Choices, Costs, Horizons and Incentives

Economics, many people think, is about money and finance. Nothing could be farther from the truth.

Which is not to say that economics is not about money and finance – it is about that as well, but you’d be doing economics (and yourself) a disservice if you thought that economics was only about money (and finance).

A larger, more general framework for thinking about economics is to realize that it is about four things that I mentioned in yesterday’s post: choices, incentives, costs and horizons. Of the four, perhaps the one that is most misunderstood is incentives. Yes, incentives can be, and very often are, monetary in nature – but very often is not always.

Tyler Cowen puts it well in his book “Discover Your Inner Economist”:

The central concept of economics is not money but rather incentives. Quite simply, an incentive is anything that motivates human behaviour, or encourages an individual to make one decision rather than another. An incentive can be money, but it can also be a tip, a smile, or an act of praise.

Something that acts as a push for us to do (or not do!) something is all an incentive is – and if you get incentives right, you can get people (including yourself) to do what you want them to.

Incentives, and the way we interpret them, are what help us choose, and that’s the second key concept in economics: it’s a matter of being incentivized to make a particular choice, out of all the alternatives available. Quite often, though, understanding the set of choices itself can become tricky.

Think about this little puzzle (adapted from a truly wonderful book called “Thinking Strategically: The Competitive Edge in Business”, by Avinash Dixit and Barry Nalebuff):

Amar, Akbar and Anthony are three friends who, having quarreled, have decided to settle that quarrel with a shootout. They stand at the three vertices of a triangle, and decide to take turns shooting at each other, one bullet per attempt, until only one person is left standing. Amar will go first, he can shoot at either Akbar or Anthony. Assuming Akbar survives, he’ll go second, and he can shoot at either Amar or Anthony, assuming Anthony is alive, and Anthony will go third. And on and on it will go, in this order, until only one person is alive. Amar is a lousy shot – he shoots with only 10% accuracy. Akbar is pretty good, he’s working with 80% accuracy, while Anthony is just plain lethal – fully 100% accurate.

Now, Amar hires you as a consultant and asks, whom should I shoot?

What would your answer be?

It turns out that Amar’s best option is to shoot in the air (because even if you succeed in killing whoever you aim at, the survivor is left with only Amar to aim at).

The point is: any well informed decision needs two things to begin with: a clear idea of all the choices available, and a clear idea of the incentives involved (“I hate Akbar! I want to kill him!” may be a great incentive, but a higher probability of staying alive is surely the better incentive).

And this applies to everything in life: one helping of desserts or two? (Hint: how about none?). Only one more YouTube video before I get back to completing this blog post, or ten? (How about re-reading “Thinking Strategically” instead?)

The trouble is, our brain isn’t always the best at interpreting incentives correctly, which brings us to the third key concept in economics: horizons. Or, if you have had enough nerd talk for one day, we could also call it the instant gratification monkey problem. Call it what you will, the problem is that we tend to prioritize choices that payoff in the short run, but create problems in the long run. If you’ve ever had that last “one for the road” drink, or ended up actually eating that second dessert (and who hasn’t?), you don’t really need an explanation for this. We tend to choose those options that payoff over the short horizon, and ignore the long term consequences.

And in retrospect, that pounding headache the next morning is really not worth it, or to put it another way, the cost is too high.

Costs are not just monetary in nature, of course, and hangovers are a great way to explain this. You don’t pay any money the next day, but nobody who has experienced one would argue that hangovers are in any way cheap. Worse, costs are almost always a little higher than you think.

The price of the party the night before isn’t just the morning after, but it is also the fact that you could have spent the last evening reading a book, watching a movie, going out for a drive – anything but the party. Not only do you not get to watch that movie (the opportunity cost, as we economists call it), but you also have the goblins drumming away inside your head.

Choices, incentives, horizons and costs.

The truly tricky thing, and this is what makes economics such a worthy endeavour, is that each of these four aren’t understood by all of us in a rational, objective manner. Our brain processes each of these for us in ways that are subject to the way we are raised, the environment in which we are raised, our emotional state at the time of making decisions, and much else besides. Our decision making, predicated on these four concepts, is gloriously uncertain, fickle and inconsistent.

But it is exactly this that makes studying economics such a lot of fun.