ET Column

Be Careful What You Ask For

There is this funny story about the “Cobra Effect” based on an anecdote from British
colonial time in Delhi.

Apparently, the officials of the British government were terrified by a large number of
venomous cobra snakes in the city. To solve the problem, someone came up with a brilliant
idea of an exchange offer to the people of Delhi. Money for dead cobras.

Guess what happened next? Soon, the enterprising Delhites were breeding cobras. When
the government found out, they scrapped the bounty scheme, whereupon the cobra breeders
set the snakes free. And the cobra population went up, not down.

A similar incident occurred in Hanoi under the French colonial rule. There were too
many rats so the rulers introduced a bounty scheme for, of all things, rat tails. Pretty soon,
Hanoi was full of tail-less rats running around. The bounty hunters never killed them.
Instead, they just severed their tails released them back into the sewers so that they could
continue to procreate and make more rats, which of course, increased the rat catchers’
income.

Why did both situations backfire? Because the well-intentioned people who created the
bounty schemes didn’t think about second order effects. They didn’t pause, reflect and ask
how people will respond to their brilliant sounding idea.

Thinking about first order effects is easy. Thinking about second or higher order effects is
hard. Charlie Munger complains that

Too little attention [is given] in economics to second order and even higher order effects. This defect is
quite understandable, because the consequences have consequences, and the consequences of the
consequences have consequences, and so on. It gets very complicated.

It’s fascinating to observer how this problem keeps repeating over and over. One variant is
called “you get what you measure.” For instance, if hospitals are asked to publish their
mortality rate, the ones with the highest mortality rates are incentivised to turn away
terminally ill patients.

If someone is paid on a cost-plus basis (e.g. for generating electricity), you can be
confident that there will be plenty of gaming in the form of cost padding. Businesses which
pay their managers to deliver strong near-term earnings also crate incentives for those
managers to cut corners which increase near-term earnings (for example by cutting
expenditures on brand building, research and development, and employee training) but
destroy long-term value.

Another variant of this issue is something I learnt from the famous investor Jim Rogers
who, in one of his books wrote that you (i.e. a regulator) can either control the price of a

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product or a service, or its supply, but you can’t do both. Back in the days of industrial
licensing the government wanted to fix both the maximum production of Bajaj Auto scooters
in a year and their maximum price. It failed to do both. Limiting production well below actual
demand simply caused a black market to emerge and lucky allottees would simply sell their
allotment letters at several times the maximum price allowed to be charged by the
government.

The US government spends tens of billions of dollars ever year to stop addictive drugs
from reaching its populace. Its prisons are full of drug dealers and drug addicts. All that
money spent does nothing but increase the price of drugs and the profit margin for those folks
who have an incentive to smuggle it across the US border. No matter how risky the US
government makes it for smugglers and drug dealers to do whatever they do, the addicts can
still buy the drugs. The more they try to stop it the more they fail. In the meantime the tens of
billions of dollars spent every year could have been spent on finding a solution for malaria.
Also, in the meantime, in another country — Netherlands — where drugs are legal, crime
rates are so low that the government is shutting down prisons.

Back in India, they price urea so low that it gets smuggled across the borders to Sri Lanka,
Bangladesh and Nepal and sold at much higher prices.

Recently, the Indian government put a cap on the price of stents used in heart surgery —
even for private, for-profit hospitals. Soon after the price controls were announced, some
manufacturers announced their intention to withdraw their stents from the market. So, while
the original intention (stop price gauging) was good, the outcome is not. Do we need a black
market in stents?

In 1975, the American economist Steven Peltzman studied the impact of seat belt laws on
automobile death rate. What he found was quite revealing. While the use of seat belts made
people safer inside the car, it also made people drive more rashly. As a result there were more
accidents causing more fatalities outside the cars. The two effects cancelled each other and
there was no overall reduction in the number of automobile deaths.

This effect, called the Peltzman effect has wider applications. Basically, the idea is that
whenever the government tries to regulate something, there will be an incentive for people to
game the system. And gaming systems comes as naturally to some people as breathing. We all
remember what happened during the hours after our PM appeared on TV on the night of 8
November 2016 don’t we?

One of the key elements of a good system design, therefore, is to avoid creating incentives
to game it as much as possible. People who design systems should always ask a critically
important question: “And then what?” to make them think of ways in which people will game
them.

This particular idea — of asking “and then what?” applies not just to regulators. It applies
to everyone, including investors. As Warren Buffett writes:

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The key thing in economics, whenever someone makes an assertion to you, is to always ask, “And then
what?” Actually, it’s not such a bad idea to ask it about everything but you should always ask, “And then
what?”

Indeed, some of the best investment ideas occur when a great business encounters a
problem which causes a temporary blip in its earnings growth but is perceived by the market
as a significant-negative news. The loss of a customer which does not destroy the business. A
flood. A fire. A strike. A few bad quarters caused by temporary factors — my current
favourites are demonitization and GST — which have absolutely no bearing on the business’s
bond with the customer and its ability to delivery profitable growth over the long term.

The market is a pari-mutuel system wherein one is not betting against the house, but is
betting against other investors. In such a system the behaviour of others changes the odds. If
temporary bad news causes the stock prices to decline much more than they should, the smart
investors see that as an opportunity. Paradoxically, bad news for a business can be great news
for an investor because it gives him a rare change to buy at a fabulous price. Such an investor
does not panic and run for the exit at the first time of trouble. He pauses. He reflects while
others panic and sell. He quietens his mind so as to avoid jumping to hasty conclusions. He
carefully studies the “bad” news. He notes the drop in price. And once in a while, his analysis
shows that the market’s reaction is overdone and he buys into a wonderful business at a
bargain price.

Thinking about first order effects is easy. Thinking about second or higher order effects is
hard. But just because it’s harder, doesn’t mean one shouldn’t do it. Indeed, the practice of
routinely thinking about second and higher order effects by asking “and then what?” should
not be limited to chess players and regulators. It should be adopted by investors as well.

Sanjay Bakshi

The author is a Managing Partner in ValueQuest Capital LLP, a SEBI Registered

Investment Adviser. He is also an Adjunct Professor at Management Development Institute,
Gurugram.