The Price of Everything

by Eduardo Porter

  The education premium is bigger than ever. In 1973, men who had at least a college degree made 55 percent more than those who had only completed high school. In 2010, they made 84 percent more. Yet perhaps due to the hollowing out of the labor market, this premium is no longer working well as an incentive. The educational attainment of the average American worker grew only one year from 1980 to 2005.

  These days the American Dream is a pretty misleading reverie. The hourly wage of the average shop-floor worker was lower in 2009 than it was in 1972, after accounting for inflation. The typical American family—two earners, a couple of kids—made less than it did a decade before. It’s been forty years since the last time the average worker could afford to pay the bills of the average household on a forty-hour workweek at the average wage. At the end of the first decade of the new millennium, the prosperity boom experienced by many workers in the twentieth century looks like a flash in the pan.

  A BANKER’S PARADISE

  This reconfiguration of prosperity is not simply about changes in the way we pay for work. The entire set of rules governing American capitalism changed. Those that emerged over the past three decades hammered the middle class.

  Trade barriers fell during this period, and capital controls were done away with. Welfare payments were redesigned to force the unemployed to look for work. Large swaths of regulation were cast aside as misguided hindrances to business. The shift lifted many of the protections that had shielded American workers from some of the harshest economic forces. And it provided enormous opportunities to those able to seize them.

  Take banking. Finance today is one of the most lucrative industries for bright college graduates. But it wasn’t always this richly paid. Financiers had a great time in the early decades of the twentieth century. From 1909 to the mid-1930s they made about 50 percent to 60 percent more than workers in other industries. But the stock-market collapse of 1929 and the Great Depression changed all that. In 1934, corporate profits in the financial sector shrank to $236 million, one eighth what they were five years earlier. Wages followed. From 1950 through about 1980, bankers and insurers made only 10 percent more than workers outside of finance.

  To a large extent this mirrors the ebb and flow of restrictions governing finance. A century ago there were virtually no regulations to restrain banks’ creativity and speculative urges. They could invest where they wanted, deploy depositors’ money as they saw fit. After the Great Depression, President Roosevelt set up a plethora of restrictions to avoid a repeat of the financial bubble that crashed in 1929.

  Interstate banking had been limited since 1927. In 1933, the Glass-Steagall Act forbade commercial banks and investment banks from getting into each other’s business—separating deposit taking and lending from playing the markets. Interest-rate ceilings were also imposed that year. The move to regulate bankers continued in 1959 under President Eisenhower, who forbade mixing banks with insurance companies. Barred from applying the full extent of their wits toward maximizing their incomes, many of the nation’s best and brightest who had flocked to make money in banking left for other industries.

  Then, in the 1980s, the Reagan administration unleashed an unstoppable surge of deregulation that continued for thirty years. By 1999, the Glass-Steagall Act lay repealed. Banks could commingle with insurance companies at will. Ceilings on interest rates had vanished. Banks could open branches anywhere. Unsurprisingly, the most highly educated returned to finance to make money. By 2005, the share of workers in the finance industry with a college education exceeded that of other industries by nearly 20 percent. These smart financiers turned their creativity on, inventing junk bonds in the 1980s and moving on, in the last few years, to residential mortgage-backed securities and credit default swaps. By 2006, pay in the financial sector was again 70 percent higher than wages elsewhere in the private sector. Then the financial industry blew up.

  Since the end of 2008, when the demise of the investment bank Lehman Brothers sent financial markets into a tailspin around the world, bankers have argued insistently against regulatory efforts to limit their remuneration packages, observing that curtailing financial activity will hamstring their ability to hire the best of the best. That’s perhaps true. The new financial regulations passed by Congress in 2010 may reduce the financial sector’s profitability. Bonuses might suffer.

  Still, this is probably a good thing. Only 5 percent of the men who graduated from Harvard in 1970 would end up working in finance fifteen years later. By the 1990 class it was 15 percent. Meanwhile, the percentage of male graduates going into law and medicine fell from 39 percent to 30 percent. Of the 2009 Princeton graduates who got jobs after graduation, 33.4 percent went into finance; 6.3 percent took jobs in government. From our current vantage point, this looks like a misallocation of resources. For the good of the rest of the economy, bankers should earn less.

  CHAPTER SIX

  The Price of Free

  TO THOSE WHO believe the Internet will change everything, October 10, 2007, marks a minor watershed. On that day, the British alternative band Radiohead offered fans the chance to pay whatever they chose to download its new album In Rainbows. If they wanted, they could get it for free. About a million fans downloaded the album in the first month, according to comScore, a market research firm, of whom more than six in ten paid nothing. Several million more downloaded the album from peer-to-peer services that offer fans the ability to share their music online, rather than from Radiohead’s free Web site.

  To economists, whose understanding of civilization starts with the assumption that people are hardwired to seek value for money, what was perplexing was that 38 percent of those who downloaded In Rainbows, by comScore’s estimate, chose to pay even though they didn’t have to. Could these fans have been overwhelmed by some altruistic urge to give money to rock stars, rich though they are? Maybe they believed it was unjust to pay nothing for something they coveted, made by people they loved. Maybe they appreciated the novelty of the experiment.

  ComScore estimated that the band made $2.26 per download; a decent sum considering the audio file available for download was of fairly low quality. Moreover, the band didn’t have to share any of the money with a record label. And there was more money to be made. Fans rushed to buy a higher-quality version of the album when it went on sale a few months later—pushing it to the top of the American and British charts. In the United States it remained on the charts for fifty-two weeks, longer than any other Radiohead album. By October of 2008, In Rainbows had sold more than 3 million copies, according to the band’s publisher, including 100,000 of a special boxed set that retailed for about $80. This surpassed the sales of the previous two albums, Hail to the Thief and Amnesiac . Pumped by the enormous publicity surrounding the album’s release, the subsequent concert tour was a smashing hit.

  To believers in the transformational potential of the Internet, Radiohead’s experiment suggested that the information economy could revolutionize capitalism by allowing creators to make a living while giving away their creations for free. This new economy might require people to radically change their approach to property. But In Rainbows demonstrated that if creators would free themselves of the capitalistic shackles represented by record labels, Hollywood studios, and other representatives of corporate greed that siphoned off a big slice of their revenues, this new paradigm could work out for everybody.

  No longer would it be necessary for creators to hide behind the walls of copyright erected to protect “intellectual property.” The production of information goods would be supported by consumers’ altruism, much like philanthropy or tipping. Artists could stoke consumers’ sense of fairness and reciprocity by giving away the product of their toil to anybody who wanted it for free.

  Yet despite the utopian feel of Radiohead’s implicit proposition, In Rainbows was less a product of communitarian idealism than of stark, urgent necessity. The nexus between creativity and commerce that has powered capitalism for hundreds of years is under incre
asing threat. Computers and the Internet have made it so easy to copy and share information around the world that its creators have lost their ability to charge for it. Radiohead was looking for alternatives to survive in a world in which, like it or not, its fans could listen to its music at will, free of charge.

  Music is the tip of the iceberg. Over the past decade or so, most young people have come to believe that news is a free commodity too, readily available online. Google scanned millions of out-of-print books and, if the courts accede, hopes to create a vast free library online. Movies are available gratis to those with a broadband connection and a modicum of computer chops. VoIP technology allows anyone with an Internet connection to make free phone calls around the world. And corporate software giants now must routinely compete with the “freeware” designed by thousands of engineers, contributing their labor to a collective enterprise.

  The information revolution has even undermined the old economy’s paragon of free media: broadcast TV. An hour-long show on most television networks typically involves forty-two minutes’ worth of programming and eighteen minutes of ads, which are supposed to pay for the show. In 2009, for instance, advertisers reportedly paid about $230,000 for a thirty-second spot on ABC’s Desperate Housewives. At that rate, each of the 10.6 million households watching Desperate Housewives was worth about seventy-nine cents to the network.

  Digital video recorders like TiVo that allow viewers to skip commercials threaten to deprive the networks of this money and allow fans to watch shows at no cost in money or time. “Your contract with the network when you get the show is you’re going to watch the spots. Otherwise you couldn’t get the show on an ad-supported basis,” said a frustrated Jamie Kellner, chairman and chief executive of Turner Broadcasting, in a 2002 interview. “Any time you skip a commercial or watch the button you’re actually stealing the programming.” Viewers, of course, have no legal obligation to watch anything. Still, Mr. Kellner accurately articulated the implicit economic trade-off that has sustained broadcast TV. If that falls apart, it will need to fund itself another way.

  THE ALLURE OF THE FREE

  We can’t have a functioning economy based on free stuff. It would violate an ironclad law of the universe known as “There’s No Such Thing as a Free Lunch.” The term apparently originated in the United States of the mid-twentieth century, when some perspicacious observer noted that the free food offered to patrons at bars and saloons was not really free, but incorporated into the price of drinks. It has found a place in astrophysics, where it means that in a closed universe, as most believe ours to be, you can’t conjure up new matter or energy out of nothing. But it is most important to economics, distilling the very essence of the discipline. The saying means that in a world of scarcity all decisions entail a trade-off. You usually can’t get something without giving up something in return. You might not always recognize the price, but even hidden prices can be high.

  Free is precisely the kind of concept that can make us part with our money without noticing that we are doing so. Businesses have long used the device to lure customers to spend. Tricks include the standard “buy one, get one free” and the typical late-night cable-TV pitch, which asks viewers to “call now and get” some free knickknack on top of the advertised product.

  Receiving something gratis conjures a sense of indebtedness and incites deep-seated feelings of reciprocity that can be stroked for profit. Sales representatives of the direct sales giant Amway have been known to leave potential clients with a free sample basket of toiletries and other household goodies and return a few days later to make the sale, harnessing the customer’s feeling of obligation. In the 1970s, members of the Hare Krishna Society would give a flower or a small trinket to passersby before hitting them for money. It worked so well that airports where Hare Krishnas operated posted signs and made public announcements to forewarn people about what they were up to with their “gifts.”

  Getting something for free adds to its intrinsic value. In an experiment at the Massachusetts Institute of Technology, two thirds of students who were offered a ten-dollar Amazon gift card for one dollar or a twenty-dollar card for eight dollars chose the latter because it provided them with a higher profit. But when the prices of both cards were dropped by one dollar, everybody switched to take the ten-dollar card because they would get it for free, even if choosing the alternative would have netted them thirteen dollars.

  The mirage of free is so tempting that governments spend a lot of effort protecting us from its allure. In 1925 the Federal Trade Commission tried and failed to stop the John C. Winston Co. from providing “free” encyclopedias that came with costly supplements attached. The appeals court decided a customer would have to be “very stupid” to think the free offer was really free. But in 1937 the Supreme Court supported the FTC’s action to stop the Standard Education Society from pulling a similar gimmick. Justice Hugo Black pointed out: “There is no duty resting upon a citizen to suspect the honesty of those with whom he transacts business.” And in 1953 the consumer regulator forced the Book-of-the-Month Club to stop using the big ads with enormous print offering a free book, only to warn customers in the smallest of print that they had to buy four more books a year from the catalog as part of the deal.

  THE CONFLICT BETWEEN makers and consumers of information is of paramount importance to our era. The American historian Adrian Johns argues that just as the key industry of the nineteenth century was manufacturing and the central industry of the twentieth was energy, power in the twenty-first century will gravitate toward those who are better at producing and managing knowledge and information.

  Those extolling the social benefits of free online information see themselves as countercultural revolutionaries willing to liberate the era from the oppressive shackles of capitalism, lift it from under the thumb of profit-seeking corporations, and take us all back to our supposedly communitarian roots. But free lunches aren’t easy to find among precapitalist societies either.

  Gifts play a big role in many societies. There’s the potlatch among the natives of the American Northwest and the kula among Melanesians of the Trobriand Islands, cycles of ritual gift giving among neighboring tribes. Bronislaw Malinowski, the anthropologist who studied natives of the Trobriand Islands off Papua New Guinea in the 1910s, witnessed farmers take mounds of yams and taro root to the fishermen’s village. Then he saw the fishermen reciprocate, taking mounds of fish to the farmers’ village.

  But these gifts aren’t free. The French sociologist Marcel Mauss argued that such acts of conspicuous giving are designed to foster a sense of indebtedness in the receiving group, creating social pressure for it to reciprocate with a gift at least equal in value. This tends to act as a social bond. When Malinowski thought to have found a definitive gift with no strings attached—small presents husbands regularly gave their wives—Mauss objected that these presents, called buwana or sebuwana, were “a remuneration-cum-gift for the service rendered by the wife when she lends what the Koran still calls ‘the field.’ ”

  The price of any commodity in a market transaction is the point at which both the buyer and the seller find the transaction to be profitable, leaving them both better off. Free things, even if only a mirage, can short-circuit society by introducing two distortions. They encourage consumers to consume much more than they otherwise would, and they discourage producers from producing enough to satisfy consumer demand.

  Take spam. It amounts to around 90 percent of worldwide e-mail traffic. That’s because it’s virtually free to send. In 2008 researchers estimated that spammers’ costs for domain registrations, hosting fees, e-mail lists, and so forth amounted to next to nothing: $80 per million messages. So spammers send tons, and recipients pay the price. A study at a German university concluded that each one of its employees spent about twenty hours a year detecting and deleting spam. Considering the average wage in Germany amounted to about €20 an hour, spam was costing the university some €400 per employee. Across eight thousand em
ployees it added up to €3.2 million.

  If spam were costly to send, it would be less abundant. On April 1, 2002, the Korean Internet portal Daum started charging bulk e-mail senders a fee of up to ten won (about 0.8 cents) per message, depending on the volume sent. Inbound bulk e-mail fell 54 percent in the first three months of the fee.

  Just as costless spam encourages its overproduction, free information inhibits its creation. Those who believe information online should be available at no cost like to see it as the light from a light-house. Any ship passing through the bay at night will benefit from its light, yet this use will not reduce the supply of light for other ships in the vicinity. The analogy is apt. Downloading a copy of the latest Batman movie doesn’t make it less available to others. The cost of making one more copy is so close to zero that we can’t tell the difference. So the supply of Batman never ends.

  But the analogy also highlights creators’ existential problem: somebody has to pay for the lighthouse’s light. The light and the movie won’t happen unless shipowners and Batman fans can be made to pay for them. Lighthouses—like clean air and national defense—are known because of their peculiar nature as “public goods.” The fact that consumers can use them without paying has a name too: the “free rider problem.” It is a problem because private companies cannot earn enough money from selling public goods to give them a reason to produce them. So left to the private sector, they won’t be produced. Transported to the Internet era, the argument suggests that if information becomes truly free, we will stop producing any.