Saturday, February 25, 2012

Cyber Schools via SB 619: A Cost Effective Opportunity - If We Do It Intelligently

The ability for students to take K-12 courses online is a good thing. Many advanced students can earn credits and advance their college readiness and/or high school graduation date. Struggling students can earn credits to catch up on courses they may have previously failed or to make up for the credits they missed by failing one or more courses. Online learning offers another way to learn that fits some students learning styles better than the traditional classroom.


To enhance the use of online learning in our traditional public schools through a “blended model”, I will support the following:

  1. Eliminate the need for getting “seat time waivers”, by requiring MDOE to establish an after the fact reporting system instead, based on previously adopted qualifications criteria. HB 5392 (Rep. O’Brien) may be the vehicle to get this accomplished.

  2. Require the Michigan Department of Education to execute a Request for Proposal process for online course providers to bid to provide individual courses that public schools across the state can purchase, similar to how MIDeal works for trucks and other items. This has the potential to lower the costs of individual courses students may access to accelerate their progress or make up classes needed to graduate.

  3. Amend the Public Employee Relations Act (PERA) to make the offering of online classes, the awarding of credits for online classes or the supervision of students taking online classes an impermissible subject of bargaining. Unless this is so designated, as a “work condition”, it is a mandatory subject of bargaining under current collective bargaining law, and often used as an impediment for school districts to implement online learning, other than as a “pilot program” which currently has that protection.

    MCL 423.215  currently states the following is an impermissible subject of bargaining: 
    “Decisions concerning use of experimental or pilot programs and staffing of experimental or pilot programs and decisions concerning use of technology to deliver educational programs and services and staffing to provide the technology, or the impact of these decisions on individual employees or the bargaining unit.”

    The language regarding cyber learning, however, when mixed in with the pilot program language, has been unclear and a continuing point of contention in negotiations with teacher unions. Clarity would help.

Another benefit of cyber schools is that they may be more efficient and thus cost less per student. This is a good thing. But herein lies an issue. "For state aid purposes, the State School Aid Act provides that the per pupil foundation allowance for PSAs (including cyber schools) is equal to the foundation allowance of the school district in which the PSA school is located, subject to a maximum PSA foundation allowance of $7,110." House Fiscal Agency Memorandum dated 12-5-2011

The simple truth is, we really don't know just what the costs of the full-time online schools are. But, the sources noted in the Appendix below appear to indicate that the full-time online schools can and do operated at a lower cost per student. If that is true, as a fiscal conservative, it does not appear that we should pay any more than we have to.

It is important when setting up an entirely new system of delivering education that the question be asked, “How should this be funded? Is following the same payment system as for the traditional public school wise if the cyber schools have an entirely different cost structure?”


To the extent that the cyber schools can offer the courses at lower cost, the profits would go to the providers. Now, there is nothing wrong or evil about profits in a free enterprise system, but profits offered in a price fixed system are not good. Prices fixed at higher than market clearing prices will not result in an optimal allocation of resources. The supply will proliferate and drain money from the traditional public schools. This is particularly true when SB 619 would allow the online schools to cherry pick the lowest cost grade levels to offer, to maximize profits. My preference would be that if we can get these services at a lower cost for equal or better quality, the savings should go to the taxpayers.

Differing Costs by Grade Level. It is generally acknowledged that it costs different amounts of money to educate an elementary student than a middle school student or a high school student. Middle and high schools offer more extracurricular activities, such as sports, band and drama. A higher proportion of elementary students ride the busses than high school students, many of whom drive themselves to school, and thus cost more for bussing per student. Middle and high schools typically require more administrators per student than elementary schools. The differences go on and on. Nonetheless, when it comes to funding traditional public schools, the foundation grant per student is the same, regardless of the mix of elementary, middle and high school students in a school or school district. Over time, the schools have simply managed their expenses within the funds allocated to them, accommodating the cost differences. Whether traditional public schools should be allocated different amounts for different levels of students is an open question, but one left for another day. Nonetheless, the question is very pertinent for online cyber schools.

Charter Schools? This difference in cost of differing grades issue has been brought up in the context of regular charter schools, also known as public school academies. To the extent that many charters only offer elementary school grades, critics charge that they are unfair competition with traditional public schools because the charters only admit the students that they can educate cheaply. Also, charter school are not required to participate in the Michigan Public School Employees Retirement System, into which the traditional public schools have to pay 24.46% of wages paid into the system in the 2011-12 school year and projected to be 27.37% in the coming school year unless reforms are made. Charter supporters counter with the argument that the charters can only receive the lowest foundation grant that any traditional public school receives and that, in contrast with traditional public schools, charters cannot levy school bond millages for facilities, but must pay for the brick and mortar through the foundation grant funds. The ultimate resolution of this significant argument is also left for another day.


A Procurement Model Option? I have explored the possibility of some system under which online education providers would be required to bid to provide the services so that the costs to the state reflect the actual costs plus reasonable profit to the providers. What I would like to create is a free market, competitive system where price discovery occurs naturally. A bidding process would require each provider to adjust its bids according to those different costs of providing the service for whatever combination of education services it seeks to provide or risk being outbid. However, so far I have not come up with how this could be done.

Arbitrary Foundation Grant? Alternatively, an arbitrary "foundation grant" amount will be paid to the cyber schools. If set as the basic foundation grant received by traditional public schools, I don’t know why we would want to pay a Cadillac price for an Chevy Impala product. That simply is not fighting for the hardworking taxpayer, paying more than we have to.


Pay for Performance? Another alternative would be for the cyber schools to only get paid for courses successfully completed by the students. Successfully completing an online course is difficult, taking a great deal of discipline, so merely enrolling in courses, and the cyber schools receiving foundation grants simply based on enrollment does not appear to be the answer. If this is based on the schools' self-reported success, this would put an incentive to bias results towards "successful completion" even when students did not learn. On the other hand, there are many courses for which there are no third party testing services to verify the students learning. Nonetheless, without some such "payment for performance", I fear that we will not have the quality of performance taxpayers have a right to expect for the use of their taxpayer funds. It will be argued that good performance is not always achieved in the traditional public schools either, but that does not excuse simply opening up a new potential avenue for student failure while potentially wasting taxpayer money.


Compromise Sought. I have previously said that until I see that some of these concerns are addressed, I will be a "No" vote on SB 619. I now seek a compromise.


I have learned that the amount paid for online learning is entirely a function of the adoption of the School Aid Bill in the Appropriations process. As such, there is no way within SB 619 to set the appropriate amount cyber schools should be paid, whatever that is. So, I will be proposing an amendment to require the Michigan Department of Education, together with the House and Senate Fiscal Agencies (and perhaps the Department of Treasury and the Michigan Department of Technology, Management & Budget (DTMB)) to study and report on the costs of online learning, to provide objective information on the proper level of funding for these programs in the future. Perhaps this will lead to a more rational approach to the issue of funding online programs than I currently hear.

Appendix: Costs of Online Learning

First, we should distinguish between “supplemental online” courses which are purchased individually by school districts or others from full-time online schools. Supplemental online courses are usually courses with no teacher on the other end, other than the one who previously narrated the recorded lesson. The student is usually overseen be some school employee, usually simply in a monitoring role (although there seems to be some question of whether this needs to be a certified teacher monitoring the students if this is being done in school in the absence of a seat time waiver). The students taking the supplemental courses are usually doing so to make up credits for courses they had previously failed. The school the student is enrolled is responsible for all reporting, etc.

The full-time online schools, on the other hand:

  • Must adhere to all state and federal accountability req. (State Assess., NCLB, etc.)
  • Special Needs Accommodations (all)
  • Student Support Services (Enrollment, Counseling, Extra-curriculars)
  • Serve all grade levels
  • Data compilation (Tracking students’ academic records)
  • Full-time Staff (benefits)
  • Student Technology

Now, let’s explore the full time online cyber schools’ cost structure, from what little research currently exists.

1. One study estimated that about $1.6 million was needed for start-up money for a full time virtual school, and then between $3650 and $8300 per student thereafter, depending on program type, size, and quality, as well as level of investment into research, development and innovation. See “Costs and Funding of Virtual Schools”, by Augenblick, Palaich & Associates, October, 2006,

2. Colorado Cyberschools Enrollment, Costs and Funding Per the Colorado Cyberschool Association (2004), they estimated the costs as follows:

  • Curriculum/content: $1080
  • Instruction: $2400
  • Course Mgmt/technology $750
  • Student Support $1580
  • School Admin $700
  • District Admin $700
  • The estimated total cost per student $7210

The report also stated the following payments in various states:

  • Florida Virtual School: $4,820 per FTE (03-04); FLVS receives funding only for course completions (similar to Texas)
  • Minnesota: Full FTE funding at the school district level or$4,600 for students in grades one through six, and $6,000 for students in grades seven through twelve. Based on per course apportionment.
  • California: online programs receive FTE funding (termed ADA for Average Daily Attendance in California) at the level of the school district’s “normal” funding.
  • Wisconsin: 12 virtual school; $5845 per student
  • Ohio: Full-time, multi-district programs. State funding follows the student, districts lose most of the state foundation funding, but none of the local funding. Receive state funds directly from the state; these funds have been transferred from school district allocations

3. provided the following chart, based on $6500 per student:


This chart reveals a significant opportunity to lower costs long run through economies of scale. As the number of students an online provider serves, the average cost per student for technology and curriculum goes down significantly as those costs are mostly fixed costs. One does not have to recreate the curriculum for each student. The marginal cost per student would be the costs of the textbooks (hard copy or lease costs for online versions if not created inhouse), some other materials, and the computer and Internet access. These would hardly reach 44% of the $6500 or $2,850 per student.

4. K12's Flood is reported in a 2004 article to have said “that states need to allocate approximately $4,800 to $5,000 per student to adequately support virtual schools.” Virtual-School Costs Under Siege, April, 2004.

5. The Wisconsin Virtual Academy employed one teacher for every forty-two students, producing above-average student achievement for half the cost of normal per-pupil expenditures ($5,500 as opposed to $9,000-$13,000). The Rise of Cyber-Schools, Online Education and Its Enemies, by Liam Julian.

Friday, February 24, 2012

Medical Marijuana Law Needs Clarification, But Should We Decriminalize Marijuana? - Part 2

In my February 18, 2012 blog posting of "Medical Marijuana Law Needs Clarification, But Should We Decriminalize Marijuana?" , I said that "I will be exploring this [marijuana] issue further, looking at the difference between “legalizing the use of marijuana” vs. “decriminalizing the use of marijuana”, or if there is any difference at all. Then I intend to work with others interested in this issue to craft a solution. I do not support a people’s referendum on this issue, as once enacted, any tweaks found to be beneficial in the future would require a ¾ vote in both houses of the legislature, which is always very difficult to get." This blog posting addresses those issues.

Legalizing vs. Decriminalizing the Use and/or Possession of Marijuana

Marijuana is an illegal Schedule 1 drug under the federal Controlled Substances Act (CSA). CSA is Title II of the Comprehensive Drug Abuse Prevention and Control Act of 1970 (84 Stat. 1236, 21 U.S.C. Section 801 et seq.). CSA does not recognize the medical use of marijuana. In fact, in Gonzalez v. Raich, 545 US 1 (2005), the U.S. Supreme Court held that the federal law superseded the California Compassionate Use Act under the U.S. Constitution Commerce Clause, even where the marijuana was personally grown for the litigants' personal use allegedly for medicinal purposes only.

Under our system of government, the U.S. Supreme Court is the final arbiter on what the Constitution is. Therefore, any state law that attempts to "legalize" marijuana is likely to be found to be preempted by the federal law, as unconstitutional. As a State Representative, I swore an oath to uphold the state and federal Constitutions, so proposing a bill that violated the Constitution is not proper. Therefore, I favor decriminalizing marijuana, rather than legalizing marijuana as in the "Committee for a Safer Michigan" proposed constitutional amendment.

"Constitutional Amendment To End Marihuana Prohibition In Michigan

A Petition to amend the Michigan Constitution, Article 1, to add:

Article 1 Section 28. Repeal of Marihuana Prohibition.

For persons who are at least 21 years of age who are not incarcerated, marihuana acquisition, cultivation, manufacture, sale, delivery, transfer, transportation, possession, ingestion, presence in or on the body, religious, medical, industrial, agricultural, commercial or personal use, or possession or use of paraphernalia shall not be prohibited, abridged or penalized in any manner, nor subject to civil forfeiture; provided that no person shall be permitted to operate an aircraft, motor vehicle, motorboat, ORV, snowmobile, train, or other heavy or dangerous equipment or machinery while impaired by marihuana."

In addition to the federal preemption/Constitutional problem, a law enacted by voter initiative in Michigan faces another thorny problem. Once enacted, such a law enacted by initiative may only be amended by the legislature with a 3/4 vote in both the House and the Senate, and signed by the Governor. Such a supermajority is extremely difficult to achieve, so problems or ambiguities such as in the Michigan Medical Marijuana Act are difficult to cure or clarify. Presumably, amendments passed by simple majorities of the legislature which clarify the Act but which do to make obtaining marijuana more difficult would pass legal muster, but more restrictive amendments would likely fail.

Questions that the proposed constitutional amendment would not address are suggested in this Q and A about the Medical Marijuana Act:

"Question: Where can I consume medical marihuana?
Answer: Presuming you are registered with the state patient registry and carrying your registry identification card, you may consume medical marihuana on your property or elsewhere. However, the law does not permit any person to do any of the following:
  (1) Undertake any task under the influence of marihuana, when doing so would constitute negligence or professional malpractice.
  (2) Possess marihuana, or otherwise engage in the medical use of marihuana:
  (a) in a school bus;
  (b) on the grounds of any preschool or primary or secondary school; or
  (c) in any correctional facility.
  (3) Smoke marihuana:
  (a) on any form of public transportation; or
  (b) in any public place.
  (4) Operate, navigate, or be in actual physical control of any motor vehicle, aircraft, or motorboat while under the influence of marihuana.

Question: I live within 1000 feet of a school, AKA a "drug free zone". Can I still grow and/or possess my medical marihuana there?
Answer: The MMMA does not address this issue.",4601,7-154-27417_51869_52140---,00.html

The proposed amendment would not address issues of location, amounts, etc. which probably should be more restrictive than stated in the proposed amendment.

Issues in Decriminalizing the Use and Possession of Marijuana

If we were to decriminalize marijuana, the question arises of "Just what activities would you wish to decriminalize and which activities would remain criminal acts?"

First, let's look at what the specified marijuana crimes are and their punishments. Here is what I have found online regarding Michigan Marijuana Crimes and Punishments and cross referenced with the Michigan Compiled Laws via .




Marijuana Use

Misdemeanor MCL 333.7404(2)(d)

90 days



1st Offense

Misdemeanor MCL 333.7403(2)(d)

1 year


2nd Offense

Felony MCL 333.7413(2)

2 years


In a park

Misdemeanor or Felony .7410a

2 years


Manufacture, Delivery or Possession with Intent to Deliver

Less than 20 Plants

Felony MCL 333.7401(2)(d)

4 years


20 to 200 Plants

Felony "

7 years


200 or more Plants

Felony "

15 years


Less than 5 Kilograms

Felony "

4 years


5 to 45 Kilograms

Felony "

7 years


45 Kilograms or more

Felony "

15 years


License sanctions for any marijuana charge

1st Offense

6 month suspension MCL 333.7408a(1)(a)

2nd Offense in 7 years

1 year suspension MCL 333.7408a(1)(b)

"Marijuana Laws in Michigan

LegalMatch Law Library Managing Editor, Ken LaMance, Attorney at Law

Can I be Arrested in Michigan for Carrying Around a Small Amount of Marijuana for my Own Personal Use?

Yes you can, but the punishment will probably not be very severe.  Michigan is unusual in that it makes very little distinctions between its marijuana offenses (it does not separate most of the crimes by age or weight of drug), so that the crime is solely for the act itself.

In Michigan, possession of any amount of marijuana is a misdemeanor that carries a $2,000 fine and a maximum of a year in jail.  Actually smoking marijuana (a separate crime) in any location, including your house, is also a misdemeanor, but will only get you 90 days in jail and a $100 fine.  However, conditional discharge is available in all use and possession cases, which means that the judge has wide discretion to use alternative sentencing (rehab, community service, etc...) for first time offenders.  Usually, conditional release lets a person opt for probation rather than trial. After successfully completing probation, the individual's criminal record does not reflect the charge.

A more serious crime is smoking marijuana in [or within 1000 feet of] a public or private park, which can even be deemed a
felony at a judge's discretion, and this crime carries a 2 years sentence.  But it too is conditional, so the judge may offer you probation instead (on the first offense only). 

So Michigan has Fairly Lax Marijuana Laws?

Concerning possession and use, yes.  But Michigan also has some of the most severe cultivation laws in the country.  Marijuana cultivation of ANY KIND is a serious felony, with the minimum punishment being 4 years in state prison and a $20,000 fine.  If the cultivation is more than 20 plants, both the sentence and the fine shoot up to 7 years in prison, and $500,000, respectively.  The final category of cultivating 200 or more marijuana plants more than doubles the time in prison (to 15 years) and assigns an astounding $10,000,000 fine. 

What About Sales or Deliveries?

Like most states, Michigan allows for delivery without remuneration (lawyerspeak for "gifts") of marijuana to be classified as simple possession (1 year sentence, $1,000 fine).  Unusually though, Michigan puts no weight restrictions on the gift, so technically "giving" someone 20 kilos of marijuana would get the same penalty as giving them a single joint (it is unlikely that a judge will agree to this, however). 
The crime of selling marijuana mirrors the cultivation 4-7-15 year punishments (and fines) exactly.  The division of the crime is done by weight, however, instead of number of plants (the three divisions being less than 5 kg, 5 - 45 kgs, and more than 45 kgs).  This means that most sales (the vast vast majority of which are under 5 kgs) will result in a felony with a 4 year minimum sentence."

Activities that would be protected under the Committee for a Safer Michigan proposed constitutional amendment:

  • religious, medical, industrial, agricultural, commercial or personal use,
  • possession or use of paraphernalia
  • possession,
  • ingestion,
  • presence in or on the body,
  • marihuana acquisition,
  • cultivation,
  • manufacture,
  • transfer,
  • sale,
  • delivery,
  • transportation

I have re-organized the list from the amendment into a potential hierarchy of activities, with the ones on the top probably the most acceptable, with decreasing acceptability as you go down the list. In other words, would we want to keep manufacture, sale or delivery as crimes? Or only over certain amounts?


This warrants much discussion, but I also provide the MPP Model State Decriminalization Bill  proposed by the Michigan Marijuana Project. Note that it decriminalizes the use or possession of one ounce of marijuana or less, and makes it a civil offense instead. Does this go far enough? If we really wish to lessen the mass incarceration of African Americans AND significant reduce the cost of police enforcement, the courts and corrections, we may need a much bolder change in the laws, without going so far as the proposed constitutional amendment would.

Based on the chart above of the marijuana violations and penalties, I could see elimination of the criminal charges of use and possession, as well as the license sanctions for marijuana charges (i.e., revising or repealing, MCL 333.7404(2)(d), .7403(2)(d), .7410a, 7408a(1)(a), and 7408a(1)(b). Whether we did anything with the manufacture, delivery or possession with intent to deliver violations under .7401(2)(d), depend on whether we wanted to create a decriminalized market for marijuana to allow the market supply and demand drive down the cost of marijuana to eliminate the criminal black market. To the extent that marijuana is available without violation of Michigan law, perhaps there will be little incentive for any drug dealer to possess 45 kilograms or more. The large drug dealers might well be left for the federal government.

The activities prohibited under the Medical Marijuana Act in the Q and A above could apply similarly to any marijuana use. The use and possession by minors could be handled similar to how the cigarette laws are currently. An enhanced drug awareness and treatment program, as mentioned in the model act below, might be worth considering.

Saturday, February 18, 2012

Medical Marijuana Law Needs Clarification, But Should We Decriminalize Marijuana?

The people of the State of Michigan enacted the Michigan Medical Marijuana Act, and I certainly intend to abide by the people’s wishes. However, most people that I have talked to voted for the Act as an act of compassion for those in pain, and few of us want to deny something that will help alleviate the pain for those suffering. Most did not intend to legalize marijuana.

Nonetheless, to the extent that stores selling supplies to grow marijuana have proliferated throughout the state, people have the perception (whether or not it is a reality) that the law has opened the door for marijuana use far beyond the intent of the people who voted for the Act. Numerous provisions of the act are very ambiguous, leading to unequal enforcement of the Act throughout the state. More clarity is needed.

The entire issue of providing more clarity while maintaining the intent of the Act (as well as staying within the legal wording of the Act) is before the Judiciary Committee in the House of Representatives, chaired by Representative John Walsh. John is a very bright and fair chairman, and I feel confident whatever he and his committee comes up with will be of high quality.

I have visited a dispensary, and witnessed for myself what appeared to be a service that is needed for both caregivers and patients, in matching them up and recommending appropriate marijuana based substances in a multitude of forms. I believe there is a place for these dispensaries, properly regulated, and I would support such recommendations if they come out of committee. I have talked with Representative Walsh about these, and I sense he agrees with my conclusion. So, stay tuned on that.

On a broader note, I am significantly rethinking my opposition to the legalization of marijuana. Recently I attended a luncheon sponsored by the Legislative Black Caucus, at which Michelle Alexander spoke. Michelle is a graduate of Stanford Law School (my alma mater), a former Associate Professor at Stanford Law School and currently a professor at the Law School at Ohio State – and thus, in my opinion, is a credible source. She has written a book entitled, “The New Jim Crow”, about which she spoke that day.

The theses of her book is that the mass incarceration of black males that stems from the “drug war” causes far more problems than the drugs would themselves. I had never before connected the dots as follows:

(1) marijuana use and possession is illegal,

(2) police attempts to enforce the law fall disproportionately on the poor and especially the urban blacks, (Alexander’s research indicates that this is not just a problem for blacks, but also for the poor of any race or national origin. Nonetheless, the “color blindness” with which we consider the issue contributes to the failure to objectively look at the unintended consequences of our policies.)

(3) young blacks are taken out of their communities and put into prison and labeled “a criminal”,

(4) once released from prison, the now “ex con” finds difficulty in finding employment, and in desperation to survive, commits further crimes of drug distribution, burglary, etc. and all too often re-arrested and sent back to prison,

(5) the absence of employed black males in the urban black population contributes to poverty among the urban blacks,

(6) single parent families in poverty contribute to poor student performance among school age children, contributing to struggling students academically and a high drop out rate, particularly among black males who have few successful black male role models and among whom it is not culturally “cool” to be smart, and

(7) this contributes to the continuation of the cycle. This results in not only a dysfunctional black community in the urban areas, but also enormous costs of maintaining our prisons. Michelle.

Michelle Alexander’s presentation caused me to wonder if the hazards of marijuana use (of which there are clearly some) come close to the damage the criminalization of marijuana use has caused. Looking at the issue as an economist does, weighing the costs vs. the benefits, has it been worth it? To me, it now appears not.

I will be exploring this issue further, looking at the difference between “legalizing the use of marijuana” vs. “decriminalizing the use of marijuana”, or if there is any difference at all. Then I intend to work with others interested in this issue to craft a solution. I do not support a people’s referendum on this issue, as once enacted, any tweaks found to be beneficial in the future would require a ¾ vote in both houses of the legislature, which is always very difficult to get. I perceive this may be an issue for which a coalition of groups may form, as there is the perception that the approximately $2 billion spent in Michigan each year on corrections surely could be used in other areas, such as education. A preliminary study suggests that perhaps about $300 million per year could be saved in police protection, judicial and legal services and corrections combined if marijuana use and possession were decriminalized. If marijuana convictions lead to later crimes, the savings may be more.

A study of the Michigan inmate population shows that, as of 2007, about 9% of the inmates were there because of “drug crimes”, plus an indeterminate number of drug related crimes within the 23% whose most serious crime was nonviolent. So, the racial disparity in impact of marijuana laws may be a much more important impetus in revisiting such laws, although there may be more political support for reducing the costs of corrections as the motivation.

P.S. Response to questionnaire from in the 2010 campaign:

Oh, by the way, I looked up my answer to the questionnaire in the 2010 campaign, and it appears I am being consistent, other than my recent wondering about legalizing marijuana.

“I support the patient’s right to access marijuana for pain control purposes. Some friends have related to me the relief they have experienced, and I am for that.
I do not favor the widespread use of marijuana, however. I understand the arguments that people should be free to do whatever they wish with their bodies. I have also heard the arguments that marijuana use does not cause health problems despite long-term use. (I don’t know if I am completely convinced, but be that as it may.) Nonetheless, I see any non-prescription drug use as counterproductive to an individual’s success in life and do not support its promotion. I fought to keep my college fraternity free of drugs and have never used an illegal drug, and don’t wish to encourage their use.

To the extent that a patient can get the equivalent of a doctor’s prescription (I understand they don’t “prescribe” marijuana, just opine that marijuana may enhance their pain control.) with a patient simply saying they experience pain (a subjective thing that doctor cannot objectively document), that feels more open to what I feel comfortable with. Nonetheless, that is what the people of the state have approved, and I will not seek to repeal the law. Thus, that means I would not seek to impair the care-giver-patient relationship provided for within the MMMA.”


Saturday, February 4, 2012

In Defense of Free Markets – Private Enterprise – Capitalism

Recently we have heard capitalism attacked. Perhaps not so surprisingly, from Newt Gingrich in his trying to turn Mitt Romney’s business experience at Bain Capital into a negative, something many people did not expect to happen until President Obama would attack Romney in the 2012 fall General Election. So, this raises the questions, “How good is capitalism? Are free markets beneficial? Should private enterprise be prized?”

The Invisible Hand. Economics is the study of the allocation of scarce resources. Adam Smith in “The Wealth of Nations” [published as a five-book series in 1776] espoused what came to be known as the “invisible hand” theory, when he explained how rational self-interest in a free-market economy leads to economic well-being. According to Adam Smith, in a free market each participant will try to maximize his or her self-interest. He believed that there was a natural force, or "invisible hand", that would guide market participants to trade in mutually beneficial exchanges of goods and services where everyone would be better off than when simply producing for himself/herself.

Someone earning money by his own labor benefits himself. Unknowingly, he also benefits society, because to earn income on his labor in a competitive market, he must produce something others value. In Adam Smith’s words, “By directing that industry in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

Smith claimed that an individual would invest a resource—for example, land or labor—so as to earn the highest possible return on it. Consequently, all uses of the resource must yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result through competition for scarce resources.

Theory of Pure Competition. This idea of reallocation of resources morphed into the theory of pure or “perfect” competition. The standard model of price competition that is presented in almost all principles of microeconomics texts, tells us that in an un-concentrated market with many small suppliers, the consumer will pay lower prices than she would if the same market less competitive. And, best of all, resources would be allocated where each unit of resource would return the highest rate of return in the system possible. In other words, this would be the most efficient economic system. If “excess profits” were earned from a resource (whether it be one’s labor, land or capital) in a particular market segment or other economic pursuit, resources from another market segment would rush in to capture those excess profits, and as a result, the system would reach a new equilibrium where returns would be equalized. When a new disruption would occur, a similar readjustment would occur. Conversely, if a resource was not earning what it could earn in another pursuit, that resource would be redeployed into a higher paying pursuit. Prices (or rates of return) were the signals the participants in the market paid attention to. Price competition is the essential element in this theory. Due to the interaction of supply and demand, prices were at market clearing levels, meaning there were no surpluses or shortages in the long run as market participants responded, generating stability in the marketplace.

Creative Destruction. While the theory of pure or perfect competition viewed the world in rather static equilibrium, momentarily disrupted from time to time, followed by reallocation of resources to a new equilibrium, Schumpeter introduced the argument that capitalism exists in the state of ferment he dubbed "creative destruction," with spurts of innovation destroying established enterprises and yielding new ones. He believed creative destruction is the process in which technological advance is the main source of economic growth and improvements in the quality of life, as the new innovative processes or new products dynamically leapfrogged competition. He envisioned the process of creative destruction being the form of competition in capitalism that is capable of dramatic improvements in the quantity and quality of our lives. And, many economists also believe that smaller, often start-up, firms are the most likely source of new leapfrog innovation. See “Schumpeter’s Creative Destruction: A Review of the Evidence”, by Arthur M. Diamond, Jr. at

As another writer eloquently put it:

“Capitalism, Socialism, and Democracy [Joseph Alois Schumpeter’s 1942 book]. . . is also a sparkling defense of capitalism on the grounds that capitalism sparks entrepreneurship. Indeed, Schumpeter was among the first to lay out a clear concept of entrepreneurship. He distinguished inventions from the entrepreneur’s innovations. Schumpeter pointed out that entrepreneurs innovate not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. These innovations, he argued, take just as much skill and daring as does the process of invention.

Innovation by the entrepreneur, argued Schumpeter, leads to gales of “creative destruction” as innovations cause old inventories, ideas, technologies, skills, and equipment to become obsolete. The question is not “how capitalism administers existing structures, ... [but] how it creates and destroys them.” This creative destruction, he believed, causes continuous progress and improves the standards of living for everyone.

Schumpeter argued with the prevailing view that “perfect” competition was the way to maximize economic well-being. Under perfect competition all firms in an industry produce the same good, sell it for the same price, and have access to the same technology. Schumpeter saw this kind of competition as relatively unimportant. He wrote: “[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization ... competition which ... strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives.” The Concise Encyclopedia of Economics.

The conclusion that might be reached is that the more open the economy is to creative destruction, the faster will be the rate of technological advance, and the greater will be the improvements in longevity, health and quality of life. The United States during the twentieth century was a notable exemplar of openness to creative destruction and we have reaped the benefits from a vastly expanding economy, substantial technological advances, and improvements in longevity, health and quality of life as a result.

An Extension of the Market Reallocation of Resources. Market forces are driven by prices and prices are affected by market forces. The price and use of farm lands serve as good examples. When farmers can earn profits from the production of their crops, that affects the price of their land. As the price of corn goes up, the sales price and lease costs of land capable of producing corn goes up. When prices collapse, land prices and rents fall. Farmers also respond to the relative prices of corn, soybeans and other competing crops to determine how much of each crop they will produce.

Prices also affect whether a resource is used at all. When prices go up, land which might have been marginal for earning a profit when prices are low begin to be placed into production. This explains the increase in the number of tilled acres of corn in recent years as corn prices have surged. A resource which has zero or a negative value will not be used. This explains the vast acreage of farm land in the Upper Peninsula that was formerly farmed but now is reverting to brush and forest lands. Some of these lands are now being considered for production, due not only to the rising prices of the crops, but also due to innovations in crop varieties which are increasing the productivity per acre and reducing the number of growing days needed to produce the crop.

Similarly, a vacant, obsolete property in a downtown area may have a negative value due to the extensive costs of demolition and/or renovation that would be needed to put it back into use. This explains the need for “brownfield” tax credits or allocations of funds to make the property economical for reuse.

Another extension of this theory relates to wages. The higher the cost of any resource, the less of it that gets used. If a resource is artificially priced higher than its value, less of it gets used. To the extent that it is artificially priced higher than someone can use it and still make a profit, it does not get used at all. This explains why conservative economists (and politicians who follow such economists) do not like minimum wage laws, “living wage” laws, prevailing wage laws or even unions. By constraining the drop in wages due to changes in the economy, labor becomes surplus, i.e., people become unemployed. Thus the irony of people who are trying to be compassionate and want people to have a living wage actually help cause the poor to have no wage at all. We would be better off to allow wages to drop and retain people in jobs.

Similarly, people who try to artificially prop up wages by protecting union wages to “preserve the middle class” cause the loss of the very jobs they are trying to protect. Conservatives also object to trying “to protect the middle class” as they view America as without classes, as anyone can move from one income level to another based on his or her merits. We believe in (1) the need for incentives to develop a set of talents and skills (through education, training and experience) that are of value in the marketplace and (2) the need to develop a work ethic that is of value either as an entrepreneur or as an employee for another. We are better off as a society to promote the continued development of our individual and group productivity to continuously improve our competitiveness in the marketplace, both as individuals and as a country in the global marketplace.

But, the objection is that we have developed life styles that require high incomes. First, I would argue that we have lost the distinction between something that would be nice to have versus what we actually need to have. But the “invisible hand” also helps us out, at least in the long run. As wages in an area decline, the demand for goods (food, entertainment, housing, etc.) also declines. As demand declines, the prices of those goods must also decline to retain “market clearing prices”. Witness the cost of housing in Michigan and throughout the country. As prices adjust, the cost of living adjusts downward so that we don’t experience as much of a loss of the non-essentials as might otherwise be expected. But, this is a long run phenomenon, and the transition may be painful and the pain not evenly distributed among all among society.

Reflections on the 2012 Republican Primary Campaigns. Mitt Romney has been attacked for his role as a venture capitalist with Bain Capital, a private equity company. An eloquent defense of venture capitalists is contained in “Stop vilifying venture capitalists”, A paragraph in that article points out a vulnerability that detractors seize upon.

“Venture capitalists won't always get it right though. Sometimes they'll encourage companies to take on too much debt, or they'll back ill-conceived business plans. When the venture capitalists and entrepreneurs make bad decisions, it hurts just as when the government makes a bad decision. But when venture capitalists and entrepreneurs make bad decisions, the people who are hurt are people who knowingly chose to invest, work for or do business with them.”

Another potential vulnerability is the the existence of dividend recaps (i.e., the way private equity firms can make money even if the equity of the company they invest in is wiped out). See “Let's be honest about private equity”. That is, in a leveraged purchase of a company, the private equity firm sometimes pays “dividends” to itself from the cash from the loans. If later the company does not succeed, it appears as if the private equity firm hollowed out the company to benefit itself to the detriment of the company which later may be forced into bankruptcy. This looks even worse if the company received favorable tax treatment from state or local governments through tax abatements or credits.

CNN's Fareed Zakaria puts these attacks into an interesting perspective:

“Instead, a second line of attack has been gaining traction against Romney – that of Romney as job-killer or Romney as the private equity guy, who buys companies, hollows them out and outsources jobs.

Now it is striking that this attack is coming in a Republican presidential primary. After all, what Romney did while at Bain Capital was classic capitalist “creative destruction.” He took over businesses and tried to make them more productive and efficient. To do so, he often had to shed jobs.

Republicans should be celebrating Romney’s prior work as an example of how the market functions – driving out inefficiency, generating productivity and creating a lean, mean capitalist machine.

The fact that Romney’s past has turned into a line of attack tells you that something has changed in America. Even in the Republican Party, there is a huge concern about what globalization and technological change are doing to the average, middle-class American. There is a sense that the system is not working for the median American worker.

If you look at job creation over the last 20-25 years in America, you’ll notice that we haven't been able to create any jobs in what is called the “tradable sector” of the economy - those jobs that are subject to global competition. The only jobs we’ve really created have been in industries like health care, government, and construction, which are basically local industries shielded from global competition. You can't outsource the building of a New York skyscraper to a Chinese worker.

America hasn’t been able to create jobs in any sector that’s subject to global and technological pressures. As a result, there is a huge sense of disillusionment, disappointment and pessimism among Americans.” “Zakaria: Romney’s real problem”.

Query? Why haven’t we been able to continue to compete in the “tradable” or manufacturing sectors? The reason most often given is that the labor cost of producing a product in the U.S. exceeds the labor cost in the emerging economies of China, India, Korea and others. With the labor cost being a product of the wage and benefit rates times the productivity, we can compete in terms of labor costs by either increasing productivity or decreasing wage and benefit rates. To the extent that wage laws and union contracts have made wages and benefits “sticky downward”, we have lost competitiveness when our productivity gains have not occurred quickly enough. Recent news articles, however, indicate that America is regaining our manufacturing competiveness, as labor costs are rising in China. See, for example,China’s manufacturing industry becoming less competitiveand “Can China compete with American manufacturing?”

Theory of the Firm. A business has many stakeholders. The reason for the existence of a business is to return a profit, that is, a return on the investment of resources employed by the firm, whether it be the owners’ labor, land or capital. Therefore the owners or investors are stakeholders. Other stakeholders are the firm’s customers, who must be satisfied or the firm will cease to exist. The employees also have a stake in the success of the business. Many argue that businesses also have another stakeholder – the community at large. That is, the needs of the surrounding community needs to also be considered in the decision-making of the business leaders. This is certainly the case where considerable “externalities” such as pollution occurs. But, many believe that a company also “owes” the community more, such as in decisions whether to close a plant – whether it be to entirely go out of business, relocate or to “outsource” part of its production.

Conservative economists will argue that to the extent that the needs of stakeholders other than the owners are taken into account, distortions in the market result. That is, to the extent that employee wages and benefits are more costly than justified by the market or its competitors, the business gets less competitive and may be forced out of business. Or, if a firm were coerced by government edict to remain open when it is losing money, a misallocation of resources would occur. Or, if prices were restrained lower than the market allowed, less of the product or service would be produced than if market clearing prices were to occur.

CNN’s Michael Lind has written an insightful piece on this issue:

“In a presidential primary season distinguished so far by the absence of substantive debates, the controversy over whether Mitt Romney and his partners at Bain Capital should be considered job creators or job destroyers raises a profoundly important issue.

Beyond the concerns about the loss of American jobs to off-shoring or automation and the food-fight tactics of Romney's rivals is a legitimate question about what kind of capitalism 21st century Americans should want.

The choice is between "stakeholder capitalism" and "shareholder capitalism." According to the theory of stakeholder capitalism, corporations are and should be quasi-public entities with responsibilities to the nation-state and to the communities in which they are embedded. The corporation should make a profit and provide a fair return to investors. At the same time, workers who contribute their labor to the company have a legitimate interest in it as well as investors who provide capital. Managers serve the company and the country, not merely the investors.

In the theory of "shareholder capitalism," the corporation exists solely for the purpose of the investors, whom the managers serve as agents. In shareholder capitalism, short-term profits are the only goal, and if that means laying off workers instead of retraining them or reassigning them, breaking up the company and selling the assets to enrich private equity partners and shareholders, so be it.
. . .

What are the implications? If America continues to favor shareholder capitalism, there is no guarantee that policies to favor American business will preserve or create jobs or help anyone other than investors. On the other hand, if the United States were to move away from shareholder capitalism toward stakeholder capitalism, the law might limit hostile takeovers of companies or require workers and even local governments to have a say in corporate decisions. In some cases this might preserve jobs and factories at the expense of innovation and efficiency.

As a practitioner of the shareholder capitalism of the last generation, Mitt Romney as president would probably support policies that assume that the short-term interests of investors like Bain are identical to the long-term interests of the economy. By the same token, he would probably resist policies that increased the influence of managers, workers and local communities over companies at the expense of shareholders and financiers.” “What kind of capitalist is Romney?”

Mitt Romney has been attacked as being a “vulture capitalist” as well, because as a private equity firm, Bain Capital sometimes purchased companies that they perceived had greater value as a sum of its parts than as an ongoing business. That is, companies can sometimes be undervalued by the market and if purchased, the company can be dismantled and its parts sold for a greater amount than the price the entire business was valued. Also, in attempts to turn around companies, the purchased companies (or companies they invested in) were restructured to reduce their costs to be more competitive. This may have involved closing down of plants and/or outsourcing some production, causing jobs to be lost in certain communities. Economists who believe in “creative destruction” as important to reallocate resources to where they have higher value believe this is a good thing, but those intimately affected obviously think otherwise.

For example, some commentators, mostly from the left of the political spectrum see venture capitalists as immoral, as they don’t sufficiently consider the humans involved. See “Immorality and venture capitalists”, Froma Harrop, January 22, 2012.

Pushback Versus Attacks on Romney. Pushback is developing against charges that Romney was a "vulture capitalist" or a “predatory capitalist” who looted companies and fired workers when he was running the private equity firm Bain Capital in the 1980s and 1990s. See, “Perry donor defects to Romney”, citing Bain attacks” and Gingrich attack exposes desperation and elitism”.

Crony Capitalism. Another term that might be confused is the term “crony capitalism”. This refers to the granting of favors by government entities to certain companies and not to others. The favors might be tax abatements, tax credits, special contracts, subsidies, mandates, etc. The basic objection is the picking of winners and losers by government. What makes this favoritism objectionable is the disbelief that governments or government “experts” can do a better job of allocating resources in the marketplace than the “invisible hand”. See “Can Monkeys Pick Stocks Better than Experts?”. While this article reports of slightly better investment results than throwing darts, the results were not much better than the DJIA, and they questioned whether they were better at all when you considered the risk-return ratio and the long run results. In other words, do government experts actually have a clearer crystal ball then the most expert private investors and companies looking for opportunities? Critics say, “No!’Another objection to such favors is the opportunities for corruption in the political system, something clearly seen in some areas in Michigan and elsewhere. Thus, conservatives do not defend this kind of “capitalism”.

Conservatives also object to other interference in the marketplace. For example, the National Highway Traffic Safety Administration’s tough new fuel economy mandates forcing automakers to spend $50 billion to $150 billion on technology to more than double current vehicle performance to get today’s light vehicle fleet average today of about 22 mpg up to 54.5 mpg in 13 years is thought to be an arrogant disregard for the marketplace. Source: “Column: Feds mark taming of Detroit”. To the extent that such government action attempts to allocate resources differently than the market otherwise would, such conservative economists, commentators and politicians believe that the country is worse off, as fewer products or services will be produced, lowering the standard of living that our country’s citizens would otherwise enjoy.

Where Does the Free Market Fail?

a. Business Cycles. Any market is subject to the possibility of booms and busts, and free markets are no exception. Due to human psychology, in the absence of price controls, there will be periods of great optimism (or excessive exuberance or "irrational exuberance" as expressed by then-Federal Reserve Board Chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the Dot-com bubble of the 1990s, warning that the market might be somewhat overvalued).


Whether they be tulip bulbs as in the 'Dutch Tulip Bulb Market Bubble' which occurred in Holland during the early 1600s when speculation drove the value of tulip bulbs to as much as six times the average person's annual salary or the high prices of internet stock companies in the late 1990’s, or the real estate prices in the 2000’s, optimism will exceed reality as people try to “get their share” along with everyone else. When the bust comes, then excessive fear will cause the prices to plummet, often well beyond reasonable values. Eventually, people begin to realize that the market has adjusted too much and will begin to pick up again. This “greed” and “fear” cycle is as old as time and there is little that anyone can do to prevent it. That is, when you are in a greed period, how can you tell it is irrational exuberance or just “a new time in history” as many thought the internet bubble was?

The “prevention” tried by the government sometimes has been price controls which artificially constrained the price signals in the market and caused shortages for those products or services whose prices were held down. (Conversely, excess production has occurred where the prices were held artificially high, as with price supports for farm products.) The “cure” imposed by government has been federal deficit spending to try to “prime the pump” or “cheap money” by the Federal Reserve Bank in downturns, but the reverse has less frequently been used to “choke off” booming economic times, as this
would not be politically popular.

b. Monopolies/Oligopolies/Restraints of Trade.
The conditions for perfect competition and the efficient allocation of resources are violated where an industry becomes too concentrated in one or few competitors, or competitors engage in anti-competitive practices, such as price fixing. The excesses of the big trusts in the early 1900’s brought on the Anti-trust laws and regulations
which continue through today.

c. Natural Monopolies. There are some services for which it does not make sense to duplicate providers. Examples would be electrical, phone or natural gas lines into neighborhoods, as there would be massive duplication of capital costs which would make providing those services much more expensive. Roads, rail lines and airports would be other examples. These economists have long believed that the most appropriate way for these services to be provided would be either by the government or by private firms under government regulation. |

d. Externalities. There are some economic activities in which the total costs of the activity are not entirely borne by the private company, while enjoying all of the benefits. The typical example used is a business which is causing pollution which harms others, but which harm is not compensated for by the firm. The typical response to these problems are regulations, such as air pollution control requirements, to either reduce the externality or to compensate those harmed by the activity.

There are also activities for which a business would find it very difficult to capture all of the benefits of providing a service. For example, if a private company were to construct a road, the only way to capture all of the benefits would be to charge tolls for its use. The costs of collecting those tolls (or charging special assessments for those benefitted and excluding others from using them) may be excessive in comparison to the benefit. In those cases, it makes more sense for the public to in some way share in the cost of the roads in the entire city, state or country and forego the expense of the toll or special assessment collection.

Conclusion. I believe in the free market system. It has provided us in the United States with as unparalleled standard of living while allowing us to enjoy individual freedoms previously unavailable to the masses.