Thursday, September 18, 2008

Not having a profit incentive to mislead you, as is the case with the government, can sometimes be extremely valuable

With regard to Mark Thoma's September 18th post, "Risk Absorption as a Last Resort":

One of the great things the government can often do far better than the private sector is insurance, especially for things that involve very large and very dangerous loss, where you really want to make sure you'll get fully paid for the loss (minus the deductible).

For some very large and dangerous risks, there's just a very dangerous chance that a private company won't end up with the funds to pay, and it can be very hard for people and firms to tell if a private insurer is really safe. An insurance companies financials can be extremely complicated, and there's a huge profit incentive for an insurer to mislead about them, as well as about tricky stipulations written in fine print legalese in a long insurance contract that may result in a denial of your claim.

In such a case, not having a profit incentive to mislead you, as is the case with the government, can be extremely valuable when a risk is so great that you want to be absolutely sure that it will be covered. You won't be fooled be some legalese stipulation in the fine print that results in a denial of your claim, and you won't be fooled as to the financial strength of the insurance company, only to find out later that they only have enough money to cover a fraction of your claim.

There can also be huge economies of scale and transactions and advertising costs in insurance, which can mean a big cost advantage for a giant government insurance program.

In the real world, and known and accepted in economics for a very long time, there are sometimes severe free market imperfections. The world is not identical to simple models; among other important problems, asymmetric information, economies of scale, and transactions costs can be great, making it so that a strong government role can greatly increase efficiency, wealth, and welfare.

Bottom line: Would you rather have your old age social security payments and Medicare insurance guaranteed by the United States government or a private company that you hope will have the money to pay your checks and medical bills when the time comes, and won't go the way of Lehman Brothers, AIG, or Enron.

And even if you wanted to go with a private company, you might have to spend an enormous amount of time researching the companies, the programs, the legal contracts, etc. to decrease the odds that you will be fooled by these companies which may have a great profit incentive to mislead you. But with the government you can just much more quickly buy knowing that they don't have a profit incentive to mislead or trick you. This can save a very large amount of time if asymmetric information is great, and obviously time is money.

American's today spend a great deal of time researching financial and other products to make sure that they aren't taken. Much of this is time that could have been spent producing if there were better government regulation, guarantees, and/or programs. I know this time cost very well, as I assign a great deal of work every week in my personal finance courses.