Saturday, August 21, 2010

ObamaCare: the error of categorical risk management

In the world of risk management households and firms exercise incremental risk management. That is, decisions are made on the cost-benefit of increasing levels of risk management. For example, should a firm such as a distribution warehouse have fire extinguishers available every 100 feet, 50 feet, 5 feet? Should a household install smoke detectors on each level or in each room of their principle residence?

Households and firms make decisions regarding risk management by looking at what point does the current cost and future maintenance (rising costs) of a particular risk management technique outweigh the incremental risk reduction gained.

This incremental approach has an implicit assumption that nothing is absolutely safe. This is very true. However, items and situations can be reduced to a level of reasonable safety at a reasonable cost.

However, other institutions outside the household and firms exercise categorical risk management. Categorical risk management appears when the "cost" component of the cost-benefit approach to risk management is born by an exogenous entity. That is, when the institution making risk management decisions has no cost basis they opt for categorical risk management. The implicit assumption to categorical risk management is that no risk can be taken. Items and situations must be absolutely safe. (1)

What institutions have no cost basis, exercise categorical risk management, and make the assumption that absolute safety must exist? Government agencies, public interest private organizations, and public interest movements have no cost basis and exercise categorical risk management. The cost basis used by these organizations is taxes, donations and in some cases law suit proceeds.

When you have no cost basis in risk management (using other people's money) your incentive to produce the product of risk management is no longer cost-benefit based. The incentive becomes purely benefit based. That is, the public must be made safe at any cost.

How does this difference in incremental risk management and categorical risk management relate to ObamaCare? Beyond ObamaCare being a price fixing scheme, the health-care reform legislation comes from the same group of institutions that have the mind-set of categorical risk management. The mandated coverages, deductibles, co-insurance requirements, the requirement everyone must buy coverage or else be fined, etc. comes from the exact same organizations that perceive absolute safety at any cost. In other words, the absolute coverage mandates, the exercise of categorical risk management, the deletion of incremental risk management, is due to the years and years of making risk management decision with other people's money.

Hence one of the drivers of the future increased cost of health-care via ObamaCare, which is becoming increasing evident, is in fact due to the framers of such legislation exercising categorical risk management based on their prior experience of of using other people's money, leading to incentives to produce purely benefit based items with disregard to cost-benefit incremental risk management.

(1) Applied Economics, Thomas Sowell, pages 144 - 145

1 comment:

  1. Yes. Costs are a feedback. Take that feedback away and bad decisions are made.