferred is essential to the basic idea of insurance, too much knowledge is fatal to it. If the insurance company had a crystal ball that enabled it to predict accurately the cost in terms of benefits to be paid for each of its customer, it could more accurately price its premiums. But, because the premium is pretty much equal to the risk assumed, there is no risk transferred and the reason for insurance in the first place is would be obviated.

What automobile insurance customer would not increase coverage and/or reduce his deductible if he could do so retroactively after an accident? If you did not have health insurance and learned that you had a condition whose treatment was likely to be quite expensive, wouldn’t that change your cost-benefit analysis of whether to obtain insurance?((Stick a pin in this; I plan to discuss the feature of the Affordable Care Act that mandates coverage for preexisting conditions in the next post.))

Jay Bohn
August 5, 2021

In this post I will describe some basic concepts behind insurance. This discussion is a building block for other, more meaty posts that should be coming soon.

The basic concept of insurance is the spreading (perhaps a better word is “exchange”) of risk. Bad things happen in our lives, some thankfully relatively rare (like a sinkhole swallowing your house) others certain (death, as the most obvious example). Insurance is a contract whereby the insurer (which I will call the “insurance company” hereafter) agrees to pay to or for the beneficiary (or loss-payee depending on the type of insurance) a defined monetary benefit in the event that the specified bad thing (often called a “peril”) happens within the policy period. The insurer undertakes the risk of having to pay the benefit in exchange for the payment (usually by the insured) of the premium. From the insured’s point of view, the insured is assuming the certain loss of the premium in exchange for the right to the policy benefit if and when the peril occurs. Insurance can be seen as a bet between the insured and the insurance company, which acts as a sort of casino.

The insurance company has income from both policy premiums and its ability to invest its reserves between the time the premium is paid and the time it actually has to pay the benefit. The insurance company will pay not only the policy benefits, but also its own operating costs and possibly taxes and dividends to its investors.

There are several types of insurance. The types and policies can be very sophisticated and I am only discussing basics here.

Life insurance pays a death benefit if the insured dies within the policy period. A common type of life insurance policy is described as a “whole life” policy. Under such a policy premiums will be paid for the insured’s whole life (or a substantial part of it); so as long as the premiums are paid, the death benefit will eventually be paid. The premium will be lower the younger the insured is at the time the policy is issued because the expected life span (and premium-paying and investment periods) is/are longer. The insurance company wins the bet by the insured’s living longer, while the insured “wins” by dying sooner.

Another type of life insurance is the term policy. The policy will only pay a death benefit if the insured dies within the specified term. Premiums are likely to be lower than for a whole life policy for an insured of the same age and health because the insured may “lose” by outliving the policy term.

Another common type of insurance is casualty insurance. The casualty insurance policy pays if the insured property is damaged, such as a dwelling’s being destroyed by fire. Other examples of casualty insurance are flood insurance and title insurance.

A third type of insurance is liability insurance. A liability insurance policy has two significant benefits: it will provide a defense to a lawsuit asserting a covered claim and will also pay (up to the policy limit) if the insured is legally adjudged liable for damages resulting from such a claim.((The insurance company will almost always have the right to control the defense and to negotiate a settlement, but the insured’s consent to a settlement may be required.))

Some insurance policies, such as automobile insurance, will combine aspects of more than one of these types. An automobile policy will typically provide liability protection for claims by third parties in an accident and also pay for damage to the insured’s own car arising from such a casualty.

Health insurance may have evolved into a fourth type. The classic hospitalization/major medical policies that used to be advertised in the Sunday supplements 50 years ago that paid benefits of $50 to $100 a day were casualty policies insuring against the need to pay large medical bills. Now, however, health insurance polices provide coverage for routine doctor visits, medical tests, vaccinations, and periodic physical examinations. The payout is more certain, so the premiums are higher.

My next post will discuss insurance premiums in more detail.

Jay Bohn
August 2, 2021