Wednesday, July 15, 2009

Price Competition in Higher Education and Health Care

In a market of voluntary exchange, when sellers of goods and services compete, they compete in two primary ways: price and quality. For example, when I buy a computer, it matters to me firstly, the speed of the processor, the amount of Ram, the size of the hard drive, expandability, operating system, and so on (quality) and secondly, the price. And these both matter when I buy a pair of shoes, or a flight to Minneapolis, or a vacuum cleaner, or a 45-minute massage.

If both price and quality competition are strong, the products will generally both decline in price and increase in quality. But of course the relative importance of either price or quality can be be weaker, if consumers don't emphasize one or the other in their buying.

If quality is not very important, then prices will be driven down even more strongly. This is the type of trend seldom see, but sometimes it happens in some raw material.

Vice versa, price can be of weak importance. For example, with Veblen goods, that is, status goods: things like designer clothes, expensive cars, fine jewelry, huge vacation homes, and so on. Quality matters a lot, but price is less important, since the customers buying these products are much less price sensitive. Thus, relatively marginal improvements in quality count for huge increases in price. Thus, price increases are kept unusually high.

But even more relevant these days than Veblen goods are two other important areas or weak price competition, where price growth is strong. In particular, health care and higher education.

In both of these we observe strong price growth because of factors that weaken price competition. In health care, health costs are primarily paid by insurers, Medicare and Medicaid. Only a very small percentage of health care is paid out of pocket, and prices are not conspicuously advertised. And even then health insurance itself is insulated from price competition by being provided by employers. Paying health insurance out of pocket tends to reduce costs. Thus, in contrast to areas of health care where costs are usually paid out of pocket, such as cosmetic surgery and laser eye surgery, areas of non-elective care that are not paid out of pocket see strong long term price growth in excess of inflation.

Higher education similarly is being paid for by loans or by scholarships or by parents' college funds. Very little again is being paid directly out of pocket by students.

When a buyer is putting down someone else's money for a purchase, price sensitivity decreases, especially if it is someone impersonal, that we don't have any emotional attachment to ("Nobody spends somebody else's money as wisely as he spends his own"). Certainly, we clearly don't have any emotional attachment to our insurer, to the federal government or the a scholarship organization. We, quite frankly, don't really have a lot of emotional attachment to our future self (who we haven't met yet) who will be paying for the loans, as well.

In health care and higher education there is constant demand for ever better quality. This quality costs money, which drives up costs and without a check from consumer demand, this will increase rapidly. Now, we should recognize that there are many factors that may drive up prices in health care and education. In medical care, there is also dramatic growth in regulation (which grows ever more expensive). With higher education there is also the influence of college ratings and how they are calcuated, as well as that most colleges are not for profit (another short post on the same article). And in both cases there is the simple fact that we can afford to pay more because of greatest prosperity. These other factors are undoubtedly relevant. It's just that all industries have upward price pressure, bot in those cases price competition via consumer demand keeps prices in check and may even push prices downward despite all these factors. Weak price competition thus might be better described as permitting price growth by opening the spigot wide open to other factors.

Of the two, the rise in the cost of higher education is actual the more disturbing trend, since, whereas it is clear the health care has dramatically improved as costs have increased, it is not clear that education has gotten any better while costs have risen.

This is relevant for us now since policies are being pursued that will further weaken price competition. Much talk has been made of expanding higher education through increased lending. Considerations are also being considered of expanding health care by making the government an insurance provider (More health insurance not the answer). The idea behind the latter in particular is that government can control prices simply by fiat, namely through price controls. Of course, this will invite all the problems of shortage that price controls always entails.

Obviously, the way to control health care costs is to expand the amount of care covered out of pocket, with more individuals opting for high deductibles, that merely serves to cover emergencies and not basic health care, and to have more health insurance paid by the insuree, instead of their employer. And similarly, we should be contract student loans or increasing the amount that students have to pay out of pocket if we want to control costs.

The current policies unfortunately will have consequences completely in contradiction to the intentions of their advocates.

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