Naked Economics (6 page)

In 1995, I was traveling across South Africa, and I was struck by the remarkable service at the gas stations along the way. The attendants, dressed in sharp uniforms, often with bow ties, would scurry out to fill the tank, check the oil, and wipe the windshield. The bathrooms were spotless—a far cry from some of the scary things I’ve seen driving across the USA. Was there some special service station mentality in South Africa? No. The price of gasoline was fixed by the government. So service stations, which were still private firms, resorted to bow ties and clean bathrooms to attract customers.

Every market transaction makes all parties better off.
Firms are acting in their own best interests, and so are consumers. This is a simple idea that has enormous power. Consider an inflammatory example: The problem with Asian sweatshops is that there are not enough of them. Adult workers take jobs in these unpleasant, low-wage manufacturing facilities voluntarily. (I am not writing about forced labor or child labor, both of which are different cases.) So one of two things must be true. Either (1) workers take unpleasant jobs in sweatshops because it is the best employment option they have; or (2) Asian sweatshop workers are persons of weak intellect who have many more attractive job offers but choose to work in sweatshops instead.

Most arguments against globalization implicitly assume number two. The protesters smashing windows in Seattle were trying to make the case that workers in the developing world would be better off if we curtailed international trade, thereby closing down the sweatshops that churn out shoes and handbags for those of us in the developed world. But how exactly does that make workers in poor countries better off? It does not create any new opportunities. The only way it could possibly improve social welfare is if fired sweatshop workers take new, better jobs—opportunities they presumably ignored when they went to work in a sweatshop. When was the last time a plant closing in the United States was hailed as good news for its workers?

Sweatshops are nasty places by Western standards. And yes, one might argue that Nike should pay its foreign workers better wages out of sheer altruism. But they are a symptom of poverty, not a cause. Nike pays a typical worker in one of its Vietnamese factories roughly $600 a year. That is a pathetic amount of money. It also happens to be twice an average Vietnamese worker’s annual income.
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Indeed, sweatshops played an important role in the development of countries like South Korea and Taiwan, as we will explore in Chapter 12.

Given that economics is built upon the assumption that humans act consistently in ways that make themselves better off, one might reasonably ask: Are we really that rational? Not always, it turns out. One of the fiercest assaults on the notion of “strict rationality” comes from a seemingly silly observation. Economist Richard Thaler hosted a dinner party years ago at which he served a bowl of cashews before the meal. He noticed that his guests were wolfing down the nuts at such a pace that they would likely spoil their appetite for dinner. So Thaler took the bowl of nuts away, at which point his guests thanked him.
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Believe it or not, this little vignette exposes a fault in the basic tenets of microeconomics: In theory, it should never be possible to make rational individuals better off by denying them some option. People who don’t want to eat too many cashews should just stop eating cashews. But they don’t. And that finding turns out to have implications far beyond salted nuts. For example, if humans lack the self-discipline to do things that they know will make themselves better off in the long run (e.g., lose weight, stop smoking, or save for retirement), then society could conceivably make them better off by helping (or coercing) them to do things they otherwise would not or could not do—the public policy equivalent of taking the cashew bowl away.

The field of behavioral economics has evolved as a marriage between psychology and economics that offers sophisticated insight into how humans really make decisions. Daniel Kahneman, a professor in both psychology and public affairs at Princeton, was awarded the Nobel Prize in Economics in 2002 for his studies of decision making under uncertainty, and, in particular, “how human decisions may systematically depart from those predicted by standard economic theory.”
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Kahneman and others have advanced the concept of “bounded rationality,” which suggests that most of us make decisions using intuition or rules of thumb, kind of like looking at the sky to determine if it will rain, rather than spending hours poring over weather forecasts. Most of the time, this works just fine. Sometimes it doesn’t. The behavioral economists study ways in which these rules of thumb may lead us to do things that diminish our utility in the long run.

For example, individuals don’t always have a particularly refined sense of risk and probability. This point was brought home to me recently as I admired a large Harley Davidson motorcycle parked on a sidewalk in New Hampshire (a state that does not require motorcycle helmets). The owner ambled up and said, “Do you want to buy it?” I replied that motorcycles are a little too dangerous for me, to which he exclaimed, “You’re willing to fly on a plane, aren’t you!”

In fact, riding a motorcycle is 2,000 times more dangerous than flying for every kilometer traveled. That’s not an entirely fair comparison since motorcycle trips tend to be much shorter. Still, any given motorcycle journey, regardless of length, is 14 times more likely to end in death than any trip by plane. Conventional economics makes clear that some people will ride motorcycles (with or without helmets) because the utility they get from going fast on a two wheeler outweighs the risks they incur in the process. That’s perfectly rational. But if the person making that decision doesn’t understand the true risk involved, then it may not be a rational trade-off after all.

Behavorial economics has developed a catalog of these kinds of potential errors, many of which are an obvious part of everyday life. Many of us don’t have all the self-control that we would like. Eighty percent of American smokers say they want to quit; most of them don’t. (Reports from inside the White House suggested that President Obama was still trying to kick the habit even after moving into the Oval Office.) Some very prominent economists, including one Nobel Prize winner, have argued for decades that there is such a thing as “rational addiction,” meaning that individuals will take into account the likelihood of addiction and all its future costs when buying that first pack of Camels. MIT economist Jonathan Gruber, who has studied smoking behavior extensively, thinks that is nonsense. He argues that consumers don’t rationally weigh the benefits of smoking enjoyment against future health risks and other costs, as the standard economic model assumes. Gruber writes, “The model is predicated on a description of the smoking decision that is at odds with laboratory evidence, the behavior of smokers, econometric [statistical] analysis, and common sense.”
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We may also lack the basic knowledge necessary to make sensible decisions in some situations. Annamaria Lusardi of Dartmouth College and Olivia Mitchell of the Wharton School at the University of Pennsylvania surveyed a large sample of Americans over the age of fifty to gauge their financial literacy. Only a third could do simple interest rate calculations; most did not understand the concept of investment diversification. (If you don’t know what that means either, you will after reading Chapter 7.) Based on her research, Professor Lusardi has concluded that “financial illiteracy” is widespread.
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These are not merely esoteric fun facts that pipe-smoking academics like to kick around in the faculty lounge. Bad decisions can have bad outcomes—for all of us. The global financial crisis arguably has its roots in irrational behavior. One of our behavioral “rules of thumb” as humans is to see patterns in what is really randomness; as a result, we assume that whatever is happening now will continue to happen in the future, even when data, probability, or basic analysis suggest the contrary. A coin that comes up heads four times in a row is “lucky” a basketball player who has hit three shots in a row has a “hot hand.”

A team of cognitive psychologists made one of the enduring contributions to this field by disproving the “hot hand” in basketball using NBA data and by conducting experiments with the Cornell varsity men’s and women’s basketball teams. (This is the rare academic paper that includes interviews with the Philadelphia 76ers.) Ninety-one percent of basketball fans believe that a player has “a better chance of making a shot after having just made his last two or three shots than he does after having just missed his last two or three shots.” In fact, there is no evidence that a player’s chances of making a shot are greater after making a previous shot—not with field goals for the 76ers, not with free throws for the Boston Celtics, and not when Cornell players shot baskets as part of a controlled experiment.
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Basketball fans are surprised by that—just as many homeowners were surprised in 2006 when real estate prices stopped going up. Lots of people had borrowed a lot of money on the assumption that what goes up must keep going up; the result has been a wave of foreclosures with devastating ripple effects throughout the global economy—which is a heck of a lot more significant than eating too many cashews. Chapter 3 discusses what, if anything, public policy ought to do about our irrational tendencies.

As John F. Kennedy famously remarked, “Life is not fair.” Neither is capitalism in some important respects. Is it a good system?

I will argue that a market economy is to economics what democracy is to government: a decent, if flawed, choice among many bad alternatives. Markets are consistent with our views of individual liberty. We may disagree over whether or not the government should compel us to wear motorcycle helmets, but most of us agree that the state should not tell us where to live, what to do for a living, or how to spend our money. True, there is no way to rationalize spending money on a birthday cake for my dog when the same money could have vaccinated several African children. But any system that forces me to spend money on vaccines instead of doggy birthday cakes can only be held together by oppression. The communist governments of the twentieth century controlled their economies by controlling their citizens’ lives. They often wrecked both in the process. During the twentieth century, communist governments killed some 100 million of their own people in peacetime, either by repression or by famine.

Markets are consistent with human nature and therefore wildly successful at motivating us to reach our potential. I am writing this book because I love to write. I am writing this book because I believe that economics will be interesting to lay readers. And I am writing this book because I really want a summer home in New Hampshire. We work harder when we benefit directly from our work, and that hard work often yields significant social gains.

Last and most important, we can and should use government to modify markets in all kinds of ways. The economic battle of the twentieth century was between capitalism and communism. Capitalism won. Even my leftist brother-in-law does not believe in collective farming or government-owned steel mills (though he did once say that he would like to see a health care system modeled after the U.S. Post Office). On the other hand, reasonable people can disagree sharply over when and how the government should involve itself in a market economy or what kind of safety net we should offer to those whom capitalism treats badly. The economic battles of the twenty-first century will be over how unfettered our markets should be.

T
he black rhinoceros is one of the most endangered species on the planet. Some 4,000 of them roam southern Africa, down from about 65,000 in 1970. This is an ecological disaster in the making. It is also a situation in which basic economics can tell us why the species is in such trouble—and perhaps even what we can do about it.

Why do people kill black rhinos? For the same reason they sell drugs or cheat on their taxes. Because they can make a lot of money relative to the risk of getting caught. In many Asian countries, the horn of the black rhino is believed to be a powerful aphrodisiac and fever reducer. It is also used to make the handles on traditional Yemenese daggers. As a result, a single rhino horn can fetch $30,000 on the black market—a princely sum in countries where per capita income is around $1,000 a year and falling. In other words, the black rhino is worth far more dead than alive to the people of impoverished southern Africa.

Sadly, this is a market that does not naturally correct itself. Unlike automobiles or personal computers, firms can’t produce new black rhinos as they see the supply dwindling. Indeed, quite the opposite force is at work; as the black rhino becomes more and more imperiled, the black market price for rhino horn rises, providing even more incentive for poachers to hunt down the remaining animals. This vicious circle is compounded by another aspect of the situation that is common to many environmental challenges: Most black rhinos are communal property rather than private property. That may sound wonderful. In fact, it creates more conservation problems than it solves. Imagine that all of the black rhinos were in the hands of a single avaricious rancher who had no qualms about making rhino horns into Yemenese daggers. This rancher has not a single environmental bone in his body. Indeed, he is so mean and selfish that sometimes he kicks his dog just because it gives him utility. Would this ogre of a rhino rancher have let his herd fall from 65,000 to 4,000 in thirty years? Never. He would have bred and protected the animals so that he would always have a large supply of horns to ship off to market—much as cattle ranchers manage their herds. This has nothing to do with altruism; it has everything to do with maximizing the value of a scarce resource.

Communal resources, on the other hand, present some unique problems. First, the villagers who live in close proximity to these majestic animals usually derive no benefit from having them around. To the contrary, large animals like rhinos and elephants can cause massive damage to crops. To put yourself in the shoes of local villagers, imagine that the people of Africa suddenly took a keen interest in the future of the North American brown rat and that a crucial piece of the conservation strategy involved letting these creatures live and breed in your house. Further imagine that a poacher came along and offered you cash to show him where the rats were nesting in your basement. Hmm. True, millions of people around the world derive utility from conserving species like the black rhino or the mountain gorilla. But that can actually be part of the problem; it is easy to be a “free rider” and let someone else, or some other organization, do the work. Last year, how much time and money did you contribute to preserving endangered species?

Tour and safari operators, who do make a lot of money by bringing wealthy tourists to see rare wildlife, face a similar “free rider” problem. If one tour company invests heavily in conservation, other tour companies that have made no such investment still enjoy all the benefits of the rhinos that have been saved. So the firm that spends money on conservation actually suffers a cost disadvantage in the market. Their tours will have to be more expensive (or they will have to accept a lower profit margin) in order to recoup their conservation investment. Obviously there is a role for government here. But the governments in sub-Saharan Africa are low on resources at best and corrupt and dysfunctional at worst. The one party who has a clear and powerful incentive is the poacher, who makes a king’s ransom by hunting down the remaining rhinos, killing them, and then sawing off their horns.

This is pretty depressing stuff. But economics also offers at least some insight into how the black rhino and other endangered species can be saved. An effective conservation strategy must properly align the incentives of the people who live in or near the black rhino’s natural habitat. Translation: Give local people some reason to want the animals alive rather than dead. This is the premise of the budding eco-tourism industry. If tourists are willing to pay great amounts of money to spot and photograph black rhinos, and, more important,
if local citizens somehow share the profits from this tourism,
then the local population has a large incentive to keep such animals alive. This has worked in places like Costa Rica, a country that has protected its rain forests and other ecological features by setting aside more than 25 percent of the country as national parks. Tourism currently generates over $1 billion in annual revenue, accounting for 11 percent of the national income.
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Sadly, this process is working in reverse at the moment with the mountain gorilla, another seriously endangered species (made famous by Dian Fossey, author of
Gorillas in the Mist
). It is estimated that only 620 mountain gorillas are left in the dense jungles of East Africa. But the countries that make up this region—Uganda, Rwanda, Burundi, and Congo—are embroiled in a series of civil wars that have devastated the tourism trade. In the past, local inhabitants have preserved the gorillas’ habitat not because they have any great respect for the mountain gorilla, but because they can make more money from tourists than they can by chopping down the forests that make up the gorillas’ habitat. That has changed as the violence in the region grinds on. One local man told the
New York Times,
“[The gorillas] are important when they bring in tourists. If not, they are not. If the tourists don’t come, we will try our luck in the forest. Before this, we were good timber cutters.”
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Meanwhile, conservation officials are experimenting with another idea that is about as basic as economics can be. Black rhinos are killed because their horns fetch a princely sum. If there is no horn, then presumably there is no reason to poach the animals. Thus, some conservation officials have begun to capture black rhinos, saw off their horns, and then release the animals back into the wild. The rhinos are left mildly disadvantaged relative to some of their predators, but they are less likely to be hunted down by their most deadly enemy, man. Has it worked? The evidence is mixed. In some cases, poachers have continued to kill dehorned rhinos, for a number of possible reasons. Killing the animals without horns saves the poachers from wasting time tracking the same animal again. Also, there is some money to be made from removing and selling even the stump of the horn. And, sadly, dead rhinos, even without horns, make the species more endangered, which drives up the value of existing horn stocks.

All of this ignores the demand side of the equation. Should we allow trade in products made from endangered species? Most would say no. Making rhino-horn daggers illegal in countries like the United States lowers the overall demand, which diminishes the incentive for poachers to hunt down the animals. At the same time, there is a credible dissenting view. Some conservation officials argue that selling a limited amount of rhino horn (or ivory, in the case of elephants) that has been legally stockpiled would have two beneficial effects. First, it would raise money to help strapped governments pay for antipoaching efforts. Second, it would lower the market price for these illicit items and therefore diminish the incentive to poach the animals.

As with any complex policy issue, there is no right answer, but there are some ways of approaching the problem that are more fruitful than others. The point is that protecting the black rhino is at least as much about economics as it is about science. We know how the black rhino breeds, what it eats, where it lives. What we need to figure out is how to stop human beings from shooting them. That requires an understanding of how humans behave, not black rhinos.

Incentives matter. When we are paid on commission, we work harder; if the price of gasoline goes up, we drive less; if my three-year-old daughter learns that she will get an Oreo if she cries while I’m talking on the phone, then she will cry while I am talking on the phone. This was one of Adam Smith’s insights in
The Wealth of Nations:
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Bill Gates did not drop out of Harvard to join the Peace Corps; he dropped out to found Microsoft, which made him one of the richest men on the planet and launched the personal computer revolution in the process—making all of us better off, too. Self-interest makes the world go around, a point that seems so obvious as to be silly. Yet it is routinely ignored. The old slogan “From each according to his abilities, to each according to his needs” made a wonderful folk song; as an economic system, it has led to everything from inefficiency to mass starvation. In any system that does not rely on markets, personal incentives are usually divorced from productivity. Firms and workers are not rewarded for innovation and hard work, nor are they punished for sloth and inefficiency.

How bad can it get? Economists reckon that by the time the Berlin Wall crumbled, some East German car factories were actually destroying value. Because the manufacturing process was so inefficient and the end product was so shoddy, the plants were producing cars worth less than the inputs used to make them. Basically, they took perfectly good steel and ruined it! These kinds of inefficiencies can also exist in nominally capitalist countries where large sectors of the economy are owned and operated by the state, such as India. By 1991, the Hindustan Fertilizer Corporation had been up and running for twelve years.
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Every day, twelve hundred employees reported to work with the avowed goal of producing fertilizer. There was just one small complication: The plant had never actually produced any salable fertilizer. None. Government bureaucrats ran the plant using public funds; the machinery that was installed never worked properly. Nevertheless, twelve hundred workers came to work every day and the government continued to pay their salaries. The entire enterprise was an industrial charade. It limped along because there was no mechanism to force it to shut down. When government is bankrolling the business, there is no need to produce something and then sell it for more than it cost to make.

These examples seem funny in their own way, but they aren’t. Right now, the North Korean economy is in such shambles that the country cannot feed itself, nor does it produce anything valuable enough to trade to the outside world in exchange for significant quantities of food. The nation is on the brink of famine, according to diplomats, United Nations officials, and other observers. This mass starvation would be a tragic repeat of the 1990s, when famine killed something on the order of a million people and left 60 percent of North Korean children malnourished. Journalists described starving people eating grass and scouring railroad tracks for bits of coal or food that may have fallen from passing trains.

In the United States, there is a great deal of hand-wringing about two energy-related issues: our dependence on foreign oil and the environmental impact of CO
₂
emissions. To economists, the fix for these interrelated issues is as close to a no-brainer as we ever get: Make carbon-based energy more expensive. If it costs more, we will use less—and therefore pollute less, too. I have powerful childhood memories of my father, who has no great affection for the environment but could squeeze a nickel out of a stone, stalking around the house closing the closet doors and telling us that he was not paying to air-condition our closets.

Meanwhile, American public education operates a lot more like North Korea than Silicon Valley. I will not wade into the school voucher debate, but I will discuss one striking phenomenon related to incentives in education that I have written about for
The Economist.
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The pay of American teachers is not linked in any way to performance; teachers’ unions have consistently opposed any kind of merit pay. Instead, salaries in nearly every public school district in the country are determined by a rigid formula based on experience and years of schooling, factors that researchers have found to be generally unrelated to performance in the classroom. This uniform pay scale creates a set of incentives that economists refer to as adverse selection. Since the most talented teachers are also likely to be good at other professions, they have a strong incentive to leave education for jobs in which pay is more closely linked to productivity. For the least talented, the incentives are just the opposite.

The theory is interesting; the data are amazing. When test scores are used as a proxy for ability, the brightest individuals shun the teaching profession at every juncture. The brightest students are the least likely to choose education as a college major. Among students who do major in education, those with higher test scores are less likely to become teachers. And among individuals who enter teaching, those with the highest test scores are the most likely to leave the profession early. None of this proves that America’s teachers are being paid enough. Many of them are not, especially those gifted individuals who stay in the profession because they love it. But the general problem remains: Any system that pays all teachers the same provides a strong incentive for the most talented among them to look for work elsewhere.

Human beings are complex creatures who are going to do whatever it takes to make themselves as well off as possible. Sometimes it is easy to predict how that will unfold; sometimes it is enormously complex. Economists often speak of “perverse incentives,” which are the inadvertent incentives that can be created when we set out to do something completely different. In policy circles, this is sometimes called the “law of unintended consequences.” Consider a well-intentioned proposal to require that all infants and small children be restrained in car seats while flying on commercial airlines. During the Clinton administration, FAA administrator Jane Garvey told a safety conference that her agency was committed to “ensuring that children are accorded the same level of safety in aircraft as are adults.” James Hall, chairman of the National Transportation Safety Board at the time, lamented that luggage had to be stowed for takeoff while “the most precious cargo on that aircraft, infants and toddlers, were left unrestrained.”
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Garvey and Hall cited several cases in which infants might have survived crashes had they been restrained. Thus, requiring car seats for children on planes would prevent injuries and save lives.