Category: Micro

Not Quite As Simple As One Would Like It To Be

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Simple economic analysis can take you a very long way.

Not only do I hold this statement to be true, but it is one of the cornerstones of this blog. The idea that at its heart, economics is about a few important principles, and that the judicious application of these principles can take you a very long way – this idea has motivated nearly all of my writing on this blog.

But as with everything else in life, so also with this alluring, tempting idea. Every now and then, simple economic analysis can only take you so far, and you must wheel out the heavy artillery to make further progress.

In yesterday’s video, we heard John Cochrane talk about how if there is a problem, look first for the regulation that caused it. And there is more than an inconvenient iota of truth in that assertion. But between too much regulation and too little regulation lies that slippery little point of the optimum amount of regulation. Nobody knows exactly where that point lies, and it moves once you get close to it, but it is very much there. Finding it is all but impossible. Keeping it in sight once you find it is impossible.

But it’s there all right.

Consider housing.

The conventional wisdom has been that if restrictive zoning regulations are removed, ease of getting building and other permissions simplified, and taxes on construction lowered, it will increase the stock of housing of all kinds including affordable housing. This, in turn, will lead to lowering of house prices – “richer renters trade up into new luxe units, starting a chain of move-ins and move-outs that lower prices for modest homes”. This can be called the “trickle-down” theory of housing affordability. Instead, I’m inclined to believe that a meaningful dent in the housing affordability issue in the medium-term has to involve an increased supply of large volumes of public (or heavily subsidised) housing.

https://gulzar05.blogspot.com/2023/05/some-thoughts-on-affordable-housing.html

You’ll meet economists who tell you that housing can only be solved by removing as much regulation as possible. You’ll meet other economists who tell you that public housing is the only solution to the problem. And you’ll get bloggers like me, who will tell you that the truth lies somewhere in the middle. But by referring to Gulzar Natarajan’s (GN) excellent blogpost, let me explain to you why I think so:

  1. People in India think like much of the rest of the world, and are inclined to view housing as both a place to stay, but also as an investment asset. These are GN’s words, not mine, taken more or less directly from his blogpost, but they are worth repeating here. Yes the demand for housing is more than the supply, in many cities the world over, but that demand itself rather complicated to think about.
  2. For example, some people buy a house to stay in it. Others buy a house in order to sell it at a high price later, without ever having stayed in it. A Knight-Frank report form 2019 tells us, for example, that 25% of all residential houses in Gurugram are vacant. That number is almost 22% for Pune, 15% for Mumbai and about 10% or so for Ahmedabad, Bengaluru and Delhi.
  3. Who is likely to be able to afford to buy a house as an investment?
  4. Which types of houses will have higher margins?
  5. So the supply of what type of houses will go up?
  6. The answers most likely to be correct for the three questions above are “More affluent folks | luxury housing as opposed to affordable housing | Luxury housing”.
  7. By the way, Noah Smith has an excellent post (referenced by GN in his blogpost) that goes against the case I’m building here. It is, hopefully, free to read, and the link is here. Here’s an excerpt: “…you could probably get them to admit that if we built 10 market-rate (“luxury”) apartments for every resident of Austin, most of them wouldn’t get filled, and landlords would be forced to slash prices, and regular folks would have cheap apartments to live in”
  8. That is, Noah is saying that an increase in supply will get prices down eventually. And with reference to the excerpt, it’s not just “them” – I will also agree that prices will come down eventually. How long will the “eventually” take is one good question to ask in response. That is, how long before the price of those unoccupied apartments will come down? Will the rate of reduction be the same for all cities in all countries? Will class distinctions matter, for example? What about religion, what about caste and what about availability and affordability of public transport?
  9. Or as GN puts it: “We need to step back here a little bit. The starting conditions of the cities under consideration matter. For example, how segmented is the housing market, how do the prices in the different segments compare, what’s the likely profit differential between higher-end and marginal housing, what’s the marginal demand for higher end housing, how does it compare with the supply, how do the starting prices for each housing segment compare with the annual incomes of different population groups etc. Differences in each can generate entirely different outcomes.”
  10. There are many points to make over here, related to pricing, regulations, urbanization, public transport, urban sociology, and much else besides. But for the purposes of this blog post, I’ll leave you with just this one thought: economic models need to be rooted in the lived reality of whichever specific region you are modeling for. Noah isn’t wrong in his post, and neither is GN. But the “correctness” of their argument is very much dependent on whether they’re talking about Bombay or Austin.
  11. Context matters, in other words, and a good first pass answer as an economist always is “Well, that depends.”

On Enshittification

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The writer and activist Cory Doctorow has coined a memorable term for this tendency for platforms to fall apart: enshittification. “Here is how platforms die,” he wrote in January. “First, they are good to their users; then they abuse their users to make things better for their business customers; finally, they abuse those business customers to claw back all the value for themselves.”

https://timharford.com/2023/03/the-enshittification-of-apps-is-real-but-is-it-bad/

What a lovely word, enshittification. I’m sure you’ve experienced the feeling of your own favorite app/online service going down Route Enshittification, pedal to the metal. Tim Harford refers to Facebook, Instagram, Twitter and Tiktok going down this route, with his own personal experience being a witness to the slow and – as he explains later on in the blogpost – inevitable degeneration of Amazon.

The problem, Harford says, is due to two important concepts that are (at least tangentially) from the field of microeconomics: network effects and switching costs.

What are network effects? The quote isn’t my own, and I’ve forgotten where I’ve filched it from, but here’s the easiest way to understand network effects:

“The first person to buy a fax machine was an idiot. The second was a genius.”

What this means is that just the one fax machine isn’t a useful thing, at all. You need another fax machine to send a fax to. Ditto with email addresses, if you’re looking for a more modern example (well, more modern than fax machines, at any rate!). People from the technology/marketing side of things are probably more familiar with Metcalfe’s Law:

In 1985, the economist George Gilder named the idea Metcalfe’s law. It’s probably the most celebrated equation of its kind since Gordon Moore’s observation about computer chips. Metcalfe says his motivation was not science but commerce. “It was a sales tool,” he says. “People were building small networks and not finding them useful. So I ginned up a slide on an Alto that showed that the cost of a network goes up linearly with the number of nodes, but the number of possible connections goes up as the square. Our salesforce took this 35-millimeter slide and told people the reason they weren’t useful is that they weren’t big enough. The remedy, of course, was buying more of our networks.”

https://www.wired.com/story/plaintext-the-man-who-discovered-network-effects-isnt-sorry/

And what are switching costs? As the phrase itself suggests, they’re the cost of switching from one service provider to another. I’ve had a lot of reasons to be deeply unhappy with my bank over the past year or so. I’m really tempted to switch. But the very thought of having to jump through a million hoops to do so, not to mention having to think through all of the ways my life has become immeasurably intertwined with my curren’t bank’s systems, makes me not want to go ahead with it. The only option that leaves me with regard to my current bank is to bleat at them in outraged fashion once I defeat their IVR. But anyways, that’s switching costs.

Now, combine these two things – network effects and switching costs, and the result, Tim Harford says, is enshittification:

Both switching costs and network effects tend to lead to enshittification because platform providers see early adopters as an investment in future profits. Platforms run at a loss for years, subsidising consumers — and sometimes suppliers — in an effort to grow as quickly as possible. When switching costs are at play, the logic is that companies attract customers who they can later exploit. When network effects apply, companies are trying to attract customers because they will draw in others to be exploited. Either way, exploitation is the goal, and the profit-maximising playbook will recommend bargains followed by rip-offs.

https://timharford.com/2023/03/the-enshittification-of-apps-is-real-but-is-it-bad/

Well, TMKK?

  1. As Tim writes in his post, as a smart, trained-in-microeconomics consumer, go to town on all the deals that a start-up offers you. Before the enshittification process starts, and while the app is in the “let’s get network effects to work for us” stage, make sure you double down on acquiring all the freebies on offer
  2. Don’t get attached to the awesomeness of a brand. Get attached to the early stage marketing offers of all brands. Remember, economics is “the dismal science”, and the dismal conclusion from Tim’s post is that all brands will eventually enshittify themselves.
  3. Read Tim’s post, all of it. Ask yourself if you’re in favor of eliminating switching costs. Remember that the opportunity cost of eliminating switching costs is that apps won’t bother with trying to build out network effects. That means a) no mad offers at the outset, but also, b) weaker network effects on your app. There is, unfortunately, no such thing as a free lunch!

Microeconomics and Credit Card Reward Points

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A lovely little article in the New York Times is worth a ponder, especially if you are a student of microeconomics:

There’s an undeniable feeling of excitement when you turn your daily credit card swipes at Starbucks into first-class airfare or a weekend jaunt to Costa Rica. Thanks to mobile banking and the ease of autopay, you can scrupulously avoid any additional costs by paying your monthly bill in full. Free flights and exclusive discounts abound.
Something for nothing, right?
Not exactly nothing. Credit card perks for educated, usually urban professionals are being subsidized by people who have less. In other words, when you book a hotel room or enjoy entry to an airport lounge at no cost, poor consumers are ultimately footing the bill.

https://www.nytimes.com/2023/03/04/opinion/credit-card-rewards-points-poor-interchange-fees.html

As you probably already know, one can “earn” reward points for spends on your credit card. You can then use these points to buy stuff, or earn cashbacks on these points, or spend them at partner stores. And there are other perks and benefits too. If you’ve travelled through an Indian airport, you might have seen the crowd waiting to get into an airport lounge – more often than not, access is tied to the kind of credit card you have in your wallet.

But remember, there is no such thing as a free lunch. You may not be paying for these perks as a credit card holder, but one of the first lessons of economics is that somebody, somewhere, is paying for it. So who is paying, in this case? As the last sentence in the excerpt makes clear, according to the article, that someone is the group of poor consumers.

Some background, based partially on the article in question, and partially on my own understanding of this space:

  1. Richer consumers are likely to spend more, but tend to not revolve much, if at all. To this group of consumers, a credit card is a way to get a (up to) 45 day interest free loan, with the added bonus of these reward points to boot. Remember, incentives matter – and these reward points are the carrot that is offered to people in order to get them to sign up.
  2. Dangling these reward points as a carrot makes business sense, for that allows a credit card company to sign up folks who will spend more via these credit cards. Credit card companies make money when people “revolve” – that is, when they spend using their credit cards, but do not pay up the entirety of their credit card bill on time. How much money do these companies make? Here, take a look.
  3. So consumers who take a credit card, spend a lot on it, and pay back the entirety of their credit card bill – these kinds of customers are actually a loss-making proposition for the credit card company.
  4. Consumers who spend a fair bit, find themselves unable to repay the entirety on time, and end up paying over months (if not years) – these customers are where the credit card companies earn their bread and butter (and jam and peanut butter, while they’re at it).
  5. Consumers who borrow a lot using their credit cards, and default on these loans – these are the very worst type of consumers for credit card companies. Risk departments in such firms exist to predict which consumers should be denied access to credit cards, and which of the existing customers are likely to default on their credit card loans.
  6. But broadly speaking, the NY Times article says that it is pt. 4 consumers (and pt. 5 consumers) who end up paying for the freebies that pt. 3 consumers enjoy. (but also see below, after this section)
  7. In addition, another way to make money for these credit card companies is to charge higher credit card processing charges to all consumers. This fee changes from country to country, but as a thumb-rule, assume it to be around 1-2% of each transaction. That’s not an exact estimate, but good enough for us over here. Rewards to specific folks, to be offset by diffusing the costs of offering these rewards across a much wider group, in other words. And note that merchants (who are charged these fees) will usually pass these fees on to the consumers. See here, for example.
  8. A 1-2% increase in price may not be the end of the world if your income is high enough – it is an inconvenience, not a crisis. But for low income earners, already on a tight budget, this price increase across all transactions can bite a fair bit.
  9. An out and out free market economist might say that this is fine, the market will work itself out. That is, if this 1-2% charge is an act of rent collection, new entrants in such a market will end up charging lower to no fees, and incumbents will be forced to respond by lowering their own fees. That’s econ 101, but life is more complicated than that.
  10. And that is a good first-pass answer, but as many people will tell you, markets don’t always work as designed or intended. Incumbents will go out of their way to prevent new entrants (through lobbying, through pricing, through R&D, and through a dozen different ways), which is why regulation is important.
  11. But will regulators do what they’re supposed to? What are their incentives? How can we make sure that regulation will be balanced between the interests of the incumbents, the new entrants, the potential entrants, and the customers? Hello, industrial organization, and hello, public choice.
  12. What is the role for government in all of this? In terms of participation (think UPI, for example, but note that this is a complicated story in its own right), in terms of regulation (both from a domestic and international financial markets perspective) and in terms of oversight?

All these points (and I hope you come up with more) are worth thinking about as a student. Remember, these points aren’t proven facts – they are a summary in part of the article an in part of my own reflections for having read the article. Discussions such as these are a great way to outline a research agenda – but that is when the job of a researcher begins. Can we convert these points into testable hypotheses? Can we get data to prove/disprove these hypotheses? Can that data then be used to reach a definitive conclusion? Can that conclusion be used to formulate policy, or start a business?

In terms of research about this topic, sample this from the conclusion of a paper on the topic: “While credit card rewards are often framed as a “reverse Robin Hood” mechanism in which the poor subsidize the rich, our results show that this explanation is at best incomplete.”

But also from the very last paragraph of the same paper:

We conclude by documenting that the costs and benefits of credit card rewards are unequally distributed across geographies in the United States. Credit card rewards transfer income from less to more educated, from poorer to richer, and from high- to low minority areas, thereby widening existing spatial disparities.

https://www.federalreserve.gov/econres/feds/files/2023007pap.pdf

And here’s the link to a directive from the RBI about the issuance of and conduct regarding credit and debit cards in India.

Homework: who (ultimately) pays for CRED from a distributional perspective? Whatever your answer, explain your reasoning, and either provide data to back up your arguments, or explain what kind of data you would need to research this question further.

Try discussing this question with your friends and your professors (including ChatGPT, and yes, you should be thinking of it as one of your professors) – it will be a great way to learn the nuances of microeconomics!

My thanks to Mihir Mahajan for suggesting this topic.

Google and CCI Doodle

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Commoditize Your Complements

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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

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Why is it bad to be rich?

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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

AshishLeave a comment

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?

AshishLeave a comment

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

Ashish2 Comments

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.