When Incentives Go Wrong: The Cobra Effect

A story goes that during their colonial rule of India, the British rulers were unhappy with the number of venomous Cobra snakes rolling around the streets of the capital Delhi.
They wondered- how could we get rid of these snakes?
They followed a financial route- offering a bounty for every dead cobra presented to the authorities. This seems perfectly rational- under colonial rule the natives were not exactly the most well off or comfortable people, so most would certainly be willing to kill snakes in exchange for payment. And the British were right, for a while- the number of cobras on the streets decreased initially.

But of course, we wouldn't be recalling this story if nothing went awry. After a while the British found that more cobras were on the streets, despite the same number, if not more, of Indians presenting them dead cobras. What was happening?

The answer was simple but ingenious. The natives were offered financial incentive to kill snakes for the British- but they were now not just from the streets of Delhi, but from farms- cobra farms specially created by the locals to provide a supply of cobras that could be killed and then exchanged for money. Of course some of these cobras managed to escape the farms and go onto the streets, explaining the lack of drop in number despite the incentive program.

This is an example of the Cobra Effect (named after this story)- the name given to a situation in which an attempted solution to a problem makes the situation worse rather than better.
Want to see a modern day example of the Cobra Effect? Check out the article on how it affected Mexico City here.

The Great Penny Debate Part II: Why The Penny Needs To Go.

Welcome back. Here in the second instalment of the debate on Pennies, we shall look at a selection of the arguments against the penny and for its abolition.

1) Value for Money
Many pro-pennyists counter-argue the idea that pennies are bad value for money for the government with the claim that, while pennies may well be financially inefficient, this doesn't mean their abolition will improve the financial efficiency of the Mint- in fact it may worsen it. They argue that should the penny be abolished, demand will rise for the next lowest coin- the silver nickel, worth 5 cents, which actually loses more money per coin than the penny. So, the argument goes, more investment will have to go into a bigger loss-making product should the coin be abolished.

With the cost of producing a nickel at 7.7 cents, and that of a penny at 1.26, this is theoretically true. Take the cost of making one dollar with either coin- it would cost (7.7*20) 154 cents to create a dollar with nickels, but just (1.26*100) 126 cents to do so with pennies. A 28 cent difference, quite decent proof that the penny is more cost-effective to produce. But this hits a snag- these figures are correct, but as of 2008. Seven years ago.

Today, the tables have figuratively turned. As of late 2014, a Nickel costs 8.1 cents to produce (a 3.1 cent loss), whereas a penny costs 1.7 cents to produce (a 0.7 cent loss). This may not seem to be a game-changing difference from 2008, but it makes all the difference. Today, making 1 dollars' worth of nickels costs 162 cents. Making the same from pennies costs 170 cents. The prices of the two have crossed, to the point at which nickels are now more cost-effective than pennies- rendering the pennies causing greater financial inefficiency.

2) Productivity
Just as the potential 'rounding tax' could have tiny but compounding impacts upon the spending of consumers, there already exists a tiny but recurrent way in which we lose because of pennies- not in terms of money, but time. Whether it's spending time rummaging in our pockets for a few remaining pennies, or waiting to receive them as change, it wastes time- not in the short term, but the seconds add up and become minutes, minutes, over the course of a year or two, hours. Hours that can be spent being more productive, whether it's a store employee gaining more time to perform other duties or the customer having more time to spend in town and buy other stuff.

It's difficult to imagine seconds making such a difference, but added up in the long term, they can. Economist Robert Whaples quantifies the losses that the penny can cause. Using the average American wage of $17 an hour, he evaluates every two seconds of the average American's work time to be worth a cent, and thereon estimates that time lost due to the complications brought on by pennies can cost around $300m per year to the US Economy.

Whaples proposes that rounded sale prices would help improve productivity of the economy as a whole, not by giving one significant boost but by trimming the excesses, the little seconds of time wasted because of the business of handling pennies.

3) Are they Useful?
Have a look at this menu here. The price of a full dinner with multiple courses, at just 25 cents, is one that you might think is ridiculous, but that was how things were in 1900, the year this American bistro menu comes from.

Go forward to 1931, and food was still ridiculously cheap in comparison to the modern day. A penny could buy you an egg, or a pound of flour.

Today? Well, if you can find anything that I could buy with a penny in any store today I'll give you one (not that you'd probably appreciate it). The fact is that pennies were not always the lowest valued coin- until 1857 you could get a half-cent, and currencies throughout the world have seen smaller denominations than a penny (think, for example, the British shilling). But over time, they have been taken out of circulation, for a number of reasons, but primarily because of inflation. Rising prices nullify the value of all denominations of money- and at one point we must re-evaluate whether any certain coin is necessary. We have very little use for pennies- so why should we carry on keeping them in circulation?

Economist Greg Mankiw summarises it effectively, stating "the purpose of the monetary system is to facilitate exchange... the penny no longer serves that purpose."


RECOMMENDED READS

2014 Biennial Report to the Congress (US Mint) http://www.usmint.gov/about_the_mint/PDFs/2014-rd-biennial-report.pdf

Congress Looking At Steel Pennies And Nickels (2008) http://www.nbcnews.com/id/24491928/ns/business-stocks_and_economy/t/congress-looking-steel-pennies-nickels/#.VR2wlZPF8yA

How Much Does It Cost to Make A Penny? http://blogs.wsj.com/economics/2014/12/15/just-how-much-does-it-cost-to-make-a-penny/

The Penny's End Is Near http://www.consumeraffairs.com/news04/2006/07/penny_sense.html

The Great Penny Debate Part I: Why Pennies Should Be Kept.

The penny coin. The cent coin. Whatever you call it, we're all undoubtedly acquainted with the coin that holds the lowest value in your currency, whether you're from America or Britain or pretty much anywhere else. Except Canada, and a number of other countries who have decided to abolish the penny from their currency. But why have they done it, and does it mean the penny holds no point in our modern economies?

In this first of a two-parter, we'll look at the reasons why pennies should be kept in our economies.

1) 'Rounding Tax'
Perhaps the most prominent argument of the pro-pennyists, much research suggests that removing the penny from the currency would cause a change in price; naturally, if the penny was to be abolished we would no longer be seeing any '.99' prices. Instead, we would see either '.95' or '.00' prices- and considering that businesses would have to lose .4 on any purchase should they round it down, rounding up would seem an attractive option. This would have rather insignificant effects on the consumer in the short term, but in the long term it has the potential to further weaken those closer to the bottom of the economic ladder.

Data from the Federal Reserve indicates that Americans earning under $10k and also those with less than 12 years of education, use cash for over half of their purchases. This is opposed to credit cards, particularly spending online. Credit card real world spending would also be affected by 'rounding tax', though as no online transactions are made in cash they would be unlikely to be affected. This would put online spenders at a very slight advantage, whereas for the more disadvantaged it could make a huge number of tiny differences to their spending. These may not directly cost them in the short term, but in the long term the cost can aggregate into something considerable.

Canada has implemented a system of 'rounding' that charges credit card users differently from cash users in the real world- for example, something costing $2.98 would be rounded up to $3 for cash users, while the price remains the same for credit card users. This is an example of the potential imbalances that could arise and, in the long term, harm those who use cash.

2) Charity

The 'Common Cents' campaign has seen considerable success,
like many other charities, thanks to the penny.

Abolishing the penny is a move that is likely to work against the interests of charity organisations. Many charities rely significantly on spare change for funding, and though it may seem small, the total power of the penny shouldn't be underestimated: in 2009, the Leukemia and Lymphoma Society of the USA celebrated raising $150 million- entirely in the form of 1.5 billion pennies. The organisation 'Common Cents' organises what it calls 'Penny Harvests', and was able to collect $756k in 2009 exclusively by collecting pennies.

The penny holds a special place in this respect because in a way respect is just what it lacks; it is one of the most common items given to charity, and arguably one of the most beneficial for all parties. No one has bankrupted themselves by giving a penny to charity- yet all the pennies put together have been shown to make rather significant differences. The 'Common Cents' guys call the penny "the philanthropic property of young people"- and it seems they do have a point, so abolishing the penny could indeed harm charitable organisations.

3) Appeal to Tradition
This is not so much a practical argument for keeping the penny, but rather a sentimental one. Many feel an attachment to the penny, for various reasons- whether it is its role in infant numeracy development (who doesn't remember playing with penny coins while learning numbers), its historical/cultural value (Lincoln holds a cherished place on the penny in the USA) or just the traditional side of everyone who dislikes change (or should I say likes change, see what I did there? No? Sorry.).
Even one of the staunchest of critics of the penny, Professor of Economics at Wake Forest University Robert Whaples, admits this, stating "The vast majority want to keep a penny... it's a sentimental attachment."

3 Things to Note From the 2015 Budget Announcement.

Chancellor George Osbourne with his red Budget Box of policies. [EPA]

It's Budget Day! Today saw the announcement of the British Coalition Government's budget for the forthcoming fiscal year, by Chancellor George Osbourne. The Budget, in essence, evaluates the past year and sets out the plans for the next year with regards to economic policy; things like whether taxes on certain things should be raised or lowered, whether the government will invest further in a project and so on.

The whole event gives itself much reason to be sceptical; they are often used as more politically charged electioneering events, and even moreso with Britain just a couple of months away from an election. Here are three things I took away from the Chancellor's speech today.

1) Britain's economy is doing relatively well.
As Osbourne proudly announced today, Britain had the fastest growing economy of any developed nation in the world, as deemed by the International Monetary Fund, who estimated Britain's unemployment and inflation rates to be lower than they turned out. These two numbers are in fact lower than ever, with unemployment expected to fall to just 5.3% this year and inflation below 2%. But with regards to employment, there is a problem; because many of the jobs 'created' have been what are known as 'zero hours contracts'- these are job contracts within which the employer is under no obligation to give no minimum number of hours to its workers.
According to the Office of National Statistics, 697,000 people (over 2% of the British workforce) are employed under ZHCs, and over one third of them are unhappy about the number of hours they are receiving. These employees often receive so few hours that they are unable to afford the rising cost of living, but their employed status puts unemployment benefits out of their reach. Their lack of status as a full employee then puts them in a position where they can't access benefits such as holiday pay, leaving many in a worse financial situation than they would be if they were out of work. A significant proportion of the jobs created under the Conservative government have been ZHOs, with over 100,000 being created between 2013-14. So employment may be higher, but with cases such as those of Zero Hour Contracts, one must think more about the quality of employment being created than the job alone.

2) "Football, beer, and above all gambling, filled up the horizon of their minds. To keep them in control was not difficult."
I'm often reminded of this poignant quote from George Orwell's literary masterpiece, 1984, whenever rumours are abound of government plans to reduce taxes. No doubt Osbourne and Co. have announced this with the election fast approaching in mind, and with the Chief Executive of the British Beer and Pub Association calling him a "hat-trick hero" because of it, there's no doubt it will work in gaining Tory support with many. As Osbourne announced tax duty of a pint of beer and cider are to drop by 1p and 2p respectively. For the third year in a row, Osbourne announced tax duty of a pint of beer and cider are to drop by 1p and 2p respectively. He claims it has the potential to create 3,800 jobs in the forthcoming year, but I wonder: is this really the way we should go trying to create employment?
The government seems to be continuing (rightly IMO) its efforts to minimise the nation's consumption, following up on its previous promise to increase tobacco duty by 2% starting today, but why is it doing the opposite with alcohol? Alcohol is an equally damaging drug, if not more damaging due to how much more common it is and its association with events such road accidents and street violence. One-third of the visitors to our already suffering A&E facilities are there due to alcohol- even more during the weekends. 2014 saw almost 6000 more people having to receive alcohol treatment than 2013. The total cost of alcohol-related harm to society is £21bn, and it is costing the NHS £3.5bn a year.
The state of our society with regards to alcohol, why it may not be spectacularly poor on a global stage, has much much to improve. And in my opinion, lowering taxes on alcohol, making it cheaper, is no way to solve the problems that are worth far more than 3800 jobs this could bring.


3) Google and Co. will soon have to pay their taxes
In 2012, Starbucks made profits of over £400m in Britain- yet paid £0 to the Treasury as corporation tax that every registered company operating in the country is obligated to pay. Google had a turnover of £395m in the same year, yet paid just £6m. And it's not just these two companies; six major technology firms including Apple, Google and Facebook made profits of over £14bn in Britain, but paid just 0.3% of this in the form of tax. It sounds scandalous, but the thing is that these companies didn't technically break the law- they didn't evade tax, they avoided it thanks to loopholes that allowed them to store their profits in accounts abroad, avoiding the tax radar of Britain. This left the government pretty powerless to prosecute, but what Osbourne has announced here today is a plan to close that loophole to prevent such behaviour continuing.
Dubbed the 'Google Tax', the 'Diverted Profits Tax' plans were announced today- to put it simply, companies will have to report themselves to the HMRC (Tax authorities) if they are making annual turnovers of over £10m, and will have to comply with investigations that determine how much of the profits have been moved abroad, and pay the taxes determined as a result. The government expects to make £3.1bn from this move over the next five years- not a significant amount, considering the scale of government finances, and it is something that clever corporate lawyers are probably going to flout sometime soon. But nevertheless, it's an important move from the government to let multinationals like Google and Starbucks know that there is no place for tax avoiders in Britain.


Recommended reads: 

Budget Calculator: How Will The Budget Affect You [BBC] http://www.bbc.co.uk/news/business-17442946

The Budget- Official Document https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/413949/47881_Budget_2015_Web_Accessible.pdf

Alcohol treatment in England 2013-14 http://www.nta.nhs.uk/uploads/adult-alcohol-statistics-2013-14-commentary.pdf

Why You'd Be Mad To Buy A $17000 Apple Watch.

So just earlier today, Apple announced to an excited bunch of journalists in San Francisco their plans to release their new Apple Watch in the coming months. The much awaited product is to go on sale on April the 24th, with a wide range of watches and accompanying straps ranging from £300 to a whopping £13500 ($350 and $17k in the USA respectively).
The lower end of that price range gets you an Aluminium watch case, and a 'Sport Band', something that appears to be essentially rubber/plastic strap (though probably one very well made). But it gets more spicy looking at the higher end of the range- for £13500 you can get an 18-Carat Rose Gold Case with a 'Rose Grey Modern Buckle' (a leather strap, pictured). Especially considering this watch performs no more or fewer functions than its £300 sibling, it seems a steep price to pay indeed.

But no, Apple are not going crazy with their pricing strategy. The watch is one of the widest ranging products in the world; you can get a £10 classic from your local Argos, or opt for something like this Blancpain Tourbillon (I'll let you check the price of that one for yourself). Watches can be quite extraordinarily luxurious goods, along with things like Fountain Pens and perhaps cars.

So why spend such extravagant amounts on a timepiece? An argument that holds for most other consumer goods is that the product's function is better if more is spent on it. A basic example is how spending more money on a TV will probably get you a bigger screen, or how a more expensive sports car is likely to be faster than a cheaper one.
However this fails to hold for most luxury goods, simply because there is usually a limit to just how good something can be. Much is made of the precision and smoothness of higher end timepieces, but for most people this is a bogus excuse for buying a watch. The owner of a cheap watch is very unlikely to be disadvantaged in comparison to a Rolex owner because his time is a few seconds inaccurate, or his watch hands don't move in a buttery smooth way. Being honest, the function of a cheap and expensive watch is usually identical; yes, more expensive watches may gain you extra gauges and measurements, but the basic function (that is, telling the time) is not improved upon in a way that reflects the extra premium.

However, the design is, of course, a significant area of difference between cheap and more expensive watches, as is quality of material- and this is indeed a more significant reason why people buy expensive watches. They are more likely to look good, and the quality is likely to be such that they last for a much longer time. This allows, in many cases, for watches to be passed on as family heirlooms, as items passed down through generations.

The Six Million Dollar Patek Phillippe

And that long-term aspect brings me onto a significant economic reason for buying an expensive watch. Expensive watches are arguably very strong investments to make; if they are kept safe and maintained well enough, their price can rise exponentially over time as they become rarer and more cherished. The world's most expensive watch was a vintage Patek Philippe- sold in 2010 for almost $6m, kept since the 1940s. Investment is where expensive watches are necessary- firstly a cheaper watch, even if it is 100 years old, is unlikely to have much visual or brand appeal, and secondly it would be far less likely to be in working order after a long period of time. Expensive watches, integrated with various precious metals and crystals to keep it durable, are thus far more likely to be appreciating assets.

This brings me to the $17000 Apple Watch Edition. Here are just a couple of reasons why you may want to buy it, and my opinion why you'd be mad to:

1) The looks. Not only do you want the latest Apple device on your wrist, but the most expensive and shiny one. You overlook the fact that the actual software, function and quality of timekeeping of your watch you spent thousands on is pretty much identical to the $350 base Apple Watch, and not so different from a cheaper smart watch either. Not $17k different, anyway.

2) Investment. Though a more credible reason than just simply wanting to show off, you'd have to use it pretty conservatively to keep it maintained for a significant time enough for it to appreciate. Being a used luxury product it is likely to steeply depreciate for the first few years, after which numerous iterations of the Apple Watch are likely to have been released and yours will be running far from perfectly (anyone who owns an Apple product more than 3 years old will know this). Vintage watches are usually running as they were when new- but being a battery operated, software-running device, it is unlikely that there will be much interest in a laggy 20 year old Apple Watch, if it even still works. Too much modification to the watch (new batteries, hardware) will be likely to remove the original 'vintage' appeal of the watch and thus fail to increase its value, if anything decrease it.

3) You are an Apple fan with genuinely too much spare money to spend, and you buy it knowing you're gonna buy the next Apple Watch when it comes out anyway. If so, good for you mate.

Of course, this isn't to say you shouldn't buy an Apple Watch Edition or an Apple Watch generally. If you have the money and the interest in the product, go ahead, as I'm certain many people will. The functionality and competence of the watch against its smartwatch competitors would be unquestionable, Apple is likely to be at the forefront of this new technology with companies like Pebble, Samsung and Motorola.

But it would be wrong to treat it as a 'traditional' clockwork watch. It seems unlikely that it will be anywhere near as effective in appreciating over time. It appears the watch is evolving as we speak- we are indeed entering the new generation of timepiece, for better or for worse.


RECOMMENDED READS

Apple Watch: Timekeeping https://www.apple.com/uk/watch/timekeeping/

Why Watches Are A Timely Investment http://www.thisismoney.co.uk/money/investing/article-2631408/Why-watches-timely-investment-100-years-First-World-War.html

Top 5 Best Investment Luxury Watches http://acl90210.com/best-investment-luxury-watches/

Is A Rolex A Good Investment? http://www.borro.com/uk/borro-blog/is-a-rolex-watch-a-good-investment