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Monday, March 21, 2005

If You're Paying, I'll Have Top Sirloin (From Catallarchy)

Patri Friedman over at Catallarchy gives us an example of how "splitting the bill" is a bad way of paying for things:

Suppose the tab is split not at each table but across the 100 diners that evening across all the tables. Now adding the $4 drink and dessert costs only 4¢. Splurging is easy to justify now. In fact you won’t just add a drink and dessert; you’ll upgrade to the steak and add a bottle of wine. Suppose you and everyone else each orders $40 worth of food. The tab for the entire restaurant will be $4000. Divided by the 100 diners, your bill comes to $40. Here is the irony. Like my neighbor at the theater, you’ll get your “fair share.” The stranger at the restaurant a few tables over pays for your meal, but you also help subsidize his. It all “evens out.” But this outcome is a disaster. When you dine alone, you spend $6. The extra $34 of steak and other treats are not worth it. But in competition with the others, you’ve chosen a meal far out of your price range whose enjoyment falls far short of its cost.
Click here for the whole article.

As we tell even our introductory finance students, a similar problem exists with CEOs of large publicly held corporations. IT's the classic Jensen & Meckling problem: they typically hold far less than 5% of the firm's outstanding common stock. So, while they get 100% of the beenfit from a perquisite (like a thick carpet in their office, expensive artwork on their walls, or a membership in the country club) they pay only a fraction of the cost. As a result, they overconsume. Rationally, we should anticipate this, and take steps to make sure that other mechanisms are in place to offset this.

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