Government Smart to Pivot Away from Elimination strategy

Government right to pivot away from elimination

Ananish Chaudhuri

Ananish Chaudhuri is Professor of Experimental Economics at the University of Auckland and the author of the book “Experiments in Economics: Playing Fair with Money”. The views expressed are his own.

It is clear that the government has begun to realize how costly lockdowns can be in terms of their economic and social impact. As a result, the government now seems to be willing to pivot away from their goal of total elimination. This is made clear by the recent announcement by the Minister of Health that Auckland will most likely be allowed to drop down from the current 2.5 level even if community transmission does not drop to zero.

This is welcome news since elimination via lockdowns was never really a feasible goal given the significant collateral damage inflicted by such lockdowns.  

Some commentators, however, would like us to “stay the course”.  According to this view: “We’ve come this far and given up so much, it would be crazy to stop now.”

This is actually a common intuition among many but happens to be misguided. Economists call this the “sunk cost fallacy”. To understand why, I need to relate two stories.

The first story refers to an exercise that I often carry out in my classes on decision making. This is called “The $20 auction”.

I start the lecture by taking out a $20 bill out of my wallet and tell my students that I am going to sell it to the highest bidder.

I then invite students to bid on the $20 bill with one small caveat. This is an “all pay” auction. That means that everyone who bids an amount must pay with only the highest bidder winning the money. But the losers must also pay whatever they bid.

This type of situation is quite commonplace. Think about running for public office. Every candidate/party spends substantial amounts of money but there can only be one winner with the expenses incurred by everyone else being lost. Similarly, right now companies around the world are in a mad race to develop a vaccine for Covid-19. They will spend billions of dollars in doing so and finally only one of them will be successful; the one whose vaccine eventually goes to the market. The investments made by others will likely come to nought.

As the auction starts, there is a general sense of amusement at first. A titter here, a nervous chuckle there. But eventually someone or the other takes the plunge and bids $1. If the bidding stops there, then this person would have won $20 for $1 and will make a $19 profit.

But soon others join the fray and the bids start to increase. Pretty soon, people actually start to bid more than $20 to win $20! Why?

Suppose you have bid $20 while someone outbids you by going up to $21. If this person wins the $20, then this person has lost $1 while by being outbid you are now looking at losing the entire $20 you bid. So, even if one has to go above $20, people do it because now it is a question of minimizing losses.

The second story comes from my colleague Tim Hazledine at the University of Auckland and relates to Auckland’s City Rail Link.  According to Tim, when the city rail link was first proposed the benefits of the project (on a net present value basis) were estimated to be about $2 billion, and the construction cost was originally estimated to be about $2 billion also. Then, in April 2019, with $700 million already spent, the costs were revised upward to $4.4 billion with no change in the estimated benefits and no guaranteed finish date.

In April 2020, the city rail link management announced that, because of Covid-19, costs would rise further and the impending May budget should make allowances for this. No mention was made of the possibility that Covid-19 may actually reduce the benefits of the rail link, through more people continuing to work at home rather than commute. Tim wrote:

“Adding in some substantial costs missing from the official calculations, the costs of disruption to business and citizens during the build, and the cost of the huge subsidy on the price of rail tickets, it seems sadly reasonable to predict that we now have a $5 billion+ monster on our hands. Even with more sunk costs incurred since last year, we are looking, in the best scenario, at having to fork out another $4 billion to finish a possibly $2 billion value project.

This behaviour lies at the crux of the sunk cost fallacy; the idea that people often pursue goals even when the benefits fall short of the costs.

Countries keep on fighting ruinous wars even when it is clear that nothing remotely resembling victory is possible. Candidates keep campaigning even when it is clear that the additional costs of doing so will outweigh any potential benefits given the virtually zero chance of victory.  In fact, the fact that they have incurred substantial costs is reason for doubling down and getting in deeper.

This argument applies to our policy on Covid-19 as well. The fact that we have incurred substantial costs does not imply that we should continue to do so when the projected benefits fall considerably short of the costs. A recent report from the Productivity Commission suggests that the cost of extending our April lockdown by five days outweighed the benefits by more than 90 to 1.

So, it is good news that the government, albeit belatedly, has recognized the error in the previous approach and is now adopting a more practical view of controlling the pandemic.

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