In Free to Choose, Milton Friedman described a simple classification of spending. This led to what can loosely be defined as “Friedman’s Law” - The further away actual consumers are from actual spending the less efficient a market will be.
Friedman placed spending into one of four categories. In essence, he created a matrix. On one side is whose money is being spent (yours or someone else’s), and on the other is on whom the money is spent (you or someone else). Thus, the first category is you spending your money on yourself. The second is you spending your money on someone else. The third is you spending someone else’s money on yourself. And finally, the fourth category is you spending someone else’s money on someone else.
A colleague suggested a stellar real-world example to illustrate the various categories: weddings. Imagine a couple getting married. Spending via the first category provides the most efficient wedding. The couple spends their own money on their own wedding. They will most likely be concerned with how each penny is spent, and spend it on the exact wedding they want. Many times, they might decide not to have a wedding at all. They could choose simply to fly to Las Vegas or go to the local justice of the peace.
The second category is a bit less efficient, but not dramatically so. In this “traditional” category, one (or both) of the couple’s parents decides to make them a wedding. The parents will most likely be frugal with their money, but yet spend it on aspects of the wedding that the couple might not choose themselves. This might simply be having the wedding at all. Whereas the couple on their own might decide it is not worth it, having someone else pay might mean a wedding party takes place. The money might be spent carefully, but the value of the money is not necessarily maximized.
In the third category, the parents simply tell the couple they will pay for the wedding. There might be a specific dollar amount, but the premise is still the same – the incentive to economize is decreased. However, it is not quite a total loss of efficiency as the couple will most likely get good value for the money by spending it on the aspects of the wedding most important to them.
The last category is the least efficient. A wedding planner is hired to make a wedding. Other than a potential total budget number, the wedding planner is not incented to spend wisely. Further, aside from some potential consultations, it is unlikely that the money will be spent to maximize the value to the couple. The wedding planner might be influenced by kickbacks and other external economic drivers. Their ultimate goal is likely to end up on reality television, and the best means is to spend as much money as possible on as lavish a reception as can be conceived.
Friedman’s Law can, of course, be applied to any industry. An industry dominated by category three or four spending is likely to be wrought with inefficiencies and saddled with excessively high prices. Three prime examples are health care, higher education, and auto body repair. In all three, the consumer is rarely directly paying for the goods and services received, and also not necessarily choosing which goods and services are received.
As it applies to government spending…