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We recently had a class assignment – Analyze Alan Greenspan’s decision to keep the interest low for a long time and raising it very slowly. Many say this policy along with a lackluster regulatory policy led to the current housing led credit crisis.

It was a very interesting exercise and though I wasn’t able to reach the “right” conclusion, I felt that the he did indeed keep the interests low for a longer time than needed. This conclusion came based on my analysis of the GDP gap as perceived (based on Taylor rule and then data) by Greenspan vs. my own estimate of the GDP gap. The increasing natural rate of unemployment also provided some direction towards my conclusion. I cannot exactly share my data, charts, and analysis here because … it was an assignment that may be given next year also and I don’t yet know my grades on the assignment .

What I want to discuss here is one of the statements made during the class –  The economists have not yet build a model that can capture the true relationship between Alan Greenspan’s decisions and the housing crisis. My question is – Can such a model be built? Can it be predictive in nature, and not just retrospective? Lets start by asking a more fundamental question…

Can consumer behavior be modeled? To some extent, yes. Marketers tend to model behaviors all the time in order to sell consumers exactly what they want, and do not want, in the most (un)appropriate times. Numerati (Stephen Baker’s book) talks about various such models and how it is revolutionizing the industry. But this behavior is always predicted based on certain other behavioral patterns and not on demographics, access to cash, and spending power (Note that such models also do exist but may not be the right way to segment consumers).

How can you predict what a consumer will do when he is given easy access to large amount of cash? We look for patterns. We look around ourselves and see what do people do in such cases. When a person gets a great job that comes with large salary incentives, what does he purchase first? When a new generation enters the workforce, what do parent recommend them they do with the money earned? When somebody wins a lottery, what is the one thing he invests in? Does ‘buying a house’ answer all the questions above to some extent? Probably yes.

How can we test this hypothesis? Can this pattern be quantified in an equation? Can it lead to building a model that can actually prove that Greenspan is the root cause of this disaster? Thoughts?

Law of diminishing returns in a classic economic concept. Though it is really easy to visualize (or feel), it has proven very difficult for economists to really prove.

Lets first discuss what this law is all about. Lets say you want to start a business of selling milkshakes. You purchase all the necessary equipments and raw materials and are ready. A few days later you realize that it takes you about 10 minutes to serve a customer all by yourself. You hire a person to help you. He manages the cleaning of blender and you take care of serving the customers. You see that it takes only 7 minutes for you to serve the customers now. You get creative and hire another person. He takes care of all billing activities and you are free to just take orders and prepare the milkshake. The time to serve the customer reduces to 4 minutes. You are happy. But then you get more creative and hire another person just to take orders. Suddenly the time to serve a customer increases to 5 minutes. You realize that if you now end up adding one more person to the group the serving time will increase to 7 minutes. This is law of diminishing returns.

Law of diminishing returns state that as you add an incremental unit of a certain variable input, there will come a time when adding further units of the variable input (with all other inputs constant) will actually start decreasing the marginal output.

Why does this happen? That is a difficult question to answer but easy to understand. Conflict may be an appropriate word to describe the situation. Because all other inputs are constant, increasing of one particular input creates a conflict and hampers proper interaction between them. In the earlier example it is possible that the space in your shop is limited and continuous movement by 4 people is resulting in a loss of productivity. If you keep adding seeds to a pot, the number of flowering plants that actually grow will increase. But throw a large number of seeds, and there is a conflict and only a few plants actually survive. Over-utilization could be another reason. Taking the same example from above, if the blender keeps running for a long time, it may breakdown occasionally thus bringing down your marginal output. We can see this phenomenon occurring around us as well. Study for an hour, you learn, study for another hour, you learn more. But keep studying long hours and there comes a time, due to fatigue, that your learning comes to a standstill or becomes marginal.

So what is in it for us business folks. If it hasn’t become obvious yet, a LOT.  Every manager, in every capacity, should keep a close tab on this relationship and monitor the productivity of his/her resources. It should be on his dashboard for easy access. With experience, not only will he be able to isolate areas of conflict, overutilization, and fatigue but will also be able to mitigate the problem by either increasing other resources or controlling the increasing resource.

The law is widely used in a number of studies in various disciplines. Search the internet for numerous stories that correlate happenings with this law.