Thursday, October 19, 2006

JC's Life: A Journey in the Incentives of the Law - Part 3

Note: This is the continuation of a longer story. Click below to read:

As Country became chaotic, eventually everyone except JC and the original Mr. Customer moved out of Country (even the members of the court left).

JC and Mr. Customer knew they had taken a good step in the past when they decided to create the court to enforce explicit promises. From this past experience they knew that the Court needed to act even when there was no explicit agreement to act or not to act in a certain way. So they decided to bring another third party to Country, provided him with a gun, and told him to shoot whoever person committed the following acts: 1) did not fulfil an explicit promise; 2) caused harm to some other person; 3) took some other people's belongings; 4) created more more serious wrongs against other people; among other acts.

Without noticing, JC and Mr. Customer created the bases of what later would be denominated in Country as Contract Law, Tort Law (yes tort, not cake nor pie), Property Law and Criminal Law.

With these enhanced powers, the Court of law made everyone better off again. JC's business became prolific again, and he no longer had an incentive to hit pedestrians (at least not on purpose). Now he knew that even if there was no agreement between him and the injured party, he could be held liable and could be shot to death.

The penalty of being shot to death was eventually eliminated (at least whenever pedestrians were hit). Every injured pedestrian knew that if JC was shot, then his fabulous pizzas would no longer be available, and JC had an incentive to bribe the injured pedestrian so that he wouldn't take him to court. In the end all these cases were settled outside the court, and injured pedestrians were just compensated by JC for the harm that he had caused.

So, it seems like a socially optimal solution had been achieved since having to pay damages disciplined JC when driving and led him to be careful when delivering pizzas. Completely eliminating the possibility of hitting pedestrians could only be achieved if JC's business was shut down, but this wasn't an optimal action to take because pedestrians actually liked to consume these pizzas. In the end pedestrians were happy for having the right to be compensated when they were hit by JC's car and also because they knew that JC was being sufficiently careful when driving (some people say that some pedestrians tried to get hit on purpose to be able to get a compensation from JC, but this is another story).

As people started moving back to the new Country, JC realized that he no longer could run the business by himself, so decided to hire an employee to deliver the pizzas... oh, boy, if JC had only known what he was getting himself into... (to be continued).

Wednesday, October 18, 2006

JC's Life: A Journey in the Incentives of the Law - Part 2

Note: This is the continuation of a longer story. Click below to read:

So, last time we had John Cautious (JC for short) having bought a car for his deliveries of pizzas. The creation of the court of law directly benefited him and Mr. Customer, and, over time, it also brought additional benefits to his business; namely, an increased customer base. What happened is that Country had become well known for its Court and people started moving into what was known as "those fabulous lands in which promises had value."

Needless to say that owning the car had become absolutely necessary to attend the increased number of orders of pizzas. Driving fast became necessary as well. One problem was that pedestrians were walking on the streets of Country and this could potentially delay his deliveries, having an adverse effect on his business. But his business was not affected at all. Why? Because JC chose not to care about pedestrians and eventually hit one or two of them with his car -'that will teach them not to interrupt my way', he thought.

And yes, pedestrians sometimes played the role of his customers, but JC didn't care. With such a large population, hitting an eventual pedestrian would not affect his customer base. Come on, who would care about pedestrians whenever hitting them brought no consequences? It might actually become a fun thing to do.

Well, it surely wasn't any fun for pedestrians. One of the injured ones went to the famous court of law and requested that JC be shot, or at least that he pay a compensation for the damage that was caused. JC won the legal battle. The court concluded that there was no contract in which JC had promised not to hit pedestrians.

This legal sentence only brought chaos to Country. This was the case not only because JC simply kept on hitting pedestrians, but also because other inhabitants of Country knew that the Court would only act whenever there was a specific promise to act (or not to act) in a certain way. Over time the streets of Country became full of criminals as there were no explicit agreements not to steal or damage other people's belongings.

Now Country was in a really bad situation again. Everything would have been better if such legal sentence had never been written. It seems no one had realized that this sentence was not only going to have an effect on JC and the pedestrian, but also on all the other inhabitants of Country.

As a result, JC had to shut his business down and thought about joining the great migrating wave. Was this the end of the fabulous lands of Country? Of course not. Check part 3 (forthcoming) to know what happened.

Saturday, September 30, 2006

UVa Living Wage Q&A

I found this Q&A document by Professor Edgar Olsen regarding the Living Wage campaign at UVa.

Monday, September 18, 2006

JC's Life: A Journey in the Incentives of the Law - Part 1

Welcome to the life of John Cautious (JC for short from now on). JC's business is simple: to prepare and to deliver pizzas (cheese with onions) in the lands of Country. His business is so simple, that he is both the owner and his only worker.

It seems old days when he first started the business and got his first order. The excitement of getting this first order vanished as soon as he handed the pizza to his only possible customer and all the retribution he got was a door shut right in his face. He had no one to complain to, for there was no government or any legal courts at the time in Country.

JC is not perfectly rational, but he has the ability to learn. After that event, he decided to hand in the pizza only after having gotten the money for it. And so he did, but as soon as he got the money he realized that Mr. Customer didn't have anyone to complain either, so JC kept both the money and the pizza and drove away.

At this point in time, JC and Mr. Customer reached a really bad situation: the former wanted the latter's money, and the latter wanted JC's pizzas, but neither trusted each other anymore, so they simply stopped trading.

Both agents dealt with this dilemma for a while until a court of law was created. This court had the duty of enforcing both parties promises: JC's promise to deliver the pizza, and Mr. Customer's promise to pay for it. If one party did not fulfill its part, the court had the power to shoot it to death (nowadays the court has become more mild and does not apply such extreme punishment; the effect, however, is the same: that neither party find it worth to not fulfill its promise).

Fables are told these days in Country on how the court of law was created. Some say that JC and Mr. Customer sat down one day and thought of a way to prevent either party from walking away: allow a unbiased third party to monitor their actions. This fable says that they both helped this third party obtain the gun and the bullet that was to be used in case one of them broke his promise.

This is the nicest fable, however. Another one tells the story of Mr. Customer hiring Mr. Mafia to force JC to deliver free pizzas, and another one says that it was JC who hired Mr. Mafia to get free money from Mr. Customer. In either of these cases it seems that Mr. Mafia realized that he was better off by obtaining money from both -rather than just one- of them and ended up acting impartially.

No matter how the court was created, finally JC and Mr. Customer were able to do some business. The court of law successfully eliminated the individual incentives to behave opportunistically and made everyone better off. Formally, this court was in charge of enforcing the promises made by the parties, or of making a contract out of those those promises.

Delivering pizzas eventually became prolific and JC was able to buy a car for his deliveries. Everything seemed to be working perfectly in Country but now the possibility of hitting Mr. Pedestrian became latent. This added all sorts of complications, which we will check in further detail in the next few parts of this story.

Saturday, August 05, 2006

Evaluating Evaluations

Just like with any other course, at the end of a summer class students are given the chance of evaluating the performance of the instructor. The standard practice at the University of Virginia in summer classes is that students can complete their evaluations even after they have taken their final exam, or even after having received a letter grade in the course.

This is an odd practice and would not only lead to biased evaluations, but also to non-representative scores for the students.

Let's briefly analyze the incentives that this practice creates. First, because several students' opinions are going to be influenced by the grade they got in the class, this system will lead to negatively biased evaluations (say, if the instructor gave a final exam that was hard in the eyes of the average student).

Because the students are likely to respond in this way, instructors fearing bad evaluations are also likely to become more generous when writing a final exam, when grading it, or when assigning final grades for the course. (Read Freakonomics for actual data on how teachers react when their students grades are used to reflect the performance of themselves as teachers). In the end, exams or grades don't really reflect the level of knowledge of students.

Yes, stating these likely reactions makes some people mad, for they say they would never be influcenced in such a way. This is true for some people, but not for others. But why risk having such biases whenever a simple change can make things a lot better?

For classes in the economics department, the students can fill their evaluations anytime before final exams start, and instructors are not allowed to see the results of their evaluations until after final grades have been assigned. I don't think there is a perfect mechanism that would lead to no biases, but in my point of view, the one described in this paragraph strictly dominates the previous one.

It came as a surprise to me that in summer classes the office of the registrar allows evaluations to be completed even after students have received a final grade. It was far more surprising to realize that this is the standard practice used by most departments at the University during Fall or Spring semesters. The economics department is one exception, and is apparently seen as a strange being for choosing that things be done in a better way.

Sunday, July 30, 2006

Do Incentives Work?

Update (8/5/2006): In case it wasn't clear, this post was just meant to be a joke. I am a great believer that incentives do work by changing the behavior of people and making them react strategically. In the video above the participants try to do their best to avoid the punishment. Most of the fail, yes, but that's just because they were not given sufficient time to react to the incentive. If they had been given a couple of days to prepare, you can be sure that most of them would have memorized the tongue twister and succeeded in the contest. The original post is below:

If people expect to receive a punishment when they do something wrong, then they should be incentivized to do things the right way (as long as the punishment is harsh enough). The following video from a Japanese show seems to violate this postulate. In spite of the harsh punishment that is expected, five out of six participants could not say the tongue twister. What was the punishment? Well, check the video and judge by yourself if it was harsh enough.

Saturday, July 29, 2006

To Punish or to Prevent?

'I would free the leader of the terrorist group, for he no longer represents a threat to society'. These words were said by the father of a candidate for the Peruvian presidency, just a couple of months ago. The person he was talking about was Abimael Guzmán, the leader of the terrorist group Sendero Luminoso (Shining Path) who has been in jail since 1992. According to his reasoning, Guzmán should be set free because he is old now, apparently sick, and because of the shining path's disappearance since he was captured.

This is just to motivate what the purpose of the law should be. Indeed, laws are enacted with the purpose of changing the behavior of agents, and this is done by providing them with incentives. In what follows let's just focus on laws that provide negative incentives; that is, punishments.

If it were to be the case that a law only has an effect on the agent that broke it, then the reasoning in the first paragraph would be valid. Say that a law forbids that agents kill people. If someone breaks this law, then this agent should be imprisoned so that he can no longer kill any more people. But if the agent that broke the law can prove that it would be unfeasible for him to kill more people then he should be freed, for the purpose of the law will be met in the future whether he is in jail or not (and indeed, it would be more efficient to free him so that resources don't have to be spent to keep him in jail).

This point of view however, is incredibly naive because laws cannot be applied in isolation to a single agent. As a result, once a law is applied a message is sent to the rest of the society, and its members will react accordingly.

Someone who believes in the naive approach will believe that the best thing to do is to free all those criminals who no longer represent a threat to society. This however will send a clear signal: commit a crime, then behave well and you will be freed. This application of the law has little impact in deterring or preventing other agents from breaking the law. A much greater deterring effect has an application of the law that doesn't just punish an agent for his specific wrongdoing, but that also takes into account the message that is sent: break the law and you will be punished, no forgiveness granted.

It may seem trivial that the purpose of a criminal law is not just to punish, but -perhaps more importantly- to prevent, or to change the behavior of potential law-breakers. This is why decisions from the legal system are made public. A potential paradox here is that if this is true, then the legal system does not necessarily make justice in a specific case, but instead seeks long term efficiency (which can be incongruent with justice in a specific case).

The message that the application of the law sends to other agents is also present, however, in areas other than criminal law. In these areas it is easier to forget the effect that the application of the law will have on future parties, and we might be tempted to apply justice in a specific case. Say a court of law has to decide whether to enforce a contract that has unfair terms against a woman who is single, unemployed and mother of five children, and who wishes to be released from the contract because she didn't read it before she signed it. In this case, allowing her to be released from the contract would seem like the most fair thing to do (considering her situation). However, if she were to be released, then future parties will have little incentives to inform themselves when signing a contract. In addition, future agents will find that fewer possibilities for contracting will be offered, because fewer agents will be willing to engage in such relationships knowing that their contractual partners can get released from their obligations at their own will.

Monday, June 26, 2006

The Ripping (off) Point: an unfinished story

The Tipping Point by Malcolm Gladwell seeks to analyze those minimal aspects that make society go from one equilibrium to another one. Some examples are the creation of fashion trends, or a sudden decrease in crime rates. He compares these changes with epidemics (I think he calls them social epidemics at some point, from what I can recall).

As a dismal scientist, the idea of unstable equilibria came to my mind. More precisely, how a very small exogenous shock could make a long run equilibrium unstable and make us go to another long run equilibrium. An example of this is how excited I was about this book and how fast I was reading it, but it only took a few minutes for some bastard to steal it (this morning) and I have been forced to switch to a non-reading equilibrium (at least temporarily).

Any readers out there recommend that I buy the book again? I'm just asking because I've already been through the experience of books that are really good at the beginning but then turn out to be a complete disaster: the most extreme example of this is The Fabric of Reality by David Deutsch (simply throw the book away once you finish the second or third chapter).