The Market System’s Inherent Inability To Accurately Price Mandatory Products & Services
The Market’s Cost/Demand Pricing Mechanism Is Unable To Factor Future Costs & Benefits To 3rd Parties Into Its Pricing Equation
By David Grace (www.DavidGraceAuthor.com)
The purpose of this article is to explore the economic principles of the Market System with regard to how that system deals with pricing vital goods and services such as medical care.
Let’s get something straight right now. I’m not a liberal. I don’t believe in Social Justice. I would never argue that social programs should be enacted simply to be nice to people or to fulfill some humanitarian purpose.
If you’re expecting a defense of liberalism or socialism you’re going to be disappointed.
What Is Economics? What Is An Economic System?
It’s been said that Economics is the study of how people manage the conflict between humanity’s unlimited desire for goods and services versus the limited quantity of goods and services available to fill those wants.
If you think of money as merely a medium of exchange, you can think of an Economic System as the collection of rules and practices that govern the allocation of resources with regard to the creation of and distribution of products and services.
The Market System Allocates Resources By Balancing Costs Against Demand
The economic system we’re most familiar with is the Market System.
In its purest sense, the Market System creates products/services and allocates products/services to potential consumers based on the balance between
- the cost of delivering a product or service, including some level of profit (the price), and
- the number of people who are both willing and able to pay that price
Under the Market System you don’t have stores filled with products people don’t want at prices they aren’t willing and able to pay. In that sense, the Market System’s price/demand balancing tool is self-executing and, in many ways, efficient.
The Effect Of Artificially Increasing Or Decreasing Prices In A Market System
Because price is the crucial factor that the Market System uses to allocate resources, if you short-circuit the price/demand mechanism by tinkering with a discretionary product’s price you risk misallocating resources by over or under producing that product to meet artificially high or low demand.
For example, there is a certain demand for chocolate-covered cherries. They cost a certain amount to produce and sell at a price that some number of people are willing to pay for a certain total quantity of them.
If you artificially lower the price by subsidizing the manufacturers with tax breaks or with subsidy payments or if the government gives an $X/box rebate coupon to people in the military or people on food stamps or whatever then people who weren’t crazy about chocolate-covered cherries might start buying them (or buying more of them) instead of other, now relatively higher-priced candies.
The chocolate-covered cherry factories would increase production to meet the increased demand and the Market would allocate more chocolate, more cherries, more labor, more electricity, etc. to this product.
On the other hand, if a special tax was placed on chocolate-covered cherries, thus making them more expensive, the reverse would happen and fewer resources would be allocated to their production.
Why should we care if the market allocates more or less resources to any specific product?
Because nothing exists in a vacuum. If more cherries are used to make chocolate-covered cherries that might increase the demand for and thus the cost of cherries thus raising the price of frozen cherries, canned cherries and cherry pies which would in turn affect the demand for those other products.
When you tinker with the pricing of discretionary products you may cause secondary and even tertiary effects, and then you have to start worrying about the Law of Unintended Consequences. Do that with enough critical products and you can screw up an economy.
All of this is pretty basic Market System theory.
But resource allocation based purely on price doesn’t necessarily yield good results for all products and services because there are fundamentally different classes of products and services — discretionary products/services and mandatory products/services.
Discretionary Products/Services
Chocolate-covered cherries are a purely discretionary product. Not everyone likes them and for the people who do there are substitute products — chocolate-covered almonds, Cadbury cream eggs, etc.
For that reason, nobody worries too much if an outbreak of leaf-curl attacks the cherry trees drastically reducing the harvest thus increasing the cost of cherries and ending up doubling the cost of chocolate-covered cherries.
For non-luxury items, as a general rule the more discretionary a product is, the more sensitive it’s sales volume is to increases and decreases in price.
But what if the product is not discretionary at all?
How Do We Identify Mandatory Products/Services?
Mandatory products/services are generally those the individual requires in order to either live or to work.
Mandatory products/services that we need in order to live are usually things whose absence we can insure against — treatments for life threatening diseases, end-of-life care, etc.
Mandatory products/services that we need in order to earn a living are products/services that are vital to the individual’s ability to earn money — day care, job training, etc.
We can usually purchase insurance that will pay for a product/service necessary to keep us alive. We can generally borrow money to purchase a product/service necessary for us to be able to work.
The problem arises when the cost of the insurance is more than many people who need the product can afford to pay or the loan payments for, or the direct cost of, the work-related product/service exceeds a reasonable portion of the income that the job in question will generate, i.e. the cost of day care equals 50% of the take-home pay that the parent would earn from that job.
Mandatory Products Are Fundamentally Different
A deficiency of the Market System is that the price/demand mechanism that self-regulates the allocation of resources between different products and services doesn’t differentiate between products that fall at different places on the continuum between purely discretionary products/services (Tiffany paperweights) and purely mandatory products/services (kidney dialysis treatments).
For reasons that will be discussed in this column, the price/demand allocation mechanism that works so well in allocating resources between discretionary products such as chocolate-covered cherries, chocolate bars, ice cream, carrots and broccoli functions poorly when it’s relied on to handle the allocation of resources for mandatory products like insulin, dialysis treatments, and clean water.
If you made a discretionary product such as chocolate-covered cherries essentially free the demand would go through the roof and people would find many more uses for them. Teen-aged boys might start loading slingshots with them.
Unlike purely discretionary items, the demand curve for mandatory products/services does not materially increase as the price approaches zero. Only people who really need dialysis treatments ever purchase them and they only need and only buy a certain number of them no matter how cheap they are.
Diabetics don’t guzzle more insulin if you cut the price in half.
If we make a graph with price increasing on the vertical axis and the quantity sold increasing on the horizontal axis, the demand line for a discretionary product will show low sales at a high price and then sales volume will increase as the price declines until it eventually craters as the price approaches zero.
The demand line for a mandatory product/service such as dialysis treatments is materially different.
Because the consumer knows that he will die without the mandatory product/service, sales volume will be relatively high even at a high price. Sales will slowly increase as the price declines until the price reaches the point where almost all of the people who need the mandatory product can afford to purchase as much of it as they need.
At that point the demand line for a mandatory product will essentially become a vertical line meaning that no matter how much farther the price drops the quantity consumed will not change because no matter how low the price goes all people with kidney failure will be getting all the treatments they need and the lower price won’t stimulate any additional demand.
Even though the demand curve for a mandatory product looks vastly different from the demand curve for a discretionary product, the Market System uses the same price/demand tool to allocate resources for both very different types of products.
The Market System has no tools that allow it to monetize or even calculate the worth of products/services that may be valuable, useful or essential but whose price does not take into account the direct and indirect financial benefits to third parties from providing that mandatory product/service nor is it able to factor in the direct and indirect costs to third parties from not providing that mandatory product/service.
The Missing Factors In The Market System’s Pricing Of Mandatory Products/Services
Unknown Benefits & Costs To 3rd Parties
The Market System does a great job of using specific, identifiable monetary costs and direct revenues to allocate resources, but it has no way of monetizing the costs to third parties from not allocating resources to a mandatory product/service, nor is it able to monetize the benefits to third parties from allocating resources to a mandatory product/service.
Unknown Benefits & Costs Arising At A Later Time
The Market System is only able to say: I need this much money in hand today in order to deliver this much product/service to this person today.
The Market System has no tools that will tell it:
- If I deliver this product/service to this person today how much other money/benefits will flow to other players in the economy from other sources over the next year?
- If I don’t deliver this product/service today how much in other costs/detriments will be incurred by other participants in the economy over the next year?
It has no way to calculate the cost to the economy or the society from 50,000 diabetics NOT getting insulin.
It has no way to calculate the cost to the economy or the society from 50,000 kidney patients NOT getting dialysis.
It has no way to calculate the cost to the economy or to the society from 10,000 parents who would work if they could get day care NOT getting day care and thus not having jobs?
The Market System knows that the break-even cost of providing day care is $XX per day paid now. It knows that given her income a particular parent can only afford to pay 50% of that $XX dollar fee per day in cash now.
But that’s all it knows.
It doesn’t know that if she can’t get day care she will stay at home and live on food stamps and other government services that cost taxpayers money instead of her earning a living and paying taxes.
It cannot calculate or monetize the societal costs incurred when people don’t work such as:
- They lose the work ethic and they transition from middle-class values to lower-class values
- Their children grow up without a work ethic and adopt lower-class values
- They feel useless which can affect both their and their children’s mental health and use of drugs and alcohol
- Labor is lost to the economy
- The individual consumes taxes instead of paying taxes
Even if the Market System could calculate those third party costs and third party benefits it has no way to incorporate those future third party costs and benefits into its pricing model.
An Example To Make This More Understandable
Lets explore this pricing limitation using a fire-protection service example.
Suppose we had no municipal fire department. Instead, suppose every property owner in our city had to pay a subscription fee to a private fire department if they wanted fire protection. Suppose half the property owners paid that fee and half did not.
The Market System can calculate the cost per building to provide fire protection to that number of buildings. The Market System settles on a fire-protection services fee of $X/month/square foot based on the volume of customers, building types, building locations, etc.
What the Market System can’t calculate is the cost to the city of a fire that starts in an uninsured shack and isn’t extinguished, engulfs the entire block of largely uninsured shacks and is not extinguished, and in the summer heat and high winds, spreads halfway across the city.
A Provider Cannot Include In Revenue Today And Costs Today Any Benefits & Costs That Accrue To 3rd Parties A Year In The Future
The fire-protection company’s pricing today can’t take into account things like:
- the cost of city buildings that may be destroyed in a big fire;
- factories that may be destroyed leaving citizens unemployed and unable to pay their bills;
- the loss of taxes from the closed factories and unemployed workers;
- hospital and other medical costs to treat the injured citizens;
- insurance claims for insured structures that were destroyed;
- higher casualty insurance premiums charged in the future
Even if the Market System could calculate all these potential costs it still has no ability to factor any of them into the private fire-protection company’s subscription price because those costs are not costs to the fire-protection company.
They were costs to other people.
They were, in fact, costs to property owners, businesses, hospitals, individual citizens and to the city government.
Similarly, the Market System is unable to monetize the indirect benefits to third parties from having every structure in the city covered by a fire-protection service and thus avoiding a huge fire.
If a factory that signed up with the fire-protection company didn’t burn down because a philanthropist had paid the fire-protection subscription fees for every otherwise unsubscribed building in town, that additional coverage and the avoidance of the big fire would only save the fire-protection company a little money, certainly far less than it charged the philanthropist to provide fire protection services to all those shacks that otherwise would have burned.
In other words the financial benefit directly accruing to the fire-protection company from someone covering every building in town would be insufficient to materially reduce the company’s fees.
There is no way that the fire-protection company can take these future third-party costs into account in calculating the subscription cost it has to charge for its fire protection service today nor does it have any way to take these future third-party benefits into account to materially lower the price of its service today.
That doesn’t mean that these third party benefits and costs aren’t real.
These risks and these benefits have to be calculated and paid by the third parties who benefit from every property owner having fire-protection, namely, the citizens of the city as a whole, the businesses in the city as a whole, the hospitals in the city as a whole, the property owners of the city as a whole and the city itself.
The only way that present and future benefits and costs to third parties can be factored into the Market System’s Price/Demand resource-allocation model is if the third parties themselves pay part of the cost for the fire protection service.
For example, the city could subsidize part or all of the cost of all property owners’ fire-protection subscription fees or the city could directly provide fire protection services and levy its own fees by way of a general tax or a real-property tax called a “fire protection” fee.
In short, once it’s determined that providing a mandatory product/service saves more money than it costs, the people who benefit from everyone having access to that mandatory service, generally the citizens, need to participate in paying that cost as a tax.
There are all kinds of costs and all kinds of benefits that cannot be monetized by a mandatory product’s seller but which are nevertheless real costs and real benefits to real people and real businesses from making that mandatory product available to all consumers who need it.
To the extent that the Market System is unable to calculate or take those other costs and benefits into account when allocating resources then, in that regard, it’s an inefficient or at least an incomplete system.
Those third parties, through the medium of government, have to make the best decisions they can as to whether or not a mandatory product or service has sufficient indirect benefits and avoids sufficient indirect costs that the economy, the country, its people and its businesses are richer when those mandatory products/services are made available and poorer when they are not made available to those who need them.
Our country has already made that decision with regard to fire departments, free immunizations against communicable diseases, public schools, clean water, clean air, and some other products and services.
I would argue that the economic value (lower crime, higher standard of living, less disease, more tax revenue, etc.) flowing from increasing the supply of many mandatory products is greater than the cost of increasing the supply of those mandatory products.
I don’t say this on any moral or philanthropic grounds. I say it because as effective as the Market System is, it lacks the ability to calculate or monetize the indirect third-party benefits of providing these mandatory products and it lacks the ability to calculate or monetize the indirect third-party costs from not providing them.
The Alternate Attempt To Supply Mandatory Products & Services Through A Central Planning System
The inability of the Market System to monetize the value and the costs of mandatory products/services to consumers who were willing but unable to pay market costs for them was one of the factors that spurred the creation of the ill-fated Central Planning System.
In a Central Planning System the government looks at the country as a whole and tries to calculate what quantity of which products and services will be needed when demand is calculated based on supposed need without regard to the costs of production.
For example, under a Central Planning System the government might calculate the number of acres of arable land and from that figure determine how many tractors would be needed to farm it.
The government would then build factory capacity sufficient to manufacture that number of tractors. The cost of producing all these tractors would, at most, only be balanced against the perceived country-wide need for them versus the calculated country-wide need for other manufactured items — fire engines, diesel trucks, locomotives, automobiles, etc..
In contrast, in a Market System the cost of each tractor would be balanced against the amount of money each individual farmer would be willing and able to pay and investors would fund the construction of the factory capacity needed to supply that volume of machines because the investors would have calculated that there are enough willing and able buyers to allow the factory to sell tractors at a profit.
In a Central Planning System the government treats the entire county like one single, vertically-integrated business with everything being consumed in-house.
The number of ways a Central Planning System can and does go wrong is substantial and the communist experiments have revealed most if not all of them.
The Market & Central-Planning Systems’ Differing Strategies For Dealing With Discretionary & Mandatory Products
While the Market System treats all products/services as if they were discretionary, a Central Planning System treats all products/services as if they were mandatory.
Where the Market System uses price/demand as the sole mechanism to allocate resources for both discretionary and mandatory products, the Central Planning System goes exactly in the opposite direction and uses human planning as the sole mechanism to allocate resources for both discretionary and mandatory products.
The basic issue that spawned much of the interest in a Central Planning System still exists, namely, what tools does a country’s economic system have to allocate resources between products that fall in vastly different locations on the discretionary product/services — mandatory product/services continuum?
We know that the Market’s price/demand system works well for products on the discretionary end of the spectrum. How can the Market System work well to make available products/services on the mandatory end of the spectrum?
How Do People Get Products/Services?
At the most basic level people get products and services in only three ways:
- They purchase them with their own money, already earned or borrowed
- They purchase them with money given to them by either (1) the government, or (2) insurance
- They are given to them directly by the producer
The Central Planning System is how medical care is handled in the United Kingdom and Canada and it often results in chronic under-allocation of resources. A recent study found that the average wait time for surgery in Canada was five months with a neurosurgery wait time of over 11 months.
Let’s skip the Central Planning System approach as the preferred solution to the question of how to allocate resources for mandatory products in a sufficient quantity to satisfy all the consumers who need them.
That leaves us with either the government subsidizing the individual’s purchase of mandatory products/services or insurance companies funding the purchase of mandatory products/services.
Different Strategies Have Been Used To Allocate Resources For Mandatory Products
The government acts like an insurance company and directly pays the providers a portion of a scheduled price to furnish the mandatory product to a qualifying individual.
This is how Medicare works.
The advantages of this model are
- The profit motive encourages the establishment of a wide range of providers and encourages those providers to streamline operations and invest in new technology.
- The resources needed to provide the services are allocated by the market instead of a government budgeting process
The government pays part or all of the cost of commercial insurance which insurance pays part or all of the cost for the mandatory product/service.
This is one of the principles behind the Affordable Care Act.
The provider of the mandatory product/service charges its customers a price calculated on a sliding scale with the government reimbursing the provider for any revenue shortfall.
Under this model a nonprofit-corporation provider would determine the full cost of the product/service on a “break even” basis. Based on that price the family income of those who could afford to pay that full cost would be calculated.
Thereafter the family income of each applicant would be compared to the full-price family’s income and a proportionately lower price would be set for each applicant.
As a practical matter, the provider could not charge any consumer more than the break-even price no matter how wealthy they were because if it did those richer consumers would just patronize another provider that did not use the sliding-scale model.
Problems In Determining The Reimbursement Payment
Under this model the provider would sign a contact with the government agreeing that it would provide the mandatory product/service to all consumers regardless of income with charges to be assessed on a sliding scale.
In return the government would agree to reimburse the provider’s losses stemming from providing services to some consumers at prices below the break-even cost.
The reimbursement agreement would need to define what would be recognized as legitimate costs and would have to include caps on salaries and bonuses.
Conclusion — The Market System’s Cost/Demand Price Does Not Necessarily Reflect The Real Value Of A Product Or Service
The market price charged by a provider to administer a treatment for cholera in a country that is subject to cholera epidemics might be $200 but immunizing all at-risk citizens and thus avoiding an epidemic could easily be worth $150 each to that country’s economy.
In that case the provider gets it’s cost/demand price of $200 but that price will actually be paid by the two parties who both benefit from that product: $50 from the individual who doesn’t get sick and $150 from the government that is spared the expense of medical care, quarantine, lost employment, embargoed exports, and lots of other real costs to that country’s economy and infrastructure.
The people who complain that the government shouldn’t be paying part of the cost for medical care, day care, education, job training, etc. because it’s giving money away to people who didn’t earn it are completely ignoring the real economic benefit to the economy and to the country from people receiving those mandatory services and the real economic costs to the country from them not receiving them.
It costs you money to change your oil but you spend that money because on balance it’s cheaper to change the oil than to have to replace your engine a year from now.
On balance a city is richer with a municipal fire department than without one, with free disease immunizations than without them, with subsidized sliding-scale day care than without it, with subsidized sliding-scale medical insurance than without it.
Like changing your oil, over time, the costs of doing those things are less than the costs of not doing them.
It’s not about giving people things they didn’t work for.
It’s about spending some money now to avoid spending a lot more money later.
That’s what smart people do.
– David Grace (www.DavidGraceAuthor.com)
