Category Archives: finance

The ‘Bad Version’ and How to Tax the Rich

A ‘bad version’ is a technique used by television writers to inspire creativity when experiencing a creative block. The technique involves writing a purposefully awful section of plot as a way of helping the writer find creativity and, eventually, the ideal solution: it’s a way of “nudging your imagination to someplace better”.

In The Wall Street Journal, Scott Adams offers some “imagined solutions for the government’s fiscal dilemma” — bad versions of ways to incentivising the rich to willfully pay more tax. Those incentives:

  • Time: Anyone who pays taxes at a rate above some set amount gets to use the car pool lane without a passenger. Or perhaps the rich are allowed to park in handicapped-only spaces.
  • Gratitude: The government makes it a condition that anyone applying for social services has to write a personal thank-you note to a nearby rich person […] It’s easy to hate the generic overspending of the government. It’s harder to begrudge medical care to someone who thanks you personally.
  • Incentives: Suppose the tax code is redesigned so that the rich only pay taxes to fund social services, such as health care and social security. This gives the rich an incentive to find ways to reduce the need for those services.
    Meanwhile, the middle class would be in charge of funding the military. That feels right. The country generally doesn’t go to war unless the middle-class majority is on board.
  • Shared Pain: I doubt that the rich will agree to higher taxes until some serious budget cutting is happening at the same time. That makes the sacrifice seem shared. […] Change the debate from arguing about which programs and how much to cut, and instead to do what the private sector has been doing for decades: Pull a random yet round number out of your ear, let’s say a 10% cut, just for argument’s sake, and apply it across the board. No exceptions.
  • Power: Give the rich two votes apiece in any election. That’s double the power of other citizens. But don’t worry that it will distort election results. There aren’t that many rich people, and they are somewhat divided in their opinions, just like the rest of the world.

First Offers and Aggressive Offers: Optimal Negotiating Tactics

When negotiating ensure that you make the first offer and make sure it’s an aggressive one: this is almost always the optimal negotiation strategy. That’s the conclusion from a study looking at negotiation tactics and the anchoring effect (from the same researchers that discovered the optimal starting prices for negotiations and auctions).

One of the researchers gives a good overview of the study‘s findings in an article for Harvard Business School’s Working Knowledge that provides succinct negotiation tactics and reasons for why you should make the first offer. Topiccs include: when you should not make the first offer, how to counter first offers, how to construct a reasonable—yet aggressive—offer, how to protect yourself from the effects of anchoring, and more.

Some key points worth considering (in no particular order):

We might expect experts to be immune to the anchoring effect. Real estate agents, for example, should be able to resist the anchoring effects of a property’s list price because of their presumed skill at estimating property values. Testing this theory, [it is clear that] anchors affect the judgment of even those who think they are immune to such influence. But why?

Every item under negotiation (whether it’s a company or a car) has both positive and negative qualities—qualities that suggest a higher price and qualities that suggest a lower price. High anchors selectively direct our attention toward an item’s positive attributes; low anchors direct our attention to its flaws. […]

The probability of making a first offer is related to one’s confidence and sense of control at the bargaining table. Those who lack power, either due to a negotiation’s structure or a lack of available alternatives, are less inclined to make a first offer. Power and confidence result in better outcomes because they lead negotiators to make the first offer. In addition, the amount of the first offer affects the outcome, with more aggressive or extreme first offers leading to a better outcome for the person who made the offer. Initial offers better predict final settlement prices than subsequent concessionary behaviors do.

There is one situation in which making the first offer is not to your advantage: when the other side has much more information than you do about the item to be negotiated or about the relevant market or industry. […]

How extreme should your first offer be? My own research suggests that first offers should be quite aggressive but not absurdly so. Many negotiators fear that an aggressive first offer will scare or annoy the other side and perhaps even cause him to walk away in disgust. However, research shows that this fear is typically exaggerated. In fact, most negotiators make first offers that are not aggressive enough.

 

The Drinkers’ Bonus: Alcohol Intake and Increased Earnings

Drinking alcohol — and the increased social capital that it leads to — may not just be responsible for a possible increase in life span; it may increase your earnings, too.

In an analysis of both the General Social Survey and the published literature, researchers for the Reason Foundation show that alcohol drinkers earn, on average, 10% more than abstainers (pdf). This is known as the drinkers’ bonus.

Recent studies indicate that drinking and individual earnings are positively correlated. Instead of earning less money than nondrinkers, drinkers earn more. One explanation is that drinking improves physical health, which in turn affects earnings (Hamilton and Hamilton, 1997). We contend that there is an economic explanation. […]

Drinkers typically tend to be more social than abstainers. As Cook (1991) explained, drinking is a social activity, and one reason people drink is to be sociable. In the medical literature, Skog (1980) showed that moderate drinkers have the strongest social networks. Furthermore, Leifman et al. (1995) documented a negative relationship between social integration and abstinence. Whether abstainers choose not to be as social or whether organizers of social occasions involving drinking exclude abstainers is unclear. Abstainers may prefer to interact with other abstainers or less social people. Alternately, abstainers might not be invited to social gatherings, work-related or otherwise, because drinkers consider abstainers dull.

Corcoran et al. (1980), Montgomery (1991), and Putnam (2000) each made convincing cases that social networks are important for finding jobs and earning promotions. Montgomery (1991) explained that companies prefer acquaintances of employees because employees screen potential candidates and thereby reduce the cost of search. Approximately half the workers surveyed in the Panel Study of Income Dynamics found their job through friends or relatives, and one-third reported help from acquaintances in obtaining their job (Corcoran et al., 1980). Therefore, a person with more contacts will have more labor market options (Burt, 1997). Granovetter (1995) suggested that a large quantity of weak ties or friends-of-friends may be most important to garnering the best job offers.

Thus, if social drinking enables greater social networks, it will also increase earnings. In terms of search theory: the more one drinks, the more people one knows, and the more people one knows, the lower the marginal costs of search.

The study is packed full of excellent references to published studies (as you can tell from the above excerpt), so I suggest reading the accessible (and very short!) report. It’s also worth noting footnotes four and five, describing how this is just like all investments in capital, in that an optimal level exists: “you must drink more than 21 drinks per week to earn as little as a non-drinker”.

via @phila_lawyer

Against Behavioural Economics and Irrationality

Praising Maurice Allais as the father of behavioural economics rather than Kahneman and Tversky,  John Kay introduces us to some of Allais’ ideas while simultaneously providing one of the finest arguments against the simplistic view of behavioural economics as the study of irrationality:

The skill of piecing together sense from fragmented and inaccurate information is a central attribute of human intelligence. Literal interpretation, and insensitivity to context, are not marks of rationality but mental disorders. […]

The [behavioural economics] experimenter’s trick is to construct an artificial situation in which normally sensible behaviour gives what he thinks is the wrong result. The “mistake” is detected in a meaningless problem designed solely to elicit the “mistake”. […]

Allais was less concerned to show that our behaviour was irrational than to argue that the premises of rationality itself were irrational. […]

Allais’ most famous experiment showed that we often treat very high probabilities very differently from certainties, although “rational” individuals would regard them as almost the same thing. But very high probabilities often are different from certainties: very high probabilities are usually derived from calculations whose relevance and validity are themselves uncertain. […]

Irrationality lies not in failing to conform to some preconceived notion of how we should behave, but in persisting with a course of action that does not work. Sometimes in modern economics and political life, there is a big difference.

The example Kay uses is a bit glib but does serve its purpose.That last paragraph, however, is the crux of it all. As you may have guessed, this is the Allais that designed the Allais paradox — an experiment in behavioural economics that shows the above wonderfully.

Building a Brand In a Recession

The recent recession saw sales of condoms, guns and burglar alarms soar. This is because, when fear enters our mind in terms of losing our job or of not being able to pay bills, we focus on two of our most basic drives: fear and sex.

The key to selling and building a brand during financial crises, therefore, is simple: manage fear. Understand how it works and how it affects purchasing behaviour. This advice on brand-building during a recession comes from Martin Lindstrom, ex-advertising agency executive, author of Buyology, and one of TIME‘s 100 Most Influential People in the World, 2009.

First, there’s always good news in bad times. A standard approach in this situation is to address consumers’ problems. And people always have problems. The fact is we rarely know what we want, but we have no trouble pointing out our difficulties. For example, no one knew they wanted an airbag, but everyone agreed they wanted safer cars.

It’s therefore important to ask yourself what sort of problems are consumers facing during this economic recession? There are many. […] Convert problems into assets for your brand.

Second, add a practical dimension to an irrational decision. No matter how much money you may have in the bank, or how secure your employment may be, it’s now fashionable to save your money and buy everything at a discount. What can a brand owner do? Particularly in light of the fact that a discounted brand typically takes seven years to recover!

The answer is simple. Add a practical dimension to the equation. […]

Third, you have to systematically remove fear. Hyundai did it. And a stream of new banks are doing it. Both have succeeded in identifying why consumers are reluctant to spend. Once this is understood, then you can harness it and build a better product by addressing the fear and finding a way to eliminate it. Your sales may be down. But do you know why? People are certainly buying less, and explanations like, “Well, there’s a recession going on out there,” are not helpful. What’s important is to understand the fundamental role of fear, and then turn it around to strengthen your brand. Some of the world’s most enduring grocery brands were built on the back of the Great Depression. Each one turned the threat into an opportunity.