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Category Archives: Economics

Why Fiddling With Prices Doesn’t Work

The fact is, if you don’t find it reasonable that prices should reflect relative scarcity,
then fundamentally you don’t accept the market economy,
because this is about as close to the essence of the market as you can find.

— Joseph Heath

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Inevitably, when the price of a good or service rises rapidly, there follows an accusation of price-gouging. The term carries a strong moral admonition on the price-gouger, in favor of the price-gougee. Gas shortages are a classic example. With a local shortage of gasoline, gas stations will tend to mark up the price of gasoline to reflect the supply issue. This is usually rewarded with cries of unfairness. But does that really make sense?

In his excellent book Economics Without Illusions, Joseph Heath argues that it doesn’t.

In fact, this very scenario is market pricing reacting just as it should. With gasoline in short supply, the market price rises too so that those who need gasoline have it available, and those who simply want it do not. The price system ensures that everyone makes their choice correctly. If you’re willing to pay up, you pay up. If you’re not, you make alternative arrangements – drive less, use less heat, etc. This is exactly what market pricing is for – to give us a reference as we make our choices. But it’s still hard for many well-intentioned people to understand. Let’s think it through a little, with Heath’s help.

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Daniel Kahneman Answers

In one of the more in-depth and wide-ranging Q&A sessions on the freakonomics blog has run, Daniel Kahneman, whose new book is called Thinking, Fast and Slow, answered 22 questions posted by readers.

Three of the questions that caught my attention:

Q. As you found, humans will take huge, irrational risks to avoid taking a loss. Couldn’t that explain why so many Penn State administrators took the huge risk of not disclosing a sexual assault?

A. In such a case, the loss associated with bringing the scandal into the open now is large, immediate and easy to imagine, whereas the disastrous consequences of procrastination are both vague and delayed. This is probably how many cover-up attempts begin. If people were certain that cover-ups would have very bad personal consequences (as happened in this case), we may see fewer cover-ups in future. From that point of view, the decisive reaction of the board of the University is likely to have beneficial consequences down the road.

Q. Problems in healthcare quality may be getting worse before they get better, and there are countless difficult decisions that will have to be made to ensure long-term system improvement. But on a daily basis, doctors and nurses and patients are each making a variety of decisions that shape healthcare on a smaller but more tangible level. How can the essence of Thinking, Fast and Slow be extracted and applied to the individual decisions that patients and providers make so that the quality of healthcare is optimized?

A. I don’t believe that you can expect the choices of patients and providers to change without changing the situation in which they operate. The incentives of fee-for-service are powerful, and so is the social norm that health is priceless (especially when paid for by a third party). Where the psychology of behavior change and the nudges of behavioral economics come into play is in planning for a transition to a better system. The question that must be asked is, “How can we make it easy for physicians and patients to change in the desired direction?”, which is closely related to, “Why don’t they already want the change?” Quite often, when you raise this question, you may discover that some inexpensive tweaks in the context will substantially change behavior. (For example, we know that people are more likely to pay their taxes if they believe that other people pay their taxes.)

Q:How can I identify my incentives and values so I can create a personal program of behavioral conditioning that associates incentives with the behavior likely to achieve long-term goals?

A. The best sources I know for answers to the question are included in the book Nudge by Richard Thaler and Cass Sunstein, in the book Mindless Eating by Brian Wansink, and in the books of the psychologist Robert Cialdini.

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From Daniel Kahneman Answers Your Questions

Charlie Munger: Why Bureaucracy is not Shareholder Friendly

Charlie Munger, the billionaire partner of Warren Buffett at Berkshire Hathaway, explains why bureaucracy is not shareholder friendly:

The great defect of scale, of course, which makes the game interesting—so that the big people don’t always win—is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality—which is again grounded in human nature.

And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. But, of course, it isn’t. It’s not done until AT&T delivers what it’s supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.

They also tend to become somewhat corrupt. In other words, if I’ve got a department and you’ve got a department and we kind of share power running this thing, there’s sort of an unwritten rule: “If you won’t bother me, I won’t bother you and we’re both happy.” So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They’re too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments—because we do. But it’s a terrible problem to get big bureaucracies to behave.

So people go to stratagems. They create little decentralized units and fancy motivation and training programs. For example, for a big company, General Electric has fought bureaucracy with amazing skill. But that’s because they have a combination of a genius and a fanatic running it. And they put him in young enough so he gets a long run. Of course, that’s Jack Welch.

But bureaucracy is terrible …. And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who’d come up by some career path—I don’t know exactly what it was, but it could have been refrigerators or something—and all of a sudden, he’s loaning money to real estate developers building hotels. It’s a very unequal contest. And in due time, they lost all those billions of dollars.

Munger is perhaps the only person I know who reads more than we do. In fact, we get a lot of our reading off his book recommendations.

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You can learn a lot from Warren Buffett and Charlie Munger. Reading all of the Berkshire Hathaway Letters to Shareholders was better than my MBA. I’m serious.