Full text of Econ Focus (Federal Reserve Bank of Richmond) : Spring 2004, Volume 8, Number 2

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» The Baiting Game »Plans for Spam »New Day for Tobacco
»An Interview with James Buchanan »Is the Market Moral?

S P R I N G

2 0 0 4

T H E

F E D E R A L

R E S E R V E

TOUGH

CHOICES
The Peculiar
Economics of
Health Care

B A N K

O F

R I C H M O N D

VOLUME 8
NUMBER 2
SPRING 2004

COVER STORY
10

Working for Health Care: Employer-Sponsored Health Insurance
Is Commonplace, But It’s One of Many Factors Distorting the
Market for Medical Services
The health-care sector is growing rapidly, as researchers develop new
procedures and patients demand more services. Yet no one seems
particularly happy with the current system. A look at what’s wrong —
and what’s right — with the U.S. health-care market.

FEATURES
16

Putting on the Brakes: Certificate of Need Regulations
Try to Steer Health-Care Supplies, But It’s Hard to Keep
Them From Fishtailing
Health-care providers in the Fifth District must have a certificate of need
to make major capital investments. Many economists question regulating
an industry so closely, but state officials say government must intervene to
minimize unnecessary development and improve quality of care.
20

Our mission is to provide
authoritative information
and analysis about the Fifth
Federal Reserve District
economy and the Federal
Reserve System. The Fifth
District consists of the District
of Columbia, Maryland, North
Carolina, South Carolina,
Virginia, and most of West
Virginia. The material
appearing in Region Focus
is collected and developed by
the Research Department of
the Federal Reserve Bank
of Richmond.
DIRECTOR OF RESEARCH

Jeffrey M. Lacker
D I R E C TO R O F P U B L I C AT I O N S

The Baiting Game: Using Economic Incentives to Attract New
Businesses Isn’t as Simple as It Seems

John A. Weinberg
EDITOR

Aaron Steelman

Economic development officials point to South Carolina’s efforts to lure
BMW to the Palmetto State as an example that incentive programs can
work. But for every success story, there is a tale of disappointment.

MANAGING EDITOR

Kathy Constant
BUSINESS WRITERS

24

Charles Gerena
Betty Joyce Nash

No, Thank You: How Economics May Help Slow the Onslaught
of Spam E-Mail

P RO D U C T I O N A S S O C I AT E

Tired of getting e-mails from strangers promising riches and romance?
Well, there are some interesting proposals to prevent them from making it
to your inbox. But whether they will work is another matter.

Robert W. Kidd
Christian Pascasio
Karl Rhodes

Bridgette Craney
CONTRIBUTORS

ECONOMICS ADVISERS

27

Unwelcome Guests: A Global Economy Grapples with the
Economic and Ecological Effects of Invasive Species

Andrea Holland
Robert Lacy
Ray Owens
C I RC U L AT I O N

World trade provides American buyers with a broader variety of goods and
services. But it also exposes us to nonnative plants and animals that can be
destructive to our environment and economy. The challenge is to manage
the impact of invasive species without choking off trade.
30

No More Big Four? Small Cigarette Manufacturers Grab
Market Share
Just a few years ago, small cigarette makers accounted for only 2 percent of
the domestic market. But that figure has risen to 15 percent, as their
lower-cost products take on the Big Four’s established brands.

DEPARTMENTS

1 Noteworthy
2 Federal Reserve/Information, Please?
5 Legislative Update/The Mixed Bag of Medicare Drug Coverage
6 Jargon Alert/Externality
7 Research Spotlight/Are Criminals Rational?
8 Short Takes
32 Interview/James Buchanan
36 Economic History/“Sold, American!”
40 Regional/District Economic Developments
48 Opinion/Is the Market Moral?
COVER ART: IMAGES.COM/CORBIS

Shannell McCall
Walter Love
DESIGN

AURAS Design
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
Phone: (804) 697-8000
Fax: (804) 697-8287
E-mail: rich.regionfocus@rich.frb.org
www.rich.frb.org/pubs/regionfocus
Subscriptions and additional copies:
Available free of charge by
calling the Public Affairs
Division at (804) 697-8109.
Reprints: Text may be reprinted
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Permission from the editor is
required before reprinting photos,
charts, and tables. Credit Region
Focus and send the editor a copy
of the publication in which the
reprinted material appears.
The views expressed in Region Focus
are those of the contributors and not
necessarily those of the Federal Reserve
Bank of Richmond or the Federal
Reserve System.
ISSN 1093-1767

NOTEWORTHY
Beyond Money and Banking: How Federal Reserve Banks
Can Inform Broader Economic Policies

T

“The story of how
a Reserve Bank,
through its regional
publication, put itself
at the center of a
national debate on
interstate economic
rivalry is instructive.”

his magazine has dedicated considerable
attention over the last
couple of years to the strategies
employed by local and state
governments or public-private
partnerships to promote economic development. This issue
of Region Focus contains a story
about one of the more controversial of these strategies—the
tax incentives and subsidies
offered to firms to influence
plant and other business location decisions. While some see
such measures as a useful tool
for attracting new investment
into an area, others see the
bidding wars that sometimes
result as mutually destructive
contests that weaken state and
local governments fiscally
without significantly affecting
ultimate outcomes.
As always, our reporter
sought out economists with
expertise on the subject at
hand, and, as is often the case,
he found good sources within
the Federal Reserve System.
The thoughts of Ray Owens,
one of our own Richmond Fed
economists, are prominently
featured in the article, as are
those of Art Rolnick, director
of research at the Minneapolis Fed. In fact, the development of the Federal Reserve
Banks’ interest in and expertise on this subject is an interesting story in its own right.
The Minneapolis Fed’s 1994
Annual Report issue of its magazine The Region included an
essay titled, “Congress Should
End the Economic War Among
the States.” Like our own Bank,
Minneapolis uses its Annual

Report to put forward discussions of important economic
policy issues. While I am quite
proud of the essays that have
appeared in our own Annual
Report, I will readily acknowledge that this particular essay
from our sister Bank had an
especially substantial—and I
think constructive—impact on
public discussion of this subject.
The essay contributed to its
consideration in Congress, as
noted in our article in this issue,
and also led to a National Public
Radio symposium on the topic
in 1996. In addition, the essay
motivated further thinking and
research on the topic by other
economists, including several
here at the Richmond Fed.
This story has not yet
reached a conclusion. A broad
consensus on the issue of
special incentives for business
location has yet to emerge.
Most people recognize the
destructive potential of bidding wars. But some would
argue that there are enough
special cases in which incentives are beneficial that a
blanket prohibition, such as
the one suggested by the Minneapolis Fed, is unwarranted.
Still, while the Minneapolis
position has not won the day,
debate about how states and
regions should promote their
economic growth is certainly
further advanced than it was
before the Minneapolis Bank
got into the fray.
The story of how a Reserve
Bank, through its regional publication, put itself at the center
of a national debate on interstate economic rivalry is

instructive. It illustrates how
the Reserve Banks, through
their research and publications
functions, are able to promote
public awareness and greater
appreciation of a wide array of
economic policy problems,
from monetary policy to international finance and trade to
regional economic development. Indeed, our unique position as regional Reserve Banks
gives us the opportunity to
serve as a link between the
local and the national aspects
of policy issues.
So I tip my hat to the Minneapolis Fed for a job well
done. And I look forward to
future opportunities for our
Richmond Fed to contribute
to the building of wellinformed public opinion on
matters of economic policy.

AL BROADDUS
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Spring 2004 • Region Focus

1

FEDERALRESERVE

Information, Please?
Through its
disclosure
regulations, the
Federal Reserve
strives to improve
transparency in
consumer finance
markets

FEDERAL RESERVE BANK OF DALLAS

BY CHARLES GERENA

The Fed’s
Regulation Z
keeps evolving and
expanding to keep
pace with changes
in the financial
services industry.

2

Region Focus • Spring 2004

hen Jack Weiss joined the
Federal Reserve Bank of
Richmond as a bank examiner in the mid-1970s, it had been only
a few years since the Federal Reserve
System ventured into the realm of consumer protection. In addition to
auditing a bank’s safety and soundness,
he had to verify compliance with a series
of federal laws that were passed in the
late 1960s and early 1970s because of
wide disparities in how the consumer
finance industry operated and how it
was regulated by states.
Congress charged the Federal
Reserve and a varied group of federal
agencies — from the Office of Thrift
Supervision to the Department of
Housing and Urban Development —
with enforcing these laws. It also gave
the Fed unique authority to write the
regulations for the various disclosure
and anti-discrimination provisions.
Lawmakers recognized the Fed’s credibility as an apolitical organization and
its expertise in banking regulation.
At first, banks only had to answer a
question on the exam form to prove
they were following the Fed’s disclosure requirements. “It didn’t say whether
the disclosures were correct or not, it
just said whether they were provided,”
recalls Weiss. But as consumer credit
regulations grew in detail and scope, the
Richmond Fed and other Reserve Banks
created specialized teams of examiners
to conduct separate compliance audits.
Today, Weiss and other consumer
compliance examiners help the Federal
Reserve enforce a book of regulations
several inches thick. Many of the regulations focus on mandatory disclosures
outlined by Congress and crafted by the
Fed. By making creditors describe the

W

price and terms of their product in a
consistent manner, buyers can comparison shop. By making firms account for
how they approve or deny credit, the
Fed and other regulators can look for
patterns of discrimination.
Here is a taste of how the Fed’s disclosure requirements pull back the
curtain on the consumer finance industry and the value of what it reveals.

Knowledge is Power, But at
What Price?
Consumer protection groups want borrowers to know what they’re getting
into; ignorance breeds fraud in their
eyes. But why should the Federal
Reserve care if John Doe knows the
over-the-limit fee on his credit card?
Besides the fact that the Consumer
Credit Protection Act of 1968 and subsequent legislation make it the Fed’s
business, market transparency has economic benefits. “If consumers are better
informed about practically anything,
they will make better decisions and the
markets will function better,” notes
Thomas Durkin, an economist at the
Federal Reserve Board of Governors and
an expert on consumer credit regulation.
Generally, consumers gain from a
transparent market because they should
be better matched to their needs and
prices should be more competitive.
Lewis Mandell, professor of finance and
managerial economics at the State University of New York at Buffalo, says that
consumer finance companies benefit as
well. Informed borrowers are expected
to make fewer missteps, creating surplus
capacity in credit markets because there
is less unrecoverable debt to write off.
If transparency benefits both sides
of the market, why doesn’t it occur on

its own without government regulation?
“Sometimes, if you have a monopoly
position [as a result of] consumer ignorance, you may not want to give up
some of those profits,” surmises
Mandell, but the answer is not that
simple and is still under debate among
economists.
Regulation Z is the Federal Reserve’s
primary means of encouraging transparency in consumer finance. Implementing provisions in the “Truth in Lending” portion of the Consumer Credit
Protection Act, it mandates that creditors
standardize how they describe the cost of
their services and requires disclosure of
prices and credit terms, both before and
after customers sign on the dotted line.
For example, a credit card solicitation must include key information such
as the minimum finance charge that customers have to pay and the grace period
for repaying credit without incurring
finance charges. The most important
disclosure is the annual percentage rate
(APR), which is supposed to express the
total cost to customers of credit purchases, cash advances, and balance
transfers on an annualized basis.
Regulation M imposes similar disclosure requirements on companies
that offer consumer leases. These companies must provide information on
the cost and terms of leases so consumers can compare one lease with
another or weigh leasing against purchasing a product outright.
Not surprisingly, banks and other
consumer finance companies grouse
about the dozens of detailed disclosures
they make in the name of creating an
informed public. Richard Insley, a
banking consultant who used to be a
compliance officer at Signet Banking
Corp. and an examiner at the Richmond
Fed, says it hasn’t been easy or cheap
for banks to keep up with disclosure
requirements. “The early nickname
given to the Truth in Lending law was
the ‘Lawyers and Printers Relief Act.’
Truth in Lending has been an enormous
regulation that covers just about every
imaginable credit product that consumers use,” says Insley, president of
Richmond, Va.-based APR Systems Inc.

Economists have found that the
monetary burden of consumer credit
regulations is proportionately larger for
small firms, according to Richmond
Fed economist John Walter. For
example, a bank needs a compliance
officer to make sure that it follows all
of the regulations, whether it has
branches nationwide or a single office
in a rural town.
Computer technology has dramatically reduced compliance costs and
improved the reliability of disclosures
for everyone, notes Insley, but the
chances of violating Regulation Z are
significant. According to the Federal
Reserve’s 2002 Annual Report to Congress, 77 percent of banks examined by
the Fed and other federal agencies were
fully compliant with the regulation.
However, that is the lowest compliance
rate among the consumer protection
regulations tracked by the Fed.
“In a bank of any size with any kind
of sophisticated product line, if you look
long enough you’ll find something
wrong,” Insley adds.
The Fed’s Thomas Durkin believes
that the price of keeping up with regulation changes is the real issue. “Banks
can comply with anything. They just
don’t want the regulations changing all
of the time.”
Of course, the consumer finance
industry is always evolving and the
Federal Reserve has to keep pace. There
are new services like refund anticipation
loans and overdraft protection that
aren’t subject to the same disclosure
requirements as standard consumer
loans. Debit cards function like credit
cards, yet they aren’t subject to the same
requirements either. In addition, Congress amends Truth in Lending and
other consumer credit laws in response
to industry changes, and that usually
requires the Fed to tweak its regulations.
Balancing the potential benefits of
market transparency against the potential costs to industry is the job of James
Michaels and his colleagues at the
Federal Reserve Board’s Division of
Consumer and Community Affairs.
The division’s goal is to tailor disclosure requirements “so that you have the

intended impact without creating
unnecessary burdens or risks,” says
Michaels, assistant director for financial services regulations. But there are
always tradeoffs, so the division reports
both sides to the members of the
Board of Governors and they decide
which way to go.
Michaels believes that public
comment periods and hearings are
useful for determining the benefits and
costs of the Fed’s regulations. However,
it is a major challenge to do a benefitcost analysis of market transparency.
There is a consensus that credit
markets are more competitive and consumers have greater awareness of the
terms of their credit since the 1960s.
But how much of these benefits came
from mandated disclosures or what its
impact has been in dollars and cents is
hard to pin down, says Durkin.
Also, disclosures only give consumers
the means to make wiser credit decisions. People still take on more debt
than they can afford. “If he has to pay
a doctor bill … and doesn’t have any
money or made a Super Bowl bet and
the bookie is coming after him with a
ball-peen hammer, the rational consumer may take out a loan at a high
rate of interest,” explain SUNY’s Lewis
Mandell. “We can also assume that there
are a lot of folks who cannot calculate
interest or totally ignore it because they
don’t understand the concept.”
Mandell insists that the current multitude of disclosures “may be more
harmful than beneficial.” Based on 35
years of research, he has concluded that
consumers aren’t capable of focusing
on more than one piece of information
when evaluating credit. “I would like
to see a lot of stuff disclosed, but …
there has to be one point that is ‘superdisclosed’ in order to reach as many
people as possible.”

A Watchful Eye
While disclosures under Regulations Z
and M provide a means for people to
help themselves, other mandated disclosures help the Fed ensure equal
access to credit.
Regulation B implements the Equal

Spring 2004 • Region Focus

3

Credit Opportunity Act of 1974, which
prohibits creditors from treating borrowers differently on the basis of their
race, ethnicity, religion, gender, marital
status, or age. Among its many rules,
Regulation B prohibits firms from
doing anything to selectively attract or
discourage certain borrowers from
applying for credit. It also establishes
boundaries on what creditors can ask
borrowers during the pre-screening and
evaluation of applications, and requires
firms to provide a detailed notification
when they deny an application or make
a decision that adversely affects an
existing customer.
On top of disclosing the reasons
behind their actions, creditors are
required by Regulation B to retain any
records concerning those actions for 25
months. In addition, they must collect
information on the race, gender, marital
status, and age of people who borrow
money to buy a house.
Regulation C, which fulfills the provisions of the Home Mortgage Disclosure Act of 1975, also requires financial
institutions to collect data. They must
provide information on the geographic
distribution of their mortgage and
home improvement loans, organized by
gender, race, and other applicant characteristics.
Using computer models, consumer
compliance examiners use the information obtained under Regulations B and
C to detect potential problems in a
bank’s lending practices. Jack Weiss
describes the steps taken by the examiners that he manages at the Richmond
Fed. “A regression analysis takes loans of
a similar category like purchase money
mortgages,” then compares approved
and denied applications “to see whether
the bank’s loan policy is being applied
uniformly to ensure discrimination does
not take place.”
The regression analysis doesn’t always
raise a red flag if a bank’s lending is biased. “It is only an indicator,” says Weiss,
and not every bank makes enough loans
to produce sufficient data for this analysis. As a result, examiners also conduct interviews to see if discrimination is taking place and pull samples from the bank’s
4

Region Focus • Spring 2004

files to perform various types of analysis.
For example, an examiner might do
a pricing analysis to see if every customer with a Hispanic last name paid
more interest than the average customer
was charged. At that point, a more thorough examination would be conducted.
Even with all the information at the
examiner’s fingertips, Weiss says that
verifying compliance with Truth in
Lending disclosures is more straightforward than checking for violations of
fair lending regulations. In fact, examiners will often reach conclusions that
are very different from what consumer
groups come to when they look at the
loan information provided to the public.
Henry Franzyshen, a supervisory
examiner at the Richmond Fed, says
that his colleagues must rule out all
appropriate factors before they charge
discrimination. “While the Regulation
C data may show minorities are being
denied at a higher rate, the data only
includes a limited number of borrower
and loan characteristics such as income,
race, sex, location, and loan rate spreads.
But information from credit bureaus
and other sources might point to valid
reasons for any lending disparities, based
on sound financial practice.”

On the Front Burner
While disclosure requirements will always need adjustment, Weiss doesn’t see
the amount of requirements decreasing
in the future. “Congress and consumer
advocates think this information needs
to be put forth. They just won’t touch it.”
Actually, the Federal Reserve’s regulatory responsibilities keep on growing. In
1999, the Financial Modernization Act
gave the Fed and other regulators the task
of implementing restrictions on how
banks use their customers’ personal information. Two years later, Regulation P
required financial institutions under the
Federal Reserve’s supervision to disclose
their privacy policy. They also must ask
customers if they want their information
shared with nonaffiliated third parties.
More recently, the passage of the Fair
and Accurate Credit Transactions Act
last December will require the Federal
Reserve, the Federal Trade Commission,

and other federal banking agencies to
jointly write at least 10 new rules concerning consumer privacy, according to
staffers at the Board of Governors. The
rules will include model forms for creditors to use for obtaining information
on applicants and regulation of creditors’ use of medical information.
In addition to privacy issues, the Federal Reserve will soon have to deal with
the growing amount of consumer credit sold through the Internet. “The information flow to people is coming faster
and through more types of devices,” adds
consultant Richard Insley. As a result, a
person waiting at an airport can shop for
a loan using his web-enabled telephone.
As more people use the Internet to
shop for credit, Insley thinks more needs
to be done to ensure compliance with
disclosure requirements. “I suspect there
are a lot of people out there who are shopping [for credit] and missing information
they are supposed to have.”
RF

READINGS
Consumer Credit in the United States.
Washington, D.C.: National
Commission on Consumer Finance,
December 1972.
Durkin, Thomas A. “Consumer
Awareness of Credit Terms: Review
and New Evidence.” Journal of Business,
April 1975, vol. 48, no. 2, pp. 253-263.
Durkin, Thomas A. and Gregory E.
Elliehausen. 1977 Consumer Credit
Survey. Washington, D.C.: Board of
Governors of the Federal Reserve
System, December 1978.
Furletti, Mark. “Credit Card Pricing
Developments and Their Disclosure.”
Discussion Paper, Payment Cards
Center, Federal Reserve Bank of
Philadelphia, January 2003.
Joint Report to the Congress Concerning
Reform to the Truth in Lending Act and
the Real Estate Settlement Procedures Act.
Washington, D.C.: Board of
Governors of the Federal Reserve
System and the. Department of
Housing and Urban Development,
July 1998.
Visit www.rich.frb.org/pubs/region
focus for links to relevant Web sites.

LEGISLATIVEUPDATE
The Mixed Bag of Medicare Drug Coverage
BY C H A R L E S G E R E N A

T

costs, the theory is that it will make them more conservative
he Medicare reform bill signed by President Bush last
about what they purchase,” explains Taylor. “But to put [a gap]
December will help thousands of Medicare recipients
in the middle as opposed to having a high up-front deductible
by providing drug coverage for the first time. But it
or higher cost sharing, I don’t know what the rationale is for that.”
comes at a high price in terms of its potential macroeconomic
Most observers believe the coverage gap kept the price tag of
consequences and unintended effects on access to drugs.
Medicare drug coverage at a politically acceptable level.
Starting in 2006, seniors can choose a stand-alone prescription
Another way that lawmakers hope to rein in costs is to bring
drug plan (PDP) under Medicare Part D or drug coverage
private-sector competition into the delivery of drug coverage.
through a Medicare Advantage comprehensive plan (formerly
The federal Centers for Medicare and Medicaid Services will
Medicare+Choice or Part C). The standard drug benefit will
contract with health insurers to provide PDPs and Medicare
cover 75 percent of medication costs between $250 and $2,250,
Advantage plans with drug benefits. The country will be divided
then no further assistance will be provided until expenses reach
into at least 10 regions, and a minimum
a “catastrophic” level of $5,100. Those
of two drug plans from different firms
with low incomes may qualify for a special
Basic Medicare Drug Benefit
will have to be available in each region.
drug benefit with no gap in coverage.
These insurers are expected to
Drug coverage will add approximately
Plan Component
Beneficiaries Pay
negotiate
lower prices for drugs, but
$534 billion to the cost of Medicare over
Premium
$35/month ($420/year)
policy
analysts
like Edwin Park of the
10 years. Such a large expansion in an
Deductible
$250
Center on Budget and Policy Priorities
entitlement program carries the risk of
Initial coverage
25 percent of expenses
have their doubts. Park says the best
pushing the federal budget into structural
between $250 and
way for them to secure a discount is to
imbalance, whereby planned government
$2,250
guarantee a certain market share for a
expenses exceed average tax revenues
Coverage gap
All expenses between
drug manufacturer, usually by adding its
generated by an expected level of
$2,250 and $5,100
product to their preferred drug list. But
economic activity. Entitlements, which
Catastrophic
5 percent of expenses
he questions whether this would be
already consume more than half of the
coverage
above $5,100, or
achievable. “How much market share
budget, are much harder to cut than
$2/generic drug and
$5/brand-name drug
are you delivering when you are breaking
discretionary programs.
(whichever is greater)
up [the market] into multiple regions?”
What will stop mounting drug prices
SOURCE: The New Medicare Drug Benefit: How Much Will You
Furthermore, Park thinks it’s unlikely
from ballooning the overall cost of
Pay?, Families USA, Spring 2004
that firms could get better drug bargains
Medicare? Congress hopes the drug
than large government purchasers like
benefit will save money by encouraging
the Veterans Administration could.
more seniors to use medications that prevent conditions before
Private insurers also are expected to use cost- containment
they worsen and require expensive treatment. Generally, seniors
tools more aggressively than government agencies could. They
with insurance are less price sensitive in their demand for drugs.
won’t be subject to political pressures, plus they will be able to
“They don’t think very much about the cost,” says Roland
use preferred drug lists.
McDevitt, a senior consultant for Watson Wyatt Worldwide.
The downside of using such tactics is that some drugs may
“They take whatever [the doctor] prescribes and get the latest
not be covered or may require a higher co-payment. This won’t
generation of drugs designed for their condition.”
be an issue if seniors can shop around for drug coverage that includes
To keep the fiscal burden of the Medicare drug benefit from
their medications. Additional payments will be given to health
growing out of control, lawmakers put cost-containment
insurers to offer PHPs and Medicare Advantage plans, but
mechanisms into place. For example, as Medicare Part D
Families USA, a healthcare advocacy group, notes that some
spending rises, the deductible and the level at which catastrophic
regions may not get any takers.
coverage starts will rise as well. This will shift more costs onto
All told, seniors will have fewer alternatives if no MedicareMedicare beneficiaries.
sponsored plan works for them. Medicaid won’t be allowed to
Will cost shifting help contain overall drug prices as well? Lynn
fill in coverage gaps in the Medicare drug program, while states
Taylor, senior policy analyst at the Institute for Health Policy
would be hard-pressed to fill the gaps on their own. Furthermore,
Solutions, says the coverage gap will result in the most financial
employers could eliminate drug coverage for retirees when the
assistance going to occasional users of drugs and frequent users,
Medicare benefit becomes available, despite the availability of
leaving the average Medicare recipient to pay for their medications
federal subsidies.
RF
out of pocket. “Any time you make people absorb more of the

Spring 2004 • Region Focus

5

JARGONALERT
Externality
BY A A RO N ST E E L M A N

ILLUSTRATION BY TIMOTHY COOK

I

6

magine you have high blood pressure and seek a doctor’s
advice. There are different things that he might prescribe:
He might put you on medication, or he might say that
the problem can be handled through exercise and diet. Both
solutions could have side effects, some negative and some
positive. The medication, for example, could cause you to
feel light-headed. The changed diet and exercise regime, on
the other hand, could help you lose weight and increase your
energy level.
Many types of economic activity also have side effects.
In some ways, these side effects are like those of the medical
patient mentioned above: They can be either negative or
positive. But in other ways, they are
different: They are felt not just by
the patient but by a larger group of
people. Economists refer to these
side effects as “externalities.”
Consider the case of a factory
that pollutes the air of neighboring
property owners. Those people are
not engaged in the manufacturing
process but they feel its effects.
They, not the owner of the factory
or the consumer of its goods, bear
the cost. This is an example of a
negative externality.
Now consider the case of a positive externality. Let’s say that you
enjoy gardening and plant a variety
of flowers in your yard. You benefit
from the beauty of those plants,
but so do your neighbors who can view them at no charge.
In both cases, government action may seem desirable.
One of the most common approaches is regulation. In the
case of the factory, the government might put a cap on the
amount of pollutants it can discharge. In the case of the
homeowner, the government might require all citizens to
meet minimum requirements regarding the upkeep of their
property.
The government might decide to forego regulation,
however, and impose taxes instead. It could tax the factory
according to the amount of pollution it produces. That may
induce the factory to cut emissions on its own, but if not,
the government could use the tax proceeds to compensate
those affected by the smoke. In the case of the homeowner,
the government could subsidize improvements people make
to their houses and lawns.
Both of these solutions—regulation and taxation—can
be blunt instruments, though, and can produce side effects

Region Focus • Spring 2004

of their own. It may be more desirable for the market to
work out these problems on its own. But how? In a 1960
article in the Journal of Law & Economics, Ronald Coase
argued that such externalities can be “internalized” as long
as property rights are fully allocated and transferable, and
transaction costs are low.
Consider the case of the factory. Assume that the factory’s
emissions cause damages of $100 per year, that a smoke-preventing device could be installed for $90 per year, and that
the government taxes the factory to cover the damages. In
this scenario, the smoke-preventing device would be installed
and the factory owner would be better off by $10 annually
than if he had paid the tax. “Yet the
position achieved may not be
optimal,” Coase writes. “Suppose
that those who suffer the damage
could avoid it by moving to other
locations or by taking various precautions which would cost them,
or be equivalent to a loss in income
of, $40 per annum. Then there
would be a gain in the value of production of $50 if the factory continued to emit its smoke and those
now in the district moved elsewhere or made other adjustments
to avoid the damage.”
Under a robust system of property rights, the parties would have
a strong incentive to negotiate and
arrive at this more efficient solution. For instance, the factory owner might simply buy the
homeowners’ right to clean air—at a cost between $40 and
$90 annually—and continue operating his plant as he had
before.
Naturally, some economists were skeptical of Coase’s
theorem and pointed to cases where they thought it would
not apply. Yet in many of those cases, voluntary, mutually
beneficial arrangements had long been the norm. The most
famous example involves bees.
Bees require nectar from plants, and plants require pollination. So when plants were producing nectar and did not
need pollination, beekeepers paid farmers for the right to
put their hives on farmers’ fields. And when plants were producing little nectar but needed pollination, farmers paid beekeepers. There was no regulation, tax, or subsidy involved.
This does not mean that the market can handle all externalities. But Coase’s theorem should give us pause about the
extent to which state intervention may be necessary.
RF

RESEARCHSPOTLIGHT
Are Criminals Rational?
BY A A RO N ST E E L M A N

E

If criminals are indeed rational, where is the evidence?
conomists use models to explain a wide variety of pheEconomists Jac C. Heckelman of Wake Forest University and
nomena. Most of the models assume that people are
Andrew J. Yates of the University of Richmond use a novel
rational—that they act purposively and respond to
data set to test this hypothesis: penalty statistics from the
incentives. This assumption applies to people in all walks of
National Hockey League (NHL).
life, from investors to politicians to criminals.
During the 1999-2000 season, the NHL experimented
David Friedman, an economist at Santa Clara University
with a new system: Some games had two referees, others just
and author of Hidden Order: The Economics of Everyday Life,
one. There were more penalties called during two-referee
nicely summarizes the way economists look at crime: “A
games, meaning that players were less likely to get away with
burglar burgles for the same reason I teach economics—
breaking the rules than they were in a one-referee game. But
because he finds it a more attractive profession than any
what about deterrence? Did the additional referee prevent
other. The obvious conclusion is that the way to reduce burplayers from committing penalties that they otherwise would
glary—whether as a legislator or a homeowner—is by raising
because they knew their chance of being caught was greater?
the costs of the burglar’s profession or reducing its benefits.”
It doesn’t seem so. “The number of referees is not statistiOne might say, “That’s ridiculous. I don’t break into
cally significant in any of
people’s homes because
the regressions, suggestit’s morally wrong, not
ing that players do not
because I have decided
commit fewer infractions
that it isn’t worth the
“And a Hockey Game Broke Out:
in response to the
risk.” This is probably
increased number of reftrue for most people—
Crime and Punishment in the NHL” by
erees.”
and it may be the most
Does this give us
significant reason why we
Jac C. Heckelman and Andrew J. Yates.
reason to doubt the
don’t have more crime
Economic Inquiry, October 2003, vol. 41,
rational criminal hypoththan we do. But that
esis? Perhaps. But there
doesn’t necessarily mean
no. 4, pp. 705-712.
are at least three reasons
that such law-abiding citwhy it might not.
izens haven’t done a
First, the statistical
benefit-cost analysis of
techniques used to
their own.
measure deterrence, or
“Crime also has assothe lack thereof, are imperfect and may not capture the full
ciated with it psychic costs. Many people do not commit
effects of an additional referee. Second, it’s not clear that all
crimes because they believe doing so is ethically wrong. And
teams would respond to an additional referee in the same
the feelings we have about what is right and wrong are imporway. For instance, teams that play relatively well in “shorttant,” writes University of Chicago economist Gary Becker.
handed” situations— penalty periods in which they have
In other words, guilt is a real cost. You may not have to
fewer players on the ice —might not be as concerned about
answer to the law for committing burglary, but you will have
being called for penalties because the costs to them are not
to answer to your conscience.
as high. (Conversely, the additional referee should have a
Still, we need legal sanctions to protect us from those less
greater deterrent effect for teams that play relatively poorly
scrupulous: criminals and would-be criminals. What those
shorthanded.) Third, and most important, hockey is a game
sanctions should be and how they should be enforced are
of reaction. Decisions have to be made on the fly, with little
matters of opinion. But, generally, economists would say that
time for serious contemplation. So the conditions are very
if you want less crime, you should stiffen penalties and expend
different than when one is planning a burglary.
more resources on enforcement—though the exact mix is a
“Because many sports infractions take place during the
matter of debate, since empirical studies differ over the relheat of competition and may be accidental or retaliatory in
ative effectiveness of these two forms of deterrence. You
nature rather than planned in advance, the act of commitshould also keep in mind that the optimal amount of crime
ting a sports infraction may be more analogous to a crime
is not zero. Eradicating all crime would be extremely costly
of passion than a calculated benefit-cost analysis performed
and probably would require draconian measures that most
by a rational criminal,” Heckelman and Yates conclude. RF
people would reject as unworthy of a free society.

Spring 2004 • Region Focus

7

SHORTTAKES
R A L LY I N G F O R R E F O R M

Lawmakers Pressed
on Malpractice

A

CHARLES GERENA/FRB OF RICHMOND

year after West Virginia
“fixed” its tort system
to make malpractice insurance
more affordable and available,
medical professionals elsewhere in the Fifth District are
having insurance problems, especially certain specialties like
obstetrics and trauma care.
While the American Medical
Association says the situation has reached a crisis level
only in North Carolina and
West Virginia, lawmakers
throughout the region are
being lobbied hard to follow
the Mountain State’s lead.

Physicians lobbied
outside of the Virginia
State Capitol in
February for changes to
the state’s medical
malpractice rules.

8

In March 2003, the West
Virginia Medical Professional
Liability Reform Act changed
several aspects of the state’s
tort law. The bill’s provisions
included a $250,000 limit on
“pain and suffering” damages
and a $500,000 overall cap
on damages paid by trauma
centers.
Since then, the West Virginia Hospital Association has
noted an improvement in recruitment efforts at the state’s
hospitals. Still, the state has
only one major private provider
of malpractice insurance —

Region Focus • Spring 2004

Medical Assurance of West
Virginia — and its parent company stopped providing it reinsurance last December. Another firm, NCRIC Inc., announced in January that it
wouldn’t renew its malpractice policies in West Virginia
as they expire.
Other parts of the Fifth
District don’t have such a limited market for malpractice
insurance. But some have experienced significant increases
in premiums, and that has doctors worried about the future.
In the last 12 months, physicians
converged on statehouses in
Virginia, Maryland, North
Carolina, and South Carolina
to rally for changes in tort law.
Two proposed reforms
could help reduce the number
of frivolous lawsuits, which
doctors and insurers say have
pushed up malpractice costs.
One proposal would require
plaintiffs to pay for defendants’
legal bills if they lose. Roy
Cordato, vice president for research at the John Locke
Foundation in Raleigh, N.C.,
believes this would bring balance to a system where the
potential payoff from a suit
is much higher than the expense of filing a case. “The
lawyer doesn’t look at the legitimacy of the complaint,” explains Cordato. “What he
looks at is the probability of
getting a settlement.” And the
odds are in the plaintiffs’ favor
because defendants often settle out of court to avoid a
big jury award.
Another reform proposal
would subject malpractice lawsuits to arbitration or a review
panel of medical experts before trial. G. Robert Thomspon, an economist at Clem-

son University, believes the latter would help discourage frivolous lawsuits.
But other tort reforms are
more problematic. For instance, caps on jury awards
haven’t been proven to affect
the price of malpractice insurance, and Thompson suspects that caps may encourage incompetent doctors to
migrate to a state because they
know their liability is limited.
Another imperfect solution, which is being considered
in West Virginia, is to start a
patient injury compensation
fund. South Carolina created
such a fund in 1977 that pays
for any part of a malpractice
judgment or settlement over
$200,000. Virginia created a
more specialized fund in 1987
that pays for lifelong medical
care for infants that suffer
brain injuries at birth. But
both programs are underfunded and they have no
upper limit on payouts. They
also don’t charge deductibles,
co-payments, or any other
form of cost sharing that
would shift some of the risk
burden onto doctors. Consequently, physicians have no incentive to avoid lawsuits, creating a moral hazard problem
according to Thompson.
Cutting back on the number of lawsuits and the size of
jury awards alone does not
make malpractice insurance
more available or affordable,
since certain market forces are
also driving the current premium increases. Still, there is
relatively broad support for
tort reform among economists, who see it as a good
first step toward fixing a very
difficult problem.
—C HARLES G ERENA

BAD CONNECTION

Southwest Virginia
Loses Call Center

I

nternet travel agency Travelocity.com has announced
plans to close its call center in
Clintwood, Va., by the end of
2004, putting roughly 250 people out of work. Clintwood is
in Dickenson County, in the
state’s southwest corner, an
area that has suffered economic hardship in recent
decades. Dickenson’s population has fallen from a peak
of 23,000 in 1950 to 17,600 in
2000. As of December 2003,
the county’s unemployment
rate stood at 11 percent.
Some of the work done in
Clintwood will be sent to a facility in India. Similar outsourcing recently has occurred
at call centers operated by
other companies in the Fifth
District. (See Charles Gerena’s article, “On Hold: Fifth
District Call Centers Are Shedding Workers Due to Technological Improvements and
Globalization,” from the Winter 2004 issue of Region Focus.)
Travelocity originally
planned to employ up to 500
people at the Clintwood facility, which opened its doors
in mid-2001. But sluggish business for the travel industry
following the terrorist attacks
of Sept. 11, 2001, reduced the
demand for workers.
The Virginia Coalfield Economic Development Authority and the Dickenson County Industrial Development
Authority courted Travelocity,
with the county taking out a
$250,000 loan to improve the
company’s call-center facility.
(For more on economic development incentives see Karl

Rhodes’ article, “The Baiting
Game,” on pp. 20-23 of this
issue.)
— A ARON S TEELMAN

E L E C T R I C D E B AT E

Is Deregulation
Working?

I

t seemed like a great idea.
And it may turn out to be a
great idea yet. But, so far, efforts to deregulate the electric industry have fallen short
of their original promise.
“I’ve been somewhat disappointed at the way deregulation has unfolded,” says Jack
Reasor, president and chief executive officer of Old Dominion Electric Cooperative,
headquartered in Glen Allen,
Va. Before joining Old Dominion, Reasor was chairman of the Senate Subcommittee on Electric Utility
Restructuring in the Virginia
General Assembly. “I question
whether it [deregulation] can
work in the electric utility
industry,” he says candidly.
A lot of people share Reasor’s doubts these days, particularly in California, where
the restructuring of electric
markets began in earnest in
the late 1990s. A firm belief
that competition would lower
the state’s high electric rates
led to fundamental changes
in state laws and regulations
affecting the ownership of
generating plants and the
way wholesale electricity markets functioned. California’s
efforts to deregulate its industry were among the earliest and most comprehensive in the nation.
Unfortunately, California’s deregulation plan failed
miserably. By June 2000, the

state was experiencing soaring wholesale prices for electricity, and by 2001 there were
rolling blackouts and a bigtime crisis. While other factors, such as a time-consuming
process for licensing new generating plants and unusually hot, dr y weather, contributed to the problems, the
California restructuring plan
was clearly flawed.
California’s experience
with deregulation was sobering for those developing restructuring plans in other
states. The Enron scandal and
issues with manipulation of
wholesale markets raised further questions about the feasibility of deregulation
Even in states that managed to avoid California’s
calamities, there was growing suspicion that deregulation helped only a select group
of consumers. “Whether deregulation has been a success or
not depends on whom you
talk to,” says Robert Burns, a
senior research specialist with
the National Regulatory Research Institute in Columbus,
Ohio. “Large commercial and
industrial customers have benefited, but there hasn’t been
much benefit at all for residential customers.”
Legislators in several Fifth
District states have acted in
recent months to either slow
down electric deregulation
or better protect consumers
from potentially higher electric rates in a more deregulated environment. Legislation passed in the 2004 session of the Virginia General
Assembly calls for an extension of electric rate caps until
Dec. 31, 2010, unless ended
sooner by a finding that a

competitive market for generation exists. (Rate caps are
a common feature of deregulation plans and offer consumers some protection
against volatile price swings
during the transition to more
competitive markets.)
Among the legislative proposals in Maryland to protect customers from rate shock
is Senate Bill 739, which restricts residential rate increases to no more than 10
percent in any one year.
Despite the setbacks in
California and elsewhere, the
debate over restructuring will
continue. Competitive markets have great allure, and
economists certainly prefer
them where possible.
And amid the setbacks,
there have been some overlooked success stories in deregulation, which hold promise
for future restructuring efforts. William Hecht, chairman of PPL Corporation, an
electric utility headquartered
in Allentown, Pa., says Pennsylvania “got it right.” The
state’s restructuring effort
gives each electric customer
the option of choosing an electricity supplier. He credits a
system that allows new electric-generating capacity to be
built “in response to economic
price signals, not through the
old central planning approach,”
as a key to Pennsylvania’s success. Restructuring efforts in
Texas and Ohio have also garnered praise.
There is even talk about
giving deregulation another
shot in California. New governor Arnold Schwarzenegger is an advocate but, not
surprisingly, strong opposition exists.
— R O B E RT L AC Y

Spring 2004 • Region Focus

9

W O

R

K

I

N

G

F

O

R

Health Care
Employer-sponsored health insurance is commonplace, but it may be
one of many factors distorting the market for medical services
BY BET TY JOYCE NASH

T

he Northern Neck
Free Health Clinic in
Kilmarnock, Va., serves
up medical care to the working
poor. “I have right here a 28year-old with breast cancer,”
says Jean Nelson, executive
director. The patient lacks
health insurance because she
works part-time, ironically, at
a hospital. The free clinic itself
can barely afford to insure its
employees. “Our premiums are
incredible, but you don’t bring
in employees to a free health
clinic and not give them health
insurance.”
Health coverage in the
United States is built around
employer-sponsored insurance
plans. Employees receive access
to group health plans at a cheaper
rate than they could buy
individually. Of course, workers
get the benefit of insurance at the expense
of higher wages, but they’re not taxed
on the insurance as they would be on the
added pay. This “third-party” payment
system has complicated the economics of
health care enormously, economists say.
“When consumers are out there,
they’re using someone else’s dollars to
order very expensive services,” says
Chris Conover, who researches health
care at Duke University’s Terry Sanford
Institute of Public Policy. “[There’s] not
the price and cost discipline you see in
most other markets.”

10

Region Focus • Spring 2004

Markets and Health Care
The United States spends more on
health care for each person than any
other industrialized nation, all of which
offer some form of guaranteed health
coverage. In 2002, the United States
spent $1.6 trillion, or $5,440 per
person, 9.3 percent more than in 2001.
Health spending grew 5.7 percent faster
in 2002 than the overall economy,
according to the Centers for Medicare
& Medicaid Services (CMS). Health
care’s share of the gross domestic
product jumped to 14.9 percent in 2002

after nearly a decade in the 13
percent range.
Of that $1.6 trillion, more
than half came from private
payers. Employer-sponsored
insurance, with its tax subsidy,
has become the cornerstone of
the U.S. health insurance
market. Today, about 175
million people are covered
through an employer plan,
down from nearly 178 million
in 2000, with about 242 million covered by a private plan
of some sort and 74 million
covered by a government plan.
Workplace insurance dramatically shaped the system, says
David Cutler, an economist at
Harvard University and author
of Your Money or Your Life:
Strong Medicine for America’s
Healthcare System.
“It led to insurance being
tied to work, for good (more risk
pooling) and ill (people locked into
their jobs),” says Cutler. The downside
of workplace insurance is that low wage
and part-time workers often aren’t
offered health insurance. An upside,
though, as Keith Crocker and John
Moran point out in an article in the
RAND Journal of Economics, is that
workers are less mobile when insurance
is bundled with employment. That
creates more commitment to insurance
pools, providing “more complete insurance of health risks than would be

1847 The Massachusetts Health Insurance Co. of
Boston began to insure against sickness.
1939 Revenue Act of 1939 establishes employee
tax exclusion for compensation for injuries,
sickness under workers’ compensation, accident,
or health insurance.
1943 War Labor Board ruled that World War II’s
wage freeze did not apply to fringe benefits.
1965 Congress establishes Medicaid and Medicare
to cover poor people and people over 65.
“Historically, health care didn’t function anywhere near traditional textbook
models,” Morrisey says. For example,
competition in hospital markets tended
to lead to higher costs rather than lower
costs, as hospitals engaged in “medical
arms races” to install the latest advances
in equipment.
“What we’ve seen with the advent
of managed care beginning in the mid1980s through the mid-1990s was that
managed care really did put health-care
markets back on their textbook feet,”
he says. Selective contracting allowed
volume discounts and accompanying
lower prices. The rate of premium
increase declined steadily.
“By the mid-’90s they believed if
they hadn’t slain the cost dragon they
had at least curbed it,” notes Robert
Hurley, an associate professor of health

I
I

50

I

40

I

30

I

20

I

I

60

10

I

I

I

I

I

I

Inflation-adjusted spending
Share of expenditures

I

I
I
I
I
I
I
I
I 0
1964 1969 1974 1979 1984 1989 1994 1999
Calendar Year

SOURCE: Centers for Medicare & Medicaid Services

Spring 2004 • Region Focus

11

E XPENDITURES

800
700
600
500
400
300
200
100
0

I

Health Care Spending and
Consumers’ Out-of-Pocket Payments

OF

Markets began to work, to some degree,
during the managed-care revolution of
the mid-1990s. Escalating costs in the
late 1980s sent premiums up by 17 or 18
percent. The recession of the early 1990s
pushed managed care to the forefront as
big purchasers of health benefits hired
insurance firms to manage care and benefits aggressively.

1789 Congress establishes U.S. Marine Hospital
Service funded by contributions from seamen’s
wages.

I

Enter Managed Care

Dates That Shaped the Market

CURRENT DOLLARS

and people being priced out of the
market. [You do] all these things in the
hope you’ll make insurance affordable
for most people. But it generally drives
the cost higher in that market.” For
example, the 48-hour maternity mandated hospital stay seems sensible, but
not everyone needs it and it pushes
costs higher for everyone.
“You load the cost into the system
and… you are in effect shifting the cost
to those other purchasers,” Miller says.
“If you look at the cross-sectional
dynamics of the uninsured, they tend
to be younger, healthier and not have
as much money to buy a deluxe policy.
[They’re] less likely to pick up on a
more expensive policy.”
Another complicating factor is
asymmetric information. It’s difficult
for people to observe the quality of
goods and services they purchase in the
health-care market. How would a
person know, for example, whether a
heart condition warranted angioplasty
or surgery? How good are the drugs,
doctors, and procedures at solving
medical problems?
“There’s that physician who has to
play the agent for us,” says Mike Morrisey, a health economist at the University of Alabama at Birmingham.
Information flow in health care is
also a problem. While medical technologies have flourished, health care
lags other industries in using information technology to improve outcomes
and efficiency. “It’s taking a long time
for the industry to get its act together,”
Conover notes. Further complicating
the system are doctors’ individualized
practices and unique role within the
hospital. Though they usually have no
economic stake in health facilities,
they nevertheless, have the hospital at
their disposal.

SHARE

available in a competitive market.”
But overall, the economic consequence of employer-paid insurance is
troubling: Consumers never see the
true costs of medical care because they
don’t pay with their own dime.
That’s thrown the market out of
whack. Markets work when buyer and
seller let the invisible hand determine
price, right? But in the health-care
market, consumers buy medical care
while employers and insurance firms
pay for it and still other participants
provide goods and services.
The third-party payment system has
contributed to several commonly identified economic problems. The first is
moral hazard. Since people aren’t
paying the full cost of health care, they
aren’t as sensitive to price. They tend
perhaps to buy more than they need
and don’t shop for the best buy, inasmuch as that’s possible in health care.
Third-party payment for medical care,
subsidized by tax policy, is illogical,
observes economist Milton Friedman in
an essay on “How to Cure Health Care”
published in The Public Interest.
“Why single out medical care? Food
is more essential to life than medical
care,” he writes. “Why not exempt the
cost of food from taxes if provided by
the employer?” Friedman argues that
the tax exemption of employer-provided care has fueled the inflation in
health care spending. He says employees would be better off buying their
own insurance policies or paying for
medical care with the higher pay they’d
get if they didn’t get tax breaks on
medical benefits.
The second problem is the issue of
adverse selection. If healthy people
forgo insurance as costs rise, employers may drop plans altogether as only
the least healthy people remain in the
pool. Adverse selection ultimately will
drive insurers out of unprofitable
markets, further depressing competition. Regulations enacted to guarantee
access can work in reverse. They can
make insurance unaffordable, says Tom
Miller, formerly a health-care analyst
at the Cato Institute and now senior
economist with the Joint Economic
Committee of the U.S. Congress.
“That’s a factor in the cost of care

you have to accept me,” and ultimately
weaken selective contracting.
In Greenville, S.C., for example, one
hospital sued to be included in the
provider networks of two health plans,
previously under exclusive contracts
with a competing system. The Center
for Studying Health System Change
reports: “Consumers now have equal
access to both hospital systems, but
plans’ ability to hold down costs may
have been weakened.”

administration at Virginia Commonwealth University. But from 1996
through today, premiums have gone
from no change in 1996 to the 13.9
percent increase in 2003. The ability of
health plans to extract discounts dried
up as consumers and providers alike
demonstrated they didn’t like the
restrictions of managed care.
Much employer-sponsored coverage
was through managed care in the 1990s.
Those plans have dwindled, however,
and serve only about 24 percent of
insured people today. Preferred-provider
plans dominate the health insurance
market and with a broader panel of
providers, prices can’t be negotiated.
“Employers haven’t been as supportive, consumers have been unhappy
and providers have made it clear they’re
not going to take what they have in the
past,” Hurley says.
Regulations can also impede market
function. “Some providers in any given
state, be they hospitals, physicians, or
nursing homes, are very good at understanding their market and have been
able to go to state legislatures to seek
protection,” Morrisey notes. Along with
mandated benefits, there are “willing
provider” laws. Those laws say, “If I’m
willing to live by conditions of contract,

Prices Rise, Demand Drops
The number of working-age Americans
who receive health insurance through
an employer fell from 71 percent in
1987 to 68 percent in 2000, according
to research by Harvard University
health economist David Cutler, despite
the booming economy of the 1990s.
Recent Census Bureau estimates put
the percentage of working-age people
who are covered by employment-based
insurance at about 66 percent in 2002.
Premium hikes and a changing employment picture share blame as part-time
and low-wage jobs replace higherpaying ones, especially in Fifth District
states formerly reliant on manufacturing. As lower-wage service industry jobs
proliferate, the number of people

Increases in Health Insurance Premiums Compared to
Other Indicators, 1988-2003
18

I

16

I

14

I

12

I

10

I

PERCENT

I

20

12.9%*

12.0%
10.9%*

8.5%
8.2%*
I

6

13.9%^

14.0%

I

8

Health Insurance Premiums
Workers Earnings
Overall Inflation

18.0%

4

I

2

I
I

0 I

1988

5.3%*

I

I

I

1991

I

I

I

I

0.8%
I

1995

I

I

I

1999

I

3.1%

I

I

I

2.2%
I

2003

* Estimate is statistically different from the previous year shown at p‹0.05: 1996-1999, 1999-2000, 2000-2001, 2001-2002.

^Estimate is statistically different from the previous year shown at p‹0.1: 2002-2003.
NOTE: Data on premium increases reflect the cost of health insurance premiums for a family of four.
SOURCE: KFF/HRET Survey of Employer-Sponsored Health Benefits: 1999, 2000, 2001, 2002, 2003; KPMG Survey of EmployerSponsored Health Benefits: 1993, 1996; The Health Insurance Association of America (HIAA): 1988, 1989, 1990; Bureau of Labor
Statistics, Consumer Price Index (U.S. City Average of Annual Inflation (April to April), 1988-2003; Bureau of Labor Statistics,
Seasonally Adjusted Data from the Current Employment Statistics Survey, 1988-2003

12

covered by employer coverage could
continue to slide.
But what Cutler found was that premium costs affect insurance decisions
hugely. Twenty percent of uninsured
workers who are offered coverage decline
it, citing cost as the reason. For every $10
increase in monthly employee premium,
0.4 percent of employees opt out.
And health premiums are climbing.
Premiums rose 13.9 percent between
2002 and 2003, the third straight year
of two-digit increases and the biggest
jump since 1990, according to the
Kaiser Family Foundation and Health
Research and Educational Trust.
Some employers have either
dropped coverage altogether or require
workers to pay a bigger share—to save
money and to heighten consumer
awareness of the true costs of medical
care. If people pay more out of pocket,
then they’re less likely to use medical
services and prescription drugs excessively, the thinking goes.
The number of working-age adults
with no health insurance increased by
2.4 million in 2002, the biggest jump
in more than a decade, says John
Holahan, an economist who studies the
issue for the Urban Institute. Overall,
there are 43.6 million uninsured Americans, or 15.2 percent of the population.
Many of those people lost benefits after
losing a job, or changed from a large to
small firm that doesn’t offer insurance
or can’t pay the higher premium costs.
Eight of 10 of the uninsured come from
working families, according to a report
issued by The Kaiser Commission on
Medicaid and the Uninsured.
Workplace-provided insurance is
shifting as the job market shifts.
“Whether you’ll see job gains in industries with employer-sponsored insurance is a big unknown,” Holahan says.

Region Focus • Spring 2004

Fifth District: Challenges
for Coverage
Some Fifth District states face difficulties in health spending and access, partly
because of below-average household
income, minority populations, and shifts
in employment. For example, while
North Carolina boasts many high-technology jobs, the state is reeling from
massive layoffs in the textile industry

A Subscription Prescription
A patient wrenches his back just before
heading to the airport for a trip. He calls his
doctor, who prescribes a muscle relaxant, and
the patient stops to fill it en route. An hour
later, he’s checking in when his cell phone
rings. It’s the doctor, giving him the lowdown
on the medicine and instructions to minimize
discomfort during his trip. After he hung up, a
fellow passenger turns and asks incredulously,
“Was that your doctor you were talking to?”
These days, quick, personal medical service
is astounding. But for $68 a month (for a
person over 36), if you live in Norfolk, Va.,
you, too, could have it. Dr. David Grulke and
his two partners run a subscription medical
practice that he says has freed him from the
hassles of paperwork and impersonal, hurried
patient care. Sound expensive?
“But in reality this is a modest expense
for something we think is a great value,”
Grulke says. “We want people who are
committed to their health and who ask
questions and [want] to be educated. They’re
easy to take care of. Patients who don’t take
their medications and don’t show up for
appointments— they’re a liability.” Grulke
handles no insurance, but patients need to
carry it for lab work, hospitalization, and
procedures referred by Grulke.

alone, 8,315 in 2003. “We’re very much
in this transition because we used to
be a manufacturing state,” Conover says.
“That’s changing—[there’s a] shift
toward services, lower-paid jobs.” Manufacturing jobs have higher rates of
coverage than service jobs, he notes.
Firm size and industry type influence
insurance decisions. Large firms are
more likely to offer coverage than small.
Firms with highly paid workers typically
will offer coverage while those with lowwage workers and high turnover
probably won’t. Regional differences
account for still more insurance variability. Employers in the Northeast are
more likely to offer health coverage than
those in the South and West, according to Linda Blumberg of the Urban
Institute.
Other coverage issues lie in simple
demographics. All Fifth District states
except West Virginia have a higher pro-

In 2002, Grulke quit his previous practice,
which had been bought by a corporation
along with 13 others. After the purchase,
Grulke says he spent half his time doing
paperwork after hours, much of it associated
with information required by the company. He
spent less time absorbing medical details
crucial for good care. And he saw between 36
and 42 patients each day.
Now, Grulke and his two partners limit
the practice to 600 patients apiece, about 20
to 25 a day, and set aside 15-minute slots for
a typical visit, rather than 10. He has gone
back to allotting an hour for an annual
physical for new patients, 45 minutes for an
established patient, rather than the 20
minutes prescribed by the corporate owner.
He also sets aside a 15-minute slot every hour
for those who need a same-day appointment.
Grulke has practiced internal medicine for
26 years and neither he nor his partners have
been threatened by legal action. But he’s
grateful that he cut his daily patient load
when he did. “It’s only a matter of time if
you see 40 people a day because you’re
gonna miss the x-ray that showed up lung
cancer. We have time to think. If the patient’s
not getting better, they have easy access back
into the practice.”

portion of African Americans than the
national average. And African Americans are uninsured at a relatively high
rate—20.2 percent in 2002 compared to
10.7 percent for white people.
Three Fifth District states, Maryland, North Carolina, and Virginia, saw
uninsured rates rise between 2001 and
2002, by 1.5 percent, 1.6 percent, and
0.9 percent respectively, according to
the Census Bureau.
And people make less money in
three Fifth District states and Washington D.C. than the U.S. median of
$42,409. The three-year average
median household income in the Carolinas is about $38,400; in West Virginia, about $30,000; and in D.C.,
about $41,313, according to the Census
Bureau. Also, more people were out of
work in 2003 in three Fifth District
states than in the nation as a whole.
Nationally, the jobless rate was 6

It may seem like an ideal way to practice
medicine, but it sounds like a recipe for
adverse selection, and eventually, losing
money as the sickest people dominate the
practice. But Grulke says he’s happier and
making more money than before, and when a
doctor knows intricate details of a patient’s
condition, it saves money for everyone in the
long run. Those patients don’t show up in the
emergency room or take inappropriate
medication and develop even more problems.
Half of Grulke’s patients are over 65 and some
of the ones who are under 65 have health
issues. But he also has healthy patients and
nearly all his patients want to learn about any
medical condition they might have, he says.
“They want to find out what to do about it.”
But what about the people who can’t
afford this boutique care? Grulke replies that
even the state would save money if it paid
him his monthly fee to care for Medicaid
patients because they wouldn’t wind up in the
emergency room.
So far, though, the fee-for-service medical
practice is rare. A spokesman for the
American Medical Association, Toni Xenos, says
the AMA has no estimates of how many
doctors do business this way.
—B E T T Y J OYC E N A S H

percent in 2003, while in North Carolina the rate of unemployment was 6.3
percent; South Carolina, 6.4 percent;
and Washington, D.C., 6.6 percent.
These factors translate into fewer
people insured by employer-sponsored
plans. And even those insured may pay
more for health care in some Fifth District states. Employers in the Greenville, S.C., area, for example, back away
from subsidizing rich benefit packages,
according to Hurley. He studies healthcare markets for the Center for Health
System Change, a project of the nonprofit Robert Wood Johnson Foundation. One of the project’s study areas
is the Greenville metropolitan area.
Half of privately insured people in
families in the Greenville area faced outof-pocket costs of $500 or more in 2001,
compared to 36 percent of similarly
insured people in metropolitan areas of
200,000 or more.

Spring 2004 • Region Focus

13

“It reflects the benefit designs,
[they’re] more meager for people
there,” Hurley notes. “We attribute
that to low levels of unionization.” He
adds that the burden on workers has
been even greater in the soft economy,
with some employers dropping coverage altogether.
Going without health insurance can
be expensive, as uninsured people tend
to forgo preventive health care. Taxpayers foot the bill, of course, for
charity care and for lost economic
potential. Even relatively healthy young
adults from 19 to 29, who represented
30 percent of the uninsured in 2002,
use acute care services and are at higher
risk of pregnancy, injuries, and some
chronic diseases such as HIV.
And people without insurance are
more likely to die prematurely, among
other factors. A 2003 Institute of Medicine study found that uninsured
people received health-care services

valued at about $99 billion in 2001,
taking into account money paid from
their own pockets, insurance paid, and
any workers’ compensation payments
or charity care received. Charity care
totaled $35 billion in 2001, mostly
funded by taxpayers. The study further
estimates the potential economic value
at between $65 and $130 billion annually, including higher expected lifetime
earnings, because of improved productivity and better educational outcomes.

Placing a Premium
on Health Care
Health-care spending has grown since
the 1960s as people have become more
insulated from costs. But over the same
period, the field of medicine has made
substantial advances in lengthening
peoples lives through managing chronic
illnesses like cancer and cardiovascular
disease. For example, many medical specialties such as oncology and critical care

medicine weren’t developed until the
1970s and 1980s. Today, life expectancy
is close to 80 years, compared to 45 in
1900, having declined pretty much
steadily since the mid-1950s.
“On average, given the extraordinary
costs of illness and premature death,
society is better off exchanging more
money for better health,” writes Sherry
Glied, an economist at Columbia University’s Mailman School of Public
Health, in the Journal of Economic Perspectives. She also points out that there
has been little variation in the annual
rate of growth in per capita real health
expenditures, increasing only slightly
faster in the five years following the
introduction of Medicare and Medicaid in 1965. Glied suggests that the
introduction of new and expensive technology most likely explains the growth
of health-care costs, largely because of
increased demand. “… although the
measured price of medical services has

Better Data, Better Care
While medical innovations help us live longer,
healthier lives, the health-care industry is
behind the curve in using information technology to improve efficiency and patient outcomes, analysts say.
Indianapolis-based insurer Anthem Blue
Cross and Blue Shield is working to change
that with the help of Dr. Richardson Grinnan,
a former physician. Grinnan uses “Informatics”
to study claims data. The idea is to better
understand variations in medical practices and
costs in hospitals and among physicians. An
insurance company has a bottom-line interest
in good care, Grinnan notes.
“Anytime you deliver quality care, it’s
going to be the most affordable care,” he
explains.
Change in hospital and physician cultures
comes slowly. Tradition is likely to hold sway.
Grinnan tells the story of a doctor in a hospital who had mentioned to an administrator
that good outpatient congestive heart failure
management would prevent many hospital
admissions. The administrator replied, “Why
would you do that?”
To encourage participation in the
informatics program, Anthem puts up money.
The company adjusts the future year’s
contract by 1 percent, which can amount to

14

Region Focus • Spring 2004

$500,000 to $1 million for a large hospital,
Grinnan says. “That money helps underwrite
infrastructure and activities to make sure that
the care process is being reinforced,” he says.
One of the motivations for Anthem’s
quality emphasis is the significant press
coming out of the Institute of Medicine and
other respected organizations saying there’s
too much variation in practice. “There are
slightly less than 50 percent of the people
receiving the best practices as promulgated
by the evidence,” Grinnan notes. Measuring
outcomes and processes is the way of the
future, he says.
“If we start managing resources correctly,
we will be able to improve health outcomes,
we’ll reduce medical errors, [have] fewer malpractice suits, and [insurance] rates will go
down,” he says.
In Anthem’s year-old program, hospitals
need to computerize orders, for example.
Most medication errors occur because of
problems in transcribing, Grinnan says. Orders
can be misinterpreted, just plain illegible or
even have a decimal point in the wrong
place. Order-entry programs have reduced
medication errors by half. Another step
toward reducing errors is by matching medication bar codes with codes on patient

identification bracelets.
Grinnan has been in medicine his entire
life; his father was a doctor. “[I was] always
impressed with how hard my dad worked,” he
remembers. He finished medical training in
1975, almost 10 years after government reimbursement, Medicare and Medicaid, came on
line. He witnessed waste and even back then
was intrigued about how to use resources in
a logical way.
“The spirit [then] was just to use
everything that’s available ...without a whole
lot of rigor placed on what we should be
focused on,” he says. “I just had a sense that
couldn’t last forever.”
Anthem’s program, called the Quality-InSights Hospital Incentive Program, is the first
of its kind in the nation. However, Grinnan has
been applying informatics to measure quality
of care since the mid-1990s. His medical management group analyzes practice patterns and
compares data to established best practices.
For example, the team studied variations in
hospital admissions for asthma patients.
Through education about asthma control and
proper use of peak flow meters, emergency
room visits and hospital admissions for
asthma patients fell by 30 percent.
— B E T T Y J OYC E N A S H

been rising, the quality adjusted cost of
medical treatment for many widespread
conditions … has declined,” she writes.
It’s worth noting that in 1962, 46
percent of health spending was paid by
people out of their own pockets. By
2002, people paid only 14 percent of
health spending out of pocket, according to the CMS. Between 1965, the year
Medicare and Medicaid legislation
passed to guarantee medical care for
elderly and poor people, and 1970, the
government’s share of total health
spending grew from nearly 12 percent
to 24 percent. During that same time,
out-of-pocket payments fell from 45
percent to 34 percent.
Today, health care swims in a fast
current of expensive prescription drugs,
an aging population and increased
utilization, a nursing shortage, cost shifting
from Medicaid, and the constant
development of expensive, gee-whiz
medical technology. No wonder we’re
drowning in costs. And, of course, medical
malpractice insurance and claims, rising
dramatically, don’t help. Doctors often
order unnecessary and expensive tests.
“To know that all your clinical decisions
can be Monday morning quarterbacked?
That’s not going to contribute to a very
efficient system,” notes Conover.
Blockbuster drugs also exacerbate
costs, but as some popular drugs, such
as Prilosec, go off patent, premium
costs will level off, says Gary Claxton,
a health analyst at the Kaiser Family
Foundation. Health-care spending
growth in 2003 is predicted at 7.8
percent, down from the previous year’s
9.3-percent level, according to CMS.
The spending cycle and premium increases depend also on the insurance business cycle, says Claxton of KFF. “In the
late ’90s, it was not very profitable,” he
notes. “In the last few years, they’ve been
raising premiums faster than the costs
are going up to help raise profitability.”
Health economist Morrisey says
premium prices also depend on the job
market. When jobs are plentiful and
employers are looking for workers, they
worry about the quality of the health
plan and make sure people have lots of
choice. Then premiums rise because
choice is expensive.
The rate of increase will moderate

Health Plan Enrollment For Covered Workers, by Plan Type, 1988-2003
Conventionala
1988
1993
1996
1998*
14%
1999*
10%
2000* 8%
2001* 7%
2002* 4%
2003* 5%

HMO

PPO

POSb
73%

16%
21%

46%
27%

31%

29%
24%
27%
24%

7%

28%

27%
28%

11%

26%

35%

14%
24%

39%
42%
46%

24%
21%
23%

52%
54%

18%
17%

*Distribution is statistically different from the previous year shown: 1996-1998, 1998-1999, 1999-2000, 2000-2001, 2001-2002, 2002-2003.
aConventional health insurance provides for hospital, surgical, medical, major medical, comprehensive, catastrophic, and dental plans.
Rates depend on which plan you buy into, the level of coverage you and your employer choose, and whether you purchase individual
or family protection.
bA point-of-service (POS) plan offers managed-care benefits within a network of medical providers but also allows you to receive care
outside of the network whenever you wish. When you receive out-of-network care, you pay more.
SOURCE: Kaiser/HRET Survey of Employer-Sponsored Health Benefits: 1999, 2000, 2001, 2002, 2003; KPMG Survey of Employer-Sponsored Health Benefits:
1988, 1993, 1996

in the next two years, he says, but as
jobs increase, premiums will start to
swing to the other end of the cycle.

Policy Options Proliferate
Still, the problem of access to affordable
health care vexes nearly all stakeholders
in the health business. Solutions saturate
the airwaves as politicians promote
variations on policies that include tax
credits, tax free savings, and universal
health coverage. While it’s unlikely that
the United States will sever its ties to
employer-sponsored health insurance
anytime soon, economic theory suggests
that moving away from third-party
payments could lead to a more efficient
health-care system.
A policy including tax credits to buy
higher-deductible insurance, more
money and better access for high-risk
pools, flexible regulations, and proper
incentives could guide people in a new
direction, Miller says.
For example, the Medicare bill
passed late last year contained a health
savings account provision. People
under 65 can contribute to an account
if they have a qualified health plan—
one with a high deductible—and the
investment is tax-free as long as it’s
used to pay for medical expenses.
This plan replaced the Medical Savings Account (MSA), a pilot program created in 1996 to promote the idea of taxfree savings for health care and expired
at the end of 2003. The U.S. General Ac-

counting Office found that four of every
10 people who established MSAs in 1997
had previously been uninsured. Premiums for the higher-deductible policies
are generally lower. The accounts are
owned by the employee and fully transferable. Savings accounts also increase
choices. Health-care shoppers could spend
money on alternative therapies that may
not be covered by traditional insurance.
The idea is to encourage consumers
to spend their own money on care. By
shopping around and researching
options, they make personal choices.
“The general indications are that
people will spend less and spend
better,” Miller notes.
RF
READINGS
Crocker, Keith J., and John R. Moran. “Contracting
with Limited Commitment: Evidence from
Employment-Based Health Insurance Contracts.”
RAND Journal of Economics, Winter 2003, vol. 34, no. 4,
pp. 694-718.
Cutler, David. Your Money or Your Life: Strong Medicine for
America’s Health Care System. New York: Oxford
University Press, 2004.
Friedman, Milton. “How to Cure Health Care.” The
Public Interest, Winter 2001, issue no. 142, pp. 3-30.
Glied, Sherry. “Health Care Costs: On the Rise Again.”
Journal of Economic Perspectives, Spring 2003, vol. 17,
no. 2, pp. 125-148.
U.S. General Accounting Office. “Medical Savings
Accounts: Results from Surveys of Insurers.”
December 1998.
Visit www.rich.frb.org/pubs/region focus for links to
relevant Web sites.

Spring 2004 • Region Focus

15

Putting onthe

BRAKES

Certificate of need regulations
try to steer health-care
supplies, but it’s hard to keep
them from fishtailing
very month, members of the
board of directors for the
Central Virginia Health Planning Agency Inc. gather in a blue-gray
meeting room. The conservative color
scheme is everywhere, even in the
speckled fabric of the chairs where the
board members sit. Only one thing
sticks out: the honey-colored wooden
podium where health-care providers
pitch their proposals for new facilities
and equipment.
In Virginia and throughout the rest
of the Fifth District, providers must
obtain a certificate of need (CON)
before making major capital investments. They have to demonstrate that
the expenditure is necessary to fulfill
the needs of the community, which are
determined by state health officials and
detailed in a formal plan.
At the January meeting of Central
Virginia’s health planning board, three
groups explained why the region needs
additional diagnostic imaging equipment.
Their proposals faced the scrutiny of the
board, which makes its recommendations to the state health commissioner.
After an hour of presentations, reports,
and intense questioning, two of the three
CON applicants were rebuffed. A fourth
applicant withdrew from consideration
before the meeting.
Many economists question the necessity of regulating the health-care supply

E

16

Region Focus • Spring 2004

BY CHARLES GERENA

so closely. Their view is that companies
introduce goods and services only when
they expect to be rewarded with higher
revenue and profits. Meanwhile, consumers usually benefit from the
increased competition in the form of
broader choices and better prices. In
short, markets tend to work pretty well
by themselves.
But state health planners and other
CON supporters counter that health care
isn’t a typical market. They believe that
government must intervene to minimize
unnecessary development and improve
the accessibility and quality of care.
“We are coping with an imperfect
system,” notes Pamela Barclay, deputy
director of health resources for the
Maryland Health Care Commission,
which reviews CON applications.
Instead of consumers buying health care
directly, government- and employer-provided insurance pays for it. But some
medical services are reimbursed at
higher rates than others and not everyone has the same level of coverage,
creating distortions in the market.
The CON process is also imperfect,
but states have used it to address problems in an industry that affects everyone’s well being.

CON to the Rescue
Health-care planning dates back to the
1940s. During the Great Depression

and World War II, few hospitals were
being built or updated, and the supply
of medical facilities was inadequately
distributed among and within states.
Communities responded to this crisis
by financing and planning hospital
development themselves, sometimes
with the help of government agencies.
In 1946, their efforts were aided by
federal subsidies.
States began regulating the supply
of health care through certificate of
need reviews in the 1960s and ’70s,
partly in response to lobbying from hospital operators who favored centralized
health planning. By 1974, Congress
required states to have a CON program
in order to receive federal dollars for
psychiatric, substance abuse, and other
health services. It also approved direct
funding of CON programs.
“States weren’t seen as micromanaging health-care markets. It was routine
for communities to be involved in planning,” says John Steen, a New Jerseybased medical consultant who serves on
the board of directors for the American
Health Planning Association (AHPA).
Also, “states and federal officials
were really concerned about rising
costs,” notes Frank Sloan, director of
Duke University’s Center for Health
Policy, Law, and Management. “CON
was the first major cost containment
program implemented.”

while West Virginia, Maryland, and the
Carolinas have reviewed or revised
their regulations over the last five years
instead of eliminating them.
Why does more than two-thirds of
the nation still conduct CON reviews?
Part of the reason is political pressure,
particularly from health-care providers
with an established market presence.
State lawmakers also believe that
CON reviews give communities a voice
in health-care development. Public
hearings are usually held before a CON
application is considered and whenever
a state’s health plan is being updated.
“It’s a process in which providers and
consumers of services can get together,
examine problems, and exercise their
best judgement,” says Dean Montgomery, current AHPA president and
executive director of the Health
Systems Agency of Northern Virginia.
States have another motive for
trying to maneuver health-care supplies: They have a big stake in containing medical costs. In communities
with a low concentration of businesses,
a big chunk of medical services are
reimbursed through Medicaid and
insurance provided to state employees.
And there is reason to be worried
about health-care providers gaining
more pricing power and increasing
their capital investments. Despite the
changes in medical reimbursement,
insurers have less power to negotiate
lower rates with providers. “In the late
’80s and early ’90s, they were able to
[reduce costs] the easy way because
there was fat in the system,” says
medical consultant John Steen. But
managed care has reached its limits in
cost reduction and people have been
demanding more services.

ices, many other factors affect healthcare costs (e.g., labor, physicians services) that CON laws have not attempted
to control,” noted a January 1999 study
by the University of Washington. Furthermore, a 1998 study by Duke University’s Frank Sloan and Christopher
Conover didn’t find a marked increase
in health-care expenditures in states that
dropped CON reviews.
Meanwhile, CON regulations may
sometimes constrain supplies too well,
making it difficult for health-care
providers to respond to market
changes. Let’s say an imaging center
wants to buy another MRI machine
because its existing equipment is operating 18 hours a day and on weekends
to keep up with demand. The center
may fail to get a CON because there is
underutilized capacity elsewhere, even
though that capacity may be in a lesspopulated area, inconvenient to
patients, or outdated.
Additionally, hospitals can be prevented from moving capacity to highgrowth areas or redesigning it for
services that are in greater demand.
Charlotte Lynch, manager of business
planning at Gaston Memorial Hospital
near Charlotte, N.C., recalls how she
struggled to obtain a CON to redistribute its unused bed capacity to the
hospital’s Women Center. Initially, the
state wanted to de-license 40-plus
acute care beds in the hospital’s inventory before it would approve the CON.
Rather than relinquish capacity that
was needed to accommodate future
growth, the hospital eventually gave up
some of its psychiatric beds.
Hospitals often must obtain a certificate of
need to purchase new equipment, such as
MRI machines.

The Verdict
Has this faith in the certificate of need
process been justified? It depends on
what criteria you use.
Constraining the health-care supply
via CON review may have tempered
growth in hospital beds and nursing
home development. But it hasn’t been
conclusively shown to slow growth in
overall per-capita medical spending.
“While CON laws can be effective
in slowing the expansion of some serv-

CORBIS

The idea was that by controlling the
expansion of health-care supplies, fewer
development costs would be placed on
the shoulders of consumers. At the time,
cost-based reimbursement systems—
especially the massive Medicaid and
Medicare programs created in the
1960s—enabled health-care providers to
pass along most of the expense of new
equipment and services to third parties.
Since capital improvements could translate into increased revenue with little
downside risk, providers were perceived
as having an incentive to over-invest.
Lastly, state and federal lawmakers
were concerned about health care
quality and access. By using CON
reviews to steer new development, they
aimed to prevent providers from
expanding only in affluent areas that
were already well served. According to
Lee Hoffman, chief of the CON
program at the North Carolina Division of Facility Services, if there is no
designated need for additional services
in a metropolitan area, “providers
prefer to take their chances in a rural
area [rather than have] nothing at all.
It gets their foot in the door.”
CON programs proliferated until
the early 1980s when the federal government changed how it paid healthcare providers. Under a new per-case
prospective payment system, providers
received a predetermined amount of
money for each patient treated, regardless of the cost of the services required.
The amount paid depended primarily
on the diagnosis-related group into
which the patient was classified.
Private health insurers adopted this
payment system as well, which removed
the incentive to over-invest that many
policymakers had been concerned with.
Meanwhile, market-based approaches
such as managed care emerged as alternatives for containing medical costs,
which were still rising despite the widespread usage of CON reviews.
In 1986, the federal government
stopped funding CON programs and
14 states eventually abandoned their
programs. Today, 36 states and the District of Columbia regulate health-care
supplies to varying degrees. Virginia
lawmakers backed off from eliminating
the state’s CON regulations in 2001,

Spring 2004 • Region Focus

17

Path of Least Resistance
Specialty hospitals tend to stay away from states where medical facilities have to obtain a certificate
of need to add capacity, as shown below. Is that good or bad? Specialty hospitals outperform
general hospitals in terms of costs, but they are less likely to have an emergency room and they
treat a smaller percentage of Medicaid patients.

Distribution of U.S. Population

Non-CON
States
49%

CON
States
51%

Distribution of Specialty Hospitals

Non-CON
States
83%

CON
States
17%

Distribution of General Hospitals

Non-CON
States
55%

CON
States
45%

NOTE: Twenty-six states and the District of Columbia were counted as “CON States” because they require a certificate of need
to develop acute care beds. The total number of states with a certificate of need process of any type is much higher (36).
SOURCE: Specialty Hospitals: Geographic Location, Services Provided, and Financial Performance, General Accounting Office, October 2003

“As soon as you want to expand… and
you’re not at the target occupancy, their
thinking is ‘Let’s take some of this
excess capacity away from them because
they don’t need it,’” complains Lynch.
Health-care providers can make
adjustments to the CON process or the
state health plan via the public review
process. But some states take at least
a year to update their plan, while other
states have much longer planning horizons. And there’s no guarantee that
providers will get the changes they
want. Lynch says it took years before
North Carolina recognized a need for
acute care beds.
State officials would be hard-pressed
to admit these shortcomings in CON
programs. Instead, they have moved
cost containment down their list of
policy goals and emphasized CON’s
role in meeting an equally important
goal: to intervene in health-care
markets when accessibility and quality
take a backseat to profits.
How much state governments intervene in markets depends on how many
medical services they regulate and how
large a capital investment must be
before it is subject to CON review.
Maryland and West Virginia regulate a
wide range of medical services under
CON and have relatively low capital
cost thresholds, plus they review hospital rates. The Carolinas, Virginia, and
the District of Columbia have com18

Region Focus • Spring 2004

prehensive programs as well, while the
latter two still have regional health
planning agencies that evaluate CON
applications.
An agency under the state’s department of health typically evaluates applications to determine how proposed
projects meet the state’s health plan.
The plan identifies the quantity and
type of services needed in certain
regions based on population growth,
utilization rates, and other data. Then
anyone can apply for a CON to meet
these needs.
Other criteria are also used to determine if a proposed project is in the
public interest. They include the
project’s economic impact on existing
facilities, the applicant’s history of providing charity care, and the geographic
accessibility of the project.
With the latter, one would think
that the development of health-care
infrastructure should follow population
growth. “In some respects that’s true,”
says Ken Cook, president of Roanoke,
Va.-based Vantage Healthcare Consulting Group Inc. and former executive director of southwest Virginia’s
health planning agency. “But we also
want to force [development] to move
out into surrounding areas.” For
example, Lynchburg has more nursing
home beds per thousand seniors compared to the four rural counties surrounding the city.

Have these market interventions
worked? A recent General Accounting
Office report found that states with
CON programs appear to have better
access to health care because they have
fewer specialty hospitals than states
without CON. Such facilities are less
likely to have an emergency room and
to accept Medicaid patients. On the
other hand, states without CON have
slightly more general hospitals than
non-CON states, and these facilities
have to serve everyone. (See pie charts.)
On the whole, “it is very difficult to
steer” the development of medical
services, notes Frank Sloan. There have
been some attempts to prevent hospitals from moving from the inner city
to the suburbs, but they have failed to
prevent health care providers from
chasing population growth.

It’s Good at Playing Monopoly
Most health-care economists, consultants, and regulators would agree that
certificate of need regulations have
been good at one thing—producing
markets with varying levels of protection. Such markets affect access and
quality of medical care, both positively
and negatively.
“Health care is a service where a significant portion of the population
cannot afford to pay for it because they
are underinsured or uninsured,” explains Lynn Bailey, a consulting economist in Columbia, S.C. By awarding a
limited number of CONs for particular services in a geographic area, states
essentially create franchised territories
for general hospitals in exchange for
them serving the entire population. “It
is a social contract.”
In general, protected markets have
a high cost of entry. The CON application process can take several years,
especially if there are appeals, and
require tens of thousands of dollars
to pay for consultants, lawyers, and
processing fees. But once a healthcare provider gets its “franchise” for
offering a certain service, it’s in a
better position to charge higher
prices and generate a reliable revenue
stream because others can’t readily
follow. “If you have a monopoly in a
town, an insurer has to negotiate with

that monopolist. It’s not going to get
the same price as an insurer who has
the ability to take its business elsewhere,” explains Sloan. This probably
doesn’t help contain costs, but it does
make it easier for providers to acquire
credit and invest in new technology
and staff training.
Another benefit of market protection is that it supposedly prevents a
specialty facility from entering a community and cherry picking profitable
outpatient services like ambulatory
surgery and cardiac catheterization.
While cherry picking is a savvy business move, it could hurt long-established general hospitals that use
moneymaking outpatient services to
pay for money-losing inpatient services
like the emergency room. Hospitals
must compete to hold on to their best
customers while caring for the indigent
and uninsured whom they are legally
required to serve regardless of their
ability to pay.
On the other hand, companies
usually have less incentive to be innovative and efficient if they don’t have
to face the constant challenges of competition. So health planners perform a
delicate balancing act. “If you design
your CON program right so that you
allow enough competitors to get in, you
won’t make an inefficient system. ...
Providers will have to compete on
quality,” says Cook.
Finally, limiting the growth of new
medical capacity may help build up the
volume of procedures at existing facilities. This would enable providers to
spread out the cost of equipment over
more patients. It also would enable
medical professionals to gain experience that helps them improve patient
outcomes, which is why malpractice
insurers often refuse to provide coverage unless providers reach a certain
threshold of patient utilization.
However, CON programs have had
a mixed record when it comes to
increasing patient volume at facilities
and their impact on outcomes hasn’t
been proven. Furthermore, such benefits of limiting medical capacity would
have to be balanced against making
services available to the greatest
number of people, notes Sloan.

Watch Where You Swing
That Thing!
In the final analysis, the certificate of
need has been a blunt instrument of
public policy. So why not let health-care
markets figure out the best combination of supply and demand? Then state
governments could deal with quality
and access problems by establishing
standards for care and expanding public
medical facilities.
CON advocates argue that healthcare markets can’t fix themselves
because they are dysfunctional. For one
thing, patients usually depend on
health-care providers to tell them what
services they need, so providers are in
the position of redirecting patient care
to utilize any new capacity. “It’s not like
buying a car where you can determine
the best quality you can get for the
lowest price. We really depend on
doctors to advise us what facility to go
to and what services we need,” says Joel
Grice, director of the South Carolina
Bureau of Health Facilities and Services
Development, which manages the Palmetto State’s CON program.
Health-care markets malfunction
for a less sinister reason as well: They
have little price competition, which
tends to encourage overproduction.
Normally, suppliers produce more as
prices increase until their services
become too expensive for buyers. But
prices for certain medical services can
continue to rise without patients
demanding less.
Why? The demand for many
medical services is very price inelastic.
Patients care more about getting the
best care available than about how
much they’ll pay, especially in an emergency situation or when treatment
options are limited. Also, patients don’t
know the actual costs of their care.
Market information is not readily available, plus insurers act as a third party
that separates patients from providers
in transactions.
Even if these market malfunctions
could be fixed, broad regulation of
health-care markets is more politically
desirable than deregulation. If a nursing
home closed down as a result of market
competition, the cost of relocating
former residents would make the front

page of local newspapers. In contrast,
the shortcomings of CON programs
impact everyone, so it’s not as obvious
to individuals.
Still, government regulation is considered a necessary evil to protect
patients from the ups and downs of
unfettered market competition. In fact,
some lawmakers and health care
experts believe that health care shouldn’t be a profit-making business.
Notes economist Lynn Bailey, “We
haven’t resolved the issue of whether
health care is a private good regulated
by market forces—those who pay for
it get it and those who can’t pay for it
don’t—or a public good that benefits
the entire community.” European countries have long considered health care
a public good, but following the same
path in the United States—via universal health insurance or a government-run
hospital system—wouldn’t be cheap.
Until our society decides how
health-care markets should function,
CON programs will continue trying to
steer supplies in the Fifth District and
throughout the nation.
RF

READINGS
Conover, Christopher J. and Frank A. Sloan.
“Does Removing Certificate-Of-Need
Regulations Lead To A Surge in Health Care
Spending?” Journal of Health Politics, Policy, and
Law, June 1998, vol. 23, no. 3, pp. 455-481.
Effects of Certificate of Need and its Possible
Repeal. University of Washington School of
Public Health and Community Medicine,
January 8, 1999.
McGinley, Patrick. “Beyond Health Care
Reform: Reconsidering Certificate of Need
Laws in a Managed Competition System.”
Florida State University Law Review, Summer
1995, vol. 23, no. 1, pp. 141-188.
Report of the Special Joint Subcommittee Studying
Certificate of Public Need to the Governor and the
General Assembly of Virginia. Senate Document
No. 6, 2001.
Schneiter, Ellen Jane, Trish Riley and Jill
Rosenthal. Rising Health Care Costs: State
Health Cost Containment Approaches. Portland,
Maine: National Academy for State Health
Policy, June 2002.
Visit www.rich.frb.org/pubs/regionfocus
for links to relevant Web sites.

Spring 2004 • Region Focus

19

The Baiting Game
Using economic incentives to attract new businesses
isn’t as simple as it may seem

BY KARL RHODES

C

CORBIS

ritics of economic development incentives ranted and
raved in 1992 when South Carolina put together a $130 million
package to persuade BMW to build a
plant in Spartanburg County.
In the decade that followed, BMW
silenced those critics by building a
world-class facility and expanding it
several times. The company’s initial
employment estimate was 1,900. But
by 2001, the plant was providing jobs
to more than 4,300 people and an
annual economic impact estimated at
$4.1 billion, according to a study by the
Moore School of Business at the University of South Carolina.
The BMW incentives “turned out
to be chicken feed given the economic
impact of the plant,” says Ray Owens,
a vice president and senior economist
at the Federal Reserve Bank of Richmond. Unfortunately, “for every BMW,
there are plenty of broken promises.”
Even when economic development
incentives are highly profitable for one
state, offering them is bad public policy
for the country as a whole, says Art
Rolnick, director of research for the
Federal Reserve Bank of Minneapolis.
“You are misallocating resources. You are
interfering with interstate commerce. It
is economically inefficient,” he says. “And
sometimes you induce a company to take
a second-best location.”
Rolnick views incentives as a “negative-sum” baiting game that should be
outlawed by Congress because it pits
states against each other at the expense
of the national economy. For every
winner there is a loser, he contends, and
corporate subsidies reduce state governments’ ability to fund public goods,
such as education and transportation.
But without those extra incentives,
firms with “market power” tend to raise
prices to pay for the inefficiencies of
their existing locations, say some
observers. Rolnick responds that
antitrust laws—not incentives—should
be used to prevent the inefficiencies of
“market power,” which he equates to
“monopolistic situations.” States should
not subsidize monopolies, but they
often do, he says. “The monopolies are
the ones who are the most successful
in using these subsidies.”

Big-league sports franchises are a
prime example, Rolnick says. “These
guys have a monopoly in a unique way
because they are a very special form of
entertainment, and they have played
the bidding wars to the hilt. Billions of
public dollars have gone to these
private companies because … they can
provide a very credible threat that ‘if
we go, you don’t get anybody.’ ”
Some economic development officials agree with Rolnick’s suggestion
that Congress should outlaw incentives.
“I would testify for that bill the minute
they write it,” says Aris Melissaratos,
Maryland’s secretary of Business and
Economic Development. “I really don’t
like this continuing bidding war,” he
explains. “Even though … in most cases
it’s a rational quantitative analysis of
payback, some jurisdictions at times
act irrationally and create a bidding war
that just gets out of hand.”

Which Bait Works Best?
In North Carolina, the debate over tax
credits for job creation intensified
when Michael Luger, a University of
North Carolina economist, published
a study questioning the effectiveness
of an economic incentive program
called the Lee Act. Luger estimated
that “only around 4 percent of the jobs
claimed to be created with Lee Act
incentives actually were induced.”
North Carolina granted $208 million
of tax credits under the program in the
years 1996 through 2001. Since then,
North Carolina has scaled back some
aspects of the Lee Act to free up funds
to use in more targeted incentive
programs, says Don Hobart, general
counsel for the state’s Department of
Commerce. Hobart says tax credits
under the Lee Act have been more
effective than Luger’s 4 percent figure
would indicate, but he concedes that “tax

Swapping Fish Stories
Virginia hooked a semiconductor manufacturer
in February 2002. Cerxon Microtechnologies LLC
was just a startup operation, but it seemed like a
pretty big fish in the small pond of Henry
County, where plant closings had pushed the
unemployment rate up to 13 percent.
Cerxon garnered several hundred thousand
dollars in state and local incentives because it
promised to invest $6.6 million and employ 250
people. Gov. Mark Warner hailed the Cerxon
deal as “a tremendous win for Henry County
and all of Southside Virginia.”
The company relocated to the county from
Camden, S.C., a city that apparently made no
attempt to retain Cerxon. In sharp contrast,
Virginia gave the company a $200,000 grant
from its Governor’s Opportunity Fund, a
$100,000 grant from its Tobacco Commission,
plus nearly $1 million in loans and other
incentives from Henry County.
“Oh my God!” exclaimed Daniel Young,
director of grants and incentives for the South
Carolina Department of Commerce, when he
learned about the incentives Virginia paid to
attract the company. “Camden was not real
upset when that project left,” he said. “To my
knowledge, we did not counteroffer because I
don’t think [Cerxon] was really big enough. ... I
believe it was a one- or two-person operation.”

In Virginia, Cerxon employed a few people,
but it never came close to generating 250 jobs
or investing $6.6 million. It went out of business
in December 2003.
While Virginia was luring Cerxon away from
South Carolina, the Palmetto State was wooing
CropTech away from the Old Dominion. CropTech
was a highly touted biotech company that
planned to use genetically altered tobacco to
manufacture pharmaceuticals. It grew up in
Virginia Tech’s Corporate Research Center, but it
shopped around for a new location as it geared
up for mass production.
Virginia made an effort to retain the company,
but its incentives paled in comparison to the
multimillion-dollar package that South Carolina
put together to attract CropTech to Berkeley
County. At a press conference in May 2002, the
chairman of the Charleston Regional Development
Alliance raved about CropTech’s potential. “The
company’s unique processes and creative
approaches will provide top-quality jobs for area
residents,” he said, “and its research will help
improve the lives of people around the world.”
Things didn’t pan out that way. Nearly one
year later— on April Fools’ Day— the headline in
The Post and Courier told Chapter 11 of the
CropTech story. “Berkeley may lose CropTech,” it
— KR
said. “Virginia firm files for bankruptcy.”

Spring 2004 • Region Focus

21

Virginia officials put together a huge incentive package in the mid-1990s, when Motorola executives
were looking to build a $3 billion semiconductor
plant west of Richmond. In addition to offering $60
million for achieving production milestones, Virginia
officials accelerated plans to extend Route 288
through rural Goochland and Powhatan counties.
They also expedited $12 million to jumpstart a new
School of Engineering at Virginia Commonwealth
University. Until Motorola came around, neither of
those projects were high priorities for state funding.
Microelectronic engineering became a major
focus of the new school, and Motorola engineers
helped design the school’s electrical engineering
curriculum. Also, two community colleges in the
Richmond area established specialized microelectronics technology programs to prepare
thousands of employees to work at Motorola.
The plant was delayed, but another semiconductor manufacturer, Infineon Technologies, built a
plant on the east side of the city.
VCU graduated its first class of engineering
students in 2000. By then, the $323 million
extension of Route 288 was under construction,
but the Motorola site was sitting idle, and the
community colleges were scaling back their
microelectronics programs.
In 2002, Motorola abandoned plans to build
its proposed plant.
Virginia never paid any production-milestone
incentives to Motorola, but the phantom plant
did have a big impact on the Richmond
economy. Some residents complain that the
project caused a misallocation of transportation

INFINEON TECHNOLOGIES RICHMOND

The Big One That Got Away

Virginia’s big semiconductor catch turned out
to be Infineon Technologies. The company built
this clean room and fabrication plant east of
Richmond.

and education resources, while others say things
worked out for the best.
“I’ve always viewed Route 288 as a big
benefit of Motorola,” says Ray Owens, a senior
economist at the Federal Reserve Bank of
Richmond. “It was the missing link of Richmond’s
circumferential beltway.”
Also, VCU’s School of Engineering helped
attract Infineon, which currently employs about
1,750 people, says Mark Kilduff, executive
director of the Virginia Economic Development
Partnership. The engineering school, he notes,
“still is a great benefit to Infineon,” and it has
helped attract other high-tech companies to the
— KR
Richmond region.

incentives represent a blunt instrument
for economic development from a state’s
perspective, whereas other programs are
a lot more surgical.”
The Tar Heel State has beefed up
its One North Carolina Fund, which
makes performance-based cash grants
for industrial recruitment. The fund
used to receive just $1 million or $2
million per year, but in 2001, the
General Assembly made a one-time
contribution of $15 million. And now
the Department of Commerce is
seeking another $20 million for the
fund from the 2004 General Assembly.
Last year, North Carolina also
established its Site Infrastructure
Development Fund, which makes cash
22

Region Focus • Spring 2004

grants for site improvements to companies that are relocating to or
expanding within the state. The fund
has received a one-time appropriation
of $24 million.
“Companies want money upfront
now,” says Daniel Young, director of
grants and incentives for South Carolina’s Department of Commerce.
“They’re all doing their 15-year models,
and the more you put in upfront, the
greater the impact. If you start spreading it out on taxes and soft money, and
spreading that over years, you don’t get
the bang for the buck.”
Most of South Carolina’s hard-dollar
incentives are grants to localities for
infrastructure improvements. Young

refers to this deal-closing fund as the
“checking account.” Annual appropriations to that account have been about
$18 million for the “past six or eight
years at least,” he says.
Virginia is trying to increase its
Governor’s Opportunity Fund from
$17.5 million in the current two-year
budget to $23 million for the coming
two years, says Mark Kilduff, executive
director of Virginia’s Economic Development Partnership. That pot of
money attracts lots of attention, he
says, but the vast majority of the state’s
economic development deals do not
qualify for those funds.
A more common form of upfront
assistance in Virginia is work-force
training. “That program is meaningful
to 99 percent of the companies we
work with,” Kilduff says, because it
helps defray the costs of pre-employment training.
Maryland’s secretary of Business and
Economic Development also puts
work-force training at the top of his
list. “That is an incentive that I am very
much in favor of because it enhances
productivity of the worker and the
enterprise,” Melissaratos says. “It
makes that enterprise more competitive, and the skill set is retained for the
worker in case something at that
company doesn’t pan out.”
Whether a state offers work-force
training or tax credits or performance
grants, it’s important to keep incentives
simple, says David Satterfield, executive director of West Virginia’s Economic Development Office. In recent
years, West Virginia has boiled its
incentive programs down from 21 to
four, and Satterfield is determined to
make them “predictable, meaningful
and based on common sense.”
Prospects should not need an army of
tax lawyers to determine an incentive’s
true value, he says. “If they don’t understand it, they won’t appreciate it.”
During most of the 1990s, Washington, D.C., refused to play the baiting
game, and schools of companies swam
across the Potomac River to Northern
Virginia. “Five or six years ago, the city
was really an economic desert,” says
Chris Bender, a spokesman for the
Office of the Deputy Mayor for Plan-

ning and Economic Development.
“The businesses that were here were
categorically fleeing for more fertile
ground. There just was no support.”
The District became more business
friendly in the late 1990s, Bender says,
following the election of Mayor
Anthony Williams and the designation
of enterprise zones covering two-thirds
of the city. Since then, the District has
experienced an “economic renaissance,”
Bender says. “We were rated No. 1 in
foreign real estate investment in the
world in 2002. Our office vacancy rates
are the lowest in the country despite
the highest rents.”
Many law firms, associations, and
multinational corporations want a presence in Washington, D.C., but the city
still struggles to attract and retain an
adequate retail tax base. Bender says a
new shopping center in the low-income
Brentwood area is one of the District’s
top incentive success stories. With significant assistance from the city, Rhode
Island Place has attracted the District’s
first Home Depot and a Giant Food,
the only grocery store in the Brentwood area.
Washington, D.C., is saddled with a
high percentage of federal property
that doesn’t generate any tax revenue,
Bender explains. So city officials have
to find creative ways to capitalize on
the remaining real estate. “We do that
by getting businesses here, and that
takes incentives,” he says. “We do need
incentives. There’s no question about
that.” (For more on Washington, D.C.’s
commercial real estate market, see the
cover story from the Fall 2003 issue of
Region Focus titled “Building in Uncle
Sam’s Backyard.”)
West Virginia’s economic development officials take a similar view. The
Mountain State has upped its ante on
incentives since Gov. Bob Wise took
office in 2001. Most notably, West Virginia has raised $225 million for a new
economic development grant program.
“I look at [incentives] like my retirement plan,” Satterfield says. “I’m
putting money away and investing it
hoping that there’s going to be a gain.”
People investing in West Virginia are
hoping to increase the value of their
companies in much the same way.

“They expect the state to bring something to the dance.”

No Fishing Allowed?
Rolnick, the economist at the Federal
Reserve Bank of Minneapolis, admits
that government officials have little
choice but to offer incentives. “Here in
the Twin Cities … if somebody comes
after 3M or General Mills or the Minnesota Twins … you, as a mayor or a
governor, have to respond.” But Congress should end this baiting game by
taxing the value that private companies
receive from any preferential treatment, he says. “The federal government
would tax that income at a confiscatory rate.”
In 1999, Minnesota Congressman
David Minge introduced the Distorting Subsidies Limitation Act, which
would have placed a steep federal excise
tax on incentives—not the 100 percent
tax that Rolnick advocated, but a substantial tax nonetheless. The legislation
never received a full hearing, Rolnick
says. “The economics of it are pretty
clear,” he says. But “there are huge conflicts of interest here. In the current
system, politicians are allowed to give
away goodies, and if you end the bidding
wars, they can’t give away goodies.”
At the Federal Reserve Bank of
Richmond, Owens is not quite that
cynical. “If the world were a perfectly
competitive place, incentive programs
would be silly,” he agrees. “But these
programs are designed by people existing in the real world—not the perfect
world of principles [of economics]
textbooks.”
It would be impossible to equalize
what every state has to offer, adds
Kilduff at the Virginia Economic
Development Partnership. “Would
every state and every locality have to
have the same tax rates?” he asks.
“Would every community have to have
an interstate? Would every community
have to have a university?”
To evaluate a particular proposal to
eliminate incentives, you would have
to look at how incentives are defined,
says Hobart at the North Carolina
Department of Commerce. “Is it truly
preferential treatment? Or is just smart
public policy?”

Hobart suggests that most wealthy
states would gladly quit the baiting
game while they are ahead. “Any state
that already has a great quality of life
and a solid, well-developed infrastructure for transportation and education
would have no problem eliminating
pure economic development incentive
dollars from all states,” he predicts.
Not necessarily, says Kilduff. He
asks: How would the United States
stop foreign governments from baiting
their hooks with incentives?
Rolnick says international trade
agreements should include subsidy
restrictions. “It is the federal government’s responsibility to negotiate good
trade agreements,” he says. “Just as we
don’t want trade barriers, we don’t want
subsidy wars.” And besides, “most of
the subsidy wars are internal,” he contends. “Minneapolis and St. Paul go
after each other’s companies, and from
the state’s point of view, that’s crazy.”
That logic also applies to neighboring states, says Maryland’s Melissaratos.
“This is a pretty small planet, and I
hate to see us fighting for jobs with Virginia. We need to face the global competition together.”
RF

READINGS
Burstein, Melvin L. and Arthur J. Rolnick.
“Congress Should End the Economic War Among
the States.” Federal Reserve Bank of Minneapolis
Annual Report, 1994.
Holmes, Thomas J. “Analyzing a Proposal to Ban
State Tax Breaks to Businesses.” Federal Reserve
Bank of Minneapolis Quarterly Review, Spring 1995,
vol. 19, no. 2, pp. 29-39.
Holmes, Thomas J. “The Effect of State Policies
on the Location of Manufacturing: Evidence
from State Borders.” Journal of Political Economy.
1998, Issue 106, pp. 667-705.
Luger, Michael I. and Suho Bae. “The Economic
Effects of Business Tax Incentives: The Case of
North Carolina.” Working Paper, Office of
Economic Development, University of North
Carolina – Chapel Hill, March 2003.
Owens, Raymond E. and Pierre-Daniel Sarte.
“Analyzing Firm Location Decisions: Is Public
Intervention Justified?” Journal of Public
Economics, 2002, Issue 86, pp. 223-242.
Visit www.rich.frb.org/pubs/regionfocus for
links to relevant sites.

Spring 2004 • Region Focus

23

24

No,
Thank
You
Region Focus • Spring 2004

How economics may
help slow the onslaught
of spam e-mail
BY AARON STEELMAN

I

f you have an e-mail account,
chances are your inbox has been
inundated with unsolicited messages — otherwise known as “spam.”
According to Brightmail Inc., which
develops spam-filtering software, roughly
60 percent of all Internet e-mail is spam.
Spammers advertise many different types
of products, but among the most
common are financial services, adult
entertainment, and medical treatments.

Most people quickly identify such
messages as spam and delete them,
much as they throw away junk mail they
receive through the postal service. So
why do spammers keep at it, if such a
small percentage of their messages actually make it through to their recipients?
Because spam is cheap. It costs very
little to send an unwanted solicitation,
and the marginal expense of adding
extra recipients — perhaps thousands
of them, in some cases — is negligible.
Spam may still “pay,” then, even if only
a tiny fraction of people respond.
Given the economics of the spam
business, what can be done to stop —
or at least slow — its growth? Consider
four proposals that have been discussed:
one that relies on legislation, one that
depends on technological innovation,
and two that use economics to stop
spammers at their own game.

“CAN-SPAM” Law
In the late 1980s, the fax machine was
the hot new technology. It helped
people send documents much more
quickly and cheaply than ever before.
It also led to a phenomenon similar to
spam: “blast faxing.” Direct-mail companies compiled huge databases of fax
numbers and sent out unsolicited advertisements that clogged fax trays like
spam clogs inboxes today. By 1991 there
was enough opposition to blast faxing
that Congress passed a law designed to
virtually ban the practice. Some blast
faxes still get through, of course, but the
number has dwindled. Given the perceived success of this measure, many
have urged Congress to take a more
active role in stopping spam.
On Jan. 1, 2004, the “CAN-SPAM”
law took effect. The law has three
major provisions: unsolicited e-mail
has to be marked as such, spammers
have to include a valid return address,
and recipients must be allowed to opt
out of receiving similar messages in
the future. In March, four of the
country’s biggest e-mail and Internet
service providers — America Online,
EarthLink Inc., Microsoft Corp., and
Yahoo Inc. — filed lawsuits against
spammers in federal courts in California, Georgia, Virginia, and Washington state.

Anti-spam activists were heartened
to see the government take action to
help stop the onslaught of spam, but
many wanted a tougher law. For
instance, some argued that consumers
should be able to sign up for a “Do Not
E-mail” list, similar to the national “Do
Not Call” list recently aimed at telemarketers. Others were skeptical that
any sort of legislation would put a
serious dent in spam volume because the
federal government can police only
those spammers operating in the United
States. If U.S. laws start to put a pinch
on their business, they would have little
problem moving overseas.

Better Filters
If some of the world’s best information
technology minds can design e-mail pro-

grams that even technophobes feel comfortable using, shouldn’t they be able
to design ways to stop spam from
getting through? That has long been the
hope of people who are opposed to both
spam and government efforts to curtail
its growth.
To some extent, e-mail filters have
improved. For instance, many users of
Hotmail, the free Internet e-mail service
offered by Microsoft Corp., have noticed
fewer junk e-mail messages making it
to their inboxes recently. But the quest
for the technological “silver bullet” to
stop spam outright has proved elusive.
This had led some to search for other
methods to stop spam — methods that
may involve some government intervention but are less blunt than much of
the anti-spam legislation being proposed.

Spam Categories
Percentage
24%

Category
Products

18%

Financial

14%

Adult

11%

Scams

7%

Health

6%

Internet

6%

Leisure

4%

Fraud

2%

Political

1%

Spiritual

7%

Other

Description
E-mail offering or advertising general goods and services. Examples:
Devices, Investigation Services, Clothing, Makeup.
E-mail that contains references or offers related to money, the stock
market, or other financial “opportunities.” Examples: Investments, Credit
Reports, Real Estate, Loans.
E-mail containing or referring to products or services intended for
persons above age 18. Examples: Pornography, Personal Ads, Relationship Advice.
E-mail recognized as fraudulent, intentionally misleading, or known to
result in fraudulent activity on the part of the sender. Examples:
Investment Proposals, Pyramid Schemes, Chain Letters.
E-mail offering or advertising health-related products and services.
Examples: Pharmaceuticals, Medical Treatments, Herbal Remedies.
E-mail specifically offering or advertising Internet or computer related
goods and services. Examples: Web Hosting, Web Design, Spamware.
E-mail offering or advertising prizes, awards, or discounted leisure
activities. Examples: Vacation Offers, Online Casinos, Games.
E-mail appearing to be from a well-known company, but are not. Also
known as “brand spoofing” or “phishing,” these messages are often used
to trick users into revealing personal information such as e-mail
addresses, financial information, and passwords. Examples: Account
Notification, Credit Card Verification, Billing Updates.
E-mail advertising a political candidate’s campaign; offers to donate
money to a political party or political cause; offers for products
related to a political figure/campaign, etc. Examples: Elections,
Donations, Political Parties.
E-mail with information pertaining to religious or spiritual evangelization and/or services. Examples: Psychics, Astrology, Organized Religion,
Outreach.
E-mail not pertaining to any other category

SOURCE: Brightmail Logistics and Operations Center

Spring 2004 • Region Focus

25

60%

I

20%

I

0

I

40%

I

80%

I

100%

I

Percentage of Total Internet
E-mail Identified as Spam

4
.0
Feb 04
.
Jan 03
c.
De 03
v.
No 03
t.
Oc . 03
pt
Se 03
g.
Au 03
y
Jul 03
e
Jun 03
y
Ma 3
r. 0
Ap 03
r.
Ma
SOURCE: Brightmail Logistics and Operations Center

Make Spammers Pay
If spam is profitable because it is cheap
to send, then why not increase the costs,
many economists have asked. The most
common proposal along these lines is
simply to tax all e-mail a small amount,
say a penny per message. For most email users this wouldn’t amount to
much, because they may send only a few
dozen messages a week. But for spammers, who send out thousands upon
thousands of messages, the costs could
quickly become prohibitive. If the idea
of taxing non-spammers at even a
nominal rate for the offenses of spammers sounds unfair, there is a twist on
this idea: Everyone with an e-mail
account would get to send, say, 500 or
1,000 messages per year for free and
after that the sender is taxed on a permessage rate. This would exempt most
individuals from taxation, but still
ensnare spammers.
A similar proposal offered by Shyam
Sunder, an economist at Yale University, would have spammers pay
customers to receive their e-mail messages. “Just as postage on a letter
provides a useful disincentive for junk
mailers and signals recipients as to the
material’s importance, so the adoption
of a voluntary ‘postage’ scheme for email — with the recipient receiving the
postage — would help the recipients
screen out spam,” Sunder argues. The
system would work as follows. Senders
would affix any amount of postage they
liked to their message. If the price were
26

Region Focus • Spring 2004

right, the recipient would open it and
the value of the postage would be transferred to an account managed by their
Internet Service Provider. If not, the
recipient would simply delete the
message and no postage would be
deposited. E-mail from friends and
business acquaintances would not
require any postage, because presumably
these are messages that the recipients
usually wish to receive anyway. “This voluntary e-mail postage is a market-based
solution for efficiently serving the legitimate interests of both the sender and
the recipient,” Sunder concludes.

The “Idiot Tax”
In discussions of spam, senders are
always made out to be the bad guys.
That’s understandable. They are the
ones causing the problem, it would
seem. Presumably, however, they would
stop spamming if nobody responded to
their — often ridiculous — solicitations. But enough people do respond
to make it profitable; the number is
probably small, perhaps only one out
of 1,000. Why not tax that person who
in effect is creating a negative externality for everyone else? (See this issue’s
“Jargon Alert” column for a discussion
of externalities.) Some have called this
proposal an “Idiot Tax.” This may seem
a bit harsh. But, conceptually, the proposal makes a lot of sense. The
problem with this scheme, as with
others involving taxation, is enforcement. It’s not at all clear how one could
put this plan into practice.

What’s the Big Deal, Anyway?
These proposals might sound interesting but one might ask: What’s the big
deal about spam, anyway? If most people
can identify unsolicited e-mail and
delete it in a matter of seconds, what’s
the problem? These are reasonable questions. It may be that efforts to stop
spam amount to going after a fly with
a hammer. For some people, however,
spam is more than a pest — it keeps
them from using the Internet and e-mail
as much as they otherwise would.
In a recent survey conducted by the
Pew Internet & American Life Project,
77 percent of e-mail users said spam was
making their online experiences

unpleasant and annoying. Even more
telling, 29 percent said they had cut
their use of e-mail because of spam.
Ferris Research Inc., based in San Francisco, estimates that spam costs
businesses $10 billion annually due to
lowered productivity and the additional
equipment and labor needed to filter
spam. Whether the costs of spam are
indeed that high is a matter of debate.
But the point is they are not trivial,
and this means that efforts to stop spam
cannot simply be dismissed as meritless.
Whether those efforts are futile is
another matter. It may be that we have
no good solution to the problem of
spam — that is, a solution that imposes
fewer costs than spam itself. If so, we
may have to simply wait and allow spam
to die a natural death. This, arguably, is
what happened with blast faxes. Sure,
Congress passed a tough law to stop
their proliferation, which, no doubt,
helped to slow the practice. But what
probably helped their demise even more
was the advent of e-mail, which made
the fax somewhat antiquated. In short,
as technology changed, many would-be
blast-faxers may have become spammers
instead. The work didn’t change, but the
medium did.
What will replace e-mail? Who
knows. But it may be that, in 10 years,
we will look back nostalgically at how
we conquered the problem of spam
when, in fact, what really happened is
that spammers found newer and
cheaper ways to reach consumers. RF

READINGS
Kraut, Robert E., James Morris,
Shyam Sunder, and Rahul Telang.
“Pricing Electronic Mail to Solve the
Problem of Spam.” Working Paper,
Social Science Research Network
Electronic Library, July 2003.
Pew Internet & American Life
Project. “The CAN-SPAM Act Has
Not Helped Most Email Users So
Far.” March 2004.
Wastler, Allen. “Spam — Time for the
Idiot Tax.” www.CNNMoney.com,
June 24, 2003.
Visit www.rich.frb.org/pubs/
regionfocus for links to relevant sites.

unwelcome

guests

A global economy grapples
with the economic and ecological
effects of invasive species

BY CHARLES GERENA

E

Asian beetle discovered in Northern Virginia this year led to the removal of
200 ash trees to prevent its spread. Stilt
grass, which may have come to America
as packing material for Japanese porcelain, overtakes riverbanks and forestland
in West Virginia.
Humans are starting to recognize
the unintended consequences of their
globetrotting: The estimated price tag
for the damage caused by invasive
species and for controlling their spread
is well over $100 billion annually.
However, researchers are only beginning to understand what triggers an
invasion. As a result, policymakers still
can’t assess the risks of invasion in
order to make the best investments in
prevention and control.
Until researchers can reliably
predict invasions and that knowledge
is translated into tangible actions,
global commerce won’t bear the monetary costs that nonnative organisms
may impose. According to several economists, invasive species may be the only
negative externality of world trade.
“Anti-globalization people tend to
point their finger at trade as causing all
kinds of problems, but usually those
problems can be mitigated in other ways
besides reducing trade,” says economist
Christopher Costello at the University

of California, Santa Barbara. “The damaging [aspect of invasive species] is
inherently bundled with trade.”

The Great Migration

KUDZU PHOTO/JACK ANTHONY

very year, peregrine falcons
join thousands of other migratory birds that fill the autumn
skies over the Eastern Shore of Virginia National Wildlife Refuge. This
isolated spot on the southern tip of
the Delmarva Peninsula is merely a pit
stop on a much longer journey that
eventually brings these birds back to
their native habitats.
Generally a plant or animal is tied
to a single place that has what it needs
to live and grow. Sometimes organisms
cross natural boundaries like a mountain range or a river to find a new
home, but such natural dispersal is
usually rare and gradual. This enables
ecosystems to adjust to changes.
As trade has crossed the boundaries
of land and water, however, people
have carried large numbers of plants
and animals into new habitats accidentally and intentionally. This has
greatly accelerated the rate of dispersal beyond nature’s grasp.
Nonnative species are generally
benign, and often beneficial, from an
economic and ecological standpoint. But
a few become invasive and overpower
native plants and animals, causing
greater harm than good. Beaver-like
nutrias from South America destroy
productive wetlands in Maryland. An

Plants and animals have been imported
since colonial times. In fact, the first
major product of Chesapeake colonists
was tobacco grown with imported seed.
Currently, nonnative crops like corn
and wheat, and nonnative livestock
account for nearly all food production.
Organisms have been introduced for
non-food uses, too. Insects have been
recruited for biological pest control,
birds from around the world have
served as pets, exotic plants have beautified backyards, and fish have been
stocked in lakes for anglers.
Such intentional introductions of nonnative species have been beneficial. Others have been failures. Nutrias were
brought to Maryland in the 1940s and
1950s to help the fur industry, but they either escaped or were accidentally released
into the wild and started chewing up
marshes along the Eastern Shore.
Introductions aren’t always obviously good or bad notes David Lodge,
a biology professor at the University of
Notre Dame. The rewards of introducing a nonnative species can be
immediate, while potential damages

Spring 2004 • Region Focus

27

MARYLAND DEPT. OF NATURAL RESOURCES

The potential threat that the northern
snakehead posed to native fish prompted
Maryland officials to eradicate it in 2002.

from a species becoming invasive can
take years to emerge and are spread
among millions of people.
Damage may also be less visible if it
occurs underwater or in the wilderness.
It’s even harder to detect when a plant
or animal is introduced accidentally.
John Randall, acting director of the
Invasive Species Initiative at The
Nature Conservancy, says researchers
have a better sense of what has been
deliberately introduced.
Ballast water is a major pathway for
accidental introductions. Ships take on
water at a port to compensate for the
weight of offloaded cargo, then discharge water at the next port when it
loads a new shipment. Floating in the
water and inhabiting the sediment on
the bottom of ballast tanks are countless microbes and small sea creatures
that move from port to port. Some of
these nonnative organisms become
invasive, such as the infamous zebra
mussel that migrated from the Caspian
Sea in ballast water and eventually
clogged water intake pipes throughout
the Great Lakes region.
Global shipping provides other
means for nonnative species to hitch a
ride. Insects and fungi can stowaway
on wood pallets or packaging material,
as well as on horticultural and food
imports. Even places like West Virginia
with no international port can have
unwelcome guests because highways
and railroad tracks also facilitate interstate and international commerce.
Using these and other pathways,
numerous invasive plants and animals
have relocated to the Fifth District.
One of the biggest invaders is kudzu,
an Asian import initially used by
Southern farmers in the 1930s to
prevent soil erosion. Today, the vine
covers an estimated 7 million acres in
28

Region Focus • Spring 2004

the Southeast, smothering native
plants and damaging man-made structures like power lines. Two insects also
originated in Asia but probably got
here accidentally: the hemlock woolly
adelgid that affects forests in Maryland, Virginia, North Carolina, and
South Carolina; and the emerald ash
borer found in landscape trees shipped
to Maryland from Michigan.
Other nonnative plants and animals
are on the radar screen. They include
the lionfish, a venomous tropical fish
sighted off the coast of North Carolina,
and the Rapa whelk, a Japanese snail
that could prey on native oysters in the
Chesapeake Bay.

When Animals Attack
Is the lionfish or the Rapa whelk considered invasive? Generally, scientists
differ on where they draw the line
between a migration and an invasion.
They agree that a nonnative species
is considered invasive when it escapes
the bounds of cultivation or captivity
and out-competes species that are more
desirable, imposing ecological and economic damages that exceed their benefits. This doesn’t happen often —
about 10 percent of plants and animals
live outside of their usual habitat and
roughly 10 percent of those survivors
are troublemakers. Still, given the many
thousands of species that inhabit the
earth, that is a significant number.
Researchers have been trying to
figure out how invasive species beat the
odds, and they have found some clues.
It typically takes a large contingent of
a nonnative organism to survive in a
new environment. Also, the organism
needs a new home that is comparable
to its original habitat, doesn’t have too
much competition for food and space,
and doesn’t experience adverse weather
for several years.
It helps if an organism is “weedy,”
meaning it can tolerate wide variations
in its environment. Furthermore, natural
forces or human activity can alter an
environment in such a way that creates
an opening for nonnative species. For
instance, stilt grass readily grows in West
Virginia along roads cut into forests for
logging and coal mining.
Even when a nonnative organism

persists, it usually settles into a niche
and doesn’t overwhelm other plants
and animals. The problems start when
predators, pathogens, or other natural
barriers fail to limit the expansion of
the organism’s population.
When these variables trigger an
invasion is the $64,000 question.
“Nobody can tell you what the effect
of introducing an organism into a novel
habitat is yet,” says A. Whitman Miller,
assistant director of the Marine Invasions Research Program at the Smithsonian Environmental Research Center.
“You can introduce the same organism
100 times and it won’t take, then on
the 101st time it will.”
The ecological damage of invasive
species also is an open question, but
researchers know enough to be concerned about the planet’s future biodiversity. Henry Lee II, a research
ecologist with the U.S. Environmental
Protection Agency, says that invasive
species threaten to homogenize ecosystems. “It’s like all of the restaurants
turning into McDonalds.”
One would think that the arrival of
a new species broadens biodiversity.
That’s true in the short run, but in the
long run invasive plants and animals
can push native species into the
margins of an ecosystem. In fact, invasive organisms are thought to be a
leading cause of species endangerment
and extinction.
In contrast, some researchers have
asserted that the spread and dominance
of invasive species is part of the process
of natural selection, where only the
strongest survive. Lee concurs that
many invaders are organisms that have
managed to survive polluted environments and are colonizers.
However, the outcome of this
process may be unacceptable. “We’ll get
hardier species [as a result of the spread
of invasive plants and animals], but
they’re not also ones that we want,”
explains Lee. He cites the Norway rat,
a scourge of city dwellers across Asia,
Europe, and North America.
The widening presence of invasive
species could have other long-term
consequences. Less redundancy of
natural resources could weaken ecosystems to outside shocks. In addition,

there could be less fodder for the discovery of new products. The Pacific
yew, a tree native to the northwestern
United States, supplies the active ingredient in a chemotherapy drug.
Invasive species also have economic
consequences in the short term. They
damage billions of dollars in crops,
timber, and other natural resources.
They can also depress property values.
There are examples of ranches in the
West and Midwest that have lost value
because of leafy spurge, which overtakes
grazing land used by livestock, while the
loud calls of coqui frogs in Hawaii have
been blamed for declining property
values and tourism.

Eradicating Nutrias without
Killing the Golden Goose
The economic and ecological consequences of invasive species can be significant. Yet globalization has made it
nearly impossible to prevent every
plant and animal from escaping its
habitat. The challenge is to manage the
impact of invasive species without
choking off trade.
Do we know enough to do this?
Ann Bartuska, an ecologist and deputy
chief of research and development at
the USDA Forest Service, thinks there
is sufficient information to act. “We
won’t be 100 percent certain about the
outcome, but we can monitor the
effects of regulations and adjust them
when necessary.”
Policymakers can do two things —
prevent future invasions of destructive
organisms and control existing pests.
Since there is uncertainty about which
nonnative species pose the greatest threat,
they have favored control measures says
Jason Shogren, an economist specializing in natural resource conservation and
management at the University of Wyoming.
Risk-averse officials prefer “to control
the things they already see than prevent
things that might not be there.”
Such caution avoids investing in preventive measures whose cost effectiveness would be unclear. But it can backfire, says Shogren. By only combating existing invasive species, “you end up with
greater probabilities of invasions” in the
future. Additionally, the money spent on
control efforts represents resources that

would have been used for something else,
plus future invasions will require additional trade-offs.
Ecologists strongly believe that preventing an invasion is better than managing the aftermath. Once a population
of invasive species starts expanding, its
exponential growth makes eradication
exponentially difficult.
A variety of prevention tools are
currently employed, including regulation of plant and animal imports and
fumigation of wood packaging material
entering the country. The U.S. Coast
Guard is considering mandating ships
to use some form of ballast water management. Also, federal legislation is
pending that would require treatment
of ballast water, establish a screening
program, and require the creation of a
monitoring and early detection plan.
Federal officials could choose to
follow Australia, New Zealand, and
South Africa in creating a “white list”
of plants and animals evaluated and
approved for importation. Organisms
that haven’t been screened would be an
assumed threat and kept out of the
country. While the horticulture and pet
trades have objected to this approach,
the opposite approach of assuming that
an organism is innocent until proven
guilty has one big disadvantage. You
have to wait until an invasion has
occurred before reacting.
Anti-globalization advocates and
others believe that the threat of invasive species justifies banning or
restricting trade with other countries.
Economist Chris Costello counters that
freer trade may actually mitigate some
of the damaging effects of invasions.
“… Although reduced protectionism
raises the volume of trade and hence
the platform for biological invasions, it
also changes the production mix of participating countries…” he noted in a
August 2001 paper co-authored with
Carol McAusland. This could make
these countries less susceptible to invasive species. “… For countries that initially import agricultural products,
reduced tariffs will lead to a decrease
in the volume of agricultural output.
This reduces both the quantity of crops
available for damage by exotic pests
and the amount of land that is dis-

turbed and thereby aiding the propagation of exotic species.”
Tariffs could be selectively applied
to countries with species that are the
most likely to cause harm in the United
States. However, such a system would
have to be based on sound science and
not used as a form of disguised protectionism, notes Shogren.
Costello suggests imposing liability
rules on global transactions. A contract
could hold a seller responsible for any
invasive species that is found in the
buyer’s country that could only have
resulted from the transaction. The
seller could post a bond to cover that
liability and get it back after 10 years
of no invasions.
The result is that sellers would have
an incentive to reduce the risk of invasions. In addition, the costs of invasive
species management would eventually
be reflected in the price of goods from
exporting countries.
Tariffs or liability rules would impose
costs on global trade. Such costs might
disproportionately affect developing countries that want to export, but they also
stand to benefit the most since they are
less equipped than rich countries to deal
with the damage wrought by inadvertently imported plants and animals. RF

READINGS
Bright, Chris. Life out of Bounds: Bioinvasion in a
Borderless World. New York: W.W. Norton &
Company, 1998.
Costello, Christopher, and Carol McAusland.
“Protectionism, Trade, and Measures of Damage
from Exotic Species Introductions.” Working
Paper, University of California, Santa Barbara,
August 21, 2001.
Mooney, Harold A., and Richard J. Hobbs
(editors). Invasive Species in a Changing World.
Washington, D.C.: Island Press, 2000.
Olson Lars J., and Santanu Roy. “The Economics
of Controlling a Biological Invasion.” Working
Paper, University of Maryland at College Park,
May 2003.
Pimentel, David, et al. “Environmental and
Economic Costs Associated with Non-Indigenous
Species in the United States.” Working Paper,
Cornell University, June 1999.
Visit www.rich.frb.org/pubs/regionfocus for
links to relevant sites.

Spring 2004 • Region Focus

29

No
Big

More
Four?
Small cigarette manufacturers
grab market share
B Y R O B E R T W. K I D D

P

hilip Morris USA Inc., R.J.
Reynolds Tobacco Co., Brown
& Williamson Tobacco Corp., and
Lorillard Tobacco Co., popularly called
“The Big Four,” have held a commanding
position among domestic cigarette manufacturers throughout the United States
for the last 40 years. By 1997, the Big
Four’s combined market share hit a historical peak of 97.7 percent, according to
industry analyst John C. Maxwell, Jr. in
his quarterly publication The Maxwell Report. The United States Department of
Agriculture (USDA) described the industry then as “hourglass shaped.” Thousands of tobacco farmers supplied only 13
cigarette manufacturing establishments,
which then shipped the manufactured
product to hundreds of thousands of
wholesale and retail establishments.
In the last five years, however, the
tobacco industry has lost its hourglass
figure as start-up competitors — includ30

Region Focus • Spring 2004

ing a few in the Fifth District — have
entered the cigarette manufacturing
market. And as the Big Four lose market
share, state budgets aren’t getting as
much money as was originally estimated
through tobacco settlements.
Susan Craven, president of the
Council of Independent Tobacco Manufacturers of America (CITMA),
observes that “there is a flurry of startup activity” in the cigarette manufacturing industry. Some reports, for
instance, estimate that there might currently be more than 100 startups,
including those in the Fifth District
such as Poison Inc. in Castle Hayne,
N.C.; S&M Brands in Keysville, Va.;
and Star Scientific in Chester, Va. Small
manufacturers, which were relegated
to only 2.3 percent of the domestic
market in 1997, now account for more
than 15 percent, according to The
Maxwell Report.

Why the sudden emergence of
these small manufacturers? The Big
Four all point to the Master Settlement
Agreement (MSA) to help explain their
accelerating loss of market share. The
MSA was a record-setting settlement
between nearly all the states and the
Big Four in November 1998. The agreement “absolutely and unconditionally”
releases the participating companies
from all current and future suits by participating jurisdictions in tobaccorelated health-care claims. In return,
the Big Four agreed to make payments
to the participating states, projected at
the time of settlement to be worth
about $204.5 billion through year 2025.
Although the Big Four freely bargained for the terms of the MSA, they
blame the payment obligations for higher prices. The major cigarette companies
have increased their prices more than
$1.10 per pack since 1998, effectively

doubling the average price of cigarettes
in five years, according to a 2001 Presidential Commission Report, Tobacco at
a Crossroad: A Call for Action.
The steep increase in cigarette prices
opened the door for smaller manufacturers with lower cost structures to grab
market share. In 2001, Maxwell observed
that “with ease of entry into the market
being very reasonable many new companies are being formed. For only a few
hundred thousand dollars, a secondhand
maker can be purchased” and quickly
become profitable. In an effort to explain
their sharp drop in market share to
stockholders, Lorillard estimated in its
2002 annual report that smaller competitors were pricing their brands as
much as 60 percent below the major cigarette manufacturers
However, skeptical industry observers believe the Big Four’s price hikes
were much greater than required to
meet their payment obligations under
the MSA. For instance, the Presidential Commission Report states that only
“roughly half” of the increase is to cover
the costs associated with the MSA.

A Shrinking Market
According to The Maxwell Report,
domestic cigarette shipments totaled
about 403 billion in 2003, down 35
percent from 1981, when domestic
shipments reached a historic high of
636.5 billion.
In the past year, the Big Four took
significant steps to regain U.S. market
share. On October 27, 2003, R.J.
Reynolds announced its agreement to
acquire Brown & Williamson (the U.S.
cigarette and tobacco operations of
British American Tobacco Company)
and create a new holding company,
Reynolds American Inc. The two companies have a combined 32 percent of
the domestic market share. If U.S. and
European regulators approve the acquisition, the new Reynolds American
would become the second largest manufacturer behind Philip Morris, which
has about 50 percent market. (Lorillard
has about 10 percent of market share.)
According to R.J. Reynolds, the deal is
expected to improve efficiency and
generate more than $500 million in
annualized savings.

Rather than actively pursuing a
business merger, Lorillard attempted
to strengthen demand through promotional initiatives and by altering its
pricing schemes. The company halted
its wholesale price increases in March
2002, and in May 2003, lowered the list
price of its discount brand, Maverick,
by $1.10 per pack of 20 cigarettes.
However, because of higher promotional expenses and lower sales volume,
Lorillard’s revenues and net income
decreased in 2003.

Tough Times for Local Farmers,
State Governments
Since MSA payments to states can be
adjusted for changes in the Big Four’s
domestic sales and market share, state
governments aren’t receiving the money
they had anticipated. For example, RJR’s
payments went from $2.5 billion in 2002
to $1.8 billion, a drop of 28 percent.
(Each state’s allocation of the MSA was
initially based on its smoking-related
health-care costs. About 9 percent of
total disbursements are allocated for
Fifth District states, while populous
states like New York and California each
receive more than 10 percent of disbursements.)
With smaller MSA payments, states
are being forced to revise their budgets.
For instance, Virginia’s Department of
Planning and Budget recommended
lowering the appropriation for the
Tobacco Indemnification and Community Revitalization Fund and the Virginia
Tobacco Settlement Fund. Recommendations included reductions of $3.8
million and $2.9 million for 2005 and
2006 respectively.
Not only will state governments be
affected, so will local economies throughout the Fifth District. Philip Morris and
Lorillard both have their headquarters,
manufacturing, and storage facilities in
North Carolina and Virginia. Although
Brown & Williamson is currently headquartered in Kentucky, the facility will
close and the new company will be in
Winston-Salem, N.C., home of R.J.
Reynolds. The proposed acquisition will
result in tobacco processing and cigarette
manufacturing redundancies that will be
eliminated to achieve the expected cost
synergies. For instance, a tobacco-pro-

Less Demand Means
Less Production
Fifth District
State

2000 Tobacco 2002 Tobacco
Production
Production
(1,000 POUNDS)

MD
8,265
NC
406,500
SC
81,260
VA
56,613
WV
1,560
Fifth District Total
554,198
U.S. Total
1,052,999

(1,000 POUNDS)

2,380
357,350
59,475
66,180
1,950
487,335
889,632

cessing plant in Chester, Va., which employs 132 people, is expected to be closed.
Because demand for cigarettes is
dropping, so is U.S. tobacco production. According to the USDA, total U.S.
tobacco production fell from 1.1 billion
pounds in 2000 to 890 million pounds
in 2002. During this same time, production in the Fifth District fell from
554 million pounds to 487 million
pounds. However, the Fifth District’s
share of U.S. production slightly
increased from 52 percent to 55
percent, indicating that production is
decreasing at a slower rate in the Fifth
District than in other regions.
According to a 2000 USDA report,
the “loss of tobacco-related income and
jobs will have little noticeable long-term
effect on the U.S. economy as a whole,
but there will be difficult transitions for
many farmers, workers, businesses, and
communities.” Since tobacco farming
and manufacturing is concentrated in
the Fifth District, and the Big Four
seems likely to become the Big Three,
the region is particularly vulnerable to
competitive dynamics and will continue
to face challenges resulting from these
anticipated transitions.
RF

READINGS
“Frequently Asked Questions about the Tobacco
Settlement.” Washington, D.C.: National
Conference of State Legislatures, March 1999.
“Tobacco at a Crossroad: A Call for Action.”
Washington, D.C.: United States Department of
Agriculture, May 14, 2001.
Visit www.rich.frb.org/pubs/region focus for
links to relevant Web sites.

Spring 2004 • Region Focus

31

INTERVIEW

James
Buchanan
Editor’s Note: This is an abbreviated version of RF’s conversation with James Buchanan. For the full interview, go to our Web
site: www.rich.frb.org/pubs/regionfocus.
Economists have long treated people in the marketplace
as rational actors pursuing their own self-interest. But
until the mid-20th century it was common to view people
in government in a very different light — as selfless public
servants. Such a distinction, argued James Buchanan, was
unnecessary and incorrect. People in the public sector are
self-interested just like everybody else. Using this basic
assumption, Buchanan and others were able to apply the
tools of economics to politics. This line of inquiry soon
become known as “public choice” and spread rapidly
throughout the United States, Europe, and Asia.
Most of Buchanan’s academic career has been spent in
Virginia: first at the University of Virginia in Charlottesville, then at the Virginia Polytechnic Institute in
Blacksburg, and later at George Mason University in Fairfax. As a result, he and his colleagues are often referred to
as members of the “Virginia School.” In the early 1960s,
Buchanan was one of the founders of the Public Choice
Society (PCS). The PCS holds annual meetings where papers are presented and discussed. It is also loosely affiliated with the academic journal Public Choice, which was
long edited by Gordon Tullock, one of Buchanan’s most
frequent collaborators.
Buchanan was awarded the Nobel Prize in Economics in
1986. Although he is now in his mid-80s, he still pursues
an active research agenda and continues to lecture regularly. Aaron Steelman interviewed Buchanan at George
Mason University on Feb. 2, 2004.
32

Region Focus • Spring 2004

RF: Public choice is often described as “politics without romance.” Could you please
describe what this phrase means?
Buchanan: I actually used that as the title of a
lecture I gave at the Institute for Advanced
Studies in Vienna in 1978. I think that if you had
to boil public choice down to three words, that’s
a pretty good description, but on the other hand
it’s not complete either. The phrase captures the
idea that public choice does not look at politics
through rose-colored glasses—it is skeptical that
the actions of people in politics are necessarily
focused on promoting the public interest. Instead,
it takes a more hard-nosed, realistic view of government. But what it leaves out is that we must
have a legitimizing argument that politics is
worthwhile— that politics is an exchange in the
sense that we give up something but we also get
back something.
RF: Public choice is now a recognized subdiscipline within economics. But when you
first started doing work in public choice, how
was that research greeted by the profession?
Buchanan: It was certainly outside the mainstream. I think many of my colleagues at the
University of Virginia didn’t particularly like
using economics to analyze politics. But I have
to say that when Gordon Tullock and I published
The Calculus of Consent in 1962, the book received
quite warm reviews by both economists and
political scientists. And, between the two groups,
I think the book’s impact was greater among
political scientists in the following respect: They
had further to go. Economists were familiar with
the tools we were using and the basic assumptions about rationality that we were making, but
to many political scientists, these ideas were
rather novel. Also, I think you can’t leave personalities out of this either. Bill Riker was very
active in introducing public choice and positive
political economy to other political scientists
and to his students at the University of
Rochester. The fact that he came onboard very
early was extremely important.
RF: People working in the public choice tradition are often referred to as members of the
“Virginia School.” Could you please explain
how and when that term came into being?

Buchanan: Mancur Olson came up
with that term. He was the one who
first characterized us as the Virginia
School —I don’t know exactly when
but it was probably in the mid1970s, after we had already moved
from Charlottesville to Blacksburg.
It was fine by us. So we went with
it, as did other people. But we didn’t
coin the term ourselves.

I think that if the
Nobel Prize were
decided by American
economists, I never
would have been

Buchanan: I think you have to look at this on
different dimensions. The public choice program
originated at the University of Virginia from 1956
to 1968. Warren Nutter and I set up the Thomas
Jefferson Center for Studies in Political Economy.
The research program at the Center was broader
in scope—it wasn’t confined to public choice per
se. That was a very productive and exciting time.
We had a great group of people there: Ronald
Coase, Leland Yeager, Tullock, and Nutter were
all on the faculty. And, without question, we had
the best graduate students I have ever worked
with—really top-notch kids.
We were never that productive in terms of producing good graduate students at VPI. But the
public choice program became more developed
there. We enjoyed tremendous support from the
university administration, which in some ways had
been lacking at Virginia. And Tullock, who had
left Virginia a few years before I did, came to VPI.
He and I started collaborating on a lot of projects, and we set up the Center for the Study of
Public Choice along with Charlie Goetz.
One of the things that I think was really important about VPI was the unique atmosphere and
geography: We were all located close to each other
and had constant interaction. Plus, at VPI there
was a young man named Winston Bush whose
enthusiasm and intellect really inspired a lot of
interesting projects, such as our work on the political economy of anarchy. Winston was a great
mathematical economist, who unfortunately died

awarded it.

SCOTT SUCHMAN

RF: Richard Wagner, who was
one of your students at the University of Virginia and has been
your colleague at both the Virginia Polytechnic Institute (VPI)
and George Mason University, has written that
VPI was the most fertile place for public
choice scholarship. Do you agree?

quite young in a car accident, but for a few years
was a real live wire who really kept things going.
We also had a great visiting fellow program. It
wasn’t unusual for us to have eight or nine visitors
at one time. So, in the sense of sheer output, I
think Wagner is right: VPI was the most productive place.
RF: At last year’s meetings of the Public Choice
Society in Nashville, I was struck by the large
percentage of participants from continental
Europe. Did public choice take off internationally during the period you were at VPI?
Buchanan: Yes. Many of the visiting fellows who
came to Blacksburg were from Europe or Asia. It
was also around this time that they set up their
own organizations: the European Public Choice
Society and the Japanese Public Choice Society.
In some ways, the Europeans were more eager to
work on constitutional political economy issues
than were the Americans. In fact, I think that if
the Nobel Prize were decided by American economists, I never would have been awarded it. My
work has been much more warmly received in
Europe than in the United States.
RF: Could you describe how Frank Knight
and Knut Wicksell have affected your thinking and career?

Spring 2004 • Region Focus

33

Buchanan: They were certainly the two most
important influences on my work. Knight’s influence was more as a role model than as someone
whose work I tried to build on, although he certainly made very important contributions of his
own. Knight and I had very similar backgrounds:
He was a farm boy from central Illinois who spent
some time in school in Tennessee and who ultimately rejected the religious milieu in which he
had been raised. I really liked his attitude toward
the world and his willingness to question anything
and anybody. He had a real passion for ideas.
Wicksell, on the other hand, was more of an
accidental discovery. I was going through the
stacks of the old University of Chicago library
after I had finished my dissertation and I ran
across his dissertation, which had never been
translated from the very difficult German. In that
book, he was saying things that I
felt inside me but
I never dared to
If you want to improve
say. He really reinforced a lot of
government, you must
things that were
sort of inchoate in
try to improve the
my thinking. The
central idea I got
rules of the game
from Wicksell is
that we can’t imrather than the
prove politics by
simply expecting
individual players.
politicians to do
good. There are
no interests other
than those of individuals, and politicians will pursue their own
interests just like anyone else, by trying to get reelected, advance their careers, and so on. This
means that economists ought to stop acting as if
they were advising benevolent despots. If you
want to improve government, you must try to
improve the rules of the game rather than the
individual players.
RF: Looking back over the past 40 years, what
do you think are some of the most important
contributions that public choice theorists have
made?
Buchanan: I think that the most important contribution, by far, is to simply change the way that
people look at politics. I often have been asked if
public choice had a causal influence in the decline
of confidence in politics and politicians compared
to, say, 40 years ago. My answer is: yes and no.
Once governments began, in the 1960s and 1970s,
34

Region Focus • Spring 2004

to overstep their bounds and take on projects that
ultimately proved to be great failures—and this
is true not only in the socialist states but also in
the democratic states of the West—public choice
came along and gave people a systematic way to
analyze and explain these failures. So public choice
wasn’t the cause of distrust in government but it
did help us understand the deficiencies of the
political process. It changed the way that we look
at collective action.
RF: Many commentators frequently decry
voter turnout rates of, say, 50 percent as “too
low.” But, actually, it’s surprising that this
many people go to the polls because the chance
of being instrumental is virtually zero. Does
public choice have a good explanation for why
people vote?
Buchanan: That is one of the central puzzles we
have faced since Anthony Downs and Gordon
Tullock raised the question in the 1950s. From a
purely rational standpoint, people don’t have much
of an incentive to vote but, as you said, about half
of them do. Why? I think this gets us into social
psychology. People may vote simply as a means of
expression rather than as a way of influencing the
outcome of an election. They also may feel some
sort of duty is involved. But, given the framework
that economists would traditionally look at this
sort of question, it’s hard to come up with a satisfactory answer.
RF: Many people who have done important
academic work in the public choice tradition
have subsequently gone on to hold high-level
appointed offices in the federal government.
Is there something ironic about this, in your
view? Or is this training useful?
Buchanan: I’m not sure that it helps much. If
you’re on the inside, maybe you don’t want to be
trained in public choice. For instance, if you are
going into the bureaucracy, perhaps you wouldn’t
want to have read the public choice literature on
bureaucracy. I certainly wouldn’t get excited about
more public choice people filling government positions. Absorbing and doing are quite different
things in this context. I think that there is little
doubt that public choice has been enriched by
people who have used government experience to
inform their academic work. But I don’t know
that public choice has done much to influence the
way that government officials actually behave.
RF: It is widely believed that public choice theorists are more suspicious of government

action and more friendly toward market solutions than economists generally. Do you think
this is accurate?
Buchanan: Yes, to some degree. But a continuing critique of public choice is that the whole
research program is ideologically driven. I think
that is completely wrong. It all goes back to the
first question you asked about public choice being
described as “politics without romance.” If you
look at politics in a realistic way, no matter your
underlying ideological preferences, you are going
to come out more negative than you started. There
are many public choice people whose normative
views are not at all market-oriented. But, as scientists, they reach conclusions that may not particularly support those normative preferences.
RF: What do you think of the various “heterodox” schools of economics that are challenging the basic assumptions of neoclassical
economics?
Buchanan: For more than 20 years, I have predicted that you would see more collaboration
between psychologists and economists. That prediction is finally becoming realized with the widespread emergence of “behavioral economics,” as
characterized by the work of Dick Thaler, Bob
Frank, and others. They pick out particular anomalies and use them to try to chip away at the neoclassical edifice. Many of those anomalies are
interesting, but they are just that—anomalies and
thus not very generalizable. I don’t think that
behavioral economics is a spent force yet, but I
don’t know how much further they can go with
it, because what they have to offer are critiques
rather an alternative program of inquiry. Still, I’m
sympathetic to the idea that economists have
pushed this homo-economicus model too much.
RF: In a series of articles on what he calls
“rational irrationality,” Bryan Caplan has tried
to reorient public choice to focus more on
voter-driven political failure and less on the
perverse influence of special interests. What
do you think of this line of inquiry?

RF: What, in your view, is the
proper role of government?
Buchanan: Well, I think the state
should fund the classic public goods
and you could probably do that
with government spending at a level
of roughly 15 percent of gross
domestic product (GDP). But I’m
not willing to say that that is all
government should do. As long as
government grows within a proper
set or rules, then I would rather not
put limits on its size. I am reluctant
to say, for instance, that having
public spending at 40 percent of
GDP—which is about what we
have now—is necessarily wrong.
RF: Why do so many voters hold
views that are at odds with mainstream economic theory?

➤ Previous Faculty Appointments
Virginia Polytechnic Institute and State
University (1969-1983); University of
California at Los Angeles (1968-1969);
University of Virginia (1956-1968); Florida
State University (1951-1956); University of
Tennessee (1948-1951)
➤ Education
B.S., Middle Tennesee State College (1940);
M.A., University of Tennesee (1941);
Ph.D., University of Chicago (1948)
➤ Selected Publications
Author or co-author of more than 20 books,
including The Calculus of Consent: Logical
Foundations of Constitutional Democracy
(1962); Cost and Choice: An Inquiry in
Economic Theory (1969); The Limits of
Liberty: Between Anarchy and Leviathan
(1975); and Better than Plowing: And Other
Personal Essays (1992)
➤ Awards and Offices
Winner, 1986 Nobel Memorial Prize in
Economic Sciences; Fellow, American
Academy of Arts and Sciences; Former
President of the Southern Economic
Association, Western Economic Association,
Mont Pelerin Society, and Public Choice
Society

Buchanan: Part of the blame falls
on economists. As scientists, we are
incredibly attracted to grapple with
interesting puzzles that may have
little immediate practical application. And, indeed, we are rewarded
for doing that through academic
promotions and greater prestige
within the profession. So that type
of work has a lot of private value to
economists. Contrast that with
making basic economic truths—
such as the benefits of free
trade—accessible to a wider audience. Economists gain very little
from doing that—for instance, it
probably won’t get you tenure. But
there is an enormous public value
associated with having an economically literate
society. We need more Bastiats who are willing to
talk to the public. As it stands, economists are
losing the battle.
RF

Spring 2004 • Region Focus

SCOTT SUCHMAN

Buchanan: I don’t know Caplan’s work very well.
But I think there is something to what he is
trying to argue. For instance, I think there is the
following bifurcation in the choice process: We
may want to do things collectively that we are
not willing to sustain privately. It may be true
that the welfare state represents what people
actually want. They may want the government to
take care of everybody, and so they vote for can-

didates who run on such a platform, including
the higher tax rates needed to pay for it. At the
same time, given those high levels
of taxation, they may decide to
James Buchanan
quit working, like the Swedes, and
spend time at their summer home.
➤ Present Position
So even though they voted for the
Distinguished Professor Emeritus of
whole program—on both the
Economics, George Mason University, and
spending and taxation sides—they
Distinguished Professor Emeritus of
are not willing to support it
Economics and Philosophy, Virginia
through their private actions.
Polytechnic Institute and State University

35

ECONOMICHISTORY

“Sold,American!”
How auction
markets improved
the tobacco trade
and why they are
becoming obsolete

D

SPECIAL COLLECTIONS & ARCHIVES, JAMES BRANCH CABELL LIBRARY, VCU LIBRARIES

BY CHARLES GERENA

uring the 1920s, the above
phrase would frequently end
the rhythmic, almost hypnotic
chant of auctioneer L.A. “Speed” Riggs,
indicating that American Tobacco Co.
had won its bid for a farmer’s tobacco.
Riggs helped growers get a good price
for their crops in piles at the Liberty
Warehouse in Durham, N.C. They
needed all the help they could get.
In general, the tobacco plant is a
tough agricultural good to appraise.
Environmental conditions and cultivation techniques influence the color,
texture, and size of the plant’s leaves;
then the curing of leaves after they are
harvested creates additional variations.
Leaves picked from different positions
of a stalk have unique characteristics
as well. Even though grading systems
attempt to capture these variables,
determining the sale price of tobacco
is still more art than science.

The Golden Leaf Rush

A typical tobacco auction at
the turn of the century brought
buyers and sellers together in
Richmond, Va.

36

or quantity of the good cannot be substituted for another equal part or quantity. “Each lot of tobacco stands on its
own,” says Prince. In contrast, “a bushel
of wheat is a bushel of wheat.” This is
why tobacco hasn’t been traded along
with wheat and other agricultural products on a commodity exchange like the
Chicago Board of Trade.
Instead, buyers and sellers have
struggled for hundreds of years to
create transparent, centralized markets
where both sides have enough information to reach a mutually agreeable
price. Until four years ago, tobacco auctions in Maryland, Virginia, and the
Carolinas provided those markets.
Large warehouses would be filled with
the smell of the golden leaf and the
singsong cries of auctioneers like Speed
Riggs. They created a dynamic environment that benefited both buyers
and sellers.
But in these uncertain times, a
growing number of tobacco farmers
and manufacturers like Philip Morris
are trading the advantages of auction
markets for the greater certainty of
contracts. In a sense, tobacco marketing has come full circle — buyers are
dealing directly with sellers as they
once did hundreds of years ago.

Region Focus • Spring 2004

“The buyers look at every lot of
tobacco,” says Eldred Prince Jr., a
history professor at Coastal Carolina
University who has studied tobacco
farming in South Carolina. “Some of
them will smell it as well as look at it.”
Because many variables influence its
value, tobacco isn’t fungible — one part

Tobacco marketing in America started
in the 1600s with frustrated colonists
trying to survive in the Tidewater
region of Virginia and southern Maryland. Colonists had access to Atlantic
trade routes by using navigable rivers
like the James to get to the Chesapeake
Bay, but it didn’t help them economically because they had a hard time producing anything to trade.

Then John Rolfe, the infamous
husband of Pocahontas, hit pay dirt in
Jamestown. The tobacco seeds that he
brought from the Caribbean thrived in
Virginia soil, producing leaves with a fragrant aroma when snuffed and a sweet
taste when chewed. The British loved
Rolfe’s product and, by 1617, colonists
harvested enough tobacco to export.
In the coming years, demand for America’s first commercial export grew, becoming so strong that farmers devoted
most of their land to tobacco rather than
food. Exports from the colonies to England expanded from 20,000 pounds in
1617 to more than 40 million pounds in
1727. Production eventually expanded geographically as well, venturing westward
in Virginia and southward into North
Carolina and South Carolina as tobacco
became more valuable than cotton or
other crops and Tidewater land became
depleted of nutrients.
While some growers sold their
tobacco to traveling merchants, most
brought their crops to market. Water
was the primary means of transportation. Plantations near rivers and their
tributaries had their own docks so that
growers could ship tobacco leaves in
heavy barrels called hogsheads, while
farmers without water access rolled
hogsheads over land to the nearest port
or navigable body of water. In time, port
towns throughout the Fifth District
profited from the tobacco trade, including Alexandria, Va. and Port Tobacco,
Md. on the Potomac River; Richmond
and Petersburg on the James River; and
Port Roanoke (Edenton), N.C. and
Charleston, S.C. near the coast.
Once the farmer got his tobacco to
market, a merchant would weigh and
examine each hogshead, then compensate the farmer for his goods. The
payment would be in the form of
bartered goods or tobacco receipts,
which could be used to pay wages, settle
debts, and make purchases. In this way,
tobacco became a form of currency.
Tobacco was so lucrative that it was
hard to prevent overproduction. Periodic gluts in the tobacco market
occurred, causing prices to fall and incidents of fraud to rise.

Keeping Auctions Alive
Only two warehouses in Maryland continue
holding auctions for air-cured tobacco as
hundreds of farmers choose to sign contracts
with buyers or take advantage of a statesponsored buyout program. Other states in the
tobacco belt have more warehouses in
operation than Maryland, but even their ranks
are dwindling. This has prompted two farmers’
cooperatives and a nonprofit organization to
create alternatives to the warehouse-based
auction system.
A farmer can get five cents or more per pound
for selling his tobacco crop under contract, but
what happens if a leaf dealer closes its receiving
station before the harvest is over or rejects a
farmer’s crop? “If you disagree with [a buyer’s
decision] what opportunity do you have?” says
Arnold Hamm, assistant general manager of the
Flue-Cured Tobacco Cooperative Stabilization Corp.
“Farmers are fearful that they will have nowhere to
market their tobacco.”
Only a few growers sell a portion of their
tobacco directly to buyers and some through
the auction system in order to keep their
options open and maintain some bargaining
power. But most use contracts to secure a
commitment for 100 percent of their crops.
That’s why the Flue-Cured Tobacco
Cooperative created its own auction system in
2002 after testing the concept in 2001. The
system consists of 14 marketing centers located
in leased space at warehouses in Georgia,
North Carolina, South Carolina, and Virginia.
The Burley Tobacco Growers Cooperative

Merchants usually loaded their
purchases onto ships sight unseen. And
when they did inspect a hogshead, it
wasn’t easy. “They would open it and try
to feel down [but] there were always
problems with farmers packing bad stuff
at the bottom,” describes James Crawford,
an adjunct geography professor at Virginia
Tech who has studied the Old Dominion’s
tobacco culture. Some planters even
loaded hogsheads with bricks and rocks
to increase their weight.
In 1619, Virginia lawmakers responded to these problems by passing the first
laws to inspect tobacco before it was sold.
If a warehouse manager found anything

Association, which has members in West
Virginia and four other states, opened its own
marketing center in a former tobacco
warehouse in Cynthiana, Ky. in 2002.
In western North Carolina, the state’s Rural
Economic Development Center has maintained an
auction market for burley tobacco in the region
since 2001. The center uses tobacco settlement
funds to lease two warehouses in Asheville.
In each case, auctions are conducted as
they were traditionally done in tobacco
warehouses, with one important difference.
Since the center’s owners receive outside
funding, they don’t have to levy warehouse
charges, auction fees or sales commissions.
Some warehouse owners have complained
that this arrangement has given marketing
centers an unfair advantage that has accelerated the demise of the auction system. In fact,
several warehouse owners sued the Flue-Cured
Tobacco Cooperative several years ago for
violating antitrust laws. According to Hamm,
business courts ruled in the co-op’s favor twice
and an appeal also went its way. “As a
cooperative, we can use a tobacco farmer’s
[membership fees] to assist them in the
marketing of their product.”
The jury is still out on whether marketing
centers will save the tobacco auction system. The
Flue-Cured Tobacco Cooperative’s centers have
handled 5 million to 6 million pounds of tobacco
each year, but that is a fraction of the total volume
sold through auctions and contracts.
—C H A R L E S G E R E N A

awry with a hogshead, the entire contents
of the barrel could be confiscated and
burned. Additional laws were passed
throughout the 17th century to deal with
the quality issue, as well as to control the
burgeoning tobacco supply. Grading standards were created, as well as inspection
stations, to enforce those standards.
Still, fraud persisted and the English
continued to complain about their
tobacco imports from the colonies.
This forced merchants to discount the
price they paid to reflect their uncertainty about quality.
In 1730, Virginia established an
inspection system where hogsheads of

Spring 2004 • Region Focus

37

USDA/KEN HAMMOND

Inspectors appraise a bale of tobacco in a
warehouse in the Danville, Va., area.

tobacco had to be examined and graded
by bonded inspectors at legally established warehouses before they were
shipped to England. Once it was clear
that the system provided a quality
advantage for Virginia tobacco, Maryland followed suit in 1747 and the Carolinas in 1754.
In addition to providing locations
where tobacco could be objectively
evaluated, warehouses also became the
centralized markets for trading the
crop. Merchants and growers continued to directly trade with each other,
making private deals while tobacco was
being inspected. They also interacted
in markets outside of the warehouse
and at plantations.

Markets Discover the
Auctioneer’s Cry
In the early 1800s, the auction system
used by the French became a popular
way to trade tobacco in the Southeast.
“Some planters brought their crops
to market and independently sought …
the most appealing price,” wrote Billy
Yeargin, a Raleigh, N.C. tobacco historian, in his master’s thesis for Duke
University. “Some cried the bids for
their own tobacco or employed
someone else, perhaps the inspector,
to do the job. The intent was to establish competition among purchasers.”
By the 1820s, private auctioneers
stepped forward to help growers get
the best price for their tobacco while
guaranteeing the quality of tobacco.
Just before the Civil War, businessmen in Danville, Va., opened a full-time
38

Region Focus • Spring 2004

auction market whereby tobacco leaves
were stacked into loose piles on the
warehouse floor rather than sold in
hogsheads. This method, which had
been experimented with in Richmond
and elsewhere, allowed buyers to walk
along the piles and closely inspect the
leaves before making a bid.
This “loose-leaf ” auction system
spread throughout Virginia and the
Carolinas. It took longer to take hold
in Maryland, according to historian
Eldred Prince Jr. “Marketing was different in different tobacco regions. In
the tobacco counties of southern Maryland, buyers would often go from farm
to farm buying leaf.”
Overall, auction markets lowered
transaction costs and increased
transparency. Buyers could view crops
from a variety of growers in one place,
and they could use the grades assigned
by inspectors and their own judgment
to make appropriate bids based on their
quality. Farmers also benefited because they
had access to a broader range of offers.
But problems with the auction
system grew as tobacco manufacturers
began producing cigars, pipe tobacco,
and cigarettes in addition to snuff and
chewing tobacco. Each product
required tobacco with specific qualities, yet there was no uniform method
of describing these specifications.
The grading process used by manufacturers to determine prices varied
from company to company and it wasn’t
public knowledge. Thus, farmers still
couldn’t judge whether they were getting
a fair deal out of the auction process.
In fact, they suspected warehouse operators and tobacco buyers of stuffing
their wallets with profits while leaving
them struggling to make ends meet.
To gain more control over pricing,
farmers tried to collectively deal with
buyers outside of the auction system several times during the early 20th century.
One such effort was an organization
formed by farmers called the Tri-State
Tobacco Growers’ Cooperative.
By 1922, the cooperative managed
to control half of the tobacco produced
in North Carolina, South Carolina, and
Virginia. According to Prince, R.J.

Reynolds bought tobacco from the
cooperative, but the two largest buyers
— American Tobacco and Imperial
Tobacco of Great Britain — refused to
deal with it.
These buyers and some warehouse
owners chose to encourage defections
from the cooperative, using accusations
of communism, racist propaganda, and
other tactics. “They dipped their
arrows in venom,” says Prince. The
organization collapsed after five years.
Other efforts failed as well, as Pete
Daniel describes in his book, Breaking
the Land: The Transformation of Cotton,
Tobacco, and Rice Cultures Since 1880. “In
these reform efforts growers found traditional approaches to their problems,
but attempts to implement them failed,
due in part to their lack of organization and dedication but also due to
concerted attacks from the interests
that profited most… There was, in
addition, a strong tradition of rural
independence.”
In recognition of the need for standards in tobacco auction markets, Congress enacted the Tobacco Inspection
Act in 1935, which established the
framework for development of official
grading standards. The legislation also
authorized the Secretary of Agriculture
to designate auction markets where
growers would receive mandatory
inspection of their crops to determine
their grade and type.

Auctions Circumvented in the
Name of Certainty
Today, warehouse floors no longer have
row upon row of tobacco leaves waiting
for inspection. Many facilities have
closed due to lack of volume.
Richard Harris, vice president of
sales and operations for DIMON Inc.,
a Danville, Va.-based leaf dealer, gives
his tally. In Virginia, North Carolina,
South Carolina and two other states
where flue-cured tobacco is produced,
the number of warehouses shrank from
150 to 38 over the last four years.
(Maryland farmers market a special
type of air-cured tobacco.)
Some blame the reduced demand
for American-grown tobacco among

domestic and overseas tobacco manufacturers, who are increasingly buying
from cheaper foreign producers. This
has been reflected in reductions in
federal tobacco quotas during the last
few years.
More importantly, people have been
turning away from the auction system
since 2000 because contractual
arrangements can provide more certainty
and security. About 80 percent of tobacco
is sold on contract, with a farmer
committing his crop to a single buyer.
By bypassing auctions, farmers
know ahead of time what they will
receive for each grade of tobacco when
they bring their crop to a buyer’s
receiving station. In addition, they are
immediately paid for their entire crop
in one transaction and they don’t have
to shell out warehouse charges.
Tobacco buyers — primarily leaf
dealers that make purchases for manufacturers like Philip Morris — also
favor direct contracts. They collect
their purchases at receiving stations
instead of at warehouses where they are
charged fees, and they don’t have to pay
an army of agents to purchase tobacco
from multiple warehouses. (Of course,
some of these cost savings are offset by
the added expense of operating stations.) In addition, buyers get their
tobacco more quickly, decreasing the
amount of waste due to spoilage.
Above all, contracts can give
tobacco buyers more control over their
supply. According to Arnold Hamm,
assistant general manager of the FlueCured Tobacco Cooperative Stabilization Corp., buyers are starting to sign
production contracts with growers that
dictate the quantity and quality of
tobacco they want.
This improved communication benefits farmers as well. They are better
able to match their product to the
demands of the marketplace, within
the limits of Mother Nature, of course.
In contrast, auction markets don’t
always give buyers what they want.
According to a January 2001 report by
agricultural economists at North Carolina State University, farmers harvest
leaves from fewer parts of the stalk

than they used to. Some even harvest
all the leaves with one pass through the
field with no differentiation among
stalk position. This is because the price
they get for leaves from more desirable
stalk positions aren’t sufficiently high
to justify the additional labor costs of
selective harvesting.
In economic lingo, auction markets
have been unsuccessful at transmitting
incentives for quality. “The fact that
cigarette manufacturers do not translate their apparent wishes for separation by stalk position into financial
incentives in the marketplace seems to
bear little economic logic, and has not
been adequately explained by either
cigarette manufacturers, leaf merchants, or auction operators,” noted
the N.C. State report.
Auction markets also haven’t been
able to give buyers enough tobacco to
compete for. Some blame reductions in
quotas that have shrunk the supply of
tobacco too sharply. These reductions
“have brought the size of the U.S. crops
down by more than half in the last five
years,” says DIMON’s Richard Harris.
In response, Philip Morris, the largest
purchaser of U.S. leaf, began contracting for its burley tobacco in 2000. A
year later, R.J. Reynolds, Brown &
Williamson, and Lorillard also started
dealing directly with farmers. “When
you had the largest buyer in the market
doing that, others had to follow suit to
protect their supply.”
Buyers could have paid more for
tobacco to ensure an adequate supply,
since higher prices would have motivated growers to produce more. (The
quota system limits this market
response, although farmers can produce
3 percent above the quota and lease the
right to increase production further.)
Instead, they avoided the perils of price
competition and locked in their supplies with individual farmers.
There are suspicions that buyers are
offering higher contract prices now to
lure farmers out of the auction system
and its price supports. Under the
federal tobacco program, a grower’s
crop is inspected and assigned a grade.
If it fails to get an offer of at least a

penny above the price support established for that grade, the farmer can
sell it to an authorized cooperative or
stabilization corporation. He is paid
using money borrowed from the
USDA’s Commodity Credit Corp., then
the crop is reinspected, processed, and
sold to repay the loans. In this manner,
tobacco farmers are assured a minimum
price for their crops.
Some farmers not only want to
retain price supports, but they also
want the bargaining power that warehouse-based auctions provide them.
Rather than depend on supplying one
buyer at one price, they want the ability
to solicit multiple buyers to get a better
price, especially during shortages.
Farmers also worry that direct contracting favors big agribusiness over the
little guy. Large buyers of tobacco will
likely sign contracts with only largescale farms since smaller ones don’t
have the capacity to provide the quantities they are looking for or the technology to meet their quality standards.
Regardless of the reasons, contract
buying is likely here to stay, just as it is
for other agricultural goods like produce
and poultry. Whether auction markets
will be around is another question. The
number of buyers and sellers bargaining
on the warehouse floor may eventually
be too small to sustain this historic means
of marketing tobacco.
RF
READINGS
Brown, Blake and Tomislav Vukina. “Provision of
Incentives in Agricultural Contracts: The Case of
Flue-Cured Tobacco.” Working Paper, North
Carolina State University, January 2001.
Dimitri, Carolyn. Contracting in Tobacco? Contracts
Revisited. Washington, D.C.: Economic Research
Service, U.S. Department of Agriculture, June
2003.
Middleton, Arthur Pierce. Tobacco Coast: A
Maritime History of Chesapeake Bay in the Colonial
Era. Newport News, Va.: Mariners’ Museum, 1953.
Robert, Joseph Clarke. “Rise of the Tobacco
Warehouse Auction System in Virginia, 18001860.” Agricultural History, October 1933, vol. 7,
no. 4, pp. 170-182.
Visit www.rich.frb.org/pubs/regionfocus for
links to relevant Web sites.

Spring 2004 • Region Focus

39

District Economic D
BY ROBERT LACY

Output of goods
and services in the
Fifth District
appeared to expand
at a relatively brisk
pace, and unemployment rates
edged down in the
final quarter of
2003. Payroll
employment, however, was slightly
lower than a year
ago, suggesting that
many employers
remained cautious
about hiring.

Did You Know. . .
Hickory. High Point.
Drexel. Thomasville.
If you shop for furniture, you may associate these names
with some of the
best-known furniture
brands around. What
you may not know is
that they are all
small towns in North
Carolina, where
quality furniture has
been manufactured
for more than 100
years. According to
2001 Census data,
more people are
employed in
furniture manufacturing in North
Carolina than in
any other state in
the country.

40

A rebound in manufacturing output capped a
fourth quarter of solid economic performance
in the Fifth District, but anemic payroll
employment data continued to raise doubts
about the vigor of this economic recovery.
Outside of the hard-hit textile sector, most
District manufacturers reported higher shipments throughout the quarter. Additionally,
District retailers said that sales during the
holiday season were good and generally met
their expectations.

Retail Sales Solid
The District’s retail sector also expanded at a
solid pace in the fourth quarter of 2003. District
retailers posted fairly strong holiday sales,
especially during the last few weeks of December.
Two upscale regional malls opened in the
Richmond, Va., metropolitan area, expanding
the retail sector there and boosting fourthquarter employment. Retail employment in
the District overall, however, grew only 0.2
percent in the fourth quarter compared to a
year ago.

Manufacturing Turns Up
The District’s manufacturing sector rebounded
in the fourth quarter — our monthly survey of
manufacturers indicated that shipments and
new orders rose in each of the final three
months of the year. According to our survey
indexes, fourth-quarter performance was the
strongest since spring 2002.
Despite the pickup, however, there remained
a sense that the manufacturing recovery was
fragile. Many District manufacturing firms
continued to struggle, even outside the longsuffering textiles and apparel sectors. A District
plastics manufacturer, for example, told us, “I
thought the manufacturing economy was getting
better. Unfortunately, after a small spurt, things
have gone south again.”
In short, although District manufacturing
appears to be on the mend, the sector has not
completely recovered.

Furniture Manufacturing Employment, 2001*
75,581

Labor Markets Mixed
In contrast to the generally upbeat business
readings, the news from the District’s labor
markets was mixed. The U.S. Department of
Labor’s monthly survey of establishments indicated that Fifth District employment dropped
slightly from a year ago. But, on a brighter
note, the District’s unemployment rate edged
lower in the fourth quarter, to 5.1 percent.
The latest unemployment rates suggest substantial differences in economic conditions
across the District. In the Carolinas, the
unemployment rate remained above 6 percent
in December, a little higher than the U.S.
average. By contrast, Virginia’s 3.6 percent
unemployment rate for the month was the
third lowest in the nation. The unemployment
rate in the Washington, D.C., metropolitan
area was a remarkable 3.0 percent in December — the lowest rate for a large metropolitan
area in the United States.

Housing Leveling Off

20,396

NC

VA

5,493

4,310

SC

MD

1,323
WV

*The estimate for Washington, D.C., ranges from 100 to 249.

Region Focus • Spring 2004

The housing sector has continued to be a star
over the last few years, holding up remarkably
well during and after the 2001 recession.
Boosted in part by exceptionally low mortgage
rates, housing starts and home sales surged
through 2002 and much of 2003.
But housing activity began to show signs of
leveling off in late 2003. District building
permits were flat in the fourth quarter of 2003
compared to a year ago. For the year as a
whole, building permits in Fifth District states
dropped by a slight 0.5 percent.

c Developments
Nonfarm Employment

Unemployment Rate

Personal Income

Fourth Quarter 2003

Percent

Third Quarter 2003

DC
MD
NC
SC
VA
WV
5th District
US

Employment
(Thousands)
669
2,467
3,835
1,778
3,523
725
12,997
130,109

% Change
(Year Ago)
0.9
-0.2
0.1
-2.3
0.7
-0.6
-0.1
-0.2

4th Qtr.
2003
6.7
4.2
6.1
6.7
3.6
5.6
5.1
5.9

DC
MD
NC
SC
VA
WV
5th District
US

4th Qtr.
2002
6.5
4.2
6.6
6.2
3.9
6.2
5.3
5.9

Fifth District

DC
MD
NC
SC
VA
WV
5th District
US

Income
($ billions)
25.4
205.0
236.4
108.2
247.9
44.0
867.1
9,248.0

United States

Nonfarm Employment

Unemployment Rate

Personal Income

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2003

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2003

4%

8%

3%

7%

% Change
(Year Ago)
2.7
3.5
2.8
3.3
3.4
3.2
3.2
3.6

First Quarter 1992 - Third Quarter 2003

9%
8%
7%

2%

6%

6%

5%

1%
5%

4%

0

3%

4%

-1%

2%

-2%
1992

1994

1996

1998

2000

2002 2003

3%

1992

1994

1996

1998

2000

2002 2003

FRB—Richmond
Services Revenues Index

FRB—Richmond
Manufacturing Shipments Index

First Quarter 1994 - Fourth Quarter 2003

First Quarter 1994 - Fourth Quarter 2003

1%

1992

1994

1996

1998

2000

2002 2003

Unemployment Rate
First Quarter 2000–Fourth Quarter 2003

40

40

8%

30

30

7%

20

20

10

10

0

0

-10

-10

-20

-20

MD
NC
SC
VA

6%
5%

-30

4%
3%

-30
1994

1996

1998

2000

2002 2003

2%
1994

1996

1998

2000

2002 2003

2000

2001

2002

NOTES:

SOURCES:

1) All data series are seasonally adjusted.
2) FRB-Richmond survey indexes are diffusion indexes. Positive numbers represent expansion, negative
numbers contraction.
3) State nonfarm employment estimates are based on surveys of establishments. These employment
figures differ from those used to calculate state unemployment rates.

Income: Bureau of Economic Analysis, U.S. Department of Commerce, http://www.bea.doc.gov
Unemployment rate: LAUS Program, Bureau of Labor Statistics, U.S. Department of Labor,
http://stats.bls.gov
Employment: CES Survey, Bureau of Labor Statistics, U.S. Department of Labor, http://stats.bls.gov

2003

For more information, contact Robert Lacy at 804-697-8703 or e-mail Robert.Lacy@rich.frb.org.

Spring 2004 • Region Focus

41

DISTRICT OF COLUMBIA

BY ANDREA HOLLAND

ith weak labor market conditions in the District of Columbia since the onset of the recession in 2001, initial unemployment claims have
received much attention from business analysts. Movements in the level of initial claims for unemployment
insurance (UI)—insurance against loss of income due
to unemployment—are considered a leading economic
indicator because, over time, they are helpful in
gauging future labor market activity. Decreases in
initial claims typically foretell a strengthening labor
market, while rising initial claims indicate weakening
labor market conditions.

W

In the District of Columbia, following a pickup in
initial claims in late 2001, payroll employment growth
slowed. In 2003, however, initial claims eased in each
quarter, and for the year, were 10.8 percent below the
2002 level. Following this decline, the pace of job
growth picked up. Employers increased payrolls by 4.4
percent in the fourth quarter of 2003, marking the
largest quarterly payroll gain since 1999.
Despite the importance of using initial claims as a forecasting tool, many applicants do not reap UI benefits.
Nationwide, for example, program participation
reached only 41 percent in 2003, in part because large
segments of the unemployed don’t meet set requirements for wages earned or time worked prior to
becoming unemployed. In the District of Columbia,
only 38 percent of the jobless participated in the
program in 2003.
For those who meet program requirements, UI benefits can extend for up to 26 weeks. In 2003, on average,
UI benefits were collected for 16 weeks nationwide
while in the District of Columbia, for 20 weeks. The
duration of a job search typically lengthens in economic downturns, prompting more participants to
receive the full 26-week allotment. In the District of
Columbia, for instance, the percentage of participants
receiving full-term UI benefits jumped from 50 to 80
percent from 2000 to 2003, respectively.
Many participants choose a job over fully exhausting
their UI benefits because the program replaces only a
portion of their wages. Weekly UI benefits in the District of Columbia were typically $255 in 2003, or 25
percent of the District of Columbia’s average weekly
wage of $1,039. By comparison, participants nationwide collected $259 a week, or 37 percent of the average
weekly wage of $701.

42

Region Focus • Spring 2004

Unemployment Insurance:
Initial Claims Applications
Percent Change From Prior Year

150
US

DC

100

50

0

-50
98

99

00
01
02
03
Shaded Bar Represents Recession

SOURCE: U.S. Department of Labor

4th Qtr
2003

Nonfarm Employment
Manufacturing, NSA
Professional/Business Services
Government
Civilian Labor Force

Unemployment Rate
Building Permits, NSA
Home Sales

Percent Change
at Annual Rate From
3rd Qtr 4th Qtr
2003
2002

668.6
2.8
142.5
230.5
311.9

4.4
0.0
3.3
3.9
2.0

0.9
-3.4
2.5
0.3
3.2

4th Qtr
2003

3rd Qtr
2003

4th Qtr
2002

6.7
87
17.3

6.6
182
16.3

6.5
394
15.2

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, not seasonally adjusted (NSA); BLS/Haver Analytics
Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®

U

MARYL AND

BY ANDREA HOLLAND

n Maryland, business analysts have closely watched
initial unemployment claims because job growth has
remained sluggish while other indicators of economic
performance have advanced. Initial claims measure
first-time applicants for unemployment insurance
(UI)—which replaces a portion of income if an applicant has been terminated through no fault of his own.
Initial claims are one of 11 leading indicators used by
the Department of Commerce to measure economic
trends in the near future, particularly payroll activity.
When initial claims rise, unemployment is also usually
rising, suggesting weaker labor market conditions.

I

Unemployment Insurance:
Initial Claims Applications
Percent Change From Prior Year

150
US

MD

100

50

0

-50
98

99

00
01
02
03
Shaded Bar Represents Recession

SOURCE: U.S. Department of Labor

4th Qtr
2003

Nonfarm Employment
Manufacturing
Professional/Business Services
Government
Civilian Labor Force

Unemployment Rate
Building Permits, NSA
Home Sales

2,467.5
151.7
360.1
463.3
2,924.7

Percent Change
at Annual Rate From
3rd Qtr 4th Qtr
2003
2002

-3.8
-1.7
-3.7
0.4
0.0

-0.2
-1.7
-1.4
0.0
0.8

4th Qtr
2003

3rd Qtr
2003

4th Qtr
2002

4.2
6,878
142.1

4.3
6,602
140.0

4.2
6,488
122.3

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Building Permits, number of permits, not seasonally adjusted (NSA); U.S. Census Bureau/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®

Illustrating this relationship, initial claims in Maryland
headed higher in two quarters prior to the onset of the
most recent recession. Three quarters later, in the first
quarter of 2001, payroll employment began to weaken.
Of late, initial claims have moderated. After peaking
in early 2003, initial claims contracted on a year-overyear basis in the third and fourth quarters. The dropoff is encouraging, as Maryland’s labor market
continued to struggle in 2003. Payroll growth was negative in the fourth quarter of 2003, and the state lost
23,700 jobs, reducing employment to its lowest level
since late 2002.
Regardless of the role of initial claims as a key gauge of
future payroll activity, a large number of applicants do
not receive UI benefits. For instance, of those unemployed in Maryland in 2003, only 39 percent participated
in the state’s UI program. Typically, a large share of the
jobless don’t meet state requirements for wages earned
or time worked prior to being separated from their jobs.
During recessionary periods, Maryland residents
meeting program requirements, on average, will draw
UI benefits for a longer period of time. For example,
in 2000, participants typically collected UI benefits for
13 weeks. By 2003, the average collection period had
climbed to 16 weeks. The share of persons receiving UI
benefits for the full 26 weeks allotted generally rises
during business cycle downturns. From 2000 to 2003,
full-term collectors increased from 28 to 35 percent.
Full-term collectors are somewhat limited due to the
program replacing only a share of lost wages, making
employment more attractive. Typically, Maryland’s
insured received 35 percent of the state’s average weekly
wage in 2003. Maryland’s replacement rate is on target
when viewed against programs nationwide: Participants
collected 37 percent of the average weekly wage.

Spring 2004 • Region Focus

43

hN O R T H

CAROLINA

BY ANDREA HOLLAND

A

lthough the North Carolina economy has
expanded in recent quarters, the pace of job creation in the state remains weak, pushing initial claims
for unemployment insurance (UI)— government-sponsored protection that replaces a portion of lost wages
—into the spotlight. Economists watch closely for
changes in the number of initial claims filed because,
typically, a rise in initial claims has often preceded a
drop in nonfarm employment and vice versa.
This association was intact during the most recent
business cycle in North Carolina: Two quarters after
initial claims spiked up, job numbers in the state began
to erode. The latest statistics show that initial claims
have trended down in the last three consecutive quarters, but the labor market has yet to pick up. But some
good news is in evidence. The pace of job losses has
slowed on a year-over-year basis, and payrolls contracted a modest 0.1 percent in 2003, following declines
of 1.0 and 1.5 percent in 2000 and 2001, respectively.
Notwithstanding the value of initial claims as a
forward-looking estimate of labor market conditions,
some claimants do not collect UI. Typically, the participation rate is fairly low because a large number of
unemployed don’t meet set requirements for wages
earned or time worked prior to becoming unemployed.
Illustrating this, the portion of jobless North Carolinians receiving UI benefits was only 41 percent in
2003, matching the national rate.
For eligible North Carolinians, UI benefits extend for
up to 26 weeks. North Carolina residents received UI
for a shorter period of time than any other District
state in 2003, drawing UI benefits for 13 weeks, on
average. Economic downturns typically increase the
proportion of claimants who collect UI benefits for
the 26-week maximum. For example, from 2000 to
2003, the share soared from 20 to 39 percent, the
second most extreme rise districtwide.
But many jobless opt for employment over collecting
the full UI benefit allowed because UI replaces only
a portion of wages. In 2003, North Carolina’s typical
weekly UI benefit amount matched the national rate.
The UI benefits in North Carolina were typically $259
a week in 2003, 41 percent of the state’s average weekly
wage of $628. By comparison, participants nationwide
also received $259 a week, but the UI benefits replaced
only 37 percent of the national average weekly wage
of $701.

44

Region Focus • Spring 2004

Unemployment Insurance:
Initial Claims Applications
Percent Change From Prior Year

150
US

NC

100

50

0

-50
98

99

00
01
02
03
Shaded Bar Represents Recession

SOURCE: U.S. Department of Labor

4th Qtr
2003

Nonfarm Employment
Manufacturing
Professional/Business Services
Government
Civilian Labor Force

Unemployment Rate
Building Permits, NSA
Home Sales

Percent Change
at Annual Rate From
3rd Qtr 4th Qtr
2003
2002

3,835.4
597.2
426.6
658.7
4,187.5

0.4
-4.8
-0.6
5.8
1.1

0.1
-4.8
3.0
0.3
0.8

4th Qtr
2003

3rd Qtr
2003

4th Qtr
2002

6.1
19,448
305.3

6.5
20,761
314.0

6.6
20,963
250.4

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Building Permits, number of permits, not seasonally adjusted (NSA); U.S. Census Bureau/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®

SOUTH CAROLINA

o

BY ANDREA HOLLAND

espite robust growth, the post-recession economy in South Carolina has failed to create many
jobs. As a result, initial claims for unemployment
insurance (UI)—social insurance benefit funded by
business payroll taxes that protects workers against
loss of income due to involuntary job loss—have
increasingly made headlines. Initial claims are one of
10 measures that make up the Conference Board’s
composite index of leading indicators, which is
designed to signal peaks and troughs in the business
cycle. Usually, an increase in initial claims is triggered
by rising unemployment, suggesting weaker labor market conditions.

D

Unemployment Insurance:
Initial Claims Applications
Percent Change From Prior Year

150
US

SC

100

50

0

-50
98

99

00
01
02
03
Shaded Bar Represents Recession

SOURCE: U.S. Department of Labor

4th Qtr
2003

Nonfarm Employment
1,777.9
Manufacturing, NSA
271.0
Professional/Business Services, NSA
179.2
Government
329.7
Civilian Labor Force
2,029.4

Unemployment Rate
Building Permits, NSA
Home Sales

Percent Change
at Annual Rate From
3rd Qtr 4th Qtr
2003
2002

0.5
-4.5
1.3
6.0
0.2

-2.3
-6.4
-2.5
-1.8
2.4

4th Qtr
2003

3rd Qtr
2003

4th Qtr
2002

6.7
8,212
150.3

6.5
9,703
155.3

6.2
6,711
125.5

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, not seasonally adjusted (NSA); BLS/Haver Analytics
Professional/Business Services, thousands of jobs, NSA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®

In most Fifth District states, rises and falls in initial
claims lead payroll activity by roughly a year. The relationship is not as strong in South Carolina though.
Initial claims and payroll employment growth weakened concurrently in 2000 and have continued to track
one another in recent periods. For the year just ended,
initial claims and employment activity remained sluggish in South Carolina. But looking only at the fourth
quarter, statistics were more encouraging: Over the
year, initial claims contracted by 10 percent.
Even though initial claims data are believed to be a
reliable predictor of future shifts in employment, many
residents who submit an initial claim do not collect
UI. In 2003, for example, only 39 percent of the jobless
in South Carolina were enrolled in the UI program.
The participation rate is typically low because large
segments of the jobless don’t meet state requirements
for wages earned or time worked prior to being separated from their jobs.
As in most states, jobless South Carolinians who qualify
for the program may receive UI benefits for up to 26
weeks. In 2003, the average South Carolinian collected
UI benefits for 13 weeks, about three weeks less than
the typical job hunt lasted nationwide. Not all unemployed find jobs in the 26-week period, however, especially during slumps in the business cycle. For instance,
41 percent of South Carolina program participants collected UI benefits for the full term in 2003, up from
25 percent in 2000.
For many participants, employment is more attractive
than collecting UI benefits because UI only replaces
a share of lost wages. In 2003, South Carolina’s wage
replacement rate matched the national rate.

Spring 2004 • Region Focus

45

uVIRGINIA
BY ANDREA HOLLAND

apid growth of Virginia’s economy in mid-2003
has so far translated into weak job creation,
boosting business analysts’ interest in initial unemployment claims. The Department of Labor tracks
changes in the number of first-time applicants for
unemployment insurance (UI), which replaces a share
of income while the unemployed search for a new job.
Decreases in initial claims typically point to a
strengthening labor market, while rising initial claims
foretell weakening labor market conditions.

R

For example, going into the recession of 2001, Virginia
businesses began to shed workers two quarters after
initial claims began to rise. Coming out of the recession, payroll employment in Virginia began to pick up
in early 2003, roughly a year after initial claims began
to head lower. Since then, job numbers in Virginia have
steadily trended upward, and businesses added 19,700
workers in the fourth quarter of 2003, pushing total
employment growth for the year into positive territory.
Despite the importance of initial claims data as a reliable forecasting tool, many first-time applicants are
not accepted to the program. For instance, Virginia
had the smallest percentage of insured unemployed in
the Fifth District in 2003—only 36 percent. During
the same period, the nationwide participation rate
stood at only 41 percent, largely because many unemployed don’t meet set requirements for wages earned
or time worked prior to becoming unemployed.
For the unemployed meeting program requirements,
UI benefits can be collected for up to 26 weeks, though
many find jobs before the term expires. Prior to the
recession in 2001, participants in Virginia received UI
benefits for 10 weeks on average. In 2003, however,
the collection period reached 14 weeks—marking the
largest jump districtwide. The proportion of claimants
who collect all 26 weeks of their UI entitlement (also
known as the exhaustion rate) typically rises during
economic downturns. For example, Virginia’s exhaustion rate reached 41 percent in 2003, up from 25
percent in 2000.
Many participants choose a job over exhausting their UI
benefits because the program replaces only a portion of
their wages. The typical UI benefit in Virginia equaled
roughly 38 percent of the state’s average weekly wage in
2003. When viewed against the national average, Virginia’s replacement rate is on point. Nationwide, participants collected 37 percent of the average weekly wage.

46

Region Focus • Spring 2004

Unemployment Insurance:
Initial Claims Applications
Percent Change From Prior Year

150
US

VA

100

50

0

-50
98

99

00
01
02
03
Shaded Bar Represents Recession

SOURCE: U.S. Department of Labor

4th Qtr
2003

Nonfarm Employment
Manufacturing
Professional/Business Services
Government
Civilian Labor Force

Unemployment Rate
Building Permits, NSA
Home Sales

Percent Change
at Annual Rate From
3rd Qtr 4th Qtr
2003
2002

3,523.0
304.4
548.4
646.1
3,796.7

2.3
-2.5
-1.9
3.5
0.1

0.7
-4.7
0.8
1.4
1.6

4th Qtr
2003

3rd Qtr
2003

4th Qtr
2002

3.6
14,069
186.8

3.8
14,230
180.1

3.9
14,262
161.8

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®

WEST VIRGINIA

w

BY ANDREA HOLLAND

est Virginia’s labor market remains lukewarm
despite steady growth in other sectors of the
economy, prompting economists to keep a close eye on
initial unemployment claims, which measure newly
laid-off workers and are used to forecast trends in the
labor market. Initial claimants are first-time applicants for unemployment insurance (UI)—a compensation plan by which the federal and state government
provides money to workers who’ve lost their jobs
through no fault of their own. Typically, when initial
claims rise, unemployment is usually rising, suggesting
weaker labor market conditions.

W

Unemployment Insurance:
Initial Claims Applications
Percent Change From Prior Year

150
US

WV

100

50

0

-50
98

99

00
01
02
03
Shaded Bar Represents Recession

SOURCE: U.S. Department of Labor

4th Qtr
2003

Nonfarm Employment
Manufacturing
Professional/Business Services
Government
Civilian Labor Force

Unemployment Rate
Building Permits, NSA
Home Sales

Percent Change
at Annual Rate From
3rd Qtr 4th Qtr
2003
2002

724.7
64.6
58.3
141.0
798.1

-2.8
-5.6
-4.7
3.0
-3.5

-0.6
-4.4
1.7
-0.8
0.5

4th Qtr
2003

3rd Qtr
2003

4th Qtr
2002

5.6
1,126
35.2

6.4
1,291
33.6

6.2
992
29.5

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics
Manufacturing, thousands of jobs, SA; BLS/Haver Analytics
Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics
Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics
Unemployment Rate, percent, SA; BLS/Haver Analytics
Building Permits, number of permits, not seasonally adjusted (NSA); U.S. Census Bureau/Haver Analytics
Home Sales, thousands of units, SA; National Association of Realtors®

For more information regarding state summaries, call 804-697-8273 or
e-mail Andrea.Holland@rich.frb.org.

On average, initial claims data lead payroll employment growth by just under a year in the Fifth District.
But in West Virginia, initial claims have a longer lead
time. Illustrating this, initial claims in the state rose
in the fourth quarter of 1999, but payroll employment
didn’t weaken until five quarters later. The latest data
show that initial claims peaked in the first quarter of
2003, and have since trended down. The turnaround
is encouraging, as West Virginia’s labor market has yet
to show much improvement. The state shed 5,100 jobs
in the fourth quarter, marking the third straight quarter
of eroding payrolls.
Notwithstanding the significance of initial claims as a
reliable approximation of future payroll activity, large
segments of initial claims applicants do not meet the
program’s enrollment criteria. Nationwide, for instance,
participation rates are only 41 percent because a large
portion of the jobless don’t meet set requirements for
wages earned or time worked prior to being separated
from their jobs. Of the unemployed in West Virginia
in 2003, only 39 percent were program participants.
During recessionary periods, the insured unemployed
in West Virginia typically draw UI benefits for longer
periods of time. For example, the average collection
period reached 15 weeks in 2003, up from 13 weeks
in 2000.
West Virginians can collect UI benefits for up to 26
weeks, but for many participants securing new
employment is more attractive than collecting UI benefits because UI replaces only a share of lost wages.
Typically, West Virginians received $222 a week in
2003, or 41 percent of the state’s average weekly wage
of $540. By comparison, participants nationwide collected $259 a week, only 37 percent of the average
weekly wage of $701.

Spring 2004 • Region Focus

47

OPINION
Is the Market Moral?
BY A A RO N ST E E L M A N

E

conomists are often asked to advise government offiRawls’ Egalitarianism
cials on policy issues, including many that are imbued
John Rawls reignited interest in social contract theory with
with moral content. Consider, for instance, the subhis 1971 book A Theory of Justice. According to Rawls, people
ject of this issue’s cover story—health care. Some people
should act as if they are standing behind a “veil of ignorance”
argue that health care is a human right and that the governwhen choosing rules to govern society. In other words, they
ment should provide a minimum level of medical coverage
should pretend that they are in the “original position” and
to everyone. Or consider the issue of taxation. Some believe
know nothing about the social class they will be born into
that the United States should adopt a more progressive
or the abilities they will possess. In such a situation, Rawls
income tax structure so that the rich would pay a higher
argued, people will follow the “maximin” rule: They will pick
percentage of total taxes, while others believe just the
a society that puts its least fortunate individuals in the least
opposite, that the only “fair” tax is a flat tax.
unfortunate situation—in short, a society that takes extreme
Economics, however, is a positive science. As such it
caution to protect people from economic hardship. Rawls’
can’t provide answers to these kinds of moral questions. The
theory was enormously influential, but it begged the folrole of the economist is to describe the
lowing question: Are people really so
consequences of public policies, not to
risk-averse? If not, they may opt for a
prescribe them. For instance, econosystem that would still protect them
mists can advise policymakers about
from misfortune but would not involve
“The role of the economist
the most efficient way to achieve unithe level of government intervention
versal health care coverage, but not
that is probably required to maintain
is to describe the
whether the goal itself is wise or worthe maximin rule.
consequences of
thy. To answer that question, we must
Nozick’s Libertarianism
turn to the realm of ethics.
public policies, not to
There are, of course, many competRawls’ Harvard colleague Robert Nozick
ing ethical theories. But three deserve
penned his 1974 book Anarchy, State, and
prescribe them.”
special mention: utilitarianism, egaliUtopia largely in response to Rawls’ work.
tarianism, and libertarianism. All three
Nozick argued that individuals “have
traditions are rich and have many disrights, and there are things no person or
tinguished proponents. But for simplicity we will associate
group may do to them.” This led him to conclude that “a
each with a specific writer: John Stuart Mill, John Rawls, and
minimal state, limited to the narrow functions of protection
Robert Nozick, respectively.
against force, theft, fraud, enforcement of contracts, and so
on, is justified; that any more extensive state will violate
Mill’s Utilitarianism
persons’ rights not to be forced to do certain things.” Nozick’s
book was tightly argued. But it required readers to accept its
Utilitarianism posits that public policies should be judged by
central premise—that people do, indeed, have natural rights—
their consequences. In the early 1860s, for instance, Mill
as a given. He did little to show how this assumption could
argued that actions “are right in proportion as they tend to
be derived rationally.
promote happiness; wrong as they tend to produce the reverse
of happiness.”
Whom to Believe?
Utilitarianism faces a number of criticisms. The most basic
perhaps is: How do you measure happiness? Mill and his
When pressed, followers of each of these theories will admit
mentor, Jeremy Bentham, recognized this problem and sugtheir limitations. (For instance, few egalitarians would choose a
gested that pleasure be measured in units called “utiles,” but
desperately poor society in which everyone earned the same
they were less clear about how this could be done in pracsmall amount of money over the present-day United States, which
tice. Utilitarianism has also been criticized because it supis less equal but much richer.) Still, each theory presents an inposedly ignores problems of “justice.” Certain actions, critics
triguing way of looking at the world that can help us choose what
maintain, are wrong by their very nature and a just society
we wish to accomplish with public policy. And once that has been
would prohibit them. Mill agreed that some things, such as
decided, economics can help us determine the most efficient
theft, should generally be prohibited—not because they are
means to achieve these ends. It is important, though, not to coninherently wrong, but rather because they tend to lower
flate the two: Ethics has its role, as does economics, but the two
overall well-being.
should remain clearly distinct.
RF
48

Region Focus • Spring 2004

NEXTISSUE
Back to School
Layoffs in the manufacturing and information technology
sectors have put thousands of workers in the Fifth District
back on the job market. Many have returned to school to
acquire new skills that they hope will make it easier to land,
and keep, their next jobs. What sort of retraining programs
are available in the region — and which have proven to be
the most effective?

Secondhand Pollution
North Carolina has petitioned the Environmental Protection
Agency to crack down on air pollution coming from coal-fired
power plants in 13 other states. Policymakers in the Tar Heel
State say action is necessary to keep the skies clean, but
others worry that such measures could chill economic
development and cost jobs at a time when employment
figures are already weak.

Interview
An interview with Kenneth Elzinga, an
antitrust expert at the University of Virginia
and co-author of the “Marshall Jevons”
mystery novels, whose central character uses
economic logic to solve crimes.
Jargon Alert
You may think elasticity applies only to
rubber bands and spandex, but the term is
used by economists in a variety of contexts.
Research Spotlight
Does school choice increase school quality?
New data from North Carolina.

Drug Reimportation
Prescription drugs are often cheaper to buy in Canada than in
the United States, where many are originally developed and
produced. But their reimportation back to the United States is
currently prohibited. Would lifting this ban help senior
citizens and other prescription drug users throughout the Fifth
District, as some claim? Or would the benefits be illusory?

The Summer 2004 REGIONFOCUS
will be published in July.
Articles will also be available
online at www.rich.frb.org/
pubs/regionfocus.

Historically Black Colleges
The Fifth District has a large number of historically black
colleges and universities (HBCUs). Those schools have
educated generations of students, but some institutions are
coming under severe financial pressure, as black students
enroll in ever-larger numbers at schools that once prohibited
or discouraged their attendance. What does the future hold
for HBCUs?

To receive an e-mail notice
when each new issue of
REGIONFOCUS can be viewed
online, please contact
rich.regionfocus@rich.frb.org.

F R B

R I C H M O N D

Economic Quarterly
T

he Richmond Fed’s Economic
Quarterly contains original
research from the Bank’s economists and visiting scholars. To be
added to the EQ mailing list or to
view the issues online, please visit
http://www.rich.frb.org/pubs/eq.

Winter 2004: Vol. 90, No. 1
K J. Alfred Broaddus, Jr., Macroeconomic Principles and Monetary
Policy
K Thomas M. Humphrey, Classical Deflation Theory
K Raymond E. Owens and Pierre-Daniel G. Sarte, Accommodating
Rising Population in Rural Areas: The Case of Loudoun County,
Virginia
K John R. Walter, Closing Troubled Banks: How the Process Works

Fall 2003: Vol. 89, No. 4
K Elise A. Couper, John P. Hejkal, and Alexander L. Wolman, Boom
and Bust in Telecommunications
K Andreas Hornstein and Per Krusell, Implications of the CapitalEmbodiment Revolution for Directed R &D and Wage Inequality
K Yash P. Mehra and Elliot W. Martin, Why Does Consumer Sentiment
Predict Household Spending?
K Edward Simpson Prescott, Firms, Assignments, and Earnings

Summer 2003: Vol. 89, No. 3
K
K
K
K

John A. Weinberg, Accounting for Corporate Behavior
Robert L. Hetzel, Japanese Monetary Policy and Deflation
Margarida Duarte, The Euro and Inflation Divergence in Europe
James H. Stock and Mark W. Watson, How Did Leading Indicator
Forecasts Perform During the 2001 Recession?

Spring 2003: Vol. 89, No. 2
K J. Alfred Broaddus, Jr., Monetary Policy in a Low Inflation
Environment
K John R. Walter, Banking and Commerce: Tear Down This Wall?
K Kartik Athreya, Unemployment Insurance and Personal Bankruptcy
K Huberto M. Ennis, Economic Fundamentals and Bank Runs

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