Free Lunch (4 page)

Taking all the above as read, we still need to answer the question: why do we spend in the way we do? It may seem trivial but it was something that obsessed many of the great economists of the past, particularly in the nineteenth and early twentieth centuries. They were concerned with the satisfaction or ‘utility’ people obtained from consuming things. Some even believed it could be precisely measured. We need not trouble ourselves with that but utility is still a useful idea. In general, for example, the more of something we consume, the less satisfaction or utility we will get out of each extra one. One bar of chocolate a day is fine for me but a second I could take or leave. After a third I would feel queasy and after a fourth I would be quite ill. The amount of utility we get from each extra one, each ‘marginal’ one, falls. This is known as ‘diminishing marginal utility’ – the more you have the less you want another one. It can even go negative. After six cups of coffee in a morning, I would pay somebody to drink the seventh I was offered.

Diminishing marginal utility does not apply to everything. Collectors may get more satisfaction out of the final acquisition that completes a set than the first that began it. One harmless bit of fun economics opens up is thinking of exceptions to the rule. Are addicts, for example, subject to diminishing marginal utility?

Utility does allow us to answer some of the great mysteries of our time. Why, when there are so many wholesome alternatives around, do people buy and eat Pot Noodles, that well-known convenience food? Why don’t students blow their entire loan in frenzied partying in the first week of term? Why do old men who drive cars in the middle of the road always wear trilby hats? Actually I cannot help with the third one (and if anybody can, let me know) but I can with the other two. It has to do with utility. What we all try to do, subconsciously – although I have met a few strange economists who do it consciously – is try to maximize our utility. In other words, we try to get the most out of what we spend. I would not be doing this if I spent my entire income on Mars bars, because diminishing marginal utility would kick in quite quickly. It may be that I could do it by alternating fillet steak with Pot Noodles. I suspect, however, that many aficionados of Pot Noodles maximize their utility by alternating them with copious quantities of beer in the student bar. As for why those same students do not blow their student loans in the first week, it is because it would not maximize their utility to have one glorious but soon forgotten binge and live on nothing for the rest of the year.

Incentives work everywhere

The idea that ‘incentives work’ underpins much of economics. It is also a basic tenet of economics that can be extended to other areas of life. Gary Becker, an American economist, won the Nobel Prize for economics in 1992 ‘for having extended the domain of microeconomic analysis to a wide range of human behaviour and interaction, including non-market behaviour’. Some of the ways incentives work are fairly obvious, if nevertheless controversial. How do you reduce the murder rate? By making the death sentence mandatory for all convicted murderers. I shall leave to you the question of whether this would, in turn, give juries an incentive not to convict. Crime and punishment are areas where the incentive model can be widely used. What is the best way of stopping people speeding in their cars? Is it to try to persuade them of the dangers of driving too fast or is it to install speed cameras on every stretch of road and slap heavy fines on transgressors? Current government policy in Britain, having tried the former for many years, now emphasizes the latter. Road safety is an area where incentives could be used more widely. Safe and conviction-free drivers already benefit from lower insurance premiums than their more dangerous counterparts. Why should not the government extend this incentive principle by varying rates of road tax depending on the safety record of the driver? Road safety is also an area, however, where incentives may operate in a perverse way. Do seat belts make people drive more carefully or, knowing that they are better protected in the event of a crash, more dangerously? Would the best way of ensuring safe driving be to require every vehicle to be fitted with a large spike in the centre of the steering wheel, as has been suggested, because nobody would then take any risks?

There are more entertaining examples of incentives. Why, in most western societies, is polygamy banned? On the surface it looks like a case of men, against their own self-interest, legislating in favour of women, ensuring they are not forced to share a husband. This assumes, however, that polygamy is a state desired by most men, which is debatable, since many would argue that one wife is plenty. It also ignores the fact that, in any society where there is a roughly equal number of men and women, polygamy will mean that, for every man with five or six wives there will be four or five sad and lonely ones without any wives at all. There is also the strong possibility that wives in a polygamous marriage will be less loyal, ready to respond to the blandishments of the richer chap down the road. Incentives work, and men can do without that kind of competition. Men have an incentive to outlaw polygamy. You can extend this to plenty of other areas. Were more liberal attitudes towards the position of women in the workforce driven by fairness, or by the desire of many men to be able to spend their afternoons on the sofa, watching the racing on television?

Steven Landsburg, in one of his regular pieces for
Slate
, the online magazine, offered another interesting angle on the role of incentives in society. Why, he asked, is there so much obesity around, particularly in America? The usual explanations revolve around the malign influences of TV, cars and fast food (including the defining moment when the standard unit of consumption for teenagers became, not the four-ounce hamburger but our old friend the Big Mac). These are all good reasons. Lack of exercise in childhood, with fewer children walking to school, often results in obese teenagers. But why do people stay obese? Why don’t they lose weight when they realize how dangerous it can be to carry too much fat around? According to Landsburg, it is because they have lost the incentive to lose weight. And incentives, as we know, are the key to economic behaviour. He writes:

Here’s one plausible story: The nineties saw the advent of drugs like Pravachol and Lipitor that can dramatically cut your cholesterol and increase your life expectancy. With medical advances like that, who needs to be thin? Of course obesity is still bad for you – but it’s not as bad for you as it used to be. The price of obesity (measured in health risks) is down, so rational consumers will choose more of it. With the success of the human genome project, even greater advances are just over the horizon, making obesity an even greater bargain. Today’s expanding waistlines might reflect nothing more than a rational expectation of future progress against heart disease.

Landsburg also offers, perhaps tongue in cheek, an explanation of why low-fat foods contribute to obesity.

Suppose a scoop of ice cream a night would add 10 pounds to your weight, and you’ve decided that’s not worth it, so you don’t eat ice cream. Now along comes a low-fat ice cream that allows you to eat two scoops a night and add 10 pounds to your weight. That’s a better deal, and a perfectly rational being might well opt for it. So when low-fat foods come along, some people sensibly decide to become fatter.

Economists, you see, have an explanation for everything. Why do tall people tend to be more successful in life? The usual explanation is that employers favour them, particularly in leadership positions. There is, however, little evidence of that. And if there was evidence of such discrimination, short people could legitimately cry foul. The key, according to researchers at Pennsylvania State University is that what matters is not height in adulthood but height during adolescence. Tall adolescents are usually picked for school sports teams, are chosen as prefects and, in the case of boys at least, often fare better with the opposite sex. It is during adolescence that, thanks to their height, the tall acquire both confidence and leadership qualities. This explains, incidentally, why some short people have risen to the top. Very often they will have been tall for their age during adolescence and then stopped growing. Does it work as a general rule? Ask around.

Work or leisure?

Finally in this section, let me come to a question of incentives that causes much debate among economists. When somebody wins a large sum on the football pools, the lottery or
Who Wants to Be a Millionaire?
the question usually asked is: will your winnings mean that you will give up work? There is another question, to which I shall return later in the book, which is: will this money make you happy? In response to the work question, the answer is either the heart-warming but probably unrealistic: ‘I won’t let it change my life,’ or the more usual: ‘You bet your life I’m giving up work.’

Very few of us win large sums of money, although the prospect of doing so gives us an incentive to play the lottery or do the pools, however long the odds. But many of us are faced with smaller versions of this kind of decision. Suppose, at a time of negligible inflation, you receive a 25 percent pay rise. The choice is between being better off financially or, instead, working four days a week instead of five and enjoying the same standard of living as before. A manager could, in other words, reward his best staff by paying them more, only to find that he then sees less of them.

This is known as the ‘work–leisure trade-off’ and it is quite interesting and important. By leisure, by the way, we do not mean just going to the cinema or lounging around the pool. It also includes those hours you spend sleeping, washing up or cleaning out the drains, in other words all non-work hours. If you spent all the time working, not only would you be very tired, but there would be no time to spend the money you had earned. That is one end of the spectrum in terms of the work–leisure trade-off. If you did not work at all but spent all your time on the beach, you would have no money to eat. That is the other end of the spectrum. For most people there will be a trade-off between work and leisure somewhere in the middle. To go back to the earlier discussion of why people spend in the way they do, people will be ‘indifferent’ between a certain amount of time spent in work, say forty hours a week, and a certain amount of leisure, the rest of the week. When wages rise people are indeed better off, and could work fewer hours. On the other hand, leisure has become relatively more expensive – think how much you could be earning while you are relaxing – creating an incentive to work longer hours. The balance between these two effects, the income and substitution effects, will determine whether higher wages result in longer or shorter hours.

On the face of it, the long-run evidence suggests that higher wages do result in fewer hours worked. I described in the last chapter how incomes have risen in real terms – they have outstripped inflation – but alongside this we have also seen a decline in hours worked. In the past fifty years or so, a typical manual worker’s week has dropped from forty-eight hours to forty or fewer, with a corresponding reduction in the standard white-collar week. Prosperity brought with it a demand for greater leisure – the income effect dominated the substitution effect. To remind you how this works, the rise in income has, in effect, made it possible to buy more leisure time, and this is what most people have chosen to do. This is despite the fact that leisure time has become more expensive in terms of what the worker could have earned by, say, working Saturday mornings.

Interestingly, many would testify that this process came to an end in the 1990s, with many managerial and white-collar staff being required to work far longer than their statutory hours of employment, and to take work home. More people took second jobs, notably in America and Britain. There are also big variations in working hours, even among industrial countries. Americans work more than 1,900 hours a year, compared with fewer than 1,600 in Germany and about 1,700 in Britain. The differences are accounted for by variations in both weekly hours and holiday entitlements.

Work and tax

All this is rather important, particularly when it comes to economic policy. In the 1980s, when Margaret Thatcher was in office in Britain and Ronald Reagan was in the White House, there was great stress on the role of incentives and on how they could be sharpened by means of income tax cuts. The argument was that if you allowed people to keep more of their earnings – in effect boosting their wages – they would work harder. If you hit them with punitive rates of tax, on the other hand, they would work less hard. Embarrassingly for the British government, a piece of research commissioned by the Treasury and carried out by Professor Chuck Brown of Stirling University found that the opposite was true. When taxes were cut, it either made no difference to people or they worked fewer hours. But when taxes went up, they were obliged to work harder to maintain their level of (post-tax) income. A furious debate ensued, after which there was no clear winner. Most people, it turned out, were in no real position to alter their hours of work, these being fixed by the firm they worked for. The more difficult question of whether lower taxes meant they worked harder during their allotted time, in other words raised their productivity, is still not conclusively settled.

I shall return to tax later. One area where tax changes do appear to have had a clear effect on people’s appetite for work is in the case of women. In Britain married couples used to be taxed jointly. A woman getting a part-time job would be taxed at her husband’s highest marginal tax rate, which in the 1970s in Britain could be as high as 83 percent and for most of the 1980s was, for higher-rate taxpayers, 60 percent. In such circumstances many couples decided it was not worth the wife working. Independent taxation, the separate taxation of husbands and wives, introduced in the late 1980s by Nigel Lawson, one of Thatcher’s three Chancellors, changed all this. Women had their own tax-free allowance and paid tax at a rate that reflected their earnings, not those of their husbands. This made a big contribution to one of the features of Britain’s job market in the latter part of the twentieth century – a huge increase in the number of women working.