Economics and Finance Symposium - Economic Policy Challenges: Microeconomics and Regulation

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ROSE: I'd like to welcome everyone to the final panel of today. If you spend much time around MIT, you all know that physics has an uncertainty principle, and as you've discovered today, so does economics. And indeed, in this panel, the uncertainty principle we're grappling with is will our final panelist make it off the plane that is supposed to be coming from Washington, DC landing in Logan in time to join us at the very end of our panel discussion? We'll wait and see.

So we started this morning with a discussion of contributions that MIT faculty and alumni have made to advance economic modeling methodologies and science, particularly in the microeconomic realm, but broadly. But MIT economists have seldom been content with only these objectives as laudable and as invaluable to academic progress as those may be. Indeed, a hallmark of the MIT economics department has been the firm insistence on integrating economic science with applications.

Economics faculty and alumni have at least one foot on the ground at all times. Sometimes, as you've heard from Esther Duflo, both feet on the ground in entire teams in countries around the globe. So we've asked our current panel to switch gears from a focus on the macroeconomy, as uplifting as the last panel's discussion of that was, and shift attention to discuss what microeconomists have contributed to important policy questions and operations of government policy, regulatory policy, and corporations.

And this panel could, of course, as the others, be an entire day of discussion in and of itself, but Jim Poterba has told me that we do have a firm stop, because people might want to be able to eat at the end of the day. And so we will try to limit our time to give you a bit of a teaser to many of the important issues that we could discuss but give you a sense for some of the contributions.

So I'd like to just briefly introduce our panel, and then I'll let them weigh forth. Our first panelist is Dennis Carlton. Dennis has an MIT Ph.D. In economics and is the Katherine Dusak Miller professor of economics at the Booth School of Business at the University of Chicago. Dennis is going to share his perspectives on economic contributions to competition policy broadly-- that'll be a theme of his-- and is well-positioned to do that, both through his experiences, as been mentioned earlier, as deputy assistant attorney general for economic analysis at the Department of Justice, also as a member of the Antitrust Modernization Commission. Policy roles, which greatly complemented Dennis's research expertise in this area, as well as other broad areas of industrial organization, anti-trust, and regulatory economics.

Our second panelist, Dick Schmalensee, is not quite an MIT lifer, despite the dual bachelor and Ph.D. Degrees from MIT and his role as the Howard Johnson professor of economics and management, director of the MIT Center for Energy and Environmental Policy Research, and dean emeritus at the Sloan School. Now why do I say he's not quite a lifer? Well, Dick spent a few years away from us at the University of California, San Diego, which today looks particularly attractive to him.

Dick has had a career that has spanned a broad range of research areas, ranging from industrial organization, management, strategy to antitrust, regulatory, and environmental policies. And I believe Dick is going to weigh in, in particular, to share with us some of the contributions of microeconomics to solving some of the questions that Bob Gordon raised in the last panel, namely how do we think about intelligent energy policy and environmental policy given the substantial challenges that we face not just as a country, but as a world?

Hal Varian, who is an MIT undergraduate and has a Ph.D. in economics from the University of California, Berkeley, gives us a little bit of a change of pace. So how-- well, he has in his past life been a professor at Berkeley in three departments there-- business, economics, and information management. Currently, he's chief economist at Google. And as you know, economics undergraduates and even a healthy fraction of economics Ph.Ds often choose to ply their trade in the private sector.

It's a little less common for faculty to make that transition from academics to the business world, although MIT alumni have done that consistently over time, and some of our most distinguished alumni have done that in very successful careers in both academics and the corporate world, as well as sometimes the policy world.

I think of people like George Schultz, who moved from the University of Chicago to Bechtel or Gary Loveman who leapt from Harvard Business School to become CEO of Harrah's. And today Hal is going to share with us some of the contributions that microeconomics have to understanding the operation of firms in the information economy, the challenges that are posed by some of the really dramatic technological innovations that we're grappling with, and how we might make sense of that.

And then finally, if US Air is cooperative, and Logan snow crews are doing their job, Mark McClellan, who has a Ph.D. from MIT as well as an M.D. and MPA from Harvard, is going to talk with us about health policy. And Mark, again, as you're catching this theme, has not only had a very distinguished research career in this area, but has been a very important policymaker in a number of health-related policy positions.

So without further ado, I'm going to ask Dennis to kick off this discussion.

CARLTON: Thank you. I'm very pleased and honored to be here to celebrate with MIT, and I want to really thank MIT for the fine education they gave me in economics and in operations research, and also thank them for how nice all my professors were and the MIT administration when I was a student.

My topic today is regulation with a special focus on antitrust, and I'm going to talk about three things. I'm going to talk about the enormous impact that economics, specifically industrial organization, has had on antitrust, and the very important effect that antitrust has had on industrial organization. I'm then going to identify a few key hot topic areas that are emerging in antitrust, and finally, I'll conclude by drawing some lessons about how economics can best be used to influence policy here and around the world.

Before about 40 years ago, antitrust was abysmal in its use of economics, both at the government agencies, and in court decisions with rare exceptions. But industrial organization in microeconomics provided a very simple and powerful way to understand competitive behavior amongst firms. And it really produced a revolution in antitrust thinking, and this revolution is often traced to Aaron Director, who taught at the University of Chicago Law School and co-taught, actually, a course in antitrust with Edward Levy, who was not only president of the University of Chicago, but also an attorney general of the United States.

By the 1960s, we heard this morning, and certainly by the 1970s, there was a growing economics group at the Department of Justice. And in the 1980s, the chief economist position was elevated to deputy assistant attorney general, which put it on a par with the other legal deputies. When I was there at the Department of Justice about two years ago, I had about 60 Ph.D. economists under my direction, and they were doing very important research, and moreover, they were listened to.

On most cases, the economists are asked to produce a memo that goes to the front office, together with the legal staff producing their own separate memo. And each are weighed in terms of making the decision. The same is true about the importance of economics at the other government and antitrust agency, the Federal Trade Commission.

Let me talk briefly now about some of the interactions between antitrust and industrial organization and vice versa. Let's start out with one of the key areas in industrial organization and antitrust-- cartels. It's a pretty simple theory. A bunch of firms get together. They collude to raise price. That's bad. So what does the Department of Justice want to do? They want to stop that.

So what I'm going to illustrate will be an example of how some very simple ideas matter a tremendous amount. What we know is from just very basic economics that your incentive to engage in a cartel is going to depend upon the penalties. So the Justice Department looked and noticed that the fines were pretty low. So the fines were raised from 10 million to 100 million. And then they looked about jail time, and they noticed that they weren't sending very many people to jail for very long. So they raised the jail penalty to 10 years.

And then they did something very clever. They introduced what's called a leniency program, and they said, if you're currently in a cartel, and you come to us and you squeal on everybody else, we'll give you leniency. You won't go to jail. We'll reduce your fine, and when you get sued civilly by a private plaintiff, and you're guilty, because you're telling us you're guilty, you'll be subject to damages. Under the antitrust laws, civil damages are trebled.

But if you come to us, and we give you leniency, we're not going to allow the court to multiply your damages by three. So wow. Pretty powerful incentives. And by and large, there weren't a lot of cartels that were being investigated. It was hard to find them. They put in place these three programs that I just discussed. All of a sudden, people are lining up around the block to say, I'm in a cartel, I'm in a cartel, and I think economists were pretty surprised by how many there were. Very simple idea, very effective.

Secondary are government policy mergers. In the early 1980s, Bill Baxter, a former Stanford professor, a law professor, was the Assistant Attorney General, and he produced the merger guidelines. Reissued merger guidelines would be more accurate. But these merger guidelines were based explicitly on economic reasoning, heavily based on George Stigler's theory of oligopoly, and it gave economic structure for the first time to merger review.

And today, the latest econometric techniques and industrial organization theories are being used by the staff of economists I referred to to analyze mergers. And they do very, very good work. While I was at the Department of Justice, I noticed something. I actually wrote a paper about it, and I said, boy, you guys are doing all this work about using fancy econometric models, merger simulations to predict what's going to happen if a merger occurs, and you're using that to decide whether or not to challenge a merger.

Why don't you keep following things? that way we can test subsequently for those mergers that go through. Which of our techniques, which of our theories actually do a good job at predicting, say, the pricing behavior? Unfortunately, we don't do enough of that at the agencies.

Let me turn to the last sort of important element in the antitrust cases through our cartels, through our mergers. The last area is what I'll call section two cases or bad conduct cases. These are often the cases that make big headlines. So there have been a number over the last several years-- the breakup of AT&T, the government attack on IBM, a whole series of Microsoft cases, and a whole series of litigation involving credit cards.

I've been involved in various aspects of all these cases, and my point here isn't to discuss whether these cases were decided rightly or wrongly. But what my point is to illustrate that each of these cases unleashed an enormous amount of research among industrial organization economists about practices that maybe they were vaguely aware of but didn't really appreciate their importance.

So for example, there's now a huge literature on what I'll call dynamic strategic behavior in which a firm that has some market power is able to engage in various types of strategies against its rivals in order to either preserve its market power or to swing its market power from the product over which it has the market power legitimately into areas where it wouldn't otherwise have market power but for its acts.

What are some of the acts that have been attacked? Bundling. You buy my product, this product. Then you have to buy this other product from me. You know, tie-in sales. Issues about how I deal with my rivals who may depend upon me for certain critical inputs and the like. Another area that developed, a booming area, had to do with networks. Network effects occur when, for example, my use of a word processor program is influenced by how many other people are using it, because I want to communicate with them. Huge area that developed.

Another area is this recent area of what are called two-sided markets. What's an example of a two-sided market? Credit cards. How does that work? My usefulness as a customer of having a credit card depends upon how many firms accept that credit card, so there are two mechanisms of payment by which a credit card company at least could get paid either by the customer or by the firm, and there are various types of revenue flows.

The fact that antitrust cases provide practical examples to industrial organization economists is what is motivating, I think, a lot of very good research into uncovering better how current industry practices work. What are some common features of these cases? Let me just mention two. Many of these industries are undergoing rapid technological change. Now we know from a lot of the panels and a lot of the work of economists in this room how important technological change is.

What does that mean for these cases? That means when you're intervening in a case, you want to make sure you're not preventing technical change by what you're doing, and you're not impeding it. That's a pretty hard problem to figure out how firms compete when it's technological competition rather than price competition that is emerging. We have much better models of price competition than we do of technological competition.

And finally, the second common element of a lot of these cases is a vertical aspect. In many of these cases, the firm that's being attacked under the antitrust laws or what I'll call the dominant firm is providing an essential input to its rivals who then compete against that dominant firm in other aspects. And the question is, what are the requirements one firm has with another about duties to deal and on what terms?

Let me just turn now to what looked like the emerging hot topics in the field of both antitrust and industrial organization. And I'll mention just three. First one, I've already alluded to. That's bundling and tie-ins. When a firm sells a product of which it may have some unique power, market power, it can bundle that product and say, you want to buy that product from me? You also have to buy these following other products from me. Or it might package the products together as one product.

Question is when is that an antitrust violation versus when is it, for example, if I'm bundling products together in one product, when is it desirable technological change? How do you strike that balance? That's been a problem, a difficult problem to figure out in some past antitrust cases, and I predict that's going to continue to be a difficult problem that will dominate a lot of research that IO economists are doing.

Second area, important area, has to do with intellectual property. I'll speak about patents. The patent system has been widely studied, and a lot of people have come to the conclusion that it's broken. Why is it broken? A lot of what are called weak patents are given. What's a weak patent? You get something that really isn't that important, an idea. You get it patented at the patent office, and then, perhaps, if you go to litigation, the court says, eh, it's not so important. It's not valid.

How did this problem arise? An interesting way. In 1982, there was a restructuring of the court system, and the normal appellate court system was replaced by a specialized patent court. And people thought that would be good. We'll get a lot of people who have specialized knowledge, and patents will be more accurately given when they're deserved. But what happened was a little different. Unexpectedly, there was an enormous increase in the number of patents that were granted, and this led to the problem that I just alluded to of weak patents.

And what kind of problems did weak patents create? Well, if you're an inventor, and you come up with a new product, all of a sudden you might get sued by 1,000 different people. And this is especially a problem in high tech industries, where design of a particular product can trigger literally hundreds or even thousands of patents. In the antitrust area, this problem has led to what's called the patent ambush problem, and this is a serious problem. In fact, I'm giving a paper on this in two weeks. There's a conference in Europe specifically with one third of the day devoted to the patent ambush problem in antitrust.

What is that problem? That's a problem where a patent holder, in a sense, misleads, misuses the patent system in order to induce firms to make a technological investment that's irreversible. Once they've made it, the patent holder shows up and says, surprise. I have a patent. You owe me a lot of money as a royalty. Creates ex post market power where none might otherwise exist.

The last hot topic I'll talk about has to do with information, and this is a question as to who owns information. So think about the internet. I buy a lot of stuff on the internet. Do I own that information? Does the seller own the information? Does my credit card company, if I pay by credit card, own the information? Does a search engine own the information? Who can use it and how?

When people start using information, when there's a lot of information available, intermediaries are going to develop, intermediaries that bunch together buyers who can negotiate against sellers. Is that an antitrust violation? How about intermediaries that put together a whole bunch of sellers who then can gang up on one buyer? Is that an antitrust violation? When you start thinking about putting together intermediaries or running auctions, you're getting very close to starting to study or restudy how markets form. Economists have not really paid as much attention as they should to the fact that a market is a product that can be viewed as a product that firms produce.

What are the rules that govern a market? Now if you look at something like the Chicago Mercantile Exchange, they now own the Chicago Board of Trade. There have been futures exchanges around for a long, long, long time. They are in the business of creating markets. We haven't done enough study of markets. We haven't done enough study of how the rules get created to make a market work to generate liquidity. And this is going to get close to not just antitrust, but SEC and CFTC regulation of financial markets.

And the final issue that's related to information has to do with privacy concerns. This is probably less antitrust, but I know it's something that, for example, the Federal Trade Commission is very focused on. Well, let me just conclude by asking what lessons, if any, about regulation generally do I draw? Well, I think there are really three points I want to make. The first is that simple ideas have high value added. And that's the thing where I would stress regulatory policy could enjoy large payoffs. The example of the leniency policy was a huge-- the leniency policy was an excellent example of showing how very simple ideas about economic incentives can change things a lot. Second, a lot of regulation, including antitrust, has an international dimension. And we have to cooperate internationally. The difficulty this raises is that many international organizations, foreign organizations, don't quite have the same staff of economists or the appreciation of economics that a lot of US agencies have.

So how do you convince them what to do? Well, I think the best way to do it-- I mean MIT does it by training Ph.D.s who then go to those countries-- but there's another way of doing it, and that is the agencies themselves can run training programs to bring people to the United States and teach them economics. And I actually started doing that at the Department of Justice, and I think that was a very effective way of teaching the staff, not the political appointees, but the staff of international agencies how they should think.

And the final thing I'll mention may seem like a detail, and I used to think it was a detail, but I've now come to realize it's really not. And that is if you look domestically, the institutional structure of the regulatory agency matters a lot. What do I mean by that? There are some government agencies that have what I'll call a public interest standard in which their goal is to advance the public interest. There are other agencies-- for example, the Department of Justice-- where their role is to enforce the antitrust laws and make sure that there is no harm to competition.

So imagine a telecommunications merger. It turns out that both agencies review the telecommunications merger. The Justice Department puts conditions on to make sure there's no harm to competition. The FCC can go much further. They can put on whatever conditions they feel are important in order to promote public interest. My own experience suggests that the more carefully delineated the objectives are of the regulatory agency, the more likely you are to avoid what looked like arbitrary imposition of conditions that might be used to promote sort of the pet idea of one of the agency regulators. So thank you very much.


SCHMALENSEE: We are fully staffed. As a near lifer, I'm delighted to be here today, and I must say what a privilege it has been to be here these many years as part of this extraordinary, extraordinary community. As I listened to the previous panel, I was struck by the notion that the difference between policymaking in the macro sphere and in the micro sphere is a little like the difference between drivers and mechanics on a racing team.

Everybody knows what drivers do. Everybody knows what macro people do. They do inflation and unemployment, and their stuff is on the front page of the paper. The mechanic is kind of in the garage late at night, dirt under the fingernails, skinned knuckles, nobody watches, and nobody has a clue what they're doing until the car doesn't go.

It wasn't macro policy that got us into this mess, I think one can argue. And, of course, from a micro point of view, the calls for more regulation as a response, the undifferentiated calls for more regulation that we heard in the aftermath of the initial stages of the crisis are a lot like telling a mechanic to use more wrenches. One does need to get closer to the details.

So my focus is to be on energy and environmental policy, but I do want to say a few words about micro or structural policy more broadly that, to some extent, will echo what Dennis said. It's a lot less fun to teach antitrust and regulation than it was when I started, because there are fewer really dumb policies. There are fewer of the antitrust cases that came down in the '50s and '60s that were really great fun to teach to an economics class, because you could pick them apart. And you could say this decision is pursuing-- whatever it's pursuing, it's not pursuing any single objective. It makes no sense. The economics is bad and so forth.

That has been transformed under the influence of economics, and you get decisions you disagree with, but you don't get decisions and arguments in cases that make no economic sense. They're pretty rare and insignificant cases. And we don't regulate airlines, and we don't regulate interstate trucking, and we don't do a lot of things that were fun to talk about in class, because you could say, why are we doing this, and get students to understand.

There are still some policies that fit the bonehead description, and that's because, I think, like the mechanics, we tend to work not on the front pages of the paper, but in the third page of the business section. And the policies are usually covered-- the debates are covered, if they're covered at all-- by reporters who don't actually understand the issues.

The other point to make, and I'll come back to it briefly, is that there are still plenty of analytically difficult problems, policy problems. There may be political problems and administrative problems, but there are also difficult technical problems. Dennis mentioned two-sided markets and credit cards as a classic example.

Well, the Federal Reserve was taxed by the Dodd-Frank bill with regulating an aspect-- let me not get into it-- of the pricing of debit cards. And while there is a literature on this, which I've contributed, Dennis has contributed, others have contributed going back at least a decade, about the only consensus in that literature is that what the Fed did was wrong.

We don't have the right answer. We don't have a prescription that says, marginal cost pricing. Well, we know that's wrong in this case. We don't have that answer.

So let me tell some good news before I tell some bad news. So there has been a lot of progress beyond antitrust in the general area of energy and environmental regulation. We used to regulate the wellhead price of natural gas. That was another one of those great policies to talk about in class, because it served no useful purpose and had a very high cost.

We moved away in large parts of the country in the 1990s from the traditional model of regulating electric utilities. We found ways, following models in Chile and England, of bringing competition into the system, of reducing the scope of regulation, and increasing the scope of competition. Economists played a significant role.

You even now see some regulators thinking about incentives, about the incentives given to regulated firms. One would not read that in the '40s and '50s too often. Since the Reagan administration, cost-benefit analysis has been required in the process of making federal environmental rules, as well as other rules. Sometimes this is even an aid to decision rather than a defense of a decision already made.

But this is now a bipartisan thing. The guidelines for doing cost-benefit analysis don't get torn up every time an administration changes. It begins to look a little bit like antitrust. It's something you do as part of good government, and that is economics. And finally, at least until the recent demonization of cap and trade, policymakers had come to appreciate the ability of market-based mechanisms to achieve environmental goals at reduced cost. The high watermark, at least so far, is the European Union's emission trading system for reducing carbon dioxide emissions-- ironically, a system sold to them by the first Bush administration and then the Clinton administration based on our experience with the acid rain program enacted in 1990.

There are other elements of good news, other elements where other areas, where economics has had an impact on the way decisions are made and on the policies that have resulted. But frankly, it is amazing when you look across energy and environmental policy, the extent to which policy is still inefficiently pursuing goals that don't make much sense. And I think the hard problems really are political, not technical, and really do come from the fact that this stuff tends to be on the second page of the business section.

Let me give you an example that infuriates me, but I'll try to control myself. It's outside this area. It's Massachusetts auto insurance. Now we're the only state in the union that regulates the prices of auto insurance, the only state in the union. You will occasionally see third page discussions of the business section about, could competition work? This is not an open question. But in Massachusetts, it is.

So why doesn't it just get answered correctly? A, there isn't really intelligent public debate, because it's kind of an obscure question, and not that many people really realize that in the rest of the country, you could have the gecko if you want the gecko, but not here. And they don't quite realize there is an agency that has an interest in continued regulation, and there are a set of companies that don't operate outside Massachusetts that have an interest in the continuation of this regime.

That kind of-- it happens in a small room not on the floor of Congress, not in front of the press. It happens in a small room with a few people taking minutes that decisions are made is a reason why bad policies persist. People don't watch the mechanic. People don't understand the mechanic much of the time. So let me give you a few examples of bad policies that have persisted for awhile, and then just to give us a depressing conclusion that tries to echo the macro panel, I'll talk a little bit about renewable energy.

So since 1970, the Environmental Protection Agency has been required to regulate local air pollution under the demonstrably false assumptions that perfect safety is possible and that damage functions are discontinuous. It is sometimes required by law to disregard cost. Second example-- despite the partial success of the 1990s, much of the US electric power sector-- and I should give Paul Joskow credit for pushing a lot of the change that did occur, and Paul being frustrated by the fact that it stalled. And a large fraction of the country didn't move to restructure. About a third of the country didn't move.

Unlike telecommunications, unlike electric power in the European Union, there is no overall effective national policy. There is, in a continent spanning system, a dominance by state regulators. There is an extraordinary heterogeneity in legal regimes, organizational forms, even though the electrons whiz around. It is a system that has been in place more or less since the 1930s and is dead stuck. Huge barriers to reform-- not technical. Not technical. Lots of great economic work has been done in bringing market forces to bear in electric power, but politically, there are awesome obstacles.

Finally, since the 1970s, with all due respect to Bob Gordon, I think discussion of energy independence has driven out much intelligent debate about energy policy. Except for oil, which we don't use to generate electricity, we're self-sufficient. And despite the subsequent discovery of huge oil fields in Alaska, great advances in technology, and ongoing subsidies, US oil production peaked in 1970. Full stop. Peaked in 1970. Has declined since. We will not drill our way to independence. If you listened to the last presidential debates, you would never get that impression. You would get the impression, if we just drilled a little more-- well, that is technically nuts.

So it is frustrating when one works in these areas that level of debate on important questions about energy policy. So finally, let me talk about the whole issue of renewable energy and climate change. I'm glad Bob Gordon mentioned a climate tax. I've worked the climate change issue in one fashion or another since I was at CEA, and it is, to my mind, the most complex public policy problem I've ever seen, in part because of its international dimension, in part because of its inner temporal dimension, in part because of all the uncertainties involved, in part because of all the mechanism design problems involved, but many of the incoming members of this Congress don't believe there's a problem.

That's step one. And step two, we're not going to deal with it. The state of public debate is we're not dealing with climate. I'm sorry. That was yesterday's question. Well it goes on. The substitute seems to have been, we will do renewable energy. I love the sun, and I love the wind. Just let me be very clear on this. How could you be opposed to the sun and the wind? But let's just for a moment get serious. 29 states and the District of Columbia have requirements that certain fractions of electricity be generated from renewable energy. The president of the State of the Union talked about 80T of electricity generated by clean sources by 2035. However, it has been made clear that almost everything is clean, so we seem to be OK there.

But let's be clear what all of this focus on renewable energy is. It is not a responsible reaction to climate change. It deals only with one sector, provides no incentives in transportation, no incentives for energy efficiency in heating and cooling and industrial processes, transportation, provides no direct incentive to back off coal, which is the main way you reduce carbon dioxide emissions. It's not a good way to create jobs. I mean Detroit learned that having a big domestic market doesn't necessarily give you a healthy domestic industry, and switching from one capital intensive way of generating electricity to another capital intensive way to generate electricity is probably not the recipe to cure mass unemployment.

It is industrial policy. It is industrial policy. It is the government picking a winner and saying the Chinese think solar is a big deal, so we're going to think solar is a big deal. Now if you work in the energy and environmental policy field, and you see industrial policy coming up again, despite the governments-- and that's a plural governments-- despite governments' terrible record at picking winners, and even worse record at developing national champions that can compete internationally, it's a little bit depressing.

This has enormous political momentum. The level of debate is very low. Those people who know the issue and have thought about these things are drowned-- their voices are drowned out by the voices of special interests operating like the mechanics in the garage where it's quiet, not on Sunday afternoon in front of the audience like the macro people. We all have envy of the macro people. They get the attention. But I think the fact that they get the attention means that the debates are at a higher level. The fact that it's economy-wide issues means there's less scope for special interest.

A lot of micro policy is frustrated. Even though there's good economics and progress to be made, it's frustrated by the fact that it is very hard to get past special interests when there isn't widespread attention. So I'm trying to match the earlier panels that dealt with the macro economy for being negative. This is about as well as I can do it. There has been progress. There's been a lot of work done here. Antitrust in particular has been revolutionized by economics, but if you look in energy and environmental policy or broadly in areas of regulation, there is much to be depressed about. There are plenty of areas where economists are unanimous and unable to move the needle. But there's always tomorrow. Thank you.


VARIAN: So I grew up on a small farm in Ohio, and when I was in junior high, a momentous event took place in my life. The Russians shot off Sputnik. That was a satellite. And Congress got very upset about falling behind in the space race and all of this stuff. They passed something called the National Defense Education Act, and it was because of that act and the scholarships that they provided that I was subsequently able to attend MIT. And that's had a huge intellectual impact on my life, so thanks to Sputnik and thanks to MIT.

Now I'm going to be more optimistic. I think I'll be the most optimistic person that you've heard today, because after all, I do come from California, where it was 63 degrees when I left, and I'm counting the minutes until I get back. But we live in a period of great innovation, and I refer to this as a time of combinatorial innovation, and by that I mean, every now and then you get a set of component parts become available that innovators can combine and recombine to create new inventions.

Now this is an old idea. Marty Weitzman, also an MIT grad, has written about it. Joseph Schumpeter has written about it. He wasn't an MIT grad, but hey, nobody's perfect. Think of something like in the 19th century, there were standardized mechanical parts became available. Beginning in the 20th century, you electrification, motors, electric motors, gasoline engines. In World War II, we saw radar, electronics. In the '20s and after, microelectronics, integrated circuits, software, and now the web.

So the nice thing is you've got these components. You can create all sorts of innovations by combining them in novel ways. And I think exploring this idea might help address what Bob Solow talked about this morning of trying to make that connection between investment and technology and how it actually turns into products. So you get a very rapid pace of innovation.

I'll just give you a recent example. Back in 2005, Google released Google Maps, where you could display maps in a convenient way, and a computer engineer named Paul Rademacher looked at this, and he dumped the JavaScript from the web browser that we used to call Google Maps, and he hacked it for awhile, and he was able to combine Craigslist house rentals with the Google Maps and put these two pieces of software together.

So what did Google do when we saw this egregious violation of our intellectual property? We did the obvious thing. We hired the guy. We put him to work building an API so that anybody could do this. And so Google Maps then a few months later, under Paul's guidance, released this API, and there was a huge growth of innovation as people found all sorts of ways to combine this particular component, a geocomponent, a map with all sorts of interesting capabilities.

Now this kind of combinatorial innovation is a global phenomenon. It's particularly global, because the costs of communication have really collapsed in the last 10 or 15 years. So even a very, very small company, 10 or 15 people, can now be born global and has access to communications and a computation infrastructure that even the largest multinationals could not afford just 10 or 15 years ago.

So small firms can use Skype and chat and wikis, docs, source code repositories, email, video, et cetera to work around the globe and around the clock, because you don't have to worry about everybody going to bed at the same time. You're able to continue production in other parts of the world, and there's a whole host of these what I would call micro multinationals that are springing up in various places, mostly connected to universities, where you can see this kind of innovation take place in a very vibrant environment.

And not only do you have this efficiency in development, you can also host your software products at data centers run by Amazon, Google, Microsoft, and other vendors of cloud computing so that they've essentially changed what was a fixed cost and a barrier to entry into variable cost, so you can get firms entering at much smaller scale, and so you can get much more innovation going on. I think this is also leading to a big improvement in business processes. So I think there's an area that we haven't really gotten into much. That's what you might call the nanoeconomics of the firm. I know we're talking about microeconomics, which is taking the firm as given, but withinside the firm, there are business processes and communication patterns that go on. And the fact that we have these highly networked, highly computerized organizations makes life much more efficient.

As a little example, Yan Chan, who's a professor at University of Michigan, did a study where she took students and gave them questions from Google. One team of students went off to answer the questions using the library, and the other team used a search engine, and you could compare the time to answer these different questions.

Turns out it's about seven minutes using a search engine and 21 minutes using the library. So you're saving about 15 minutes a day on a question, and if you take some average numbers for how often you ask a question on Google, that adds up to about $200 billion of savings and lost time.

Now there are some subtleties here, because it used to be asking questions was expensive, or maybe I should say getting answers was expensive. So we didn't ask very many questions, or we only asked really important questions. But now getting questions answered is very cheap, so we ask a lot of them, so there's a bit of a consumer surplus calculation that has to be gone through to do this right. But no matter how you cut it, you get a pretty big increase in productivity in knowledge work.

Now think about the way we do knowledge work. So everybody in this audience is a knowledge worker, I'm quite sure, and one of the things you do is you produce documents. And in most cases, those documents are reviewed by other people. So you get input into what you do. And traditionally, we had technological devices like typewriters and carbon paper, and you would shorthand. People would transcribe your document. It was sent around for commentary, and people scribbled notes on it, and it was all combined into a new document. It went around again.

Then we had great innovations like white out-- that was a great innovation-- and post-it notes, and that made it much easier to do this kind of process of revision. When we went to email, we mirrored that same process of creating and circulating a document and getting comments on it just using a software for.

So it's very inefficient when you stop and think about it, because you could do so much better by having a master copy up in the cloud and having the computer do all the revision tracking and keeping track of who did what, and be able to restore the document to its stage at any point. And you end up with a huge productivity improvement, and hopefully, you get not only better documents, but better ideas and better decisions by removing a lot of the transactions cost from this process.

And by the way, I think it is tricky, because a lot of those transactions costs don't show up in GDP, so it's a little hard to talk about the productivity increase. I think there's definitely a productivity increase, but there's a challenge in terms of measuring it. Now along with this improvement in computation and communication, the cost of experimentation and exploration has dropped rather dramatically. So I talked about combinatorial innovation, where you have lots of innovators trying different things, but any single innovator or any single firm can also try lots of different things. That's called experimentation, and we heard Esther Duflo talk about that this morning.

We saw experimentation in the age of agriculture with the huge productivity improvements that came from agricultural research stations. You look at the age of manufacturing. David Hounshell has written a wonderful book called From an American System a Manufacturer to Mass Production, and you can see these technological improvements that went place because of tinkering of trying to work on improvement in the production process through assembly lines and time and motion studies. Remember in the '80s, the Japanese system of manufacture, Kaizen, which was the idea of continuous improvement in the production process. And so all of these things dramatically improved productivity by experimenting and trying to find better ways to do things.

Now in the internet age, the fantastic thing is that experimentation and continuous improvement is just dramatically cheaper, because you can design software, so it allows all the parameters to be variable, and then you can implement a system, try out different configurations in real time, and really get a continuous improvement in the processing of your system.

So for example, at Google, we are firmly committed to experimentation. Last year, we ran 5,000 experiments in the search engine side of the business. That resulted in 400 improvements in search quality, and on the ad side, we ran about the same number, 4,000 to 5,000, with, again, several improvements, and at any one time, there's about 500 experiments running on both the ad side and the search side, so 1,000 all together. And anytime you use Google, you're probably in a dozen experiments or a half dozen experiments at least.

So this is a system that is continuously improving, because we're continuously running experiments and trying to improve the system to make it function better. And it's far, far easier to do that in the web environment than it is to do it in Africa for sure, but we know the value of experimentation really pays off. I'll give you an example there.

Back in 2006, Google wanted to get into voice recognition. Now we had no data and no expertise, so the first thing we did is we hired some expertise. We got some of the world experts in this area, and then we created a system called GOOG-411, which was an automated information system, where you could call GOOG-411 and say, pizza, Mountain View, and it would come back and say, do you mean Joe's Pizza on 123 Main Street? And you could say yes, or you could say no. And that allowed you to find what you wanted.

Now the great thing about it is it was a light client on the phone. In fact, it was virtually no client. And all the calculation took place in the cloud. It took place on the Google servers. So this system could learn in real time. When it said something and thought it recognized what you said, it said yes or no, and you answered yes or no. And that was a data point for it to learn from.

And so in the space of a year, we had an absolutely fantastic state of the art data system, and even now, if any of you are using Android phones, it works exactly the same way. When you talk to your Android phone, it is learning from your response whether it's got the right voice recognition, and this system is continuously improving to recognize a variety of accents, a variety of languages, and you can do this in a real time. And by the way, you can do the same thing with optical character recognition, so you can get a much, much better system there by doing the same thing.

So the old systems, you ran the learning part as a batch process, and then every time there was a new release of the system a couple times a year, it got a little better, but now the model is you have continuous learning, so you're learning all the time, and the system is evolving in real time. Now I want to spend just a minute talking about the role of modeling in business and economics, because this was one of my assignments.

When I went to work at Google, I started as a consultant back in 2002, and I asked Eric Schmidt what I should work on, and he said, oh, why don't you work on this ad auction? I think it might make us a little money. Well, he turned out to be right. I mean, it is a funny thing. Even in 2002, Google did not have a clear idea of how it was going to make money, and the ad auction was one choice among several.

So I built a model of the ad auction using game theory, the kind of game theory I was taught at MIT. It was a very simple model you could do using high school algebra, and it turned out to be a pretty accurate and a pretty useful way to understand the dynamics of what was going on in that auction. And kind of the surprising thing in retrospect is that other companies who were built around auctions like eBay and Yahoo never really bothered to hire people who are experts in this area until much, much later, but not until 2005, 2006. Nowadays, everybody wants to have a chief economist. Yahoo, Microsoft, Intel, Amazon have all hired chief economists in the last few years. So economics is really on a roll in Silicon Valley.

Now the good news is, I think, that standard techniques from economics really work very, very well on business problems. And I mean the kind of modeling and econometrics you get from an undergraduate or maybe an introductory graduate education in economics. And it's important to realize this, because it's a little discouraging working as an academic economist, because the problems that you work on are so hard. They're so difficult. And there are much, much easier problems in industry.

I think that's because in industry we have better data and easier to access data. We have pretty much a closed system, so you don't have worry about lots of other things going on. It's inherently less complicated, and we have this capability of experimenting, which you typically don't have in economics, or if you do have it, as we heard this morning, it tends to be something that's quite costly to implement.

So one kind of nice example is auctions, where those of you who are aware of what's been going on in academic and business research, in this area, there's been really some fantastic ways in which the theory and the empirical analysis of the data have fed on each other. We have a much, much better understanding of how auctions work for privatization, for IPOs, for ads, and all sorts of other things. So it's a great example of how you can have very practical outcomes from something that started as a kind of esoteric area of research.

And finally, I want to say one word about policy, because I was on my prescription. If you look at most businesses now, pretty much everyone has a real time database, a database of what's going on in their business, a data warehouse or database. And you look at these. They're extremely powerful. Google, of course, has a lot of data. But it's not just Google. You could look at UPS or FedEx or Walmart or Amazon or MasterCard, and they can actually query what's happening in the last day and in some cases, even what's been happening in the last hour.

Now this is actually much, much better data than the federal government has, and I think that one of the advances that we're going to see in the next decade is we're going to figure out ways for the federal government to get access to some of this real time data that's being produced in the private sector, and that's going to allow us to have a much better handle on what's going on in the economy. So I think that the real time economics, real time econometrics is going to be something that's very important from the viewpoint of policy in the next few years. Thanks.


MCCLELLAN: Well, good afternoon. I'm really glad to join you all, and I'm sorry it was late. I'm coming from Washington, DC, not the happy, sunny land that Hal just described, where there's transformative information technology, and people are hiring and presumably listening to economists, but the land where whether you're describing last night's traffic during the storm or just about any political issue these days, including environmental economics, the word is gridlock.

But despite that, I still want to try to convey a sense of some optimism, and I gather from some of the comments earlier that not all of the speakers have been that optimistic about the impact of economics on policymaking. I think there is, in health care at least, which is what I'm going to focus on, some reason for hope, but also some reasons for skepticism. And it all kind of reminds me of one of my first briefings when I went to Washington and started working in economic policy, and I'm not going to even say which administration this was in. I worked in more than one.

But at that White House briefing, we were debating the administration's position on a very important policy initiative related to Medicare. And I started off my presentation as part of this debate by saying that this is an idea that virtually every economist in the country thinks should be done now. And without missing a beat, one of the senior White House advisers who was there, who shall remain nameless, said, is that a pro or a con?

And they get-- and so I think there's still this sense that a lot of these good ideas that economists have are missing something, are missing a connection to the public. They're missing paying attention to those nano details that we've heard about from some of the earlier speakers, or something that's standing in the way of having a bigger impact. And I think that's really not a challenge for the rest of the world. I think that's a challenge for us, who are doing applied economics to find ways to make our work more practically relevant.

The good news here is I think that some of that is happening, and I want to take the recent health care reform law and the health care reform debate, and we're just continuing to provide some examples of that. Leading up to the implementation of the law, virtually all of the major decisions about what kinds of subsidies would be provided and how insurance choices would be set up in these new exchanges and the fact that an individual mandate might be needed to get broad participation and prevent adverse selection, all of those are a reflection of empirical work by applied economists here and elsewhere.

People like John Gruber here at MIT had a fundamental impact on the economic modeling that went into and that had a tremendous influence on the legislation that was put together on scoring by the Congressional Budget Office, on the debates around which kinds of policies might practically work or not. You can still debate, and many economists have, about whether some of the conclusions built into those models are the right ones. But you can't say that they weren't influenced by the applied economic research that has been done in decisions about insurance choice, decisions about labor supply, decisions in microeconomics that have been applied to health care in recent years.

But I want to make a distinction between that kind of microeconomic analysis, which is having some impact, and a big area that I think is still missing in health care and probably in other fields like education as well, where the impact of empirical economics is much more limited, I think, in part, because of how compelling the evidence is is also missing as well. And in that respect, I want to talk about health care costs, health care quality, the kinds of decisions that go into determining health care costs and quality at an even more micro level. Decisions like what kinds of services, what kind of treatments does a doctor decide to provide for a particular patient?

There's a good deal of economic evidence that those decisions are influenced by a range of economic and policy factors. Similarly, what kinds of behavioral choices are made by consumers, both about which doctor to go to, which treatments to use, how to use them, and even more fundamental treatments about their own health, their own diet, their lifestyles, whether they smoke, whether they engage in other kinds of behaviors that have health implications.

And here, the impact of economics on policy has been more limited, and I think it's at least in part because of some of the limitations of the evidence. And this is very important for policymaking. Aside from the fact that we have been able to come up with some estimates of what the impact of coverage expansions would be and things like that, that's all done on top of this much more micro level of health care delivery in the United States, where there's a tremendous amount of variation that continues to occur that we haven't done a good job of explaining or at least describing policy solutions to address.

Around the country, Medicare costs vary more than two-fold from region to region from places like Miami to places like Minneapolis. There also are big variations in health care costs. Going along with that are some big variations in how health care is delivered that seem to persist year after year. Some people have said that, well, maybe it's just a difference in preferences or some hard to measure differences in health status that account for this.

But also true is the fact that variations exist in health care cost growth from area to area around the country and in changes in medical technology use that are equally as big-- growth rates ranging from one to two percentage points per person higher than GDP to four or five percentage points higher than GDP over the last decade or more. And we haven't done much during this whole time period to address whether there are any consequences of those variations for health and what kinds of policy changes could have a more fundamental impact on our health care costs.

A lot of people have looked at these kinds of descriptive statistics and said, gosh, if we could get the growth rate down a little bit, if we could deliver care in what looked like more efficient ways, we could easily pay for making health insurance more widely available. We could easily address the long-term fiscal challenges facing the country, but we haven't figured out policies that help us get from here to there. There is suggestive evidence, but it's not yet compelling evidence. And I want to give examples of that in three areas before I finish my remarks.

One of them is in the incentives facing health care providers, physicians, hospitals, other providers. A second set involves consumers and the demand side of health care, so supply and demand side. So let me start with providers, because this actually was a big part of the recent health care reform debate.

Some of you may remember President Obama saying at one point that if there was a good idea out there for reforming health care from the provider side, for paying doctors differently, paying hospitals differently, it's in the law. And he's right. There are a broad range of proposals in terms of changing the way that health care payments work designed to address some of those apparent inefficiencies in our health care system by promoting more high value decisions by providers.

The basic idea here is to move away from a traditional way of payment in health care based on fee for service, where insurance plans, Medicare, and other plans typically pay based on the volume and intensity of services provided. So reimbursement goes up with the volume and intensity of treatment. I got some firsthand experience with the practical side of these reforms, which people have been talking about in health care and applied economics for some time, with one of my first meetings with the CEO and the leaders from a number of health care organizations around the country after I became administrator of the Medicare and Medicaid programs.

They came in and said, look, Mark. We're trying to do a number of things to improve care, which we think are the right things to do from the standpoint of patients, from a standpoint of delivering care more effectively. We're trying to do things like use health information technology so that we have something like real time data on patients. I noticed, Hal, none of your examples were from health care.

And we're trying to do things like have nurse practitioners and allied health professionals work with our patients with chronic diseases to give them some more education support that our physicians just don't have time to do in terms of understanding why they're on the medications that they're on, the nutrition changes that might make the most difference for their health, other lifestyle changes.

We're trying to coordinate care in new ways, so when patients leave the hospital, there's actually a plan in place that's shared with the post-acute care providers and the family to prevent the very high rate of readmissions. In Medicare, still today, about one in five patients are readmitted to the hospital within 30 days after they're discharged.

And the problem is we think all these things are actually working. Here's the data showing it. We've gone to some extra effort to show these impacts on quality of care, and we think it's saving money for the Medicare program, because we're using fewer services and billing Medicare less. But for every single one of these things that we're doing, we're getting killed. We're getting killed in two ways.

First of all, traditional health care payment systems don't pay for any of those things that I just described, and second, to the extent that they actually work and lead to fewer duplicative lab tests or imaging procedures or fewer readmissions or fewer visits back to the doctor, because patients are doing better, we lose again, because we're not reimbursed for any of those steps. So the basic idea behind a lot of these reforms on the supply side is to move away from those traditional ways of paying based on fee for service.

What we came up with in the Medicare program based on some microeconomic theory and applications on the supply side was to start a second track of payment. We didn't get rid of Medicare's traditional payments overnight. That wouldn't have been acceptable to beneficiaries or providers, but the providers who are participating in this pilot program started tracking how their patients were doing in terms of some important health outcomes and results like for their overall population of patients. Could they significantly increase their use of evidence-based preventive services? For their patients with diabetes, could they get improvements in important proximate outcomes for the disease like the level of blood sugar control, and could they reduce important complications that led to hospital admissions or premature death? They started tracking all these things. Not traditionally part of health care payment or policy, but they started doing it for this program, because they now had a reimbursement path based on it.

And what Medicare did was we took in the information that they provided on performance, on the outcomes that their patient population was actually getting. We also started tracking the overall spending in the Medicare program for these beneficiaries, not just physician cost, but everything-- hospital cost, rehab cost, post-acute care cost, drug cost, all of it.

And the deal was if they could show significant improvements in most of these dimensions of outcomes for their patient population, and if we saw reduction and the overall trend in spending, they could keep most of the difference. They were now accountable for the first time for the results of care for their patients, both in terms of health and in terms of overall spending.

And that program, now five years in, has shown some impact on health care costs and on health outcomes. Of the 10 medical practice groups that participated, all of them showed significant improvements in outcome. Nine out of 10 showed significant reductions in cost trends. Five out of 10 showed reductions in cost trends of more than two percentage points per year, which would be enough to pay for the expansion of health insurance in the recent legislation. And so that's some relevant evidence of this question.

But it's only one study. It's only one pilot program, and there have been a lot of other studies on similar kinds of reforms, which have found mixed results depending on the context in which they're implemented and depending on how widely and in conjunction with what other reforms these changes are implemented. So the upshot of all that is in the bottom line for at least Washington-based policy analysis, what does the Congressional Budget Office think of this kind of evidence for all of these reforms, this long list?

And I just gave you one example of reforming provider payment. The sum total of savings estimated by the Congressional Budget Office in the health care reform legislation was around $5 billion out of a $1 trillion bill. And that's not because of not paying attention to these reform issues, but because of the limited evidence that exists on them. Now over the next few years, Medicare and the private insurers they're working with it in the states now have some very broad authority to try out more of these kinds of reforms.

And a big challenge and a key unanswered question for economists is, can we find a way to use this very broad authority and this very good multibillion dollar opportunity to show whether some of these kinds of reforms can really be implemented in a truly compelling way, one that could be extended more widely in our health care system? But it is very slow going and very limited evidence right now.

So that's the supply side. That's where a lot of the focus was in the recent health care legislation. What about the demand side? Well, there's also a lot of evidence from microeconomic studies that what people pay for their health care does influence their choices. Randomized studies and other studies showing that higher co-payments, higher out of pocket payments reduce use, that there is an elasticity of demand for healthcare just like for any other services.

The challenge with this evidence from a public health standpoint is that it looks like the services that are affected are mixed. Both services that seem to be of high value and services that seem not to be of high value, you might say, well, what does it matter what you experts say about how consumers are responding? It's consumer choice, and they're presumably making some rational decisions. But even if you say that, even if you say that consumers know best, the estimated demand elasticity here is not that large in studies that have just looked at incremental changes in co-payments and incremental insurance reforms.

And not only that. There's considerable evidence that people are very risk averse when it comes to high out of pocket expenses with respect to their health. People don't want to face an out of pocket risk of many thousands of dollars in cost if they or their loved one has a serious illness, and they need to have access to very valuable treatments. So here, too, there's an economics answer. Ken Arrow decades ago showed that the optimal policy in this kind of setting where you need insurance because of risk aversion is a policy with a high deductible upfront and catastrophic protection on the back end. And we've actually tried to implement some of those with HSAs and other high deductible health plans.

But the problem is that, still, something like 90% or more, even if you have a deductible of as high as $10,000, 90% or more of health care spending occurs when you're past that out of pocket limit. And once again, you're then kind of out of the realm where demand side incentives, at least on our traditional insurance plans, would make a difference.

Applied microeconomics in health care started to affect this as well with some innovative insurance design, where the consumers can be more sensitive to cost. In particular, consumers with high expected health care costs can get more of an opportunity to save money when they use less expensive care, but not through that kind of traditional insurance design. I'll give you a couple of examples.

Safeway had recently implemented a program for doing colonoscopies through what's called a tiered benefit design, where they looked at what they were actually spending on-- this is a procedure that everybody over 50, including everybody in this room, should be getting, but many people don't. And if you look at the actual cost of the procedure out in California, it varies something like five-fold ranging from around $2,000, $3,000 from some providers who seem to be doing it well, high volume practices, things like that, to upwards of $25,000.

So what Safeway did was try to look at some of the evidence, and then group providers into tiers based on this cost. And the idea was that they would pay something close to the full cost for what they regarded as a good quality colonoscopy, and a patient would have-- their beneficiaries would have a choice of whichever provider they wanted to go to. But they would pay for the difference at the margin. They would pay for the marginal cost difference between, say, the $20,000 provider and the $3,000 or $4,000 providers.

Now the Pacific Business Group on Health is doing something similar with knee surgery. Same thing-- fivefold variation in cost. No clear relationship to outcomes, and they're implementing the same kind of reform and payments. They're moving away from a traditional insurance design, where if you have a serious enough illness-- cancer, serious heart disease, something like that-- to where you're hospitalized once or twice in the year, any kind of traditional insurance plan, you're going to be at your out of pocket maximum no matter what you do-- $15,000, $20,000 a year. Under these plans, those patients can still have differences in their costs of $10,000, $20,000, $30,000 or more, which is enough, it looks like, to start changing behavior.

Now these are hard to implement. The examples that I gave you took a lot of work by the employers, the payers involved working with their beneficiaries, explaining the changes, working with the providers, and getting enough acceptance, enough political acceptance from all the stakeholders to move them through. And even if they have an effect, we're only talking about each of these procedures, even though they're common, is only a small part of overall health care cost. So the effect overall that we've seen from the evidence so far seems to be pretty incremental, like not enough to really alter those overall health care spending trends that I alluded to before.

So the question is, is there a faster way to get there? And that brings me to one final demand side issue, and that's around the choice of insurance plans. If people had better incentives for their insurance plan choice, economic efficiency might become more prominently observed in behavior and might lead to a faster impact of these kinds of reforms both on the demand side and on the supply side in the way that care is paid for, and therefore, perhaps, in the way that care is delivered.

And if you look at the incentives facing Americans today for health insurance, economic theory and evidence tells us that we're not doing a very good job. So perhaps that's some reason for depression. Today if you have coverage through your employer, you have an open-ended tax subsidy that's proportional to your marginal tax rate since it's regarded as an employer benefit. That means that you don't pay the full out of pocket cost for your insurance plan. If you're in a moderate to high income tax bracket, that means you're paying something like only 30, 40. You're paying-- the tax break is 30%, 40%, 50% of the cost of your insurance plan.

And there's a tremendous amount of evidence that increasing those costs at the margin would lead people to choose plans that have lower premiums that tend to drive more efficient care. And yet we persist in keeping this kind of subsidy in place. Well, one of the things that the health care reform law did was change that incentive. It doesn't do it until 2018, so there's still plenty of room for people to come back and modify this politically difficult step, and it only affects plans at a very high level of spending, something like the top 7%. It gradually might affect more over time.

But the point is that today we're a long way from that efficient kind of choice system for insurance for people who have employer coverage. It's the most common way to get coverage today. Same thing is true for different reasons in the Medicare program, where there is one dominant government-run plan that relies heavily on price regulation. There are some other private plan choices, but there's not the same kind of paying the marginal difference in premiums that would drive more efficient choices.

There are a lot of subsidies built in. There are even subsidies in effect for supplemental coverage to wrap around efficient plan designs in Medicare and shield people from paying out of pocket costs, from paying even limited out of pocket costs, without making them face the full marginal cost, marginal spending consequences of those decisions. One exception to that in the Medicare program today, and I think it's instructive, is Medicare Part D. That's the prescription drug benefit that was added to Medicare in 2006, which I had the privilege or curse of implementing in my time in the last administration.

But it was set up differently. It was set up with a flat subsidy for beneficiaries that was based on your income and your health status, but it was a fixed amount of money. And the deal was you could choose from a range of competing plans that were allowed to vary their plan design, in some cases quite significantly, as long as they met an actuarial minimum value test. And if you chose a more expensive plan, if your plan costs $2.00 more than an alternative, your payment for the plan would be $2.00 higher, paying the full cost at the margin.

And interestingly, what happened when this system was set up was that people migrated-- first of all, seniors were very frustrated or very annoyed. And I heard from many of them. I heard from thousands of them around the country that they didn't want to see all these choices. In some cases, 30, 40, 50 or more. Lots of different choices. It was very confusing. It was taking a lot of their time to sort this out. They were worried that they didn't even fully understand it in spite all of our efforts to provide information, objective information on the premiums and the out of pocket costs that people would face based on their drug use in each of the plans.

So they were very frustrated by having to take all the time. Now why couldn't the government just come up with one simple clear plan design and just give it to us and make it much easier for us? But the flip side of that was that people ended up choosing plans that were very different from the model envisioned in the law. There was a standard benefit design, a sort of traditional insurance with a deductible, a co-payment, and catastrophic protection on the back end. Between, there was that famous donut hole, because the expected cost of the benefit was more than the Congress thought they could subsidize. But basically, it's a traditional insurance design.

Today no one in the Medicare program is in a plan with that kind of traditional insurance feature. People have overwhelmingly signed up for plans that have a tiered benefit design, going back to the demand changes that I was talking about earlier. What that means is if there's a generic drug, which those drugs work just as well as the brand name drug, and they're available after patents expire for drugs for many common illnesses. Those drugs are basically free under these plans. You might pay $1 for it.

And virtually all other drugs are available, but people pay much more of the cost difference out of their own pocket. So if there's a generic available that the brand name version of that drug will typically be much more expensive, close to the full price, so people would get letters from their plans. Mrs. Smith, you're on the brand name version of this beta blocker drug. It's costing you $72 a month. You could switch to this generic version, which the doctors say, which the FDA says works just as well. It'll cost you $1. You'll save $71 a month if you switch to that drug.

In cases where generics weren't available, the plans would typically negotiate a lower price for a preferred drug within a category of similarly acting medications. Those might cost $30 a month, and again, you could take the more expensive non-preferred one, but you would pay the difference in cost. And the plans had to meet an actuarial value test of the same value as a traditional insurance plan. But the difference is instead of saving just 20% or 25% of the cost like you would with traditional co-insurance, you save almost the full differential in cost.

Well, people overwhelmingly chose those plans, because they had higher premiums, and then they switched the drugs they were using. The Medicare drug benefit is still-- it's a significant government cost-- no question about it-- because of the subsidies involved. But it's currently running about 40% below the actuarial in the CBO projections at the beginning of 2006. And there are a number of reasons for that, but one important reason is that seniors have overwhelmingly switched which drugs they use from brands to generics, where they're available. The use of generics among seniors is running around 80% of prescriptions. And they switched from non-preferred to preferred brand name drugs.

There was a lot of complaining about the drug benefit. I thought there was going to be a lot more complaining about switching drugs based on these tiered benefit features, but that really hasn't been as big of a problem. And so this program, even though Congress had a chance to come in and change it and reform it in the last round of health care reform legislation, they didn't. They made it more generous. I guess that's probably not good for the long term fiscal outlook, but no fundamental changes in the structure of the program was my point.

So the upshot is that there may be a way to move towards more efficient health care through implementing insurance choice with full cost payment at the margin, and that, by the way, is what the exchanges in the new health care reform law may be able to do in principle. There is still a big unanswered question for economists and for the policymakers who may listen to them about how these insurance exchanges for people who aren't buying coverage through their job and who aren't on Medicare or Medicaid, how they will actually work.

And we'll see how that plays out over the next couple of years, but the law itself sets up a flat subsidy, very much like the one I just described in Medicare Part D. It depends on your income. It depends on your health status. But if you choose a less expensive plan, you may be able to save, depending on how it's implemented, the full difference in cost at the margin.

And this is why, I think, that even though there are many states, especially states with Republican governors, given the strong political opposition on the Republican side for some understandable reasons to the law. If you look at states with Republican governors, they are moving forward on implementing the exchanges, and they're trying to do it in ways that would meet those kinds of competitive design features that I just described with a lot of support from economists.

So those are areas where there is some impact of health care, of economic analysis on decision-making, but still a lot of very important questions ahead in the next few years that may determine our overall cost. I see Jim getting up. I just want to make one final point here about economics in health care. The most important thing in economics, and the reason why it's so hard, I think, to reform these policies without and why it's so hard to get public confidence in making changes just because economists think they're good without even more compelling empirical evidence behind them, is because health care is so valuable.

Kevin Murphy and Bob Topel, Bill Nordhaus, David Cutler, some of my work with David-- what all has shown over the last 30, 40, 50 years-- name your time period-- medical innovation on average has been extremely valuable, more value creation than in all other sectors of the economy combined. I mean it's great to have jet travel and iPads and 3-D TV and Google Maps, but what people really seem to like is the time to enjoy it, the time to spend with it, living longer, living better, plus the sunsets, plus time with family, and all of that.

So there is a potential for doing much better here, but we have to find better ways to bring the microeconomic evidence to bear showing that we can improve the margin without taking away from that average, that tremendous average value of innovation. Thank you all very much.


PRESENTER: OK. I'm afraid given the hour that we are not going to have time for questions at the end of this session, but let me thank all of the panelists here. I want to just say a couple of things before we close. I mentioned this morning that economics has, in fact, played a central role in MIT'S intellectual history for nearly 150 years. And I think that as you've seen from the enormous range of presentations today, that's in part because economics, just like the science and technology and other areas that MIT is so fundamentally committed to, has an enormous opportunity and potential and reality to improve the human state of existence.

I would point to two illustrations of that based on what we've heard. In the macro area, the last two years have not been a good time for the public view of economics and economists. But I think that rather than pointing to the crisis and saying, why wasn't it noted in advance, one could also look and say, this has dramatized the cost of getting off the right path in terms of economic outcomes and economic policy. And it underscores the importance. It underscores the social return to getting the policy mix right and the value to the research and the policy advice that comes as one tries to implement and to use the tools of economic analysis.

In the micro area, where we just heard the last panel talk about some of these applications, one example that I love to cite-- it's not a great moment for MIT, because it's an example from Kenneth Arrow-- Nobel laureate at Stanford University, but someone who was rejected from our Ph.D. program when he applied-- can't win them all. But Ken Arrow working in the White House in the early 1960s said as a staffer at the Council of Economic Advisers, one day he got a proposal, which suggested using nuclear explosives to build a second canal-- in this case, through the Yucatan.

And it's just a simple application, the kind of thing that Hal Varian was pointing to, of diminishing marginal utility. He wrote back on the top of it like the credit card ad, first canal, priceless, second canal, worthless. He cites it has one of the highest social value activities that he was ever associated with to dissuade whoever was proposing this from actually undertaking it. But I think it does illustrate how on a whole host of these places, that's a perfect example of the mechanics working through the night to keep things going. But there's an enormous range of places in which the use of applied microeconomics and microeconomic theory has really improved the way in which we do a whole range of different things.

I want to close this afternoon on behalf of Andrew Lowe and Bob Solow, who have worked with me as the organizers of this panel, by thanking an enormous team of people who have helped to make this event go so smoothly and who have assisted us on a whole different set of dimensions. You don't manage to get 1,045 people registered for an event at Kresge without an enormous group that supports the undertaking.

And I would particularly point first, of course, to our speakers and our panel chairs who have added the excitement of this program and really kept us riveted from quantitative easing to cell phone pricing to air conditioners from CO2 to QE2 to ZLB. We've run the gamut today of different activities and different places where economics fits in.

But then there's the support team, and that's Ted Johnson and Rebecca Tyler and Lilly [? Munet ?], who have been at the MIT 150 office and for over two years have been working on planning the set of symposia and other activities. Kathy Levine and Nicole Silva and Eva Carbone at the MIT conference services team, Gail Gallagher and Joe Cohen and Lee Corbett, who are part of Institute events and were key in making this all come together. And then in the Sloan School, Jana Cummins and Jessica Cologne and Lisa de Forge and the Economics Department, who have been the key teams in terms of making this all work.

One of the many decisions that Bob and Andrew and I had to make in planning this was, did we thank them all today, or did we thank them all tomorrow? And we managed on a 3-0 decision to decide we just thank them both days in case anybody came one day but not the other. So on that note, thank you all for coming and joining us. We are adjourned. We will gather again tomorrow morning. The program begins.