Naked Economics: Undressing the Dismal Science

At its heart, economics is the art of allocating scarce resources, and this first chapter outlines how markets do just that. Wheelan writes that economists use the rhetorical question “Who feeds Paris?” as shorthand for the myriad transactions happening each minute that are needed to run a modern economy. Economics accounts for what we do, the progress we make, and who gets what in society. One basic assumption underlying all economics is individuals’ maximization of utility. That just means that each of us make choices based on what we deem important. Notably, this is not the same for everyone, nor does it stay constant for one person within their lifetime because people’s priorities change.

Wheelan makes it clear that maximizing utility is not the same as being selfish. On the contrary, people do things all the time that don’t bring them direct benefits—or that could even put them in harm’s way. On the surface, helping others or being altruistic seem counterintuitive, but however indirectly, people do gain something from such behavior. The science of the brain indicates that it brings them positive feelings. Further back in time, altruism and banding together helped people protect themselves and propagate the species.

In order to maximize utility, we balance many things. We factor in future benefits versus instant gratification, work versus leisure, what not to buy so we can afford something else, and so on. The cost of things affects our decisions: when the cost of something falls, it appeals to us more, and when cost rises we use less.

A second assumption in economics is that businesses try to maximize profits. Businesses add value to inputs, and how to do that involves complex decisions. Prices are the key to many of these decisions, and people and businesses go where the profit is. However, barriers also exist that prevent businesses from entering markets—natural ones like geography and artificial ones like government policies and tariffs. Also, firms must choose the best way to make their product or provide their service given the available inputs at hand. In the end, the question remains: “What is going to make the firm the most money in the long run?” (17).

Businesses pursuing profits and individuals seeking utility brings supply and demand into play, which determines the price of goods and services. How much of something is available (supply) and how many people want it (demand) determines its price (at least in theory). In reality, firms have a bit more leeway in determining a price. They can choose from various strategies to maximize profit, including price discrimination. This is when the same product or service is sold to different people at different prices, such as tickets on the same airplane flight.

The author asserts that each transaction in a market is beneficial for all actors involved. This is because both firms and individuals are acting in their own best interests. His example is sweatshops in developing countries. While they may seem subpar in many ways by Western standards, they benefit the people who work in them because they offer a better option than anything else in that given location. Still, he concedes, we’re not entirely rational beings, as the new field of behavioral economics (economics paired with psychology) indicates. Sometimes, it turns out, we do act against our interests, often because we use intuition that is less than precise or because we lack willpower.

The topic of this second chapter is incentives, or what makes people behave the way they do. Wheelan explains incentives by starting with the story of the black rhinoceros in Africa. The rhinos are very valuable for the price their horns in the illegal trade. Being endangered only makes the rhinoceros’ horns more valuable which induces more poaching in what becomes a vicious circle. Thus, there is a high incentive for some to kill the rhinos and a relatively low incentive to save them. Rhinoceros are owned communally in the countries where they exist. This sounds good in theory, but it’s actually problematic. First, anyone who lives near them may not be invested in protecting them if the rhinos cause crop or other damage. In addition, protecting them takes money, and no one wants to take the initiative. Why should they? Finally, the governments of these countries are too weak or corrupt to help.

The key to saving the rhinos is to alter the incentives. As Wheelan puts it, “Give local people some reason to want the animals alive rather than dead” (33). One way is to share the proceeds from tourism, which is quite lucrative; then the locals will have an incentive to keep the rhinos alive. Another possibility, more controversial, is to remove the incentive to kill rhinos by removing their horns. Also open to debate is auctioning off the rights to kill a very small number of the animals and then using the money for conservation efforts. These solutions deal with the “supply” of rhinos. In terms of demand, if that could be partially satisfied by selling horns obtained and held legally (by governments), this might lower the price and reduce the incentive to poach the rhinos. Again, the money made could go toward conservation. While there’s no perfect solution, there are various options to alleviate the problem, all from using the incentives available.

Wheelan provides some outrageous examples of command economies, which operate without incentives, causing terrible inefficiencies and sometimes disasters like famines. In the former East Germany, the cars were so bad that they were worth less than the raw materials that went into making them. But Wheelan also points to public education in the modern-day US as an example of misaligned incentives. He argues that teachers’ pay not being tied to performance prevents students from getting a better education because they don’t get the best teachers. Since teachers don’t get extra pay for being productive, the more qualified ones leave for professions that do reward productivity. This describes a phenomenon known as “adverse selection.”

It’s important to keep in mind that people’s behavior is complex and not easily predicted. This can lead to something called “perverse incentives”—that is, when laws or policies result in people acting in ways that were not intended. When Mexico City, for example, wanted to reduce air pollution, it devised a plan that required every car to stay off the road once a week (different days based on license plate number). However, instead of using public transit more, many people just bought another car; these were often old, secondhand cars, which made them cheaper but also more polluting. The net effect ended up being worse than doing nothing.

Corporations, too, have lots of problems with incentives that don’t match up, thanks to principal-agent problems. In short, this is when an employee’s interest doesn’t align with the company’s interest. It can happen at a low level, such as cashiers stealing from the register, or at the highest levels, with CEOs making decisions that help themselves but hurt the company. Stock options were supposed to rectify this by paying CEOs in part with company stock. In theory, when the stock goes up both the CEO and the firm benefit. However, there are many ways that CEOs can boost stock prices in the short run that harm the company in the long run.

A classic principal-agent problem led to the financial crisis in 2007. Bank employees were taking unusually high risks with their institution’s money by allowing mortgages to high-risk borrowers. Banks then bundled the mortgages into a financial instrument that they sold to entities like hedge funds. When too many people defaulted on their mortgages, everyone lost.

Wheelan presents a model hypothetical case of how misaligned incentives can make us worse off, called the prisoner’s dilemma. In it, two people are arrested on a possible murder charge and questioned separately. Person A and B are each presented with options. If A turns on B and B stays silent, A will be set free. The same deal is true for B. If both A and B turn on each other, both will receive sentences. However, if both stay silent, they will both be set free. Wheelan shows how each person thinks through the possibilities of punishment and can end up acting in a way that isn’t in their best interest. It boils down to one person not trusting the other to act in a way that will lead to the best outcome for both.

Wheelan ends the chapter focusing on two other aspects of incentives. The first is creative destruction, which is when the market turns toward something new because of people’s incentives; the old product or industry dies out. One example is the boom in the computer industry in the 1990s. As Wheelan puts it, the same decade represented “bad years to be in the electric typewriter business” (49). He argues, however, that this is necessary for progress in the long run. Unfortunately, for individuals, the long run doesn’t matter; people need money to pay their bills and raise their families in the present. For this reason, so governments need to address the fallout of creative destruction when it occurs.

The other aspect is that transferring money to the poor (via taxes on the rich) is complicated and difficult, as the rich do what they can to avoid paying taxes. In fact, Wheelan asserts, taxes can be a powerful disincentive to engage in whatever activity is being taxed, including earning income. Because the tax rate is so high on additional income, and because women’s jobs so often constitute a “second income,” many married women who are high-income earners opt to stay home and not work, creating inefficiency. To Wheelan, the same thing happens with corporate taxes; a high rate eats into profits and limits the amount available for research and development, investment in new equipment and facilities, etc. This can harm growth and affect jobs. Overall, economics is about how to make incentives work for everyone.