Saturday, 3 October 2009

Windfalls, incentives and Monopoly

Markets and economies generally work because people have incentives to find welfare-enhancing trades.

If you can keep the profit you make from a trade and spend it on something nice, you are more likely to make the trade. The same applies to working an extra few hours, or selling your car to someone who needs it more than you do.

This is why incentives are important. And it is the basis of the major objection to high taxes and redistribution - it is meant to dilute incentives and discourage people from achieving maximum economic productivity.

So what if the tax is a complete surprise?

If a government creates a straight one-off windfall tax, it cannot affect economic behaviour before the windfall, because it is unforeseeable. It should not, in theory, affect economic behaviour after the windfall, because it is a one-off tax and therefore there is no reason to expect it will happen again.

So why don't governments finance all their operations by a series one-off windfall taxes? Because of course, then they wouldn't be one-offs. People would come to expect some kind of random tax in the near future and it would undoubtedly affect their behaviour just as much - or more - than a regular income or consumption tax.

But where does a windfall stop being a windfall and start being a predictable tax event?

I have been dabbling in a game called Monopoly City Streets, which is based on the board game Monopoly - I trust I don't have to explain to readers of this blog how that works. The key point is that you spend money to buy properties, and make it back by charging rent.

A few days ago Monopoly City Streets underwent a major unannounced rule change, and the amount of rent paid on the most expensive properties was cut drastically.

Should this have affected behaviour? Well, it did change the incentives in the game, by affecting the relative returns on different assets. So future investments will be quite different than those before the change.

But should it change how people relate to the game itself? The change caused a storm of protest among players who had been investing on the basis of the old rule...many of whom threatened to stop playing. They had, as they saw it, invested hours or days of time in building up a portfolio whose value had just been arbitrarily cut by the "government".

If they'd known their time would be wasted, they might not have spent any time on the game in the first place. Should they stop playing now? Should they simply adjust their strategy to the new rules and carry on?

Classical economic theory doesn't shed a great deal of light on this dilemma. Rationally, decisions should be affected only by a cost-benefit analysis of the future, not past. Costs incurred in the past - time or money - are sunk. If you've just had $1 billion confiscated, it should just be as if you never had it in the first place.

But two factors mean that these windfall actions are relevant. The first is this: expectations about the future are based on experience of the past. If people believe that the government has a habit of imposing capricious taxes, they'll act as if more taxes are in their future.

The second is resentment, originating in a desire to be treated fairly. People who feel they are not, or have not been, treated fairly are less willing to participate in a social system.

In fact, these two factors may come from the same place: the need for simple ways to predict the future. If people are going to act on anything other than the immediate influences on them in the present, they need to have enough certainty about the future to take that into account too.

Since we usually can't predict the future with any degree of precision, two straightforward heuristics can be used:
  1. The future will be like the past
  2. The world is fair
The danger, then, of windfalls and other economic surprises is that they weaken our heuristics about the future. The economic damage this can do will be the subject of a future article.

Monopoly City Streets also presents a number of other good economics lessons, and I'll write more about those soon too.

Update: this is all a bit like the Paradox of the Unexpected Hanging. If you haven't seen that one, it's one of the classic logical paradoxes. Solutions welcomed!

1 comment:

codemonkey_uk said...

Both the heuristics wrong, the first is only mostly wrong, but still useful, the second is fundamentally wrong, and worse than useless.

The future will *usually* be *mostly* like the past.

The world is *not* fair.

The issue of fairness amuses me, that we want something does not make it so. Every parent has to tell their children, life is not fair. As adults we fight to make the world more fair. That despite this, intelligent people might think that the world *is* fair, baffles me. That economists might operate on the basis that the world is fair would be funny, if it weren't so sad.

Recommended reading for people who think the future is like the past: Any history book, or The Black Swan.

Recommended reading for people who thing the world is fair: Anything put out by Amnesty International or the Red Cross.