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 cant 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

Economists 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 govt anti-poaching programs,
and lower market price for these illicit items

How do we save the rhino?

Its about economics; science tells us where it
lives, but economics can help stop humans
from killing them.
Incentives matter; if youre 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
Economists 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
Its 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 dont 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
companys 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 firms
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 banksand the hedge funds that ran alongside themwere 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 didnt have
to repay their bonuses earned in the good
years

Other culpable parties: the credit rating

agencies; Standard and Poors, Moodys,
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
dealershipor you paying your professor
to give you a grade

Still a problem; senior executives will be taking

risks with firms 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=Q0zE
XdDO5JU

Real Estate Agent

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.

The Prisoners Dilemma

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


1.
2.

1.
2.
3.
4.

Two Strategies the prisoners may use:

Confess to the murder
Deny having committed the murder
There are 4 possible outcomes:
Both prisoners confess
Both deny involvement.
One confesses, the other denies
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

Renewable Natural Resources:

Fisheries
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.

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 dont 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

Taxes
Its 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 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
firms 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 Carbon?
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 nonrenewable resources, and curtail CO2
emissions

The Ideal Tax?

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!!

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
cant 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

Price Discrimination
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

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.

Examples
of Price Discrimination

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