A game of incentives, intentions and institutions

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Pre-cursory notes (skip):

Blog 4. Happier with the process through which this blog has come up—the reading started way before the deadline pressure.

I started off with reading about financial institutions, but then took a search towards economic institutions. In my mind, both of these were the same—banks, insurance companies and the likes. It turns out institutions in economics are a much more abstracted view point to look at the world. This was interesting, new information to me.

Unfortunately that also meant that I spent most of my time reading up about them, and realised only towards the end that I would need information diversity to mould this into the ongoing storyline and way of writing I want to pursue. Learning for next week: how to pick up the right set of things to read.

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You book an Uber. The driver arrives directly to your location, has a clean car and greets you well while not being too intrusive. After the ride ends, you give the driver a five star rating and compliment them for the cleanliness and professionalism. If the story ends there, the driver has little to no motivation to retain their attitude — keeping the car clean is costly and driving without conversation gets boring. The driver needs to be incentivised to keep up the good work.

Cab booking, and the gig economy in general, relies heavily on creating the right incentive programs to manage and expand their supply side. Developing an incentive program is more difficult than you think.

Incentives may be of various types

  • Positive: Rewarding better rated drivers with better commissions, vs Negative: Punishing low rated trips with fines
  • Extrinsic: Additional remunerations for good behaviour, vs
    Intrinsic: Deriving satisfaction from appreciation
  • Fixed schedule: Get paid by the hour, irrespective of ride time
    Variable schedule: Commissions on per ride ride basis, higher the rides higher the income

The incentive structure in a system should ideally be designed with the intention of creating win-win relationships. The right set of incentives pushes people to go beyond their abilities and over deliver. Playing with these simple incentives can lead to a startlingly different service.

A couple of examples:

  • Blu is a cab hailing service active in the NCR region, that works on a fixed-schedule basis remuneration i.e. their drivers get paid even for the time they are not carrying a user. What this leads to is that the rides are much easier to get, drivers are more patient, and overall experience feels safer — of course a premium attaches on to the price.
  • The YouTube Incentives program is one of the backbones on top of which YouTube created the supply side of it’s ecosystem. YouTube promises to pass on ~50% of all it’s ad revenue on to the creators. This is in stark contrast to TikTok, that has a static $1Bn creator fund, irrespective of how much the platform makes. As the number of creators rise, the revenue per creator drops. This in turn has resulted in lesser thoughtful and innovative content on TikTok.

“Never, ever, think about something else when you should be thinking about the power of incentives.”

— Charlie Munger

So yeah, incentives are important. But your mom giving you a candy each time you study is an incentive program that is easy to predict. At a larger scale, even programs built with the best of intentions may go haywire — the unintended consequences are large. Post 2002 bankers in the US were incentivised on the quantum of loans disbursed, and were soon blindsided to the quality of backing assets. While this was in good intention to boost the economy, it led to the 2008 financial crisis when the bubble burst.

Institutions come into the picture, as structures that determine the incentives and constraints placed on economic actors, and to make sure these are being done with the right intentions.

Economics defines institutions as well-established arrangements and structures that are part of the culture or society, e.g., competitive markets, the banking system, customary tipping, and a system of property rights are examples of economic institutions. These institutions play a large part in shaping the economic outcomes — they determine not just the size of the pie, but also the distribution of the pie among different groups and individuals.

Economic institutions are determined as collective choices of the society. However, there is no guarantee that all groups will prefer same economic institutions. This is where politics comes in. Whichever group has more political power, is likely to choose the economic institutions — and their choices are driven towards institutions that help them retain the power.

A brief example of this is the monarch system present in Europe during the middle ages. The king and his family had “de-jure political power” — the power was theirs by law. And in absence of any resistance, they deployed heavy tax, labor laws, and next-to-none property rights that ensured their power grows. This de-jure political power enabled them to define the economic institutions that best suit them, and determined the upcoming economic performance.

However, as trade grew, sections of the society—specifically merchants and traders — grew stronger and developed “de facto political power”. There came a time when they garnered enough power to overthrow the king, and set up new political institutions. This in turn led to updation of economic institutions — property rights became a standard, tax laws were relaxed — and people were incentivised to invest and innovate; further leading to the industrial revolution in some ways.

This can be summarised as below. Reference: https://economics.mit.edu/files/4469

From the above, it is evident that political institutions that put a check on political power, can enable impressive economic growth. Another interesting example from the past is the division of North and South Korea. Both the countries were completely at par at the time of division, but employed completely opposite political and economic institutions — South Korea being democratic and North Korea going the communist way. The GDP per capita for South Korea has grown almost 40x, while North Korea remained almost stagnant.

That’s the crux — incentives, created by institutions, with the right intentions govern a lot of how our economy functions. Thankfully, these economic institutions are often very slow moving, and don’t really change without a “shock”. In effect, the current landscape of organisations around us is not something that would change quickly.

With that context set, I will try to read more about the current economic and financial institutions present around us, and how they control the flow of money in the economy.