This opening module of the Power of Markets course covers the basic assumptions about market participants made by economists, the concept of opportunity cost, and the key determinants of supply and demand. We will then learn how to use the supply-demand framework to explain and predict market outcomes and to show how government policies affect those market outcomes. We will look at how quantity demanded and supplied respond to their key determinants in quantitative (elasticity) as well as qualitative terms. The last two weeks of the first module will investigate consumer behavior more closely and show how consumer choices are driven by the interplay of preferences and budget constraints. We will employ the consumer choice framework to examine investor choice as well as policies such as ObamaCare and school choice. Finally, we will also address the concept of how to distribute a given amount of goods across a society’s consumers in the most efficient manner.
Excise Subsidies - Health Care and Consumer Welfare
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From the course by University of Rochester
The Power of Markets I: The Basics of Supply and Demand and Consumer Behavior
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University of Rochester
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From the lesson
Week 4 - Consumer Choice and the Benefits of Exchange
Using Consumer Choice Theory to Analyze Investor Choice as well as Policies Such as ObamaCare and School Choice. Promoting Efficiency in the Distribution of Goods.
Meet the Instructors
Mark ZupanProfessor of Economics and Public Policy
Simon School of Business
To be able to analyze the impact of Obamacare,
or the Affordable Care Act, that was passed in
2010, let's first take a look at the impact
of subsidies, excise subsidies, on
healthcare consumption and consumer welfare.
The fundamental point we'll make here.
Is that it's better to give people lump sum transfers, and leave
the choice how to spend the money in their hands, based on their
preferences, than to subsidize a particular product such as healthcare.
There'll be a dead weight loss relative to
a lump sum transfer if we use excise subsidies.
Let's see why. And by the way, on healthcare, businesses
a subsidy has existed since the 1940s.
Largely provided by businesses, and then also
through the government through Medicare and Medicaid.
And the way businesses started providing the subsidy, it's
a great example of the law of unintended consequences.
There were price ceilings on what you could pay labors during World War two.
to try to keep the price of labor from rising too rapidly.
And so what companies ended
up doing is finding other ways they could attract workers
to their particular business during a period where labor was scarce.
And so certain companies, like the Kaiser shipbuilding company, decided
to offer free medical care, or reduced prices on medical care.
This grew in practice the benefits weren't taxed.
it kept spreading, and then there were some questions in Washington,
should we tax these benefits or not?
But by this time, so many people were receiving
the benefits, there was too big of a push back.
And that subsidized through no taxes being applied on corporate-sponsored
healthcare benefits has created a subsidy for healthcare consumption.
Now let's take a look at the impact of
subsidies, and why they're inferior to lump sum transfers.
Let's look in particular at the case of healthcare.
All other goods and outlays on them on the vertical axis.
The original budget line is AZ, where the consumer ends up
buying H1 units of healthcare nine in this particular situation.
And the price of healthcare in this situation, is $5 per unit.
For each
$5 drop in outlays in other goods, we get, reach $5
less spent on other goods, we get one more unit of healthcare.
And we can see that because if we give up all $100 on outlays on other
goods, we can end up at the other extreme of 20 units of healthcare being bought.
Now, what if the government says, look. We're going to subsidize through,
perhaps not taxing corporate benefits, or providing such a subsidy directly.
To ensure that the price of health care is $3 per unit as opposed to $5.
The budget line pivots from AZ to AZ prime.
The consumer's optimal point changes from W to W prime.
And instead of the original nine units of healthcare being bought,
15 units are now bought. How
much does the government end up paying for those 15 units?
The government provides $2 per unit in the form of a subsidy.
So the amount of the subsidy across all 15 units is $30.
15 units times a $2 per unit subsidy. And the way that gets reflected
in the graph is the height difference between W prime and
T. W prime is what, consumers
actually end up paying, $3 per unit on the new budget constraint.
T is the original market price, the $5 per unit.
The underlying cost of healthcare.
Government covers the difference between the rest.
W prime to T prime.
Now, if we provided the same exact subsidy.
But instead of saying it has to be spent on healthcare.
But to, provided it as a lump sum grant.
We can show why this consumer would be better off.
So say we took the subsidy of WT,
W prime T, and provided it as an income effect purely, and just shifted out
the original budget constraint by that, by that vertical distance of W prime T.
So, with the extreme we could give this consumer
$30 that could be spent on other goods, a
point A prime as opposed to original $100 that
could be spent if only other goods were purchased.
A lump sum subsidy would shift the entire
budget constraint to A prime Z double prime.
The same $5 initial cost of health care
gets preserved, but now it's purely an income affect.
The consumer would be better off under such a lump sum transfer.
Would be able to attain W double prime on a difference curve U3.
And the fundamental
point is that, giving freedom of choice to
the consumer to follow his or her own preferences.
And letting him or her make that trade
off, is better than trying to tilt consumption.
Trying to introducing a substitution effect, as
oppose to just providing a direct income effect.
The same dollar expenditure gets a consumer
further out on their indifference curve map.
Let's look what this means in the form of measuring
consumer surplus with demand curves and the cost consumers pay.
When we reduce the price from $5 per unit to $3 per unit through the subsidy.
The added consumer surplus is the blue area.
P, E, B, P prime.
How much does the government though end up
paying to produce that increase in consumer surplus?
It's the rectangle, P, C, B, P prime.
It's both the blue area of consumer surplus that's
generated, but also, the additional cost, the additional triangle, ECB.
because, for all 15 units, the government has to
pay a height of $2 per unit times 15 units.
So it's the entire rectangle.
So this subsidy, this excise subsidy produces
what economists call a dead weight loss.
The expenditure is higher than it needs to
be to produce that increase in consumer surplus.
A lump sum subsidy.
A direct transfer of the blue area, P,
E, B, P prime, could accomplish the same mission.
The same increase in consumer surplus, but at lower cost.
We wouldn't sacrifice that red triangle.
So, fundamentally, it's the same way of
showing that for the same expenditure, we can
get more consumer surplus or achieve the
same gain in consumable surplus at lower expenditure.
Lumps sum transfers will do the work more effectively And that's
something to keep in mind as we'll turn next to analyzing Obamacare.
During discussions on the legislation, a lot
of talk about, how do we bend the cost curve?
How do we reduce expenditures on healthcare?
Fundamentally, Obamacare will end up raising expenditures on healthcare.
Because it provides subsidies, as we'll see, for greater healthcare consumption.
It will also create deadweight losses along the way, and we'll see why.
So, the impact will be the exact opposite of what
the legislation purportedly was designed to do.
To bend the cost curve, among other things.
Studies that have been done, consumers are
very, are much more sensitive than you'd think,
to having to have skin in the game
in having to pay their own healthcare expenditures.
The leading study done by Rand, for example,
indicates that for 50% copays up to some catastrophic
limit, individuals will end up spending 67% less
on insurance coverage than if there is no copay.
Or, or, sorry.
Not insurance cover. Overall medical care.
And 72% less on hospital care.
When they have more skin in the game, and they have
to pay half of any expense out of their own pocket.
The subsidies, however, if anything, move us away from having skin
in the game, and that's why, instead of bending the cost curve
down, it's, Obamacare will, it will end up bending the cost curve up.
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