Speaking (Bob) Frankly

Economists' proofs that markets lead to "efficient" outcomes hold only under a specific set of assumptions, including perfect competition, perfect information, and the absence of externalities. These assumptions, of course, never completely hold - the world we live in is one of "market failure." The benefits of markets are often hard to see and appreciate; understanding them is an important contribution of economics, but it is also important to understand market failures. One of the most acute observers of market failure is Cornell's Bob Frank, who Steven Pearlstein writes about in his Washington Post column:

Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.

Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.

Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.

How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?

And how is it rational that first-year associates at top law firms are paid more than federal judges?

One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.

The intellectual roots of this economic theory of relativity go back to Adam Smith, Alfred Marshall and Thorstein Veblen. It got a big boost from game theorists, among them University of Maryland's Thomas C. Schelling, who won a Nobel Prize for his work on unproductive arms races, both economic and military. More recently, the hot new area of behavioral economics has focused considerable light on the seemingly irrational side of homo economus.

Perhaps nobody has done more to expand our understanding of relative competition than Robert H. Frank of Cornell University. Frank's particular focus has been on the importance of status in consumer choices. His point is that the desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.

It is this compulsion to keep up with the Joneses, Frank argues, which leads us to over-spend on status goods that, in the end, make us no happier. Meanwhile, we wind up under-investing in leisure time or "public goods," such as better schools and parks, that would give us more satisfaction.

The latest example of Frank at work is his piece in today's New York Times. He looks at the puzzle of why people contribute to political campaigns, which seems to go against our assumption that people behave in a narrowly self-interested manner:

The problem, as described by Mancur Olson in his classic book, “The Logic of Collective Action,” is that even those who share a presidential candidate’s policy goals will reap no significant material advantage by donating their time or money. After all, with cash donations legally capped at $2,300, even donors who give the maximum have no realistic hope of influencing an election’s outcome. Nor can any individual volunteer — even one whose efforts resulted in hundreds of additional votes for his candidate — realistically hope to tip an election.

Although the logic of the free-rider problem may seem compelling, people’s behavior strikingly contradicts many of its predictions. Last month alone, for example, the presidential campaign of Senator Barack Obama raised over $32 million from more than 250,000 individual donors and sent huge numbers of volunteers into the field. (Disclosure: I’m an Obama contributor myself.) Other campaigns have benefited in similar, if less spectacular, ways from their supporters’ willingness to set narrow self-interest to one side.

Frank goes on to describe a theory from Albert O. Hirschman that posits alternating periods dominated by collective action and by selfishness. So, while Obama was criticized for saying positive things about Ronald Reagan, his "movement" may be a sign that the Reagan era is over...

One crucial thing sometimes students (and professors) misunderstand about the free rider problem - and the assumptions we make about behavior in general - is that economics does not exist to tell people how to act. Economists are social scientists, and our task is to explain human behavior. In Frank's example, what is problematic is not the behavior of the donors, but the fact that economic theory has a hard time explaining it.