Sunday, December 9, 2012

The Four Ways Money Can Be Spent, By Milton Friedman

In Chapter 4 of his book "Free to Choose" Milton Friedman describes the above matrix that depicts how the relationship between the benefactor and the beneficiary influences the exchange of goods.  Below is the excerpt from the book explaining the matrix:

When you spend, you may spend your own money or someone else's; and you may spend for the benefit of yourself or someone else.  Combining these two pairs of alternatives gives four possibilities summarized in the  following simple table.

Category I in the table refers to your spending your own money on yourself.  You shop in a supermarket, for example. You clearly have a strong incentive both to economize and to get as much value as you can for each dollar you do spend.

Category II refers to your spending your own money on someone else. You shop for Christmas or birthday presents. You have the same incentive to economize as in the first case but not the same incentive to get full value for your money, at least as judged by the tastes of the recipient. You will, of course, want to get something the recipient will like--provided that it also makes the right impression and does not take too much time and effort. (If, indeed, your main objective were to enable the recipient to get as much value as possible per dollar, you would give him cash, converting your Category II spending to Category I spending by him.)

Category III refers to your spending someone else’s money on yourself--lunching on an expense account, for instance. You have no strong incentive to keep down the cost of the lunch, but you do have a strong incentive to get your money’s worth.

Category IV refers to your spending someone else’s money on still another person.  You are paying for someone else’s lunch out of an expense account. You have little incentive either to economize or to try to get your guest the lunch that he will value most highly. However, if you are having lunch with him, so that the lunch is a mixture of Category III and Category IV, you do have a strong incentive to satisfy your own tastes at the sacrifice of his, if necessary.