REPOST: Moral Hazard vs. Adverse Selection

Back in 1992, Nobel Laureate Peter Diamond proposed a solution to the adverse selection problem in health care. The NY Times reprinted an old editorial by Professor Diamond based on an article in Econometrica :

The core of the problem is that insurance companies can pick and choose their customers. They tailor policies to attract low-risk individuals, leaving those who are -- or are about to be -- chronically ill to fend for themselves or else pay huge fees.

To solve this adverse selection problem, Professor Diamond would eliminate worker-based coverage and replace it with a government-determined risk pools:

First the government divides the entire population into many large groups. Then, the government creates a Federal Health Insurance System (HealthFed), modeled on the Federal Reserve System, ... There would be redistribution between groups and pricing of alternatives to reflect optimal social insurance principles.

But any solution to the adverse selection problem would also exacerbate the moral hazard problem, so vividly described by my colleague Larry Van Horn

I start each day with my morning “cocktail” of an ACE inhibitor, Beta blocker, and Statin - all grossly subsidized by my health plan. I pay the same monthly premium as every other employee at my workplace with a family health plan. My wages have been reduced to fund the insurance premium behind the scenes, so I never know how much was taken from me. I know the only way to get my money back is to consume the services and drugs.

To solve the moral hazard problem, make consumers face the consequences of their risky behavior, with, e.g., with polices that have big deductibles.

My take away: Democrats are concerned with adverse selection, and want to increase consumption of health care; Republicans are more focussed on moral hazard, which would reduce consumption of health care. Pick your poison.

What they don't tell you about Thanksgiving in school

Peter Klein gives us a more complete story of the first Thanksgiving:

Faced with potential starvation in the spring of 1623, the colony decided to implement a new economic system. Every family was assigned a private parcel of land. They could then keep all they grew for themselves, but now they alone were responsible for feeding themselves. While not a complete private property system, the move away from communal ownership had dramatic results.

Is the Pope committting the nirvana fallacy?

Pope Francis made headlines this week by criticizing free market (Anglo-American) capitalism:

"Just as the commandment 'Thou shalt not kill' sets a clear limit in order to safeguard the value of human life, today we also have to say 'thou shalt not' to an economy of exclusion and inequality. Such an economy kills," Francis wrote in the document issued on Tuesday.

But does this mean that the alternative is better?  The relevant question is not whether capitalism kills but rather whether the Pope's implied alternative would do any better.  In this classic clip from Milton Friedman, he says that the record of history is "absolutely crystal clear" on this point:

The "Replacing Our Bodies Overnight with Technology" Act

Jordan Weissman at the Atlantic thinks we should call the new bill in the Senate that raises the minimum wage and provides tax breaks for technology the ROBOT Act. Because the demand for robots will increase.

In other words, this bill would make it more expensive to hire workers and cheaper to buy the technology to replace them. From a political horse-trading perspective, this makes total sense. From a job-creation perspective, it's a little alarming.  

Never Punt

Risk on trading in Greek debt

Following up on our earlier post about Risk-on, Risk-off trading.

Here is an update of the time series graph, showing that after peaking at 48%, when the European Central Bank said it would buy Greek Debt, the risk premium on Greece debt has dramatically fallen. 

HT:  Matt D.

REPOST: Sales "bunching" and high-powered commission rates

Ian Larkin studies the use of "high powered" quarterly sales commissions, used by virtually every firm that sells software. A typical incentive compensation scheme (as a function of sales) is highly convex: a sales person earns 2% if she sells $100,000 worth of software; 5% if $500,000; 8% if $1,000,000, ..., up to 25% if $8,000,000.

Ian finds that these high-powered (convex) compensation schedules give sales people an incentive to "bunch" sales into the same quarter. Just as concave production costs can be reduced by "smoothing", i.e., holding inventories to buffer sales shocks, so too can convex commissions be increased by "bunching" sales into the same quarter, the opposite of "smoothing."

Using proprietary data from a large vendor he finds that 75% of sales are occur on the last day of the quarter; and 5% of sales occur on the first day of the quarter, as sales people give discounts to customers to accelerate or delay purchases. These discounts cost the firm about 7% of revenue, which is about the same amount that it pays out in sales commissions.

The 7% revenue loss suggests that there is a way to make both firm and its salespeople better off: adopt linear commission schemes to eliminate the incentive to "bunch," and split the 7% savings between the firm and its sales people in the form of higher commission rates.

When asked why they use these costly incentive compensation schemes, managers say only that they need them to retain their "superstar" sales people. But surely there is a better way to retain superstars, isn't there? As always, I would like to hear from readers on whether they think this would work.

Why are turkey prices 9% lower when demand is highest?

The NY Times explains the debate among economists who worry about such things:

The most intuitive and popular explanation for a high-demand price dip is that retailers are selling “loss leaders.” Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups. Likewise, Macy’s offers a big discount on select TVs on Friday, which will ideally entice shoppers to come in and buy clothes, gifts and other Christmas knickknacks on that frenzy-fueled trip.

When you price complementary products (chapter 12) it makes sense to reduce the price.  An alternate explanation is from the demand side:

Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales. Perhaps, during the holidays, the composition of consumers changes; maybe only rich people or people who really love turkey buy it in July, but just about everybody — including lower-income, price sensitive shoppers — buys it in November. Or maybe everyone becomes more price-sensitive in November because they’re cooking for a lot of other people, not just their nuclear families. 

“People are a little less picky about what they’re buying for other people,” explains Judith Chevalier, an economics professor at the Yale School of Management. “Let’s say I prefer Coke over Pepsi. If I’m buying for myself, I’ll probably buy Coke even if it’s more expensive. But if I’m buying soda for a party, I have no reason to think everyone else also prefers Coke, so I’ll go with whichever brand is cheaper.”

If turkey demand becomes more price elastic around Thanksgiving then we know that it makes sense to reduce price (Chapter 6).  A related explanation is that prices dont change, but rather the more price sensitive consumers substitute toward the cheaper brands. 

 One paper looking at canned-tuna prices argued that this kind of brand substitution was the primary case for an overall decline in price during Lent. It turns out that the cheapest tuna brands aren’t significantly discounted during Lent, but because the cheap brands temporarily accounted for a much higher share of overall sales, they dragged down the average price of a can of tuna.

HT:  Sam

If only President Obama had read chapter 19

If you sell insurance at a single price, anticipate that high risk individuals will be more likely to buy, and price accordingly. 

Recent data out of Kentucky, which has one of the best performing exchange websites in the U.S., show that the average age of enrollees is about 51, ten years above expectations.  To insure these higher cost individuals, premiums will have to "skyrocket" and this leads to the so called "death spiral." 

This happened in New York, New Jersey and Massachusetts where young people opted out of the system as a whole because of high prices.

“As premiums rose, healthy people dropped out meaning the risk pool was high,” Herrick says. “Premiums rose again, and more healthy people dropped out. The costs for individual insurance were double and triple the national average.”

If President Obama had read Chapter 19, he would have known to anticipate this kind of adverse selection.

Don't worry though, I am sending him a copy of my book. 

HT:  Roberta

Randomized experiment tells us how to get some welfare recipients back into the job market

Helping needy people can reduce the incentive to get back into the work force.  For example, when I take a job, I lose my welfare check plus other benefits, and this raises the 'opportunity cost' of taking a job. 

Economists call this an "effective high marginal tax rate" because the incentive to off welfare is reduced in much the same way that high marginal tax rates reduce the incentive to work harder. 

So how do welfare recipients respond to these incentives?  A randomized trial from Canada sheds light on the answer:

Basically, a group of welfare recipients were randomly split into a treatment group that received a supplementary payment that reduced the effective marginal tax rate on income from 100 percent to 50 percent for a three -year period, and were compared to a control group that was randomly selected to receive no change to the current program. (The details are available in an excellent program final report from 2002.)

The findings:

People respond to incentives.  During the period of the reduced marginal tax rate, reported work earnings and reported income rose for the test group vs. control during the experimental period.  

Marginal is not average.  At the peak effect of the program (16 months after random assignment), about 30 percent of the treatment group were employed full-time versus 15 percent of the control group. — the vast majority did very little different than they would have done otherwise...

This cost taxpayers more money, not less.  In round numbers, as compared to control the treatment increased total reported take-home earnings by about $200 CD [Canadian $] per month, about $100 CD of which was greater reported wage income, and about $100 CD of which was the supplemental cash transfer from the government  

The effect disappeared after the program ended.  After the program period (... about five years after program entry), the treatment group had about the same level of reported employment and income as the control group. 

 HT:  Instapundit