Category: Economics

Seasonal advice from the dismal science, Part 3 of 3

Buy next year’s Christmas gifts next December, not next week. The sales will beckon and a few organized shoppers will be tempted. Resist. What you gain in lower prices, you will lose as the year wears on. There are interest payments and storage costs, but worse is the loss of adaptability. If your gifts are carefully chosen, some of them will need to be junked as your friends, or their tastes, change. If they are bland and generic, worse yet. Flexibility is valuable, and there’s nothing wrong with paying for something valuable.

Make your New Year’s resolutions a little firmer. It was Thomas Schelling who pointed out that the your fight to lose weight is effectively a battle of wits with yourself: the body-conscious dieter battles the weak-willed gourmand who chooses chocolate dessert at every opportunity. Elementary game theory suggests that your inner dieter can gain the upper hand by making a strategic pre-commitment. Make a bet with a friend that you’ll lose 20 pounds or donate $200 to a favorite charity, and another one that if you don’t lose 10 pounds you have to send $200 to Martha Stewart.

Sign a petition: Alan Greenspan to replace Santa Claus. “He knows if you’ve been bad or good, so be good for goodness’ sake.” Haven Gillespie’s famous lyrics suggest that behind the cotton-wool beard lurks Clint Eastwood. What a joke. We all know that Santa loves the kids too much to follow through with sanctions on naughty children. Naughty children know it too, which is why parental threats over the next few days will go unheeded. Nobel laureates Finn Kydland and Edward Prescott anticipated just such credibility problems – with monetary policy, as it happens, not stockings, but the principle is the same. Inflationary monetary policy has been banished by drafting in hard men such as Paul Volcker and Alan Greenspan. Now that Mr Greenspan is retiring we know what his next post should be: Replacing that soft old fool Santa Claus. Children would know they had to be good, would be good, and the stockings would be filled after all.

Merry Christmas.

More on the Xbox shortage

I’m finishing an MA in Economics at Boston University right now, and am also the author of "PSX: The Guide to the Sony Playstation" which is being released this week.  In the course of research for the book, I interviewed a number of VPs at Sony about why they priced at 299 when the PS2 came out.  The waits for the PS2, in fact, were much longer than those for the Xbox360, and still no rise in prices.

Here’s my understanding of the pricing situation:

1) Console prices are announced months in advance of the system release, unlike many other products.  There is a general consensus that a price above 299 (or 399, perhaps, which is the true price of the 360) will be unsuccessful.  In the mid and late 90s, a huge number of consoles bombed by announcing prices of 400-1000 (Sega Saturn, cd-i, 3DO, Amiga CD32, etc.). Third party developers are essential to a system’s success (a system without games, after all, does nothing), and in order to have games ready for a system, they evaluate a system a year before launch.  A high price would discourage developers -> discourage games -> lessen demand.  Given the competitiveness of the console game market, I have no doubt that major third-party game producers (Activision, Ubisoft, Square, EA, etc.) would balk if Microsoft were to raise prices, fearing, justly or not, that system sales two years down the road (when their games are ready) will be lower. For the 500-pound gorillas (EA in particular) there might even be contractual stipulations with MS about the system price.

The other reason is the one Alex gave – The $700 consoles on ebay represent the highest WTP on the demand curve, not the average.  Personally, I don’t think MS would’ve sold 500k Xboxes at $500.  Why MS didn’t auction off "limited edition" systems early, as you said, remains a mystery though. Nintendo has done exactly that with some items (in charity auctions, however).

In any case, the basic pricing structure is no mystery at all.  MS needs to satisfy both end-users AND third-party developers, not just end-users. They’re selling a *platform* more than a product.

Seasonal advice from the dismal science, Part 2 of 3

Gift-giving advice today…

Do not buy gifts for nieces, nephews or grandchildren. Send money if you must, but other gifts will be spectacularly incompetent. Using questionnaires, the Joel Waldfogel famously revealed (in an article entitled ‘The Deadweight Loss of Christmas’ – JSTOR) that the typical $50 gift is valued at between $35 and $43 by the ungrateful recipient, but that gifts from grandparents, aunts and uncles were even less welcome. If you are content to spend $50 to provide $35 worth of pleasure to your distant relatives, then next time please use me as your middleman.

It’s the thought that counts. His detractors rarely admit this, but Professor Waldfogel explicitly asked his subjects not to consider sentimental value. Sentimental value might indeed outweigh the waste of a poorly-chosen tie, but the cheaper the tie the more likely that is to happen. A $50 tie valued at $40 by the recipient is still a good gift if it also creates $15 worth of warm fuzzy feelings. But think how much better it would be to give a $5 tie valued at $4, which still created the same $15 of fuzzy feelings: this is a much more efficient way to produce a smile.

Actually, maybe it’s better if you don’t give anything at all. Steven Landsburg reminds us that one of Christmas’s greatest philanthropists was Scrooge. His miserly refusal to eat a Christmas turkey, year after year, meant one more turkey that someone else could afford. His capacious bank account meant that money was available to lend out to entrepreneurs and kept interest rates low. There’s nothing wrong with spending money if you’re going to enjoy it, but if it’s going to be frittered away on chintz then you couldn’t ask for a better role-model than Scrooge.

Tomorrow: making those New Year resolutions stick, surviving the sales, and why Alan Greenspan should replace that soft fool Santa Claus.

The Cuban Cigar Mystery

Why are Cuban cigars good?  It’s not as if communist economies are known for producing quality goods so why the exception for Cuban cigars?  I have a few hypotheses:

  1. Cuban cigars are not good.  The contrary impression is due to rememberances of things past and the sex appeal of the forbidden fruit.  (Testable hypothesis: Are Cuban cigars as highly prized in countries where they are not banned?)
  2. The Cuban "terroir," the soil, climate and environment are unique.   (Maybe but Communists destroy good terroir – see Zimbabwe, the Ukraine etc. – all the time.)
  3. Castro puts a huge amount of resources and incentives into producing cigars because a) he likes to smoke and b) exporting cigars and doctors is good for the brand image.  Cuban cigars are like Soviet chess.
  4. Castro has basically privatized the cigar industry allowing for significant market incentives.

Comments are open for those who know more about cigars and the Cuban cigar industry.

Who benefits from fair trade?

…conservative commentator Philip Oppenheim…argued recently that in
Britain, it’s supermarkets that profit most from fair trade sales. They
charge a premium for fair trade bananas, for example, while a
"minuscule sliver ends up with the people the movement is designed to
help"…

Here is more.  In case you don’t know, fair trade sells a product at a premium price, under the promise that the workers are treated better and paid more.  But will that improve living standards?  Hmm…this sounds like a problem in tax incidence theory.  To make the best possible case for fair trade, I will assume the promise of good treatment is credible.

Let’s say the supermarket has some market power and would have liked to price discriminate on coffee sales.  Now you can buy either normal coffee or fair trade coffee, and the richer,
more conscientious people are willing to pay more for the latter.  Some people can be charged lower prices, while others pay higher prices.  Fair trade will likely increase coffee output, relative to a world with no fair trade.  Profits will go up.  But what happens to input prices?  Will wages of Rwandan coffee producers rise?

It depends on the alternative to market segregation.  It is possible that if only a single kind of coffee can be sold, the market would opt for the more expensive coffee, involving better treatment of all workers.  Even if you don’t expect this today, it might happen in a few years’ time.  If McDonald’s can improve the treatment of all the chickens it buys, maybe Starbucks or some other force will force the coffee sector to clean up its act.  So development optimists should be suspicious of fair trade.  It could diminish long-run general progress by giving the conscientious an outlet for their charity.  By splitting up the market, we are institutionalizing especially poor treatment for one class of workers.  Furthermore the high profits from price discrimination imply that
producers will be keen to continue such segregation rather than end it.

How about a genre called "Exploitation Coffee"?  You pay less, and they promise to treat the workers especially poorly.  That wording is a less effective marketing ploy, but that is what quality differentiation and indeed "fair trade" boils down to.

It is well known that price discrimination can either raise or lower the average level of prices, but it does increase price dispersion.  We can expect it to increase wage dispersion as well.  It is harder to predict whether price discrimination will raise or lower wages at the bottom level of the scale. 

By increasing output, fair trade can bid up wages for coffee producers.  But fair trade also diverts some drinkers from Exploitation Coffee.  If the switching effect is large, wages for producers of Exploitation Coffee can fall.  Just as we have created two classes of market prices, so have we created two classes of market wages.  If you believe that coffee producing firms have some degree of monopsony power, this is  sustainable and again will increase profits but possibly worsen human misery for the poorest.

These are all "existence theorems."  I would not be surprised to learn that current benefits from fair trade are positive.  But since I am a development optimist, I have reservations about the institution in the longer run.

Exam question: How much of this analysis also applies to free-range vs. factory-farmed chickens?  Hint: not all of it (why not?)  Comments are open…and might you know of empirical work on how fair trade influences wages?

Seasonal advice from the dismal science, Part 1 of 3

Burn your Christmas card list. Deep down, we all know that many Christmas card exchanges are more like vendettas than expressions of seasonal goodwill. Is your yearly card from former neighbors Mr. and Mrs. Grinch a genuine effort to keep in touch – or does it reflect the fact that they’ll be damned rather than be the first to stop? Thomas Schelling argues for a bankruptcy procedure in which all lists should be burned and people could start again, motivated only by genuine good-will. Take his advice and you’ll be doing yourself a favor, not to mention releasing all those near-strangers you inflict cards upon. (Read more.)

Take your children to a good fire-and-brimstone Christmas service – but make it brief. Robert Barro and Rachel McCleary have investigated the connection between religion and economic growth, with two notable results. First, belief in heaven and hell is good for business, presumably because it generates trust and substitutes for expensive legal proceedings. Second, time spent in church is not time well spent: presumably you make some contacts but could more profitably seek them elsewhere. To ensure successful offspring, send them to a church that instills the fear of God into them without demanding too much face time. Shop around.

Establish firm property rights over the TV remote. I can’t stress this one too much. Ronald Coase taught us that disputes over shared resources can always be resolved, provided the costs of negotiation are low and property rights are clearly established. Arguments only happen because it’s not clear who has the right to name the channel. Therefore, somebody must be given the control of the TV remote and should auction off the right to choose the channel to the highest bidder, perhaps in half-hour slots. It doesn’t matter much who the owner of the remote is – the choice of programming should be the same. Still, in our household I’ve always been in favor of giving the job to the paterfamilias.

Further advice to follow tomorrow.

Solving Das XBox Problem

The usual explanation, a shortage generates hype, doesn’t make much sense.  First, as Tim Harford also points out hype can be generated by high prices as well as by shortages.  Very high end luxury items, for example, like Lamborghini’s are difficult to obtain but also very expensive.  Second, it’s implausible that a shortage
now could generate such greater sales later as to be worthwhile this is especially true given that Christmas is the peak selling season.  You want
hype before not during Christmas. 

The Cultural Foundations of Economics

Here is a new paper on culture and economics, destined for the Journal of Economic Perspectives, hat tip to the New Economist blog.

Imagine economics is no longer built around the dual of preferences and constraints.  We would instead have the following starting points:

1. Priors.  Without differing Bayesian priors, there is neither trade nor disagreement.  Your priors depend on your cultural background.

2. Beliefs. What model of the economy — and more importantly of yourself — lurks in your mind?

3. Peers. Which people do you accept as your relevant peer group?  This often determines the working model for your beliefs.

4. Stories. What stories do you tell yourself about who you are?

Arguably these analytical categories are more fundamental to human behavior than utility maximization.  Combine them with evolutionary biology, and a bit of neuroscience, a marriage with sociology and social psychology, and we have the foundations for a revolution in economic science.  Fifty years or so from now, that is.

Has there been a free trade breakthrough?

We at MR are reluctant to recycle posts from the past, but I stand by this previous analysis about WTO agreements on agricultural subsidies.  One excerpt:

Many agricultural interventions keep world prices up, not down, by
preventing the reallocation of farming to its most productive
geographic venues. Nonetheless it is not obvious that the very poor
countries would be big winners in any competitive reshuffling of
sectoral specializations. In fact we might expect technology to make
agriculture increasingly high-tech. We are then back to the case where
export subsidies hurt taxpayers in rich countries but help consumers in
poor countries.

Also keep in mind that many poor countries already enjoy free
bilateral access to EU markets for many agricultural commodities, with
rice, sugar, and bananas being prominent exceptions. So if
liberalization causes food prices in Europe to fall, agricultural
exporters in the poor countries may again be worse off.

Addendum: Today’s NYT has an excellent article on the same.

Plus ca change…

I had the same reaction as Pablo Halkyard at the PSD Blog to yesterday’s article in the NYTimes on Bolivian water privatization so here is his post:

Juan Ferrero’s
article in today’s New York Times discusses the poor results of water
privatization and nationalization in Bolivia, as well as the country’s
turbid future as it struggles to reform.

After
days of protests and martial law, Bechtel – the American multinational
that had increased rates when it began running the waterworks – was
forced out. As its executives fled the city, protest leaders pledged to
improve service and a surging leftist political movement in Latin
America celebrated the ouster as a major victory, to be repeated in
country after country.

Today, five years later, water is again as cheap as ever, and a
group of community leaders runs the water utility, Semapa. But half of
Cochabamba’s 600,000 people remain without water, and those who do have
service have it only intermittently – for some, as little as two hours
a day, for the fortunate, no more than 14.

The sad
part is that I have read the exact same article by Juan at least four
times in the last two years – although sometimes the names of Peru or
Ecuador are plugged in for Bolivia, or electricty/gas replaces water as
the featured sector.

See also my earlier post on some surprising benefits of water privatization.

Adverse selection is NOT the problem

The adverse selection story is a wonderful example of McCloskey’s argument that great rhetoric persuades even when it shouldn’t.  The market for lemons is simple enough for your friends to understand but profound enough for them to be impressed at your learning, so it’s a hard story not to tell!      

The facts of the matter, however, are that adverse selection is not an important part of the market for automobiles (trucks), or of auto, life insurance or health insurance (on the latter see below).

One reason adverse selection may not be that important in practice is because buyers and sellers use testing and certification to remove the most important information asymmetries.  You can buy a decent used car, for example just get it inspected or certified.  Only if such adjustments are illegal, or in some other way not allowed, will adverse selection become important.

Second, the asymmetry may run in favor of the sellers.  Do I really know more about my own life expectancy than an insurance firm that has access to sophisticated actuarial models?  And, assuming that I do have extra information is it all that important?  After all "the race is not to the
swift, nor the battle to the strong, neither yet bread to the wise… but
time and chance happen to them all."  Or, more prosaically, the signal is near irrelevant when the noise to signal ratio is high.
 

Third, propitious selection can be more important than adverse selection.  What sort of person buys a lot of life insurance?  Is it people who expect to die soon?  Or is it the sort of person who is so worried about not leaving their family in trouble that not only do they buy life insurance they also buckle their safety belt and eat healthy?  The price of life insurance falls the more you buy so evidently insurance companies believe it is the latter.

Everyone talks about adverse selection in the market for health insurance but in fact non-group policies in these markets are not relatively expensive and not hard to get.  The national average annual premium for reasonably generous coverage for a single person is just $2,268.

Sure, that’s a lot of money but the point is that it’s not a lot relative to what an employed person and their employer would pay for similar coverage in the group market.  There is no evidence for an adverse-selection death spiral in the market for health insurance.  That’s not surprising because non-group health insurance is medically underwitten (i.e. medical inspections just like car inspections).  Most people are accepted a few are not.  Only in states that require insurance companies to accept all or most buyers are rates high relative to the group market (rates in New Jersey, an outlier, are almost three times as high as the national average.)

There are problems in the health insurance market, including a lack of long term insurance, job lock and the inequity of affordability, but adverse selection is not one of them.

Thanks to Bryan Caplan, Robin Hanson, Tyler Cowen, Tim Harford, and Ray Lehmann for discussion.

Addendum: Comments are open.

Risk vs. uncertainty

Have you ever read Frank Knight, or the Austrians, and wondered what this distinction is all about?  Neuroscience comes to the rescue:

In the
experiment, test subjects made ambiguous bets while their brains were
scanned using a functional magnetic resonance imager (fMRI).

In one
example, the subjects were given the choice between betting money on
the chances of drawing a red card from a "risky" deck that had 20 red
cards and 20 black cards–that is, where the probability of choosing
either color was 50:50–and making the same bet with an "ambiguous" deck
where the color composition of the cards was unknown.

In
most cases, the subjects chose to make the risky bet. Logically,
however, both bets would have been equally good because in both cases,
the chance of pulling a red card on the first draw was 50:50.

The
brain scans revealed that ambiguous wagers were often accompanied by
activation of the amygdala and orbitofrontal cortex (OFC), two areas of
the brain that are involved in the processing of emotions. In
particular, the amygdala has been found to be closely associated with
fear.

A
correlation between aversion to ambiguous decisions and activation of
emotional parts of the brain makes sense from an evolutionary point of
view, Camerer said. "Freezing in the face of danger is an old,
emotional response which probably was evolutionarily adaptive in our
ancestral past."

In the modern human brain, this translates into a reluctance to bet on or against an event if it seems at all ambiguous.

Could this help explain the absence of various long-term insurance markets?  Thanks to  Chris Masse for the pointer.