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In addition to watching what consumers do well, it is also useful to pay attention to what they do wrong. Among the many kinds of mistakes that people make, one class is of particular concern - self-interest sometimes leads people to do the wrong thing. In theory, that's not supposed to happen in a free market. One of the most famous quotes in economics comes from Adam Smith in the Wealth of Nations:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.... [H]e intends only his own gain, and he is in this ... led by an invisible hand to promote an end which was no part o f his intention.

There is a view that if everyone were to follow his or her own self-interest, the outcome would be the best for society. While that is true in some cases, Smith's invisible hand has a limited span. The problem is that there are all sorts of actions that have consequences to others that don’t get priced in the market, Economists call these negative externalities. For example, if you buy The Club to deter auto theft and all this action does is send the thief to the next car, then the price of The Club doesn't reflect its value to society (which is zero).

And it isn't just consumers who make mistakes. As we'll see in the example of video rental pricing (Blockbuster Blocks the Pain), sellers sometimes take actions that benefit themselves less than they hurt consumers. Looking for inefficient behavior by buyers or sellers is a system­atic way both to identify problems and to solve them. We can iden­tify problems by looking for behaviors that create an external harm that is greater than the internal benefit. Or to put it more plainly, the trick is to look at some choice that buyers or sellers make whereby the decision maker's benefit from the choice is less than the costs that it imposes on others.

The general problem is one of misguided or missing incentives. But the good news is that there is a simple and powerful idea about how to improve defective incentives: internalization. The problem is that the buyer or seller doesn't take into account the external costs of his or her decision making. So the solution is to internalize those external effects. In other words, if the decision maker is made to "feel your pain," she will end up doing the right thing.

There's an old joke about two hikers walking through the woods. They come upon a hungry-looking bear. One of the hikers starts to put on his running shoes. The other hiker says, "You can't outrun a bear." To which the first hiker replies, "I don't need to. I only need to outrun you."

Of course, this joke is all about the negative externality that can be created when one person takes precautions to avoid being a victim. Sometimes the primary impact doesn't reduce crime but merely shifts it to someone else.

Why Lojack Scares Thieves (and The Club Doesn't). Think about car alarms and burglar alarms. People have an incentive to buy too many of these crime-shifting activities because an individual doesn't feel the pain when the criminal or the b ear goes down the street and victimizes someone else.

Not all victim precautions have this unfortunate side effect. Alarms that silently alert the police don't cause burglars to switch houses, because the intruders don't learn about the precaution un­til the police arrive to arrest them. This is in sharp contrast to put­ting bars on your windows, which potential thieves can observe before starting a job.

Silent house alarms and other types of hidden precautions can create a positive externality. If 20 percent of the houses in a city have silent alarms, thieves may be generally reluctant to break into any house-including unprotected ones-because they can't be sure which ones have a silent alarm.

This is not just a nice theory. One of us (Ian), with Steve Levitt of the University of Chicago, found that installing concealed Lojack car transmitters had a dramatic impact on reducing the overall amount of auto theft. Lojack transmits a signal that lets police track a stolen car, but because it is hidden, potential thieves can't distinguish the protected cars from the unprotected ones. Ayres and Levitt found that investing $400 in Lojack reduces other peo­ple's expected auto theft loss by more than $4,000.

Lojack is particularly good at deterring professional car thieves. If only 3 percent of the cars in a city have Lojack, then a professional who boosts fifty cars a year suddenly has a 78 percent chance of encountering one. If the thief takes a hundred cars, the probability rises to 95 percent. A little bit of Lojack goes a long way toward discovering and deterring auto-theft rings. Lojack has busted up more than sixty chop shops in Los Angeles alone-thus helping not just the Lojack owner but the owners of all the other cars in the shop and all those that would be in the shop the next week.

So think for a moment what all this means for car owners' incentives to buy Lojack instead of The Club. The Club, like outrunning the other hiker, merely shifts crime to non-Club owners. Lojack helps other people; The Club hurts other people. The problem is that individual car owners have no economic incentives to take these opposite, spillover effects into account when choosing which device to purchase. People buy too many Clubs and not enough Lojacks.

Can you see how internalization could be used to solve this problem? Somehow we have to increase the price of The Club so that its buyers feel the pain of the deflected crime, and we have to reduce the price of Lojack so that its buyers share the benefits they provide to others. How could this be done?

One answer would be to turn to government. The government could impose a tax on crime-shifting precautions and subsidize hidden precautions like Lojack. Massachusetts does this by man­dating that insurance companies give a 25 percent discount on theft insurance for cars that have Lojack. Not surprisingly, Boston has a higher proportion of cars with Lojack than any other city in the United States, and Ayres and Levitt showed that Lojack caused Boston auto theft to drop by about 50 percent.

But do we really need a government mandate? What private en­tity might help consumers internalize these two very different spillover effects? Insurance companies are a natural answer because they directly feel the spillover effects. If an Allstate customer uses The Club, Allstate will most likely have to pay out less to that customer for auto theft. The customer's use of this device, however, increases the likely amount that Allstate will have to pay out to its other customers As the thief simply moves down the road. In contrast, if the customer buys a Lojack, Allstate saves money on the amount it has to pay out to all the rest of its customers. So instead of having Massachusetts mandate a subsidy of Lojack, why not just have insurers voluntarily set insurance prices that give the right incentives?

We've posed this question to several insurers, and their answers were disappointing at best. One explanation for their inaction is the lazy monopolist model. While the insurance companies have the claims data and plenty of actuaries to calculate the magnitude of the spillover effects, they profess absolutely no interest in learning about the ways in which one customer's actions affect another customer's losses.

But there is a subtler reason that insurance companies don't give the appropriate subsidies, and it, too, is an externality story. The largest insurance company in any city controls only about 20 percent of the market. This means that most of the external effect of Lojack or The Club is going to fall on other insurance companies.

The same externality problem that distorts customer incentives plays out at the insurance level as well. An individual insurance company captures, at most, only 20 percent of the benefits of Lojack and thus does not have sufficient incentive to subsidize its use. Indeed, an insurance company may even want to raise its rivals' payouts. If Allstate got all its customers to buy Lojack, its rivals' payouts for auto theft would decline. Conversely, if Allstate got all its customers to buy crime-shifting devices, then the cost of auto theft would be concentrated on Allstate's rivals, driving up their cost of doing business.

That said, we'll stick with the lazy incumbent model. The spill­over benefits of Lojack are so large that even if a firm captured only 20 percent of the benefits, that would be plenty. Recall that a $400 investment in Lojack leads to a $4,000 fall in car thefts; 20 percent of the gains is $800. A large insurance firm has plenty incentive to encourage Lojack usage all on its own .6

Blockbuster Blocks the Pain. Not so long ago, Blockbuster's customer-relations strategy was "managed dissatisfaction." The stores were frequently_ out of the most recently released hit video. You often had to reserve the new release in advance and could rent it for only one night. But now, Blockbuster offers a guarantee that it will have the newly released video in stock and rentals are for two days . What happened?

Blockbuster found a way to solve a serious incentive problem and improved its business in the process. Let's start with the source of the incentive problem. The studio has a movie that has finished its theatrical release and TV pay-per-view tour and is ready to debut in the video rental stores. How should it set the price?

If the studio charges a low price, then Blockbuster will buy plenty of tapes. But it's Blockbuster, rather than the studio, that makes all the money.

Figuring that a hit video will be rented out some thirty to fifty times, studios used to charge Blockbuster around $65 for a new release. (A month or so after Blockbuster bought its supply at 565, the studios would then cut the price to $20 to promote retail sales.)

The high price made Blockbuster very cautious about which videos to buy and how many copies to hold. While empty shelves led to customer dissatisfaction, people often rented something else in place of the new release they wanted. It was better to have new releases be frequently out of stock than to buy extra copies at $65 a pop.

Incentive problems exist when the two players don't have the same objective-when the two parties don't feel each other's pain. The studios didn't feel the hurt when customers couldn't find their desired movie, and they didn't feel Blockbuster's pain when the movie sat on the shelf and didn't go out enough to earn back its price.

The studios simply wanted the video stores to stock up. Once the stores bought a movie, the studios didn't care how often the movie was either rented or out of stock. Meanwhile, the video stores were forced to play a tight inventory management game in order not to give away too much to the studios.

The result? Too few movies on the shelves, and unhappy cus­tomers. Predictions abounded that Blockbuster would be made ob­solete by pay-per-view cable-and good riddance.

Before we flip over the cards and reveal how the studios and Blockbuster solaced this problem, think about what it would take to get them to have a shared objective. Look again at the incentive problem. The studios wanted Blockbuster to take all the risk and pay its share of the rental profits all up front. The Wall Street journal describes how the new CEO at Blockbuster (John Antioco) addressed the problem:

Mr. Antioco knew from his experience as a customer the frustrations of Blockbuster stores.... One of Mr. Antioco's first moves as CEO was to persuade studios to change their video-supply deals to make it easier for Blockbuster to stock many copies of new-release movies. Blockbuster's revenue skyrocketed so much immediately afterward that Mr. Redstone, on seeing the figures in his New York office, joked to an associate that his computer must have been broken.'

What was the solution? The incentive problem was resolved when Blockbuster and the studios agreed on a revenue-sharing deal. Under this scheme, Blockbuster got to buy tapes at a much discounted price. In exchange, the video chain gave up to 40 per­cent of the rental revenue back to the studio.

These deals also specified that Blockbuster had to take every movie the studio released on video, and the studios sometimes dic­tated the quantities. So, not only did the studios get potentially more money, they also got to push mediocre movies.

This practice was great for Blockbuster and the studios, but not for smaller stores. They used to be able to count on customers who didn't find (or even expect to find) the current hit at Blockbuster coming to them for their deeper and more idiosyncratic inventory.

The Film Is in the Mail: The Netflix business model is itself worthy of a why-not Netflix is a mail­order version of a for-profit lending library-but for DVDs, not books. You pay Netflix $19.95 per month. For that fee, you can have three DVDs checked out at any time. When you're done with a movie, you mail it back to Netflix, and it will mail you the next film you want to see. The postage is on the company, and you never pay late fees (or what Blockbuster euphemistically calls "extended rental charges").

Three years into its rental exchange model, Netflix broke the million­member mark. While this is an intriguing mail-order business, the rental exchange idea might be even better for a bricks-and-mortar store. If an aver­age customer rents five movies a month and round-trip postage and mailer costs are $2, that means 50 percent of the company's revenue is going to cover postage. Thus it shouldn't be too surprising that Blockbuster and Wal*Mart have both entered the rental exchange business. Now, though, people simply turn to Blockbuster, and the independents are finding it tough to compete.

It's worth noting that the revenue sharing was not extended to DVDs. The average purchase price was low enough, around $20, that Blockbuster decided to forgo the revenue sharing in favor of straight buy and rent. Perhaps this was because the other provisions of the deal ("You also have to buy one hundred copies of The Adventures of Pluto Nash") were too onerous. The studios do have a revenue-sharing arrangement with Netflix, the largest online DVD rental company, and revenue sharing is the standard practice with the movie cinemas.

The take-home lesson of Blockbuster is that there can be great payoffs to asking whether you're feeling other people's pain. Ignoring others' interests leads to inefficient decisions. The result can be worse for them and for you. The solution comes from designing incentives so that all parties more fully feel the impacts that their decisions have on each other.

Creativity requires spending time "doing nothing" - workaholism guarantees its death

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