Commoditize Your Complements

I wrote about a post written by Joel Spolsky last year, and one of the many positive externalities positive spillovers of writing on this blog has been the fact that I’ve gotten to know about Joel and his writing. It is a positive treasure trove, and well worth dipping into.

But the reason I’m writing about him today is because I originally meant to write a post on a recent Ben Thompson post (AI and the Big Five). While going over that article and taking notes, I came across a reference to an old article written by Joel:

Once again: demand for a product increases when the price of its complements decreases. In general, a company’s strategic interest is going to be to get the price of their complements as low as possible. The lowest theoretically sustainable price would be the “commodity price” — the price that arises when you have a bunch of competitors offering indistinguishable goods. So, smart companies try to commoditize their products’ complements. If you can do this, demand for your product will increase and you will be able to charge more and make more.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

I found parts of the write-up mysterious, because I’m not familiar with both the firms and the products that have been spoken about in it. Partly a function of I not knowing enough about the tech world, and partly a function of the article itself being quite old (Transmeta, Ximian, Gnome are examples, of you are wondering).

But the core insight from the article? Both spot on, and an excellent example of a TMKK in a into class about micro.

What is the core insight? A simple, almost throwaway line in micro classes:

All other things constant, the demand for a product will go up when the price of the complement goes down

And we’ve all gone through examples of how “the demand for tea will go up when the price of sugar comes down”. But consider this instead:

When IBM designed the PC architecture, they used off-the-shelf parts instead of custom parts, and they carefully documented the interfaces between the parts in the (revolutionary) IBM-PC Technical Reference Manual. Why? So that other manufacturers could join the party. As long as you match the interface, you can be used in PCs. IBM’s goal was to commoditize the add-in market, which is a complement of the PC market, and they did this quite successfully. Within a short time scrillions of companies sprung up offering memory cards, hard drives, graphics cards, printers, etc. Cheap add-ins meant more demand for PCs.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

Why did this matter to Microsoft? That is, why would they want to ensure cheap add-ins (complements) for PC’s, so that the demand for PC’s (the product) go up? They didn’t actually manufacture the PC’s back then, so how were they profiting?

Microsoft’s goal was to commoditize the PC market. Very soon the PC itself was basically a commodity, with ever decreasing prices, consistently increasing power, and fierce margins that make it extremely hard to make a profit. The low prices, of course, increase demand. Increased demand for PCs meant increased demand for their complement, MS-DOS. All else being equal, the greater the demand for a product, the more money it makes for you. And that’s why Bill Gates can buy Sweden and you can’t.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

As always, do read the rest of Joel’s write-up, please.

Homework:

  1. What examples can you think of where this lesson has been applied in a modern context? Software or otherwise.
  2. How can those of us in the education sector think about the applicability of this lesson?
  3. Industrial organization remains an underrated subject. Discuss.

Sharmaji ka beta, the global edition

Why is it bad to be rich?

Navin asked this question on Twitter recently:

(My thanks to Mihir Mahajan for pointing the tweet out to me, and for requesting for a post on this topic)

My current plan is to answer this question over three posts. In today’s post, I’ll try and answer this question using a first principles approach. That is, without using Google, or ChatGPT3, or my notes and references, I’ll answer this question using nothing more than what I think are the basic, foundational principles of economics.

In tomorrow’s post, I’ll trawl through the internet (and make use of ChatGPT3), and throw in articles/blog posts I’ve bookmarked over the years that speak to this point. And finally, in the post the day after tomorrow, I’ll speak about books you might want to read about this topic.

But even before having written down a single word re: my first principles argument, here is my answer in short: it is wonderful to be rich.


Six principles, if you ask me, that you absolutely must learn if you are a student of economics (and note that whether you like it or not, everybody is a student of economics):

  1. Incentives Matter
  2. TINSTAAFL
  3. Trade Matters
  4. Costs Matter
  5. Prices Matter
  6. Externalities Matter

As I was telling somebody the other day, most – if not all – problems in economics can be thought of using these six principles. If you truly understand these six principles and all of what they imply, you will be able to reduce every economic problem you meet down to the application of these six principles. The applications may be nuanced, there may be more than one principle applicable, and you may have to supply a lot of caveats. But you’ll go a very long way towards tackling your problem of choice by starting with these six principles.

And I’ll fire my first salvo at Navin’s question by deploying the third principle in the list: trade matters.

People get rich by trading with other people. Sure, people have gotten rich in the past (and in some cases, even today) by expropriating property, through loot and through dacoity. But I hope you don’t think I’m ducking the issue by saying that’s not the focus of today’s post. My focus in today’s post is about people who get rich through peaceful, voluntary trade. This particular process of getting rich focuses on offering you, through entirely peaceful, non-coercive means, a trade.

You are free to evaluate the terms of this trade, and if they seem agreeable to you, you enter into this trade. Note that the only reason you do is because you think that doing so is to your advantage. You are better off for having done this trade, relative to the option of not doing so. And the person who offered this trade to you is presumably better off for you taking the other end of it, for why else would she have offered you this trade instead?

That’s a non zero sum game, and the more we play such games with each other, the better off we are. That’s what the principle of “Trade Matters” means, and that is what it entails: peaceful, voluntary trade leaves both parties better off, and the world is therefore better off for this trade having gone through. If, as a consequence, both parties get richer, that’s A Very Good Thing, and it is therefore good to be rich.


But remember that for some problems, the applications of these principles may be nuanced, and that there may be more than one principle applicable.

First, opportunity costs. TINSTAAFL stands for There Is No Such Thing As A Free Lunch, and even to a non-zero sum game, opportunity costs are very much applicable. In the context of international trade, your level of analysis matters. Trade might make sense at the level of the parties involved in the trade, but that doesn’t necessarily mean that everybody else is better off as a consequence:

Because in the case of trade between countries, as opposed to trade between individuals, there are people who will lose out. If a university in the United States of America hires me to teach online classes to the students over there, there isn’t a hypothetical amateur cook who is losing out. There is an actual person in that country who could have taught this course, but is no longer able to because of me.
The university that hired me is better off, because it is able to hire the services of a teacher for less money. To the extent that I do about as good a job as the person I replaced, the students are (at least) indifferent. And given how strong the dollar is, I am certainly better off!
But it is not enough to say that both parties in this trade are better off (I and the university). A complete economic analysis should also include the person in the USA who is out of a job, and I would argue that one should also include what I find myself unable to do here in India as a consequence of teaching that course abroad. Both of these are the opportunity costs of this trade, and a complete economic analysis should include these aspects as well

.https://econforeverybody.com/2023/01/10/so-no-one-loses-when-it-comes-to-trade-rightright-part-ii/

Trade might then, at the margin, cause an increase in inequality. You’d be surprised at how old (but still somewhat underrated) an idea this is, but the opportunity cost of more trade might well imply an increase in inequality. So you might well say that it is bad to be rich because the opportunity cost of you being rich is that somebody else is (comparatively) poor.

But be careful with how you proceed with this! It cuts both ways, this analysis. Is the opportunity cost of reducing inequality a reduction in the creation of wealth? When you attempt to reduce inequality by taxing the rich, you reduce their incentive to trade. And remember, they get rich by voluntarily trading with you, and if that trade leaves you better off, you’ve made yourself poorer in the bargain.

If you tax Amazon so much that Amazon decides it is better for them to shutter up altogether, have you made the world better off or worse off? I’d urge you to ignore your first, visceral take, and take a look at your Amazon app to find out how often you’ve ordered from Amazon in the past month before answering this question.

So I’d argue that it still is good to be rich – but it ain’t for free. But in my opinion, the price is worth it. One can, and one should, argue about what the appropriate level of taxation should be. One can, and one should, worry about tactics used by Amazon to make sure that they remain a monopoly provider of certain goods and services. One can, and one should, worry about whether Amazon pushes its employees a little bit too much. I’m not defending Amazon as a perfect company without flaws. But I very much am saying that the world is a better place because Amazon exists. There are costs that we bear for having Amazon in our midst, but those costs are worth it.

And I picked Amazon as a stereotypical example here, but the argument is about the underlying idea, not about the specific organization. Trade matters, even after acknowledging that there are opportunity costs involved with trade.


We’re trading right now, you and I. You’re paying me with that most precious of all commodities in the year 2023: attention. And I can’t begin to thank you enough for having given me your attention so far, because I know that reading this ain’t easy. Pleasurable, hopefully, and worth your while – but not easy. And you’ve chosen to continue to pay me with your attention because what you’re getting in return – the pleasure you feel in tackling my arguments – is worth your while.

But how do you know that it is worth your while? You could have been doing something else with this time. You could have been learning how to code. You could have finished at least part of some project or an assignment. You could have picked strawberries. You could have milked a cow.

The point is that you could have been doing something that actually earns you cold hard cash, instead of reading this article. And it is your assessment of your own opportunity costs that allow you to continue reading this article. You know that you can ‘afford’ to spare the time required to read this article.

But how do you know this? You know it because you are part of a national (and global) economic system that depends upon the principle that ‘prices matter’.You have at least an implicit valuation of how much a minute of your time is worth, and you have made the rational decision to ‘spend’ this time reading this blog.

What is my point? My point is that we know how much it costs to enter into a trade only if we know how much that trade is worth to us, and we only know how much a trade is worth to us by having a sense of what we’re worth to society. Trade matters is a principle that works only if we know the price of a good or a service, and we know the price of a good or a service best in a free market economy. Deciding how much to produce something, and deciding at what price to sell it is a truly difficult problem to solve in an economy that is not based on markets.

So yes, trade matters, but so do prices.


But speaking of prices, it gets trickier still.

  1. What if you set prices to not just lure the buyer into buying your product, but at a price which is so attractive to buyers that your competitors cannot afford to match it? What if they go out of business as a consequence, leaving you as the only game in town? What if you then raise prices?
  2. What if you use patents to make sure that others cannot sell the same goods that you are selling? What if you abuse the patenting process to stymie the competition? What if you then become the only game in town, and raise prices to eye-watering levels?
  3. What if the price at which you sell the product you are selling does not take into account the damage done to the environment?
  4. What if the buyer isn’t aware of further purchases she might need to make for having bought your goods? What if she realizes later that the true price of the good in question is much higher?
  5. What if the buyer is tempted into buying the product because of shady marketing techniques?
  6. What if you lobby with the government to make sure that nobody else but you can sell the product that you’re selling? Will you then be able to charge a higher price?

Each of these questions merits a much deeper exploration than is possible in this blogpost (for those who are interested, or wondering, here are the topics you want to think about in the case of those six questions: monopoly | propoerty rights and patents | externalities | asymmetry of information | microeconomics/ behavioral economics | public economics). These topics would just be the start, there are many nuances to consider in each of the six questions. But for having raised these six questions, and the two separate arguments I’ve made in the last two sections above, here is my answer to Navin’s question about why it is bad to be rich:

It is bad to be rich if you live in a world without a fully operative price system, and/or a world in which non-voluntary trades can take place.

Interpret that sentence however you like, but begin to worry if you are convinced that there is only one interpretation, or if you are convinced that your interpretation is the only correct one!


I write on this blog for many reasons, but chief among them is a very personal reason. I would like my thinking, and my writing, to be become clearer and better over time. I’ll be the first to put my hand up and say that there are days on which I think I succeed in this endeavor, and there are days on which I don’t. But taken as a whole, I am convinced that I am a better thinker and writer than I was in 2016, which is when I started this blog.

Far from perfect, in case it needs to be said, but the benchmark isn’t perfection, the benchmark is Ashish of 2016. And on any given day, it is the Ashish of the previous day. One day at a time, as it were.

And one thing that has happened over these past six years is that I have become better at distilling in my own head what economics ultimately comes down to. Six microeconomic principles, and three big picture questions. I have outlined the six principles above, and I have written about the three big picture questions before, but here they are once again:

  1. What does the world look like?
  2. Why does it look the way it does?
  3. What can we do to make the world a better place?

Students who have learnt from me these past six years will be familiar with this list. But there is a crucial component that is missing in this list of six principles and three big picture questions: time. On my blog, I have attempted to get around this problem by speaking of an alternative framework, which I have shortened in my head to the CHIC acronym: Choices, Horizons, Incentives and Costs:

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.

https://econforeverybody.com/2018/05/03/choices-costs-horizons-and-incentives/

I have also written about time, and how it is ever-so-confusing to think about it in the context of economics. In my classes, I show students the circular flow of income diagram, and once they’ve understood it, I ask them to think of it as a video, rather than a still picture. That is to say, time matters.

Time matters.

Go and read the responses that Navin got on his original question on Twitter. I sent this essay that you are reading right not to some people, and they highlighted this same problem – they thought of intergenerational problems about being rich. Inheritance and the perpetuation of inequality across time, for example. Almost the entirety of my blogpost tomorrow, where I will share many articles that answer Navin’s question, focusses on this issue.

So here’s a question I have been grappling with for a while: should I update my list of six principles (Incentives matter | TINSTAAFL | Trade Matters | Costs Matter | Prices Matter | Externalities Matter) to also include Time Matters? And if yes, how do I expound upon this principle?

Here’s another way of thinking about this issue – one of my objectives on this blog is to teach economics to anybody and everybody. So ask yourself this question – what do we need to do to simplify economics down to its absolute bare minimum? Will somebody who has learnt about economics by attending my classes, or reading my blog, be able to answer Navin’s question? And the short answer to this question is yes, they will. But in an incomplete fashion, because in the context of this question (and many others besides), time matters.

Time, as it turns out, really and truly matters. And for me to teach this principles, I need to try and understand it better myself.

Onwards!

Happy New Year

Many years ago, and this happened soon after our daughter was born, my wife and I finally got a chance to go out on a date. Our daughter, we felt, was now old enough for us to be able to step out of the house for a while.

Lunch and a movie was the plan.

Lunch was very good indeed, both the meal itself, and the rare ol’ pleasure of being able to enjoy each other’s company in diaper-less surroundings. And then we went for the movie.

And that, unfortunately, explains the title of today’s post.

For the movie that we chose that day has the same title as does this post.

And it was an abomination of a movie.

It is difficult to put into words exactly how bad it was, for I don’t remember much of it (which is a blessing, I suppose). Within the first five minutes or so, it became painfully clear that this movie was going to be a complete dud. We could have sat outside in the lobby instead, and it would have been a better use of our time. We could have gone up and down the escalators in the mall that we saw the movie in for three hours, and that would have been a better use of our time. We could, in short, have done absolutely anything else for those three hours, and it would have been a better use of our time.

And yet, in spite of knowing this with the kind of crystal clear certainty that is rarely afforded to us humans, we still sat through the entirety of that – for lack of a better word – movie.

Not our proudest moment, especially because both of us have PhD’s in economics – we clearly fell prey to the sunk cost fallacy.

What is the sunk cost fallacy?

Rather than share the Wikipedia page about the topic, as I would have done until now, I asked our new overlord its opinion on the matter:

https://chat.openai.com/chat

We’ve got the chance to come out on a date after such a long time, we figured. Who knows when we’ll get another opportunity like this? We shouldn’t waste it. That’s how our reasoning went.

Failing to realize, of course, that watching that damn thing was the most horrible waste of our time. As I’ve already mentioned, we could have done just about anything else with the time that we had, and we would have been better off. But as ChatGPT3 so smugly told me, our “tendency to justify continued investment in a decision based on the amount of resources already invested” is what caused our downfall.


And that’s the tricky thing about the sunk cost fallacy. Explaining it is easy, and understanding it is easy. Applying it? Ah, that’s the difficult bit. And it happens to the very best of us!

I drove to the store last night only to find on arrival that I had forgotten my wallet. I returned home frustrated and ready to veg out in front of the tv. It occured to me, however, that my earlier trip was a sunk cost. If the trip was worthwhile the first time it must be worthwhile to return (not so much time had passed as to change the utility of the calculation). I still felt frustrated and I didn’t really want to return but I forced myself to behave like a rational utility maximizer. As I headed back, however, I felt better. Reason and emotion cohered once again as the sunk cost became psychologically sunk.
Score one for economics. A sunk cost is only sunk if you choose to ignore it and economics helps us to do this. But note to self: have more sympathy for students who find the economic way of thinking to be unnatural. Often, they are right.

https://marginalrevolution.com/marginalrevolution/2003/12/behaving_like_a.html

(Something I found myself wondering about while I was pasting this blogpost here. Note that the extract above is the entire blogpost! Woud this blogpost have been written at all in the age of Twitter? Were we better off then, or are we better off now? Along which dimensions? But anyway, back to our regular programming.)

But let me go back to the point about explaining and understanding sunk costs being “easy”. Is it, really? What are you optimizing for when you “succumb” to the sunk cost fallacy?

What if you choose to finish a task in spite of knowing that it isn’t “worth it”? Are you necessarily an “irrational” person? What if you choose to finish the task to make a point? What if making the point matters more than succeeding at said task? What if attempting to complete a task is more about signaling to others about the kind of person one is? Would this then still be a fallacy?

Many years ago, Tyler Cowen wrote a blogpost about the sunk cost fallacy (in fact, a response to Alex Tabbarok’s post excerpted above), and had this quote within it:

One might prefer that, if others have made significant sacrifices in attempting to realize some valuable state of affairs S, then their sacrifices not be in vain. That is, one might prefer that these sacrifices causally contribute to the realization of some valuable state of affairs…Interestingly, one sometimes is in a position to determine, by one’s own actions, whether the past efforts of others will have been in vain. This is true, for example, when it is within one’s power to finish some valuable project in whose service others have labored, but which they are now not in a position to complete. Let us say that when one acts so as to prevent the past efforts of others from having been in vain one redeems those efforts.

https://marginalrevolution.com/marginalrevolution/2004/03/when_is_it_rati.html

What does this mean, exactly? Consider this:

Dus is a 2005 Indian Hindi-language action thriller film directed by Anubhav Sinha, based on the lives of seven fictional SIT (Indian Special Investigation) Team officers. It stars Sanjay Dutt, Sunil Shetty, Abhishek Bachchan, Zayed Khan, Shilpa Shetty, Esha Deol, Dia Mirza and Raima Sen.
Dus is a tribute to late celebrated director Mukul S. Anand, who had died while filming the incomplete 1997 film of the same title, which starred Dutt and Shetty with Salman Khan. It was a critical and commercial success.

https://en.wikipedia.org/wiki/Dus

I have not seen Dus, and I don’t know if it was “the realization of some valuable state of affairs”. But if one is able to determine, by one’s own actions, whether the past efforts of others will have been in vain, what then? It might be the right thing to make sure that “their sacrifices not be in vain”. Honoring somebody’s memory – is that a sunk cost fallacy or not?

Maybe it is not so easy, after all, to explain and understand the sunk cost fallacy.

Has it been all a waste of time then, I writing this post and you reading it?

Ah well, in any case, Happy New Year to all of you!

How Might You Use Incentives in Your Own Life?

It’s all very well to dispense gyaan about incentives, but what is the TMKK?

For those of you new in these parts, TMKK stands for To Main Kya Karoon? Learning about economics for its own sake only make sense in terms of scoring marks in an examination. But a subject truly comes alive when you are able to understand its relevance and importance to your own life – preferably directly, but at the very least tangentially. Don’t get me wrong, I am not at all suggesting that intellectual pursuits for their own sake are not worth it. But I am very much suggesting that the ability to answer a TMKK for oneself makes it much more interesting.

So how should once use incentives in one’s own life?

  1. You can make museum visits less boring.
  2. You can lose weight. I cannot find the reference I’m looking for right now, but Tim Ferriss once spoke about how you can send a truly embarassing pic of yourself to a friend, with instructions to post it on social media by the end of the month – unless a certain amount of weight loss has been achieved. If pics on social media is not your thing, give an amount of money that will truly pinch you to your friend, with instructions to donate it to a cause/political outfit that you truly loathe – again, unless a certain amount of weight loss has been achieved.
  3. What is the Pomodoro technique if not an incentive mechanism? There is more to it, sure, but incentives are certainly involved, no?
  4. If you have a gym buddy, yes, that too is an incentive mechanism. There is another phrase for it – peer pressure. That simply means that it’s not so much about you missing gym, but about the pressure you feel for letting your friend down. But the underlying mechanism? Incentives! In this case, it is a non-monetary, negative incentive.
  5. In my opinion, nobody does gamification using non-monetary incentives better than Duolingo.
  6. Ask ChatGPT3 for more examples! I could have done this myself, of course, but you really should get in the habit of using ChatGPT3 as a tool to do all kinds of research – it’s what you’re going to be doing in your careers in many different ways, so the correct time to get started is yesterday.
  7. Think about examples from your own life where you’ve tried to design incentives for yourself. Ask yourself which ones worked and which ones didn’t, and then ask yourself if we humans treat positive and negative incentives the same way.
  8. Best of all, try designing incentives for somebody in your family. See how they respond to your incentive mechanism, and see if you can iterate it (the mechanism) for the better. If you’re looking for an example – what if you promise to make breakfast in bed for a family member who promises not to look at their phone after dinner throughout the week. Will this work? Try it out! (Note: not a single “I just need to do this one little thing” allowed!). Try the same experiment the next week, but this time, use a “punishment” instead. Say, a fine of a thousand rupees, payable to you, if they break the rule.
  9. If you do “run” the experiment in pt. 8 above, ask yourself if Goodhart’s Law applied.
  10. Get better with every passing week at designing incentives, refining them and implementing them, both for yourself and for others. You’ll be surprised in two regards. First, you’ll be surprised at how easy it is to design better and better incentives. And second, you’ll be surprised to learn that GoodHart’s Law is always applicable. Tricky little beasts, incentives.

Incentives Matter

A little hobby of mine, that I have managed to get my daughter hooked on to as well, is etymology.

I’ve long held that concepts become more interesting, more relatable and therefore more memorable – in the literal sense of the term – once you’re able to tell yourself a story about the underlying concept. Look up the etymology of the word “average”, for example, and it is likely to be a story you won’t forget in a hurry. By the way, here’s a fun question the daughter asked some months ago, and I’ve been kicking myself for not having thought of it first.

So what is the etymology of the word incentive?

From Medieval Latin incentīvus (“that strikes up or sets the tune”), from incinō (“to strike up”), from in- (“in, on”) + canō (“to sing”).

https://www.google.com/search?q=what+is+the+etymology+of+incentive

I like words. I like stories that can be fashioned out of, and about, words. If you click around on the search result that I have linked to, you realize that you can go down quite a rabbit hole about the history of the word incentive. Words such as kindle, singing, and incendiary crop up, and the associations these words can conjure up in one’s mind can result in a very pleasant couple of hours. But the phrase that resonated the most with me was “sets the tune”. It fits nicely with what incentives actually do in real life – they do set the tune on which we are tempted to dance.

Now who sets the tune, for whom, and with what consequences – that’s a whole other story, and practitioners of public policy can tell this tale much better than most other folks. But even outside the always-fascinating drama that is always being staged in the theater of public policy, this story is at the heart of what plays out in applied economics. Who is incentivizing whom, towards what end, and do the incentives end up producing intended or unintended consequences, and at what cost – these are fascinating questions to answer.

My favorite story about getting incentives right comes from Marginal Revolution University:

And my favorite story about getting incentives wrong comes from Calvin and Hobbes:

https://calvinandhobbes.fandom.com/wiki/Calvin%27s_Allowance

And that’s the tricky thing with incentives. Getting them right is a surprisingly difficult thing to do. The reason it is a surprisingly difficult thing to do is because of a variety of reasons, but it is possible to start to think about building a framework that one might use to design incentives.

Begin by asking yourself this question: Who is designing the incentive, and for whom?

Let’s begin with a simple example. Let’s say I am designing an incentive for myself. If, I say to myself, I can finish writing the blog post you’re reading right now without taking a break, I’ll reward myself by having a cup of coffee. In this case, I am designing an incentive for myself – I am setting a tune for myself to dance to.

Note two other things about this little incentive scheme:

  1. It is a positive incentive. I am not going to punish myself if I do not finish my designated task – that would be a negative incentive. I am, instead, going to reward myself if I finish my designated task. Think of the old English phrase “the carrot and the stick” to get a sense of what a positive and negative incentive mean.
  2. It is a non-monetary incentive. I am not going to reward (or punish) myself with money. There is no prize money, nor is there a fine. There is, instead, a non-monetary reward – a nice hot steaming cup of coffee. Incentives need not always be monetary!

So, a positive, non-monetary reward to finish a task. What could possibly go wrong? Consider the opening paragraph of Ch. 6 of a lovely little book called In The Service of the Republic:

In 1902 in Hanoi, under French rule, there was a rat problem. A bounty was set—one cent per rat—which could be claimed by submitting a rat’s tail to the municipal office. But for each individual who caught a rat, it was optimal to amputate the tail of a rat, and set the rat free, so as to bolster the rat population and make it easier to catch rats in the future. In addition, on the outskirts of Hanoi, farms came up, dedicated to breeding rats. In 1906, there was an outbreak of bubonic plague that killed over 250 people.

Kelkar, Vijay; Shah, Ajay. In Service of the Republic . Penguin Random House India Private Limited. Kindle Edition.

By the way, the footnote associated with this little tale contains the link to the fuller story, and is worth reading in its entirety. It would appear that the cobra story from India doesn’t have any corroborative evidence. For those who don’t know the background, there is a very similar story from India, only involving cobras isntead of rats. (If you will permit a slight digression: I was telling both of these stories to my daughter, and her only observation was to note that the cobra story was unlikely because “won’t cobras be an example of an apex predator? They can’t grow as quickly as rats, correct?”)

But what can go wrong is what the government in Hanoi discovered – that the person for whom the incentive has been designed may well end up hearing a completely different tune than the one that the designer of the incentive intended. That is, the designer would like you to do x, but you end up doing y instead.

Teachers may set up assignments to incentivize learning, but students are playing a different game. They are looking to minimize efforts in order to maximize marks. Ditto for managers and members on a team in the corporate world. Ditto, as I and my wife have been discovering to our chagrin, for parents and kids! That last bit has been a particularly aggravating discovery, since both my wife and I are economists.

But this phenomenon of incentives not working out as envisaged has an entire “law” of its own, called Goodhart’s Law. This is what it says:

“Any measure that becomes a target stops being a measure”

You’ll find different phrasings of the same idea online, but that’s the simplest way to express the idea. If the measure (to stop the culling of the rat population) is rat’s tails that have been cut off, and you make this the target – well, they stop being a measure of the culling of the rat population!

And that’s why designing incentives is so very tricky. The Indian government found this out to its cost in the aftermath of demonetisation, for example, but rather than look for examples elsewhere, I think you learn about incentives best when you try to think of examples from your own life.

But you cannot – simply cannot – be a student of economics without appreciating both what incentives are, and how difficult it is to design and implement them. The study of this facet of economics will last for your entire life, and you will always find something interesting to learn about it, every single time.

Incentives matter.


Now, if you will remember, I had promised myself a cup of coffee if I finished writing this blog post without taking a break. Goodhart’s law would imply that I would indeed finish writing this blog post without taking a break, but presumably at the cost of either its length, or its quality, or possibly both. I leave it to you to judge if that has been the case.

Me?

I’ll go brew that cuppa.

What Am I Optimizing For on EFE in 2023?

Six principles, three big picture questions, and three bonus questions.

Anybody who’s attended a principles class taught by me knows what is coming next. It is my deeply rooted conviction that almost every single problem/concept/idea in economics can become more relatable by simplifying it down to one out of these twelve things: six principles, three big picture questions and three bonus questions. If you get the hang of these twelve things, you can go a very long way in terms of both understanding what economics is about, and how economics can be used to make the world around you a slightly better place.

And while mastery over these twelve things will likely take a lifetime – and almost definitely more than that – familiarity with them isn’t so difficult. And my aim is to write blogposts – in one way or another, and as much as possible – centered around one of these twelve things.

Not just blogposts, but we’ll leave that for aother day. For today’s blogpost, a simple list of what these twelve things are.


First, the six principles:

  1. Incentives matter
  2. TINSTAAFL – There is no such thing as a free lunch
  3. Costs matter
  4. Trade matters
  5. Prices matter
  6. Externalities matter

If I’m teaching a class in a semester at a college, I would dearly like to spend as much time as possible in speaking about just these six principles. Different teachers the world over may have a slightly different list, but I would be surprised if there were to be no overlap at all between two different lists. We may define concepts within these principles slightly differently, we may disagree on some of the underlying mechanisms, but here’s a nice way to think about my list. I am more than willing to listen to arguments about what I really should be adding to my list, but you’ll have to do a lot of convincing to make me remove an item from this list.

These six principles really do define economics for me. They can be expanded upon in multiple ways, a million derivatives can be constructed, there are endless tangents that can be drawn, and the nuances for each can be separate books in their own right. But at it’s heart, these six principles do most of the weight-lifting when it comes to economics.


Next, the three big picture questions:

  1. What does the world look like?
  2. Why does it look the way it does?
  3. What can we do to make the world a better place?

I don’t much like the artificial divide of the subject into “micro” and “macro” economics, but if you like, you can think of the six principles as a way to think about an introduction to microeconomics, while these three questions are a way to get started on thinking about macroeconomics. Depending upon how you want to go about answering the third question, there is yet a further division that is possible, between short term macroeconomic fluctuations and long term growth theory. But we’ll get to that in a bit.

But you can’t really begin analyzing macroeconomics without having a sense of what the world looks like today. Which countries in the world are doing well today, and how do you define “doing well”? Which countries in the world are not developing as rapidy as one would have hoped for? A comparative analysis of what the world looks like is where the study of macroeconomics should start.

At which point, the second question comes into its own. Why is Afghanistan doing so poorly when compared to its peers (howsoever defined), or when compared to its neighbours? Is it because Afghanistan is a landlocked country? Are all landlocked countries poor? If not, why not? Is it because of natural resources in Afghanistan? Is it because of geo-politics? Is it because of colonization? Does religion have a role to play? The list of questions is nowhere near complete, and this is just one nation. We can go on and on like this for all nations – and multiple careers have been spent on answering only parts of one question for just one nation.

And then we come to question number three, the most vexatious question of them all. Just two little words in that sentence, but what a world of (intellectual) pain they bring forth into the world.

“What can we do to make the world a better place?”

Who is we? What form of government works best to make one’s own country a better place? Is the answer to this question always the same regardless of the stage of development? Is your answer based on ideals and hope, or on empiricism? For which part(s) of the world and in which time period?

Does the word better mean the same thing to all people? Are we in a better world when everybody has access to a washing machine? Or are we in a better world when we don’t generate more carbon emissions? Can we have both? If yes, how?

These three questions define macroeconomics for me. Most of what we do in big picture economics (a term that I prefer to macroeconomics, for reasons I’ll get into in a later blogpost) can be thought of using this framework.


There are many good things that have happened as a consequence of blogging regularly here on EFE. But one of the best things to have happened is that I’ve been able to come up with three additional questions – questions that I find myself asking ad nauseam, both to myself and of other people:

  1. What are you optimizing for?
  2. Relative to what?
  3. Over what horizon?

That first question, strictly speaking, isn’t really a question economics can answer. What you are optimizing for is a question that requires deep introspection, and the answer likely comes from either other domains, or from a place that will perhaps forever lie beyond the fartherest probes of academia. But I will say this much – it is impossible to proceed further in economic analysis of any kind, without clarity about the answer to this question.

The second question here really is just another way of saying opportunity costs. But it is surprising to see how easy it is to forget that opportunity costs are real. This is particularly true in the case of public policy, but “relative to what” is a question that more people need to ask of themselves (myself included).

And finally, that most problematic of all questions: time. Just when you think you’re done with intellectual wrestling, trying to answer that third question can often bring you all the way back to square one. Is your answer to the first two questions the same over all time horizons?

I could have optimized for playing (judge me all you like) Subway Surfers instead of writing this post, because I was optimizing for relaxing myself. Or that, at any rate, is the story I tell myself when I give in to temptation. That choice is the best for me (if at all) only in the very short run. That is, over a very short horizon. So is playing yet another round of Subway Surfers really the best thing that I can do? Back, as I said, to square one.

India can optimize for (extending PMGKAY/ reviving the old pension scheme / pick whichever topic makes you the most uncomfortable), and ask yourself why what India is optimizing for. Ask what the opportunity costs of doing so will be. And finally ask if your answer (whatever it may be) remains the same if you ask what is best for India over the course of the next two years. What about two decades? What about two centuries? Which is the best timeframe to use to answer this question, and whatever your answer, what are you optimizing for? Back, as I said, to square one!


In one way, this is exactly what I have been doing in any case these past six years – writing blogs about these topics. A little bit of circular logic is involved here, of course. If I say that this framework:

six principles | three big picture questions | three bonus questions

can be used to think about any topic in economics, maybe I say I’ve been writing about this because I now think about those blogposts that I have written using this framework.

Be that as it may, writing here on EFE has convinced me that this framework can be used to think about all questions in economics, regardless of whether you have been formally trained in the subject or otherwise. And my attempt, this year, is going to be to think about as many questions as I can, explicitly using this framework. Of course I’ll benefit, but hey, as the sixth principle reminds us, externalities matter. You’ll benefit too!

Or is it the other way round?

Consoles, Competition and Comprehension

If you are studying microeconomics, whether in undergrad or postgrad courses, it can sometimes get a little too theoretical. Or that, at any rate, is how I used to feel about the more abstruse parts of advanced micro. And while memorizing the millionth derivation in order to regurgitate it in an examination, I would often wonder if there was any relevance of what I was attempting to study to the real world outside.

If you, today, as a student of micro share this opinion, let me ask you this: are you interested in video games? Are you living in fond hope that a PS5 will land up in your living room? Or are you figuring out ways to get XBox Pass?

If the answer to any of these questions is yes, I’m guessing that you like playing video games. Do you know how the industry started? Do you know what the Gang of Four was all about? Do you know how different business models in the industry originated? How they evolved and why, and with what consequences? Had you heard about the Great Video Game Crash of 1983? I knew a little bit (but not a lot) about the answers to all of these questions, save for the last.

But the reason I bring this up is because Ben Thompson has an exellent essay out on the evolution of the gaming industry, with a lovely recap of all of what happened, and why. You’ll learn about vertical and horizontal integration, lock-ins, attempts to create monopolies, attempts at preserving monopoloies, about how business models had to change to account for changing strategies, changing technologies and changing aspirations on part of creators, consumers and corporations. It’s head-spinning stuff!

It begins with a description of the world’s first video game (OXO, 1952, in case you were wondering) and ends with how the FTC (perhaps) doth take things too far with the Activision acquisition by Microsoft. And in the interim, it touches upon names that will evoke nostalgia among folks of a certain vintage, and curiosity among folks of a more recent vintage.

If you are a student struggling with micro but happen to love video games, this essay might motivate you to read more about the evolution of the video game industry, and understand micro better in the process.

If you are a teacher struggling with helping students fall in love with micro, consider reading and using this essay.

And a meta lesson: a great way to learn about microeconomics is to pick your industry of choice, and ask how it has evolved over time, and why. The answers to these questions is a great way to become a better student of economics.

If you’re looking for suggestions in this regard: music, television, movies, gaming, publishing, hospitality and sports (football, cricket and tennis would be great examples). And if I may offer one piece of contrarian and possibly heretical advice – begin with the industry and work your way to the textbook, rather than the other way around.

Do border regions have better food?

Do border regions have better food? What exactly counts as a border region? The parts of the United States near Canada? The best food in Italy is not obviously at the (rather skimpy) borders. China and India might be the best food countries in the world, but because they are so large most of their cuisine is not “border cuisine.” So I say no.

https://marginalrevolution.com/marginalrevolution/2022/11/requests-from-benedikt.html

As always, read the whole post – and in particular, the Wikipedia link to James Steuart (not a typo). But given my deep love of all things gastronomical, I wanted to expand on this point a bit.

  1. Tyler’s first question is worth thinking about (what exactly counts as a border region?), and the way I choose to define it more or less defines the direction in which this post is going to go. A border region, for the purposes of this post, is where a confluence of two or more cultures is observed. That is a ridiculously loose definition, I know, but this is a blogpost, so please let’s go with this for the moment.
  2. Does that definition necessarily mean better food? Well, that requires a definition of the phrase “better food”, but more variety and a greater degree of syncretism can reasonably be expected.
    • Think Massaman curry in Phuket, for example. Read this paragraph from that Wikipedia article to get a sense of what I’m trying to get at. This spice, frequently used in both Chinese cuisine and coastal Indian cuisine(s) is another good example.
    • Will the food in Chennai be necessarily better than in the interior parts of Tamil Nadu? Not necessarily, but it will be more varied in terms of influences, and especially as a tourist, that’s a good thing. It’s a good thing in general too, if you ask me!
  3. A confluence of culture is likely to be positively correlated with greater commerce, and that is likely to imply higher rent for real estate. Higher prices will imply a greater incentive to be better at making and selling food, so the quality will likely be higher (so long as you know where to look and how to choose). You could make the same point for costs of labour.
  4. More trade is also likely to imply fresher ingredients, and therefore better food.

What else am I missing?


So my answer would actually be yes, but it very much depends on how you define “border cuisine”.

Incentives Matter, the International Trade Edition

A chart and a paragraph from The Economist to get us started today. First, the chart:

https://www.economist.com/finance-and-economics/2022/11/06/who-wins-from-the-unravelling-of-sino-american-trade

I’ve been a student of economics for a little more than two decades, and the one thing that is quite familiar to me in this chart is how large China’s share is in US imports (that’s what the “17” at the bottom right of the chart represents. Spend some time going over the rest of the numbers on the right of this chart, and come to the realization that China is about 50% more than all of the other nations on this chart combined.)

Being a student of economics in these past two decades makes it inevitable that some notions of how the world works and functions will get deeply ingrained. And the idea that China will be much larger in everything compared to, often, the addition of all other countries performances has become a useful rule of thumb. Note that I am not advocating forming such a rule for the future – I’m simply saying this has been the case for the past two decades.

But as the Nobel Laureate said, the times, they’re a-changin’:

Yet Mr Trump’s tariffs seem to have played an important role. According to recent analysis of industry data by Chad Bown of the Peterson Institute for International Economics, a think-tank, China’s share of America’s imports rose from 36% to 39% this year in goods not covered by tariffs. For goods subject to a 7.5% tariff, however, China’s share sank from 24% to 18%. And for those hit by a whopping 25% tariff, which covers lots of it equipment, China’s share of imports fell from 16% to 10%. Overall America is now much less dependent on Chinese goods, from furniture to semiconductors.

https://www.economist.com/finance-and-economics/2022/11/06/who-wins-from-the-unravelling-of-sino-american-trade (Emphasis added)

This post isn’t about whether Trump should have imposed those tariffs or not, nor is it about whether those tariffs have been worth it. That is an important topic, but we’re going to skip over it in today’s post. Today is just a reaffirmation of a principle of economics:

When something becomes more expensive, there will be lesser demand for it.

That, of course, is just another way to state the law of demand. You can draw a curve, if you like, or you can phrase it the way I did, or you can write out a paragraph that gives an application of the law, like The Economist did. But the next time you read people opining about whether Policy X will work or not, ask yourself how the incentives have been realigned as a consequence of the new policy.

By how much will demand go down (elasticity), should this policy be implemented or not (geopolitics), and what might be the impact of this policy on China and America and other nations (international trade) are all excellent questions, and they will keep all manner of professionals busy for decades to come.

But again, that’s for another day. Today’s post is about helping you realize that the law of demand is one way to understand incentives, and (don’t stop me even if you have heard this before) it is about chanting a mantra that all economics students would do well to internalize:

Incentives Matter