Shopping is in the air at this time of year. Gift-givers hope their presents will hit the target — that is, the gift is something the recipient really wants and would have bought for themselves given sufficient finances and opportunity.
An economist would rate this purchase at an optimal level of economic efficiency. But if the gift is not really something the recipient wanted, then the gift did not bring as much pleasure as it might have. That is, the money was not spent as efficiently or productively as it could have been.
Milton Friedman, winner of the 1976 Nobel Prize in Economics, looked at the efficiency of personal spending in his book Free to Choose. In a simple but elegant diagram, he listed four ways to spend money: 1) spending your own money on yourself; 2) spending your own money on someone else; 3) spending someone else’s money on yourself; 4) spending someone else’s money on someone else.
Spending your own money on yourself: Here, you have the strongest incentive to economize and to get the highest value. When ordering dinner in a restaurant, only you can really decide if the extra cost of a higher-priced meal is really worth it. Only you can make the call as to whether you would rather spend $100 on a steak dinner or $20 on something cheaper, saving $80 for the future
Spending your own money on somebody else: This is what most of us are doing right now during the holiday season. We have the same incentive to economize but not the same knowledge of what recipients would do with the money if they were spending it on themselves. It explains why so many gifts are returned or exchanged after Christmas. Theoretically, gift cards would yield greater efficiency — but gift cards are not nearly as much fun for the giver!
Spending someone else’s money on yourself: The classic example is buying lunch on an expense account. You have a strong incentive to get your money’s worth but not to economize.
Spending someone else’s money on someone else: This method has the weakest incentive to economize or get the best value. This, unfortunately, probably explains why many government programs are not very efficient. Politicians are spending other people’s money — that is, taxpayers’ money — buying things they think are best for the country (theoretically, at least).
So how efficient is holiday spending? At least it earns second place in terms of economizing!
Steve Huxley is the chief investment strategist forAsset Dedication.