While reading about the toxicity of 30-year mortgages this weekend,
i came across the Alchian-Allen Effect.
What is this Alchian-Allen effect?
Imagine a fruit F grown in city-A.
Let's say the higher-quality of fruit F sells in city-A for $2,
whereas the lower-quality of fruit F sells in city-A for $1.
Based on the fact that higher-quality of the fruit sells for twice the price of the lower-quality fruit, there would be a certain distribution of the consumption of both the varieties of the fruit. Based on the price-sensitivity of the people who buy the fruit in city-A, a certain percentage of people would buy a certain amount of the lower-quality fruit (as it is half-price of the more expensive variety).
Now, think of a city-B that imports both the varieties of Fruit F. Let's say the transportation costs from city-A to city-B add $1 to the price of each fruit F. This is irrespective of the variety of the fruit being transported (after all the truck doesn't care how good the fruit is).
Assuming there's no price-gouging going on in city-B,
the higher-quality of fruit F sells in city-B for $3,
whereas the lower-quality of fruit F sells in city-B for $2.
Now, if the price-sensitivity of the people of city-B is similar to those in city-A,
then one would see a larger percentage of people in city-B buying the higher-quality fruit F in city-B.
The simple reason being,
- residents of city-A
need to pay a 100% premium for the better quality of fruit
($2 instead of $1),
- residents of city-B
need to pay just a 50% premium for the better quality of fruit
($3 instead of $2).
An extreme result of the Alchian-Allen effect can be seen when the source of the additional fixed-cost has a limit. In the above example, if there is a limit to the amount of fruit that can be transported from city-A to city-B, then only the higher-quality fruit would be transported to city-B. This would result in city-A having all the lower-quality of the fruit (and if any higher-quality fruit was leftover due to the limit on transport to city-B).
NOTE: In both the individual scenarios above, the anchoring effect appears to be at play as well. The Alchian-Allen effect can be seen as a composite of 2 instances of the anchoring effect with a common fixed-cost being the main differentiator between the 2 scenarios - ultimately leading to 2 different outcomes.
Alchian-Allen effect in Software-Development
1. Buying Software vs. Building Software ?
Nowadays, most software teams that work of huge problems, are often posed the question - "Build or Buy". Whether to develop a necessary piece of software in-house or opt for such a software-solution from some other team/company.
The Alchian-Allen effect may NOT be immediately obvious when choosing between Build vs. Buy, it tends to play a significant role over the long-run. Consider a team that opts for the "Build" option because the overall costs of developing the solution in-house are perceived to be lesser than the price demanded by existing solution providers. Such a team will in the future perceive the cost of each additional feature to be significantly higher (as anchored to the relatively lower cost of the initial deployment).
Contrast this with a company that opts for the "Buy" option i.e. gets the software developed/maintained by another team/vendor, even though they perceive the initial deployment cost to be significantly higher. Such a team will in the future perceive the cost of each additional feature to be significantly lower (as they are anchored to the relatively higher cost of the initial deployment).
Can this explain, why sometimes Non-Commercial Open-Source Software is criticized due to the costs associated with maintaining it over the long-run? Whereas such costs associated with similar proprietary software are written-off as "just the cost of doing business".
2. Grooming/Training within vs. Hiring from the outside ?
Let us compare 2 situations...
Scenario A - An employer is asked to invest in an existing employee. This could be in the form of a paid training/certification, or even some dedicated time-off for the employee to focus on learning/improvement, and other such secondary activities. Let's say the cost of such grooming/training an existing employee is $X.
Scenario B - An employer in considering hiring a new employee. There are 2 potential candidates. The difference between the 2 being that one of them has had the additional relevant training as part their previous work and is also demanding a slightly higher pay (let's say the same additional amount of $X) compared to the other candidate.
Note that both the above scenarios involve the employer choosing between...
- An employee with a certain set of skills.
- An employee with a certain larger set of skills that, and costs $X more.
It sounds plausible that, when anchored with the relatively larger costs associated with hiring a new employee, a typical employer would view the amount $X as "a good deal", and is thus more likely to choose better employees when hiring. Whereas, when viewed in the context of a relatively smaller cost to the company of an existing employee, given the choice of a similar cost of training/grooming $X, they may view the same $X as too high a price to pay.
If this sounds like your team,
then the Alchain-Allen effect appears to be biasing you
towards better external hires than better grooming within the team.
No comments :
Post a Comment