Author Archives: making7

Cheaters, Bystanders and Free-riders

There are three types of problematic players that were identified in The Externalities Game experience recently completed by engineering students at ASU in Arizona and management students at MDI in India:

  1. Cheaters produced more than the social optimum strategy agreed upon by the group, thereby accumulating more points for themselves at the expense of other players.
  2. Unfortunates attempted to submit production decisions, but were thwarted by the unreliable communications systems on CORE, and thus received no credit.
  3. Screwups did not submit a decision because they didn’t understand the instructions.

In reflecting on the game experience, it may help to think about these players as categories of human behavior and how these behaviors manifest in the real-world.  For example, people often cheat, even if it is just a little bit, in everyday situations.

In the game we saw this as there were a many players that “cheated” by taking a few more points for themselves, but only three people that took as much as they can get (and one player that took nothing).  According to Dan Ariely, players that cheat a lot are rare, but players that cheat a little are common.

The unfortunates might have tried to cheat, but because their messages never got thru to the TEG Administrator, they were disqualified from the game.  Some students (on Twitter) accused the instructor of purposefully altering the numbers, while others blamed the technology, while others say that the students themselves should have done more to make sure the message got through.  In this case, no one person or group is at fault.

The plight of the unfortunates in TEG is analogous (although nowhere near as serious) as the victims of global climate change depicted in our previous post.  In response to the “Climate Justice” video embedded therein, many students tweeted how awful it was that innocent children in Bangladesh are suffering so much and that somebody should do something about it.  But who is to blame in this case?  Is it the children’s fault they were born into poverty?  Is it the industries who create most of greenhouse gas emissions?  Or is is the consumers who buy the energy intensive products on the market?  In problems of negative externalities, it is often difficult to determine where the blame lies, which makes it difficult to reconcile the injustice.  If we don’t know who is to blame for an injustice, or even if we do know who to blame in a particular situation, does that mean we have no obligation to help those who were harmed?

A recent review article in Nature written by Ezra Markowitz and Azim Shariff, entitled “Climate Change and Moral Judgment”, describes why climate change poses extraordinarily difficult challenges for our moral judgment.  The authors explain that because climate change is characterized by abstractness and uncertainty, as well as perceived to negatively impact distant people (geographically and temporally), it is a particularly difficult problem to assess morally.  Therefore, climate change is most likely perceived as an unintended and unfortunate side effect of goal-oriented behavior, which is likely to be judged less harshly than harms caused intentionally, and therefore results in less motivation for mitigation and adaptation.

Unclear blame can be a cause for inaction, but so can the norms of society.  If helping someone means violating the norm of a group, individuals of that group are likely not going to offer assistance.  In what is referred to as the ‘bystander effect‘, people realize someone is in trouble and needs help, but do nothing about it.  The following video shows how people tend to overlook those in need, especially in very public places, because they would have to violate the norm of others around them.

The bystander effect was observed in our class last Thursday.  In the absence of strong leadership, many students were content to remain quiet, or tweet out their complaints, or merely call for action by “someone” to do “something,”  rather than commit themselves to do what they felt was right.  The students waiting for someone else to take action are analogous to the bystanders in the video.

Moreover, research shows that the bystander effect is strongest when the victims belong to a different identity group than the bystanders.  For example, the norm in the ASU class became figuring out how to help the unfortunates at ASU and to let the unfortunates in India figure it out for themselves.  The group assumed that the MDI players would step in and help without even asking them if that was the case.

Also, most players concluded that the ‘screw-ups’ don’t deserve any points from others.  (One self-anointed ‘screw-up’ agreed with this view).  Neither did the one student who submitted zero for her production deserve any assistance, in the minds of the consensus. Everyone knew that these players could use some help, but nobody stood up in class to make a case otherwise; it would have violated the class norm to stand up an offer an alternative opinion.

Related to the bystander effect is what is known as the free-rider problem. This is a term traditionally used in economics and game-theory where someone in the group who contributes nothing benefits from the efforts of others.  For example, in public transit a free rider is literally someone who rides for free while other passengers pay their fares.  In global climate change, if only a few countries reduce their GHG emissions (and suffer economically for it), all countries will still benefit from overall reduced emissions.

The free rider problem often results from public (i.e., non-excludable) goods, where it is impossible to enforce ownership rights that prevent others from consuming the good.    For example, national defense and many highways are public goods because we all use them and benefit from them, yet we can’t prevent others from using them, too.  (Vehicle registration and drivers licensing laws could attempt to prevent access to public highways, just as tolls and user fees attempt to assign the cost of the highways primarily to those who drive on them).  Because the benefits of public goods are shared and non-excludable, there is an incentive to free-ride on the efforts of others.  This video explains the free rider problem in the context of public goods and how a traditional solution to the problem is taxation.  The idea is that everyone contributes to paying for the public goods that the government provides, and therefore users are no longer free-riders and are less likely to misuse the public good they help pay for.

However, not all free-rider problems can be solved through taxation.  We often see free rider problems when working in groups.  For example, sometimes one person in the group ends up doing most or all the work, yet everyone in the group ends up with the same grade.  This is practically what happened in TEG, where relatively few players during the game put effort into figuring out a strategy for the class to follow, but everyone benefited.  Some students did actually stand up, offer strategies and solutions, and told the rest of the class what production plan they should follow. But the majority of the class however never got out of their seats and remained quiet.  Although there was a clear imbalance in effort, the benefit of the strategy proposed (in terms of grade points) is enjoyed by most of the class.

As for the ‘screw-ups’, this category includes at least one person that was sick and missed class and didn’t realize what they were supposed to do for the game.  Is it really their fault that they missed the deadline?  Should we just assume that those players that did not follow instructions are to blame?  Or did something prevent them from submitting that was out of their control?  If it isn’t us that this happened to, it is easy to forget that things do happen to people.  Wouldn’t we want others to sympathize if the tables were turned?

These concepts and questions posed should help prepare you for next week’s reflective class discussion and the assigned personal reflective essay.

Teamwork & Motivation

One of Ken Robinson’s criticisms of Higher Education is that traditional models isolate students, evaluate them all individually, and create a “disjunction between them and their natural learning environment”.  He points out that in a school students are expected to do their “own work“,or risk accusations of cheating that would be called “collaboration” outside the university.

By contrast, one of the explicit learning objectives in accredited engineering undergraduate programs is learning to work in multidisciplinary teams.  Therefore, it behooves us to understand what motivates people and how to structure environments that encourage them to work together — particularly because new information communications technologies (ICT) allow people to work collaboratively more effectively than ever before.

In this video, Clay Shirky introduces us to the idea of “cognitive surplus” — which is term used to describe the otherwise idle hours that people are willing to apply to solve real problems in collaborative settings.  This violates what is understood to be conventional economic wisdom — that people don’t work for free.  (The analogue in education would be that students will not do what is not graded).  However, Shirky’s examples illustrate the difference between things that people are extrinsically motivated to do (working for pay or other rewards from other people), and those that they are intrinsically motivated to do (working for “fun”, or the personal satisfaction derived from the work).

Shirky quotes the famous engineer and inventor Dean Kamen, saying that free cultures “get what they celebrate”, but I suspect that Kamen is no longer concerned with collecting public accolades.  In this video, he tells a series of powerful stories about his personal motives.

As it turns out, Kamen’s motives are not so much different from those of American undergraduate students (the most closely studied population in the history of science).  In this video, Dan Pink explains how cognitive labors are not subject to monetary incentives.  In tasks that require thinking and creativity, people are more driven by a sense of purpose than by pay (or grades?)

This realization calls into question how we assign group work in classrooms.  If we operate on the premise that students will only do what they are graded on and we recognize that group grades allow some students to “free ride” on the labors of others, then we might predict that student work groups will either fail predictably, or result in just a few students doing all the work.

The classic solution to problems of cooperation in groups has been institutionalization.  That is, we form bounded organizations (such as companies and professional societies) that define rules of interaction, belonging, and status.

In this video Shirky attempts to answer the question “How do groups get anything done?”  He argues that advances in ICT have reduced the transaction costs of cooperation so much that we can now substitute coordination for planning.

The “carrots” (incentives, or rewards) and “sticks” (disincentives, or punishments) available to institutions don’t apply to open organizations with transaction costs so low that any individual can contribute any amount.

One of the implications of moving group work outside the institution means that cooperative relationships can form outside the normative goals of the institution.  That is, cooperation can now exist among individuals that are at odds with the status quo ideals of the mainstream.  He predicts 50 years of chaos.

It should be clear that education has already begun the process of de-institutionalization.  As Shirky suggests, “we can see it coming.  We might as well get good at it.”

On Moral Leadership

“The central concept is influence rather than authority. Both are dimensions of power but the latter tends to reside in formal positions, such as the principal or headteacher, while the former could be exercised by anyone in the school or college. Leadership is independent of positional authority while management is linked directly to it.”

– Tony Bush (2012) Theories of Educational Leadership and Management

Leadership requires the ability to influence the behavior or decisions of other people.  From this perspective, leadership might look a lot like advertising, or marketing.  In this TED talk, Seth Godin (speaking as a marketer) makes important distinctions between these.  To be a leader, he says, is to be a heretic.

But Godin fails to give his audience any direction on what it takes to be an effective leader.  There is a vast literature on leadership styles, and any number of effective mechanisms by which to influence others toward pro-social goals (i.e., goals that are good for the entire group, not just one or a few people).

One style of leadership that is often overlooked is moral leadership.  That is, the type of leader that is able to influence others thru moral persuasion.  In this case, the leader does not bribe, or bully, or appeal to the self-interest of others — but to their sense of fairness, justice, or some other foundational moral principle.

This type of moral leadership typically requires sacrifice.  It requires that the leader take personal risks, and from these risks often comes moral credibility.

Introduction to The Tragedy of the Commons

All professionals enjoy a privileged position in society.  For example, licensing laws prohibit entry into professions such as medicine, law, or professional engineering.  As a consequence, the people who DO have a license to practice can charge higher rates.  Additionally, professionals often enjoy public subsidies — either reducing the cost of education or underwriting institutions that enable the practice (such as public hospitals, courts,  research grants, or public works).

In return for this privileged standing, society places expectations on professionals.  Most notably, professionals are expected to hold the social good above their own.

Individually, all professionals have an incentive to cheat society by cutting corners to reduce their own costs, abuse the power that expertise offers, or otherwise unfairly place their own interest ahead of others.  For example, some doctors that own stock in pharmaceutical companies have been charged with preferentially (or unnecessarily) prescribing drugs produced by the companies they own, thereby increasing their own profits at the expense of patients and insurance companies.

However, in these cases it is clear that the abuses perpetrated by the individual will tarnish the reputation of the entire profession, placing the privilege enjoyed by the profession at risk.  Thus, all profession have internal regulatory bodies that sanction those deviants that fail to ascribe to a code of conduct that protects both the public and the profession (as a whole).

The interaction between the individual professional and the  group can be modeled as a problem in non-cooperative game theory.  In this class of problems, individuals can unilaterally (i.e., without making agreements with others) advance their own position, but only at the expense of other individuals in the group.  Alternatively, if all people in the group agree to cooperate, the entire group can be better off.

Without some sort of individual restraint of ambition or avarice, a group confronted with a non-cooperative game theoretic problem will either degenerate into a tragic catastrophe, or result in the savvy players making suckers out of the naive. The first six minutes of the Dark Knight movie (starring Heath Ledger as the Joker) illustrates this point.  Notice how the Joker uses greed to turn the individual members of his gang against one another.

In fact, the entire plot of the Dark Knight movie revolves around the Joker setting up one non-cooperative game theoretic problem after another, just to see what might be revealed about the character of his victims.

The classic example of a non-cooperative game theoretic problem is The Prisoner’s Dilemma.  In this video clip, Salman Khan explains the problem that two prisoners face when they are being interrogated separately by the police, and why the police are likely to get confessions.

A special type of game-theoretic problem involves managing common pool resources.  In this case, every individual has an incentive to take more from the common resource, but if all individuals take too much, the resource will be ruined and everyone will suffer.  This special case is called The Tragedy of the Commons.

Khan explains the problem in terms of public fisheries, but in Khan’s explanation, the individuals also have private ponds in which they can keep their own fish.  In this case, private ownership changes the incentive structure such that owners will more carefully manage the resources and maintain the longevity of the fishery — which is also in the public interest.

However, privatization of some common pool resources, such as the atmosphere, is highly problematic. Elinor Ostrom points out that cooperation between individuals can exist despite the incentive to cheat and in the absence of a third party (meaning someone outside the group) enforcement.  In these instances, groups typically institute their own mechanisms of enforcement.

Because some common pool resources (such as the atmosphere) are not amenable to privatization, Ostrom’s discovery of alternative mechanisms may be especially important to sustainability.  However, recognition of game-theoretic problems significantly complicates moral analysis.  Because the outcomes of an interesting game-theoretic problem depend on interaction between two or more players, where should the moral culpability for the tragedy reside?

In fact, doing the “right thing” in a non-cooperative game theoretic problem might actually encourage other players to do the wrong thing, by improving their payoffs.  The converse is also true.  Doing the wrong thing (that is, defecting or failing to cooperate), or at least the credible threat of the wrong thing, might actually turn out to be the only way to ensure that other players do the right thing, as this video from a popular British game show illustrates.

Negative Externalities & the Coase Theorem


Standard economic theory states that any voluntary exchange must be beneficial to both parties in the trade because no one would ever knowingly and voluntarily enter into a trade that somehow left them worse off. However, economic activities can cause additional effects on third parties not directly involved in the exchange. These effects are called externalities, because they are not borne by the people making the decision about the activity. They are also known as spill-over effects, and they can be negative (e.g., health problems caused by pollution from a factory), or positive (honey bees kept for honey that also pollinate crops).

When externalities are present, market prices fail to correctly signal the complete cost of goods or services, resulting in a misallocation of resources. In particular, negative externalities are a concern because they result in the market producing costs that subtract from social welfare. The following video explains the concept of negative externalities in micro-economic terms.

In Khan’s view, which corresponds to the standard neoclassical understanding of externalities, the solution to problems of external cost is to internalize the costs. In Khan’s example, simply raising the price of plastic bags by charging the bag producers (or consumers, it doesn’t matter) for social costs such as cleaning up litter will decrease plastic bag production and free up resources (capital, energy, material, labor) to produce other goods that people ultimately find more satisfying.

If plastic bags kill animals (or people), the economist asks “What are consumers willing to trade (in money) for these lost lives?”

Simply find that number, and adjust the price of bags accordingly until the enjoyment from the last bag produced (the marginal bag) is equivalent to the distress (i.e., cost) of the last (marginal) life loss.

This simplistic view of internalization is not particularly concerned with problems of distribution — i.e., who is killed, or who benefits (e.g., from plastic bags). The primary concern in the Khan video is allocation (how much to produce of which goods).  Internalization of external costs solves the allocation problem, but could still result in problems of distributional injustices.

“Solutions” to Negative Externalities

The following video reveals three theoretical ways to address the allocation problem of externalities, including: 1) taxation, 2) regulation, and 3) property rights. Taxation places the financial burden of external costs on the producer. Regulation can be in the form of requiring a technological fix or limiting the quantity of goods and/or pollution produced. The property rights solution is also known as the Coase Theorem, developed by Nobel Prize winner Ronald Coase. The theory states that optimal allocation of resources is achievable without any government intervention, provided that transaction costs are low and property rights are pre-determined. In this case, Coase claims that the polluting and damaged parties will negotiate a transfer of payments between them to either accept damage or reduce pollution — whichever is more profitable.

The Coase Theorem does not consider whether the Farmer or the Fishermen drive the harder bargain. That is, so long as profits (or enjoyment) as a whole are optimized, then the Coase Theorem is satisfied. But what if property rights are assigned to the Farmer? Suppose the Farmer would profit 10 (dollars, or whatever) from fertilization of the corn field. The fisherman enjoy fishing so much that they’d be willing to pay 15 to fish. According to Coase, the Fishermen complain to the Farmer that the fertilizer is killing fish, but the Farmer says that without the fertilizer, his profits would be reduced to 10. So the Fisherman offer to pay 6 to the Farmer to persuade him to stop using the fertilizer.

The Farmer’s profits are now 11 (5 from unfertilized corn farming and 6 from payments received from Fishermen) and the Fisherman pay only 6 for something that they enjoy as much as 15. Everyone is better off.

But what if the Farmer drives a hard bargain? Maybe he thinks, “If these crazy, rich Fishermen will pay 6, then they’ll probably pay 7, or 8.” Even in the case of ideal conditions for Coasian bargaining, there is nothing to guarantee that the moral implications of the externality will be resolved, partly because Coase is concerned only with the optimal allocation of resources and not the optimal distribution of benefits (or profits) resulting from the economic activity.

When the Farmer controls the property rights, and is under no obligation to sell them, the Farmer-Fishermen interactions can be modeled as The Dictator Game, wherein the Farmer can capture all the benefits of fishing for himself!

Aside from this distributional issue, and the moral problems that it creates, other obstacles often prevent Coasian bargaining. Coase himself admits that in reality, transaction costs are rarely low enough to allow for efficient bargaining. Moreover, direct causality is often difficult to prove.

Imagine the Farmer claiming, “My fertilizer doesn’t kill fish. The fish love my fertilizer.”

If the Fishermen don’t realize what is killing fish, then how would they know to approach the Farmer with an offer?

Or, what if the Fishermen value the fish highly, but simply have no money to pay? Perhaps instead of the recreational fishermen represented in the video, they are subsistence fishermen who use the lake to feed themselves. To the Fishermen, the fish are priceless. But a willingness to pay does not equate to an ability to pay!

The External Costs of Climate Change

Richard Tol wrote in his 2009 paper entitled, The Economic Impact of Climate Change, that “Climate change is the mother of all externalities: larger, more complex, and more uncertain than any other environmental problem”. The reason for this complexity is that emissions of green-house gases from any geographical location on the Earth’s surface travel to the upper atmosphere and play a role in affecting climate globally. Hence, the impact of any particular emission of greenhouse gases (GHGs) is not realized solely at its source, either individual or geographical; impacts are dispersed to other actors and regions of the Earth. Furthermore, GHG emissions are responsible for a myriad of impacts including changes to Earth’s climate system, manifested in events such as drought, floods, sea-level rise, temperature changes, extinction of species, and spread of disease.

This video draws attention to the fact that climate change will adversely impact people that are unable to protect themselves and did little or nothing to create the problem.

The moral complexities surrounding global climate change beg the ethical questions, “What are the developed world’s obligations to the developing countries? And should the developed countries risk their own sense of well-being to meet these obligations?”

Lastly, economists might ask “If property rights were well-defined, could Coaseian bargaining resolve the problem of global climate change?”

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Understanding Depreciation & Taxes

The post comparing the cost of buying versus leasing a new car introduced the term “book value” to refer to the value of the car as an asset, that the leasing car will carry on their books, but never explained exactly why the leasing company would do any such thing.  It’s not clear that the leasing company should be concerned with the book value at all, given that book value is not the same as market value, and in any case they aren’t allowed to sell the asset.

Rather than worrying about book value, the leasing company might consider the entire purchase price of the vehicle as an expense as soon as it is incurred.  Thus, they would deduct the full cost of the car against any revenues they have during the year, as this video from the Khan Academy illustrates:

Slaman Khan highlights the problem that this sort of accounting creates for the business, which is to say that profits appear highly variable.  That by itself may not be a problem, until you consider the tax implications.  Businesses only pay income taxes on their profits.  When the business operates at a loss, there are no profits to tax.  So you can see that deducting the full cost of the car (or truck) in the same year that it is purchased results in a loss, which results in no tax bill during the year the vehicle was purchase,d and then larger tax bills in future years.

But the IRS does not recognize the full purchase price of the car as being “lost” as soon as it is paid.  After all, the business didn’t really lose the money — they simply traded money for a new vehicle.  If they wanted to (or had to), they could sell the vehicle at the end of the tax year and recover whatever the market value of that asset is.  The proceeds of the sale would increase revenues, and might result in a profit that is taxable.

The IRS takes a dim view of businesses that appear to be “losing” money, when they are actually using the money to purchase tangible assets, simply so that the business can defer payment of taxes. So, the IRS require businesses to depreciate the assets, which in the ideal would mean that they can only expense the portion of the asset purchase price which represents the loss of market value (called, mark-to-market accounting).

However, the true market value of used goods cannot be determined without an actual sale.  And selling something just to try and figure out what someone will pay for it is expensive (due to transactions costs), inconvenient, and usually pointless.  Therefore, the there IRS specifies a depreciation schedule for different types of assets that requires businesses to record the “book” value (an assumed market value) for the purpose of computing profits, and thereby taxes.

In this next video from Khan Academy, Salman Khan explains how to depreciate the truck on the businesses books (using straight-line depreciation).  The impact of depreciation is to report the same total profit, but to report it earlier.  The fact that profits come sooner means that taxes are paid earlier.  From our understanding of time preference, we know that businesses would prefer to delay tax payments, but the IRS would likely prefer to accelerate them.

Khan uses the terms “capitalization”, and “depreciation” as if they were interchangeable.  Another term is called “amortization” which also refers to the process of spreading out a large payment into multiple instalments.  Although this terms are very similar, they aren’t identical.  In this video, Khan explains that depreciation is a term that is used to refer to the declining value of tangible assets, like equipment.  However, intangible assets, such as a fee paid for a multi-year license are not subject to depreciation.  In this case, the word for doing the exact same mathematics as depreciation (spreading the cost out over the useful life of the asset) is called amortization.  Both depreciation and amortization are specific examples of the more general term, capitalization.

The simplest method for calculating depreciation is straight line.  However, we know that tangible (or hard) assets are likely to lose more value at the beginning of their useful lives than they are at the end.  That is, straight line depreciation does not reflect market value well, and as a consequence businesses using straight line will pay taxes too soon.  The real market value curve fluctuates, but likely takes the general form of exponential decay, meaning it declines rapidly at first and more slowly in each subsequent year.

Perhaps because exponential decay was too complicated to calculate before the introduction scientific calculators, several accelerated methods of depreciation have been invented that approximate exponential decay.  These are the Sum Of the Years Digits (SOYD), the Double Declining Balance (DDB), the units of production method, and the Modified Accelected Cost Recovery System (MACRS — pronounced “makers” in the video below).  This video shows how to calculate the straight line, the SOYD, DDB and units of production using Excel.

The key parameters in depreciation calculations are the initial value (price paid for the good), the residual value (also called the salvage value), the lifetime of the good.  The book value in a given year is the initial value minus the depreciation that has accumulated since the purchase.

This video explains the straight line and SOYD methods graphically.  Most errors on the Fundamentals of Engineering Exam come from confusing book value in a given year with the depreciation in a given year.  Depreciation is the change in book value.

It’s important to note that depreciation is of little practical importance in not-for-profit operations, and for businesses that chronically lose money.  These businesses likely keep books that record the initial purchase prices, book values, and depreciation amounts anyway, but because they do not pay taxes, there are no tax implications.

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Perpetual Bonds, the Long View, and Hyperbolic Discounting

There is a special type of cash flow diagram that we can’t work with using the standard formula for calculating present value: the perpetual bond.

In this case, the number of compounding periods is infinite, because a perpetual bond makes payments forever (assuming that the bond issuer, a/k/a borrower, is still solvent!).  Fortunately, this case allows us to use a much simpler formula:

In fact, the simplicity of this formula P = A/r may cause us to question whether it could really be true.  To test whether the answer derived in the previous video makes any sense, we can consider the reciprocal problem, if we deposit a certain finite amount of money in a savings account at the present day, how much interest should we expect to be able to draw from that balance?

However, not all problems of time preference are financial problems.  There are many contexts in which it is essential to understand the trade-offs between sacrifices made now for benefits that are reaped later that have little to do with borrowing and lending money.  Extremely long-term problems, such as those associated with the environment or sustainability (e.g., global climate change) are not amenable to net-present-value analysis using exponential discounting.

As it turns out, exponential discounting is not the only sensible approach to understanding time preference.  An alternative to exponential is hyperbolic discounting, which values the long-term more and the near-term less than exponential.

While the exponential discount rate is justified by the opportunity costs of compound interest, the hyperbolic discount rate is justified by human and animal behavior.  That is, real human decision processes are better represented by the hyperbolic form.

Experiments like The Marshmallow Test exist in any number of human and animal decision problems.  The next video uses the common example of the snooze button to demonstrate that people do not intuitively or heuristically exhibit time preferences that conform to exponential discount models.

As a consequence, if long-term environmental policies or investment must be justified exclusively by exponential discounting, it is likely that decisions will be made that we will eventually regret.
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