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8- How Understanding Economics Helps in Policy

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8. How Understanding Economics Helps in Policy

James D. Gwartney, Professor of Economics, Florida State University



For anyone seeking to affect or even evaluate public policy options, economic thinking is crucial. It helps us to avoid some of the worst, and yet most common, errors in the public policy arena. Economic thinking emphasizes the role of incentives and the importance of comparing each potentially favored option with other real and available options, not with perfection. Let’s look first at today’s discussion of “green jobs” on the one hand, and then turn to reform of the medical care system in the United States.


Jobs are typically used to produce goods and services that we value. But let’s not forget that it is the value of the goods produced that is important, and the jobs are merely a means to that end. If people don’t keep their eyes on this basic fact, they can be misled to support projects that destroy wealth rather than create it.


Politicians like to talk about the jobs created by their spending programs. Suppose the government spends $50 billion employing one million workers to install photovoltaic cells to generate electricity for electric utility firms to distribute to customers. Supporters of projects like th is often argue that they should be undertaken because they will create a huge number of jobs. Is this a sound argument? To answer this question, consider the following two points. First, the government will have to us e either taxes or borrowing to finance the project. Taxes of $50 billion will reduce consumer spending and private savings by this amount, and this will diminish employment in other sectors by a magnitude similar to the employment created by the spending on the project. Alternatively, if the project is financed by debt, the additional borrowing will lead to higher interest rates and future taxes to cover interest payments. This will also divert funds away from other projects, both private and public. Thus, the net impact will be primarily a reshuffling of jobs rather than job creation.


Second, what really matters is the value of what is produced, not jobs. If jobs were the key to high incomes, we could easily create as many as we wanted. For example, the government could pay attractive wages hiring the unemployed to dig holes one day and fill them up the next. The program would create jobs, but as a nation, we would also be poorer because such jobs would not generate goods and services that people value. Job creation, either real or imagined, is not a sound reason to support a program. Instead, the proper test is opportunity cost—the value of what is produced relative to the value of what is given up. If people value the output generated by the government spending program more than the production it crowds out, it will increase our incomes and living standards. If the opposite is the case, then the additional spending will make us worse off. Economic thinking helps a careful analyst see how to advise allies and to expose the errors of opponents, when policy errors like this become real threats.


Health care gives us more examples. Government health policies have generated perverse incentives that have led to undesirable outcomes. In a normal market, consumers pay for the service and choose from whom to buy. Sellers in a true, more open market are compensated by their customers. Competition from rivals provides sellers with a strong incentive to keep costs and prices low. Sellers thus have a strong incentive to serve consumers’ interests: if they do not, consumers will buy from competitors who do that better.


Key relationships that make real markets work have been eroded by U.S. health care policies that evolved over the previous six decades and more. The structure of the health care market is now permeated with perverse incentives that encourage people to engage in actions using resources inefficiently and imposing those costs on others. These incentives underlie both the poor performance of the industry and the rising health care costs we all know about. Examining the incentives helps us see what can be done to improve outcomes.


We turn now to the four major reasons for the poor performance of the health care industry. First, the structure of today’s government programs relies on third-party payments that erode the incentive to economize. Very little health care is purchased directly by consumers. Most is paid for indirectly through taxes or insurance premiums. When someone else is paying the bill, the patient has little reason to conserve on the use of the resource and the provider has little incentive to keep costs low.


Second, the huge tax advantage providing for the purchase of health insurance through one’s employer undermines competition and makes it very costly for individuals or families themselves to purchase a health insurance policy that fits their preferences. Rather than allowing consumers to choose, government subsidies and regulations push them into standardized and controlled group plans provided through employers. Moreover, under this system, losing your job means also losing your health insurance. People do not generally buy auto, life, or homeowner insurance through their employers. Why do so many buy health insurance this way? Answer: The tax system subsidizes them to do so and punishes them with higher personal costs if they do not.


Third, state regulations that force insurers operating in the state to cover numerous services like in vitro fertilization, drug rehabilitation, marriage counseling, acupuncture, and massage therapy also drive up costs and make it still more difficult for consumers to purchase a pol icy that fits their preferences. Interestingly, the political pressure for this coverage does not come from consumers but rather from suppliers wanting taxpayers to subsidize their operation.


Fourth, regulations prevent consumers from purchasing a health insurance plan offered in another state.

Thus, if you would like to purchase insurance that would provide you with inexpensive basic coverage at a low cost, but you happen to live in a state that has adopted many of the expensive mandates, you are out of luck. Essentially, the government has organized the health insurance business into separate cartels that operate in each of the 50 states. You can buy nearly everything ranging from groceries and automobiles to life and auto insurance from providers in other states, but not health insurance.


Economic thinking allows policy professionals to ask the right questions, thus helping good thinking to overcome some tempting policy errors that are made every day.



James D. Gwartney holds the Gus A. Stavros Eminent Scholar Chair at Florida State University, where he directs the Stavros Center for the Advancement of Free Enterprise and Economic Education. He is the coauthor of Economics: Private and Public Choice, (South-Western Press, 2008), a widely used principles of economics text that is now in its 13th edition. He is also the co-author of Common Sense Economics: What Everyone Should Know About Wealth and Prosperity (St. Martin’s Press, 2005), a primer on economics and personal finance designed for the interested lay person. His pub lications have appeared in both professional journals and popular media such as The Wall Street Journal and The New York Times. His Ph.D. in economics is from the University of Washington. His current research focuses on the measurement and determination of factors that influence cross-country dif ferences in income levels and growth rates. In this regard, he is the senior researcher responsible for the preparation of the annual report, Economic Freedom of the World, which provides information on the institutions and policies of 140 countries. During 1999-2000, he served as chief economist of the Joint Economic Committee of the U.S. Congress. In 2004 he was the recipient of the Adam Smith Award of the Association of Private Enterprise Education for his contribution to the advancement of free-market ideals. He is the current president of the Southern Economic Association.


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