Commitment Devices

The other day, ran into this person who had signed up for a yearlong plan at the local fitness center for a substantial fee. Given that his apartment complex offered the same fitness facilities for free, I wondered why he had to spend all this money. His rationale was that the fact he paid up would motivate him to actually go through the fitness program and in the process, achieve his goal of losing some weight. It stuck me rather odd - until I started thinking about it. There are enough examples of people signing up for such external devices to ensure desired outcomes in future and it comes down to our inability to rationally compute the future returns from a cost incurred in the current period. The rational agent computing the Net Present Value of future benefits is good for text books but as usually happens in Economics, fails spectacularly in practice. Turns out that this is not all that uncommon - there is even some research in Economics around this.
These mechanisms, which serve to nudge us towards actions that we would otherwise avoid, are called 'Commitment Devices'. Think of them as self-preservation devices employed by the future self on the current self to ensure that the actions of the current self do not harm the future self. It is always tempting to eat the extra cake today since the marginal utility to the current self is almost always much higher than the disutility the cake would do to the future self. To keep the current self from eating the cake, imagine the future self from employing a commitment device which could be something like a financial penalty that kicks in every time you break a dietary restriction.
And the full year gym subscription is one such commitment device - the friendly gym next door has already figured that out and lured you into one such contract. 

Nassem Taleb is coming out with a new book: “Antifragile: Things that gain from disorder”:

http://www.fooledbyrandomness.com/Prologue.pdf 

Basically, continuing from the Black Swan, focuses on phenomena (in business, economic systems, life in general) that have the capacity to thrive and grow when exposed to volatility, randomness, uncertainty etc. Fascinating concept.

A couple of snippets from the prologue: 

What is antifragile loves randomness and uncertainty, which also means – crucially – a love of errors, a certain class of errors. Antifragility has a singular property of allowing us to deal with the unknown, to do things without understanding them  —and do them well. Let me be more aggressive: we are largely better at doing than we are at thinking, thanks to antifragility.

By grasping  the  mechanisms  of  antifragility  we  can  build  a  systematic and broad guide to  nonpredictive  decision making under uncertainty in business, politics, medicine, and life in general  —anywhere the unknown preponderates, any situation in which there is randomness, unpredictability, opacity, or incomplete understanding of things.

What is the price of Free?

One of the few things that seem to unite economists of almost every stripe is their criticism of the culture of gifting every holiday season. The argument is fairly simple – buying a gift for a person is making an assumption that the recipient would extract the same value from the gift that had the giver had expected. And we all know how flawed that assumption is – just look at all the gifts that made you go ‘What on earth was she thinking when she gave me this – what use will I find for this?’ before you tossed the gift aside and never ever looked at it again. Every one of those cases was a pure waste in terms of economic value terms: money was spent but no utility derived. Except of course, the utility for the giver derived from the satisfaction of giving – which, unfortunately, economics does not recognize.

Giving stuff away for free has the same issue – the giver incurs a cost in the transaction, but if the recipient does not see at least that value, there is a net economic loss incurred. Which is why economists have long argued against subsidies – if you want to give, the most optimal thing to do is to give cash or semi-liquid options like food coupons which offer the flexibility to the recipient. This argument works well when the relationship is largely transactional, like it is between the government and the citizens.

But how about a relationship between the employer and the employee where there are other motives like employee motivation are involved? For instance, Google famously offers gourmet, free food to all its employees at a considerable cost. In pure economic terms, that is clearly not the most optimal allocation of resources – but then why do they do it? Conventional wisdom says that signals like these have a positive impact on employee loyalty. Not sure if there is any data to back this up - however, that has not stopped companies from routinely indulging their employees with free food, free massages et al. At least Google has managed to leverage this to create an employee-centric image. And maybe the moral here is this: if a company does want to give anything away for free, make the transaction so unique and special that employees will find it hard to put an economic value to the transaction. While that does not take away the problem of economic waste, it does make it worthwhile.

Does your company pamper you with freebies and if yes – would you be better off if it gave you the equivalent amount in cash and let you make the decision on how to use it? Would that reduce your relationship with your employer to merely transactional or would you respect your employer more for having trusted you to make the best use of the cash and thereby, ensuring that there is no economic waste generated out of this transaction? 

What is the right price?

The question is obviously not a simple one – contrary to what standard micro-economics would have us believe. This stuck me the other day when I happened to buy a wicker basket from a roadside vendor. He was part of the large (and growing) informal economy that makes up urban India today. You find them at just about every street corner – selling all sorts of goods and services.

What made this transaction particularly interesting to me was the following:

1. This was typically a low-frequency purchase and clearly not an impulse buy.
2. It was a high value transaction, relative to what you would normally spend at a street vendor.
3. There is obviously no standard price – after all, this is the informal sector.
4. The product itself was manufactured by the vendor himself, usually at the point of sale itself.

All this meant that she would have to be facing the following challenges on a continuous basis:

1. Estimating the demand (Rate of Sale) is not easy – while the response from a supply point of view would be to build to a replenishment level model, pricing the product to ensure an acceptable average revenue stream is practically impossible.
2. Given the low frequency of her sales, she would be forced to cover her costs from a fewer number of transactions. And given that she and her family would be operating in a hand-to-mouth situation, there is literally no room for error – she would have to earn enough to survive on a daily basis.
3. And what it makes even more complicated is factor #4 – given that there is no principal-agent transaction here, she has no clear way of measuring the marginal cost of each product. And that makes identifying the minimum acceptable price for each incremental product impossible to ascertain.

Formidable challenges, as anyone who has gone through an elementary course in micro-economics would realize. In fact, I am pretty sure that this would stump your favorite economist. And yet she does it on a continuous basis – and to me, it is condescending to write her off as being stuck in the poverty trap. One thing we definitely ought to do is to take a brief moment and admire her ‘jugaad’ ability.

And oh by the way, she started with a price of Rs. 450 and we settled at Rs. 200. The haggling process took less than a minute and throughout this brief transaction, she kept pointing towards her brood of kids who were looking on with a mixture of amusement and pathos. And as I walked away, I couldn’t help but feeling –did the presence of the kids contribute to a guilt-induced circuit breaker in the negotiation process? In other words, was I snookered?