The Armchair Economist

Economics & Everyday Life

Steven E. Landsburg

• Publisher: Simon & Schuster UK
• Year: 2012
• Print ISBN: 9781471101311
• eBook ISBN: 9781471112232
• Topic: Business
• Subtopic: Business General
• Index: Business

Air bags cause accidents, because well-protected drivers take more risks. This well-documented truth comes as a surprise to most people, but not to economists, who have learned to take seriously the proposition that people respond to incentives. In The Armchair Economist, Steven E. Landsburg shows how the laws of economics reveal themselves in everyday experience and illuminate the entire range of human behavior. Why does popcorn cost so much at the cinema? The 'obvious' answer is that the owner has a monopoly, but if that were the whole story, there would also be a monopoly price to use the toilet. When a sudden frost destroys much of the Florida orange crop and prices skyrocket, journalists point to the 'obvious' exercise of monopoly power. Economists see just the opposite: If growers had monopoly power, they'd have raised prices before the frost. Why don't concert promoters raise ticket prices even when they are sure they will sell out months in advance? Why are some goods sold at auction and others at pre-announced prices? Why do boxes at the football sell out before the standard seats do? Why are bank buildings fancier than supermarkets? Why do corporations confer huge pensions on failed executives? Why don't firms require workers to buy their jobs? Landsburg explains why the obvious answers are wrong, reveals better answers, and illuminates the fundamental laws of human behavior along the way. This is a book of surprises: a guided tour of the familiar, filtered through a decidedly unfamiliar lens. This is economics for the sheer intellectual joy of it.

 

      CHAPTER 1      

THE POWER OF INCENTIVES

How Seat Belts Kill

Most of economics can be summarized in four words: “People respond to incentives.” The rest is commentary.

“People respond to incentives” sounds innocuous enough, and almost everyone will admit its validity as a general principle. What distinguishes the economist is his insistence on taking the principle seriously at all times.

I am old enough to remember the late 1970s and waiting half an hour to buy a tank of gasoline at a federally controlled price. Virtually all economists agreed that if the price were allowed to rise freely, people would buy less gasoline. Many noneconomists believed otherwise. The economists were right: When price controls were lifted, the lines disappeared.

Perhaps each generation has to learn this lesson anew. When gas prices spiked in the summer of 2008, journalists predicted that petroleum-addicted Americans would pay any price necessary to maintain their old habits. Economists were certain that gas consumption would fall. Once again the economists were right. By August 2008, gas consumption had fallen by about 8.5 percent, which (not coincidentally) was just about exactly the consensus forecast among economists.

The economist’s faith in the power of incentives serves him well, and he trusts it as a guide in unfamiliar territory. Back when seat belts (or air bags or antilock brakes) were first introduced, any economist could have predicted one of the consequences: The number of car accidents increased. That’s because the threat of being killed in an accident is a powerful incentive to drive carefully. But a driver with a seat belt or an air bag faces less of a threat. Because people respond to incentives, drivers are less careful. The result is more accidents.

The governing principle is precisely the same one that predicts behavior at the gas pump. When the price of gasoline is low, people choose to buy more gasoline. When the price of accidents (e.g., the probability of being killed or the expected medical bill) is low, people choose to have more accidents.

You might object that accidents, unlike gasoline, are not in any sense a “good” that people would ever choose to purchase. But speed and recklessness are goods in the sense that people seem to want them. Choosing to drive faster or more recklessly is tantamount to choosing more accidents, at least in a probabilistic sense.

An interesting question remains: How big is the effect in question? How many additional accidents are caused by seat belts, air bags, and other safety equipment? Here is a striking way to frame the question: Seat belts tend to reduce the number of driver deaths by making it easier to survive an accident. At the same time, seat belts tend to increase the number of driver deaths by encouraging reckless behavior. Which effect is the greater? Is the net effect to decrease or to increase the number of driver deaths?

This question can’t be answered by pure logic. One must look at actual numbers. The first person to do that was Sam Peltzman of the University of Chicago. He found that the two effects are of approximately equal size and therefore cancel each other out. When seat belts were first introduced (along with padded dashboards and collapsible steering columns) there were more accidents and fewer driver deaths per accident, but the total number of driver deaths remained essentially unchanged. Pedestrian deaths, however, appear to have increased—pedestrians, after all, are not equipped with padded dashboards. Subsequent studies have found comparable results for air bags and antilock brakes.

I have discovered that when I tell noneconomists about Peltzman’s results, they find it almost impossible to believe that people would drive less carefully simply because their cars are safer. Economists, who have learned to respect the principle that people respond to incentives, do not have this problem.

If you find it hard to believe that people drive less carefully when their cars are safer, consider the proposition that people drive more carefully when their cars are more dangerous. This is, of course, just another way of saying the same thing, but somehow people find it easier to believe. If I took the seat belts out of your car, wouldn’t you be more cautious when driving? What if I took the doors off?

Carrying this logic to its extreme, we could probably cut the accident rate dramatically by requiring each new car to have a spear mounted on the steering wheel, pointing directly at the driver’s heart. I predict there would be a lot less tailgating.

At the other extreme, NASCAR drivers have cars so safe that they can generally crash into concrete walls at high speeds and walk away with no injuries. How do they respond to all that safety? In the words of the economists Russell Sobel and Todd Nesbit, “They race them at 200 miles per hour around tiny oval racetracks only inches away from other automobiles—and have lots of wrecks.” And when the cars get safer, they have even more wrecks. NASCAR introduces hundreds of safety-related rule changes every year, which has allowed Sobel, Nesbit, and others to test and confirm this prediction.

One of the most dramatic rule changes followed the tragic crash that killed Dale Earnhardt Sr. at the Daytona 500 in 2001. Drivers are now required to wear a head and neck restraining system, or HANS device, which affords considerable protection in the event of a crash. According to the economists Adam Pope and Robert Tollison, the HANS device has increased the frequency of crashes by roughly 2 percent. Driver deaths and injuries are down, but pit crew injuries are up.

It is in no sense foolhardy to take more risks when you have a seat belt. Driving recklessly has its costs, but it has its benefits too. You get where you are going faster, and you can often have a lot more fun along the way. “Recklessness” takes many forms: It can mean passing in dangerous situations, but it can also mean letting your mind wander or fiddling with your iPod. Any of these activities might make your trip more pleasant, and any of them might be well worth a slight increase in accident risk. So it would be a mistake to conclude that seat belts are counterproductive. They’re definitely good for drivers, just not necessarily in the way you might expect.

Occasionally people are tempted to respond that nothing—or at least none of the things I’ve listed—is worth any risk of death. Economists find this objection particularly frustrating, because neither those who raise it nor anybody else actually believes it. All people risk death every day for relatively trivial rewards. Driving to Starbucks for a Mocha Frappuccino involves a clear risk that could be avoided by staying home, but people still drive to Starbucks. We need not ask whether small pleasures are worth any risk; the answer is obviously yes. The right question is how much risk those small pleasures are worth. It is perfectly rational to say, “I am willing to fiddle with my iPod while driving if it leads to a one-in-a-million chance of death, but not if it leads to a one-in-a-thousand chance of death.” That is why more people fiddle with their iPods at 25 miles per hour than at 70.

Peltzman’s observations reveal that driving behavior is remarkably sensitive to changes in the driver’s environment. This affords an opportunity for some drivers to influence the behavior of others. Fans of The Simpsons might recall that Homer and Marge once posted a “Baby on Board” sign in their rear window so that other drivers would stop intentionally ramming their car. Even outside cartoons, people use those signs to signal other drivers to use extraordinary care. I know drivers who find these signs insulting because of the implication that they don’t already drive as carefully as possible. Economists will be quite unsympathetic to this feeling, because they know that nobody ever drives as carefully as possible (do you have new brakes installed before each trip to the grocery store?) and because they know that most drivers’ watchfulness does vary markedly with their surroundings. Virtually all drivers would be quite unhappy to injure the occupants of another car; many drivers would be especially unhappy if that other car contained a baby. That group will choose to drive more carefully when alerted to a baby’s presence and will be glad to have that presence called to their attention.

This, incidentally, suggests an interesting research project. Economics suggests that many drivers are more cautious in the presence of a Baby on Board sign. The project is to find out how much more cautious by observing accident rates for cars with and without the signs. Unfortunately, accident rates can be misleading for at least three reasons. First, those parents who post signs are probably unusually cautious; they have fewer accidents just because they themselves are exceptionally careful drivers, independently of how their sign affects others. Second (and introducing a bias in the opposite direction), those parents who post signs know that the sign elicits caution from others, and they can therefore afford to be less vigilant themselves. This would tend to involve them in more accidents and at least partially cancel the effects of other drivers’ extra care. Third, if Baby on Board signs really work, there is nothing to stop childless couples from posting them dishonestly. If drivers are aware of widespread deception, they will tend to suppress their natural responses.

This means that raw accident statistics cannot reveal how drivers respond to Baby on Board signs. The problem is to find a clever statistical technique to make all the necessary corrections. I do not propose to solve that problem here, but I offer it as an example of a typical difficulty that arises in empirical economic research. Many research projects in economics revolve around creative solutions to just such difficulties.

After this slight digression into the challenges of empirical research, let me return to my main topic: the power of incentives. It is the economist’s second nature to account for that power. Will the invention of a better birth control technique reduce the number of unwanted pregnancies? Not necessarily: The invention reduces the “price” of sexual intercourse (unwanted pregnancies being a component of that price) and thereby induces people to engage in more of it. The percentage of sexual encounters that lead to pregnancy goes down, the number of sexual encounters goes up, and the number of unwanted pregnancies can go either down or up. Will energy-efficient cars reduce our consumption of gasoline? Not necessarily: An energy-efficient car reduces the price of driving, and people will choose to drive more. Statin drugs like Lipitor lower the price of being a couch potato and could therefore lead to more heart attacks. Low-tar cigarettes could increase the incidence of lung cancer. Better football helmets can mean more football injuries. Low-calorie synthetic fats could partly account for the obesity epidemic.

Criminal law is a critical area for understanding how people respond to incentives. To what extent do harsh punishments deter criminal activity? The death penalty is of particular interest. The deterrent effect of the death penalty has been studied intensely by innumerable government commissions and academic scholars. Often their studies consist of nothing more than examining murder rates in states with and without capital punishment laws. Economists tend to be harshly critical of these studies because they fail to account for other important factors that help to determine murder rates. (Often they fail even to account for how stringently the death penalty is enforced, although this varies appreciably from state to state.) On the other hand, the refined statistical techniques collectively known as econometrics are designed precisely to measure the power of incentives. This makes it natural to apply econometrics in examining the effect of the death penalty. One of the leaders in this effort has been Isaac Ehrlich of the State University of New York at Buffalo, whose pioneering research led him to a striking conclusion: During the 1960s (the last decade before the U.S. Supreme Court declared a moratorium on the death penalty), each execution prevented approximately eight murders. After the death penalty was reinstated, subsequent research found comparable numbers for more recent periods.

The details of Ehrlich’s methods have been widely criticized by other economists, but it is possible to make too much of this. Most of the criticisms involve esoteric questions of statistical technique. Such questions are important. But there is widespread agreement in the economics profession that the sort of empirical study that Ehrlich undertook is capable of revealing important truths about the effect of capital punishment.¹

Edward Leamer of the University of California at Los Angeles once published an amusing article titled “Let’s Take the Con out of Econometrics,” in which he warned that the prejudices of the researcher can substantially affect his results. He showed that a simple econometric test, with a pro–death penalty bias built in, could demonstrate that each execution prevents as many as 13 murders. The same test, with an anti–death penalty bias built in, could demonstrate that each execution actually causes as many as 3 additional murders. Still, unless one goes very far in the direction of building in a bias against the death penalty, most econometric research reveals a substantial deterrent effect of capital punishment. Murderers respond to incentives.

How can this be? Are not many murders crimes of passion or acts of irrationality? Perhaps so. But there are two responses to this objection. First, Ehrlich’s results indicate that each execution prevents eight murders; it does not indicate which eight murders are prevented. As long as some murderers can be deterred, capital punishment can be a deterrent. The second response is this: Why should we expect that people engaged in crimes of passion would fail to respond to incentives? We can imagine a man who hates his wife so much that under ordinary circumstances he would do her in if he thought he had a 90 percent chance of escaping execution. Perhaps in a moment of rage, he becomes so carried away that he will kill her even if he has only a 20 percent chance of escaping execution. Then even in the moment of rage, it matters very much whether he perceives his chances to be 15 percent or 25 percent.

(Let me mention a third response as well. Ehrlich did not just make up the number eight; he arrived at it through a sophisticated analysis of data. Skepticism is fine, but it is incumbent on the serious skeptic to examine the research with an open mind and to pinpoint what step in the reasoning, if any, he finds suspicious.)

There is evidence that people respond significantly to incentives even in situations where we don’t usually imagine their behavior to be calculated or even rational. Apparently psychologists have discovered that if you hand people unexpectedly hot cups of coffee, they typically drop the cup if they believe it’s cheap but manage to hang on if they believe the cup is valuable.

Due to some combination of arthritis (which makes it difficult for me to turn my head to the right) and irresponsibility, I had a years-long habit of backing the right rear corner of my car into lampposts, trees, and other stationary obstructions. Often enough so the body shop owner joked about giving me a quantity discount, I paid $180 to get my bumper repaired, and I came to think of this as an unavoidable expense. Then in 2002 I got a new car with a fiberglass bumper, backed it into a tree, and discovered that this repair was going to cost me over $500. I have not backed into anything since. Even economists respond to incentives.

Indeed the response to incentives may be as innate as any other instinctive behavior. In a series of experiments at Texas A&M University, researchers allowed rats and pigeons to “purchase” various forms of food and drink by pushing various levers. Each item has its price, such as 3 lever pushes for a drop of root beer or 10 for a piece of cheese. The animals are given “incomes” equal to a certain number of pushes per day; after the income is exhausted the levers become inoperable. In some versions of the experiments the animals can earn additional income by performing various tasks. They earn additional lever pushes at a fixed wage rate for each task they perform.

The researchers have found that rats and pigeons respond appropriately to changes in prices, changes in income, and changes in wage rates. When the price of root beer goes up, they buy less root beer. When wage rates go up, they work harder—unless their incomes are already very high, in which case they choose to enjoy more leisure. These are precisely the responses that economists expect and observe among human beings.

Incentives matter. The literature of economics contains tens of thousands of empirical studies verifying this proposition, and not one that convincingly refutes it. Economists are forever testing the proposition (while perhaps secretly hoping to make names for themselves by being the first to overturn it) and forever expanding the domain of its applicability. Whereas we used to think only about shoppers responding to the price of meat, we now think about drivers responding to seat belts, murderers responding to the death penalty, and rats and pigeons responding to wage, income, and price changes. Economists have studied how people choose marriage partners, family sizes, levels of religious activity, and whether to engage in cannibalism. (This trend has gone so far that the Journal of Political Economy published a satirical article on the economics of toothbrushing, which “predicted”—on the basis of certain assumptions about how the cleanliness of your teeth affects your wages—that people spend exactly half their waking hours brushing their teeth. “No sociological model,” boasted the author, “can yield such a precise conclusion.”) Through all the variations, one theme recurs: Incentives matter.

CHAPTER 2

RATIONAL RIDDLES

Why U2 Concerts Sell Out

Economics begins with the assumption that all human behavior is rational. Of course, this assumption is not always literally true; most of us can think of exceptions within our immediate families.

But the literal truth of assumptions is never a prerequisite for scientific inquiry. Ask a physicist how long it will take a bowling ball to land if you drop it from the roof of your house. He will happily assume that your house is located in a vacuum, and then proceed to calculate the right answer. Ask an engineer to predict the path of a billiard ball after it is struck at a certain angle. He will assume that there is no such thing as friction, and the accuracy of his prediction will give him no cause for regret. Ask an economist to predict the effects of a rise in the gasoline tax. He will assume that all people are rational and give you a pretty accurate response.

Assumptions are tested not by their literal truth but by the quality of their implications. By this standard, rationality has a pretty good track record. It implies that people respond to incentives, a proposition for which there is much good evidence. It implies that people will be willing to pay more for a 26-ounce box of cereal than for an 11-ounce box, that highly skilled workers will usually earn more than their unskilled counterparts, that people who love life will not jump off the Golden Gate Bridge, and that hungry babies will cry to announce their needs. All of these things are usually true.

When we assume that people are rational, we emphatically do not assume anything about th...

Table of contents

• Cover
• Half-title page
• Title page
• Copyright page
• Contents
• Preface to the Second Edition
• Introduction
• I. WHAT LIFE IS ALL ABOUT
• 1. The Power of Incentives: How Seat Belts Kill
• 2. Rational Riddles: Why U2 Concerts Sell Out
• 3. Truth or Consequences: How to Split a Check or Choose a Movie
• 4. The Indifference Principle: Who Cares If the Air Is Clean?
• 5. The Computer Game of Life: Learning What It's All About
• II. GOOD AND EVIL
• 6. Telling Right from Wrong: The Pitfalls of Democracy
• 7. Why Taxes Are Bad: The Logic of Efficiency
• 8. Why Prices Are Good: Smith versus Darwin
• 9. Of Medicine and Candy, Trains and Sparks: Economics in the Courtroom
• III. HOW TO READ THE NEWS
• 10. Choosing Sides in the Drug War: How the Atlantic Monthly Got It Wrong
• 11. The Mythology of Deficits
• 12. Unsound and Furious: Spurious Wisdom from the Media
• 13. How Statistics Lie: Unemployment Can Be Good for You
• 14. The Policy Vice: Do We Need More Illiterates?
• 15. Some Modest Proposals: The End of Bipartisanship
• IV. HOW MARKETS WORK
• 16. Why Popcorn Costs More at the Movies: And Why the Obvious Answer Is Wrong
• 17. Courtship and Collusion: The Mating Game
• 18. Cursed Winners and Glum Losers: Why Life Is Full of Disappointments
• 19. Random Walks and Stock Market Prices: A Primer for Investors
• 20. Ideas of Interest: Armchair Forecasting
• 21. The Iowa Car Crop
• V. THE PITFALLS OF SCIENCE
• 22. Was Einstein Credible? The Economics of the Scientific Method
• 23. New Improved Football: How Economists Go Wrong
• VI. THE PITFALLS OF RELIGION
• 24. Why I Am Not an Environmentalist: The Science of Economics versus the Religion of Ecology
• Appendix: Notes on Sources
• Index
• About the Author