The Out-in-the-Open Economist

I recently finished reading Tim Harford’s The Undercover Economist. It was well-written, fun to read, persuasive – everything the reviews said it would be. Still, I found myself disappointed. I think I was misled by title. I imagined an “undercover economist” solving economic puzzles, exposing hidden schemes, ferreting out economic principles at work in the most unexpected of places. But Harford’s perspective is really just the conventional wisdom of the mainstream economics profession, applied to the most traditional of economic problems: how firms choose prices and product characteristics, what’s wrong with healthcare, why some economies grow and others don’t, etc. It should have been titled The Out-in-the-Open Economist.

But the book wasn’t written for professional economists, and some of the book’s insights will seem novel and surprising to the layman. A fairer complaint about the book would be this: that Harford places too much weight on the idea that efficiency and distribution can be separated. Here’s how Harford puts it (p. 73-74):

…[T]hink of … the 100-meter sprint. The fastest sprinter will win the race. If you wanted all the sprinters to cross the line together, you could just change the rules of the race, ordering the fast runners to slow down and everyone to hold hands as they crossed the line. A waste of talent. Or you could move some starting blocks forward and some starting blocks back, so that although each sprinter was running as fast as he could, obeying the usual rules and objectives of sprinting, the fastest had to cover enough ground that he would end up breaking the tape neck-and-neck with the slowest.

[Kenneth] Arrow demonstrated that the same approach could work when trying to balance the excesses of competitive markets: instead of interfering with the markets themselves, the trick is to adjust the starting blocks by making lump-sum payments and levying one-time taxes.

In other words, all you have to do is change people’s initial wealth endowments, and then let the market rip. The problem is that you can’t just change the endowments once. Lump-sum transfers happen in real time, and any policy that establishes a system for making them will create ongoing incentives. Taking Harford’s metaphor, what if the runners know in advance that their starting blocks will be moved to reflect their ability levels? Then the plan reduces runners’ incentives to develop their skills in the first place, and increases their incentive to hide their abilities from the handicappers. Failure to train is rewarded with later starting blocks; displaying your talent is punished with earlier starting blocks.

In economic systems, the attempt to achieve equity by altering initial endowments can be even more pernicious. Take, as one example, the case for land reform. There are some very good arguments for redistributing land in countries with a history of corruption, where elites have been enabled (usually through government power or colonial history) to claim ownership of most of the land. The problem is that each land reform sets a precedent for future land reforms. As a result, any recipient of redistributed land knows there’s a chance his land will be confiscated in a future land reform, and all his investments in the land could be lost. That’s a pretty good reason not to bother making such investments in the first place. So for a land reform to be effective, the government must be able to credibly commit that it will only happen just this once. That is much easier said than done. A government powerful enough to force a redistribution of land is powerful enough to do it again, perhaps for less than admirable reasons.

If an allegedly one-time redistribution can create undesirable incentive effects, then so much the more so for ongoing redistribution devices, including most welfare programs. Subsidies affect the incentives of recipients (or parents of recipients) on one end, while the taxes required to fund them affect the incentives of taxpayers on the other. In some cases, the gains in fairness might be worth the efficiency loss. And the efficiency loss from transfer programs might be small when compared to the efficiency loss from other interventions, such as price controls. But let’s not pretend the loss is nonexistent.