Wednesday, June 17, 2009

What's the objective function? 

When you teach a graduate course in price theory, you typically are teaching solutions to a "constrained optimization" problem. �Thus the calculus along with Lagrangean multipliers and all that. �Those who think there's too much math in economics don't deny that this is the problem; they only think that forcing the problem into a calculus form oversimplifies and ignores some real, important issues.

All would agree that part of the problem has to be an agreement on what it is you are trying to maximize or minimize. �You are either maximizing profits subject to some constraints on cost or quantity of inputs, or you are minimizing cost subject to some level of output. �We believe people make decisions this way even if they can't write a function down on paper. �They're impelled to do so by the never-ending quest for more. �

I got to thinking about this today after reading Megan McArdle's important post on health care costs being the Laffer Curve of the Left. �In doing so she takes a shot at the original Laffer curve:
It is also true that some countries have cut marginal tax rates, and thereby actually raised the tax revenue they collected. For all the derision about the Laffer Curve, it is absolutely correct--indeed, it has to be; it's basically just an identity. Tax revenues peak somewhere. If you're to the right of that peak, you could raise revenue by lowering rates.

What's left is the empirical question: are we to the right of that peak? Empirical answer: no we are not. It was not unreasonable for Ronald Reagan to believe that we might be, since the world didn't have all that much experience with lowering 70-90% marginal tax rates.
But notice what she's maximizing: Tax revenues. Why on earth would we want to do that? What I am interested in is a tax system that maximizes economic growth, not revenue. �The growth-maximizing tax rate is, we can pretty easily show, below the revenue-maximizing tax rate (I know I had seen this in a seminar at Claremont many years ago, I think by James Buchanan.) �If I could cut marginal tax rates by 10% and increase the long-run growth rate of per capita GDP from 1% to 2%, that's a great increase (living standards would double in America every 35 years rather than every 70). �If the deficit rises from the tax cut and I could cut spending to rebalance without damaging that long-term rate, I've maximized the right thing.

So let's turn to health care. �The entire debate is framed, as McArdle does, on health care costs. �The New York Times reported yesterday that Obama is emphasizing cost minimization:
The president�s emphasis on reducing health care costs over expanding insurance coverage, which dates to his campaign, reverses Democrats� priorities of recent years. Obama advisers say the focus on cost savings has appeal for all Americans, not just the uninsured. Some advisers, including veterans of the Clinton administration, say President Bill Clinton�s emphasis on covering the uninsured helped doom his health care plan in 1994.

�We have made cost control a coequal objective, just as important as the expansion of insurance coverage, which has traditionally been the dominant goal for Democrats,� said Rahm Emanuel, the White House chief of staff. �The entire discussion has to be centered on controlling or reducing costs.�
McArdle takes this thinking to task:
�We have been trying to control health care costs since the 1970s made it clear that Medicare was going to get really, really expensive. And any idea that you care to name, from comparative effectiveness research to healthcare IT to preventive medicine . . . these have all been on the table for more than thirty years, under one name or another. They haven't happened.
But it's asking still the wrong question. If we minimize cost of health care, what is being held constant? The quantity of health care. There is no other way to do this; all choices on scarce goods involve competing claims only some of which will be fulfilled. You cannot simultaneous reduce cost and increase quantity. �And what do we want from health care if not maximize health for the most people? �Sure, you still have the aggregation problem of whose health, how do you make the interpersonal comparisons, but that is a problem in every public policy question we try to answer. �

There needs to be a reframing of the health debate. �Conservative solutions should run away from cost minimization because it necessarily involves controlling the level of health people can have. �That should be abhorrent to them. � �Instead ask: what system maximizes health of the citizens, properly measured.

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