Microcredit Finance- Continued..

In the developed world

Microcredit is not only provided in poor countries, but also in one of the world's richest countries, the USA, where 37 million people (12.6%) live below the poverty line.  Among other organizations that provide microloans in the US Grameen Bank started their operation in New York in April 2008. According to economist Jonathan Morduch of New York University, microloans have less appeal in the US, because people think it too difficult to escape poverty through private enterprise.

Efforts to replicate Grameen-style solidarity lending in developed countries have generally not succeeded. For example, the Calmeadow Foundation tested an analogous peer-lending model in three locations in Canada, rural Nova Scotia and urban Toronto and Vancouver, during the 1990s. It concluded that a variety of factors—including difficulties in reaching the target market, the high risk profile of clients, their general distaste for the joint liability requirement, and high overhead costs—made solidarity lending unviable without subsidies. However, debates have continued about whether the required subsidies may be justified as an alternative to other subsidies targeted to the entrepreneurial poor, and VanCity Credit Union, which took over Calmeadow's Vancouver operations, continues to use peer lending.

Criticism

Gina Neff of the Left Business Observer has described the microcredit movement as a privatization of public safety-net programs. Enthusiasm for microcredit among government officials as an anti-poverty program can motivate cuts in public health, welfare, and education spending. Neff maintains that the success of the microcredit model has been judged disproportionately from a lender's perspective (repayment rates, financial viability) and not from that of the borrowers. For example, the Grameen Bank's high repayment rate does not reflect the number of women who are repeat borrowers that have become dependent on loans for household expenditures rather than capital investments. Studies of microcredit programs have found that women often act merely as collection agents for their husbands and sons, such that the men spend the money themselves while women are saddled with the credit risk.As a result, borrowers are kept out of waged work and pushed into the informal economy.

Many studies in recent years have shown that risks like sickness, natural disaster and overindebtedness are a critical dimension of poverty and that very poor people rely heavily on informal savings to manage these risks (see, for example, The Microfinance Revolution: Sustainable Finance for the Poor by Marguerite Robinson). It might be expected that microfinance institutions would provide safe, flexible savings services to this population, but—with notable exceptions like Grameen II—they have been very slow to do so. Some experts argue that most microcredit institutions are overly dependent on external capital. A study of microcredit institutions in Bolivia in 2003, for example, found that they were very slow to deliver quality microsavings services because of easy access to cheaper forms of external capital.Global data tables from The Microbanking Bulletin show that savings represent a small source of funds for microcredit institutions in most developing nations.

Because field officers are in a position of power locally and are judged on repayment rates as the primary metric of their success, they sometimes use coercive and even violent tactics to collect installments on the microcredit loans. Some loan recipients sink into a cycle of debt, using a microcredit loan from one organization to meet interest obligations from another. Also, counter to the original intention of the microcredit system to empower women, one of the effects of an infusion of cash into local economies has been to increase dowries, with women forced at times to take microcredit loans as the only means to pay these increased dowries for their daughters.

Bangladesh's former Finance and Planning Minister M. Saifur Rahman charges that some microfinance institutions use excessive interest rates. In recent years, there has been increasing attention paid to the problem of interest rate disclosure, as many suppliers of microcredit quote their rates to clients using the flat calculation method, which significantly understates the true Annual Percentage Rate.

There are other related criticisms, in the corresponding section, within the article on microfinance.

Role of developing countries—a recent Forbes ranking

The US business magazine Forbes ranked the world's top 50 microfinance institutions. Seven of the 50 were little-known institutions from India, the most of any country. They included Kolkata-based Bandhan (ranked 2nd), Microcredit Foundation of India (13th) and Saadhana Microfin Society (15th). Those ranked above even Bangladesh-based Grameen Bank, which, along with its founder Muhammad Yunus, was awarded the Nobel Prize in 2006. Grameen Bank ranked 17th in the list, below another Bangladesh-based institution, ASA.

India and Bangladesh together are home to the most MFIs. Those in other countries included five from Bosnia and Herzegovina, four each from Morocco and Peru, three from Colombia, two each from Ecuador, Ethiopia and Serbia, and one each from 15 other countries, including Russia, Pakistan, Mexico and Brazil.

Besides those already mentioned, other Indian MFIs include Grameen Koota (19th), Sharada's Women's Association for Weaker Section (23rd), SKS Microfinance Private Ltd (44th) and Asmitha Microfin Ltd (29th). Grameen Koota and SKS Microfinance use the same model as Grameen Bank.

Forbes magazine said that "microfinance has become a buzzword of the decade, raising the provocative notion that even philanthropy aimed at alleviating poverty can be profitable to institutional and individual investors."

"Billionaires, global leaders and Nobel Prize recipients are hailing these direct loans to uncollateralised would-be entrepreneurs as a way to lift them out of poverty while creating self-sustaining businesses," it stated.

Forbes made the ranking of MRIs by using data available from the Microfinance Information Exchange and the analysis from rating firms Micro-Credit Ratings International Limited and MicroRate. The ranking was based on six key variables: gross loan portfolio, operating expense, operating expense divided by the average number of active borrowers as a proportion of gross national income per capita, outstanding balance of loans overdue by more than 30 days as a proportion of gross loan portfolio, return on assets, and return on equity. "Each microfinance institution earned scores in four equally weighted categories—scale, efficiency, portfolio risk and profitability. Rankings were then based on the combined average score of those four categories."

Microcredit Finance

Microcredit is the extension of very small loans (microloans) to the unemployed, to poor entrepreneurs and to others living in poverty. These individuals lack collateral, steady employment and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit. Microcredit is a part of microfinance, which is the provision of a wider range of financial services to the very poor.

Microcredit is a financial innovation that is generally considered to have originated with the Grameen Bank in Bangladesh. In that country, it has successfully enabled extremely impoverished people to engage in self-employment projects that allow them to generate an income and, in many cases, begin to build wealth and exit poverty. Due to the success of microcredit, many in the traditional banking industry have begun to realize that these microcredit borrowers should more correctly be categorized as pre-bankable; thus, microcredit is increasingly gaining credibility in the mainstream finance industry, and many traditional large finance organizations are contemplating microcredit projects as a source of future growth, even though almost everyone in larger development organizations discounted the likelihood of success of microcredit when it was begun. The United Nations declared 2005 the International Year of Microcredit.

 

History

Microcredit has been practiced at various times in modern history; Jonathan Swift inspired the Irish Loan Funds of the 18th and 19th centuries [1], in the mid-1800s, abolitionist/legal theorist Lysander Spooner wrote about the benefits of numerous small loans for entrepreneurial activities to the poor as a way to alleviate poverty [2], and microcredit was included in portions of the Marshall Plan at the end of World War II. However, in its most recent incarnation, with attention paid by economists and politicians worldwide, it can be linked to several organizations starting in Bangladesh in the 1970s and onward.

Principles

Microcredit is based on a separate set of principles, which are distinguished from general financing or credit.  Microcredit emphasizes building capacity of a micro-entrepreneur, employment generation, trust building  and help to the micro-entrepreneur on initiation and during difficult times. Microcredit is a tool for socioeconomic development

Strengths

In the past few years, savings-led microfinance has gained recognition as an effective way to bring very poor families low-cost financial services. For example, in India, the National Bank for Agriculture and Rural Development (NABARD) finances more than 500 banks that on-lend funds to self-help groups (SHGs). SHGs comprise twenty or fewer members, of whom the majority are women from the poorest castes and tribes. Members save small amounts of money, as little as a few rupees a month in a group fund. Members may borrow from the group fund for a variety of purposes ranging from household emergencies to school fees. As SHGs prove capable of managing their funds well, they may borrow from a local bank to invest in small business or farm activities. Banks typically lend up to four rupees for every rupee in the group fund. Groups generally pay interest rates that range from 12% to 24% a year, based on the flat calculation method. Nearly 1.4 million SHGs comprising approximately 20 million women now borrow from banks, which makes the Indian SHG-Bank Linkage model the largest microfinance program in the world. Similar programs are evolving in Africa and Southeast Asia with the assistance of organizations like Opportunity International, Catholic Relief Services, CARE, APMAS and Oxfam. Microfinancing also helps in the development of an economy by giving everyday people the chance to establish a sustainable means of income. Eventual increases in disposable income will lead to economic development and growth.

Jason Cons and Kasia Paprocki of the Goldin Institute, while quite critical of some unintended side-effects of microcredit, nonetheless acknowledge its "enormous potential as a tool for poverty alleviation."^[1]

Microcredit and the Web

The principles of microcredit have also been applied in attempting to address several non-poverty-related issues. Among these, multiple Internet-based organizations have developed platforms that facilitate a modified form of peer-to-peer lending where a loan is not made in the form of a single, direct loan, but as the aggregation of a number of smaller loans—often at a negligible interest rate. There are several ways by which the general public can participate in alleviating poverty using Web platforms.

Lend to micro-entrepreneurs:

Kiva.org is the first micro-lending website that enables an individual to lend money to a micro-entrepreneur in the developing world through a microfinance institution. As of November 2008, over 100 field partners have collaborated with Kiva, dramatically extending its scope and reach.

New platforms that connect lenders to micro-entrepreneurs are emerging on the Web, such as Rang De (India) [6], dhanaX (India) and http://www.babyloan.org or http://www.veecus.com (France).

Invest in microcredit securities:

MicroPlace.com, a wholly-owned subsidiary of eBay, was launched in October 2007. With Microplace, retail investors in the US can buy securities issued by security issuers. Therefore, MicroPlace is tapping into the socially responsible investment world and can attract larger capital to microcredit. Deutsche Bank estimates that $250 billion is needed to raise enough capital to get it into the hands of the one billion working poor who could benefit from microcredit. While the US gave $303 billion [8] in charity to all causes, they invested $2.4 trillion in socially responsible investments.

Guarantee loans to micro-entrepreneurs:

United Prosperity will enable an individual to guarantee a loan to the micro-entrepreneur they choose to connect and support. The guarantee allows the microfinance institution to raise funds in local currency from local banks and make a loan to micro-entrepreneurs. Since the guarantee is only for a part of the loan amount, the guarantee allows the guarantors to multiply the impact of their money.

Contribute to micro-entrepreneurs:

Wokai(lending to China) allows contributors to contribute towards micro-entrepreneurs they choose to connect and support. Since the contribution is a donation, contributors in the United States may also get a tax deduction.

Ensure microcredit reaches the poorest families:

The Microcredit Summit Campaign brings together microcredit practitioners, advocates, educational institutions, donor agencies, international financial institutions, non-governmental organizations and others involved with microcredit to promote best practices in the field, to stimulate the interchanging of knowledge, and to work towards reaching the following goals:^[4]

• Working to ensure that 175 million of the world's poorest families, especially the women of those families, are receiving credit for self-employment and other financial and business services by the end of 2015.

• Working to ensure that 100 million families rise above the US$1-a-day threshold adjusted for purchasing power parity (PPP) between 1990 and 2015.

Contd.. Opportunity Cost- Get the most out of life

 

My seatmate might have profited from reading Alfred Marshall who called economics "the study of mankind in the ordinary business of life." This was the enterprise of Marshall and Adam Smith and Friedrich Hayek and Milton Friedman: they tried to understand what people do and the implications of their behavior for the society at large.

But my favorite definition of economics is a variant of Marshall's. It comes from a student who heard it from another teacher of hers: economics is the study of how to get the most out of life. I like this because it strikes at the true heart of economics—the choices we make, given that we can't have everything we want. Economics is the study of infinite wants and finite means, the study of constrained choices. This is true for individuals and governments, families and nations. Thomas Sowell said it best: no solutions, only tradeoffs. To get the most out of life, to think like an economist, you have to be know what you're giving up in order to get something else. That's all opportunity cost is:

Opportunity cost is what you have to give up to get something.

What could be more straightforward? If you want something you have to give up something. The idea turns out to be a little subtler than it appears at first glance. Let's look a little more closely.

Milton Friedman used to say that economics is simple. All you have to remember is that demand slopes downward and that nothing's free. The hard part is applying those two simple ideas. When Friedman said that nothing was free, he meant that everything has a cost. Take the proverbial free lunch that Friedman delighted in pointing out didn't exist. Suppose I invite you to lunch and it's on me—I promise to pay and I keep that promise. Free, right? No, says the economist.

Economist: There's no monetary cost. Today. But there's an expectation that you'll return the favor and treat me to a future lunch.

You (believer in the free lunch): But you don't realize I'm not a nice person. I don't plan on reciprocating and I'm going to keep that promise to myself. Today's lunch is free.

Economist: No. Even if you don't plan to reciprocate, the guilt at being a moocher is a cost.

You: You don't realize just how not-nice I am. I have no conscience. So I do get a free lunch.

Economist: Alas, no. You have to listen to me talk while we're eating.

You: I won't be listening. I'm going to daydream about an upcoming vacation. I'm going to pretend to be pay attention.

Economist: Still not free. The cost of having lunch with me, even when I pay, even when you don't plan on reciprocating and even when I do all the talking that you ignore, is the pleasure you would have received doing something else instead. Whatever you gave up to have lunch with me. Not just the money. Not just the time. But the value or pleasure you would have received from doing something else.

So one of the keys to thinking like an economist is always remembering that everything has a cost. This may be one reason economists have fewer friends than they otherwise would. Sometimes people are very happy holding on to the naïve view that something is free. We like the idea of a bargain. We don't want to hear about the hidden or non-obvious costs. Thinking about foregone opportunities, the choices we didn't make, can lead to regret. Choosing this college means you can't go to that one. Marrying this person means not marrying that one. Choosing this desert (usually) means missing out on that one. Sometimes, people just want to eat their cake and have it, too, without being reminded that they missed out on a spectacular piece of pie.

All true. But if you want to get the most out of life, you have to take account of the opportunity cost, the foregone alternatives. Better to make good choices and learn how to live with them than make bad choices in blissful ignorance that lead to ruin. Here are some applications of how understanding opportunity costs helps you get the most out of life.

The real cost of college

What's the cost of college? The obvious part of the cost of college is tuition. It's not room and board because those would be incurred anyway. But the opportunity cost includes the foregone wages from the jobs you could have had if you hadn't gone to college. This is one of the reasons we go to college when we're young without any experience in the workplace—our wages are relatively low so the foregone earnings from going to college are lower.

The return on your investments

Economists do know something about the stock market. If you tell me you have a great investment track record, I want to know: compared to what. A mutual fund manager who earned 12% last year for his investors seems to have had a banner year. But mutual funds indexed to the S&P 500 earned over 15%. If both funds had a similar level of risk, that mutual fund manager had a negative return of 3%. Similarly, holding your assets in the form of cash means foregoing the opportunity to invest them. The opportunity cost of cash is the return you could earn by investing it.

Home ownership and home improvements

Real estate agents like to tell you that a house is a great investment. Your house is appreciating and you get to live in it. Sometimes both are true statements. But appreciation of the house isn't enough to make it a good investment (or a reason to buy a particularly large house on the argument that if the investment is going to appreciate, it's better to have a bigger stake). Home owners like to savor how much they sold their house for above what they paid for it. When measuring the return, they rarely subtract the direct monetary costs—the repairs, the taxes, and the fees and commissions of lawyers, real estate agents and government agencies. But I've never known the proud Boston or Washington or L.A. house seller who calculates the foregone investment opportunities from tying up the down payment and the mortgage payments over the life of the time in the house.

Similarly, real estate agents (and contractors) like to tell you that re-doing your kitchen is a good idea because you'll get the money back in the form of a higher price when you sell your house. So the kitchen is free! And in the meanwhile, you get to enjoy the pleasures of the kitchen. That logic is fine as long as you get enough pleasure from the kitchen to offset the opportunity cost of tying your money up in cabinetry and granite and giving up the return you could have earned doing something else with the money.

One aspect of home ownership and opportunity cost is particularly tricky. Suppose your house appreciates. You could sell it and move to a smaller house or a house in a different neighborhood. But you decide to stay. The appreciation of your house means it has gotten more costly to live in it. But that increase in cost, being an opportunity cost rather than an out-of-pocket cost does not mean you are worse off. In fact, it is a sign that you are better off—an asset you own has appreciated and your wealth is higher at least as long as the appreciation stays in place. Opportunity cost is different from what we think of colloquially as cost, which usually means a monetary payment. Opportunity cost guides rational decision-making. But an increase in costs doesn't necessarily mean that you are worse off than you were before.

Sunk costs are sunk, historical costs are history

Opportunity cost is a forward-looking concept. If my car breaks down and I fix it, and it breaks down again, the decision to fix it a second time is independent of the first repairs costs. It is irrational to think that I have to fix it because I've put so much money into the car already—if I don't fix it, I'll lose all the money I've already invested. I've already lost the money on the first repair. Now I should only ask whether the second set of repairs are worth it.

A variation on the "sunk cost" argument is the irrelevancy of historical costs. What the seller paid for a house twenty years ago has little effect on the market price today. Complaining that the seller is charging an exorbitant price compared to what the seller paid originally, only insures you will have trouble finding someone to sell you a house that meets your standards of a fair price. On the flip side, explaining to a prospective buyer in a housing market that has collapsed, that your price is high because after all, you paid a lot for it once and it's only fair that you get your money back plus a fair return, is unlikely to be a successful strategy for selling your house. Market prices ignore history.

Replacement costs are more relevant than historical costs. If a friend gives you a Van Gogh as a wedding present and a few years later, a drunken dinner guest plunges a carving knife through it after losing his balance, your guest wouldn't tell you to shrug it off because after all, it was a gift, you didn't pay anything for it.

Self-sufficiency vs. relying on others

Perhaps the most important application of opportunity cost is the decision to do things for yourself vs. hiring someone. Doing it yourself is often cheaper and can be fun. But the cost of doing it yourself is the value of the other things you could have done with your time. Those other things might include working a part-time job or doing consulting, which means you forego money. So doing it yourself can be costly in the monetary sense. But the non-monetary costs can dwarf the monetary costs. Time spent painting your house yourself is time you can't spend reading to your children or being with your spouse or volunteering at the local soup kitchen.

Ultimately, anything close to genuine self-sufficiency is the road to poverty. An avid do-it-yourselfer might change her own oil, bake her own bread and build a bookcase in her basement workshop. But she won't forge her own steel and the fashion her own car. She won't grow her own wheat or mill her own flour. She won't cut down a tree and plane the wood for that bookcase. And even if she did, she'll buy the saw. She won't make it for herself.

By specializing in a very small set of skills, selling those skills in the marketplace and relying on the skills of other specializing individuals we create much of what we call specialization. We specialize because the costs of self-sufficiency are so high.

Of all the constraints we face, the constraint of 24 hours in a day and a finite lifetime are ones we cannot escape. Getting the most out of life means using that precious time wisely. Using that time wisely means using and understanding opportunity cost.

 

Contd... The concept of Demand

The most famous law in economics, and the one economists are most sure of, is the law of demand. On this law is built almost the whole edifice of economics. The law of demand states that when the price of a good rises, the amount demanded falls, and when the price falls, the amount demanded rises.

Some of the modern evidence supporting the law of demand is from econometric studies which show that, all other things being equal, when the price of a good rises, the amount of it demanded decreases. How do we know that there are no instances in which the amount demanded rises and the price rises? A few instances have been cited, but most have an explanation that takes into account something other than price. Nobel laureate George Stigler responded years ago that if any economist found a true counterexample, he would be “assured of immortality, professionally speaking, and rapid promotion” (Stigler 1966, p. 24). And because, wrote Stigler, most economists would like either reward, the fact that no one has come up with an exception to the law of demand shows how rare the exceptions must be. But the reality is that if an economist reported an instance in which consumption of a good rose as its price rose, other economists would assume that some factor other than price caused the increase in demand.

The main reason economists believe so strongly in the law of demand is that it is so plausible, even to noneconomists. Indeed, the law of demand is ingrained in our way of thinking about everyday things. Shoppers buy more strawberries when they are in season and the price is low. This is evidence for the law of demand: only at the lower, in-season price are consumers willing to buy the higher amount available. Similarly, when people learn that frost will strike the orange groves in Florida, they know that the price of orange juice will rise. The price rises in order to reduce the amount demanded to the smaller amount available because of the frost. This is the law of demand. We see the same point every day in countless ways. No one thinks, for example, that the way to sell a house that has been languishing on the market is to raise the asking price. Again, this shows an implicit awareness of the law of demand: the number of potential buyers for any given house varies inversely with the asking price.

Indeed, the law of demand is so ingrained in our way of thinking that it is even part of our language. Think of what we mean by the term “on sale.” We do not mean that the seller raised the price. We mean that he or she lowered it in order to increase the amount of goods demanded. Again, the law of demand.

Economists, as is their wont, have struggled to think of exceptions to the law of demand. Marketers have found them. One of the best examples involves a new car wax, which, when it was introduced, faced strong resistance until its price was raised from $.69 to $1.69. The reason, according to economist Thomas Nagle, was that buyers could not judge the wax’s quality before purchasing it. Because the quality of this particular product was so important—a bad product could ruin a car’s finish—consumers “played it safe by avoiding cheap products that they believed were more likely to be inferior” (Nagle 1987, p. 67).

Many noneconomists are skeptical of the law of demand. A standard example they give of a good whose quantity demanded will not fall when the price increases is water. How, they ask, can people reduce their use of water? But those who come up with that example think of drinking water or household consumption as the only possible uses. Even here, there is room to reduce consumption when the price of water rises. Households can do larger loads of laundry or shower quickly instead of bathe, for example. The main users of water, however, are agriculture and industry. Farmers and manufacturers can substantially alter the amount of water used in production. Farmers, for example, can do so by changing crops or by changing irrigation methods for given crops.

What the skeptics may have in mind is not that people would not cut back their purchases at all when the price of a good increases, but that they might cut back only a little. Economists have considered this thoroughly and have developed a measure of the degree of cutback, which they call the “elasticity of demand.” The elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. The greater the absolute value of this ratio, the greater is the elasticity of demand. When there is a close substitute for one firm’s brand, for example, a small percentage increase in that firm’s price may lead to a large percentage cut in the amount of the firm’s good demanded. In such a case, economists say that the demand for the good is highly elastic. On the other hand, when there are few good substitutes for a firm’s product, the firm might be able to raise its price substantially with only a small decrease in the quantity demanded resulting. In such a case, demand is said to be highly inelastic.

Interestingly, though, if a firm is in a position whereby it can increase a price substantially and reduce sales only a little, and if its owners want to maximize profits, the firm is well advised to raise the price until it reaches a portion of the demand curve where demand is elastic. Otherwise, the firm is forsaking an increase in revenue that it could have had with no increase in costs. One important implication of this fact is that the elasticity of demand in a market is a negative test for whether the firms are acting together as a monopoly. If, at the existing price, the elasticity of the market demand for the good is less than one, that is, if the demand is inelastic, then the firms are not acting monopolistically. If the elasticity of demand exceeds one—that is, if the demand is elastic—then we do not know whether they are acting monopolistically or not.

It is not just price that affects the quantity demanded. Income affects it too. As real income rises, people buy more of some goods (which economists call “normal goods”) and less of others (called “inferior goods”). Urban mass transit and railroad transportation are classic examples of inferior goods. That is why the usage of both of these modes of travel declined so dramatically as postwar incomes were rising and more people could afford automobiles. Environmental quality is a normal good, and that is a major reason why Americans have become more concerned about the environment in recent decades.

Another influence on demand is the price of substitutes. When the price of Toyota Camrys rises, all else being equal, the quantity of Camrys demanded falls and the demand for Nissan Maximas, a substitute, rises. Also important is the price of complements, or goods that are used together. When the price of gasoline rises, the demand for cars falls.

 

Contd. . Incentive matters

How might captains be convinced to take better care of their human cargo?

You might lecture the captains on the cruelty of death, and the clergy from their pulpits did just that. You might increase the funds allotted by the state provided to the captains based on the number of passengers they carried. You might urge the captains to spend more of those funds for the care of their passengers. (Some entrepreneurial captains hoarded food and medicine meant for the convicts and sold them upon arrival in Australia.) You might urge the captains to spend the money more carefully. Shame them into better behavior.

"The government decided to pay the captains a bonus for each convict that walked off the boat in Australia alive."

But a different approach was tried. The government decided to pay the captains a bonus for each convict that walked off the boat in Australia alive.

This simple change worked like a charm. Mortality fell to virtually zero. In 1793, on the first three boats making the trip to Australia under the new set of incentives, a single convict died out of 322 transported, an amazing improvement.

I don't think the captains got any more compassionate. They were just as greedy and mean-spirited as before. But under the new regulations, they had an incentive to act as if they were compassionate. The change in incentives aligned the self-interest of the captains with the self-interest of the convicts. Convicts were suddenly more valuable alive than dead. The captains responded to the incentives.

Incentives matter. The most famous example in economics is the idea of the demand curve—when something gets more expensive, people buy less of it. When it gets less expensive, people buy more of it.

Some find this bedrock principle of economics hard to accept, based on introspection. "When the price of gas goes up, I still buy gasoline," says the skeptic. Or in its more extreme form: "You need gasoline, so people will keep buying it even when it gets more expensive."

You may still buy gasoline when it gets more expensive. But you will try and find ways to buy less. Not necessarily zero, less.

Thinking about how people respond to the incentive of the higher price opens up a world of possibility beyond the cold turkey of going without. When gasoline gets more expensive, some people car pool, some people drive at slower speeds, some try and combine multiple errands into one trip. Let the price of gasoline rise enough and be expected to stay higher for a long enough period of time and some people will buy a car that gets better mileage, move closer to work or postpone or cancel that order for the pleasure boat that takes $400 to fill its tank when gasoline is $3 a gallon.

Not everyone will do all of these things. Some people will do very few of them. But the overall effect of an increase in the price of gasoline is to discourage the purchase of gasoline.

And as something gets less expensive, we want to have more of it, everything else held equal.

People respond to incentives. But how they respond can be very creative. During a period of hyperinflation in Chile, the story is told that the government's imposition of a maximum price made it unprofitable for suppliers to sell bread—the legal maximum was below the cost of production.

A simple prediction would be that bread would disappear from the shelves. But that prediction underestimated the ingenuity of bakers in responding to incentives. Their first response was to shrink the loaf of bread until the cost of a loaf fell below the legally mandated price. The government then mandated a minimum weight for a loaf of bread. The bakers responded by selling the bread raw, so that the weight of the raw dough could meet the minimum. As inflation climbed, it became unprofitable to sell even the raw dough to meet the minimum. So the enterprising bakers sold the raw dough in bags with water so the minimum weight could be achieved.

Despite a common belief that economics is about money, non-monetary incentives can be just as important as monetary incentives in affecting behavior. Time is one important non-monetary factor in what we do.

Suppose you're a huge Beatles fan. It is announced that through a miracle, the Beatles will be reunited for one farewell concert one month from today. All four Beatles will be appearing in a small intimate theater near your house. You're ecstatic until you hear that the concert is free and that seats for the concert will be handed out on a first-come, first-served basis: the first 250 fans in line be allowed to hear the Beatles.

The concert isn't free. It's going to be very expensive—if you want to attend you're going to have live in front of the theater for a month. Otherwise, you won't be one of the first 250. And it might be dangerous as well. When goods are priced so that people want to buy a lot more than is available, people don't always line up courteously.

Yogi Berra once famously remarked (or at least supposedly remarked) when asked about a popular restaurant, "It's so crowded, nobody goes there any more." Like all good Yogiisms, the statement's absurd but closer examination reveals a hidden truth. What he could have meant was that is was so crowded that a person with a high value of time or a desire for a more relaxed atmosphere had better alternatives. Or to say it more succinctly, "It's so crowded, nobody who's anybody goes there anymore." In fact, Yogi may have meant the opposite—it's so crowded, you have to be somebody to get in—the owners keep out the riff-raff.

So money isn't all that matters. Adding time to the list of incentives isn't enough either. People care about their reputation and fame and their conscience. They care about glory and patriotism and love. All of these can act as incentives.

When an economist says that incentives matter, the non-economist sometimes hears only that people respond to prices. But what the economist really means is that holding everything else constant—the amount of fame or shame, glory or humiliation—and increase the monetary reward, and people will do more of it. Lower the monetary reward while holding those non-monetary factors constant and people will do less of it.

Economists often focus on monetary incentives because they are observable and usually easier to change than non-monetary incentives. An economist will say that when the income of doctors goes up, more people will want to be doctors. People often misunderstand this statement to imply that doctors are motivated by money rather than non-monetary motives to be doctors. But all it means is that holding the non-monetary satisfactions of medicine constant, increasing the monetary satisfaction will make medicine more attractive relative to other professions. If we could measure or stimulate the non-monetary satisfactions of doctors, those factors would be just as relevant as the monetary ones.

The difference between monetary and non-monetary incentives can be seen in the shortage of kidneys available for transplant. It is currently against the law to buy and sell kidneys in the United States. The current supply of kidneys relies on altruism. Thousands of people each year endure the risk of death to donate a kidney to a loved one or a stranger. Others give up their kidneys after death. This willingness to donate is motivated by a desire to help others and that is a powerful incentive. But it is not a sufficiently powerful incentive to create a supply equal to the demand. Thousands die each year waiting for a kidney transplant.

If we want to increase the number of kidneys available to patients with failing kidneys, we're back in the situation of the Australian convicts and those tough captains. We need to increase the incentive to provide kidneys. We can exhort people to give up their kidneys—running more public service announcements and trying to convey the satisfactions that come from helping others. But allowing people to buy and sell a kidney legally is more likely to increase the number of kidneys available for transplanting than begging and pleading.

The role of incentives plays a critical role in the way that individuals treat their own property relative to the property of others or communal property. People are more likely to change the oil in their own car relative to a rental car. Private farm plots in the former Soviet Union outperformed communal farms there.

The Pilgrims in Plymouth used communal farming their first winter but then after a dismal harvest that first year, moved to a system where there was a more direct incentive other than guilt and honor. Governor Bradford summed it up in his journal:

"And so assigned to every family a parcel of land, according to the proportion of their number, for that end, only for present use (but made no division for inheritance) and ranged all boys and youth under some family. This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content. The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability; whom to have compelled would have been thought great tyranny and oppression."

Not only were all hands more industrious—the incentive to harvest communal corn before it was fully ripe, a problem equivalent to poaching in the case of wildlife, was also eliminated.

Incentives matter. Tangible rewards, monetary or in-kind—as in the case of corn in Plimouth—are very powerful. The focus on monetary incentives creates a straw man—homo economicus, a mercenary who will do anything for a price. I used to tell my students that I would be happy to let them purchase an "A" in my class. The price was the GDP of France. My point was that my price was sufficiently high that it was essentially infinite. But truth be told, I like to think that even an exorbitant bribe would have been unsuccessful.

But even if I would have kept my honor and integrity intact in the face of an enormous bribe, I can imagine a non-monetary price where I would forfeit even my honor. I suspect I would gladly sell a grade or do something else dishonest for much less than the GDP of France if it meant saving the life of one of my children. Properly defined to include non-monetary costs and benefits, perhaps every man really does have his price.

Source: www.econlib.org

Key ideas you should know before uttering economics.. 2 b continued

Here are ten fundamental ideas to help you explore and understand the world around us using the economic way of thinking. I've written an essay on each idea and listed some reading and listening suggestions if you want to learn more. The essays are all written for a beginner but some of the ideas are subtle and will be of interest to much more experienced readers. The suggestions for further learning include classic works of economics, podcasts, entries from the Concise Encyclopedia of Economics and other resources from this site and elsewhere. Enjoy.