Examining the distortions when market principles are applied in areas of no-choice.
By Desaraju Subrahmanyam.
See the post 'Business, Government and Services' for an introduction to the terms 'state', 'area of choice', 'area of no-choice'.
ABSTRACT
Approaching services in areas of no-choice in the same way as services in areas of choice distorts the service. The supply, or the price (or both) become distorted. We illustrate these distortions through the California power crisis of the early 2000s. We then discuss the distortions in healthcare services. We conclude with a discussion of areas that are seemingly areas of no-choice, food and general insurance, which are almost completely provided in society through markets, yet do not suffer from distortions.
WESTERN ENERGY CRISIS
In the mid-90's, California began changing its power sector by ushering in deregulation. The objective was to increase competition and bring down prices. New rules called for the Investor Owned Utilities, or IOUs, (primarily Pacific Gas and Electric, Southern California Edison, and San Diego Gas and Electric) to sell off a significant part of their electricity generation to wholly private, unregulated companies. The buyers of those power plants then became the wholesalers. The incumbent utilities were still responsible for electricity distribution. They were now required to buy the electricity that they used to own themselves, through a newly created day-ahead only market, the California Power Exchange (PX). A total of 40% of installed capacity was sold to what were called "independent power producers", which included Mirant, Reliant, Williams, Dynegy, and AES.
But deregulating the producers of energy did not lower the cost of energy. Deregulation did not encourage new producers to create more power and drive down prices. Instead, with increasing demand for electricity, the producers of energy charged more for electricity; they used moments of spike energy production to inflate the price of energy. Signs of trouble first cropped up in the spring of 2000 when electricity bills skyrocketed for customers in San Diego, the first area of the state to deregulate. Experts warned of an impending energy crisis. The trouble spread statewide that summer, and Governor Davis began asking the Federal regulator FERC to probe possible price manipulation by power suppliers. In January 2001, energy producers began shutting down plants to increase prices. When wholesale electricity prices hit new highs and the state began issuing rolling blackouts, Governor Davis issued a state of emergency on January 17, 2001. This officially came to be called the Western Energy Crisis.
At no point during the crisis was California's energy supply [the sum of in-state generating capacity and out-of-state imports] less than demand. But California's energy reserves were low enough that during peak hours the private industry, which owned the power-generating plants, could effectively hold the state hostage by shutting down their plants for "maintenance" in order to manipulate supply and demand. These critical shutdowns often occurred for no other reason than to force California's electricity grid managers into a position where they were forced to purchase electricity on the "spot market", where private generators could charge astronomical rates. Even though these rates were semi-regulated and tied to the price of natural gas, the companies (which included Enron and Reliant Energy) controlled the supply of natural gas as well. Manipulation by the industry of natural gas prices resulted in higher electricity rates.
AN EXPERT'S TESTIMONY
S. David Freeman was appointed Chair of the California Power Authority in the midst of the California crisis. He had 40 years of experience with the electric power industry as a regulator, an official in federal and state government, and as the manager of large public utilities. In testimony submitted before the Subcommittee on Consumer Affairs, Foreign Commerce and Tourism of the Senate Committee on Commerce, Science and Transportation on May 15, 2002, he made the following statements:
"There is one fundamental lesson we must learn from this experience: electricity is unlike anything else in our economy. It is truly the lifeblood. Ordinary consumers and businesses alike CANNOT DO WITHOUT IT for even an instant [emphasis added]. Reliable, smooth electricity at a reasonable, predictable price is an absolute necessity. [This] makes opportunities to take advantage of a deregulated market endless. If Murphy’s Law were written for a market approach to electricity, then the law would state 'any system that can be gamed, will be gamed, and at the worst possible time.' And a market approach for electricity is inherently gameable. Never again can we allow private interests to create artificial or even real shortages and to be in control.
"The words competition and deregulation are seductive. They sound great but the reality we found in California was quite different. A public utility industry whose books are open to public inspection, who are legally responsible for providing reasonably priced electricity, and who did just that for decades, were replaced by companies that operated in secrecy, are accountable to no one (apparently not even their shareholders or employees), could sell or withhold power as they pleased and had no obligation to build new plants.
"Proponents continue to talk of the potential benefits of deregulation. In California we learned who got the benefits - it was the power marketers. As for the consumers, in 1996 when deregulation was launched, the consumers were promised a 20% rate reduction by April, 2002. Instead the consumers are paying rates that are 40% higher!
"Consumers of all sizes cannot be well served by blind faith in the market. Any market for electric power generation must be combined
with sufficient governmental participation to assure that the lifeblood of our society doesn’t operate in ups and downs. Such volatility and shortages may be acceptable for oranges or stocks but society simply can’t tolerate it for electricity. It is a public good that must be protected from private abuse. The system of public utilities with a duty to keep the lights on at just and reasonable rates set by regulators served this country rather well during most of the 20th century."
COMPETITIVELY PRICED ELECTRICITY
The distortion in electricity 'markets' is not limited to the Western Energy Crisis.
In an article published November 6, 2007 ("Competitively Priced Electricity Costs More, Studies Show"), the New York Times revealed that retail electricity prices had risen much more in states that adopted competitive pricing than in those that had retained traditional rates set by the government.
The source of the data was the Energy Information Administration. A non-profit advocacy group, Power in the Public Interest, used the data to compare prices in 13 states and Washington, all of which have adopted market pricing for industrial users, with the rest of the nation.
The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to 2007.
According to the New York Times, "The data are the latest to show that competition, which was promoted by big industrial companies and Enron as the best way to create competitive incentives to reduce prices, has instead resulted in higher and faster rising prices. Some big industrial customers have turned against the changes they once championed, saying that if markets produced lower prices they would favor them but that electricity auctions have not worked... In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates."
HEALTHCARE SERVICES
We can similarly see distortions in healthcare, which is approached as an area of choice here in America.
Healthcare in America is paid for, in general, and at least partly, by for-profit health insurance companies that sell insurance directly to the public; and it is provided, in general, by for-profit healthcare corporates. So there are actually two for-profit services at play for the public - the insurance service and the medical service. Both these services are distorted.
The distortions on the insurance side include denial of insurance coverage, bumping 'customers' from insurance coverage, denial of claims, densely-worded contracts, and business activity focussed on denial of insurance, bumping 'customers' from insurance and denial of claims (inflating administrative costs thereby).
Imagine a business investing its energies in DENYING service to customers, rejecting customers and chopping customers! It is a travesty, yet this is what health insurance companies do. Why? Because there is no genuine customer, and there is no genuine business!
The distortions on the medical side include unnecessary 'care', and sky-high 'prices' of care.
Unnecessary medical care takes the form of unnecessary tests and procedures, unnecessary drug prescriptions, even unnecessary hospitalization. Tests, drug prescriptions and hospitalization do not add value for the customer, they are not a legitimate provision of services for gain of state. Yet when provided by a for-profit business, they are 'billed' willy-nilly, exactly as if more of them meant more gain of state to the consumer, like a car packed with goodies, extras and doodads - in short, as if more is better. Doctors focus on billing when that focus has no relation to the requirement they have to cater to, which is to prevent loss of state and restore lost state.
In his book Shock Therapy for the American Health Care System, Robert Arthur Levine, MD points out that there are two factors that make up 40% or more of the health care dollars spent:
1. unnecessary care
2. administrative costs of insurance companies.
As for sky-high 'prices' - benchmark the prices paid for lab tests and pharmaceuticals in the US against prices paid in other industrialized countries, where there is no direct for-profit mechanism applied to healthcare. Compare the differences with area-of-choice products and services like cars.
The price of the drug (or the test) does not represent any gain of state to the consumer; there may be a high cost to creating it, but this is not necessarily the case, and when it is not, the high price reflects one thing and one thing only - the lack of choice or the helplessness of the consumer over using the drug.
There is not a single known case of a country that has a largely free market, for-profit healthcare system organized on the lines of, say, the US auto industry, that delivers decent healthcare to the general population (to the common man, or the Average Joe / Jane) in the same way that decent autos are delivered.
FOOD AND CHOICE
If applying market principles to areas of no-choice distorts the supply and the prices, why - it can be asked - is the food market not distorted? Is food not the biggest area of no-choice?
We argue that the food market escapes the prediction of the no-choice model because the food market is actually a food item market, and every food item is, to a large extent, an area of choice rather than an area of no-choice.
Food is - for civilized man - at once something that prevents loss of state (proximately by staving off hunger, and ultimately by repleneshing body energy) and something that brings gain of state (by sensual pleasure in the combination of taste, texture and temperature). Food available in the market caters at least somewhat to the gain-of-state aspect - its selling proposition at least in part is the gain of state it gives you. Of course the gain is different for different food items and markets - it is lower for 'basic' food items such as vegetables or bread, which in themselves offer lower gain of state, and it is higher for 'exotic' food items such as restaurant foods, which offer higher gain of state.
The principle of dimishing gain-of-state applies to food items - the consumption of any food item reduces the gain of state on the subsequent consumption of the same item (but different food items have different gain of states). However, we have to eat 'food' - as distinct from any particular food item - everyday to prevent loss of state. The principle of diminishing gain-of-state does not apply to 'food' (that is, marginal utility is meaningless for 'food'). The net effect is that we eat a variety of food items, and the extent of the variety is given by what we can afford. The gain-of-state aspect of food translates into demand for a variety of food items, ACCORDING TO THE CURRENT LEVEL OF THE ECONOMY. On the other hand, people will eat the same food item everyday when they eat to stave off hunger.
Insofar as food items provide gain-of-state, they are a legitimate area of business. But where there are food shortages, say on account of droughts or floods, and people are starving or dying of starvation, any item of food is needed to prevent loss of state; there people need food items to stave off hunger and death, not to enjoy the sensual pleasure of eating. Therefore, although many people may need food in such situations, that is not 'demand', and is not a legitimate area of business.
People have no choice but to eat food, but even in basic (raw) food-products there is some real choice, a real variety of options: you can eat wheat or rice or cereals or meat or nuts or vegetables or lentils or eggs or fruits or dairy products or fish - each has its own distinct economic, geographic and cultural characteristics: know-how, supply levels, sources. Further, foods like vegetables, lentils, fruits, meat and fish come in many varieties of their own. To stave off hunger you can eat any of these foods and you can eat them in any mix. This 'choice' comes from nature - both the nature that is out there, the environment, and the nature that is in here, human nature. The environment provides a wide variety of possible foods which humans harness; and humans are adapted to taking a wide variety of food.
(Economists call this variety of consumption options as 'substitute goods'.)
You can eat less KINDS of food, and more KINDS of food.
Further, within broad limits, you can eat less, and you can eat more (although you may not eat as much as you need to or want to). Food consumption has high proportionality of quantity.
This vast, powerful choice in the hands of consumers prevents distortion in the food market.
The other important point is that in the case of food, the choice of substitute goods is with the consumer - the consumer has choice over what to buy, how much to buy, when to buy, how often to buy - or not to buy at all.
Healthcare is not at all like this. if you get malaria you do not have a meaningful, economically distinct choice of 'a' or 'b' or 'c' or 'd' or 'e' to cater to it; nor can you make-do with some 'mix' of them. Even if there are substitute goods (alternative drugs or therapies), the consumer has no choice over what to buy, how much to buy, when to buy, how often to buy. He or she always has to buy what somebody else tells him to buy, and ONLY what somebody else tells him to buy.
(Food is a good illustration of 'gray area', which was described in the earlier post 'Business, Government and Services'. With food, the area of no-choice and the area of choice are not absolutely distinct; it is difficult to tell apart the two services except at the extremes. Whereas 'food', in the abstract, is an area of no-choice, any actual item of food is largely an area of choice. So if the food business escapes the prediction of the no-choice model, it is because, very likely, the food business actually services an area of choice and not an area of no-choice, or it services what becomes an area of no-choice only in an extreme sense and in extreme cases of shortage.)
GENERAL INSURANCE
The other area that escapes the prediction of the no-choice model is general insurance - that is, insurance for cars, homes, factories, farms, art collections and so on.
General insurance is a service for restoring loss of state, and therefore falls in an area of no-choice. But the market is not greatly distorted.
There are reasons for this. As we discussed in 'SERVICES, PROPORTION AND PRICE', there is magnitude of choice and no-choice. If your car requires a denting-painting job, there is loss of state, but not of high magnitude; correspondingly the force of no-choice is not very strong. It is possible to get by without restoring state for a few days or weeks. This helps to keep auto insurance (by and large) from becoming the horror story that healthcare is.
But there are other, perhaps more powerful, factors. For one, general insurance is almost entirely concerned with states that can be and are priced; thereby the price of restoring lost state can be derived from, and is limited to, the price of gaining state. For another, general insurance such as auto insurance is usually mandatory by law, which makes for a large, 'assured' customer base. These factors have a beneficial effect on both price and service.
Mandating that everyone buy insurance sounds innocuous, but as a principle it is a massive distortion of the market principle that the consumer has a choice between buying and not buying. However, it acts as a counter-distortion to the original distortion, and can be effective in making for a functioning market and service, as with auto insurance, or indeed, health insurance as in the Swiss system.
UP NEXT: Summation
