The Dumbest Economic Claim Ever? Christmas Edition

Joel Waldfogel’s article “The Deadweight Loss of Christmas”, published in 1993 in the American Economic Review, is a good example of the kind of contributions that have earned economics its reputation of being the “dismal science”. In this paper, Waldfogel argues that the tradition of giving gifts at Christmas leads to an inefficient allocation of resources. The deadweight loss entailed by gift-giving can be straightforwardly spotted on by simple microeconomic reasoning. That suggests that everything else equals, it would be better to give gifts in cash rather than in kinds. At first sight, this claim will strike most as being absurd. More than the reasoning itself, what sounds absurd is the underlying hypothesis that Christmas traditions have anything to do with efficiency. But of course, the fact that this assumption is counterintuitive does not mean that it is irrelevant, nor that the claim about inefficiency is false. Moreover, the reasoning may also be extended to other contexts, such as for instance when governments make in-kind transfers. So, what can we say about the normative implications of Walfdogel’s microeconomic argument? Let start by sketching it briefly.

We have a situation with two agents, a gift-giver G, and a gift-recipient R. We should consider the effect on R’s welfare that results from G giving a gift in kinds instead of a gift in cash. We can do this based on simple graphical reasoning using indifference curves.

The horizontal axis represents the amount of gift good X. Its price is denoted Px. The vertical axis represents the amount of all other goods Y, setting the unit price Py = 1, so that Y is equivalent to money. Before receiving the gift, R is consuming basket I located on indifference curve U1. Suppose that G gives a$ as a gift-in-cash. R’s budget constraint moves from aa’ to cc’. As a result, R now consumes basket III, located on indifference curve U3. Note that part (but not all!) of the a$ are used by R to consume more X. Suppose instead that the gift consists of only the gift good X, for the same monetary value a$. Hence, R receives a/px units of X. R again arrives on budget constraint cc’, but this time at III, which is located on indifference curve U2. It follows that R would prefer to receive the gift in cash than in kind. The inefficiency of the gift in kind can be precisely measured by writing the hypothetical budget constraint bb’ which is tangent to U2. The gap between b and c on the vertical axis represents the deadweight loss of giving a gift in kind instead of cash. The distance ac indeed represents the minimal expenditure to increase R’s utility from U1 to U3, or in other words R’s willingness to pay to go from I to III. The distance ab represents the minimal expenditure to increase R’s utility from U1 to U2. In other words, R’s willingness to pay for the gift in kind is inferior to its cost (measured by ac). The distance bc is thus the loss of value generated by the Christmas tradition of making gifts in kind.[1]

There is nothing to say about the logic of this microeconomic reasoning. If R’s preferences are convex (i.e., X and Y are imperfect substitutes), R will want to use any supplementary budgetary resources to consume an additional mix of X and Y. If G’s gift only consists in X, he forces R to allocate all the additional resources to X, against what she would prefer to do.

That said, we need to make a bunch of assumptions to jump from this microeconomic result to the normative conclusion that at Christmas, it would be better to give gifts in cash. I will briefly review them.

Assumption 1: R’s preferences are monotonic and uniquely defined over the (X, Y) space of baskets of goods.

That implies that R prefers to consume more than less (why not!) but more significantly that she doesn’t care about the mechanism that allocates the goods to her. More concretely, R is indifferent about what the fact of receiving gifts in kind at Christmas may signal. Moreover, she has no interest in being surprised by what she receives. Most persons’ actual preferences are different: everything else equals, we tend to give meaning to the fact of receiving a gift in kind.

Assumption 2: G’s preferences are not normatively relevant.

We have focused on the effect of gift-giving on R’s utility. But of course, G may prefer to give a gift in kind than a gift in cash. That does not eliminate the possible deadweight loss on the recipient’s end, but it can more than compensate for it. I would conjecture that most persons find giving gifts in cash boring and uninspiring. But there are opportunity costs in giving gifts in kind, e.g., the time spent finding the appropriate gift. So, the implications of relaxing this assumption are mixed.

Assumption 3: R perfectly knows her preferences or is more informed than G about them.

See footnote 1. This is probably not universally true.

Assumption 4: Preference-satisfaction is the only thing that normatively matters.

To bridge the above microeconomic result with the intended normative conclusion we need to assume that welfarism is true, i.e., that social welfare is only a function of individual utility, and that social welfare is the only relevant normative criterion when comparing different alternatives. Most economists are welfarists when normative issues are at stake. But welfarism is doubtful. It is incompatible with the fact of granting normative importance to other values, like freedom for instance. And, in the present case, it is oblivious to the important role of traditions in fostering the sense of community, in sustaining family relationships, and other non-individualist considerations.

It might be answered that the fact that many persons sell the gifts they received the day after Christmas is an indication that the practice of gift-giving is indeed inefficient. True. But that doesn’t change the fact that economic efficiency is only one normative consideration among several other relevant ones. And also, that signals that the inefficiency of this practice is less concerning in a market economy than in any other economic system. After all, we can safely give gifts, be assured that in case it leads to inefficiency, market mechanisms will correct the failures the day after! A happy conclusion for this Christmas Eve!

Merry Christmas!

---

[1] Waldfogel points out that the size of the deadweight loss depends on the comparative degree of information that G and R have on R’s preferences. If R perfectly knows her preferences, the deadweight loss will be maximal. If however G is better informed than R, a gift in kind may create value!