It's that time of year when lots of people are giving to various charities, and I've been thinking about, if I decided to give, how I would decide. My mental economic model for businesses is that businesses engage in trade. Trade is the exchange of one thing for a more valuable thing. On both sides. From that I've tried to build a model for charities and philanthropy.
Economics of trade
Suppose you (running a business) have a sandwich that you're selling for $2. It's very likely that the sandwich is worth less than $2 to you. If it was worth more than $2, you'd rather keep the sandwich, so you wouldn't be selling it. So let's say it's worth $1 to you. Now suppose I have $2 and decide to buy a sandwich from you. It's very likely that the sandwich is worth more than $2 to me. If it was worth less than $2, I'd rather keep $2 than buy the sandwich. So let's say it's worth $3 to me. Both of us have chosen to trade something less valuable for something more valuable. Before the trade, the sum total of what we had was $1 (your sandwich) + $2 (my money) = $3. After the trade, we have $2 (your money) + $3 (my sandwich) = $5. Trades generate value out of thin air. The world is now $2 richer because of this trade. Free markets make for wealthy countries because people aren't prevented from trading.
Model for Gifts
If you think about trades, they work because both sides have the right incentives. When they both choose to trade, the world is better off. When either chooses not to trade, there's no harm done. Yes, there are some cases where the world is better off if they trade, but they don't both choose to trade, but in those situations a change in price will enable the trade, and both will end up benefiting.
With giving gifts, not only charities but also Christmas gifts, birthday gifts, etc., the person paying and the person receiving the sandwich are not the same. It's much harder to ensure that the trade is actually increasing wealth in the world. Suppose I buy you a sandwich, and I paid $2 for it. I don't know how much it's worth to you. You could say that it's worth $5 to you, but since it's not your money on the line, there's no incentive for you to say the true value. Suppose it's worth nothing to you. So before the trade, the seller has $1 (sandwich), I have $2 (money), and you have $0, a total of $3. After the trade, the seller has $2 (money), I have $0, and you have $0 (sandwich), a total of $2.
Gift giving opens up the possibility that a trade makes the world worse off economically. There are other reasons to give gifts of course, but just keep in mind that economically they're not so good.
Christmas and Birthday gifts are rare; the most common source of economic loss from giving is kids (and to a lesser extent, spouses). Kids might say they really want the $150 pair of shoes, but since they're not the ones working 20 extra hours to buy those shoes, they have no incentive not to make the trade. They make that sad face, or whine, or tell you that all their friends have those shoes, or nag you a great deal. They know how to manipulate parents. Lots and lots of inefficient trades are made by or for kids, causing parents to struggle to make ends meet.
These inefficient trades also can occur with charities. If you're giving to a charity and they “do good” with that money, you don't know whether what they did was worth more than what you gave. You end up judging based on how good it makes you feel, which means charities have an incentive to make you feel good, through special events (seeing lots of people involved in a “special event” makes you much more likely to give money), pictures of needy people (seeing a few people makes that emotional connection that you don't get if you read about helping millions), and other tactics. My view of charities, until recently, has been that there's a high potential for inefficiency and emotional manipulation, just as with kids. I've been trying to form a model that would help me make decisions about whether to give, and to whom, that isn't just to make me feel good, but something that will actually do good.
There's something I left out of the model of trades. There's more than just the two parties involved. Maybe the business polluted to make that sandwich. Maybe I littered instead of throwing the sandwich wrapper away. The trade didn't take into account these “externalities” — effects on the rest f the world outside the seller and the buyer.
The standard solution to this is to estimate those effects and charge people for them. Let's take an extreme example, with $5 of pollution for a sandwich. (I think this is extreme for sandwiches but there are probably other industries for which it's reasonable to say the damage to the environment is higher than the value of the product.) Before the trade, there was $1 (your sandwich) + $2 (my money) + $5 (rest of world) = $8, and after the trade there was $2 (your money) + $3 (my sandwich) + $0 (rest of world) = $5. Although the seller and buyer are better off, the trade made the world worse. If we could charge the seller $5 for polluting, the price of the sandwich would be $7 instead of $2. And at $7, I wouldn't buy the sandwich, since it's only worth $3 to me. The trade would be stopped, which is just what we wanted here. To make money, the business needs to figure out how to reduce pollution.
I like the charging-for-pollution solution better than laws against pollution, or trade-and-cap systems (I'll have to make another post about that). With a law, the business's incentive is to fight the law, doing as little as possible, because they still make more money if they pollute. Whereas with charging, the businesses makes more money by not pollution. Since profit motivates business, I want the system to give more profit when the business pollutes less. However it's often impractical to measure the impact of pollution, and that's why we have simplistic black-and-white laws in place.
Model for Philanthropy
We have this artificial line between business and charity. We even call the charities “non-profits”, to distinguish them from businesses (even though some businesses don't make a profit). And there's the sense that charities do good for the world and businesses are bad. I think the world is more complicated than that. There's a whole set of potential projects that have both business and philanthropic aspects. For example, microfinance can generate profits and help lots of people at the same time. Tesla Motors might not ever make money, but it could jump-start the market for cleaner cars. Neither counts as a charity; you're not just handing out money. But there's the potential for it to do more good than a charity. The tax laws in the U.S. encourage giving to charity over investing in a “socially reponsible” business that does good things for the world.
If I'm going to do something with money that I don't need, I want to put it into a place that gives the highest return on investment. But in the case of philanthropy, in that return I need to consider not only what I get back, but also what good it does for the world. Externalities are a way of looking at this. Normally an externality is something negative. But there are also positive externalities. If I invested in a business that makes less profit than other businesses, but generates a lot of good in the world, that's a positive externality. The return on investment for me might be low, but the return to the world could be high. Whether it's classified as an investment or a charity isn't relevant (except there are tax implications that affect the return on investment); I want to find things that have a high rate of return. There's also regular shopping. Just as I might avoid “sweatshop“ products, I might favor products that have positive externalities.
Unfortunately, I haven't found much that can guide me to high-return philanthropy. Businesses report cost and revenue but not externalities. Charities report costs and donations but not the effects they have. I started following GiveWell a while ago because they seemed to be the only ones that came even close to what I was looking for. I was pleased to see they got mainstream press recently. They tend to pick things that are more tangible, and they seem to consider “saving lives” separately from economic benefit, but in general I like what they're saying and doing. I like that they focus on benefits more than cost efficiency, and they're trying to compare different approaches to see what's most effective. I'm also following Acumen Fund, which tries to help people through investments rather than charity.
Businesses looking for customers use emotions, marketing, sales tactics, and they come to you. When they get investors they use numbers, and you tend to go to them. I want to see the numbers side of philanthropic organizations. I don't want them contacting me to tell me how they're “doing good”. I assume almost all of them are doing good. What I'm really trying to decide, by building an economic model, is where to invest. It may be giving to a charity; it may be investing in a business; it may be buying products. It'll probably be all three. The main problem I see is that there isn't enough information, for businesses or charities, and that there's this artificial line drawn between the two. There should be a unified way of thinking about business and charity that finds the best of both, and allows for new types of organizations that don't fit into the current system. Good information about externalities would change the world.