How Do People Make Economic Decisions?

0:00What I want to talk about today are a few of the most basic principles of economics and what I want to get across with this talk is a description of what we call like the economic point of view which is a way of looking at things and understanding how economic principles play a role in shaping the world we live in and I hope I'll be able to explain these ideas in very simple terms and then show you how you can use even very simple concepts to think about much bigger and more complicated problems in the real world. So just to start I should say something about about why the economic point of view is important at all. One of the most important ideas spread by Ludwig von Mises and others was the notion that ideas are what shaped the course of history. Even the most powerful nations in the world ultimately rest on the ideas held by the people in them.

0:47So all it takes to change things is to change the ideas people have about the world. And so economics, which is a part of every bit of our everyday lives, is absolutely vital for people to understand in order for them to be able to hold informed opinions about human society and the way it works. And one way economics helps us to change these ideas is that it gives us a very specific scientific way to look at certain questions and answer certain problems. So what I mean is if we think about discussions of economic policy that we usually hear on the TV and in the news and so on, a lot of time, a lot of the time when we argue about about these things. Reporters and analysts focus on questions like what rights does the government have to make me do this or that or they say things like my individual rights come before those of society or something along those lines and these ideas are important but with economics we can actually avoid some of these very difficult problems just by pointing to the results of our logic and saying well look it doesn't really matter what we think should be the case, should be the goal that we're aiming for.

1:56The policy that we're discussing can't possibly produce the results that you want it to. So, for example, in the recent healthcare debate, a lot of the focus was on issues like, is it constitutional and things? And as important as those questions are, economists ask questions like, what are the necessary results of this policy? okay so with that in mind we can start with the basics with maybe the broadest of all economic questions which is why do people do what they do what motivates people and this is obviously a very important question in economics but the answer is very simple people do things which they believe will make them happy individuals are always choosing to do whatever it is that they believe will increase their welfare and this idea of welfare of human happiness is an umbrella which actually covers everything that people are capable of valuing from very simple things like providing for your own immediate physical needs but also this also includes broader activities things that we would consider selfless

3:06as opposed to selfish things like giving to charity and things like this and this is a big difference actually in the way that Austrian economists see the world as opposed to most economists because most economists tend to assume that people only value things for their own uses for very narrow selfish purposes and that they only value a very small number of easily definable things like their money income. So it's very, most economics is actually quite unrealistic in this sense, whereas the Austrians I think tend to get it right because they understand that people can actually pursue anything they want. So, Washington Economics is capable of explaining all the choices that human beings make as opposed to just a very few. Okay, so there's this whole range of things which motivate people and economists call these motives incentives.

3:55This is one of the big concepts in economics. Some of you may have heard of or actually read the famous book by Stephen Leavitt and Stephen Dubner called Freakonomics, which is very popular these days, which basically argues that everything in economics is an incentive problem. And they ask all kinds of very strange questions like, what do sumo wrestlers and high school teachers have in common? Or why is it that the vast majority of all drug dealers still live with their moms? And the answer, by the way, is that sumo wrestlers and high school teachers both have a very high incentive to cheat, and in fact do cheat. And most drug dealers live with their moms because the vast majority of drug dealers make less than the minimum wage.

4:42But anyway, the point is that with this kind of reasoning, you can answer all kinds of very strange questions just with a little bit of economic thinking. By the way, I would actually hesitate to recommend that book for economics or any of the many books like it because I think there are some problems with it that I'll just mention in a few minutes. But in any case, these economists spun a really elaborate explanation for these strange little problems out of this very simple concept of incentives. And incentives are basically just a fancy way of saying that people do things that they believe will make them happier. So we realize that individuals pursue happiness by themselves, but then the next question is, what if, in order to make myself better off, I need the help of someone else?

5:27How can people be induced to behave in a certain way which benefits me? And again, the answer is simple. You have to provide them with a benefit. you have to provide them with an incentive so for example I don't want to work I would rather watch my Jersey Shore marathon in my underwear so someone else offers to pay me to work and that payment is my incentive it's a reason that I for me to do something it's a benefit that I gain and of course the cost of choosing to work is that I miss out on the delightfully tasteless Incentives are simple, but they get a bit more complicated when we look at society and many individuals and see that all of society is essentially a network of incentives provided by people to get other people to do things that they maybe normally wouldn't do.

6:19But the key to understanding this is that in doing this, in doing things for other people, we actually make each other better off. And I think a little bit later, Dr. Thornton is going to talk about social cooperation in the division of labor and how this increases welfare, so I'm not going to step on his toes too much. But I will just point out that the market is this amazing method of coordinating different people's incentives, coordinating the different things that people want. And it works without having to organize it from the top down by force. by Force. And once we understand this, it becomes very important also to understand what people want to do and try and look at the economy and see if it's organized in a way that allows for that to happen, that allows for people to achieve their goals.

7:09And especially we have to look at how society is organized because it turns out that government tends to create disharmony through various artificial restrictions which create perverse The best way to think about this is to just take the idea of how a free market works and what kind of incentives it provides and compare that to economic systems which aren't completely free, to see the contrast. And when we compare free and regulated economies, we of course, we always have to remember that even free markets aren't perfect. Sometimes the market does generate strange incentives for people.

7:55But the point is that these problems tend to be minimal if people are free to choose whether or not to interact with each other, to make contracts with each other. And if people are free to change the arrangements they have if they don't work. But it probably won't come as a surprise to you that the most serious problems appear when government intervenes in the economy. So you can think about incentive problems by comparing which kind of behavior is desired and which kind of behavior is actually rewarded. Now if they're the same, then there's no problem. But when you reward behavior that you don't want, you simply encourage it. So to take a recent example, there was this fuss a few weeks ago about the budget and the concern that the government would shut down if they didn't reach an agreement on spending.

8:44So fortunately they did reach an agreement and the world did not end as of course it would have if the government had been around for a few days. But the principle behind determining the budget is a classic example of terrible incentives. And the reason is that next year's budget is essentially based on this year's expenses. So the idea is that if the government spends its budget this year, next year it gets at least that amount plus new funding, funding for new projects that they have. And so, of course, this is a famous case of bad incentives because the policy rewards spending and at the same time people are just left having to hope that next year, simply out of their good nature, the spenders, the politicians will just decide not to spend as much.

9:34But, of course, the whole policy rewards spending because they get more money depending on how much they spend this year, right? Okay, so how do you solve problems of conflicting incentives when you end up rewarding behavior that you don't want? The easiest answer is that you can form more explicit contracts. You can carefully define what's expected of everybody. And this way people can choose the arrangement which serves them best, and over time they can try to invent new ways to solve any new problems which come up. And immediately you can see why this might pose a problem for government, The Government is a very important part of the process. The contract that people have with government is really just an idea. It's not really defined. And in any case, it's very difficult to change from the outside.

10:20But from the inside, governments can change the contract without requiring much consent of the people on the outside. So governments can very easily be insulated from demands of people outside government. The taxpayers can't just draw up a new agreement, they can't just make a new contract if they think that the current one is bad. They can't sort of take their business elsewhere as they would in the marketplace. And so these incentive problems persist because there is no real contract between, say, people and government. So another way to improve incentives is to enforce property rights, one of the more fundamental concepts, again, in economics. And a really good way to look at this is to look at environmental problems. A very common claim made against free markets is that they result in all kinds of environmental destruction.

11:11But environmental problems are actually just a good example of incentive problems that are caused by government interventions in the economy. If you look at the historical record and even today, you see environmental disasters most often in places where there are no property rights or where the government has granted privileges to people to exploit natural resources. So the key point is that if you have to decide how to use your own resources, you make a much more careful use of them than when someone gives you their resources. So a little example and I'll explain how it figures into the bigger picture. Just imagine if I say to you that I'll give you $100 and you can spend it however you want, but in 20 minutes you have to give me back whatever is left over that you haven't already spent.

11:59So what do you do? Well, you go out and spend it as fast as possible, right? Because in 20 minutes, you lose the money whether you've bought anything or not. And this is basically, this is the principle in resource economics. This is the bad incentive that exists. Because what happens is, you have, for example, governments who either, through using the land themselves or leasing it out to various corporations In that situation, you have governments who own the forests and they lease them out to timber companies for a certain period of years. But because the timber companies don't own the forest and they only have access to the resources for a limited time, their incentive is to just take everything they can as fast The American Buffalo, which was endangered for a very long time, was hunted almost to extinction because nobody owned the animal.

13:01This is the result of completely deforesting various forest areas, and this happens both in the US and in places like the Amazon. There are many other famous historical cases of this sort of thing as well. The American Buffalo, which was endangered for a very long time, was hunted almost to extinction because nobody owned the animal. and almost to extinction because nobody owned the animals or the land they lived on. Nobody had an incentive to make sure that the population was kept high. This is one of the most famous problems in resource economics, it's called the tragedy of the commons. And the idea is that when many people own a resource or when nobody owns a resource, when government owns a resource, nobody really has an incentive to keep the value of the Research High, because nobody is really bearing the cost of using the resource, if that makes any sense.

13:56And in general, the great solution to this is to transfer ownership from a situation of no ownership or government ownership to private hands, because in that case, the property belongs to individuals, and they have the maximum incentive to keep its value high. And you avoid all these sorts of environmental problems. And just to show you how powerful this idea of individual property rights and contracts can be, even in cases where property rights aren't clear or where there's community ownership, so you have many people making a claim to the same resources, it's still the case that free systems develop better solutions than the ones created by governments.

14:45Nobel Prize winner in economics of a couple of years ago, Eleanor Ostrom, has spent a lot of her career explaining how it is that communities develop methods of dealing with resource problems and environmental destruction, and how people naturally evolve solutions to these problems, usually without the help of government. In fact, it's even been suggested that in the case of very large scale problems that we hear a lot about, such as climate change, there may be ways in which the free market can provide answers as to how to encourage good behavior by people to solve these problems without actually having any recourse to government. Okay, so that's incentives. And talking about how incentives and how they work and don't work leads to another huge idea in economics, the idea of unintended consequences.

15:36Again, the idea is all in the name. Sometimes we do things as individuals or as a society which have results that no one intended. Unintended consequences can be good or bad. Good unintended consequences would be things like the emergence of markets. For the most part, people don't get together and simply say, let's start a highly specialized and developed economy together. Things start out much smaller than that, with individuals trading with each other to make themselves better off and at the same time making others better off, and this snowballs or money is another good example. Individuals start by finding commodities, which are valued by many people, and they use these commodities just as tools to exchange with other people, not necessarily to be used on their own.

16:29and people do this because it makes them better off but before long there's a medium of exchange money which is used by many people which has emerged spontaneously and which helps everyone so these are good unintended consequences consequences that help people achieve a greater degree of welfare and which can't be imitated or artificially created by governments as mr. French was pointing out but there are also many bad unintended consequences and these are often the results of government interventions and the major way in which government creates unintended consequences is through playing around with prices. The most common examples are things like the minimum wage. When people argue that we should raise the minimum wage they usually claim that it's to help certain people, those who have low incomes, who are relatively uneducated, who have trouble making a living and so on. But economics shows us that the minimum wage is actually cause unemployment among helping these very people and also helps to cause various types of discrimination against

17:29those groups and essentially all government programs follow this pattern. They actually hurt the people that they're designed to help. This is a point that Mises made many times that even from the perspective of the people who are in favor of the interventions, those interventions are still failure. So these are sorts of unintended consequences and another really good example of unintended Consequences comes from environmental regulation again. Ever since the Endangered Species Act was passed, it has made things very difficult for anybody who owns land on which an endangered species happens to live, because if it's established that an endangered species lives on your property, you can't do anything to disturb the habitat of the animals, you're prohibited from building or really doing anything near the habitat, and in some cases your land can actually be effectively seized from you.

18:21So the rules can be very extreme. Sometimes even if you have just a couple of endangered birds, it can mean that you can't use any of your land at all because anything could be construed as destroying the habitat. So this is a real problem for landowners and a response to this regulation by landowners is that sometimes when they find endangered animals on their land, instead of reporting to the habitat to the Environmental Protection Agency. So their land can simply become regulated or confiscated. They just kill the animals to avoid their trouble. And there's a name for this practice, it's called shoot, shovel and shut up. And the idea is that you don't want your land taken away from you. So if you happen to stumble across the habitat of endangered animals on your land, you're not going to tell anybody about it. Why would you? You just kill them, put them in a hole So it's obvious when you think about it that a landowner who has a significant investment in his property isn't just going to give it up.

19:24This is another example of how the economic way of thinking, just thinking a little bit about incentives, helps us understand problems which people tend to completely miss. Without thinking about incentives, it's very easy to get caught in the trap of thinking, well, the best way to preserve endangered species must be to simply make a law that punishes people for hurting them. But of course, no, that's not the case because the unintended consequence is that the law makes it in the interest of owners to kill the endangered species instead of the other way around. Okay, so incentives and unintended consequences lead to the next problem I'll talk about, the most famous kind of incentive problem, which is called moral hazard. Of these problems I'm speaking about, this is one which you would probably not hear about in most standard introductory lectures to economics, but that's exactly why I'm including it in the basic principles. One of my teachers in graduate school used to say that moral hazard is actually

20:24the most important problem in economics and that's actually pretty close to the truth because we can see this principle absolutely everywhere we look and that's why it's important to learn even at the introductory level. And with moral hazard, the principle is also pretty easy to understand. Moral hazard is basically the notion that when you can push the cost of your own behavior onto other people without them really being able to do anything about it, this changes your behavior. By the way, moral hazard is actually a bad name for this problem because it's not a moral problem, it's an economic one, but that's a side point. So moral hazards do exist in the free market, but the most significant cases, again, happen because of government intervention. And so one way to think about moral hazard is to ask how your behavior would change if you could make other people responsible for your actions.

21:16Economists usually talk about this problem in terms of insurance. You buy health insurance to help you in case you have some kind of accident, right? But the problem is, you have some control over how risky your behavior is. You can control how healthy you are to some extent. So, if you have health insurance, maybe because you know that you won't have to pay if you get hurt, you start doing riskier things than you normally would. Maybe you take up chainsaw juggling or bullet catching Catching or something. Or maybe, and this is much more realistic, you have car insurance and because of that you start driving a little bit more carelessly than you normally would because if you get in an accident you're not the one who's going to pay the bill. With a cost reduced it becomes that much easier not to pay attention. This sort of thing actually does happen.

22:04There's a very famous study by an economist named Sam Peltzman who showed The theory showed that laws which require you to wear your seatbelt actually cause traffic accidents. So why would this happen? Well, it's because when you wear your seatbelt, you feel safer. And because you feel safer, you take more risks. And taking more risks causes more accidents. So this is one example where a government intervention, in this case designed to make people safer by making you wear your seatbelt, actually makes driving more dangerous. and I'm not claiming by the way that you make a conscious decision to do these things in the sense that you think well today I'm just going to be really reckless I'm just going to go crazy on the road and I don't care what happens it's more that there are subtle changes in your environment and in the arrangement of your incentives certain types of behavior carry higher rewards or lower costs than the otherwise would because of regulations like this and this results in you making different decisions so you can use the idea of incentives and more hazard to understand all kinds of decisions

23:07In the recent financial crisis, we had a round of bailouts where failed firms were saved by the government, and a major concern of economists was that this was a moral hazard situation. The problem is that if we just rescue a firm every time it fails, the behavior of the firm starts to change because they're not bearing the cost of their behavior. here. They start to invest in riskier forms of business because they assume that they won't be responsible if they fail. The cost gets pushed onto the taxpayers instead. So by bailing firms out, you just encourage reckless decisions and you promote the same sort of problems which got the firms into trouble in the first place.

23:54And actually, the US experience is not the most extreme one. Two of my economist colleagues have a new book out called Deep Freeze, which is about Iceland's economic collapse in the past few years, which was probably maybe the worst in the world in this most recent great recession and what they point out is how Icelandic banks had an explicit guarantee from the Icelandic central bank that they would be bailed out in the event that their business went sour and this had a really obvious result because banks were explicitly told that they were too big to fail They completely ignored all reasonable guidelines for keeping themselves solvent. And eventually when the banks failed, the central bank of Iceland couldn't handle the strain and then the whole system collapsed.

24:42But this is a very important real-world example of how this very simple idea of moral hazard can have really revolutionary consequences. I don't actually have a copy of this book with me, but I think it's for sale downstairs in the bookstore. And if you're interested in these ideas, then I recommend the book to you. It's a little more advanced. But it has a lot of interesting material to help you understand how all these economic problems tie together in the big picture, especially in terms of government meddling and monetary policy. The book's also written by one of my Ph.D. advisors, so I have to say nice things about it, whether I want to or not. So thinking about incentives can be a very useful way to think about how people behave in the world. But now, after talking about how important incentives and incentive problems are for a minute, I'm going to confuse you for a second by talking about why incentives aren't important.

25:34And what I mean is, as I mentioned before, some economists think that all of economics is just trying to arrange people's incentives. But that isn't everything. And this is one place where Austrians tend to do better than most other economists. So as an example, Austrians are very interested in discovering economic laws, certain relationships which are true in all times and in all places. And these laws are more fundamental than people's incentives because they exist no matter what the arrangement of incentives is. So a famous example is Mises' argument against socialism. Usually when economists talk about socialism, they talk as if socialism were just a problem of incentives. that is, how do we motivate people to do the right things, to produce the right things when government is controlling all the production in society.

26:27But what Mises showed was that the problem of socialism was much deeper than that. He argued that no matter what the incentives for people are, no matter how well you try and organize a society, a socialist economy can't work because it doesn't have a functioning price system, because it doesn't have a system of private property exchange. That criticism of socialism, it's a little bit complicated, but the punchline is that it doesn't matter how you try to motivate people. Without private property, you have no way to rationally organize a society. So the last sort of unifying theme I want to mention is the idea of choice. If there's one core principle of economics, it would be choice. Essentially everything economics teaches is related in one way or another to human beings is choosing between alternative possibilities and economic science is basically teasing out those many implications of human choice and probably the most important implication of choice is cost. Choice implies something which is not chosen. We can't do everything

27:28we want. So every time we make a choice, we have to choose to give up something else. So for example, for you guys to be here today, you had to give up something else. Justin And we call this thing that we give up an opportunity cost, because we're giving up the opportunity to do something else. And this is really important because it means that every human action has a cost. There is no such thing as a free lunch. No matter what you do, you're always paying for it in some way, whether in terms of your time or your money or what have you. There's always something given up. And this was one of the points that Henry Hazlitt makes in his famous book, Economics and One Lesson, which is a great introduction to how to think about economic policy and all its hidden costs.

28:18That book is all about understanding how, for everything we see being done, there's always something which remains unseen, something we've given up. The one lesson of economic policy that Hazlitt talked about is that we can't just look at the results of a policy for a few people or for a short time, we have to look at how our policy affects all people and at all times, and this means looking at examining those things that we had to give up. So, to take one example, it has pointed out that it's very easy to look at the results of certain, say, government interventions and see results which look as if they're very beneficial to society. You can actually see and interact with and use say like a new community center in your neighborhood for example.

29:10But what you don't see is what could have been done with the resources used to build that center if they had been left to the free market. You don't see what you could have had otherwise. So maybe in that case you could have had your new 50 foot solid gold statue of Justin Bieber instead of the community center. You can see that this is kind of a theme to my understanding of pop culture, that's the only name I know, even though you guys are probably way too old for that. In fact, actually, the example is probably really bad, because if you guys don't like Justin Bieber, then you're going to be begging for government intervention, and I've just totally undermined the free market. But anyway, Justin would want you to know that in order to get the new public roads or public buildings or what have you, we have to give up something else.

29:58and we have to think about these trade-offs that we make whenever we make our policy decisions. So at the introductory level I recommend the Haslet book, Economics in One Lesson, and also a few years ago the Mises Institute recorded a series of conversations with Austrian economists about different aspects of the book and why it's continuing relevance for us today and I recommend those interviews to you as well. So, well, I think I'm out of time so with that I'll...