This paper relates quality and uncertainty. The existence of goods of many grades poses interesting and important problems for the theory of markets.
Akerlof, G. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84(3), 488-500
It’s a paper that every undergraduate student ought to read. Not just economics undergraduate student, mind you, but every undergraduate student. Because it helps you get an understanding of many modern businesses today.
But first, a relatively simple explanation of the core idea of the paper:
Suppose buyers cannot distinguish between a high-quality car (a “peach”) and a “lemon”. Then they are only willing to pay a fixed price for a car that averages the value of a “peach” and “lemon” together (pavg). But sellers know whether they hold a peach or a lemon. Given the fixed price at which buyers will buy, sellers will sell only when they hold “lemons” (since plemon < pavg) and they will leave the market when they hold “peaches” (since ppeach > pavg). Eventually, as enough sellers of “peaches” leave the market, the average willingness-to-pay of buyers will decrease (since the average quality of cars on the market decreased), leading to even more sellers of high-quality cars to leave the market through a positive feedback loop.
Thus the uninformed buyer’s price creates an adverse selection problem that drives the high-quality cars from the market. Adverse selection is a market mechanism that can lead to a market collapse.
Akerlof’s paper shows how prices can determine the quality of goods traded on the market. Low prices drive away sellers of high-quality goods, leaving only lemons behind. In 2001, Akerlof, along with Michael Spence, and Joseph Stiglitz, jointly received the Nobel Memorial Prize in Economic Sciences, for their research on issues related to asymmetric information.
Now, one way to understand the value of many businesses today is to realize that they’re solving asymmetry of information problems. Or at least, that’s how I think of it when I end up looking up the rating for a restaurant on Zomato in a unfamiliar part of town. I don’t know enough about this part of town, and I certainly don’t know this restaurant. Should I walk in for a meal or not?
I could always check if the people already inside are smiling or not, of course, but let’s face it, most of us will simply Zomato our way through this problem. Zomato is reducing the asymmetry of information problem. Successfully or not is a matter of opinion and perhaps controversy. But my argument here is that this is a potentially useful way of thinking about the problem: how to decide where to eat?
How to decide whom to trust? Look ’em up on Facebook, or Twitter, or Instagram, or wherever it is that people look up people these days.
How to decide which product to buy on Amazon? Check out the user ratings. In fact, sort by average user ratings! Yes, Amazon does provide this option.
How to decide which book to read? Goodreads.
How to… you get the drift, right. Part of the reason these firms are so highly valued by the public is because they solve the asymmetry of information problem.
And so does Airbnb. Or does it?
And that brings us back to Devon Zuegel’s tweet.
Every review left on Airbnb informs potential users about the quality of a stay at a particular host’s place. The more information they are able to glean from reviews left by previous users, the more they are likely to definitively transact…or not. That is, potential users will either stay at a particular place, or will definitely not.
Since Airbnb gets a cut from each transaction, but not from each no-stay, they have an incentive to put up only positive reviews. And that is the problem that we have to think about when we read Devon Zuegel’s tweets. Is Airbnb incentivized to leave only positive reviews up? Short answer: yes. Therefore, will they leave only positive reviews up? I’d say it’s a question of horizons, but it is also a question of the calculus.
Airbnb will not last for very long if they pull down every single negative review, because that will destroy trust.
every now and then…
particularly for really highly rated hosts…
especially during a pandemic…
will the odd negative review…
have a higher chance of being pulled down?
Nothing in life is ever black and white, and the truth lies somewhere in the middle. So no, Airbnb will not pull down every single negative review, but we also shouldn’t assume that it will leave every single negative review up.
More information in the hands of the consumer is a wonderful thing, and it does reduce the asymmetry of information. But who is providing the information to the consumers, and what are their incentives? What if the providers of the good/service are the ones that are making information available to the eventual consumers? Will that need to be regulated, and if so, how?
Zomato, LinkedIn, Uber, Airbnb – it’s a great time to be alive, because these firms, and many others like them, have provided for many services that would simply have not been possible otherwise. They have successfully reduced the asymmetry of information problem. But it’s not the end of the asymmetry of information problem, not just yet.
The key point made in the book is that entrepreneurship is not – and should not – the responsibility of the private sector. Indeed, it cannot be the responsibility of the private sector.
Early on in the book, she makes the strongest case there is to be made for her thesis, by arguing that the United States of America has known this, and practiced this, for years on end. The rest of the world, she says, would do well to emulate the USA:
If the rest of the world wants to emulate the US model they should do as the United States actually did, not as it says it did: more State not less.
LOCATION: 372 (Note that the location refers throughout to the Kindle version)
I want to focus on three key points in this essay: horizons, incentives and spillovers. Let’s tackle each in turn.
Moonshots is a word that has become increasingly popular over the last two decades, and it refers to projects or even ideas that have a relatively low chance of succeeding. The payoff, if these ideas succeed, is so large that that it may compensate for the relatively low probability of this actually happening. That, of course, is exactly what expectations are all about.
But for a firm, particularly one that may not have the luxury of time and money on its side, placing bets on projects that may not work out – and indeed most of them will not – is a rather risky thing to do. Money is an obvious constraint, but a less obvious one is time.
Firms just do not have the luxury of waiting while a project turns out to be successful… eventually. These kind of moonshots, then, are perhaps best handled, for this specific reason, by the state.
In fact, the point is even more nuanced, because a firm is much more likely to (if at all) invest in a moonshot project based on a specifically desired outcome. The word project itself is an indication of this fact – this is not “blue sky research” that we are talking about.
But blue sky research is important!
A core difference between the US and Europe is the degree to which public R&D spending is for ‘general advancement’ rather than mission-oriented. Market failure theories of R&D are more useful to understand general ‘advancement of knowledge’–type R&D than that which is ‘mission oriented’ (Mazzucato 2015). Mission-oriented R&D investment targets a government agency programme or goal that may be found, for example, in defence, space, agriculture, health, energy or industrial-technology programmes (Mazzucato and Penna 2015).
Governments need to focus, for the sake of their own economies, their domestic firms and their long term growth, on focusing on moonshot projects, precisely because firms are reluctant to do so. The state needs, in other words, to take risks that private firms will not.
Saying this is easy, but how to go about doing this?
That is, if governments need to tackle long-term low-probability-of-success and uncertain-outcome initiatives that are important, but unlikely to be taken up by the private sector, the question that then arises is: how?
Mazzucato offers two points in this regard that I found interesting:
Block (2008, 188) identifies the four key characteristics of the DARPA model:
1. A series of relatively small offices, often staffed with leading scientists and engineers, are given considerable budget autonomy to support promising ideas. These offices are proactive rather than reactive and work to set an agenda for researchers in the field. The goal is to create a scientific community with a presence in universities, the public sector and corporations that focuses on specific technological challenges that have to be overcome.
2. Funding is provided to a mix of university-based researchers, start-up firms, established firms and industry consortia.
3. There is no dividing line between ‘basic research’ and ‘applied research’, since the two are deeply intertwined. Moreover, the DARPA personnel are encouraged to cut off funding to groups that are not making progress and reallocate resources to other groups that have more promise.
4. Since the goal is to produce usable technological advances, the agency’s mandate extends to helping firms get products to the stage of commercial viability. The agency can provide firms with assistance that goes well beyond research funding. Part of the agency’s task is to use its oversight role to link ideas, resources and people in constructive ways across the different research and development sites.
In effect, she is suggesting that government alone cannot do this, it needs to be a “scientific community” that is decentralized, has autonomy, sets the agenda, and applies Darwinian principles (see point 3). Hmm, sounds familiar. Different context, but a similar lesson!
And elsewhere in the book, her example of how Japan did this in the 1970’s is instructive:
The general point can be illustrated by contrasting the experience of Japan in the 1970s and 1980s with that of the Soviet Union (Freeman 1995). The rise of Japan is explained as new knowledge flowing through a more horizontal economic structure consisting of the Ministry of International Trade and Industry (MITI), academia and business R&D. In the 1970s Japan was spending 2.5 percent of its GDP on R&D while the Soviet Union was spending more than 4 per cent. Yet Japan eventually grew much faster than the Soviet Union because R&D funding was spread across a wider variety of economic sectors, not just those focused on the military and space as was the case in the Soviet Union. In Japan, there was a strong integration between R&D, production and technology import activities at the enterprise level, whereas in the Soviet Union there was separation.
Equally important were the lessons learned by Japanese people that went abroad to study Western technologies for their companies, and relationships between those companies and US firms. These companies benefited from the lessons of the US (hidden) ‘Developmental State’, and then transferred that knowledge to Japanese companies which developed internal routines that could produce Western technologies and eventually surpass them.
So, bottom-line: the state has to get in this business, but it can’t “go” it alone. There needs to be a community of academicians, researchers, firms, scholars – and as the example of Japan shows, this community needs fostering, and horizontal collaboration.
Or, if you prefer to put it simply, this is going to be hard.
Academia suffers from the same problem that government bureaucracy does in India: the incentives are all wrong. Both are about risk minimization.
A professor in a college has no incentive to try and do something new, something risky, something innovative. Why, if you think about it, should she? Your best case scenario is that it works, but you get no upside for it: remember, wages aren’t a function of what you do, they are a function of how long you have been in the system. Your worst case scenario is that what you tried to do blows up in your face. So why take the risk?
And it is the same, of course, with a government bureaucrat. And that makes the conclusion of the previous section even more problematic, for where, exactly, are you going to unearth government bureaucrats willing and able to make this happen?
I’m all for the state being more entrepreneurial. I buy into the idea. But I worry, especially in a country like India, about the feasibility of it, for hey, incentives matter!
In a blogpost I had written earlier this year about the budget, I had touched upon this point:
Here is Ninan’s solution:
“Is there a solution? Yes, railway engineers of old like the metro builder E Sreedharan, builders of government companies like D V Kapur and V Krishnamurthy, and agricultural scientists like M S Swaminathan have shown how they made a difference when given a free hand. Vineet Nayyar as head of Gas Authority of India was able to build a massive gas pipeline within cost and deadline in the 1980s. The officers who are in charge of Swachh Bharat and Ayushman Bharat, and the one who has cleaned up Indore, are others who, while they may not match China’s speed, can deliver. Perhaps all we have to do is to spot more like them and give them a free hand.”
But as any experienced HR professional will tell you, spotting them is very difficult, even in the corporate world. And as any corporate CEO will tell you, giving these talented folks a free hand is even more difficult. And as any student of government bureaucracy will tell you, achieving the intersection set of these two things in a governmental setup is all but impossible.
And so what we need to study and copy from China is not so much anything else, but lessons in achieving, and sustaining, excellence in government bureaucracy. Or, if you prefer, how to improve state capacity.
In short, quality of government, not size of government, is what matters for freedom and prosperity.
That point resonates even more in this context: fostering an ecosystem led by the government is dead in the water without either the proper incentives, or at least bureaucrats who are able to work through poorly designed incentives. It is a hard problem, state led entrepreneurship, and made harder by the problem of incentives.
Or externalities, if you prefer. It doesn’t matter how hard the problem is, the payoffs are worth it!
Ruttan (2006) argues that large-scale and long-term government investment has been the engine behind almost every GPT (general purpose technology) in the last century. He analysed the development of six different technology complexes (the US ‘mass production’ system, aviation technologies, space technologies, information technology, Internet technologies and nuclear power) and concluded that government investments have been important in bringing these new technologies into being.
(Note: emphasis added)
If those GPT’s are the outcome of general, as opposed to specific, R&D, sign me up. They are magnificent positive externalities. Indeed, elsewhere in the book, Mazzucato points to how almost everything produced by Apple today simply could not have been produced without an entrepreneurial state:
The final point that I’ll make relates to how Mazzucato proposes “capturing” some of these externalities:
Where an applied technological breakthrough is directly financed by the government , the government should in return be able to extract a royalty from its application . Returns from the royalties , earned across sectors and technologies , should be paid into a national ‘ innovation fund ’ which the government can use to fund future innovations . Granting a return to the State should not prohibit the dissemination of new technology throughout the economy , or disincentivize innovators from taking on their share of the risk . Instead it makes the policy of spending taxpayers ’ money to catalyse radical innovations more sustainable , by enabling part of the financial gains from so doing to be recycled directly back into the programme over time .
Mazzucato does present alternative schemes to the one shown above, but this is the one that strikes me as being the one with the most promise, if administered well, with appropriate risk-mitigation built in. But again, saying that is much easier than actually getting it done.
But all the being said, one simple fact is inescapable: India needs to be thinking about how to get something like this off the ground, and ASAP.
For that reason alone, more of us should be reading this book.
The more I think about time, the more confused I get. The more I read about time, the more I cannot help but think about time.
In today’s post, I hope to be able to inspire you to get as confused about time as I am.
Before we get to the five links, here are some questions for you.
Should I have a gulab jamun after lunch today? If you are anything at all like me, your answer is likely to be a resounding “aye!”
Do you know who might want to say no? 70 year old Ashish (assuming I live to be that age) might not be such a big fan of I having that gulab jamun today.
Should 38 year old Ashish (for that is how old I am right now) listen to the entreaties of a 70 year old Ashish who doesn’t exist?
Well, if 38 year old Ashish wants 70 year old Ashish to have a chance of existing, I think it makes sense to ditch that damn dessert.
But, uh, good luck trying to convince 38 year old Ashish at 1.45 pm of the importance of thinking about the hypothetical existence of 70 year old Ashish.
That’s the problem of time discounting.
How important is the future, compared to the present?
Think of it in terms of gulab jamuns or interest rates offered to you by the bank, it’s the same thing. A weeekend trip to Goa (38 year old Ashish says yes!), or a fixed deposit in the bank (70 year old Ashish says yes!)?
Now: that was the easy bit. Let’s amp things up a little.
Do you wish your parents had saved a little bit more when they were younger? Hell, imagine if your grandparents hadn’t had that gulab jamun when they were young, and put the money in a fixed deposit instead. Go as far back in time as you wish, and imagine how important a rupee saved a couple of centuries ago would have been today – for you.
But, um, by that measure, shouldn’t you be saving every single rupee you can today for your child’s tomorrow? The argument holds whether you have children or not, by the way. If you wish your great-great-great-grandfather had been more financially responsible at age 27, when he was unmarried and without kids, then that goes for you today as well!
And all that being said, let’s get cracking with today’s set of links!
“Time discounting research investigates differences in the relative valuation placed on rewards (usually money or goods) at different points in time by comparing its valuation at an earlier date with one for a later date”…
… says the very simple introduction to time (temporal) discounting on behavioraleconomics.com. While you’re on that page, also look up hyperbolic discounting.
“Someone with a high time preference is focused substantially on their well-being in the present and the immediate future relative to the average person, while someone with low time preference places more emphasis than average on their well-being in the further future.Time preferences are captured mathematically in the discount function. The higher the time preference, the higher the discount placed on returns receivable or costs payable in the future.”
.. That is from Wikipedia, and as homework, ask yourself if you should live life with a zero discount rate attached to most things.*
“What has become known as the “Ramsey formula” says that the rate at which one should discount an increase in consumption that occurs in the future depends on three key factors, elaborated upon below: our pure rate of time preference, our expectations about future growth rates, and our judgment about whether and how fast the marginal utility of consumption declines as we grow wealthier”
.. So here’s a way to understand the point above: I was in Europe on work recently. Should I have splurged on a three star Michelin meal in Paris? Or banked the money I might have spent over there and gone for three such meals when I was 70 instead? Will such a meal at age 70 hold the same importance for me as it does now?**
“When brain science was young, it was thought that the frontal lobe had no particular function. There were famous cases such as that of Phineas Gage, a railway worker who, in an explosion, had a long iron rod driven through the front of his brain. The rod was removed and Gage, miraculously, survived, seemingly with his intelligence, language and memory intact. Before long he was back at work.However, observation of others with frontal lobe damage soon revealed the cost – problems with planning, and also, strangely, a reduction in feelings of anxiety. What was the link between the two? Both planning and anxiety are related to thinking about the future. Frontal lobe damage leaves people living in a permanent present, and as a result they will not be bothering to make plans, so can’t be anxious about them.”
.. That is from a review of one of the finest books I have read, Stumbling on Happiness, by Daniel Gilbert. Read the book, please. I promise you that it is worth your (excuse the pun) time.
“But there’s an alternative path. Generations overlap, and so by doing more to empower younger people today, we give somewhat more weight to the interests of future people compared to the interests of present people. This could be significant. Currently, the median voter is 47.5 years old in the USA; the average age of senators in the USA is 61.8 years. With an aging population, these numbers are very likely to get higher over time: in developed countries, the median age is project to increase by 3 to 7 years by 2050 (and by as much as 15 years in South Korea). We live in something close to a gerontocracy, and if voters and politicians are acting in their self-interest, we should expect that politics as a whole has a shorter time horizon than if younger people were more empowered.”
Via Marginal Revolution, this lovely, thought-provoking essay by William Macaskill. As both the MR blog post and Macaskill are careful to point out, this necessarily implies that younger people should be more informed, for such a system to have even a shot at succeeding.
But hey, that’s as good an argument as any for the existence of this blog!
*Yes, you should, far as I can tell. But god, it’s hard!
**If you were wondering, the answer is no. I didn’t go for that meal. I wish I had though!