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!

NAAC Visits and the G20

There is much angst in Pune, about how little time it took for Senapati Bapat Road to look really, really nice.

The G20 summit in Pune concluded recently, and the transformation of the surroundings near where the summit was held was a sight to behold. Neat red markings for a bicycle lane on either side of the road, immaculately painted dividers, spruced up lamp-poles, jazzed up signals, pretty little lights dangling from the many trees that line this road, lovely flowers planted along the median, and a thorough Potemkin-ization of anything deemed even remotely non-presentable – everything was achieved with a speed and efficiency that is scarcely believable.

Although as a true-blue Puneri, it gladdens my heart ever so much to realize that some things will never, ever change:

But this unbelievable improvement in efficency, I’d argue, is very familiar to students who have been in college/University when the NAAC committee has come a-visitin’. It’s the same kind of transformation, and it is equally unbelievable. Flower-pots will appear near entrances, walls will be given a fresh coat of paint, friendly signages will pop up all over campus, washrooms will positively gleam with cleanliness, and the entire campus will look brand new.

Incentives matter.

What happens if you as a citizen complain about, say, a lack of footpaths? You are issued a token, not a footpath. What happens if you as a citizen ask the PMC to repair some broken down traffic signals? You know the answer by now. What happens if those broken down signals are on a road that will be noticed by the G20 dignitaries?

It’s not so much the priority that is missing, which is the only thing I’d correct in Amit’s tweet. What’s missing is the incentive to do the best job possible – when it is the citizens that are doing the belly-aching. When it is the people holding the purse-strings, or the people who call the shots that send along gentle reminders – well, the incentive is clearly present, no?

And that’s why campuses will look their resplendent best during NAAC visits, and that’s why Senapati Bapat Road looks as pretty as it does right now.

Because, alas, incentives matter.

Old timers who have been staying in Sus village for years will regale you with stories of how roads become as smooth as silk literally overnight come the month of December, year after year. It’s the same ol’ story, with the same ol’ underlying reason: incentives matter.

Which begs the question: how can we get the incentives of the PMC to be aligned with our interests? Answering the question is easy. Implementing it? Ah, that is beyond the scope of this blog, for now.

Also, note that this has nothing to do with the BJP, or the Congress, or AAP, or indeed with any Indian political party. We aren’t unique as a nation in this regard, and no political party in our country is uniquely good (or bad) in this regard. All political parties in all nations are staffed with members of the same species that you and I belong to, and we all respond in much the same way to incentives. So please, don’t attack or defend whichever political party you have in mind.

One good thing about the principles of economics is that they work the same way on everybody, everywhere. The sooner we realize this, the better it will be for all of us.

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!

So No One Loses When It Comes to Trade, Right?…Right?! Part II

Actually, there is somebody who loses out in the case of the cook coming to work at our place.

But for this story to make sense, please first read last Friday’s post, and then yesterday’s post. I’ll wait, there’s no hurry. Done? All right, here we go.

So, as I was saying, there is somebody who loses out in that little story. Who? The amateur cook inside of me. That part of my personality loses out, given the fact that I’m optimizing for my income. Society rewards me more for boring people about economics than it does for me cooking meals for my family. In order to maximize my family’s income, I spend more time boring people about economics, and less time on practicing my cooking skills.

The more time I spend boring people about economics, the better I get at this skill. The less time I spend in cooking up delicious meals for my family, the worse I get at that skill. And so over time, I become a (hopefully!) better teacher of economics, and not as good a cook as I might have been.

And so, as I said, the amateur cook in me loses out in this trade. Or put another way – and if you are an economist reading this, you were probably getting impatient for me to say this – the opportunity cost of being an econ teacher is not being an amteur cook at home.

But this is exactly why international trade is such a political hot potato! 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 lesser 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 anlaysis should include these aspects as well.

Even if you were to include this analysis, it still makes sense to go ahead with this trade. It isn’t for free (TINSTAAFL) – that is to say, there are opportunity costs, but even so, the world as a whole is better off.

But how diffused/concentrated are the gains from this trade in both countries? The dollar value of this trade – the gains from trade – might be such that the parties who are a part of this trade are better off. But is the number of people who are better off more than the number of people who are worse off?

Don’t think about this in the context of my examplein this blogpost. What about in the case of importing cheap Chinse goods into India? What about in the case of India exporting software to America? What about in the case of cheap textiles being imported into India from Bangaldesh? Are the dollar gains in case of such trade concentrated, and are the number of people unemployed more diffuse?

And if so, should we just shrug and say that this is the cost of doing business? Or should we institute a form of government that seeks to redistribute the gains from international trade? How well might such a scheme work – does our understanding of governments and their performance the world over fill us with optimism that they can perform this task efficiently?

More: who is likely to have a louder voice in public discourse? Will it be the people who gain from trade, or the people who lose from trade? Who is the government therefore more likely to listen to? Should we therefore abandon international trade altogether? What role should academicians play in this discourse? What role do they play in this discourse?

And it is this that makes the study of international trade so very fascinating. The realization that trade is a Very Good Thing, but that at the same time it is Definitely Not Without Costs. Increasing international trade, while minimizing the damage done to the domestic economy is the tightrope that many countries have walked in the past, and not all of them have been successful all the time. Throw into the mix cultural factors, political pressures and environmental concerns, and you have the recipe for an extremely fertile field of study.

But if you have thought that international trade is just plain awesome, with no downsides, you’re wrong. And if you’ve thought that international trade is just plain horrible, with no upsides, you’re wrong. Getting both sides to talk to each other, and figuring out where exactly we should be on the Say Only No To Trade – Say Only Yes To Trade spectrum is an ongoing battle that will never end.

Enjoy the ride, for what else is there to do?

So No One Loses When It Comes to Trade, Right?…*Right?!*

Friday’s post taught us that trade is a good thing, and that more trade makes us better off.

The magical part is that it makes both parties better off:

This is what economists mean when they say that trade is a non-zero sum game. Trade leaves both parties better off. Both parties in this “game” win. No one loses.
And this is a surprisingly counter-intuitive idea. Sports teaches us that for one side to win, the other has to lose. Sure, draws are possible in sports, but read the sentence again. For one side to win, the other has to lose. In trade, that is not necessarily the case. Both parties can (and often do) win.
Trade is a non-zero sum game, and the more you play this game, the richer you get.

https://econforeverybody.com/2023/01/06/oihr/

In that post, I’d used the example of why we as a family employ the services of a cook, in spite of the fact that I love to cook at home. Employing the services of the cook frees up my time, and so long as I use this time productively, I end up earning enough to both pay for the services of the cook and have a surplus left over in the bargain. The cook is better off because she has a job, I am better off because I earn more money as a consequence of paying the cook money, and so everybody wins.

In classes, I wait for this idea to sink in and say that therefore the idea that we should not buy stuff made in other parts of the world is wrong. That is, we as Indians should be buying stuff made in, say, the USA. Or Europe. Or China. Because if we don’t buy the stuff that we do from there, we must:

a) either import it from someplace else.

But we presumably weren’t importing it from someplace else because someplace else was more expensive (or of lesser quality, or both). So it probably leaves us worse off.

OR

b) manufacture it ourselves. But that’s like me cooking instead of the cook – sure I can do it, but because that leaves me less time to do econ-prof-things, I find my family’s finances to be worse off. Similarly, the opportunity cost argument applies in the context of India too. Manufacturing it ourselves presumably means diverting resources from other things that we could have done with those resources instead. So it probably leaves us worse off.

You might say that hey, us producing this stuff instead still does mean that we are producing something. How does that not leave us better off? Well, ask yourself why you weren’t producing this thing in the first place? If you were able to do a better job job in terms of the quality of the finished product, or in terms of being able to manufacture it at a lower price, or in terms of being able to utilize inputs more efficiently (or some combination of all of these things), why weren’t you producing it all along? Proof by negation, if you like. And that is why I say that it probably leave us worse off.

So, paradoxically, not trading more with other nations leaves us worse off.

Either my blog post on Friday and my blog post today are wrong, or we should be trading more with other countries in order to be better off.

Which is it? And why?

Trade Matters

If there’s one thing you should know about me, it is this: I love food.

Most of us do, I suppose, although I know people who are very much in – and very happy to be in – Team Eat to Live. But based entirely on a magnificently unscientific sampling exercise carried out by yours truly, I feel reasonably safe in saying that more than half of the people I’ve met love food.

But ah, not as much as I do. Me, I dream about food. I plan my day around food. I look up recipes on YouTube, read books about cooking food, read books about the history of food, watch food shows, and some of my best friends in Pune happen to be chefs at restaurants. Food is what makes life wonderful. Fact.

This is an obvious corollary, but I also like to cook. I should be honest and tell you that I am nowhere near as good a cook as I would like to be, but I get a little better every year. Some recipes are now definitely a part of my repertoire, and through a series of hits and misses (of which the latter are far superior in number to the former), I keep adding to to it every year.

But even so, we have a cook who comes home to cook our meals for us. Sure, sometimes my wife or I will take over the kitchen, but on a daily basis it is the cook who bakes for us our daily bread.

Which begs an obvious question.

Why?

Why, that is, do we have a cook coming at home to make our food for us when I like cooking and eating so much?

And my answer to this question is what toda’y blogpost is about.

The reason we have a cook at home is because paying the cook her salary is what makes us rich.


What allows me to type out this post instead of chopping up vegetables for dinner tonight? What allows me to read abstruse papers in economics to prepare for a class that I will teach today, instead of parboiling some rice? What allows me to curl up with a book on public policy, instead of kneading the dough to roll out some chapatis?

Time, of course. I earn time by paying the cook her wages. Because it is the cook who is doing all of these things, I have time on my hands.

What do I do with my time? Well, I write blog posts, I read abstruse papers, and I curl up with books. This allows me to get a little bit better at economics every passing year. Getting a little better at economics every passing year opens up new avenues to teach with every passing year. This teaching earns me enough money to live a comfortable life – and this comfortable life includes paying the cook her wages.

That is what I mean when I say that paying the cook her salary is what makes me rich.

Who loses out in the little “game” that our family plays with the cook? The game, in this context, is simply a way to refer to the fact that we pay the cook her monthly wages in return for the cook cooking our meals for us. Is my family worse off for having done so? I would argue no, for reasons I spoke about above.

Is the cook worse off for finding employment at our place (and at other homes in the neighborhood)? I have not asked her this question, but I feel reasonably safe in saying that she is not worse off. If anything, I would guess that she is better off because she has this job.

And so money exchanges hands for services rendered, but neither party walks away thinking that they got the short end of the metaphorical straw. We say thank you to the cook when we pay her her wages. And the cook says thank you to us when we pay her her wages.

Steven Horwitz speaks about going into a store to buy a turkey:

That turkey is not a gift, as the grocer gets my $9 per pound in return. It is instead a mutually beneficial exchange. We are genuinely thanking each other for having made us each better off. I am happier with the turkey than the $9 and the grocery store prefers the $9 to the pound of turkey. When we thank each other, we genuinely mean it. We are both grateful for the exchange.

https://fee.org/articles/the-double-thank-you-of-the-market/

Substitute the $9 per pound with the monthly wages of our cook, and substitute the turkey for the services rendered to us by the cook, and you will see that we’re both telling you the same story. Both sides of the transaction – in both cases – are benefitting from having been a part of the transaction, and therefore both are saying “thank you”.

(Fun question for you to think about: if you think Amazon is evil, does that make you evil too? This is assuming that you have transacted at least once on the Amazon platform, but then again, you almost certainly have, in one way or the other)

This is what economists mean when they say that trade is a non-zero sum game. Trade leaves both parties better off. Both parties in this “game” win. No one loses.

And this is a surprisingly counter-intuitive idea. Sports teaches us that for one side to win, the other has to lose. Sure, draws are possible in sports, but read the sentence again. For one side to win, the other has to lose. In trade, that is not necessarily the case. Both parties can (and often do) win.

Trade is a non-zero sum game, and the more you play this game, the richer you get.

And as I’ve said often enough on this blog, it is my deely held conviction that life is also a non-zero sum game – but that’s a story for another day.

For the moment, this lesson is more than enough for this blogpost:

Trade is a non-zero sum game

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?

Principles of Economics and Nuclear Reactors

I read a great essay recently that does a fantastic job of explaining why we should be pushing to use much more nuclear energy than we do at present:

Nuclear energy has been quietly producing carbon-free energy for decades, but most don’t know that it accounts for 20% of the US’s electricity and over half of its carbon-free electricity. It’s been the underdog energy source—rarely celebrated, or worse, villainized, and deeply underinvested in.
The war in Ukraine and subsequent global energy crisis, alongside longstanding concern around climate change, has policymakers grappling with how to ensure energy is reliable, abundant, and carbon-free. Nuclear energy is the only energy source that solves for all three.
So why aren’t we building more?

https://juliadewahl.com/nuclear-energy-past-present-future

Oh, and by the way, do take a look at the artist who made the picture at the start of the essay!


I hope you read the whole thing, and I hope that you, like me, are also a fan of using much more nuclear energy in the years to come. If you aren’t, maybe this essay will convince you to at least read more about the issue.

But this essay is also a great way to brush up on your knowledge of the principles of economics!

  1. Take a look at how the author highlights the efficiency of nuclear energy in comparison to other sources. The technical term for the energy industry is “capacity factor”.
  2. How safe (or dangerous, if you prefer to be clear about framing effects) is nuclear fuel? Well, shouldn’t one always be asking relative to what? And if you do ask that question, take a look at this chart for an answer!
  3. Do incentives matter? You bet they do!
  4. Does government support matter? Yes, and yes.
  5. Don’t externalities matter? You bet they do.

Do read the whole thing, please. There’s lots of nice little nuggets in the essay that make it a very enjoyable read, including an xkcd cartoon, great resources that you can add to your bookmarks folder and lots of statistics and links to very interesting reads (Noah’s post on construction productivity is a personal favorite).

But most importantly, if you are a student of economics, get into the habit of reading stuff and deploying your knowledge of the principles of economics. It makes the read more interesting, more thought-provoking and best of all, more understandable.

Incentives Matter, and so do Externalities

In my Principles of Economics classes, I spend a lot of time explaining what I think are the six core principles of economics:

  1. Incentives Matter
  2. There Is No Such Thing As A Free Lunch
  3. Trade Matters
  4. Costs Matter
  5. Information Matters
  6. Externalities Matter

Note that the fifth point is really about prices, which are really about information.


And a recent blogpost by Gulzar Natarajan, one of my favorite bloggers from India, showcases two of these principles really well: incentives, and externalities.

When compared to the task at hand, relocating supply-chains especially from China and attracting global contract manufacturers in various sectors to establish facilities in India, the PLI scheme outlay at Rs 1.97 trillion (~$25 bn) over five years is modest. The scheme extends 4-6% subsidy on incremental sales. However, this is only a small share of the at least 18-20% cost advantage, not to speak of several other locational and supply-chain advantages, enjoyed by manufacturers in China and Vietnam. This coupled with stiff production expansion targets the inevitable bureaucratic difficulties with accessing these benefits mean that the substantive benefits from PLI Scheme are limited. In fact, a recent Bloomberg Intelligence report estimates that it would taken about 8 years to move just 10% of Apple’s production capacity out of China. 

https://gulzar05.blogspot.com/2022/10/some-thoughts-on-pli-as-industrial.html

The PLI scheme incentivizes the domestic manufacture of products across fourteen sectors, by providing subsidies linked to “incremental sales from products that are manufactured in domestic units”. That quote is from the Wikipedia article about the scheme, which is a good place to begin reading more about PLI.

On the face of it, you might think that Gulzar Natarajan’s take on the PLI scheme is a negative one. Because even if the scheme is fully utilized, it still falls short of China’s 18-20% cost advantage, plus the locational and supply chain advantages enjoyed by China (and Vietnam). In fact, as he goes on to say in the blogpost, “the PLI is unlikely to be substantive enough to be a game changer for India’s manufacturing sector”.

Worse, as a Business Standard article that the author links to points out:

Global players have raised concerns on the slow and complex disbursement process, causing some of them to question whether they want to go ahead with their investment commitments under the scheme. Others are questioning the qualifying criteria. And still others are struggling with the “China factor”.

https://www.business-standard.com/article/economy-policy/govt-takes-plis-back-to-the-drawing-board-amid-critical-challenges-122092101038_1.html

But neither the Business Standard article, nor Gulzar Natarajan’s blogpost should be construed to mean that the PLI scheme is a failure (not yet, at least). The Business Standard article points out that the silver lining to the rocky start to the PLI scheme is the willingness of the government to listen (about which more later). And Gulzar Natarajan points out that a good way to think about the PLI scheme is to think of it as a complement to marketing campaign of Make in India. If (my emphasis, not GN’s) the PLI scheme is able to “attract the critical mass of a few big contract manufacturers to establish massive manufacturing facilities in the country”, that in and of itself will be a Very, Very Good Thing.

Which brings me to the second principle of economics at play in this blogpost: externalities matter.

This is perhaps an example to avoid evaluating policies based solely on their substantive merits. The circumstances and their externalities matter, and are often more important than the policies themselves. To put this in perspective, if India’s manufacturing sector moves to the next level in scale and productivity towards the later part of the decade, I’m inclined to argue that while the PLI’s contribution by itself would be small (say, less than a tenth), it could not also have happened without the PLI Scheme.
When examining policies, researchers and commentators fail to see the larger context in which they are being implemented. They are blind to the complex theory of change associated with major policies. More often than not, transformational changes in health, education, nutrition etc are not brought about through technocratically designed and targeted policies. Instead they are brought about by community and stakeholder mobilisation, which engenders a virtuous cycle of ownership and engagement, and which can in turn be triggered by standard policies and programs which are effectively implemented. The entire process has space for improvisation and innovation to improve design and implementation quality.

https://gulzar05.blogspot.com/2022/10/some-thoughts-on-pli-as-industrial.html (emphases added)

Sure, it is entirely possible that the PLI scheme doesn’t meet its stated aims and targets. But if it acts as a catalyst in terms of better scale and productivity, thereby giving a boost to India’s manufacturing sector in the medium to long term, that would be a great start. That is, the positive externalities wrought by the scheme might end up mattering more – and that is just fine.


But.

If you are a student of economics intending to eventually work in the realm of policy-making, you would well to focus on the phrase “community and stakeholder mobilization”. You can come up with the most well-thought-out policy in the world, but it means nothing if you don’t have a) community buy-in and b) the ability to listen to feedback and rework your policies iteratively.

In The Service of the Republic, Ajay Shah and Vijay Kelkar describe Satya Poddar’s four-step policy process:

  1. Defining the future state, or the preferred policy outcome,
  2. Preparing a blueprint for the design and specification of the future state,
  3. Defining the transition path from the current to the future state, and…
  4. Building political consensus or garnering public support for the change.

Of which, the fourth step is often ignored or downplayed, to the detriment of the whole scheme. Remember, announcing a scheme isn’t policymaking. That’s the easy bit. Making it happen is the real challenge, and that requires having a very sensitive ear to the ground at all times.

And that’s why the willingness of the government to listen matters so much, for the success of the PLI scheme depends (very much so) on our ability to tweak it as we go along.

…the success of the Scheme will depend on how nimble, flexible, and courageous are the relevant Ministries of Government of India in responding to emergent problems and trends and adapting the scheme guidelines(say, in calibrating import duties up the value chain). Policy making will have to become entrepreneurial in being able to reap gains from the PLI Scheme.

https://gulzar05.blogspot.com/2022/10/some-thoughts-on-pli-as-industrial.html

Re: the break on the blog (the last post was on the 19th of September): I just felt like taking a break, so I did. 🙂