A Red Zone for Baseball

The stature of baseball, our national pastime, is in decline. Television viewership is so low that regular season football games outdraw the World Series. Baseball is in need of rescuing. So, cue up the William Tell Overture. Here comes the Lone Economist on his rhetorical white steed to do his darnedest.

My plan is to introduce a new class of statistics that are not only statistically valid (unlike some traditional baseball statistics), but also heighten interest in watching the games. These posts will be rather technical and not intended for the statistically uninitiated.

I hope to someday publish a book easily understandable to the average baseball fan. For now, think of these posts as the technical appendix of that future book.

The Perspective of Baseball Statistics

A while ago I wrote about the importance of being mindful of one’s choice of perspective when analyzing the economics of the U.S. healthcare system (It’s the Perspective Stupid). Many public health experts claim they have the indisputable weight of science on their side when they compare U.S. health outcomes to those of other countries. Yet when we see that they have chosen a purely global perspective – as opposed to an individual perspective, for example – their patina of objectivity is revealed to be largely subjective, something less than pure science.

Most analysts are unaware of the choice of perspective they have made. It is one of the reasons partisan arguments rage on and on without resolution. Both sides think they are talking about the same thing when they aren’t even talking about the same plane.

The subjective and often unconscious choice of perspective affects other areas of quantitative analysis as well. Almost all baseball statistics assume the perspective of an individual player. Player statistics, like earned run average (ERA) for pitchers and on base percentage (OBP) for batters, have been standards for over a hundred years.  The Sabermetrics revolution in the 1970’s greatly refined and expanded these types of measures which ultimately led to their use in the management of teams (e.g., the Moneyball phenomenon) and fantasy sports leagues.

However, the player perspective is not the only perspective one can choose. One could choose to take the spectator perspective. From the spectator’s perspective, the drama and entertainment generated during a game is from the suspense of not knowing which team will win until the end. This is what makes the game fun to watch.  When the spectator anticipates that a team is about to score, interest is at its highest and maximum attention is paid.  At other times, spectator attention wanes.  That is why close games are more interesting than lopsided games, because even when one team is likely to score during a lopsided game, it is unlikely to make any difference in which team wins.  There is little suspense in the game’s outcome. From the spectator’s perspective, the most interesting statistic is the one that predicts what will happen next, i.e. how likely is the batter going to reach base or the batting team to score.

In other sports, one doesn’t need fancy statistics to figure this out, it’s obvious. In baseball, not so much. To see what I am getting at, consider the argument that there are only two types of team sports.  There is baseball and its variations like softball and cricket and then there are the goal-line sports, i.e., football, soccer, basketball, hockey, rugby, polo (regular and water), lacrosse, ultimate frisbee, and quidditch.

O.K., that last one only exists in Harry Potter novels. But their commonality is obvious. These are just variations of the same game.  Each team tries to put an object in a goal on either side of a rectangular space within a fixed time limit.  Anticipating when a team is likely to score is quite simple.  The closer the object is to the goal, the more likely the team is going to score. Besides time, these sports are one-dimensional.

I believe this simplicity is key to the popularity of the goal-line sports. Every American football fan knows their team is likely to score when they have the ball within 20 yards of their opponent’s goal line (aka the Red-Zone).  They don’t need sophisticated math skills or knowledge of complex rules to appreciate the situation.

Baseball, however, is not so simple.  A baseball in play can go anywhere within the ballpark and even out of it.  Scoring doesn’t depend on the location of the ball and there is no clock.

In contrast to one-dimensional goal-line sports, baseball is multi-dimensional and consequently much harder to predict. It is generally understood that the closer the runner is to home the more likely he is to score, other things the same. However, is the team more likely to score when the bases are loaded or when only third and second are occupied? 

Each additional ball that the home plate umpire calls is believed to improve the batter’s chances of reaching base and each additional strike should have the opposite effect, but what is the net effect of a full count (i.e. 3 balls and 2 strikes)? 

Then there are the effect modifiers, such as the innate abilities of the pitchers and batters, the proportions of the ballpark, and the size and location of the home plate umpire’s strike zone.

Only long-time students of the game are likely to have the experience and knowledge to make informed estimates of these scoring possibilities.  What this series of posts provides is a systematic explanation of how to sort through all the facts, figures and formulas as well as a list of simple statistics that can be observed throughout the game to indicate when a batter is likely to reach base and when he isn’t and when a team is likely to score and when it isn’t. In short, it identifies a Red Zone for baseball.

The Wrong Weapon for the Wrong War

The emergency fiscal and monetary policies recently announced remind me of the saying: Generals always fight the last war and economists always fight the last recession. The Great Recession of 2007-2009 was a demand shock recession. The banking system collapsed which required large purchases of bonds by the Federal Reserve and fiscal stimulus to prop up aggregate demand and employment.

But the Covid-19 recession is of an entirely different nature. It is a supply shock recession which was caused by a disruption in the productive capacity of the US and our trading partners, especially China. Although temporary, this supply shock will likely last for several months.

Flooding the markets with cash will prevent the banks from insolvency and it might allow stock market speculators to cover their margin calls, but that won’t stock grocery store shelves or fill our ports with loaded ships.

With so much new money chasing fewer goods I would expect inflation to finally return from its long slumber. Fighting the oil supply shock of 1973-74 with expansionary monetary and fiscal policy was a major cause of inflation in the 1970’s. Once started, inflation is a difficult malady to eradicate in an economy.

A better policy would be to attempt to ameliorate the temporary disruption to our supply chain with rationing of essential goods. I know that solution sounds bad (because it is) but its better than doing nothing and even better than throwing money at a drop in real output.

Where Have You Gone, Vilfredo?

We’re still talking about the high price of drugs and how to lower them while not decreasing incentives for research and development. There is a mechanism for achieving this that was explored over a hundred years ago by an Italian engineer, statistician and economist named Vilfredo Pareto.

Government economic policies often contemplate exchanges of wealth where one side benefits at the expense of the other, such as a wealth tax or land reform. One of Pareto’s contributions was that markets are forums for mutually beneficial exchange, the special case of transactions where both sides benefit.

Naturally, involuntary wealth redistribution is difficult to achieve politically. Reallocations where at least one person benefits and no one loses are always preferable. Under the right conditions, a market will solve an economic problem through only mutually-beneficial exchanges.

The policy implication is that if the right conditions do not exist, create them in order to find the politically easy way to solve the economic problem.

The economic problem with the international pharmaceutical industry is that people are dying who could be saved at a cost of only a few dollars. The missing condition is that the marginal cost of producing a drug is much less than the price necessary to make its development feasible. For a market to function well, the price of the good must equal the marginal cost of producing the good (P = MC).

The existence of unexploited mutually beneficial exchanges is a clear sign that a condition for an efficient market solution is missing. Such is the case with today’s pharmaceutical industry.

Today’s Pharmaceutical Industry

To see how this might work today, let’s establish some broadly summarized facts.

There are several patented drugs that fit the following general description.

  1. Of all the people world-wide who suffer from a treatable condition, US residents represent no more than 10%.
  2. The multinational pharmaceutical company that has patent protection for a drug that effectively treats the condition sets a price that will maximize the return on its investment, a price much greater than the marginal cost of production.
  3. Private and public insurers in the US — representing the majority of US residents with the condition — pay the high price.
  4. Payers in many other countries decide that at such a high price they can save more lives by not purchasing the patented drug at all or rationing a limited quantity of it.

Each point makes perfect sense separately. It is only the final result that is a real head scratcher: a large percentage of the people in the world with a treatable condition do not receive the effective drug even though the marginal cost of producing it is almost zero.

Many prescription drugs sold by pharmacies fit this description. For example, there is Harvoni, a treatment for hepatitis C, an often-fatal infection, produced by Gilead Sciences. In 2017, Medicare and Medicaid (M&M) paid more than $3.7 billion dollars to treat 50,000 beneficiaries. M&M pays for the treatment for any beneficiary diagnosed with hepatitis C. Even more U.S. residents with hepatitis C are covered by private insurers. These insurers have a similar policy and pay similar prices. In contrast, the UK’s National Health Service (NHS) spent a comparable amount per beneficiary, but for only 10,000 beneficiaries. There are 210,000 people in the UK diagnosed with hepatitis C.

Revlimid (generic name: Lenalidomide) is another example. M&M paid over $3.5 billion to treat over 40,000 beneficiaries for this cancer fighting drug in 2017. The NHS covers this drug for multiple myeloma, but only for patients who cannot take the current thalidomide-based standard of care or are not able to have a stem cell transplant. Coverage is denied when used to treat myelodysplastic syndrome (MDS), a rare blood disorder. Consequently, only 2,100 patients are covered for this drug in the UK.

Clinically administered drugs, usually injected into the patient in a clinical setting, also fit this pattern. For example, Opdivo (generic name: Nivolumab) is used to treat cancer. In 2017 M&M spent $1.6 billion to treat 33,000 patients. The UK’s NHS only approved this drug in late 2017 and only for 1,300 cancer patients.

A study published in 2009 found that 26% of cancer drugs evaluated by the NHS were either denied coverage or only covered provisionally due to a lack of effectiveness relative to cost. Another study published in 2017 concluded that the U.S. paid the highest average price for cancer drugs compared to six other countries, but the authors could find complete price information in each country for only eight patented drugs out of 99 approved by the Federal Drug Administration. Many of these drugs are very hard to obtain in these other countries because of rationing, even if their prices are relatively low.

A Pareto Solution

The world pharmaceutical market exists in what economists call a Pareto Inferior solution. This is the situation where there are mutually beneficial trades that are left unconsummated. For illustrative purposes, here is a hypothetical life-threatening medical condition and its hypothetical effective drug treatment.

There are 10,000 insured patients in the US with the medical condition. At $250,000 per patient, the producer receives $2.5 billion as compensation for the cost of developing the drug.

World-wide there are 100,000 people who suffer from this medical condition, but at such a high price, other countries either ration the drug or deny coverage entirely.

It doesn’t take high-level math skills to see that if all countries agreed to pay $25,000 for each patient, a 90% reduction in the price, the producer would still earn its $2.5 billion reward (100,000 × $25,000 = $2.5 billion). Remember that the marginal cost of producing additional units of the drug is zero.

This is a Pareto improvement because at least one person benefits and no one suffers a loss. Specifically, the U.S. treats the same number of patients, but spends less money and the rest of the world increases the number of patients treated at a favorable price while the producer is unaffected.

The Bottom Line

Since large pharmaceutical companies are multinational monopolies, the best way to negotiate with them is vis-à-vis an international organization deputized to represent the participating governments of the world. A lone government simply setting the price it pays to be no larger than those paid by other countries will achieve little. The pharmaceutical giants already set their prices globally. The occasional exception to this rule will disappear if the suppliers see that a price concession to one country brings down the world-wide price.

By widening the base, the number of patients covered, this international agency could offer a deal to the pharmaceutical companies too good to refuse. A single, international price would eliminate arbitrage, the very phenomenon pharmaceutical companies fear so much. Research and development costs would be covered. The U.S. would save money and the rest of the world would save lives.

As Vilfredo Pareto might have said, vincono tutti (everybody wins).

The Problem with Drug Price Regulations

In previous posts I asserted that the Centers for Medicare and Medicaid Services (CMS) pays much less than private insurers for the same healthcare services because price discrimination by healthcare providers is easy to achieve (here and here). In general, price discrimination gets a bad rap in the economic literature and is even illegal in many instances. But in the case of healthcare, it serves a useful purpose. This is an underappreciated strength of the US healthcare system.

Such is not the case for the pharmaceutical drug market, however. Pharmaceutical producers’ inability to prevent arbitrage severely limits their ability to price discriminate. If they could perfectly price discriminate, the prices charged to poor, uninsured people would be much lower than they are currently, perhaps only a few dollars for a round of treatments.

This is a bold claim, so I should support them with some evidence.

Price Discrimination in the Pharmaceutical Drug Market

Perfect or “first degree” price discrimination would allow the producer to sell each unit to each customer at a different price. Each customer would have to pay the absolute maximum that they individually could and would pay. A millionaire would pay perhaps a million dollars for a single pill. A homeless vagabond, maybe only ten.

As long as the price the customer pays is greater than the marginal cost of producing it, the transaction adds to the producer’s profit. Even if the cost of the research to bring the drug to market was several billion dollars, the marginal cost of producing an extra pill is only a few dollars at most. Refusing to sell a pill to a customer for anything less than $1,000, for example, would lower the producer’s profit if the most the customer can pay is a few dollars. Consequently, even a profit-maximizing pharmaceutical producer has an incentive to sell its drug to poor customers at a very low price. This is not just theoretical conjecture. Real pharmaceutical companies do this in a limited way. If you go to almost any pharmaceutical company website, you will see a statement that says something like, “If you are unable to afford ____, we can help”. The picture below is from the website for Harvoni, a very expensive hepatitis C treatment.

Of course, anybody can claim to be uninsured, poor and suffer from Hepatitis C. Pharmaceutical companies must contend with the same information asymmetry that private insurers face. It is difficult for them to be sure their product is not being resold to customers who could otherwise pay more.

Pharmaceutical Companies Set Their Prices Globally

The “resale” problem also applies to sales to healthcare systems in other countries. It would make perfect sense for pharmaceutical companies to negotiate a different price for each country. Countries with single-payer systems could negotiate a much lower price than fractious systems like the one in the U.S. But the incentive to purchase the drug in the low-price country and resell it to the high-price country at a small markup would be very great. Consequently, pharmaceutical companies normally hold the line when negotiating with single-payer countries and refuse to lower their price.

The following is from a description of the Democratic proposal to lower drug prices:

The legislation would create a maximum price to aid negotiations called the Average International Market price. Drawing on the idea of an international pricing index — which Trump has said he supports but that many Republicans dislike — the so-called AIM would be the average price of a drug in six countries (Australia, Canada, France, Germany, Japan and the United Kingdom) weighted on the basis of sales volume.

The underlying assumption here is that these other countries pay significantly less than the US for the same drugs. But as I have asserted before, this doesn’t happen to any significant degree. Pharmaceutical companies don’t price discriminate in the way this legislation assumes they do.

Here is a passage from an article in the Guardian about the UK’s decision to ration Harvoni, the treatment for hepatitis C mentioned above:

An estimated 215,000 people in the UK have chronic hepatitis C infection (160,000 in England), which new but costly drugs can cure. Addaction, a charity that helps people overcome drug and alcohol abuse, says the decision to treat [only] 10,000 people a year is “manifestly unfair”.

The article also reveals that the cost of Harvoni ranges from £26,000 to £78,000 in the UK depending on the length of treatment. These prices are consistent with those paid in the U.S.

The marginal cost to the producer of a round of treatments for one patient are only a few dollars. The producers of Harvoni forego profits by not selling the drug to the UK at a much lower price for the nearly 200,000 people who will not receive any treatments. The reason why is because they fear it would lower revenues from the patients who can pay the high price, especially from the U.S.

A policy to simply pay the average paid by other wealthy countries will achieve nothing. This Democratic proposal to lower drug prices is very similar to many other proposals. It sounds good. Its proponents can crow about how they are sticking it to the big, bad pharmaceutical companies. But it is unlikely to have any real effect. And if it did have an effect, it would probably do more harm than good.

Harvoni and all the other hepatitis C drugs that are now on the market only exist because their producers had a realistic expectation that they would recoup their investments selling at very high prices. If we arbitrarily decrease these prices, we decrease the incentive to develop new drugs.

The AIM component of the Democratic proposal would, by itself, be ineffective, but it is a step in the right direction. What’s missing is a coordinated effort by the wealthy countries to find a price that each can afford to pay. A price that adequately compensates the pharmaceutical companies for their costs of investment in research and development.

The solution to this kind of international problem was outlined long ago by an Italian genius named Vilfredo Pareto.

More about that next time.

If the Market for Pharmaceutical Drugs is Sick, then What is the Cure?

Markets, like people, can be either healthy or sick. Healthy markets need no assistance from the government to provide adequate quantities at reasonable prices; however, sick markets do.

For a market to be healthy, its price must equal the marginal cost of production. In equation form this is P = MC. Marginal cost (MC) is the incremental cost of producing one more unit of a good and price (P) is the amount of money a consumer must pay for that unit. This equation is as fundamental for economics as “energy equals mass times the speed of light squared (E = MC2)” is for physics.

Sovaldi, a treatment for Hepatitis C, is just a combination of common chemicals. Consequently, the marginal cost of producing one additional pill of it is approximately the same as that for aspirin. You can buy the latter for a few cents, but one pill of Sovaldi will set you back around $1,000.

It is safe to say that the price of Sovaldi is no where near its marginal cost. This situation is quite common in the US and has led to the consensus that the pharmaceutical drug market is sick. There are several proposals for reducing drug prices that range from government production to partial regulation. Which is the best treatment for this illness?  

The Lone Economist has argued that healthcare policy proposals often seek to dictate a result without considering the root cause of the problem. They treat the symptom rather than the disease itself. So, it is important to understand why the pharmaceutical drug market is sick.

Research and Development are Sunk Costs

Unlike that of most goods, almost all the cost of producing a pharmaceutical drug is incurred before the first pill is even sold. Economists call them “sunk”. It may cost only a few cents to produce one additional pill of a new drug, but the research and development costs can be billions of dollars. Charging a price equal to the marginal cost would result in huge losses for the manufacturer.

How then can a pharmaceutical company earn a normal profit from its enormous investment? The answer is to grant them a monopoly — in the form of a patent — and allow them to earn monopoly profits to compensate them for their investment costs.

But aren’t monopolies bad? Don’t monopolies charge prices above the marginal cost of production and sell quantities below the optimal level?

The answer to these two questions is yes, in general. But if pharmaceutical companies could really maximize their profits, they would sell the optimal quantities of their drugs and, oddly enough, poor people would be able to buy the drug just as easily as rich people.

The Power of Price Discrimination

Price discrimination is the practice of charging a higher price to customers who are willing and able to pay a higher price and a lower price to the rest. The Lone Economist has explained that the U.S. healthcare system relies on price discrimination to shift much of the cost of healthcare for the poor and chronically sick to the healthy working-age population. Private insurers pay much more than public insurers for the same services.

The lone exception to this rule is the provision of pharmaceutical drugs. Private and public insurers pay approximately the same prices for the same drugs. The reason is that price discrimination is not as easy to enforce in the drug market as it is in the healthcare services market. This is unfortunate because taken to its logical conclusion, perfect price discrimination in the pharmaceutical market would result in poor people paying only a few cents for a pill and the rich paying thousands of dollars. Pharmaceutical companies might earn enormous excess profits, but the distributional problems that currently exist would not happen if perfect price discrimination was possible in the drug market.

Arbitrage in the International Drug Trade

Monopoly power is not the only condition needed for price discrimination to occur. The other one is the power to prevent arbitrage, the reselling of a good.  For example, if I wanted to sell you pills for $1,000 each and the same type of pills to somebody else for $100 each, then that person would have a large incentive to resell you their pills for $200 each. Unless I can stop them from doing that, I will not be able to price discriminate.

It is impossible to conduct arbitrage for a geographically fixed service like a hospital stay, but not so for a pill. As a result, there is very little price discrimination in the international pharmaceutical industry. The reason why is that these companies know that if they sell the same pill to the UK at a much lower price than they do in the US, then their US sales will be undercut from arbitrage. What usually happens is the UK either purchases a very small amount of the drug at the US price or refuses to buy it at all.

Economic Policy Myopia

Many of the proposals for fixing the pharmaceutical industry assume the U.S. government has the same amount of market power in that market as it does in the healthcare services market. The fact is that the government’s power to dictate pharmaceutical prices is much more limited than it is for services, like surgery. Pharmaceutical companies operate in a global market. The U.S. government is just one large payer out of several.

This policy myopia reminds me of the wealth tax proposals. A wealth tax is a tax on capital. Unlike the labor market, the capital market is global. This makes taxes on capital much less lucrative and much more expensive than taxes on labor. Capital can just as easily flow out of a country as it can flow into it. This is why we rely so heavily on taxes on labor.

The primary motivation for a wealth tax is that it is considered by many to be fair. Tax fairness is good, but like most other good things, it comes at a high price. We shouldn’t pay too much for it.

The most likely outcome of the current proposals for fixing the price of pharmaceutical drugs is a drastic decrease in investment into developing new drugs. In the long-run, this harms everybody.

The optimal policy must take into account the international nature of the pharmaceutical industry. There are huge opportunities for improving the performance of the international pharmaceutical market, if only we would exploit them.

More on that in future posts.

The Lone Economist Does Drugs

The prices of some life-saving drugs are astronomical in the United States with some treatments costing over $100,000 over the course of a year. Unlike its pricing policies for other types of healthcare, Medicare pays roughly the same for prescription drugs as private insurers.

This policy has come under attack by several policy-makers and politicians from both parties. The proposals differ in some details, but they generally advocate a more aggressive stance by Medicare to negotiate with pharmaceutical companies. These strategies range from using the government ‘s considerable market power – this is how it dictates prices for surgical procedures — to suspension of patent rights.

The Lone Economist agrees that the current policy leaves much to be desired. Medicare pays too much for these drugs and a more intelligent system would result in lower prices and longer lives. But like the proposals to eliminate the health insurance coverage gap, i.e. Medicare For All and The Public Option, the drug price proposals attack the symptoms and not the causes while ignoring the good parts of the status quo. In our effort to make the goose lay more golden eggs, let’s not kill the goose.

Granted, the causes of high drug prices are complex. An intelligent policy proposal would require a careful analysis of facts, an unsparing assessment of theories. Such analyses do not easily translate into marketable shibboleths. But the alternative is to squander real opportunities to improve the situation and ultimately result in policies that do more harm than good.

The next several posts will explain the complexity of the pharmaceutical industry using standard economic concepts. Here is a very brief synopsis of the major points:

  1. Cost structure: Unlike medical and surgical services, a large majority of the cost of producing pharmaceutical goods is incurred before the first unit is sold, i.e. the costs are “sunk”. It requires large investments of capital. The marginal cost of an extra unit is very small. The average cost declines significantly with higher levels of output.
  2. Corporate conduct: Pharmaceutical companies are multi-national corporations. They maximize profits by exploiting differences in national regulations, wealth and culture. Regardless of how unfair it may seem, labeling this behavior “bad” is not helpful. But it does point to an optimal strategy.
  3. Market efficiency: The principles of mutually beneficial exchange show that there are available reallocations that result in improvements for all parties.
  4. The bottom line: The governments of the U.S. and other countries and private insurers should form an international agency to negotiate with pharmaceutical corporations. This would result in lower prices and death rates world-wide and no decrease in pharmaceutical investment levels.

Optimal Medicare Expansion

I have explained Optimal Medicare Expansion (OME) in several posts but haven’t provided a comprehensive summary of all its features vis-a-vis the other public health insurance proposals.  Each proposal I have seen has at least one major flaw compared to OME. What follows is a brief synopsis of its features with comparisons to the major proposals. I’ve provided links to posts that explain the various features.

Basic Design

Beneficiaries: All residents not eligible for Medicare Parts A-D.

Coverage: All healthcare services covered by Medicare Parts A-D. Only applies to services after the household deductible is satisfied. Primary insurance.

Household deductible: Minimum is zero. No maximum. Zero for low-income households. Increases with household income and decreases with pre-existing conditions, including age and gender. Not based on actual payments to providers, but rather the payments that would be made to providers if they were paid Medicare rates.

In-network providers: Paid full Medicare rates with no balance billing allowed for services that exceed the deductible. No restrictions on payment rates or balance billing before services exceed the deductible.

Out-of-network providers: Paid partial Medicare rate for non-emergency services and full Medicare rate for emergency services after deductible is satisfied. Balance billing allowed for all non-emergency services. No balance billing allowed for emergency services after deductible satisfied.

Proposal Pros and Cons

Optimal Medicare Expansion (formerly called Medicare Prime)

Pros: Closes coverage gap. Stabilizes private insurance market. No individual mandate. Reduces price of private insurance for low-income and middle-income families. Does not require an increase in taxation. Allows families to pay more for higher intensity coverage. Reduces information asymmetry.

Cons: Does not minimize national costs per increased quality-adjusted life years.

Affordable Care Act (also known as Obamacare)

Pros: Decreases coverage gap. Reduces increase in premiums for pre-existing conditions including age and gender. Allows families to pay more for higher intensity coverage.

Cons: Creates dead-weight losses. Imposes costs on taxpayers. Does not close the coverage gap. Creates an unstable individual health insurance market. Increases price of private insurance for families that do not qualify for subsidies. Creates complex regulations. Does not minimize national costs per increased quality-adjusted life years.

Medicare-For-All (proposed by Bernie Sanders, Elizabeth Warren and others)

Pros: Closes coverage gap. No individual mandate. Eliminates premiums and out-of-pocket costs. Minimizes national costs per increased quality-adjusted life years.

Cons: Creates a massive increase in deadweight losses and costs borne by taxpayers. Crowds out private insurance. Causes a large decrease in quantity supplied of healthcare.

The Public Option (proposed by Pete Buttigieg, Michael Bloomberg and others)

Pros: Builds upon Obamacare. Further reduces coverage gap. Offers lower premium health insurance option.

Cons: Creates dead-weight losses. Imposes costs on taxpayers. Does not close the coverage gap. Creates an unstable individual health insurance market. Increases price of private insurance for families that do not qualify for subsidies. Creates complex regulations. Does not minimize national costs per increased quality-adjusted life years.

Hustlers, Handicaps and Health Insurance

I’ve been calling my idea for a better public health insurance system Medicare Prime. However, I should have Googled it first, since there is a company that has already trademarked that name. So, I’ll use Optimal Medicare Expansion (OME) from now on.

Part of the fun of being a masked vigilante is that I can insult self-important groups with reckless abandon. So, it’s high time the Lone Economist skewered that most solipsistic of associations, golfers. They’re crazy. I know this because I used to be the president of a local Rotary Club full of them. My job was to start every meeting with a few announcements and friendly banter. One of our members — I’ll call him “Steve” — had graduated from the cross-state rival of the university I graduated from. We often teased each other about the other’s alma mater.

On one occasion before I called the meeting to order, Steve let it drop that he had just returned from a pilgrimage/junket to the golfers’ holy land, Scotland. The other members were abuzz with admiration. So, I commenced the meeting with “I hear Steve is quite the golfer. Hey, Steve. What’s your handicap? I mean besides graduating from the University of __________”.

A sudden hush seized the congregation. This was what standup comedians call “misreading the room”. Joking about colleges was fine, but golf was sacrosanct!

What does golf have to do with health insurance? Here is a parable that tees up the relevant issues.

You wake up one morning with a fever and sore throat. Your mother, a registered nurse who knows that aspirin and rest is a cheap yet effective treatment, gives you an aspirin and orders you to bed. But the pain persists, and you don’t want to spend the day in bed. So, you appeal to your grandfather for help. He’s an irascible curmudgeon not afraid to opine on things about which he knows nothing. The old man hands you a bottle of Oxycodone, an opioid pain-killer, with a wink. He has an unlimited supply that he can pass along to you any time you need it.

Your grandfather’s remedy seems easy and costless, but you have this nagging feeling that something is not right. Aren’t opioids addictive? Could this be an example of a cure worse than the disease? Wouldn’t it be better to treat the cause of your problem (i.e. infection) rather than just the symptom (i.e. pain)?

This parable encapsulates many of the issues that fuel our health insurance policy debates. Private insurance markets suffer from adverse selection, the coverage gap that results from an information asymmetry between the insured and the insurer. Potential customers know more about their future healthcare needs than insurers. High-cost customers will pay relatively small premiums while low-cost customers will forego insurance. Insurers struggle to avoid bankruptcy while a lot of people are uninsured.

All the proposed remedies to adverse selection treat the symptom (i.e. coverage gap), but not the cause (i.e. information asymmetry). They concentrate on the weaknesses of our current public insurance system and ignore its strengths. Therefore, they decrease one problem while increasing another.

For example, Obamacare attempts to eliminate the coverage gap by subsidizing premiums for individual health insurance and mandating the purchase of insurance. But subsidies increase another problem caused by health insurance, moral hazard. They shift costs onto taxpayers and create an unstable insurance market. And the mandate (like your mother’s order to stay in bed) isn’t enforceable.

Proponents of Medicare-For-All and the Public Option demonstrate a surprising lack of knowledge about the U.S. healthcare system. (Guess who the irascible curmudgeon represents.) Medicare compensates healthcare providers for only part of the costs they incur caring for beneficiaries.  Private insurers make up the difference by paying providers more than the costs they incur treating the privately insured. Consequently, replacing private insurers with expanded Medicare coverage while paying providers Medicare rates, would amount to a large pay cut for providers. Many doctors would cease practicing medicine. Many hospitals would close their doors. And paying providers what they receive now from all payers would cost taxpayers much more than $32 trillion over ten years.

What we really need to do is adopt a policy that attacks the root cause of adverse selection, information asymmetry. We need an antibiotic, not a pain-killer. This is where golf hustlers and handicaps come into play.

A golf hustler is someone who pretends to be a much worse golfer than he really is. By doing this, he can lure the unsuspecting average golfer into making an unfavorable bet. Once the average golfer loses to enough hustlers, he might refuse to play people he doesn’t already know from fear of being hustled. This is golf’s version of adverse selection caused by information asymmetry.

Golfers discovered long ago that simply prohibiting hustling doesn’t work well.  The financial incentives are too great. Instead, golfers solved their hustler problem by creating a handicap registry. A handicap is basically a golfer’s average score above par with some adjustments. By making every golfer’s handicap public information, registries discourage hustling.

Like golf, health insurance is another forum for gambling. When a company sells you insurance, it is gambling that the premiums you pay are greater than the healthcare costs it will incur on your behalf. Like the average golfer, it is afraid of being hustled by potential customers who hide their pre-existing health conditions.

OME would solve this problem by providing people with an incentive to share their information while compensating them for their pre-existing conditions. The lower a household’s OME deductible, the more insurance coverage they have access to. Even for households with non-zero deductibles, the cost of private insurance and the cost of being treated by out-of-network providers will be lower if their OME deductible is lower.

If the size of the deductible is dependent on pre-existing conditions, then the household has an incentive to reveal information about its conditions. They want a lower deductible. This would be a signal to the private insurer that would guarantee that there is no information asymmetry and that their liability is limited. In effect, the OME deductible acts like a golf handicap.

Medicare already uses handicapping to some extent. For example, Medicare Part C, aka Medicare Advantage, purchases health insurance from HMO’s for Medicare beneficiaries. The premiums paid by Medicare to HMOs are risk-adjusted, meaning that a higher premium is paid for beneficiaries with pre-existing conditions.

Health insurance should be a guard against uncertainty, not compensation for chronic sickness or poverty.  The former is a service best produced by a private market, while the latter is wealth redistribution, a service reserved for governments.

Relying on private organizations to serve both purposes does not work well. OME would fulfill the government’s role of wealth redistribution while facilitating private industry’s role of providing health insurance.

There is No Such Thing as Universal Healthcare

Medicare For All is often described as being one way to achieve universal healthcare, a system in which all residents are assured access to healthcare. Such descriptions remind me of the tired but true adage that there is no such thing as a free lunch.

A while back, the Lone Economist conceded that the USA spends much more money on healthcare per capita than other large economies while suffering a higher death rate, but that this was an irrelevant statistic from an individual perspective (It’s the Perspective, Stupid). The posting was light on details and might have given the impression that I am dismissive of the shortcomings of the USA healthcare system. So, let me better explain my position.

The evidence that the USA spends much more on healthcare per capita than other countries is very well established. But the evidence that the USA death rate is much higher than other countries is less so. Facile international comparisons often draw unjustified inferences. Underlying cultural differences in countries might be driving the results and obscuring the true relationship between healthcare provision and death rates.

To prove my point, I compare the USA death rate to those of two other countries, Canada and Great Britain (GB). [Technically, GB is not a country, but I could not find death statistics for Northern Ireland.] Although the healthcare systems of these countries are different from that of the USA (i.e. they both have universal healthcare), they are English-speaking with similar economic and legal systems. Consequently, the potential for confounding, i.e. mistakenly measuring the effect of health insurance coverage on death rates due to unobserved reasons, is reduced, but not eliminated.

Figure 22.1 illustrates the number of deaths per 100,000 people in Canada, the USA, and GB in 2015.  At 846, the USA’s death rate is comfortably between those of Canada (i.e. 740) and GB’s (i.e. 988); however, there are two underlying factors that confound their comparability.

Figure 22.1 Raw and Adjusted Death Rates per 100,000 persons in 2015

Data Sources:

National Center for Health Statistics (https://www.cdc.gov/nchs/data_access/vitalstatsonline.htm), Mortality Multiple Cause Files, mort2015us.zip;

Office for National Statistics (https://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages/deaths/datasets/deathsregisteredinenglandandwalesseriesdrreferencetables), drtables15.xls;

(https://www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/populationestimates/datasets/populationestimatesforukenglandandwalesscotlandandnorthernireland)

National Records of Scotland (https://www.nrscotland.gov.uk/statistics-and-data/statistics/statistics-by-theme/vital-events/general-publications/vital-events-reference-tables/2015/section-5-deaths)

Office for National Statistics

Statistics Canada (https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1310071001)

First, death rates rise dramatically with age and both the populations of Canada and GB are older on average than that of the USA.  Therefore, other things the same, the death rates of Canada and GB should be higher than the USA’s.  If we adjust the populations of Canada and GB so that they have the same age distribution as that of the USA, their death rates shrink considerably.  In fact, after this adjustment the USA has a slightly higher death rate than GB.

The second reason the raw death rates are not comparable is that death is counted equally whether the decedent is old or young.  I think most people would admit that learning of the death of anyone causes sorrow, but that learning of the death of a child is especially horrifying.  I also think these feelings are not entirely subjective.  The younger one is, the more years of potential life one has, making death at a young age a worse – and objectively measurable – phenomenon than death at an old age.

If we accept the premise that the death of a child is worse than the death of an adult, then we should weight deaths of children more than deaths of adults.  Differentially weighting the age groups results in the third set of death rates in Figure 22.1 labeled YPLL(100)-adjusted.  After this last adjustment, the death rate of the USA is 75% greater than Great Britain’s and more than double Canada’s.

This weighting factor is based on Years of Potential Life Lost (YPLL).  PYLL is normally calculated as 75 minus the age at death for those who die before age 75.  But 75 is an arbitrary number that is supposed to indicate the age at which death is no longer considered premature.  The average life expectancy in the USA, GB and Canada is greater than 75 – especially for people in their 60’s – so I used 100 instead of 75.

To understand why this adjustment makes such a large difference, see Figure 22.2.  This graph shows GB/USA and Canada/USA death rate ratios by age group in 2015.  If the distribution of death rates were the same for different age groups in each country, the bars in the graph would have approximately the same height.  In fact, the death rate ratios for both Canada and GB are approximately 70% to 80% in the youngest age groups, i.e. 0-14, and are especially low in the working-age groups, i.e. 15-64.  It is only in the retirement-age groups, i.e. 65 and older, that the death rate ratios are close to 100% or greater.  This illustrates that comparative death rates in Canada and GB vis-à-vis the USA are especially low in the younger age groups when years of potential life are at their highest.

Figure 22.2 GB/USA and Canada/USA Death Rate Ratios by Age Group, 2015

The different death rates by age group between countries are a result of many factors, not just the availability of health insurance.  For example, relatively permissive gun control laws in the USA explain some of the difference, but even after excluding all deaths due to external causes, such as gunshot wounds and suicides, the adjusted death rate for the USA is much larger than that of the other two countries.  Immigrants have relatively long life-expectancies and Canada has a 50% higher proportion of immigrants than the USA; however, Great Britain has the same proportion of immigrants as the USA, so the “immigrant effect” does not explain the very significant differences in adjusted national death rates.

Back to my main point, no country can afford to provide unlimited healthcare to everyone. There are not enough doctors, nurses, and pharmacists in existence or even potentially in existence to do this. Even countries with universal healthcare must limit the provision of healthcare in some way.

Figure 22.2 is particularly telling about the consequences of the different ways GB and the USA limit healthcare. GB limits healthcare by intensity of treatment while the USA limits it by age. Great Britain’s National Health Service does not pay for several expensive procedures and medications that the USA’s Medicare and private health insurers pay for, but a significant percentage of the USA population under age 65 have only the relatively stingy Medicaid or no health insurance at all. Consequently, GB has significantly lower death rates for people under age 65 and significantly higher death rates for people age 75 and older.

From a national perspective, there is an undeniable arithmetic logic to universal healthcare. It results in fewer years of potential life lost. From an individual perspective, however, the math is much different. People who would otherwise not be able to obtain private health insurance, a minority of the population under age 65, gain while the majority loses. The fact that the sum of the gains is far greater than the sum of the losses does not change this distributional reality.

For many cultural and historical reasons, getting people to look at our healthcare system from a national perspective is a heavier lift in the USA than it is in the rest of the world. Individualism is our defining national characteristic. Calling single-payer systems, like Medicare For All, “universal” implies that we can have a system that imposes no individual sacrifices. Unfortunately, there is no such system.

Free PIE for Everyone!

Readers of my blog are aware that I am not a big fan of Obamacare and Medicare For All (MFA). I have proposed an alternative to these two programs, Medicare Prime (MP). But the term “alternative” implies that this new proposal is opposed to Obamacare and MFA. The fact is that MP is a generalized version of MFA that borrows many features from Obamacare. MP bridges the gap between the current program, Obamacare, and its proposed replacement, MFA. If we understand this, we better understand the trade-offs we are proposing and the relative strengths and weaknesses of these programs.

The Lone Economist likes to elucidate through historical perspective. So, let me explain what I mean by “generalized version” using this technique. In 1905, a little known 26-year old clerk in the Swiss patent office published a peer-reviewed article, “On the Electrodynamics of Moving Bodies“, in the German-language Annals of Physics. It was only later that the author, Albert Einstein, realized his theory of moving bodies was a special case of a more general explanation of gravity. The original paper was then dubbed the special theory of relativity when a subsequent paper published in 1916 publicized his general theory of relativity. Neither paper was known outside the German-speaking scientific community until after the end of the First World War. The international fame these two papers eventually received publicized the concept that debates over opposing ideas were sometimes about special cases of the same general theory.

It was 1936 when economists, not of the Marxian persuasion, found themselves in existential crisis. Since the beginning of the Great Depression in 1929, large market-directed western economies had been in continuous recession. The prevailing theory for nearly a century predicted that such extended periods of high unemployment were not possible in such economies. Therefore, this theory was useless when formulating a policy that would end the slump.

In that year, a British economist, John M. Keynes, published a book that claimed the prevailing theory of how market-directed economies worked was only a special case of how they worked in general. According to Keynes, market-directed economies quickly regained full employment under certain conditions but not under others. In effect, there were times when an economy could get stuck in neutral and only a push by the national government could get it moving again. It was only after the publication of this book that the prevailing special case theory was even given a name, Classical. With a nod toward Einstein’s contribution to scientific discourse, Keynes titled his book, The General Theory of Employment, Interest and Money.

The General Theory of Public Insurance Expansion

So, standing on the shoulders of giants, the Lone Economist identified his own general theory. Public insurance expansion (PIE) is a policy of extending Medicare and Medicaid coverage to more people than currently qualify, i.e. people over age 65, the disabled, and the poor. Although Medicare currently charges a premium and shares some costs with its beneficiaries, its proposed expansion would do away with these features. So, we’re talking about expanding the breadth of coverage as well as the number of covered persons.

MFA is the special case of PIE where coverage is extended to everybody. But is that the optimal amount? Is there a point at which the benefits of additional PIE are outweighed by its costs?

To answer this question, we must acknowledge that PIE affects more than just patients. It also affects healthcare providers and taxpayers. By outlawing private insurance, we would be effectively nationalizing the healthcare industry. All doctors and hospitals would involuntarily and exclusively become government vendors. The Lone Economist is no lawyer, but I can’t imagine a set of circumstances where our federal judiciary would find that constitutional.

In my previous posts, I’ve described the general conditions necessary that would allow a less extreme version of PIE that just might survive judicial review. Individuals would be free to purchase private insurance or not. Private insurers would be free to sell insurance of whatever quantity and quality to whomever they wish or not. Providers would be free to join a public network with limitations on payments and quality or not.

For adverse selection to be eliminated and moral hazard contained while allowing these freedoms to exist, public insurance would need to be primary regardless of provider and non-exclusive for out-of-network providers. Most importantly, the degree of coverage would need to be dependent on household income and preexisting medical conditions, including age.

To see why MFA and MP are separate special cases of PIE, consider my suggestions for the parameter values that would determine the cost of MP. Using a simple model, I estimated that the combination of parameter values a = .5, b = 1.38, c = 4, and d = .35 would result in government expenditures approximately the same as they are currently. This would also result in more families qualifying for 100% coverage than currently qualify for Medicaid. Families that now qualify for a premium subsidy would benefit from lower premiums under MP.

If we consider the parameter value combination of a = 0, b = 0, c = ∞, and d = 1, we get MFA. Everyone would be included in the middle-income group and everyone’s MP deductible would be zero. There would be no distinction between an in-network provider and an out-of-network provider. All providers would be paid the full Medicare rate. Thus, all healthcare expenditures would be paid by the government.

This is how the Lone Economist summarizes these health insurance proposals. MFA is free PIE for everyone, while MP is free PIE for the poor and sick, no PIE for the rich and half-priced PIE for everyone in between. The latter is just not as catchy as the former, but a lot more realistic.