So You Want to Know About Economics

by Roopa Pai

  Today, we use the word ‘commons’ to mean any shared resource—the cookie jar at home (‘Mom, Bhaiya finished my share of the cookies too!’), the overhead water tank in your apartment complex (‘I bet that awful lady in 6E who is always having houseguests used up all the water. I’m going to complain to the association!’), a neighbourhood park (‘The mela people littered it so much I can’t even go there for my morning walk. Next year, no permission for the mela!’), or the air in a city (‘Those people driving around in their big cars ruin the air for all of us!’).

  As you can see, the problem remains the same. If no one is supervising how much of the commons each person uses, or how each person uses it, it is human nature to either take more out of it for yourself (especially when no one is looking!), or use it in a way that only benefits you, until the commons is either depleted (cookies finish) or becomes unusable (park gets too full of litter).

  What is the solution? In large communities, like cities and countries, the government acts as regulator and policeman, deciding who can use a shared resource (the commons), how much each person (or corporation) can use it, and in what manner each person (or corporation) uses it. In India, for instance, you need to have licences (which the government issues) for activities that involve extraction of non-renewable resources, like coal mining and drilling for petrol. Some countries like China even regulated (until recently) how many children a couple could have (one). They were trying to control their population, because a larger population would cause ‘overgrazing’ on the country’s ‘commons’, or its shared resources.

  In smaller communities, however (like an apartment complex, or a neighbourhood), where everyone can sit together and talk about things, the community itself can regulate the ‘grazing’—everyone realizes that losing the resource is bad for all of them, so they figure out a way to work things out among themselves to make sure the sharing is fair. In our cookie jar example, you and your brother may decide to split the cookies amongst yourselves right at the beginning and not filch from the common jar, because a fight over cookie sharing only leads to Mom refusing to bake any more cookies for a month, no matter who ate whose share. Which is bad news for both of you.

  BIG QUESTION 3

  My mom says that whenever I take part in a mela again, I should serve my lemonade only in reusable glasses, not in disposables. That will not only reduce the litter my stall creates, it will also be better for the environment. I agree in principle, but I also know that many people prefer disposables because they feel it is more hygienic. What if no one buys my lemonade because I am using reusable glasses?

  Excuse me, is this even an Economics question? Actually, erm, yes. Doesn’t it belong in a book on the environment?* Weirdly enough, while it could certainly be in that book, it is definitely not out of place here. A new branch of Economics called Behavioural Economics is now all the rage, and it explores how human psychology impacts how and where people spend their money.

  Human beings are generally rational. You will see very few people burning a currency note, for instance. But we often also behave in highly unpredictable and irrational ways. Our behaviour when we are in a group (while watching a T20 cricket match in a stadium, say) is very different from our behaviour when we are alone (like when we are watching the match at home). This irrational, unpredictable behaviour influences how we make decisions about what to buy, too.

  We are guided by:

  ▶Our emotions. ‘This is a great product at the right price, but I don’t like the woman who runs the store, so I will not buy it.’

  ▶Our moral conditioning. ‘This is cheap, so who cares if it was made using child labour? I’ll buy it!’ or ‘This is a great product, but it uses too much water. I will not buy it.’

  ▶Social pressure. ‘This phone is perfect for my needs and so well-priced, but will my friends think I’m cheap if I buy this over the more expensive one?’ (see ‘Snob Effect’, page 118)

  Manufacturers—and governments*—will lose their customers if they don’t think about all these factors before they start selling their products. As a manufacturer of lemonade who wants to make as big a profit as possible while being responsible about the environment, so should you.

  Let’s list out the points you should consider while thinking of your particular problem.

  ▶You know very clearly which side you are on. You think disposables are bad for the environment, and you don’t want to be responsible for adding more disposables to the already overflowing landfill outside your town through your actions.

  ▶You want to make a profit. What’s the point of being an entrepreneur if you don’t make a profit?

  ▶A lot of your customers are going to have some problems with reusables, for the following reasons:

  ♦They will worry about hygiene (what if the glasses haven’t been washed well after the last person used them?).

  ♦They may want the convenience of picking up their drink from your stall and then walking around the mela sipping on it, which they cannot do if the lemonade comes in a glass which has to be returned. And so on.

  But here’s the thing. In their hearts, most of your customers also want to do the right thing. They do care about the environment—many of them are probably carrying cloth bags with them for their mela shopping—and they will support a young entrepreneur who is using reusables.

  Remember, though, that they are more likely to support you if it is convenient to do so and if there is something in it for them. Economists refer to this ‘something in it for them’ as an incentive. If you want to influence your customers’ buying behaviour (i.e., make sure they buy your product), you should give them ‘incentives’.

  Incentives need not be related to money. You don’t have to sell your lemonade at half the cost to push them to buy it (if you do, human psychology will kick in again and they will probably think that you are selling it cheap because there is something wrong with it!). Although money incentives work—otherwise stores would not be having those fabulous sales—psychological incentives often work even better. You could, perhaps:

  ▶Name your product cleverly, so that it induces curiosity and draws customers. Like, say, ‘Litter-free Lemonade’, or ‘Garbage-hatin’ Lemonade’.

  ▶Appeal to customer hearts, not heads. Gently nudge customers to buy your product over others with posters that evoke nostalgia (‘Your Naani doesn’t serve her nimbu paani in plastic cups and neither do we!’) or guilt (A visual of a dustbin full of used paper-plastic cups from fast food places and roadside coffee tea places, with the line ‘How many trees did you destroy last week?’) or good old awww (‘Show the planet some love—drink our lemonade!’).

  ▶Address your customers’ concerns. Make sure your glasses are sparkling. Have someone in a clean apron wiping off freshly washed glasses in the stall, with a clean cloth. Make sure your surfaces and counters are wiped down regularly. Stand the clean glasses upside down on cheerful and clean teacloths. Make customers forget their hygiene argument.

  ▶Make things convenient. Have a couple of friends and family with ‘Garbage-hatin’ Guys and Gals’ sandwich boards walking around the mela with empty trays. Tell your customers they can hand in their used glasses to them once they are done. Destroy the ‘but I don’t want to come back all the way here to return my glass’ argument.

  ▶Create one killer incentive. Make badges—’I did my bit for Swacch Bharat today’—and pin them to every customer’s sleeve. Your customers will love it. Everyone will know how virtuous they’ve been without them having to say anything. What’s in it for you? Other people will ask your customers about the badges, and word about your lemonade will spread.

  Honestly, wouldn’t you buy lemonade that sells itself this way? See, it isn’t all that difficult to be a responsible entrepreneur and make a profit in the bargain. Do it!

  Bet you didn’t know that!

  The seat-belt rule actually causes more accidents!

  ‘Provide the right incentive, and you can twe
ak customer behaviour’ is a mantra that most economists believe staunchly in. But even well-meaning, well-thought-out incentives can sometimes have very unexpected outcomes. In his best-selling book The Armchair Economist, American economist Steven E. Landsburg offers data showing how seat-belts and airbags, both of which are meant to protect people inside a car, often end up causing more accidents, if not more deaths! He explains this apparently contrary phenomenon using behavioural economics. When they know their ride is safer, he says, drivers take more risks, and drive more recklessly. If you find that difficult to believe, says Landsburg, think about the opposite: do people drive more carefully when they think they are more at risk? Of course they do! The opposite is true too. Simple!

  Consider another example. In the recent past, instead of paying their CEOs (Chief Executive Officer, or the Big Boss of a company) a fixed salary, some companies have started paying them a variable salary. Part of the salary is fixed, but the other part depends on how well the company does that year. If the company makes a profit of, say, ₹10,000, the CEO gets to keep, say, 5 per cent of it (₹500), since it was under his leadership that the company did so well. This was meant as an incentive to keep the CEO working hard and thinking creatively, because the company’s profits were linked to his own. The thinking was that with a fixed salary, the CEO wouldn’t care so much how the company did, since he was assured of getting his fat pay cheque at the end of the month.

  Now companies are rethinking this again, because what actually happened with the variable salary was that dishonest CEOs began showing false profits! If the company had made a profit of ₹10,000, they would fudge the accounts and show it as ₹20,000, so that they got to take home ₹1000 extra instead of only ₹500. The incentive backfired! Of course, that doesn’t mean that incentives don’t work. They do, although it may not be in the way that you think they will, or want them to.

  Just as an exercise, think about the incentives people offer you to change your behaviour. (Remember not all incentives are ‘positive’ ones. For instance, fear of punishment is a big ‘incentive’, and very popular with all figures of authority—governments, schools, parents.) Do all the incentives you are offered work the way they are supposed to? Are positive incentives more effective in your case than negative ones, or is it the other way around? Do you work harder at your studies if your parents promise you a reward for doing so, or if they threaten to take your TV rights away?

  Think about the incentives governments offer. Is Singapore so clean only because there is such a stiff penalty for littering? Do you think there should be such a penalty in India too? What about a penalty for peeing and spitting in public? Would it work? More importantly, would it be fair to impose such a penalty without first having enough dustbins/public toilets in place for people to use?

  BIG QUESTION 4

  My dad tells me that I should put all the profits from my lemonade stall into a savings account in a bank. Should I? He also says the bank will not only keep my money safe but will, a year later, give me more money than I put in. That’s weird. Shouldn’t I be paying the bank for keeping my money safe?

  You have a wise dad. And that is a good question. But before we answer it, let’s talk about banks a little. What is a bank, anyway? It is a ‘financial institution’ that essentially has one main function—lending money to anyone that wants to borrow it. Banks and individual money-lenders of one kind or another have existed since ancient times; some of the first mentions of a simple money-lending system, as far back as 3500 years ago, come from India’s Vedic texts. But the word ‘bank’ dates back only to the fourteenth century when the Renaissance was sweeping across Italy. Moneylenders in Florence used to sit at bancas (Italian for ‘table’) covered with green tablecloths, dispensing loans to people.*

  Why would anyone lend his hard-earned money to someone else? Out of the goodness of his heart, to bail out a fellow human in trouble? One would wish that people were so kind, but classical Economics tells us that it is mainly selfish impulses that make people do the things they do. So why do people lend money? In other words, what’s in it for the lender? The answer is: a lot of money!

  You see, when the borrower returns the amount he borrowed to the lender, he also pays him a ‘borrowing fee’ (called ‘interest’). This fee is the money-lender’s income, what he gets to keep for himself. Essentially, therefore, a bank or a money-lender is earning money without doing any work at all. In fact, many people see usury, which is the fancy word for the practice of charging a borrowing fee, as a way for the lender to take advantage of the borrower’s misfortune when instead he could have lent him the money for nothing.

  This was precisely the reason that many ancient and medieval cultures, and religions like Christianity and Islam, prohibited usury for several centuries. People who practised usury were hated and looked down upon as greedy loan sharks, feeding off the blood of people in need. Even today, Muslim law considers usury a sin, and Islamic banks do not charge interest on loans. The rest of the world, however, has made its peace with having to pay interest to banks on borrowed money. The good part is that the interest rule applies to banks as well. When they borrow money, they have to pay it back with interest too.

  But how does that make sense? Why would banks need to borrow money? They already have all the money they need, don’t they? Actually, no. There is only a limited amount of money in the system, and banks need to borrow money too, if they want to have enough to lend to someone else. Banks borrow mainly from the central bank (in India, this is the Reserve Bank of India), and from—hold your breath—you! Yup, the money you put in your savings account is actually money that you are lending to the bank! So of course they have to pay you a borrowing fee, which is why your money ‘grows’ when you put it in a bank.

  But if banks are lending and borrowing all the time, and paying out the interest they collect from their borrowers to their lenders, how do banks make any money at all? A-ha! They’ve worked that one out nicely. They simply charge a higher borrowing fee from borrowers than they give to lenders! In other words, a bank’s lending interest rate is always higher than its borrowing interest rate.

  Let’s see how this works.

  You borrow ₹1000 from your bank. The bank charges you a ‘borrowing fee’, or a ‘lending interest rate’ of 10 per cent per year. That means, when you return the money to the bank a year later, you will have to pay:

  1000 + 10% of 1000 = 1000 + 100 = ₹1100.

  At the same time that you were borrowing from the bank, your sister was lending a similar amount to the bank, by depositing ₹1000 in her bank account. The ‘borrowing fee’ that your sister can charge the bank (or the ‘borrowing interest rate’) is fixed, and is, let’s say, 8 per cent. When the bank pays back her money a year later, she will get:

  1000 + 8% of 1000 = 1000 + 80 = ₹1080

  You see? When you borrow ₹1000 from the bank, you have to pay them ₹1100 after a year, but when they borrow the same amount from you, they only have to pay you ₹1,080 after a year. The difference (1100–1080 = ₹20) is the bank’s income, the money they get to keep for themselves.*

  Twenty rupees may seem like a small amount, and really not worth the bank’s while to do all the work involved in earning it. But remember that banks do not lend and borrow just a few hundreds of rupees, they lend and borrow hundreds of crores of rupees, so the difference between the money they pay out (to lenders) and the money they earn (from borrowers) is ginormous. That makes it very worth it for them!

  Who wants to be a millionaire?

  In fact, the longer you keep your money in the bank, the more it grows, because of a useful trick called compounding. Also, the younger you are when you start putting money in a bank account, the more you stand to gain. Here’s how compounding works.

  Let’s say you start earning a salary at the age of twenty-three. Each month, you take ₹1000 out of your salary and put it in a piggy bank. At the end of one year, you put the ₹12,000 you have saved into a bank account
and forget about it.

  Let’s say the bank is paying you 8 per cent interest every year. At the end of Year 1 after you put the ₹12,000 in, your money has grown to:

  12,000+ 8% of 12,000 = 12,000 + 960 = 12,960

  The next year’s interest is calculated on this number, not on your original deposit. This is called compounding*. So, at the end of Year 2, your money has grown to:

  12,960 + 8% of 12,960 = 12,960 + 1036 = 13,996

  By the time you are thirty-three, at the end of Year 10, your money has more than doubled, to ₹25,907. By the time you are forty-three, it has grown to over ₹55,000. And by the time you are fifty, your ₹12,000 has grown to close to a lakh, without you lifting a finger.

  Now consider this. If, instead of putting aside ₹1000 a month from your salary, you put aside ₹2000, and, at the end of the year, deposited ₹24,000 in the bank as your initial deposit. What would this amount to at the end of Year 10? Almost ₹52,000. By the end of Year 20, it would be around ₹1,18,000. And by the time you are fifty, it would have grown to almost ₹2 lakh!

  Remember that we are only talking about the money you put aside that one year, the year you were twenty-three. If you put aside a similar amount (₹12,000) every year for the next ten years, you will have almost ₹2 lakh in the bank by the time you are thirty-three, not fifty! It’s like magic!

  Now imagine if you started putting your savings in a bank when you were only fifteen. Do you have rupee signs dancing in front of your eyes? Good. Now stop imagining and go put your money in that bank already!

  Bet you didn’t know that!

  Banks work out of big fancy buildings for a reason!