Healthcare isn't the only example of a two-tier system

Merit goods are defined as goods that are deemed to be socially desirable. Socially desirable things can often be provided by the market. However, merit goods are deemed to be somewhat problematic because either: (1) the market doesn't provide enough of the good, compared with the socially efficient (economic-welfare-maximising) quantity; or (2) the good is important, and if it was distributed by the market, some people would miss out on the minimum quantity of the good that is deemed to be necessary. Who decides what is socially desirable or what the minimum quantity of the good is? Those are political decisions. In other words, what constitutes a merit good is mostly a political decision, not an economic decision.

If merit goods are not provided in sufficient quantities, or are provided in sufficient quantities but not to everyone who we think needs them, then that suggests a role for government. That means that the government either subsidises merit goods or provides the merit goods itself. I was tempted to provide some examples that fit into each of those two categories, but it turns out that, for every example I considered (health, education, public transport, the arts) the government tends to do a mixture of both subsidising and public provision.

However, let's focus on public provision of merit goods. There is no free lunch. When the government spends on health or education, that means less spending on other things. There are trade-offs, and that makes it difficult for government to provide gold-plated goods and services to everyone. Sometimes, people just want more than the government is able to provide. That's why in New Zealand, alongside the public healthcare system, there is a growing private healthcare system, accessed mainly by those with private health insurance. This unavoidably creates a disparity in people's access to healthcare. Some people can only afford to access the public healthcare system, while others can choose to access public healthcare, or to pay extra (either directly or through health insurance) to access private healthcare.

Many people take issue with the disparity in access, arguing that it creates a two-tiered system and is therefore unfair. Take this article from The Conversation yesterday, by Elizabeth Fenton and Robin Gauld (both University of Otago):

Many seem to accept the argument that a two-tier public-private health system is not morally problematic, given most essential health services remain free to all. Some might go further and argue justice demands a two-tier system because health is only one public good the state is obliged to provide. Limiting non-essential healthcare services ensures it can meet those obligations.

The second private tier protects the liberty of those who want and can afford to purchase those services, while the first public tier focuses on meeting everyone’s needs to a sufficient level.

But the justice argument supports this conclusion only if the services and benefits provided in the first tier meet that threshold of sufficiency. Where exactly this threshold lies has been the subject of perennial debate.

Fenton and Gauld are clearly in favour of a more generous public healthcare system, which in turn would limit the necessity for the private healthcare system. Their argument is valid. It's simply a question of prioritisation of government spending (but keeping the trade-offs in mind). However, I do want to take issue with this bit from their article (aside from them saying in the quote above that health is a public good, when it isn't [*]):

When the worse-off are required to accept services below reasonable expectations of routine care (and the demonstrable harms that result), individuals are no longer in the same boat. The better-off live in a world of social goods and privileges inaccessible to the worse-off.

Why we accept this in health and not other sectors is an important question. It is hard to imagine school teachers only taking bookings months out to see parents seeking help for their troubled children, or denying entry to public schools due to limited capacity.

It is also doubtful we would accept teachers setting up private classes and consultation times to provide a timely service to those who can pay.

Fenton and Gauld need to reconsider their example of education. Education is a two-tier system as well. There are both public schools (nominally free) and private schools (with high fees). Parents can (and do) pay for private tuition for their children as well. Some of that private tuition is conducted by people who are teachers in their regular day job (a consequence of the education system paying teachers poorly). And that isn't even considering post-secondary education, where there are both public and private providers as well. 

Healthcare isn't the only example of a two-tier system. Consider transport (public transport vs. taxis or Uber), justice (legal aid vs. private lawyers), or security (police vs. private security firms). Unless there is some law that prevents the private sector from operating, any time the government is publicly providing a good or service, we'll end up with a two-tiered system, with one tier accessible to everyone, and a separate tier accessible to those who are willing and able to pay more.

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[*] Public goods are goods that are non-rival (meaning that one person's use of the good doesn't diminish the amount that is available for everyone else) and non-excludable (meaning that no one can be prevented from accessing the good). Healthcare doesn't meet either of those conditions (for some further explanation with other examples, see here and here). Healthcare is a private good - it is both rival and excludable. It may be a publicly-provided good (in many countries like New Zealand that have a public healthcare system), but that doesn't make it a public good.

The compensating differential for university professors

I love my job. I honestly have the best job in the world [*]. Now, there is a serious problem inherent in those statements. It isn't that we shouldn't love our jobs. Every one of us deserves to do a job that we love. The problem is that, when we do a job that we love, we are willing to do so for a much lower wage than we could earn in a job that we didn't love nearly as much.

This is what economists refer to as a compensating differential. Consider two jobs that are similar in almost all ways, except that one job has some attractive non-monetary characteristics (e.g. it is a job that is pleasant, fun, and/or clean), while the other job has unattractive non-monetary characteristics (e.g. it is a job that is unpleasant, boring, and/or dirty). More people will be willing to do the first job. This leads to a higher supply of labour for that job, which leads to lower equilibrium wages. In contrast, fewer people will be willing to do the second job. This leads to a lower supply of labour for that job, which leads to higher equilibrium wages. The difference in wages between the attractive job that lots of people want to do and the unattractive job that fewer people want to do is the compensating differential.

Is there a compensating differential for university professors? According to this 2018 article by Daniel Hamermesh (Barnard College), published in the journal Economics of Education Review (ungated earlier version here), there is, and it is substantial. Using data from the American Community Survey for 2012-2016, and comparing workers with doctorates working in academia with workers with doctorates working in other occupations, Hamermesh finds that:

Comparing pay differences at various quantiles of the distributions, near the bottom of the pay distributions academics earn more than other doctorate-holders; but the differences rise steadily as we move up the earnings distributions, with academics’ pay beginning to fall below that of other doctorate-holders at the 17th percentiles of the distributions. At the 25th percentiles of the distributions the earnings advantage has turned into a disadvantage of 6%; at the medians it is 19%; and it rises to an astounding 50% disadvantage at the 95th percentiles. At the means academics receive 24% lower pay than non-academic doctorate-holders...

University professors get paid less than doctorate-holders in other occupations. The mean difference is US$29,802 (US$121,704 vs. US$91,902), and the difference at the 95th percentile is a staggering $196,594 (US$394,058 vs. US$197,464). Controlling for various demographics, the mean difference in pay is 17 percent.

This suggests an incredibly large compensating differential for being a university professor. What explains it? Hamermesh looks at the flexibility of work timing using a simple utility model calibrated to data from the American Time Use Survey, and concludes that:

Under what seem like reasonable assumptions about utility a not tiny, but also not huge part of the earnings differential can be explained by the more equal distribution of leisure across days of the week that academics enjoy.

To be more specific, time flexibility can explain no more than a quarter of the difference in pay between university professors and other doctorate-holders. Hamermesh then looks at data from a survey of 288 academic economists, which asked which aspects of their job contributes most to their enjoyment of being a professor. The survey results show that:

Freedom and novelty of research, and the satisfaction of working with young minds, are by far the most important attractions of academe, listed by 88 and 74% of survey respondents respectively. Only 36% of respondents listed time flexibility as a top-three attraction, slightly fewer than listed enjoying intellectual and social interactions with colleagues.

University professors are poorly paid compared to workers with doctorates in other occupations. The compensating differential here appears to capture how much professors value the freedom and novelty of doing their own research, and the thrill and inspiration that comes from working with students. I totally buy into that argument. I love my job.

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[*] Important note to my employer: Nothing in this post should be taken as an indication that I don't deserve to be paid way more than my current salary.

The case against 'greedflation'

The latest economics buzzword is 'greedflation' - the idea that firms exploit inflation by raising prices to create excessive profits (for example, see here). Aside from being a cool portmanteau and inspiring new memes, I just don't see it. In fact, I've said so. I wrote an article in The Conversation about it last month, and I was interviewed on RNZ's The Detail podcast last week (see also here, and similar points picked up by the New Zealand Herald's Front Page podcast here). I was pretty clear on The Detail - I'm a greedflation skeptic. This post outlines the theoretical and practical reasons why I believe that greedflation is an illusion.

First, let's consider how firms price their products. As I teach in my ECONS101 class, we assume that firms with market power are trying to maximise profits. If the firm sells a single product at a single price-per-unit, the profit-maximising quantity is the quantity where marginal revenue is exactly equal to marginal cost. As shown in the diagram below (which assumes a constant-cost firm, a point I will return to later), the profit-maximising quantity is QM. To sell the quantity QM, the firm sets the price equal to PM, because at that price the quantity of the product that consumers want to buy is exactly equal to QM. The difference between the price PM and the firm's costs PS is the firm's mark-up. The firm's producer surplus (profit) is equal to the area of the rectangle CBDF.

Now, once the profit-maximising price is set, there is no reason for the firm to deviate from that price. If the firm raises the price above PM, then by definition their profits must decrease (because PM is the price that maximises profits, so any other price must decrease profits for the firm). So, here we have the first theoretical case against greedflation - a firm that is already profit-maximising has no incentive to increase prices, because they are already maximising profits. It makes no sense for the firm to try and 'trick' consumers into paying a higher price, because consumers would buy less of the good.

Now, consider what would cause the firm to change the price it sets. First, a firm would likely change prices if its costs change. This is shown in the diagram below. If the firm's costs decrease from MC0 to MC1, then the profit-maximising price decreases from P0 to P1. This also works in reverse - if the firm's costs increase, then the profit-maximising price increases. This would not be 'greedflation'. Most proponents of the idea agree that a firm that is passing on higher costs to the consumer is not exploiting the consumer. Moreover, the research of Nobel Prize winner Daniel Kahneman and others shows that consumers see higher prices as 'fair' when they are driven by higher costs.

Second, a firm would likely change prices if demand changes. This is shown in the diagram below. When demand is shown by the curve D0, the profit-maximising price is P0, but when demand increases to D1, the profit-maximising price increases to P1, even though costs are the same. Is this 'greedflation'? Perhaps, if the firm tries to hide its increase in price behind a smokescreen of 'it's because of inflation'. Moreover, Kahneman's research (noted above) does show that consumers find price increases that arise from demand changes to be unfair. On the other hand, economists expect firms to increase prices when demand is high. It's how markets work on a routine basis, and isn't unique to a time of higher-than-usual inflation.

Third, a firm would likely change prices if consumers' price elasticity of demand changes. Price elasticity of demand is the consumer's responsiveness to a change in price. When demand is more price elastic, the demand curve is flatter, and the firm's optimal mark-up is lower. This is shown in the diagram below. If the demand curve is D0, then the profit-maximising price is P0, but if the demand curve was more elastic (D1), then the profit-maximising price is lower (P1), even though costs are the same. Why would demand become less elastic? There are many factors that affect the price elasticity of demand. However, most of them are fairly static and don't change much. The availability of substitutes, though, can change. When there are fewer substitutes available, as would happen if competition in the market decreased, that would make demand less price elastic, and raise the profit-maximising price for remaining firms in the market. Is this 'greedflation'? Again, perhaps, if the firm tries to hide its increase in price behind a smokescreen of 'it's because of inflation'. But I'd still argue that this is a routine consequence of a decrease in competition, and not unique to a time of higher-than-usual inflation. This explains the case of Air New Zealand, for example, which has been raised as an example of 'greedflation' in New Zealand. Jetstar wound down its services during the pandemic, reducing competition in the market for domestic air travel, and not surprisingly, Air New Zealand raised domestic airfares.

Ok, so we've established the conditions where firms with market power would increase prices (higher costs, higher demand, lower competition). However, as I note in my ECONS101 class, pricing in the real world is not as simple as that shown in the diagrams above. First, firms often don't know for sure what their demand curve is, and so they won't know for sure what their marginal revenue curve is, and so setting the price at the quantity where marginal revenue is exactly equal to marginal cost is difficult in practice. However, that doesn't mean that firms can't set a price at all. It just means that they can't always do it perfectly. A good manager has a fundamental understanding of their market, which means that they understand in relative terms how price elastic or price inelastic the demand for their product is. They can use that fundamental understanding to set the mark-up. They won't get it perfectly correct, but they shouldn't systematically get it wrong (if they did, they wouldn't be a manager for long). Then having set the price using their fundamental understanding, they adjust the price occasionally to take account of changing costs or changing market conditions. For example, they raise prices if their costs increase, or they lower prices if a new competitor opens down the street from their store.

Second, firms don't change their prices every time that market conditions change. That's because of menu costs - literally, the costs associated with changing prices. Menu costs may be low if all they require is changing some settings in the point-of-sale system, but can be higher if they require printing and attaching new price labels. Firms prefer to avoid these costs, as well as avoiding the uncertainty for consumers that constantly changing prices cause, so they tend to increase prices only infrequently.

Both of those real-world pricing problems mean that firms will often increase their prices by more than is justified by a strict accounting of an increase in their costs. Perhaps they are 'catching up' on an increase in costs from a few months earlier. For example, say that the firm has costs that go up from $10 to $12 to $15 from Month 1 to Month 2 to Month 3, but they keep their price the same at $20 from Month 1 to Month 2, and then raise it to $30 in Month 3. If you were looking for 'greedflation', you might then see evidence in favour of it between Month 2 and Month 3, when price increased by 50% but costs only increased by 25%. However, you are ignoring the previous month, when costs increased but the firm didn't change their price.

So, that's the theoretical and practical cases against 'greedflation'. I simply don't think that firms are hiding price rises behind a smokescreen of high inflation. There isn't much incentive for them to do so. Is there empirical evidence to support the idea of 'greedflation'? Quite the contrary. In the latest issue of AEA Papers and Proceedings, this article (ungated earlier version here) by Christopher Conlon (New York University) and co-authors looks at the relationship between changes in firms' mark-ups and changes in prices (as measured by the producer price index, deflated by the consumer price index). They note that:

Our starting point is the observation of Syverson (2019) that for markups defined as price over marginal costs (μ ≡ P / MC), an approximation provides

(1) ΔP ≈ Δμ + ΔMC.

Therefore, increases in markups should yield increases in prices unless they are offset by marginal costs changes.

Using annual data from CompuStat on revenue and cost-of-goods-sold for nearly 8000 firms, and covering the period from 1980 to 2018, as well as quarterly data from 2018 to 2022, Conlon et al. find that their data:

...do not reveal a strong correlation between markup and price changes during the sample periods.

In other words, price changes are not driven by changes in markups, which leaves changes in marginal costs as the explanation. In other words, there is no evidence of 'greedflation'. However, that doesn't mean that changes in competition are implicated solely, either. Conlon et al. note that:

A second explanation, proposed by Syverson (2019), is that if cost of goods is more similar to average costs than marginal costs, then we need to also adjust for the scale elasticity AC/MC,:

(3) μ ≡ P/MC = P/AC × AC/MC

So, if prices are increasing at the same rate as mark-ups, then that could be because average costs are increasing, or it could be because the ratio of average costs to marginal costs is increasing. That would happen if there were a re-balancing of costs from variable costs (MC) to fixed costs (a component of AC). Conlon offer some evidence from other studies that supports this argument. However, that's not 'greedflation' either.

The case against 'greedflation' is strong. Just because it makes a nice meme, that doesn't mean that it is true.

Is good research a substitute or complement for good teaching?

University lecturers engage in two main activities: teaching, and research. Some people believe that the two activities are complements. For example, higher-quality research is associated with a better or deeper understanding of the discipline, which can then be passed onto students with higher-quality teaching. On the other hand, teaching and research may be substitutes. Academics have limited time to devote to each activity, and naturally spending more time on one means less time devoted to the other. That would suggest that higher-quality research would be associated with lower-quality teaching.

So, which is it - complements or substitutes? Past studies I've written about (see here and here) haven't provided good evidence either way. So, I was interested to read this 2018 article by Ali Palali (CPB Netherlands Bureau for Economic Policy Analysis) and co-authors, published in the journal Economics of Education Review (ungated earlier version here). They first provided a much more thorough explanation than mine above of the mechanisms that might relate teaching and research:

The first type of mechanisms suggests a positive relationship between research quality and teaching quality via complementarity between skills... Conducting research can both enhance proficiency of the teacher in the subject and keep him up-to-date with the latest developments in the discipline. As a result, research activities have a positive impact on teaching quality...

The second set of mechanisms suggests a negative relationship between research quality and teaching quality. Both research and teaching activities require investment of time and effort. Time and effort spend on research reduces the amount of time and effort that can be spent on teaching, unless some activity benefits both research and teaching (e.g. reading a scientific paper can simultaneously contribute to research ideas and to teaching preparation)... A negative relation between research and teaching can also result if (contrary to the first set of mechanisms) teaching and research require a different set of skills. If research requires more specific skills (e.g. synthesis, deduction) than teaching (e.g. communication, mentoring), this can lead to disparities between skill transfers.

Palali et al. used data on student performance from over 9000 students in the BA and MA programmes at Maastrict University in the Netherlands over the period from 2008 to 2013, essentially identifying the relationship between student performance (measured by grades) and the research quality of their teachers. This approach is valid because, after students have chosen their courses:

The Scheduling Department at SBE allocates students into tutorial groups using a computer program. Once the online registration is closed, all students taking the same course are randomly assigned to tutorial groups by a computer program. Subsequently, tutorial teachers are randomly assigned to tutorial groups within a course...

The randomisation ensures that good students are not systematically paired with good teachers (or good researchers, for that matter), and means that the results of the analysis are plausibly causal, rather than simply correlations. They measure research quality using research publication, which in the first instance is a dummy variable that captures whether each academic has any research publications in the previous four years, or alternatively a measure of the total number of research publications in the previous four years. They also use measures of quality based on a dummy variable for whether each academic has any publications in journals rated 'A', 'B', or 'C' (in a classification used at Maastricht University). In their analysis, Palali et al. find that:

Only for master students a positive effect of this research quality measure is found on student grades. Students of teachers with at least one publication the past 4 years have on average 0.35 (in a scale of 0–10) higher grades than those of teachers with no publications in the past 4 years...

...the coefficient estimate for the total number of publications in the last 4 years shows that the total number of publications has no effect on student performance.

Those two measures mostly ignore research quality. However, moving onto their other measures, Palali et al. find that:

The coefficient estimate for master students shows that there is a significant positive effect on student grades for master students. Having a teacher with at least one A level publication in the last four years in associated with a 0.43 higher student grade. This suggests that in master programs students taught by teachers with high quality publications perform better, but students of teachers with many publications do not. Thus, quality seems to be more important than quantity.

So, overall, the results suggest that research and teaching are complements, but only for postgraduate (Masters-level) study. Why might that be? Palali et al. suggest that:

Most of the courses in bachelor programs are mandatory courses at the introductory level. Master courses, on the other hand, are more often elective courses, and are more specialized courses on a specific topic, and followed by students that are more interested and motivated. It is also generally the case that teachers give special topic courses which primarily focus on their field of interest. This can increase the effects of skill transfers and the effects of interactions between teachers and students.

On the other hand, Palali et al. also find little evidence for any relationship between research quality and student evaluations of teaching (also such evaluations have their own problems - see here and the links at the bottom of that post).

So, should we conclude that research and teaching are complements, or that there is no relationship between them? Before we conclude, we need to note that there is a problem with this analysis. Higher-quality teaching should manifest in students doing better in their subsequent studies, not just in the particular course they are studying in at the time. Higher student grades in courses taught by better researchers could simply mean that better researchers grade their students more generously (perhaps so they don't have to spend time on student complaints, and can therefore devote more time to high-quality research). The effect on future grades is relatively easy to check for (such as in studies on teacher value-added, see here). When Palali et al. look at future grades, they find that:

...there are no dynamic effects. Although coefficient estimates are positive, they are small in magnitude and insignificant.

So overall, it remains difficult to say whether good research and good teaching are complements or substitutes.

Read more:

• Are teaching and research substitutes or complements?
• Adjuncts are better teachers than tenured professors in introductory courses