Naked Economics

by Wheelan, Charles

  In fact, criminals are some of the most innovative folks around. Drug traffickers can make huge profits by transporting cocaine from where it is produced (in the jungles of South America) to where it is consumed (in the cities and towns across the United States). This is illegal, of course; U.S. authorities devote a great amount of resources to interdicting the supply of such drugs headed toward potential consumers. As with any other market, drug runners who find clever ways of eluding the authorities are rewarded with huge profits.

  Customs officials are pretty good at sniffing out (literally in many cases) large caches of drugs moving across the border, so drug traffickers figured out that it was easier to skip the border crossings and move their contraband across the sea and into the United States using small boats. When the U.S. Coast Guard began tracking fishing boats, drug traffickers invested in “go fast” boats that could outrun the authorities. And when U.S. law enforcement adopted radar and helicopters to hunt down the speedboats, the drug runners innovated yet again, creating the trafficking equivalent of Velcro or the iPhone: homemade submarines. In 2006, the Coast Guard stumbled across a forty-nine-foot submarine—handmade in the jungles of Colombia—that was invisible to radar and equipped to carry four men and three tons of cocaine. In 2000, Colombian police raided a warehouse and discovered a one-hundred-foot submarine under construction that would have been able to carry two hundred tons of cocaine. Coast Guard Rear Admiral Joseph Nimmich told the New York Times, “Like any business, if you’re losing more and more of your product, you try to find a different way.”8

  The market is like evolution; it is an extraordinarily powerful force that derives its strength from rewarding the swift, the strong, and the smart. That said, it would be wise to remember that two of the most beautifully adapted species on the planet are the rat and the cockroach.

  Our system uses prices to allocate scarce resources. Since there is a finite amount of everything worth having, the most basic function of any economic system is to decide who gets what. Who gets tickets to the Super Bowl? The people who are willing to pay the most. Who had the best seats for the Supreme Soviet Bowl in the old USSR (assuming some such event existed)? The individuals chosen by the Communist Party. Prices had nothing to do with it. If a Moscow butcher received a new shipment of pork, he slapped on the official state price for pork. And if that price was low enough that he had more customers than pork chops, he did not raise the price to earn some extra cash. He merely sold the chops to the first people in line. Those at the end of the line were out of luck. Capitalism and communism both ration goods. We do it with prices; the Soviets did it by waiting in line. (Of course, the communists had many black markets; it is quite likely that the butcher sold extra pork chops illegally out the back door of his shop.)

  Because we use price to allocate goods, most markets are self-correcting. Periodically the oil ministers from the OPEC nations will meet in an exotic locale and agree to limit the global production of oil. Several things happen shortly thereafter: (1) Oil and gas prices start to go up; and (2) politicians begin falling all over themselves with ideas, mostly bad, for intervening in the oil market. But high prices are like a fever; they are both a symptom and a potential cure. While politicians are puffing away on the House floor, some other crucial things start to happen. We drive less. We get one heating bill and decide to insulate the attic. We go to the Ford showroom and walk past the Expeditions to the Escorts.

  When gas prices approached $4 a gallon in 2008, the rapid response of American consumers surprised even economists. Americans began buying smaller cars (SUV sales plunged while subcompact sales rose). We drove fewer total miles (the first monthly drop in 30 years). We climbed on public buses and trains, often for the first time; transit ridership was higher in 2008 than at any time since the creation of the interstate highway system five decades earlier.9

  Not all such behavioral changes were healthy. Many consumers switched from cars to motorcycles, which are more fuel efficient but also more dangerous. After falling steadily for years, the number of U.S. motorcycle deaths began to rise in the mid-1990s, just as gas prices began to climb. A study in the American Journal of Public Health estimated that every $1 increase in the price of gasoline is associated with an additional 1,500 motorcycle deaths annually.10

  High oil prices cause things to start happening on the supply side, too. Oil producers outside of OPEC start pumping more oil to take advantage of the high price; indeed, the OPEC countries usually begin cheating on their own production quotas. Domestic oil companies begin pumping oil from wells that were not economical when the price of petroleum was low. Meanwhile, a lot of very smart people begin working more seriously on finding and commercializing alternative sources of energy. The price of oil and gasoline begins to drift down as supply rises and demand falls.

  If we fix prices in a market system, private firms will find some other way to compete. Consumers often look back nostalgically at the “early days” of airplane travel, when the food was good, the seats were bigger, and people dressed up when they traveled. This is not just nostalgia speaking; the quality of coach air travel has fallen sharply. But the price of air travel has fallen even faster. Prior to 1978, airline fares were fixed by the government. Every flight from Denver to Chicago cost the same, but American and United were still competing for customers. They used quality to distinguish themselves. When the industry was deregulated, price became the primary margin for competition, presumably because that is what consumers care more about. Since then, everything related to being in or near an airplane has become less pleasant, but the average fare, adjusted for inflation, has fallen by nearly half.

  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.11 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.12

  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.”13

  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.”14

  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.15

  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.16

  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 wr
iting 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.

  CHAPTER 2

  Incentives Matter:

  Why you might be able to save your face by cutting off your nose (if you are a black rhinoceros)

  The 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.