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PROFESSOR: We began our
discussion by talking about
how society would choose
across different income
distributions, which involve
the trade-off between
preferences for more equal
distribution of income and the
efficiency cost of transferring
income through
both taxation and welfare
programs. We then moved on to
talk about what the government
does in practice in terms of
taxation and income
redistribution.
What we're going to do today is
actually recognize that, in
fact, most of government
spending, most of what we
raise taxes for is not pure
income redistribution.
We talked about things like the
TANF program, which gives
money to single mothers, or the
SSI program, which gives
money to disabled people.
That's not most of what the
government raises money for.
In fact, 95% of the transfers
that the government makes are
not income based transfers.
They're transfers of what we
call social insurance.
So most of what the government
does today is not take from
the rich and give to the poor.
Most of what the government
does today is take from
everyone to provide insurance
for everyone.
Now basically, we talked in the
uncertainty lecture about
why people would value
insurance.
So essentially we think about
people choosing across states
of nature like they're choosing
across goods.
Then they will want to optimize
across those states,
hit by a car versus not hit by
a car, the way they optimize
across goods like
CDs and movies.
And we said the way they
optimize across states is by
buying insurance.
That's the way you essentially
transfer resources from the
state where something goes
bad to the state
where something goes--
I'm sorry, from the state where
something goes good to
the state where it goes bad.
The way you effect that
transfer, effectively, is by
paying insurers when things go
good and getting from insurers
when things go bad.
That's insurance, and insurance
is an enormous share
of the US economy.
Currently, US as a whole spends
about $2 trillion a
year on insuring ourselves
against adverse risks of
various types.
There's health insurance, which
is money we pay up front
to insurers, and they cover our
medical costs should we
get sick or become injured.
There's disability insurance,
which is money that you pay in
the form of taxation, and the
government uses that money to
give you a benefit should
you become disabled.
There's unemployment
insurance.
We know about that.
Unemployment insurance is money
that your employer pays
in taxes, and in return, should
you lose your job due
to a layoff you receive income
when you're laid off.
That's certainly a topic
of much conversation
these days, et cetera.
So there are a number of social
insurance programs that
are out there to help
individuals with the adverse
risks they face.
The big question we have to ask
in starting this lecture
is, well, why does social
insurance exist?
After all, there's actually
an enormous robust private
insurance market.
There's health insurance,
there's life insurance,
there's casualty insurance.
The private market insures
us for lots of risks.
The question is why does the
government come in and also
provide us this social
insurance?
So we individuals will demand
insurance for risk.
We know private insurance exists
for things like health
insurance, life insurance, fire
insurance, auto insurance.
We know it exists, and that adds
up to about $2 trillion
of private spending.
Yet at the same time the
government also provides on
the order of another trillion
dollars of social insurance
spending every year for things
like health insurance, and
disability, and other things.
So the issue is why does the
government need to do that?
Why does the government
need to roll
in and provide insurance?
We know individuals want it.
We know a private market exists
that provides it.
What's the market failure
that justifies a
government role here?
Think about the role of the
government in the economy--
and this is a very small
part of this course--
but the focus of the other
course I teach, 14.41.
The basic question is in this
course we've largely learned
the governments serves to screw
up the market if the
market's working well.
The only time the government
can help is if there's a
market failure, if
there's something
wrong with the market.
Well in this case, what could
the market failure be?
And the market failure, in the
context of insurance, is the
problem of asymmetric
information.
Asymmetric information,
information that is held
differentially between parties
on either side of a
transaction.
And that when there's asymmetric
information, when
different parties know different
amounts about a
transaction, that can lead
to market failures.
So the classic example of this
comes from the Nobel Prize
winning economist
George Akerlof.
It's called the lemons
problem.
The lemons problem is,
basically, he did the example
of the used car market.
Imagine you've got a used car
market, which is a set of
individuals who want to sell
their cars and a set of
individuals who want
to buy those cars.
And let's start with the full
information benchmark.
Let's imagine there was perfect
information about the
exact quality of every car.
Imagine there was some test
you could do which would
perfectly tell you exactly how
long the car is going to last,
how well it's going
to run, et cetera.
In that world there will be
a set of transactions.
Some individuals will want to
sell their cars because they
want to buy up, other individual
will be happy to
pay that price, there will
be a set of transactions.
Now imagine we go to the real
world, especially a real world
when Akerlof wrote his article
in the '70s when, basically,
if you went to buy a used car
you had to look at it and
decide does it look OK.
There's clearly asymmetric
information.
Clearly the seller of the car
knows much more about its
underlying qualities than
the buyer of the car.
And in particular, the buyer
should be suspicious saying,
wait a second, why are
you selling this car?
If it's such a good car why
are you selling it?
And the very fact that I see
you selling it makes me
suspicious that something's
wrong with it.
Given that I'm suspicious
something's wrong with it I'm
going to be willing to pay less
for it than I would if I
knew for sure it was OK.
The fact that I don't have full
information as a buyer
means that I'm going to pay less
for it than I would if I
had full information.
Well if I'm going to pay less
for it but the seller has a
certain amount he's willing to
sell it at, the seller will
say, well, I'm not going to
sell it to you for less.
I have a certain supply curve
at which I want to sell.
If I can get x for the car I'll
sell it, but if you're
not going to pay me x I'm
not going to sell it.
So the sale doesn't happen.
So what you have is a car where
in a full information
world a sale would happen, both
parties would be happy
with that sale.
But in an asymmetric information
world, since the
first party, since the buyer's
suspicious of the quality and
is therefore willing to pay
less, and the seller won't
accept less the sale
doesn't happen.
And that's a market failure.
Relative to the 14.01 world we
started with, where everybody
knows everything, where there's
full information, the
market has failed because sales
which would make both
parties better off do not
occur due to asymmetric
information.
So that is an example of the
market failure caused by
asymmetric information.
Now let's flip this around
and talk about insurance.
In insurance it's the
opposite case.
In insurance, I, the person
demanding the insurance, know
more about me than the insurers
who's selling me insurance.
I know whether I'm someone who
gets sick a lot, whether I
like skydiving, whether I
engage in other risky
behaviors that may have health
problems for me, whether I am
someone who smokes in bed so I'm
likely to catch my house
on fire so that I really want
house insurance because I'm
going to catch my house
on fire, et cetera.
I know all that stuff about
me, the insurer doesn't.
So the insurer, as a result,
might be unwilling to sell me
insurance at a fair price.
So to put this in numbers, let's
consider an example.
Imagine that you are starting up
a health insurance program
for MIT graduates.
You want to say look, MIT
graduates are a pretty healthy
lot, and so I'm going to start
up a health insurance program
for MIT graduates.
I'm going to make money since
they're basically pretty
healthy, but they're
risk averse so they
will buy the insurance.
So imagine the facts
are the following.
Imagine that for every for every
100 MIT graduates, over
the next year, 90 of them will
spend nothing on medical care,
and 10 of them will
spend $1,000.
But we don't know which ones,
there's uncertainty.
So I'm left with this
90% chance of zero,
10% chance of $1,000.
So everybody graduating, since
we're a pretty healthy crop,
90% of you will spend nothing
but 10% of you will spend
$1,000, and you don't
know which.
And you're going to start
an insurance.
You could say look, I'm going
to start an insurance.
What I'm going to do is I'm
going to say is what's the
expected payout that I'm going
to have as an insurer
over the next year?
Well, the expected payout over
the next year is $10,000
total, right?
And let's say there's
100 students you are
going to sell to.
The expected payout the next
year is $10,000 total.
10 students will cost you $1,000
nine students will cost
you nothing.
Expected payout next year is
$10,000, or per student you're
selling to the expected
payout is $100.
Right?
Have I got that right?
Yeah.
$100 per student you're
selling to.
So if you sell to 100 students
at $100 you will break even.
You will collect $10,000
at an expectation
you'll pay out $10,000.
So if you roll in and offer
insurance for $100 and you
sell to all these students
then you'll break even.
Let's say you then said
fine, I'm going to
offer it for $110.
Well, as long as people are
somewhat risk averse, in our
standard model they'd still
like insurance for $110.
They'd still be willing to pay
a little risk premium--
remember about risk premiums
to get health insurance.
So you still sell it, let's
say, and you make $1,000.
Then you're going to sell to
100 students at 10 extra
dollars to make $1,000 profit.
So this is a pretty
good product.
I'll make a $1,000
profit on this.
Now, what's in fact the problem
with this analysis?
The problem is that what
if some of the
healthy guys say, look--
what if people know whether
they're healthy or sick?
What if it's not uncertain?
Or what if people have
a good inkling?
What if, in fact, half of the 90
people who will spend zero,
what if 50 of them actually
know they're
going to spend zero?
What if, in fact, the
story is different?
It's not totally uncertain,
but 50 people know they're
going to spend zero.
They're really healthy and they
don't like the doctor,
they know they're going
to spend zero.
Whereas the other 50, well, 40
of them might spend zero and
10 might spend $1,000.
Well in that case, the 50 that
knows they're going to spend
zero won't buy the
health insurance.
They'll be like why
should I buy it?
I know I'm going to spend zero,
why should I pay $100 or
$110 dollars for health
insurance?
So then, how much
will you sell?
And let's say you charge
$110 to make a profit.
You'll sell to 40
guys, 40 healthy
guys, and 10 sick guys.
So 50 guys times $110, so
you'll make $5,500.
What will you pay out?
You'll pay out $10,000 because
the 10 sick guys are
definitely buying, right?
The 10 guys who'll end up
getting sick are definitely
buying along with
40 healthy guys.
So you will collect $5,500 but
you'll pay out $10,000.
You'll lose money.
Why will you lose money?
You'll lose money because you'll
be collecting as if
you're dealing with a full
probability distribution but
you're only going to see
a truncated probability
distribution.
You're only going to see the
distribution for the people
who have some chance
of getting sick.
The very healthy people
drop out.
As a result you lose money.
This is the insurer problem.
If the healthiest people don't
buy insurance then they can't
price it fairly.
How would you overcome this?
Well, you would have to raise
your price a lot, right?
So let's say you say fine, I'm
going to overcome this.
If I raise my price to
$200 or to $210 then
I'd make money again.
If I raise my price
$210 that's 50
people buying at $210.
Then I get $11,000 in premiums
and I don't have to spend
$10,000, and I make
money again.
What's the problem with
that solution?
Yeah?
AUDIENCE: People will
probably be dropping
out because you just--
PROFESSOR: Some of these 40 will
say, well, I was happy to
pay $100 but I'm not
happy to pay $200.
The chances are really low
I'm going to get sick.
So this goes down.
So you collect less money
but you still pay
out to the sick people.
And you never win.
You can never win.
As you raise the price the
healthier and healthier people
drop out until you just simply
can't make money.
Yeah?
AUDIENCE: Is there any situation
where if you have a
large enough number of people
that you're supplying to you
can set the price at a certain
level such that you're
guaranteed that there are at
least going to be a large
number of people left after
dropping out so that you won't
lose money?
PROFESSOR: Yes, and what's
that going to depend on?
So one extreme example is what
I've described here, where as
you raise the price more healthy
drop out and so you
can never make money.
Under what conditions will that
be a particular problem
or not be a problem?
Well there's two key factors.
First of all, it's going
to be how imperfect
the information is.
For example, if people know for
sure whether they're going
to be in the zero bucket or
the $1,000 bucket then by
definition you can't
make money.
If you know for sure, with 100%
certainty, then why would
you ever buy insurance unless
you're going to be in the
$1,000 bucket?
And why would you ever pay
more than $1,000 for it?
So there's no way to make money
if people know for sure.
So the first thing is where
nobody has any idea at all.
Then this is going to be less
of a problem because healthy
people won't drop out because
nobody knows who's healthy.
So the first issue is going to
be the asymmetry of your
information.
The second factors is
going to be what?
The level of risk aversion,
because if people are very
risk averse then they may be
willing to pay a lot for
insurance even if the odds are
low it's going to hurt them.
So in this case, once again if
people know for sure, risk
aversion doesn't matter.
But if people don't know for
sure, if there's some
uncertainty, then you may get
healthy people buying health
insurance because they're
risk averse.
They may buy it anyway, and
so then you may not
have a market failure.
So basically, the more asymmetry
of information there
is the more likely you're
going to lose money?
What happens if you're
going to lose money?
You're not going to start your
insurance company and MIT
students will end
up uninsured.
That's a market failure.
The market for insurance will
fail, the market for insurance
will fail because you will
end up not being
able to make money.
You're not going to be able to
make money because only the
sickest people will buy, and
you lose by definition.
That's the problem that we have
with private insurance.
If the healthiest people stay
out, then the insurer can't
make money.
The insurers need a distribution
of healthy and
sick to make money, they
can't make money if the
healthy stay out.
So what can we do about this?
What can we do about this?
Well there's two classes of
solutions we can have. The
first is we can subsidize.
Imagine if we said, we MIT, will
roll in and provide the
insurance for free
to everyone.
And then we'll pay the insurer
what they want.
So MIT will come in, they'll
absorb the cost of the insurer
and give it to MIT students
for free.
Well, in that case all the MIT
students would take it, it
would be free, and the insurer
could charge $100 or $110
based on the negotiation
with MIT.
And the insurer will provide the
insurance because everyone
would take it.
And MIT would just
pay the cost.
So the market failure would be
solved, but of course at a
cost of MIT having to pay
$10,000 or $11,000, or
whatever it's going to be.
So the market failure would be
solved by subsidizing the
healthy people to come in.
So essentially, if you pay off
the best risks to come in the
market you solve the market
failure because then the
insurer knows they're getting a
good distribution of risks.
What's the other thing
you can do?
Well the other thing you can do
is the centerpiece of the
current health care reform bill,
which I'll talk about
next time, which is you can
mandate that everyone buy
health insurance.
If there was a law that every
MIT student had to have health
insurance when they graduate
then, once again, the insurer
would know what the distribution
of risks are and
they could sell insurance
at a fair price.
They wouldn't have to worry if
the healthy drop out because
the healthy couldn't,
it would be illegal.
Now, these two solutions--
so you can subsidize
or you can mandate.
Now these solutions--
Yeah?
AUDIENCE: Weren't a lot of
health insurance companies
also looking at medical
records of
people before deciding--
were they unequally pricing
health care based
on someone's history?
And I know that caused a lot
of controversy say over
pre-existing conditions.
PROFESSOR: Yeah.
Let me talk about
that next time.
What you're asking is isn't it
in fact possible asymmetric
information could flip?
Isn't it possible insurers could
now know so much about
us from public records that they
could start to have more
information about us than we
even have about ourselves?
And then they could decide to
get rid of us because they
know we're a bad risk even
if we don't know.
So could we be soon living in a
world of reverse asymmetric
information?
And that's possible, and I'll
talk about that next time.
But for now let's assume we live
in a world where you know
more than the insurer.
So you can subsidize the guys,
you can mandate it.
Now each of these have
pros and cons.
If you subsidize them then the
MIT students are happy.
They get insurance for free,
but MIT is out $10,000.
Or if it's the government,
the government's
out a lot of money.
How does the government
raise that money?
It taxes people, and that
has efficiency costs.
So one thing we could
do is make health
insurance free for everyone.
That's what Canada does.
Health insurance is
free for everyone.
And the problem is to do that in
the US would cost something
like a couple of trillion
dollars.
That's a lot of money
to raise in taxes.
And that would cause
inefficiency from raising that
money in taxes.
On the other hand the
mandate doesn't cost
the government anything.
But it makes healthy people very
upset because suddenly
you're an MIT student, you know
for sure you're not going
to spend zero but the government
mandates you have
to pay that $100 premium.
Well now you're upset.
So basically there's no good
answer here to solve this
asymmetric information
problem.
Either we have to spend a lot
of money and then people
aren't upset but
taxpayers are.
Insurers aren't but
taxpayers are.
Or we have to mandate people
to buy, in which case the
healthy will be upset they're
being forced to buy something
they don't want.
And that's the difficult
position we face ourselves in
with social insurance
programs.
But the bottom line is what
we have is this failure of
private insurance markets due to
asymmetric information and
the need for the government to
come in and take one or both
of these routes to
fix the problem.
If the government doesn't then
you don't get people getting
insurance that they'd
like to have. You
get a market failure.
You get a market failure in
people not having insurance
that they would value.
And that's why we have
governments come in and
provide social insurance.
Now, as I said, the government
comes in and provide many
types of social insurance
of many types.
There's medical social
insurance, and here the
government does that through the
form of what we call two
programs, Medicare
and Medicaid.
Medicare is universal, heavily
subsidized health insurance
for the elderly.
Medicaid is like a
welfare program.
It's means tested, categorical,
free health
insurance for the poor.
So Medicare's for the elderly,
Medicaid's for the poor.
In neither case is there a
mandate, in both cases the
government, essentially,
is making it free.
Essentially it's gone the
subsidy route, as a result at
an enormous cost to
the US taxpayer.
Medicare is now about a $500
billion a year program.
Medicaid is approaching a $400
billion a year program.
It's almost a trillion dollars
US taxpayers are paying to get
people to buy health
insurance.
So by solving it with this route
these are incredibly,
especially Medicare is an
incredibly politically popular
program because why not?
People are getting
it for free.
But the cost is an enormous
budgetary pressure on the US
government.
That's for health.
We also have disability
insurance, DI.
That's for people who have
a career-ending injury.
If you fall off your motorcycle
and get paralyzed
and can't work anymore you can
get disability insurance,
which is money which compensates
you for being
unable to work having a
career-ending injury.
So this is another form
of social insurance.
We have workers' compensation,
which is insurance that you
have to insure yourself against
injuries on the job.
So if you slip and fall on the
job and have to miss a couple
weeks of work this covers
your medical costs
and your lost wages.
And we have unemployment
insurance, which as I
mentioned, is insurance for
people who lose their jobs due
to economic circumstances.
Unemployment insurance is not
for people who get fired
because they're crappy
workers.
It's for people who lose their
job because they're laid off
for economic circumstances.
They get some replacement of
wages under that unemployment
insurance programs.
These are the kind of social
insurance programs that we
have in the US.
And the arguments for them is
basically more complicated
version of the arguments
I just made over there.
The argument for all these
programs is that private
insurance markets for things
like unemployment or injury
will not function well due to
asymmetric information so the
government needs to come in and
provide that insurance.
But at the same time all of
these insurance programs have
a cost. Not just the cost of
raising the money but the cost
of what we call moral hazard,
which is that when you insure
people against adverse risk you
encourage adverse behavior.
When you insure people against
adverse risk you encourage
adverse behavior.
And the problem here is another
form of asymmetric
information.
So one problem of asymmetric
information is since insurers
don't know enough about you
they'll under insure you.
So it's a market failure.
This is a flip side market
failure, which is since
insurers can't perfectly be sure
about what's wrong with
you, you will be encouraged to
misrepresent your state in
order to collect money.
So a classic example
here is workers'
compensation insurance.
Workers' compensation insurance
is about a $50
billion a year program that
provides money to people who
are injured on the job.
The problem is injured on the
job is very hard to verify.
Most of the injuries are
not losing an arm.
Most of the injuries are
straining your back.
As anyone with back problems
knows it's pretty darn hard to
verify if your back's
hurt or not.
My first job in my first summer
after MIT was I was a
filing clerk at a
doctor's office.
The doctor did workers' comp--
this is a real story.
Doctors do workers' comp claims.
It was one doctor with
a staff of five secretaries and
an enormous filing staff.
And the reason was the doctor
saw a patient every three
minutes all day.
They'd come in, he'd say, yeah,
you're hurt, here's your
chit for workers' comp,
off you go.
All day.
So basically, because it's
incredibly hard to verify,
this doctor was just-- basically
his role was saying
yes to people so they could
get out of work.
This is the problem we
have with a system--
this is another information
asymmetry, which is now you,
the insured, know more about
what's wrong with you than the
insurer does.
But it's a different form of
information asymmetry.
Now it's that you may actually
not be as injured as you claim
or need insurance
as you claim.
As a result you over claim
insurance, and that costs the
insurance industry money.
Now, moral hazard,
theoretically, is unambiguous.
But obviously it's going to
vary across situations.
There's not going to be a whole
lot of moral hazard in
programs that insure you
against blindness.
And in that case that's because
it's pretty easy to
observe if someone's
really blind.
There's not a whole lot of
information asymmetry.
There's going to be a lot of
moral hazard in programs that
insure you against having a bad
back because that's harder
to observe.
And in fact we have lots of
evidence that moral hazard's a
big problem with social
insurance programs. So one
type of evidence is sort
of fun stories.
So there's stories about, for
example, the Massachusetts
prison guard who got about
$25,000 in workers' comp
claims because he claimed he
hurt his back at work until
people went online in order to
see that the same guy was
running a karate school.
And there was videos of him
doing karate moves and stuff
online running his
karate school.
Or the other guy, who
unfortunately had good
instincts, he was on workers'
comp because he was injured.
But then there was footage of
him at 9/11 flying down and
carrying buckets back and forth
and helping put out the
fire, which was a nice thing
for him to do, but clearly
illustrated that he was not
too injured to be able to
carry out his job.
So basically, there's lots of
observational evidence.
But there's also very clear
statistical evidence, which is
if moral hazard doesn't exist
then when the program gets
more generous I shouldn't
be more injured, right?
My injury should be
something that
happens or doesn't happen.
But if more generous programs
lead to more injuries, or
people staying out of work
longer, or people using more
health care then that suggests
moral hazard.
The generosity, whether you're
sick or not, shouldn't be
affected by the generosity
of health insurance.
But if you suddenly see more
generous health insurance
leads to more people
being sick that
suggests moral hazard.
And there's hundreds of studies
of this type showing,
in all these realms, enormous
moral hazard.
Showing, for example, for
workers' comp, that when you
make workers' comp more generous
people report more
injuries on the job.
Here's my favorite
fact about that.
Someone did a study of type of
injury reported to workers'
comp by day of the week.
And what they found was on
Mondays compared to other days
of the week there was a very
high share of sprains and
strains and a low share of
lacerations, of cuts.
So every other day of the week,
say it was 50% cuts and
50% strains.
On Monday it was 75% strains
and 25% cuts.
Why is that?
Well, that's because guys got
hurt over the weekend playing
softball and they came in on
Monday and they said they got
hurt on the job.
Now you can't do that if you cut
yourself on the weekend in
your shop because it's scabbed
over by Monday.
But if you hurt your back on
the weekend you can drag
yourself over and say, ooh,
I hurt my back at work.
So that's exactly the kind of
evidence that's consistent
with moral hazard.
And we see that everywhere.
There's huge amounts
of moral hazard.
Moral hazard, for example, in
health insurance the best
estimates are that the amount
of extra money that we spend
on society on health care
because of moral hazard on the
order of $500 billion a year in
terms of extra care that's
used because people
are insured.
That does nothing to improve
their health, they just use it
because they're insured.
It's on the order of $500
billion a year.
This is an enormous problem.
So here we have what we call
the classic social
insurance trade off.
On the one hand, people
value insurance.
Insurance is very valuable to
help you in the state when you
get in an accident or are
injured in some way.
On the other hand, giving people
insurance against those
bad outcomes will encourage
bad behavior.
And that bad behavior has
two forms of costs.
There's two costs to
that bad behavior.
The first cost is the tax costs
and the deadweight loss
of taxation, which is if there's
$500 billion extra in
medical care used because people
are insured then that
means that's $500 billion of
taxes we have to raise, or
$500 billion in resource
costs to society.
Well, not all that's
government.
But a couple hundred billion
in taxes we have to raise,
that causes deadweight loss.
The more important cost is
really the overall efficiency
loss from people using resources
inefficiently, from
people not behaving optimally
because of the incentives of
social insurance.
So let's go back and think about
the case of workers'
comp, and let's think about
our standard leisure
consumption trade off.
We have our standard leisure
consumption trade off where
you have leisure on this axis,
consumption on this axis, some
budget constraint, and people
choose how much leisure to
take and how much consumption
to take.
Now the slope of this budget
constraint is minus your wage.
That's the price of leisure.
So the price of sitting at home
is the wage you could
have earned out in the market.
What this means is you will sit
at home until the value
you get from sitting at home
falls below the value you get
out in the market.
So in other words, you wouldn't
work 24 hours a day
because that 24th hour, the
sleep would be so valuable
that it would clearly exceed
the wage you could earn.
So when you decide how hard to
work, when an individual
decides how--
presuming we can freely
choose our hours--
we decide how hard to work, we
basically trade off how much
we value not working versus
how much we'd
earn if we do work.
If you're in a high wage you
might work more hours, if
you're in a low wage you'll earn
less because if you're in
a low wage you might as well sit
at home and watch Oprah.
If you earn a high wage you're
not going to watch Oprah
you're going to go
earn the money.
And that's how we make our
labor supply decisions.
We set the wage equal to the
marginal value of leisure.
That's how we make our labor
decisions, is we say if the
marginal value of the next hour
of leisure exceeds my
wage I'll stay home.
If the marginal value of the
next hour of leisure is below
my wage I'll going to work.
And that's how we make our
labor supply decisions.
What does workers' comp do
to this, or UI or other
programs like that?
What that says is wait a second,
now if I sit at home I
don't just get the marginal
value of my leisure, I also
get a check from
the government.
So now if I sit at home I get
the marginal value of my
leisure plus a workers'
comp check.
Whereas if I work I still
just get my wage.
So what's that going to do to
the amount of hours I'm going
to want to work?
It's going to reduce them
because now it's makes sitting
at home more attractive because
now I'm going to work
only until my wage exceeds my
marginal value of leisure plus
workers' comp.
So if workers' comp is big
enough and my wage isn't that
high, in the limit, if workers
comp replaced all my wages I
would never work.
If workers' comp had what we
call a 100% replacement rate,
replacement rate, if it replaced
100% of my wages I
would never work.
Why?
Because by definition this side
would always be less than
this side, so I'd never work.
And that's the efficiency loss
of these social insurance
programs. That people are not
engaging in productive trades.
Society just cares
about this part.
Society just cares about your
wage versus your marginal
value of leisure.
So if you work less than that
because of this part then
that's a distortion, that's an
efficiency cost to society.
You are sitting at home when
you should be making a
productive trade of your
labor for output goods.
And that's the efficiency cost
of social insurance.
So what do we do?
We want social insurance, on the
one hand, because private
insurance markets fail.
We don't want social insurance,
on the other hand,
because people are going
to sit at home.
What do we do?
Well the answer is
we compromise.
We have social insurance but
don't make it that generous.
So for example, the unemployment
insurance
program, that's insurance that
is valuable because there's no
way to get private insurance
against losing your job.
I'd never want to sell
that product.
We know who'd take
that, right?
On the other hand, we know
there's moral hazard.
We know that people sit at home
longer rather looking for
a job because they
get UI checks.
There's great evidence
of that.
For example, if you look at how
long people sit at home,
everyone sits at home and then
suddenly gets a job the week
UI runs out.
That's an exaggeration, but
roughly speaking, there's a
huge amount of people
sitting at home
collecting the UI checks.
What do we do?
Well the UI replacement
rate is around 50%.
We say, look, we know you're
going to want to sit home so
we're going to make your
life uncomfortable.
We'll only give you half of what
you'd earn at work, but
we don't want you to starve so
we'll give you half of what
you earn at work.
And so the replacement rate
is chosen to trade off the
benefits of insuring people
against these bad events
against the costs of distorting
their behavior
through moral hazard.
And that's the social
insurance trade off.
That's how we set up these
social insurance programs.
They sort of embody
that trade off.
Questions about that?
Now, so what I want to do in the
remaining time is I want
to talk about the nation's
largest single social
insurance program, one you've
heard about a lot, which is
Social Security.
We're going to talk about
Social Security.
I'm going to come back next
lecture and we'll go over a
bit what's going to be on
the final in the last 15
minutes next time.
But the first part of the
lecture I want to talk about
health insurance, which is our
single largest government
expenditure.
But the single biggest
government program right now,
social insurance program, it
remains Social Security.
Medicare is going to pass it
in about two years, but for
now it's still Social
Security.
What is Social Security?
Social Security is insurance
against the income loss from
retirement.
We know that when you have to
retire you're going to suffer
a big income loss.
What the government does is
insures you against that
income loss by providing
you Social Security.
And here's how it works.
How many of you have seen a pay
stub and you've seen the
word FICA on it, and then
there's a charge that's coming
out of your pay?
FICA is the Federal Insurance
Contribution Amount.
That's the money you're paying
in to support the social
insurance program.
You pay that in, and that's
currently 12.4% of wages, well
6.2% on you and 6.2%
on your employer.
You each pay 6.2%
of your wages.
That goes into a trust fund and
that money then gets paid
out to retirees, and hopefully
paid out to
you when you retire.
So the way Social Security works
is you pay in money when
you're young, that money
gets paid out to
you when you retire.
Not that same money because
your money going in now is
going to today's retirees.
Future workers will pay in and
that money will go to you.
And the Social Security
replacement
rate is around 50%.
So to try to deal with this
problem the Social Security
replacement rate's around 50%.
So what's the benefit
of Social Security?
Well, clearly the benefit is
people don't want to starve
when they retire.
We'd like insurance
against the income
loss of when we retire.
Now, our own savings can do that
to some extent but it's
not perfect because you don't
know exactly how much to save,
you don't know when you retire,
you don't know how
long you'll live.
So the government
social insurance
program helps with that.
But there's also a moral hazard
cost, which is if you
insure people against retirement
you encourage
retirement, because now we're
saying is if you work you get
your wage but if you retire you
get your Social Security.
So now, you're eligible for
Social Security at age 62.
So at age 62 you're suddenly
eligible for about half your
wage in Social Security.
So now your decision
is, gee, do I work?
Well that's contrasted against
my marginal value of leisure
plus half my wage.
So unless the marginal value of
leisure is less than half
my wage I'm going to quit.
So what Social Security is
doing is distorting your
decision and causing you
to retire early.
That's the moral hazard part.
Now in the US we recognize
this, and we do
sort of a neat trick.
What we do in US is we have
something called an actuarial
adjustment to your Social
Security benefits.
What that means is the
following, you're 62 and you
say, wait a second, I can retire
now, and if I retire
now I'm going to get
half my wage.
So why not retire now?
We say, wait a second, we've
got a deal for you.
If you work one more year and
retire next year then we'll
give you 7% more every year
for the rest of your life.
Your check will be 7% higher
for the rest your life.
If you work two more years it
will be 14% higher, 3 more
years 21% higher, et cetera.
We recognize the moral hazard,
and we raise the check the
longer you work to
make up for it.
So the US recognizes that, and
as a result there's not a huge
moral hazard from Social
Security in the US.
It's pretty modest. In Europe
this is not the case.
Let's take the country--
let me back up.
So what the actuarial adjustment
does is says we
recognize that Social
Security is
essentially taxing your work.
To offset that we're going to
subsidize you to work more by
raising your Social Security
check the more you work.
In Europe they're not
as smart as us.
They don't recognize this, or
if they do they're not smart
enough to reflect it.
They don't have an actuarial
adjustment.
So here's how the Social
Security system works in the
Netherlands, for example.
When you reach 55 in the
Netherlands your choice is you
can work or you can stop working
and get a Social
Security check which is
90% of your wage.
So literally, your choice is
work or sit at home and get
90% of your wage with no
actuarial adjustment.
So unless the value of your
leisure is less than 10% of
your wage you can just
sit at home.
But wait, that's not all.
This is a very generous
program, right?
How do they pay for that?
They pay for it by
taxing workers.
So if you work you get your wage
but then you pay a 40%
payroll tax.
So actually, you can work and
get 60% of your wage or sit at
home and get 90% of your wage.
Guess what?
No one works after age 55
in the Netherlands.
Literally.
Now people will do
some underground
work that's not taxed.
They'll paint houses or things
which they can do on the
underground economy.
But literally, nobody works
after 55 in the Netherlands.
Economics works.
When you make the incentives
that blatant economics works.
And that's the moral hazard.
That's an example of not
respecting the social
insurance trade off, erring on
the side of insuring people
over respecting the problems
of moral hazard.
And the answer is part of the
major problem that they have
in these countries, part of the
major deficit, prolonged
deficit problem they face is
that older people don't work.
Now these countries have started
to recognize this, and
they're starting to try
to deal with this.
In fact, the country of France,
you may have noticed,
recently tried to
deal with this.
They have proposed raising their
retirement age, which is
age 60, beyond which,
essentially, no one works in
France, to age 62.
What happened?
You may have heard, massive
strikes, enormous political
strife because people don't
understand economics.
People don't understand that,
gee, yes that'll be a bummer
if you work a couple years
longer, but that's what's
going to make our
economy fiscally
sound and more efficient.
And in the long run we all
benefit from that.
So the government's, by the
way, not proposing that
today's retirees are hurt,
saying starting in 20 years
you have to work two
years longer.
So overall everyone's going to
benefit, but the bottom line
is people are too short-sighted
to understand
the economics, and that leads
to the rioting and things we
saw in France.
This stuff is hard to
a normal person.
You guys are smart and you spent
a semester learning it.
If you take a regular person in
the street they just don't
understand this trade off,
and that's the problem.
That's the problem in trying
to deal with these moral
hazard issues by making social
insurance less generous.
Now, let me talk about one
other issue with Social
Security because it's been in
the news and will be in the
news, which is the fact that
Social Security is
running out of money.
Now, Social Security is running
out of money because
here's a dirty secret
about Social
Security you may not know.
How many of you have ever
heard of a Ponzi scheme?
Anyone watch Boardwalk Empire?
They're doing that now,
Boardwalk Empire.
A Ponzi scheme was named after
Charles Ponzi, a Boston
investor, and here's how the
Ponzi scheme worked.
I teach two classes.
I teach now and I teach
again at 2:30.
I teach 14.01 now,
14.41 at 2:30.
Let's say I walked in here this
morning and I said, tell
you what guys, you each give
me $1 and on Wednesday I'll
give you $2.
Now you're thinking, well,
that's bullshit, but you know
what, I want a good grade so
I'll give him the dollar.
So you give me the dollar.
I then go to my 2:30 1441 class
and say, hey guys, you
each give me $3 and on Wednesday
I'll give you $5.
They are like same thing,
whatever, but they're higher
classmen than you, they
have more money,
they give me the money.
I take their $3, I pocket $1.
I come back on Wednesday
and give you each $2.
You're like, holy shit,
that worked.
I'm like, I've got a better
deal for you.
You guys give me $6 and next
time I see you in class--
semester's ending, but
you get the point--
I'll give you $10.
You're like, great, this guy's
trustworthy, we'll do that.
You give me the $6.
I pocket $1,
I go back to my 14.41 and say
here's the $5 I owe you.
They say, wow, that's great.
I say, so I've got a better
deal for you.
You give me $11, and
so on and so on.
And as long as you're both
willing to play I can continue
to pocket the money
and make money.
This is also called the
pyramid scheme.
You might have heard a guy
named Bernie Madoff.
Never invest your money with a
guy who's last name is Madoff.
Bernie Madoff, for 20 years ran
this kind of Ponzi scheme.
What he'd do is he'd find
investors, he'd take money
from them and promise them a
return, he'd then find more
investors, take the money from
the new investors and pay off
the old investors,
and keep going.
There was nothing real behind
what he was doing.
He made it work for 20 years
until someone didn't want to
play anymore.
What if we did this, and it
was the last class and you
guys said, well, see you
Professor Gruber.
I'm like, wait a second, if you
give me $20, and you're
out the door.
Now I got to go to my next class
and I don't have any
money for them.
Then the whole thing collapses
And it collapses because a
Ponzi scheme is not
a real investment.
The asset behind a Ponzi scheme
is not a bank account.
The asset behind a Ponzi
scheme is trust. And
basically, as long as someone's
no longer trusting
or can no longer pay
in, it goes away.
Now, here's a little secret.
Our Social Security system
is a Ponzi scheme.
The nation's largest
social insurance
program is a Ponzi scheme.
How is that so?
Well because you guys are
paying in now, and those
checks are going to
today's elders.
There's no guarantee that 40
years from now kids will pay
in to support you.
No guarantee at all.
You can pay in your whole life,
and then people could
vote out Social Security
when you're
retired and you're screwed.
It's a Ponzi scheme.
There's nothing behind this
except trust in the
government's programs.
The only asset behind this is
the trust the government would
never screw the voter,
the elderly voters,
by ending the program.
As long as the government is
willing to force young people
to pay checks to support
older people the
program can never end.
But if the government ever is
unwilling to do that then a
whole generation is going to
suffer from the Ponzi scheme.
Now that's pretty unlikely
because elderly voters are
pretty powerful.
It seems unlikely that Ponzi
scheme will ever collapse.
That's why we don't think of
it in those terms. But it
really is just that.
It's just a Ponzi scheme, in
this case supported by trust
in the government.
The problem is this Ponzi scheme
works well so long as
more people are paying in than
are collecting money.
So right now we have, in the US,
we have about 10 workers
for every elderly person, or
about eight workers for every
elderly person.
So we can collect a lot of money
to pay off the elderly.
The problem is that number's
diminishing rapidly because of
the aging of the baby boomers.
There's a huge bulge of
individuals who are about to
become elderly and collect
their Social Security.
By the year 2025 that 8:1 will
ratio be more like 4:1, and
we're suddenly going to
be short on money.
Here's the way I think about
it most scarily.
How many of you guys have
grandparents in Florida?
OK, you've got a few
grandparents in Florida.
The US in 2025, the US as a
whole, will be older than
Florida is today.
Because if you think of Florida
as full of old people,
that's the US in 20 years,
in 15 years.
We're moving to a very aging
society, and that's going to
put enormous pressure on
this Ponzi scheme.
And that's why, in about 30
years or in about 25 years,
Social Security goes bankrupt.
We actually run out of money
unless we fix the program.
So currently we have a situation
where we are
projected for that program to go
bankrupt-- it's actually in
about 30 years--
the program to go bankrupt
because we have to pay out so
much to this large
group of elderly.
And that's a problem the
government needs to deal with.
And it's going to have to deal
with it in one of two ways.
It's going to either have
to raise taxes.
We currently pay about
12.4% in payroll.
To solve this problem forever
that tax rate would have to go
up by about three and
a half to 4%.
So we'd have to pay the three
and a half to 4% more of our
wages to solve this problem.
Or we're going to have to cut
benefits, do things like
saying to people they can't get
their benefits at 62, that
goes up to 64.
And you can see US style rioting
rather than French
style rioting.
That's the difficult problem
the government faces going
forward is that something
has to give.
We either have to raise taxes to
support this program or we
have to cut the benefits that
elderly people get.
Yeah?
AUDIENCE: This might just
postpone the problem, but
would it be possible for
the government to
taper off the benefits?
So for instance, at 62, when
you're eligible, you could get
let's say 50% of what you'd
normally would be getting, and
that amount would slowly
increase as you get older.
So when you're making your
labor decisions you would
work, but maybe only half or
quarter time what you normally
would work and that might--
PROFESSOR: Certainly there are
compromises along the way but
that still goes in the category
of benefit cuts.
You're just talking about
a different way to
do a benefits cut.
There's lots of very subtle
and interesting ways--
and believe me, when the time
comes I'm not just going to
say we're cutting everybody's
benefit 10%.
It will be something much more
subtle along the lines you're
describing, sufficiently
complicated that people don't
understand it so that they can
try and slip it by people.
If they're going to cut benefits
it's going to be that
complicated, and that's the
trade off we're going to face.
All right.
OK.
So next class we'll talk about
health insurance and we'll do
a final session.
