Real Value, a economics documentary by the legendary Behavioral Economist, Dan Ariely, is a available in full length on YouTube. Ariely is know for his ground breaking work on experimental economics, covering fascinating and unconventional economic topics such as pain, attraction and cheating.
Tag: economics
The Net Benefits of Gaming
Is the video game industry a net benefit or a cost to society? Does it do more harm than good? If you were to perform a cost-benefit analysis of the video game industry you would go about trying to quantify the economic benefits (job creation, research and development, etc) against the societal costs (addition, power consumption, etc).
From a qualitative perspective, I would image that the effect of the video game industry on societies would be somewhat similar to wars. Wars have a huge cost to society. They take up huge resources both in terms of labor and capital but more importantly is the destruction of human lives and the irreparable damage it can leave on its participants.
At the same time, wars have been known to accelerate the advancement of certain technologies and scientific discovery. Often, these advancements will have applications far beyond than just some wartime utility.
In the same vain, there are undoubtedly victims of the video gaming industry. Games are hyper-optimized to reward the user of playing and video game addiction is well recorded academically. Countless hours are spent daily on video games, that could otherwise have been deployed to more productive uses.
Yet, the video game industry is also a hotbed for technological advancement. There are countless examples of technologies that were originally developed for the gaming industry, which subsequently found application elsewhere. Slack – a public company with a $16 billion market capitalization as I write this – was originally developed as an internal chap application for a gaming company.
Cost-Benefit Analysis of the South Korean Digital Game Industry
In this cost-benefit analysis of the South Korean Gaming Industry, the researchers attempted to estimate the economic costs and benefits of the digital game industry. Addiction to digital games induces economic costs such as increase in crime, facilities investments for curbing addiction, increase in counselling costs and other welfare losses. The digital game industry in South Korea which is known to have one of the highest rates of game addiction.
The annual cost of game addiction is estimated to be approximately $3.5B while the annual benefit is approximately $24.3B ($3.7B for addicted user market). The proportion of the total costs to total benefits from the game industry is an alarming 14% (95% for addicted user market).
What is Inflation Anyway?
I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.
We don’t seem to ask ourselves how we come up with these number, do we?
Do We Even Know What Inflation Is?
The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”
In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).
If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?
How to Measure Inflation?
This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.
Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?
What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches?
And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.
So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.
The Value of the Road Not Taken
In 1916 Robert Frost published his poem The Road Not Taken. It is a narrative poem, where the narrator describes a moment when he comes to a fork in the road while taking a walk through a forest. After mulling it over, the narrator decides to take the road that seems to be less travelled.
The poem is by many regarded as one of the most misunderstood poems in history. It is often quoted when expressing views of individualism and not conforming to general convention.
At the end of the poem, the narrator sighs as he tells the reader that he took the road less taken and that it made all the difference. But the sigh is left open to interpretation by Frost, as the reader does not know if the sigh is from relief or regret.
The Misinterpreted Message
“You have to be careful of that one; it’s a tricky poem — very tricky,” Frost is known to have said about the poem. The story has it that he wrote it to tease a friend of his, Edward Thomas, who often had problems with coming to a decision over choices that were offered to him. Frost describes him as a person who, “whichever road he went, would be sorry he didn’t go the other”.
An economist would tell you that the problem that Edward Thomas – just as the narrator in the poem – was battling with was the Opportunity Cost of the choices that he had.
Opportunity Cost
The Opportunity Cost of a decision basically equals the benefit of the best alternative option that you have to choose from. This means also means that the opportunity cost is dependent on the situation that you find yourself in at any given time. Furthermore, it means that your opportunity cost is not the same as my opportunity cost.
The concept of opportunity cost is well known in economics and finance, where it is relatively easier to measure the potential outcomes. The Opportunity Cost of Capital, for example, is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
Mistakes of Omission
In The Road Less Taken, the narrator has two choices. Therefore, his opportunity cost is whichever road that he will not take. If he picks the wrong road, he will have made a Mistake of Omission. When asked about their biggest mistakes at the Berkshire Hathaway 2011 annual meeting, the legendary investors Warren Buffett and Charles Munger highlighted specifically about their Mistakes of Omission.
The Road Less Taken
Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;
Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,
And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.
I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
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Solving the Tragedy of the Commons
Common resources are resources which are both non-excludable and rival. Unlike public goods, common resources get depleted as more people use them. An example of a common resource is the Tuna in the ocean.
Tunas are non-excludable since there is no property right to fish in the ocean and no one can legally be prevented or fish for Tuna. The fish are also rival which means everybody fish for Tuna in the ocean which will then leads to the tragedy of the commons which is the depletion of the Tuna stock in the ocean.
Common Pool Resources
The definition of the tragedy of the commons is that the tendency of any resource that is unowned and non-excludable which leads the resource to be overused and under-maintained. A case study of the tragedy of the commons is the Tuna catch which is rapidly depleting by 75% since 1960.
Although nobody wants this to happen this happened because the fisherman has no incentives to conserve and maintain common goods because he/she doesn’t own the stock of resource. There are three approaches to solving the tragedy of the commons:
- command and control,
- cultural norms,
- property rights
1. Command and Control
Command and control can be defined as rules and regulations which can be set to limit or avoid this tragedy but this method work for sometimes and it becomes inefficient and ineffective in the long run. For example, when fishing stocks start to collapse, some rules were made so as to improve the stock like a number of boats that can fish or the number of days to fish in a year. This then becomes ineffective as the fisherman starts to build advanced boats and fishing equipment which makes the regulation more and more complex over time.
2. Cultural Norms
The second approach is the cultural norms and this can evolve where people that overfish are socially disapproved while those that contribute the growth of the resource are honoured and this can help to develop procedures for managing natural resources but it can work on groups that are small and stable and it takes time to develop.
3. Property Rights
Another way to tackle the tragedy of common resources is by making the common resource excludable by creating property rights on them. This will make common resource behave more like a private group. For example, in New Zealand, an innovative solution was pioneered for the tragedy of the commons.
A tradable allowance in fish is created which means property right was created. New Zealand implement what is called Individual Transferable Quotas (ITQs) and this gives a property right to a certain tonnage of fish and the sum of the ITQ is the total allowable catch per year. This ITQs can be bought and sold by the fisherman and the best part is that there are no restrictions on boats or equipment.
- Nordic Fishmonger: The Icelandic Fisheries Management System
- Project Sensor: Biosphere 2 | Environment Monitoring System
- Fundamental Finance Playbook: TCI and the Becoming of the Cable Cowboy
This system is quite effective in New Zealand as it helps to increase the total catch dramatically since it was implemented in New Zealand and this is possible because a fisherman owns a right to a certain amount of fish year by year and he will try to preserve the values of his property over the long run which means that he will not overfish and he will also ensure that another fisherman obeys the ITQs. This means that under the right system the tragedy of the commons can be reduced.
William Forster Lloyd
In 1833, a British mathematician and economist by the name William Forster Lloyd published two lectures titled On the Checks to Population. In one of those lectures, Lloyd describes the phenomenon of the Tragedy of the Commons, with an analogy of a cattle herders that shared a common parcel of land, that they used for grazing.
As Lloyd describes, each individual herder is incentivised to add cattle to his herd as the herder will reap advantages for each additional cattle but the damage to the parcel of land will be shared by all herders. As all herders try to maximize their own benefit of the parcel, this eventually leads the parcel to be overgrazed and potentially destroyed.
Garrett Hardin
In 1968, the ecologist Garrett Hardin coined the phrase Tragedy of the Commons, when an article by the same name was published in the academic journal Science. The article derived its title from Lloyd’s lecture and further outlined the problem described by Lloyd of people being trapped in a tragedy of common resources being depleted, by actors rationally acting on their own incentives.
Prior to Hardin’s publication, terms such as the Commons, Common Pool Resources, or Common Property were very rare in the academic literature. Hardin’s article, however, was focused on the perils of population growth and did not focus directly on proposing a solution for the Tragedy of the Commons problem.
In fact, Hardin concludes his article by saying: “The only way we can preserve and nurture other and more precious freedoms is by relinquishing the freedom to breed, and that very soon. “Freedom is the recognition of necessity”–and it is the role of education to reveal to all the necessity of abandoning the freedom to breed. Only so, can we put an end to this aspect of the tragedy of the commons.”
Elinor Ostrom
It was Elinor Ostrom who pawed the ground for providing solutions to the Tragedy of the Commons. Ostrom was a political economist and a brilliant mind, who dedicated her life to the study of common goods and different systems used to manage common pool resources.
Both Lloyd and Hardin had asked the reader to “imagine a pasture open to anyone.” There was no empirical evidence or data to support the claim. It was a strictly theoretical exercise. The presumption that prevailed was that humans were helpless, trapped within this tragedy.
Elinor Ostrom, along with other scientists, disproved this idea by conducting a wide range of studies on how people in small, local communities manage shared natural resources, such as pastures, fishing waters, and forests.
In the Mid-Eighties, Ostrom and her colleagues started to review the empirical research written about common-pool resources. They discovered that much research had been done on the topic but that it was divided by disciplines, sectors, and regions.
Scholars studying inshore fisheries in Africa would be unaware of studies of resources in Africa. Sociologists would not be aware of the work done by economists and vice versa. Ostrom and others began to synthesize and map out the existing academic research.
In 2009, Elinor Ostrom along with Oliver E. Williamson was awarded the Nobel Prize in Economics for her analysis of economic governance, especially the commons. She is the only woman to have received the prize.
Read More on Economics on How to Value Stuff
The Peltzman Effect & Risk Compensation
Peltzman effect is a theory which states that people tend to increasingly engage in risky behaviours once a security measure has been mandated. This effect is named after Sam Peltzman, an economist who postulated the theory with the use of seatbelts in automobiles.
The original context of the theory was the regulation of risk as the government tries to make things safer by issuing new regulations. Peltzman used auto safety as a case study, where the government made people wear seatbelts and also regulated various other features in the manufacturing of automobiles, such as pop-out windshields and other protective devices which are meant to make us safer.
The Economics of Risk
According to economic theory, when you make things cheaper then you will get more of them. This is what led to Peltzman postulating that when you make a car safer in this way, drives will adjust their behaviour in response to the perceived level of risk.
In other words, if driving becomes safer, the drivers will become riskier when driving. Hence, the increase in safety measures will be compensated by riskier behaviour. This is what economists call Risk Compensation. In the case of auto safety, Peltzman predicted that the increase in risk behaviour would lead to more accidents, that would partly or completely offset the safety benefits of the regulation.
Later, Peltzman performed a study to see what the effects of the first generation of automobile safety regulations were auto-related accidents. The study did not focus on the first order effect (driver safety) but on the global effect (did more people survive on the road or did the automobile death rate goes down).
Risk Homeostasis
The conclusion of the study was that there was no effect on the death rate but there was a reduction in the probability that you would die in an accident which is the main purpose of the device. However, this benefit was completely offset by more accidents and many accidents involve people who weren’t in cars that are protected.
The Peltzman effect shows that people tend to drive recklessly and with less attention since they felt safer in the car which leads to more accidents than when these safety devices came out. The ratio of fatalities in accident went down but there was an increase in the accident which offset the decreased fatality rate.
He then concluded that if government regulates risk or anything, there is going to be an incentive created for behaviours that offset some part of what the government is trying to regulate and it could be a complete, partial, or more than complete offset. And the main thing that this regulation does is that it makes the consequences of an accident less severe.
Examples of Risk Compensation
Although the Peltzman study used the auto safety regulations as an example of risk compensation, this phenomenon has been observed in a range of activities. A few examples would be:
- The use of helmets in skiing, snowboarding and rollerblades has been observed to increase risky behaviour.
- A popular aphorism amongst skydivers, named Booth’s rule nr. 2 states that the safer skydiving gear becomes, the more chances skydivers will take constant
The Water and Diamond Paradox
How can we know the true value of a thing? This has been a philosophical question that dates back to the times of Aristoteles. Philosopher throughout the ages have asked themselves why water which is vital for all life is cheap while diamonds are expensive even though we can easily do without them?
Diminishing Marginal Utility
The solution to the Water-Diamond Paradox is the economic law of diminishing utility. This can be defined as the economic law which states that when there is an input in the production of a community while the other factors are fixed, it is going to get to a point whereby any addition of the good to the consumer of the good is going to lead to low satisfaction with the diminishing increases in the output.
Supply and Demand
A case study is that assuming you are hungry and you find one apple then it is going to precious to you and you are going to eat it to satisfy your hunger and to stay alive. Then if you go for a walk and you see two more apples then you can eat one just for the fun of it and keep the second one till when you are hungry.
If you then happen to see an orchard with lots of apple fruit and you decide to stay close to the orchard, it will come to a time when you will grow tired of eating an apple as it will be nauseating to you. You can then trade some apple for some other commodities that other people will find it to be valuable to them while it is invaluable to you.
This case study shows that each additional value of a given good satisfies a less important need. You can see this as the first apple that you take is mainly for the appraisal of your hunger so as to survive while the second apple fills you up and the third apple was kept for later so as not to be hungry in the future.
This also implies that the first apple that you saw was priceless as you need it to avoid starvation while the second one was just a pleasurable snack while the value of other apples that you find keeps decreasing.
There is no such Thing as Fixed Value
The example above shows that no good has a fixed value. A good will always be considered valuable when people value them. For example, imagine that your parents would buy a sculpture which they really love. Later, once they once they are passed on, you inherit the sculpture. However, you have never liked the sculpture and you feel like it is taking up space.
You mean to throw it away but you’re reluctant to do so because of the sentimental value your parents attached to the sculpture. When discussing your predicament at a party, you discover to your amazement that there is an art collector in town that has been looking for this exact sculpture for years. Suddenly your perceived value of the sculpture has gone up and you are not willing to part with it unless the art collector submits a reasonable bid for the artwork.
In the context of the Water-Diamond Paradox:
- During a drought, people would value water more than rare diamonds as they need it to survive.
- As soon as there is enough water, they will tend to value diamonds more as they have the essential needs to satisfy their hunger and thirst then people try to satisfy their sophisticated needs.
- This theory applies to all the needs in human lives.
How to Value Stuff 