2012-10-31

Third Parties, Or, Why Does Everything Cost So Much?

The impact of third parties on markets is a general price increase, funded through economic rents. That sentence is rife with jargon, so let's take a closer look at what this means.

The Health Care Market
In the market for health care, there is a third-party intermediary standing between the buyer and the seller: the insurance company. Insurance companies can potentially introduce market failure into health care markets by interrupting the normal sequence of signals sent between consumers and producers.

Suppose you require a surgical procedure that is priced at $1 million. Unless you are in an income bracket much higher than mine, this is essentially a non-starter; you cannot pay, you cannot receive the procedure. You go home and write your will.

In a more "standard" market than health care (one without intermediaries), a surgeon would only offer a $1 million procedure a finite number of times before either (a) ceasing to offer the procedure altogether, or (b) offering the procedure at a price that is actually relevant to the market. If there 3,000 patients in the city who require this procedure, the surgeon would certainly love to perform that procedure 3,000 times at a total revenue of THREE BILLION DOLLARS, but as noted above, it is unlikely that most patients would be able to afford the procedure. In a normal market, the surgeon would instead lower the price to something more attractive to patients, say $250,000. Even at $250,000, many patients will be unable to pay; but more of them will be able to pay than before. Suppose 1,000 patients can afford the procedure at $250,000; the surgeon earns $250 million dollars in revenue, pay the overhead costs, and walk away with a tidy net profit for herself.

But that's not how the health care market works.

In the health care market, insurance companies extract a steady income stream from all potential patients (or their employers). They invest this money and earn a profit from the proceeds of their investments. They are profitable before any patient requires any procedure, because they charge you money, which you give them, and then they invest that money for themselves, and take home the interest as income for themselves. Theoretically, the insurance companies keep this money in relatively liquid investments, which they can use to pay out for occasional claims for medical expenses (in return for the steady income stream you have agreed to pay them).

In practice, though, insurance companies negotiate long-term contracts with health care providers (the surgeon, in this case). They agree to pay for all surgeries deemed medically necessary, at the asking price. The surgeon is very pleased by this, because she may now charge a higher price. But in exchange for this agreement, the surgeon must agree to lower her price.

Now, pay attention. In a "standard" market, the surgeon must choose a price that is attractive enough to "ordinary people" to generate an acceptable income stream for herself. Her asking price is the mechanism by which she entices patients to undergo the procedure. In the real world, the surgeon is offered something very close to an "all or nothing" deal. She has only to set a price attractive to one, very wealthy customer: the insurance company. She must set a price lower than $1 million, but now has the ability to set a price higher than $250,000.

It does not matter what price she chooses here. If the insurance company attempts to force her down to a $250,000 price, the surgeon will simply refuse to accept payment from the insurance company, and instead she will deal directly with the consumers, i.e. the patients, in the "cash market for health care." If she chooses a $1 million price, the insurance company will refuse to deal with her at all. Therefore, any price between $250,000 and $1 million is a good deal for both parties.

Patients, meanwhile, are no longer directly involved in the market transaction. If they want to improve their lot, they must attempt to negotiate for lower insurance premiums. But that is the insurance market, not the health care market. Patients, direct health care consumers, have no impact on the pricing of health care services because they are not participants in the market for health care.

Where does the "extra money" come from? It comes from the return on the insurance company's investments. It collects small premiums and invests them elsewhere, attempting at all costs to avoid paying insurance claims so that it can continue earning investment returns. Because interest on investments accrues over time, the insurance company also has an incentive to delay claims payments, even if it does eventually agree to pay them. You probably have plenty of personal experience with this.

Thus, the impact of third-party market intermediaries is an increase in the asking price for the relevant good or service.

Intermediaries In Other Markets
Naturally, the above analysis applies equally to any market in which a third-party positions itself as an intermediary between the buyer and the seller. Can you think of any examples?

One example is the market for homes. While the buyer and the seller do, technically, negotiate with each other over the price, in most home transactions, the buyer does not have enough cash on hand to afford to purchase the property outright. Instead, the buyer must secure a mortgage from a financial intermediary. (This intermediary then interacts with many other intermediaries: the title company, the city, various contractors, perhaps additional financial services providers, and so on.)

Indeed, any purchase that commonly involves a loan is an example. Lenders are intermediaries between the producer and the consumer. Lenders have an incentive to offer the producers higher prices than the buyers themselves would tend to offer (since the buyers do not have enough cash-on-hand). Producers, then, have an incentive to charge higher prices. The difference between what consumers would otherwise offer and the real-world price is the economic profits generated by the lender from the interest charged to the consumer. Here again, the lender doesn't simply give up the full interest value. Instead, the lender invests the interest charge and earns a profit from it, only a part of which is offered to the producer in the form of a higher price.

Another extremely important market featuring costly third-party intermediaries is the education market. In the market for higher education, the above holds true: a lender agrees to provide college loans to students in the same way that a mortgage lender offers a mortgage to a home buyer. The price then increases.

In the other education markets, the grift is a little different (but economically equivalent). Standing between students (or their parents) and teachers is an enormously fat bureaucracy, funded by the taxpayer. Rather than negotiating on an agreeable price for primary or secondary education, local governments simply levy any tax rate they so choose. If the consumer does not pay, the consumer goes to jail. If the consumer chooses not to make use of public schools, the consumer must either pay a separate set of fees and fill out an intense set of home-schooling paperwork, or go to jail. We often hear that public education is under-funded, and yet the system is still funded by economic rents unfairly extracted from the consumers. All those rents that do not end up in the hands of the actual producers (teachers) instead end up in the coffers of the teachers' union bosses, the school district administrators, the superintendents, and so on. The system is flush with money, despite all claims to the contrary.

Conclusion
What do all of these markets have in common? All of these markets are extremely costly, represent a large share of our economy, are heavily regulated (if not entirely socialized), and involve an obtrusive third party standing between the consumer and the producer.

In today's world, if we wish to decrease prices and increase efficiency, we should devise ways of getting around the intermediaries, so that consumers and producers can interact directly with one another.