How To Spend It

Have you ever read that FT supplement and wondered how and why the mix of products is changing with increasing income inequality?  Anna Yurko tackles this question:

The
distribution of consumer incomes is a key factor in determining the structure
of a vertically differentiated industry when consumer’s willingness to pay
depends on his income. This paper computes the Shaked and Sutton (1982) model
for a general specification of consumers’ income distribution to investigate
the effect of inequality on firms’ entry, product quality, and pricing
decisions. The main findings are that greater inequality in consumer incomes
leads to the entry of more firms and results in more intense quality competition
among the entrants. This is due to the elasticity of consumer demand for
quality being higher in more inegalitarian economies. More intense quality
competition among firms causes them to locate their products in higher ranges
of the quality spectrum, closer to each other, decreasing the degree of product
differentiation. Competition between more similar products tends to reduce
their prices. However, when income inequality is very high, the top quality
producer chooses to serve only the rich segment of the market, and the low
price elasticity of demand of these consumers allows him to charge a higher
price. The conclusion is that income inequality has important implications for
the degree of product differentiation, price level, industry concentration, and
consumer welfare.

My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments.  More concretely, there is often more profit from serving the very top, who will always pay more for something just a wee bit different or a wee bit better.  So stay away from producing the mid-level cheeseburger, where price elasticity of demand will kill your profits.  You can’t charge the rich very much for it, and the presence of the poor keeps the price down for the middle class.  Here is the paper.  Anna is currently a job market candidate at the University of Texas, here is her CV.

Comments

Kudos to Anna for the fine paper and the
important empirical work but I don't know
why economists spend so much time on the
obvious.

I will add that the way to determine quality
is very important here as well. FOr some
products and services, quality is easy to
determine for others not so. In such a
situation the demand-supply curves for
quality signaling mechanisms also warrant
attention.

"My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments."

This seems reasonable. If you wander the aisles of your local Whole Foods you won't see much in the way of price competition.

However it is only half the story. If you head on over to your local Walmart you'll see plenty of products that employ low price as a differentiating feature.

It appears that the consumer economy is bifurcating. Suppliers can move up and compete on quality and design, or move move down and exploit economies of scale to compete on price.

This is probably in part due to increasing income inequality, although it is unlikely to be the whole explantation. Plenty of wealthy people shop at discount retailers for the simple reason that for many mundane purchases the quality of products available at Walmart is good enough.

In fact the existence of discount stores may be critical to the success of premium retailers like Whole Foods. Shopping at Walmart (or Target, Costco etc) allows consumers to spend a lower proportion of their disposable income on mundane purchases, freeing up disposable income for expenditure on the luxury items sold by high end retailers.

This seems pretty plausible, but I'd like to play supply-side devil's advocate. Corporatist economies tend to have high taxes, highly regulated labor markets, and strong welfare states, all of which implies low income inequality. Likewise, they have strong industrial policy which implies high barriers to entry and little product differentiation.

slocum: "So the rich consistently pay much more for products that provide relatively marginal improvements in function. "

My guess is that you are not aware of those who are rich but who choose not to spend their incomes or wealth on expensive status goods. Many wealthy peaple drive Honda Accords, shop for bargains at Kohl's, and fly economy class.

Many luxury goods provide utility that just cannot be described as "marginal improvements" over the economy offerring. For example, within 8 miles of my home are four golf courses with great variation in greens fees. I have played all four. To the avid golfer, the experience at the economical and midrange municipal courses just does not compare with that at Jerry Jones luxury Cowboys Golf Club.

Likewise, few would agree that a four-day Disney World vacation is comparable to two weeks in France or Italy.

I agree that SOME high-income families waste a lot of money on status goods. But my experiences with dozens of high-income individuals leads me to believe an equal number spend their money wisely.

re Diamond good. Yes! I propose a luxury tax on boats. Let's see how that works out.

You write "My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments."

This is inconsistent with the model, where quality competition is associated with MORE intense price competition, not less. "More intense quality competition among firms causes them to locate their products in higher ranges of the quality spectrum, closer to each other, decreasing the degree of product differentiation," In the Shaked and Sutton model this paper is based on, closer products <==> more intense price competition.

The high end implications of this paper may be obvious, but the implications for the middle of the market are perhaps far less so.

There will always be a place for low cost providers, and in a growing market of well of people there will be an increasing place for that extra bit of quality, or at least perceived quality. But that middle quality, middle price segment of the market looks to be increasingly difficult to make gobs of money in, and that I think is the highlight of the story here.

I thought "Trading Up" was a great book talking about these issues.

... but my first thought today was similar to Slocum's. Everybody (Trading Up) reaches for the "luxuries" they can afford. Sometimes these luxuries are decided by consensus, for signaling, rather than for their performance or reliability. Maybe in the vast swath of the middle class that is the main driver.

I probably shouldn't have lumped boats in with diamonds. I did it because "Tom" did, which was a mistake.

For most boats, there's a very substantial increase in intrinsic utility with price. Prestige is probably not that big a factor, so they are not "diamond goods".

For a few boats, like Larry Ellison's 452.75ft yacht (who's specs were changed just in time to make sure it was a bit longer than Paul Allen's yacht), the prestige factor probably is the dominant factor. In fact, most of his spending, on the margin, may well go to such goods and services.

slocum: "When you get when you pay to play the high-priced courses is not much better fairways and greens, but rather the chance to rub shoulders with other rich people and the experience of being catered to. "

First, I doubt that you have played both the high-priced and low-priced courses in Texas, Tennessee, Louisiana, and Arizona, or you would never have made this statement. I can't speak for other states, but my bet is that one would see the same variation in quality. I am positive the high priced courses in Florida also have much better fairways and greens than the low price course in the four states I listed.

Many of us consider the "experience of being catered to" a significant improvement in quality. If you do not, that is fine. But your original statement was about "products that provide relatively marginal improvements in function". What is a "marginal improvement" is very obviously different for you than it is for those of us who pay four times as much to play a high-priced course.

I have "rubbed shoulders" with other rich folks at the municipal Grapevine Golf Club, where greens fees are $32 on weekends. I don't need to go to the Cowboys Golf Club and pay $150 greens fees to do so. But I still play at the more expensive course when I need to treat myself to the best available conditions.

Wouldn't it be easier just to look at the disposable income of the mean family versus inflation?

brutus: "But are the greens that much better at The Country Club than at Ponkapogue?"

I do not know those courses. I do know luxury golf courses in north Texas. The layout, the bunkers, the greens, and the fairways at the Cowboys Golf Club, or at Colonial Country Club, or at the Preston Trails Golf Club are head and shoulders above that of the typical municipal golf course. The avid golfer knows the difference and understands why the prices vary.

brutus: "No financial pressure to send off 200 foursomes per day to spike up the greens!"

When did you last play golf, brutus? Grass-damaging spikes have been prohibited from quality golf courses for about a decade.

Slocum sez:

"But now increasingly the case that what the rich buy are 'gold plated' versions of the same things virtually everybody has."

Perhaps in basic consumer electronics, hardly anywhere else.

In most cases difference is obvious to the rich and not-so-rich.

One may consider a 3000 sq ft house in hot and dusty Central CA the same as a similar house on a beach in Santa Monica. But most reasonable people will disagree.

4 days family vacation in Cancun, planned 6 months in advance, is not the same as deciding on Thursday to spend weekend shopping in Milan and getting there by private jet.

Even a good public school is not quite the same as a top private school plus private lessons in languages, music and arts.

Run of the mill suburbian hospital/docs are not bad, but easy access to the very best specialists is immeasurably better.

Perhaps one likes to clean and/or one likes to cook. But most people would really love to have a maid, a butler and a personal chef.

Perhaps at some level of wealth a saturation is achieved. Perhaps a family with $100M could live just as well as a $1B family.

But there is usually a huge difference in lifestyle between middle class and $100M family.

As a relatively new student of economics this seems like a perfect real world example of the elasticity of demand. The point as I understand it is that the market is moving in two directions, that of competition for quality of high priced goods for upper income individuals and that of lower priced (and at times lower quality) goods for those with less. Where are the markets for well made, but not luxury goods for middle to upper middle income individuals?

Other's have probably made this point more poignantly but I am saying we have to consider rational choice with this argument. Most of the really wealthy people I know are not showy, and will gladly shop for a bargain, particularly for goods that we all have to have and traditionally have less demand elasticity (milk, utilities, other necessities.)

It seems that studying the recent quality defects from some low cost retailers particularly with toys is important. To what extent will public outcry over lead based toys affect consumers' preferences for these low priced goods? Will those who cannot afford or will not pay for specialty toys simply buy less or will specialty and U.S. based toymakers benefit?

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