News flash: Basic Economics Surprises Reporters

Another former student asks:

Am I missing something here? What’s so remarkable about realizing that quantity demanded rises with a decrease in price? Are they just that dumb?

Well, no you’re not missing anything here, but obviously the reporters and possibly the Subway managements missed something in their Principles of Economics classes.  Actually they missed three things.

First, you’re right.  Lower the Price and people buy a larger quantity.  Umm, that’s basic demand.

Second, apparently the Subway sandwich folks were also surprised that when they lowered the price it resulted in more total revenue!  Well, as we teach in principles, if demand is price elastic, then a lower price results in more total revenue.  We also teach that products with good substitutes are price elastic.  When incomes decline, everything becomes more price elastic.  News flash, folks, we’re in  a recession and shoppers are price sensitive.  That’s called elastic price elasticity of demand in techno-talk!

Finally, they seem surprised that overall profit margins didn’t decline.  Well, they apparently don’t have a real good grip on their fixed vs variable costs.  Selling more sandwiches doesn’t add to the rent or to the utility bill.  Labor didn’t go up much since a 12 inch can be made in just about the same time as a 6 incher.  Each one gets the same bag.

Yeah, reporters and a lot of managers don’t remember their principles of econ.


Does insurance raise prices?

A former student asks:

I have a quick question for you. I would like your take on how insurance affects price in a particular market. My understanding is insurance would increase the number of people of are ABLE and willing to use a good/service. Where I am going with this is… Do you think eliminating insurance in a market that depends on it as the major source of funding would reduce price. For instance if you eliminated health insurance would the price of medical services decrease.

Well, let’s think about this.   First off, in theory, “insurance” wouldn’t or shouldn’t have any effect on either prices or quantity of the underlying goods/services.  This would be because of two reasons. First, “insurance” should provide coverage for events or needs that people don’t want to have happen such as being in an auto accident or having cancer.  The probability of these events happening (which would result in a claims situation) should be independent of whether or not people have insurance.  So the quantity purchased wouldn’t change, and hence neither would price. Or at least in theory they wouldn’t. The second reason in theory is because the presence of insurance you should be just spreading the cost of what will be purchased across a large group of people but not actually changing the total amount available to spend.  But again, this is the theory of insurance.

In practice, we have an additional problem:  moral hazard.  Moral hazard arises to some degree whenever insurance is offered.  One aspect of moral hazard is that the insured person’s behavior changes  because they are insured.  An example is where drivers (documented in some studies) drive more dangerously and take more risks because they are insured.  This changes the probability of a claim.  When this happens it does increase the quantity of the insured products/services that will be purchased.  In healthcare we don’t see this in terms of people choosing to get cancer or some other awful disease because they’re insured,  but we do see people engaging in more risky and less-healthy lifestyles.  So, yes, because of moral hazard there is some tendency for the presence of insurance to increase the demand for the underlying goods/services.

There is another way, though, that is unique to healthcare that serves to increase demand for healthcare services.  When healthcare services are paid for by insurance, we have a third-party paying the bill.  The buyer and reciever of services (the insured patient) not only isn’t paying directly, they usually don’t even know the price of the services they are getting.  Further, the seller (the doctor or hospital) knows the decision-maker (the patient) isn’t paying, someone else is.  So there’s a tendency to order/use more services than would happen if the patient knew the price. This happens when a family takes a child to the doc for sniffles or a cold.  If the were paying or knew the full price of the doc visit they might not go.  Or when a doctor decides to order another test or cat scan just to reassure the patient that everything is being looked at.  I do  believe this effect has definitely increased the usage of healthcare services and thus has increased demand.  It has also removed a check on price increases.

So overall, you are correct. I do think that the presence of insurance in healthcare has resulted in higher consumption and higher prices than would likely happen in the complete absence of insurance.  Of course we need to keep in mind that a complete absence of healthcare insurance is not really feasible or socially desirable since it would mean that anyone unlucky enough to get seriously ill would soon be  bankrupt and probably unable to buy what they need, ultimately increasing death rates.  The key is to get whoever the insurer is ( private firms or government) focused on price and cost control and monitoring of what really works (eliminate the excess consumption of services).   Right now, in the system we have, insurers really try to make money not by controlling costs or usage but by selecting only healthy people to insure and cutting off people who get sick.