Who Says There's No Such Thing as a Free Lunch

One of the most popular sayings associated with the “dismal science” of economics is “There’s no such thing as a free lunch.” The major idea behind this phrase is that even if you aren’t given a bill to pay, there is always an implicit cost associated with any action.

The economic concept supporting this statement is that of opportunity cost, which is defined as the best foregone alternative. Simply stated, it’s what you give up in order to do something else. Consider the following example: you have $10 that you can either spend on a movie or a pizza. The opportunity cost of going to the movie is therefore the pizza that you give up by attending the movie, and vice versa.

But what about when a good is free to consume? What is the opportunity cost in this situation? Usually in cases like this, the opportunity cost is associated with the value of your time or some other implicit cost. For example, if you work hourly, the time it takes to wait in line for a “free” offer is time that you could’ve spent working and earning money; “free” in this case simply means that there is no explicit monetary cost, but it says nothing about the implicit costs of waiting for the item. Another common example is when you receive a “free” weekend getaway, but the cost is that you have to sit through a 2-hour sales pitch with a timeshare organization.

I was thus astonished when I received something truly for free a few weeks ago at Auntie Annie’s pretzel shop. I was at the mall with my friend when the two of us realized we were getting pretty hungry. Wanting to avoid eating a fast-food meal at the food court, we decided to each grab a pretzel at Auntie Annie’s to hold us off for awhile. As we were waiting in line, one of the workers started giving out samples. My friend suggested that we try them since the line was pretty long and we were quite hungry. As I walked over to receive the samples and my friend stayed in line, the worker also instantly handed me a coupon: BUY ONE PRETZEL, GET ANOTHER ONE FREE. Having already committed to wait in line to purchase two pretzels before I got the coupon—it was my friend’s birthday so the two pretzels were on me—I actually received a free pretzel! After consulting with some other economists, none of us could find an implicit cost that I incurred in order to receive the free pretzel (though you could argue that my time to write this blog post is an after-the-fact cost associated with the pretzel purchase). In short, who says there’s no such thing as a free lunch?

Discussion questions:

1. Can you think of a time in your life where you actually received something for free? That is, there were no explicit monetary costs or implicit opportunity costs.

2. If I was just passing by Auntie Annie’s and received the coupon, why would the second pretzel not be free? What opportunity costs would be associated with using this coupon in that case?

3. Suppose you have a “Buy 10 pretzels, Get One Free” card for Auntie Annie’s. Does it distort your behavior in any way? Is the 11th pretzel actually free?

Scrooge's Economic View of Christmas

We all know how easy it is to get caught up in the Christmas spirit and gift-giving frenzy. A lot of time and energy is spent thinking of the "perfect gift" for friends and family. While I'm sure many are successful in this endeavor, there are undoubtedly a large number of gifts given that people would rather trade in for cash—even if that cash amount is less than the retail price of the good.

Thanks to eBay's anonymous online service, consumers can now do just that! According to a recent study from eBay, more people than ever will sell unwanted items this year. The ongoing recession is partly to blame: many people can probably use the cash from selling gifts to lower their credit card debt, pay their mortgage, or simply cover the bills. But people's general preference for cash to gifts can be explained using the economic fundamentals of utility.

Now that the holiday season has come and gone, many of us find ourselves thinking, "What will I do with another FM transmitter for my iPod?" Oftentimes, both the gift giver and gift receiver could be made better off (that is, receive a higher level of utility or happiness) if a cash exchange had taken place instead. To understand the economic rationale behind this, we turn to the basic consumer theory model of budget constraints and indifference curves.

Recall that an indifference curve maps out all the possible consumption bundles of goods that yield the same level of utility to a given consumer. Indifference curves tell us nothing about what we can afford, but rather how happy a particular bundle will make us. On the other hand, budget constraints show the consumption bundles that we can buy given our income and the prices of goods. Similarly, budget constraints say nothing about what we would like to buy, but rather what we can afford. A consumer's optimal bundle of goods is located where the budget constraint is tangent to the highest possible indifference curve.



But what happens to your budget constraint when you receive a gift? Consider the following simplistic example. You consume only two categories of goods: books and food. You have $80 each week to spend on these two goods. The price of a book is $10, and the price of each unit of food is also $10. Suppose that without receiving a Christmas gift, you would consume 2 books and 6 units of food. This is represented by the graph below:



But now suppose that your grandmother gives you 5 books for Christmas. This means that you can now afford 8 units of food and 5 books without spending any money on books, and you could afford 13 books if you don't spend any money on food. Assume that you cannot return or immediately sell the 5 books your grandmother has given you. If you have a high preference toward food over books, you may find that there is no indifference curve tangent to your new budget constraint in the region where you can now consume-between (4 books, 8 units of food) and (13 books, 0 units of food):



In this case, the optimal consumption bundle does not satisfy the tangency condition because there is no tangency in this restricted region of the budget constraint; we call this a corner solution. In other words, if instead your grandmother gave you the cash she spent on the books (5 books x $10 per book = $50), your budget constraint would also include the grey, dashed region below, and you would be made better off since you can now consume 3 books and 10 units of food.



Discussion Questions

1. How much money could your relative have given you, instead of the present, that would leave you at least as well-off as if you had received the present (that is, with the same level of utility)? Draw this on a standard budget constraint-indifference curve diagram.

2. What elements of real life does standard consumer theory ignore?

3. What gifts, if any, could your grandmother have given you instead of 5 books that would be just as good as if she had given you the cash she spent on them?

Deterring Suicide Bombers

So far this year, Israel has suffered two attacks at the hands of Palestinian men who resided in East Jerusalem. In the wake of the attacks, Israeli Prime Minister Ehud Olmert renewed a legislative proposal aimed at deterring would-be terrorists by punishing the families of the attackers. Punishment would include home destruction and cancelled access to Israeli social insurance programs. Eric Westervelt's NPR story offers more on the proposed law.

For the moment, let's leave aside the major issue of whether it is moral to punish people for murders committed by a dead relative. The objective of the law is clear: to provide a disincentive to suicide attacks by punishing the perpetrator's surviving family members. Should the law pass, suicide bombers would forgo not only their own lives but also, potentially, the welfare of their families. By raising the opportunity cost of a suicide attack, the supporters of the law hope to reduce the number of attacks. Recent research on the economic roots of terrorism can help us think about whether the policy will achieve its intended consequences.

In a 2003 research paper, Alan Krueger and Jitka Maleckova found that participation in terrorism is unrelated, and possibly even positively related, to a person's income and education. As Daniel Lerner pointed out in a study of Middle East extremism in the 1950s, would-be terrorists are not so much have-nots as they are want-mores. In a more recent article in The American, Krueger cites Claude Berrebi's research on the characteristics of Palestinian terrorists from the West Bank and Gaza Strip:

"[Berrebi] compared suicide bombers to the whole male population aged 16 to 50 and found that the suicide bombers were less than half as likely to come from families that were below the poverty line. In addition, almost 60 percent of the suicide bombers had more than a high school education, compared with less than 15 percent of the general population."

Apparently, better-educated terrorists are more likely to be committed to their organization's goals and also more likely to have the financial means to participate actively. After all, a person needs some level of income security to have pursuits beyond basic subsistence.

Krueger and Maleckova also cite some anecdotal evidence suggesting that terrorist groups attempt to recruit somewhat educated suicide bombers. Nasra Hassan, a UN relief worker, interviewed 250 Palestinians militants and their associates between 1996 and 1999:

"A planner for Islamic Jihad explained to Ms. Hassan that his group scrutinizes the motives of a potential bomber to be sure that the individual is committed to carrying out the task. Apparently, the groups generally reject for suicide bombing missions 'those who are under eighteen, who are the sole wage earners in their families, or who are married and have family responsibilities.'"

The evidence presented by Krueger and Maleckova casts doubt on the effectiveness of the Israeli Prime Minister's proposal. The threat to families isn't much of a threat to a terrorist with minimal or zero family responsibilities. The law may not present much of a threat to terrorists with families either. If the suicide bombers tend to be a bit more educated and financially stable than their peers, they will probably develop a contingency plan that softens the punitive blow to their families. Similarly, terror groups may alter their tactics in response to the law, perhaps offering some sort of compensation to the families of suicide bombers as a recruitment incentive.

Discussion Questions

1. Economic analysis allows us to answer "what if?" questions, such as "What would happen to the number of suicide attacks if the Israeli government punished the families of suicide bombers?" Economics is not so great for dealing with "what should?" questions; but as citizens, we still have to tackle them. What should the Israeli legislature do about Olmert's calls to punish the families of suicide bombers?

2. In Krueger's article from The American, he suggests using "demand-side" policies to reduce the number of terrorist attacks. In the "market" for terrorists, the demanders are terrorist groups hoping to employ the services of suicide bombers. According to Krueger, what types of policies might suppress the demand for terrorists? Can you think of ways for Israel and its allies, like the United States, to go about attacking the financial resources of terror groups?

3. Krueger points out that we're unlikely to find many would-be terrorists among the illiterate and destitute. What does he say about the notion that "the elite become terrorists because they are outraged by the economic conditions of their countrymen?"

None and Done: The Labor Market for Young Basketball Talent

The 2008 Celtics-Lakers NBA finals featured two great straight-from-high-school athletes: Kobe Bryant and Kevin Garnett. The NBA benefits from a host of other players drafted straight from high school, such as LeBron James, Dwight Howard, Tracy McGrady, Amare Stoudemire, and Tyson Chandler.

Early entry into the NBA is a classic example of opportunity cost—the notion that the cost of something is what you give up to get it. For elite players, attending college can cost millions in forgone earnings as an NBA player. So until recently, the decision for most was simple. Skip college, sign a huge NBA contract, and worry about getting a degree later, if at all.

Curiously, a 2005 collective bargaining agreement between the NBA and the players' union implemented a draft-eligible age limit of 19 with the requirement that athletes be one year removed from high school. This was great news for the NCAA, since most draft-worthy players would spend their first year away from high school wowing college basketball fans. Without the rule, we'd have missed Derrick Rose in the 2008 NCAA tournament. Of course, Rose might not have missed us, since he'd be earning a big paycheck as a rookie in the NBA.

As a recent article in the New York Times points out, labor mobility and the presence of European leagues offer young players an opportunity to break free from the strictures of NBA and NCAA rules. Europe promises pay and a chance to develop against professional players, an alternative that may prove superior to an earnings-free year of college ball and freshman classes.

Discussion Questions

1. Why would the NBA players' union support the age barrier to draftees? Why would the NBA support the restriction?

2. College basketball generates big money. Should college players be compensated in accordance to the value that they add to their school's program? How would less-than-NBA-caliber players benefit from such a system?

3. Under what circumstances might it make sense for a phenomenal young athlete to play one year in the NCAA rather than playing professionally abroad?

No Free Lunches? What About Taco Tuesday?

In the second game of the World Series, Jacoby Ellsbury's second-base steal triggered Taco Bell's "Steal a base, steal a taco" promotion. Between 2:00 PM and 5:00 PM on Tuesday, October 30, Taco Bell made good on a promise of free tacos to anyone in America.

Discussion Questions

1. As with most free stuff, the taco promotion involved some hidden costs for the would-be freeloaders. What are some of the costs associated with taking Taco Bell up on its offer? Did the promotion involve external costs (costs borne by people who were not part of the taco transaction)?

2. An ABC News article pointed out that there has been at least one stolen base in every World Series since 1990. Taco Bell must have expected to make good on the promotion. Why would a profit-maximizing business offer this type of promotion?

3. A free taco isn't exactly "lunch" when you can only get it between 2:00 PM and 5:00 PM. Why were people willing to stand (or drive) in line at odd dining hours in order to get a taco that would normally run you less than a buck?

4. Sunk costs are costs that have been incurred and cannot be recouped, such as the time it took you to get to Taco Bell before realizing there was a long line. Were people sticking out a 20-minute wait for a $1 taco because they failed to ignore sunk costs?

5. In his new book, Tyler Cowen offers the following explanation of signaling: "We signal every time we incur a cost to send a message about ourselves to the outside world." Often, the higher the cost incurred, the stronger the signal. Think of the costs people incur to signal to prospective employers that they have an MBA from Wharton, or to signal to acquaintances that they attended Game 2 of the World Series. Were people signaling their devotion to the Red Sox or, more improbably, to Taco Bell? If the tacos were truly free, would anyone be able to make a strong statement about their baseball fanaticism? Might signaling help to explain the long lines in the final days before the release of products like Apple's iPhone and Microsoft's Xbox?

iQueue

The Apple iPhone is this summer's must-have gadget, and lines began forming across the country four days early for the chance to grab one of the first available. iPhones sell for about $500, and if you hope to get one early, you may have to queue up for days just for the privilege.

Paradoxically, the type of people who are willing and able to spend $500 on the iPhone are also likely to have high-paying jobs that make it difficult to take an entire week off to wait in line. Fortunately for gainfully employed iPhone seekers, summer has brought with it a surplus of young people looking to earn a bit of extra money.

Ads are popping up all over Craigslist for so-called "professional waiters" who, for a fee, will line up to buy you an iPhone. The going wait rate is currently around $250 in New York and $200 in San Francisco. Lines are now full of people donning "iWait" shirts to show off their newfound occupation.

While the iPhone scene is replete with interesting economics, perhaps the most interesting phenomenon is the group of people who choose to bear the cold nights themselves rather than pay an iWaiter. With an ample supply of "low-skilled" workers fit for the job, many still choose to do the waiting themselves. Why would someone prefer to spend his or her own valuable time waiting in line when they could pay someone else who, by virtue of their offer, almost certainly has a lower opportunity cost?

Discussion Questions

1. What factors determine a person’s opportunity cost of waiting in line to buy an iPhone?

2. What benefits might people reap from waiting in line? (Maybe they enjoy the camaraderie? Perhaps they are "purchasing" a good story to tell at parties?)

3. All transactions involve an element of risk. Contracts, social norms, property rights, insurance, and consumer protection laws can help to mitigate transaction risks and facilitate trade, but waiting in line to buy an iPhone is a fairly informal transaction. What risks do line waiters assume? What risks do the people paying line waiters assume? Search for some iPhone line waiting listings on the Craigslist site for the San Francisco area. In what ways do iWaiters attempt to mitigate transactions risks?

4. If people are willing to pay upwards of $700 ($500 cash, $200 for a waiter) for an iPhone, why doesn't Apple raise the price?

Financial Times economics reporter Tim Harford addressed a similar question about the Xbox 360 shortage of 2005 here and here.

Something to Remember

Every once in a great while, I read something that seems so simple and profound that I have to stop and think about it for a while. Such a moment occurred for me today, while reading Margaret Wertheim's excellent piece "The Shadow Goes," which appeared on the op-ed page of yesterday's New York Times.

The central paradox of the article is that while nothing can go faster than the speed of light, shadows—being nothing themselves—can. All the laws of physics were designed to describe the behavior of things that are, not things that aren't. I'm paraphrasing. Read the article.

Economics, like physics, is full of shadows. The idea of opportunity cost—the value of the path not chosen—is probably the most important "shadow concept" in economics. What is the value of the job not accepted, or the passed-over pair of shoes? What path would the economy have taken if interest rates had been raised rather than lowered? What laws govern the behavior of worlds that remain unrealized because we chose a different alternative?

Does it matter? Probably not. Economics probably isn't missing a theory of non-phenomena, just as physics isn't really missing a theory of shadows. But as summer begins, and we are able to remove ourselves from the fits and starts of the academic year, it's a good time to take a step back and look at the wider picture, to filter out the noise of the myriad economic models we surround ourselves with every day, and think for a moment about the really important things we've learned and done in the past school year.

There's a concrete way to do this. Once, when I was around eleven years old, I stood in a field in New Hampshire at the camp where I had spent the last three summers. It was a beautiful evening, warm even for a New England July. At the time, I made a conscious effort to try to record in my memory the panorama before me: the shadows of the giant trees as they fell on the lodge, the playing fields, the tennis courts, the shack where the counselors hung out, the gravel road leading to the main gate. I remember little else about that summer, but I can still remember that one scene.

Just as I have forgotten most of that summer, so too will most of us forget a great deal of what we have learned in this past academic year. Now—before it is too late—take a few moments to pick one thing, one detail, that you feel is worth remembering. Then go somewhere and think about it for a few hours. Talk to a friend about it. Write about it. Then get ready for next year—there's a lot more to learn!

Note: Aplia Econ Blog will return in the fall with the new academic year. (Of course, if we see something we feel we just must write about, there might be a post or two in the upcoming months.) Until then, have a great summer!

Postwar Economics

You'd think that wartime devastation would bode ill for the economic prospects of Iraq's most war-torn cities. For example, you might expect that the Japanese cities of Hiroshima and Nagasaki, which were destroyed by nuclear weapons, would have experienced slower than usual economic growth in the decades following World War II.

Surprisingly, though, long-run economic growth is resilient to the damages of war. Edward Miguel and Gerard Roland, economists at UC Berkeley, examined bombing patterns in Vietnam and found that after a generation, the heavily bombed areas shared more or less identical economic indicators with areas subjected to far less or zero bombing.

So what, in particular, might we expect Iraq's postwar economy to look like in another generation? Austan Goolsbee proposes some answers to these questions in his latest New York Times column. Citing the Miguel-Roland study and others, Goolsbee suggests that the devastation of war, in and of itself, will have minimal bearing on Iraq's prospects for economic recovery. Instead, he argues that Iraq's artificial borders pose the biggest threat to prosperity because they force a contentious mix of ethnic and religious groups to live within the same national boundaries. Read Goolsbee's column to learn more about obstacles to economic recovery in post-war Iraq.

1. Miguel and Roland found no links between the intensity of wartime bombardment and long-term economic performance. What comparisons did they make in order to arrive at this conclusion?

2. The absence of a link between wartime devastation and economic stagnation does not suggest that war is "good" for the economy. Sure, spending during wartime and reconstruction can temporarily accelerate growth, but what are the opportunity costs of going to war or rebuilding afterwards? That is, what do nations forgo when they devote resources to war? Here's an archived entry about the costs of war.

3. Wartime destruction may not create long-term obstacles to economic prosperity, but history does raise some red flags about Iraq's borders. Consider the "Artificial States" hypothesis of economists Alberto Alesina, Janina Matuszeski, and William Easterly: National borders that (1) divide ethnic groups into separate countries or (2) appear unusually straight on the map typically enclose lots of internal ethnic and religious conflict. According to the column, what are the differences between natural and artificial borders? How are the post-war economic recoveries of Japan, Europe, and Vietnam consistent with the "Artificial States" hypothesis?

4. Although more straight-edged than some African nations, the British-drawn Iraqi borders surround a volatile mix of ethnic (Kurd and Arab) and religious (Sunni and Shia) divisions. According to Alesina, in what ways do ethnic (or religious) conflicts divert resources from the pursuit of economic prosperity? How is Iraq's mineral wealth likely to affect its internal ethnic and religious strife? Natural resources and governing institutions are two of the many determinants of economic growth. What does the "Artificial States" study suggest about the relative importance of each?

5. Given the evidence from the "Artificial States" study, what policies, if any, might moderate the internal strife of artificial states? Consider migration policies and the constitutional provision of authority among regional and national governments.