The Costs of Commitment

A good post by my friend the Prolix Patriot examines Washington's historical streetcar lines and development. One bit of discussion focuses on how fixed services like subways and streetcars are visible commitments by the city to a certain course of action. Bus lines can be rerouted easily and some of Metro's remedies for budget shortfalls involve just that. In contrast, rerouting services with large fixed costs would be inordinately expensive. Thus, the permanence of a service gives others confidence that it will continue.

Being an economist I immediately thought of the similarity with the Asset Substitution problem from corporate finance. In short, an entrepreneur (or agent) goes to investor (or principal) with a profitable project with a certain level of risk. The investor makes a costly investment in the project. The entrepreneur then actually does a different, more risky, project which will give him more benefits if it succeeds and for which the entrepreneur will bear the greater costs if it fails. There are several ways to minimize the problem including insurance contracts and bond covenants. In each case the agent makes a costly decision to signal his commitment to a certain action. Sociologists might point to engagement rings as another example of this theory. Biologists could cite adaptations such as peacock's feathers, although that has more to do with signalling health than any costly commitment. Perhaps those who've watched National Geographic more recently could offer some ideas. For cities, once potential home-buyers see a commitment to providing transit, they might be more willing to buy a house rather than continuing to rent. This can have great benefits for neighborhood stability and quality of life, many of them traditionally promoted as the benefits of homeownership.

It's more evidence that understanding incentives is vital for making good decisions - in many walks of life. Politicians and planners who ignore this fact in search of some Utopian vision do so at their, and their city's, peril.