Thursday, March 18, 2010

Disingenuous Value

My friend Kyle and I have coined a new phrase: Disingenuous Value.

Disingenuous value occurs when one, intentionally or otherwise, confuses cost with value.

Cost does not equal value.

Cost is what an item, well "costs". Value is what you receive in return.

Cost does not equal value. This is not only implicit in free market theory, it's required. It's the very basis that establishes the definition of a free market, which has nothing whatsoever to do with Capitalism (that's a different subject). Free markets do not require capitalism, any more than they require democracy, republicanism, or even currency.

A free market exchange is one in which two individuals exchange goods such that for each the value received is greater than the cost. The general rule is that it's an uncoerced exchange, but I'm going to state that that is not really a specific requirement, because as long as the value exceeds the cost one would voluntarily make the exchange. Coercion is only required if the cost exceeds the value. If I value your bushel of corn more than my chicken and you value my chicken more than your corn we make a trade, and each has received value greater than the cost.

I use the chicken/corn example because it shows that free markets function independently of the overall political, economic, or even monetary system being used.

Cost does not equal value.

Where things get complicated is when there is a third party involved. Specifically we were discussing this in the context of healthcare, but fundamentally it happens whenever there is a third party exchange going on.

For example, let's say one has employer provided health care. It's easy to say that it costs the company $X. It is disingenuous to say that the company is providing $X value, or providing $x worth of additional compensation. This is Disingenuous Value.

Tell 10 people that it costs the company X to provide their health insurance and give them the option to take X home instead, and 9 out of 10 will take the cash (the other 1 of 10 probably has a chronic condition and is being subsidized by the other 9). In this case, for 9 or the 10 the value is less than the cost.

Cost does not equal value.

The same thing is true of a retirement account. Say your company matches your 401(k) contribution at 100% up to $4000 per year. The cost to the company is again easy to calculate, it's $4000 plus the amortized cost of running the program. Let us call it $4250 a year in cost.

What is the value to the employee? It's certainly not the $4250 the program cost. And we are talking about funds that are in a retirement account with penalties for accessing it, and future money is always worth less than current money (the time value of money) so the actual
value to the average worker is probably closer to $3000. (i.e. $4k minus taxes and penalties).

Note that for someone in a higher tax bracket and close to retirement, the value is actually greater than for the average worker.

When the employer states that it is providing $4000 worth (i.e. value) of compensation in the form of a 401(k) match, that is a disingenuous value.

Value is what it's worth to the buyer. Cost does not equal value.

When a custom homebuilder offers to include a kitchen cabinet upgrade "a 30,000 value" to close the deal, ask him to keep the cabinets and take $30 grand off the price instead. It's not going to happen. That 30k is a disingenuous value. Actually in this case it's simply made up BS on his line card. Switching out oak cabinets for Walnut or Maple probably only cost the builder 8-10K (remember he's saving the cost of the oak, and he does not have to tear out an old kitchen either). On the other hand, when you go to sell your property, the nicer cabinets are only going to add a couple thousand to the resale value, and only if someone actually likes walnut or maple better than oak.

Value is what it's worth to the buyer. Market value is what you can sell it for. Cost does not equal either one.

As for health care...

The reason health care is so expensive is multifold. Much of it is simply because technology costs. In the 1970's I you had cancer it was basically "go home and die." Modern chemo and radiation therapy is so precise that in most cases you won't even lose your hair anymore, although it's still physically exhausting. That kind of technology costs, though we can all agree that it delivers quite a bit of value.

Another big driver is defensive medicine. Lawyers cost money, and they make the entire system more expensive. They do this for everything though, and Tort Reform is a subject for another day.

The third big driver of cost is 3rd party payers.

Simply put, when a 3rd party pays for XYZ, the cost to the 3rd party exceeds the value to the person receiving the good.

Cost does not equal value.

How much are you (yes you personally) willing to pay for that blood test? Your co-pay is $20. So the cost to the receiver is $20 (plus the opportunity cost of going to the doctor instead of doing something more productive, but let's ignore that for now). The cost to the HMO is probably on the order of $250. What is the value? That's hard to quantify, because value is the perceptible return received. It's obviously greater than $20, or you wouldn't have paid the co-pay. It's also obviously less than $250 because other people's money is always worth less than yours.

Further, there is no way to establish a market value either, since to establish a market value thing need to, well, be traded on the open market.

This is why Libertarians and Fiscal conservatives are really keen on Medical Savings accounts coupled with high deductable insurance for catastrophic events. For 95% of one's health care, the payee and the receiver of the good are the same person. A two party exchange.

This drives down costs, and drives up value. And if it has the side effect of making individuals more responsible for themselves, well, that's what we call a bonus.

Next up, is Social Security an example of a) Disingenuous Value, b) a Ponzi Scheme, c) simply evil, or d) some combination of the above?

[You did pick d) right?]

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