Health insurance markets and health care

Vijay K. Mathur

Published in Standard-Examiner, Ogden, Utah, April, 3, 2011

This year, on March 23, was the first anniversary of the Affordable Care Act. Experts of different stripes from conservative think tanks, conservative politicians, media pundits and editorial writers of conservative media outlets are on the bandwagon of criticizing the law. The column on ACA by Wisconsin Republican Sen. Ron Johnson in the Wall Street Journal on March 23 caught my attention. He heaped praise on the medical care his daughter got. He had insurance through his employer. His praise was sprinkled by highly critical remarks on ACA.

According to Senator Johnson, ACA will destroy the quality of care and innovations in medical care, and implement bureaucrats' take over: I wonder where he got that information about ACA. He had nothing to say about the imperfections (concentration of economic power) in the insurance markets, lack of health insurance to almost 47 million people now and increasing rapidly over time, denial of insurance based on pre-existing conditions and other hardships people face in getting and continuing their health insurance coverage.  

Similarly, Sen. Orrin Hatch in columns, including one in the Standard-Examiner, on March 27, tried to make the case for repeal of the law. The ACA, according to him, will increase insurance premiums, increase unemployment, taxes and deficit. It was not clear where he got his data to make such unsubstantiated claims contrary to other analytical evidence. He praised Utah's health care system. However, if Utah has such a good system, why such a high growth in enrollment during 2009-2010 and in the expenditure, and why is Utah Health Exchange plagued with low enrollment and high premiums? Moreover, the claim that ACA is a government takeover overlooks the fact that UHE, as in some other states, is a government-organized market place, just like ACA requires.

The column by Doug Olson, a small business owner, in the March 24 Standard-Examiner, points out the problems he faced in getting insurance from varied insurance companies in covering his wife's surgery-related medical bills. His experience is indicative of the problems ordinary people face in getting insurance, especially those with preexisting conditions. Sometimes insurance companies refuse coverage on the pretense that the doctor-approved treatment is experimental. A former health insurance executive, Wendell Porter, describes such an incident in his book, "Deadly Spin," which resulted in the death of a child.

Utah politicians do not have to worry about their lifetime taxpayer-paid coverage after only 10 years of service in the Legislature. I am sure federal government employees and politicians will not willingly reduce or do away with their generous taxpayer-provided coverage. Why do the politicians think that other people have to fend for themselves and be deprived of the opportunity to obtain lower priced group coverage if their employers do not provide insurance?

I understand that medical care in the U.S. is among the best in the world for those who have access to it at an affordable price. But those who are priced out of the market for any reason do not even have the opportunity to access the second-best medical care. As Professor David Cutler at Kennedy School of Government at Harvard states in "The Economists Voice," "Substantial empirical evidence shows that the major issues influencing insurance take-up are price and accessibility." The subsidies to low- and middle-income persons under the ACA will go a long way for many Americans to afford insurance and hence adequate medical care.

The access to medical care and its cost not only depends upon insurance markets but also on the pharmaceutical drugs markets and medical care markets in various regions of the country. For example, if medical care industry increases prices, it tends to increase insurance premiums. The cost of drugs, profit motive, monopolistic practices and diversified insurance pools also affect premiums.

The study by Leemore S. Dafny in American Economic Review's September 2010 issue finds that controlling for other effects, health insurers charge higher premiums to more profitable firms, and within an insurance company premiums escalate in the most concentrated (indicative of market power) markets. This study challenges the notion prevalent among many faithful but misinformed supporters of free competitive markets that health insurance markets are highly competitive. The Wall Street Journal, March 26-27, reports that the Justice Department has opened its antitrust probe into the Blue Cross-Blue Shield insurance plans' anti-competitive behavior in several states.

It is hoped that cool heads will prevail in the health care debate. The debate should be guided by factual information and solid objective analysis of the consequences of ACA, rather than ideology. If the ACA has certain deficiencies, then the responsible action will be to remove those deficiencies and substitute them with policies, which assure adequate health care for all Americans.

Mathur is former chair and now professor emeritus of economics, Department of Economics, Cleveland State University, Cleveland, Ohio. He writes original blogs for the Standard-Examiner http://blogs.standard.net/economics-etc/

Is lobbying to buy political influence bribery?

Vijay K. Mathur

Published in Standard-Examiner, March 19, 2011, Ogden, Utah

In governments, bribery is when someone pays, in kind or otherwise, for something of value from a politician or public official who willingly accepts or solicits payment (directly or indirectly) for public services and/or political favors. Bribery is mutually beneficial to both the giver and the receiver. Bribery breeds corruption and is a crime under the laws and 38 countries are parties to the Anti-Bribery Convention of OECD (Organization of Economic Cooperation and Development).

According to Wikipedia, Transparency International rated 22 countries in 2008 on the Bribery Payment Index on a scale from 1 to 10, where 1 means that bribery is an accepted norm and 10 means that "bribes are unknown." Even though the U.S. is one of the leaders in spearheading efforts to stamp out bribery and corruption around the world, its own rating on the bribery index is not very encouraging. The index for US was 8.1, and it ranked 9th where eight countries were less bribe-prone than U.S. The Foreign Corrupt Practices Act, enacted in 1977, prohibits businesses from bribing foreign officials to obtain business favors. However, the U.S. Chamber of Commerce is pushing to weaken the law, according to the website The Raw Story. On the annual Corruption Perception Index published by Transparency International, the U.S. is ranked 22 out of 91 countries; it is not an admirable showing.

Bribery is a hidden cost of doing business, and therefore it is passed on to the consumer in the form of higher prices. But it breeds inefficiencies because it directs resources to those who may not be able to compete in open market competition, and hence it adversely affects economic growth. Bribery results in general in the retention and enactment of regulations and laws contrary to the general welfare of most people, in corruption in governance, and it makes corruption contagious.

The question arises, is lobbying for favors from public officials and politicians the equivalent of bribery? Lobbyists are guided by their self-interest, just as in bribery. They represent business groups as well as non-business groups. Businesses lobby to gain contracts, secure market shares, tax breaks, subsidies and favorable regulations and laws. Non-businesses lobby to retain and/or pass laws and regulations, which may benefit only a selected group of people while imposing costs on the majority. But business lobbying dominates the total lobbying dollars. According to the Center for Responsive Politics, the top 20 lobbyists' spending ranged from $107.27 million (Pfizer Inc) to $738.8 million (U.S. Chamber of Commerce) during 1998-2010. In addition to spending on political campaigns, the total spending to lobby Congress and federal officials increased from $1.44 billion in 1998 to $3.49 billion in 2010. In 2010 there were 12,964 registered lobbyists spending on average $267,664 each, whereas the top 20 lobbyists spent an average of $26.23 million each.

Conceptually, lobbyists' spending on politicians and public officials is legally sanctioned bribery protected by increasingly stretched umbrella of the first Amendment of the Constitution; this protection is further stretched by the recent Supreme Court ruling in Citizens United v. Federal Election Commission. An outrageous example of lobbyist's influence is found in Utah where a legislator introduced bill SB231, which would have benefited his big donor at the expense of local zoning laws.

Congress has the power to regulate lobbyists' spending as well as legislators' and public officials' conduct at the receiving end, for example closing the revolving door between governmental services and lobbying. But so far lobbyists have the upper hand. Lobbyists argue that they perform valuable service to politicians and officials by providing issue-information. Even though their role in providing information is laudable, the corrupting influence of lavish spending by lobbyists overshadows their role as conveyers of information. For example the 2009 study by Deniz Igan, Prachi Misra and Thierry Tressel of the International Monetary Fund shows a significant link between spending on lobbying by financial institutions and high-risk lending and securitization practices. Such practices, motivated by financial gains, resulted in the most severe financial crisis and recession in recent memory.

The U.S. credibility in fighting a war on bribery and political corruption around the world is at stake if we do not "clean our own house." Perhaps an incentive system with penalties could focus more attention on receivers than on givers of financial favors; it is cost effective to monitor and discipline receivers. Like bribery, lavish uncontrolled spending by lobbyists to gain favors from politicians in the name of free speech has a corrupting influence on the politics and economics of free markets. It is more acute when there is lack of transparency in governance. Professors Jacob S. Hacker and Paul Pierson appropriately state in their book "Winner-Take-All Politics," "Markets are inevitably shaped and channeled by political forces, dependent on the rules that are created and enforced by those who control the coercive power of the state."

Mathur is former chair of the economics department and professor emeritus of economics, Cleveland State University, Cleveland, Ohio.  He writes original blogs for the Standard-Examiner at http://blogs.standard.net/economics-etc/.

Elements of socialism part of free enterprise economy

Vijay K. Mathur

Published in Standard-Examiner, February 28, 2011, Ogden, Utah

We hear a lot of negative talk about socialism from Utah legislators and other conservative groups like the Tea Party Express. However when it comes to their actions and/or proposals for legislation, they forget that their agendas can also be deemed socialistic.

Let me first explain socialism. In socialism the government controls means and quantities of production, as opposed to communism where, in addition to production, government also determines quantities of consumption. Just like the U.S. economy, Utah is a mixed economy where private markets, by and large, function in most private goods (a generic term which includes services as well), but the government plays a significant role in the provision of public goods and in other areas. For example, it fosters competition in markets, regulates damage and promotes beneficial spillover effects.

Private goods are those goods in which consumption primarily benefits the consumers who pay for those goods (no externality of benefits in consumption). But public goods, if provided in the market by some, benefit all, even those who do not pay for them (externality of benefits in consumption); hence no one will have the incentive to provide those goods. Therefore, economic efficiency requires that public goods be provided collectively (by government) using taxes to pay for them. That is not socialism, because the price system in markets fails to allocate resources and output. National defense and environmental quality are examples of public goods.

Even the 19th century intellectual and a classical British economist John Stuart Mill, the greatest defender of free markets, liberty, property rights and a severe critic of socialist thought, recognized the important role of government. Robert Ekelund, Jr. and Robert Hebert, in their book on the history of economic thought, state that Mill considered administration of justice, establishment and enforcement of property rights including environmental protection, protection of interests of minors and incompetents and provision of public goods like roads, canals, dams and other infrastructure projects as necessary functions of government. Mill also favored equal distribution of wealth (not income). In his view people are entitled to the income they earn from their own labor, but wealth is not an "end of itself."

Even Andrew Carnegie, according to David Nasaw in his book on Carnegie, an ardent supporter of capitalism, believed in and practiced wealth redistribution. Warren Buffet, Bill Gates and many others are also following the footsteps of Andrew Carnegie. Perhaps lawmakers, working on estate taxes, should read "Gospel of Wealth II," an article by Andrew Carnegie published in 1906 in North American Review.

In modern times, as Ekelund and Herbert state, "Every capitalist economy today possesses some socialist elements or institutions and vice versa." In fact we even have some programs that do not meet pure free enterprise test. For example, subsidies to ranchers, farmers, oil and gas producers, as well as many other spending and tax incentive programs do not meet the pure free market test, but we have them, supposedly, for the general welfare of the people. In fact, Article I, Section 8 of the Constitution even recognizes the role of government in promoting general welfare of the people.

In Utah, legislators are proposing legislations to control curriculum, giving control of public schools and higher education to the governor, to teach that the U.S. is a constitutional republic and not a pure democracy, and to eliminate tenure at public universities. Are these examples of socialism? In one sense such legislations do interfere with freedom of thought of educators and organizations, which Mills strongly defended. The irony is that the same politicians and conservative groups cry socialism when the federal government passes regulations that the state has to comply with, while ignoring socialistic leanings of state regulations.

Appropriate rules and regulations are a significant part of the free enterprise system. Food safety regulations benefit both producers and consumers, drug regulations are essential part of markets in pharmaceutical products, patent laws and enforcement protect innovations and hence businesses, financial regulations protect financial industry and consumers from fraud, environmental regulations protect people and businesses from health hazards and environmental damage. There are a host of other regulations that are essential for smooth operation of markets. Bloomberg Government Insider, Winter 2011, reports, "In a Bloomberg poll in December, that found 70 percent said government regulation is needed 'in most cases to protect public interest'..." But surprisingly 53 percent "of the respondents agreed that 'most American businesses' can not be trusted to act in public interest."

It seems that many media pundits, political leaders, bloggers, and media talk show hosts misguide the people when they label federal and state programs as products of socialistic agenda without understanding socialist thought and intent of regulations and laws in a mixed economy. Perhaps they need to be educated in the workings of the market economy, its limitations and the role of government.

Mathur is former chairman of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He also posts original blogs for the Standard-Examiner at http://blogs.standard.net/economics-etc/ .

Monopolization and the costs of drugs

Vijay K. Mathur

 Standard-Examiner, February 11, 2011, Ogden, Utah

 The patent system in U.S. has existed since 1790, but it has expanded substantially since 1836. It is designed to protect new inventions by establishing property rights to holders. On one hand the patent system is designed to encourage inventions, but at the same time it confirms monopoly power to the inventors. Since uncontrolled monopoly power is an inefficient market structure, Congress has to balance it with the incentive for inventions. At present this right is generally granted for 20 years.

After the 20-year brand-name monopoly is over, pharmaceutical companies have to face competition from generics. A recent news story in The Wall Street Journal, Jan. 13, points out that, "Brand-name drug companies are fighting to weaken a provision of the health care overhaul that was designed to open up generic competition in biotechnology medicines and save billions."

Biologic drugs are biologically synthesized, as opposed to chemically based drugs. The health care law of 2010 made the entry of generics relatively easy in the market place for generic biologics (biogenerics) to provide effective competition to brand-name biologic drugs. Biologic drugs are very expensive and thus have a very high profit margin. A February 2008 study by economist Dr. Robert Shapiro (Chairman of Sonecon, LLC, a private consulting firm and former undersecretary of Commerce for Economic Affairs) and his co-authors, shows that across all treatments the average cost of biologics is $16, 425, which is 20 times the average cost of traditional drugs. Therefore, drug companies like Genentech, Amgen, and Merck are very much concerned about losing their market share and profits with the advent of generic biologic drugs.

At present, fortunately for brand-name drug companies, Food and Drug Administration has not come up with an evaluation process for biogeneric drugs. Hence, in the meantime, biologic drug companies, who control close to 20 percent market share, are working on two fronts to maintain their monopoly power and profits. They are partnering with other companies to develop "biosimilar" drugs, which are copies of their brand name drugs. They are also engaged in intense lobbying efforts to convince FDA to grant them exclusivity rights for 12 years; it is a cheaper way to preserve monopoly power. Sens. Orrin Hatch of Utah and Kay Hagan of North Carolina, both Republicans, sent a letter to FDA requesting, " to interpret the law in ways favorable to the brand-name makers." These efforts to block the entry of biogeneric drugs is in addition to barriers to entry posed by complexity and cost of developing bioglogics as opposed to developing traditional drugs.

Biologic name-brand companies are asking FDA for 12 years of exclusivity rights to market their drugs, as opposed to five years pushed by counter groups like insurance companies and generic biologic companies. Drug companies argue that exclusivity rights will permit more inventions of these complex drugs. However, this argument is not supported by convincing evidence on their research and development efforts in relation to profits. Supporters of generics would argue that the development of generics would save patients billions of dollars. At present many patients cannot afford these lifesaving drugs. The research by Dr. Robert Shapiro and his co-authors shows that competition from biogeneric drugs across 12 treatments will result in an average price discount of 35 percent and will save a total of $378 billion over 20 years. Sen. Hatch, who claimed that health care legislation would be very costly to the nation, is now trying to push FDA to maintain the monopoly power and profits of these large biologic drug companies. Government action is the cheapest way to acquire monopoly power to control output, prices and profits.

According to Kaiser Family Foundation Americans spent $234.1 billion on prescription drugs. The pharmaceutical industry is the third most profitable industry. Prices of prescription drugs have increased at the average rate of 3.6 percent per year, much higher than the general inflation rate during 2000-2009. The average brand-name prescription drug price was four times the average price of a generic and manufacturers received almost 78 percent of the retail price. A Congressional Budget Office study in 2006 found that median return on assets of pharmaceutical companies was close to 12 percent, almost double the return for other Fortune 500 companies.

It is about time that politicians, including Sen. Hatch, pay attention to their voter-patients' concerns about high drug prices, health insurance cost and medical care cost. Protecting exorbitant profits of drug companies by promoting monopoly power does not benefit this nation, given the very high fraction of spending on prescription drugs by private and public sectors. Efforts should be made to open the drug market for all types of drugs for more competition, including importation of drugs from Europe and Canada.

Mathur is former chairman of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He also blogs for the Standard-Examiner at http://blogs.standard.net/economics-etc/.

Senator Hatch, balanced budget amendment is misguided

Vijay K. Mathur

Published in Standard-Examiner, January 30, 2011, Ogden, Utah

 Sens. Orrin Hatch, R-Utah, and John Cornyn, R-Texas, are attempting to push once again the balanced budget amendment; Senator Hatch thinks that this time most people are frightened by the deficit and the debt.

He did not succeed previously, but this time most in Congress will join their hands in harmony to tackle this supposed threat to national economic security. However, the senators do not realize that their amendment will increase economic and political insecurity. It seems that Sens. Hatch and Cornyn are not familiar with the way fiscal policy works and the real affects of public debt.

In his column in this paper on Jan. 27, "Balance the budget," Senator Hatch states that Washington spending is leading the nation into bankruptcy. However CBO's estimates on President Obama's budget show that the actual deficit was 9.9 percent of the GDP in 2009. It is projected to be 10.3 percent in 2010, and is expected to decrease continuously through 2020, when it would be only 5.6 percent of the GDP. This data does not show that we are on the path to bankruptcy.

Senator Hatch claims that Congress cannot be trusted to remain on the path of fiscal balance. However, he forgets that budget deficits have been with us since the 18th century. They have been generally on an increasing path since 1932. The deficit during 2002-2009 (including recession years) has been increasing at the average rate of 36 percent per year. Most of this period consists of President George W. Bush's years, when Senator Hatch voted for the discretionary war on Iraq and the Bush tax cut. He could have made a serious attempt to balance the budget and propose a war tax to pay for the war during this time period when the average economic growth was 5.9 percent per year.

After WW II, the federal debt (excluding debt held in federal government accounts) reached its lowest points at 23 percent of the GDP in 1974 from the high of 108.6 percent of GDP in 1946. After a slight increase in late '70s, there has been generally an upward movement in public debt as a percentage of GDP since 1982, irrespective of the political party in power. Senator Hatch is frightened by the increase in debt, not realizing that the economy has gone through a very severe recession, one not seen since the Great Depression. The CBO's debt forecast of 90 percent of GDP by 2020 should be viewed in proper perspective. Like us, most developed nations faced severe recessions during 2007-2009.

Therefore, for example, Euro area debt was 92 percent of GDP in 2010 and is not expected to be less in 2011; our debt will be 63 percent in 2011. We are fortunate that our economy is bouncing back with positive growth, partly because of the fiscal stimulus and assistance to the financial market, and it shows in the CBO's deficit forecast.

Senator Hatch exaggerates the burden on future generations. Most of the public debt is held domestically, and therefore to that extent domestic bondholders are asset rich. There is a transfer of income from non-holders of government bonds to holders. It does not affect the income of the country. Even if our children and grandchildren inherit debt, they will be asset rich. To the extent foreigners own our debt, there is a leakage of interest income from the U.S. But if foreigners get rich they will spend it somewhere, including imports from the U.S. To take advantage of high-income foreigners' demand, we have to become more competitive in the world market. It also requires that we save more and consume less, so that we have enough supply to meet foreigners' demand for our products. There is no convincing evidence that public debt reduces national saving or reduces our competiveness.

The real problem arises when the increase in public debt is beyond our capacity to service it and deprives us in meeting our other public demands for security and other services. Estimates show that interest payments in 2010 would be 2.9 percent of GDP, which would decline with increasing growth rate. Also, in the current environment of low interest rates, we have not seen any crowding out of private investment.

The effort on the part of private and public sectors should be to direct spending which helps develop new technologies, infrastructure, human capital and futuristic products so that we could compete in the world market.  Future generations will thank us for the real assets they will inherit, and at the same time we would generate robust growth and revenues in the current period. We need a sensible and stable tax structure and spending priorities, which encourage productive entrepreneurship.

Politicians should not think of the federal budget like state and local budgets. The federal budget is one of the most effective tools of fiscal policy. The amendment would deprive the federal government the use of that tool to manage the economy. Unless Congress can outlaw business cycles, the balanced budget amendment should be permanently buried.

Mathur is former chair of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He offers original blog posts for the Standard-Examiner at http://blogs.standard.net/economics-etc/. He resides in Ogden.

The unemployment problem

Published in Standard-Examiner, Ogden, Utah, December 9, 2010

Vijay K. Mathur

Americans are frustrated about the unemployment picture and, in spite of the efforts made by the administration to stimulate the economy, unemployment is stubbornly parked between 9 and 10 percent. It is higher than the unemployment rate, which prevails when the economy's growth rate is at full employment without significant inflation rate. Now you may ask why there is unemployment when there is full employment? Let me explain.


At any given time there is always unemployment because the labor market is constantly in flux. There are three main types of unemployment in addition to seasonal. The first is frictional unemployment. During any month, thousands of people are changing their jobs, waiting to start a new job, waiting to be recalled after being laid off from the job, and entering and reentering the labor force to look for jobs. This unemployment is for a short duration (usually 1 to 26 weeks); 54.2 percent of the people were unemployed for one to 26 weeks in the second quarter of 2010. It has decreased from 82.8 percent in the second quarter of 2007. This is partly due to the fact that those who are employed are not leaving their jobs, causing a drop in turnover rate, and those who are unemployed are unemployed for longer durations (27 weeks and more).

Frictional unemployment arises when the labor market is in the process of matching workers with available jobs. This matching process takes time until workers with different talents, experiences, aspirations, and at different locations, find jobs which match goals of businesses at different locations looking for workers with certain skills, experiences. If people with skills in demand are frequently in and out of the labor market and if duration in searching for jobs increases due to wage expectations, lack of information, uncertainty, and locational immobility, frictional unemployment will rise. For example, an IMF study estimates that negative equity problem in the housing market, which has led to decreased mobility, has added 0.5 percent to 1.5 percent to the unemployment rate.

The second type of unemployment is structural unemployment, which arises when people are chronically unemployed. Their skills do not match what businesses demand due to changes in industrial composition or they are unskilled, hence they are employed for very short periods of time. Full employment implies that the only unemployment left is frictional and structural; economists call it a full employment unemployment rate or natural rate of unemployment (NARU).

Following the consensus among economists on NARU of 5.5 percent before this recession, the current unemployment rate of 9.8 percent in November 2010 is 4.3 percent above NARU. This 4.3 percent unemployment rate is cyclical unemployment, which arises due to lack of aggregate demand in the economy for goods and services. This is the third type of unemployment rate.

Growth rate of GDP currently is below the full employment growth rate because of the excess unemployment rate above NARU. But, we have come a long way since the decline in growth rate at around minus 6.8 percent. That was at the lowest point of the recession in January 2009.
The good news in October 2010 was that from September 2009 to September 2010, the job openings' rate was constant, the hiring rate increased, the job separations' rate decreased and all components of GDP grew in the third quarter. However, the unemployment rate is stuck at a higher level. Most likely, NARU has increased as well because of changes in both frictional and structural unemployment. Bureau of Labor Statistics (BLS) data show that from the second quarter of 2007 to the second quarter of 2010, one- 26 weeks of unemployment as a share of total unemployment decreased by 28.6 percent. The share of 52 weeks or more increased by 21..4 percent. These were record-high increases since 1967.

The current high unemployment rate is not due to the entry of more people into the labor force, because labor force participation rate has been stuck at 64 percent to 65 percent since last January.

To bring down the unemployment rate, policies must be aimed at reducing cyclical, frictional and structural unemployment. Reducing cyclical unemployment requires increasing aggregate demand (consumption, private investment, government expenditure, and net-exports). Reducing frictional unemployment will require stimulating demand, removing uncertainties in regulations and fiscal policy, detailing better information flow in labor markets and fixing the mortgage mess. Training and technical education programs must be implemented on a large scale for people who are structurally unemployed.

Let us hope that Congress does its part in implementing a far-sighted expansionary though sustainable fiscal policy, which complements the Fed's monetary policy to stimulate aggregate demand. Congress also has to work on the long-term goals of energy independence, reducing carbon imprint, building human capital stock, sensible immigration and free trade policy, which does not encourage outsourcing.

Mathur is former chair of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden. He also offers blog posts for the Standard-Examiner at http://blogs.standard.net/economics-etc/.

The 'free rider' problem

Vijay K. Mathur

Published in Standard-Examiner, Ogden, Utah, January 15, 2011

A free rider is a person who enjoys the benefits of goods without contributing to the full cost or partial cost of providing them. This problem usually arises when there are spillover benefits or costs in the provision of goods.

The free rider problem is usually more acute in the case of public goods. Public goods are those where we cannot exclude others from their consumption, unless incurring substantial cost if the goods are provided at all, and the consumption by anyone does not reduce the amount available to others. Examples of pure public goods are national defense and environmental quality. The spillover effects of public goods deem it necessary to provide these goods collectively either through taxes and/or subsidies.  However, there are other areas where the free rider problem may arise due to significant spillover effects.

 Suppose in a neighborhood, a homeowner improves his house and pays for the improvements. This action by a homeowner also improves the value of houses of his neighbors. Neighbors enjoy this benefit even though they do not pay for it. Similarly, if a neighbor does not maintain his house, it will bring down the value of other neighbors' homes. This is a cost to the neighbors. In fact, the self-interest of the next-door neighbors dictates that they should also not maintain their homes. This type of behavior is responsible for the deterioration of housing in many inner cities around the country. That is the reason we have zoning laws, a collective action to make people maintain their properties.

If zoning laws are not enforced promptly and efficiently in neighborhoods, all households bear the consequences of diminishing housing values. Salt Lake City's recent decision to enforce sidewalk snow removal regulations for homeowners is meant to mitigate this problem.

A variant of the free rider problem may also arise in condo developments and/or gated communities where homeowners' associations impose flat maintenance fees on all units irrespective of their sizes and acreages. If there is a flat maintenance fee assigned to each homeowner, owners with bigger houses and acreages free ride on others with smaller units and land area. An appropriate policy will be to assign fees based upon the square feet of the unit and acreage outside the unit requiring maintenance.

The free rider problem also exists in public school systems. Low-income people, who have more than the average number of children in public schools and live in smaller homes with lower property taxes, free ride on others who have fewer children in public schools, have higher income and live in bigger homes with higher property taxes. The counter argument in public education is that higher income people with smaller families benefit from the education of others in terms of knowledge base and reductions in other harmful activities like crime when the population is more educated. Hence, they enjoy the flow of benefits from others' education. But the same argument can be made by high-income earners and the effect of their children's education on others, including low-income earners.

A stronger argument for public education at all levels is that it increases the knowledge base of the community, the state and the nation. Knowledge has significant spillover effects, where the more educated the general population, the more knowledge accumulation. It is like a public good. Accumulation of knowledge capital, especially in the modern economy, is crucial for economic development and the prosperity of a nation.

Pharmaceutical companies free ride on basic research and development at universities, but that has not stopped the public from supporting institutions of higher education. Drug companies, as well as other companies, are recognizing the benefits they derive from basic R&D at universities and hence are increasingly supporting those R&D programs. This free riding is beneficial to the society in the case of drugs' development. Drug companies face very large investments and risks in clinical trials. A very small fraction of efforts result in successes, but success brings substantial rewards to drug companies as well as to the society.

The free rider problem in the health insurance market is very pervasive. The so-called mandate in the health care law, that all must buy insurance or pay additional tax, implies that those who reap the benefits of health care by showing up in emergency clinics of hospitals must pay at least some amount for those benefits. Uninsured people are passing costs of their benefits by increasing others' insurance premiums.

There are many other areas where the free rider problem may arise, but it is important to note that the spillover benefits have to be significant enough to outweigh the costs of fixing such problems. We definitely do not want to impose a tax on people who benefit from neighbor's gardens, because costs will outweigh benefits.

Mathur is former chair of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden. He also blogs for the Standard at http://blogs.standard.net/economics-etc/.