Breaking Free From Widget Economics

Ahh the widget, anyone educated in the English speaking world has probably heard of Widgets.  The fictional abstract every good which is to commodities what Blackacre is to real property.  For many decades widgets have been used to teach students about mathematics, economics and contract law and perhaps a variety of other concepts too.

Widgets are an important teaching tool which allows educators to convey concepts which can often be complex in terms which are easy and understandable to the student.  However, there comes a time in everyone’s life when he or she must break free from the Widget economy.  The problem with widgets is excellently summarized on Wikipedia’s widget page where it references a scene from the movie “Back to School” where Rodney Dangerfield’s character Thornton Melon is sitting in an economics class where a classic widget example is being given.  The normally crude Melon makes an important insight to the professor, where he criticizes the hypothetical business model for making unrealistic assumptions about business, including the use of widgets.  Rodney Dangerfield points out that when using widgets one is not taking into account things like whether they are fungible and that every industry has certain characteristics which need to be taken into account. By the way, here is a link to a youtube clip of the scene which I think is a superb criticism of how academic economics can be completely out of touch with real world business practices.

I like that scene from “Back to School” a lot because it excellently captures the problem of widget economics, the professor, speaking in an arrogant and pedantic British/Aristocratic accent confidently outlines his model of a fictional firm.  Meanwhile, the unsophisticated, yet business savvy character played by Dangerfield tears into the professor’s lecture, pointing out all of the unique costs and considerations that go into any kind of business model which the professor seems to completely leave out.  This of course points to the very real fact of how many of the so called experts in business who sit in their academic halls and think tanks, have no actual experience in running a business themselves, and can be profoundly ignorant of many of the real life pressures which go into running a business.  I believe that there is something to be said for the fact that there are times when businessmen, living and working in the real economy on a daily basis, can have real insights into how economies work, insights which are often lost on the highly educated, yet experientially deficient academics.  And the problem of the widget economy is one such example.

Now when I use the phrase “widget economy” or “widget economists”, I am not referring to any one person or any one thing, but rather, the attitudes about economics seen in so many people which reflects the idea that the real economy functions like widgets do.  And in so doing, one becomes a widget economist when they seem to give the impression that the real economy, is in fact a widget economy. The widget economy is a world where every industry functions the same way.  The laws of supply and demand affect them equally, the strategy for success is the same as well.  Widget consumers are all the same as well, always pushing it towards market clearing price, they never miss a beat.  Goods are all fungible to the same degree, and elasticity is uniform unless the professor purposely changes it.  The widget economy creates the impression that all industries work the same way.  Now I know what you are all thinking, surely no one actually believes that all industries work the same way and have the same pressures.  And that may be true, even the dullest students can probably figure out that there are real world pressure which can affect the functioning of an industry in various ways.

But the problem of widget economics is not that it causes students to actually believe that all industries are literally the same, the problem of widget economics is that it creates a presumption in people that the normative model of a business should be that seen in widget economics until proven otherwise.  And thus, when one is confronted with an industry that appears to have things like heavy public involvement or social control, the presumption which is created is that this is the result of meddling public officials who are ignorant in economics, and that if you simply left it up to the supply and demand of the market, it would be able to figure itself out.  But this presumption is not only wrong, but dangerously wrong.  I am a proponent of the belief that all industries are unique, and that there are always the real world considerations involved like those mentioned by Dangerfield’s character.  And while the widget model firm is a helpful tool in teaching general concepts, our first step at looking at an industry should be from a descriptive stance, rather than a normative one. 

Ultimately economics is a behavioral science, and in the behavioral sciences, when you see a behavior or practice which seems to be nearly universal among a species, our presumption should be that it has some functional purpose behind it.  To say that things like the welfare state, or regulation of finance, or public involvement in healthcare are simply the result of foolishness which has no real world benefit or purpose would be to essentially say that it was a random fluke.  Now it is true that governments are certainly capable of making mistakes and crafting policies which are bad, as all living entities have the capacity to produce some behaviors which are simply mistakes.  However, the examples of practices I just gave are nearly universal in advanced market economies around the globe, which would put them absurdly outside the margin of error if they were merely flukes which harm society and were put into place by the very institutions whose job it is to protect society.  Even the excuses put forth by Public Choice Theorists for these things by blaming them on some flaw in democracy do not seem to be adequate, for one, many of these things existed in non-democracies, and also because democracies have shown to have the ability to self-correct for bad policies and change laws over time if they are truly causing harm and bring no benefits.  Now I suppose that a reasonable person after a thorough investigation could come to the conclusion that these are all just flukes, however, I still believe that the most prudent and scientific way to go about this is to assume that there is some underlying functional explanation for a near universal policy, and that this assumption should only be rebutted only after clear evidence is presented.

Widget economics on the other hand goes in a reverse manner, and says that industries should function like the theoretical firms presented to us in class, rather than the functioning observed in the real world.  I find this approach to be horribly unscientific.  There are some industries which simply shouldn’t be left up to the traditional widget paradigm.  I will now delve into 2 industries which are constantly criticized by widget economists for not following the rules: health care and education.  The widget economists proclaim that if we simply left these up to supply and demand that everything would work its course.  Hopefully I can show why that presumption is utter nonsense.

                Healthcare

Healthcare is an industry which has heavy public involvement nearly all over the world.  As I pointed out this near universal practice of social control of healthcare should put it far outside the margin of error of mere a fluke which violates the laws of economics. But the overall trend of the past 100 years has only been more public involvement in healthcare, rather than less, even the free market bastion in America recently enacted more control over it. So what is it about healthcare which makes it so likely to be controlled?

For one, demand for healthcare is nearly completely inelastic, for obvious reasons.  When the alternative to not getting a certain procedure done is death or severe suffering, most people and their families see cheaping out on their own survival as a non-option.  And so because of this most people will do whatever it takes to pay for vital expenses, including draining their entire life savings or incurring massive loads of debt.  This makes it difficult for the traditional rules of neoclassical economics and marginalism to do their trick.  Under marginalist theory we are told that eventually the price of a good can go up to a point when many potential buyers decide that it simply is not worth the opportunity cost and opt out, which will eventually bring it to an acceptable equilibrium.  But healthcare is not your average widget, the price of healthcare can become enormous and demand does not seem to become any less.  True, there are many impoverished people in America for whom healthcare is simply too expensive, and they simply cannot afford it.  But that is simply a matter of physical impossibility, where the individual who does not physically possess the amount of money needed or the means to borrow it is simply unable to purchase it.  Virtually anyone who can buy healthcare within the realm of physical possibility does so. 

Now one can look at this and say that this is simply a problem of supply and demand, and that healthcare purchasers outnumber healthcare providers to a degree which causes these high prices, and that in a free market, you would simply get more doctors coming into the system who seek to profit from this disparity, and eventually an equilibrium will be reached.  Now perhaps in the long run, increased healthcare providers and innovations in technology can do this, but I believe that it could take many years for this to occur.  And for reasons I will describe later regarding education, the price of medical schools has risen to a degree that it actually acts as a prohibitive measure.  Medical schools are incredibly expensive to operate, much more so than almost any other field because of the equipment, drugs and subjects that are needed to teach medicine and the time it takes to train a doctor so that he is competent to practice medicine.  Many universities are hesitant to open medical colleges because the upfront costs are so expensive that even if the long term operation would bring profit down the road, the profits are so far down the line, and the upfront costs are so expensive, that raising the capital needed is all but impossible for many schools.  Of course one possible solution could be to simply get rid of medical schools as a requirement for licensing, and allow anyone to be a doctor.  Even though this solution is enthusiastically supported by many widget economists, the practicality and desirability of such a scheme is questionable.  Much of the regulation in industries like medicine or law has come from within the industry itself with things like Medical Associations or Inns of Court.  If consumers had to navigate through a market where many practitioners are all out charlatans, it hurts public trust in the industry itself, discouraging innovation and entry into the field.  Another possibility is that consumers would eventually learn to only go to people with the letters “M.D.” or “D.O.” following their name, and that hospitals would only hire such individuals to be doctors, in which case you are simply left with a market situation which hardly differs from the one we have now. 

Now one could say that this situation of chronic high costs is simply a result of price fixing by governments, and that by enacting legislation which puts caps on the charges for procedures, it raises the opportunity cost for those seeking to profit by becoming a healthcare provider, thereby creating chronic shortages and high costs which are never abated.  Now, for one, if that were the case, we would expect to see prices inflate even more if there were no price restrictions in place, which could then make even more people unable to afford healthcare.  Or perhaps, given its seemingly ceilingless inelasticity, that society will just end up spending more on healthcare in total (and this higher costs of healthcare to GDP does seem to be observed in countries with a more “free market” healthcare system).  However, while I do think that there may be some truth to the notion that price fixing plays a role in all of this, I believe that this practice of fixing prices actually emerges from market mechanisms themselves, and not governments.  And here’s why.

Most healthcare patients end up purchasing insurance to help pay for their healthcare costs, and indeed, healthcare insurance plays a huge role in the US healthcare system.  But healthcare insurance is not your average insurance provider.  Insurance is generally an industry whereby the insurer agrees to cover a policy holder to pay for whatever unexpected costs could arise in the future which the parties agree to be covered.  Car insurance covers possible auto accidents, casualty insurance covers costs of property damage, life insurance gives a payment upon unexpected death (unless of course it is whole life insurance, but lets not get into that).  The insurer makes a bet with destiny that the person they are covering will not incur these costs, and so long as a large enough amount of policy holders do not incur these costs, the insurer walks away with a profit.  The insurer makes his money, and the policy holder gets the peace of mind which comes with owning insurance, a win win situation which even a widget economist can understand.

But health insurance is different, though it does cover unexpected emergency costs like illness or accidents (however you can rest assured that they word the policy to get out of as many of these as legally possible), health insurance also covers routine medical procedures like check-ups and prescriptions.  If the health insurance provider is making a bet with destiny, it is one he will lose, because all he is doing is essentially acting as a payor for expected expenses, rather than an actual insurer of unexpected future costs.  So how does the health insurance provider make money?  And more importantly, why do people even bother to purchase health insurance to pay for things like routine check-ups? The answer of course lies in the relationship between healthcare providers and insurers.  Healthcare insurers do cover unexpected health costs like normal insurers, however they also cover routine costs for which there is seemingly no way to possibly profit.  As such one would expect this to really have no profitability, but yet health insurance is a gigantic and profitable industry.  This occurs because healthcare providers and insurers make deals regarding policy coverage, and in these deals they do a variety of things including agreeing on the costs for certain procedures. So for any given procedure such as a colonoscopy, the insurer and provider agree on a fixed cost which the provider will charge for each person that they give a colonoscopy to who is covered by that policy.  These agreements cover a wide range of procedure and thus create an example of endogenous price fixing within a free market, with all of the problems which price fixing can bring.  The rates agreed upon are usually favorable to the insurer, so that he pays lower costs, and to make up for this below market clearing price put in place, the health care providers charge higher rates for the non-insured.  Thus, the uninsured routinely pay higher prices for healthcare and effectively subsidize the insured.  And because of this price disparity, the incentive to purchase insurance is incredibly high for the consumer, because otherwise they are needlessly paying a higher price.

The insurer then, by cutting down on routine sunken costs via pricing agreements is able to profit from the normal insurance “bet with destiny” paradigm.  A large percentage of the price the purchaser pays for health insurance is simply going towards the discount for routine healthcare, while the rest of the policy price goes towards the normal insurance paradigm of pooling money with the anticipation that only a few of the policy  holders will incur major costs and thus give a profit to the insurer.  But wait, there’s more.  Because pricing agreements with healthcare providers can be tedious and a lot of work, insurers and providers tend to develop reciprocity agreements whereby the provider agrees not to accept any other kind of insurance, and the insurer agrees not to enter into agreements with hospitals run by other health care provider corporations.  This in effect keeps insurance local in its scope, and makes it so that in a city which could have 100 hospitals and clinics, only a portion of them are able to accept the average policy holder’s insurance, thus limiting the place where they can obtain care.  This process localizes healthcare to a very fine degree, those people who called for lifting laws which ban interstate healthcare providers are perhaps ignorant of the amount of good this could bring. Because even within a state, one can find that the healthcare providers and insurers on one side of a state, are completely different than one on the other side of the state.  And even if one could have interstate run companies, the chances of it increasing the options for a patient or decreasing the costs do not seem likely.

 So the result? Treating healthcare like a widget does not seem to reduce costs.  Because healthcare is so expensive due to its virtually inelastic demand, most citizens need to purchase health insurance to be able to afford medical care, and they often do so through their employers who purchase complete packages of coverage.  And because so many citizens have health insurance, the healthcare providers will need to accept insurance in order to be able to actually get paid.  However, due to unique nature of health insurance which sets it apart from other forms of insurance, insurers only agree to pay for healthcare costs if they can get the provider to agree to a set of conditions, which include pricing agreements and restrictions on accepting other brands of insurance.  This price fixing lowers the profitability of healthcare, which not only creates the economic calculation problems of price fixing, but also forces them to raise rates for the uninsured, thereby forcing more consumers to purchase insurance and making providers even more dependent on the restrictive agreements of insurers.  Thus, consumers are left with chronically high prices, which only seem to go higher yet no increase in supply as the costs of entry and pricing agreements impede this market mechanism for working as neoclassical economics tells us it should.  The free market and the widget laws of economics do not create better quality of care or cheaper prices as we are told. 

This creates a very real argument for things like single payer insurance, or schemes seen in foreign jurisdictions whereby the public directly subsidizes providers by paying for things like medical equipment and drugs, which reduces the sunk costs for providers and allows for cheaper costs to consumers.  In many of these countries, procedures can be cheapened to a degree where many individuals do not need to purchase insurance to avoid insolvency, major procedures and unexpected costs from accidents may only amount to a few thousand dollars, as opposed to tens of thousands of dollars like what we see in America on a regular basis.  Now, a smart-alec might say that these are simply tax payer funded schemes, and that I am just trying to sell you a free lunch.  But that smart alec might need to contend with the fact, that even when public spending is taken into account, the US still spends far more per capita on healthcare than those countries with those schemes, and US citizens are not receiving any higher quality of care or better health out of such a disparity.  It could seem to reason that the cause of this may be that simply leaving healthcare up to a free market, due to its unique pressures, causes higher prices because of the inelastic demand, lower doctor to patient ratios, and reciprocal agreements between insurers and providers. 

One could also take a deeper view at all of this and say that the public control of healthcare around the world could actually be a form of rationing.  Rationing usually occurs when there is significant scarcity of a vital good, to the degree that simply leaving it up to supply and demand would alienate many parts of the population, which of course degrades social cohesion and risks the costs of disruption from things like inequity aversion bubbling up.  If that is the case, then clearly we are suffering a chronic underproduction of healthcare providers, underproduction which free markets seem to be unable to cure due to the unique dynamics.  But why is there chronic underproduction?  Why aren’t we seeing the free market produce the amount of doctors needed to bring prices back down?  That may actually have something to do with the nature of education, another industry which widget economists seem to completely misunderstand.

                Education

Education is another area which is steeped in public control, and one where widget economists often claim that simple supply and demand will make it better.  But once again, the widget economists are mistaken.  Education has long been a non-profit industry which has been funded and even run by public institutions for centuries.  While it was once a luxury only enjoyed by the rich, in recent decades it has become greatly more accessible to the public.  However, this has come with the added cost of higher tuition rates.  Widget economists complain that public subsidies are to blame, and that if we simply left it up to the free market tuition rates would drop, and we would get all the benefits widget economics promises, including perhaps a greater number of medical school graduates to alleviate the doctor to patient ratio which plagues healthcare.

But these claims are a misunderstanding of what actually motivates educational institutions.  It would be laughably false to say that institutions like Harvard, Cambridge or Stanford are motivated purely on profitability.  The truth is that one of the reasons for education’s unique traits lies in this dynamic.  It is true that all education institutions need to have monetary inputs which at the very least cover the costs of outlays if they wish to survive.  However to do this they must be able to attract students, and of course they don’t just want to have students who pay their tuition, they would prefer to have remarkable students who will not only give money to the school in the future, but could serve as examples of outstanding alumni to attract to future students.  Indeed, institutions like Harvard Law School probably receive more benefits from simply saying that they boast graduates like Barack Obama and Mitt Romney (the two major candidates of the last US election) than they do from those alumni who modestly practice law and quietly give donations in the future.

Of course to attract such students they would want to have a good reputation.  And for most schools, that means having noted alumni and having noted faculty.  In order to attract noted faculty, a school like Harvard wants to get the best and brightest it can, respected scholars who are superstars in their field.  But to do that of course they must be able to give that person a good deal, because if Harvard can’t give someone the likes of Joseph Schumpeter or Francis Crick a good deal, then Yale, or University of Pennsylvania will certainly give them one.  And so, in this competitive bidding competition between educational institutions, the universities try to attract highly rated faculty by giving them good pay and benefits, and also giving them academic freedom and a position which allows them to continue their work which made them great in the first place.  And while there are no doubt, economists and biologists out there who are every bit as capable of teaching students as people like Schumpeter and Crick, the fact is that these individuals simply aren’t as famous, and by attracting famous faculty these schools are paying an extra price simply because their celebrity attracts higher demand among employers.  This of course raises the costs of the university, which then either come from increased tuition or getting donations and grants.

Of course, raising the rates of tuition poses a problem for the college, as if the prices become too high, they may make it impossible for individuals who are of true genius, yet come from families of limited means to be able to attend.  Many individuals like Bill Clinton grew up in poverty, yet listing Bill Clinton as an alumni, and the donations and exposure he brings has certainly been a worthy investment for Clinton’s alma maters of Georgetown University and Yale Law School.  So, in order to bring about the best and brightest, schools seek to give scholarships to potential students, so that the truly remarkable people like Bill Clinton are able to afford attending that school, which in the long run brings more benefits to the school.  However, by giving scholarships, the schools are forced to raise tuition rates even higher, so that those students from wealthier families are effectively subsidizing those who come from limited means. 

And so, with the combination of obtaining highly rated faculty and bright, beneficial students, the university finds itself having to raise tuition in order to meet these effective sunk costs.  And as demand rises and more people apply, the schools are faced with the ever increasing task of choosing just who to let in, after all, an individual may come from money, but that doesn’t mean that he or she will be a truly remarkable alumni.  Powerhouse schools like Yale or Harvard of course are able to set the bar high, by imposing strict GPA and SAT requirements, which lower the glut of applicants.  But this leads to a trickle-down effect whereby  up and coming institution try to step in and offer deals to individuals who have good grades, yet have enough money that they would not be able to receive scholarships from higher rated schools.  And so, with time, the institution hopes to improve the caliber of its alumni, and by having distinguished alumni they will attract distinguished students, and distinguished faculty, which overall can raise costs.  And this tends to make it so that higher rated schools charge higher tuition, which makes them even more dependent on having to use scholarships to attract those diamonds in the rough.  Lower rated schools have a lower applicant pool, and therefore have lower tuition, as more applicants can afford the rates without needing a scholarship, and with their extra cash they can hope to attract highly rated faculty, and provide discounts to get distinguished alumni.  However, if they succeed in getting distinguished alumni and highly rated faculty, the trend is almost inevitable that they will have to charge increasing rates for tuition.

Now imagine for a second that Harvard instituted a new policy, whereby they would accept applicants with no regard to scholastic achievement, instead simply left it up to supply and demand and awarded spots to those who could bid the highest.  At the same time, Harvard announces that in choosing faculty, it is only going to hire those who are willing to work for lower wages, and that as long as they can teach, if they are willing to accept the salary offered, they will get the position over a comparatively more famous, yet higher in demand scholar.   Ok, now that you are done laughing, I think we can all agree that such a policy would greatly hurt the integrity, quality and esteemed position of Harvard if it were to seriously undertake such a policy. 

This shows that academia simply has non-profit quality incentives built in, which make the widget model virtually inapplicable to this.  And in fact, when one looks at those for profit schools in America, like Phoenix University, it is shown that not only do students pay vastly higher tuition, they also incur greater amounts of debt and get lower paying jobs than those who graduate from traditional non-profit universities.  Now some of this may be because of simple cultural bias towards traditional institutions, but then again, cultural bias does create real costs which must be considered when dealing with such things.

So because of this unique process, many universities are non-profit.  And being non-profit, they can actually be inhibited in opening things like medical schools, which as mentioned earlier have enormous upfront costs that make them prohibitive for smaller colleges.  This shortage of medical schools of course limits the number of medical school positions available in America, which not only raises costs via supply demand, thus further affecting opportunity costs for potential doctors, but also limits the number of med school graduates.  And this small number of med school graduates of course feeds the scarcity dilemma that worsens the absolute clusterfuck that is healthcare which I described earlier.

The solution?  Well for one, society has already found ways of ameliorating this, and that is to have public funding for many schools.  This can come in the form of direct grants and subsidies, opening up state run universities, and of course the taxation subsidy of allowing them to claim non-profit status, the mechanisms of which I described in a prior article regarding charities.  Though, there are individuals such as myself who question whether the current regime is enough.  Education is greatly important in our society, and I consider it to be a public good to have a higher number of educated persons in a society.  Furthermore, given the economic situation in the developed world, education is practically a must for most people, if they want to have any hope of obtaining job positions which give them a livable income and opportunity advancement.  This of course makes education like healthcare in that demand is quite inelastic, which lowers the chances of prices ever going down if the government were to truly “get out of education”.  If individuals under the current semi-subsidy situation are already willing to go into debt by as much as $300,000.00, I find it extremely hard to believe that they wouldn’t be willing to pay that amount or even more if education was left purely up to market forces with no public funding.  In other words, not only would education prices not go down, more people would be denied access to education and universities may have to sacrifice quality in order to meet the increase costs associated with lack of subsidies.  That to me, sounds like a rather stupid idea, which is why I oppose those who wish to get the government out of education.

In my opinion, our society would probably benefit from even more public input into education, so that we can increase access to education for people.  Also, when done in combination with social control measures for healthcare, funding medical schools and boosting the numbers of graduates can be a great way to alleviate the healthcare problem.

Of course, the widget economists, upon hearing such a proposal, will once again come out of the woodwork and tell me that in order to do these things I will need to get that from taxation, and since there is no such thing as a free lunch I’m just stealing capital from the private sector which hurts economic development.  Well for one, I could say that, what proof do we have that private individuals are actually going to put that money for better use?  Surely some may, but there are also many idiots out there who are going to waste their money on things which bring society no benefit.  But that generalized criticism of the concept of opportunity cost is for another day.  The best response I would give would simply be that by doing things like boosting med school graduates and increasing the numbers of educated people, I am actually lowering costs for a variety of services including medical care since you are allowing more people to enter the field.  And at the same time, by lowering the costs of healthcare and education costs, you are really reducing sunk costs which are doing very little reinvestment in the first place, and by lowering sunk costs, you are in fact freeing up capital for individuals to invest in other, more productive places, which, if one believes in the Laffer Curve (as most widget economists do) would mean that we are in fact boosting wealth and growth to a degree which more than covers any increase in taxation. 

                Conclusion

I think it still is quite reasonable to suggest that from the reasons I laid out in this essay that one can make a very logical and sound argument that the near uniformity of social control and public funding for industries like healthcare and education are not mere flukes caused by the economic ignorance of lawmakers and voters.  But rather, this apparent phenomenon is because these actions do serve a functional purpose which benefits society and the markets.  Markets have a tendency to promote beneficial policies which are not confined to mere market mechanics, but can spill over into political entities as well.  After all, the voters who have supported these policies are the very same market participants who are driving the economy in the first place.  They are the market.  And unlike the pundits who sit in the Cato Institute and chastise the world for not “understanding” their economic theory, these people actually know what it is like to work in business, and they know that business is not something done on a chalkboard in a classroom, it is something done in the real world, and that means it comes with all the uniqueness, specificity, randomness and socio-cultural phenomena which can arise in the real world.   Economics would be better served if it could shed its skin, loosen up and join the real world.  Rather than being the stiff, rigid and overly academic field characterized in the scene from “Going Back to School”, it should be one which is entirely more attuned to the real world.  And that means being open ended, that is to say always willing to question ALL the assumptions imbedded in its models, and to not close itself in to unproven absolutes.  It should also join the rest of the sciences, and be more open to the concept that when confronted with a disparity between theory and real life practice which is outside the margin of error, our first presumption should be that the real world is right and the theory is wrong, rather than the other way around.

And at the center of all this is to destroy the problem of widget economics.  Now don’t get me wrong, I still think widgets are an invaluable tool for teaching students, and I don’t advocate getting rid of them.  However, I think that when teachers use widgets for conveying concepts to students, they should include an important caveat: widgets are not real, no two industries are the same, every industry has its own unique pressures which can change the dynamic of supply and demand, and there really are no goods which are going to function exactly like a widget.  Either that, or we should just do what my friend at Unlearning Economics thinks, and simply throw neoclassical economics out the window and start all over again from the basics.