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Archive for February 2nd, 2011

Moral Harzards in life.

Moral hazards remained me of relationships. Before they begin you’re always worried about the other person what they think, how they are feeling, and more importantly to the self interested mind what they are thinking of you.

However after a while you don’t have quite as much of a incentive to care. You each know each others weaknesses you’ve adapted to them and you’re more prone to take reckless action with each other. You begin to let the person know who you really are and how you really feel. This is where moral hazard comes into play. Before hand you’d be cautious and therefore not release your feelings. However after a while a history has developed that lets you do and say things that wouldn’t normally be allowed. For instance someone in a relationship might make fun of the other person. If I were to make fun of a random person on the street then chances are it wouldn’t go over very well. I might get stabbed, it depends on what street you are on. However when I joke around with someone else that I know the consequences are lower or deferred, which then allows you to have more leeway with the things that you would say or do.

Just like you can have Moral Hazard in relationships you can also have Adverse Selection. When one party enters into a relationship knowing more about it than the other it can lead to future problems. In an extreme case imagine a situation where a young man was courting and married a young women who was pregnant (with out the young man knowing). This would then place the young man at a serve disadvantage because of the lack of information at the time of marriage.

Likewise we enter into relationships in business all the time. And in doing so just as it would seem absurd for someone not to reveal they were pregnant in a relationship it would also be absurd to believe that we shouldn’t disclose other types of information when entering into a formal contract.

Is trust economical?

As we learned from our activity on Monday where most of us picked up 50 cents, trust seems to be prevalent amongst the majority. At least the majority of those in the room. Why? As a consumer, don’t I want to insure that the job is done right by having inspector check the work of a repairman? Couldn’t I just factor into every purchase and repair a little extra money to insure that I’m getting the exact product that I’m paying for? On the other side of the coin, don’t I want to take the money that I could spend to drag an inspector with me on the shopping trips with my girlfriend to spend on some new fishing equipment?

An issue that we have is trust. How do we insure that we can trust that something will be done the way that it should be? I have found 3 factors that help insure trust with a party selling a product or service since starting this class.

Number 1: A business in a permanent public setting tends to have a better track record. If I promise to provide a product or service to a person then I don’t deliver and that person discovers my dishonesty, they know right where to find me. As with the story from class, it’s easy to sale an American a rock instead of a camera as long as you can get away fast.

Number 2: No store wants a bad reputation. It may be hard for Kelsey to find someone to study with after having taken the quarter from the other kid in class. It may have just been 25 cents, but when trust is broken it can be really hard to mend. Word can also spread from an act.

Number 3: Chain stores are more risk aversive by hiring more lawyers. Fine print can be a real issue for a consumer. Chain stores also provide more products and services, allowing them room to slack in some areas without suffering large damages.

Unless you have the ability to drift (traveling salesman), dishonesty isn’t a great way to go.

Applying Friedman To EGYPT!

It has been hard for me to stay focused this week; I’ve been watching the situation in Egypt more or less incessantly as it has progress. Reading about insurance in the sphere of economics was interesting, but since so many others have already blogged about it i’d like to take it from a different angle-the protests turned pandemonium in Egypt.

What started as non-violent protests against the long-time Egyptian president Hosni Mubarak recently turned violent as pro-Mubarak forces stormed into the streets. I presume we have all heard about this biggest story of he week and I don’t need to explain the wild situation anymore. So as the molotov bombs fly and reporters bunker into their hotel rooms the economics side of me (admittedly a recent addition) asks what economic implications do these riots have for Egypt and what economic reasons helped lead to these riots?

As far as implications are concerned I believe they will be huge. As an abstract example, I am planning on traveling to Egypt sometime in my lifetime, but now, I will probably not be able to for a long time. The infrastructure of the area is being destroyed and phone, internet, and communication lines sabotaged. Regardless of who comes out “on top” in this situation rebuilding with be a necessity. Property as well as trust in government and the system it seems, has been broken.

More importantly than future implications I believe, are the economic reasons for Egypt’s protests. To bring the conversation to Friendman’s theme that insurance encourages more irrational behavior (as other posts perfectly describe) is interesting to consider here. Normally, when a crime is committed in any partially civilized country, the perpatrator is punished. The same goes for a looter, a violent person, or arsonists. Essentially a government, in my opinion acts as a  universal insurance provider by giving consequences based on citizens action. In Egypt however, the government and military for the matter are by-and-large non-existent; I think this drastically effects individuals actions and helps propel the movement forward (as in more violent, less democratic, etc).Or their is the self-creation of citizen check points all across downtown Cairo because the Military was unwillingly to help. Additionally, if Egypt’s financial system failed like that of Greece, Portugal, and Spain would it significantly effect the global market? Their are many interesting aspects of this crisis I had to bring up in my post.

All i know for sure is that we need to talk about the crisis in Egypt tomorrow in class if for nothing more than for the reason that it is a huge global issue with far reaching implications. Hopefully though we can connect it to economics in some way.

Facebook: The Most Annoying Signaling Mechanism of ALL Time.

College seems to be the ultimate hub of signaling, because as is demonstrated through the peacock example (Leeson 94), signaling proves to be fairly successful when it comes to attracting a mate. I am perpetually amused by this phenomenon in an annoyed sort of way. Perhaps it annoys me most because it frequently achieves its desired end. But don’t even get me started on the signaling that occurs on Facebook…

Anyhow, signaling can be very effective in a variety of contexts, as is shown by Leeson with the Jolly Roger. I never knew there was so much more to the skull and cross-bones flag! I think that a lot of people signal but are unaware that they are doing so. Being aware of the signals we send certainly makes us more effective.

On somewhat of a side note… I have been feeling ridiculously guilty since Tuesday’s class after walking out 75 cents richer, at the expense of a fellow (and likely also poor) college student. I suppose it bothers me because I’m worried about the signal I may have sent. :) Frankly, I was shocked to be the only one who chose to install a low quality part. It seemed like such the obvious choice from an economic perspective, especially in an econ class. I supposed I would be a fool if I didn’t take the route likeliest to produce the greatest profit to myself. Besides, somebody had to demonstrate the effect of asymmetric information, right? 😉 It would be interesting to see how such a situation would play out in the real world with “real” money. The game strikingly demonstrated the power incentives hold, and likewise sends a warning to those creating incentive structures and those who must navigate such asymmetric situations.

Social “Jolly Roger”ing

As I was reading chapter four of The Invisible Hook I was amazed at just how much sense the concept of the Jolly Roger makes. As I continued to read of it and learn of some of the potential problems that could face the Jolly Roger my mind kept coming back to the concept of social Jolly Rogering.

Every day on campus we see tons of Jolly Rogers and we also fly our own individual Jolly Rogers. The Jolly Roger that I am most fascinated by is the “Hey I’m a super cool indie chick/boy”. We all know these people, we see them every day. In case you don’t know who I am talking about I will describe a few of the Jolly Rogers they fly. You can probably find these people in their skinny jeans, flannel shirts, and TOMS riding their road/cruiser bikes with their so-called “green” grocery bags hanging from the handlebars. Or perhaps you can see them sitting in the local eco-friendly coffee shop drinking from their reusable thermoses and discussing the latest Sundance Film Festival hit. This indie group attracts their same kind and they tend to run in packs while they all fly the same Jolly Roger flags.

As a group they continually face one of the problems that Leeson discusses on pg. 104 of the text. He states that “weaker pirate crews had an incentive to free ride on the skull-and-bones imagery”. This problem of free riders is something that has made itself apparent among my group of friends with the idea that something is “cool” as long as only a select few know about it. Once this “cool” thing becomes hip among the general population it loses its affect and is “lame”. This is illustrated by an experience I had. A few years back my friends were completely obsessed with the band Neon Trees and we went to every show. Now that they have become popular my indie friends think they are “sell outs” and refuse to listen to their music.

The Jolly Roger signal is one that we witness every day. The Jolly Roger flag brought me to the realization of just how applicable economics theories and concepts are in many different aspects of life. But mostly it just made me wonder what kind of Jolly Roger flags I fly every day and if they are really portraying me as I want to be perceived by others.

The Flag that Solved it all

            Not knowing much about pirates before reading Lesson book “The Invisible Hook”, I guess I just had the Hollywood idea of pirates.  Pirates roam the oceans with the skull and cross bone flag, killing everything in their path, and that pirates were these stupid savages.  Well that doesn’t seem to be the case at all, in fact pirates seem to be very good business men.  I wonder how they got such a bad rap or maybe that is what they wanted.  The bad rap that they got might just be the reason why they were successful at what they did. After reading this chapter it all makes logical sense why they did what they did.  For example, pirates didn’t want to go to battle with target for one main reason, they wanted to maximize their profits.  They could not do this by going to battle, battle was expensive.  It seem sometimes you would lose more than gain from the battle.  For instance the ship getting damage, injured men, destroying the merchandise and the big the lost of time.  See after battle you have to repair the ship, which was not a easy task, and take time off for the injured men.  This was a big expense to them.  While they could be out at sea capturing more of their targets to maximize their profits, they were at the harbor repairing, which also left them vulnerable to other pirates.  Their greatest invention to doing this was the “Jolly Roger”, it was to terrify Merchantmen.  When merchantmen saw this flag flying in the air they knew what it meant and what to do if they wanted to live.  So this flag was great on both parties, it kept casualties low on both sides.  Something that I found surprising in this chapter was the pirates were hanged either way if they massacred merchant crews or not.  So for pirates to massacre the resistors was costless.  So I wonder if they didn’t have such a harsh punishment for the pirates that didn’t kill the merchantmen if pirates would have even avoided more battles. 

What’s Your Incentive?

Leeson tells us that pirates had incentive to minimize violent conflict.  Having read Friedman I labeled pirates the “lowest-cost avoider”.  They had incentive to not fight and they were largely in control of whether or not to fight, using the sneak-up tactic and their “Jolly Roger.”  Then I thought that merchants had the same incentive, unless they thought that by fighting they could escape.  And then I started getting all confused, so I decided to break down the possible scenarios like Friedman does.

The Merchant loses everything.  This is an inefficient outcome for the Merchant.
The Pirate gains everything.  This is the MOST efficient outcome for the Pirate.

The Merchant keeps everything.  This is the MOST efficient outcome for the Merchant.
The Pirate gains nothing.  This is only a slightly inefficient outcome for the Pirate.  (He tried and got nothing.  And that Merchant knows their strategy now.  Not a real biggie.)

The Merchant loses everything.  This is the LEAST efficient outcome for the Merchant.
The Pirate gains everything.  This is an* efficient outcome for the Pirate.
*Damages incurred prevent this from being the MOST efficient outcome.

The merchant keeps everything.  This is an* efficient outcome for the Merchant.
*Damages incurred prevent this from being the MOST efficient outcome.
The Pirate gains nothing.  This the LEAST efficient outcome for the Pirate.

For either party to achieve the MOST efficient outcome, they can’t fight.  If they do fight, one party will inevitably get the LEAST efficient outcome.  So it seems like they would never fight, right?  But if the merchant thinks by fighting he can escape where otherwise he couldn’t have, the incentive, then, is to fight.  So it’s not so simple, but it’s interesting to analyze incentives like this.  I think.

Insurance and trust

As was evident in Tuesday’s class, I was the only one in class to get shafted and left the class with no quarters.  I placed my trust in Kelsey and she took advantage of me.  Of course the incentives are low (only quarters) but the principle displayed in class was very interesting.  The overwhelming majority of the class chose to install quality parts and not to inspect.  I believe this is more of an emotion-based rational decision.  When I bought my iPod 2 years ago from Best Buy I also paid for a 2 year insurance policy.  I have used it 4 times, and no questions were asked by Best Buy, though all 4 times were for honest reasons.  I think it was something like $70 dollars, and that was worth it to me.  I value listening to music where ever I am very much and the cost of dealing with Apple directly and waiting for iPods to be sent to me in the mail are greater than $70.  But then I know people who buy these kind of policies and deliberately destroy them so they can get a new model or upgrade if the model they ruined is no longer manufactured.

Friedman was right, having insurance lowers the buyers incentives to a degree.  I’m sure everyone would drive more carefully if purchasing car insurance wasn’t the law.  People wouldn’t build their houses under sea level, in tornado alley, or hurricane prone areas if they didn’t have insurance of the government wouldn’t bail them out.  Perhaps the world would be more efficient without insurance?  I’ve never been in any sort of accident and have never been to the hospital.  All that wasted money could have been used to pay for college or vacations.  But the insurance industry does provide many jobs for many people.  In the end I guess the markets will decide.

Insurance: A winning gamble

Does insuring your home or vehicle really cause you take more risk? Or to pay less attention to the risk? As I thought about this in Chapter 6 of Friedmans book, I couldn’t help but think that just because someone is insured doesn’t mean they take more risk. While it may not be in the factory director advantage to prevent fire because he doesn’t pay the cost, I still find it hard to believe that he would allow himself or other workers to be so careless as to encourage fires. This careless attitude would most likely bleed into other aspects of the factories production. The resulting externalities could have a much deeper negative impact.

Just because I have insurance on my car does not mean that I drive recklessly because I know that I will be able to buy a new car with the insurance money. I have to factor in the externalities of medical bills, time lost at work, time without a car until the insurance comes through and so forth. I felt that Friedman failed to show these externalities as a reason to why insurance works. This is why although insurance companies pay off sometimes, mostly they profit. Maybe I misunderstood but this is how I felt.

Either way, insurance seems to be something in which both parties essentially receive the best out come of the situation. Insurance companies make lots of money each year, profiting from those afraid of loss. And the people who lose are covered by the companies, and those who don’t receive the feeling of safety that if something did happen, they would be cover. Everybody wins.

Insurance. Is it worth it?

Everybody knows about risks.  It doesn’t take a PHD or even a bachelors in economics to be able to explain it to someone else or at the very least provide an example of it.  Everybody attempts to minimize their own risk by various methods.  Some effective some not so much.  I still can’t for the life of me figure out why people where helmets while skydiving.  Do you really think that a helmet is going to save you from a free fall? Or why do people wear seat belts while drunk driving?  But I guess that it is their own way of minimizing their own risks.

Unfortunately there are some risks that just cannot be changed or avoided.  For example, your house burning down.  This is the one Friedman uses.  There is nothing that I can reasonably do to stop so wacko from preforming arson.  But in order to counter balance that we have come up with an ingenious device called insurance.  Insurance basically transfers the cost of a risk to another party.  That party is willing to accept that risks for a small fee.  sometimes that small fee is completely worth it.  Like when your house burns down and it is covered.  Other times it is useless.  Such as when I pay to be covered for open heart surgery.  I will never use it.

Sometimes I think that insurance is just a wait.  This is where the principle of “Moral Hazard” comes into play.  Somethings are just not worth the cost or to put it better, my time.  Its just to big of an inconvenience for me.  For example, when I was a child I was always told to where elbow and knee pads while roller skating.  I HATED IT! I thought it was a waste of time.  Even when I fell it hurt just as much with them as it did with out.  Therefore i would put them on to show my mom that they were there are then promptly ditch them in the bush out front.