Discover more from Economic Forces
There is risk in buying knowledge. Who should bear the risk?
You are reading Economic Forces, a free weekly newsletter on economics, especially price theory, without the politics. You can support our newsletter by signing up here:
It is possible to imagine the following scenario. People like to consume fruit. In fact, it is the only thing they consume. To consume fruit, one must first grow the fruit. Some people are born with an endowment of seeds each period and some people get nothing. (To make things simple, we will also assume these are GMO seeds that prevent the fruit from producing seeds of its own.) In addition, some people are born who know how to grow fruit and some are born with no such knowledge. Finally, some people (regardless of whether they are born with any seeds) like to grow fruit. Others do not. This community is small enough that everyone knows everyone else.
In this sort of a world, you can think about the various different incentives.
People with seeds, knowledge of how to grow them, and the desire to grow them will have the easiest life. We can ignore these people.
People with seeds, knowledge of how to grow them, but no desire to grow them, will sell their seeds and their knowledge. (Seed and knowledge sellers)
People with seeds and desire to grow them, but no knowledge of how to do so would like to purchase this knowledge. (Knowledge buyers)
People without seeds, but with the knowledge and desire to grow would like to purchase seeds. (Seed buyers)
People with seeds, but no knowledge or desire to grow will want to sell seeds. (Seed sellers)
People without seeds or the desire to plant them, but with the knowledge to plant them will want to sell that knowledge. (Knowledge sellers)
People without seeds or the knowledge of how to grow them, but want to grow them will want to buy both seeds and knowledge. (Seed and knowledge buyers)
It seems pretty straightforward here that there are gains from trade to be had. All we need to do is match these people up with one another for mutually beneficial trade. That seems easy enough. Seed buyers can buy seeds from seed sellers in exchange for a promise of fruit in the future. Knowledge buyers can purchase knowledge from knowledge sellers in exchange for future fruit. Et cetera.
Nonetheless, we can also easily imagine problems. For example, it is possible that certain seeds just randomly won’t produce much fruit. It is also possible that not everyone is honest.
Under these conditions, who would have an incentive to cheat?
Since everyone knows everyone else, we know who will not cheat. Assuming that there is no way to counterfeit seeds, whether someone has seeds or fruit is easily verifiable. Furthermore, since everyone knows everyone else and could be ostracized for lying, there is no incentive to lie about whether or not the seeds yielded fruit.
The most obvious candidates for cheating are seed sellers. People cannot fake seeds, but they can fake knowledge. Thus, seed sellers have an incentive to pretend they are not just seed sellers, but they are also knowledge sellers. Why? Because selling both seeds and knowledge is going to warrant a bigger promise of fruit than seeds alone. And they can get away with it. In the event that the seed and knowledge buyer plants the seeds, there is some probability that the seeds will produce a lower yield regardless of the knowledge. Thus, there is no easy way to distinguish between false knowledge and bad luck.
There are several possible solutions to this problem. The first is simply to let this play out. Over time, certain seed sellers who are selling knowledge will be shown to be lying because the yields on these seeds will be below what is statistically likely given what people know about seeds. In other words, these sellers will develop a bad reputation and people will stop purchasing knowledge from them. Whether or not this is the best solution to the dishonesty problem depends on how long it takes for this information to be revealed — and, of course, that length of time is endogenous since it depends on the chosen behavior of the dishonest people.
An alternative solution would be a change in contract enforcement. Since all of these transactions are loan contracts, one possibility would be to say that if the amount of fruit produced is below a certain threshold, then the grower’s loan would be forgiven. An optimal threshold would get the liars to reveal their type (i.e., stop selling knowledge they don’t have). Even without an optimal threshold, this should speed up the process of determining whether or not the knowledge sellers have actual knowledge and discourage the fakes from trying to pretend they have knowledge that they don’t have. However, this comes at a cost to sellers of actual knowledge since, through no fault of their own, they will occasionally not be repaid.
Of course, there is also a political alternative. The genuine knowledge sellers might reject the idea that sometimes they shouldn’t get paid. This is just bad luck, after all. Why should they bear the burden and not the borrower? This coalition will find support with the seed sellers who see this as an opportunity to continue their grift. If successful, this coalition might push to make sure that there is some sort of social norm or law that emerges such that the contract is always enforced and that any existing current debts are simply rolled over into the future. After all, the bad luck isn’t their fault so the borrower responsible for the planting should bear all of the risk.
It is difficult to work out all of the welfare effects and evaluate the ethics of the possible solutions. Nonetheless, given that the problem is that some knowledge producers aren’t actually producing knowledge that provides any sort of economic return, it seems like this last, political solution is the worst possible solution. It does nothing to eliminate the incentives of the bad actors.
Anyway, last week President Biden announced that knowledge buyers will continue to bear all of the risk here in the real world. Knowledge sellers, both genuine and not, will continue to avoid all risk. However, some of those knowledge buyers will get some of their money back; not from the knowledge producers, of course, but from everyone else.