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Substitution Effects

There are many distinguishing features of those persons who have mastered the economic way of thinking, including an awareness of “substitution effects” – the topic of my latest column for AIER. A slice:

Named after University of Chicago economist Sam Peltzman, the Peltzman effect occurs when the changing riskiness of engaging in some activity causes people to change their behavior in ways that offset, partially or fully, the change in riskiness.

My late, great George Mason University colleague Gordon Tullock offered what is perhaps the most vivid example of the Peltzman effect. Gordon famously observed that government could, without outlawing driving, immediately reduce the number of traffic fatalities to near-zero by taking just one simple step, namely, mandate that a steel dagger be fitted onto every steering column and pointed at each driver’s heart. Outfitting automobiles with these daggers would so raise the riskiness of driving that less driving would occur, and that which did occur would be done with the utmost care.

The beauty of Gordon’s steel-dagger hypothetical is that, in its vividness, it serves as a springboard for revealing what is equally true, but less obvious, for lesser and more realistic changes in risk. While everyone sees that drivers drive less cautiously without daggers pointed at their hearts than with the daggers installed, too few people naturally see that drivers also drive less cautiously when other, more modest improvements in automobile safety are put in place. The steel-dagger hypothetical positions the economist to ask: “If making driving more safe by removing steel daggers will cause drivers to drive less cautiously, won’t making driving more safe by, say, installing shoulder harnesses and airbags have a similar effect on drivers?” I can attest from many years of using this example with my undergraduate students that the point is made effectively.

And the point here is not that technology or government regulation that reduces the risk of serious injury while driving is a bad idea. Instead, the point is that, because of substitution effects, we should always be aware that outcomes quite different from those that seem most obvious are possible. Mandating greater automobile safety might reduce traffic fatalities. Or it might not — or not by enough to justify the cost of the additional safety.

Society abounds with substitution effects. In our daily lives we routinely do such substitutions without thinking about them, as when the child buys more M&Ms after the price of gummy bears increases, and when the homeowner personally installs her new electrical outlet when the price of hiring a professional electrician rises. Unfortunately, the reality of substitution effects is too often ignored by politicians and regulators, as when they raise minimum wages under the mistaken assumption that ‘rich’ companies will respond by doing nothing other than pay the higher wages by dipping into their cash reserves.