Elasticity

Elasticity

Elasticity describes responsiveness in percentage terms: for a small change of 1 percent in one quantity, by what percentage does another quantity change? The most commonly used elasticity is the price elasticity of demand, the application developed by Alfred Marshall in 1890. It tells us the percent reduction in the quantity demanded of a good when the price is increased by one percent, holding everything else constant. A price elasticity of ice cream of -2 means that when the price of ice cream increases by 1 percent, the quantity of ice cream purchased goes down by about 2 percent.

Elasticity is one tool for thinking at the margin. To illustrate, let’s tackle a simplified version of a question that many professionals have had to answer implicitly or explicitly: Do you prefer to spend time at work, or with your family or on personal projects? Economists don’t regard this as a well formulated question because the answer will likely depend on how many hours you are currently working and how many hours you are currently spending with your family or on projects. If you are working few hours and have a considerable need for money, you will likely want to spend more time working. At the other end, if you are working many hours and you rarely see your family, you would probably prefer additional family hours. In sum, to answer this question it is helpful to think about the value of your last (marginal) work hour. In addition, this marginal hour may not be adding much to your income. An extra hour may bring little additional income, and that income may matter less to you than the alternative use of your time. Measuring an elasticity would require comparing percentage changes, rather than simply asking about an additional hour.

Accordingly, when making this decision, you want to think about whether in your current situation (working as many hours as you are now), you would like to spend an extra hour working or with family. Thinking at the margin means thinking precisely in those terms: what value do you derive from that additional (also called marginal) hour?

Marie-Pascale Grimon, then a PhD student at the Harvard Kennedy School and a teaching assistant of Richard Zeckhauser’s, described this dilemma: “Often times, I find myself or others around me making decisions based on absolutes instead of thinking marginally. Are those extra five hours of work worth the extra money when compared to spending an extra five hours with family? Of course, having a job and earning a decent living are good things, but usually we forget to ask ourselves whether that additional time spent doing such and such is worthwhile.”

Iris Bohnet, a professor and colleague of Richard’s at the Harvard Kennedy School, specializes in behavioral economics. She applied the elasticity concept in some research with Richard related to trust. Imagine that you lost $100 because of a hole in your pocket – how would that make you feel? Now, imagine that you lost $100 because you lent a friend money and he skipped town without repaying the interest-free loan as agreed. How would you feel about this loss?

In either case, you lost $100. But in the first case the loss was caused by bad luck, and in the second by lack of trustworthiness by a friend. If you feel worse in the second scenario, you exhibit what Iris and Richard called “betrayal aversion.” That aversion implies that people care about how the outcome came to be. Specifically, when the probabilities of loss are the same, people who exhibit betrayal aversion prefer the loss to be caused by natural circumstances as opposed to by the actions of another person. In other words, betrayal is worse than bad luck.

Iris and Richard conducted some clever experiments to learn about how people’s willingness to trust changes when the likelihood or cost of betrayal changes.

Betrayal aversion and elasticity of trust Iris Bohnet Intrigued by the findings of our initial experiments in the United States, we went out into the world to see how robust betrayal aversion was. It turns out we found it everywhere we went. Many people in China and Vietnam, in Saudi Arabia and Turkey, in Brazil and in Switzerland, also exhibited betrayal aversion, though not always to the same degree as in the United States. These findings have implications for institutional design. We think of legal systems’ fostering trust by compensating victims for their material losses when they are wronged. But if people are betrayal averse, arrangements that focus on compensating the victims of betrayal for the material losses experienced will not effectively foster trust. For example, in many contractual arrangements, damages are thought to compensate a person for the injury caused by their counterpart, by making the potential victim of breach equally financially well off whether the contract was performed or breached. The more betrayal-averse a person is, the less effective are institutions that decrease the risk of material losses rather than the risk of betrayal. This insight led to a fruitful research program that kept Richard, various doctoral students and postdoctoral fellows, and me busy for quite some time. It also lent itself to the exploration of another of Richard’s favorite concepts, elasticity. To better capture how people responded to changes in the institutional environment, specifically the cost and the likelihood of betrayal, we introduced the notion of the “elasticity of trust.” It measures how much more people are willing to trust given changes in either the cost or the likelihood of betrayal. We took the insights from our research to our teaching on negotiation and decision making, in both degree and executive education programs. In true Kennedy School fashion, this led to a request from a government to help them think about their institutions in light of betrayal aversion. Richard did not join me in the United Arab Emirates, but it was a lot of fun for a young assistant professor to work with Sheikh Mohammed, the prime minister of the United Arab Emirates and the ruler of Dubai, and his cabinet in Al Ain, an oasis close to the Omani border. I taught them about decision making, trust, and negotiation. We discussed Islamic contract law and how it compared to contract law in Switzerland, a civil law country where “pacta sunt servanda” (agreements must be kept), and in the United States where the common law notion of “efficient breach” describes how a party can breach a contract if it finds it more attractive to pay damages than to honor its commitments.