Is Governance Really So Difficult?

Why is taking economic decisions at a national level such a tantalizing task? Why do government policies fail (sometimes miserably)? Why are people still living on the streets under BPL?

You can expose yourself to an array of criticism and theories spun by supposedly thoughtful individuals at any cafe. These folks go on blurting how the present is worse than a decade ago and on and on. I had heard about their side, I wanted to know about the other side too.

Does anybody know how to govern? How to implement schemes and incentive programs to propel a nation to zero inequality, equitable distribution and a teeming economy? The truth is, nobody knows. Neither the cafe hotshot nor the Chief Economic Advisor to the President. It is because systems such as human society are bafflingly complex. Let me share a simple scenario that highlights how incentives can play out in the real world.

A Tale of Two Companies

Logical behavior of rational humans acting in their own best interest end up making the situation worse off for all — Prisoner’s dilemma.

Imagine a town that is infested by rats. To solve the rat problem, two companies are formed. One sells rat traps and the other sells rat poison. Sales were good and gradually, the rat population started to dwindle.

For sake of argument, let’s say a rat trap sells for $100 and rat poison for $50. The town has 1000 customers, 500 of which go to Rat Poison Company (RPC) and 500 buy from Rat Trap Company (RTC).

Both companies have a share of the market based on marketing, customer preference and most importantly, the financial demography of the town (which basically means those who can’t afford expensive goods won’t buy it).

But one day, the manager at RTC had an ingenious idea. He summoned the manager of its rival RPC to a secret meeting and coolly laid out his plan before him. By the end of their secret meeting, both parties were shaking hands and grinning sheepishly.

To everyone’s surprise, the sales of RPC started declining. And it didn’t recover. In fact, RTC ended up dominating the market. Why? The potency of rat poison produced by RPC was decreasing thereby making them ineffective to kill rats. And because rats were an imminent mishap to the town in the absence of a preventive measure, those who used rat poison were forced to switch to rat traps.

This raises the very interesting question, why did RPC allow itself to suffer lose and possibly bankruptcy? Can you figure out what is happening here? (Hint: Think incentives).

Here is what happened at that secret rendezvous of the competitors. RTC stated flatly that because they were competing for market dominance, both of them were depriving themselves of potential profit. So, they asked RPC to deliberately reduce the effectiveness of their poison. This will force all customers to buy rat traps because they cannot do without.

Rat Trap Company promised RPC to give them $35000/mo as reimbursement. RTC pockets an additional $15000 and RPC gets an additional $10000 without doing anything. The companies walk home not only pulling money from thin air but also becoming brothers in conspiracy. This is the reason why the rivals were shaking hands and grinning at the confidential meeting.

Is this optimal?

As morally upsetting and conventionally twisted this arrangement might seem, according to an economist, it is a perfectly justified case of how firms act in ways to optimize profit. Why? Because incentives!

She might even approve of this strategy but she won’t. Because the firms actions don’t play out in a vacuum. They affect everybody in the real world. So, is this arrangement bad? Yes. Very bad.

• As there is virtually no competition to RTC, they can establish a monopoly and charge whatever they want. This is detrimental to the customers who are forced to pay more because of their constrained circumstance (the rat problem). Money that should pay electric bill goes to buy traps. Hospital bills for Uncle Sam’s treatment goes unpaid. You get the point.

• Lack of competition stifles any attempt at innovation. People look for better ways to do things in the hopes of making profits off a successful venture (an invention, a discovery etc). Innovation creates real value in society. Lack of innovation will lead to a dead-end of real value growth, making everybody in the town worse off in the long run.

• Concentration of wealth. Money that should go to pay for a youth’s college is going into the hands of RPC and RTC. Wealth inequality is almost always an indicator of a poor economy. Because, people can’t get exponentially productive and if earning is a measure of one’s productivity, how are a selected few earning exponential gains especially when the town cannot afford to send kids to college? (Note: Exponential gain in itself is not an anomaly, especially in a highly advanced society. Think Zuckerberg creating Facebook. That was instantaneous creation of a lot of value and simultaneously, a fountain of exponential profit for Mark).

This is something I cooked up but it is not hard to see how such incentive driven behavior can affect others, the people and the environment. Such behavior plays out all the time across thousands of companies and firms in inconceivable ways. The real question is, Can we do any better at understanding this web of intricacy?

How is Hilsa population related to rising petroleum prices?

I was motivated to think about incentives while reading the newspaper today. Hilsa, a sought-after fish species, swims to the river to lay eggs in still water and then swim back to the sea. Newborn Hilsa then join the sea later. Fishing of young Hilsa is banned around the Bay of Bengal. However, due to skyrocketing petrol prices, fishermen are unable to keep up their profits. That further supplemented by Covid induced demand slash has forced them to break law and fish in the river or near the shores thereby depleting the young Hilsa population fiercely who are caught in finer fishing nets while swimming back to the sea. Seemingly unrelated, eh?

In conclusion

I found sharing these scenarios fruitful because they concisely highlight how is it not obvious to anticipate human behavior.

It is buffoonery to criticise someone without prior knowledge of all facets relevant to the case. With that note, governments (good governments at least) always optimize their decisions in the long-run. And at the hazard of sounding obvious, behavioral economics is a fucking awesome subject to study!