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Wednesday, June 27, 2012

Just Wait Until It’s Free

The quip “If you think it’s expensive now, just wait until it is free” is funny because of the unfortunate truth it contains. The truth is unfortunate less because it’s impossible to provide benefits without costs than because politicians constantly try to convince voters otherwise. To paraphrase Thomas Sowell: The first law of economics is that there’s no such thing as a free lunch; the first law of politics is to disregard the first law of economics.

Politicians convince only the naive that government can provide free benefits, but the political process creates a lot of naivety. This naivety in turn allows politicians to enact policies that make it rational for consumers to act as if they believe government has lowered the cost (often to zero) of goods even when they know better. As the joke suggests, however, the more the “as if” cost of a good is reduced, the more its real cost is increased. This can be explained by making use of the important distinction between the total cost consumers pay for a good and the marginal cost they pay—that is the additional amount they pay to buy one more unit of the good.

The most obvious way the government can make people act as if the cost of a good has been reduced is to lower its price. The most direct way to do that is by imposing a price ceiling below the market price. We mention a price ceiling briefly only to explain why we do not consider it in detail. When the price of a good is legally lowered, the amount supplied will decrease, so consumers cannot act as if the cost has been lowered by purchasing more, despite their desire to do so. Also, it quickly becomes clear to consumers, once the aggravation of longer lines, poorer service, and declining quality is considered, that the cost of the good has become higher, not lower.

A more lasting way for politicians to give the impression they have lowered the cost of a good is to subsidize its supply. This can be done by transferring an amount covering all or part of the cost to suppliers for every unit of a good sold to consumers. This per-unit subsidy would cause a corresponding drop in the cost of production and thus in the price of each unit of the good. We assume the supply curve is horizontal—that is, prices won’t rise to offset increased consumer purchases in response to the price subsidy.

For example, the entire cost of providing a year of K-12 government schooling is subsidized, and parents can send all their children to a government school regardless of how many they have. There are, of course, restrictions on which school parents can send their children to, and they have little control over who teaches their children. Similarly, government medical care subsidies, whether provided through Medicaid, Medicare, or tax advantages bestowed by not taxing employer-provided insurance as income, lower the price paid directly for medical care. Here again, relatively few restrictions on the amount of medical care people demand have been imposed, but this is likely to change rather significantly in the future.

If they give it any thought, most people recognize that any market prices they pay directly for government schooling and medical care are far less than the total amount they actually pay for these services. But they seldom know how much they are paying over and above the direct out-of-pocket price, and even if they did, it would not influence how much of the subsidized services they demand. This begins the explanation of why subsidizing goods increases their cost.

When politicians subsidize the supply of a good, they reduce its marginal cost to consumers by increasing the amount they pay in taxes to finance the subsidy. The marginal cost—the additional amount paid when another unit is purchased, as determined by the now-lower price—is the only cost consumers pay attention to. The total subsidized cost, in the form of higher taxes and/or insurance premiums, also increases when a consumer buys another unit of the service, but that increase is spread over all consumers, often many millions of them. So the increase in this cost is effectively zero to a consumer deciding how much of a subsidized good to buy, and is therefore ignored.

In other words, subsidizing the supply of a good creates an external cost of the type that is referred to as a “market failure” when it results from private activity (think of pollution, which is really the result of the absence of markets), but is referred to as protecting consumers against market exploitation when intentionally created by government policy. The subsidy creates a situation in which each consumer can benefit by shifting much of the cost of her consumption to the rest of the population—the larger the subsidy the larger this external cost. The result is excessive consumption of the subsidized good as each consumer expands her consumption beyond the point where the marginal value she receives becomes less than the marginal cost of producing the good—that is, less value is received from additional units than is sacrificed to produce them.

Some argue that subsidizing certain goods is justified because their production and/or consumption generate external benefits and would therefore be underconsumed if not subsidized. It is possible that a government subsidy can increase consumption of a good by exactly enough to offset the underconsumption due to an external benefit that would otherwise exist. But a realistic view of the knowledge political authorities possess, and the incentives they face, raises serious doubt that such goods can be correctly identified, or the right subsidy applied if they were. For example, there are private firms that generate both external costs (say in the form of pollution) and external benefits when producing a good. It is easy to model a situation in which efficiency requires that such a firm’s production should be subsidized despite the pollution it creates. However, we challenge any government agency to determine when such situations exist, as they surely do, and then accurately determine what the efficient subsidies are. And even if such information were available, it would be largely ignored since the political considerations that determine what goods are subsidized, and by how much, seldom have much if anything to do with economic efficiency.

The point is that no matter why government subsidizes a good, whether to improve economic efficiency or, more likely, to satisfy some constituency under the pretense of reducing the good’s cost, the effect is invariably to increase its cost. Even though the immediate effect is to decrease the good’s price by the subsidy’s per-unit amount, with the per-unit cost (price plus the cost of the subsidy) remaining the same, the lower price will quickly motivate an increase in the amount demanded. This will cause the price, and therefore the per-unit cost, to increase for at least three reasons, even if, as we have assumed, the supply curve is horizontal.

First, consumers have little motivation to shop carefully because the price, or direct cost, is often a small percentage of the total cost. In some cases, such as government schools (where the price is zero), consumers typically are not allowed to compare alternatives, but are assigned to a particular supplier (school). Even when consumers can choose their suppliers, they have little motivation to ask about the cost of the good, as is the case of medical care—the direct cost of which is only about 13 percent of the total cost in the United States. With consumers paying little attention to the cost of the goods they consume, suppliers have less motivation to compete on price and greater latitude to direct their customers into costly options that add little if any value.

Second, the less of the total cost consumers pay directly for a good, the less control they have over its quality or the convenience with which it is delivered. The result is that the quality of subsidized goods declines relative to their increased cost. Indeed, government schools provide a clear example of declines in educational quality, particularly in the inner cities where parents are less able to afford private schools, while cost has increased significantly. By most measures the quality of American medical care has improved, as access to improved drugs and the availability of technically advanced medical devices have increased, but at a greater cost than necessary. And the extra cost has not resulted in life expectancies equal to those in some countries with lower per-capita spending on health care, although there are many factors other than such spending that affect life expectancy. And it should also be pointed out that in countries where medical care is provided by the State, there are longer waits for that care than in the United States.

What can be said with confidence is that the control people have over the medical care they receive is becoming more like the control pets have over the medical care they receive. In both cases, the ones receiving the care are not the ones paying directly for it. Doctors consider those paying directly their customers, and primarily cater to their desires (and instructions).We might have some advantage over our pets in this regard since we still pay directly for a portion of our care. But when considering our diminishing control over health care decisions that affect our lives, we should ask ourselves: Are the bureaucrats representing those paying for most of our medical care as concerned with our well-being as we are for the well-being of our pets?

A third reason why subsidizing goods increases their cost is the burdensome red tape that invariably accompanies the production and consumption of such goods. It is customary for people to complain about the forms that have to be filled out and records that have to be kept by teachers and their students, and doctors and their patients. There is also the accompanying cost of the hoards of bureaucrats necessary to formulate, enforce, and keep records on all the rules and regulations, most of which have no obvious connection with doing a better job educating and healing. But such complaints, and the promises of politicians to reduce red tape, have no effect because there is a good reason for much if not all of it. One of the unappreciated advantages of market exchanges is that when consumers pay with their own money and suppliers have to compete for that money by producing value, people are motivated to make decisions that benefit others. This market accountability is destroyed when suppliers are being paid by third parties for most of the cost of making a good available to consumers. Red tape is a poor substitute for market accountability, as is evident from the fact that it does not prevent the cost of subsidized goods from increasing. But if markets are not allowed to function, the alternative to red tape would be an almost complete lack of accountability. The only way to reduce red tape is to eliminate the subsidies and restore the effective and efficient accountability that only a market can impose.

Even though most of the cost of a subsidized good is paid indirectly, it commonly increases to the point where there is a noticeable and negative public reaction. When this happens, the political response to public complaints about the escalating cost is almost always to increase the subsidy, not to reduce or eliminate it. This will be accompanied by political attempts to convince the vast majority that a relatively few rich taxpayers will pay the subsidy thanks to efforts to make them “pay their fair share.” The reality is that almost everyone ends up paying more one way or another. The total cost continues to go up, as do the inconvenience and red tape imposed on consumers and suppliers by government, which then provides more jobs for both government and private-sector bureaucrats.

When the cost-increasing effects of ever larger subsidies overwhelm the ability of politicians to convince voters that the cost is being paid primarily by others, political efforts are made to reduce the cost. But these efforts typically involve more bureaucratic control, which imposes yet more restrictions on the types of goods and services available, who is eligible to receive particular types, and the amount of compensation received by suppliers.

This has clearly been the case with health care. Since government began to provide significant health care subsidies, reform has consistently meant increasing the size and scope of the subsidies and the legislative detail imposed on health care decisions. It is interesting to note that physicians experienced large income increases with the big boost in medical subsidies beginning in 1965 with Medicaid and Medicare. Their increased compensation was part of the general increase in medical costs as consumers became less concerned with the cost of their care and demanded more of it. Not surprisingly, physicians are less enthusiastic about the 2010 Affordable Care Act, which is threatening to reduce their incomes. But consumers have the most to lose from increased government control over health care decisions. Without market prices determined by free exchange and undistorted by government subsidies, goods will have to be rationed by government authorities. They won’t be called death panels, but they will be making decisions that will result in shovel-ready action.

The experience in government education is different from that in medical care for the obvious reason that it has long been financed entirely by government subsidies. Therefore, cost increases in government education cannot be obscured with increased subsidies. Also, school choice has been far more limited than the choice of doctors and hospitals. This may be why providing consumers more choice has been recommended as the best way to reduce educational cost and improve its quality. Privatizing schools would be the most effective way of achieving these improvements by insuring that people are paying the full cost of education directly with their own money. A clearly second-best approach would be providing parents of school-age children educational vouchers that could be used to pay for tuition at any school, private or public, that parents chose. Even this second-best approach has been effectively resisted by the government-school lobby, which has so far been able to convince the public that competition would reduce the quality of education. Fortunately, more people are starting to see this lobby as the biggest obstacle to genuine educational reform.

Most people would like to have their purchases subsidized by government. Once we start down that road, however, it is hard to keep the subsidies from spreading to a wide variety of things almost everyone purchases. The result is we find ourselves heading toward the situation described by Frédéric Bastiat, the nineteenth-century economist, when he said, “The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else.” Such an attempt to reduce the cost to everyone is clearly a guaranteed way to increase the cost of everything. If you think it is expensive now, just wait as the politicians continue to disregard the first law of economics.

  • Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.