The Lock-In Effect

The lock-in effect is a phenomenon which may be talked about inside or outside of economics. We are going to talk about it in the context of economics first then we are going to go a bit beyond the economics to show the political and social implications of the effect.

Like path dependency, lock-in occurs in economics when an actor acts in a certain way because it is more efficient when change costs are considered, although it may not be efficient when change costs are not considered. Lock-in is generally viewed as a bad thing because if change costs were negligible then actors could almost always act in ways that are more efficient. Most schools of economics assume that change costs are reduced to 0 in the long run.

Change costs include but are not limited to hiring and firing costs, transaction costs, transportation costs, communication costs, other switching costs, even more switching costs, and certain taxes and legal costs. Consider the following example of how taxes on capital gains can cause lock-in (more rigorous research available here):

  1. If I purchase a stock for $10 and it appreciates to $15, then I sell it, I realize a capital gain of $5.
    1. An alternative for the same security from the business perspective could be that I purchase a stock for $10 and the company pays me a $5 dividend instead of retaining the money and appreciating the stock fundamentally (that is, due to real reinvestment into the business). Dividends are treated as income in the tax code, not as capital gains.
    2. The interesting point is that if capital gains and income are equally taxed, then capital gains will produce a lower effective tax rate over time compared to the dividend income tax approach. This is because it allows the gains to grow on a compounding basis.
  2. Now, consider that we institute a capital gains tax. If I am invested in some company, I have an incentive not to switch to another company, even if the latter company would yield me a larger rate of return. This lock-in incentive is equal in amount to, and directly caused by, the capital gains tax.

Here’s the thing: Lock-in costs and the lock-in effect apply to more than financial transactions and economics. The only example I will discuss here is the political example, but a more general social implication is a strengthening of habitual action, related to what I call Newtown’s First Law of Behavioral Economics.

In politics, several important lock-in effects exist. Lock-in effects in the political system are generically referred to as political entrenchment and three notable examples include terms, incumbent advantage, and regulatory capture.

  • Electing politicians for terms of any number of years, rather than allowing them to be fired at any time, creates a lock-in cost.
  • Incumbent advantage acts as a lock-in cost for the voter because switching representatives becomes harder for incumbents.
  • Regulatory capture means that industries which are being regulated end up controlling their regulators, turning the regulators into their helpers. Regulations, and laws in general, exhibit lock-in costs because they are difficult to change, particularly after regulatory capture has occurred.

How do we get rid of economic lock-in effects? Flexible contracting, improved communications technology, and more.

How do we get rid of these costs in politics? Shorter term durations, improved campaign competition (perhaps including the demolition of the two party system, or more energetic primaries), and polycentric or private law.

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