Sunday, August 14, 2011

Usury 2: Relativity?

In the previous usury post, I said that one way we could explain a pattern of [splurging up front, massive debt thereafter] is if the same consumption bundles are not offered over time.  What if people strongly prefer today's bundles to tomorrow's?  Of course, the meat of the explanation is in giving you a compelling reason to believe this may be the case.

So, here's a reason.  Suppose there are relative effects together with concavity.  That is:
  1. Utility depends on what your peers are doing.  When other people are eating better food, you get higher utility from better food yourself.
  2.  The losses from being worse off than your peers are more severe than the gains from being better off than them.  When you smell the steaks your neighbors are eating, you really want steak too.  When your neighbors aren't eating steaks, you would still like a steak but not nearly as much as when it was being dangled in front of you.
If these hold, then people care about their position relative to the pack, and in particular it's better to stick with the pack than to spend some time below and some time above it.  When your friends are splurging backed by 15% interest credit card debt, you feel like you need to as well.  When you crash later, at least they will be crashing too.  So, we can get stuck in an equilibrium where, given that everyone's taking on massive debt, it's optimal for each individual to take on massive debt.

So when I say that different consumption bundles are offered over time, I don't mean that the physical goods are any different over time.  I'm imagining social effects as part of the consumption bundle, and that's what's changing.

*

A couple of comments.  First, I like this explanation but I do think of it as a partial explanation.  It doesn't explain why this equilibrium was selected in the first place, but it goes a long way to explaining the extent of people's willingness to do what other people are doing.  At the very least it serves to magnify tendencies that may have their roots in other explanations.

For example, perhaps credit card companies pulled one over on people, maybe they managed to actually trick them.  I'm  not going to reject this explanation per se, but a takeaway from today is that there can be much less of this than you would require if it were the whole story.  We don't need everyone to be deluded, to end up in an equilibrium where everyone is taking bad deals.

Second, I think the above is a nice story for understanding status quo effects more generally.  Especially when it's costly to gather the info necessary to find the best course of action, "do what everyone else is doing" is a particularly cheap and safe shortcut.  If they're right, great.  If they're wrong, at least you all go down together.

I'm going to be loose here, but note that without the concavity and relative effects, people would observe the crowd's opinion, and then perhaps do better by putting even a slight amount of their own effort into further information-gathering.  (With everyone doing this, the crowd could actually get pretty smart).  But here, you have to put a serious amount of effort forward in order to get enough additional info to make deviating from the crowd worthwhile at all.  (So collective ignorance is supported as an equilibrium).

I expect that:

  • Most people model most of their behavior off the status quo among their peer group, while selecting a few areas to focus on much more intently, as opposed to spreading their attention across all areas.
  • Status quo sunscreen usage doesn't necessarily reflect the available information together with how much people care about health risks per se, ignoring social effects.  Maybe we're just in a bad equilibrium.

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