The Becker-Posner Blog

The Rise in the Price of Oil-Becker

The run-up in the world price of oil during the past several years, and especially the rapid climb during the last few weeks to over $120 per barrel, has fueled predictions that the price will reach $200 a barrel in the rather near future. Such predictions are not based on much analysis, and mainly just extrapolate this sharp upward trend in oil prices into the future. The price of oil in "real" terms (i.e., relative to general prices) will not reach $200 in this time frame without either terrorist or other attacks that destroy major oil-producing facilities, or huge taxes on oil consumption. I try to explain why in the following.

The two previous sharp increases in the world price of oil, in 1973-4 and 1980-81, were due to supply disruptions. The first one was the result of the formation of OPEC that led to output restrictions by members of this cartel, while the later one was due to the Iran-Iraq war that curtailed petroleum production in these two countries. Although the world price of petroleum rose by a lot in all three episodes, worldwide oil production went down in the two earlier ones, while production has risen during the current price boom. The present boom in oil prices has been mainly driven by increases in demand from the rapidly growing developing nations, especially China, India, and Brazil, although output growth in the US and European have added to world demand, and speculation on potential future price increases also contributed to the increased price of oil. To be sure, supply problems in Nigeria, Venezuela, Russia, and other major oil-producing states have contributed to accelerations in the oil price increases at times during the current boom.

Note the contrast between the major causes of the current explosions in oil and food prices. Although the sharply rising prices of different commodities are often lumped together, increases in the prices of corn and other foods have in larger part come from the supply side rather than from demand. The main supply culprits in the market for foods have been the diversion of corn acreage to the production of ethanol, and the increased cost of fertilizers and chemicals used in food production due to the rise in the price of oil (see my discussion of rising food prices on April 13 and 17).

The rapid growth of world oil prices during 1973-74 and 1980-81 contributed in a significant way to the world recessions during those years. Yet even though world oil prices in real terms are now above the prices in 1981, the previous peak in oil prices, and despite the sharp run-up in prices during the past couple of years, the world economy has not (yet!) been pushed into recession. One reason for the difference is that unlike the previous episodes, the current price rises have slowed rather than eliminated the boom in world output. Another difference from the previous episodes is that the share of oil and other energy inputs in GDP is down by a lot in the developed world since 1980, especially in Japan and Europe, but also in the US.

Of course, even with energy's smaller role in the production of output, any rise in oil prices to over $200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible, given the expected continuation of the rapid growth in the GDP of China, India, Brazil, and other major developing countries. For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small. The small elasticity of both the supply and demand for oil explains why the moderate reductions in world oil supply during the earlier price spikes, and the moderate increase in world demand during the current price boom, produced such large increases in price.

However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.

Clearly, given high enough oil prices, many ways are available to increase the supply of petroleum, Explorations for additional supplies will be extended deeper into oceans and other remote places because the high cost of extracting oil from these sources would be offset by the high energy prices. Usable petroleum is also already being extracted from oil sands and oil shale, and high and rising oil prices will speed up and extend this process. The reserves of tar sands in Canada and Venezuela are huge; indeed, Canada is getting much of its oil production from this source. Oil shale is also abundant in several places, including the United States, and while extraction of petroleum from shale is expensive and complicated, the high prices have induced some countries to start doing this.

Rising prices of oil and other energy inputs will eventually be controlled by new technologies that greatly economize on the use of these inputs. Increased supplies of oil and other energy sources that become profitable to exploit only with prolonged high prices will also push these prices back.

Why We Should Be Rooting for $200 per Barrel of Oil--Posner

As Becker explains, we cannot predict the future price of oil. But it is unlikely to rise in the foreseeable future to $200 a barrel, especially if we think in inflation-adjusted terms. Oil prices in real terms have fluctuated a great deal. In December 2007 dollars the price of oil was below $20 in 1946, above $100 in 1979, and only about $10 a recently as 1998. High prices affect both demand and supply; the recent price peaks have already reduced demand for gasoline in the United States and increased efforts to discover and exploit new oil fields. The United States has large untapped oil reserves both offshore and in Alaska, and there are many other untapped reserves elsewhere in the world. Supply is responding to the high price of oil and will respond more. If Iraq ever stabilizes, its output of oil will increase. Were the world price of oil to rise to a level close to $200, both demand and (with a lag) supply would respond. Oil trapped in sand and shale--a potentially very large supply--would become economical. In the longer run, very high oil prices will further stimulate the development of alternative fuels.

Major political or natural catastrophes could of course alter the picture. Middle eastern oil supplies are vulnerable to the ever-present threat of war in that region, and the oil industries of Venezuela, Nigeria, and possibly even Saudi Arabia are vulnerable to political unrest, civil war, or terrorism.

I would like to see the price of oil rise to $200, despite the worldwide recession that would probably result, provided that it rises as a result of heavy taxes on oil or (better) carbon emissions. The taxes would jump start the development of clean fuels, and the financial impact on consumers could be buffered by returning a portion of the tax revenues in the form of income tax credits. That would not reduce the effect of the taxes on the demand for oil or the incentives to develop alternative fuels, because the marginal cost (the production and distribution cost plus the tax) of oil to consumers would not be affected. Higher oil prices are necessary to check global warming, reduce traffic congestion, and reduce dependence on foreign oil, so much of which is produced by countries that are either unstable or hostile to the United States. Heavy taxes on oil would reduce not only the amount of oil we import but also the revenue per barrel of the oil exporting nations, so there would be a double negative effect on those countries' oil revenues: they would sell less oil and earn less per unit sold. The reason for the latter effect is the upward-sloping supply curve for oil. Suppose the first million barrels of oil can be produced at a cost of $1 per barrel and the second million at $2 per barrel. If total demand is one million barrels, the suppliers break even: they have revenues of $1 million and costs of $1 million. If total demand is two million barrels, the suppliers have revenues of $4 million (because the price of all barrels is determined by the price that the marginal purchaser is willing to pay) but costs of only $3 million ($1 million for the first million barrels, $2 million of the second). The lower the price of oil received by the oil producers (that is, the price net of tax), the lower their net income.

Unfortunately I cannot see a confluence of political forces that would make heavy taxes on oil feasible. We seem to be experiencing a democratic failure, in which long-term problems simply cannot be addressed.

The Outlandish Farm Subsidies--Posner

The President has expressed dissatisfaction with the proposed Farm Bill wending its way through Congress. He wants farmers whose annual incomes exceed $200,000 to be denied subsidies; the present cutoff is $2.6 million and Congress will not go below $950,000. The President's concern with farm subsidies cannot be taken very seriously, since in 2002 the Republican Congress with Administration connivance greatly increased these subsidies and at the same time repealed some of the modest reforms that the Clinton Administration had introduced in 1996. The Administration's current proposals would, if enacted, be a step in the right direction, but they will not be enacted, and, judging from the 2002 legislation, they are intended I suspect merely to embarrass the Democratic Congress.

The deregulation movement passed agriculture by, leaving in place a series of government programs that lack any economic justification and at the same time are regressive. They should offend liberals on the latter score and conservatives on the former; their firm entrenchment in American public policy illustrates the limitations of the American democratic system. A million farmers receive subsidies in a variety of forms (direct crop subsidies, R&D, crop insurance, federal loans, ethanol tariffs, export subsidies, emergency relief, the food-stamp program, and more), which will cost in the aggregate, under the pending Farm Bill, some $50 billion a year, or $50,000 per farmer on average. Farm subsidies account for about a sixth of total farm revenues. So, not surprisingly, the income of the average farmer is actually above the average of all American incomes, and anyway 74 percent of the subsidies go to the 10 percent largest farm enterprises. The subsidies are regressive, especially during a recession coinciding with worldwide food shortages (i.e., high prices).

There is no justification for the Farm Bill in terms of social welfare. The agriculture industry does not exhibit the symptoms, such as large fixed costs, that make unregulated competition problematic in some industries, such as the airline industry, about which Becker and I blogged recently. It is true that crops are vulnerable to disease, drought, floods, and other natural disasters, but the global insurance industry insures against such disasters, and in addition large agricultural enterprises can reduce the risk of such disasters by diversifying crops and by owning farm land in different parts of the nation and the world. If a farm enterprise grows soybeans in different regions, a soybean blight in one region, by reducing the supply of soybeans, will increase the price of soybeans, so the enterprise will be hedged, at least partially, against the risk of disaster. Supply fluctuations due to natural disaster create instability in farm prices, but farmers can hedge against such instability by purchasing future or forward contracts. There is no "market failure" problem that would justify regulating the farm industry. All the subsidies should be repealed.

This of course will not happen, and that is a lesson in the limitations of democracy, at least as practiced in the United States at this time, though I doubt that it is peculiarities of American democracy that explain the farm programs, for their European counterparts are far more generous. The small number of American farmers is, paradoxically, a factor that facilitates their obtaining transfer payments from taxpayers. They are so few that they can organize effectively, and being few the average benefit they derive (the $50,000 a year) creates a strong incentive to contribute time and money to securing the subsidies. The free-rider problem that plagues collective action is minimized when the benefit to the individual member of the collective group is great. Then too many of the members of the farm community and hence recipients of the subsidies are wealthy, and the wealthy have great influence in Congress as a result of the lack of effective limitations on private financing of congressional campaigns and on lobbying generally. In addition, the allocation of two senators to each state regardless of population enhances the political power of sparsely populated states, which tend to be disproportionately agricultural. The key role of Iowa in the presidential electoral process is a further barrier to the abolition of farm subsidies, and the final factor is the alliance of urban with farm interests in support of the food-stamp program, itself inferior to a negative income tax, which would give the poor money but allow them to make their own consumption choices.

A puzzle about the farm programs is the heavy emphasis on money subsidies, since by reducing the cost of farming they encourage greater output, which results in lower prices for farm products, thus offsetting some, perhaps much, of the effect of the subsidies. (The lower prices are not a social benefit, because as the result of subsidization they are below cost.) Acreage restrictions, which used to be the core of federal farm policy, and which correspond to the type of entry-limiting regulations imposed on airlines, railroads, trucking, pipelines, long-distance telecommunications, banking, and the wholesale sale of electricity, before the deregulation movement, are more efficient at raising farmers’ incomes by reducing output, in effect cartelizing agriculture. Those restrictions have been reduced, but between them and export subsidies (which reduce the supply of agricultural products to American consumers) farm prices in America are higher than they would be without the farm programs, and this contributes to the regressive effects of the programs.

Farm Subsidies and Farm Taxes-Becker

Posner presents evidence on the sizable subsidies received by American farmers from the federal government of the United States. However, the US is not unique, for every rich country including France, Germany, Great Britain, and Japan, heavily subsidizes their farmers, no matter how small the agricultural sectors. In fact, some of these other countries subsidize farmers more generously than even the United States. On the surface, this universal tendency for rich countries to subsidize farming, no matter how different are the details of their political systems, is a paradox. For since only a small fraction of the populations of these countries work in agriculture, farmers cannot contribute much to any majority voting coalition.

Add to this paradox that pretty much every developing country, no matter whether they have democratic or totalitarian political systems, rather heavily tax farmers in order to subsidize their urban populations. Taxing of farmers is as true of India as of China, Mexico as well as Argentina, Egypt as well as South Africa, and similarly for the other poorer nations. In all these countries, farmers are a significant fraction of their populations, and they form a majority in many, such as India and China.

This different treatment of farmers in rich and poorer nations is dramatically seen in the causes of and the responses to the recent worldwide explosion of food prices. American and European subsides to biofuels are an important factor behind the rise in food prices, for these subsidies directly raised the price of corn to consumers, and indirectly raised the prices of other grains (see our recent discussion on April 13 and 17 of the rise in food prices). Riots broke out in many cities around the world in protest against the increases in the prices of bread and other food stables. To quell these riots and other urban unrest, many countries restricted their exports of agricultural goods in order to lower the prices and increase the supply of these goods to their urban citizens. The effect of these export restrictions was to lower the incomes of the farmers in these countries since they were prevented from selling some of their produce on the world market where prices are higher.

This response to rising food prices by the governments of poorer nations is not explained by any concern about fighting poverty in these nations. The fact is that farmers in developing countries are much poorer on average than are their city residents, which explains the continuing migration from the rural areas to cities in these countries. So by putting restrictions on the exports of farm goods, developing countries are not only making their economies less efficient, but also they are adding to the overall incidence of poverty among their populations. The gap between the incomes of rural and urban families is much smaller in developed countries that subsidize rather than tax farmers. Indeed, with the high prices for cereals and other foods during the past couple of years, average farm incomes are often above those of city residents.

I believe that the explanation for the very opposite treatment of farmers in developing and developed countries is interest group competition (see my "A Theory of Competition Among Pressure Groups for Political Influence", The Quarterly Journal of Economics (Aug., 1983), pp. 371-400. This analysis shows that small groups, like farmers in rich countries, often have much greater political clout than large groups, like farmers in poorer countries. The reason is that even large per capita subsidies to small groups, such as farmers in the US, impose rather little cost (i.e., taxes) on each member of the large groups, like urban and suburban residents of the US. As a result, these large groups do not fight very hard politically against the small per capita taxes used to subsidize farmers.

By contrast, a large subsidy to farmers in developing countries would require imposing high per capita taxes on their relatively small urban populations since farmers are a rather large proportion of the total population in these countries. Instead, the same political pressures as in developed countries lead poorer countries, regardless of the nature of their political systems, to subsidize the smaller urban populations at the expense of the larger farm populations.

Hence a common approach to the political process based on interest group pressures can explain both the taxing of poor farmers in developing nations, and the subsidies to well off farmers in richer nations.

Greater Regulation of Financial Markets? Becker

The major deregulation movement of the past 100 years started with the Ford and Carter administrations in the 1970s, and continued through the Reagan years. This movement came to an end with the passage of the Americans with Disabilities Act of 1990 under the administration of George W. Bush. Since then some sectors, such as labor markets and product safety, have been regulated much more extensively, while others, including commercial and investment banking, have had no further declines in the extent of regulation. Despite the considerable and tangible successes of this deregulation movement, the pressure is intense to significantly increase the regulations affecting consumer safety, the introduction of new drugs, and especially financial markets.

The 1970s saw a bipartisan reduction in the regulation of airline travel, trucking, security exchanges, and commercial banking. Measures of the success of this deregulation include sharp declines in the cost of air travel and of shipping goods by truck, huge reductions in commissions on stock transactions, and higher interest rates on bank deposits. Not only has no serious attempt been made to re-regulate these activities, but also European and many other nations on all continents have copied the American deregulation of airlines and securities.

The impetus to tighter regulations varies from sector to sector, although there is a growing belief that many activities are insufficiently regulated. Obviously, the current turmoil in the financial sector is stimulating many proposals to regulate extensively various types of financial transactions. Yet it is not obvious that the problems in the financial sector resulted mainly because of insufficient regulation. For example, commercial banks are probably the most heavily regulated group in the financial sector, yet they are in much greater difficulties than say the hedge fund industry, which is one of the least regulated industries in the financial sector. Banks participated very extensively in originating mortgages, including subprime mortgages, and in buying mortgage-backed securities, and so they are suffering from the high foreclosure rates, and the sharp decline in the market value of these securities.

One reason why extensive regulation of commercial banks did not prevent many banks from getting into trouble is that bank examiners became optimistic along with banks about the risks associated with mortgages and other bank assets because the market priced these assets as if they carried little risk. It would run counter to human nature for regulators to take a skeptical attitude toward the riskiness of various assets when the market is indicating that these assets are not so risky, and when originating and holding these assets has been quite profitable. One can expect regulators to mainly follow rather than lead the market in assessing riskiness and other asset characteristics.

To some extent that was also true of the Fed's behavior during the past few years. I believe that Alan Greenspan is right in claiming that the main cause of the housing boom was not the Fed's actions but the worldwide low interest rates due to an abundant world supply of savings. The demand for very durable assets like housing is greatly increased by low interest rates. Still, the Fed seems to have contributed to the booming demand for housing and other assets by keeping the federal funds rate artificially low during the boom years of 2003-05.

In evaluating the need for greater financial regulation, one should also not forget that the American economy greatly outperformed the European and Japanese economies during the past 25 years. Might that not be related in part to the fact that the United States led the way with major financial innovations like investment banks, hedge funds, futures and derivative markets, and private equity funds that were only lightly regulated? An infrequent period of financial turmoil may be the price that has to be paid for more rapid growth in income and low unemployment. Rapid income and employment growth might be worth an occasional period of turmoil especially if they do not lead to prolonged slowdowns in the real part of the economy. So far the effects on GDP and employment have not been severe, although the financial distress is not yet completely over.

Nevertheless, a few important regulatory changes are probably warranted. For the first time the Fed allowed investment banks access to its federal funds window, and the Fed guaranteed $29 billion worth of mortgage-backed assets to induce J.P. Morgan to take over that investment company. Since these types of Fed actions would likely be repeated in the event of future financial turmoil, investment banks would have an incentive to take on additional risk since they can reasonably expect to be helped out by the Fed in the future. For this reason it might be desirable for the government to impose upper bounds on the permissible ratios of assets to equity held by investment banks. The ratio of assets to the equity of the five leading investment banks did increase greatly from about 23 in 2004 to the highly leveraged level of 30 in 2007.

Other regulations of financial institutions may also be merited, but elaborate new regulations of the financial sector would be counterproductive. For example, the Fed has proposed limits on how much mortgage interest rates can exceed the prime rate for low-income borrowers with poor credit ratings. This would be a foolish intervention into the details of credit contracts that have all the defects of usury laws.

The financial sector has served the economy well by managing, dividing, and pricing different types of risks in the economy. It would be a mistake if Congress and the President allow the present financial turmoil to panic them into inefficient new financial regulations.

Re-Regulate Financial Markets?--Posner's Comment

I no longer believe that deregulation has been a complete, an unqualified, success. As I indicated in my posting of last week, deregulation of the airline industry appears to be a factor in the serious deterioration of service, which I believe has imposed substantial costs on travelers, particularly but not only business travelers; and the partial deregulation of electricity supply may have been a factor in the western energy crisis of 2000 to 2001 and the ensuing Enron debacle. The deregulation of trucking, natural gas, and pipelines has, in contrast, probably been an unqualified success, and likewise the deregulation of the long-distance telecommunications and telecommunications terminal equipment markets, achieved by a combination of deregulatory moves by the Federal Communications Commission beginning in 1968 and the government antitrust suit that culminated in the breakup of AT&T in 1983.

Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money. This encourages risk taking that is excessive from an overall social standpoint and was the major factor in the savings and loan collapse of the 1980s. Deregulation, by removing a variety of restrictions on permitted banking activities, has allowed commercial banks to engage in riskier activities than they previously had been allowed to engage in, such as investing in derivatives and in subprime mortgages, and thus deregulation helped to bring on the current credit crunch. At the same time, investment banks such as Bear Sterns have been allowed to engage in what is functionally commercial banking; their lenders do not have deposit insurance--but their lenders are banks that for the reason stated above are happy to make risky loans.

The Federal Deposit Insurance Reform Act of 2005 required the FDIC to base deposit insurance premiums on an assessment of the riskiness of each banking institution, and last year the Commission issued regulations implementing the statutory directive. But, as far as I can judge, the risk-assessed premiums vary within a very narrow band and are not based on an in-depth assessment of the individual bank’s riskiness.

Now it is tempting to think that deregulation has nothing to do with this, that the problem is that the banks mistakenly believed that their lending was not risky. I am skeptical. I do not think that bubbles are primarily due to avoidable error. I think they are due to inherent uncertainty about when the bubble will burst. You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table. There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in. (Remember how Warren Buffett was criticized in the late 1990s for missing out on the high-tech stock boom.) I suspect that the commercial and investment banks and hedge funds were engaged in rational risk taking, but that (except in the case of the smaller hedge funds--the largest, judging from the bailout of Long-Term Capital Management in 1998, are also considered by federal regulators too large to be permitted to go broke) they took excessive risks because of the moral hazard created by deposit insurance and bailout prospects.

Perhaps what the savings and loan and now the broader financial-industry crises reveal is the danger of partial deregulation. Full deregulation would entail eliminating both government deposit insurance (especially insurance that is not experience-rated or otherwise proportioned to risk) and bailouts. Partial deregulation can create the worst of all possible worlds, as the western energy crisis may also illustrate, by encouraging firms to take risks secure in the knowledge that the downside risk is truncated.

There has I think been a tendency of recent Administrations, both Republican and Democratic but especially the former, not to take regulation very seriously. This tendency expresses itself in deep cuts in staff and in the appointment of regulatory administrators who are either political hacks or are ideologically opposed to regulation. (I have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.) This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry.

Why Is Airline Service So Bad? Posner

Airline delay has increased in the last five years, and the statistics understate the amount of delay because airlines have increased scheduled flight times--the flight from Chicago to Washington used to be scheduled for an hour and a half; now it is scheduled for two hours. Flights are horribly crowded, food and beverage service has deteriorated in first class and virtually disappeared in coach, and the incidence of mislaid baggage has increased.

Delay is the main problem, and the one that I shall focus on. Many culprits have been named--high fuel costs that have contributed to deferred maintenance that results in cancellations, the failure of the Federal Aviation Administration to upgrade the air traffic control system so that it can handle more traffic with less spacing between aircraft, more turbulent weather perhaps due to global warming, and crowded aircraft that result in delays in boarding and hence in departure. But all these seem to me to miss the point. Persistent delay is usually the result of a failure to use price to equate demand and supply. When demand increases in advance of an increase in supply, failure to raise price results in buyers' incurring cost in the form of delay rather than in the form of a higher price. The cost of delay is a deadweight loss, whereas a higher price would be merely a wealth transfer to the sellers and would finance an increase in supply.

Some delay in the provision of services is unavoidable because of fluctuations in demand; it usually is wasteful to increase supply to the point at which every spike in demand can be accommodated without rationing (i.e., queuing, delay). But the persistent delays that airline passengers have been encountering for many years now cannot be explained by demand uncertainty. The delays impose enormous costs, particularly but not only on business travelers. The value of Americans' time is high.

So why are airline prices so low? The answer may lie in the lumpiness of airline service. (This was pointed out many years ago by the Chicago economist Lester Telser, and was repeated last week by Holman Jenkins in the Wall Street Journal.) The fixed costs of modern passenger aircraft are very high, but the marginal costs--the costs of carrying one more passenger if the plane is not full--are very low. At any price above marginal cost, the airline is better off selling a ticket than flying with the seat empty. Competition between airlines will therefore exert strong downward pressure on price. Prices tend to be pushed down to a level at which the airlines find it difficult to finance the purchase of new planes. As the existing planes age, equipment failures become more frequent, contributing to delays and cancellations. Airlines prefer delays to cancellations, because they get to keep the fares, and they resist raising prices to reduce congestion because that will make it more difficult to fill the planes, and an empty seat is, as explained, very costly in revenue forgone. Furthermore, airline service is quite uniform across airlines, which makes travelers more sensitive to airline prices than, say, to hotel prices, since hotels compete in many other dimensions besides price.

Another aspect of lumpiness that should be noted is the difficulty of adjusting prices to different passenger time costs. Business travelers have higher time costs than leisure travelers, but there are not enough business travelers to fill a plane of efficient size, and even if there were, no one airline could significantly reduce the problem of delay, just as no one driver can affect traffic congestion by reducing the number of his trips.

I am not aware that the delay costs of airline service, and the costs of the other disamenities (the very crowded airplanes and slow boarding and deplaning in coach) in the current market, have been quantified, but assuming that they are, as I suspect, very substantial, the question arises what if anything should be done to alleviate the problem.

One possibility would be to allow the airlines to agree on minimum prices: in other words, to exempt the airlines from section 1 of the Sherman Act, which forbids competitors to agree on prices. The problem is that the airlines would fix a profit-maximizing minimum price, and it probably would exceed the price necessary to reduce congestion to the optimal level. Moreover, any increase in the price level would attract inefficient entry.

Another possibility would be to return to the regulatory system administered by the Civil Aeronautics Board before the deregulation of the airline industry in 1978. The CAB did not regulate rates, but it controlled entry into city pairs and used that control to limit entry to the point that flights were frequent and uncrowded. If a flight was canceled or delayed, it was usually easy to get a seat on another flight leaving soon. But with entry tightly limited, prices were above the competitive level; planes were not just uncrowded, they flew nearly empty. Prices have fallen sharply since deregulation. Competition has also led the airlines to adopt a variety of cost-saving measures. Pilots' wages are now much lower. Before deregulation, the powerful pilots' union (powerful because of the enormous costs of a work stoppage to a company that cannot produce for inventory and thus make up some of the revenue that it loses from a strike) was able to extract some of the airlines' regulation-enabled cartel profits, in the form of supracompetitive wages for pilots.

Another option would be to encourage, or at least place no antitrust or other obstacles in the way of, mergers between airlines. If there were only two airlines on every route, tacit collusion between them would probably keep prices high but not so high as if there were a single airline or an explicit price-fixing agreement. But any increase in prices would attract entry, pushing prices back down. Moreover, mergers often result in higher rather than lower costs.

A better alternative than any I have discussed thus far would be a heavy tax on airline transportation, with the tax rate varying according to the contribution of a particular route, time, or type of plane to congestion (for example, in general large planes would be taxed less heavily per passenger than small ones, because for a given number of passengers there are fewer big planes to clog the airways and runways than there would be small ones). To the extent effective, the tax would eliminate the deadweight cost of congestion.

The Decline of Airline Service-Becker

The increase in flight delays is just one aspect of a general decline in airline service. A few prominent examples of this decline are the elimination of meals in economy on domestic flights, more lost baggage, and dirtier seats and toilets. Posner gives several reasons why service has declined, with concentration on flight delays. I will add one reason to those he mentions that has been very important but is usually overlooked; namely, that the decline in service is an integral part of the substantial fall in the cost of airline travel after the airline industry was deregulated.

The crucial point is that the lower income and leisure flyers, and families with children that now make up the vast majority of customers on domestic routes, and a substantial fraction on international flights, prefer lower prices to better quality service and higher prices. On this interpretation it is no surprise that Southwest Airlines achieved remarkable success by offering low prices with no meals, and only non-reserved economy seats. The revealed preference of the majority of flyers has been that they prefer lower prices to meals and many other amenities that were once standard on flights in the United States. American Airlines and other more traditional airlines have been forced to react to the competition from the no frills airlines by, for example, eliminating meals, and sometimes eliminating first class seats and even reserved seats, so that they too can offer lower prices.

The same considerations explain the greater crowding on flights since airlines can offer much cheaper seats with average loads of 80 percent rather than say 50 percent. The reason is that the cost of handling the additional 30 percent of passengers is very low compared to the high cost of owning and operating planes, and compared even to the reduced revenue they receive from these passengers. Most persons who now fly prefer lower prices with more crowded planes and greater delays in boarding to the high prices and low occupancy rates that prevailed prior to deregulation.

The same trade off between price and service applies to the flight delays discussed by Posner. These delays are stochastic in that they vary from day to day according to different probability distributions of delay times. When delays persist, airlines are forced by the regulatory authorities to increase their scheduled flight times to recognize that typical travel times are longer. Airlines can cut down their delays by having greater amounts of deicing equipment during winter in the event of unexpected icing of planes, greater reserves of crews in case some crew members call in sick or get stranded, a larger number of backup aircraft in case some aircraft develop mechanical problems, and so on for other determinants of delays.

I am arguing that many passengers prefer the combination of low fares and greater delays on average to higher fares and fewer delays because it is cheaper to operate planes when inventories of people and equipment are smaller. Consider as an analogy a clothing store that has a large inventory of merchandise. It charges customers a lot for the suits and dresses it sells partly to help finance the convenience to customers of having many types of clothing to choose from. More generally, sellers often offer customers goods that have at least two dimensions: price and size of inventories. Prices generally are higher when inventories are greater so that delays in buying particular merchandise due to unexpected surges in demand are shorter because of the greater inventory of goods.

Of course, not all passengers are identical, and some of them prefer shorter delays and higher prices to the present situation. A number of airlines have been started in order to cater to these customers by providing exclusively first class or business class seats. These airlines have generally not been successful, probably because there are not enough of these customers to support commercial airlines that only offer first class service. Instead more affluent flyers have opted to buy shares in or outright ownership of private planes where service is far better and delays are much shorter. Private planes even have shorter delays from air traffic congestion because they frequently use less crowded airports.

Air traffic delays at major airports can be reduced through varying pricing of take offs and landings with time of day and the density of traffic, as discussed by Posner. Implementation of such sophisticated pricing is always difficult with publicly owned resources like airports and roads. So the privatization of airports could make possible greater flexibility in pricing the use of airports to take account of congestion.

The high fixed cost and low variable cost of airlines do not imply that airlines must be unprofitable in a competitive environment. Southwest and Jet Blue are two examples of airlines that have done quite well by offering low prices and limited service. Airlines made considerable profits in the latter part of the 1990s, but then the industry was hit first by 9/11, and then by the sharp run up in the cost of their fuel. Fuel costs have become more important to airlines than labor costs.

The hotel industry offers insights into the airline industry. This industry is more competitive than the airline industry since entry into the hotel industry is even easier than into the airline industry, and hotels also have high fixed costs of operations and relatively low variable cost of servicing individuals who occupy their rooms. Hotel prices adjust in the short run to the level of demand, but there are times when it is hard to get rooms, and people with reservations are denied rooms because of overbooking. Yet hotels have on average been quite profitable, which has stimulated various booms in the building of new hotels. To be sure, airlines have been exposed to major shocks, such as deregulation, terrorism attacks, and expensive fuel, but there is no intrinsic structural reason why the airline industry should be less profitable than the hotel industry.

Addendum on Rising Food Prices-Becker
It was an oversight that I did not discuss explicitly long term prospects for food price increases. The brief discussion below corrects this.
A major concern about the rapid rise in food prices is that these high prices will persist into the indefinite future, and perhaps food prices will rise much further. An analogy is often drawn with oil prices since both have risen rapidly during past couple of years, and there is much fear by oil importing countries that oil prices will continue to go up during the next few years.

However, the analogy to oil is seriously flawed. Whatever happens to oil prices, there are grounds for much greater optimism about food prices. Any increase in the production of oil is limited by its fixed availability at different locations on earth. The supply responses to higher prices of agricultural production will be much greater than that of oil production for two fundamental reasons. The first is that only a small fraction of potential arable land is used for farming because the growth of cities and suburbia has led to mass conversions to other purposes of land formerly used to grow foods. Persistent high and climbing prices of grains and other foods will induce conversion of some of this land back to farming.

The second reason for optimism relates to the lower productivity of food production in the poorer parts of the world relative to the United States and other developed countries. Higher food prices will induce an increase in productivity in developing nations by encouraging greater use of machinery, fertilizers, and other forms of capital. It will also encourage consolidation of some agricultural holdings into the hands of more efficient farmers. Efficiency in oil production is more uniform in different parts of the world than is food production since the major energy international conglomerates produce all over the globe, including many poorer nations.

Rising Food Prices and Public Policy-BECKER

The World Bank's index of food prices increases by 140 percent from January 2002 to the beginning of 2008, and a full 75 percent just since September 2006. This highly unusual explosion of food prices has been seized upon by neo-Malthusians as the beginning of a day of reckoning due to the collision between he limited capacity of the earth to produce foods and the growing demand for food and other commodities induced by rapid world population and income growth. Malthusians have turned out to be wrong in the past when they extrapolated from events like food price inflation to prophesies about world catastrophe-witness the embarrassingly wrong predictions in Paul Ehrlich's The Population Bomb about the impending mass world starvation in the 1970's due to what he considered vastly excessive world population growth. They are also wrong about this current food price rise because it has nothing to do with population growth, and is only a little related to the rapid expansion in world incomes in recent years.

Rather, the boom in petroleum prices and subsidies to ethanol and other biofuels are the most important forces explaining the recent increase in food prices. Both the sharp run up in oil prices, and the continuing subsides to ethanol production in the United States, and to a lesser extent Europe, induced an increasing diversion of corn from feed and human consumption to the production of biofuels. The main goal of the diversion has been to produce more ethanol as a substitute for gasoline. During the past year, one quarter of American corn production, and 11 percent of global production, was devoted to biofuels, and the US contributes a lot to the world corn market. The growth in demand for biofuels explains why acreage was shifted from other grains to corn-the acreage devoted to corn in the United States increased by over twenty percent in 2007-8, while that devoted to soybean production declined by more than fifteen percent. The reallocation of production away from other grains explains the rapid price increases for wheat, soybeans, and rice as well as for corn.

The huge increase in petroleum prices also pushed up the cost of producing foods, and hence food prices, since energy is an important input in the production of fertilizers and agricultural chemicals. Other factors affecting the rise in food prices include the drought in Australia in 2006-07 that cut world grain production during those years, and the fall in the value of the dollar that may have increased the dollar value of foods and other commodities.

The Malthusian forces of population and income growth ontributed only a little to explaining the big increase in grain prices since 2002. The large rise of world food prices came after food prices had been either stable or declined for many years.
Although incomes in China and India, countries that account for almost 40 percent of the world's population, did grow rapidly during this decade as well as during the 1990's, global consumption of corn, wheat, and rice grew more slowly since 2000 than during the five years earlier. To be sure, the slower growth in consumption is partly the result of the rapid increase in grain prices. However, if an unusually large increase in world wide demand for grains to use as feed for animals and for human consumption explained the rapid increase in these prices, consumption should have grown more rapidly during the later period, even after adjusting for any induced increase in grain prices.

Some countries, including Argentina, India, Russia, and Vietnam, have responded to the sizable run up in food prices by severely restricting, or heavily taxing, food exports. By reducing exports of rice and other grains, these policies lowered the supply of these grains to importing countries, and helped bid up world prices. At the same time, however, these restrictions kept a lid on domestic prices of rice and other grains by diverting some supplies to domestic markets.

Governments in countries that restricted food exports usually responded to urban riots and other domestic disturbances, such as those in Egypt, Haiti, and Vietnam, that were protests against food price increases. The restrictions on food exports reflect the general tendency of governments in poorer countries to favor urban consumers over farmers. Since food accounts for a large fraction of household spending in poorer countries-over 70 percent in poor households- sharp food price increases would cut by a lot the purchasing power of poorer urban consumers. On the other hand, farmers are hurt by restrictions on their food exports since they get lower domestic prices than they could get on the world market. Restrictions of food exports also lower the efficiency and overall incomes of the countries imposing them since a lid on domestic food prices discourage farmers from increasing their food production at a time when world food prices have been rising at a fast pace.

Some analysts have justified these export restrictions as a way to combat the effect of rising food prices on poverty. However, poverty is much more prevalent among rural than urban families in developing countries like China, Egypt, India and Vietnam. So restrictions on food exports in developing nations not only lower the efficiency of their food production, but also usually raise inequality and overall poverty. The greater political clout of urban households in developing nations is the pressure behind the support for these inefficient and inequitable export restrictions, just as the greater political clout of farmers in developed nations maintains the inefficient, and probably energy-wasteful, ethanol subsidies in the United States and other rich countries.

Food Prices and Malthusian Economics--Posner's Comment

Becker is right of course that a growing demand for food, resulting from world population growth, relative to supply cannot explain the very steep food-price increases that have occurred since 2006; world food prices are 75 percent higher than they were that year and obviously world population has not grown by that percentage, But I do not take this to be a refutation of Malthus, whose insights have relevance to the modern world.

Malthus argued that if a population is living at the subsistence level, if population increases geometrically (for example, a couple has three children, each of the three children eventually marries and produces three children, and so on) but food production only arithmetically, there will be more people than can be fed, and so population will decline through starvation, disease, or war until a new equilibrium is reached. (Because the population is assumed to be living at the subsistence level, the equilibrium cannot be achieved through higher food prices.) Malthus did not foresee the technological advances that have resulted in a faster rate of increase in the food supply than in the population, or increases in wealth that enable food prices to rise to prevent shortages should demand outrun supply. Nor did he foresee modern contraception technology, or China’s one-child policy. But given his assumptions, his analysis is sound and it gave Darwin the clue he needed to develop the theory of natural selection. In Malthus's model people kill each other to avoid starvation, and those who do best in the desperate struggle survive--hence survival of the fittest as determined by a competitive process.

As Becker points out, Paul Ehrlich and others predicted in the 1970s (beginning with the first "Earth Day," in 1970) mass starvation as a result of continuing population growth. They were wrong, in part by failing to predict the Green Revolution, which greatly reduced the cost of food production. The situation today is different.

The demand for agricultural products has grown, though not as a result of population growth; instead as a result of increased demand for ethanol and other biofuels, and for food that requires more agricultural acreage to produce. Today, besides people and pigs eating corn, our motor vehicles "eat" corn that has been converted into ethanol. And in China and India, which together contain a third of the world's population, increased wealth has led to an increased demand for meat, in China for beef. Cattle eat corn and other crops and are in turn eaten, but the amount of crops consumed in this process is several times greater than the amount that would be consumed if people ate the crops directly, rather than indirectly by eating vegetarian farm animals. China's consumption of beef, which has been growing rapidly for a number of years, is expected to grow 4 percent this year--yet it will still be only about 15 percent of U.S. beef consumption per capita.

Increased demand for agricultural products should lead to increased supply, but the supply response is limited because of the higher price of gasoline, an important input into food production, and because of scarcity of good agricultural land (in part a result of population growth), which implies an upward-sloping supply curve for food..

The fact that increased demand for agricultural products, and resulting high prices, are due to factors other than growth of population does not make a demand-supply imbalance any the less serious. We may be seeing the beginnings of an attenuated Malthusian response in Egypt, where there have been riots recently over food prices. Egypt is a poor country, and to avoid violence the government has had to increase its food subsidies--making the country poorer and hence more vulnerable to political instability, which could result in an Islamic insurrection. In poor countries today, as in ancient Rome, keeping the urban population happy is the foremost political imperative, because urban riots, especially in a nation's capital, can bring the government down. Urban residents are not farmers, so rising food prices only hurt, and do not help, them. But urban food subsidies immiserate the rural population, and limits on food exports, designed to control domestic food prices, disrupt the international agriculture market.

Our ethanol subsidies, and equivalent policies, such as the European Union's rejection of genetically modified foods, and the wealthy nations' (including the United States') tariffs on agricultural imports, could in principle be abandoned in order to increase the supply of food. But domestic interest-group pressures (which in the United States include the disproportionate influence that Iowa exerts in presidential politics) make reform unlikely.

Compensation under Competition--Posner

It used to be thought more widely than it is now that in a competitive market, the compensation of workers, on the assumption that it is left to the market, will be efficient. That of course is a major assumption, given unions, minimum wage laws, laws against employment discrimination, and other regulations of employment. But such regulations do not bear significantly on the employment of executives and professionals, and it is they with whose compensation I shall be concerned. Shouldn't we expect that they at least--corporate executives, lawyers, and other elite workers--are efficiently compensated, provided their employers are operating in a vigorously competitive market, as most markets nowadays, other than those that are natural monopolies (that is, markets in which economies of scale are obtainable over the entire range of feasible output), but fewer and fewer markets are naturally monopolistic?

The answer should be yes, but increasingly it seems, as a matter both of theory and of evidence, that to implement efficient methods of compensating executives and professionals is extremely difficult, and maybe as a practical matter impossible for a free-market system to accomplish.

There is a long-standing concern that corporate executives are more risk averse than a corporation's shareholders, because the latter can eliminate firm-specific risk by holding a diversified portfolio, while the former cannot, because they have firm-specific human capital that they will lose if the firm tanks. The solution to this problem was thought to consist in making stock options a large part of the executive's compensation, so that his incentives would be closely aligned with those of the shareholders. True, because he would bear more risk, he would have to be paid more in total compensation than if he did not receive a large part of his compensation in the form of stock options. But the cost to the corporation of the additional pay would presumably be offset by the gain to the shareholders from the executives' enhanced incentives to maximize shareholder wealth.

But we are beginning to realize that the grant of stock options may make corporate executives take more risks than the shareholders desire. Suppose that instead of being compensated for bearing risk just by being paid a higher salary or given even more stock options, the executive is guaranteed generous retirement and severance benefits that are unaffected by the price of the corporation’s stock. Now he has a hedge against risk, and can take more risks in operating the corporation because his personal downside risk has been truncated. Perhaps this was a factor in the recent stock market bubbles--the one that burst in 2000 with the crash of the high-tech stocks and the one that burst this year as a result of the collapse of the subprime mortgage market and the resulting credit crunch. A bubble is both a repellent and a lure. It is a lure because during the bubble values are rising steeply, so an investor who exits before the bubble has peaked may be leaving a good deal of money on the table. He will be especially loath to do that if he is hedged against the consequences of the bubble's eventual bursting.

Boards of directors could devise compensation schemes that limited the attractiveness of risky undertakings, but they have little incentive to do so. The boards tend to be dominated by CEOs and other high corporate executives of other firms, who have an interest in keeping executive compensation high and who are abetted by compensation consultants who naturally recommend generous compensation packages to directors who are recipients of generous compensation and therefore believe that the CEOs of the companies on whose boards they sit should be paid top dollar.

It is not clear what the free-market antidote to this tendency to ratchet up executive compensation is. The compensation of the CEO and other high officials of a large corporation is usually only a small part of the corporation's costs, so shaving such compensation is unlikely to be a powerful competitive weapon. But more important, what rival corporation would have the governance structure that would enable such shaving to be accomplished by overcoming the obstacles that I have discussed? The private-equity firm is a partial answer, because it has only a few shareholders and so need not delegate compensation to a board of directors that has other interests besides the welfare of the shareholders at heart. The reason it is only a partial answer is that there are too few owners of capital who want or have the ability or experience to participate as actively in management as the private-equity entrepreneurs and there are too many efficiently large corporations for all of them to have the good fortune of being owned by a handful of entrepreneurial investors. There is a vast pool of passive equity capital that can be put to work only in companies that are organized in the traditional board-governed corporate form.

Here is another though related example of a stubborn efficiency-in-compensation problem, also in a highly competitive sector of the economy: law-firm billing practices. Major law firms, with few exceptions, base their bills to their clients on the number of hours that the firm's lawyers work on the client's case or other project. In other words, they bill on the basis of inputs rather than outputs. This is rational when output is difficult to evaluate, as is often the case with a law firm's output because of the uncertainty of litigation (in nonlitigation practice, because of legal and factual uncertainties). The fact that a firm loses a case doesn't mean that it did a bad job; both the winner's firm and the loser's firm may have done equally good jobs--the lawyers don't control the outcome. A law firm can give the client a pretty good idea of the quality of the lawyers it assigns to the client's case, because there are observable proxies for a lawyer's unobservable quality, proxies such as his educational and employment history. What the client cannot readily judge is whether the law firm put in excessive hours on the case, and the result, according to persistent and cumulatively persuasive anecdotage, is a tendency for law firms to invest hours in a case beyond the point at which the marginal value of the additional hour is just equal to the marginal cost to the client. Young lawyers often feel that they are being assigned work to do that has little value to the client but that will increase the firm's income because the firm bills its lawyers' time at a considerably higher rate than the cost of that time to the firm. The very high turnover at many law firms is attributed in part to dissatisfaction of young lawyers with the amount of busywork that they are assigned, work that bores them and does not contribute to the development of their professional skills, yet may be very time-consuming.

The problem is compounded by the distorted incentives of corporate general counsels. A general counsel wants to show his boss, the corporate CEO, that he monitors expenses carefully, and, since he knows that he is likely to lose at least some of his cases, he also wants to be able to avoid if possible being blamed by his boss for the loss. Hourly billing serves both of these ends. The law firm and the general counsel play a little game, in which the law firm prices its hours on the assumption that it will not be able to collect its billing rates on all of them, and the general counsel reduces the number of hours that he is willing to pay for. He can then show his CEO that he squeezed the water out of the law firm's bills. At the same time, by paying a prominent law firm by the hour, he can assure his CEO, in the event a case is lost, that he had told the firm to do as much work as was needed to maximize the likelihood of a favorable outcome, rather than paying a fixed rate agreed to at the outset that might have induced the law firm to skimp on the amount of work it put into the case.

One can imagine a law firm's adopting a different method of pricing, in which it would charge at the outset a fixed fee, subject to adjustments up or down at the end of the case based on outcome, amount of work, or some other performance measure or combination of such measures. The conventional law firm billing system is a form of cost-plus pricing, which is considered wasteful. But litigation is risky, and cost-plus pricing diminishes risk by eliminating a contractor's incentive to cut corners. If the disutility of risk to a general counsel is great, he will prefer to "overpay" law firms rather than trying to explain to the CEO that the novel compensation deal that he worked out with the law firm that lost the case was not a factor in the loss; that he had not been penny wise and pound foolish.

Although the compensation practices that I have described seem inefficient, it does not follow that corrective measures would be appropriate. They would be costly and the net benefits might well be negative. It is efficient to live with a good deal of inefficiency. Stated otherwise, the fact that competitive markets contain large pockets of inefficiency is not in itself inefficient. For example, while cartel pricing is inefficient, if the cost of preventing cartelization exceeded the benefits one wouldn't want to prevent it. Yet cartel pricing would still be inefficient in the sense of misallocating resources, relative to the allocation under competition. We must live with a good deal of inefficiency, but it is still inefficiency.

Risk-Taking by Top Executives-Becker

Executive compensation has been criticized both for being too generous, and for encouraging excessive risk-taking relative to the desires of stockholders. Yet while there are links between the level of pay and the amount of risk chosen, these are mainly distinct issues. Executives may be paid little, but the pay can be structured to have a much better payoff when profits are high than when profits are low. In this case, the average level of pay over both good and bad times would not be particularly generous, but its structure would tend to encourage risk-taking behavior. On the other hand, a CEO's pay might be excessively high on average, but not appreciable better when his company does well than when it does badly. He would be overpaid, but he would not have a financial incentive to take much risks.

Does the pay structure in American corporations, with the growing emphasis during the past several decades on stock options, bonuses, and severance and retirement pay, encourage excessive risk-taking, where "excessive" is defined relative to the desires of stockholders? It may look that way now with the sizable number of major financial companies that have taken huge write downs in their mortgage-backed and other assets, while top executives of some of these companies have only had modest declines in their pay (although others, such as the head of Bears Sterns, have taken huge hits). However, these financial difficulties do not necessarily imply that heads of most financial companies knowingly engaged in more speculative activities than desired by stockholders because of the incentives CEOs had. A more compelling explanation is that heads of companies have undervalued the risks involved in holding derivatives and other exotic securities, particularly securities that were rather new and not well understood. Let me stress, however, that I am not trying to excuse the many CEOs in the financial sector and in other sectors who got off much too easily for terrible investment decisions.

Bubbles are prolonged periods of excessive optimism where the true longer-term risk to holding particular assets is generally underestimated. The housing boom of the past few years now appears to have been a serious bubble where pervasive optimism about housing price movements raised the rate of increase in housing prices far beyond sustainable levels. Sophisticated lenders as well as low-income borrowers underestimated the risks involved in the residential housing market, as they appeared to have assumed that housing prices would continue to rise for a number of years in excess of ten percent per year.

Evidence suggesting that the risk taken by companies during the recent boom was not mainly due to a principal-agent problem between executives and stockholders is that the major private equity firms also experienced serious loses on their investments, especially on their housing investments. Private equity companies have much less of a principal-agent problem than do Citicorp, Bears Sterns and other publicly traded companies because private equity companies have a concentrated ownership. Also borrowers in the residential housing market have basically no principal-agent problems since they buy for themselves; yet many of them too took on excessive risk because of undo optimism about the housing market.

The private equity example provides a more general way to test whether CEOs take greater risks than their stockholders desire. One can analyze the relation between the degree of concentration of stock ownership in different companies and various measures of risk, such as their year-to-year variance earnings, adjusted for industry and other relevant determinants of this variance. The excessive risk argument would suggest that the more concentrated the ownership, the smaller would be the actual exposure to earnings and asset risk.

Another test of the excessive risk argument is whether the trend toward greater compensation in the form of stock options and other performance contingent compensation increased the risk taking of companies. Some have attributed much of the dot-com bubble to increased performance based compensation. However, most dot-com companies that went under were quite small and rather closely held by venture capitalists and similar investors. Hence these companies did not have a sharp conflict between stockholders and managers. Moreover, during the dot-com bubble, assets of minor Internet companies were raised in market value to more than 100 times earnings, even when they had no sales, let alone earnings. Such huge earnings-profits ratios suggest excessive risk taking by stockholders more than by managers.

Economic theory does imply that the increasing trend toward performance-based compensation would increase the degree of risk-taking by top executives. It is much less clear whether this effect is large- doubts are expressed by Canice Prendergast in his study "The Tenuous Trade-Off Between Risk And Incentives", Journal of Political Economy, 2002, (Oct), 1071-1102. It is also unclear if CEOs have been induced to take more risks than the level of risk desired by stockholders. Furthermore, and most important, there is no persuasive evidence that the structure of CEO compensation played an important roll in either the dot-com or housing bubbles.

Drugs and the Cost of Medicare -Becker

Medicare is the federal system that covers hospitalization, physician care, drugs, and a limited amount of nursing home care for men and women over age 65. President Lyndon Johnson started it in 1965 in a modest financial way when the elderly were a small fraction of the adult population, and when drugs and surgeries to treat diseases of old age were far fewer and less complex. This program has grown in the 42 years since then into a major entitlement, with spending of almost $400 billion, which is more than 3 percent of American GDP. Of even greater concern is the projected growth in this program during the next several decades.

If past growth in Medicare is a reasonable guide to future growth, and assuming that real GDP grows at an annual rate of two and one half percent, Medicare spending as a share of GDP will double by 2020, and increase some 3-4 times by 2050 to 10 percent or more of GDP. Dollar spending on Medicare patients would increase to over a trillion dollars by 2020. Less than half of the projected increase would be due to the further aging of the population, while the majority is the result of the expected continuing growth in spending on hospitalizations, surgeries, and drugs for the elderly of given ages.

Much of the increased spending would occur even with the most efficient health delivery system since senior citizens along with younger adults put a high value on living longer in reasonably good health. The value placed on longer life and good health generally rises as incomes grow; indeed, economic analysis and past experience indicates that the willingness to pay for better health will increase in the future at least as rapidly as incomes do.

Still, there is no doubt that while the American health care delivery system has many strengths, including an encouragement to medical innovation, medical costs for the elderly could be significantly reduced with no reduction in quantity and quality if various inefficiencies in the system were corrected. Numerous proposals have been advanced to make the Medicare delivery system more efficient. Former Secretary of State and of the Treasury George Shultz, along with Professor John Shoven, in an important forthcoming book, Putting our House in Order, review several of these proposed reforms and advance their own thoughtful reforms for social security as well as Medicare and Medicaid. We discussed various reforms of American spending on medical care in our blog posts on January 13 of this year, and I will not repeat them now.

Instead, I discuss why drugs should have an important role in inefficient as well as efficient medical delivery systems. Medicare only started to cover spending on drugs in 2003, and the coverage had various defects. These include a deductible that is much too low, and a "doughnut" where there is no coverage at all for additional spending in the middle ranges of drug spending (see my discussion on Feb. 13, 2005 of these and other defects of drug coverage, with suggestions for how to make that coverage more effective). It is no surprise that spending on drugs by the elderly were not part of Medicare at the beginning since drugs were a minor part of their total medical spending in 1965. However, discoveries since then have led to various blockbuster drugs, and many less revolutionary advances in medications. These include drugs to lower blood pressure and cholesterol, to treat Parkinson's disease and other disorders of the nervous system, to help thin the blood, to overcome erectile dysfunction, to fight Aids, and to reduce testosterone to combat the spread of prostate cancer. The share of their total medical care that seniors spend on drugs has moved steadily upwards during the past 40 years, and now is more than 12 percent, and before long might approach 20 percent.

Drugs should be part of an effective health delivery system not only because of the continual introduction of new drugs, including a growing importance of genetic based drugs, but also because drugs have a very attractive cost structure, especially for the growing elderly population. As the number of persons over age 65 increases during the next several decades, it would be useful to have a health delivery system in which costs do not rise as rapidly as the number of persons treated. Surgeries do not have this property since their cost tends to increase in proportion to the number of surgeries performed since each one takes a more or less fixed number of surgeons and supporting personnel. Hospitals also have few economies of scale with respect to the number of in-patients treated once a relatively small efficient bed size is reached.

Drugs have a totally different cost structure. They typically have very high fixed costs of research and development and low marginal costs of adding additional users. To develop a new drug to treat depression, or Alzheimer's, or another serious medical problem, usually requires hundreds of millions of dollars in the form of spending on research and various stages of clinical trial development, including many failures before a successful treatment is developed. Once a valuable drug is developed, however, the cost of producing each pill is usually small, certainly a tiny fraction of its fixed costs of development. This means that additional users can be added with relatively little increase in total costs, and a decline in average cost per user.

This property of the cost of producing drugs has two extremely important implications for Medicare costs. The first is that drugs are an efficient way to treat diseases and disorders that hit a large number of men and women since then the fixed costs can be spread over a larger number of users. This makes them particularly valuable to the elderly who are a growing share of the population in the United States and all other developed countries, and in many developing countries as well, including China. Moreover, the U.S. and world populations are also increasing, which increases the demand for all drugs, including those that help treat older persons.

Drugs are also valuable in inefficient delivery systems that have trouble choking off medical treatments that would not pass a benefit-cost calculation. This would characterize systems with highly subsidized medical care, with excessively low deductibles, or with rules that cannot deny treatments to the very elderly and those close to dying who would benefit only a little from receiving treatment. Surgery, hospitalization, and close physician supervision are expensive ways to treat seniors who do not benefit much from this care since the cost of these procedures tend to rise in proportion to the number treated. On the other hand, while treating seniors with drugs sometimes also may not add much in the way of benefits, the additional cost per user would be much smaller than the average cost per user. This property of the cost of using drugs makes them particularly useful in the American medical system since that system errs on the side of generosity toward the elderly and others compared to the health care systems in most developed countries.

This advantage of drugs in inefficient health delivery systems does not argue against the need for major reforms of Medicare to make it more efficient. It recognizes, however, the value of second-best solutions in a political environment where reforms of health care are likely to come slowly because they run up against many powerful vested interests.

The Medicare Challenge--Posner's Comment

Becker makes the ingenious suggestion that the effect of adding drug coverage to the Medicare program is to prevent spending on drugs from growing as rapidly as the number of persons covered by Medicare. The reason is that because the marginal cost of drugs tends to be very low; most of the costs of drugs are fixed costs of research and development. Hence the larger the number of persons eligible for Medicare drug benefits, the lower the average cost of drugs.

Nevertheless the net effect of the addition to drug coverage on total Medicare spending is likely to be a substantial expansion in the total cost of Medicare. As of January of this year, 25 million persons had enrolled in Medicare Part D (the drug part), and the total annual expense to Medicare is estimated to reach $36 billion this year. As the program is only two years old, further increases in enrollment and usage can be expected, irrespective of increases in the eligible population, since more than 40 million persons receive Medicare benefits.

The net addition to Medicare costs will be less than the cost of Medicare drug coverage if drugs are a net substitute for other covered treatments. But they may not be, because there is also a complementary relation between drugs and other forms of treatment, such as surgery; to the extent that drugs reduce the pain, discomfort, or disability of surgery, they may increase the demand for surgery by reducing its nonpecuniary costs, a cost reduction that though real will not be reflected in the Medicare cost figures.

In addition, by increasing the demand for drugs, Part D will increase the net expected profits from new drugs, and thus increase the incentive to create such drugs, with the heavy fixed costs that, as Becker points out, are entailed by the development of new drugs.

Still another problem with Medicare drug coverage is that people have less aversion to popping a pill than to being operated on or otherwise confined in a hospital. The cost of surgery, as it appears to most people, includes a significant nonpecuniary element that of course is not reimbursed by public or private health insurance. Taking drugs does not impose such costs unless a drug has serious side effects. Hence the Medicare drug subsidy should cause a greater percentage increase in demand than the traditional Medicare subsidies did.

Drugs also provide an attractive but costly substitute for life-style changes designed to improve one's health. If the choice is between giving up rich food and taking a pill paid for by Medicare, the latter may be preferred though the social cost may be higher; the subsidy confronts the consumer with false alternatives from an overall social perspective, just like monopoly pricing.

The addition of drug coverage to Medicare entrenches the worst feature of the Medicare program, which is the lack of a means test. There is no reason why people who can afford to purchase health insurance that will cover their medical expenses in their old age should be subsidized by the taxpayer. There is, however, no political will to require a means test. More broadly, there is no political will to reduce public expenditures on health care. The focus of politicians is not on containing costs but rather on what has the opposite effect: expanding coverage. Congress is moving to require health insurance companies to cover mental illnesses, despite uncertainties about the efficacy of treatments for mental illness and the "cosmetic" element in the treatment of such illness because of the lack of a clear distinction between being mentally ill and simply being less happy, focused, energetic, outgoing, and, in short, successful than one would like to be. Especially because of the optional character of treatment for borderline mental "illness," demand for such treatments will be highly responsive to a subsidy, assuming the insured person who demands such treatments can shift some of the cost to the other members of his insurance pool. Notice too how the movement to require insurance coverage for mental illness will interact with Medicare drug coverage to further expand drug usage by the elderly.

In addition of course the politicians want to extend health-insurance coverage to the 40 million plus uninsured Americans, and this will increase the demand for medical services. What politicians say in a presidential-campaign year is not, however, a reliable guide to their intentions. I suspect that when the new Administration takes office in January of next year it will find that fiscal constraints preclude any significant expansion in the gargantuan federal subsidies for health care (including such indirect subsidies as imposing mandates on private insurance companies); but neither can we expect meaningful measures of cost containment.