Here at Economic Forces, we often argue that economics can help us understand the actions that people take. Although we typically discuss actions taken in the market, the basic idea can apply outside the market as well. In fact, today I would like to argue that economics can help us to understand inaction. We can use same sort of tools that we use to explain why people take particular actions to also explain why they do nothing. In fact, this can help us to understand some otherwise puzzling observations.
Those Pesky Fixed Costs
A lot of economic decisions require paying some type of irreversible fixed cost. Moving from one place to another requires substantial fixed costs both in terms of the monetary costs associated with moving, but also the opportunity cost of being farther away from family and friends. Moving back allows you to recover some of that cost (you get the benefit of being closer to family and friends), but requires new monetary costs. You cannot recoup the original cost. The same is true about building a factory. When a company is determining whether or not to build a factory, there is a substantial fixed cost associated with doing so. For example, the construction itself is costly and must be paid before any production is done. If the company decides to shut down the factory, they might not be able to find a buyer for the structure. Even if they do, they are unlikely to recover the cost of building the factory since the factory was built for a particular use that is likely different from the use case for the new buyer.
There are many more examples, but the basic lesson here is that there are things that people have the option to do that they might not want to do because of the fixed costs involved. For example, suppose I pay the fixed cost of building a factory in Vietnam to export to the United States. The dollar subsequently depreciates thus making my product more expensive to Americans. Meanwhile the cost that I pay the workers is paid in the local currency. Had I known this was going to happen, I might not have chosen to build the factory.
The same can be said for a long-distance move. I might pay the cost to move to take a new job. Once I get there, the company decides that they need to eliminate some jobs to save on costs and mine is one of them. I’ve now given up the connections with family and friends and paid a substantial amount of money to move and am unemployed. Had I known this was likely to happen, I would not have moved. However, moving back is costly. What should I do?
In these types of situations, it is best to think of people as having the option, but not the obligation, to take a particular action. That particular framing is useful because we have some idea about how to put a value on the option to take a particular action. We can rely on the same type of logic that we use for thinking about financial options.
One can think about the intuition as follows. One’s objective should be to maximize the value of the option, but how does one do that? Well, consider this example. Suppose that you want to build a new factory. Demand is rising, on average, over time. Some component of the demand for your product is predictable and some is not. Standard logic is that if the present discounted value of the factory is greater than cost of building it, you should build it. Uncertainty about future demand gives you an incentive to wait because the expected present discounted value is moving around with fluctuations in demand. Just because the expected present discounted value is greater than the cost today doesn’t mean that it will be a month from now or a year from now. Demand could decline unexpectedly. In other words, what you want is some kind of buffer between the expected present discounted value and the cost such that even unexpected declines in demand shouldn’t lead to losses. But how do you determine that buffer?
The way to think about this is as follows. The value of exercising the option on the day you exercise it (in this case the value on the day you build the factory) is the expected present discounted value less the fixed cost of building the factory. Since demand is rising, the longer you wait, the greater the exercise value. All else equal, this increases the value of the option. However, the longer you wait, the lower the present discounted value of the option to build the factory. You choose your threshold for demand to balance this tradeoff and maximize the option value.
Once you have chosen that threshold, your best course of action is to do nothing until demand hits the threshold.
Economic decisions that have these characteristics often result in lumpy empirical observations. What I mean by this is that if you are looking at a single decision-maker, it will appear as though the decision-maker is doing nothing for long periods of time, but they periodically make large economic decisions.
A prime example can be found by looking at data on investment. If you look at time series data for the U.S., investment trends upward like a lot of other macroeconomic variables in a growing economy, but it is fairly volatile compared to output. If you look at the distribution of investment in any given period of time, you can understand why. You will find that there is a very small fraction of firms that are investing in any given period. However, those firms that are doing the investment are spending very large amounts on the investment.
There are many other types of economic decisions that fit within this category. Let’s discuss some examples.
Some Examples
Why Do Exchange Rates Seem to have So Little Effect on the Distribution of Trade?
In the aftermath of the collapse of the Bretton Woods system when exchange rates started floating, real exchange rates became substantially more volatile. This matters because if the real exchange rate is fluctuating, the real purchasing power of the currency is changing. If there is a real appreciation of the dollar, then the cost of foreign goods have fallen. This also means that foreign inputs are cheaper. Thus, one would expect that significant fluctuations in the real exchange rate would alter the location of production.
However, people started noticing that the fluctuations in the real exchange rate seemed to be detached from reality. What they meant by this is that by the mid-1980s, despite some pretty wild swings in the real exchange rate, this didn’t seem to have a large effect on the location of production.
Paul Krugman’s explanation for why these fluctuations in the real exchange rate seemed detached from reality was based on this option value logic. Entry and exit from particular markets entails substantial fixed costs. Thus, the real exchange rate would need to appreciate above some threshold before it made sense to enter the export market. For those already in the export market, the real exchange rate would have to depreciate below some threshold to convince people to exit. However, what this means is that there are upper and lower thresholds for the real exchange rate. As long as the real exchange rate fluctuates within those thresholds, there is no entry or exit. Thus, there could be a lot of movement in exchange rates with little corresponding activity.
Why Don’t People Move When Things Get Bad?
The same logic applies to decisions about whether or not to relocate yourself. Sometimes people are living in areas that are on the decline. Labor market opportunities are declining. Nonetheless, people stick around. Why don’t they leave for better opportunities?
If you move, you give up the labor market opportunities you have now in favor of the labor market opportunities you have elsewhere. One might think that as long as the latter are greater than the former, you should move. However, moving entails a substantial fixed costs. The monetary cost of moving you (and possibly your family) and all of your stuff is significant. At the same time, you might also be leaving friends, family, familiarity, and local knowledge. When you move, the family who might’ve watched your child when you went to work is replaced by a daycare. You don’t know who to call when you have a leaky pipe. There is also uncertainty about the new location. What happens if you move and the market in your new area takes a turn for the worse?
As my colleague John Gardner and I have written about, moving is therefore best thought about in terms of option value. People will choose a threshold for how bad things need to get before they are wiling to leave. It is not sufficient for people to simply see better opportunities. There is uncertainty about the durability of those better opportunities and large fixed (and sunk costs) associated with moving. They want to make sure that it is really worth it before they make the move.
Do Unpopular Policies Survive?
We can even think about this in terms of non-market behavior. For example, how can we think about policy? People love to point to policies that purportedly have greater costs than benefits. They come up with all sorts of reasons why this is the case. A common argument is that policies that have a net cost to society get implemented and survive because the benefits are concentrated among a small group of people and the costs are dispersed within a large group of people. The people receiving the benefits have a strong incentive to keep the benefits flowing. Since each individual paying the costs is only paying a very small fraction of the costs, they don’t have as strong of an incentive to go out and try to stop or later repeal the policy. Furthermore, even if the costs exceed the benefits, the fixed cost of getting rid of an existing policy might be larger than the cost savings. In that case, the policy survives. (It also reveals a point of contention in this literature. The costs of organizing against the policy are fixed costs. Although they don’t count in terms of the flow of costs, they are costs nonetheless. Critics of these bad policies tend to ignore these costs and focus on the flow of benefits and costs. But we’ll leave that aside.)
However, in a dynamic environment when the net costs of a particular policy are changing over time, it stands to reason that if those net costs get large enough, there are rewards to political entrepreneurs to pay the fixed cost of organizing a coalition to eliminate those policies. Thus, we might think of political entrepreneurs as having the option to organize. These political entrepreneurs wait until the net costs are large enough to justify organizing a coalition.
On this topic, Brian and I wrote a paper with Alex Salter on the efficiency of policy. In that paper we start with the idea that the policy process works as follows. Interest groups are organized and negotiate over policy. Organizing a new interest group is costly. Nonetheless, political entrepreneurs representing potential interest groups have the option to enter and overturn a costly policy. They will enter if the net costs of the policy exceed some threshold. This entry point puts an upper bound on the net costs of any policy. In addition, policies that seem inefficient in a static sense are efficient in a dynamic sense (at least in the limit as the time horizon gets arbitrarily large). As a result, there might be long periods of time in which it might not seem like anyone is doing anything about a costly policy. Then, all of the sudden, there is a change in policy.
It’s a Post About Nothing
Seinfeld was a popular television show about nothing. It shouldn’t have worked, but it did. Doing nothing is also an important component of economic decision-making. It doesn’t like it would be all that interesting, but many economic decisions involve choosing the optimal time at which to make a decision and take action. In the meantime, empirically it appears as if you are simply doing nothing. That can be puzzling. However, if you understand option value, economic reasoning can not only explain the actions that people take, it can also explain the actions they do not take or why they wait so long to act.