EconTalk |
David Henderson on the Essential UCLA School of Economics
Sep 20 2021

41fOlNmq7rS-200x300.jpg Economist and author David Henderson talks about his book (co-authored with Steve Globerman) The Essential UCLA School of Economics with EconTalk host Russ Roberts. Much of the conversation focuses on the work of Armen Alchian and Harold Demsetz, who both saw economics as a powerful tool for understanding human behavior and how the world works.

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Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.

READER COMMENTS

Steve Mills
Sep 20 2021 at 1:29pm

It’s Bedford Falls, not Bailey Falls.

Thanks.

Lawrence
Sep 21 2021 at 7:25am

What a fine interview. It’s not only rewarding to understand the key insights that made studying with these economists such a great experience, but the accounting of memories really brings it to life.

Carl Pearson
Sep 22 2021 at 3:55am

Enjoying this episode as usual, but: the call back to Lisa Turner and the organic farming episode – superb. One of the best episodes in the archive; folks who haven’t heard it should absolutely go back to that one.

Jim D
Sep 22 2021 at 12:17pm

OK discussion but a lot of simplistic straw man attacks.

E.g., discussion of auto safety implied that moral hazard would keep auto fatalities high but:

In 1913, 33.38 people died for every 10,000 vehicles on the road. In 2019, the death rate was 1.41 per 10,000 vehicles, a 96% improvement.

In 1923, the first year miles driven was estimated, the motor-vehicle death rate was 18.65 deaths for every 100 million miles driven. Since 1923, the mileage death rate has decreased 93% and now stands at 1.20 deaths per 100 million miles driven.

Brian Halbert
Sep 22 2021 at 4:43pm

As mentioned, in cases where the output of labor is easy to value, we already have a system to capture that: piece work and ‘by-the-each’ pricing; and the farming example is relevant, because such wages are often used in that sector.

However, in most industries, this is not so clear. Baseball (and Football) were mentioned, but I think a wrinkle that should be noticed is this: Moneyball suggests that baseball employers were *very bad* at judging contribution to output (in this relatively simple, widely studied output) for 80 years.

If true in such a straightforward industry, for so long, is *any* moderately complex labor actually priced according to output value?

Education is another example — the ‘society value’ produced by it is tremendous, but wages don’t match. This may be distortion due to public vs private industry, though.

Luke J
Sep 29 2021 at 8:24pm

Are laborers only risking their labor – not their homes and assets ? Not so clear to me. Every potential new-hire is asked about their familiarity, valuation, and commitment to the success of the company product. Employers want employees invested, even if not with stock purchases. Maybe capital financers actually have less to lose of their total wealth if a product or company fails. Based on debt-to-wealth ratios (i.e. paycheck to paycheck), most employees are playing all chips-in.

Comments are closed.


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AUDIO TRANSCRIPT
TimePodcast Episode Highlights
0:37

Intro. [Recording date: August 31, 2021.]

Russ Roberts: Today is August 31st, 2021. My guest is economist and author David Henderson, a research fellow at Stanford University's Hoover Institution and an emeritus professor of economics with the Naval Postgraduate School. David blogs at EconLog. He's the editor of The Concise Encyclopedia of Economics. Both are part of the Library of Economics and Liberty, which hosts EconTalk. And, this is David's second appearance on EconTalk. He was here last in--amazingly, a long time ago, David--July of 2007, when we were discussing Disagreeable Economists.

Our topic for today is David's new book, The Essential UCLA School of Economics, co-authored with Steven Globerman.

I want to thank Plantronics for providing today's guest with the Blackwire 5220 headset.

David, welcome back to EconTalk.

David Henderson: Thanks, Russ.

1:28

Russ Roberts: So, this is a very short, very well-done introduction to the UCLA [University of California, Los Angeles] School of Economics. It's focused mainly, but not exclusively, on what I think of as the two best economists not to win a Nobel Prize: Armen Alchian and Harold Demsetz, two of my favorite economists. I feel they've received insufficient attention here, their work, on EconTalk, so I'm really glad we're here to talk about them, as well as UCLA generally.

I want to start with an insight that you quote of Alchian's. You say his work was guided by the insight, quote, "You tell me the rules and I'll tell you what outcomes to expect." And, I think that's an incredibly deep, simple way of capturing a key part of the economic way of thinking. What does that mean to you, that phrase?

David Henderson: And, by the way, Armen started with that idea. Not in those words exactly, but with that idea in my first class I ever had with him at UCLA, in the graduate program in September 1972. He said if you look at incentives--if you look at the way incentives are structured--you can understand a lot of behavior that otherwise is mysterious.

So, I still remember my first day of class. He said, 'Now, when you go to the UCLA bookstore to buy the books, you're going to be in a long line. And, you're going to be really angry about that. But, you shouldn't be angry. You should be happy, because it means that economics works. Economics explains behavior. The people working there are on just a standard wage. They don't have a strong incentive. But, more important, there's no real ownership. This is essentially a cooperative. And, so, no one is,'--what he later introduced us to,--'is called the residual claimant. No one gets this big benefit if they do better.' And so, I wasn't happy when I heard that. But, I thought, wow, this guy is real. This guy from the get-go is trying to tell us how important economics is, how important incentives are. And, then, of course later, how important property rights are in explaining behavior.

Russ Roberts: And, he was--he was a provocateur, I assume, in the classroom. I never had a class with him--

David Henderson: He was--

Russ Roberts: but my understanding from former students of his like yourself, is that he loved saying things that would shock people, and give answers to puzzles of everyday life that he thought were true and surprising.

David Henderson: Yes. He would come to class pretty much every day and say, 'Why do we see this?' And, of course, one of the things he laid out the first day of class is: 'If you don't put up your hand, I don't know you. And so, take a chance, and your whole capital value is at risk here.' And so, I got that. I had already kind of got that, but I really got it. And so, we'd put up our hands and answer, and he'd say, 'No, no, no.' And, not give any reasons. We'd go back to our carrels [small individual study booths in a library--Econlib Ed.] and say, 'Now, why was he right? Why were we wrong?' And, every once in a while, we'd figure out that one of us was right. And, we'd go back to class the next day and say, 'Professor Alchian, we think--blah, blah, blah.' And, he said, 'Oh yeah, I know.' 'Well, why didn't you admit it?' 'Well, I wanted to see how confident you were of your answer.'

Russ Roberts: Wow. That reminds me of a story from my graduate school days when Gary Becker asked a question, he asked us, 'Does this variable go up or down?' And, someone said, 'Up,' and he said, 'Do you want to flip that coin one more time?' So, you know, it gets a little scary in there. I actually once answered, 'Up,' and he said, 'Are you sure?' And, I said, 'Down,' and he said, 'No, you had it right the first time.' Because I was panicking. But, those were--was he intimidating?

David Henderson: Yeah, he was intimidating. And, actually, I mean, what I figured out later was he's kind of a shy man. And, by the way, I think his shyness--I know I'm going a little afield here, but it relates to your introduction--I think his shyness is in some part the reason he didn't win the Nobel Prize. He was shy and humble. And so, he never really pushed himself. It wasn't, 'I, I, I.'

Russ Roberts: He's not a self-promoter.

David Henderson: Yeah, he wasn't a self-promoter at all. And so--but yeah, he was intimidating.

5:45

Russ Roberts: So, he wrote a textbook with William Allen. The first edition was called Exchange and Production.

David Henderson: No, University Economics.

Russ Roberts: No, I think the first one was called Exchange and Production by itself, no?

David Henderson: University Economics, 1964. And Exchange and Production came later.

Russ Roberts: Hmm.

David Henderson: Yeah. Yeah.

Russ Roberts: That's interesting. Because I don't think that's what it says in the introduction to the current one, but maybe I misunderstood it.

David Henderson: Oh, really?

Russ Roberts: But, the current edition, which is edited by Jerry Jordan, who I think was a student of Alchian's is called Universal Economics. And, I just want to put a plug in for it. You can get it for $8.99 on your Kindle. It's 740-plus pages. And, the only thing I don't like about it is it has the answers to the questions. Which I don't think Alchian maybe would have liked given what you just said.

David Henderson: Yeah. He answered every-odd one at the back of University Economics. So, you had to figure out half the answers on your own without that crutch.

Russ Roberts: But, I think the new one has them all, for what it's worth.

David Henderson: Okay, yeah.

Russ Roberts: But, that book was a very--people ask me all the time, 'I want to learn more economics. What textbook should I read?' And the answer is: There really aren't textbooks to read because textbooks are not written to be read. They're often written to be used as a reference in a class where there's a lecture. But, University Economics, now Universal Economics, the book by Armen Alchian and William Allen, and now edited with Jerry Jordan's help, it is actually a book you can read--more or less. I mean, there's some things in there that you're not going to want to read--charts and graphs and other things--but there's a lot of exposition in there about how the world works, is my memory. Is that right?

David Henderson: Yes. That's right. It's kind of old-style: in other words, it's actually a literary work as well as a textbook.

And, by the way, it's very--I TA'd [TA=Teacher Assistant--Econlib Ed.] out of it my first quarter at UCLA to 18- and 19-year olds. So, on Sunday afternoon, I would answer every question at the back of each chapter, just in case they asked. Which they never did. And, I learned so much from that. But, I thought, 'This is too hard for these undergrads,' and sure enough, I think that was true.

Russ Roberts: And when people look at that book, if you leaf through it in its physical form, it doesn't look like a modern graduate textbook because there are not many equations, if any.

David Henderson: Right.

Russ Roberts: And, I think that lures people into thinking, 'Oh, this is a simple--an easy book.' But it's not. It's deep and it's challenging. And, of course, great economics doesn't have to be mathematical.

David Henderson: Right. Right. And, that's one of the things I learned from Alchian was that you can be completely rigorous in words. And, I remember once I used some term--I said that someone would minimize the cost on some assignment I did for him. And, he answers, 'On the margin, if you minimize the cost, you're going to produce zero.' And, it's like, 'Oh, yeah.' So, he said you would economize--that was his term. Which is a little vague, but still, it was better than I had.

Russ Roberts: Well, I think he meant: Balance the costs and the benefits to get to the best place you could get.

David Henderson: Yeah.

Russ Roberts: That complicated idea is captured in maybe that one word, 'economize'.

David Henderson: Yeah.

9:09

Russ Roberts: Now, you mention property rights. Both Alchian and Demsetz emphasized the importance of property rights, the applications of property rights. And, we'll talk a little bit about Demsetz's contribution in particular. But I want to start with an example from your book, which is the power of private property and a lesson that you use about Robert Barro, past EconTalk guest and a first-rate economist.

David Henderson: Yeah. Bob Barro was at University of Chicago at the time. One of his favorite colleagues to talk to was Bob Lucas. Bob Lucas--I don't know if he was literally a chain smoker, but he smoked a lot. And, Barro hated cigarette smoke. So, Barro had a sign on his door, 'No smoking except for Bob Lucas.' And, the idea was, the trade-off with other people wasn't worth it. Like: You want to come and talk to me, don't smoke. With Bob Lucas, I'm gaining so much from you, Bob, that I am willing to suffer with that cigarette smoke.

Russ Roberts: And, it's a beautiful example of the subtlety of property rights. And, also by the way of free association, the idea that you can let people into your house if you choose--

David Henderson: Yes--

Russ Roberts: and you can keep them out if you choose. That's, in a way, the essence of private property. And here, because he--in theory, I mean, he literally didn't own his office--but he had, there was a norm established about who could come into his office.

David Henderson: Yeah.

Russ Roberts: He chose to have a nuanced norm: Some people could, some people couldn't, under certain circumstances.

David Henderson: Right, right. Yeah.

And so, Demsetz, of course, what he's most known for--and we emphasize this in the book--is his theory of property rights, which was kind of basic in the 1960s. Not a lot of bells and whistles, but still it was path-breaking. It was published in the American Economic Review in 1967. They would never publish an article like that today. There are no equations. There aren't even graphs. There aren't even tables.

Russ Roberts: There's no data.

David Henderson: Well, data, not in a numbers' sense.

Russ Roberts: No numbers, yeah.

David Henderson: No numbers. But, there are data.

Russ Roberts: Yeah.

David Henderson: And, the idea is that he's asking: When do property rights come about?

And, he's essentially saying it's endogenous: It comes about depending on the circumstances.

So, he looks at Canadian Indians, now often called First Nations People, in Quebec, where the fur trade were starting to really soar. There was a lot of the fur trade. Well, if you have beavers on your property--well, I'm calling it your property--if you have beavers in a certain area, you don't want people from other tribes coming and taking those beavers. So, they started establishing property rights, the various first nations tribes did, because it was worth it. Because, there was a potentially huge loss from having someone take your property.

And, then he contrasts this with the American Southwest, where the lands are so vast, the animals are moving from point A to point B and that might be 50 miles, and it's very hard to establish property rights.

So, essentially it comes down to property rights will be established when the gains exceed the costs, which--and then you've got to know a lot about the gains and a lot about the costs.

But, that was a really nice insight--as opposed to what? As opposed to property rights are established when governments say they are property rights. In other words, it was this thing that came about in an economy without necessarily a huge government, or maybe even no government at all.

Russ Roberts: And, it's an example of the work that Elinor Ostrom did that got her the Nobel Prize--the informal norms and cooperative ways that people find to get around social problems. And, I think it's not just that you don't want other people taking the beaver. It's that, for the tribe as a whole, for the people as a whole, you want to preserve the quality of, and the potential wealth of the stock of animals in your area. And, you want to avoid the Tragedy of the Commons--that is, killing an animal that is relatively small or young in the case of fishing, taking a fish that's small, rather than throwing it back. If you throw it back and no one owns it, you have no chance of getting it: it's one of those in a zillion. If it's your lake, your property, your area of where you can catch, say, a lobster, you have an incentive to release it and let it grow to a more optimal size. And, that way get more value out of the resource. And, I think that insight is also really important.

David Henderson: Yes. And so, he had that insight; that insight is in there. And, by the way, the article that gets cited most is an article in Science by Garrett Hardin called "The Tragedy of The Commons." He used it to look at population, which I think is a misuse actually; but that's another story. But it was actually Demsetz. Demsetz didn't come up with the term, but Demsetz came up with the idea over a year before Hardin's article was published, which I think is really interesting.

Russ Roberts: The idea that in the absence of property rights, common property is overused and not used efficiently, and by that meaning to maximize as much as possible, the overall value of the resource to the group.

David Henderson: Yes. And can I mention one other thing about that?

Russ Roberts: Sure.

David Henderson: Alchian and Demsetz wrote another piece that Steve Globerman and I highlight, on--and, I remember this happening when I was a teenager in Canada--where they took all these baby seals and clubbed them to death, and they showed it on this Canadian show that was the equivalent of 60 Minutes. And, we were just horrified. Well, Alchian and Demsetz looked into it and said: the Canadian government had set a quota of 50,000. So, you better get in there to get one of those or some of those 50,000. So of course, they're going to go in there and just kill them mercilessly. And, that was the result of some pretty un-thought-out rules. And, again, that's Alchian and Demsetz, both, in understanding the role of incentives.

15:44

Russ Roberts: The other, of course, important role of property rights that they both were aware of and talked about is the role in reducing conflict. Walter Williams used to say: through most of human history, the way you got wealthy was to hit your neighbor over the head with a club and take your neighbor's stuff. And that, of course, makes you wealthy if you've got the club; it makes the neighbor poorer. And it's not just zero sum: it's actually negative sum because then you invest in resources to keep from being clubbed over the head. That, one of the great advantages of property rights--in theory, if they're enforced and successful--is that it reduces the fight over whose is what, what belongs to whom.

David Henderson: Right. No, that's right. And, that's key. And, again, and that also relates pretty closely to exchange: both sides gain from exchange. And, that's just a key insight economists have generally, but that's all the way through the work of the UCLA economists, especially Alchian and Demsetz.

Russ Roberts: Why is that important, do you think? I think that's an underrated, and when you tell that to people they go, 'Yeah, big deal.' Why do you think that's important? Mutually beneficial exchange?

David Henderson: Well, okay. I remember Demsetz came to at the University of Winnipeg when my Libertarian Club used our whole annual budget to hire him to give three talks. And that's what convinced me I might want to be an economist. And, I still remember in Q-and-A, when someone--it was a professor--said, 'Michael Harrington in his book, The Other America, says in any transaction, there's a winner and a loser.' And, blah, blah, blah, blah. And, I'm wondering now, how's Demsetz going to handle that? And, Demsetz says, 'Well, that's obviously wrong. In any transaction there's a winner and a winner. Otherwise the transaction wouldn't take place.' And, it was like, duh: Like, I immediately got it. And, it was just this powerful thing. And so, then that made me--well, I'm talking about me. But, anyway, that leads to the idea that exploitation is very hard to define, because in an actual voluntary transaction--not slavery, which of course is involuntary--but in a voluntary transaction, both sides gain. So, it's even hard to find that there is exploitation in a certain sense.

Russ Roberts: And, we have an episode with Mike Munger on what he calls Euvoluntary--E-U Voluntary, spelled out--to try to add some nuance to this idea, because we could imagine transactions that were nominally voluntary, but where one party might be, quote, "in extremis"--be in a very difficult situation.

But, I think what's powerful about the mutually beneficial exchange idea--a phrase that rolls off my tongue rather effortlessly--but, I think probably for listeners and others, it's like, 'Mutually, wha-? what?' It just means that for a transaction to take place, both parties have to expect to be better off. That's just a novel idea.

But, as you point out, a lot of people think, well, obviously there's somebody who's going to lose. They're going to make a bad trade. And the idea that trade is mutually beneficial--to both parties--especially when there are lots of alternatives, right? Which starts to get you to thinking about competition, why competition is important. It's actually a deep, important idea.

David Henderson: It is, it is. And, of course, exchange leads to comparative advantage because if you have the possibility of exchange, you say, 'Okay, what am I the least-cost producer of? And, I'll start doing more of that.'

And, so, yeah. And it's all the way through economics. This is not just UCLA economics.

Russ Roberts: Yeah, of course.

David Henderson: It's just that the UCLA people emphasized it in a way that sometimes others don't.

19:48

Russ Roberts: Yeah, it's funny: There was a tweet today on Twitter. Somebody said, 'Capitalism didn't produce your iPhone, workers did.' And, of course, in some sense that's a true statement. But, 'produce,' there, the right way to think about it is workers manufacture a phone--which is amazing, an extraordinary thing. They do that with the help of a great deal of capital. But, the thing that's crucial is that the idea behind it got thought of by someone. And that happened to be a visionary--in this case, Steve Jobs, with the help of a bunch of friends and colleagues, plus investors who took a chance and risked money. But, what we see: 'Oh, well, the workers are making the phone. They're the people I should be grateful to. And you should be grateful to people who produce the things you [inaudible 00:20:42]. I have no problem with that. But, it's easy to forget that that's waaaay down the creation process. The manufacturing, the conception, the risk-taking--and of course, a lot of products fail and investors lose all their money. And, this was one that we noticed made it. But, if we only focus at that last stage, we're going to really miss what's happening there.

David Henderson: Right. And, by the way, and the other thing going on of course, is those workers are in an exchange.

Russ Roberts: Oh, excellent. Yeah, talk about that.

David Henderson: Yeah. Yeah, they're exchanging their labor for money. There's a division of risk. So, they are risking losing a job if the product fails, but they aren't risking losing their paycheck, that two-week paycheck--

Russ Roberts: Or their house--

David Henderson: no matter what happens to the project. Yes, yes.

Russ Roberts: Right, they are only risking the ongoing payment. And, assuming that they have alternatives, which I think many workers do, they're getting more from that exchange than if they didn't take the job.

It doesn't mean--I think the reason that the Michael Harrington Other America thing gets stuck in people's minds about a winner and a loser is they think, 'Well, okay, both people are better off, but who gets more?'

David Henderson: Right.

Russ Roberts: And, I think that's a misleading--it's the wrong way to think about it. And, often it's not even answerable, what 'more' means.

David Henderson: Right.

Russ Roberts: Sometimes there's more as measured by money. You could say, 'Well, the profits of the owner might be bigger than the net benefit over the alternative of the workers.' But, the idea that exploitation, because you think the salary is low in that workplace, is tricky because it is voluntary.

Now you could say if they don't have any alternatives, how voluntary is it? And, that's a legitimate question. Obviously, I talk often on the program about what a dispiriting and mediocre education system we have for especially people growing up in poverty, and that limits your alternatives. And that's part of the reason why people have to take low-paying jobs: even when they have alternatives, all of the alternatives are relatively low-paying. But, you don't want to blame the person who has actually hired that person--

David Henderson: Right--

Russ Roberts: and, paid them--out of their profit, expected profit--for the level of the wage. They're just the people who write the paycheck, sign the check. They don't set the amount. Competition does.

David Henderson: Right, right. And, they're the ones who actually place the highest value on those workers, or else they wouldn't be employing them.

Russ Roberts: Right. Yeah.

23:11

Russ Roberts: And, we did an episode a while back--I'm looking it up here, it's 2012--with Lisa Turner. She's an organic farmer or was at the time--I hope she's still thriving as a farmer, and I hope she's still listening. But, she talked about how challenging it was to hire young people because they'd come to her and say--you know, she'd offer them a job and she'd tell him what the wage was. And, they'd say, 'Well, I think that seems like a low amount. I should get more than that.' And she'd say, 'Well, let me explain something. This isn't a charity. I'm not doing this out of the goodness of my heart. I enjoy--' she might enjoy hiring them and seeing them flourish in the workplace. But, 'For me to make it worthwhile to hire you, it has to be the case that what you do for me is worth at least or more than the amount I pay you.'

And, that is, like, a mind-blowing idea for a non-economist--sometimes--for everyday human beings.

David Henderson: Yeah.

Russ Roberts: And, it really gets back to our point about mutually beneficial exchange. It's saying, 'I'm not hiring you because I think you deserve a job and I'm not setting your salary because I think what's a fair wage. I'm setting it based on the fact that I have to be able to attract you in to this opportunity. And, you better be able to contribute at least as much as I pay you, or then it's welfare. It's a handout.'

David Henderson: Yeah. Yeah. And, by the way, I think I'm getting a little afield, but I think it's worth saying that I think that's why it's really useful when you're a young person to have a job, even, like, in high school. And, I remember when this guy had a drive-in--you know, like a Dairy Queen-type-thing, hamburgers and fries and stuff--a couple of blocks from where I lived in Carmen. And, I was about 11 or 12. And he came to me and asked me if I would clean up in the morning after all the stuff on the ground, and put it in the incinerator. And, he offered me 50 cents. And, I had to get up at 7 o'clock and go and do it. And, I was done by 8. And 50 cents to an 11- or 12-year old was a great deal, especially when every once in a while I find a quarter on the ground.

Russ Roberts: Yeah.

David Henderson: But, anyway, so: I knew he was doing it because he needed that work. And, I was in no position to judge whether it was worth $.50 or $.75, although I visited him and I introduced my daughter to him decades later. And, he said, 'I would have offered you $.75, but you didn't bargain.' But, anyway, so it was worth at least $.75. And, I just learned a lot just from that one job.

Russ Roberts: I think it's an interesting challenge as a human being: When we're interacting with strangers in the workplace, we're not working for a family in a voluntary way--which is a beautiful thing also--or with, in a nonprofit doing work that again is unpaid. When we're working in the marketplace, typically hired by a stranger, it's easy to think of it as: 'What's in it for me? Okay. I got paid.' That's great. The whole idea that I need to think about what I contribute to the world if I want to be compensated is not natural. We tend to think of work as an entitlement, as a way--just a question of justice. The idea that economics teaches is--not always true a hundred percent of the time and in any precision--but the idea that part of what determines how much I earn is determined by how much I contribute is really a beautiful idea that unfortunately, I think we usually forget, because we see the transaction as a transaction, when in fact something much broader is taking place.

David Henderson: Right. That's right. And, by the way, I think that's one reason it's very useful for people to be discussing the pay that really high-level professional athletes get. Because everyone understands that.

Russ Roberts: That's interesting.

David Henderson: Everyone understands that Mahomes is going to get paid well because he's such a great quarterback. And, so, I think that can help people think through, at their level, 'Well, what am I doing? What value am I creating? And, therefore, what should I get?'

Russ Roberts: And, to be fair, to the skeptics of the market system, what's amazing about sports and the reason I think economists tend to enjoy sports, maybe in one particular way that you're discussing is that there's a scorecard. We know who wins.

Now, we may not easily know how much each person contributes. And, I think our UCLA economist wrote a really important--did some really important work on that phenomenon, which is the question of team production, right? When things are done in a team it's often hard to ascribe the outcome to any one person. But of course, a great football coach, or a great baseball general manager understands, has some non-easily-quantified ways of figuring out who is contributing. It may not always be accurate. They do the best they can. But that there's a score--there is some bottom line that often a little more observable in terms of statistics, say, of a quarterback or a hitter in baseball that's not literally there in the workplace.

In the workplace you see in inputs--you know, how many hours people are in the office, sometimes. But, you don't always know what they actually contribute. And, that of course is a challenge in thinking about how to organize a workforce. But sports is an example where you see that the wages and pay is often determined by productivity.

David Henderson: Right. And, by the way, I'm glad that kind of segues nicely into one of the major Alchian/Demsetz contributions, which was the theory of the firm.

Russ Roberts: Yeah, talk about that.

David Henderson: Yeah, they wrote an article in the American Economic Review, and this one was listed as one of the top 20 of the century of articles by some economists, including Kenneth Arrow and others. And, the idea was that the firm is team production, that's what it's about. And so--but as you said, you have trouble often monitoring inputs, monitoring the productivity of inputs. So, the firms that tend to do well are going to be ones that do that well.

And, again, that's where it's really important to have what's called a residual claimant, an entity that has the right to the revenues that are left after all outlays have been paid. That's the residual--the profit, essentially.

And so, if you have a residual claimant, that residual claimant has very good incentives to monitor the workers, figure out who is shirking--they use the word 'shirking' a few times in that article, I believe. And, try to figure out who is contributing the most--or, not the most, but who is contributing at least what he or she is paid.

And, that whole idea was a further advancement along the lines that Ronald Coase had started in 1937 with his article, "The Nature of the Firm." And so, this was another major step. This was in 1972, I believe, so 35 years later, they kind of advanced the ball on that, Alchian and Demsetz.

Russ Roberts: The reason why I think it's such an important paper--there are a lot of reasons, but I think a lot of times, quote "for simplicity," economists assume that, say, productivity is observed. And it's almost never observed. It's observed in so-called piecework: picking walnuts or fruit or vegetables over a certain time period, you have a very good measure of how much work a worker does and whether they're worth it or not. In fact, typically with piecework, you pay them a certain amount and they monitor themselves. If they can't earn enough in an hour to make it worthwhile, they'll quit. And, there's still a challenge of what to set the wage at. You can still mess that up, the piecework rate.

But most of life is not like that. Your individual productivity is not observable. You're working in a team.

You could argue actually that academic life is a little bit unteamly, that there is collaboration that takes place, but when you teach in a classroom, there's not much teamwork--

David Henderson: Right--

Russ Roberts: It's up to you now. Assessing the quality of teaching is incredibly hard. There are many ways to do it badly. I don't want to suggest that it's easy

But, the more interesting cases, I think, are where a team of people work on a serious project that requires multiple people's involvement--and a sports team, again, is an obvious example. It's often very hard to figure out what any one player contributes to the team or anyone colleague contributes to the work project.

And, thinking about that subtly--it's not enough just to point out, 'Well, it's hard to do.' It's not enough to point out that firms that do a better will make more profit than ones that don't--there were other insights in that article I don't remember very well now at last--but they started a whole literature on thinking about that challenge that essentially had been ignored, I think until then, more or less.

David Henderson: That's right. And, some follow-on work, not done at UCLA, but it was done by my colleagues when I was at University of Rochester Business School, William Meckling and Michael Jensen, where they took that and pushed it to the next step. And, so, yeah, there was a kind of an incremental building from that insight through the 1970s and 1980s.

33:00

Russ Roberts: It's part and parcel of what we were talking about before, that economists at UCLA--and other economists as well, of course, but especially at UCLA--were interested in understanding how the world works. They'd see something out in the world that seemed puzzling. You know, another example that would be the work that Ben Klein did and others on vertical integration. Like, why is it that a firm might buy a supplier, or supply its own stuff? Why wouldn't it take advantage of Coase's insight and say, 'Well, a firm could just buy its raw materials. Why would it want to have to then use this less effective--on the surface--method of command and control of top-down, of making your own stuff? Which means you have to hire people, decide on what the inputs are, figure out how much to pay them. Wouldn't it be better to let the marketplace produce that at a competitive price, and then you would just buy it the open marketplace?'

And, their understanding, their insight that, in certain situations, two firms would have an incentive potentially to exploit the other; and to avoid that you would buy the firm and do the production of the input yourself. I didn't say that very well. You can take a crack at it. Go ahead.

David Henderson: Right. And, Steve Globerman and I, in the book, talk about that. The example of, say, a coal mine, and they want to ship their coal out. So, they need a rail line. Well, if they make a deal with a railroad to produce a railroad, a huge part of the cost of the railroad is sunk. So, they might take advantage of the railroad and say, 'Well, we're not going to pay what you thought we were going to pay to ship the coal.' On the other hand, there's one coal mine there. And, the railroad could say, 'Well, we're the only game in town. We're going to charge you even more than you thought we would charge.'

And so, a simple solution is to vertically integrate: Have the same company own the coal mine and the railroad. And, yeah, so that is a big part of vertical integration.

By the way, one of the things that UCLA contributed to, as well as other economists or legal economics scholars like Robert Bork, is the idea that vertical integration isn't something to worry much about. And, that one has lasted.

In other words, court decisions from the Supreme Court on down have found, 'You know what? This vertical integration isn't anti-competitive. It's just solving these kinds of problems.'

So, that's, I think, a long run policy effect of work done, not just at UCLA, but partly at UCLA.

Russ Roberts: And, of course there are other ways to solve the problem. You could have long-term contracts, but they have other costs. And so, this vertical integration idea, the reason I love it is that--if you're not careful, you might think, well, the reason you might have your own railroad line, if you're a coal company, is that that you way you won't have to pay for your railroad because it would be yours. Don't laugh, David. That's a very common mistake that I think people make in forgetting about opportunity cost, right? The fact that there are other uses for those resources. And, it's not just the out-of-pocket payment that counts.

David Henderson: No, that's right. That's why when I was eight years old, I wanted to own a candy store--so I could have all the candy I wanted.

Russ Roberts: Free candy! Except you have to buy the store, which is really expensive. Yeah, that's a good example.

And, of course, there's a little bit of truth to it because if you did own the candy store--nah, that's not true; I was going to commit another fallacy. I'm going to leave that one alone.

35:42

Russ Roberts: Speaking of fallacies, let's turn to an important insight of Demsetz's, which has come to be called the Nirvana Fallacy. And, I think it's a very common mistake that people make. So, talk about what Demsetz argued in that paper.

David Henderson: Right. So, we have a whole chapter on that, because it was that important. Demsetz wrote an article in 1966 in the Journal of Law and Economics called "Information and Efficiency: Another Viewpoint." And in it, he identified what he called the Nirvana Approach. Economists who talk about it now call it the Nirvana Fallacy. Wikipedia even has a quite good entry on it.

Russ Roberts: We'll put a link up to that.

David Henderson: And, the idea, and what he did was he took a famous piece by Kenneth Arrow in the early 1960s on incentives to invent, in which Arrow identified all these market failures--ways that markets would underinvest in invention and innovation. And, Demsetz said: this is the quintessential example of the Nirvana Approach.

And, within the Nirvana Approach, he identified three fallacies: the Grass Is Greener fallacy, the Free Lunch Fallacy, and the People Can Be Different Fallacy.

And so, what we did in that chapter was laid out literally what Arrow had said, and then how Demsetz identified which of those three fallacies was at work. Arrow looks at ways the market might not be optimal in some narrow sense and then says, 'Oh, well then we'll have some kind of government subsidy or government regulation' without examining, 'Okay you just pointed out how incentives in the private sector might be non-optimal. How do incentives in the government sector work? Why do those people suddenly have the right incentive to do the right thing?'

And, Demsetz was kind of merciless at laying this out--not in a nasty way, just in a very tight, analytic way that Arrow just had not identified why that would work better. And so, that one lasted. I mean, people still--what, 55 years later?--talk about the Nirvana Fallacy.

39:12

Russ Roberts: Yeah. I think, I'm going to defend Arrow for a minute, even though I really love the Nirvana Fallacy and Demsetz's observation. I think there's nothing wrong with identifying the fact that markets work imperfectly, incentives aren't perfect. There's fraud; there's a lot of things that go wrong in private voluntary transactions. There could be intimidation, there could be violence, there could be asymmetric information, there could be externalities. There's a long list of things that people like to point to. It's okay, I think, to point out that it could be better if the government did it. The challenge is showing that it could actually work that way.

And, I don't think it's enough to critique--the way I understand Demsetz or at least the way you're saying it--I don't think it's enough to say that, 'Well, government will also have bad incentives.'

It's not a bad thing to point out and it's often true. And, I think it would be naive to say, 'But, there'll be overcome by public spiritedness.' And, then at that point you want to do some kind of case study, ideally, or how, in some situations, perhaps some societies, the governments' done it, others--the private sector has done it--and see maybe which case might be more attractive. You may not be able to judge it easily--

David Henderson: Right--

Russ Roberts: There's the famous example of the economics of the lighthouse. It's quite complicated, but for a long time economists used the lighthouse as an example of something that could not be provided privately because the incentives weren't there. They would say, 'Well, what are you going to do? Are you going to turn off the light for the people who don't pay? And, then what about the ones who have paid? It'll be dark on the ocean for them' And, that was an article by Paul Samuelson, saying that the lighthouse is a public good that has to be provided publicly.

Coase came along and said, 'Well, private lighthouses exist.'

David Henderson: Right.

Russ Roberts: It's awkward for the theory that they can't exist. They actually do exist. And, they overcome the free-rider problem and the problem of turning off the light, not by creating associations and dues and ways of enforcing that--I'm not sure exactly, I don't remember the article so well; it's one of my favorite articles on economics, though. And, I think later, by the way, some people have come along--we'll try to link to this--who critiqued Coase's analysis, at least the history of the lighthouse and how it was actually provided. But, I do think it's a great example of how the ivory tower, if you're not careful, you can essentially--to use an inside joke--assume a can opener.

And, our side--free market people tend to do that, too: 'Oh, the profit incentive will solve that.' Sometimes it does, sometimes it doesn't. Often, it does. That's why my view on this is that there's a presumption that market incentives work well. Not always--they may not work in a particular situation.

But, similarly, I don't want to say, 'Well, government never works well because they're all just a bunch of bureaucrats with no incentive.' They're sometimes inspired by their desire to be good public citizens. It's possible they can do a good job. You never want to argue that, say--well, anyway, I'll just leave it at that and let you respond.

David Henderson: Yeah, and by the way, on the lighthouse, one of the textbooks that I actually really liked and used in a course, when I taught at the Naval Post-Graduate School was Joe Stiglitz's Economics of the Public Sector. On the cover is this big picture of a lighthouse. And I always just found that so ironic.

Yeah, so that was always what Coase had going for him, I guess, getting away from UCLA; but Coase, he was kind of an honorary UCLA-er in a sense.

Russ Roberts: Very much in the tradition of--an emphasis on transaction cost, which is part of the UCLA tradition to a large extent.

David Henderson: Yeah. And, his whole idea, and Demsetz and Alchian, and all those people was: Let's look at the reality. Let's look at actually what goes on. That gets back to Demsetz's property rights with Indian tribes and so on. Oh, sorry.

43:10

Russ Roberts: Go ahead.

David Henderson: I wanted to shift it and make sure we talk a little about Hirshleifer. Is that all right?

Russ Roberts: Yeah, sure. And, I'm going to try to get us to Earl Thompson before we're done. Go ahead.

David Henderson: Okay, okay. One of the things that I enjoyed when Steve Globerman and I were writing this piece was to look back at Jack Hirshleifer's work. Now, Jack--first of all, he was a fantastic person. I just really liked him as a person.

Russ Roberts: He was. He really was delightful.

David Henderson: Yeah, yeah. And, very not full of himself.

Russ Roberts: Sweet. Sweet. Sweet. Yeah.

David Henderson: Yeah. I'm glad you knew him. And so, he wrote something for the Rand Corporation called "Disaster and Recovery." And, it was when people were really worried--this is, like, late 1950s, early 1960s--people were really worried about: We could have an all-out nuclear war. What would things look like afterwards? And so, of course, we don't have experience with that other than in Japan, which was localized. But, he said, 'Okay, let's look at other things. Let's look at Japan. Let's look at Germany after all the bombing; and so on. And, let's look at how quick recovery was.' And, the bottom line--to simplify a little--is: Recovery was quick. It was amazing how cooperative forces came together and just started digging themselves out.

So, I think he mentions--I'm not sure if what it's the Dresden firebombing or the Hamburg bombing or one of those--where, within a few days, electricity was flowing again. Which is key in a modern society. And so, Jack--we have a chapter just on Jack Hirshleifer's work on that issue. And, again, it was really pathbreaking at the time.

Russ Roberts: Yeah. I can't help but think about it in our current world where we kind of shut down our economy. We didn't destroy it through bombing, but because of the pandemic, we basically put it into deep freeze for a while. Many societies, many countries and economies have done that as a response to COVID.

And, I think it's really important, and I don't remember if Hirshleifer talks about this--it's really important to remember that buildings are bad, when they're destroyed. Deaths are a horrible tragedy when they're innocent people. But, a lot of what is not destroyed is not observable. A lot of what is not destroyed is know-how. A lot of what is not destroyed is creativity. A lot of what is not destroyed is the trial-and-error, the results of trial-and-error that people have figured out. And, one of the reasons I think it's quite beautiful that people respond relatively quickly to a natural disaster is they take the capital we can't see, which is the human capital inside the brain--inside their heads spread out across different people--and they reconnect.

Arnold Kling writes about this, these patterns of specialization and production that take place in a healthy economy. And, after a tragedy or destruction, whether it's a hurricane or a war, all of a sudden--people often emphasize that, 'Oh, and now they can use these new technologies.' Well, they could have used those before. Nothing stopped them. It's not the opportunity to use the latest technology that makes that recovery quicker. It's that it's an enormous incentive to find ways to reintegrate what you understand with those of others like you, and that you can share and cooperate with in a commercial way.

And, of course it's happening in government--the example of the electricity coming back. It's also happening in voluntary ways. People are doing all kinds of things, again often unobserved. They're not unobservable, but they're often not observed by the economists. The casual help that people give each other in a crisis to get through is taking place. And, all that stuff is bubbling around. And, it's really, it's quite a beautiful example of human activity and cooperation.

David Henderson: It is. It reminds me of two things, one in Hirshleifer's work, and one of my own little experience. Hirshleifer talks about how after World War II, when the Allies controlled Germany, they kept Hitler's price controls. And, the money supply had roughly quintupled but prices hadn't been allowed to go up much at all since the late 1930s. And so, you had all these inflationary pressures that weren't allowed to come out through higher prices.

Russ Roberts: Shortages, perhaps?

David Henderson: And, therefore--incredible shortages--and people going out into the country on the weekends to trade for food and so on.

And, Hirshleifer has a table in there of the calories people had. And, they were close to starvation. And, then Ludwig Erhard whom he talks about, with General Lucius Clay's support, managed to deregulate prices in the summer of 1948. And, we got what was called the Germany Economic Miracle. In the Hirshleifer chapter, we quote from Walter Heller, who was later John F. Kennedy's major economist, Chairman of the Council of Economic Advisers. And, Hirshleifer quotes from Heller, about Heller understood the power of getting rid of price controls.

And, by the way, I did my own piece on this in the encyclopedia, The Concise Encyclopedia of Economics, titled "The German Economic Miracle." So, that's that one thing.

My other thing is: I lived in Washington, D.C. from December 1981 to July 1984. And, I remember--I worked at the Council of Economic Advisers, so the Old Executive Office Building. And, we had this huge storm one afternoon, so we got let out of work early; and I'm going along Constitution Avenue to cross into Arlington, Virginia. And, I'd already had this idea just being around Washington by then a couple of years, that people don't cooperate a lot. This is not like living in Pittsburgh or something.

Russ Roberts: Not a small town.

David Henderson: Well, yeah.

Russ Roberts: It's not like Bedford Falls in It's A Wonderful Life.

David Henderson: And so, I'm driving along and there's all this ice to drive on. And, I grew up in Canada, so I was used to driving on ice, right? And, people are spinning out, and I'm getting out of my car and helping push people. And, it was one of the most wonderful days I had in two and a half years of living in D.C., feeling like a real citizen, having other citizens appreciate that, being cooperative in a way that I hadn't seen him among Washingtonians before.

Russ Roberts: They were surprised to see you, I guess. But, it does, it happens a lot actually in places that get a lot of snow. Right?

David Henderson: Yeah, yeah.

Russ Roberts: Because everybody understands that sometimes you just need a second shoulder or a second set of legs to push somebody out of a snowdrift.

David Henderson: Right, right.

Russ Roberts: And, in snowy places, that's an economic observation: In snowy places, I think you get a little more cooperation, at least in the winter. Maybe it doesn't extend to the summer.

David Henderson: Right, right. No, I think that's right. That's right. Yeah.

50:47

Russ Roberts: I'm going to mention one of the UCLA economists we haven't mentioned, and I don't think he's mentioned in your book, which is Earl Thompson. And, Earl Thompson was a slight--he's an underappreciated economist. He had a crazy idea that everything we observed is efficient. Everything. Anything you see that looks crazy or wrong or inefficient or dumb or a mistake, it's not. It's there for good reason.

And, my favorite example of this was that I think he explained the high taxes on jewelry and diamonds as a way to discourage foreign invasion. Right? Because, by putting a high tax on the sale of jewelry there'd be less jewelry sold, and so there'd be less plunder opportunities. It seemed a bit of a stretch.

David Henderson: Yeah.

Russ Roberts: It seemed a bit of a stretch, but that's one example that wasn't so compelling. But, many of the other things he came up with to explain the real world were very thought-provoking. And, he was a fabulous UCLA economist in the puzzle sense. And, I may have talked about this on the program before, but I once had dinner with him and, and he, he challenged me to explain the price of the markup of food. Because a lot of people look at restaurant food and they go, 'Wow, the raw materials are so cheap. Obviously they're ripping us off.' They forget, of course, that one of the most important raw materials that goes into the food is the time of the people cooking it and the people serving it. And, those are not so cheap, and they're not easily observed. And, you look at the fact that it's a steak and you forget that somebody had to spend time, had to be hired by the restaurant to cook it. So there's a markup.

But Earl's insight, which was fantastic, is that part of the markup for the food has to incorporate the time you spend at the table. And, he suggested--and I've never seen anyone test this. I don't know if it's literally just a prediction. But his claim was that the longer the food took to eat, the bigger the markup would be because built into the price had to be the fact that you were renting the table. And, you could separate it: you could have a meter just for the table. You could make the food really inexpensive and then charge more to the people who lingered longer at the table over the food or ate more slowly. But, of course that would make eating less pleasant maybe, to hear the meter ticking. And so, it's just incorporated into the food on average. And, that was just a fabulous insight.

So, Earl is gone. I think all the people we've talked about, almost all of them are gone. Jack Hirshleifer, Armen Alchian.

David Henderson: Ben Klein is still around.

Russ Roberts: Ben Klein is still alive. But, Harold Demsetz and Earl Thompson have all departed, and they were really wonderful at the craft of thinking about how to apply economics to real-world problems.

53:29

Russ Roberts: I want to close with one last insight that came out of UCLA economists' work, which you also profile in your book, which is the question of whether firms maximize profits. And, Alchian--was Demsetz his coauthor? I can't remember--

David Henderson: No, no.

Russ Roberts: Just Alchian, 1951?

David Henderson: Just Alchian, 1950.

Russ Roberts: 1950. So, talk about that paper and how he looked at that, because it's really interesting.

David Henderson: Alchian--there was this whole controversy at the time, do firms maximize profits? And, you might expect Alchian to say, 'Well, you know, of course they do,' but that's not where Alchian went. Alchian said, 'You probably typically don't know enough to maximize profits. There's so much uncertainty.'

Russ Roberts: It's not a simple equation, you plug in a bunch of numbers and figure out: it's not a calculus problem in real life.

David Henderson: Yeah, yeah, because of all these uncertainties. So, he said, 'Here's what we can say. The firms that make closer to optimal decisions are going to do better. And so, the environment will select them for survival and select the others for failure.'

So, he gave an analogy, which I think we used literally in the book, which was people leaving Chicago, driving from Chicago, and it turns out--they don't know this, but there's only one route out of Chicago that has gas stations, and the others don't.

Russ Roberts: Suppose.

David Henderson: Suppose, right. Suppose. And so, we can predict, if we know that route, which people are going to get far out of Chicago and which people aren't. And so, that's kind of like the profit thing.

So, we give the example, let's say the minimum wage goes up, and there are some firms that are very heavily labor intensive and other firms that aren't. Even if firms aren't saying, 'Well, is this worker worth hiring at this higher wage?' Even if they aren't doing that, the firms that are more labor-intensive are going to do worse than the ones that are more capital intensive. So, we, the analysts looking at the results say, 'Oh, the ones that shifted to capital did better.' It might not have been a shift to capital at all. It's just the ones that were more capital-intensive did better. And so, the environment selected the ones that were closer to what the optimum would be. And, that's kind of the spirit of his article.

Russ Roberts: And, I'd never thought about it, but there's a paper by Becker--I can't remember if he has a co-author; I think it's just by Becker; it was very early in his career--where he says, 'Let's assume that people aren't rational. Let's assume they just randomly pick how much they buy a particular good.' And, what he showed in that paper--it's a really simple little geometry paper, which I used to love and I don't like so much anymore. I'm going to tie it into the Alchian paper and you can respond. But, his point was that even if people choose randomly, because of the higher price now--let's say there's an increase in the price of the good. What he's trying to show is that even if people aren't rational, demand slopes downward.

So, even if people just choose randomly, because of the increase in price--you go look at the article if you want--but the basic point is that you're more likely to choose less of the good that's gotten more expensive because of the way it changes your opportunities. It's an application of the 'as-if' hypothesis that Friedman put forward in his paper on Economic Methodology, where he argued that: We don't really have to know why people do what they do, precisely. If we want to make predictions, it's enough just to know that they act as if they're maximizing, say, utility or profits.

An example--I think it's in there--is the example, there's one I know is in there: that's the truck driver. The truck driver doesn't know physics. But, the truck driver acts as if the truck driver has a knowledge of physics. They will slow down on a wet road. They'll have a very good intuition about the amount of friction that's between the tires and the road. And they, of course, don't know the actual equation, but they'll act--if we assume they do know it, our prediction will be right, because they act as if they know it.

And, I used to really love that. I think it's actually quite an unhealthy problem for a healthy way to look at economics, because--as we talked about with an episode with Paul Fleiderer; we'll put a link up to it--if you do that enough, you start to think that it's not just as if: they actually do. That they don't just act as if they're maximizing utility, they actually do maximize utility.

That that's the way the human brain is working when we make decisions about what to buy and what career to go into and how long to stay in school and so on.

And, if that's wrong, the whole idea of Welfare Economics is in deep trouble. But, we need to hold on to that idea as economists, I think emotionally, because we want to be able to do well for our economics. We want to be able to say we have a theory of what people actually do, not how we can make accurate--we care about--let me say it a different way. We care about more than making accurate predictions, most of us, most economists. And, therefore, I think this whole idea of what's revealed to us through competition can mislead us as to something we do care about, which is: what do people do in situations when they're the residual claimant? Do they only care about profit? Maybe. Maybe they don't. Maybe they care about other things. And, I think if we're not careful, we miss that. So, that's my critique of that strand of thinking.

David Henderson: Yeah, I remember that Becker article, I think it was around 1962--

Russ Roberts: Yep--

David Henderson: And, if I recall correctly, he actually had a debate with Israel Kirzner--

Russ Roberts: Oh, really?--

David Henderson: I think Kirzner weighed in in a different journal, maybe the Southern Economic Journal? And, I remember liking them both, and I can't remember many of the details. But Becker had that in his textbook. He had that and I remember just actually flipping the coins to do the exercise when I was studying for my comprehensive and going, 'Oh yeah, that works.' But, yeah. Yeah.

59:53

Russ Roberts: Anything you want to say in closing? Anything you want to say about UCLA?

David Henderson: Yeah. So, we've covered--oh, just a little on regulation and Peltzman and Hilton.

Russ Roberts: Yeah, go ahead.

David Henderson: So, one of the other strands of the UCLA people was on regulation. And, one of the major contributors was George Hilton. Again, a guy who was all words and occasionally charts, but no equations.

And, another one was Sam Peltzman, who did a lot of stuff on regulation. I had the fortune of having in my last year at UCLA, before he went back to University of Chicago where he'd gotten his Ph.D. And, he did two pathbreaking studies while I was at UCLA. One was on the Food and Drug Administration [FDA] in which he looked at the Kefauver-Harris Amendment to the food and drug law in 1962, and showed that it had slowed new drug development by 60%. So, for an average of roughly 40 new drugs every year, the number went down to about 16. And, he had other ways of looking at, 'Well, were those mainly bad drugs that were not developed?' And, the answer was No. And so, it added--it turns out now--billions of dollars and years to the drug development process. That was one.

And, the other one was his thing on car safety. He looked at the laws in the late 1960s that were due in part to Ralph Nader. You had padded dashboards, required seat belts--all these things to make it safer in the event of an accident.

And, he looked at the data and found that fatality rates hadn't fallen for people in cars. And so, what's going on?

Well, then he noticed that fatality rates had risen for motorcyclists and pedestrians. So, he hypothesized that what was happening is because people felt safer in a given accident, they were driving more intensely: faster, following closer, and so on. And therefore, in a given accident they were safer, but the people outside the car were more in danger. I remember teaching that to a class here in Monterey at the Naval Postgraduate School, and finding some students were pretty skeptical, and I said, 'Okay--'

Russ Roberts: People don't like that result. It's a bridge too far for many non-economists.

David Henderson: Well, here's how I got a number of them there. I said, 'We were driving along one day, we had a station wagon and my daughter was young and she was in the back seat with her seatbelt on. And I was going 70 in a 55.' [70 mph in a zone where the maximum legal speed was 55 mph--Econlib Ed.] And, there was this thing back, because this is a station wagon, that she wanted to get access to some game or something she wanted to play. And, I said, 'Well, honey, to do that, you have to take off your seatbelt.' And, she said, 'I know.' And, I said, 'Okay.' And, what did I do? I slowed down to 55. And, I laid that out to my students. And, I saw a lot of heads go, 'Oh yeah, that's exactly what I would do.'

So, what are you telling me? It's less safe inside: I'm going to drive more carefully.

And so, anyways, and so that--and Robert Tollison, and a coauthor who I've forgotten but we do quote him in the book--looked at NASCAR [National Association for Stock Car Auto Racing] races and found the intensity went up when the driving got safer.

Russ Roberts: Yeah. So, I'm always been fascinated by this example we've talked about in the program a number of times. Sam's been on the program, talking about it as well. Most people--and even sometimes me--are uncomfortable with the idea that incentives have an effect in our subconscious or unconscious. And, I use it in my book on the financial crisis, my book Gambling With Other People's Money--the idea that you would get bailed out, or you could be bailed out, or the fact that you might not lose all your money, or you might lose other people's money, but not yours--changes the way you take risks in investing.

And, I think economists are very comfortable with the idea that this can work, as I said, unconsciously or subconsciously.

I think, again, non-economists find that kind of weird. Like, 'Come on, people aren't really paying that much attention.'

But, if you think you are going to lose all your money, that's yours, you will pay attention.

David Henderson: Yeah.

Russ Roberts: So, people do understand that. And that's your daughter-case. And, I think that's true.

The example I use, which I've used before, is that football helmets, which are designed to reduce the risk of brain damage, of course can be used as a weapon in football. And, the NFL, the National Football League--we're talking about American football now--they've become very aware of this and they've tried to change the way people play football: You can't lead with your head, you can't go head-to-head in tackling another player--which used to be very common through much of the NFL's early days. And, 'Come on. Are you really going to be less careful because your helmet is stronger?' And, the easy way to think about it is, 'Okay, maybe not every second, every time. But, let's play without helmets. Do you think you're going to play the same speed and recklessness that you play with the helmet?'

And, of course the answer is, 'Probably not.' You're going to be a little more careful, now--maybe not every time. You might forget, you might get excited and do something, quote, "irrational." But, in general, those kinds of effects are going to have an impact. How big they are--these are the things economists love to think about. I am a sucker for them myself. But they have some impacts, some of the time, I suspect.

David Henderson: Yeah. Yeah. And, I want to just give one example more in your area of the moral hazard with money. John Anderson ran as a third-party candidate against Reagan and Carter in 1980.

Russ Roberts: Yep.

David Henderson: And, he needed to get five percent of the vote or more in order to have the Federal Government cover a huge part of the cost of his campaign. And, I remember watching him on TV that night as the results were coming in. And--obviously he lost--and he said--

Russ Roberts: He didn't win the election, but did he get to five percent?

David Henderson: Well, that's where I'm going to go.

Russ Roberts: Okay, go ahead--

David Henderson: He said, 'This was one of the neatest things I've ever done in my life. And, if the results don't come in right, it'll be one of the most expensive.' Well, it was already expensive: it's just he didn't bear the expense.

Russ Roberts: Yeah.

David Henderson: He got seven percent, so he got his bail-out.

Russ Roberts: My guest today has been David Henderson. David, thanks for for being part of EconTalk.

David Henderson: Thanks, Russ.


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