The Economic Naturalist's Field Guide

1. Economic inequality is rising, driven by market forces and policy choices

By one measure, the top 1 percent of earners have captured almost 80 percent of all earnings growth since 1979.

Globalization and technology have expanded markets, allowing small differences in talent or decisions to translate into enormous differences in rewards. This has led to explosive growth in CEO pay and winner-take-all markets in many industries.

Policy changes have exacerbated these trends:

• Tax cuts favoring high earners
• Deregulation of financial markets
• Weakening of labor unions

The result is growing gaps between:

• Rich and poor
• Skilled and unskilled workers
• Capital owners and wage earners

While some inequality provides useful incentives, extreme inequality can harm economic growth, social mobility, and democratic institutions. Policymakers should consider ways to moderate inequality while preserving economic dynamism.

2. Consumer behavior is shaped by social context and relative comparisons

The plain fact is that the kind of house people feel they need depends on the kind of house that others around them have.

Relative position matters. People's satisfaction depends not just on their absolute consumption, but on how it compares to others. This leads to "expenditure cascades" where increased spending by top earners puts pressure on those below to spend more to maintain their relative position.

Key examples:

• Housing: Families stretch budgets for homes in good school districts
• Cars: SUV boom driven by safety concerns relative to other large vehicles
• Luxury goods: Serve as positional markers of status

These relative comparisons can lead to collective overconsumption and debt, as individually rational decisions produce suboptimal outcomes for society. Policymakers should consider how to dampen these arms races in consumption.

3. Efficient pricing can reduce waste and improve resource allocation

When price is different from marginal cost, moving it closer to marginal cost will almost always enable us to make some people better off without harming others.

Prices convey information about costs and value, guiding resource allocation. When prices don't reflect true costs, it leads to inefficient overconsumption or underconsumption.

Examples of inefficient pricing:

• Underpriced parking leading to traffic congestion
• Flat water rates encouraging waste
• Artificially cheap gasoline promoting pollution and sprawl

Solutions:

• Congestion pricing for roads
• Peak-load pricing for electricity
• Carbon taxes to account for environmental costs

While efficient pricing can be politically difficult, it often allows for win-win outcomes by reducing waste and generating revenue that can be used to offset impacts on vulnerable groups.

4. Environmental policies should leverage market incentives, not just regulations

The only effective remedy is to change people's incentives.

Market-based approaches like carbon taxes or cap-and-trade systems can achieve environmental goals more efficiently than rigid regulations. They provide flexibility for businesses to find the lowest-cost ways to reduce pollution.

Key advantages:

• Harness profit motive to drive innovation
• Automatically adjust to changing conditions
• Generate revenue that can be used to offset economic impacts

Examples of success:

• SO2 cap-and-trade system reduced acid rain at low cost
• British Columbia's carbon tax cut emissions while growing economy

While regulations still play an important role, especially for local pollutants, market-based policies should be the centerpiece of efforts to address global challenges like climate change.

5. Winner-take-all markets are expanding, concentrating rewards at the top

In entertainment and communications, even more than in General Electric's business, many costs are fixed, and the cost of serving additional customers is generally small.

Technology and globalization are expanding winner-take-all markets where small differences in performance lead to enormous differences in reward. This dynamic is spreading beyond entertainment and sports to many knowledge-based industries.

Key drivers:

• Low marginal costs of serving additional customers
• Network effects creating dominant platforms
• Enhanced ability to measure and compare performance

Examples:

• Software (e.g. Microsoft, Google)
• Online retail (e.g. Amazon)
• Financial services

While this can spur innovation and efficiency, it also contributes to rising inequality and market concentration. Policymakers may need to consider ways to preserve competition and ensure gains are broadly shared.

6. Behavioral economics provides new insights into saving and borrowing decisions

Many people have difficulty weighing the trade-off between immediate benefits and future costs.

Cognitive biases lead people to make financial decisions that conflict with their long-term interests. Traditional economic models assuming perfect rationality often fail to explain real-world behavior around saving and borrowing.

Key insights:

• Present bias leads to undersaving for retirement
• Mental accounting affects how people categorize and spend money
• Choice overload can paralyze decision-making

Policy implications:

• Auto-enrollment in retirement savings plans
• Restrictions on predatory lending practices
• Simplification of financial products and disclosures

By understanding these psychological factors, policymakers and businesses can design better systems to help people make sound financial decisions.

7. Financial markets are prone to bubbles and crises without proper oversight

Asset bubbles like the one that caused the current economic crisis have long plagued financial markets.

Competitive pressures and misaligned incentives can lead financial institutions to take on excessive risk, especially when they expect to be bailed out if things go wrong. This can create bubbles that eventually burst, causing widespread economic damage.

Contributing factors:

• Herd behavior among investors
• Moral hazard from implicit government guarantees
• Complexity obscuring true risks

Potential solutions:

• Enhanced capital requirements for banks
• Skin-in-the-game rules for securitization
• Macro-prudential regulation to address systemic risks

While free markets generally allocate capital efficiently, financial markets require careful oversight to prevent instability that can harm the broader economy.

8. Luxury consumption often provides little lasting satisfaction

Persuasive scientific evidence suggests that when everyone acquires bigger houses and more expensive automobiles, the new higher standards quickly become the norm, with the result that these expenditures yield little lasting satisfaction.

Hedonic adaptation means people quickly get used to higher levels of consumption, returning to their baseline level of happiness. This is especially true for positional goods whose value comes from how they compare to what others have.

Examples of low-satisfaction luxury spending:

• Oversized homes requiring long commutes
• Ultra-expensive watches and jewelry
• Lavish weddings and parties

More satisfying uses of money:

• Experiences and travel
• Time with family and friends
• Pursuing meaningful work or hobbies

Understanding these dynamics can help individuals make wiser spending decisions and policymakers design tax systems that discourage wasteful consumption arms races.

9. Public policy should focus on improving overall economic welfare, not just GDP

Is GDP a reasonable measure of economic welfare?

GDP has limitations as a measure of societal well-being. It fails to capture many important factors that contribute to quality of life and can even increase due to negative events like natural disasters.

Key shortcomings:

• Ignores income distribution
• Excludes non-market activities like childcare
• Fails to account for environmental degradation
• Doesn't reflect improvements in product quality

Alternative measures to consider:

• Genuine Progress Indicator (GPI)
• Human Development Index (HDI)
• Measures of subjective well-being

Policymakers should take a more holistic view of economic welfare, considering factors like health, education, environmental quality, and social cohesion alongside traditional economic metrics.

Last updated: September 22, 2024