I would like to introduce you to the idea of a money pump. A money pump is a person whose irrationalities can be systematically exploited for financial gain. The simplest money pump is a person who prefers an apple to a doughnut, prefers a doughnut to a chocolate bar, and prefers a chocolate bar to an apple. Just offer them an apple in exchange for their doughnut plus a penny. They will accept. Then offer them a chocolate bar for their apple plus a penny. Then offer them a doughnut for their chocolate bar plus a penny. They end up with their original doughnut and are three pence poorer. Repeat for ever.
Money-pump arguments are sometimes deployed to object that people cannot be irrational, otherwise they would be bankrupted by money pumping. But economists are increasingly coming to realise that, instead, we should be looking for money pumping in action.
Given our anxiety about small risks, what would the money pumping look like? It would be an insurance policy focused on the narrowest possible slice of risk. It would be sold alongside another product or service, often at the last moment. It would be marketed by creating anxiety and then offering the product to make the anxiety go away. In short, it would look like the collision damage waiver, the extended warranty, and PPI [payment protection insurance]. These bespoke slices of insurance are among the largest money-pumping projects in the modern economy. No wonder the banks abandoned their principles to join in.
Tim Harford, “How insurers keep the money-pump flowing”, TimHarford.com, 2016-09-21.
August 14, 2018
QotD: The money pump
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