Thursday, June 25, 2009

Economics Lesson of the Day: Public vs. Private Efficiency

I wrote this all out for a guy who wound up missing the point spectacularly anyway... so to get some good out of it, here's my Econ 101 lesson for today (bear in mind it was directed at a specific individual) slightly edited for style:
What you're forgetting is that that for a job to be a net producer it actually has to add value and capital to society. Value is subjective, and is revealed through things like consumer preferences. Since there are millions of consumers and every one of them is different, economic "value" is an extremely complex thing, so the combined power of millions of people trading with each other is the only way to really see what proportion of the population values certain things and by how much.

When a particular product is valued greatly and the supply is low - then prices rise signaling to producers that now would be a great time to get in on the action and make more of that product. New businesses open up in that field and suddenly supply starts to increase (bringing prices down, but now meeting demand for that good). This means that when a company is making a profit, this is generally because it is offering something valuable to it's consumers... Thus it should be said that they are adding wealth/value to society.

However, if a product is not highly valued, consumers won't volunteer to pay as much for the good or fewer people will be willing to pay - which in turn sends a signal to producers that said product *is not* wanted and capital would be best used elsewhere... Subsequently, if a company producing the non-valued product is over producing, then they will be operating at an economic loss and will have to adjust their output down to compensate or go out of business... this may mean laying off workers.

Because the market is based on voluntary transactions, that information is conveyed relatively quickly through profits & losses... Government can, as we've seen, fuck with that system very easily. For example by mitigating the losses that would have told producers that X or Y jobs were inefficient or not valued, thus contributing to a decline or a slowdown in generating real wealth when companies are unable to see actual market signals... Which means: There will be less stuff produced that people need or want, and thus more scarcity of highly valued goods and higher costs of living+lower quality of life overall... This is a bad thing.

Further, by trying to provide services itself, Government inherently works less efficiently than private companies.

Here's some hypothetical math to demonstrate why:

Let's look at how $500,000 might be employed to produce a good by a private company operating within a free-price, profit & loss system and government (which intrinsically operates without respect to profits or losses and is the rule-maker and thus can arbitrarily control prices).

Ex A: Private Company

A company that's earned that money in profits (in a free market) has done so by providing a product or service that is valued by their customers. If it was not valued, then consumers would have bought something else, right? Because they've earned profits, the company has received the signal that demand for their product is high and thus an expansion might be in order. The market rate, including benefits is - for example - $50,000.

But these are new jobs so they'll have to hire 1 new manager, and an HR person as well, lets say they're both worth $75,000.

SO... Our company hires 1 HR person, who hires 1 manager, and 7 new workers.

Those workers then spend their salaries on everything you talked about above [going to pay salaries of barbers, car-dealers, grocers, etc. - since everyone buys stuff there's always secondary & tertiary effects in the overall economy of employing someone].

Overall, this has been an activity which adds value to society, since 1. Consumers provided proof that they wanted/needed what's being sold, 2. The company's business model is efficient enough that profits aren't eaten up by operating cost, and 3. More of the right (for that moment) stuff is now being produced, thus increasing everyone's ability to get said product. Now, I know you're probably thinking about "CheapChineseCrap" or "SUVs", but imagine that this company is producing Flu Vaccines instead. We now have +7 workers creating the vaccine.

Ex B: Government

First. They have no way of effectively knowing if what they want to produce is needed or wanted, because instead of a profit & loss mechanism or a free price system, their "profits" are collected involuntarily, and prices are set either by some market-mimicking standard as the USSR did it, or by arbitrary fiat like Hugo Chavez. Ignoring the fact that this requires an inordinate amount of force... which I know you don't really care too much about, the point is that there's no automatic way to know what's actually needed at any given time.

So instead of acquiring the information naturally through observation of prices and profits - we have to hire "experts" to tell us what's needed, and we need someone in charge of determining what prices are. Since everyone in government is funded by taxes instead of via voluntary payments then you also need a tax-collector. Let's say that the "expert" can be responsible both for what gets produced and at what price they'll sell it and he manages to discover that we need more flu vaccines and ties the sell price at market value. Everything being equal to the private company, let's get back to the math model:

Same $500,000 but this time taken by force via taxation.

Government has to first hire someone to collect the taxes... say $50,000 to that person. The expert commands $100,000 but that's very important, so we'll accept that too. Then they still have to hire a manager, at $75,000 and an HR person do to that hiring at $75,000 – and finally, as many workers to actually produce the vaccine as they can with the remainder.

So where does this leave us? With 1 Expert, 1 Taxman, 1 HR guy, 1 Manager, and... Well gosh, only 4 workers. I should also note that I'm being extremely generous, since government would probably opt to work at a loss to provide the vaccine at a nominally cheaper price, they would be paying far more than $50,000 to some unionized work force complete with life-time pension guarantees, and it wouldn't take 1 “expert”, but a whole team. But for my scaled down purposes... this will be fine.

So, you might think, “So what? Everyone has a job right?”

Sure... Everyone has a job - well, actually, 6 people instead of 7 have a job because the administrative side is a little more top-heavy and you can't afford to hire as many people with the same budget, but whatever... People are employed. But you know what the world doesn't have??

Enough Flu Vaccine.

Thank you for playing.

The person's response was to criticize my hypothetical numbers in the above example and completely and utterly ignore the principles involved. But because his response might very well be something that other people think when they read this... I shall quote it (unaltered) below:
"Sean, after trying to read your multi-page rant, I just about burst out laughing when I realized that you don't even grasp that the government buys more flu vaccine than anyone. In any case, people will not give up flu vaccines. They will give up the countertops. Your analogy is wrong.

And btw, a company that has one HR worker for every seven employees is DoA. Your numbers are completely made up, and actually in denial of the facts. Overhead for government agencies compares very favorably to the private sector."

Yes, in the real world - Government BUYS most of the flu vaccine produced... but first off, the above parable has nothing what-so-ever to do with which consumers are purchasing the good! It's set in an actually free-market where government isn't the buyer... This is why it's a *hypothetical example*.

It also has nothing to do with the specific good in question... I used "flu vaccinations" because he's someone who complains about people buying SUVs and stuff from China all the time as being terrible, but the reality is, if the government wanted to produce ballpoint pens, the argument and analogy remains identical.

That said... the fact that we have government as the main consumer of flu vaccines and regularly have shortages requires me to diverge from the point of the original lesson and talk about something else important as well [see below].

Thirdly... Again missing the point, he nit-picks my specific nominal cost of things like HR people.

Ok... He got me! One HR person isn't necessary for 4-7 employees. In reality, lets say you have 1 HR person per 20 employees, then what you need is 1/5th of an HR person's time to hire 4 new people or about 1/3rd of an HR person's to hire 7 - whatever. The reality though is that you're paying the HR guy either way a full salary and not per hire anyway, so assuming an equal salary in the private vs. public examples subtracts $75,000 in both cases. My POINT was that the cost there is the same and something you'd have to factor into the usage of the "available" $500,000 established by the (hypothetical, simplified) example.

The difference, which he failed to recognize, is that in a free market system a private company obtains information from price-signals and based on their profits or losses - whereas a government, with no concern for "losses" and greatly distorting price-signals has to hire some variety of experts to tell them what to produce, in what quantity and within what time frame...

Of course, in short, the mere requirement of government to collect taxes to fund their work rather than acquiring money from customers who voluntarily come to your shop and give it to you means that public systems inherently have several more layers of bureaucracy tacked on to everything they do. This means hiring far more administrators than workers than you would ever find in a private equivalent. Unfortunately - since many of the administrative costs are hidden with wild accounting schemes (i.e. Medicaid owing money to itself and such) and separate budgets for different agencies (the hypothetical "Vaccine Production Administration", the IRS, Congress, FDA, etc. etc. etc.) means most people will never be able to properly see the total costs, or the total number of administrators who were "necessary" to produce the vaccinations.

Sadly, my Economics Lesson fell on entirely blind eyes earlier today - but hopefully someone will get some use out of it all the same. In either case - I wrote it all out and it's now here for the world to view for all time. :)

* * * * *

"CASE STUDY": Government involvement as main buyer of flu vaccines

I said earlier that when there are shortages of a good that the free-market result is higher prices which compel other companies to join the market and start producing more of that good until an equilibrium has been met - i.e. until demand is satiated.

Obviously, I've simplified the price-signal relationship to some extent, since some goods are just legitimately scarce. Precious metals are hard to get to and the price jumping 300% in a year will definitely push more companies into the Platinum business, but they have to dig it out of the ground, so there's only so much output they'll be able to create no matter how much demand there is for the stuff. That said, vaccines don't fall into that category and we have shortages in flu vaccine every year, so what gives?

WELL. Your first thought might be that no price-signal is being sent to producers that flu vaccine is highly needed, i.e. prices are too low for the good and producers aren't getting the message that demand is much higher than supply.

This might lead you to believe that government is simply underpaying and therefore potential flu vaccine producers never get the idea to enter the market and make more of what's needed. The solution then, would be for government to increase the price they're willing to pay for the vaccine. And that would probably be true if this were an unfettered market... It would also just happen naturally as limited supply would command higher prices for a highly valued good.

HOWEVER... This isn't an unfettered market! It's a highly controlled, regulated and skewed market where the participants are playing by different rules than you or I. The government is not actually a market participant in the same sense as anyone else. Normal people have to earn the money they get, bear the losses of bad decisions and have to work within the system by engaging in voluntary transactions with everyone else. Government on the other hand is bound by no such concerns... It gets it's money by force, and as a result bears *none* of it's losses and has incentive to engage in economically profitable actions only so far as the public holds politicians accountable for fiscal irresponsibility (which is apparently not at all). In reality, politicians are of course motivated by political success, which typically means not adding to the economy as discussed above and producing more wealth but merely transferring wealth from some people to more politically connected people.

So there are two main factors contributing to flu vaccine shortages that have nothing what-so-ever to do with low prices, but everything to do with the way the Government skews the market. First, government erects barriers which either disallow alternate suppliers to join the market or cause the costs of doing business to rise excessively through various requirements, fees and other taxes that even when high priced goods are sending signals to other producers to make something of high value, no one new is able to produce the good. As an added bonus, most of these laws have historically been supported by the major companies already working in the industry affected since restrictions like that limit their potential competition and enables them to have monopolies or near-monopolies and keep prices/profit margins artificially high.

You'll notice that the manufacturers of the flu vaccine have steadily declined since the 1960s...

It should be noted that government involvement since the 1960s has also increased dramatically, in both regulations [1] and FDA [2] requirements [3] & costs (upwards of $1 Billion per approval [4] in fees & testing costs) and in spending which has gone up drastically: For instance, total Health Care spending at the State & Federal level [5] over the same time period has gone from $
37.69 Billion in 1960 to $1.042 Trillion in 2009 (Adjusted for inflation to 2009 dollars) see below to view the increase graphically in "actual" non-adjusted dollars.

So in reality, allowing more companies easier access into the vaccine market and reducing the government-imposed costs to produce vaccines would go a long way to reducing costs (I personally vote for abolishing the FDA and moving to a private system like the way Underwriter's Laboratory tests all consumer electronics cheaply & successfully), but government will have none of that.

The other irony of this is that while vaccines are expensive to make and supply is naturally limited by the low production, government probably over pays for flu vaccine! I know that might seem a little counter intuitive, but these companies aren't run by idiots - they know that government's pockets are deeeeeeeeeeeeeeeep, and even the most scrupulous people are bound to realize the benefits of a "customer" with a bottomless bank account and the willingness to write blank checks. Government can get it's money by force, (or apparently now, just print more of it whenever they run out!) so they have no incentive to be frugal with it anyway, politicians really only have incentive to make sure their blank checks get spent in their home states. Regardless, the lesson here is that because government involvement distorts market forces so much, we get the beautiful joy of experiencing shortages of something we really need (flu vaccines) - while also paying too much per unit - with no effective way of either increasing supply *or* lowering cost.

Awesome, huh?

[Minor follow-up: Upon some further inspection, it appears that indeed the intuitive thing is probably happening. Government programs under pay for medical supplies & services: According to the GAO, Medicare pays about 87 percent of market rates for most services, but about 34 percent for anesthesia services - Thus, in addition to the restrictions the Federal government places on suppliers and the excessively high cost of regulation, they do in fact also distort the price-signal relationship by under paying. Crap... That's even worse.]


[1] Miller, Henry I., and David R. Henderson. "The FDA's Risky Risk-Aversion." Stanford University: Hoover Institute - Policy Review 145 (2007). Hoover Institute - Policy Review - The FDA's Risky Risk-Aversion. 26 June 2009 .
Ruwart, Dr. Mary J. "ISIL -- Death By Regulation: The Price We Pay for the FDA." International Society for Individual Liberty: Libertarian Activism Worldwide. 26 June 2009 .
[3] "Regulation Search: vaccines drugs." US Government Printing Office. National Archives & Records Administration. 26 June 2009 .
[4] Katiin (Ph.D), Kenneth I., Dr. Christopher-Paul Milne (DVM, MPH, JD), Joseph A. DiMasi (Ph.D), Ken Getz (MBA), Janice M. Reichert (Ph.D), and Dr. Richard I. Shader (MD). Outlook 2008. Rep. Boston, MA: Tufts Center for the Study of Drug Development, 2008. 26 June 2009 .
[5] "Health Care in United States 1960-2010 - Federal State Local." Federal State Local Government Spending in United States 2007 2008 2009 2010 2011 - Charts Tables. 26 June 2009 .

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