Year: 2009

Pizza Delivery Incentives

Domino’s likes to announce that it doesn’t penalize its delivery boys for not meeting its 30-minute guarantees. It says so on its website, on its menus and the statement is even tagged on the uniforms of said boys.  This seems like a good strategy to have – after all, you don’t want your delivery people to cause or suffer accidents. It is also a good strategy to announce.  Apart from the good reputation you get, it also stops the delivery guys from giving a sob story and getting sympathetic customers to condone delays – this is assuming that Domino’s wants data on delivery performance so that it can track the efficiency of its operations.

Of course, saying that they  won’t penalize delivery boys for bad performance is not the same thing as saying that they won’t reward them for good performance. The two aren’t the same, because of the endowment effect. Then again, you shouldn’t reward them every time they do an on-time delivery, because it will effectively amount to the same thing. You need to reward them for aggregate performance.

Dear Expats

So, you’ve got a job in India. Welcome. I like the fact  that a stint in India is a valuable addition to your CV. I also appreciate that your salary enables you to live among India’s rich. I also understand that you’d like to stay in yuppie enclaves as you find yourself most comfortable there. But having done that, what sense does it make for you to complain that India’s rich yuppies behave like the rich yuppies back home? If you really want to “find” yourself, well, locate yourself elsewhere. There is a lot of India for your kids to experience, if you can sacrifice the comforts of an expatriate lifestyle.

Also, most Indians aim to live their lives. We aren’t particularly interested in being a country-sized museum of anthropology for you guys to visit for extended periods when you get bored of your suburban life.

H G Wells’ Alien

One of H G Wells’ stories or novels had a character who behaved as if he was well-up on all the latest news, but had an out-of date library. If I remember correctly, that character later turns out to be an alien. Does anyone remember the name of the story? Is it from “War of the Worlds”?

I Wasn’t Talking to You

The dark lord says:

The typical arguments are made by the right too. If the economy is going good “see, the deregulation has brought about unprecedented wealth. How can you propose more regulation?”

When the economy goes bad, we get the answer “see, the crisis is brought about due to regulation in the housing mortgage market. How can you propose more regulation?”

Yes, the libertarian right makes this argument, but there is a consistency in it. We believe that most regulations do harm, and that a lightly regulated economy works best.

If the socialist left made the counter-argument, that too would be internally consistent. If you really wanted to regulate the economy all the way to the Soviet Union, you could justifiably claim that both the US and India are variants of the same system. But in my post, I wasn’t arguing with the socialist left – I don’t need to, as history has already answered them.

My argument is with those who say that “we need a free market with some regulations, but that doesn’t mean that we should be socialist”. If you hold that belief, I would expect you to believe that there is some point at which additional regulations do more harm than good, so you’d support some regulations and oppose others. But what I notice is that for supporters of regulation, the right amount of regulation is always “A little more than we have now”.

We Always Need More Regulations

As Ajay Shah points out, we don’t just regulate our financial system, we micro-manage it. When things are going well in the US, and we make the case for deregulation, we get the answer: “See, even in the US, we don’t have a completely free market system. Even they have regulations. How can you propose that we junk ours?”

When things go wrong in the US, we get the answer: “See what happened to the US because they followed a free market system? How can you propose that we junk our regulations? We need more.”

This bias ensures that we will always follow suit when the US moves left, never when it moves to the right.

Perverse Consequences

Two nights before the first communion, Father Antonio Isabel closeted himself with him in the sacristy to hear his confession with the help of a dictionary of sins. It was such a long list that the aged priest, used to going to bed at six o’clock, fell asleep in his chair before it was over. The interrogation was a revelation for Jose Arcadio Segundo. It did not surprise him that the priest asked him if he had done bad things with women, and he honestly answered no, but he was upset with the question as to whether he had done them with animals. The first Friday in May he received the communion, tortured by curiosity. Later he asked Petronio, the sickly sexton who lived in the belfry and who, according to what they said, fed himself on bats, about it, and Petronio answered him: “There are some corrupt Christians who do their business with female donkeys.” Jose Arcadio Segundo still showed so much curiosity and asked so many questions that Petronio lost his patience.

“I go Tuesday nights.” he confessed. “If you promise not to tell anyone I’ll take you next Tuesday.”  (Gabriel Garcia Marquez, One Hundred Years of Solitude)

The purohit who did my upanayana when I was 8 was very wise. He confined himself to forbidding me from throwing stones at dogs.

The Chinese Stock Market

In late 2007, the Shanghai stock market was going through a boom. A Professor of Economics was visiting China and there he learnt that everyone, everyone was expecting the stock market to crash after the Olympics in September 2008. In other words, they assumed the market to keep rising like a Diwali rocket till then, and then fall dramatically.

The professor was amused that no one had reasoned backwards from there. Everyone expected the market to fall in September. So, what would happen in August? Wouldn’t they think, “Hey, I don’t want to get too greedy. I know that the index will rise another month, but what if it suddenly starts falling  and I am caught short? I had better sell right now and book my profits.”

Now, if many people think so, prices will fall, not in September, but in August. But if everyone knows that everyone else is thinking that way, why would they wait till August? Won’t they start selling in July? And so on, by induction, if people expect the market to tank in September, prices should fall right now.

This is what traditional economics suggests. Behavioural economics argues that the professor’s analysis is incomplete. Obviously, not everyone will decide to sell in August, but some people will. What will happen in the market is the classic battle between greed and fear. Some people, overcome by greed, will hold on in the hope of making even more gains, while some people, overcome with fear, will sell. At some point, fear will overcome greed and the market will crash.

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Responses

Venu says

I find it worrisome that you are making quite strong claims (global warming can be handled by markets alone) and then casually stating that you don’t have any evidence for them.

No! I didn’t say that.  All I say is that we will not act on Global Warming at the optimal time. To use an overworked analogy – Hitler. Perhaps there was a time at which he could have been tackled without the enormous carnage of WWII. My view is that given what human nature is, this was unavoidable. We aren’t good at foreseeing and agreeing to act on uncertain threats in the distant future. We are, however, good at getting our act together in the face of a crisis. When we do try to fix problems too distant in the future, we make a lot of mistakes and there is a good chance that we make things worse. So, I propose that we go with the flow and not do anything about Global Warming, and leave things for our children to fix. When we do fix it, we will probably not rely on the market entirely, but we will still be relying on market-like mechanisms.

Ritwik says

Isn’t the market nothing but an aggregation of human behaviour? If you’re agreed in theory and premise with the behaviourists (about hyperbolic discounting, etc.), how are your recommendations so different from the ones they make – why do you (and others like you) consider subject matter expertise to be so important in say, science, but not in policy?

Because behaviourists have not yet come up with practical and actionable recommendations. I know that you have written out the theory of how behavioural economics will prove the EMH wrong. But behavioural economics, while it explains very well why bubbles form, is still unable to tell us the exact, or even approximate moment at which the bubble will burst. Without that, we do not know how to profit from the irrationality of the stock markets.

Likewise, all their “policy recommendations” amount to:

  1. Here is a behavioural quirk that causes ordinary human beings to behave in a way not predicted by standard economic theory
  2. Here is a policy recommendation that fixes the above, which we will assume, for the purposes of simplicity, will be put in place by detached technocrats not subject to the quirks above.

We do not yet have a model of human behaviour that can be used to make predictions about the impact of specific policies when all behavioural traits are considered, and when the fact that even policy-making and implementation is subject to the same quirks is considered. Given this, I did the only scientifically responsible thing possible – I used behavioural psychology to understand (science) but not recommend (policy)

Not everything reduces to incentives, at least in the way that we formally study them. Incentives are great at explaining the average truth, the usual explanation for why something happens. They fail miserably when explaining fringe behaviour or initiatives to tackle fringe issues. By fringe here, I mean not unimportant, but at the edge of our knowledge, efforts and motivations. Of course, one can use a slippery definition of ‘incentives’ and then everything can be considered a function of incentives.

What has this got to do with my post?

And at the end of it all, I am still wondering what your point is. Is it that we won’t be able to ’solve’ global warming, assuming that it is a problem in the first place?

See above – that we will not be able to solve Global Warming at the “optimal” time, and that we shouldn’t try to solve problems too much in advance.  Also, correcting for market failure is not a simple thing.

Markets and the Long Term

The Economist has an article on the problems of aligning the CEO’s interests with those of the shareholders. The obvious solution to this  is to ensure that a large proportion of the manager’s compensation is in the form of shares or stock options. But it turns out that during the recent financial crisis, the more shares of a bank its CEO held, the worse the bank performed.

I believe that this is confounding two different problems. The agency problem relates to aligning an incentives of the agent (i.e. the CEO) to that of the principal (i.e. the shareholders).  The second problem is that of translating long term goals into short term actions.

Human beings are not very good at solving the second problem even when the principal and agent are the same people. We aren’t good at planning our own diet and exercise so that our long-term health is maximized. The challenge is not only the intellectual one of long-term planning, it is also one of the incentive to execute the plan. Who wants health food and rigorous exercise when fried stuff and indolence are so pleasurable?

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