The Becker-Posner Blog

Consumer Protection in the Airline Industry—Posner

Last week the Department of Transportation announced a set of regulations that it calls “Enhancing Airline Passsenger Protections II,” the “II” referring to the fact that similar “protections” were imposed more than a year ago and are now being expanded. The new regulations are summarized in an article in the New York Times published on April 20. Accompanying the new regulations is a study by a pair of economic-consulting firms (one of them the well-known Econometrica) that purports to quantify the financial benefits of the regulations and concludes that they are modest but positive. Here is the study’s summary of the requirements imposed on airlines by the new regulation: 

“1 Expansion of tarmac delay contingency plan requirements and extension of EAPP1 Final Rule requirements to cover foreign carriers.

"2 Expanded tarmac delay reporting and application to foreign carriers.

"3 Establishment of minimum standards for customer service plans (CSPs) and extension of EAPP1 Final Rule requirements to cover foreign carriers.

"4 Extension of requirements to post contracts of carriage, tarmac delay contingency plans and CSPs on websites to foreign carriers.

"5 Extension of EAPP1 Final Rule requirements for carriers to respond to consumer complaints to cover foreign carriers.

"6 Changes in denied boarding compensation (DBC) policy.

"7 Full-fare advertising and prohibition on opt-out provisions.

"8 Expanded requirements for disclosure of baggage and other optional fees.

"9 Prohibition on post-purchase price increases.

"10 Prompt passenger notification of flight status changes

"11 Limitations on venue provisions in contracts of carriage." 

Do these regulations make economic sense? (They probably make political sense.) 

I won’t try to discuss all of them, but will sample each of the three kinds of requirement that the new regulations impose: (1) requirements that alter the contract between the passenger and the airline, ostensibly to make it more favorable to the passenger; (2) requirements concerning fuller disclosure of the terms of the contract; and (related to both other categories) (3) requirements designed to prevent exploitation of consumers by trickery. 

(1) includes requiring refunds for lost luggage and increasing the compensation required for passengers who are bumped from a flight because of overbooking; (2) includes such things as requiring that taxes be disclosed as part of the purchase price rather than separately and that baggage fees be more clearly disclosed to passengers in advance; (3) includes such things as post-purchase-price increases and limiting where a passenger can sue an airline (“venue”). 

(1) doesn’t make any economic sense. If airlines have to make refunds for lost baggage or increase overbooking compensation, they will have to raise prices to cover the higher costs resulting from these requirements. If passengers preferred to pay the higher price necessary to obtain these benefits, one would expect the airlines to revise their contracts with passengers accordingly. The same thing is true with regard to limiting the amount of time that an airline can keep a plane on the airport tarmac, awaiting clearance to take off, without giving the passengers a chance to leave the plane. The new regulations, in merely extending the limitations it has already imposed on domestic airlines to foreign ones, can be thought just to be closing a loophole; the economic question is why the matter of tarmac delay can’t be left to implicit negotiation between airlines and passengers, resulting in an optimal combination of ticket price, inconvenience from being stuck in a plane, and likelihood of cancellation of flights if the combination is weighted in favor of compensation for passengers inconvenienced by tarmac delay. 

(2) is another questionable category of regulations. Competitive firms don’t disclose negative features of their product (which can include price) unless there is a competitive advantage to doing so. Assuming airline taxes don’t differentiate among airlines, disclosing the taxes as part of the ticket price rather than in fine print unlikely to be noticed is not going to give any airline a competitive advantage, and it may reduce demand slightly by revealing air travel to be somewhat more expensive relative to substitutes than passengers may have thought. The effect is likely to be trivial, however. As for baggage fees, if an airline decides to compete by charging lower fees than its competitors, presumably it will advertise the fact; it will not need government prodding. 

(3) is really a variant of (2). Take the venue limitations. Venue (where the airline can be sued) is a term in the contract between the airline and the passengers, which the Department of Transportation is forcing the airlines to delete. But many consumes are unaware of the meaning or significance of such a provision, and requiring disclosure of it would merely burden the passenger with information that he doesn’t want or need—for how likely is he to want to sue the airline? So I don’t regard these provisions of the regulations as particularly objectionable on economic grounds. 

The issues become slightly more difficult when one takes account of the airline industry’s somewhat unusual cost structure. It can be argued that the airline industry would not really be very price competitive if left to itself because the provision of airline sservice has a high ratio of fixed to variable costs. Such a ratio makes price cutting a perilous method of trying to increase profits, since if prices spiral down to marginal cost the airlines are not able to cover their fixed costs. And price changes are necessarily published in advance and airlines cannot feasibly “steal” passengers from each other with secret discounts. So tacit collusion on price should be feasible, and one might expect therefore that the airlines would do anything to pack their planes, since the cost of adding a passenger in a plan that has empty seats is very slight—anything but offer a lower price than a competitor for a given quality of service. 

But if tacit collusion on price, coupled with the cost structure of the industry, caused the airlines to substitute nonprice for price competition, one would expect the quality of service to be too high (that is, that consumers would prefer a lower price at the cost of lower quality), as in the days when regulation by the Civil Aeronautics Board largely prevented price competition, resulting in extravagant nonprice competition in the form of ultra-frequent flights and lavish in-flights meals and even entertainment. The quality of airline service has of course been steadily deteriorating. Moreover, entry either of new airlines, or of existing airlines into routes they haven’t previously served, is easy, and must keep prices down. And the ratio of fixed to variable costs in the provision of airline service has declined because of rising fuel costs, a variable cost that now accounts for 40 percent of an airline’s total costs. 

Moreover, if airlines don’t want to compete on price, requiring fuller disclosure won’t have much, if any, effect. 

But the cost structure not of the industry but of the individual airliner—the high ratio of fixed to variable costs in the operation of a particular airliner—is relevant to the possibility of “market failures” that might, in principle anyway (always a vital qualification), justify regulation. I said that the airlines are desperate to pack their planes, because an additional passenger adds much more to revenue than to cost. But packing planes, necessarily with passengers have a variety of preferences, limits product differentiation. There is some: think of first class, and the recent movement toward varying the leg room of coach seats. But it isn’t feasible for airlines to offer passengers different waiting times on the tarmac when bad weather delays flight clearance; they’re all in the same boat. And when stiff baggage fees result in delays in boarding and deboarding, and difficulty in finding bin space for one’s carry-on luggage, because the fees have caused many passengers to substitute carry-on for checked baggage, all passengers (in coach) are in the same boat. The quality-sensitive passengers may incur a great deal of disutility from the degradation of quality that enables the airlines to attract a lot of quality-insensitive (in other words, price-sensitive) passengers, yet the former may not be willing to pay the very high price necessary to compensate the airlines for losing price-sensitive passengers deterred by the high price. 

This is not a genuine market failure, however— technological constraints, rather than collusion or externalities, prevent the industry from providing a level of service desired by many passengers—but it helps to explain the public pressure for quality-enhancing regulations. The Department of Transportation thinks or pretends to think that these regulations increase overall satisfaction with airline service, but this fails to consider that if passengers as a whole wanted better service at a higher price, the industry would provide it voluntarily. Service can’t be decoupled from price. 

The airline is providing a bundled or “one size fits all” product to most of its customers, and unbundling can increase demand by enabling a better matching of price to consumer preference. But except for the tiny sliver of flyers who can afford private planes, the cost structure of the airline industry, rooted in airliner design, prevents significant quality differentiation. 

I conclude that while regulations that forbid certain deceptive practices in the marketing of airline services may be justifiable, regulations that require more detailed disclosures, and in particular regulations that require quality improvements, are not justified, at least on economic grounds. The consulting report is wrong to think they’ll increase aggregate welfare, although they will modestly increase the welfare of the complainers—illustrating that the squeaky wheel is indeed greased first.

How Can Governments Help Consumers- Becker

 

The new rulings announced by the Department of Transportation to force airlines, among other things, to return the fees for checking baggage if the baggage is lost, to post full prices including taxes, and to raise the compensation for being bumped involuntarily from flights, are not very onerous to airlines. However, they do add to the many rules that already require airlines to post various prices, to compensate passengers for bumping, and to engage in other behavior that is supposed to protect passengers. The new and old rules regarding passengers, and many rules of behavior imposed on companies in other industries, such as the so-called consumer protection components of the Dodd-Frank law on financial regulation, all reflect a fall in government confidence in the ability of consumers to make reasonable choices.

I believe this lack of confidence greatly underestimates the capacity of the great majority of consumers to make forward-looking choices in their own interests. It also underestimates the degree to which the forces of competition protect consumers against the consequences of the bad decisions they do make. I briefly defend each of these claims.

Low cost airlines that provide cheap tickets and minimal services grew rapidly after the deregulation of airlines that began in the 1970s allowed the entry of new airlines. Their growth shows how sensitive passengers are to price, and how many are willing to exchange lower prices for fewer services, such as no meals, or no assigned seats. Southwest Airlines started only in the 1970s after facing much opposition from regulators, and it is now the largest American airlines in terms of domestic traffic.

Or consider whether most passengers know that many airlines now add separate charges for checked baggage, even though these charges are often not displayed prominently in advertising or in passenger contracts with airlines. It is obvious from the fact that many more bags are being carried onto planes since these changes went into effect (and thereby delaying the departures of planes) that many passengers both know about these new checked bags fees, and they have responded to them. For those who may be ignorant of these fees, Southwest Airlines constantly reminds consumers in their advertising (“bags fly free”) that they are one of the few airlines that do not charge for the first or second checked bags.

This is not to deny that some passengers are ignorant of the separate charges for baggage and food, do not realize that sizable taxes add to the full cost of airline tickets, forgot about frustrations due to long and unpleasant flight delays, and are unaware of other aspects of the full monetary and psychic cost of flying. However, if significant majorities of passengers are reasonably well informed about full prices of tickets and other aspects of the flying experience, their behavior helps protect the ignorant passengers. For airlines usually have to make their pricing and other decisions on what the clear majority of passengers know and respond to since they usually cannot separate the more active customers from the passive ones. If that majority is responsive to charges that are not prominently displayed, to taxes, and other aspects of the total cost and experience of flying, airlines will tend to keep prices and charges lower to all, including the more ignorant flyers.

Competition among airlines may be an even greater protection for uninformed consumers than the behavior of reasonably well-informed and responsive consumers. As Posner indicates, if government regulations impose costs on airlines, ticket prices will tend to rise since airlines have been struggling for decades just to earn a decent return on their capital.

Suppose, to illustrate the effects of competition, that one airline discovers its profits increase when some of the costs to passengers are placed in small print on the passenger ticket contract because enough passengers act as if they are not aware of the costs found in small print. Then other airlines competing for passengers will copy the first airline, and also put these costs in small print. Furthermore, their desire to get more of the now more profitable passenger business will induce them to reduce prices on other dimensions of travel, or add to services, such as providing assigned seats when seats were not previously assigned, or adding individual videos for each seat. The end result will be that competitive pressures that lower prices or increase services to passengers will help compensate passengers who do not recognize the costs in small print, although to be sure they may be only partially compensated.

So I clearly agree with Posner that the new regulations imposed on airlines are mainly a mistake. They add to the costs of airlines and to the costs of flying in the mistaken belief that most consumers are easily tricked by airlines. Beyond that, the regulators fail to see that competition is the most effective way to protect even ignorant consumers from the consequences of their ignorance. The competitiveness of the airline industry is evident from the many new airlines that have entered and existed this industry during the past 30 years, and from the low profits during the decades after deregulation. Encouraging competition in this and other industries is the only really effective way to help the great majority of consumers, including ignorant and easily fooled consumers.

 

How to (and not to) Help Poor Families in Developing Countries Cope with Rising Food Prices-Becker

 

Food prices are on the move once again as the world economy recovers from the financial crisis. The Commodity Research Bureau’s index of the prices of foods- including corn, wheat, steers, and sugar- doubled between 2002 and 2008, fell by 25% during the crisis, and has increased since the world recovery to a level beyond the prior peak.

Higher prices of foods mainly hurt the poor since poor countries and poorer families within a given country spend a much larger fraction of their incomes on foods than do rich countries, and then richer families within a country. For example, the share of national income spent on food is over 40% in India, less than that but still large in China, and under 15% in the United States. If families were spending 40% of their income on food, a 30% increase in food prices would raise by 12% the income they would need to maintain the same level of consumption of all goods. By contrast, a family spending only 15% of its income on food would only need a 4.5% increase in their income to maintain the same consumption basket.

This simple arithmetic explains why the current rapid price increase in foods and other commodities, and past large increases in these prices, often caused great distress among poor families of Africa, Asia, and elsewhere in the world. This distress led to food riots in many countries, and other protests by the poor against the large rise in their cost of living. Governments responded to these protests in various ways that often lowered the cost of food to consumers, but usually at the expense of inducing inefficient behavior by farmers and consumers, and often even at the expense of the poor.

For example, during the current sharp run up in food prices, several food-exporting countries, such as Russia and Ukraine, have banned, or greatly restricted, the ability of farmers to export their produce. This lowers the price of food to urban consumers in these countries, and thereby helps the urban poor. However, such bans reduce the prices received by poor farmers of these countries. This reduces their incentives to raise their production of food, and makes these farmers worse off. It also raises the cost of food to families in food-importing countries, and thereby hurts the poor in these countries. Since farmers in developing countries are generally much poorer than those who live in cities and other urban communities, the poor may overall be made worse off when countries greatly restrict their food exports.

Unlike the situation in rich countries like the United States, city dwellers and other urban populations in developing countries like China and India usually have more political clout than rural families. For example, the massive famines in China during 1958-61 that resulted from the Great Leap Forward were concentrated in rural areas partly because farmers were forced to supply much of their reduced food output to the cities. This greater political power of urban populations also explains the restrictions on food exports in developing countries, even though they discourage food production, reduce the national incomes of these countries, and also overall tend to reduce rather than increase the real incomes of their poor.

To contain the rise in the retail food costs, many countries, including China, have also imposed retail price controls on foods that figure most prominently in the diets of lower income families. This helps those poorer families that are lucky enough to be able to buy most of the food they desire, but such price controls are likely to hurt the majority of poorer families. The reason is that price controls on food prices reduce the incentives of farmers to grow more food since they cannot benefit from what would be higher prices. Artificially lower food prices not only discourage food production but also increase the demand for food. The resulting excess demand for food means that price controls cause food rationing at both the retail and wholesale levels. Richer families tend to gain from this rationing compared to poorer families since they can offer “under the table” payments and other inducements to retailers to give them a disproportionate amount of the limited available food.

Still another common policy in developing nations is to subsidize foods, such as bread and rice, which are important stables in diets of poor families. If implemented appropriately, this approach has the advantage of targeting the goods consumed more by poor families. Yet one weakness of the programs is that they also subsidize middle income and rich families that buy these staples. In addition, they discourage any efforts by consumers to shift some of their food purchases away from bread and other stables that would be rising a lot in prices without these subsidies, and toward other foods that would increase by smaller amounts.

Direct income subsidies are probably the best way to reduce the suffering by poor families due to big increases in food prices that take a sizable share of their total spending. If families below a specified poverty income level received an income supplement, then this level should be indexed to the cost of living by poor families. Especially in poorer nations this means indexing definitions of poverty to the cost of food. An income subsidy approach has the advantage of allowing prices of foods and other goods to be determined by the forces of supply and demand. As a result, it encourages famers to grow more food when food prices rise, and also encourages poor (and other) consumers to reallocate their spending away from foods that rise most in price, and toward other foods and consumer goods.

Commodity Price Inflation—Posner

Becker’s focus is the impact of food price inflation on the poor, and I have no disagreement with his analysis. I want to discuss commodity price inflation in general, and its political consequences, but I want to begin my discussion with Becker’s point about the effect on food policy of the greater political clout of urban than of rural populations. That greater political clout has been a factor in government policies since Rome provided its citizens with free bread. The concentration of population in a city, especially in a nation’s capital, makes urban residents a potential threat to political stability. It does this by facilitating large-scale demonstrations, riots, and other mob action (not only because there are many people to fill the streets, but also because information spreads very rapidly in a city, facilitating the coordination of a large group of people), with consequences—which can include bringing down the government—that we are seeing in the Middle East and North Africa today. Hence it makes political sense for a government to provide more generous food subsidies to urban than to rural residents even though the latter are needier. 

It appears that rapidly rising food prices have been a major factor in the recent and continuing unrest in the Arab countries. As Becker emphasizes, food prices are a big part of the budget of families in poor countries, even of urban residents, with their higher incomes. In fact the demonstrators who brought down the Tunisian and Egyptian governments were complaining vociferously about surging food prices, though they had other serious complaints as well. During the Egyptian crisis Mubarak promised higher subsidies in an (unsuccessful) effort to quell unrest. Other governments in what used to be the Third World will doubtless take the hint, and increase food subsidies particularly for city people, who are far more likely to bring down a regime than rural people; and so the inefficiencies and hardships that Becker points to as consequences of economically unsound food policies are likely to become even greater. 

The broader point is that commodity price inflation has inescapable political consequences. A characteristic of commodity prices is that they can and often do change very rapidly and steeply, and if the commodities are consumer commodities these changes are quickly observed and cause alarm. A notable example is gasoline. Prices of gasoline change rapidly, and like other consumer commodities purchases are frequent, so that the consumer is kept continuously aware of price instability. Prices for food and fuel are excluded from the usual measures of inflation because of their instability, but they contribute to measured inflation (if they continue rising) indirectly because they are inputs into other goods and services, as are many other commodities whose prices have also been rising. The rise in these prices reflects worldwide increases in demand, especially in rapidly growing economies such as those of China, India, and Brazil, and concerns with inflation, against which investment in commodities is a hedge. 

If food prices keep rising, we can expect more unrest in the Third World and slower economic growth. The increased unrest, however, need not diminish long-run economic growth or long-run political stability, if it is the catalyst for the replacement of authoritarian regimes with more-democratic ones—though that can only be a hope, and not a prediction. Rising food prices thus may—or may not—have a silver lining.

Paul Ryan’s Budget Proposal—Posner

Paul D. Ryan, the Republican Congressman who is the chairman of the House of Representatives’ Budget Committee, has proposed an ambitious plan for capping federal expenditures and eventually eliminating, or at least greatly reducing, the national debt. The plan is detailed, and I will omit most of the details. The significance of the plan lies not in its details, or indeed in any of its proposals, but rather in the willingness of a major politician to challenge entitlements spending. This is only part of the plan but it has great symbolic significance, displays political courage, may open a productive dialogue, and challenges President Obama to propose his own plan for limiting such spending, which he has thus far been too timid (or politically realistic!) to do. 

Ryan’s main proposals are as follows: 

1. Repeal Obama’s health-care legislation, but reform health insurance by abolishing favorable tax treatment of employer-provided health insurance and giving everyone a tax credit to assist or enable the purchase of a private health insurance policy. 

2. Replace Medicaid with a subsidy for purchasing private health insurance. Also make it a block-grant program rather than a matching program: that is, each state would get a sum of money allocable to Medicaid beneficiaries, rather than, as at present, the federal government’s matching state expenditures for Medicaid, which reduces the cost to the states of expanding their Medicaid enrollments. 

3. Replace Medicare with a subsidy for purchase of private health insurance. But this provision of the plan would not take effect until 2021; so only persons not yet 55 years old would be affected by it. 

4. Make the Bush tax custs permanent, simplify the income tax, limit the maximum income tax rate for both individuals and corporations to 25 percent, and make up the loss in tax revenues by closing unspecified tax loopholes and imposing a form of VAT (value-added tax)—in effect a sales tax—on businesses. 

5. Freeze discretionary federal spending at 2008 levels for five years. Require the vote of a two-thirds majority in Congress to increase tax rates or impose new taxes, and enact automatic caps on increases in entitlement spending. Health-care entitlements spending would be indexed to the average of the consumer price index and annual increases in the cost of health care. Total federal spending could not exceed 20 percent of GDP, compared to today’s 25 percent, which President Obama hopes to reduce eventually (by unspecified means) to 22 or 23 percent. 

The goal of Ryan’s plan is to reduce federal deficits by $4.4 trillion over the next ten years, and to do so entirely by reducing federal spending (by a total of $6.2 trillion). 

Although there are good ideas in Ryan’s plan, what it really shows is that, barring a miracle, the fiscal condition of the federal government will continue to deteriorate. Even if the plan were enacted in full—a political impossibility—it probably would make only a small contribution to reducing future deficits. 

The annual federal deficit, and therefore the national debt, grows when federal revenues fall short of federal expenditures. Revenues can be increased by higher taxes or by more rapid economic growth, so that the same tax rate produces rapidly increasing revenue; reducing the tax rate can, in some circumstances, actually increase total tax revenues, either by stimulating economic growth or by inducing more reporting of taxable income or the shifting of other income sources to taxable income. For example, reducing the corporate income tax rate would induce American multinational corporations to repatriate more of their foreign profits. 

Alternatively, federal spending can be reduced either directly, or indirectly by reducing demand for federal financial assistance—the hope of health-care reformers. 

In theory the most promising route to narrowing the gap between revenue and expenditure is economic growth, because the economy is much larger than the government. A 5 percent increase in GDP would amount to more than $700 billion; half of $700 billion would equal almost 10 percent of annual federal expenditures (currently about $3.5 trillion a year). Compounding could make aggregate economic growth over a period of years greatly exceed increases in federal expenditures. 

But the Ryan plan would be unlikely to have substantial effects on the rate of economic growth. Judging from the effects of the Bush tax cuts, the Clinton tax increases, and the high rate of growth in the post-World War II decades, in which tax rates were much higher than at present, the modest changes in tax rates proposed in Ryan’s plan would not have a significant net effect on economic growth and hence on taxable revenues, bearing in mind that the stimulus effects of tax cuts are offset to a greater or lesser extent by the direct effects of the cuts in reducing tax revenues. Of course, merely correlating past tax rates with past growth rates is crude empiricism, but my impression of the more sophisticated empirical studies of the effect of tax rates on economic growth is that they are inconclusive with respect to the effect of incremental changes from modest levels. 

I am surprised that the Ryan plan does not propose the outright elimination of the corporate income tax, which might have dramatic effects on the repatriation of foreign earnings of American corporations. The repeal of Obama’s health-care legislation would have a positive effect on economic growth by alleviating the concerns of small business, but probably the effect would be small. 

The effect of the plan on economic growth might actually be negative, if, as is entirely possible, the plan if enacted would actually increase the federal deficit. It would be especially likely to do so over the next decade, when Medicare would be unaffected because the reform of it that the plan proposes would not take effect until 2021. Medicare expenditures would grow uncontrollably over that 10-year period. There would be some Medicaid savings, but probably not too many because Medicaid is already starved for resources. With entitlements largely unaffected over the next decade, to keep spending from rising at current rates would require drastic reductions in nondefense discretionary spending (defense spending cannot be reduced much, because of growing instability abroad). Such reductions are not politically feasible. So the deficit would keep rising at least until 2011, and the long-term fiscal health of the nation would thus be riding on the Medicare reform that would take effect in that year. But ten years from now the percentage of the U.S. population that is 65 years old or older, now 13 percent, is expected to reach 16 percent. That will not only increase the costs of Medicare (quite apart from cost increases owing to technological advances in medical treatment); it will also increase the average age of the elderly population, which will further increase the demand for health care, and—critically—increase the political power of the elderly. On the basis of past voting behavior of elderly people, there seems little prospect that altruism toward their children and grandchildren will curtail narrowly self-interested (one might even say selfish) voting by elderly people to preserve their entitlements. 

As I said at the outset, the fact that a major politician is willing to advocate concrete entitlements reform is promising, but the key compromise that Ryan has made with political realities—deferring his proposed Medicare reforms for a decade—renders the plan economically very questionable. 

Perhaps some politician will be bold enough to advocate that all entitlements programs, including social security as well as Medicare, be means-tested, as Medicaid is. There is no reason why people who can afford to provide for their retirement should be subsidized by the government, which is to say by the taxpayer. But such a reform does not appear to be politically feasible.

Paul Ryan’s Roadmap for America’s Budgetary Future-Becker

 

The recent agreement between the Republican House leadership and President Obama to cut $38.5 billion from the federal budget during the rest of the year is a small step in the right direction of bringing federal spending under control. Since spending skyrocketed during past several years from about 20-22% of GDP to its present level of 25% of GDP, much more has to be done to bring federal spending back to its longer term share of GDP (for a way to approach this problem during next few years, see the Wall Street Journal April 4th op ed “Time for a Budget Game-Changer” by George Shultz, John Taylor, and myself).

A much bigger problem is presented by the expected growth in government spending on medical care and retirements during the next several decades. This growth is the main subject of Representative Paul Ryan’s recently released over 70 page “Roadmap” for entitlement control,and to a lesser extent tax reform. The report also includes cuts in defense spending and domestic discretionary spending that would help in taming the budget during the next half dozen years. Ryan's Roadmap is bold, creative, politically risky, and clearly highly controversial. On the whole, the Roadmap contains excellent proposals that, if enacted, would greatly improve the long-term budgetary situation of the federal government of the United States, and the long-run prospects for the American economy. I will briefly evaluate the main changes in health care spending.

1.     The Roadmap proposes to provide a $2300 health insurance tax credit for individual tax filers, and a $5700 tax credit for joint and family tax filers. This tax credit would substitute for the present tax exclusion of employer provided group health insurance from employees’ taxable income. This is quite close to a proposal made by Senator McCain during his campaign for president.

The present system of tying health insurance to employment through special tax advantages is both expensive and wasteful. It also discourages job turnover by employees because they have to obtain new coverage after changing employers or taking time off from work. Eliminating the tax exclusion of employer health coverage would break the artificial advantage given to employer health insurance compared to other group plans and to individual coverage. My main objection to the plan is that tax credits eliminate an important source of taxable income, so it would be better that the $2300 and $5700 government transfers be tax deductible rather than tax credits. Since individuals and families with low incomes and low marginal income tax rates would benefit little from a tax-deductible transfer, they should be helped through special provisions.

2.     The Roadmap would reform Medicaid for older recipients partly by substituting block grants to the states for the present system of matching state spending on Medicaid. This would force states to pay 100% of their expenditures in excess of their Medicaid grants rather than sharing these additional expenses with the federal government. The Roadmap would provide younger Medicaid recipients with health care debit cards that could be used only to purchase health care services and supplies. Families with incomes below 100% of the official poverty level would receive $5000 into their debit accounts (in addition to the proposed tax credit), while higher income families would receive smaller amounts. Both reforms of Medicaid are in the right direction because they introduce greater incentives to economize on medical spending by states, and by individuals and families on Medicaid.

3.     Medicare is the most rapidly growing entitlement program, and the most difficult to reform of all the entitlements. Unfortunately, to make it more politically acceptable, the reform proposed in the Roadmap will only start after 2021 when 55 year olds today will be 65. It would have been much preferable to have it start in five rather than ten years. Under the Ryan plan, seniors would no longer enroll in a government health care program, but instead they would buy health insurance from private insurance companies that would compete for their business. To help them do this, seniors would receive federal subsidies in amounts that would depend on their incomes. For example, couples with incomes below $160,000 would receive the full standard amount, whereas couple with incomes between $160,000 and $400,000 would receive only half the standard. The standard payment would be the average amount Medicare currently spends per beneficiary, adjusted for health risk, for inflation, and for increases in the medical cost index.

 There are several advantages to these proposals for Medicare compared to the present system. Competition among insurance companies will increase efficiency in the delivery of medical care, and thereby keep costs down. The subsidies will help lower-income seniors afford decent medical coverage, but higher income seniors would have to pay more of their own money for insurance rather than taxpayers’ money. In addition, individuals and families could buy more expensive coverage beyond the basic plans financed by the proposed Medicare grants, but they have to pay for that additional coverage themselves. A major weakness of the American health care system is that out of pocket expenses are such a small percent of total medical spending. This proposal helps to correct that distortion.

The Roadmap has the potential to bring major savings as well as better care to the market for health care. I do not believe that the sizable growth in the fraction of GDP spent on health care in the United States (and also in other countries) has been a waste of money. Both the young and old attach very high value to improvements in the quality of their life, and in their life expectancy. However, substantial efficiencies are certainly available through proper reforms in the health delivery system.

Politicians have been afraid to touch medical care as they call it part of the “third rail” of politics, which would involve monkeying with benefits to the elderly. Representative Ryan and his committee deserve great credit for putting forward a bold and specific plan. It can be improved, but if the main parts were adopted, it would be a big help to reining in long term medical expenses.

 

The NCAA as a Powerful Cartel-Becker

“March Madness” involves a tournament of now 68 top college basketball teams. It culminates tomorrow night in the championship game between upstart Butler and perennial basketball power, the University of Connecticut. The National Collegiate Athletic Association's (NCAA) sanctioned basketball playoffs start in middle of March and attract a large audience in attendance, and additional millions who watch the games on television all over the world. Every year prior to this final tournament, and sometimes even during the tournament, different violations become public of NCAA rules on behavior of players and coaches. Violations of these rules by colleges are to be expected because the rules are basically an attempt by the NCAA to suppress competition among schools for college basketball and football players, the two most lucrative and most watched college sports, and thereby increase the profits to schools from these sports.

The toughest competition for basketball and football players occurs at the Division I level. These sports have both large attendances at games-sometimes, more than 100,000 persons attend college football games- and widespread television coverage. As a result, many Division I schools with big time sports programs get many millions of dollars from their basketball and football programs. Absent the rules enforced by the NCAA, the competition for players would stiffen, especially for the big stars, as they would receive large scholarships and various gifts of cars, housing, and cash to themselves and their families. Payment to players, if competition for players were allowed to operate freely, would severely eat into the profits made by colleges from the big time sports.

To avoid that outcome, the NCAA sharply limits the number of athletic scholarships, and even more importantly, limits the size of the scholarships that schools can offer the best players. NCAA rules also severely restricts the gifts and housing players are allowed to receive from alumni and others, do not allow college players to receive pay for playing for professional teams during summers or even before they attended college, and limits what they can be paid for non-playing summer work. The rules are extremely complicated, and they constitute hundreds of pages that lay out what is permitted in recruiting prospective students, when students have to make binding commitments to attend schools, the need to renew athletic scholarships, the assistance that can be provided to players’ parents, and of course the size of scholarships.

It is impossible for an outsider to look at these rules without concluding that their main aim is to make the NCAA an effective cartel that severely constrains competition among schools for players. The NCAA defends these rules by claiming that their main purpose is to prevent exploitation of student-athletes, to provide a more equitable system of recruitment that enables many colleges to maintain football and basketball programs and actively search for athletes, and to insure that the athletes become students as well as athletes.

Unfortunately for the NCAA, the facts are blatantly inconsistent with these defenses. Consider the recent widely publicized violation of NCAA rules by five Ohio State football players and their coach. The players’ “crime” was that they sold some of their football memorabilia, including signed autographs, for modest sums, and for tattoos. The coach’s “crime” was that he failed to report these violations in a timely fashion. All the players involved, which includes the star of the team, and the very respected coach, will have to miss the first 5 games of the 2011 season. This is almost half of the 12 games played during the regular season. Nothing done by the players involved stolen property or anything else that would violate any laws except those imposed on players by the NCAA.

A large fraction of the Division I players in basketball and football, the two big money sports, are recruited from poor families; many of them are African-Americans from inner cities and rural areas. Every restriction on the size of scholarships that can be given to athletes in these sports usually takes money away from poor athletes and their families, and in effect transfers these resources to richer students in the form of lower tuition and cheaper tickets for games.

That players are recruited as students as well as athletes applies to a considerable extent to Stanford, Duke, Notre Dame, and a few other Division I schools that have high academic standards. The NCAA points out that the overall average graduation rate is about the same for student-athletes as it is for other students. That result also applies to African American and Hispanic students. However, the graduation rates for these minority students-athletes are depressingly low. For example, the average graduation rate of Division I African American basketball and football players appears to be less than 50%.

Some of the top players quit school to play in the NBA or NFL, but that is a tiny fraction of all athletes who dropout. The vast majority dropout either because they use up their sports eligibility before they completed the required number of classes, or they failed to continue to make the teams. Schools usually forget about athletes when they stop competing. An important further difference between athletes and non-athletes who dropout of school is that athletes would have been able to get much better financial support for themselves and their families but for the NCAA restrictions on compensation to athletes. They could have used these additional assets to help them finish school, or to get a better start if they dropped out.

In 1984 the U.S. Supreme Court declared the NCAA’s restrictions on the televising of college football games an illegal conspiracy in violation of the Sherman Antitrust Act. The court said, “good motives alone will not validate an otherwise anticompetitive practice”. Since that decision, the televising of college football and basketball games has rapidly increased. It is time for the court to apply the same valid reasoning to the restrictions on scholarships and other aspects of the competition by colleges for athletes, and to declare these restrictions also a violation of the Sherman Act. Were that done, both student-athletes and schools with greater concern for academic performance of their athletes would gain at the expense of colleges that put athletic competition before academic achievements.

Monopsony in College Athletics—Posner

The most common type of cartel is an agreement among competitors not to sell their product below a fixed price that will generate monopoly profits for the parties to the agreement. But another type of cartel, termed monopsonistic (from the Greek words for “one” and “purchasing of food”) rather than monopolistic (one seller, versus one buyer in a monopsonized market), is an agreement among competitors not to pay more than a fixed price for a key input, such as labor. By agreeing to pay less, the cartel purchases less of the input (and perhaps of lower quality), because less is supplied at the lower price (and suppliers may lower quality to compensate, by reducing their costs, for the lower price they receive). 

The National Collegiate Athletic Association behaves monopsonistically in forbidding its member colleges and universities to pay its athletes. Although cartels, including monopsonistic ones, are generally deemed to be illegal per se under American antitrust law, the NCAA’s monopsonistic behavior has thus far not been successfully challenged. The justification that the NCAA offers—that collegiate athletes are students and would be corrupted by being salaried—coupled with the fact that the members of the NCAA, and the NCAA itself, are formally not-for-profit institutions, have had sufficient appeal to enable the association to continue to impose and enforce its rule against paying student athletes, and a number of subsidiary rules designed to prevent the cheating by cartel members that plagues most cartels. 

As Becker points out, were it not for the monopsonistic rule against paying student athletes, these athletes would be paid; the monopsony transfers wealth from them to their “employers,” the colleges. A further consequence is that college teams are smaller and, more important, of lower quality than they would be if the student athletes were paid. 

One might ask why colleges choose to collude on the student athlete dimension rather than on some other dimension, such as tuition—agreeing to minimum tuition levels, or maximum scholarships. The answer I think lies in my earlier point—the “justification” (specious though it may be) that paying student athletes would corrupt the educational process, an argument that draws on a tradition of admiration for amateurism even in adult athletic competition, as in tennis until 1968. Efforts to fix the price for a college education would encounter sharper antitrust challenges—and indeed the Ivy League schools were forced by antitrust litigation to drop their attempt to limit competition in scholarship aid, a form of price fixing—in effect colluding on tuition discounts, which is what a scholarship is. 

College athletics would be less profitable for colleges if the student athlete market were competitive. If permitted, colleges would continue to agree to limit recruitment of athletes who could not satisfy degree requirements and to require athletes to attend classes and thus be bona fide students, because otherwise competition for the best athletes would tend to eliminate the “student athlete”; college teams would be largely composed of athletes who had no interest in or capacity to obtain a college education; awarding them a degree would be meaningless. The college would be engaged in a business unrelated to its academic mission and would thus have to pay taxes on its teams’ earnings. Worse, alumni donations to their alma mater, which are stimulated by the success of the college’s teams, would wilt if the teams were composed of non-students. If the University of Chicago bought the Chicago Bears, and renamed the team the University of Chicago Bears, would alumni of the University of Chicago write bigger checks to the University? 

For similar reasons, I don’t think eliminating the rule against paying student athletes would result in their being paid actual salaries. The concept of a student who is also a professional athlete would trouble alumni. I expect that instead the student athletes would receive exceptionally generous scholarships—scholarships that would yield more than the full cost of tuition and living expenses. But the sky would not be the limit, since, facing higher labor costs, college teams would be less lucrative. 

A possible legal complication in repealing the rule against athlete salaries would be the salary disparity between male and female college athletes. The only really lucrative college sports are football, a male sport, and men’s basketball. Competitive salaries for college football and basketball players would vastly exceed those for other sports, including women’s sports. Paying lower salaries to women athletes could invite challenges under Title IX of the Education Amendments of 1972, which among other things forbids sex discrimination in education that receives federal subsidies. 

The strongest argument against eliminating the NCAA cartel is that it would make colleges and universities poorer, and this would be a social loss if one assumes (plausibly) that higher education creates external benefits. Of course the government could replace the lost revenues with subsidies financed by taxes. But while monopsony is inefficient, tax increases create distortions similar to those created by monopoly and monopsony.