Saturday, 20 October 2012

The Economic Way of Thinking

Economists think about things in ways that involve words like “Value”, “incentives” and “utilities”.  Such words are often used by other subjects, so here is an attempt to explain WIHIH (what in hell is happening).  Mostly it is, I think, using the same word for different ideas.

  1.  Value

This is a source of endless confusion.  Here’s the Economist’s notion. 
a.       Think of a demand curve.   That curve traces out the willingness to pay for an additional item of the good.  If consumers are different, it’s the cumulative willingness to pay (WTP) starting with the person who values the good most, Nick, Harriet and Ali in the coffee example.  If consumers are the same, its the WTP arising from diminishing marginal utility of the good.
b.      Now suppose the price is set, by supply or law of something else: say £2.00.  At a price of £2 the Economist says, that gives the willingness to pay of the marginal consumers.  It does not give the WTP of the inframarginal consumers, indeed they earn some consumer surplus precisely because they are not marginal and it’s the marginal consumer’s WTP that the price reveals. 
c.       So what can we say about value in the marketplace?  To economists, all we can say is the value placed on the good by the marginal consumer, here £2.  All the  other consumers who are buying get consumer surplus.  We might, if we knew consumer surplus be able to work out the total WTP as well as the marginal WTP.  And if we wanted to call it that, we might be able to call total WTP total value.  But in Economics we tend not to do that; we reserve value for “value added” which is an accounting term (revenue less cost of intermediate goods used up in production).  Even if we did, economists don’t tend to talk about value in the market place since we would have to be able to count up consumer surplus to measure it.  At best, prices reveal the marginal customer’s WTP, which you might call how much the marginal customers’ values the good.  We need to know a lot more if we want to talk about every customer’s WTP or, if you so define it, their value.
d.      The emphasis on prices as revealing marginal values is, I think, helpful, since it avoids the endless debate on what is “value”.  Diamonds are very expensive and (in Western countries) water is very cheap.  But diamonds are useless baubles whereas water is vital for life.  We can then argue about whether diamond are more or less “valuable” than water, but the Economics approach cuts through this.  All we need realize is that if the price of Diamonds are high, that suggests the WTP, or “value” if you like, of an extra Diamond is by the marginal diamond buyer is very high.  Whereas with a lot of water around, the WTP, or “value” of an extra bottle of water is very low.  I think we can agree on marginal values and we can just avoid having to agree total values.
2.   Prices as incentives

Some object to prices being an incentive.  There are a number of objections.
a.       Consumers/firms don’t care about prices.   Economists: fine, that just says elasticities are low. 
A related notion is that you need, as a business, to emphasize quality, customer loyalty etc. and this somehow is more profitable.  The Economists' answer is that such things don’t come for free.  Getting loyal customers presumably means advertising, R&D etc. all of which costs.  It might shift out the demand curve, or make it less elastic, but its still not a guarantee that it will be profitable: that depends on the discounted benefits to incurring such costs.  Economists are, IMHO, good at looking at correlations between, say advertising spend and future revenue.  But the Black Box of just what neurones in the brain are activated by advertising is not well studied (for more on intrinsic motivation, see below).
b.      When Consumers/firms use prices to incentivise others, this might lead things that are not intended.  Example.  The firm rewards its workers for working quickly i.e. sets a good “price”, in this case a wage, for fast work.  But, then workers produce poor quality.  Economists’ answer.  But this certainly means that economic actors respond to prices! All that is happening here is that they have a menu of actions of dimension N, but the menu of prices they face is less than N, say M. 
c.       A more subtle criticism.  Consumers/firms/economic actors respond to “intrinsic motivation” e.g. fairness, responsibility.  If prices are then used, that will “crowd out” such responsibility.  Example: setting rewards for good performance at work is not a good idea because it offends people’s sense of responsibility and makes them perform worse (a reward for good performance improves behaviour due to extrinsic motivation, but worsens it since it weakens intrinsic motivation, perhaps because it signals that the employer does not trust the worker or if the worker tries due to a concern for social status which is undermined when it is paid for).  This is a key idea in Michael Sandel’s recent work and is discussed in a very interesting recent article by Gneezy, Meier, Rey-Biel, Journal of Economic Perspectives, Fall 2011.

The famous example is Titmuss (1970), “who argued that paying people to donate blood broke established social norms about voluntary contribution and could result in a reduction of established social norms about voluntary contribution and could result in a reduction of the fraction of people who wish to donate.the fraction of people who wish to donate”.
This is very controversial in education, with many programs now starting to pay High School students money to attend school, do exams, hand in work etc.
So what do we know about this area?  My take on the piece is that it is a bit horses for courses. In some contexts intrinsic incentives are so weak that financial rewards are very helpful.   “The current evidence on the effects of financial incentives in education The current evidence on the effects of financial incentives in education indicates moderate short-run positive effects on some subgroups of students, at indicates moderate short-run positive effects on some subgroups of students, at least while the incentives are in place.”
But the article also points out that incentive programmes must be clearly designed to be sure that such crowding out does not occur.  The conclusions are very interesting:

“When explicit incentives seek to change behavior in areas like education, contributions to public goods, and forming habits, a potential confl ict arises between the direct extrinsic effect of the incentives and how these incentives can crowd the intrinsic motivations in the short run and the long run. In education, such incentives seem to have moderate success when the incentives are well-specifi ed and well-targeted (“read these books” rather than “read books”)…

In encouraging contributions to public goods, one must be very careful when designing the incentives to prevent adverse changes in social norms, image concerns, or trust.  

Incentives to modify behavior can in some medial cases be cost effective. The medical and health economics literature intensely investigates whether, and when, prevention is cheaper than treatment (for example, Russell, 1986).  The question is economic rather than moral: certain prevention activities can cost more than than they save,  For example, cholesterol-reducing drugs can cost hundreds of dollars a month; simple exercising could, in some borderline cases, replace these drugs.
Our message is that when economists discuss incentives, they should broaden their focus.  the effects of incentives depend on how they are designed, the form in which they are (especially monetary or nonmonetary), how they interact with intrinsic motivations (especially monetary or nonmonetary), and what happens after they are withdrawn.”