Have you ever noticed that you become much more careful when you are spending your own money?
Economist Milton Friedman captured this idea with a simple framework: there are essentially four ways to spend money, and each one creates very different incentives.
1. You spend your own money on yourself
Imagine buying a laptop with your own $1,500.
You care about everything.
Is it worth the price?
Can you find it cheaper?
Is the quality good?
Will it last?
Because you are paying and you are receiving the benefit, you have a strong incentive to get the best possible value.
You care about both price and quality.
2. You spend your own money on someone else
Now imagine buying a wedding gift.
You still care about the price because the money is coming out of your pocket.
But you may not spend hours researching whether the recipient is getting the absolute best possible product.
You might simply think:
“I want to spend around $100. What is a nice gift?”
Here, you tend to care strongly about price, but somewhat less about maximizing the benefit to the recipient.
3. You spend someone else’s money on yourself
Now suppose your employer is paying for your hotel during a business trip.
Suddenly, price becomes less important.
The $350 hotel might look much more attractive than the perfectly adequate $190 hotel across the street.
Why?
Because you receive the comfort, while someone else receives the bill.
You care about quality, but you have much less incentive to worry about price.
This is why expense accounts can produce very different spending behavior from personal credit cards.
4. You spend someone else’s money on someone else
This is the most interesting category.
Suppose you are given $10 million of taxpayer money to run a public program.
The money is not yours.
And the services being purchased are not primarily for you.
That means the person making the spending decision may feel neither the full cost of overspending nor the full benefit of finding the best deal.
This creates the weakest natural incentive to control either price or quality.
And this was the larger point Friedman was trying to make about government spending.
A government official is often spending:
someone else’s money on someone else.
The Incentive Problem
The four situations can be summarized very simply:
Your money + yourself:
You care about price and quality.
Your money + someone else:
You care mostly about price.
Someone else’s money + yourself:
You care mostly about quality.
Someone else’s money + someone else:
You have the weakest incentive to care about either.
This does not mean that government employees, corporate managers, or nonprofit workers are automatically careless.
It means that the incentives are different.
That is why governments and large organizations create budgets, audits, competitive bidding, purchasing rules, oversight committees, and performance measurements. They are trying to recreate some of the discipline that comes naturally when a person is spending his or her own money.
The Bigger Lesson
The real issue is not simply whether spending is public or private.
It is the distance between three people:
the person paying,
the person making the decision,
and the person receiving the benefit.
The farther apart those three people become, the weaker the natural pressure to spend money efficiently.
That is why the same problem can appear in government agencies, corporations, universities, nonprofits, insurance systems, and even family finances.
When the person choosing is also the person paying, every dollar feels real.
When somebody else is paying, suddenly the expensive option becomes much easier to justify.
Perhaps one of the simplest rules of economics is also one of the most powerful:
People spend their own money much more carefully than they spend yours.
