Knowing and Making

Several old political problems turn out to be based on the same underlying question. Here are some examples. Should we tax the rich more? The "yes" argument says rich people need the money less (that is, poor people's utility from wealth is higher), and wealth partly arises from luck and therefore is a legitimate target for taxation. The "no" argument says that if people expect to be taxed when they're rich (and receive handouts when they're poor) they have less incentive to earn wealth, and therefore less wealth will be produced by society. Should we pay higher unemployment benefits? The "yes" argument: people are unemployed through no fault of their own; their spending will support the economy; it's moral to share resources with the poor; if it happened to you, you'd want benefits too. The "no" argument: it gives people an incentive not to work; it requires confiscation of resources from hardworking people to pay those w...

Just a hypothesis here, suggested by Chris Dillow's reference to Baran and Sweezy: ...tends to generate ever more surplus, yet it fails to provide the consumption and investment outlets required for the absorption of a rising surplus and hence for the smooth working of the system. Since surplus which cannot be absorbed will not be produced, it follows that the normal state of the monopoly capitalist economy is stagnation (p108). The essence of the market is that surplus goes to those who produce it: this is a stable situation because it gives the producer an incentive to produce more surplus. But perhaps modern economies of scale and scope lead naturally to ownership, or at least control, being concentrated in the hands of a small number of people: control can't be spread more broadly because of the rational ignorance of the crowd. Sharing a growing amount of wealth among a smaller number of people means that - as Baran and Sweezy suggest - those in control are no longer sign...

A slight misunderstanding here (in my opinion) from datacharmer at the Bluematter blog. Tim Harford: "...[was too fascinated with] behavioural economics. But the financial system did not fail because of some psychological trait, but because it was riddled with damaging incentives" In other words, let's get over evil bankers and the belief that moralizing will change the world, and let's focus on incentives. But behavioural economics is not about moralising, nor is it about blaming individuals for making mistakes in the hope that they won't make them again. It's about understanding why and how people behave the way they do; so that when we do design incentives, they will work. Of course people respond to incentives. What else would they respond to? But if you think they respond consistently, transitively, stably, and (in the technical economic definition ) rationally*, to incentives, you'll be sorely disappointed. Even the most famous exampl...

Interesting puzzle from Chris Dillow today: is it possible to genuinely align the incentives of employees and investors ? This in response to Lord Myners' debate about whether long-term shareholders should have more voting rights than short-term traders. I've touched on this question before but the question of whether shareholders have a real understanding of the company's interests is an excellent one. I have a particular interest in this question because part of my business is designing structured pricing approaches, which are intended to align the interests of supplier and client in a commercial relationship. Structured pricing generally rewards the supplier for achieving business objectives of the client. But while it's a big improvement over traditional contracts, it is still not perfect in theory. For instance, if you hire a telemarketing agency the traditional way to pay them is a fee for each day of time. They'll spend a day on the phone and charge £350. If...

Robert Peston has another example of an economic decision which looks odd from a simplistic rational point of view, but makes perfect sense when perceptions and expectations are taken into account. Firing someone often makes an important statement about the direction of a company. But (as most of us would certainly wish) it's difficult for a company to fire people at will. Thus, companies usually have to pay off the individual - whether with a pension or a lump sum. For a company the size of RBS, a £16 million payoff (or whichever part of this was actually discretionary) is easily worth the improvement in public image that comes with such a major break. Of course the payoff itself - since it inevitably has to be made public - has a perception impact, but that's probably much smaller than the damage of keeping the same person in charge. Would you argue that Goodwin's actions were egregious enough to justify sacking without compensation? Most people have made judgment calls ...

One of the primary criteria in designing any system of pay is to influence the recipients' behaviour. Traditional pay structures work on the assumption that people behave rationally. Thus, they will pay people for generating profits for their company; on the basis that if you pay them more for higher profits, they will generate more profits. This has the attraction of simplifying the manager's job - assume that the employee can figure out the best way to make profits, and leave it to them. However, this structure has at least three intrinsic problems. One is asymmetry: you can pay someone for making profits, but you can't penalise them for making losses. Virtually no employee will work for a company if there are circumstances in which they would have to pay  for the privilege. The other is the agency problem: the employee has control over the company's resources but does not get all of the benefits of using them in the most productive way. Thus, a temptation exists for ...

The motivation principle : People act in their best interest, in the light of the information available to them, over a time period that they can accurately foresee. The first two of these statements seem relatively obvious but perhaps the third is not so clear. It means that people will not take an action today, for some nebulous potential benefit one day in the future. They must gain something in return for the action either immediately, or within a time horizon that they can clearly grasp. How long is that? If I make a calm and considered decision, the time horizon may be as much as a few hours; while in the heat of the moment it may only be a few seconds. Either way, in order to act in my longer-term interest, I must get some kind of short-term payoff or else it's too easy to sell out on my decision. For example, if I want to lose ten pounds and be able to run a marathon in six months, I won't succeed unless I give myself incentives that keep paying off for all those early ...