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It's long-term value that gets eroded when businesses home in on cost cutting and price drops to sustain themselves. Something gets lost in the process. Image Credit: Gulf News

Standard game theory posits that when people undertake a transaction, the expect to get high value in exchange for the price they pay. Curiously, however, scenarios arise where this is not the case.

There are situations where consumers expect low-value payoffs. This strange phenomena (known as Kakonomics, which in ancient Greek means ‘economics of the worst’) thrives based on a tacit contract between buyers and sellers. Where there is mutual acceptance for a mediocre outcome (in exchange for a discount) as long as publicly the claims are made that the quality delivered is of a high standard.

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This is a world where we come to accept laxity and low quality results as the norm.

Not outlandish

How can this be rational? There are a number of ways where events conspire to make this outcome desirable, including the current debt-deflation paradigm that individual tenants and landlords find themselves in as both parties seek to reduce costs.

In this world, the cry publicly has been to reduce costs of maintenance, which is effectively done through a combination of reducing utility charges, salaries and in some cases, compromising the quality of the underlying asset, in order that landlords do not suffer from reduced yields.

Standard economics states that there is no free lunch, and that costs cannot in fact be significantly slashed unless there is some compromise to the services that have been offered. And so we see the phenomena across buildings, where reduced elevators are kept in service, and electricity consumption is reduced by lowering the air conditioning in common areas, and even where manpower for overheads and services is cut down.

A slippery road

Some rationalisation of budgets is in fact essential, as the focus increases on cutting costs in the post-Covid-19 world. But what we are seeing in many cases is a reduction in the quality of services and therefore a deterioration of the asset in question.

Paradoxically, in these situations, if the service is actually delivering or maintaining a high value, the outcome is resented by the customer, as the focus has shifted to cost reduction rather than quality deliverance.

Affecting all

We see this in other parts of the real estate industry too. Reductions in real estate prices tend to squeeze developer margins, which in turn leads to a renegotiation with contractors. And so the process of readjustment continues to reverberate downstream, which comes about often at compromising the quality of the asset in question.

As we look at it holistically, we realise that these outcomes occur during inflection periods, where transitions are hard. With the current emphasis on radical cost cutting across the board, there is a cascade effect that is reverberating throughout the economy.

Some of which is good as it is leading to a greater optimisation of resources, but at the macro level, optimum results are not being achieved for the society as a whole.

Aiming for a reflation

This of course, returns to the concept of incentives in the first place and how these can be more effectively used such that the social contract is maintained at high levels of quality. An obvious way is to provide for reflationary outcomes — economic policies that are being vigorously pursued in the West following a failed experiment with austerity-linked measures.

Such as further expense-based holidays by way of utility fee discounts, in addition to continued debt-free servicing periods across the board.

This has near-term results and allows for the transition period to be longer, and therefore more effective in avoiding worst-case outcomes.

In the land of the blind, the one-eyed man is normally delusional, cries the critic in the room. Reflationary policies too have a cost and these costs ultimately have to be borne by society at large.

In the final analysis, however, what consumers, producers and regulators seek is an avoidance of equilibria where — even though the buyer and seller may be individually satisfied — the overall system erodes in the long run as a result of these exchanges. Dubai and its business community have faced challenges in the past and each time there has been an adjustment period, after which growth has returned.

However, adjustment periods vary in length depending on the severity of the crisis, and it has always been a reactionary move to squeeze costs. We should be careful that, in the midst of such a process, the cement that binds the society together for a common outcome is laid and strengthened at a higher level each time these transitions occur.

Only then can we sustainably avoid the cesspool of Kakonomics.

— Sameer Lakhani is Managing Director at Global Capital Partners.