I recently gave and graded a midterm exam on the application of economics to law. On one problem a number of students made the same interesting mistake, interesting for two reasons. It illustrates one of the ways in which it is easy to misunderstand economic ideas. And it points to a conceptual mistake this is common, important and dangerous.
The problem involved the effect of alternative legal rules on the interaction between an airline and three thousand homeowners near the airport. One way of dealing with noise was for the airline to reduce it at a cost of $1 million. Another was for the homeowners to achieve the same effect by soundproofing their houses at a cost of four hundred dollars each, for a total cost of $1.2 million.
The mistake was not in predicting what happens but in explaining why.
Suppose the legal rule is that the airline has the right to make noise and with no liability for the cost to the homeowners. The obvious outcome is that the homeowners soundproof even though it would cost less for the airline to reduce the noise. That suggests the possibility of bargaining, with the homeowners offering to pay something between $1 million and $1.2 million in exchange for the airline reducing the noise.
With three thousand homeowners that is unlikely to happen. If the bargain is struck, each homeowner gets the benefit whether or not he contributed to the payment. Thus each will be inclined to try to free ride on the expenditures of the others. They face what economists describe as the public good problem—how to produce something when those who pay for it cannot control who gets it.
Suppose, however, that the three thousand houses belong not to three thousand home owners but to one real estate company that rents them out. Now the public good problem vanishes. The company gets the benefit from sound reduction and will be willing to pay for it.
The mistake was not in predicting what happens but in explaining why. A number of students said something to the effect that combining the houses under one owner "levels the playing field" between home owners and the airline. The implication of that way of putting it is that the problem is simply a conflict between two sides. Combining the homeowners into one firm increases their bargaining power and so results in their getting more of what they want, the airline less.
The result of the change is that the homeowners, now combined into a single firm, get more of what they want. But so does the airline. It is being paid at least a million dollars, probably more, to do something that costs it a million dollars. Bargaining over how much it gets is a conflict between the two sides. But the agreement to reduce noise at the expense of the homeowners, which is what combining them made possible, is a win for both.
The reason the mistake is important to me as a teacher is that it illustrates a common problem in teaching economics and probably other things as well. The student has a pattern of ideas in his head, in this case a simple model of conflict where what helps one side hurts the other. He fits what he hears into that pattern, thinks he understands it, and so never gets the actual idea I am explaining.
But this particular example of that problem is important for a wider reason. A lot of people in a lot of contexts take it for granted that games are zero sum, that what benefits one side must harm the other. That is a very dangerous mistake. Consider some examples.
Put that way the claim is obviously false, since average incomes have increased enormously over the past few centuries.
The term "competitiveness" is routinely used in a way that implies that what matters is how rich or productive the U.S. is relative to other countries, that if China gets richer that makes us worse off. It might be true if we were at war with them, but we are not. In the context of trade, China being richer means that they can buy more stuff from us and sell more stuff to us in our mutual benefit.
A closely related error is the survival of mercantilist economic theory two hundred years after Ricardo showed why it was wrong, the idea that trade is a war in which each side is trying to sell more than it buys, to get a "favorable" rather than an "unfavorable" balance of payments.
Consider discussions over what has happened to the incomes of rich and poor over the past few decades. As best I can tell—it is not a subject I have looked at very carefully—the answer is that across the income distribution people have gotten at least a little richer but that incomes have increased much more for those at the high end of the distribution. This is often represented as the poor or the middle class losing out, with the implication that the wealth of the rich came at their expense, that there is a single pool from which the rich are getting more and the poor therefore less.
Put that way the claim is obviously false, since average incomes have increased enormously over the past few centuries, both in the U.S. and globally. In any particular situation it might be true, since one way of getting rich is to steal stuff from people, whether legally or illegally. But it cannot be true in general.
It is tempting to see all political disagreements as conflicts of interest, to assume that it is simply a question of whose side you are on. If you believe that, there is no point in listening to the other side's arguments. They may say that what they propose is good for everyone, but that is just a trick to blind people to their true motives. It is a very common attitude and a very dangerous one. Carried to its limit, it implies that the other side is your enemy, in which case there is nothing really wrong with lying about them, wiretapping them, stealing votes.
All is fair in love and war, and this is war.
Speaking of which, consider the effect on a marriage of assuming that all disagreements are about which partner gets his or her way, which loses out.
Republished from David Friedman's blog.