Possible Insight

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Thoughts on the Theory of the Firm

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One of the interesting questions in economics is why markets coordinate some forms of production but firms coordinate others.  Or to put it more sharply, if centralized economic planning doesn’t work for countries, why does it work for firms?

In principle, it should be possible to coordinate production solely through market transactions among individuals.  Everyone would be some combination of an independent contractor and a capital owner.  The challenge of course would be establishing the necessarily fluid markets, not to mention all the time everyone would have to spend negotiating contracts for their labor and capital.

Thus the standard approach to explaining firms starts with the Transaction Cost theory (typically attributed to Coase).  Whenever the cost of a market-based mechanism is higher than a firm-based mechanism, a firm will end up coordinating production.  Of course, to anyone who has ever started a new firm or worked any length of time at a large one, this explanation is not terribly satisfying.  How do you know the relative costs in the first place and then explain the apparently wasted resources at large companies?  Newer theories have tried to do better, but none seem to tell the whole story.  See here for an overview of the literature.

Another unsatisfying aspect of mainstream Theories of the Firm is that they don’t explain the observed interactions of firms with the macroeconomy very well.  For example, firms don’t responsively lower existing salaries when the demand for labor goes down or the supply goes up.  Firms also seem to forego internal price-based mechanisms that would allow them to respond more flexibly to macro shifts in cost and demand.  Even more puzzling, there’s no good explanation of why and when some large firms grow dramatically while others die off. I’ve seen some attempts to address particular questions, but they seem like a patchwork rather than a coherent framework.

The always insightful Arnold Kling refers to a tweet from fellow GMU economist Garett Jones as one possible explanation: “Workers mostly build organizational capital, not final output”.  Unfortunately, this is a tweet, not a theory.  I was sort of playing around with the idea to see if I could get a decent theory out of it and I think I may have something.  It ties together microeconomics, entrepreneurship, search theory, options theory, principal-agent theory, and group dynamics.

The basic idea is: firms don’t produce products; firms produce production functions.  It seems obvious in retrospect, but a cursory search of the literature didn’t turn up anything similar.  Someone has probably thought of this before.  But perhaps I got lucky.  So I’ll run with the ball for now.

What Is a Production Function?

In economics, a production function is an abstract model of how an economic actor turns inputs into outputs.  Basically, it represents the formula or a recipe for a product.  Typically, we write Q=f(X), where Q is a vector of output quantities, f is the production function, and X is a vector of input quantities.  While “real” production functions have very specific outputs and inputs, economists often simplify the world by assuming each actor only produces one output, Goods, and there are a standard set of general inputs such as Labor, Capital, and Land.  If we know the cost curves of Labor, Capital, and Land, we can calculate a cost curve for Goods and examine the tradeoffs and synergies among Labor, Capital, and Land.

Typically, economic theory defines a firm in terms of its production function. However, anyone who has ever founded a startup or worked in a large company should find this definition puzzling.  When I’ve started companies, I could not even clearly define what our inputs and outputs would be, let alone the formula for turning the former into the latter.  When I’ve interacted with big companies, I typically see a lot of people and groups who have nothing to do with turning inputs into outputs.  For example, CTO, CIO, CFO, Corporate Development, Business Development, Product Management, Brand Management, and Market Research. In fact, when I think about the technology industry, the fraction of people actually involved in transforming of inputs to outputs, even if you count the relevant management hierarchy, seems pretty small.

So what is it that entrepreneurs and most of the of the people at large companies are actually doing?  My hypothesis is that they are exploring alternative production functions: trying to figure out ways to improve existing businesses and explore opportunities for completely new businesses.  Intuitively, this seems reasonable given my experience, but I’d never thought of how to formalize the concept.

Now some production functions are conceptually “near” current ones in that they represent small refinements to the manufacturing process or modest enhancement to existing products.  Other production function are conceptually “far” from current ones in that they introduce radical new manufacturing technologies or generate revolutionary new products.  I bet if you think about the people you’ve worked with, most of them are involved in figuring out how to produce things or what things to produce, rather than actually producing things. So they are producing production functions.

Production Function Space

The cool way to approach this kind of search problem is to posit a high-dimension space of all the alternatives with a structure that allows us to define the concepts of “near” and “far”.  In this case we have production function space.

The challenge is that most points in this space are not economically viable.  Some of them define products that nobody wants (e.g., Apple Newtons).  Some of them define products that we can’t make at our current level of technology (e.g., flying cars).  Some of them define products that we could make but whose demand curve never intersects its cost curve (e.g., diamond coated toothpicks).

Moreover, there are a lot of dependencies among points in production function space.  So you can’t consider just one point in isolation; you have to consider configurations of points.  Some Goods in one production function are Capital in another production function (e.g., Intel processors).  In other cases, demand for some Goods exists only if there is also demand for other Goods (e.g., third party iPhone cases and Apple iPhones).

Most importantly, the goal is not just to find economically viable points.  The goal is to find points that generate a lot of profit.  Given that changes in technology and fashion cause these points to constantly shift relative to each other and the high dimensionality of the relationships among points, we have a rather complex optimization problem.  I think of it as the potfolio optimization problem from finance, combined with the n-body problem from physics, combined with the protein folding problem from biology.

Given this level of complexity, we would expect that search strategies almost always use heuristics and trial-and-error rather than purely analytic optimization.

The Implications

In subsequent posts, I plan to analyze this hypothesis from several different angles.  I also hope to come up with some predictions that someone could test.  But I thought it would be useful to throw out some gross speculation right now to show how this insight crystallized my thinking and pique your interest in exploring further:

– The value of a firm is the present value of the profit stream from actual current production functions plus the option value of potential future production functions.

– Large firms tend to explore neighborhoods of production function space relatively near the surfaces defined by their current products.

– Startups tend to explore neighborhoods of production function space relatively distant from the surfaces defined by everyone else’s current products.

– Firms that have released successful new products are more valuable because this success implies greater skill in searching production functions space.

– Firms that have released successful new products are also more valuable because they then have a larger beachhead from which to explore greater regions of production function space in the future.  Luck counts.

– Large firms acquire startups in part to increase their ability to search more distant regions of production function space.

– Due to network effects among colleagues and the uniqueness of each firm’s endowments, a given firm’s ability to search production function space is proportional to the number of employees it has and their length of service.

– It is harder to observe the true contribution of a particular employee to searching production function space than it is to observe the true contributions of an employee to a specific production function.  Therefore, the principal-agent problem is worse than we think.

– Because the ability to search production function space increases with the number of people involved, “empire building” is a rational strategy for an employee to increase both his apparent and his actual value to the firm.


Written by Kevin

January 9, 2011 at 1:34 pm

Posted in Economics

Explaining Money: Part III

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In Part I, we saw how Money is an emergent phenomenon.  In Part II, we analyzed how changes to the supply of  Money affect trade.  Now, we’re going to examine how expected changes to the supply of Money in the future affect trade today.

Earlier, we considered what would happen if Sally became ill and were unable to meet the ever-growing demand for new silver figurines created by population growth and innovation.  We concluded that families would increase their reserves of figurines and the frequency of trades would decrease.  A current event affected future activity.  Now consider whether a future event could affect current activity.

Suppose Sally announces that she will retire in one year.  Moreover, she declares that she has not seen any other metalsmith whose work matches her standards for beauty and quality (and most people trust Sally’s opinion).  She’ll continue to manufacture figurines for a year, so there’s no effect on the actual supply of Money today.  It will just stop growing a year from now.  But what do you think will happen?

If I lived in this country, my wife and I would put a plan into place to accumulate a greater reserve of figurines over the next year.  If there were a significant fraction of people like us, the frequency of trades would immediately begin decreasing , with the negative impact growing over time as those with less foresight began initiating reserve plans as well.  You can see the potential for a snowball effect here: a constricting supply of figurines in circulation due to accumulating household reserves causes everyone to update their plans and desire… even greater household reserves!

We should also expect a general price decrease.  Here’s why.  Bob and Brad would probably tell their wives, Sue and Sara, that they need to accumulate a larger reserve of figurines to ensure they’ll be able to trade for necessities in the future.  So Sue and Sara will thus want to increase their sales.  But when Bob goes to buy clothes from Sara, he’s going to be less willing to part with his figurines due to his accumulation plan.  How will Sara convince Bob to buy clothes so she can help Brad build their family’s reserves?  That’s right, by lowering prices.  Same for when Brad goes to buy milk and meat from Sue.  So as the frequency of trade decreases due to greater demand for reserves, prices would go down.

But the worst part would be the effect on innovation.  If I were an entrepreneur and I knew that the supply of Money would stop growing a year from now, how would I adjust my efforts at creating new products and services?  I would probably reduce them because any innovation might end up in no man’s land; people want it, but they need to use their Money for higher priority items.  Lower chance of a payoff means lower investment.  Heck, entrepreneurs with currently successful products might well stop making improvements or even stop maintaining their means of production due to the combination of an expected future decrease in demand and their own desires to accumulate reserves. Our country could actually go backwards technologically! Not surprising though if you think of Money itself as a technology. You’d expect a similar effect if metal or computers became relatively scarce.

Of course, the opposite sequence of events would occur if everyone expected a future increase in the supply of Money.  Suppose Sally announces that her daughter, Sunny, will finish her metalsmithing apprenticeship in a year and the capacity to product new silver figurines will increase (but not double, Sunny won’t be nearly as productive as Sally to start).  I would expect the frequency of trades, prices, and investments in innovation to all increase.

Now, if Sally had ten apprentices and everyone expected the rate of new figurines introduced into the economy to skyrocket, our little economy might have a problem with runaway inflation.  Similarly, if someone figured out a way to mass produce silver figurines equivalent in quality to Sally’s handcrafted ones, people’s trust in silver figurines as Money might erode.  So more is not always better.

What we really want is for Sally and Sunny to have a fairy godfather who tells them exactly how many figurines they should make to keep up with population growth, innovation, and any changes in demand for household reserves.  I like to think he’d be named Alan.  Everyone would love Alan.  Unfortunately, nobody lasts in the fairy godfather job forever. So people in our little country would eventually need to somehow harness their collective wisdom to determine how many figurines they need.

Written by Kevin

November 17, 2010 at 10:37 am

Explaining Money: Part II

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In our last episode, we examined how Money might emerge in a toy economy. The key turning point was when we achieved common knowledge that most people would accept miniature silver figurines in trade for most goods and services. In this episode, we’ll look at what happens when events occur that erode this foundation.Because Money fundamentally relies on people’s expectations, it seems only logical to focus on a seller’s and a buyer’s expectations at the moment of a monetary transaction. Obviously, there are the necessary conditions that the seller must be willing to provide the good or service and the buyer must want to acquire the good or service. But let’s look at the expectations about Money itself that the seller and buyer must hold for a transaction to occur:

(1) The seller must believe that, if she accepts the Money, her husband will be able to use it in future trades where he is the buyer. The extent to which she believes Money will be useful in future transactions affects the price at which she will be willing to sell.

(2) The buyer must believe that he will be able to acquire more Money from his wife’s selling activities to support future trades where he is the buyer. The extent to which he believes Money will be scarce affects the price at which he will be willing to buy.

Most people focus on expectation (1). They examine reasons why the seller might not like the buyer’s Money. Potential debasement (reducing the amount of a precious commodity represented by the Money) and inflation expectations are the chief worries.

But they forget all about expectation (2). Remember that Money enables transactions that would otherwise not be possible. If a buyer has only a limited amount of Money, he will make the most important of these trades first. When he runs out of Money, all the other potential trades will not happen. So if there isn’t enough Money in circulation, it will have a real effect on the economy.

Consider the following scenario, using the setup from the previous episode. Sally becomes so ill that she can’t produce figurines anymore. The economic success enabled by Money had caused a steady increase in demand for it. The geographic area where people use Money has grown, people have moved into the area to take advantage of the better life enabled by Money, and people are constantly discovering new products and services whose trade was profitable with Money. Now the Money supply can’t expand to meet this growing demand. What do you think will happen?

Obviously, there are a bunch of lower-value transactions that simply can’t occur because there isn’t enough Money in circulation to execute them once the higher-value transactions are completed. However, the situation is actually worse. Because people will feel uncertain about whether they will have enough Money to meet future critical and surprise needs, they won’t even spend all the Money they have! They’ll want a reserve. The worse the shortage, the higher the reserve they’ll want and the worse the decrease in Money-mediated transactions. It’s just common sense to increase your inventory when future resupply is uncertain. Whether it’s money or food.

Hopefully, you can now see the outlines of my argument for why commodity Money isn’t necessarily better than fiat Money. Sellers like commodity Money such as silver figurines because it has some intrinsic value: the value determined by its demand for use in products and services. If they accept silver figurines, at the very least their husbands will be able to use the silver as barter.

But when you take into account the buyer perspective, this intrinsic value is a double-edged sword.  Inherently, the demand for the commodity as Money will always compete with the demand for the commodity as a good. So in our toy economy, if someone discovers a new use for silver or a new use for Sally’s metalsmithing skills, the supply of Money will come under pressure and potentially cause a Money shortage like the one discussed above.

I tend to think that human ingenuity will always come up with more uses for things over the long term, so I believe commodity Money tends to directly harm buyers more than sellers. However, sellers can get hurt directly too. If someone figures out a really good substitute for the commodity as good, its intrinsic value can drop dramatically. Consider the invention of white gold as a substitute for silver or machine stamping as a substitute for Sally’s smithing. Because the commodity Money would be worth fundamentally less as barter, every seller that accepted it would take a hit. What you really want is Money that has the common knowledge properties of silver figurines but whose supply can be directly managed, without competition from direct use in goods and services. That’s what fiat money is.  Of course, someone has to properly manage the Money supply. But that’s a topic for Part III.

So in summary, shocks to the Money supply can affect real economic activity and commodity money is no panacea.

Written by Kevin

October 12, 2010 at 8:16 pm

Explaining Money: Part I

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I am undertaking a Quixotic quest.  I am going to try to explain Money.  I believe that hardly anyone (including me) fully understands Money.  Even economists.  A few appear to mostly understand it.  The vast majority, even some charged with running government monetary authorities, seem to get confused by Money some of the time.  Unfortunately, we are currently living during one of those times.  In my opinion, much of the sphincter tightening economic news we have been reading about is due to fundamental misconceptions about Money by the very people charged with supervising our economy.

It will take several posts for me to complete this tilt at the windmill.  But before I get started by laying out the overall plan, I would like to thank Scott Sumner.  First, his informative blog posts on monetary policy inspired me to undertake this venture.  Second, he graciously reviewed parts of my approach.  All mistakes (and there will some, I’m sure) remain my own.

Step 1 will explain how Money is an emergent phenomenon.  Step 2 will illustrate the concept of “monetary shocks”, culminating with dispelling the fallacy of commodity money’s superiority over fiat money.  Step 3 will extend this illustration to show how expectations about Money help steer the economy.  If I haven’t painted myself into a corner by then, I may try to push my luck even further.

So let’s tackle the concept of Money as an emergent phenomenon. I claim that Money will emerge out of a desire to trade.  As a didactic device, I propose analyzing an imaginary country.  All the adults are married, the women do all the selling, and the men do all the buying.  Conveniently, all the women’s names start with S and all the men’s names start with B.  The reason for this device to create an explicit need for households to coordinate production and consumption behaviors. So let’s start by examining this country back in a time before Money existed and barter was the only means of trade.

Sue is married to Bob and is shepherd.  Sara is married to Brad and is a seamstress.  Sally is married to Billy and is a metalsmith.  Now, suppose that Billy needs clothes for his children.  He must to go to Sara and trade metal objects made by his wife for those clothes.  Unfortunately, Billy can’t just go and trade with Sara.  Billy doesn’t have enough information about the relative production value of the various metal items his wife could make to trade.  Moreover, Sara doesn’t have enough information about the relative consumption value of those metal items because that’s Brad’s responsibility.  So Sally & Billy and Sara & Brad must all get together to arrange the trade.  In many cases, the expected value from the trade won’t be worth the hassle of getting them all together, so they won’t bother.

Now, let’s consider trades between the Sue-Bob and Sally-Billy households.  Sue always has a supply of wool and sometimes has a supply mutton.  Of course, wool is useless by itself to Billy.  So if Bob needs metal items from Sally and his wife hasn’t slaughtered any sheep lately, Bob has to first go to the Sara-Brad household.  As a seamstress, Sara can always use wool.  After he trades for clothes, he can go back to Sally-Billy who always have some demand for them.  Of course, he doesn’t have enough information about the Sally-Billy clothing preferences to tell Sara what he wants.  Moreover, we have the same household coordination problem as before.  So Sue & Bob, Sally & Billy, and Sara & Brad all have to get together to hash out a trade or one person has to go back and forth among the others until they converge on an acceptable series of trades.  This inter-household coordination cost is even higher than the intra-household coordination cost discussed above, so even fewer of these trades are worth the hassle.

Notice that a lot of potential trades won”t happen because the transaction costs are greater than the expected gains.  Then one day, something important happens.  Sally makes a little silver figurine for her and Billy’s daughter, Sunny.  Bob sees it one day when he’s over completing a trade and wants one for his son, Bert.  Pretty soon, all three families and everyone in their town is in the grip of a silver figurine collecting craze.  Almost everyone wants to trade for figurines.  Everyone knows almost everyone wants to trade for figurines.  So even those people who don’t care much for the figurines know they can easily trade them to people who do want them.

Billy finds he no longer needs to bring Sally along when he trades with Sara.  Sally can simply give him five figurines to trade for clothes because they know roughly how much clothing Sara will trade for figurines.  Things also get easier for Bob when he needs metal items from Sally.  He can just trade her some of his figurines for other metal items.  Even though she can make figurines herself, especially because she makes them herself, she realizes their value in terms of trades that Billy can make down the line.

So Money has emerged.  It didn’t have to be figurines.  It could have been turquoise, salt, or leather.  The key ingredients were that it was relatively portable and a group of people began expecting everyone in the group to accept it in trades.  Within the group, the item’s trading value became common knowledge (in the game theory sense of the term).  In this case, a collecting craze precipitated this mutual agreement.  In other cases, it could arise out of established tradition, explicit negotiation, or random discovery.

Notice that Money adds value.  It’s not merely an accounting fiction.  All sorts or trades that weren’t possible before become possible, creating new sources of value.  Moreover, a lot of trades that did occur previously now produce more value because they cost less to make.  So there’s a lot of “pull” for Money to emerge.  Once it happens, there’s an equilibrium that will tend to hold unless perturbed.

Moreover, once Money emerges, it’s like any other technological innovation such as electricity or steel.  It becomes embedded in the pattern of trade across the economy.  People will be out and about more often because there will be more trades to make.  Hey, that means more restaurants and hotels.  Smaller trades become possible.  Hey, that means whole new markets for accessories to larger items.  Trades across larger distances become practical.  Hey, that means more regional specialization of industries.  And so on.

But what happens to this network of effects if something undermines common knowledge foundation of Money?  We’ll explore the possibilities in the next post.

a small country where all the adults are
married, the women do all the selling, and the men do all buying.
Conveniently, all the women's names start with S and all the men's names
start with B.  The reason for assuming such a fantasy world is to create
an explicit need for coordinating production and consumption behaviors
in households.

Written by Kevin

September 10, 2010 at 1:09 pm

Yes, You Can Save the World with Startups

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Dave Lambert pointed me to this new Kauffman Foundation paper by Tim Kane about job creation in the US.  Then Will Ambrosini pointed to this Growthology post which reproduces the money diagram from page 5 :

Look carefully.  Then think about this statement about US job creation:

The only firms that create jobs on average are brand new ones.

So yes, you can save the world with startups.

Written by Kevin

July 9, 2010 at 1:27 pm

Saving the World with Startups

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On a recent business trip trying to drum up support for RSCM, someone asked Dave and me why such obviously talented guys were starting a fund instead of a company. I’ve been thinking about that question for the last week and have a much better answer than the one I gave.

I want to make the world a better place.  But it’s not clear precisely what interventions will lead to the best outcomes over the long term. I think I’m a really smart guy, but I’m quite sure I can’t evaluate all the potential interactions within a system as complex as the world society to figure out the optimal plan.

Luckily, I don’t have to be that smart. We just have to collectively be that smart. And economic markets are the best way I know to organize collective action. The more effectively we can all create value, the better off we’ll all be. Creating wealth won’t directly solve a lot of problems, but it enables the solution of an incredibly wide range of problems.

So here’s the math that leads to my conclusion that increasing the number of startups we can fund is the best thing I can do for the world. This study shows that a 5% improvement in startup creation leads to about a half a percentage point improvement in the economic growth rate. If we could increase the rate of startup creation by 10%, we could add a full percentage point to our economic growth rate.

From this dataset, I determined that the world GDP growth rate over the last 30 years has been about 4%.  So we could probably achieve a 5% growth rate by increasing startup formation by 10%.

This seemingly small shift has dramatic results over the long term. In 50 years, world GDP would be 60% (1.6x) greater.  In 100 years, GDP would be 160% (2.6x) greater.  I think a world in which everyone were 2.6x richer would be pretty sweet.  That’s a gift I want to give to my great-great grandchildren.

Seed-stage startups are the key because that’s where businesses are born. A larger pool of innovative seed stage companies will naturally attract a larger pool of investment in later stages.  About $10B every year goes to professional investments in seed-stage startups in the US. So if we can add $1B, that’s 10%.  Even better, if we develop a better process, this process can be copied all over the world.  If it’s a lot better, I bet we can do significantly exceed a 10% improvement.

That’s why I’m focusing my time on revolutionizing the process for funding seed-stage startups.

Written by Kevin

May 1, 2010 at 3:27 pm

Small Government: Lesser of Two Evils

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Like many libertarians, I feel that small government is an eminently practical rule of thumb proven by hundreds (if not thousands) of years of observation. So when Rafe recently posted in response to a presentation that David Cameron made at TED, it got my dander up. Calling the small government philosophy, “… ivory tower idealism,” felt like a blatant misrepresentation.  But then I wondered. Maybe Rafe had formed the honest (though mistaken) impression that small government advocates think that reducing government functions will lead to some sort of emergent order utopia?

I don’t know exactly what Cameron said because I can’t find a public video archive. This Guardian account indicates that he mostly hung platitudes on the scaffolding of giving people more choice and transparency.  Choice is a big part of small government, but I thought it would be worth outlining what I think is the non-politician’s version of the libertarian small government ideology. It’s far from ivory tower.  More like back alley.

It’s based on two observations: (1) local knowledge is important to good decision making and (2) concentration of power leads to abuses. I think few  students of  political history and organizational behavior would argue against these points, so I won’t detail them here.  However, if anyone honestly thinks they are in doubt, I’d be happy to cover them in a subsequent post.

So, any time society assigns a role to government, it incurs the costs of (1) and (2).  These costs tend to increase over time and as a situation departs from the ideal future path. So the expected net present value of these costs can be substantial. Libertarians therefore conclude that  the benefits that the government brings to a role should, as a general rule, be quite large before we even consider it as an option. Notice that this does not imply no government at all. Rather, it implies we should use government sparingly.

The repeated pattern observed by libertarians goes like this. A problem arises. Everyone (even libertarians) agree that it is problem. Progressives push through a government program to address it. Initially, the program somewhat ameliorates the problem. However, the problem turns out to be trickier than first believed, so the benefits are usually not as great as expected. Over time, the problem evolves and adapts, further eroding program benefits. The government program evolves and adapts too, but more to promulgate its own survival than address the problem.

So we are left with much lower benefits than forecast and significant unforeseen costs (in the form of an everliving, mostly useless program). Libertarians conclude that in many cases the “cure” is worse than the disease.  Not that it doesn’t suck having the disease. The irony of course is that the progressives then identify the results of an old government program as a new problem that requires… another government program (cough, cough, government intervention in financial markets, cough, cough).

Of course, some illnesses are actually bad enough that the (painful) cure is better than the disease.  In those cases, bring on the government program. But let’s be realistic about the long term benefits and costs.

Written by Kevin

February 15, 2010 at 9:19 pm

Robert Reich: Wrong About State/Local Bailout

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Rafe linked to this essay by Robert Reich.  I don’t have much of a problem with his first point backing Obama’s plan to offer a tax credit for hiring.  I think temporarily suspending the employer’s share of payroll tax is a better mechanism (as suggested by Bryan Caplan a year ago), but close enough.

However, I think he goes off the rails at the end where he suggests the federal government should prop up spending by state and local governments.  No.  They’re the problem, not the solution.  Fortuitously,m Bryan’s partner Arnold Kling referred just today to this Reason essay by Steven Greenhut revealing that the number of state and local workers per 100 citizens has grown from 2.3 to 6.5 since 1946.  Yes, that’s 180% growth in the fraction of people employed by state and local governments.

Recall my own analysis showing that real per capita state and local spending in California increased 38% in the last 10 years and that we would have no budget problem if we had kept real per capita spending at 1999 levels.

The problem is we have more bureaucrats riding on the backs of productive workers.  Economic innovation and growth comes from the private sector.  Much better to substitute every single dollar Reich wants to give to state and local governments for more tax breaks to private sector employers that hire people.

Written by Kevin

January 29, 2010 at 9:39 pm

Posted in Economics

Quest for Insurance Part II: The Coverage

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The trials chronicled in Part I have a happy ending.  I eventually obtained an excellent individual plan from Assurant Health. I followed my own advice and got a high deductible plan that covers no primary care. I thought it would be worth comparing to the traditional PPO coverage I had previously.

The table below shows the salient aspects of each plan.  To compare apples to apples, I had to estimate the 2010 premiums for the previous plan. I used a 9% increase over 2009, which is what a PricewaterhouseCoopers survey says will be the average for employer sponsored plans. Note that this is less than the 10.8% actual increase my company saw from 2008 to 2009 on this plan.

Insurer Aetna Assurant Health
Annual Premiums $17,593 $7,760
Deductible $2,000 $10,000
Co-Insurance 20% None
Out-of-Pocket Maximum $8,000 $10,000
Office Visits $35 $0, after meeting deductible
Generic Drugs $15 $0, after meeting deductible
Brand Name Drugs $35 $0, after meeting deductible
Lifetime Maximum $6M $15M

We see something very interesting here. The annual premium on the new plan is $9,833 less than the estimated annual premium on the old plan. Now, we all get checkups each year.  Also, my wife and son have monthly medications they take for allergies.  Adding in the copays for those yields extra $500 on the old plan, pushing us to $10,333 more guaranteed expenditures on the old plan than the new plan. Obviously, this excess is more than the new plan’s deductible.

So there’s no way I can loose on the new plan.  If we stay healthy, I get to pocket $10,333 minus the cost of routine visits and medications.  If something bad happens and someone has a major medical issue, I save at least $8,333 due to the deductible and coinsurance on the old plan. Probably much more due to co-pays for additional office visits and prescriptions, which are not limited by the out-of-pocket maximum.  I actually ran the scenarios and there’s no way I don’t save at least $5,000 per year.

Moreover, the new plan is much better at insuring against catastrophic loss.  The lifetime maximum is 2.5 times as high.  That’s a real selling point for me. I don’t want the plug pulled on my ventilator because my insurance ran out.

How can this be? Why do we even have PPO plans? You may think the tax deductibility of employer-paid premiums is the reason.  But this doesn’t explain why employees wouldn’t choose an employer-sponsored version of the high deductible plan. Those are paid with the same pre-tax dollars.  (It also doesn’t affect me because I’m technically self-employed and deduct my premiums anyway). It certainly explains why the CEO of Whole Foods is absolutely right to offer his employee’s a high deductible plus HSA plan.  It saves everyone money. The math speaks for itself.

The only explanation that makes sense is that people want to spend more on health care when it doesn’t come out of their own pockets. A combination of moral hazard and mental accounting. On the moral hazard front, they go to the doctor more often than they otherwise would because the marginal cost to them is so low. On the mental accounting front, the automatic monthly deduction from their pay is less painful than personally writing checks to pay doctors. But it’s irrational.

Perhaps some marketing wizards should figure out how to pitch high-deductible plus HSA plans in a way that the average person would find attractive.  How about an infomercial that promises to save you thousands of dollars every year with a proven system and throws in a set of handy dandy steak knives if you act now?

Written by Kevin

January 20, 2010 at 3:14 pm

Quest for Insurance Part I: The Search

with 5 comments

As you may recall, I previously posted about my recommendations for fixing health care (Part I, Part II, Part III). Recently, I had to navigate the current system and thought I’d share my experience in the context of those recommendations. You see, COBRA ran out on my health insurance from the last startup I founded and the new one hasn’t set up a company health plan yet. Thus I had the, um, “pleasure” of trying to obtain individual coverage.

I started by going to eHealthInsurance and hitting up the big three companies: Aetna, Anthem (BlueShield/BlueCross), and HealthNet. My first disappointment came when I discovered that there is no universal application. You have to type in roughly the same information in substantially different formats for each company. What value exactly is eHealthInsurance adding here?

My second disappointment came when they all rejected the applications for different reasons. There are four people in our family. One of them was rejected by two companies, two of them were rejected by one company, one of them was not rejected at all. The reasons were allergy shots, acne, possible acne, and being underweight. The first two are minor ongoing issues.  Considering we were applying for $10K deductible plans with no office visit or prescription coverage, it’s hard to see what the problem is. The second one was unconfirmed by the first doctor, totally minor, and subsequently excluded by a second doctor. The last one is the only one that should have been of any concerned and a check with that person’s doctor would have eliminated the concern.

My working hypothesis is that these companies don’t actually want to offer individual health coverage. For regulatory or political reasons, they have to appear to offer such coverage. But unless an individual is so low risk as to be obscenely profitable, why go to the effort? It’s so much easier to focus on selling group coverage to employers.  This is a side effect of the tax deductibility of premiums for most companies but not most individuals.

Luckily, there are niche providers that pursue opportunities that are not attractive to the largest players. One of them is Assurant Health. After filling out the online application at their Web site, I received a call from their underwriting department within two days. They wanted to review the medical records for the two family members receiving allergy shots to make sure these were not indicative of larger issues. No problem, we had signed a release and I had no objection to paying a premium based on actual risk.

Now, the story takes a funny turn. Apparently, HIPAA has made doctors so paranoid about penalties for breaching patient privacy, that they don’t want to give out your medical records to anyone. Despite the general release we signed, two medical clinics wanted us to sign special releases. It took a month to actually get these special releases so we could sign them. Even then, one of the clinics also required us to call them on the phone and give them verbal permission as well. Government intervention strikes again! If the government had clearly specified the mechanism for releasing medical records, there wouldn’t have been a problem. Even better, if the government hadn’t distorted the market for insurance toward employer-sponsored coverage, this transaction would be so routine that the free market would have solved the problem

The story has a happy ending.  In Part II, I will analyze the excellent coverage we got from Assurant in the context of my previous recommendations.

Written by Kevin

January 14, 2010 at 4:17 pm