Top exam answers, Spring 2002

Top Student Exam Answers, Spring 2002

Note: These were, in my judgment, the best answers received under examination conditions. They should not be taken as model answers, in that they all contain extraneous material as well as omitting useful information. Some even reach incorrect conclusions. However, they all take intelligent approaches to the questions, are well organized and reasoned, and make sensitive use of the facts.

Question 1, Answer 1

Ideal compromise:

Do not allow drilling in ANWR

There are values to be advanced beyond human utility.

Animals will not suffer as they would if drilling were permitted.

Our ecosystem will be left intact

There will be greater beauty in the world

While there appear to be few benefits for people in preserving the ANWR, there are some.

People will feel a sense of righteousness in preserving the values mentioned above

There will be a greater emphasis on developing alternative energy sources and reducing consumption since there will be less oil available in the short term

A slightly reduced oil supply will lead to marginally higher oil prices somewhat reducing consumption and pollution.

The human benefits to drilling in ANWR are minimal.

While there will be more oil available, it appears to be relatively small amount. Almost certainly drilling in the ANWR would not eliminate our foreign dependency.

If we drill in the ANWR, the fact that this issue has taken on such symbolic importance may lead Americans to under-appreciate the importance reducing dependence on foreign oil in other manners.

The solution is short term and finite. Like all non-renewable energy sources, eventually all the oil in the ANWR will be consumed

Reject the house proposal to mandate fuel efficiency in certain vehicles

The purpose of fuel efficiency is to reduce consumption not to blindly punish people who own inefficient cars. An increase in fuel taxes would be a much better solution to this problem.

With a fuel tax, there would still be an incentive to increase fuel efficiency in vehicles, but the incentive would exist at all levels of production. Under the current proposal, once vehicles reach their mandated fuel efficiency level, there is no incentive to make them any more efficient.

A fuel tax would not punish those who own inefficient vehicles but rarely drive them. These people do not consume much. By forcing automobile makers to make more efficient vehicles, higher production costs would translate into higher prices for all automobile purchasers.

In contrast, a higher fuel tax would mean that only people who actually consume would pay.

An efficient car is a sunk cost. Once a person has an efficient car, she might drive it more since the marginal cost of doing so will be lower. This would reduce the benefit of increased fuel efficiency. A fuel tax makes the marginal cost of driving higher.

While a fuel tax would have different distributional consequences than mandated fuel efficiency in pickups, vans and SUV's, this distribution is fairer. These people should not have to meet fuel efficiency standards that do not apply to sedan owners. There is no reason why someone who values the comfort of an SUV in her daily commute should be punished any more than someone who drives her luxury sedan recreationally.

While it is unlikely that an increased fuel tax would be passed in conference, allowing the Department of Transportation to study the proposal and make suggestions makes it possible in 2004.

By resisting this proposal you will likely satisfy the energy lobby about ANWR.

Maintain the Senate requirements to increase the use of renewable energy sources and incorporate more ethanol.

For political reasons, it is important that something be done to reduce our dependence on foreign energy immediately. The political urgency demands that we make certain educated guesses about the nature of the energy industry.

It appears, a seemingly inverse tragedy of the commons exists where companies ( rather than taking from the public, refuse to make the public better.

The cost of developing the infrastructure to harness renewable energy sources is quite high. As this infrastructure is refined, however, it is likely that the costs of harnessing renewable energy will decrease. Yet since the benefits of cheaper costs are industry- wide while the costs of developing the infrastructure fall on particular firms, any particular firm acting in its best interest will wait for other firms to develop the infrastructure first. Thus, the development of new infrastructure will be slower than it should be to maximize efficiency.

Likewise, the initial costs of incorporating ethanol into fuel will be high while the long-term costs will be lower.

By mandating industry wide norms, the initial costs are spread throughout the industry and no firm is put at a competitive disadvantage by investing in new technology.

While there are distributional consequences to higher short-term energy prices, those consequences flow naturally from the problem of limited energy. Gasoline-dependent states will suffer the most if we implement these proposals, but they will also suffer the most if there is an energy shortage.

Fallback Alternative:

Accept drilling

As noted above, the costs are largely symbolic and not applicable to humans. Since this has symbolic value, it appears to be a larger concession than it actually is. If conceded in the context of passing pro-conservation legislation, then the potential false sense of security that voters may feel will be less problematic because other concrete steps will have been taken.

Refuse to implement the regulations on fuel-efficiency

If such regulations are adopted, a fuel tax will never pass. This proposal is both inefficient and unfair and you should refuse to pass any bill that contains it.

Insist on both the renewable energy provision and the ethanol provision

With the compromise on ANWR, and the refusal to implement the fuel-efficiency standards, the energy lobby should be more than placated. There must be environmental regulations to placate liberals (who will already be upset at your refusal to budge on mandatory fuel efficiency) or the bill will never pass.

If these provisions are abandoned, then there is no reason to compromise on ANWR since the status quo is better than just allowing drilling.

Question 1, Answer 2

The common goal of both Republicans and Democrats with regard to these proposals is decreasing the United States' reliance on imported oil. Whereas a Pigouvian tax could address fuel consumption and environmental concerns, these proposals represent only second best solutions:

Development of Fuel Efficiency Regulations

The Senate bill directing the DOT to study the problem of fuel efficiency regulations is a good compromise between the Democrats' environmental concerns and the Republicans' economic concerns.

Efficiency - Because this mandates standards and not specific technologies, the fuel savings are likely to be developed very efficiently. Automakers will have incentives to meet the standards as cheaply as possible to both save money and remain competitive. It is an empirical question whether increased fuel economy standards on these cars will on net decrease energy consumption. The standards could increase the cars' costs, which, depending on the elasticity of demand for these vehicles, could cause consumers to instead keep the ones they own, and/or substitute for cheaper and more fuel-efficient vehicles. Better fuel economy could also operate the same as a gas price decrease. Thus, if the price elasticity of a driving mile is very elastic, gasoline use may actually increase as a result.

However, the increased capital cost of the car may be more than offset by fuel savings in the future. Whether this information is available and can be understood by consumers may be vital. In the long term, the old, non-compliant, vehicles will eventually fall into obsolescence. When this happens, all of these vehicles will be more fuel-efficient. So this may still be effective long term.

The proposal will benefit the environment if it leads directly to less fuel consumption. There may also be a positive externality in that it could lead to the development of new technologies that can spread to other fuel consuming devices outside of cars and trucks further decreasing energy consumption.

Administration - This proposal would require the DOT to develop regulations and engage in empirical studies on the feasibility of fuel standards to decrease consumption. In addition, the proposal would require government inspection of these new vehicles to insure that they are compliant.

Distribution - This proposal probably acts progressively as the poor are more likely to not own vehicles and use public transportation instead.

Political Advantages - The advantage of this bill over the House's is that it has large symbolic value without the short-term political battle of implementing it immediately. Those against the House proposal may be agreeable to it for this reason. When the proposal comes up for approval again, they can argue its inadequacy. This also gives the other side time to shore up support for the full regulations. Also, depending on the marginal cost of a 1 mpg increase for these vehicles, this may not be as stiff a regulation as the Senate Republicans rejected.

Renewable Sources

The Senate bill requiring utilities to increase the share of electricity generation from renewable sources may also be a good compromise between the two sides.

Efficiency - There are reasons to believe that renewable sources may not be cost effective. There is an empirical question concerning the potential of renewable source to provide electricity and the costs of developing such a capability. In addition, there is an argument that if this were profitable utilities would already have market incentives to engage in their development. However, the technology may be profitable but do to heuristics or cognitive dissonance, utilities refuse or are unable to process information that indicates this is so. There may also be other constraints such as political prejudice to such ideas or economic interests from fossil fuel providers preventing such development.

The ability of this proposal to decrease our demand for foreign oil will depend on the degree to which renewable sources can be substituted for foreign oil. If oil is a small part of electricity generation, this policy may only reduce the demand for coal or natural gas. We may still depend on foreign oil for automobiles.

There is an empirical question of whether renewable sources are actually environmentally friendly. If the use of wind power involves the deforestation of large areas, the net effect on the environment may not be positive. In addition, if the capital expenditures on such systems are very high, this may jeopardize programs that can provide the same benefits at lower marginal costs.

Distribution - There is an empirical question of whether the electricity generated from these sources is transferable to other areas of the country. If not, then some consumers will bear a larger brunt of this mandate because the marginal cost of compliance may vary widely due to the regional nature of utilities and their geographical constraints. Seattle probably couldn't generate solar power reliably for instance.

Symbolic Value - Distributing our energy sources to include renewable ones has a symbolic value that suggests a commitment to environmental protection and concern for future generations regardless of the policy's actual substantive effects.

Liberty - If the use of renewable sources leads to higher electricity prices, we are forcing a solution upon individuals that they did not contract for. Libertarians would argue that individuals should be able to choose how much they want to pay for energy. The use of renewable sources should be a result of their free choice to purchase energy from such a source.

However, the objective of all of these proposals is to reduce our demand on foreign oil, an arguably communitarian objective. Therefore these proposals should and are intended to reflect the communitarian ideal. In addition, the negative externalities of pollution as a result of oil usage cannot be addressed in a libertarian way.

As both of these proposals have passed a closely divided Senate, the odds are good that they can be agreed on in committee. However a fallback alternative would be to only back the Senate Fuel Efficiency bill as it only directs a study and the House has passed a bill actually implementing it. She should have no problem getting it passed.

Question 1, Answer 3

For the first time, the national interest in reducing reliance on foreign energy sources has established a common ground between two political camps that have historically been diametrically opposed - environmentalists/conservationists and pro- development/business interests. Because there is a national benefit in the avoidance of global conflict and terrorist attacks and the benefit flows to both environmentalists and developers, both groups should pay some of the costs in order to combat the free-rider problem.

Legislative proposal:

Drill in ANWR but subject the drilling to 2 conditions: (1) the plants built for the drilling will be subject to stringent emission standards; and (2) environmentalists will have input into the location.

Set target fuel efficiency standards but do not mandate certain regulations. Thus, keep the Senate proposal of gradually increasing the percentage of electricity derived from renewable sources, but do not mandate the use of ethanol.

Divide the above proposals into dependent stages so that a certain stage of development of ANWR will only be met if a certain stage of conservation is met, and vice versa.

Include advertisements to generate public awareness of goals and benefits of the legislation.

The benefits are the following:

Benefits of Domestic Drilling:

The externalities associated with reliance on foreign sources - increased international tension and loss of life, both American and foreign - are difficult to internalize in the market system.

There are global communitarian concerns that are not easily addressed unless we use domestic sources: (1) because use of foreign sources leads to conflict between countries, inevitably, countries not associated with the specific transaction are affected. The most salient example is the loss of foreign lives in the World Trade Center attack; and (2) lack of development in ANWR would mean increased development in foreign countries. The emission standards in foreign countries are not necessarily subject to standards as stringent in the United States. Pollution is a global problem and so it might benefit environmental concerns to drill in the United States where standards can be enforced. Further, although United States' consumers pay money for the foreign oil, it is questionable morally whether foreign citizens should be subject to the pollution caused by oil production when it is the citizens of the Untied States who benefit (often those hurt by the pollution in foreign countries are not the ones reaping the benefits of oil prices). This concern could also be characterized as a distributional equity concern.

There are both negative liberty and positive liberty concerns. In terms of negative liberty, the international conflict affects the safety and security of / citizens, infringing the right to be left alone. In terms of positive liberty, the international conflict means that tax payer money is used to support troops over seas and increased defense spending, making less money available for healthcare and education.

There are also distributional affects of reliance of foreign oil that do not seem equitable. If the cost of foreign oil use were only monetary, then those who reduce their consumption would enjoy the benefits of their conservation measures. But where the cost is national insecurity, the conservationists do not reap the rewards of their reduced use. This also might lead to a moral hazard problem - if real costs are seen as something about which an individual can do nothing, there is less incentive to reduce one's use.

Another moral hazard might be that could be addressed by domestic drilling is that currently. Americans do not witness the reduction in resources that accompanies energy consumption - as long as they can pay, they are not worried. Drilling in Alaska might make the loss of natural resources more salient and encourage people to conserve whereas they might not have previously.

Benefits of performance-oriented standards:

Mandated technology can retard technological development since there is no incentive to develop more cost efficient means in order to save money

Firms have more information about technology and costs and so can make more efficient decisions

The flexibility that performance-oriented standards allow are less likely to discourage entry into the market by newer and cleaner energy sources

Benefit of the dependent stages

A significant reason why there has been opposition to drilling and to conservation is symbolic politics. This proposal allows a new symbol to be substituted for the old - the new symbol is that all must make concessions but that neither side is going to give anything up without the other side doing the same.

Benefits of the Advertisements

Public choice dictates that politicians will follow strategies that win them re election. Although both the environmental coalition and business coalition are strong and contribute heavily to re-election campaigns, in the end, it is the votes that matter and the advertisements will generate public support so that there is less reliance on the coalitions.

Although public choice also dictates that voters will vote with their pocket books there is also the competing interest of people to see themselves as citizens - and so will support legislation that benefits the country. The advertisements will strengthen this competing interest.

Although it is difficult for politicians to claim responsibility for general legislation - this may be a case where the private interest (re-election) and the public interest (national safety) align - this is such a salient concern of citizens that it is likely they would not support politicians who do not vote for it.

Alternative proposal:

Given the current political constraints, it might be necessary to offer a second best proposal:

Instead of drilling in ANWR, the US support development of energy sources in non-Middle Eastern countries such as Venezuela and Russia. This alternative is only a partial measure since it there is still reliance on foreign sources.

As an enlightened senator, you should support the former proposal. Although symbolic politics has gotten in the way of national security concerns, this proposal might mitigate this. Further, at this time in our nation's history, symbolic politics are simply not a sufficient reason for inaction.

Question 2, Answer 1

The fundamental problems with private pension plans, such as the one at Enron, seem to be informational deficiencies and conflicts of interest that lead to serious distributional effects. These problems must be remedied in order to protect unsophisticated investors from catastrophically losing value in their pensions. I have taken the liberty of outlining three potential remedies that could be used alone or, perhaps, in conjunction with one another.

Company Control with Mandated Information Sharing

We could allow the companies to maintain control of their pensions, but require disclosure by companies of private information regarding their stock, including the value of their assets, their rights to diversify, and the importance of maintaining a diversified portfolio.

Advantages

Pay at companies with riskier pensions may include a wage premium for riskiness.

Compromising the employer! employee contract relationship could lead to less than optimal terms for the preferences involved.

The information sharing may reduce the distributional effect of un-diversified pension failures disproportionately affecting unsophisticated investors.

Informational disclosure may reveal gross discrepancies between book value and actual value - one of the problems with Enron.

Disadvantages

State intervention does not make information free; it just creates new transaction costs. If the transaction costs are costlier than they are helpful, government mandated information sharing might not be warranted. In this case, the benefits probably outweigh the costs.

Employees may not have a meaningful choice to diversify; employers may have unequal bargaining power that can lead to coercion.

Employees may be unwilling to seek new employment (and more favorable terms) due to the transaction costs involved. If the employer realizes this, they may engage in rent-seeking behavior (i.e. unfair stock sale plans) and cause market failure.

In spite of information sharing, the complicated nature of the data may render employees unable to "name, blame, or claim" the wrong being done to them until a catastrophic failure occurs.

Employee perceptions of such information may be skewed due to cognitive dissonance. Even if they receive information regarding the chances of pension failure, they are likely to disregard it due to excessive faith in their abilities and those of the company.

Companies may not provide information that is completely forthcoming. The fact that the employer has an interest in encouraging investment in its stock causes a fiduciary problem. This informational breakdown may be remedied if employees are encouraged to seek outside financial guidance.

Externalities of pension failures affect others. Other family members may suffer if value is lost, taxpayers may have to provide social services, etc.

Command-and-Control Regulation

We can institute a series of regulations that would 1) allow employees to sell company stock, 2) enforce diversification, and 3) make any restrictions applicable to all levels of employees. Hefty penalties would be assessed if companies went above the "cap" amount for investing in their own stock or refused lower-level employees the right to sell.

Advantages

Employees would be diversified and would have the option to sell company stock, just like upper-level employees often can. These regulatory changes would remedy a large part of the distributional difference between the levels of company employees with regard to their 401(k).

Imperfect information (or flawed interpretations of information) generally calls for government intervention to correct the market failure.

Such regulation may remedy a potential problem with pension systems before they occur, as opposed to ex post remedies (such as litigation) that would try to make amends after the damage has been done.

Regulation is better than ex post remedies if potential losses exceed the injurer's ability to pay or insure against loss likely in the case of a pension plan collapse.

Such regulation would limit a company's ability to use its bargaining power to coerce employees into inadequate diversification.

Disadvantages

New government regulations and fines may lead companies to choose not to offer a pension system at all. Presumably, there would be wage raise to compensate; however, there is no guarantee that workers would choose to save this money for retirement. Overall, workers may pay a high cost.

This regulation may be a paternalistic interference with the employer-employee freedom to contract. Assuming that all types of risk are internalized through the wage bill, employees may prefer higher wages with a riskier pension. Liberty and market efficiency concerns are present when the individual's choice is taken away.

If government won't enforce the new regulations, the regulations will have little effect.

Tax Incentives for Diversified Savings

It may be desirable to offer workers a tax preference for diversifying their 401(k). For example, the government could offer an X% tax credit for up to the first $X,000 invested, similar to its policy on college tuition payments. This policy would directly address the underlying choice that is based on poor information. Such a tax preference would ideally be progressive because it is low and middle-level workers that are the most affected by non-diversified pensions.

Advantages

The tax preference will subsidize the correction of a bad choice; a choice that could eventually have had external consequences for taxpayers.

Employee-driven saving will motivate employees to be actively involved in retirement saving, perhaps leading to a more realistic understanding of retirement needs.

A tax preference would mitigate the tax advantage that favors the provision of non-wage benefits; workers may be more eager to diversify if they do not incur an additional penalty.

Disadvantages

Some employees may miss out on employer-matched contributions.

Overall, the ideal solution may be an implementation of the regulations, paired with informational sharing and tax incentives. Once the informational deficiencies and the conflicts of interest within the company are remedied, diversification should proceed naturally. Mandatory "pension failure" insurance may also be a solution, but this would pose hefty issues of moral hazard and adverse selection. On balance, it is best to educate and empower employees to begin making their own retirement decisions.

Question 2, Answer 2

Three proposals for regulation of private pension funds: (1) leave the allocation transaction cost decisions of employers and employees, (2) mandatory access to information and independent financial counselors, (3) require part of pension funds be invested in secure investments that insure a minimum level of retirement income.

(1) Leave the allocation to free choice of employers and employees:

Liberty:

From a libertarian viewpoint individual freedom to choose the type of compensation package, including pensions is a valuable right that deserves protection. If a person freely takes the chance of getting a larger pension with the risk of getting no pension then such a choice should be respected. Similarly, when such risk taking leads to large losses such individuals should not seek assistance since they freely undertook the risk.

Efficiency:

Workers with freedom to contract are able to negotiate a compensation package that suits their particular risk aversions, and income needs. Partial regulation of employee compensation through mandates on the types of pension choices one has could result in less mutually satisfactory employment contracts being made; where free private negotiation is allowed all mutually beneficial employee-employer relationship will arise.

Distributional aspect

If employers are able to offer creative (risky) and less expensive pension plans, such as matching 401 k contributions with company stock, they may be able to offer these savings back to the employee in the form of compensating wage differentials.

Problems

Information Problem

The liberty and efficiency principles rest on the assumption that choice is really free. Unfortunately, individuals are often at a disadvantage when it comes to fully understanding their pension program, its risks, the stability of the company they are receiving stock in, etc. Thus, choice is not really free and liberty is fictional. Where employers take advantage of informational advantages the bargain will not be efficient. People who would not have made the deal had they know the internal weaknesses of the company will be duped into making the inefficient bargains. The potential distributional gains in the form of higher wages that could be gotten in exchange for less expensive or risky pension plans may not be sought if employees do not understand the real value of their pension.

Heuristics

Even informed individuals are not necessarily capable of evaluating the risks that a particular pension plan presents. They might know that stock options are risky but assume that they are able to beat the odds. People routinely misconceive chance. In this regard individual choice might be questionable even if fully informed. Conversely some individuals may overestimate the risk and therefore choose not to take risks even though doing so would have been a good choice for them.

Externalities

Assuming that society has an interest in maintaining a minimum level of existence for all members, when pensions fail a large negative externality could fall onto the society which may end up paying welfare, food, job service, bankruptcy, healthcare and other costs for individuals who lose savings after having invested it into risky investments.

(2) Informational disclosure and mandatory access to independent financial counselors

Efficiency/ Liberty

Mandatory access to independent financial counselors would solve part of the information market failure discussed above thereby leading to more efficient employment contracts. This assumes that individuals are able to choose what is in their best interest given full information. If counselors clearly explain the real risks cognitive heuristic problems may also be overcome, but could still potentially pose a problem. Furthermore, strict punishment of fraud would encourage honest and full disclosure. This regulation preserves the libertarian freedom to choose one s own compensation, without being overly paternalistic and commanding certain risk adverse [sp.] pension choices.

The costs of this program, as well as the time involved in choosing the appropriate pensions will be shifted to the employee through less compensation, which may be undesirable to some, but this cost is likely outweighed by the improvements in bargaining ability, and subsequently more efficient relationships.

Externality

Regulating to increase information will not internalize the risk of harms inflicted on society when pension plans collapse, but it would reduce the likelihood of large disasters such as Enron, thereby making this possible externality smaller.

(3) Require part of pension funds be invested in secure investments that insure a minimum level of retirement income.

This plan distrusts individual choice the most and smacks of paternalism, but in light of heuristics and the generally unsophisticated nature of average employee investment this plan may have merit.

If worker and employers are not allowed to freely bargain some mutually beneficial agreements might not be made, leading to inefficiency.

This regulation would alleviate the externality caused when risky pensions become worthless, but is only efficient if the savings from avoiding such harms outweigh total lost investment returns that could have been realized had the individual been able to make risky investments. This is an empirical question that can only be answered with research. However, given the existence of the social security system, some of these costs are already insured against.

Insurance of a minimum level of pension could result in individuals taking even higher risks with their remaining pensions, thereby undermining the assumptions upon which the minimum level plan was established; this is a kind of moral hazard issue.

There is a communitarian interests in a workforce secure in the knowledge that they have a minimum level of retirement savings; this supports requiring a minimum level of risk free pension for all, even if doing so may require giving up freedom, or cause some to lose potentially large gains.

Conclusion:

The largest problem with bargaining over pension plans is with the lack of information, thus solving this problem goes a long way creating a fair and efficient system. Remaining issues of social costs of risk taking and irrational bargaining are partly alleviated with more information. Ultimately the choice depends on the seriousness of these problems balanced benefits of freedom and markets. A good first step would be information regulation, then if needed more invasive regulation.

Question 2, Answer 3

Approach 1: Leaving it to decisions of employers and employees: The NY Times article highlights the informational problems that plague private retirement investing by America's corporate employees. However, like the workplace safety context, it's difficult to justify government intervention where no major externalities exist and regulations would supplant / individual choices for risk.

Advantages:

Liberty and autonomy concerns dictate limiting paternalistic intrusion by the government into what is essentially a private market transaction between employer and employee. Employer contributions to 401k plans are calculated quid pro quo exchanges in which favoring corporate interests is logical (similar to a wage premium).

Private management of pension funds avoids burdensome administrative costs like those associated with Social Security. Reasoning by analogy from the standard economic argument that in-kind transfers are not most efficient, individuals are likely in the best position to judge their preferences and invest their earnings as they see fit.

Disadvantages

A potential externality exists where Enron-type victims fall into the government safety net. Overly risky investors bailed out by social welfare programs impose costs across society. [This however may refer invoke a broader libertarian commentary on the justice of social insurance.]

Informational problems abound Novice investors may not adequately appreciate the risks they face (or may act too conservatively), or may be misled by employers. Problematic heuristics and cognitive dissonance lead to less than optimal choices.

The "wage premium"-type exchange between employer and employee may not reflect fair bargaining terms. Corporate misinformation and barriers to entry and exit (sunk costs) suggest a raw deal for employees. Further, to the extent that marginal worker preferences don't reflect those of the inframarginal worker, investment policies might r be optimal for the majority of employees. [However, per Schultze, the public's views about distributional equity may be less sensitive to losses that stem from market forces than those arising from unfair government policies.]

Conclusion: While countries with more progressive attitudes toward labor might view an affirmative or inalienable right to pension funds, free-market minded Americans likely see no problem with allowing workers to trade for risk. The status quo, however, does present intolerable informational problems that warrant change.

Approach 2: Command and Control regulations that mandate a minimum percentage contribution to a diversified, government-controlled fund: Recognizing distributional inequities arising from the status quo, the choice between private management and government intervention hinges on an evaluation of how regulation handles efficiency, autonomy interests, and informational issues.

Advantages

A Social Security-type fund guarantees a minimum degree of distributional equity and could represent an efficiency gain to the extent that social insurance resources are less burdened. However, it is unlikely that the savings on rare Enron-type cases would outweigh the high administrative costs imposed by this scheme.

Government-managed pension funds could serve the communitarian ethic along the lines of that envisaged by Ackerman and Alstott's "Stakeholder Society," fostering a sense of a share in the common good rather than an individualistic, "beat the market" ethic in the retirement game.

Disadvantages

Administrative costs for such a scheme would deprive American workers of a big share of retirement savings. Further, administrative competence issues are relevant, as fund management would be prone to a type of bureaucratic moral hazard prompted by guaranteed cash flow with little competition.

Excessive regulation could bring about a "landlord will raise the rent" scenario with perverse regulatory results, as employees and employers maneuver to avoid an inefficient pension scheme and to divert compensation away from strict salary payment. Paradoxically, benefits and other in-kind transfers that are consumed in the present could further bring about chronically insufficient retirement savings.

Conclusion: A heavily bureaucratic approach to pension savings is overly paternalistic and violates investment autonomy concerns vital to the nation's economy (likely dampening liquidity in capital markets). An attempt by the government to corral savings into a superfund unduly deprives workers of their just deserts and competent investors the free exercise of their capacities.

Approach 3: Incentify investment in approved, diversified funds through tax preferences. Further, limit the percentage of company stock allowed in a 401k to 25%. Finally, allow private investment professionals into the workplace, and mandate intelligible disclosure of company financial status to employees investing in company stock.

Advantages

Tax preferences constitute an effective regulatory instrument to incentify investment in low-risk pension funds without imposing great compliance review costs on government agencies.

Liberty concerns are safeguarded by ensuring workers the right to continue to privately manage pension funds and to trade company donations of stock for risk up to a certain point.

Information asymmetries and problematic heuristics will be addressed by allowing financial advisers the chance to offer employees a fuller picture of their investment options. Private brokers are biased as well, but they face stiffer competition and reputational concerns, and lack the company's structural advantages of management authority, sunk costs, and employment inelasticity. While community and company morale could be undermined by greater transparency in reporting and a more candid assessment of the employer's viability (a problem of the second best), information disclosure is necessary to ensure that bargaining for risk is carried out on equal footing.

Disadvantages

Distributional equity: Tax preferences will be regressive to the extent that wealthier persons will face a lower marginal price for their investments. However, one could argue that the wealthy are paying more in taxes, and further are sacrificing more in terms of alternative investment opportunities by opting into the government-sponsored funds, and thus merit the advantage.

Further, to the extent that pension savings in diversified funds are not as universal an interest as health care, tax preferences represent a distributional advantage to the wealthiest half or two-thirds of Americans, a morally tenuous result in terms of fairness and community norms.

Conclusion: The final proposal best addresses liberty and efficiency concerns, despite some distributional shortcomings. Government intervention through tax preferences, combined with a few administrative control mechanisms, is on balance a sound, efficient approach to ensure sustainable and just pension practices.

Question 3, Answer 1

We return to Larry and Heloise eight years after we last saw them. This series of ads explores the inability of many seniors to secure prescription drug insurance, the cost effectiveness of the two proposals, and their respective distributional consequences. Throughout, the ads fairly weigh the arguments and ultimately endorse the Democratic insurance plan.

First: Why do we need a prescription drug benefit?

Larry and Heloise are preparing dinner when Heloise receives a call from her mother, Agnes, whose only insurance is Medicare. She explains that the doctor has switched her to a new, costly blood pressure medicine because the previous one failed, and tearfully asks for money because, on her fixed income, she cannot afford it.

Heloise is sympathetic, and agrees, but asks why Agnes has no insurance. Agnes explains that Medicare does not include prescription drug coverage. She describes how most insurance is obtained through employment, an avenue is unavailable to her. Furthermore, policies in the open insurance market frequently exclude the elderly through disqualification for pre-existing conditions and through medical exams, or even based on age alone. When insurance is available, it is expensive and its coverage severely limited. Agnes wonders if the government should play the role of grouping the elderly together into a prescription coverage pool and negotiating prescription prices for via Medicare.

Heloise agrees that this idea should be pursued because of how unfair it is that the elderly cannot afford basic necessities, and wonders about what that says about our nation's community. She remarks about the importance of the health of the elderly, the generation that raised us, and asks whether a prescription drug program would show the elderly that we appreciate the debt we owe them.

Second: Which plan uses taxes most wisely?

Larry and Heloise are taking their morning coffee, reading the newspaper, which has an article comparing the Democratic and Republican plans. Larry is concerned with which plan represents the most efficient use of his tax dollars.

He notices that the Republican plan has a deductible, which combats moral hazard by financially discouraging unnecessary use of the benefit. The Republican plan also has a higher premium, which will make the program less expensive for taxpayers, but may increase adverse selection by discouraging some of the people who don't really need insurance from joining, which would have subsidized the other insureds. Both of the plans have copays, which reduces moral hazard and adverse selection, but these cut off in the Republican plan and not in the Democratic plan. Heloise wonders if adverse selection is an appropriate concern in the context of a government health insurance program. The point is that all who need insurance get it, so if the people who need insurance are the most likely to buy it, there is no special concern, since that is the reason for the program.

Larry agrees, and says that the issue is which plan makes the best use of tax money. The Republican plan anticipates negotiation of bulk rates with the drug companies, which seems like it could save money, or could in effect act as a price control, which could lead to shortages or higher prices for non-Medicare consumers, or could discourage incentives for future development. However, if drug manufacturers are acting as monopolists, price controls could lead to efficiency gains.

An overly generous plan may also create inefficiency by inviting overuse and reducing incentives to prevent illness. Heloise counters that those who exaggerate this observation about moral hazard typically have all the health care they need at prices trivial to their incomes. Anyone who values their body will take care of it, and if they don't, it is not because they think insurance will compensate them for illness but because they do not believe they are likely to get sick. Illness is so miserable that one does not lightly court it. Furthermore, use of drugs at early stages of an illness may prevent more costly medical treatment later, and in this way the prescription drug benefit may save money. The couple agrees the Democratic plan will not have significant moral hazard problems, but will provide more extensive coverage.

The Republican plan will occur indefinitely, but the Democratic plan will only be legislated for eight years. However, if it is popular, as it is certain to be, politicians will have to extend it.

Third. Which plan is most fair?

Larry and Heloise attend a church picnic. The parishioners informally discuss the various distributive aspects of the proposed plans.

Heloise says she considers medicine a basic good which everyone should have access to. Larry brings up the (Rawlsian) idea that if people had not known what type of situation they would be in on earth, they would choose a society in which basic necessities are available. But in the US, prescription drugs are rationed by the ability to pay, even though drug makers could produce more at minimal extra cost.

Heloise tells the group that the Republican plan provides coverage for expenditures less than $2000, for those elderly who are not very sick, or of average health, but provides no benefit for the next $3000 of coverage, in effect abandoning coverage when the ill patient may need it most. The group is mystified at this gap, and agrees it is probably an attempt decrease the cost of the plan. Similarly, the Republican plan's higher monthly payments and deductible also burden the poor. They note that the Republican plan is slightly cheaper to taxpayers, but discuss how the government currently subsidizes the insurance of employed taxpayers by $60 billion per year, a comparatively large cost.

Larry observes that health care is currently actually cheaper for wealthier people because (regressive) tax deductions favor the rich, and that it's most expensive for elderly, who are not likely to be employed and therefore receive no corresponding benefit. Heloise notes that this is because the whole tax system is progressive, but she agrees the Democratic plan is fairer.

Question 3, Answer 2

To: B. Graham and Z. Miller
Re: "Larry and Heloise" Advertisements on Medicare Prescription Drug Coverage

Proposal

Advertisement 1

Main substantive message: People don't choose to be sick, to get old, or to need increasing medical attention/prescriptions.

Healthcare and prescription drugs are not services or commodities that buyers feel they have the choice to preference over others or to ignore.

The "choice" to take a medication that can save your life or slow the onset of a debilitating disease is a non-choice.

Patients often lack full information and are, therefore, unaware of medical conditions. This further reduces their ability to control consumption.

In addition, the Democratic cost sharing proposal insures that consumers are still investing in their own medical care, further lessening the potential for abuse.

Reasons for focus: Need to discount the moral hazard argument.

As it is, a substantial portion of Medicare recipients have supplemental insurance to cover their prescription drug expenditures.

Those that are unable to secure this additional insurance tend to fall in the category of people who have high-cost chronic expenditures.

It seems odd to say that this particularly vulnerable group has chosen their position. Even stranger is the argument that this group will engage in more dangerous behavior since the government is sharing the financial burden of prescriptions.

The chronic ailments typical of this group are more fairly associated with age or special disability, as opposed to consequences of risk-taking behavior.

How to convey the message:

Discussion of Heloise's mother who has just called to tell her that she has been diagnosed with Parkinson's. The disease is still at a relatively early stage, and its progress can be slowed with medication that costs approximately $300/month.

The conversation focuses on whether or not Heloise's mother will incur the additional expense by filling the prescription.

It's not as if she has any real choice in the matter or that she's bilking the insurance company by taking the medication.

Her choice involves deciding whether or not to give into a debilitating disease.

Advertisement 2

Main substantive message: The Democratic plan comports with communitarian ideals in that it provides for a particularly vulnerable portion of the population.

As American citizens we share a common identity that comes with a concern for the common good.

Society should work out the interests it wishes to pursue through politics.

Providing for our parents and grandparents is a paramount societal concern.

Reasons for focus:

In acknowledging the disconnect between what people see as best for themselves, as consumers, (not wanting to pay higher taxes) versus what they see as best for society at large, as citizens, it is important to draw attention to the communitarian vision inherent in the Democratic plan.

Regardless of whether people are content with or concerned about the general ideal of equality in the current American distributional system, society is typically more concerned with the distribution of particular goods (specific egalitarianism).

This is especially persuasive given the sympathetic "life or death" nature of the "good" at issue.

We should try to play on the sentiment that health care is widely-considered a basic good/inalienable right that should not be allocated according to the ability to pay.

How to convey the message:

Larry and Heloise have a discussion regarding the current state of American healthcare insurance.

The United States is the only developed country without universal insurance coverage.

Medicare benefits are available and provided to everyone over 65, the blind, the disabled and people with end-stage kidney failure. In total, Medicare insures about 14% of the population. a of those people have no prescription drug coverage.

The least we can do is make sure that as a community we protect those among us who really need the help, especially since none of us has found the fountain of youth yet and will eventually join at least one group of Medicare beneficiaries (over 65 category) and might need that kind of assistance someday as well.

Advertisement 3

Main substantive message: The Republican plan raises efficiency concerns.

Reasons for focus:

We need to distinguish the Democratic plan as a legitimate goal pursued through appropriate means from the Republican plan, which arguably is weaker on the means prong.

How to convey the message:

Larry and Heloise have a conversation regarding how expensive providing prescription drug coverage can be.

How effective/efficient is it to provide such minimal coverage (as in the Republican plan) at such a great cost? If the government is going to incur a multi-hundred billion dollar cost, it should be in a way that will actually make someone better off. Otherwise, what is the point?

In the Republican plan, Medicare patients would have to pay approximately $3977 of the first $5000 of prescription drugs purchased (after passing a $250 deductible hurdle). The stated plan will cost the government $350 billion to implement.

The imposition of such a large burden, especially with no assistance from $2000- 5000, on Medicare beneficiaries in many of the neediest cases will amount to no assistance whatsoever.

Costs are admittedly high in both plans, indeed higher in the Democrat's plan; however, only the latter will produce benefits that warrant the expenditure.

Preliminary Notes on a Possible Advertisement 4

Focus:

Need to rebut the argument against the Democratic plan that the 2010 sunset will potentially leave people out in the cold, whereas the Republican plan provides some coverage on an ongoing basis.

This is arguably the trickiest "selling" point.

It is better to do something effectively for a few years with renewal possibilities, than it is to do something inefficiently forever.

The endowment effect will work in favor of the plan, for people tend to place a higher value on things that they are used to enjoying. Therefore, a subsequent plan should enjoy increased support.

Question 3, Answer 3

These advertisements focus on distinctive implications of passing the Republican or Democratic plan.

1. Redistribution - it has to stop somewhere.

This message appeals to the majority working class. While society generally accepts some responsibility for supporting the needy and vulnerable, society also recognizes a need for balance. Furthermore, the status of being covered or not covered for pharmaceuticals is not especially correlated with income. Thus, the hard-working middle class will find themselves subsidizing health care for the wealthy as well as poorer elderly.

Given these two points, the Republican plan is more reasonable and fair to working class and the elderly. On the basis of their own estimates, the Democrats plan will cost taxpayers upwards of $150 billion more than the Republican plan. Unlike the Democrats plan, which requires little contribution from the elderly, the Republican plan strikes a balance between making drug coverage available to the elderly, and requiring them to reasonably contribute to their own care, reducing the burden of the plan on the average American family. [Copayments and deductibles also reduce adverse selection and moral hazard which raise the overall estimate, see the next advertisement.] Finally, I will emphasize that the Republican plan is more sustainable, while the Democratic legislation sunsets in 2010 (their attempt at reasonableness), suggesting that the next generation of elderly will not benefit from Medicare contributions they make today.

Conveyance:

Larry and Heloise and their two children illustrate the implications of the additional financial burden. Larry works long hours, but still cannot afford to send Junior to summer camp this year because their Medicare contributions were recently raised to cover the costs of the Democrats' bill. Heloise tries to tell a disappointed Junior that his sacrifice is for a good cause - helping the needy like Aunt Martha get better. But this myth is shattered when their wealthy neighbor bursts through their door and waves her array of smelling salts purchased with recently acquired, very generous Medicare coverage. Ignoring Larry's optimistic remark that he will one day share her joy, she gloats that she got her purchases in before the sunset date, "Nothing this free can last long." "Vote Republican: Sustainable Generosity."

2. Adverse Selection and Moral Hazard - The Democrats' Drugs Proposal Will Cost Far More Than Expected

Both Republicans and Democrats may have underestimated their budgets, but the Democratic underestimation is more severe. Calculations based on the CBO average of $2150/person on drugs is based on a not having insurance, but this number will increase, more so with the Democrats, once previously uninsured are covered by the plan and increase purchases due to moral hazard problems.

The difference between the Democratic and Republican plans with regards to adverse selection are slight, but notable. While Democrats might emphasize their generosity, both plans are generous, but the Republican plan reasonably so. The Democratic plan's low premiums and zero deductible gives all Medicare beneficiaries strong incentives to opt in. Conversely, limitations on benefits in the Republican plan discourages those with private insurance and/or lower drug costs from opting in, keeping down overall coverage.

The difference in Moral Hazard problems is more significant, with the Democrats plan leading to more overconsumption of pharmaceuticals than the Republican's. As with adverse selection, Republican deductibles and copayments act as check on moral hazard by requiring patients to pay part of the cost. Moreover, the lower threshold of $4000 in the Democratic plan gives patients, especially those with chronic expenditures, incentive to quickly spend to that level to gain 100% coverage for the rest of the year. Once passed the threshold, there will be no inhibitions on spending. The Republican plan delays this point for another $1000, discouraging other attempts to reach the limit while permitting coverage for those who truly need it.

Note, the fiduciary problem is less for pharmaceuticals in that physicians do not have personal economic interests in prescribing drugs.

Conveyance:

Our heroes witness a "drug run" on the pharmacy in which spry elderly persons dash into Democrat Drug Store waving their Medicare cards. Heloise catches her neighbor rushing out and inquires into the commotion. Her explanation demonstrates the collective eagerness to reach their spending threshold, after which the "really free stuff' begins. Heloise remarks she is glad some needy people are receiving care but realizes the Republican plan would do so more fairly. Red numbers churn past the promised limit of the Democratic plan.

3. Drug prices will go up for everyone

Increased consumption of pharmaceuticals by the publicly insured has consequences for the privately insured. Expensive pharmaceuticals due to over-demand from insurance distortions is already a concern. The elderly are already the heaviest users of pharmaceuticals. By further arming them with overly-generous insurance plans, this problem is exacerbated. New increases in demand will put upward pressure on the price of all prescription drugs. This will not only raise prices for everyone, a disproportionate burden on the poor and uninsured, but also drive up costs for private insurance companies. They in turn will raise premiums, leading to further adverse selection problems when the healthy opt out of insurance altogether. Finally, the increased cost in drug prices will make the Medicare proposal more expensive overall.

To the extent that the Republican proposal mitigates the increase in demand for drugs by requiring cost sharing, it will produce less of this pressure on drug prices. Conversely, the Democratic proposal will likely lead to greater demand by lowering out-of-pocket costs even more than the Republican plan.

Conveyance:

It's hay fever season. Larry stops by the local pharmacy to pick up his allergy pills and waits behind 5 elderly patients, waving their Medicare cards and ordering his same prescription. He discovers most do not have allergy problems but are interested in "trying it out." He pulls out his usual $7 copay, but this time, the pharmacist informs him that there was only one prescription left in the store and that due to popular demand, the price has gone up to $30. "Republican care about your sneeze."