The economics of despair

By Megan McArdle

This is the second piece that I've read on Charles Karelis' new book, The Persistence of Poverty. Steven Pearlstein describes it thus:

The reason the poor are poor is that they are more likely to not finish school, not work, not save, and get hooked on drugs and alcohol and run afoul of the law. Liberals tend to blame it on history (slavery) or lack of opportunity (poor schools, discrimination), while conservatives blame government (welfare) and personal failings (lack of discipline), but both sides agree that these behaviors are so contrary to self-interest that they must be irrational.

After all, the reason we study, work, save and generally behave ourselves is that these behaviors allow us to earn more money, and more money will improve our lives. And, by logic, that must be particularly true of the poor, for whom each extra dollar to be earned or saved for a rainy day is surely more valuable than it is for, say, Bill Gates.

In economics, this insight -- that the fifth ice cream sundae is less valuable than the first one -- is enshrined in the law of diminishing marginal utility.

But what if this iron law of economics is wrong? What if it doesn't apply at every point along the income scale? If you and everyone around you are desperately poor, maybe it's perfectly rational to think that an extra dollar or two won't make much of a difference in reducing your misery. Or that you won't be able to "study" your way out of the ghetto. Or that if you find a $100 bill on the street, maybe it's logical to blow it on one great night on the town rather than portion it out a dollar a day for 100 days.

Tyler Cowen's description is a little more pithy:

If your car has lots of scratches and dents, getting rid of just one doesn't help much either.

There's a lot of interesting literature on the bad incentives faced by the poor. They often have punitively high marginal tax rates, because of the lost benefits; they also face a high personal "tax" in the form of poor relatives and friends, since earning additional money makes it very likely that they will be tapped for loans and other forms of financial help. This already explains a lot of the behavior that Pearlstein describes, as do various sociological phenomena.

But I find this thesis intriguing. One way to think about it is that the poor face a lot of problems with threshold effects. If I need an apartment and a car, and I have the down payment for a Hyundai and a basement efficiency, each additional dollar improves my lot. If I need an apartment and a car, and I have $30, I might as well spend that $30 on dinner and a movie, because I'm going to end up on Mom's couch tonight either way. Once you reach the threshhold, it's easy to make a straight tradeoff between two forms of utility. But if it's going to take you nine months to save the cash you need, your choice right now becomes fun, or none.

Another way to think about it is that if you are living on the edge, this lowers, rather than raises, the returns to planning. If there's a 50% chance that an unforeseen expense will force you into bankruptcy, why not load up on some credit card debt and have fun while you can?

I'm not convinced . . . but I've added it to my Amazon queue.

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