Behind the numbers The economics of commitment
The IoD's senior economist Tej Parikh returns with his monthly blog looking behind the numbers at the wide and varied world of economics. For June, he considers what economics has to say about commitment...
In Homer’s Odyssey, the legendary Greek king Odysseus yearned to hear the captivating songs of the Sirens, majestic creatures known for luring sailors to their perilously rocky island shores.
Aware that their tunes would overpower his rational thoughts, Odysseus ordered his sailors to tie him to the mast to prevent him steering toward the Sirens as the ship passed them. Needless to say, his plan was a success.
With his ‘binding’ commitment strategy Odysseus solved what many economists call a ‘dynamic inconsistency problem’. This is when one’s preferences change over time such that they can become inconsistent at another time period.
It was a lack of consistency that many commentators bemoaned when Bank of England Governor Mark Carney’s decided against raising rates in May, reinforcing his tag as an ‘unreliable boyfriend’. Carney’s previous hints toward a potential rate hike suited his purposes earlier in the year, dampening speculative tendencies. But come May – amid poor economic growth – the Monetary Policy Committee (MPC) decided against increasing the cost of credit.
In actual fact, the Bank had always predicated its hints of a hike on the emergence of positive economic data. The MPC may have scored credibility points had it enforced an interest rate rise, but with the economy looking weaker than anticipated – given the disruption from snow as well as slowing global growth – it would have dampened economic confidence at a particularly sensitive time.
So in Carney’s case, breaking what commitment existed was well-judged. But whilst binding oneself to a decision in the future may not be appropriate in some situations, it can prove useful in others – as Odysseus’ story made clear.
This is certainly true for policymakers, as commitments can bring greater certainty for businesses. That’s why the IoD continues to press the government to clarify its overriding objectives for Brexit, and emphasises the importance of developing the proposed Industrial Strategy Council to credibly monitor the targets of the Industrial Strategy to ensure its policies have longevity.
Commitment devices are also an important tool for business leaders in helping to mitigate unproductive tendencies. For example, they can help counteract our instinctual bias toward instant gratification.
Reponses to the following question often illustrate this bias:
- Do you prefer to be given (a) £1000 today, or (b) £1005 tomorrow
- Do you prefer to be given (a) £1000 in 100 days, or (b) £1005 in 101 days
In order to be time consistent the choice for both (a) and (b) should match, but a significant number of people choose ‘£1000 today’ and ‘£1005 in 101 days’. As the options in questions 2 are so far in the future, people are willing to let an additional day go by to receive more money. But once we arrive at 100 days that decision – according to the first answer – should change.
Procrastination is often a major side-effect of our focus on the here-and-now: “I’ll write that lengthy email after one more YouTube video.”
The difficulty of self-control is a productivity challenge for many entrepreneurs and employers. One study suggests procrastination accounts for one quarter of most people’s working days, costing around $10,000 per employee per annum.
With the vast array of digital distractions vying for our attention today, it’s now a considerably greater problem. U.S. Chamber of Commerce Foundation data finds that people typically spend one hour of their time at work on social media – that increases to 1.8 hours for millennials.
The possible management solutions vary from the simple to the elaborate. Awareness is the first step. Encouraging staff to see future happiness as based on completing a task or conversely, the consequences of continued delays, is one means to challenge present bias.
Others suggest controlled procrastination, allocating time for indulgences, might be the best way to keep it at bay.
Some, however, have delved into Odyssean territory. Yale economists have created a company that allows customers to buy ‘Commitment Contracts’. For these, you make a pledge and pay a deposit. You only get the money back if you keep to your pledge (otherwise the money goes to a charity of choice).
Business leaders are well-accustomed to adapting to changes in the trading environment around them. But what the stories of Mark Carney, Odysseus, and the rest illustrate is that we often have to account for how our own preferences can shift over time, and become incongruous with one another.