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away because of price controls. Moreover, these costs are not sim-
ply money costs. Many of the costs in medical care are costs paid
in pain and deaths, rather than in money. These costs are not going
to be lower, but higher, when attempts to avoid paying the huge
costs of developing pharmaceutical drugs lead to a reduced cre-
ation of such drugs. We need not wait to see this process unfold in
the United States because we already see that countries which have
succumbed to the politically attractive policy of keeping drug
prices low by fiat, or by ineffective patent protection, have much
lower rates of discovery of major new medications than does the
United States. The costs to a pregnant woman and her baby of not
being able to find an obstetrician, or to find one in time, can be a
lifetime of coping with unnecessary birth defects.
Various organized groups in a position to bargain for lower med-
ical charges or lower drug prices”government agencies, health in-
surance companies, or large health maintenance organizations, for
example”may receive preferential prices but the total costs do not
go away and have to be paid by somebody. One consequence is a
multi-tiered set of prices for the same medical treatment or the
same medication, with the highest prices of all being paid by pa-
tients who do not have health insurance, do not belong to a health
maintenance group, and are not covered by any government pro-
gram. Thus a given medical procedure at the UCLA Medical
Center, for which Medicaid pays $127, is priced at $90 when cov-
ered by Medicare, up to $242 when covered by health maintenance
organizations, and $460 when paid by individuals without insur-
ance and who are not part of any of these plans.
In short, misconceptions of the economic function of prices lead
not only to price controls, with all their counterproductive conse-
quences, but also to organized attempts by various institutions,
laws, and policies to get those prices paid for by somebody else. For
The Economics of Medical Care 93

society as a whole, there is no somebody else. Yet few of those in
politics seem prepared to face that fact. Economists may say that
there is no such thing as a free lunch but politicians get elected by
promising free lunches.
Most of what are called attempts to "bring down the cost of
medical care" are not that at all. They are attempts to bring down
the prices charged by physicians, hospitals, and pharmaceutical
companies. Many of those who are most active in trying to bring
down these prices are most resistant to bringing down the real
costs of medical care by such things as making it harder for
lawyers to win frivolous lawsuits against doctors and hospitals or
making the Food and Drug Administration's approval process for
new medicines less time-consuming, or reducing the layers of bu-
reaucracy administering various schemes of third-party payments.
These things all drain resources that could otherwise be used to
treat or cure diseases, or to prevent them.
The negative consequences of price controls on medical care
seen in various countries around the world are not just incidental
mistakes that can be corrected by tweaking the health care sys-
tem. They are the medical version of patterns seen in response to
price controls on many sorts of goods and services, over a period
of centuries. Four things have almost invariably followed the im-
position of controls to keep prices below the level they would
reach under supply and demand in a free market: (1) increased
use of the product or service whose price is controlled, (2) re-
duced supply of the same product or service, (3) quality deterio-
ration, and (4) black markets. All these things have been found
when the prices of medical care have been controlled”and all
are particularly harmful in matters involving pain, disability, and
Increased use of the medical system by some leaves less time and
resources for others. The time taken up in a physician's office by

people whose minor problems would be handled by a brief phone
call to the doctor, or perhaps with just a chat with a pharmacist, if
they were spending their own money, means less time available at
the doctor's office for others afflicted with more serious illnesses.
Time spent by surgeons performing operations that are not med-
ically necessary, but which they may consider to be legally neces-
sary to protect themselves against ruinous lawsuits, is time that is
not available to perform surgeries that may be very necessary for
others, for whom delay is not just an inconvenience but a matter of
needlessly prolonged suffering and increasing dangers from condi-
tions that are worsening as time passes.
Reduced supply in the wake of short-sighted laws and policies
that focus on price include not only a reduced rate of discovery of
new cures and preventive vaccines, but also a reduced supply of
doctors as the growing hassles of bureaucracy and the growing
hazards of unfounded malpractice lawsuits lead some existing doc-
tors to retire earlier than they might under less stressful conditions,
and a lesser attraction to medical careers by some young people
who find all the imposed requirements, restrictions, and
hypocrisies to be things they would rather avoid by going into
other fields. But these and other hidden costs, to doctors and pa-
tients alike, are unlikely to affect those who do not think beyond
stage one when considering laws and policies.
Perhaps the most poisonous effect of attempts to promote po-
litical control of medical care and to extract multi-million dollar
damage awards in malpractice lawsuits has been a demonizing of
the very people who have extended our lives and made those lives
more healthful and vigorous than was ever common before
among elderly people. Doctors and the producers of modern
pharmaceutical drugs have been rhetorically transformed into
villains by those who would present themselves as our rescuers in
politics or in the courtrooms. There is no need to exempt either
The Economics of Medical Care 95

doctors or drug companies from criticism, where it is deserved,
but neither should our would-be political or legal saviors be ex-
empt from criticism.
Whatever policy solutions may be sought for various medical
problems should begin with a focus on the underlying realities, not
the rhetoric, the images, or the prices that appear on the surface.
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Chapter 4

The Economics of Housing

H ousing costs are a major item in mos|t people's budgets. For
those who own their own homes, the value of the house is
often the largest item in their inventory of personal wealth.
Whether housing costs are high or low affects what kind of stan-
dard of living individuals and families can afford with what is left
over after paying for a place to live. The old rule of thumb that
housing should cost about one-fourth of one's income has become
outdated for 28 million Americans, who pay upwards of 30 per-
cent of their incomes for housing. In some places, it is not uncom-
mon for people to pay half their monthly income for the rent on
their apartments. Clearly that restricts what kind of lifestyle they
can afford with the other half.
Despite a widespread recognition of the problem of high real es-
tate costs in some places, the nature and causes of that problem
have often been distorted, and much of the hand-wringing about
a lack of "affordable housing" has been done by people who are
themselves a major reason for sky-high housing prices. The politi-
cal presentation of the problem differs greatly from an economic
analysis of it.
The price of housing varies according to many things. One is
the quality of the housing itself. Mansions generally cost more
than bungalows, though there are places where a bungalow costs
more than it would cost to buy a mansion in some other places.


When we say that housing prices are higher in one community
than in another, we implicitly mean housing of a given quality.
Prices mean little if we are comparing apples and oranges”say, a
villa on the beach versus a cabin in the woods.
Many social, as well as economic, problems revolve around hous-
ing. Homelessness is one of the most painfully visible. In some
communities, very high rents and housing prices force many indi-
viduals and families into very difficult choices. Both parents may
have to work and put their children into day care facilities all day.
Some couples may be unable to afford to have children at all be-
cause they can barely afford housing, even if one or both work an
extra job. Others, who simply cannot come up with the money for
even a modest home or apartment in communities with exorbitant
housing prices, may have to live some distance away and spend two
or three hours a day commuting to and from their jobs. Two or
more families may crowd into a small house or apartment designed
for one family. Savings may be depleted in an effort to make ends
meet. As bad as such situations are, sometimes popular political
"solutions" can make things even worse.
Before considering any solutions, we need to understand what
the problem is and what the alternatives are. Why are prices for
similar housing so radically different in different communities?
Any number of factors might be responsible but the real question
is: What does the empirical evidence suggest? Given those partic-
ular factors, what needs to be done”or undone?
Prices are not the only concern when it comes to housing. The
quality of the housing matters, not just to those who live in it but
also to others who can be affected by the appearance of neighbor-
ing houses, and by whether their decay or neglect threatens to
lower the value of their own homes. Sometimes quality includes a
particular character that a particular community cherishes, either
in the style of its houses or the kinds of people who live in the
The Economics of Housing 99

community. How far can the existing community's desires go,
without taking into account what other individual residents and
potential residents might prefer? What about rent control, land
restrictions, property rights, housing segregation, slum clearance
and building codes? These complex factors need to be examined
one by one.


During the same week, an impressive-looking four-bedroom, six-
bath house with 4,370 square feet of space and "a screen-enclosed
pool/spa," located adjacent to a golf course and country club, was
advertised in the Wall Street Journal for $550,000, while a rather
ordinary-looking house on an ordinary city street with just 1,300
square feet of space and no pool, was advertised in the Palo Alto
Weekly for $1,095,000. The first house was located in Leesburg,
Florida, while the house costing nearly twice as much was located
in Palo Alto, California, near Stanford University. Meanwhile, a
house with 6,000 square feet of space, including an indoor lap
pool, and set on more than an acre of land in Elmira, New York,
was advertised for $349,000. A number of less grandiose houses in
Elmira were advertised for less than $100,000, even though most
were larger and at least as attractive as the house in Palo Alto that
was advertised for more than a million dollars.
Why were houses selling for more than ten times as much in
one community as in another? Clearly, it does not cost ten times as
much to build a house in one place as in another. Construction
costs seldom, if ever, vary by such magnitudes. Realtors sometimes
explain such disparities by saying that the three most important
factors in housing prices are "location, location, and location." In a
sense, that is true. But, in another sense, that explanation can be
very misleading. The houses in Leesburg and Elmira had more at-

tractive individual locations than the one in Palo Alto, in addition
to being more attractive houses in themselves. Nevertheless, loca-
tion is important in the sense that undoubtedly most houses in
Palo Alto cost far more than most houses in Leesburg or Elmira.
But that fact is not an explanation. In reality, it calls for an expla-
nation itself.
Housing prices may be higher in one place than in another for
any of a wide range of reasons. The growth of industry, income,
or population may be greater in one place, leading to more com-
petition for given amounts of land or housing. In addition to
these or other effects on the demand for housing, there are ef-
fects on the supply side of the equation. Restrictions on the use
of land or on the building of housing can cause rising prices of
homes or apartments.
In the case of Palo Alto, the prices of homes nearly quadrupled in
one decade”the 1970s”while the population actually declined
and several schools had to be closed, as the number of children en-
rolled fell by a third. For California as a whole, that same decade
saw its housing prices rise dramatically above those in the rest of
the country, even though the rate of increase in income in Califor-
nia was less than that in the country as a whole. This strongly sug-
gests that the cause of rising housing prices in California was not
from the demand side but from the supply side. The average home
price nationwide was $153,000 in 2002, while the average on the
San Francisco peninsula ”the area including the city and stretch-
ing southward to Silicon Valley, 30 miles away”was $500,000. By
and large, these prices more than three times the national average
were not due to grander houses on the San Francisco peninsula, but
to grander prices for ordinary houses. In Palo Alto, not a single new
house was built during the years when home prices skyrocketed.
In the popular political and media vision of the "affordable hous-
ing" issue, this is a national problem for which government subsi-
The Economics of Housing 101

dies are a necessary part of any solution. In reality, it is not a na-
tional problem but a highly localized problem in a relatively few
places with sky-high rents and astronomical home prices. More-
over, it is seldom the housing, as such, that is expensive. What has
an exorbitant price is the land on which the housing sits.

Land Use Restrictions

An empirical study under the auspices of the National Bureau of
Economic Research concluded that zoning laws "are highly corre-
lated with high prices" of housing and that severe land use restric-
tions are confined to a relatively few places, such as New York City
or parts of California. In short, it is the land that is very expensive
in these places, rather than the houses or apartments built on the
land. In most of the country, "housing costs are quite close to the
cost of new construction," the NBER study concluded, and these
are areas where "land is quite cheap." As an example of how much
the land adds to the cost of housing in various places, the NBER
study estimated that the value of a quarter-acre lot adds about
$140,000 to the price of a house in Chicago, over and above the


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