A couple of days ago I fell to talking about price-setting in health care with a certified Very Smart Economist. Bart Wilson is the Donald P Kennedy Professor of Economics and Law at Chapman University, where he works with Vernon Smith, the chap who won the Nobel Prize for helping to invent experimental economics.

We had both watched the same web video, where certified Very Smart Health Care Wonks Ezra Klein and Sarah Kliff argued . . . well, conversed . . . in favor of some sort of central rate setting to control health care costs.

Bart’s research focuses on building virtual markets in his lab, which means that he spends almost all day, every day, thinking about prices: how markets find them, and what they do. He’s not a health care wonk, but a market wonk, someone who thinks a lot, and deeply, about the mechanics of getting markets to allocate resources efficiently. So I asked him to spend a couple of hours on gchat talking about what prices do in markets, and why it’s not so easy to set them.

Of course, we’re vulnerable to the charge that this is all airy fairy theory and models, far removed from the real-world nitty gritty of health care markets. But Wilson and Smith’s models have serious real world implications—for example back in 2000, they predicted the meltdown in the California energy markets before it happened. Sometimes it’s useful to pull back a little from the specifics, and think a little bit about the deep principles that govern how those specifics work out. So what follows is an airy-fairy, theoretical, very useful discussion of the role that prices play in markets, including health care. It's been edited slightly to enhance readability.

Megan: So just to start off, let's explain what you do. Am I right to say that aside from teaching, you basically spend your days building virtual markets?

Wilson: Yes, I build virtual worlds to see how people use exchange, specialization, and property to create wealth. A nonacademic once translated what I did as building and observing economic terraria.

Most of what I do in terms of research is what I am interested in studying in the classroom. Both are fundamentally about discovery.

Megan: So in the interests of full disclosure, let me note that I know Bart socially and have been to his lab. I'm going to describe it for the reader, and you can fill in anything I'm missing:

Basically, the labs look like giant study halls where 10-20 students sit in cubicles, and play a trading game according to rules that you or your colleagues set up. There are a lot of different games, each with different rules, which experimental economists like you use to explore economic theory.

Does inflation trick people into taking deals that are bad in real terms?

Are people bad at discounting risk?

What happens to an energy market if you control prices to the consumer?

Is that about right?

Wilson: Yes, that's a broad summary of what we do. We induce an environment, give them rules, and then observe what they do.

Megan: And one of the interesting things that they do is make markets work--find the best price--even where economic theory might have said that this would be really hard. That's what started Vernon Smith, who you work with, off on experimental economics back in the 1960s, isn’t it? He ran an early experiment in a classroom, and was surprised to find how quickly they discovered the price at which the market cleared.

Wilson: Yes, he gave some people the maximum amount that a fictitious product was worth to them and to others the cost of selling a unit, all privately known (that's key), and then a set of rules by which to trade.

For the specific rules of trading he went to the library (since that's not something you get in PhD courses) and learned how the Chicago Mercantile Exchange and the NYSE worked. He implemented a version of those rules, telling his students that if they bought at price less than their value or sold at price greater than their cost, they could keep the difference in profit.

The students did all this with no information on anyone else's values and costs.

Megan: In the textbooks of the time, markets with so little information weren't supposed to work so well, is that right?

Wilson: The presumption at the time was the markets needed so-called "perfect information" on the conditions of supply and demand. With such perfect information, then the traders could find the price which cleared the market.

This classroom market didn't have such perfect information, so how would the market work? Vernon was curious.

Of course, traders don’t actually have that information in practice either.

Smith’s students found the market clearing price without perfect information—and did it over and over, in experiments he ran over a series of years. In 2002, he got the Nobel Prize for helping to found experimental economics.

Megan: So this is actually what I have called you here for today: to discuss the role of prices in markets.

You and I both watched a video from Wonkbook, in which Ezra Klein and Sarah Kliff discuss rate setting in the health care market. They argue that we know how to control health care costs, and that the way is to control the prices.

I thought it would be interesting to talk to someone who literally spends most of his life studying markets set prices

Wilson: That process is what I aim to understand.

Megan: Okay, so let me ask the obvious question: if a whole lot of health care wonks think that government-rate setting would fix health care costs, why should I be skeptical?

Wilson: Who knows the conditions of who values what and the opportunity costs of supplying health care? What set of minds in the government has the knowledge needed to make tradeoffs, to know who is best to supply this service or that one?

The values and costs of healthcare have to be discovered.

Megan: The wonks who favor rate-setting argue that health care simply isn't like any other market. For one thing, there's an information problem: how do I know if I want a heart bypass or not?

Why not let an expert who has read all the studies on heart bypasses make that decision?

Wilson: Right now, the doctor recommends to the patient what the insurance company will pay for. What incentive does the patient have to find alternatives? (None.)

There is the assumption that an expert knows all the alternatives. Doctors are not interchangeable. They know different things.

The function of a market is let us learn who will serve us sufficiently well.

Megan: So let's step back even farther, to 30,000 feet or so, for a second. What does the price do in a market? Why should I want to put a price on my lung transplant?

Wilson: A price is like a symbol at any moment of what millions of people are willing and able to do. All of the technology and services of the doctors have to be weighed against whatever else they could be applied to.

The prices of alternatives to lung transplants are doing the same thing. The difficulty is assuming that a lung transplant is "inelastic". What a price system does is find what part of say, healthcare, is on the margin.

“Inelastic” means that I’m relatively indifferent to the price. The last glass of water in a desert is the quintessential inelastic good; people will pay all they have to get it. Things can be more or less inelastic, which is to say, that demand can be more or less responsive to changes in price. Health care is often thought to be very inelastic.

Megan: But this is precisely the argument that health care wonks make: when I need a lung transplant, I don't have the time, or the emotional ability, to comparison shop. So there's no price discovery mechanism.

Wilson: Does the government know or have the ability to comparison shop for me? Do they know my circumstances?

Also, for some healthcare services, you do have the ability to comparison shop. Those services will then discipline the healthcare market in general.I want try the example of electric power and then see how it is much different than healthcare. When Intel is making computer chips, they need a secure line of power. At any moment, they don't have luxury to comparison shop. They need the power now.

I, on the other hand, have a choice to turn my clothes dryer on at noon on the hottest day of the year, or wait until 10pm.

When people like me see the price spike, we will cut off our demand thereby lowering the price that Intel will have to pay. So the example of the lung transplant sounds like to me the position of Intel. At some point in healthcare there must be a margin, like me and my clothes dryer. The problem is how to find it.

When I do not have the incentive to look for alternatives for electric power, I and everyone like me will demand power and drive the price up for Intel.Is the argument that there is no margin to be discovered in healthcare?

Megan: I think the argument is that ordinary people aren't the ones best qualified to find it. But of course, that assumes that someone else is better qualified: that the things that government can measure are the important things about health care.

Wilson: Why can't the margin in healthcare be something that I am better at getting alternative options for?

In the current system, no one has the incentive to find out what they may be. The doctors don't, and neither the patients.

Megan: I think most people agree that the price setting mechanism is broken. The question is, can you fix it by getting the government to set rates?

Wilson: When government sets a rate, will they have better knowledge? I don't see where they discover it.

Megan: What happens when they don't have better knowledge? Can you talk a bit about the risks of rate setting?

Wilson: If the maximum price set by the government is too low, there will be under subscription. If the maximum price set by the government is too high, then there will be oversubscription. Then they will have to decide which patients get the procedure.

Not all patients will have the same circumstances. Somebody will have to use some metric, like first-come, first-served, knows the doctor personally, etc., to get put into the queue. Somebody somewhere will have to assess value of that procedure

Megan: Can you talk about some historical examples where everyone said that the government had to set the price because the market was too broken to find one?

Wilson: During WWII the government set wage controls. With a limited supply of citizens and high demand for labor, the government set a maximum wage. For firms to attract labor, they couldn't use a higher wage. So they got approval to use healthcare benefits pre-tax as a way of competing for labor.

In other words, the setting a maximum wage didn't stop the firms from competing.

Megan: . . . and that was the start of the very system that everyone is now complaining about

Wilson: Exactly. Now we can't rid of pre-tax healthcare benefits.

Megan: The government sets rates for Medicare now Is that a problem? Or is it just a smaller problem than economy-wide rate setting?Wilson: I would seem to me that that is just a scaled down version of the problem.

Megan: Well, one of the things that more free-market wonks argue is that as long as there's still a private market you have some price discovery that the government can use in its own negotiations. It's when the government sets all the rates that you start to have serious issues

Wilson: So, if the government takes over all price setting, they will have nowhere to look to gauge any sense of the tradeoffs.

Megan: Do the insurance companies? That is, after all, one of the big complaints: that the private market doesn't do good price discovery either, so why not let the government come in and bargain prices down?

Wilson: The insurance companies are stuck with what doctors recommend to the patients, which it seems they are working around.

Megan: Of course, they'd still be stuck if we just got the government to set the prices

Wilson: Which is why the simple solution sounds like, let the government take it all over. But it is only the statement that is simple. The details are local. An individual's health, which doctor and which services are provided to the individual.Can I go back to the DA experiment of Vernon's?

Megan: Yes, please.

Wilson: Buyers submit a willingness to buy as expressed a bid. Sellers submit a willingness to sell expressed as an ask.

That price is a symbol. Or should I say that bid or that ask is a symbol. Because for each individual, it means something local.

Either another buyer decides to get into the market and buy, or they decide to sit this one out. It indicates locally what the buyer should do. And at the same time, globally, it means what all the buyers are willing to do.

The same thing goes on the sell side. As they go through this process, the price system discovers which sellers have the lowest costs and which buyers have the highest values.

If you came into the experiment and decided to set the price at which everyone would trade. Where on period 1 would you start? With a wild guess.

Everyone would react to it locally, but there's no guarantee you'd find the global price that you want: the one where the lowest cost sellers supply to the highest valued buyers.

Megan: And because you're setting the price by fiat. There's no reason you'd get closer in Period 2, either?

Wilson: You'd get a little feedback to move in a direction. But would you overcompensate? Move too little?

One of the problems is that we use the word "price" to cover a transaction. When you set the "price" by fiat, it doesn't mean the same thing.

There's an analogy to words. Words are symbols. Prices (not set by a central authority) are symbols. As symbols, words are indexical and iconic. So are prices.

A price indicates to each individual that they should be in or out of the market. The symbolic part kicks in when all of the individuals look at their circumstances, and this somehow leads to the lowest cost sellers supplying to the highest value buyers.

That is the meaning of the price as a symbol. Used locally by individuals for different purposes, but globally telling us what each person needs to do.

A price by fiat doesn't have symbolic meaning. It indicates locally what each buyer and seller will do. In or out. But it can't mean that for this set of circumstances we have found the lowest cost way to supply the highest valued buyers.

Megan: Sort of like if the government decided to set the value of words, and made it illegal to use them any other way? You'd lose a lot of the value of language, presumably

Wilson: Yes, because you and I use words locally for our own circumstances. Those words only have meaning in conjunction with the meaning of the words around them. The same goes for prices.

Megan: The flexibility would disappear. Which was the point, in Orwell's 1984

Wilson: Yes, that's 1984.

Right now the healthcare systems is like someone using words that are in some sort of ballpark but don't quite fit. Take this sentence: "With the snake in sight, the horse reeled his paws in fright." You know what I mean when I used "paws". But "hooves" is a better symbol for the context of the sentence.

Megan: So the danger of price controls is that you forfeit the opportunity to get a best fit. The price may be lower, but it's only "better" in a very narrow sense

WIlson: Exactly. The right meaning for the local circumstances will be lost.