Category: Money in Individual Choice

We all love the story of the rugged individual — hard-working, self-reliant, and through the magic of Adam Smith’s invisible hand, inadvertently helping others while pursuing one’s own self-interest. An entire world of economics has been built around this story. There is a lot of truth to the idea that this country was built on the frontier spirit of individual efforts overcoming difficult challenges to get ahead.

The problem with this story is that it ignores, or at least relegates to the background, the idea of each of us being part of a larger entity — be it our family, our neighborhood, our work team, or our country as a whole. Yes, we are out for ourselves to some extent, but we are also very likely to sacrifice our own interests to help others. Few people totally ignore the best interests of their family or community in their day-to-day choices. Our community identity can be as strong, and sometimes stronger, than our individual identity. Think of the basketball player who passes up the chance for glory in making the long shot and, instead, passes to a teammate closer to the basket. Think of the medic in combat who puts his or her own life at risk to save others. We thank our soldiers, police and firemen for their service knowing that they are risking their lives on a day-to-day basis to help protect us.

In some ways we are so interconnected that it is not clear that an intelligent alien entity from elsewhere in the universe would see us as separate individuals at all. To such an entity, we might be seen as the mass of humanity spread out across the globe. The dangers of world war, asteroid strikes, and irreversible climate change bind us together in a way not fully appreciated by Adam Smith’s invisible hand.

In displaying and waving the American flag, we are revealing and relishing in our larger identity as Americans. We are proud to be part of the greater team. Hopefully, we feel that same about our family. Some explore their genealogy to better appreciate their family heritage. But what about our work team. For some, there is great pride in the team’s efforts and achievements. For others, not so much.

If each individual is directly and completely responsible for a specific output or outcome, it is easy to provide incentives to reward their work. But what if your work team is producing and selling a product or service where the quality of the work in production and the marketing of the product in advertising is combined to produce sales. Are those sales the direct result of better quality or better advertising? It is sometimes hard to tell.

Moreover, the outcome of a team effort might only be determined by the interaction of team members in supporting and enhancing the efforts of the individuals on the team. This interaction and support is enhanced when the team as a whole is rewarded. For sports teams, the glory comes in winning as a team. Each member of the team understands that the others must do their part to enable the team to win. Rewarding the team as a whole can sometimes be just as important as rewarding each individual team member.

Going to one extreme or another in this regard can lead us astray. To the extent that it is possible to identity and measure an individual’s contribution that individual should be rewarded to that extent. However, it is also important to recognize and reward the team as a whole so that each team member will have an incentive to encourage, and sometimes cajole, other team members to do their best for the team. Success often requires team cohesion and coordination that cannot be achieved by each member just doing their own thing. We have our individual identity, but we also have our collective identity. Only rewarding individual identity misses the importance of our group identity in enabling good outcomes for the team.

On the other hand, if we only reward the team, as a team, and ignore the extent to which a particular individual has contributed to the team’s success, we run the risk of encouraging free riders who make little effort with the hope that their teammates will make up the difference. This was the fundamental mistake of communism — simply dividing up the team’s profits equally without regard to individual efforts. Clearly, maximizing economic productivity requires just the right combination of rewarding the team as a whole and rewarding individuals according to their individual contributions. Every enterprise may be different in this regard so broad oversimplifications of this complicated challenge are likely to be misleading. Too much emphasis on individual effort alone can be just as foolish as simply rewarding the team as a whole without regard to each member’s contribution.

Traditional economics is based on three key assumptions: (1) rationality, (2) consistency, and (3) self-interest. It assumes a cold, calculating, rational choice by each individual based on a stable set of preferences. It frequently doesn’t work out to be that simple, because social factors intervene.

We are all highly interdependent. Automobiles, cell phones, even breakfast cereals are created collectively. Stock market and housing bubbles are evidence of important contagion effects. Aliens from outer space may not see us as individuals at all, but rather as cells in a collective body that is spreading across the face of our planet. Economic theory needs drastic revision to better incorporate our collective interdependence.

Economists tried to devise methods of aggregating individual preference functions into a community-wide preference function, but finally had to accept economics Nobel prize laureate Kenneth Arrow’s Impossibility Theorem that said that under somewhat general circumstances no such aggregation of individual preferences could produce a legitimate community-wide preference function. Thus, no formal, mathematical proof has been forthcoming of Adam Smith’s idea that our collective, economic well-being as a nation can be improved from each individual pursuing their own economic self-interest, as expressed in his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations.

Instead economics detoured into game theory which provides many interesting results but does not solve the fundamental problem. Moreover, the outcome of any particular game tends to be sensitive to its own, game-specific assumptions. A more general economic theory is needed that is robust to a wider range of assumptions in general and allows for our collective interdependence in particular.

A good beginning for thinking about developing an economic theory of our collective interdependence is the 1976 book by Fred Hirsch called Social Limits to Growth published by Harvard University Press.

A new branch of economics called behavioral economics tests these assumptions by performing scientific experiments to determine how people actually behave. Behavioral economists have recorded numerous situations where people do not behave rationally.

For example, advertisers have long understood that people will go to great expense to get something for “free.” One professor set up an auction system that caused his students to bid more than $20 for a $20 bill. An irrational sense of commitment leads people to tenaciously hold on to stocks they already own, but otherwise would not be willing to purchase. These are not just trivial irregularities. There are a wide-range of situations where people behave irrationally from the point of view of traditional economics.

From its beginning, economics has had to fend off evidence of irrationality. Giffen goods that defy the law of demand by responding positively to price increases and negatively to price cuts were dismissed as special cases with little importance for overall economic policy. When some individual consumers and investors made foolish choices, economists employed the law of averages to try to reaffirm rational market outcomes. The term rational expectations was coined when this was extended to the behavior of monetary and fiscal policy makers.

Is it enough to simply dismiss irrationality by throwing it into the error term, or could it sometimes be the main effect? Bounded rationality depicts decision making in a restricted context where information is incomplete and available choices are limited. Such analysis provides the dismal science with a new basis for moving away from excessively optimistic forecasts.

The hedge fund Long Term Capital Management collapsed in 2000 when the market did not move back toward equilibrium in a reasonable amount of time. Such unexpected events are described by Nassim Taleb in his book The Black Swan: The Impact of the Highly Improbable.  Are markets ultimately efficient in the long run or is the long run just too far off? After all, it was John Maynard Keynes, the father of macroeconomics, who pointed out that “in the long run we’re all dead.”

The Achilles heel of traditional economics was uncovered when researchers found that irrationality is often predictable. Dan Ariely’s 2008 book Predictably Irrational is a recent popular contribution while the 2004 compendium volume Advances in Behavioral Economics provides a more extensive coverage from the professional literature. Also see The Paradox of Choice by Barry Schwartz, Sway by Ori and Rom Brafman, and Free Market Madness by Peter Ubel.

Economists such as Nobel prize laureate Gary Becker led the extension of economics into the social realm in studying such things as the economics of marriage and drug addiction. Becker and his followers showed how economics can influence social behavior. The new economics is showing how social considerations can impact economics. The Nobel prize in economics was won in 2009 by Elinor Ostrom and Oliver Williamson for research that showed how organizational factors can affect economic outcomes. Social factors can have an even bigger impact on the day-to-day decisions of all of us.

For example, if you ask a friend to help you move, she may be willing to sacrifice a few of her precious Saturday hours to help out. If instead, you offer her $10 a hour to help you, she may turn you down flat. How can it make sense to be willing to work for nothing, but not be willing to do that same work for money? The answer is that social relationships are quite different from economic relationships. As soon as you make it a monetary transaction, you have changed the nature of the relationship.

An important irrational distortion occurs when a person takes possession of an item. A study randomly sorted an equal number of people into two groups. In one group each person was given a coffee mug. In the other group everyone got a candy bar. They were immediately given an opportunity to exchange the item they received for the other item. Since membership in the two groups was random, on average the ratio of people with candy bars to coffee mugs should turn out to be the same in the two groups after the final exchange. To the surprise of the researchers, the proportion of candy to mug lovers turned out to be quite different in the two groups. Each group tended to hold on to its initial gift much more than traditional economics would predict.

Decision making is more than just taking into account time and money. We also must consider the mental energy necessary to make decisions. Behavioral economists have unearthed substantial evidence of omission bias in economics. The stock market provides a perfect example. Researchers have found that people who own stock A which turns out to be a loser but could have purchased stock B which ultimately turns out to be a winner have much less regret than a person who initially owned stock B and then sold it to buy stock A. Even though both people end up with the losing stock A, they feel much different about it. A recent decision to hold onto a loser is not considered anywhere near as bad as the decision to buy that loser even when the monetary loss turns out to be exactly the same.

The desire to be a winner frequently distorts economic outcomes and not just when an item is offered for “free.” A study offered people either $100 for sure or, alternatively, a chance to win $200 or nothing with a fifty-fifty probability. Since the expected value of the two alternative offers is the same, researchers expected about half of the people would take the $100 and the other half would try the gamble. A large proportion of the people chose the $100 with certainty. The $100 is enough to make the person a winner while the chance to get an additional $100 was not as important as the possibility of getting $0 and losing the winner status. The opposite was found when people were given a choice to lose $100 with certainty or lose $200 or $0 with a fifty-fifty probability. Most people chose the gamble since a loss of $0 was the only way to avoid being a loser.  Traditional economics does not provide a mechanism for understanding such an irrational inconsistency.

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Please provide your insights and comments on “Economic theory must change to accommodate irrational, inconsistent and altruistic behavior” at the bottom of this page.
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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone. 
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You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh with no charge for shipping and handling.  
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To sign up for this free monthly Money Flow Newsletter =>  click here. Economics is about the efficient allocation of resources. But gift giving is anything but efficient. From a purely transactional point of view, wouldn’t Uncle Jim be better off if you just handed him $50 than spending that $50 on another ugly sweater for him?  Why guess what the other person wants?  Perhaps a $50 gift card from Walmart might work, but what if what Uncle Jim really wants is not sold at Walmart?  Instead, what if you just give him $50 and he gives you $50?  Wouldn’t that be the most efficient gift exchange of all?  Joel Waldfogel presented and analyzed this problem in the December 1993 issue of The American Economic Review in an article entitled: “The Deadweight Loss of Christmas.” For close relationships such as a good friend or significant other, the loss of efficiency from gift giving may average about one-tenth of the value of the gift; whereas, for more distant relatives or friends, the loss of efficiency may average closer to a third of the value of the gift.  It is clear that social relationships are different from economic relationships. The problem is that economics students are taught to view the world from a purely transactional point of view. This doesn’t mean that we don’t care about other people, but just that economists don’t generally consider “intent” as important. But it is important. Meaning may be imbued into a gift by virtue of the fact that the gift-giver meant well, even if the gift was not optimal to the recipient given the amount paid for the gift. Gift giving is associated with good intent, but behavior can also be distorted by bad intent. Having your car dented in a hail storm is much less upsetting that someone denting it with a hammer.  How about all those great Thanksgiving dinners your mother-in-law made in years past? As you left, did you give her a tip, or pull $50 out of your wallet to pay her for the great meal? People who are trying to build or strengthen a relationship don’t want to be simply paid off for their efforts in some sort of quid pro quo manner. Social (noncognitive) skills are often more important than technical (cognitive) skills in navigating the real world. Unfortunately, most economic textbooks in the past have tended to ignore such considerations. Economists create a fantasy world where everything is about money and market relationships. In the past economics professors have tended to ignore aspects of life that cannot be measured or understood in terms of money. But this ignores the most important relationships of all. The problem boils down to prediction. Neurologists frequently point out that the primary purpose of the human brain is prediction. In primitive times knowing what to expect in different circumstances was often a matter of life or death. Even today, accurate prediction is often the key to success or failure. If people are motivated by things other than money, then an economic prediction methodology based primarily on money may lead us seriously astray if people tend to deviate from gaining the highest monetary return because they are willing to sacrifice money for other less tangible and less measurable objectives.  Remember over this holiday season, that it is not the gift that counts, but the thought behind it that matters. (And that there is sometimes more truth in old cliches, than in that Principles of Economics textbook.) ______________________________________________ Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone.  _______________________________________________ You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh   _______________________________________________ For a limited time (21 days) listen to Optimal Money Flow for free on your smartphone or computer from here:  https://www.hoopladigital.com/artist/7090137015  _________________________________________________ Please provide your insights and comments on the Deadweight Loss of Christmas (revisited) at: https://sites.nd.edu/lawrence-c-marsh/  _________________________________________________ To sign up for this free monthly Money Flow Newsletter =>  click here. _________________________________________________

For additional details see the Optimal Money Flow book website at: http://optimal-money-flow.website or my 2018 paper presented at 2019 American Economic Association conference in Atlanta, GA: https://www.aeaweb.org/conference/2019/preliminary/paper/FT7A95eS___________________________________The full purchase price ($24.95) will go into the student scholarship fund when purchased through Avila University Press at the link:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh

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Conservatives love to complain about the income tax. They say that taxing income undermines incentives and suppresses innovation and economic growth. Why should you work hard if the government is just going to take away a substantial portion of your hard-earned income? 

Instead, some propose the so-called “Fair Tax” which replaces all personal federal taxes with a national sales tax. To raise comparable revenue such a tax would need to be about 30 percent of the pre-tax price. Such a tax would be very regressive. In other words, it would take a much higher percentage of income from low income people than from high income people. Such a tax would be certain to draw the ire of the working class and middle class and be a nonstarter politically. So forget about the “Fair Tax” which imposes tax on purchases directly.

But what about a progressive consumption tax?  This tax would allow all earned income to be nontaxable as long as it went directly into savings and stayed in savings. It would be essentially an unlimited traditional individual retirement account (IRA). In other words, you could put your earned income directly into a savings account, buy certificates of deposit or stocks and bonds without paying income tax.  However, any withdrawal of money from any of these forms of savings would be progressively taxed annually at rates higher than the current income tax rates. Basically, as under the current income tax, you could probably cover a modest monthly rent and essential food expenditures while paying little or no tax. However, a high flying life style of buying exclusive properties, frequently eating out at the most expensive restaurants, and traveling around the world on costly vacations would cost you an arm and a leg in tax payments, because it would require withdrawing a lot of money from your savings. 

In theory there could be some real advantages to a progressive consumption tax. First, it would not undermine work incentives as much as the income tax, at least not directly. It would encourage frugality. You could earn a lot of money and not pay a penny in tax as long as you saved most of it. Since wealthy people have more money than necessary to meet basic needs, they often purchase items that do not involve producing more goods, such as in buying exclusive real estate or rare artifacts such as famous paintings. Their motivation is more in displaying their relative wealth and in accumulating more wealth than other wealthy people. A consistently and evenly applied progressive consumption tax would reduce absolute wealth but not relative wealth so their incentives would not be undermined by a progressive consumption tax. A progressive consumption tax would not bump anyone from their position on the Forbes list of wealthiest people unless they consumed relatively more than their peers. 

Second, a progressive consumption tax would encourage savings. Certainly, getting people to save more would help reduce the severity of recessions. Instead of cutting back dramatically on expenditures with a reduction in overtime pay, a reduction in work hours generally, or a temporary layoff, people could draw on their savings to maintain their basic expenditures when the economy slowed.  Moreover, with more money saved, they would have a more secure retirement. Overall, this would certainly serve as an automatic stabilizer and keep the economy from experiencing deep recessions.  

All this sounds good. If a progressive consumption tax was applied in the decades after World War II when interest rates on savings were higher and consumer demand was very strong relative to aggregate supply, it might have worked, although higher estate and inheritance taxes might have had to be added to maintain adequate revenues.

But there are some serious difficulties with implementing a progressive consumption tax during the current period. In recent decades our money flow has become so distorted that huge amounts of money are being diverted to the financial markets as the wealthy get ever wealthier. In the face of weak consumer demand, most of this money is not going into real investments in our economy, but is instead used to increase dividends and stock buy-backs. So little money is being retained by consumers that they can no longer afford to buy back the value of the goods and services they are producing. The government has had to step in with deficit spending to make up the difference. Stock and bond prices have been driven up, while interest rates have fallen so low that it is hardly worth bothering with a savings account. Under current rates, even a modest level of inflation could significantly reduce the real value of your savings over time. 

What this all boils down to is that to create and maintain a healthy economy, we need to eliminate the tax loopholes and distortions that enable wealthy individuals and corporations from shifting the burden of taxation onto the middle class and pouring huge amounts of money into the financial markets. Instead we need to direct money to working class and middle class people who will actually spend that money on the goods and services they are producing. Higher tax revenues from either a progressive income or consumption tax would enable us to cut back and ultimately eliminate the federal deficit spending. With less money in financial markets, interest rates would rise, which, along with a progressive consumption tax, would encourage people to save more money, which in turn would strengthen our automatic stabilizers in keeping our economy healthy.  

Please add your insights and comments on the potential advantages and disadvantages of the progressive consumption tax below in the comment box.

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___________________________________________________________________________

Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame
and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone. You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh  
For a limited time (21 days) listen to Optimal Money Flow for free on your smartphone or computer from here: https://www.hoopladigital.com/artist/7090137015