Economic Incentives, and the Great Hanoi Rat Massacre
Economics is all about incentives.
Incentives drive nearly everything. A characteristically great quote from Charlie Munger reads “Show me the incentive, and I’ll show you the outcome”. The engineering of incentives is constantly being worked on by individuals, institutions, and governments in order to get people to work towards desired outcomes, and the entire economic system functions because of participants who are subject to their forces.
In southern Spain, the fruit picker risks injury, heat stroke, and dehydration, bounding from tree to tree, bush to bush, and vine to vine, day-in day-out, in the earthen equivalent of a frying pan, in order to pick as many strawberries, oranges, melons, you name it, as they can before darkness falls. They are paid per piece, and so incentivized to work quick.
The young waiter in Manhattan with the hangover from Hell appears jovial, jocular even, as she sets drinks upon a table from which there’s little she’d rather do than just take them right back off, before ensconcing herself at a table in the back where she can devour them herself. She must put on this happy front because of the incentive to earn her tip. Rent is fast approaching, and her apartment in Queens is a long way from cheap.
These are explicit, well defined, incentives — the path from incentive to outcome can be traced clearly and logically. Yet even incentives such as these can have a dark side, pushing actors to game the system. Our waiter might charge extra drinks to a corporate party’s bill, who are never going to notice, so the tip will be calculated based on a higher total amount. The fruit picker may pick oranges that, under a situation of a fixed salary or wage, they would ideally have left to ripen for a few more days on the branch.
Incentives can be a force for good. Classic examples are when governments levy taxes or regulations on things which are detrimental to a society in order to discourage their use. This can come in guises such as the carbon taxes applied to manufacturing companies, or the enforced charging for plastic bags in supermarkets (so that people are more likely to reuse them.)
This particular genus of incentive can give birth to policies that disguise the presence of other incentives at play. Take the taxing of alcohol, cigarettes, sugary drinks, and the like. The forces of supply and demand work such that the higher these products are taxed, and the higher the subsequent cost to the consumer, the less of them people will demand.
These are known as “sin taxes”, and the economic logic is clear and sound. Of course, there will be spillovers — think individuals who, unable or unwilling to pay the new increased price, turn to other illicit substances, or black market alternatives, the latter being especially common with cigarettes. Overall though, the conclusion from the literature appears unequivocal — an increase in taxes on these goods will disincentivize their use (for examples, see here, here, and here.)
All fair game by the fiscal authority so far.
The less apparent incentive here manifests itself in the form of the ostensibly benevolent governments taxing these ‘old reliables’, as they’ve been called, simply because they will be predictably big revenue-generators for state coffers. Being addictive, these goods tend to be more ‘inelastic’ than others. This means that demand for them will not drop off as quickly relative to an increase in price as it might for other items. If the price of breakfast cereal rockets, I can always just go for something else — a smoothie, yoghurt, some toast, maybe even an eggs Benedict with smoked salmon and chives? I’m feeling fancy. If the price of cigarettes goes up significantly, however, smokers can find themselves up a certain proverbial creek, sans paddle.
It’s not all bad news though — the incentive to reduce consumption still remains. Recent studies have shown that increases in even the prices of highly addictive street drugs will reduce the demand for them — a $10 increase in the price of cocaine was found to cause a 10% drop in its demand.
Incentives are at work all the time in the world of business. Many pay structures have explicit incentives built in so as to engender better performance from workers. These come in forms such as bonuses, commissions, the aforementioned piece-rates, stock options, kickbacks, etc.
Some can lead to perverse outcomes — a particularly juicy one being the yarn about real estate agents told in Freakonomics.
Real estate agents charge a commission (6% being typical at the time of writing of the book) on the homes that they sell. This would appear to offer a clear and direct incentive for them to get the best possible price for their client, the seller. However, an analysis of data found that the agents themselves kept their own personal homes, when selling, on the market for an average of ten days longer than the regular Joes did, and that they sold them for an average extra 3% of the price. Why was this the case?
Sense can be made when you dig into the incentives. 3% of a $500,000 home is $15,000, a lot of money by most people’s standards. But 6% (the agent’s commission) of this extra money, that would have been earned had the seller held out, is $900, of which the agent may earn just $450 if they had to split half of the commission with their agency (a typical arrangement). Is it really worth the agent putting in 10 more days of their sweat and toil to earn another $450, when they could be channeling all those efforts into new properties, with juicy new commissions? If they do have other such opportunities to pursue, they will be incentivized to take the early offer on the table, and so costing the seller a would-be $14,100.
Of course, with many of these incentives, while they can encourage anything from questionable, to nefarious, to downright fraudulent or predatory behaviour, their directional logic is generally quite evident, and they are often necessary to drive desired outcomes.
It’s imperative to recognise, however, the possibility of actors at the margin on the lookout for ways to game the system to their advantage. As such, those responsible for putting the incentives in place should explore ways this may occur beforehand, in order to head off foul play before it can take root.
Let’s have a look at one time this was not carried out satisfactorily, which lead to a highly unpleasant consequence indeed.
In the year of our Lord 1902, the city of Hanoi found itself in the grips of a horrific rat epidemic. Recent revamps to the sewer system by the rich French colonialists occupying the city created a veritable paradise for the city’s rats, what with them having no natural predators down there, and it being only a short journey up the pipes to the colonialists’ fancy apartments were they to get peckish. The rodents began to proliferate, as rodents are wont to do, and there were major concerns as to the prospect of them carrying the bubonic plague, whose bacteria and its link to rats was discovered just a few short years before this situation occurred.
I recall, whilst living in student accommodation in New York one summer, my housemate tearing into the kitchen after hearing a scream which, according to him, was so loud that it could only have been something as serious as me accidentally chopping a finger off while cooking. He was to discover, to his initial relief and subsequent annoyance, that I had merely seen a mouse run from under the fridge to the radiator. Thus, this situation in Hanoi sounds like a special version of Hell to me, and I can empathise fully with the city officials when they decided that the newly-arrived furry friends were persona non grata, and needed to be gotten rid of.
The government, having little luck themselves quelling the numbers, started offering people a 1c bounty for every rat they killed, which they received when they turned in the tail of the dead rat.
After this policy was brought in, the rat problem perversely began to get much worse.
Officials started observing rats running around the city without tails. This happened, it turned out, because people started catching the rats, cutting off their tails, and then releasing them back into the wild so that they could continue to breed. People now had an incentive to keep as many rats alive as possible — so they could produce offspring, and thus more future tails. They even started finding pop-up rat farms on the outskirts of the city.
One can scarcely imagine the grim circumstances the people of Hanoi must have found themselves in in order to carry out this egregious feat. Incentives are a powerful weapon indeed.
Many thanks for reading, and be sure to follow for more!
