Isaac Newton gave the world the three famous laws of motion, i.e., the law of inertia, the law of momentum, and the law of reaction. The most interesting among the three laws is the law of reaction which states that every action has an equal and opposite reaction. This law may hold its valor in the world of science but when it comes to the surprising world of economics, it may prove faulty. This is because in economics actions do not have equal and opposite reactions rather they have unanticipated consequences which sometimes tend to diminish the motto of the action itself. To better understand this let us take an example of an incident that took place in the city of Delhi during the British colonial rule.
Origin of the Cobra Effect
Terrified by the rising numbers of Cobra snakes in the city the British government announced rewards in exchange for each dead cobra presented by the Delhi citizens. Initially, the bounty worked well but soon the enterprising citizens realized that killing cobras and exchanging them for rewards had become a regular source of income for them. So, they decided to set up secret cobra breeding centres where they raised cobras to kill the captive ones and exchange them for bounty reward. Due to this people exchanged more dead cobras for reward than were estimated by the British government which raised suspicion. Soon the cover from the clandestine breeding centres was blown, and the British officers, therefore, ordered the bounty program to be terminated. Now the cobras present in the breeding centres were worthless so people released them back into the city which resulted in a higher cobra population than before. The policy of rewarding those who kill cobras turned into the policy of rewarding those who breed cobras. Thus, came into existence what we know as the Cobra Effect.
Role of Feedback
People believe that the relation between cause and effect is linear, i.e. double the cause double the effect or halve the cause halve the effect. In reality, the relation is more complicated than we realize, and therefore, we need to understand the theory of Feedback Loops and the important role it plays in determining the system’s response to policy initiatives.
Feedback Loops exist whenever the output of one process or cycle becomes the input in the next process or cycle. There are two forms of basic feedback loop: reinforcing (also called ‘positive feedback’) and balancing (also called ‘negative feedback’). Balancing loops dampen the system’s output with each cycle, whereas, reinforcing loops amplify the system’s output with each cycle.
In a complex real-world system, multiple balancing and reinforcing feedback loops keep on interacting with each other. Policymakers should understand the dynamic nature of the policies that they are framing and be aware of the problems that might arise as a result of interaction between different stakeholders of the policy.
The Cobra Effect of Discounts
Set up the right incentives, be they bonuses, subsidies, or cash-backs, and people do nearly anything to achieve the stated goal. But incentive formulation requires special care and attention because they can have perverse consequences, in some cases, causing people to work against the goal you were trying to achieve.
For example, E-commerce companies equate unrealized revenue with lost revenue. This implies that products that have been added to the cart but not purchased for a long time are considered a ‘loss’. In the wake of achieving exorbitant sales target to lure investors in investing in the platform and to capture Customer Lifetime Value (CLV), young startups give their customers huge discounts, even when the discount is resulting in a loss, to continue shopping with them and not abandon their carts. Now customers deliberately abandon their shopping carts expecting to receive valuable discount offers which help them carry forward their shopping.
According to a survey conducted by Baymard, nearly 57% of people abandon their shopping carts because they feel the extra cost of shipping, taxes, etc. are too high and hence, wait until the e-commerce platform sends them abandoned cart emails containing discount offers reminding them to buy the items in their cart regardless of the affordability of the item.
The Cobra Effect of Repo Rate
Another instance of Cobra Effect was witnessed when the Reserve Bank of India (RBI) announced a series of repo & reverse repo rate cuts to encourage lending activities in the post-COVID-19 lockdown period but, the banks didn’t respond to RBI’s expansionary measures as expected. The fear of people defaulting on their loans in a crisis situation resulted in banks increasing their funds parked with the RBI from Rs.3.8 lakh crore on 31 March 2020 to Rs.7.2 lakh crore on 21 May 2020, under reverse repo operations instead of lending them out to their corporate clients.
To quantify the difference between the returns generated by parking the funds with the RBI under reverse repo operations against deploying the funds in corporate lending activities, a comparative analysis of both the situation was carried out considering a base value of Rs.7.2 lakh crore along with other assumptions such as:
Reverse repo rate = 3.35%
Corporate lending rate = 12%
Default rate = 5%
Recovery rate = 33%
According to the Brickwork Rating report, had the banks deployed their funds in corporate lending at a 12% interest rate instead of parking their funds with RBI at 3.35% reverse repo rate, the funds would have generated Rs. 35,265.6 crore of extra interest income for the bank.
The Peltzman Effect
In 1975, a study was being conducted to understand the impact of seatbelt laws on the automobile accident death rate by an American Economist, Steven Peltzman. What he found was quite revealing. While the use of seatbelts made car drivers safer inside, it also made them drive their vehicles more recklessly. This resulted in more number of accidents causing more fatalities outside the car. The safety provided by seatbelts was canceled out by the increased riskiness to people outside the car and there was no overall reduction in the automobile death rate. This effect is called the Peltzman effect.
Black Market of Bajaj Scooters
The famous investor Jim Rogers wrote in one of his books that a regulator can either control the price of a product or service or its supply, but can’t do both at the same time. Back in the days of industrial licensing, the Government of India tried to fix both the maximum production of Bajaj scooters per year and their maximum price. This led to the emergence of a black market due to the lower production of scooters as compared to their actual demand and people who had already received an allotment letter were ready to sell it in the black market at a price several times the maximum price allowed to be charged by the Government.
Well-intentioned people create growth-supportive social, political, economic, and environmental policies for the welfare of the society but since we live in a chaotic world there is always someone who finds a gaming opportunity under crisis and deliberately takes advantage of the loopholes to bend the odds in his or her favor. These people bring about the second-order effects which the policymakers had never thought about. Responding to first-order effects is easy but responding to second-order effects is way too difficult. One of the most important elements to focus while designing a good system is to avoid creating incentives to gamify the system as much as possible.
Contributor: Harshil Ghatalia
Research Desk | Leveraged Growth
I am an engineering graduate from Gujarat Technological University (GTU), Ahmedabad, and currently pursuing MBA Finance from Pandit Deendayal Petroleum University, Gandhinagar along with CFA Level 1 from CFAI, USA. I am a sports enthusiast with state and national level exposure in Basketball. I have special interests in geopolitics, macro-economics, and martial arts. I firmly believe that suffering the pain of discipline is much better than suffering the pain of regret. I’m an ardent learner who aspires to find a solution for every problem by employing my creative and analytical bent.