Naked Economics (8 page)

There are problems on the sell side, too, though they are more subtle. The better price you get for your house, the more money your agent will make. That is a good thing. But the incentives are still not perfectly aligned. Suppose you are selling a house in the $300,000 range. Your agent can list the house for $280,000 and sell it in about twenty minutes. Or she could list it for $320,000 and wait for a buyer who really loves the place. The benefit to you of pricing the house high is huge: $40,000. Your real estate agent may see things differently. Listing high would mean many weeks of showing the house, holding open houses, and baking cookies to make the place smell good. Lots of work, in other words. Assuming a 3 percent commission, your agent can make $8,400 for doing virtually nothing or $9,600 for doing many weeks of work. Which would you choose? On the buy side or the sell side, your agent’s most powerful incentive is to get a deal done, whether it is at a price favorable to you or not.

Economics teaches us how to get the incentives right. As Gordon Gekko told us in the movie
Wall Street,
greed is good, so make sure that you have it working on your side. Yet Mr. Gekko was not entirely correct. Greed can be bad—even for people who are entirely selfish. Indeed, some of the most interesting problems in economics involve situations in which rational individuals acting in their own best interest do things that make themselves worse off. Yet their behavior is entirely logical.

The classic example is the prisoner’s dilemma, a somewhat contrived but highly powerful model of human behavior. The basic idea is that two men have been arrested on suspicion of murder. They are immediately separated so that they can be interrogated without communicating with one another. The case against them is not terribly strong, and the police are looking for a confession. Indeed, the authorities are willing to offer a deal if one of the men rats out the other as the trigger man.

If neither man confesses, the police will charge them both with illegal possession of a weapon, which carries a five-year jail sentence. If both of them confess, then each will receive a twenty-five-year murder sentence. If one man rats out the other, then the snitch will receive a light three-year sentence as an accomplice and his partner will get life in prison. What happens?

The men are best off collectively if they keep their mouths shut. But that’s not what they do. Each of them starts thinking. Prisoner A figures that if his partner keeps his mouth shut, then he can get the light three-year sentence by ratting him out. Then it dawns on him: His partner is almost certainly thinking the same thing—in which case he had better confess to avoid having the whole crime pinned on himself. Indeed, his best strategy is to confess regardless of what his partner does: It either gets him the three-year sentence (if his partner stays quiet) or saves him from getting life in prison (if his partner talks).

Of course, Prisoner B has the same incentives. They both confess, and they both get twenty-five years in prison when they might have served only five. Yet neither prisoner has done anything irrational.

The amazing thing about this model is that it offers great insight into real-world situations in which unfettered self-interest leads to poor outcomes. It is particularly applicable to the way in which renewable natural resources, such as fisheries, are exploited when many individuals are drawing from a common resource. For example, if Atlantic swordfish are harvested wisely, such as by limiting the number of fish caught each season, then the swordfish population will remain stable or even grow, providing a living for fishermen indefinitely. But no one “owns” the world’s swordfish stocks, making it difficult to police who catches what. As a result, independent fishing boats start to act a lot like our prisoners under interrogation. They can either limit their catch in the name of conservation, or they can take as many fish as possible. What happens?

Exactly what the prisoner’s dilemma predicts: The fishermen do not trust each other well enough to coordinate an outcome that would make them all better off. Rhode Island fisherman John Sorlien told the
New York Times
in a story on dwindling fish stocks, “Right now, my only incentive is to go out and kill as many fish as I can. I have no incentive to conserve the fishery, because any fish I leave is just going to be picked up by the next guy.”
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So the world’s stocks of tuna, cod, swordfish, and lobster are fished away. Meanwhile, politicians often make the situation worse by bailing out struggling fishermen with assorted subsidies. This merely keeps boats in the water when some fishermen might otherwise quit.

Sometimes individuals need to be saved from themselves. One nice example of this is the lobstering community of Port Lincoln on Australia’s southern coast. In the 1960s, the community set a limit on the number of traps that could be set and then sold licenses for those traps. Since then, any newcomer could enter the business only by buying a license from another lobsterman. This limit on the overall catch has allowed the lobster population to thrive. Ironically, Port Lincoln lobstermen catch more than their American colleagues while working less. Meanwhile, a license purchased in 1984 for $2,000 now fetches about $35,000. As Aussie lobsterman Daryl Spencer told the
Times,
“Why hurt the fishery? It’s my retirement fund. No one’s going to pay me $35,000 a pot if there are no lobsters left. If I rape and pillage the fishery now, in ten years my licenses won’t be worth anything.” Mr. Spencer is not smarter or more altruistic than his fishing colleagues around the world; he just has different incentives. Oddly, some environmental groups oppose these kinds of licensed quotas because they “privatize” a public resource. They also fear that the licenses will be bought up by large corporations, driving small fishermen out of business.

So far, the evidence strongly suggests that creating private property rights—giving individual fishermen the right to a certain catch, including the option of selling that right—is the most effective tool in the face of collapsing commercial fisheries. A 2008 study of the world’s commercial fisheries published in
Science
found that individual transferable quotas can stop or even reverse the collapse of fishing stocks. Fisheries managed with transferable quotas were half as likely to collapse as fisheries that use traditional methods.
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Two other points regarding incentives are worth noting. First, a market economy inspires hard work and progress not just because it rewards winners, but because it crushes losers. The 1990s were a great time to be involved in the Internet. They were bad years to be in the electric typewriter business. Implicit in Adam Smith’s invisible hand is the idea of “creative destruction,” a term coined by the Austrian economist Joseph Schumpeter. Markets do not suffer fools gladly. Take Wal-Mart, a remarkably efficient retailer that often leaves carnage in its wake. Americans flock to Wal-Mart because the store offers an amazing range of products cheaper than they can be purchased anywhere else. This is a good thing. Being able to buy goods cheaper is essentially the same thing as having more income. At the same time, Wal-Mart is the ultimate nightmare for Al’s Glass and Hardware in Pekin, Illinois—and for mom-and-pop shops everywhere else. The pattern is well established: Wal-Mart opens a giant store just outside of town; several years later, the small shops on Main Street are closed and boarded up.

Capitalism can be a brutal, cruel process. We look back and speak admiringly of technological breakthroughs like the steam engine, the spinning wheel, and the telephone. But those advances made it a bad time to be, respectively, a blacksmith, a seamstress, or a telegraph operator. Creative destruction is not just something that might happen in a market economy. It is something that
must
happen. At the beginning of the twentieth century, half of all Americans worked in farming or ranching.
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Now that figure is about one in a hundred and still falling. (Iowa is still losing roughly fifteen hundred farmers a year.) Note that two important things have
not
happened: (1) We have not starved to death; and (2) we do not have a 49 percent unemployment rate. Instead, American farmers have become so productive that we need far fewer of them to feed ourselves. The individuals who would have been farming ninety years ago are now fixing our cars, designing computer games, playing professional football, etc. Just imagine our collective loss of utility if Steve Jobs, Steven Spielberg, and Oprah Winfrey were corn farmers.

Creative destruction is a tremendous positive force in the long run. The bad news is that people don’t pay their bills in the long run. The folks at the mortgage company can be real sticklers about getting that check every month. When a plant closes or an industry is wiped out by competition, it can be years or even an entire generation before the affected workers and communities recover. Anyone who has ever driven through New England has seen the abandoned or underutilized mills that are monuments to the days when America still manufactured things like textiles and shoes. Or one can drive through Gary, Indiana, where miles of rusting steel plants are a reminder that the city was not always most famous for having more murders per capita than any other city in the United States.

Competition means losers, which goes a long way toward explaining why we embrace it heartily in theory and then often fight it bitterly in practice. A college classmate of mine worked for a congressman from Michigan shortly after our graduation. My friend was not allowed to drive his Japanese car to work, lest it be spotted in one of the Michigan congressman’s reserved parking spaces. That congressman will almost certainly tell you that he is a capitalist. Of course he believes in markets—unless a Japanese company happens to make a better, cheaper car, in which case the staff member who bought that vehicle should be forced to take the train to work. (I would argue that the American automakers would have been much stronger in the long run if they had faced this international competition head-on instead of looking for political protection from the first wave of Japanese imports in the 1970s and 1980s.) This is nothing new; competition is always best when it involves other people. During the Industrial Revolution, weavers in rural England demonstrated, petitioned Parliament, and even burned down textile mills in an effort to fend off mechanization. Would we be better off now if they had succeeded and we still made all of our clothes by hand?

If you make a better mousetrap, the world will beat a path to your door; if you make the old mousetrap, it is time to start firing people. This helps to explain our ambivalence to international trade and globalization, to ruthless retailers like Wal-Mart, and even to some kinds of technology and automation. Competition also creates some interesting policy trade-offs. Government inevitably faces pressure to help firms and industries under siege from competition and to protect the affected workers. Yet many of the things that minimize the pain inflicted by competition—bailing out firms or making it hard to lay off workers—slow down or stop the process of creative destruction. To quote my junior high school football coach: “No pain, no gain.”

One other matter related to incentives vastly complicates public policy: It is not easy to transfer money from the rich to the poor. Congress can pass the laws, but wealthy taxpayers do not stand idly by. They change their behavior in ways that avoid as much taxation as possible—moving money around, making investments that shelter income, or, in extreme cases, moving to another jurisdiction. When Bjorn Borg dominated the tennis world during my childhood, the Swedish government taxed his earnings at an extremely high rate. Borg did not lobby the Swedish government for lower taxes or write passionate op-eds about the role of taxes in the economy. He merely transferred his residence to Monaco, where the tax burden is much lower.

At least he was still playing tennis. Taxes provide a powerful incentive to avoid or reduce the activity that is taxed. In America, where much of our revenue comes from the income tax, high taxes discourage…income? Will people really stop or start working based on tax rates? Yes—especially when the worker involved is the family’s second earner. Virginia Postrel, a columnist on economics for the
New York Times,
has declared that tax rates are a feminist issue. Because of the “marriage tax,” second earners in families with high household incomes, who are more likely to be women, pay an average of 50 cents in taxes for every dollar they earn, which profoundly affects the decision to work or stay home. “By disproportionately punishing married women’s work, the tax system distorts women’s personal choices. And by discouraging valuable work, it lowers our overall standard of living,” she writes. She offers some interesting evidence. As a result of the 1986 tax reform, marginal tax rates for women in the highest income brackets fell more sharply than tax rates for women with lower incomes, meaning that they saw a much sharper drop in the amount that the government takes from every paycheck. Did they respond differently from women who did not get the same large tax break? Yes, their participation in the work force jumped three times as much.
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On the corporate side, high taxes can have a similar effect. High taxes lower a firm’s return on investment, thereby providing less incentive to invest in plants, research, and other activities that lead to economic growth. Once again we are faced with an unpleasant trade-off: Raising taxes to provide generous benefits to disadvantaged Americans can simultaneously discourage the kinds of productive investments that might make them better off.

If tax rates get high enough, individuals and firms may slip into the “underground economy” where they opt to break the law and avoid taxes entirely. Scandinavian countries, which offer generous government programs funded by high marginal tax rates, have seen large growth in the size of their black market economies. Experts estimate that the underground economy in Norway grew from 1.5 percent of gross national product in 1960 to 18 percent by the mid-1990s. Cheating the tax man can be a vicious circle. As more individuals and firms slip into the underground economy, tax rates must go up for everyone else in order to provide the same level of government revenue. Higher taxes in turn cause more flight to the underground economy—and so on.
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