Welfare and Spending

Last year when I was in a class with Professor Baker.  He showed us, prior to class, a graph that I thought was very interesting.
He told us, that the best way money is spent is person 1 buys something for person 1.
The 2nd best way was when Person 2 buys something for person 1, (like a present).  The welfare decreases, because the person may or may not want this present.
The worst way money is spent is by Person 1 giving money (to an unknowing third party) Person 3 to spend on Person 2.  The chances that Person 2 will receive what he/she wants decreases the welfare even further.
This analogy helped me understand the disincentives of higher taxes.  It seems logical to me, but or there any other thoughts on this analogy?


Dr. Tufte said...

I actually posted this story at the beginning of the first summer session (don't worry, you'll still get credit).

The version that I heard attributed this to Milton Friedman, a 1976 Nobel Prize winner, and source for a whole bunch of ideas that show up in both principles of micro and macro texts. The next one that we will see is in Chapter 14; Friedman was a major voice suggesting that the Phillips Curve was not a stable phenomenon that could be exploited by policy makers.

morty said...

i would have to disagree, i think the 3 degrees are as follow.

the best money spent is when person 1 buys somthing for person 1.

the second best way is when person 1 buys something really cool for person 2 but ends up using it more than person 2.

and the third and worst way is when person 1 buys something from person 3 and gives it to person 2 but actually the thing he bought was stolen from person 2 so when person 1 gives it to person 2 person 2 thinks person 1 stole it and everyone loses. exept person 3 of coarse who gets off scott free.

Lizzie said...

Mmmm, let’s see here, Morty’s model or Friedman’s model??? This is a tough question, a Nobel Peace prize winner vs. an undergraduate student. Though witty and creative, I think I am going to go with Friedman on this one. Sorry Morty. ;^P

Lizzie said...

I am not sure if I understand this analogy completely, what I get from this is it is best to act in ones own self interest. But I thought that the best way to act is in the best interest of society as a whole, that way everybody can have enough fish to eat and not just one person…let’s call him Bernie. Maybe I am comparing two different ideas; a little clarification would be helpful.

Rolf Tiblin said...

I would have to disagree with Lizzie. The best way to act is not in the best interest of society as a whole, but in one's own self interest. Society ends up benefitting from this principal. Adam Smith wrote (paraphrased)..."by pursuing self interest a person (merchant etc.) frequently promotes that of society more". Let's take your fish example and Bernie to prove a point. Had Bernie been the only person with fish he could have sold them to others benefitting himself and having more money to spend on other goods from other people. They in turn would spend the money they received on goods from another. The people who bought his fish would have benfittied also by having the fish he caught. Therefore society as a whole benefitted. If Bernie had given all his fish away to benefit society no one would have ended up benefitting because Bernie would stop catching fish (which he could have been superior at doing)due to the fact that he would gain nothing from doing so. Then society ends up with nothing.

C-Dizzle said...

Let’s take a second look at “Rolf Tiblin’s” little analogy here. Let’s pretend we’re in Tufteville and Bernie poaches all the fish in tiny little town reservoir. Bernie tries to sell the fish to the townspeople but the townspeople know that Bernie just took all the fish out of the reservoir and there would be no more fish for the future. Would this benefit society?

I think the townspeople would beat up Bernie, steal his fish, and burn down his house. Now this will benefit others because now Bernie has to build another house. People in the village could offer goods and services to the fish poacher and benefit monetarily by the work done. The people who provided services and who were paid by Bernie could then spend more money buying goods from other people. These other people could then invest in a town hatchery to replenish the lost supply of fish making everyone happy.

If Bernie hadn’t have taken all the fish and tried to sell them, nobody would have beat him up, stolen his fish, and burned his house which in turn would have created no jobs for the home builders of the village. If the homebuilders of the village didn’t have this extra money to spend, the local merchants wouldn’t have benefited.

So sure…poaching all those fish would benefit a society.

Kid said...

Now C-Dizzle lets think about this logically….burning down Bernie’s would benefit others in Tufteville but what about the third party that is forgotten about. The money that Bernie now has to spend on rebuilding his house is forgone by the boat salesmen Bernie was going to buy a boat from. We are forgetting about the middle man who no longer will benefit from the economy because the money must be used for something else. This is what happens so often in our economy today. The Government spends money thinking they are helping the economy out when in reality they are only helping a specific group of people out.

To touch on a little micro it’s like the price floors on produce. The price floor is set to help the farmers make a higher profit. It doesn’t help the economy grow stronger. It actually makes it so we have to pay higher prices for produce that our country is giving away, to other countries, because the price floor created surplus. We as the middle man or forgotten third party end up paying the price while the farmers get richer.

kamm said...

I enjoyed what Rolf Tiblin had to say about this because I agree that society is still benefited when we act in self interest.

This blog reminds me of the story of a baker whose window was broken when a young boy tossed a rock through it. They didn't catch the boy and the baker was upset that he was now going to have to spend money on a new window. A small crowd had gathered and one man said to the baker, "You should look at the brighter side of things because this will benefit our economy. The glass maker will now have work and then he will make other purchases too."

The problem with looking at it this way is that there is a forgotten man. Suppose the baker needed a knew suit, and now because he has to pay for the window he won't be able to afford it. The tailor is the forgotten man because now he won't be making a suit for the baker and the baker is not happy spending his money on the window. The glass maker is really the only one who benefits because the baker couldn't act in his own self interest.

Dr. Tufte said...

Spelling mistakes in Kamm's comment.

Good comments.

WRT Lizzie's comment, society appears to do better when everyone acts in their own self-interest. However, that principle seems to work the best when there are property rights and markets in everything. The Tragedy of the Commons experiment we did was one in which there were poor property rights.

C-Dizzle's comment illustrates something that Basquiat (the 19th century French economist, not the 20th century Haitian-American grafitti artist) called the broken window effect. Breaking a window will cause GDP to rise when it is fixed, but it is not a sound strategy for improving our lot in life.

Kid's and Kamm's post really get at the heart of macroeconomics - following the logic out until it is complete, and figuring out what all the costs and benefits are.