It’s all a matter of incentives

Here is one of the easiest ways to remember economics and the incentives created by different policies. Always ask yourself who is spending the money and on whom they are spending it.

Don’t let that sound complicated because it isn’t. There are two options for each. Either you are spending your own money or someone else’s money. No other option exists. And either you spend that money on yourself or on someone else. From these two variables you get four different options with very different results.

If you spend your own money to buy something for yourself what happens? First, you are very concerned about the costs and you are very interested in the quality of product you purchase. People tend to dislike spending too much or buying something that is shoddy. So the natural incentive is to control the spending and try to guarantee the quality of the goods you receive in exchange.

You can also spend your own money on someone else. This changes your incentives a bit. You tend to be careful regarding how much you spend but you don¹t worry so much about the quality of goods you purchase. Every year Christmas presents prove that point. Just visit a major store on the first day they open after Christmas and see how many people are in line to make exchanges. You can pretty much bet that most of those people are not returning items they picked out for themselves.

Everyone has a story of some awful Christmas present that they received. Children around the world, anxious for some new toy, have frequently been terribly disappointed by socks and underwear from Granny. On Father’s Day some awful tie or odoriferous cologne is often wrapped by loving children. And many a woman has been disappointed to find that for Mother’s Day she was given new pans for the kitchen. The fact is that when you buy for others you pay more attention to the cost than to the quality.

The third option is that someone else can spend your money on themselves. That’s always problematic. They have no incentive to worry about costs but they make sure that the quality is top notch. The incentive to check quality is still there but the incentive to watch the cost is gone.

The fourth option is that someone spends your money and they spend it on you or someone else. This is the worst of the four alternatives because they have no incentive to care about either the cost or the quality. There is a tendency to waste money on poor quality items.

Now do such scenarios happen in the real world or are these merely the fantasies of some economist? Milton Friedman?

We do know that people spend their own money on themselves all the time. And people do want the best quality for the least amount of cash. That is precisely how people behave in free markets. The incentive is to try and lower costs while improving quality.

We also know people buy presents all the time. The situations I mentioned earlier of gift- giving are notoriously real.

Sometimes people are allowed to spend someone else’s money on themselves. Give your teenagers a credit card or blank cheque and see what happens. They are very likely to find something that they really like but not worry about the cost very much. That’s a common occurrence.

But that fourth one.... where do you get people spending other people’s money on other people? As Dr. Friedman put it: ‘ ... if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.’

None of the people in any four of the scenarios are necessarily bad people. They are merely acting according to the incentives. And incentives work best when you are spending your own money on yourself and worst when you are spending someone else’s money on other people. That’s why governments are notoriously wasteful and state services are known for their poor quality.

That’s also the reason we are better off moving as much as possible into the private sector where people spend their own money on themselves. Then all the incentives are to get the purchase right. Under socialism someone else is spending your money on you and the incentives they face encourages them to spend too much and give you too little in return.

Good people can make bad mistakes when they have no incentive to get things right. Leave government to it’s core functions and let the market work. It’s the best way to ensure quality service for the right price.

Author: Jim Peron is the executive director of the Institute for Liberal Studies (Auckland, New Zealand). This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Free Market Foundation.

FMF Feature Article \ 01 February 2005