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.

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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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.