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The Sovereign vs. the IdiotWhat kind of gift-giver are you?

By Joel Waldfogel
Posted Tuesday, Dec. 19, 2006, at 12:06 PM ET

Economists generally salute holiday gift-giving for its healthy effect on the macroeconomy. And indeed, gift spending boosts GNP to the tune of $100 billion a year in the United States. But on the microeconomic level, spending on gifts is a resource allocation disaster. Most of the time, people choose purchases for themselves and only buy things that they expect to value at or above the price they pay. With gifts, by contrast, recipients end up with items that givers guess that the recipients might appreciate. Both activities generate spending, but not of equal benefit. The microeconomic question about any spending is, how much satisfaction does it buy?

Economists tend to believe strongly that a person is best off when she makes her own choices rather than, say, when some bureaucrat makes choices for her. When you buy a present for your cousin, you, like that bureaucrat, have to guess at what she wants. Usually, you make your guess based on limited and outdated information. Which means that you are going to buy her less satisfaction, per dollar that you spend, than she would get if she were buying stuff for herself. I don't mean sentimental value, I mean how much she values that sweater or that dartboard or that singing fish. Hence the idea of "consumer sovereignty"—that people should be left alone to make their own decisions without interference from the government.

Many economists have recently come to believe, however, that people are inept decision-makers. They lack self-control. They save too little. They have trouble deciding whether to plan for events that are unlikely to happen. They can't remember what they've liked, and they can't even accurately predict what they'll want next week. Psychologist Daniel Kahneman won a Nobel Prize in 2002 for a career spent documenting the shortcomings of decision-making. His findings raise questions about whether people really are best suited to choose for themselves.

The two competing views of the consumer, the sovereign versus the idiot, suggest very different consequences, efficiency-wise, for gift-giving. According to the traditional sovereign view, gift-giving is likely to generate less satisfaction for recipients than their own purchases. But according to the idiot view, who knows? Maybe givers can choose items that will make recipients happier than their own choices would have.

So, compared with your cousin's own choices, how well do your gifts create satisfaction for her? How about what you buy for your wife or your boyfriend? I started doing surveys to answer this question about a dozen years ago. In the time since, I've asked thousands of college students to tell me about the holiday gifts they received. How much did they think the givers paid? Putting aside sentimental value, how much did they think those gifts were worth to them (specifically, how much money would they demand to be paid to give up each gift?). In the most recent round of surveys in 2002, I also asked people to record the same information—the price they paid and their personal valuation—for items they purchased for themselves.

Here's what I've found. On average, a dollar that people spend for themselves creates nearly 20 percent more satisfaction than a dollar that someone else spends on them. Put another—depressing—way, gift-giving effectively discards 20 percent of the gift's price. So, of the nearly $100 billion spent on holiday gifts each year, one-fifth is effectively flushed down the toilet.

Of course, some gifts end up being worth more to their recipients than their own purchases. Givers who are in daily contact with their recipients produce 10 percent more satisfaction per dollar spent than givers with only yearly contact. So, your gift for your wife or boyfriend will probably give more satisfaction than the one you bought for your aunt who lives across the country. Still, on average across all givers, the satisfaction rate remains a fifth lower for gifts than for a recipient's own purchases. At some level, givers know this, and you can see that in their behavior. The types of givers most likely to give the least valued gifts—aunts, uncles, anyone who isn't in frequent contact with the recipients—are far more likely to beg off choosing particular items. Instead, they tend to give cash or gift certificates. Which, happily, the students I surveyed tended to value at exactly the price the givers paid.

So two cheers for the sovereign consumer. As dumb as people may be, they are still better than others at choosing their own shirts and CDs and perfume. And forget about government as the sole bogeyman of inefficient allocation. Your Aunt Sally is at least as bad as your Uncle Sam.

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