DRI-309 for week of 10-21-12: The Economic Logic of Gifts

An Access Advertising EconBrief:

The Economic Logic of Gifts

The approach of the year-end holidays releases a flood of gift-oriented online content. One such article appeared on MSN on October 19. “What Women Want Men Don’t Give,” by Emily Jane Fox, seized the publication of research by American Express and the Harrison Group as an opportunity for male bashing. The full findings, though, don’t provide ammunition to either side in the battle of the sexes. But they do supply grist to the mill of economists.

Economists study the practice of gift-giving carefully. This surprises most people, who view gifts and pecuniary purchases as antithetical behavior. Yet in both theory and practice, gifts loom large in economics.

Most laymen are aware that the bulk of retail sales are expended on holiday gifts during the Christmas season. But they are probably unaware that economists are even more interested in the individual motivations for giving than in their seasonal macroeconomic impact. Senator Jed Sessions recently identified nearly 80 separate federal welfare programs that dispense around $1 trillion annually. Whether cash or in-kind, these disbursements are gifts in the technical sense. War reparations demanded by victor nations from the vanquished have sometimes changed the course of history, the most famous example being the steep debts levied on Weimar Germany by the Allies after World War I. Such reparations are yet another form of gift, this time on the national level. Their effects are proverbial among students of international economics.

The MSN article is best understood as an exercise in the modern practice of rhetorical journalism. That is, it is intended not to report facts but to produce an effect on the reader. Economists study unintended consequences of human action, and in this case the author’s attempt to manipulate her readers has produced surprising revelations about the economic logic of gift-giving.

The Process Frustrates Everybody – Including the Author

The research, sponsored by American Express and a consulting firm called the Harrison Group, surveyed 625 households whose working members ranked in the top 10% of wage-earners by income. The survey questions probed respondents’ preferences in both gift-giving and receiving. The results found “…a wide gap between what people want and what they actually get.” Apparently, the gap occurs because people do not give gifts in accordance with recipients’ wishes. Indeed, they do not even behave the way they themselves want their own gift-givers to act.

The author showcases women as victims of this asymmetry. “Two-thirds of affluent American women want gift cards. But less than a fifth of men will [comply]…Instead, 70% of American women are gifted clothing or jewelry.”

Thus, the article begins in a familiar manner. The reader is presented with stereotypes – woman as practical consumers, men as selfish dinosaurs who persist in their ways heedless of feminine sensitivities. But just when the reader feels able to predict what is coming, the article changes course.

Men, too, suffer the pain of asking without receiving. Men “…want food and alcohol – a third are hoping for gourmet foods and fine wine, and another third want gift cards. But women like to give none of these – 30% are expected to give clothing and another 15% books… What wealthy shoppers are better suited for [is] giving gifts to themselves.”

The author’s frustration seems comparable to that of her subjects. Having begun with one agenda in mind – to reinforce the stereotype of male insensitivity – she runs up against the comparable worthlessness of female behavior. When her gender angle encounters a roadblock, she makes a last-minute detour in the direction of class envy by indicting the self-absorption of “wealthy shoppers.” But she lacks the space to start up another argument and must rest content with allowing the headline to do all her work.

What Do Women Want, Generically Speaking? Does This Differ From Male Wants?

Economists try to interpret facts in light of what they know – or think they know – about human motivation. Can we take the scenario as presented above and make sense of it?

“What do women want?” is an age-old question. Economics does not recognize separate male and female systems of logic, so the apparent frustration felt by the author does not affect them. The fact that men and women behave broadly alike is not shocking. The question is: Is their behavior logically consistent?

Some commenters on the online article showed disdain for the author’s willingness to question the value of a gift. Why not accept it in the (presumably charitable) spirit in which it was offered? That is a question worth tackling.

The exchange of gifts is a ritual dating back many centuries. The distinctive features of holiday gift exchange in the Western world are its reciprocal and quasi-compulsory character. Reciprocity implies that, roughly speaking, the net monetary value of the exchanges can be treated as cancelling out. Consequently, their only real value must be to achieve some sort of efficiency. Otherwise, why bother? When it comes to random gifts, the commenters have a point. The mouth of a non-reciprocal, fully voluntary gift horse is certainly not worth close examination.

There is much to criticize about the holiday gift-giving ritual, though. The custom of giving gifts in-kind runs afoul of the long-recognized economic presumption in favor of gifts in cash. Students of intermediate microeconomics courses are routinely shown the inefficiency of programs like the federal food-stamp program, which subsidizes the consumption of (somewhat) poor people by giving them subsidized food rather than a cash payment of equal value. (Technically, the term “equal value” must refer to the value of the subsidized good – food – that the recipient chooses, which can only be determined after the consumption choice is made on pre-selected terms. But it is easy to show diagrammatically or mathematically that giving the recipient an amount of cash equal to the value of the food they choose could never make them worse off and would probably make them better off.)

The inherent logic behind the demonstration is quite straightforward. The gift confers an increment of real income upon the recipient. An addition to real income creates a willingness to consume a larger amount and/or higher frequency of all normal goods, not merely more of one specific good. Hence, the new optimal basket of consumption goods will include increases in more than just one good or service. Receipt of real income in the form of cash allows maximum scope for distributing the increase among the different possible choices.

Why doesn’t this same logic apply to gifts? The short answer is that it does. Economists have devised various ad hoc explanations to rationalize the practice of in-kind gift giving, but none of them really satisfies. That is why these research results are so unsurprising. Women prefer receipt of gift cards to clothing and jewelry. If the gift cards are issued by specialty stores, they allow the recipient a wider range of choice among the styles, brands and sizes of clothing and jewelry. If the cards are to department stores, they allow even wider branching out to other types of goods and services. There is even a legal market for the exchange of gift cards for cash (at a discount), just as food-stamp recipients once traded stamps for cash illegally at discounts up to 50%.

Gift cards are also among the preferred options of men, but men display more willingness to delegate the shopping for their preferred choices of gourmet foods and liquor. This is probably owing to the traditional division of labor, in which women shop for and prepare food but men often purchase liquor. This is the rare case in which you will be willing to let somebody else make your consumption choices for you – they are an expert and you are not (or may not be).

In the light of this, the oft-expressed nostalgia for the Christmas of childhood is understandable. Children are typically net beneficiaries of the gift-giving ritual, with their gift exports being outweighed in number and value by their imports. This favorable holiday balance of payments casts a rosy glow over the holidays that gradually dims in intensity as increasing export responsibilities accompany the aging process.

Note that there is a role for gender in these research results, all right – just not the invidious one implied by the article’s headline. Another way to consider this matter is to ask whether women’s responses would differ markedly if the gift-giver were another woman, as opposed to a man. (Later, we will consider the significance of the degree of intimacy between giver and recipient.) Assuming the answer is no – and the article made no reference to any such distinction in this research – then the economic logic above is sound.

Modifying for the division of labor, the research results show both men and women displaying the basic utility-maximizing, economic preference for cash or cash substitutes rather than narrow in-kind gifts. What are we to make of the apparent fact that both sexes appear “better suited for giving gifts to themselves?”

Utility Maximization and Selfishness

The article’s author is apparently affronted by the possibility that some of us are better suited for giving gifts to ourselves than to others and she wants us to feel her outrage. She probably likes her chances because her target – the top 10% of wage earners – is a loose proxy for “the wealthy,” who are under assault from many sides these days. The overriding sin committed by the wealthy is alleged to be “greed” or “selfishness.” This has often been likened to the behavioral assumption underlying the economic theory of consumer demand, which is utility maximization. We assume that people try to become as happy as possible.

The equation of utility maximization with selfishness simply won’t wash. For one thing, utility maximization doesn’t say anything one way or the other about other people because the individual’s utility function is assumed to be independent of the consumption of other people. “Independent” means just that. It doesn’t mean that we set out to hurt other people or to studiously ignore them. It just means that our overriding goal is our own happiness.

And in fact it could hardly be any other way. The reality of our internal and external worlds dictates it.

Each of us instinctively recognizes the difficulty of ever really knowing another person as we know ourselves. The closest most of us ever come is through the institution of marriage, yet nearly half of U.S. marriages end in divorce. The same basic conflicts that drive couples apart also militate against optimal gift-giving – budgetary disagreements, differences in tastes and preferences, in maturity and temperament, in perception and grasp of reality.

Looking out for number one has been our evolutionary priority since day one. But ever since man began congregating in groups, an ethic of sacrificing individual wants to the needs of the group was promulgated. This ethic had survival value for the group, although it tended to be hard on particular individuals. And, over time, group leaders became adept at suspending the rules in their own case.

Meanwhile, mankind slowly developed a market process for increasing wealth and happiness. This market process ran counter to the group ethic because it increasingly demanded cooperation with individuals outside the group – indeed, cooperation between individuals who never met or even suspected that they were cooperating. This extended order of cooperation was one of the market’s greatest strengths, since it prevented political, religious or cultural differences from interfering with the growth of wealth and real income.

When the social order consisted of mated pairs living in caves, it was not unreasonable for one mate to control the consumption pattern of the pair. The choices were so few and so starkly simple, the human species so primitive that one could envision coming to anticipate the wants and desires of a spouse to a high degree. Today’s sophisticated world with tens of thousands of consumption choices made by evolved human brains makes nonsense of that concept. Even spouses cannot be expected to read each other’s minds well enough to reach the apex of consumption choice.

In this context, it is worthwhile to observe that women are apparently the ones who pretend to this level of expertise. They refuse to delegate their clothing and jewelry purchases but are more than willing to overrule mens’ consumption choices, to the point of substituting clothes for food and liquor in their “gifting.” (Why not “giving,” by the way?) We accuse government bureaucrats of paternalism, but it would appear that this should instead be maternalism.

It is luminously clear that there can be only one true expert on your consumption, and that is you. Nobody else in the world could begin to accumulate the objective information on the thousands of potential goods that you can or might consume, or the subjective data on your particular tastes, preferences and attitudes towards them. It is sobering to realize that not even a life mate can approach the degree of familiarity needed to truly run your life for you.

Small wonder, then, that “nearly half of women” in the survey “said they were extremely, or very likely to buy themselves presents this holiday season. A third of men have similar intentions.”

It is idiotic to call this behavior selfishness when it merely acknowledges the practical facts of life. We need a vocabulary to describe an inordinate preoccupation with self – the kind displayed by thieves, murderers, embezzlers and the like – and this is the proper preserve of words like “greedy” and “selfish.”

The Theory of Gifts and Public Policy

The economic logic of gifts has important implications for public policy. For over four decades, various researchers have estimated the amount of welfare expenditures necessary to lift every man, woman and child above the so-called poverty line. Then they have compared this irreducible necessary minimum expenditure on fighting poverty with the amount actually spent by federal welfare programs. The ratio between what we spend and what we would theoretically need to spend has fluctuating over time. It has been as low as two and as high as ten. Currently, according to the latest estimate, it is about five.

We are ostensibly trying to eliminate poverty. We are currently spending five times more on indirect ways of doing this than we would need to spend if we simply gave cash directly to poor recipients. And we are failing to achieve the stated objective of eliminating poverty, since even if the value of cash and in-kind subsidies is added to income there are still a substantial number of people living below the poverty line. We know that cash subsidies are more effective at increasing the happiness of recipients than the in-kind subsidies, such as food stamps, in which the federal government specializes.

So why are we still pursuing a horribly wasteful and inefficient policy of fighting poverty and failing instead of implementing a simpler, much cheaper and more efficient policy that will succeed?

Put this way, the answer stands out. It is reinforced by the experience of any classroom teacher who ever explored the issue. In droves, students insist that we cannot afford to give cash to welfare recipients because they will spend the money in unsuitable ways; e.g., ways that the students do not approve of. Expenditure on illicit, mind-altering drugs is the example most often chosen to illustrate the point.

Students persist in this view even after the irrefutable demonstration that current in-kind forms of welfare, such as food stamps in both its former and present incarnations, also allow recipients to increase their expenditure on “other goods” besides the subsidized good. (In-kind subsidies hinder the flexibility of recipients but allow them to buy the same amount of the subsidized good as before with less money, thereby freeing up more regular income for use in buying drugs or other contraband.)

Thus, it is clear that the actual rationale behind the government welfare system is not to improve the welfare of recipients by maximizing their utility. Instead, it is to maximize the utility of taxpayers by allowing them to control the lives of recipients while assuaging their own guilt. Taxpayers are responding to the vestigial evolutionary call of the group ethic that demands individual sacrifice for group preservation, while meeting their own need for utility maximization. They are countenancing interference in the lives of the poor that they would never sit still for in their own lives, and which they resist even in areas as relatively trivial as holiday gift-giving.

Economists look for ways to make everybody better off without making anybody worse off. Eliminating the federal welfare system would end an enormously wasteful and unproductive practice. Research shows that private charity is highly active and more efficient than federal efforts even though substantial taxpayer income is now diverted into federal anti-poverty efforts. If federal programs were ended, more funds would become available for private charitable purposes. Recipients could choose the degree of maternalism they found tolerable and donors could demand or reject maternalism, as they saw fit.

Meanwhile, resources would be freed up at the federal level to produce other things. Dislocations among employees due to agency closures would be no different than layoffs in the private sector due to shifts in consumer demand between different goods and services. Obviously, some federal employees would migrate to private-sector charities, where employment would rise.

Another extension of these principles applies to recent attempts by federal bureaucrats to fine-tune the pattern of consumption by banning or requiring the consumption of particular foods, minerals, vitamins, fats or other substances. In principle, a case might be made for provision of information allowing informed choice by consumers. The problem is that even here, the federal government’s past efforts have worsened the very problems it now purports to solve. But there is no case in favor of allowing government to dictate consumption choices made by citizens because government cannot possibly possess the comprehensive information necessary to verify whether its actions will improve or worsen the welfare of its subjects.

The Economics of Gifts

The research results reported in the MSN article may have frustrated its author, but they are consistent with the economic principle of utility maximization – properly understood. People request the kind and general form of gifts that tend to maximize their utility, but they take exactly the same tack when it comes to giving gifts to others – they tend to maximize their own utility, not that of the recipient. We can fume, fuss, moralize and complain about this behavior, but it is the only practical way to behave. Practical human limitations dictate it.

And when it comes to public policy, it is utterly futile to expect altruism and omniscience to suddenly triumph in an arena where they are even less potent than they are in private life. Private charity has its limitations, but it is best situated to cope with the inherent difficulties involved when one human being tries to help another.

DRI-410: The Pedigree of Right-Wing Opposition to ObamaCare

The Supreme Court’s recent ruling in National Federation of Independent Business vs. Sebelius; et al decided the constitutionality of the Patient Protection and Affordable Care Act, popularly known as ObamaCare. This is the most anxiously awaited ruling in generations and potentially the most momentous. The legislation will eventually produce a de facto takeover by the federal government of the U.S. health-care sector, amounting to over one-fifth of the U.S. economy. The central focus of the bill and the ruling was the power of the federal government to order the behavior of its citizens and the nature and existence of limits on that power.

As one would expect, economic logic constitutes the heart of that legal debate. It would not astound most people to find that the best treatment of this subject was written by an economist. But it would raise their eyebrows to learn that the economist in question died in 1992 – twenty years before the ObamaCare ruling was handed down – and wrote in 1960, decades before burgeoning health-care costs first grabbed the attention of the American public.

The Mandate to Purchase Health Insurance

The linchpin of ObamaCare is a mandate that uninsured Americans either purchase health insurance or be forced to pay a forfeit. Although the forfeit is denoted a penalty in the language of the bill and by the bill’s prominent supporters – including President Obama himself – the government’s counsel presented an alternative case for the bill as a tax.

Despite the brevity of this argument – it occupied only 21 lines in the brief – it was accepted by Chief Justice John Roberts in his majority opinion. Indeed, Justice Roberts’ obiter dicta rejected the government’s primary contention that the mandate was a penalty, levied under the federal government’s power to regulate interstate commerce.

A four-justice minority consisting of Judges Thomas, Kennedy, Scalia and Alito dissented scathingly. The minority not only rejected the alternative characterization of the mandate as a tax, but also denied the constitutionality of the bill in its entirety. Thus, the dichotomy is one of the sharpest in the history of the Court.

Obama administration supporters were quick to accuse the bill’s opponents of hypocrisy, pointing out that the right-leaning Heritage Foundation had submitted a comprehensive proposal for health-care reform in 1993 in which a purchase mandate had figured prominently. Obviously, Democrats maintained, conservative opposition to a mandate had to be purely political, originating with its submission by the Obama administration.

Not so. The right-wing health-care purchase mandate has an even longer lineage than the left wing contends. Tracing this genealogy to its roots should clarify the issues involved. Our search takes us back to seminal work by the patron saint of right-wing political philosophy, F. A. Hayek.

Hayek on the Purchase-Mandate Concept

In The Constitution of Liberty (1960), Hayek begins by noting that the provision for the future is a general problem faced by members of all societies. His words are so cogent and prescient as to demand direct quotation (all emphasis added by me):

In the Western world some provision for those threatened by the extremes of indigence or starvation due to circumstances beyond their control has long been accepted as a duty of the community…What we now know as public assistance or relief…is merely the old poor law adapted to modern conditions. The necessity of some such arrangement in an industrial society is unquestioned – be it only in the interest of those who require protection against acts of desperation on the part of the needy.

It is probably inevitable that this relief should not long be confined to …the  “deserving poor,” as they used to be called, and that the amount of relief now given in a comparatively wealthy society should be more than it absolutely necessary to keep alive and in health. We must expect that the availability of this assistance will induce some to neglect such provision against emergencies as they would have been able to make on their own. It seems only logical, then, that those who will have a claim to assistance in circumstances for which they could have made provision should be required to make provision themselves. Once it becomes the recognized duty of the public to provide for the extreme needs of old age, unemployment, sickness, etc., irrespective of whether the individuals could and ought to have made provision themselves, and particularly once help is assured to such an extent that it is apt to reduce individuals’ efforts, it seems an obvious corollary to compel them to insure (or otherwise provide) against those common hazards of life. The justification in this case is not that people should be coerced to do what is in their individual interest but that, by neglecting to make provision, they would become a charge to the public. Similarly, we require motorists to insure against third-party risks…in the interest of others who might be harmed by their actions.

Finally, once the state requires everybody to make provisions of a kind which only some had made before, it seems reasonable enough that the state should also assist in the development of appropriate institutions…the cost of experimenting with and developing new institutions may be regarded as [analogous to] the cost of research or the dissemination of knowledge…The aid given out of the public purse for this purpose should be temporary in nature…intended only for a transitional period, terminating when the existing institution has grown and developed to meet the new demand.

Hayek is often cited approvingly by 20th-century liberals for his activist stance toward government welfare programs like social security and unemployment insurance. The above passages lend superficial support to this characterization. But Hayek goes on to make the crucial distinction between government interventions favorable to limited, constitutional government and those destructive to it.

It is only when the proponents of “social security” go a step further that the crucial issues arise. Even at the beginning stage of “social insurance” in German in the 1880s, individuals were not merely required to make provision against those risks which, if they did not, the state would have to provide for, but were compelled to obtain this protection through a unitary organization run by the government…”Social insurance” thus from the beginning meant not merely compulsory insurance but compulsory insurance in a unitary organization controlled by the state. The chief justification for this decision…was the presumed greater efficiency and administrative convenience (i.e., economy) of such a unitary organization. It was often claimed that this was the only way to assure sufficient provision at a single stroke for all those in need.

The Trojan Health-Care System

The appropriate icon for ObamaCare would be a Trojan, for the system parades as a prophylactic against the diseases afflicting health care but its effect on the system will be analogous to that of a computer virus, which burrows deep within it and wreaks progressively greater havoc over time.

The immediate provisions of ObamaCare do not technically require all Americans to buy health insurance. Rather, they demand that any adult who lacks health insurance at the end of the system’s first year of operations must pay a penalty on his or her income-tax return. The penalty is set low enough so as to seem attractive relative to the cost of an individual policy for those who currently lack health insurance. That is, the practical result of this provision will be to induce uninsured Americans to remain uninsured and pay the penalty rather than to buy health insurance.

Ordinarily, an uninsured adult will run certain risks. First, there is the possibility that the uninsured will acquire a condition that will substantially raise the cost of a policy or effectively foreclose the possibility of insurance. Second, there is the possibility that the uninsured will be visited by serious illness while uninsured, thus incurring a major financial setback.

ObamaCare forbids insurance companies from considering pre-existing medical conditions when evaluating the insurance risk of an applicant. The term for this policy is “guaranteed issue.” It also establishes government-run exchanges within which an uninsured will have the option of purchasing health insurance at any time, perhaps with a government subsidy.

The implications of these provisions for the health-insurance market are clear. First, the uninsured will have no incentive to purchase private insurance while in good health. Second, upon becoming sick, an uninsured will simply buy insurance at the government-run exchange. Ordinarily, it would be impractical to purchase insurance after contracting illness, since acquisition of a pre-existing condition would either make the applicant uninsurable or drive the insurance premium prohibitively high. But the provision in ObamaCare forbidding consideration of health status would preclude the former outcome, thus guaranteeing the latter.

The problem of “adverse selection” – only sick people wanting to buy insurance – is that it depletes the pool of premium-paying healthy insureds from which the insurance companies get the money to pay insurance claims. But that is just the beginning of the headaches created for private health insurance by ObamaCare. Its provisions impose a laundry list of mandated benefits insurance companies must pay – a mandate to pay out $.80-.85 worth of claimed benefits for every $1.00 in premiums collected, special benefits paid specifically to women, mandates to pay for various preventive services and more. The companies must keep the children of insured families on the family policy under the children reach age 26. The Secretary of Health and Human Services has the power to disallow premium increases greater than 10% for individual and small-group policies.

This combination of circumstances spells the end of the private market for health insurance. This is not merely the view of right-wing partisans. It is also the view of industry analysts. Secretary Sebelius, whose name is on the ObamaCare lawsuit heard by the Supreme Court, publicly declared before the outcome was known that the private health-insurance industry was “in a death spiral.” President Obama has long been publicly committed to creating a “single-payer,” e.g., government operated national health-care system. He fought doggedly to preserve a “public option” for government-provided health insurance in the ObamaCare legislation before reluctantly accepting the bill in its current form.

In other words, ObamaCare will rapidly produce the same situation created at its outset by Social Security legislation and described by Hayek above – one single, unitary organization operated by the government and subscribed by all. Rather than being reached at a stroke – the path taken by European welfare states – this outcome will be reached in a slower, more roundabout way. The direct route, a straightforward transition to single-payer, socialized medicine, was obviously viewed as politically infeasible. Indeed, ObamaCare itself passed both houses of Congress only thanks to a series of machinations unique in U.S. legislative history. Even now, the measure is wildly unpopular among the general public.

Over time, this sheltered monopoly will become more and more inefficient, less flexible and less tolerant of individual variation. It will become less receptive to innovation and suggestion from outside the ranks of government. In short, it will destroy the quality of health care it was ostensibly intended to save.

We can now appreciate the vital difference between a purchase mandate of the type advocated by Hayek and the Heritage Foundation and the one dictated by ObamaCare. The former allows Americans to choose among various types of insurance in a competitive market populated by different companies. The latter drives this competitive private market out of existence in order to force Americans to purchase the product of a single, unitary government insurance organization and would slowly, but surely degrade the quality of health care over time.

Hayek on Socialized Medicine

We have already seen that Hayek’s analysis of mandatory social insurance, directed at Social Security, accurately predicted the course taken thus far by ObamaCare. In fact, The Constitution of Liberty specifically addressed the issue of mandatory health insurance under a welfare state.

The provision against sickness presents not only most of the problems which we have already considered by peculiar ones of its own. They result from the fact that the problem of “need” cannot be treated as though it were the same for all who satisfy certain objective criteria, such as age; each case of need raises problems of urgency and importance which have to be balanced against the cost of meeting it, problems which must be decided either by the individual or for him by somebody else.

There is little doubt that the growth of health insurance is a desirable development. [Hayek was writing in 1960.] And perhaps there is also a case for making it compulsory since many who could thus provide for themselves might otherwise become a public charge. But there are strong arguments against a single scheme of state insurance; and there seems to be an overwhelming case against a free health service for all… [yet] political circumstances make it unlikely that they can ever be abandoned, now that they have been adopted. One of the strongest arguments against them is, indeed, that their introduction is the kind of politically irrevocable measure that will have to be continued, whether it proves a mistake or not.

The case for a free health service is usually based on two fundamental misconceptions. They are, first, the belief that medical needs are usually of an objectively ascertainable character and such that they can and ought to be fully met in every case without regard to economic considerations and, second, that this is economically possible because an improved medical service normally results in a restoration of economic effectiveness or earning power and so pays for itself. Both contentions mistake the nature of the problem involved…There is no objective standard for judging how much care and effort are required in a particular case; also, as medicine advances, it becomes more and more clear that there is no limit to the amount that might profitably be spent in order to do all that is objectively possible. Moreover, it is also not true that, in our individual valuation, all that might yet be done to secure health and life has an absolute priority over other needs. As in all other decisions in which we have to deal…with probabilities and chances, we constantly take risks and decide on the basis on economic considerations whether a particular precaution is worthwhile; i.e., by balancing the risk against other needs. Even the richest man will normally not do all that medical knowledge makes possible to preserve his health, perhaps because other concerns compete for his time and energy. Somebody must always decide whether an additional effort and additional outlay of resources are called for. The real issue is whether the individual concerned is to have a say and be able, by an additional sacrifice, to get more attention or whether this decision is to be made for him by somebody else. Though we all dislike the fact that we  have to balance immaterial values like health and life against material advantages and wish that the choice were unnecessary, we all do have to make the choice because of facts we cannot alter.

Thus, a half-century before our time, Hayek anticipated the present-day debates over the standard of care and death panels. The left wing and their allies in the bureaucracy and medical establishment claim that a single standard of medical care can be objectively specified and quantified by self-anointed and appointed panels of experts. The government can then enforce this standard as a way of reducing health-care costs – denying forms of treatment that fall outside its boundaries and insisting on adherence to this administratively determined code of treatment. Towards the end of life – when we putatively spend “too much” on preserving life – these same panels of experts will decide how many resources to devote to preserving life and when to pull the plug on the terminally ill. To deny those directly affected the final say in this process is the ultimate triumph of totalitarianism. In his unique style, all the more powerful for its straightforward simplicity and calm, Hayek brings this home.

The problems raised by a free health service are made even more difficult by the fact that the progress of medicine tends to increase its efforts not mainly toward restoring working capacity but toward the alleviation of suffering and the prolongation of life; these, of course, cannot be justified on economic but only on humanitarian grounds …[This] presents a problem which can, under no conceivable condition, be solved by an unlimited provision of medical facilities and which, therefore, must continue to present a painful choice between competing aims. Under a system of state medicine this choice will have to be imposed by authority upon the individuals.

Hayek also realized that health care is an economic good like any other. Individual variations physical makeup and personal preference will cause different people to value life and health differently. The only way to cater to these differences is through the workings of the price system. Although Hayek’s personal experience was primarily with the British National Health Service, he nevertheless anticipated the disastrous American evolution toward third-party payment of health-care costs by insurance providers, which has insulated the beneficiaries and demanders of health care from its costs. Both the British system of “free” health care and the American system of first-dollar insurance coverage have artificially increased the nominal costs of health care by preventing price from exercising its true economic function of regulating demand. What Hayek calls “true insurance” protects against occasional catastrophe without deceiving health-care consumers into thinking that everyday health care can be free.

Hayek on the Physician Shortage

Another iceberg hazarding our passage to socialized medicine is a looming shortage of physicians. One recent estimate cited a figure of 83% as the number of doctors who would renounce the practice of medicine rather then endure the rigors of ObamaCare. It should hardly surprise that Hayek saw this coming as well.

There are so many serious problems raised by the nationalization of medicine that we cannot mention even all the more important ones. But there is one the gravity of which the public has scarcely yet perceived and which is likely to be of the greatest importance. This is the inevitably transformation of doctors, who have been members of a free profession primarily responsible to their patients, into paid servants of the state, officials who are necessarily subject to instruction by authority and who must be released from the duty of secrecy so far as authority is concerned. The most dangerous aspect of the new development may well prove to be that, at a time when the increase in medical knowledge tends to confer more and more power over the minds of men to those who possess it, they should be made dependent on a unified organization under single direction and be guided by the same reasons of state that generally govern policy. A system that gives the indispensable helper of the individual, who is at the same time an agent of the state, an insight into the other’s most intimate concerns and creates conditions in which he must reveal this knowledge to a superior and use it for the purposes determined by authority opens frightening prospects. The manner in which state medicine has been used in Russia as an instrument of  industrial discipline gives us a foretaste of the uses to which such a system can be put.

Hayek lived to age 92, dying in 1992 despite enduring numerous heart attacks and other chronic health problems. He fled Nazi tyranny and was perhaps the world’s leading expert on the evolution of Germany from welfare state into Nazi fascism. The “medical” uses to which doctors like Josef Mengele put government power were undoubtedly in his mind when he wrote The Constitution of Liberty in 1960, so he was understating his case by picking Soviet Russia as his exemplar.

The last fifty years have evolved in certain directions that Hayek probably could not have foreseen. The disgust of many doctors today derives from their subordination to insurance companies in much the same manner as described by Hayek above. Having been forced by HMOs to submerge what they considered the interests of their patients to that of the insurance companies, they can easily foresee a far worse situation ahead – bigger and more intractable bureaucracy mobilized by the federal government and no escape in sight. After all, at least doctors and private individuals can change insurance companies, or the patient can eschew health insurance and pay cash directly for medical services. In contrast, ObamaCare portends a Sartrean environment from which there is, indeed, “no exit.”

Hayek on the Collapse of the Welfare State

Reading Hayek, it becomes clear that the problems raised by ObamaCare and health care are merely a subset of those associated with Social Security, Medicare, Medicaid and the welfare state generally. Long before the welfare state in Europe began to collapse of its own weight, Hayek explained the nature of the dilemma it faced:

The difficulties which social insurance systems are facing everywhere and which have become the cause of recurrent discussion of the “crisis of social security” are the consequences of the fact that an apparatus designed for the relief of  poverty has been turned into an instrument for the redistribution of income, a redistribution supposedly based on some non-existing principle of social justice     but in fact determined by ad hoc decisions. It is true, of course, that even the provision of a uniform minimum for all those who cannot provide for themselves involves some redistribution of income. But there is a great deal of difference between the provision of such a minimum…and a redistribution aiming at a “just” remuneration in all the more important occupations – between a redistribution wherein the great majority earning their living agree to give to those unable to do so, and a redistribution wherein a majority takes from a minority because the latter has more… the latter brings us nearer and nearer to a system under which people will have to be told by authority what to do. It seems to the fate of all unitary, politically directed schemes for the provision of such services to be  turned rapidly into instruments for determining the relative incomes of the great  majority and thus for controlling economic activity generally.

…It must seem doubtful, however, whether there exists such a distinct phase of evolution in which the net effects of those monopolistic institutions are likely to be beneficial, and still more whether, once they have been created, it will ever be politically possible again to get rid of them. In poor countries the burden of the ever growing machinery is likely to slow down considerably the growth of wealth… and thus to postpone indefinitely the time when it will prevent the evolution of alternative institutions that could take over some of its functions.

There perhaps exists no insuperable obstacle to a gradual transformation of the sickness and unemployment allowance systems into systems of true insurance under which the individuals pay for benefits offered by competing institutions [but] it is much more difficult to see how it will ever be possible to abandon a system of provision for the aged under which each generation, by paying for the needs of   the preceding one, acquired a similar claim to support by the next. It would almost seem as if such a system, once introduced, would have to be continued in perpetuity or allowed to collapse entirely. The introduction of such a system therefore puts a straitjacket on evolution and places on society a steadily growing burden from which it will in all probability again and again attempt to extricate itself by inflation. Neither this outlet, however, nor a deliberate default on obligation already incurred can provide the basis for a decent society. Before we can hope to solve these problems sensibly, democracy will have to learn that it must pay for its own follies and that it cannot draw unlimited checks on the future to solve its present problems.

It has been well said that, while we used to suffer from social evils, we now suffer from the remedies for them. The difference is that, while in former times the social evils were gradually disappearing with the growth of wealth, the remedies we have introduced are beginning to threaten the continuance of that growth of   wealth on which all future improvement depends.

Hayek clearly foresaw demands for redistribution and social justice, such as those by the Occupy Wall Street movement. He envisioned the dramatic drop in productivity in countries like Greece, Portugal and Spain and the political difficulties resulting from the decline in wealth to redistribute. Hayek also knew that the entitlement state rode a tiger: any attempt to cope would result in social disintegration. Passive acceptance of the inevitable decline in wealth would produce default and financial chaos; inflating away the value of the debt would bring everyday life to a grinding halt by dumping sand into the machinery of markets.

To a student of economics, this last passage has an effect similar to that produced on the devout by a reading of the Bible’s book of Revelations – a chilling sense of awe and inevitability.

F. A. Hayek, Health-Care Prophet

F. A. Hayek’s words prove that the right-wing stance opposing ObamaCare is not the product of politics but rather of political philosophy and economics. He predicted the essential form ObamaCare would take long before President Obama was even elected. He predicted the end of the private market for health insurance, a denouement that is now impending. He predicted the degradation of quality in health care now seen in countries like England and Canada, thanks to their nationalization of health care. The man who predicted the Great Depression and whose intellectual triumph over socialism won for the 20th century the title of the “Hayek Century” is still leaving his mark on mankind.

DRI-416: ‘Recession Ride Taxi’ is the Epitome of Capitalism

“We are all of us teachers,” was Nobel laureate-economist Milton Friedman’s thumbnail sketch of his profession. Teachers are continually on the lookout for real-life illustrations of their subject. Last week, National Public Radio (NPR) provided a dandy.

Apparently NPR saw no need to interpret its facts with the use of economic logic. Fortunately, we can remedy that monumental oversight.

Eric Hagen’s “Recession Ride Taxi”

In a June 26, 2012 story, NPR introduced its audience to Eric Hagen, a taxicab owner-operator in Burlington, VT. Like many a taxi driver, Hagen traveled a roundabout route to his profession. Laid off his job as a Wall Street banker during the Great Recession, Hagen next worked for the American Red Cross – a job that would presumably earn the approval of Barack Obama and the NPR audience. Unfortunately, it didn’t earn enough money to pay Hagen’s mortgage.

So, like millions of Americans before him, Eric Hagen found himself pushing a hack to pay his bills. But unlike his predecessors, Hagen had both the institutional freedom and the native instincts to sell himself and his service to the public.

For upwards of a century, taxis have priced their services using taxi meters that recorded both mileage and time. Eric Hagen’s method for determining his taxi fares is: “Whatever the passenger can afford.” He names his business “Recession Ride Taxi.” Not surprisingly, his stated business rationale is that many people can’t afford to pay traditional taxi rates because they are experiencing hard times. Listeners are cordially invited to the conclusion that he is being kindly and altruistic by letting each passenger set the fare.

But don’t passengers double-cross him by low-balling their rates – or even stiffing him completely? “People know there’s value in a service,” Hagen replies, “and they’re generally not going to try to get over on you.”

Never has NPR accepted a businessman’s rationale so unblinkingly. “At a time when former colleagues on Wall Street continue to feel public scorn,” the station intoned piously, “Hagen says Recession Ride Taxi is running on trust.”

And Now for the Rest of the Story…

At this point, the late Paul Harvey might have intervened with: “…and now it’s time for the rest of the story.” It begins with the recognition that Hagen is not practicing altruism, but rather the most calculated kind of economic logic. His technique dates back at least to 19th-century railroads and country doctors. Airlines have used it for decades. It underlies the success of Priceline, among other online companies.

It is called price discrimination. A seller charges different prices to different buyers (or groups of buyers) for the same good or service at the same point in time. The different prices are not functionally related to different costs of serving the different buyers or buyer groups.

Why would a seller choose this strategy in preference to the simper one of charging a uniform price to all? To earn larger total revenue and profit. It won’t always be either feasible or desirable to discriminate on the basis of price, but the potential advantage in doing so lies in the possibility that different buyers differ in their sensitivity to price. The term economists use to denote sensitivity to price is price-elasticity of demand.

Two prime sources of demand for taxis in large urban markets are out-of-town visitors (tourists and business travelers) and low-income natives. The visitors have fewer and less satisfactory substitutes for taxi travel and tend to have higher incomes. Thus, they are less sensitive to price and more willing to pay higher prices than are natives, who can acquire their own cars or beg a ride, take a bus or subway or simply walk. In the vernacular, we say that visitors’ demand is more price-inelastic (less price-sensitive). Thus, it is in a taxi owner’s interest to charge differential prices, the higher one being assigned to visitors.

Even within groups of buyers whose price sensitivity is broadly similar, there will still be individual variations in price elasticity. The dream of a taxi owner would be to somehow charge each rider the highest price he or she would be willing to pay for the trip – what the economist calls the reservation price. That would constitute the practice of perfect price discrimination and would result in the maximum collection of revenue. Of course, this is only the stuff of dreams; no seller has enough individualized information about customers to realize their dream.

Now the method in Eric Hagen’s seeming madness starts to take form.

Crazy Like a Fox

The knee-jerk response of most people would be that a seller who allowed his customers to set the price is crazy. But Eric Hagen is really allowing individual customers to tell him what price they will accept – information he can’t get any other way. His modus operandi has the general appearance of a system of perfect price discrimination, except for one thing – he can’t be sure that the price they pick will be their reservation price. In fact, he can be pretty sure it isn’t.

Still, he has gained a great deal compared to the standard, taxi-meter-determined, single-price model. Consider the comments of one regular customer, sous chef Alan Flanders. “I’d be walking to work this morning if it weren’t for Eric.” That sounds pretty extreme, but NPR pointed out that “in most cabs, this ride would cost more than $20.” But because “Hagen takes whatever amount Flanders can afford, today it’s $12.” From the consumer’s standpoint, a 40% discount on a daily commute is a stunning saving.

We have a reflexive tendency to compare the $12 Hagen collects with the $20+ he “could” have collected from a regular taxi-metered ride. Wrong, wrong, wrong. Mr. Flanders makes it clear that at a price of $20, he was walking to work, not taking a taxi. Hagen’s alternative take was $0, not $20+. The genius of Recession Ride Taxi is that it brings customers into the market who otherwise wouldn’t ride taxis at all. A taxicab driver’s competition consists not merely of his fellow cab drivers, if there are any. It also includes subways, buses, shuttles, walkers, self-drivers, people who oblige hitchhikers – every alternative means of transportation. (In Burlington, VT, the second-most-popular commuting method is walking.) His most expensive input isn’t gas or repairs – it is time. His worst enemy is an empty cab.

No wonder that the motto of veteran cab drivers has always been “keep the meter running.” In this case, Eric Hagen has taken that excellent axiom to its logical extreme. He has realized that the best way to keep the meter running is to throw the meter away.

The Implications of Profit Maximization

Not long ago, President Barack Obama made headlines by stating that profit maximization by business owners served their interests at the expense of the general societal interest. This has long been an article of faith and a general principle on the left wing. Adam Smith founded the modern study of economics in 1776 by observing that trade proceeded on the principle of mutually beneficial voluntary exchange. The left has treated this concept with a mixture of incredulity and disdain, but mostly as if it were a deus ex machina invented to excuse the excesses of capitalism.

Members of the right wing and economists have responded by citing the role played by profit in allocating resources. It is fluctuations in profit, the argument runs, which allow consumers to direct the activities of producers – increasing profits cause producers to redirect resources toward goods and services in high demand, falling profits draw resources away from things for which demand is waning. This thinking is correct and conclusive, as far as it goes. But, as the example of Recession Ride Taxi suggests, it doesn’t go nearly far enough.

Eric Hagen is admittedly and avowedly utilizing a particular pricing technique. An economist recognizes this technique as price discrimination, which is practiced by sellers expressly to increase their total revenue and profit. In the great American tradition of motivational deception, he disavows a desire for personal gain while seeking exactly that. But the overarching significance is that his customers gain from his pursuit of profit maximization and his gains in total revenue and profit.

A layman will be persuaded of this result by hearing the testimonials of Hagen’s customers. The economist is used to hearing people lie about or rationalize their actions, but expects people to act in their own interests; the proliferation of Recession Ride Taxi’s customers means that buyers are better off riding it than not. Hagen claims that he averages 20 trips per day, the average fare running somewhere between $10 and $15. That works out to an annual income in the $50-75,000 range. Not Park Avenue territory, but not bad for low-skilled labor.

The presumption that the interests of buyer and seller are inexorably at odds is utterly false. Adam Smith’s dictum has found its practical expression – unwittingly unearthed by NPR, the unlikeliest of sources.

The Implications for Regulation

The agency of NPR isn’t the only improbable feature of this case. Economists would have quoted heavy odds against the taxi business being the locus of innovative entrepreneurship. For nearly a century, in most cities and towns of the U.S., taxicabs have been stifled under a choking blanket of regulation.

Early in the 20th century, the taxicab began to threaten the streetcar as a means of commercial passenger transport. Because of relative easy of entry into the business and low labor-skill requirements, taxis were plentiful, cheap and competitively attractive to riders. Streetcar companies combined with the largest taxi companies – usually Yellow Cab – to cartelize the taxi market by tightly regulating taxi fares and entry into the business. Fare schedules – soon replaced by taxi meters – and strict limitations on the number of taxi licenses issued combined to prevent effective competition among taxi firms. This raised profits for incumbent firms but harmed consumers. In New York City, where the number of taxi licenses has not increased since World War II, the monopoly profits capitalized into the price of a (transferable) taxi license (called a medallion) have raised its value to over six figures.

Strict regulation has been another hallmark of the Obama administration. The tacit premise has been that markets are not self-regulating, beneficial mechanisms, but rather treacherous, double-edged swords that cut safely only when their every move is guided and supervised by appointed regulators. (Where these regulators acquire the moral wisdom and practical knowledge required to manipulate markets is never specified.) One might have supposed, then, that a story on NPR about mutually beneficial success in the taxi industry would have featured regulators as the prime movers and market principals as passive reactors.

The truth is just the opposite. Eric Hagen is a lone entrepreneur who succeeded by discarding the most sacred tool of taxi regulation – the taxi meter. Indeed, in most American cities, what he did would be illegal. Even if it were technically permissible, owners of airport buses, municipal buses, shuttles, and competing taxi firms would throw a fit about it – which leads us to still another field of significance.

Implications for Antitrust

Traditionally, the practice of price discrimination is viewed with ambivalence by economists. On the one hand, when different consumers within a particular geographic market face different prices for the same good, this is inefficient. Each consumer will maximize his or her utility by arranging consumption so as to equate personal willingness to sacrifice alternative consumption with the objective rate of tradeoff offered by the marketplace, where the latter is embodied in the price paid. Suppose, for example, that one consumer faces a $5 price for good X and another consumer faces a $3 price. The first consumer’s personal marginal valuation of X is $5; the second consumer’s personal marginal valuation of X is $3. Give each the opportunity to trade in X at a price of $4 and both will do so – the first would gain by buying more X and the second by “selling” (consuming less) X. That tells us that the initial position was inefficient.

Carrying this logic to its ultimate end requires that all consumers in a given market face equal prices of a good or service, in order for consumption to be efficient – that is, for all consumers to get the most satisfaction.

The theory of equilibrium price formation studied by students in their college price theory courses brings about just this outcome. The problem is that the underlying assumptions behind this theory are seldom spelled out fully enough for the students to appreciate its highly abstract character. In fact, it often seems that economists (and lawyers) are often unaware of it. Goods are assumed to be homogeneous; each seller is assumed to supply an infinitesimal fraction of the total market amount; all buyers and sellers are assumed to possess all relevant information about available goods, costs and future contingencies.

Undoubtedly, this accounts for the prima facie structure against price discrimination in the Clayton Act, one of the earliest antitrust enactments. Price discrimination is inefficient, according to the textbooks. Those same textbooks also describe a perfectly competitive industry as one in which no seller possesses any power over price – but price discrimination couldn’t exist in this environment.

A price-discriminating seller must have some discretion over price. He must also be able to segment or divide his market into identifiable groups or individual buyers and prevent them from re-selling the good or service – otherwise, the low(er)-price buyers could themselves re-sell the good to the high(er)-price buyers at a slightly lower price, thereby spoiling the would-be discriminator’s party.

Real-world markets are a good deal messier than textbook ones. The information assumed by textbooks can only arise from a market process, and the equilibrium outcome proudly touted is an ever-receding goal. Recession Ride Taxi displays the opportunistic tenor of true capitalism – regulation strands sous chefs without a ride to work and the free market comes riding to the rescue with an improvised solution – imperfect, but a major improvement on the status quo.

This has always been true. Consider our early historical examples. A railroad often provided the only timely means of getting farmers’ crops to market, and the railroad magnate would sometimes charge farmers more for a short haul on which he faced no competition than for a long haul served by one or more competing roads. Outrageous! The first federal regulatory agency, the Interstate Commerce Commission (ICC), was created to remedy just such excesses. And so it did – by raising the long-haul rates into equality with the short-haul rates! This ended the price discrimination but it worsened the exercise of monopoly pricing power.

Country doctors often served sparse, strung-out populations that were unattractive markets. In order to increase their total revenue, country doctors charged much higher rates to wealthy patients, whose price-elasticity of demand was much lower than their poorer neighbors’. Communities encouraged this as a means of attracting physicians. Doctors rationalized it as favoring the poor; this inaugurated the practice of treating physicians as noble, self-sacrificing healers rather than ordinary businesspeople.

Clearly, price discrimination could be a good thing when it promoted competition and enabled consumers to enjoy a good or service that otherwise would not be provided. And regulations against it were no panacea for improved consumer welfare. Economists took this lesson to heart by qualifying their disapproval of price discrimination to cover only those cases where it harmed competition and promoted monopoly. It is perfectly obvious that Eric Hagen has enhanced both competition and consumer welfare with his Recession Ride Taxi.

Can We Generalize the Example of Recession Ride Taxi?

It may occur to the reader to wonder: If Eric Hagen’s Recession Ride Taxi is a boon to consumers and a specimen of marketing genius, where has it been all our lives? Why hasn’t it swept all before it over the course of one century of taxicab-industry history?

The short answer is two-fold. First, it’s been there all along, right under our noses. Second, it is right for some market circumstances and wrong for others. Most American cities represent intermediate cases, in which a mix of Hagen’s technique and conventional techniques are currently optimal. But the best approach would be to junk all forms of taxicab regulation and give the “Hagen System” full scope to operate.

Veteran taxicab drivers in virtually all American cities have utilized a species of the Hagen System by engaging in informal negotiation for taxi fares. Although variation of fares by time of day is typically illegal, it is common practice among business travelers and longtime drivers to vary airport fares by time of day. This helps travelers by securing passage and gaining discounts. It helps drivers by increasing capacity utilization during slack periods of demand.

A more comprehensive allegiance to Hagen’s methods is practiced by drivers who develop a personal clientele, which they service to the exclusion of radio calls and street hails. This tends to evolve naturally into a system of tailored fares, negotiated informally between driver and customer. (Depending on circumstances and the letter of the law, the taxi meter may or may not be engaged during the trip, but its reading is irrelevant.)

The central principle of Hagen’s Recession Ride Taxi – customer-chosen fares – practically requires this kind of repeat-customer format. Hagen may give lip service to “trust” in his customers, but he wants and needs the freedom to drop the occasional customer who stiffs him or intends to repeatedly shortchange him. He undoubtedly does this not by explicitly refusing to carry, which is illegal in most cities, but by “inadvertently” lengthening his response time to the deadbeats until they drop him. (This highlights a subtle but important aspect of the business – that the taxi fare is determined not just by the monetary fare but also by the time taken for the cab to show up.)

Why hasn’t this approach – developing a personal clientele – utterly overshadowed the visible taxi market of radio calls and street hails? Much taxi business is opportunistic, arising from unique and unforeseeable circumstances that cannot be handled in a personal, repeat-customer framework. Even more telling is the fact that the repeat-customer system requires the driver to incur substantial dead mileage and time wastage in servicing what often amounts to a predetermined route. In densely packed cities with large, continuous taxi demand like New York City, Las Vegas and Washington, D.C., drivers can operate much more efficiently “on the radio” and the street by taking their next call at the closest location.

But small towns like Burlington, VT face a taxi problem not unlike the old country doctor scenario. With around 40,000 people and no other close metropolitan areas, Burlington needs to generate a critical mass of driver income in order to get any taxi service at all. Price discrimination is the tried-and-true means of accomplishing this. Economic theory predicts that the Hagen System will predominate in this setting.

Most American cities fall in between these two clear-cut cases. They are oppressed by taxicab regulation and high meter rates that have suppressed or virtually killed off demand among low-income and minority populations. (Sometimes this demand is services by informal car or bus service provided by jitneys – vehicles owned by private individuals not affiliated with a business.) The climate is favorable for the Hagen System, but it is employed only at the cost of violating the law. Big government has created so many laws, almost all of which are counterproductive and contain innate incentives for violation, that governments cannot begin to enforce most of them. Thus, enforcement is lax to non-existent.

Nonetheless, the case of Recession Ride Taxi sharpens the case against taxicab regulation. Taxi meters are not valuable ipso facto; neither are newer computer systems for automatic dispatch that have largely replaced human taxicab dispatch. Technology should be judged according to the economic value it creates for consumers. The only way to do that is to allow the market to value technology and govern its use. The illusion that sellers set price is just that – an illusion, a mirage. Pricing is a negotiation between buyer and seller and either should be free to initiate the process. When regulation interferes with that freedom, it harms those it is ostensibly set up to protect.

Thanks, NPR

We have discovered that the simple case of a single taxicab driver in Burlington, VT is, in reality, a microcosm for capitalism at work. How much of the panorama we unfolded above was dealt with by NPR in their report on Eric Hagen’s Recession Ride Taxi?

None of it. NPR ignored every relevant economic issue, presenting the case as if it were nothing more than what the late Richard Nadler satirically called “caring and sharing.” Still, we should be grateful to NPR for at least reporting the news. There is no precedent for expecting this station to produce an incisive interpretation.

DRI-438: Oh, Yeah? Prove It!

One of the unique American strains of thought is pragmatism. Confronted by a problem or a matter in dispute, the ancient solution was to rely on tradition or religion to settle it. The founding of America changed this. Our enshrinement of freedom and discovery of economic growth gave us a practical bent. We didn’t take someone’s word on faith or follow tradition blindly. We looked for demonstrable answers.

This has been characterized in various ways. Harry Truman said, “I’m from Missouri and you’ve got to show me.” Economist Donald McCloskey expressed the same basic insight differently but with equal bluntness by posing the “American question:” “If you’re so smart, why aren’t you rich?”

Economics provides a logic of choice. Many illuminating implications can be developed from it. Below, we use them to test the truth or falsity of conventional thinking. In each case, a nugget of conventional thinking is subjected to a classic American test of skepticism.

When somebody says something outrageous, a reflex response is: “Oh, yeah? Prove it!” This becomes more than mere reflex when economics suggests that a valid burden of proof can be placed. We do this below. “Oh, yeah? Prove it!” (hereinafter, OYPI) is the challenge we issue to convention, using economic logic as our engine of proof. In each case, a familiar claim is followed by the OYPI challenge that, if taken up, could prove or disprove it.

Employment Discrimination Against Women By Men

#1: “Women earn a mere 77 cents for every dollar earned by men. This ‘gender gap’ is the result of discrimination exerted upon women by men.”

OYPI: Hire women, in order to profit risklessly from the productivity differential implied by the “gender gap.” The word “discrimination” implies that women receive less monetary remuneration for equally productive work effort. This means that employers can automatically earn more profits for a given less of output than competitors (who practice discrimination against women), simply by hiring women.

Of course, the source of riskless profits from female hires cannot last indefinitely. The profits earned by the firms that hire women will attract attention and imitation from other firms. Even if we assume that the misogynistic obsession with discrimination continues to overshadow any desire or need to earn profits, financial capital will still flow to the firms that do hire women. Those firms will expand. Eventually, the wages and salaries of women will be bid up. As long as any differential unrelated to productivity remains, the process of female hires and bidding up of women’s compensation will continue. The “equilibrium” position is the outcome toward which a competitive market will gravitate and the only one consistent with long-run stability. It will produce one of two possible results. Either wages and salaries for separable, identifiable groups of people will be equal, or they will differ according to variations in productivity between the groups or differential hiring costs associated with the groups.

Since exponents of discrimination theory insist that there are no systematic productivity differences between men and women – as opposed to differences between individual men and women – they are insisting, in effect, that riskless profits lie on the table waiting to be scooped up by employers who hire women.

The reflex response of discrimination theorists (DTs) might be that males (hard-core DTs would probably refine this to “white males”) pervade and dominate higher echelons of business. First and foremost, this is false – there are some female CEOs and numerous large and small businesses headed by women, such as the multi-billion real-estate empire founded by Barbara Corcoran. Even more to the point, women control an estimated 51% of the nation’s wealth. Presumably, they would be delighted to bankroll a venture that would earn supra-normal profits by exploiting the under-utilized talents of women in business. Techniques might be as simple as employing women for hourly wages or as complex as backing a fund that owns shares of female-headed businesses.

If discrimination theorists really, truly believe their own claims with their whole hearts and souls, they will cheerfully put their money where their mouths are, even to the extent of mortgaging their net worth. If they succeed in earning the riskless, supra-normal profits whose potential is implied by their claims, they have proved their case. If not, they have proved themselves wrong.

And if they refuse to take up the challenge, it will mean that they don’t really believe their own rhetoric and all their talk of discrimination against women was a sham designed to obtain through deception what women could not earn through their own efforts.

Supra-Normal Profits Earned by Big Oil Companies

#2: “Big oil companies continually earn obscene, windfall, record profits by gouging American consumers, charging exorbitant prices for oil and oil-derivative products.

OYPI: Buy shares of publicly traded big oil companies in order to recoup real income by earning the obscene, windfall, record profits in the form of dividends and capital gains. No American citizen can fail to notice periodic bemoaning of oil-company profits by news media. These lamentations note “record” profits of firms such as Exxon/Mobil and lavish pay for executives.

Since most of the biggest oil companies are publicly traded, the indicated course of action would be for detractors to buy “a piece of the rock” by purchasing shares of the offending companies. This would tend to more-than-offset any dip in real income associated with higher oil prices.

Broadly speaking, there are two possible outcomes of these projected purchases. One possibility is that the oil companies do indeed possess the market power to realize the monopoly profits claimed by critics. If so, these profits would be passed on pro rata to those critics, who are now shareholders. Of course, the critics would not be obligated to retain them. They could distribute them to the poor, invest them in programs to support alternative energy or donate them to the government, at their discretion.

The second possibility is consistent with the decades of analysis devoted to oil companies by the economic specialty known as industrial organization. Economists know that it is absurd to evaluate profits, market power and structure in terms of absolute dollar magnitudes. For most of the last 30 years, ExxonMobil has been the largest private company in the world. In order to provide a competitive rate of return on the gigantic volume of investment capital advanced by its owners, the firm has had to earn a huge volume of profit. That huge volume of profit, however, delivers a rate of return to its investors that is satisfactory but hardly spectacular. Critics who take themselves seriously enough to buy shares will discover this homely truth, doubtless to their chagrin.

While this may be unfortunate from the standpoint of somebody who expects to get rich quick, it could hardly be any other way. The rate of return on any investment depends on the price paid for the asset. Any asset that promises a stream of above-average profits will be avidly pursued. This will drive up the asset’s price until the asset’s rate of return is no longer supra-normal in magnitude but instead merely commensurate with the risk taken in generating the profits. The jargon term economists use to describe this state of bare sufficiency is a “normal profit.”

All this is second nature to economists but journalists betray no sign of familiarity with it. Obscene Profit Theorists have dominated the popular landscape since the 1970s. If journalists and activists believe their own stories and op-eds, their logical course of action is to buy shares in companies such as Exxon/Mobil. Their professional code of fidelity to truth demands that they then report the results of their purchases to their readers.

If they actually receive the supra-normal, monopoly profits that they claim the oil companies are earning, they can document this via their rates of return on financial statements and increases in their net worth. If not, they can print retractions of their long-running vilification campaigns against big oil.

And if they ignore the challenge, they will have to explain why they passed up a simple opportunity to make money and make their case at the same time.

The Ostensible Advantages Enjoyed by Illegal Immigrants

#3: “Illegal immigrants receive free health care and welfare benefits. Their children are entitled to in-state (or free) tuition rates for education. They are treated better than native-born citizens.”

OYPI: Renounce American citizenship, cross the border and re-enter illegally. Live as an undocumented alien and meticulously document the daily facts of that life.

The premise behind much opposition to immigration – whether legal or not – is that the sum of entitlement benefits available to immigrants exceeds that attainable through work as a low-skilled worker. Indeed, some claim that illegal immigrants receive a larger real entitlement income than do native-born American citizens.

This belief, coupled with the corollary belief that immigrants cross the border with comparative ease and legal impunity, creates a stylized narrative of immigration with two key conclusions. First, immigrants come here for leisure, not work. Second, their benefits come at our expense; immigration is a net cost that makes us worse off than we would be in its absence. (Immigration opponents often insist that they oppose illegal immigration while approving, or at least tolerating, legal immigration. This is why we preserve the legal distinction here, even though there is no economic difference between the two.)

This narrative is hotly disputed by supporters of immigration, particularly economists. Given this, it would seem that Anti-Illegal-Immigrationists (AIIs) could not only prove their case but increase the living standards of the poor among their ranks by assuming the identity of the illegal immigrants they deplore.

If things go as the AIIs anticipate, they will have refuted the pro-immigration claims of their opponents. They will have powerful evidence to support a ban on immigration, or a reform of the practice. Of course, this would require a certain amount of work and intestinal fortitude on their part, but if they really, truly believe their own words, the sacrifice would be modest and the potential gain would be significant. After all, they needn’t work, since their central conclusion is that immigrants can earn more than a subsistence living simply by living off the fat of the land.

It seems only fair, though, to point out that the AIIs claims are somewhat inflated. Begin with the border passage itself. If the crossing is as easy as AIIs claim, how can smugglers command a four-figure fee for conveying illegals into the U.S. from Mexico? Why do so many illegal immigrants risk their lives crossing deserts and rivers? Why do hundreds lose their lives annually in the process? Well, we needn’t speculate on the answers to these questions, because AIIs will soon supply them from first-hand experience.

Another point on which AIIs can enlighten us is how illegal immigrants can hope to receive welfare benefits for which they do not qualify. The bureaucratic red tape that must be cut prior to receipt of federal cash or in-kind benefits is legendary. Illegal immigrants are legally ineligible for them. It is true that hospital emergency rooms must treat all applicants, whether citizens or not. But recipients are presented with a bill, and the hospital is just as entitled to collect from illegals as from citizens. Moreover, since illegal immigrants are actually somewhat more likely than low-skilled citizens to hold a job and earn income, the chances of collecting from illegals are probably better.

Receipt of low- or no-tuition public education is not a differential advantage for immigrants; it merely means they have a shot at the same lousy education as American citizens. Of course, it is true that illegals do not pay many of the taxes paid by Americans, such as income and property taxes. But they also do not receive many of the services and benefits we enjoy.

It should be noted that even if AIIs should turn out to be wrong about the relative advantages of illegal status, their acceptance of the OYPI challenge should yield highly useful information. One of the few demonstrable Congressional accomplishments of recent years was welfare reform in the 1990s. But that reform affected only one of the six categories of welfare benefits. It is probably a very bad idea to sever the link between receipt and payment of medical and educational services, both for Americans and immigrants. The OYPI challenge would shed additional light on these matters.

The most dramatic effect of this OYPI challenge would result if AIIs should take up the gauntlet only to die of thirst in the Mexican desert or suffocate crammed in the back of a truck full of illegal immigrants. Not only would they fail to prove their argument, they would fail to survive. But they would not die as hypocrites, but as honest men, however misguided.

On the other hand, if they refused to take up the challenge, they would remain alive. And they would live the rest of their lives with the realization of their own hypocrisy.

The Demand that Companies Pay Living Wages and Provide Health-Care Benefits

#4: “Companies should give their employees generous packages of health-care benefits and pay a ‘living wage.'”

OYPI: Form a company organized around the policy of industry-leading health-care benefits and guaranteeing wages and salaries sufficient to enable purchase of specified market baskets of goods and services.

For many years, left-wing commentators have opined that the “social responsibility” of business demands that companies meet certain threshold levels and forms of compensation to employees. Provision of health insurance and the offer of a “living wage” are the two best-known indices of this degree of compensation.

Certain axioms are planted deep within these demands. These are seldom, if ever, made explicit. The most fundamental is that companies can survive after meeting these standards. The presumptive basis for this claim is that worker productivity will rise sufficiently to offset any increased costs to the firm arising from the necessity to incur higher payroll costs or pay higher wages.

If adherents of Social Responsibility Theory (SRT) really believe this, then their course is clear. They shouldn’t wait around for business owners or managers to succumb to their persuasive arguments. Instead, SRT adherents should start businesses and do exactly what they demand of currently-existing businesses.

Provide generous health-care benefits to all employees. Pay a “living wage” to everybody, regardless of what employees earn currently.

SRT is perhaps the preeminent example of what the great black economist Thomas Sowell calls “volitional economics.” That is, our actions are governed not by constraints imposed by market prices and quantities but rather by our wishes. If we want a certain outcome to result, all we have to do is aim directly at that outcome, and it will eventuate. The failure to achieve it is attributable directly and simply to our unwillingness to try for it.

If we really and truly believe in SRT, then we should demand of SRT adherents what they demand of us. They should have to start businesses and live by the rules they craft for our use. After all, nobody has a stronger incentive to bring about the outcomes demanded by SRT than its own followers. If they can’t do it, it’s safe to assume that the job can’t be done.

If that is the case, it will be because businesses do not exist for the express purpose of providing real income for employees. A business is merely an intermediary between input suppliers and consumers; it allows the former to specialize in their highest-productivity occupation and the latter to receive goods in final form instead of dealing with each input supplier and then assembling the good themselves.

In order to maximize their real income, consumers want to buy each good they consume at least cost. Consumer demands discipline business behavior, forcing businesses to cut costs to the bone. This means that businesses pay wages and salaries based on the employee’s productivity, not on the employee’s needs or wants. In a competitive market, a business that based its hiring and employment decisions on fuzzy-minded notions of generosity rather than on the constraints of market prices and wages would go broke.

The consumers who ruthlessly punish any business that increases wages or benefits in excess of productivity are the same people who yearn for wage or benefit hikes. In effect, consumers are saying, “Raise my real income, but don’t you dare do the same for other people.” Of course, this is a logical contradiction. But every worker is also a consumer; everybody benefits from the cost consciousness created by marketplace competition.

SRT adherents do not believe this, or at least pretend not to. Which gives us the right to confront them with the classic American rebuttal: Oh, yeah? Prove it! Start your own company and practice what you preach. If you succeed, you have made your case. If you fail, your argument fails with you.

And if you ignore the challenge, you have deliberately passed up the chance to prove yourself right.

The OYPI Challenge

The common denominator linking each OYPI challenge is the fact that the popular assertion implies an opportunity for making money is being overlooked. In order to defend the assertion, it is necessary to show the existence of this opportunity by seizing the opportunity and making the money. If this cannot be done, then the assertion is disproved – to the extent that any statement can be disproved.

And if the challenge is ignored, that means that the authors of the statement didn’t really believe it. They were trying to gain by lying.