Price theory is going to be a central basis of most of what I write on healthcare economics — and is a key source of error on the part of policymakers and voters alike — so I’ll take a few moments to discuss how we arrive at prices in general.
First, a quiz. Let’s say I’m planning to buy transportation in the near future. These are the vehicles I’m thinking about buying, in order of preference:
- A Porsche.
- A Prius.
- A Harley-Davidson motorcycle.
- A Vespa scooter.
- A bicycle.
Assume the price of a Porsche is $80,000. How much should I pay for the Harley-Davidson?
- a. $48,000
- b. $79,998
- c. $14,606.25
- d. It’s none of your business
If you chose:
a. Nope; that’s an illegal operation. Don’t confuse ordinal numbers with continuous variables. Harley does not equal 3; it’s just third on my list.
b: That’ll get you an A in business school, if you live in the United States. And there’s an element of truth in it. Consumers always have an alternative in mind; if you know what that alternative might be, you have valuable information you can use to maximize your asking price. You’re still wrong, because the consumer may well be comparing apples to oranges. If oranges get too expensive, eventually he’s going to settle for apples. Or maybe buy some socks, or maybe not spend any money at all.
c: That’ll get you an A+ in business school, if you live in North Korea. This is the Labor Theory of Value, in which you figure the bike contains about $3000 of raw materials, 750 hours of labor at $15 (because that’s a living wage — no more than that, because motorcycles aren’t necessary) plus factory profit at the prime rate of 2.5%. There’s an element of truth in that, and your estimate is pretty close to what Harley’s sell for in real life. Because most businesses are labor-intensive, the selling price — if there is a sale at all — will correlate with the labor price in many industries. That’s a big “if” however. You can’t force people to pay more than they are willing to pay, and you can’t force someone to build products at a rate of return lower than they are willing to take. It’s also kind of stupid for producers to leave money on the table.
d: is the correct answer. The price of anything is what a consumer is willing to pay to get it. If there’s going to be a sale at all.
When a producer and a buyer agree on a price, in some respects they are bearing equal costs. In the case of the producer, he or she will establish the absolutely lowest price they are willing to sell the next unit of production, and then offer at a price somewhat above that. The consumer has a vague idea of the maximum amount her or she is willing to pay for the next unit of production, and will bid somewhat below that. If the bid/ask spread isn’t too wide, there’s a good chance a sale will happen. Note, every sale will be at a different price. But if there are enough sales, we can start looking for an average price. We can call that the “market price.”
In both cases, the producer and the consumer are dealing with a special kind of cost called “opportunity cost.” For the consumer, that’s a measure of what he or she has to give up or forego to get the product. For the producer, it’s a measure of the point at which he or she decides to do something else with their money. So, in an open market, we can say that a price is struck when the opportunity cost to the producer is equal to the customer’s opportunity cost.
The tricky thing about healthcare is, insurance or government acts as an intermediary between producers and consumers. They pay producers one thing, and charge consumers something else entirely. So in health care, the producer and the consumer may have radically different opportunity costs.
Next up: the market-clearing price