Are there different economic theories for complex/long term products?

March 30, 2012 6:44 PM

Is there an economic theory about monetary incentives doing more harm than good as economic utility becomes harder to determine/quantify?

I was reading a thread about medical research, and it occurred to me that it's getting more and more difficult to determine the effectiveness of many health care products. Then I wondered if attaching monetary incentives to create new medical products creates an incentive to lie that wouldn't exist otherwise, thus preventing better (cheaper or existing) medicine from reaching more people.

There are always incentives to cheat, but when the products are simple (like an orange or an mp3 player) the quality and utility is more obvious to everyone. As products get more complicated (medicine, financial derivatives, insurance, etc) the rules of economics would sort of break down, wouldn't they? Especially when the economic utility of something can only be determined after a long period of time?

I poked around for a while, and I found a stub about supplier induced demand, but I'm not sure if that's what I'm looking for. It seems similar to arguments about supplier indifference to use value, but I was hoping for something more succinct.

posted by deanklear to science & nature (10 answers total)

Asked mr chapps (who is an economist working with epidemiologists) and he suggested perverse incentives might be what you are thinking of. He said it would take a book to answer this, but don't mind him.

Some examples: there is big financial incentive to make "me to" drugs -- almost identical to other effective drugs where there is a big market, but little incentive to make drugs for horrible diseases where the condition is rare.

His colleague Alan Cassels also writes about marketing drugs to relatively healthy people, by creating new disorders, or by getting people to get tested for everything. Link to some radio documentaries about such things here.
posted by chapps at 7:34 PM on March 30, 2012 [2 favorites]

I think what you're looking for would be something related to access to information - how does lack of access to information distort the market. Because the core problem is that it's _possible_ for the manufacturer or care provider to lie, or produce ambiguous data, or even just honestly believe something that's not true (e.g., believing that medical interventions during birth make you safer, or that everyone should be tested for all diseases - when in reality, the risk of unnecessary interventions or false positives is significant).

Most standard economic theory starts with 'perfect access to information' so you'll have to look a little bit afield for a theory specifically addressed to this sort of case.
posted by Lady Li at 7:56 PM on March 30, 2012

Drive, by Daniel Pink touches on the idea that financial incentives make people focused on the short-term goal (monetary gain) at the expense of quality, creativity, the big picture, etc. The book has a lot of references so you might find something there.
posted by lulu68 at 8:01 PM on March 30, 2012 [1 favorite]

You're describing a kind of ex-ante moral hazard, in which one party is making a decision about an event before it takes place, where some other party will eventually shoulder the result. For example, you could determine that a line of research isn't worth following for financial reasons, leading to negative health outcomes for people. Or, the opposite -- a rush to capitalize on research leads to shoddy testing.
posted by Cool Papa Bell at 8:35 PM on March 30, 2012

For a historical example of this, we can look at the incentives paid by the US gov. to create the transcontinental railroad - the companies were paid by length and by speed of building - which created a shoddy product. Most of the transcontinental lines had to be rebuilt after they were completed. The only railroad that was economically viable was the great northern, which was built entirely free of gov. subsidies. All other lines were a net loss to everyone involved (the government and businesses running them.)
posted by Brent Parker at 9:33 PM on March 30, 2012

Thank you for all of your responses... I am still on the hunt for a modeled relationship, but it may be that one just doesn't exist. But I'm off to a good start! Thanks very much.
posted by deanklear at 9:35 AM on April 1, 2012

PS: The Alan Cassels podcasts are very, very good.
posted by deanklear at 9:46 AM on April 1, 2012

deanklear, the topic you are interested in is credence goods: goods where the consumer has to take someone's word for it that the product is improving his life.

You are quite correct that simple markets handle credence goods poorly as compared to experience goods (the utility from which the consumer can observe after buying them) and search goods (the utility from which the consumer can observe even before buying them).

But I wouldn't say that the rules of economics break down. Both markets and governments are able to supply solutions to this problem. For example, experts could sell or give you their opinions about the value a credence good will have for you -- this is approximately a doctor's job description, as well as the role of the FDA.

(Consumer Reports, movie critics, and the new Consumer Financial Protection Bureau fill analogous roles for certain experience goods.)

Is there an economic theory about monetary incentives doing more harm than good as economic utility becomes harder to determine/quantify?

Could you clarify what you mean by "monetary incentives doing more harm than good?"
posted by foursentences at 6:12 PM on April 4, 2012 [1 favorite]

Hey foursentence, thanks very much for your response.

When I talk about monetary incentives doing more harm than good, I'm thinking about the displacement of products that work well by new products that are less effective but have better marketing. An example would be new medical procedures that are popularized by the money they make for doctors, when they aren't in fact needed by most people.

I guess to formalize it, it would be the inefficiencies caused by the lure of additional profits to deliver unnecessary or less effective products that, in the long term, harm the consumer and/or the market. Perhaps this is covered in some other general theory about inefficiencies caused by greed and fraud, but I wanted to at least know what it was called.

Another situation where incentive is harmful to the consumer is when the good is inelastic, since profit lies with higher prices, as illustrated by the Enron crisis. (I guess in all cases some harm caused by incentive is present.)

Thanks again... just knowing those three terms is very helpful.
posted by deanklear at 6:51 PM on April 4, 2012

the inefficiencies caused by the lure of additional profits to deliver unnecessary or less effective products that, in the long term, harm the consumer and/or the market

In addition to "market distortion" (as Lady Li discusses above) you might get some traction with the term "rent-seeking." It's most commonly used to refer to parasitism specifically upon regulators, but it's also used to describe the exploitation of other entrenched positions (regulatory influence, information disparities, monopoly power, barriers to entry) for the purpose of obtaining ongoing (socially-harmful) private gain.


Another situation where incentive is harmful to the consumer is when the good is inelastic, since profit lies with higher prices

I think most economists would hesitate here. The typical producers of inelastic goods have an incentive to lower prices to compete with one another, no less than do producers of elastic goods. It's true that there will be cases where the producer can increase the price of an inelastic good with impunity -- I guess the classic example would be the drug dealer who hikes the price once you're addicted. But the producer's ability to do that depends on his also having some monopoly or cartel power: Stringer Bell can't pull the "first hit's free; second hit's $100" scam when Marlo Stanfield is on the next corner selling at cost. And it is true of monopolies *more generally* (whether they are selling elastic or inelastic goods) that they will sometimes have the incentive to raise prices above socially efficient levels.
posted by foursentences at 5:26 PM on April 5, 2012