Insurance – Part 2: Chapter 14

I really do like his analysis of moral hazard and adverse selection in the second half of chapter 14. Really, about the only thing I would like to see discussed more is case probability vs class probability and an explanation of what probability is. Which actually, Sowell doesn’t discuss at all here. 

He does make a gaff when he talks about how government regulation can reduce moral hazard by restricting dangerous activity. So, the government requiring you to wear your seatbelt cuts down on moral hazard, with the logic being that if you have life insurance or health insurance you are less likely to wear your seatbelt. He doesn’t make this argument precisely, but it is precisely in the same vein and logically consistent with the examples he does give.  He actually uses the prohibition of storing flammable liquids in schools. Why does this need to be a government regulation? He discusses earlier the fact that most insurance companies require dead brush to be cut back away from a building before that building is eligible for insurance coverage. Why should seat belts or flammable liquids in schools or bald tires be any different? If it affects the risk, insurance companies can and do adjust their policies and the price of their premiums. For instance, you pay more for home insurance if you don’t have a fire extinguisher and smoke detectors in your home.  

At best, government regulations have no impact. At worst, they are a detriment. The single exception might be in requiring all drivers to carry liability insurance. This is a problem peculiar to socialized roads. In society with private roads, the owner of the road might potentially bare some responsibility for whatever accidents might occur on its roads. The road owner might insure the drivers; perhaps the cost would be built in, in a similar way that the cost of risk is factored into the price of the car rentals of Hertz, as Sowell writes about earlier in the same chapter. It’s unclear what would happen in a free market. 

Otherwise, the regulations do have an adverse effect, as Sowell goes on to illustrate with the banking industry and the FDIC… something that the Canadian banking system apparently does not have, and I’ve written about this elsewhere. You can see my post on Canadian Banks from March 24th.  Their depositors are on the hook if the bank goes under. This creates market forces where depositors are interested in the solvency of their banks in contrast to American depositors whose accounts are insured by the FDIC. They don’t care at all about the solvency of the bank, so the banks are free, and in a sense encouraged, to be reckless in their business practices. If it works out, they make a lot of money. If it doesn’t work out, the depositors don’t care and the government might bail them out anyway. 

He does a fair job in discussing the differing risks of different classes, and explaining why different groups had different insurance rates. Essentially, an 80-year-old buying a life insurance policy will pay significantly more than a 30-year-old woman seeking to buy life insurance. Not many 30-year-old women die, compared to 80-year-old men. So, the risk is higher among one group than the other and is thus reflected in the price.  

And, I’ll also make a note that he did not, and that Mises did, make that insurance is for the unknown and uncontrollable future events. Yes, it is known we will all die, but it is not known when, at least for most. You can control whether or not you go to the doctor for a cold; you cannot control being admitted to the hospital for appendicitis. If you already have cancer, this is not a future event. 

Sowell finishes the chapter strong ripping on FEMA and explaining that it isn’t insurance at all, which sorta feeds into my last point about the unknown. If you build in a low-lying area that gets lots and lots of rain from time to time, you don’t know when the building will flood, but you can bet that it will be ruined by flood in the next 5-10 years. It is uninsurable. 

If you want a good handle on this subject of insurance, risk, and uncertainty, I implore you to take some time and listen to Chapter 6 of “Human Action” on Uncertainty. You might also listen to chapter 5 on time. I think chapters 5 and 6 can stand alone and provide a masterful explanation of the same things Sowell tried to cover in his chapter.

The Fallacy of Irrational Action from Richard Thaler

It’s been dry lately, and busy. It’s been a combination of being super busy, a string of shows that aren’t particularly controversial, and a bit of writer’s block. It’s been one of these constantly, every time I sit down to write. Well, one of the latter two when I do sit down to write, and then for the days where I don’t get that far it’s from being so busy and exhausted.

I’m here now and I have found time to read quite a bit lately. I looked into behavioral economics, a school of thought that Jason talked about a long long time ago. It’s interesting. I’m not sure all of it is really economics, either by Sowell’s definition or by the Misessian definition, but much of it does seem plausible. There are some very basic and fundamental problems with behavioral economics. Since the show hasn’t been giving me a lot of material lately- or what material there is, is either out dated or purely political- I’m going to take on Richard Thaler.

In his book, “Misbehaving” Thaler attacks one of the fundamentals of economics, as it has been known since the late 1800s. Thaler takes pride in demolishing “homo-economicus.” That is the “old” notion that men base all their actions according to calculations regarding their own value scale, opportunity costs, values, costs vs profits, and their time preferences, and assessments of the probability of varying unknown future events. In other words, men act rationally and are self-interested.

The Austrian School teaches that all men act, and that the purpose of each act is to relieve a felt sense of uneasiness. Or, to put it another way, each act aims at exchanging the actor’s current condition for a better condition. It is purposeful action that employs means to attain ends.

Furthermore, there is a logical structure of the mind, so that individuals prefer some things to others, our limitations of time and resources create the necessity for us to prioritize how we spend our time and resources. This leads to what is referred to as a value scale.

Individuals organize their desires in a linear sort of way, a man prefers A to B, and B to C, and C to D, and so on. Not that every person writes all this out in long hand, but merely that this is how we operate, this is how we must operate. We must act and each act precludes other acts. So that on a given afternoon you must make a choice between taking a walk or going to a movie, or going fishing. If you choose to do any of those, it is proof you prefer that activity more than the other possible activities.

Thaler presents some challenges to this notion, one being how people would respond to the different scenarios. For instance if given two choices: A, where you are guaranteed to win $100, and B, where you have a 50% chance of winning $200 and a 50% chance of winning nothing, most folks chose the sure thing. When presented with a second choice: A, a sure loss of $100, or B, a 50% chance of losing $200 and a 50% chance of losing nothing, most people take the gamble.

In each case it was just about 2 to 1.  But this isn’t really the realm of economics at all. The main point of this study is trying to understand how people make their choices, not a study of human action.

Somewhere in that book he presents a problem that actually had me questioning the whole notion of a value scale for about 5 minutes. He mentioned two guys who won tickets to a game. One man sold the tickets for $1,000. The other man went to the game. Neither could understand the logic of what the other was doing. Clearly an example of subjective value theory at work.

Consider this: suppose “YOUR TEAM” is going to the Super Bowl. You enter a raffle at work or at the local chamber of commerce or whatever and you win! Now you have two choices: you go or you don’t go and you sell the tickets for $2,000. For the sake of argument, let’s pretend there is no travel expenses, just suppose the Super Bowl is in your home town… Now, what do you do? If you go, it clearly demonstrates you prefer attending the game over $2,000. But suppose you don’t win any tickets. You can either buy the tickets for $2,000 and go, or you can not spend the money and watch it on T.V. In this case, if you don’t go it is because you prefer $2,000 to attending the game.

It seems plausible that this could happen, but how could this fit into that neat Misessian/Rothbardian value scale?  I put the book down and began to question how this could be. How can a person prefer A to B and at the same time prefer B to A? I considered if this were my situation, If I could go to the Super Bowl for free, why I would go, and why I wouldn’t go if my team did go to the Super Bowl but I had to buy the ticket.

I began to think over the fundamental premises of economics. Men use means to attain ends. Each act is intended to exchange one’s current condition for a more desirable condition. And that was it, in a flash, it made perfect sense.

Before the tickets are acquired, my condition is $X in the bank. After the tickets are acquired, I either have $X in the bank and the tickets. If I won the tickets, or $X-$2,000 if I had to buy the tickets. And, of course, $X+$2,000 if I decide to sell the tickets. Depending on what that $X is, my choice would be different. If $X=$500, I’m selling the tickets if I win them and I will not buy them if I don’t win them, obviously.  If $X=$1500 I may go to the game if I win the tickets, but I will not buy them if I don’t win them. And if $X=$6,000 I  will buy the tickets if I do not win them.

Now that’s perfectly logical and reasonable. There are actually 3 sets of value scales, not one.

1. $6,000 and tickets
2. $4,000 and tickets

1. $1,500 and tickets
2. $1,500 and no tickets

1. $2,500 (after selling tickets that were won)
2. $500 and no tickets.

Maybe the Austrians do have some cracks somewhere, but not here. Men do use reason (many times flawed). Men plan, quite imperfectly sometimes, and men do act in order to better their condition, even if they regret their actions later and their condition is actually worsened.

I do think we are homo economicus, but that doesn’t mean we are always right, or that we don’t make gross errors in our calculations. But, all the theory of homo economicus states is that we do make calculations.