The Economic Naturalist's Field Guide

More than a century later, the general public continues to regard economists with suspicion. My fellow economists often object that this attitude stems from the fact that our positions on many important public policy issues remain poorly understood. Although not the whole story, it’s a fair point.

For example, economists commonly advocate auctioning rights to discharge atmospheric pollutants, leading critics to bemoan our willingness “to let rich firms pollute to their hearts’ content.” The statement betrays a comically naive understanding of the forces that guide corporate behavior.

Firms don’t pollute because they take pleasure in fouling the air and water but because clean production processes cost more than dirty ones. Requiring firms to buy pollution permits gives them an incentive to adopt cleaner processes. To avoid buying expensive permits, firms that have access to relatively cheap, clean alternative production methods will be quick to adopt them. A firm will buy pollution permits only if it lacks such alternatives.

Auctioning pollution rights makes sense because it concentrates the burden of pollution reduction in the hands of those who can accomplish it at the lowest cost. It minimizes the total cost of achieving any given air quality target—an outcome that is clearly in the interest of all citizens, rich and poor alike. Evidence suggests that the more people learn about the auction method, the less likely they are to oppose it. For instance, although environmental groups once bitterly opposed pollution permit auctions, they now endorse them enthusiastically.

But misunderstandings of this sort are not the main reason that economists remain “in bad odor.” There are at least three other important sources of skepticism about my fellow practitioners of the dismal science. One is that our traditional models of human behavior, which emphasize narrow self-interest, strike many as overly cynical. Self-interest is clearly an important human motive, but it isn’t the only one. We vote in presidential elections, for example, even though voting entails costs and a single vote has never proved decisive. We leave tips in restaurants we will never visit again. Lost wallets are often returned to their owners with the cash intact. Focusing exclusively on self-interest, in addition to seeming mean-spirited, prevents us from saying anything interesting about an important aspect of human behavior.

A second source of skepticism is that economists’ traditional models assume, against all evidence, that consumer decisions take place in social isolation. The plain fact is that evaluations of all types depend heavily on social context. For example, the same car that offered brisk acceleration in 1950 would seem sluggish to most drivers today. Similarly, the 3,000-square-foot house that seemed spacious to a corporate executive in 1980 would probably seem cramped today. And the right suit for an interview has always been one that compares favorably with those worn by other applicants for the same job.

Once we acknowledge that context shapes evaluation, many of my profession’s most cherished propositions go out the window. Traditional models say, for example, that when rational people weigh decisions about how many hours to work each week and how much to spend on various goods, the resulting patterns tend to promote the interests of society as a whole. But that’s not true when context matters.

Deciding how much to spend on a suit for an interview is a simple case in point. Experiments demonstrate that a job candidate who is better dressed than others is more likely to get a callback. This creates an obvious incentive to spend more on interview suits. Yet if all applicants tripled their expenditures on suits, the jobs would go to the same ones as before. Under the circumstances, it would be better if everyone spent less on suits and more on, say, preventative medicine and safer cars.

A third source of skepticism about economists is our traditional assumption that people are rational and dispassionate when choosing among various alternatives. Like the assumption that context doesn’t matter, this one claims that socially benign results occur when people are free to transact with one another without restrictions. For instance, if someone with a poor credit history agrees to borrow $500 for two weeks from a payday lender at an annual interest rate of 1,000 percent, standard models insist that the state harms both the borrower and the lender if it prevents the transaction.

Since the beginning of recorded human history, however, most societies have seen fit to forbid loan contracts of this sort, ostensibly because people are not nearly as rational and dispassionate as traditional economic models assume. For instance, people often assign insufficient weight to costs and benefits that occur in the future. This makes the benefit of borrowing money seem misleadingly large in relation to the cost of having to repay it, suggesting a clear rationale for usury laws. These laws undoubtedly prevent at least some mutually beneficial transactions from taking place. Yet few societies have embraced economists’ suggestion to eliminate them. In light of many people’s inability to weigh current benefits against future costs, such bans don’t seem mysterious.

In short, much of the widespread skepticism about advice dispensed by economists may be rooted in well-founded misgivings about the wisdom of the advice itself. If traditional economic models rest on inaccurate behavioral assumptions, why should advice predicated on those models be taken seriously?

Recent years have witnessed a revolution in how economists think about human behavior. The emerging field of behavioral economics devoted its earliest efforts to documenting the existence of anomalies that contradict the predictions of rational actor models. More recently, researchers in this field have introduced new models that better describe how people actually behave when confronted with economic choices. In these models, narrow self-interest is no longer the only important human motive, context shapes evaluation, and the consequences of systematic cognitive errors are explicitly taken into account.

Although these innovations have enabled behavioral economists to offer more realistic accounts of how people make economic choices, residual skepticism about economics continues to hamper our efforts to discuss these choices in public forums. Because the predictions made by our traditional models are often wrong, readers tend to discount our arguments even when the models are right. For example, when George Stephanopoulos of ABC News challenged Senator Hillary Clinton to name a single economist who favored her proposal to suspend the federal tax on gasoline in the summer of 2008, she defiantly responded, “I’m not going to put my lot in with economists!” Opinion polls suggested that the senator’s decision to throw economists under the bus helped inflate her winning margins in the subsequent West Virginia and Kentucky primaries.

The insights of behavioral economics make it possible to discuss the economic choices we face in ways that don’t insult the reader’s intelligence. Since the late 1990s, I have been writing newspaper columns about such choices. Some have examined the economic decisions confronting policy makers in Washington. Others have considered the savings and investment decisions that flow through Wall Street. Still others have addressed the decisions we confront as individual consumers. This book is a collection of selected columns, most of which originally appeared in the New York Times, either on the op-ed page or in the business section. Although all of them were written prior to the inauguration of President Barack Obama, they speak directly to many of the political, financial, and personal decisions we’ll confront in the years ahead.

Grouped thematically, the selections cover a broader spectrum of questions than many readers might expect to encounter in economics, ranging from why John F. Kennedy’s “Ask not . . .” appeal was so effective to why people voluntarily disclose unfavorable information about themselves. If you accept my view that economics is all about choice in a context of scarcity, then virtually all choices are economic ones.

The behavioral economics revolution has done nothing to alter the fundamental economic problem implicit in every such choice: while human desires are boundless, the resources necessary to satisfy them are limited. We confront trade-offs at every turn; having more of one good thing always requires making do with less of others.

Failure to think through these trade-offs results in waste. Traditional economic discourse—as exemplified in the late Arthur Okun’s 1975 book Equity and Efficiency: The Big Tradeoff—has conditioned us to think of efficiency and equality as competing goals. Consequently many believe that we must tolerate a certain measure of waste in the name of fairness. But I argue here for the opposite claim—that efficiency is always and everywhere the best way to promote equity.

In one sense, this claim is true by definition. After all, any step that makes the economic pie larger necessarily makes it possible for everyone to have a larger slice than before. Of course, there is no guarantee that everyone will automatically get a bigger slice. Redistribution is often necessary.

But efficiency and equity are often harmonious at a deeper level. Traditional economic discourse holds that while a more progressive tax system might be desirable on equity grounds, it would impoverish the nation by inhibiting effort and innovation. Recent developments in behavioral economics, however, suggest precisely the opposite effect. As I explain in my examination of the financial advice industry, for example, reducing the tax rates on top earners likely increased the number of aspiring hedge fund managers and reduced the number of aspiring teachers and engineers. Because we live in a world with too few qualified teachers and a huge surplus of people hoping to become money managers, these tax cuts have almost surely made the economic pie smaller.

In this and numerous other ways, recent developments in behavioral economics have rendered obsolete many of the long-standing disputes between traditional liberals and conservatives. As I argue in my discussion of John Kenneth Galbraith, when these developments support the traditional liberal position on an issue—as they often do—it is typically for different reasons. Liberals have long argued, for example, that safety regulation is needed to protect workers from exploitation by firms with market power. Yet as conservatives have consistently pointed out, such regulation typically has its greatest impact in the very labor markets that are most competitive by traditional measures. A more plausible account is that workers favor safety regulations for the same reason that hockey players favor rules requiring them to wear helmets.

As the Nobel laureate Thomas Schelling explained, hockey players gain a competitive edge by skating without helmets, perhaps because they are able to see and hear a little better. Yet when all players skate without helmets, each team’s odds of winning remain the same as if all players wore them. And hence the attraction of helmet rules.

A similar logic explains the attraction of workplace safety rules. By accepting a riskier job, a worker can earn extra money to buy a house in a better school district. Yet when all workers accept riskier jobs, they succeed only in bidding up the prices of such houses. As before, half of all workers must send their children to bottom-half schools.

Once economic reasoning is untethered from the constraints of the narrowest rational actor models, it becomes clear why conventional ideology provides an essentially useless guide for the economic choices we face. These choices are always best made pragmatically—by carefully weighing the relevant costs and benefits of competing options. Thus in a choice between two mutually exclusive programs, the better choice is the one whose benefit outweighs its cost by the larger margin. Always.

Suppose, for example, that the choice is between two methods for reaching a given air quality target in Los Angeles. Program A would require all cars, new and old, to meet reasonably strict emissions standards. Program B would exempt cars more than fifteen years old from these standards but would require stricter standards for newer vehicles. Both programs would yield the same overall air quality, but because program B’s stricter standards for new vehicles are costly, it is more expensive overall than program A.

The cost-benefit test identifies program A as the better option. But supporters of program B argue that despite its higher cost, it is still the better choice, since imposing the burden of meeting emissions standards on the mostly poor drivers who own older vehicles would be unacceptable.

As I explain in my discussion of this issue, however, this argument makes no sense. More than 80 percent of the smog in LA now comes from exempt older vehicles. The money saved by eliminating the exemption and adopting less strict standards for newer vehicles would have been more than enough to give every owner of an older vehicle a voucher sufficient to buy a compliant late-model used car.

Distributional objections are more difficult to address in some domains than in others. But it is almost always an error to regard them as insurmountable. Again, when a policy change makes the economic pie larger, it is always possible for everyone to get a larger slice than before. Astonishingly, however, many politicians continue to describe such policy changes as “politically unthinkable.”

My grandest hope for this volume is that it will encourage you to join me in accusing these leaders of political malpractice. Waste makes fewer resources available to meet important human needs. And since so many important human needs remain unmet, easily avoidable waste is inexcusable.

On a more modest scale, I hope to advance the pedagogical mission I launched in my 2007 book, The Economic Naturalist, arguing that a relatively small handful of basic principles do most of the heavy lifting in economics. Mastery of these principles is enormously helpful in dealing with the many difficult decisions that life serves up. Unfortunately, however, introductory economics courses generally leave no measurable trace on the students who take them. When they are tested on basic economic principles six months after taking one of these courses, they score no better, on average, than others who never took the course at all.

This dismal performance, I believe, stems largely from the fact that most professors try to teach their students too much. When students are peppered with literally hundreds of terms and concepts, many of them couched in gratuitous mathematical formalism, everything tends to go by in a blur.

The good news is that the most important economic principles can be mastered with little difficulty by applying them repeatedly to interesting questions from familiar contexts. That’s what I’ve attempted to do in the columns selected for this book. As learning theorists remind us, the key to mastering new concepts is repetition. So much information bombards us each day that our brains have evolved this simple rule of thumb for avoiding overload: if you see a new piece of information only once, ignore it; but if it recurs frequently, develop new circuits for dealing with it. Since I draw on the same handful of economic principles to answer a broad range of questions, you will see the same arguments deployed repeatedly. If the prospect of learning to apply these arguments appeals to you, I hope you’ll view this repetition as a feature, not a bug, of this volume.

Even if my reasoning doesn’t persuade you to oppose waste in all its forms, I’m confident you’ll master that distinctive mind-set known as “thinking like an economist.”