Macro & Micro case studies

Case StudiesCase Studies CONSUMER CHOICE AND DEMAND

Case 6.1: Water, Water, Everywhere

Centuries ago, economists puzzled over the price of diamonds relative to the price of water. Diamonds are mere

bling—certainly not a necessity of life in any sense. Water is essential to life and has hundreds of valuable uses.

Yet diamonds are expensive, while water is cheap. For example, the $10,000 spent on a high-quality one-carat

diamond could buy about 10,000 bottles of water or about 2.8 million gallons of municipally supplied water (which

sells for about 35 cents per 100 gallons in New York City). However measured, diamonds are extremely expensive

relative to water. For the price of a one-carat diamond, you could buy enough water to last two lifetimes.

How can something as useful as water cost so much less than something of such limited use as diamonds? In 1776, Adam Smith dis-

cussed what has come to be called the diamonds-water paradox. Because water is essential to life, the total utility derived from water greatly

exceeds the total utility derived from diamonds. Yet the market value of a good is based not on its total utility but on what consumers are willing

and able to pay for an additional unit—that is, on its marginal utility. Because water is so abundant in nature, we consume it to the point where

the marginal utility of the last gallon purchased is relatively low. Because diamonds are relatively scarce compared to water, the marginal utility

of the last diamond purchased is relatively high. Thus, water is cheap and diamonds expensive. As Ben Franklin said “We will only know the

worth of water when the well is dry.”

Speaking of water, sales of bottled water are growing faster than any other beverage category—creating a $15 billion U.S. industry, an

average of 25 gallons per person in 2010. Bottled water ranks behind only soft drinks in sales, outselling coffee,milk, and beer. The United

States offers the world’s largest market for bottled water—importing water from places such as Italy,France, Sweden, Wales, even Fiji. “Water

bars” in cities such as Newport, Rhode Island, and San Francisco feature bottled water as the main attraction. A 9-ounce bottle of Evian water

costs$1.49. That amounts to $21.19 per gallon, or nearly 10 times

more than gasoline. Youthink that’s pricey? Bling H 2 O is available in

bottles decorated with Swarovski crystals and sells for more than $50

a bottle—that’s about 100 times more than gasoline.

Why would consumers pay a premium for bottled water when

water from the tap costs virtually nothing? After all, some bottled water

comes from municipal taps (for example, New York City water is also

bottled and sold under the brand name Tap’dNY). First, many people

do not view the two as good substitutes. Some people have concerns

about the safety of tap water, and they consider bottled water a

healthy alternative (about half those surveyed in a Gallup Poll said they

won’t drink water straight from the tap). Second, even those who drink

tap water fi nd bottled water a convenient option away from home.

And third, some bottled water is now lightly fl avored or fortifi ed with

vitamins. People who buy bottled water apparently feel the additional benefi t offsets the additional cost.

Fast-food restaurants now offer bottled water as a healthy alternative to soft drinks. Soft-drink sales have been declining for more than a

decade as bottled water sales have climbed. But if you can’t fi ght ’em, join ’em: Pepsi’s Aquafi na is the top-selling bottled water in America,

and Coke’s Dasani ranks second.

SOURCES: Dana Cimilluca et al., “Coke Near Deal for Bottler,” Wall Street Journal, 25 February 2010; Jack Healy, “Five-cent Deposits Set for Bottled Water,” New York Times, 24 October 2009; and Charles Duhigg, “That Tap Water Is Legal But May Be Unhealthy,” New York Times, 16 December 2009. The Defi nitive Bottled Water site is http://www. bottledwaterweb.com/,and the New York City drinking water department is at http://www.nyc.gov/html/dep/html/drinking_water/index.shtml.

QUESTIONS 1. What is the diamonds-water paradox, and how is it explained?

2. Use the same reasoning as in question 1 to explain why bottled water costs so much more than tap water.

3. If consumers paid an amount for water that refl ected the value of the total benefi ts they receive from consuming it, then what would

consumer surplus equal?

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Case 6.2: The Marginal Value of Free Medical Care

Certain Americans, such as the elderly and those on welfare, receive government-subsidized medical care. State and federal taxpayers spend

more than $750 billion a year providing medical care to 94 million Medicare and Medicaid recipients, or more than $8,000 per benefi ciary.

Medicaid is the large stand fastest growing spending category in most state budgets. Benefi ciaries pay only a tiny share of Medicaid costs;

most services are free.

The problem with giving something away is that a benefi ciary consumes it to the point where the marginal value reaches zero, although

the marginal cost to taxpayers can be sizable. This is not to say that people derive no benefi t from these programs. Although benefi ciaries may

attach little or no value to the fi nal unit consumed, they likely derive a substantial consumer surplus from all the other units they consume. For

example, suppose that the fi gure below represents the demand for health care by Medicaid benefi ciaries. If the price they face is zero, each

benefi ciary consumes health care to the point where the demand curve intersects the horizontal axis—that is, where his or her marginal valu-

ation is zero. Although they attach little or no value to their fi nal unit of Medicaid-funded health care, their consumer surplus is the entire area

under the demand curve.

One way to reduce the cost to taxpayers without signifi cantly harming benefi ciaries is to charge a token amount—say, $1 per doctor visit.

Benefi ciaries would eliminate visits they value less than $1. This practice would yield signifi cant savings to taxpayers but would still leave

benefi ciaries with abundant health care and a substantial consumer surplus (measured in the fi gure below as the area under the demand curve

but above the $1 price). In a Medicaid experiment in California, this $1 charge reduced offi ce visits by 8 percent compared to the control group.

Medical care, like other goods and services, is also sensitive to its time cost. For example, a 10 percent increase in the average travel time to a

free outpatient clinic reduced visits by 10 percent. Similarly, when the relocation of a free health clinic at one college increased students’ aver-

age walking time by 10 minutes, visits dropped 40 percent.

Another problem with giving something away is that benefi ciaries

are less vigilant about getting honest value, and this may increase

the possibility of waste, fraud, and abuse. According to President

Obama, “improper payments” for Medicaid and Medicare cost

taxpayers nearly $100 billion in 2009. Medicaid fraud has replaced

illegal drugs as the top crime in Florida. Crooks were charging the

government for medical supplies that were not delivered or not

needed (some supposed benefi ciaries were dead). People won’t tol-

erate padded bills and fake claims if they have to pay their own bills.

Finally, program benefi ciaries have less incentive to pursue

healthy behaviors themselves in their diet, their exercise, and the

like. This doesn’t necessarily mean certain groups don’t deserve

heavily subsidized medical care. The point is that when something

is free, people consume it until their marginal value is zero, they pay

less attention to getting honest value, and they take less personal

responsibility for their own health.

Some Medicare benefi ciaries visit one or more medical specialists most days of the week. Does all this medical attention improve their

health care? Not according to a long running Dartmouth Medical School study. Researchers there found no apparent medical benefi t and even

some harm from such overuse. Even a modest money cost or time cost would reduce utilization, yet would still leave benefi ciaries with quality

health care and a substantial consumer surplus. Research suggests that up to 30 percent of all medical care is unnecessary.

Federal legislation in 2010 expanded the coverage of Medicaid and extended insurance coverage to many without it. Research by Michael

Anderson and others suggests that one result will be a “substantial increase in care provided to currently uninsured individuals.” No question,

better health care can improve the quality of life, but overusing a service because the price is zero also wastes scarce resources.

SOURCES: Michael Anderson, Carlos Dobkin, and Tal Gross, “The Effects of Health Insurance Coverage on the Use of Medical Services,” NBER Working Paper 15823 (March 2010); David Card, Carlos Dobkin, and Nicole Maestras, “The Impact of Nearly Universal Insurance Coverage on Health Care Utilization,” American Economic Review, 98 (December2008): 2242–2258; Elliot Fisher et al., “The Implications of Regional Variation in Medicare Spending,” Annals of Internal Medicine, 18 February 2003; Gina Kolata, “Law May Do Little to Help Curb Unnecessary Care,” New York Times, 29 March 2010; and Steven Rhoads, “Marginalism,” in The Fortune Encyclopedia of Economics, edited by D. R. Henderson (New York: Warner, 1993): 31–33. A transcript of President Obama’s remarks about ‘improper payments’ is at http://www.whitehouse.gov/the-press-offi ce/remarks-president- health-insurance-reform-st-charles-mo. For more on Medicare and Medicaid, go to http://www.cms.hhs.gov/.

QUESTIONS 1. Medicare recipients pay a monthly premium for coverage, must meet an annual deductible, and have a co-payment for doctors’ offi ce

visits. What impact would an increase in the monthly premium have on their consumer surplus? What would be the impact of a reduction

in co-payments?

2. President George W. Bush introduced some new coverage for prescription medications. What is the impact on consumer surplus of offering

some coverage for prescription medication?

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Market Demand and Consumer Surplus

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