Naked Economics

Naked Economics Chapter 2

Incentives Matter

• Black Rhino in southern Africa • In 1970, 65,000; now only 4000 remain

• Why do people kill Black Rhino? • What are their incentives? • $$ • Powerful aphrodisiac/fever reducer • Yemenese dagger handle; $35,000 for one

horn in a country with a GDP of $1000 per capita yearly income

• We can’t increase supply, the market cannot correct itself

• Supply dwindles, profit $ increases, leads to greater incentive for poachers…

• Rhinos are communal property, unfortunately this creates problems.

• If they were private property, no rancher would let their supply drop from 65k to 4k in 40 years!! He would maximize the value of his scarce resource.

• But villagers derive no benefit: the rhinos cause damage and are a nuisance

(like showing strangers rats in your neighborhood…)

• If one tour operator would contribute to the preservation of the rhinos, but others contribute nothing, we have the problem of free-riders

• It spends to protect, while others benefit; it would suffer a cost-disadvantage, consequently be more expensive

• Economist’s insight: align incentives of people near the rhinos; give reason to want the rhinos alive…

• Citizens must share in the profits • (Now in East Africa, the reverse is true as

citizens were benefitting from tourists wanting to see the Mountain Gorillas, but now, there is civil war; no benefits so back to cutting timber…)

• Another solution: cut off the horn! The animal is not worth killing without the horn.

• The animal suffers slightly against predators, but poachers (illegal hunters) kill the animal anyway; it was a waste of time, and the stump of the horn is still worth $$

• Plus, to kill a rhino makes them even more rare; increases the value of the living specimens with horns!

• Can we reduce the demand? • Should we allow trade of endangered species? • Most say no! –Owning rhino horn daggers is illegal in

the US, so demand decreases and poachers have less incentive to kill…

• But others suggest selling confiscated animal parts to fund gov’t anti-poaching programs,

and lower market price for these illicit items

• How do we save the rhino? • It’s about economics; science tells us where it

lives, but economics can help stop humans from killing them.

• Incentives matter; if you’re paid on commission, you work harder

• Adam Smith: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

• Bill Gates dropped out of college out of self-interest; made us all better off…

• Self-interest makes the world go around… • If any system that does not rely on markets, personal

incentives are usually divorced from productivity • Firms in this poor system are not rewarded for hard

work and innovation; nor punished for sloth and inefficiency

• East German car production; Hindustani Fertilizer Company…

• North Korea cannot feed itself, produces nothing valuable enough to trade

• In the US, the issues are dependency on foreign oil and environmental impact of CO2 emissions

• Economist’s solution: make carbon more expensive

• American public education; the problem is the pay of teachers is not linked in any way to performance!

• Unions oppose merit pay; salaries are determined by experience and years of schooling (factors unrelated to performance)

• The incentives create adverse selection: talented teachers are likely to be good at other professions; they have a strong incentive to leave education to jobs with pay more linked to productivity

• For the less talented, the incentives are the opposite

• The data shows the brightest students shun education, and the brightest of education majors are least likely to become teachers

• So, if you pay all the teachers the same, the most talented are likely to look elsewhere.

• Humans are complex, so foretelling reactions to incentives is difficult; can create “perverse incentives”; created to accomplish something completely opposite to its effect; sometimes called “the law of unintended consequences”

Examples:

The proposal to require infants to wear seatbelts on a plane

The extra seat costs more, so more will drive

It’s more dangerous to drive, so more deaths occur

• In Mexico City, to curb pollution: all cars must stay off the road at least once a week.

• So, the people bought another car, kept the old one, which causes more pollution than the new one; more pollution!!

• For another example, see http://faculty.winthrop.edu/stonebrakerr/boo

k/slavery.htm

Good policy uses incentives to a positive end

In London, a congestion fee was introduced; each car must pay for the right to use the area

Raise prices, reduce the demand; reduce the number of cars, increase flow of traffic, encourage use of public transport

Good results: traffic fell 20%, average speed doubled, bus delays cut by half, number of bus passengers increased by 14%

But, significant effect of car traffic, so lower revenues than expected

Retailers complain that fee discourages shoppers from visiting central London

Good public policy: uses incentives to channel behavior toward a desired outcome

Bad public policy: ignores incentives, or fails to anticipate how rational individuals might change their behavior

• In the private sector, there is a “cesspool of competing and misaligned incentives”

• “Your meal is free if you don’t get a receipt. Please see a manager.”

• Discourages stealing • Why do prices often end in 99c or 95c? • The Principal-Agent Problem: principal hires

agent, but agent/employee has incentives to do things that are not necessarily in the interest of the principal/firm

• Principal-agent problem occurs at the bottom and at the top of corporations

• CEOs and other executives are agents, hired by the firm. If you own the stock, how do you know the executive will be acting in your interest?

• May rob the cash register figuratively with private jets and country club memberships

• May make strategic decisions that benefit themselves not the stockholders

• Corporate mergers do not often create value; yet it is common CEO behavior. Why?

• Brings attention to the CEO, left running a bigger company; more prestigious, yet less profitable

• Bigger companies mean bigger salaries, bigger offices, big airplanes!

• But as a shareholder/owner, we lose value!

• Some believe stock options were the answer

• Options enable recipient to purchase company’s stock in the future at a predetermined price

• Can be very valuable, or worthless • But CEOs can abuse the option game: executives play for the short run; may be

disastrous in the long run

• Michael Jensen, a Harvard Business School professor, describes stock options as “managerial herion”

• Creates the incentive to do seek short-term highs while doing long-term damage

• Studies show: companies are more likely to engage in accounting fraud, and more likely to default on debt

• CEOs face huge headaches; the Lehman Brothers and Bear Stearns destroyed by employees who took huge risks at the firm’s expense

• Wall Street is where a bad problem became disastrous

• Banks could afford to feed the real estate bubble with reckless loans because they could quickly bundle these loans, “securitize” them, and sell them to investors

• Simon Johnson, former chief economist for the International Monetary Fund said, “Major commercial and investment banks-and the hedge funds that ran alongside them-were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets.”

• transaction fees

For bankers benefiting from the transaction in the form of a fee, they did not bear the risks; their firm did!

Heads they win, tails the firm loses.

Employees lost their jobs, but didn’t have to repay their bonuses earned in the good years

Other culpable parties: the credit rating agencies; Standard and Poor’s, Moody’s,…

Gave stellar ratings to the “toxic assets”

Were paid by firms selling bonds or securities being rated! Like having an appraiser working at a used car dealership…or you paying your professor to give you a grade

• Still a problem; senior executives will be taking risks with firm’s capital

• On the one hand, firms need to reward innovation, risk, insight, hard work

• But, employees doing fancy things (designing new financial products), will know more than their superiors, who know more than the shareholders.

• The challenge: how to reward good outcomes without creating incentives for employees to game the system that will damage the company in the long run

The Crisis of Credit Visualized

http://www.youtube.com/watch?v=Q0zEXdDO5JU

“similar” and “identical” incentives The real estate agent -on the buy side; you hire an agent to help you

buy a house; she gets a percentage of the house’ value, so the higher the price, the better for her

-on the sell side; wants to sell your house quickly, may not want to wait for the “right” price as it takes time and effort and the extra payoff is small compared to the easy sell commission.

Real Estate Agent

A situation wherein rational individuals acting in their own self interest do things that make themselves worse off, and their behavior is logical.

Two men arrested for murder, and are separated and interrogated

Case is not strong, so the police are looking for a confession; choices are offered to the two men

The Prisoner’s Dilemma

Two Strategies the prisoner’s may use: 1. Confess to the murder 2. Deny having committed the murder

There are 4 possible outcomes: 1. Both prisoners confess 2. Both deny involvement. 3. One confesses, the other denies 4. The other confesses, and one denies

The Pay-off Matrix

The logical choice is to confess; they both do, and they are both worse off

Offers insight into real-world situations where unfettered self-interest leads to poor outcomes

Individuals drawing from a common resource Limits should be set to allow population to be stable or

even grow No one “owns” the fish Two choices presented to the fisherman: 1. Limit the catch for conservation 2. Take as many as possible The distrust of other fishermen leads to the best strategy

to be take as many as possible before the other guy gets them

Another example of how rational self-interest leads to a poor outcome.

Renewable Natural Resources: Fisheries

A Possible SOLUTION A community sets a limit and sells licenses;

provides incentive to conserve stocks for future catches and increase the value of the license/right to fish

Licenses can be bought and sold Environmentalists don’t entirely trust this

solution; “privatize” a public resource, and large corporations may purchase all the licenses

Considered to be the most effective tool; half as likely to collapse

Market economy inspires hard work and progress; makes winners and CRUSHES losers

“creative destruction” –Austrian economist Joseph Schumpeter

Typewriter business in the 1990s Wal-Mart versus mom n’ pop stores Technology progress leads to ended careers:

blacksmith, seamstress, telegraph operator, farmer In the US, at the beginning of the 20th century, half

of the population were farmers or ranchers; now only one in 100!

Can be destructive: bills not paid, foreclosures, factories close, “the rust belt”

Not a new issue; weavers in rural England during the Industrial Revolution burned down textile mills

Government is often in the middle; losers asking for protection, winners pressuring for freedom

It’s not easy to transfer money from the rich to the poor

The wealthy do not let laws pass easily

They change their behavior; make taxation difficult by transferring money around, sheltering income, or moving; Bjorn Borg

Taxes

Taxes may discourage economic activity Tax rates may be a feminist issue; the

marginal tax rate for a secondary earner is so high, it discourages work and the wife stays home

On the corporate side, high taxes lower firm’s return on investment; less incentive to invest in plants, research, and other economic stimulating activities

Higher tax rates create the incentive to slip into the “underground economy”; under the table payments; cash economy

Larger underground economy leads to higher taxes, which leads to more people slipping into the underground economy so higher taxes, and so on…

Social benefits can create perverse incentives: unemployment benefits diminish the incentive to work

Social Security and Medicare may reduce the incentive to save

We need a high savings rate to allow for investment that will improve our standard of living

What kind of taxes are best and how should we structure governmental benefits?

Gasoline tax – discourages driving

Income tax – discourages working

“Green” taxes and “sin” taxes

In general, economists prefer taxes that are broad, simple, and fair

Revenue generated by small tax on large group

Easily understood and collected Two similar individuals pay similar taxes IE. We should not tax the sale of red sports

cars If individuals are worse off due to tax, it is

“dead weight loss”

Tax all cars

Tax gasoline

Some say tax the use of all carbon-based fuels such as coal, oil, and gasoline

Broad-based, incentive to conserve non-renewable resources, and curtail CO2 emissions

Tax Carbon?

However, such a broad tax would likely cost the poor a larger fraction of their income (regressive tax rather than progressive)

This offends our sense of justice The lump sum tax – uniformly imposed on

every individual But the Britons rioted against the “poll tax”!!

Every adult paying the same for local community services regardless of their level of income!! Preposterous!!

The Ideal Tax?

Poverty-fighting tool: earned income tax credit (EITC)

Incentives to work: boosts low-wage earners above the poverty line

Creates incentives for individuals to get into the workforce and advance

Cannot help those most needy; those who can’t work

The US can get people to the moon, but there is rampant homelessness. Why?

We need to consider incentives, in both private and public policy, in order to push humans to improve the human condition

• To be able to price discriminate, the firm must

1. Identify and separate different buyer types

2. Sell a product that cannot be sold

• Can only be a feature of monopolistic or oligopolistic markets; where market power can be exercised

Price Discrimination

First degree of price discrimination: price varies by customer's willingness or ability to pay. This arises from the fact that the value of goods is subjective

Seller charges maximum willingness to pay

• Second degree of price discrimination: price varies according to quantity sold; may vary according to quality as well as quantity

• Third degree of price discrimination: price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability/willingness to pay.

• Travel industry • Coupons • Premium pricing • Age group/student status • Discounts for certain occupations • Employee discounts • “ladies night”, haircutting • Haggling, international prices, academic

prices, dual pricing, wage discrimination

Examples of Price Discrimination