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Incentives Matter… On the Margin (2010) – Article by G. Stolyarov II

Incentives Matter… On the Margin (2010) – Article by G. Stolyarov II

The New Renaissance Hat
G. Stolyarov II
Originally Published January 10, 2010
as Part of Issue CCXXXI of The Rational Argumentator
Republished July 22, 2014
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Note from the Author: This essay was previously published as part of Issue CCXXXI of The Rational Argumentator on January 10, 2010, using the Yahoo! Voices publishing platform. Because of the imminent closure of Yahoo! Voices, the essay is now being made directly available on The Rational Argumentator.
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~ G. Stolyarov II, July 22, 2014
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One of the favorite expressions of economists is “Incentives matter.” There is much truth to this idea, but it is instructive to examine how it works a bit more closely.

An incentive is a set of conditions that favors one course of action and/or disfavors its opposite. A positive incentive increases the reward or decreases the cost associated with a decision, while a negative incentive increases the cost or decreases the reward associated with it. An incentive can be a condition of the natural environment, a conscious human choice, or an emergent outcome – a characteristic of what Friedrich Hayek called a “spontaneous order.”

But it is not the case that all human beings are moved by the same incentives to a particular course of action or inaction. For instance, an increase in the cost of gasoline might lead some people to drive less – but a wealthy car enthusiast might just take the hit and pay the higher price; for him, a negative incentive was not a sufficient deterrent to his behavior of choice. On the other hand, ample information and culture available virtually for free on the Internet might motivate more people to become computer-literate, but for certain individuals with a strong visceral fear of electronic technology, this might not be enough; the positive incentive has failed to overcome the psychological barriers within them.

We can best see how incentives matter by examining large-scale changes in behavior. Crime statistics in an area might fall, for instance, if people were allowed to carry concealed weapons in public, where a previous law might have prohibited this. But there would still be some individual acts of crime, just as there would still be some people who would never think of committing a crime, no matter how easy it would be to perpetrate one or to get away with it. If the government raised the minimum wage, the unemployment rate would increase over what it would have been otherwise, but it is not the case that all workers – or even all workers previously earning less than the minimum wage – would suffer or lose their jobs. Some low-income workers might even get a pay raise, but likely at the expense of others being laid off or never being hired in the first place. Yet some generous employers might choose to personally absorb the cost increase and refuse to lay off any workers – but this might mean fewer other investments in their businesses or a lower standard of living for these business owners.

We can summarize this insight by stating that incentives matter on the margin. If a person’s other characteristics – including ideas held, material position, and skills – strongly favor one course of action over another, then an incentive to the contrary is unlikely to change that person’s behavior. On the other hand, if a person is barely inclined one way or another, then an incentive might result in a shift of behavior.

Once made explicit, all of this might appear self-evident to someone who paid attention in a basic economics course. Why is it important, and why does it bear emphasizing? There are several reasons.

Recognizing the marginal importance of incentives prevents individuals from looking for panaceas or overnight revolutions, of which our world yields extremely few, if any. On the other hand, it also inculcates one against despair. Any sufficiently strong incentive will result in a desirable or undesirable statistical shift, but it is unlikely to completely solve a problem. On the other hand, it is also unlikely to completely doom the state of affairs, either. Human beings are remarkably resilient and intricately complex. Crimes, disasters, bad laws, and health defects will destroy some and keep down others – but human innovation and creativity will not completely die; it will flourish somewhere, in some way or another, where the negative incentives are not strong enough to thwart the civilizing desires of the best among us. But it is also important to recognize that human existence is a continual struggle against both natural perils and the follies and even the evils committed by our fellow men. We will need more than one incentive to be favorably arranged if we are to keep these enemies of civilization at bay.

The marginal functioning of incentives is also a cause for hope. If a destructive policy were to completely cripple some facet of human life, then there might not be a way to resist it effectively. But because some individuals are sufficiently strong internally so as not to be diverted from their course by the policy, they can amass the will and the resources to resist it. Moreover, people can condition themselves to respond more or less strongly to certain incentives. The more a person can train himself to persevere in the face of significant externally imposed costs, the more likely that person is to succeed despite such obstacles. Such successes are the building blocks upon which all human civilization has been built.

It is instructive to remember that there has never been an even tolerably calm and safe environment for innovators to flourish; at every time and place in history, some force – deliberate or not, more severe or less so, but never particularly mild – stood in the way of the thinkers and creators to whom we owe our progress. Where the carriers of civilization overcame these forces, they created a more favorable environment for us. We must, likewise, strive against the challenges of our time. By overcoming existing negative incentives, we can create positive ones for the future, through the examples we set and the work we bring forth.

Click here to read more articles in Issue CCXXXI of The Rational Argumentator.

For the Love of Money? – Article by Gary M. Galles

For the Love of Money? – Article by Gary M. Galles

The New Renaissance Hat
Gary M. Galles
April 13, 2014
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It’s not unusual to hear market systems criticized for relying too much on money, as if this comes at the expense of the altruistic relationships that would otherwise prevail. Ever heard the phrase “only in it for the money”? It’s as if self-interest has a stink that can corrupt transactions that generate benefits for others, turning them into offenses. So this line of thinking suggests reliance on market systems based in self-ownership would be tantamount to creating a world where people only do things for money, and lose the ability to relate to one another on any other terms.

People Don’t Do Everything for Money

One need not go far to see the falsity of the claim that everything is done for money in market systems. My situation is but one example: I have a Ph.D. in economics from a top graduate program. It is true that, as a result, I have an above-average income. But I did not do it all for the money. One of my major fields was finance, but if all I cared about was money—as my wife reminds me when budgets are particularly tight—I would have gone into finance rather than academia and made far more. But I like university students. I think what I teach is important, and I value the ability to pass on whatever wisdom I have to offer. I like the freedom and time to pursue avenues of research I find interesting. I enjoy the ability to tell and write the truth as I see it (particularly since I see things differently from most) and I prefer a “steady job” to one with far more variability.

Every one of those things I value has cost me money. Yet I chose to be a professor (and would do it again). While it’s true that the need to support my family means that I must acquire sufficient resources, many things beyond just money go into choosing what I do for a living. And the same is true for everyone.

Ask any acquaintances of yours who they know that only does things for money. What would they say? They would certainly deny it about themselves. While they might apply this characterization to people they don’t know, beyond Dickens’s Ebenezer Scrooge and his comic book namesake, Scrooge McDuck, they would be unable to provide a single convincing example. If market critics performed that same experiment, they would recognize that they are condemning a mirage, not market arrangements.

Confusing Ends and Means

Beyond the fact that all of us forego some money we could earn for other things we value, the fact that every one of us gives up money we have earned for a vast multitude of goods, services, and causes also reveals that individuals don’t just do things for the money. Each of us willingly gives up money up to further many different purposes we care about. Money is not the ultimate end sought, but a means to a vast variety of possible ends. Mistakenly treating money as the end for which “people do everything” is fundamentally flawed—both for critics of the market and for the participants in it.

To do things for money is nothing more than to advance what we care about. In markets, we do for others as an indirect way of doing for ourselves. This logic even applies to Scrooge. His nephew Fred’s assertion that he doesn’t do any good with his wealth is false; he lends to willing borrowers at terms they find worth meeting, expanding the capital stock and the options of others.

That an end of our efforts is to benefit ourselves, in and of itself, merits neither calumny nor congratulations. Money’s role is that of an amoral servant that can help us advance whatever ends we ultimately pursue, while private property rights restrict that pursuit to purely voluntary arrangements. Moral criticism cannot attach to the universal desire to be able to better pursue our ends or to the requirement that we refrain from violating others’ rights, only to the ends we pursue.

To do things for money in order to achieve world domination could justify moral condemnation. But the problem is that your intended end will harm others, not the fact that you did some things for money, benefitting those you dealt with in that way, to do so. Using money to build a leprosarium, as Mother Teresa did with her Nobel Prize award, does not justify moral condemnation. Similarly, using money to support your family, to live up to agreements you made with others, and to try not to burden others is being responsible, not reprehensible. Further, there is nothing about voluntary arrangements that worsens the ends individuals choose. But by definition, they place limits on ends that require harming others to achieve them.

It is true that money represents purchasing power that can be directed to ends others object to. Money is nothing more than a particularly powerful tool, and all tools can be used to cause harm. Just as we shouldn’t have to forego the benefits of hammers because somebody could cause harm with one, there’s no reason to think society would be better off without money or the market arrangements it makes possible just because some people can use those things for harmful ends. And if the ends aren’t actually causing harm, then the objections over them come down to nothing more than disagreements about inherently subjective valuations. Enabling a small class of people to decide which of these can be pursued and which can’t makes everyone worse off.

Those who criticize people for doing everything for money also do a great deal for money themselves. How many campaigns have religious groups and nonprofit organizations run to get more money? How much of government action is focused on getting more money? Why do the individuals involved not apply the same criticism to themselves? Because they say they will “do good” with it. But every individual doing things for money also intends to do good, as he or she sees it, with that money. And if we accept that people are owners of themselves, there is no obvious reason why another’s claims about what is “good” should trump any “good” that you hold dear, or provide for another in service through exchange.

Criticizing a Straw Man

Given that the charge that “people do everything for money” in market systems is both factually wrong and logically lame, why do some keep repeating it? It creates a straw man easier to argue against than reality, by misrepresenting alternatives at both the individual and societal level.

At the individual level, this assertion arises when people disagree about how to spend “public” resources (when we respect private property, this dispute disappears, because the owner has the right to do as he or she chooses with it, but cannot force others to go along with or allow it; “public” resources are obtained by force). The people who wish to spend other people’s confiscated resources in ways the original owners disagree with claim a laundry list of caring benefits their choice would provide, but foreclose similar consideration of the harms that would be caused to those they claim care only about money. That, in turn, is used to imply that the purportedly selfish person’s claims are unworthy of serious attention. (Something similar happens when politicians count “multiplier effects” where government money is spent, but ignore the symmetrical negative “multiplier effects” radiating from where the resources are taken.)

This general line draws support from a misquotation of the Bible. While more than one recent translation of 1 Tim 6:10 renders it “the love of money is a root of all sorts of evils,” the far less accurate King James Version rendered it, “the love of money is the root of all evil.” When one simply omits or forgets the first three words, it becomes something very different—“money is the root of all evil.” Portray those who disagree with your “caring” ends as simply loving money more than other people, and they lose every argument by default. Naturally, it’s a seductive strategy.

At the societal level, criticizing market systems as tainted by the love of money implies that an alternate system would escape that taint and therefore be morally preferable. By focusing attention only on an imaginary failing of market systems that would be avoided, it allows the implication of superiority to be made without having to demonstrate it. This is a version of the Nirvana fallacy.

By blaming monetary relationships for people’s failings, “reformers” imply that taking away markets’ monetary nexus will somehow make people better. But no system makes people angels; all systems must confront human flaws and failings. That means a far different question must be addressed: How well will a given system do with real, imperfect, mostly self-interested people? And it shouldn’t be necessary, but most political rhetoric makes a second question nearly as important: Does the given system assume that people are not imperfect and self-interested when they have power?

Given that the utopian alternatives offered always involve some sort of socialism or other form of tyranny, an affirmative case for them cannot be made. Only by holding the imaginary “sins” of market systems to impossible standards, while holding alternatives to no real standards except the imagination of self-proclaimed reformers, can that fact be dodged. But there’s nothing in history or theory that demonstrates that overwriting markets with expanded coercion makes people more likely to do things for others. As Anatole France noted, “Those who have given themselves the most concern about the happiness of peoples have made their neighbors very miserable.” And as economist Paul Heyne wrote, “Market systems do not produce heaven on earth. But attempts by governments to repress market systems have produced . . . something very close to hell on earth.

Money at the Margin

Money is not everything. But changes in the amounts of money to be earned or foregone as a result of decisions change our incentives at the many margins of choice we face, and so change our behavior. Such changes—money at the margin—are the primary means of adjusting our behavior in the direction of social coordination in a market system.

Changes in monetary incentives are how we adapt to changing circumstances, because whatever their ultimate ends, everyone cares about commanding more resources for those purposes they care about. It is how we rebalance arrangements when people’s plans get out of synch, which is inevitable in our complex, dynamic world. In such cases, changing money prices allow each individual to provide added incentives to all who might offer him assistance in achieving his ends, even if he doesn’t know them, doesn’t know how they would do so, and doesn’t think about their wellbeing (in fact, it applies even if he dislikes those he deals with, as long as the benefits of the arrangements exceed his perceived personal cost of doing so).

For instance, consider a retail gas station faced with lengthy lines of cars. That reflects a failure of social cooperation between the buyers and the seller. Those in line are revealing by their actions that they are willing to bear extra costs beyond the current price to get gas, but their costs of waiting do not provide benefits to the gas station owner. So the owner will convert those costs of waiting in line, which are going to waste, into higher prices (unless prevented by government price ceilings or antigouging directives) that benefit him. That use of money at the margin benefits both buyers and sellers and results in increased amounts of gasoline supplied to buyers.

Further, people can change their behavior in response to price changes in far more ways than “outsiders,” unfamiliar with all the local circumstances, realize. This makes prices, in turn, far more powerful than anyone recognizes.

Consider water prices. If water prices rose, your first thought might well be that you had no choice but to pay them. You might very well not know how many different responses people have already had to spikes (ranging from putting different plants in front yards to building sophisticated desalinization plants). Similarly, when airline fuel prices rose sharply, few recognized in advance the number of changes that airlines could make in response: using more fuel-efficient planes, changing route structures, reducing carry-on allowances, lightening seats, removing paint, and more.

If people recognized how powerful altered market prices are in inducing appropriate changes in behavior, demonstrated by a vast range of examples, they would recognize that the cost of abandoning money at the margin, which enables these responses by offering appropriate incentives to everyone who could be of assistance in addressing the problem faced, would enormously exceed any benefit.

Massive Improvements in Social Cooperation

If we could just presume that individuals know everyone and all the things they care about and the entirety of their circumstances, we could imagine a society more focused on doing things directly for others. But in any extensive society, there is no way people could acquire that much information about the large number of people involved. Instead, this would extend the impossible information problem that Hayek’s “The Use of Knowledge in Society” laid out in regard to central planners. You can care all you want, but that won’t give you the information you need. Beyond that insuperable problem, we would also have to assume that people cared far more about strangers than human history has evidenced.

Those information and other-interestedness requirements would necessarily dictate a very small society. But the costs of those limitations, if people recognized them, would be greater than virtually anyone would be willing to bear.

Without a broad society, the gains from cross-pollination of ideas and different ways of doing things would be hamstrung. The gains from comparative advantage (areas and groups focusing on what they do best, and trading with others doing the same thing) would similarly be sharply curtailed. A very small society would eliminate the incentive for large-scale specialization (requiring more extensive markets) and division of labor that makes our standard of living possible. Virtually every product that involves a large number of separate arrangements—such as producing cars or the gasoline to power them—would disappear, because the arrangements would be overwhelmed by the costs of making them without money as the balance-tipper. As Paul Heyne once put it,

The impersonal transactions that constitute the market system . . . have, over the course of a few centuries, enormously expanded our ability to provide [for] one another . . . while at the same time vastly extending our freedom both by offering us a multitude of options and by freeing us from arbitrary restrictions on our choice of life goals and on the means to further those goals. To reject impersonal transactions as unethical amounts to rejecting the foundation of modern life.

Conclusion

A pastiche of false premises leads many to reject out of hand what Hayek recognized as the “marvel” of market systems, which, if they had arisen from deliberate human design, “would have been acclaimed as one of the greatest triumphs of the human mind.” This is great for those who seek power over others—they have an endless supply of bogeymen to promise to fight.

But it’s a disaster for social coordination. The record of disasters inflicted on society demonstrates what follows when voluntary arrangements are replaced by someone else’s purportedly superior vision.

But it’s often forgotten. We must continue to make the case.

Gary M. Galles is a professor of economics at Pepperdine University. He is the author of The Apostle of Peace: The Radical Mind of Leonard Read. Send him mail.

This article was originally published by The Foundation for Economic Education.

Sunk Costs: There’s No Crying Over Spilled Milk – Article by Steven Horwitz

Sunk Costs: There’s No Crying Over Spilled Milk – Article by Steven Horwitz

The New Renaissance Hat
Steven Horwitz
July 29, 2012
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Nobel Prize-winning economist James Buchanan is fond of saying, “It takes varied reiterations to force alien concepts on unwilling minds.” That aphorism is surely true. Many basic ideas in economics require repeated attempts at explanation, and a variety of applications, before people fully grasp them and their importance. The one I want to focus on today is the concept of sunk costs and the related sunk-cost fallacy.

Understanding the concept of sunk costs first requires that one understand that, for economists, what matters for decision-making is what we call “action on the margin.” By “the margin” we simply mean the action we will take with respect to the concrete choice before us. When deciding whether a particular choice is worth making, the economic way of thinking tells us to compare the additional benefits that will come from that choice to the additional costs it will entail. This type of thinking then counsels: “Choose the option that delivers the greatest net additional benefits.”

Focusing on the additional benefits and costs that come from that specific action is what economists mean by acting on the margin. To forestall one objection, I will point out that what counts as a benefit or cost is of course subjective to the chooser. You and I could be in the identical situations but appraise the costs and benefits differently, and thereby end up making different choices. Economics says nothing about what should count as a benefit or cost, only that, whatever one chooses to count as benefits and costs, one should focus on the additional, or marginal, benefits and costs of a particular option and go with the one delivering the greatest net marginal benefits.

Irrelevant for Next Decision

An implication of this point is that costs that have already been incurred and that will not change with any of the specific choices now at the margin should be irrelevant to one’s decision. These are what we call sunk costs: The resources cannot be recovered, hence the costs are sunk. Such sunk costs should not matter for one’s next decision; only the costs now at the margin of choice count. No matter what we choose next, we can’t change the fact that we spent those resources in the past.

The idea of the irrelevance of sunk costs is all around us in folk wisdom and other places. For example, good poker players understand the idea when they say, “Don’t throw good money after bad.” Sometimes novice players will think, “Well, I’ve already bet five dollars on this hand, so I might as well see it through.” Good poker players know this is bad thinking: What matters is whether your hand is worth making the next bet. That you’ve bet five dollars already is beside the point. Bygones are bygones. You can’t put the toothpaste back in the tube. There’s no crying over spilled milk.

People who understand the sunk-cost fallacy know to beware when they hear people use phrases like, “You should get your money’s worth” or “You should finish what you started.” For example, suppose you pay a hundred dollars for a gym membership and never use it. Someone says to you, “You really should go to the gym and get something for your hundred dollars.” The problem, however, is that the money is gone whether you go to the gym or not. The relevant question is whether on any given day the benefits of exercising are worth the costs of going to the gym (or giving up your next best alternative). That’s action on the margin. The money spent is irrelevant.

Additional Costs Worth It?

The same is true of the argument that we should “finish what we started,” say, in Afghanistan or Iraq. We can’t change the past and undo the deaths and financial costs of those wars. The real question is whether the benefits of continued intervention are worth additional costs, regardless of what happened in the past. Are billions more spent and many more dead Americans and their victims worth it for the supposed additional gains of continuing those wars?

Sunk costs are sunk. Eventually, of course, in facing new decisions, we can rethink the old decision that sunk those costs in the first place (such as, should we renew the gym membership, or should we enter a new war?). But until then, the past is irrelevant because whatever we choose, we can’t change it. What matters for the economic way of thinking is decision-making on the margin: the additional benefits and costs of the options in front of us right now.

Understanding that choice is always on the margin and that sunk costs are sunk can help you make better decisions in your personal life and spot fallacious reasoning by politicians. This is just another illustration that good economics is the key to critical thinking and good citizenship.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.