People respond to incentives

Steven Landsburg begins his book Armchair Economist with the statement, "Most of economics can be summarized in four words: 'People respond to incentives.' The rest is commentary."

That seems a rather different beginning than that given in most introductory textbooks, which stresses that economics is about scarcity and choice. However, on closer examination, Landsburg's statement may tell us more and at the same time incorporate the insights of the scarcity-choice definition.

When economists talk about incentives, they are thinking that people respond to costs and benefits. When the cost of something rises, people use or do less of it, while when the benefit of something rises, people use or do more of it. Rational people should not act if the benefit of acting is less than the cost, and they should act if the benefit of acting is greater than the cost.

A benefit is something that makes a person better off. How do we decide if something makes a person better off? Economists take an Aristotelian approach on this question. They assume that people have goals, though unlike Aristotle, they do not spend much time trying to evaluate whether those goals are desirable or not. Actions that move a person closer to achieving their goals are benefits.

Notice that it is the individual who decides what his or her goals are, not some authority. Economics assumes that people know what is best for themselves, that is, that people should be allowed to choose for themselves what their goals are. This is not an assumption that everyone makes. In addition, by assuming that people are goal-seeking, we are also implicitly making the assumption that people are self-interested. You might think that someone could decide that their goal was to do whatever was best for humanity, and they might. But the limits to our knowledge and ability to process information make this a goal beyond the capability of anyone to actually put into practice.

What about costs? The cost of anything is what you have to give up to get it. Often this is measured in money. When we say that something costs $5.00, that means that when you spend $5.00 to get the item, you cannot use that $5.00 to purchase some other item. Often cost includes time. If to get an item one must pay $5.00 plus wait fifteen minutes, the cost of the item includes both money and time.

Why is there any cost at all? In a world without cost, we would not need to give up anything, and there would be no need to make choices. In a world without choice, there would be no incentives. This world without incentives is the world of abundance, a world without scarcity. And this insight brings us back to the traditional definition of economics, which is that it is the study of how people make choices in a world of scarcity.

The Protestant work ethic

From the Telegraph:

Has a young Harvard graduate student in economics dealt a deadly blow to Max Weber’s theory that Protestantism favours economic development? Davide Cantoni has just produced a brilliantly argued paper which takes economic data from Catholic and Protestant cities in Germany from 1300 to 1900, subjects them to meticulous multivariate analysis, and finds no evidence that Protestantism per se made people richer.

the whole paper is available in pdf format here.

Economists on Jeopardy

Found on Greg Mankiw's blog, who got it from another blog.

The battle over CRA

Over at businessinsider.com, John Carney writes:

The CRA led directly to lending practices that included extremely low to nonexistent down payments, outrageous loan to value ratios and other "innovations" that later became some of the best predictors of defaults and foreclosures.

The comments are interesting, as a variety of people either misrepresent his position (CRA was the source of all problems) or deny that it had anything to do with the meltdown. The reasonable position, it seems to me, is that it was one stream of many that combined to produce the river of disaster we experienced.

(A number of years ago at a financially-struggling college that I know something about, the president kept telling the faculty that retention was all important and that they needed to keep that in mind. When asked if that meant lowering standards, he would vigorously deny that he wanted standards lowered, but never provided any meaningful guidance as to what it was the faculty should be doing. Pretty much all the faculty accepted that what he really wanted was lower standards but he could not say that. The Fed's denial that CRA was intended to lower lending standards seems to be pretty similar to the college-retention situation.)

Two Samuelsons

In the Washington Post Robert Samuelson ponders the future of the welfare state:

The U.S. welfare state is weakening; insecurity is rising. The sensible thing would be to decide which forms of public welfare are needed to protect the vulnerable and to begin paring others. Our inaction poses another dreary parallel with GM. It was obvious a quarter-century ago that GM the auto company could not support GM the welfare state. But the union wouldn't surrender benefits, and the company acquiesced. Inertia prevailed, and the reckoning came.

The same cycle, repeated on a national scale with sums many multiples higher, would be correspondingly more fearsome.

On Econlog David Henderson defends the legacy of Milton Friedman from snark from Paul Samuelson:

The young interviewer, Conor Clarke, owes a huge debt to Milton Friedman, who did more for him and for every healthy American male under age 54 than Samuelson ever did. I'm referring, of course, to Friedman's "nutty libertarian" crusade against the draft.

The original interview is here.

In praise of Jimmy Carter

Holman Jenkins has words of praise for President Jimmy Carter in his Wall Street Journal column:

In Mr. Carter's day, bankruptcies were scything through the railroad sector, hurtling toward a rendezvous with nationalization. Conrail, an amalgam of failed Northeastern lines, had already been taken over and analysts foresaw a $300 billion bill (in today's dollars) in the likely prospect that Washington would soon have to operate the rest of the nation's freight railroads.
...
Rail executives and economists had been arguing since the 1920s, when competition from trucks and planes began to emerge, that comprehensive federal regulation had only distorted the industry's pricing, driven away investment, and made competitive adaptation impossible.
...
It still took some doing on Mr. Carter's part. When the bill stalled, a hundred phone calls went from the White House to congressmen, including 10 by Mr. Carter in a single evening. The bill essentially no longer required railroads to provide services at a loss to please certain constituencies. It meant going up against farmers, labor, utilities, mining interests, and even some railroads....

Messing with the bond holders

There will be consequences for messing with the bondholders of Chrysler and GM, as anyone who thinks like an economist instantly recognizes. From the comments of a post in the Atlantic's business blog:

I hereby nominate Obama for the Pullman-Cleveland Award for Union-Busting, for the most anti-union action in the United States by a U.S. President since Reagan fired the air traffic controllers.

The good old days

Reason magazine looks at the increase in inequality, and finds that it is partly due to changing social norms, such as the decline of racism and acceptance of women in the workplace.

A supply-side experiment

A comment I left elsewhere:

The Obama administration is conducting an economic experiment on supply side economics. When Reagan entered office, his approach to recovery was to focus on making it more attractive to produce with lower taxes and less regulation. Obama is pursuing the opposite course, to increase taxes and regulation on producers and to make contracts less certain, thereby increasing risk. If we have a vigorous recovery next year and unemployment drops down to what it averaged in the Bush years, the supply-siders will have a hard time making a case for their theories.

Drug legalization?

Don Bourdreaux argued a couple years ago that the primary reason that alcohol prohibition ended in the 1930s not because people thought it had failed but because the federal government needed more revenue. If he is right, there should be a good chance that use of marijuana will be legalized and taxed in the next few years because with the large increase in government spending coming down the pike, the government will need all the tax revenue it can find. In addition, if marijuana and perhaps other illegal drugs were legalized, there would be a lot fewer people in jail, cutting expenses of catching, convicting, and maintaining them.
Update May 13: I got this one right. See here.

Tit-for-tat and poverty

This past semester I reread Robert Axelrod's The Evolution of Cooperation: Revised Edition. The book was originally published in 1984 and a revised edition was published in 2006. I could not see any changes in the revised edition other than a forward by Richard Dawkins.

Axelrod demonstrates that in situations where we are playing a repeated prisoner's dilemma, a simple tit-for-tat strategy is successful against a wide and diverse group of other strategies. Tit-for-tat invites cooperation and discourages exploitation. Richard Dawkins was so impressed with Axelrod's conclusions that the suggested the book should replace the Gideon Bible.

There were a number of places where I noticed potential extensions to Axelrod's discussions. For example, in his Chapter Seven, "How to Promote Cooperation," Axelrod says we need to enlarge the shadow of the future. When future interactions become more important, the temptation to exploit the other for short-term gain is reduced. Cooperation is more likely when both parties value the benefits of future interaction.

One obvious result of this principle is that we should expect married couples to do better than cohabitating couples. (For those who say that a marriage certificate is only a piece of paper, so are cash and the most of what I have in my safety deposit box.) I will leave it to the reader to complete the argument for marriage.

Another implication that Axelrod does not explore is the link between poverty and the extent to which people emphasize the present versus the future. There is a substantial literature showing that the poor tend to be present-oriented. However, correlation is not causation. Do the values of the poor, including their focus on the present, cause poverty, or does their poverty cause people to be present-oriented?

Adam Smith recognized that use of markets generated wealth because specialization and division of labor increase social cooperation. However, many or most of our interactions with others are not market transactions. A person with no concern for the future who takes short-term gains from others at the expense of long-term cooperation will earn a lower standard of living as a result. Hence, Axelrod's discussion suggests that present-orientedness causes poverty. (It may also be that poverty causes present-orientedness, in which case a feedback loop traps people in poverty.)

Addendum: The marshmallow experiment shows extreme present-orientedness in small children, but I am not sure it adds anything to the above discussion. However, it makes for fun youtube viewing.

Bush the socialist?

The Wall Street Journal has a disturbing article on the Paulson and Bernanke pressuring the Bank of American not to cancel a merger with Merrill Lynch:

In the name of containing "systemic risk," our regulators spread it. In order to keep Mr. Lewis quiet, they all but ordered him to deceive his own shareholders. And in the name of restoring financial confidence, they have so mistreated Bank of America that bank executives everywhere have concluded that neither Treasury nor the Federal Reserve can be trusted.

The political class has spent the last few months blaming bankers for everything that has gone wrong in the financial system, and no doubt many banks have earned public scorn. But Washington has been complicit every step of the way, from the Fed's easy money to the nurturing of Fannie Mae and Freddie Mac, and since last autumn with regulatory and Congressional panic that is making financial repair that much harder. The men who nearly ruined Bank of America have some explaining to do.

The anti-choice forces win a victory

There have been a number of opinion makers very critical of the decision by President Obama and the Congress to kill the voucher program in Washington D.C. George Will wrote about it in today's Washington Post.

As the president and his party's legislators are forcing minority children back into public schools, the doors of which would never be darkened by the president's or legislators' children, remember this: We have seen a version of this shabby act before. One reason conservatism came to power in the 1980s was that in the 1970s liberals advertised their hypocrisy by supporting forced busing of other people's children to schools the liberals' children did not attend.

This is a topic on which I want to write, but do not have the time right now. Maybe in the next month I will be able to sketch out my theory as to why the voucher program has problems attracting political support even though, based on theory and some evidence, it is a program that we should adopt if we are serious about helping the poor.

Update: The Washington Post supports vouchers!

Update 2: Reason TV has a video on the issue.

Another economics blog

There is another new economic blog, this one focused on economic policy. It is written by Keith Hennessey, who worked as a high level policy adviser for the Bush administration. Time will tell if it is worth reading regularly.

Is McDonald's an inferior good?

McDonald's is reported to be benefiting from the recession. That would make sense if McDonald's meals are inferior goods, something that people switch away from when they get more income. I have always thought of them that way, but it is nice to see some evidence.

The dismal science myth

I am using Heilbroner's The Worldly Philosophers in one of my classes because it can generate some good discussion. For example, he writes on page 78:

"No wonder that after he read Malthus, Carlyle called economics 'the dismal science'..."

I think there are lots of people who still accept this explanation of how economics became "the dismal science;" I did until a few years ago. However, the true story is much more interesting. It is told by Levy and Peart here. A summary of that view is on Wikipedia here. Which is more interesting, Heilbroner's view, or Levy and Peart's view?

For a book in its seventh edition, there are some errors that should not be there. On page 85-6 Heilbroner writes:

Mention of Maria Edgeworth warrants an additional word. The daughter of an economist...."

If she was a friend of Malthus and Ricardo, then her father must have been one of the first economists, as he was only 20 years younger than Smith. However, Heilbroner is confusing her father with her nephew, Francis Ysidro Edgeworth. That mistake might be excusable in a first edition, but not in the seventh of such a widely-read book.

Then there are sentences that stop an economist, though the noneconomist probably sees nothing at all wrong with them. How about this (on 49) in his discussion of Smith and Quesnay:

"To see that labor, not nature, was the source of "value," was one of Smith's greatest insights."

Economics and college presidents

My colleague Michael sent me a link to an article by an economist who is now a college president explaining how economics shapes the way he does his job. He argues that it is important to understand economic concepts such as comparative advantage, incentives, price discrimination, and sunk costs to make good decisions.

Update: I finally read the whole article with care. The part that interested me most was his discussion of price discrimination. The author writes:

Strategically, the findings suggest that more-selective institutions will be better able to price tuition and grants at relatively high levels. Less-selective colleges would be better off with a low tuition and grant strategy.

I work at a less-selective college that tries to do a high-tuition, high-grant strategy and is frustrated with the results, so his statement makes sense to me. (I once told a director of financial aid that what he was doing was what economists call price discrimination. He was horrified and denied it. I knew then that we would be having problems with admissions for a long time.)

Fiscal stimulus skeptics

Greg Mankiw had a post a while back that quoted part of an AP story identifying him as the only skeptic of a planned massive Obama stimulus package. He then followed up with a couple of other posts. There are, of course, many more skeptics than Mankiw. Skepticism seems in order partly because the evidence is that the Keynesian multiplier is low, and even more because of public-choice considerations, some of which are discussed in a Wall Street Journal commentary. For me the highlight of this commentary was its discussion of feedback, the possibility that bad economic results lead to bad policy, leading to even worse results.

Death of creative destruction?

Is entrepreneurship dying? This opinion piece in The Wall Street Journal by Michael Malone says it is being strangled with government regulation and new accounting rules.

Rent seeking

Donald Boudreaux writes about the size of government, Blagojevich, and rent seeking. His commentary is in the Christian Science Monitor, but he blogs frequently at Cafe Hayek. Speaking of which, Russell Roberts had a couple of good posts there: a good piece on the source of the housing bubble, and a link to a video from 1933 arguing that inflation was a way to cure the Depression.