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Imagine you are walking along a wide sidewalk downtown Your City, USA.  In front of you and to the left you spot a table.  People are handing out vitamin supplement samples… for free. Do you take one?

A block later, you encounter another table set up.  It’s a different group, but also handing out vitamin supplements for a small fee – say $0.25 for a mini bottle.  Do you buy one?

Now, guess which table was more successful at encouraging people to try vitamin supplements?

A recent Fast Company article citing a similar experiment conducted by J-PAL has created a bit of a stir in the social enterprise blogosphere this last week.  First, BOPreneur Paul Hudnut wrote a very thoughtful and somewhat provocative post titled, “Is It Right to Have the Poor Pay?”  Shortly after, Francisco Noguera at NextBillion posted this equally interesting response to Hudnut’s comments.

The Fast Company article concluded that J-PAL’s experiment, which demonstrated that free mosquito nets were more widely adopted than paid-for nets, had proven false the widely-held belief that it’s right to have the poor pay small fees for development-related goods and services because doing so encourages a sense of ownership.

Really?

Hudnut’s post makes the great point that, while it may not always be appropriate to have the poor pay, “charity doesn’t scale.”   Noguera agrees that “free” sometimes is the best approach, even though market-based approached are generally preferable.  He also remarks on how cross-subsidies can make the latter possible within a social enterprise model.  Both make wonderful points.

But what about the simple fact that “free” is virtually ALWAYS going to be preferable to consumers!  Especially when the alternative is a small fee.

I haven’t read the J-PAL study cited in the Fast Company article, but if it’s as straightforward as it sounds, the outcome should be no surprise to anyone.

The real question is not, “To free or not to free?”  The real question is, Do you measure success by how many mosquito nets you hand out?

If so, maybe free is best. But I’d prefer to measure success based on what % of people are using their mosquito nets six months later.  Or perhaps the % of mosquito nets that are still effective (i.e. in good shape) after 12 months.  Or the change in the number of new malaria cases in the community after 3 years.  If these are the outcomes you’re trying to impact, maybe selling them a mosquito net at a small fee still is the best solution.

Which brings me to my real point here.  Businesses frequently have to create markets and stimulate demand through consumer education and advertising (though internet startups are increasingly doing this through free).  With effort, they get people to value their product enough to pay for it.  Should international development be any different?

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My recent SocialEarth post on investing in waste discussed the chapter by Bergstrom, Kerr and Lachmann in the book, “Moral Markets.”  The chapter, which spans all of 10 pages, is so thought-provoking that I wanted to dig into it a bit more here.

How Wasting Time Changes Incentives

The basic idea, demonstrated in a game-theoretical manner by the authors, is that selfishness and “cheating” are only logical in a world where business partners are cheap and easy to come by.

Think, for example, of how easy it would be to cheat or abuse customers if they were a dime-a-dozen and virtually costless to acquire.

Lucky for us, this isn’t the case; new businesses owners quickly discover that customer acquisition is often hugely expensive.

It is this very fact – that building relationships requires an investment of time and resources – that enables most transactions between business “partners” to occur.  The sunk investment in the relationship makes exploiting a partner a costly decision. Not only would exploitation destroy the relationship and the investment of time it represents, but it would mean having to make a similar investment in a new relationship with a new partner. Social practices that require wasting time, then, create incentives that favor cooperation and build trust.

On the other hand, without this wasted time, the incentives would be such that it would make more sense for one partner to take the money and run, and then go find another partner and do the same to him.

Financial Crises and Overly-Efficient Markets

The irony here is that the authors lead us to the conclusion that making markets too efficient can actually be detrimental over the long-term.

How can that be?  Isn’t the goal to lower transaction costs?  Isn’t that one of the keys to economic growth? Not if the authors are correct and too-efficient markets skew incentives in favor of exploitative relationships that destroy trust and, ultimately, greatly increase transaction costs.

Is this starting to sound familiar? It probably should, as it could be argued that overly efficient markets were part of the cause of the recent financial crisis.

As Niall Ferguson discusses in his book, “The Ascent of Money,” the secondary market for mortgages and mortgage-backed securities (and their associated CDOs) were innovations that allowed the risks and liabilities associated with these loans to be effectively hedged and distributed throughout financial markets.

On the positive side, this meant that your local WellsFargo branch could hand out a virtually unlimited number of mortgages, since they would provide you with yours and sell it off almost immediately in the secondary market.  The fees collected on the transaction would bring nice profits, while selling off your mortgage would free up capital to provide yet another mortgage to someone else.

Throughout the early 2000s, mortgage lenders indeed repeated this process in an almost never-ending cycle that pushed rates of homeownership up to their highest levels in US history.

On the negative side, however, the fact that your local WellsFargo branch wouldn’t be bearing the risk of giving you a mortgage meant that they had little stake in the transaction. Lending relationships used to be established based on the kind of trust-building and “time wasting” discussed above, in order to protect lenders from risk of default. This new arrangement, however, allowed the old courting process to be tossed aside. After all, the person (or people) who would ultimately own your loan and collect your interest were likely to live hundreds if not thousands of miles away. So all WellsFargo had to do was collect your information and make sure you met the requirements on paper.

In fact, the distance between the actual borrowers and lenders made it easy for naive, risk-seeking “lenders” to extend credit to even the flakiest of borrowers. As we now know, the eventual result was to push even the most “sub-prime” of borrowers into homes and mortgages that they wouldn’t be able to afford. Once these individuals began to default on their loans en masse, the house of cards would come tumbling down.

Where To From Here

Bergstrom, Kerr, and Lachmann remind us that the social and cultural institutions, like courtship and time-wasting, that we have created over the centuries often play an integral role in making our societies and economies work. Yet, we also recognize that courtship is costly and inefficient, and we want to find ways to lessen these transaction costs so that our economies can continue to grow.  So what to do?

It’s tempting to simply say that we must make the courtship process more efficient.  That is, find ways to build trust while wasting less time, perhaps through more scientific and efficient vetting processes.  However, more efficient courtship, no matter how it’s done, still means fewer “sunk costs” in the relationship and therefore greater incentive to exploit.

However, what if courtship could be paired with reputational currency systems in such a way as to make the efficiency of the courtship process proportional to the strength of one’s reputation? We already approximate this in places like eBay and the job market.  On eBay, you might be willing to buy from a lower-ranked seller, but perhaps only after having the opportunity to communicate with him directly over the phone. In the job market, candidates who are referred by competent and reliable employees are likely to move through the hiring process faster than those who submit applications online.

So what if we could make our reputations more digital, portable, and universally accessible as well as acceptable/reliable?  Could we then eliminate some of the “sunk costs” associated with courtship for highly trustworthy partners while increasing the investment in “waste” required from less trustworthy peers?

It’s hard to say.  But the fact remains – until we can create new social institutions that allow us to reduce transaction costs without increasing the incentives for cheating, we must be wary of making our markets too impersonal and efficient.

After taking a hiatus from my road biking due to other commitments and cold weather, I hooked it up to my trainer last weekend and went for a ride.

It was a much-needed break from all the lack of exercise and terrible eating I had been doing. So though it wasn’t exactly fun, it felt great.

As soon as I got off the bike, I also found that I suddenly had an aversion to snacks and fatty foods. Why should this be?  I know that exercise has been shown to be an appetite suppressant, but is what’s going on here really just physiological, or could it also be psychological?

As I pondered my situation, I realized that what was pushing me to suddenly eat more healthfully was the desire to not destroy the benefit gained from exercise.  I was, it seemed, experiencing loss aversion at work.

Could this be why dieting is so unsuccessful when not accompanied by exercise?  Could it be that when a change in diet is the focal point of healthier living, that exercise feels like an additional sacrifice?

When exercise is the focal point, however, eating healthfully is a natural response based in our loss averse tendencies.  I mean, you just burned all those calories. You’re not going to put them back on by eating that fatty cheeseburger, are you?

Hat tip to A Blank Slate Blog for this interesting snippet. Racial segregation has been a serious interest of mine, and sparked an exploratory study on the experience of students of color at predominantly white colleges, which essentially became my undergraduate thesis. What my co-collaborator and I found were very much along the same lines.

Hope you find it interesting.

Hat tip to El Canasto Mini

From the_amandas photostreamI majored in sociology and anthropology in college.  A couple of weeks before graduation, my academic adviser asked me, “What is the most significant thing that the major has taught you?”  

Of course, he had to ask the question in a public venue, so I felt obligated to provide an intelligent-sounding answer (I believe I spouted off some B.S. about the role of identity in decision-making).  However, I knew that I didn’t really know.  And so did my adviser, who informed me that my answer was unsatisfactory.  The question has stuck with me since.

Now, in my defense, his question was entirely unfair.  Nobody could provide a really good answer to such a fundamental question without some perspective.  I’ve been thinking lately that my study of economics may be providing just that.

As I learn more about traditional economic theory and its corresponding mathematical models and methods, I can’t help but envision a set of perfectly crafted boxes.  These boxes are elegant and glossy.  They are well structured, with clean lines and a logical size and form.  And they are strong, capable of withstanding virtually any weight or impact.  

These boxes have a single purpose in life – to get your personal possessions from point A to point B – and these boxes are designed to carry out that mission optimally, assuming the items in your home conform to particular “standards” and common assumptions.  When that’s the case, all of your items will fit in the minimal number of boxes, while also being maximally protected from damage during the move. 

But your home doesn’t quite fit the standard.  It’s full of third generation hand-me-downs, like your grandmother’s kitchen table, and all of those unsolicited wedding gifts (ooh, another crystal bowl!).  It includes various-sized mementos from international vacations and the six months you spent overseas in India after graduating from college (you were a child of the 60’s, after all).  And then there’s the antiquated microwave – oh, and those baseball trophies from your high school glory days will need to come, too.

In this world, the econ boxes break down.  You try your hardest to shove your belongings inside them, but despite their seemingly perfect design, their size and shape feels awkward and unaccommodating.  Not only that, but a number of your items aren’t even well-suited to boxes.  Some plastic bubble wrap and duct tape would do just fine.

This is the world where sociological and anthropological theoretical models and methods thrive.  As moving boxes, they come in all kinds of odd shapes and sizes.  Some are neat, new, and glossy. Others you collected from the local grocery; they are a bit dirty inside and smell of rotting fruit, but they fit your old college textbooks just right.  Several more you’ve been saving in your basement since your last move, as they worked perfectly for that mismatched set of pots and pans in the kitchen.  

In this way, theoretical models and methods in social sciences like sociology and anthropology often lack the grace, elegance, and appearance of perfection in engineering of their economics counterparts. Yet, the “boxes” in which these disciplines organize their thinking and interpretations of human behavior are often better-suited to our messy and unpredictable world.  Not only that, but the lack of a true canon in these fields makes problem-solving and research a much more creative and inductive, rather than prescriptive and deductive, process.  

It’s that open-ended manner of thinking and approach to understanding the world that makes these “other” social sciences so valuable, and why I am ultimately proud to have undertaken that course of study.

As the current economic and financial crisis is showing us, traditional economic theory is fragile, at best.  While the mathematical rigor that economists bring to their work is admirable, it will only be through the intersection with “messier” social sciences that economics will truly realize its potential.  I hope to be part of that movement.

I just finished Thaler and Sunstein’s Nudge.  Though my enthusiasm faded a bit as the book wore on, I have to admit that the concept of choice architecture that they explore is one of the most exciting ideas that I’ve encountered in a long time.  So exciting, in fact, that I would consider making a career of it (in some ways I already am).

Enthusiasm aside, as I finished the last chapter on “Objections” tonight, I was struck by one of the authors’ comments.  

They discuss the objection that policymakers should always attempt to be neutral.  Well, the premise of the book rests largely on the fact that many of us are choice architects, even though we may not realize it.  We are involved in designing the environments in which people make decisions.  Therefore we influence decisions, whether we like it or not.  So we might as well be intentional in how we go about our design.

What struck me about the neutrality discussion was the assumption that neutrality somehow denotes innocence.  For some reason, as a society we forgive neutrality and punish or reward intentionality (depending on how things turn out).  So if I kill someone unintentionally – in a car accident, for example – I am treated differently than if I kill someone in a premeditated fashion.  The first is likely to somehow be a result of negligence, while the second is a result of something much more insidious.  In this way, they are different.  Yet, both result in the same outcome.  

Along the same lines, choice architects who drive us toward stupid decisions unintentionally are somehow innocent.  Yet, those who drive us toward bad decisions intentionally are somehow evil because they game the system.  

This seems a bit strange to me.  Maybe it shouldn’t.  But  I would prefer a set of cultural norms that places slightly greater emphasis on personal awareness and responsibility.  

If you drive, you drive safely.  If you nudge, nudge intentionally.

From liccle_minxs photostream

From liccle_minx's photostream

WordPress’s Tag Surfer feature I’m finding very handy.  This morning it served up an interesting post from The Guru Investor on the myth that it took it took investors 25 years to recoup their investment after the great crash of 1929.

Here’s a snippit, but do check it out:

“While many have cited the fact that the Dow Jones Industrial Average took 25 years to get back to its pre-Great-Depression highs as reason to worry that the coming market recovery could take a upwards of 10 or even 20 years, Hulbert says the 25-year Depression recovery figure is misleading for a number of reasons. In reality, he says, it took only four-and-a-half years after the Depression bottom for investors to recapture their losses.”

This is a bit of an old reference in internet time (from > month ago), but this is a new blog, so who cares.

Below is a link to one of the better bits I’ve heard on the reality and dangers of deratives trading, how the trade was allowed to grow and thrive over the years, and how the lack of transparency leant itself to the eventual collapse.

“Frank Partnoy directs the University of San Diego’s new Center for Corporate and Securities Law.”  He’s also a former derivatives trader.

Enjoy!

Frank Partnoy on NPR’s Fresh Air

Whether you are an avid follower and interpreter of the financial crisis or just trying to figure out why you lost your job, look no further. 

Lots of good analysis from Simon Johnson, former IMF chief economist and MIT professor, and his co-authors, James Kwak and Peter Boone.

The Baseline Scenario.

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