People understand incentives. They understand what is good for them and what isn’t. They aren’t moved by the noble intention; they are more concerned by what’s in it for them.

History is filled with examples of how schemes or policies that had good intentions ended up being gamed because they had perverse incentives for the people to game them. And those that don’t learn from history are condemned to repeat it.

Rats in Hanoi and Cobras in Delhi

In the early 1900s rats were a major problem in Hanoi. So the French, came up with a scheme. They told the citizens that a reward would be offered for every rat’s tail that was produced. The logic was that it would be easier to count the rat’s tails than having to deal with the rat corpses.

So pretty soon citizens were producing rat tails and collecting their rewards. Instead of killing the rats, they were cutting their tails and collecting their rewards. The tail-less rats were however free to roam around Hanoi and reproduce more rats whose tails would fetch more rewards.

Some enterprising citizens even had a rat breeding operation going on! They probably figured out, instead of visiting the government office with one tail, they could put economies of scale to work by having a massive rat breeding program where the rewards on the rat’s tails could be made hugely profitable.

Think about it. What did the government want? Rats eradicated. But the scheme created a perverse incentive for the people to keep the rats alive instead and let them breed. If all the rats were eradicated so would the profits. So rat eradication was definitely not what the people wanted.

Several similar tales (pun intended) exist in other countries too. Replace Hanoi with Delhi, the French with the British, and rats with cobras. But the outcome was the same. The British wanted the cobras eradicated and were willing to reward every person who brought a dead cobra. But as you can guess, the citizens’ interest was in breeding the cobras and killing them for money. If the cobras were completely eradicated (as was the good intention), the profits would also be eradicated.

And when the British wizened up to it, they discontinued the scheme. And so the Indians, just let the cobras loose creating an even bigger problem than before.

They say, in jest, that you can conserve more cobras, rats or even tigers by announcing a scalp on their heads! (In jest only…)

Your repairman has perverse incentives too

Let’s say you want your car fixed. But your repairman who charges you based parts and labor, earns more if there are more parts and more labor involved in the repair. So you are likely to receive recommendations to change the oil, the filter, the tires, the what-not.

Caterpillar Inc has a subsidiary –  United Industries and this business was into repairing railroad cars. So some enterprising employees at United Industries actually caused more damages to the railroad cars just to charge a bigger bill to the customers. Well – if they charged only as much as was needed, then United would earn far lesser profits and may need far fewer employees. So it was in the employees interests to commit this crime.

Weed in the Netherlands and the USA

Netherlands is more tolerant to drugs unlike say the USA, where drug possession and consumption is illegal. I truly laud the American intentions.

But let’s not shy of asking some simple questions.

• What drives prices? Demand and Supply. If Demand > Supply, prices go up. And if Demand < Supply, prices go down.
• And what happens to prices when demand is there but supply dries up? Prices shoot up. More people want the commodity and since it is in short supply, they will bid up the prices.
• If the prices shoot up in USA while it is cheap to produce in neighboring countries, what would happen? The price difference creates incentives for risk taking entrepreneurs like say Juan and Pablo to make use of the arbitrage. Bigger the price difference, more the incentive.

This is how Juan and Pablo are probably discussing their next big venture:

Juan proposing: “Say Pablo, you know the price of this thing (pointing to weed in his hand) is so much in USA. And it’s so cheap here. What if we can buy it here at X and sell it there at 10 X?”

To which Pablo would say: “That would be arbitrage! I love it! But what are the risks?”

Juan says contemplatively “Jail time if we are caught”

Pablo retorts “Yes. But that would be a mere speed breaker and not a dead end. We could always resume our business once we get back. But what I want to know is what would ACTUALLY KILL our business permanently?”

Juan thinks hard and then he says: “You know what, here is what I think will ACTUALLY KILL our business. Are you ready for this?”

Pablo says “Si.”

Juan says: “This business is so profitable because we can buy it cheap here at X and sell it there at 10 X the right. So why are the prices so high there?”

Pablo says: “Because it is illegal over there.”

Juan says: “Exactly! We could never pull this off in Netherlands, because they are more tolerant and therefore the weed prices aren’t high. But here, because of the restrictions, the prices are so high. So what would ACTUALLY KILL our business is: if the USA becomes more tolerant like the Netherlands. Because if they became more tolerant, the prices would fall and without the high margins our operations would be finished.”

Pablo says: “Si. Si. So you are saying that the ban on drugs actually helps us and not harm us.”

Now if you have been reading so far, let’s think through what happens when we ban consumption of any sin good.

• Does the demand decrease because of the ban? No. The demand stays where it is. In fact the demand could actually go up because of scarcity.
• Does the supply decrease? Yes. The operators who run their businesses in a legally compliant fashion are usually the first ones to exit. That leaves the field clear for illegal operators (like a Juan and Pablo kind of operation) and they thrive because the prices go up and competition goes down.
• What happens to the prices? Because there is demand and the supply has reduced, the prices are likely to shoot up.
• And then what?
  • Because the government has imposed a ban, it would end up spending more resources on ensuring that ban stays. This would just mean additional costs to the taxpayers.
  • The illegal operators like Juan and Pablo end up making huge margins because of no competition.
  • The price of the sin good goes up really high. The rich would pay more for the smuggled good. The poor are likely to end up consuming cheap and dangerous quality of the good which can actually kill them.
• The government had noble intentions when they imposed the ban. But they are likely to end up with all of these unintended consequences.

We see the same patterns playing out again and again. When Indian states ban liquor, the poor are the ones most likely to get killed consuming illicit liquor. When we impose heavy duties on cigarettes, the production of say ITC cigarettes goes down but the consumption of imported low quality cigarettes goes up.

You may think it is easy to pick faults with the policy makers. But even parents need to think of the behavior they are encouraging. For example, like every parent, I want my kids to read more and do less of screen time. But with time I am realizing that I need to be careful of how I design the system.

• If I outright ban screen time, my kids are likely to sneak behind my back and find ways to do their screen time. (Demand does not go away but supply is constrained forcing them to risk bad behavior like Juan and Pablo.)
• If I force my kids to read for 1 hour every day, they are going to sit in front of a book for an hour but not put much interest into reading.
• If I force my kids to read 100 pages everyday, I am going to see two of the world’s best speed readers at home.
• If I give my kids a limited screen time every day, guess what, the screen time is going to be even more coveted than before. All they can think of is the screen time.

So as you can see, I have to carefully think of ways to get them to read. (As an aside, I try and appeal to their interest like how reading will make them smarter and widen their world view. This seems to work for a few days at a time.)

So the next time we see rules, policies, schemes being introduced for the good of the people, let’s ask – ” … and then what will happen … and then what…”.

-Cheers

Thanks for reading! If you enjoyed this article, you may enjoy my other article on incentive caused bias.

Disclaimer: I have no interests in ITC or weed or any sin good or service. I am merely trying to observe the world through the lens of incentives.