Wednesday , April 26 2017
Home / S. Sumner: Money Illusion / Some thoughts on the cost problem

Some thoughts on the cost problem

Summary:
Scott Alexander has a post on the rapidly rising costs in areas like health, education and subway construction.  As usual, it’s excellent.  He considers many different theories, and does not find any of them to be all that persuasive. I certainly don’t claim to have all the answers, but I do feel that much of the problem reflects the fact that governments often cover the cost of services in those three areas.  This leads producers to spend more than the socially optimal amount on these products.  I’m going to provide some examples, but before doing so recall that economic theory predicts that costs in those areas should be wildly excessive.  If the government paid 90% of the cost of any car you bought, and that didn’t lead to lots more people buying Porsches and Ferraris, then

Topics:
Scott Sumner considers the following as important:

This could be interesting, too:

Scott Sumner writes It’s a crazy world out there

Scott Sumner writes Complacency

Scott Sumner writes In the news

Scott Sumner writes What caused the productivity slowdown?

Scott Alexander has a post on the rapidly rising costs in areas like health, education and subway construction.  As usual, it’s excellent.  He considers many different theories, and does not find any of them to be all that persuasive.

I certainly don’t claim to have all the answers, but I do feel that much of the problem reflects the fact that governments often cover the cost of services in those three areas.  This leads producers to spend more than the socially optimal amount on these products.  I’m going to provide some examples, but before doing so recall that economic theory predicts that costs in those areas should be wildly excessive.  If the government paid 90% of the cost of any car you bought, and that didn’t lead to lots more people buying Porsches and Ferraris, then we’d have a major puzzle on our hands.

Scott mentions that private for-profit hospitals are also quite expensive.  But even there, costs are largely paid for by the government.  Close to half of all health care spending is directly paid for by the government (Medicare, Medicaid, Veterans, government employees, etc.) and a large share of the rest is indirectly paid for by taxpayers because health insurance is not just income tax free, but also payroll tax free.  I’d be stunned if health care spending had not soared in recent decades.

A sizable share of my health care spending has been unneeded, and I’m fairly healthy.  I met one person in their 80s who had a normal cold and went to see the doctor. They said it was probably just a normal cold, but let’s put you in the hospital overnight and do some tests, just in case.  There was nothing wrong, and the bill the next day was something in the $5000 to $10,000 range, I forget the exact amount.  This must happen all the time.  No way would they have opted for those services if Medicare weren’t picking up the tab.

Just to be clear, I don’t think any monocausal explanation is enough.  Governments also pay for health care in other countries, and the costs are far lower.  It’s likely the interaction of the US government picking up much of the tab, plus insurance regulations, plus American-style litigation, plus powerful provider lobbies that prevent European-style cost controls, etc., etc., lead to our unusually high cost structure.  So don’t take this as a screed against “socialized medicine.”  I’m making a narrower point, that a country where the government picks up most of the costs, and doesn’t have effective regulations to hold down spending, is likely to end up with very expensive medicine.

To be fair, there is evidence from veterinary medicine that demand for pet care has also soared, and that suggests people are becoming more risk averse, even for their pets.  But there is also evidence cutting the other way.  Plastic surgery has not seen costs skyrocket. (Both are medical fields where people tend to pay out of pocket.)

I started working at Bentley in 1982, teaching 4 courses a semester.  When I retired in 2015, I was making 7 times as much in nominal terms (nearly 3 times as much in real terms), and I was teaching 2 courses per semester. Thus I was being paid 14 times more per class (nearly 6 times as much in real terms).  No wonder higher education costs have soared!  (Even salaries for new hires have risen sharply in real terms.) Interestingly, the size of the student body at Bentley didn’t change noticeably over that period (about 4000 undergrads.)  But the physical size of the school rose dramatically, with many new buildings full of much fancier equipment.  Right now they are building a new hockey arena.  There are more non-teaching employees.  You can debate whether living standards for Americans have risen over time, but there’s no doubt that living standards for Americans age 18-22 have risen over time—by a lot.

As far as elementary school, my daughter had 2, 3, and once even 4 teachers in her classroom, with about 18 students.  We had one teacher for 30 students when I was young.  (I’m told classes are even bigger in Japan, and they don’t have janitors in their schools.  The students must mop the floors.  I love Japan!)

There are also lots more rules and regulations.  By the end of my career, I felt almost like I was spending as much time teaching 2 classes as I used to spend teaching 4.  Many of these rules were well intentioned, but in the end I really don’t think they led to students learning any more than back in 1982.  I wonder if Dodd/Frank is now making small town banking a frustrating profession in the way that earlier regs made medicine and teaching increasing frustrating professions.

People say this is a disease of the service sector.  But I don’t see skyrocketing prices in restaurants, dry clearers, barbers and lots of other service industries where people pay out of pocket.

The same is true of construction.  Scott estimates that NYC subways cost 20 times as much as in 1900, even adjusting for inflation.  The real cost of other types of construction (such as new homes), has risen far less.  Again, people pay for homes out of pocket, but government pays for subways.  Do I even need to mention the cost of weapons system like the F-35?

To summarize, the case of pet medicine shows that costs can rise rapidly even when people pay out of pocket.  But the biggest and most important examples of cost inflation are in precisely those industries where government picks up a major part of the tab–health, education, and government procurement of complex products.  And excessive cost inflation is exactly what economic theory predicts will happen when governments heavily subsidize an activity, without adequate cost regulations.  Just as excessive risk taking is exactly what economic theory predicts will happen if government insures bank deposits, without adequate risk regulations.  Let’s not be surprised if the things that happen, are exactly what the textbooks predict would happen. Even FDR predicted that deposit insurance would lead to reckless behavior by banks, and he (reluctantly) signed the bill into law.


Tags:

 
 
 
0 0
Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

Leave a Reply

Your email address will not be published. Required fields are marked *