Discover Your Inner Economist: Use Incentives to Fall in Love, Survive Your Next Meeting, and Motivate Your Den tist

1

I Want a Banana; I Buy One

Is it still possible to learn something new about falling in love? Or how to avoid boring office meetings? The answer is yes—the stuffy old science of economics actually can make for a better life. Economics offers an understanding of markets, the incentives that drive human behavior, and how humans exchange valuables. This book will show you how to use fundamental economic principles to get more of what you want.

In the simplest economic setting, buyers and sellers create markets to come together and trade. Indeed sometimes it seems like there are markets in everything. The ideas of trade, and gains from trade; permeate virtually every aspect of our lives. You want a banana; you buy one. You want someone to fix your car, shirt, or plumbing; you pay someone to do it. Just look in the local newspaper or on the supermarket notice board. You want access to all the information in the world? Call an Internet provider, buy a connection, and then Google to the right florist for Valentine’s Day.

There are even more exotic markets. A mother once offered $500 on the Philadelphia Craigslist.org site to any girl who would step forward to take her (surely charming) son to the prom. You can buy virtual-reality games to play with, and against, your pets. A twenty-two-year-old atheist asks the religious to pay him to go to church; of course he promises to go with an open mind. He charges by the hour. You can pay to have a group of artists kidnap and then humiliate you. William Shatner of Star Trek fame sold his kidney stone on eBay for $25,000. In India it is possible to rent a crowd for your next public demonstration.

Markets can simplify our lives. Want a banana? Go to a market, say your local store, and buy a banana. It may help to recognize which supermarkets are the best, or when a banana is overripe, but otherwise the procedure is fairly straightforward. But for many other human desires, using money in a marketplace does not work very well, and sometimes it doesn’t work at all. Getting what we want is not always so simple.

Say you feel low because you’ve just broken up with a boyfriend or girlfriend. Characters on television sitcoms often advise retail therapy; the claim is that he who thinks that money doesn’t buy happiness doesn’t know where to shop in the mall. This is exactly wrong. The Beatles were closer to the truth when they sang Can’t Buy Me Love.

Rather than knowing where to shop, it is more important to know how to shop, and also to know when not to shop. To do well in life, to really fall in love, for instance, I believe we must learn what can be obtained by exchange—monetary or otherwise—and what we cannot trade for. The central concept of economics is not money but rather incentives. Quite simply, an incentive is anything that motivates human behavior, or encourages an individual to make one decision rather than another. An incentive can be money, but it can also be a tip, a smile, or an act of praise. An incentive can be a promise of lifelong devotion. So yes, you can use incentives to fall in love, even if The Beatles were right that money doesn’t work.

The fundamental economic insight, oddly enough, is that not everythingcan be bought with money. This seems so obvious to the ordinary person that most of us don’t think about it. Our Inner Economist knows that money cannot buy love, respect, or peace of mind. Our bosses—and employees—know that a bonus won’t solve every problem in the workplace. If we can’t buy it with money, there is just no marketplace for that object of desire.

Given that we don’t have markets in everything, we have to motivate other people, and motivate ourselves, to get where we want to be. Understanding and tackling this problem will fill this book. Using incentives, and using markets in the most effective ways, is far more difficult than simply going out and buying a banana.

Many of the limitations of markets are rooted in the imperfections of the human mind. Markets always interact with the complexities of human motivation, and when they are set up crudely or without much thought, they tend to misfire. Why don’t we have more markets in self-improvement? No, I don’t mean the self-help books we buy just to feel we are trying. I mean truly binding contracts, whereby we promise to lose weight, but if we don’t we must pay money to a stranger. That’s right, put up some money and hire someone to make you diet—it sounds simple enough. But no, that won’t make you want to lose weight, and building up that desire is usually the only real long-term solution.

Observers frequently believe that economists advocate the total commercialization of everyday life. We economists are accused of viewing all human choices in terms of dollars and cents. Or we supposedly believe that markets are always good, or that markets can solve all problems. I do know a few economists who hold these views, but they do not follow from the essential principles of economics.

One of the most important lessons of economics is how to cope with scarcity. We cannot always pluck bananas from trees, or get the best health care, or buy everything in well-lit, air-conditioned shopping malls. Economics developed out of a recognition of the fact that many things worth having don’t just fall into our laps in the course of our everyday lives. Even ordinary personal things like falling in love, surviving your next meeting, and motivating your dentist. The real purpose of economics is to get more of the good stuff in life.

Of course, economics is also about the national and global scale as reported in the evening news, stock prices, and world economic forums. Economists have long dreamed of making the whole world a better place. And yes, economic analyses do explain why the citizens of some countries are taking delightful vacations in Paris, while others are plowing field corn under a 100-degree sun. The founders of the science developed economics because they felt the world was full of injustices and squandered life opportunities. Economics, a cherished creation of the eighteenth-century Enlightenment, stems from the same belief in liberty and progress that influenced the birth of the American republic. The Founding Fathers believed in the power of human liberty, that is, a society based on the idea of free and responsible individuals. It is a profoundly important fact, which I will discuss further in the next chapter, that you can’t understand how incentives work if you don’t understand the importance of a respect for human liberty.

Economics, when it serves to boost the wealth of nations, as Adam Smith called it, takes people from want and misery to health and plenitude. All that is true and important. But for this book we will start with our jobs, our choices, and our personal relationships as foundation stones for all subsequent decisions. Saving the world will have to wait until chapter nine.

To be sure, this is not the only book that applies economics to everyday life. My colleagues and friends David Friedman, author of Hidden Order: The Economics of Everyday Life, and Steven Landsburg, author of Fair Play, both promote economics as a tool of universal reasoning. They urge us to apply the ideas of incentives, markets, and property rights to our families, our jobs, and our personal allocation of time. But I often disagree with their advice and fear that they, for all of their brilliance, play into the caricature of the economist. Their approach implies that ordinary life is more like buying a banana than we usually think. Just go out and use markets and incentives is their mantra. This is, at best, risky advice.

In my view the complexity and diversity of human motivations ought to underlie the very foundations of economic reasoning. How people assess their choices usually depends on social context, such as what motivations we perceive in those around us and how we think our peers will perceive us. If we want to make better decisions so we get more of the good stuff in life, we must learn how to distinguish one social context from another. If we offer an olive branch in negotiations, will this be seen as magnanimity or collapse? If we dress casually for a job interview, is this a sign of weakness or strength? We must figure out how other people identify and distinguish different contexts, and thus what they think they are doing and what they think we are doing. We must understand human beliefs.

For that reason, applied economics is as much of an art as a science. Economists cannot solve all of our problems, but contemplating the complexity of human motivation will help us make better decisions. We can learn when to just go buy something—like a banana— and when a more roundabout approach is needed. We will look at ordinary life using two primary tools: an understanding of the power (and limits) of incentives and a recognition of the complexity and diversity of human beings.

Most people think economics is dull. Many academic economists build their reputations by specializing in one narrow area of knowledge. A 1996 article in the American Economic Review—the flagship journal of the profession—was titled: Aggregation Without Separability: A Generalized Composite Commodity Theorem. Who would read a book full of that? Economics is called the dismal science for a reason.

Like professionals in any field, economists are prone to hiding behind terminology and jargon. We economists have a particular weakness for qualifying our claims to the point of obfuscating them. Harry Truman once asked for a one-armed economist, so that he could not be told on the other hand. . . .

The world has come to expect unintelligibility from economists. Charles Sykes, in his book ProfScam, reports how an actor was hired to pose as an eminent economist and present a lecture on game theory, one of the most abstruse branches of the science. The actor did not know any game theory, or any economics for that matter, but was able to bluff his way through with a seemingly formidable technical presentation. No one in the audience figured out the ruse. Afterward the evaluations praised the speaker for his clarity and intelligence.

In China, one Matthew Richardson was invited to give lectures on economics to a prestigious course at Beijing University. The previously invited economist had dropped out, and through a mixture of Chinese error and British deception, this Oxford University undergraduate managed to wrangle a substitute invitation. Yet the twenty-three-year-old Richardson was an engineering major and did not know any economics to speak of. When Richardson showed up he was paid £1,000 and put up in a hotel. He gave nine hours of lectures over the course of two days. The lectures were based on pages he had ripped out of a high school economics textbook.

On the second day of the course Richardson was running out of notes; he also suspected that the translator might be catching on to his ruse. During a coffee break he ran out of the room and did not return. The BBC described the Chinese as furious. Apart from being walked out on, nobody likes to be duped.

Economics, if practiced properly, can for the most part overcome the pitfalls of inhumanity, verbosity, and undue obfuscation. Here are three principles for distinguishing good economics from bad.

1. The Postcard Test

It should be possible to take a good economics argument and write it out on the back of a moderate-sized postcard. If an argument has too many steps, at least one of those steps is bound to be radically uncertain. Or, if there are too many steps, we won’t know how all those different steps fit together to establish the argument’s conclusion.

When my Ph.D. students come to me with new ideas, I first say in my sternest voice, Give me the postcard version. Those who know me well enter my office shouting: I have the postcard! Those who say it is necessary to read their entire forty-six page essay to grasp their central claim are told to go back to the drawing board.

2. The Grandma Test

Most economic arguments ought to be intelligible to your grand-mother. Grandma may not agree, but she should at least know what the economist is talking about. If Grandma is the economist, and speaks jargon herself, try one of your unruly cousins.

3. The Aha Principle

The Aha Principle is an extension of the Grandma Test. If the basic concepts are presented well, economics should make sense. Good economists believe that we live our lives according to economic principles that anyone can understand. Perhaps we do not always understand what we are doing when we make decisions, but economic arguments and mechanisms should be recognizable. After all, the argument is about us. So if some clearly expressed economic observation is to the point, it ought to stimulate the Aha parts of our brains. That may sound a bit metaphysical, but the idea is that a clearly expressed economic observation should really matter to us personally. It should be a revelation.

How would you feel if you read a biography of your life and found that none of the events were familiar, not even upon reflection? You might start to think that something is wrong, and the same is true for the claims of economics. If some economic insight doesn’t make sense to you, there is usually something wrong with it, not you. On the other hand, as we all know, moments of Aha can be so strong and so convincing that they can shape our lives for years to come.

When the Aha! goes off, that is our Inner Economist speaking. This book is about generating those Ahas!, and thus it is about discovering, liberating, and strengthening the Inner Economist.

We may think we know some good economic principles and try to live by them. But holding on to misguided ideas seems an inescapable aspect of good old human fallibility. Our theories of how the world works, whether they are explicit or implicit, lead us to make mistakes. Our views of the world, and even (especially!) our views of ourselves, are rife with fallacies that can be seen through the lens of good economics.

Your Inner Economist sees patterns that you might not be seeing at first glance. This book is about uncovering these hidden patterns in the world, and in our choices. Pattern recognition is one key to making better decisions. If it isn’t helping us see more patterns, it isn’t good economics.

The psychologist A. deGroot performed some fascinating experiments with pattern recognition in the context of chess. He arranged chess pieces on a board as they would occur in the normal course of a game. He allowed both chess masters and chess novices to observe the arrangement. The pieces were then swept away and the masters and novices were both asked to re-create the placement of the pieces. The masters performed significantly better than the novices. So far that is no surprise. But deGroot repeated the same experiment with pieces placed on the board randomly, in no particular order. When asked to re-create the observed patterns, the masters did no better than the novices. The masters were remembering the piece placements not by having flawless memories, but by recognizing familiar patterns and ordering them in a meaningful way. The masters, having a far larger collection of patterns to draw upon, remembered much better than did the novices. But this inventory of patterns was of no use to the masters when the pieces were scattered randomly. Other studies have found that chess masters do not have superior memories in other walks of life.

Being a great (human) chess player is not about searching through every possible combination. World-class players remain formidable when they play at very high speeds; one study indicated that up to 81 percent of the variance in chess skill can be explained by how grand-masters play with less than 5 percent of the normal time available. The key feature to becoming a chess grandmaster is the ability to acquire and keep about 30,000 to 50,000 different patterns or recognition chunks in one’s cognitive capacity. This is part of the rationale behind Malcolm Gladwell’s hypothesis in Blink, namely our ability to make rapid but accurate snap judgments in many walks of life. Often we recognize a relevant pattern from our embedded mental storehouse of possibilities, even if we are not aware of doing so.

The point of the chess analogy is that we can use economics to expand our repertoire of recognition chunks for seeing patterns in human behavior, including our own behavior and, of course, our mistakes.

Economics has many facets. Some economists focus on the statistical measurement of human behavior. Steven Levitt of Freakonomics fame made his name by studying statistics about unusual or under-explored walks of life, such as crime, real estate agents, and sumo wrestling. Other economists try to predict the next business cycle or tomorrow’s stock prices. Yet others build ever more complicated mathematical models of human behavior, sometimes under the heading of game theory. Economists in think tanks agitate for one public policy over another. At a simpler level, many textbooks teach basic terminology and how to manipulate graphs and symbols. This book will do none of those things.

Instead I will focus on using economics to hone our skills of pattern recognition—in other words, how to discover our Inner Economists. In most real-world settings, we don’t have the time or inclination to crunch the numbers, even in the unlikely event that all the data stood before us (do you know your dentist’s income-tax return, as needed to calculate his optimal bonus for good work?). We have to make rapid decisions, yet we want to make the best decisions possible. Even if we have months to ponder, we often have no more information than the bare-bones facts we started with. Yet reality is not just a buzzin’, bloomin’ confusion, to borrow a phrase from William James. There is indeed an order—sometimes a hidden order—to the social world.

We will see that there is much to be hopeful about. Small improvements in understanding can bring a much better use of incentives, leading to much better decisions and much better lives. Human imperfection is not the end of the story, but rather the beginning of a search for all kinds of riches.

2

How to Control the World, the Basics

Money may have bought Judas’s betrayal and the infamous local government of New York’s Tammany Hall, but it often isn’t the best motivator, whether in the family or at work. If you want to control more of what happens around you, you need to know how to balance the kinds of incentives you offer.

Economist Colin Camerer took a poll at the Davos World Economic Forum, which plays host to many of the world’s business titans and idea gurus. When asked what makes people tick, the responding participants cited recognition and respect as the number-one motivating factor in the workplace. Achievement and accomplishment came in second.

But not so fast—we cannot dismiss money altogether. It is obvious that economies without good monetary rewards perform poorly. Utopian communes collapse because no one does the hard work. The state socialism of the former Soviet Union led to queues and privation, not solidarity. Rather than trying to make consumers happy, managers met the artificial targets of the central planners—by cheating and lying if necessary. Few people did wonderful work for the good of the Father-land. More commonly, Soviet citizens worked to improve their social status and to receive the goodies usually reserved for members of the Communist bureaucracy. Marxist rhetoric to the contrary, it was not possible to do without monetary incentives. The Soviet Union simply had an inferior—and less fair—version of rewards and punishments. Dollars and cents matter.

Robert G. Swofford, Jr., a postal worker from Seminole County, Florida, won $60 million in a lotto drawing. He took more than a month to come forward and claim the prize. No, he was not planning the associated media events. He kept his mouth shut and divorced his wife, from whom he had separated three years earlier. The couple later reached a private settlement for sharing the funds; the ex-wife received $5.25 million and an extra $1 million for their eleven-year-old son, in return for agreeing not to seek more of her ex-husband’s winnings.

(By the way, if you are interested in karmic justice, Swofford was later shot several times, by accident, by two police deputies investigating a crime. He survived, and he later had to make an additional monetary settlement to his ex-wife’s sister, with whom he had earlier fathered a child.)

So how do we square these differing perspectives? How much does money matter? And when money isn’t enough to motivate people, what should we do?

The classic management analysis suggests that we should not offer bonuses unless we have good measures of success. Don’t pay the mechanic for finishing the job until the car starts. Hospitals are reluctant to give doctors bonuses for having a high success rate when performing heart surgery. Many doctors would be reluctant to take on the most difficult cases for fear of damaging their performance record.

The case against indiscriminate bonuses is made stronger by workers who think that bosses use bonuses to reward favorites. Such workers see bonuses as building a powerful coalition of unfair forces, rather than boosting workplace morale.

Yet bonuses remain a common form of compensation. A little economic analysis can offer a lot of conflicting insights. How can we know how to get the best results in a given circumstance? I offer three parables to help those on a quest to discover their Inner Economist: the Dirty Dishes Parable, the Car Salesman Parable, and the Parking Tickets Parable. These ever-so-slightly tragic tales illustrate guidelines for applying penalties and rewards. But to understand which parable applies and when, we’ll have to wield the deft touch of our emerging Inner Economist.

1. The Dirty Dishes Parable

Most of us have noticed that our children or our roommates neglect their responsibilities. Laundry sits in the washing machine for days on end. Dirty dishes