Tuesday, 17 September 2019

Crying babies and the Coase Theorem

This week in my ECONS102 class, we've been covering externalities. An externality is the uncompensated impact of the actions of one person on the wellbeing of a third party. Externalities can be negative (they make the third party worse off) or positive (they make the third party better off). We call them externalities because they lie outside the decision that create them - that is, some of the costs or benefits are external to the person whose action creates them.

A key part of the topic is understanding the Coase Theorem (named for the late Nobel prize-winner Ronald Coase) - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (that is, without government intervention). It's an important idea because it is tempting to believe that, whenever there is an externality, it is the government's job to fix it, often through some form of regulation. But the theorem tells us that government intervention isn't always necessary.

The Coase Theorem first requires us to recognise the rights and entitlements associated with an externality. I'll illustrate with the example from this article in the New Zealand Herald last month:
A Sydney mother is "fuming" after receiving an "unbelievable" note about her parenting in her letter box.
The new mum shared a photo of the letter on Facebook, where the next door neighbours complained about her baby crying during the night.
"We would have called you but we are never sure when you are around," the note reads.
"We just wanted to let you know that unfortunately we have had a number of disturbed nights sleep recently due to the thinness of the walls between our units."
The neighbours added while they don't have kids of their own they're sure "it's not at all easy to soothe a crying baby".
"We really would appreciate anything you can do to help us get more sleep, particularly during the early hours," the note reads.
"Thank you for your consideration of this. I am sure we all look forward to more undisturbed nights' sleep."
A crying baby creates a negative externality - they impose a cost on the neighbour, who is losing sleep. How could the two parties negotiate a solution to this problem? It depends on the rights and entitlements.

Both parties have rights here. The neighbour has the right to quiet enjoyment of their home - they shouldn't have to worry about being disturbed at night. The mother has the right to have a baby at home, and babies are known to cry. So, there are competing rights. The bargaining solution will depend on which party has the overriding rights - whose rights are protected more under the law.

Let's work it through from both possible perspectives. First, let's say that the overriding rights belong to the neighbour - their right to quiet enjoyment will be protected. The default solution is that the mother has to quiet the baby in some way (or maybe they have to move somewhere else). The alternative solution is that mother and baby stay, but they agree to pay compensation to the neighbour for the neighbour's loss of sleep. The amount of compensation would have to be at least as much as whatever the neighbour values their sleep at (otherwise they wouldn't agree, and they don't have to, since under the default solution they would get quiet). However, the compensation has to be less than whatever the mother values staying in that home with their baby at (otherwise, mother and baby would be better off moving, rather than paying the compensation).

Now let's look at it the other way. Let's say that the overriding rights belong to the mother - her right to have her baby at that home will be protected. Now, the default solution is that the neighbour has to put up with the crying (or maybe they have to move somewhere else). The alternative solution is that mother and baby move away, but are paid compensation by the neighbour in order to do so. In this case, the amount of compensation would have to be at least as much as whatever the mother values living in that house with her baby at (otherwise they wouldn't agree, and they don't have to, since under the default solution the neighbour just has to put up with the crying). However, the compensation has to be less than whatever the neighbour values their lost sleep at (otherwise, they would be better off moving or putting up with the crying, rather than paying the compensation).

The Coase Theorem tells us how a bargaining solution could arise when there is an externality problem. However, it requires both parties to reach an agreement. In this case, given that the mother is already "fuming" about the neighbour's note, that seems unlikely.

Monday, 16 September 2019

The price of petrol and airfares are set to rise

The basic model of supply and demand is one of the most commonly used models in economics. That's because it does such a good job of explaining many of the things we see in the real world. Every day, you could pick up the newspaper and see an example that can be explained with this simple model. Take this example from the New Zealand Herald yesterday:
Motorists could see high petrol prices within days following Saturday's drone attacks on Saudi Arabia's oil facilities by Iranian-backed Yemini [sic] rebels.
"It's not a good sign," said Automobile Association spokesman Mark Stockdale.
"It remains to be seen what impact it will have, how markets respond. But certainly a reduction in the supply in oil could have a negative impact on commodity prices which could result in higher prices at the pump."
The drone attacks by Yemeni rebels will reduce the supply of oil. In this diagram below, this is represented by the shift from S0 to S1. The equilibrium price of oil will rise, from P0 to P1.

That's not quite the end of the story, though. The higher price of oil leads to higher costs of production for petrol and jet fuel (because crude oil is an input into the production of those refined fuels). Higher costs of production reduce the supply of those products too (because the supply curve shows the costs of production, higher costs shift the supply curve upwards, as in the diagram above). That leads to higher prices for petrol and jet fuel.

You can take it a step further even. Higher jet fuel prices increase the costs for airlines. They pass those higher costs onto passengers in the form of higher prices as well. [*]

If you ever wondered why oil prices are important to all economies, not just the economies of the oil-producing nations. This is a good example of why - those prices flow through to the prices of lots of other goods (and services) throughout the economy.


[*] We could refer to the diagram above again. However, because airlines don't operate in perfectly competitive markets, it isn't quite correct to show their response in a supply-and-demand diagram. Having said that, the impact of an increase in input costs is qualitatively the same regardless of whether you use a model of perfect competition or a model of a firm with market power - prices increase and the quantity decreases. I make this point in my ECONS101 class - the standard supply and demand model is quite robust, if all you are interested in knowing is the expected direction (but not necessarily the magnitude) of changes in price and quantity.

Sunday, 15 September 2019

Recreational fishing and the sustainability of fisheries

In New Zealand (as in many other countries), we manage our fisheries using a transferable quota system. Quotas regulate the number of fish that are allowed to be removed from the sea in a given period of time. The total quota is set by determining a total allowable catch for a year (in theory at least this is roughly equal to the growth in the fishery stock), with some allowance made for recreational fishing. Quotas work well because they make fish excludable (no quota means no fishing) and are backed up by monitoring and enforcement. If we didn't have a quota system (or some other alternative), fish would be a non-excludable good (anyone could fish as much as they want), and that would make fish much more vulnerable to over-fishing.

Most of the time, we worry about commercial fishermen over-exploiting the fishery. This is because, while all fishermen as a group have an incentive to manage the fishery sustainably, each individual fisherman has an incentive to take as many fish as they can, in order to increase their profits from fishing. So, if the fishery isn't actively managed (through a quota system, or through some other means), it can quickly become unsustainable. However, in the quota management system we worry much less about the actions of recreational fishermen, so I was interested to read this New Zealand Herald article from last month:
Recreational fishers have dramatically increased their catch of snapper and kahawai in the Hauraki Gulf over the past 30 years, a new survey has found.
A Fisheries New Zealand national survey, conducted between October 2017 and September 2018, estimated there were nearly 2 million fishing trips taken across the country.
An estimated 7m individual finfish and 3.9m individual shellfish were caught in this period.
The survey also found the average recreational kahawai catch had more than quadrupled in the Hauraki Gulf in the past 30 years, while the snapper catch had nearly tripled, despite trending down since the last survey in 2012.
On the surface, that sounds bad for the fisheries. However, whether the increasing recreational catch is bad or not crucially depends on how much allowance is being made for recreational fishing within the rules, and how much the total allowable catch (plus recreational fishing) is, compared with the growth in the fishery stock. It seems that we might have the balance about right:
Fisheries New Zealand director of fisheries management Stuart Anderson said the results confirmed the popularity of recreational fishing among New Zealanders...
"There's been little change in the proportion of these fish caught by recreational and commercial fishers since 2012."
The survey contacted more than 30,000 people, and about 7,000 recreational fishers had their fishing outings recorded over a 12-month period.
Fisheries Inshore NZ chief executive, Dr Jeremy Helson, said the increase in snapper and kahawai catch showed stocks were in great shape and the quota management system was working.
"Like the commercial sector, recreational fishers need to respect the rules and contribute to managing our fisheries resources.
Given that the quota system has come in for some criticism of late (especially around enforcement), it is good to know that it is working well in at least some fisheries.

Read more:

Saturday, 14 September 2019

The share market effects of naming companies after blockchain

This past week in my ECONS101 class, we discussed financial markets. In particular, we discussed the efficient markets hypothesis - the idea that all publicly available information (good and bad) about an asset's future cash flows is already captured in the asset's price (in the strongest form of the efficient markets hypothesis, all private information is also captured in the asset's price). So, it was timely that the Economics Discussion Group discussed this article by Archana Jain (Rochester Institute of Technology) and Chinmay Jain (Ontario Tech University), published in the journal Economics Letters (sorry, I don't see an ungated version). The authors look at the impacts on the share price when a company adds changes its name to include "bitcoin" or "blockchain".

I'd already followed the news about one of these companies in late 2017 - Long Blockchain Corp, formerly Long Island Iced Tea - which has been in the news again recently. Jain and Jain looked at ten such companies, and compared their performance with the performance of other companies that are included in blockchain exchange-traded funds. If there was something important going on with blockchain, you'd expect it to be picked up in the share prices of these other companies as well. Instead, they found that:
...the firms that change their name to include blockchain in it had a negative return of 13.55% from day −14 to day −2. We see an increase in the return of these firms from day 0 to 1 at 34.29%. Over the five-day period from day −2 to day +2, all firms earn a strongly statistically significant abnormal return of 100.89 percent. Over a 30-day (60-day) period from +1 to +30 (+60), all firms earn a 81.47% (72.84%) percent return. However, over a 60-day period from +61 to +120, all firms earn a −56.32 percent return.
In other words, the companies that changed name were not doing well (in terms of share price) in the lead up to their name change. They then saw a massive increase in their share price, up to 30 days after changing name, presumably as investors looking to jump on the cryptocurrency bandwagon bought into the companies. Then the share price started falling back to its original level. In the meantime, it's likely that the original company owners cashed out a big payday, while the stupid investors who failed the due diligence test were left licking their wounds.

Jain and Jain's article is a brief "how-to" guide for making money from a vapourware holding company. Just add the latest buzzword to your company name, and cash out big (but make sure to do so before the SEC figures it out). It's also proof that the efficient markets hypothesis doesn't hold in the short run. Otherwise, investors wouldn't get suckered into this.

Wednesday, 11 September 2019

Pharmacies and market power

Following on from yesterday's post about market power in the market for diamonds, I was also interested to read this article in The Conversation last week, by Bruce Baer Arnold (University of Canberra), about retail pharmacies in Australia:
In Australia, you are broadly free to operate most retail premises in any location. Three coffee shops might sit side by side, along with two bike shops and a barber’s.
A consequence of the National Health Act 1953 and state and territory law is that pharmacies are different – that’s why you never see two in a row.
Location restrictions state that when pharmacies relocate, they must do so within 10km of the existing site.
The establishment of a new pharmacy must generally be at least 1.5km from an existing operation.
We also have restrictions on ownership. Pharmacies must be operated by a registered pharmacist. A single person or corporation can own no more than five pharmacies. (Though franchising – where individual owners pay for use of a national brand such as Amcal and for services provided by the brand owner – blurs that restriction.)
The current rules seek to ensure most Australians have access to a pharmacy staffed by a highly skilled professional with a pharmacy degree.
By not having too many pharmacies within the same area, and therefore reduced local competition, it increases the likelihood they’ll make enough profit to stay open.
Such restriction is pragmatic, although it discomforts free-market purists who believe fewer rules foster competition through lower prices and better service.
It's interesting to note that New Zealand currently has similar rules to Australia (although the Therapeutic Products and Medicines Bill was initially going to relax the restrictions, it seems from the latest version of the Bill that it won't - see here for more). And it doesn't take a "free-market purist" to see what is going on here. If ownership of pharmacies is restricted to pharmacists, the number of pharmacies each owner can own is limited, and regulations state that pharmacies can't be located close to each other, local competition is lessened and market power is created. Keeping competitors out of your local market is a pretty effective way of gaining and maintaining market power.

Why should consumers care? Among other things, market power for sellers leads to higher prices. We are probably paying more for medicines and other products sold through pharmacies than we would if the market were more competitive. We may also be seeing less innovation in the retail pharmacy sector - why would a pharmacy innovate if they are already making a cosy profit and their market position is protected by law?

The Australian government is worried about the market power that Facebook or Google have, and they are willing to engage in a costly regulatory battle to reduce that market power. Why aren't they worried about the market power that pharmacists have, and willing to lessen the regulatory framework that creates that market power in the first place?

Tuesday, 10 September 2019

Market power and disruption in the diamond industry

In both of my first-year economics classes, I use De Beers as an example. In ECONS101, it's an example of a firm that has market power. In ECONS102, it's an example of a monopoly firm. In both cases, it's a good example because of barriers to entry - in this case, barriers to entry that arise when a firm is the only owner of a key resource that is necessary to produce the good.

There are few real-world examples of monopolies that arise from a firm being the only owner of a key resource. That's because global competition makes it very difficult for any firm to have sole control over a resource. However, De Beers got close. In the late 1980s, De Beers controlled about 90 percent of the world's diamond supply. They owned the most productive diamond mines in southern Africa, and had supply agreements with the largest diamond producers in other countries like Australia, Canada, and the Soviet Union, who allowed De Beers to handle the wholesaling and distribution of their diamonds (see here for more on this). Controlling such a large proportion of the diamond supply gave De Beers a high degree of market power - they were effectively a monopoly.

De Beers isn't nearly as dominant now, with market share under 40 percent. However, 40 percent market share still conveys a lot of market power. But that market power might be about to fall further, as this article in the New Zealand Herald (republished from the Daily Telegraph) explains:
Diamonds may not be forever after all. The value of the gemstone is set to diminish and they will become common in computer chips, satellites and even medical implants within a decade — if Silicon Valley's avant-garde lab-grown diamond purveyors have their way.
"We want to drive prices down because we think there are going to be many more applications for diamonds at present," says Martin Roscheisen, founder of Diamond Foundry.
His company produces diamonds in a cluster of biotech start-ups. Engineers use proprietary reactors that mimic the extreme pressure and fiery heat that creates plasma that, with the addition of carbon, produces natural diamonds.
Carbon atoms are stacked one by one in a thin layer of diamond atomically and visually identical to gems in Tiffany's. Polishers in Antwerp buff each diamond up to 2000 times to create multiple facets that capture and reflect light. One carat of rough diamond takes "a few weeks" to produce and once polished, prices start north of US$1000 ($1556)...
One of the necessary conditions for monopoly is that your product has no close substitutes. A lab-grown diamond is a very close substitute for a natural diamond. If there are many (and/or close) substitutes available, then the firm's market power is diminished. It isn't all over for De Beers yet, though:
De Beers is limiting supply in the face of trade tensions between the US and China, the two largest markets. The impact of lab diamonds is still only about 1 per cent of the overall market and will rise closer to 3 per cent by 2035, Zimnisky predicts. He is reluctant to say lab-grown diamonds will crush De Beers, saying producers are more likely to focus on hi-tech applications.
So, De Beers probably has years left before lab-grown diamonds really start to cut into their profits. However, one thing is surprising to me. Why isn't De Beers investing in the market for lab-grown diamonds now? You would expect a rent-seeking monopoly like De Beers to recognise the threat and to try to act to prevent it. They could argue that lab-grown diamonds are in some way a poor substitute and should be banned. It seems like they might have tried this already, as the article notes that "US regulators ruled that the definition of a diamond grown in a lab or one chipped from rock as far as 600m below the surface were the same". Since that didn't work, then buying out your competitors might be an alternative option. A purely rhetorical battle like this is going to be pretty ineffective:
Bigger players insist mined diamonds can never be replaced. Nathan Strauss of Tiffany says it will not use lab diamonds, describing mined gems as rare and a "romantic symbol billions of years in the making with an intrinsic value far beyond their chemical make-up".
Some firms don't see disruptive innovation coming, until it's too late (see Kodak, or Nokia, for examples). De Beers probably needs to wake up, and soon, or they may only be a historical example for economics classes in the future.

Thursday, 5 September 2019

Gun buybacks and incentives

I was interested to read this article in the New Zealand Herald earlier in the week:
Some New Zealand gun owners are upset they're being compelled to hand over their assault weapons for money. Others believe a government-imposed ban on certain semi-automatics following a March shooting massacre is the best way to combat gun violence.
And The Associated Press has found at least one man may have tried to swindle hundreds of thousands of dollars from the system set up to compensate gun owners...
[Police Deputy Commissioner Mike] Clement said the man showed up at an Auckland buyback event with thousands of magazines seeking to collect hundreds of thousands of dollars in government compensation. A possible flaw in his plan? Clement himself happened to be at the event.
"It's one of those things that didn't look right, didn't feel right," Clement said.
He said police were keeping hold of the magazines and hadn't paid the man any money while they carried out their investigation.
Policy changes create incentives to change behaviour, by changing the costs and/or benefits associated with the behaviour. However, changing the costs and/or benefits can also have unintended consequences (which is something I have blogged about many times before).

In this case, the gun buyback scheme created an incentive to buy cheap gun parts overseas, import them into New Zealand, and then give them to the government as part of the buyback scheme. Any difference between what the gun parts were purchased for overseas (plus the importing costs) and the amount received from the buyback ("between 25 per cent and 95 per cent of the pre-tax price") would be pure profit to the enterprising gun part importer.

The man referred to in the article was doing something that should have been easily anticipated by the government. It's not clear whether his actions were illegal, but they certainly were not within the spirit or the intention of the scheme. That man was caught out, but it makes me wonder: how many others might have already done the same (although perhaps not to the same degree) and gotten away with it?

Tuesday, 27 August 2019

Book review: Doughnut Economics

This blog has been too quiet. I've been travelling in Europe, but now that I've finally settled (in the beautiful city of Lyon) I can do some catching up, starting with a review of Doughnut Economics, by Kate Raworth. This book is partly a critique of current economic thinking, and partly some of Raworth's ideas on a new model for economics. Any critique of economics hits the zeitgeist right between the eyes, and so this book got a lot of press when it was released in 2017 (e.g. see here), and again in New Zealand earlier this year when Kate Raworth visited the Treasury.

However, I found the book to be quite unbalanced and full of lazy writing. Raworth is a great fan of metaphors and stories, but to my taste they were overdone. Moreover, large chunks of the book were unnecessary in order to make the central argument. The first couple of chapters essentially create a strawman of economics, which Raworth can then set alight. The economics she describes, with GDP growth as its core and only goal, is not an economics I recognise. Her argument is valid in many places, but she doesn't contribute anything new in pointing out that decision-makers are not purely rational. In her desperation to make us believe that economics and economic teaching is not fit for purpose, she far over-sells her argument. For instance, she tells us to:
Search for the word 'power' in the index of a modern economics textbook and - if mentioned at all - it will probably refer you to an analysis of electricity sector reform.
So, I did search for 'power' in the textbook that I use in my ECONS101 class, The Economy (which is available as a free e-text). It doesn't have an index, but it does have a glossary, where power is defined as: "The ability to do (and get) the things one wants in opposition to the intentions of others, ordinarily by imposing or threatening sanctions." That's basically the definition that Raworth uses. The Economy is as modern as modern economics textbooks get, so it's clear that Raworth didn't fact-check her own statements.

Raworth is also very inconsistent. She decries GDP as a poor measure early in the book, but then later breathlessly tells us that 40 percent of Kenya's GDP passes through MPESA. If GDP is a poor measure, then what is 40 percent of a poor measure? She also notes Bill Phillips' MONIAC machine as both "utterly flawed" (p.56) and as a positive example of systems thinking (p.122).

The book also presents a decidedly unbalanced view of the relevant research. Raworth rightly points out the flaws and criticisms of the Kuznets Curve and the Environmental Kuznets Curve, but ignores the equally valid criticisms of The Spirit Level (one of which I discussed here) or The Limits to Growth (on the latter, she notes the ideological arguments against it, but not the severe technical flaws). Both The Spirit Level and The Limits to Growth are used uncritically as positive examples. Similarly, Raworth presents blockchain technology as a solely positive development, with no consideration of the environmental impact of energy consumption of bitcoin miners.

The book isn't all bad though. In fact, I thought the 'Embedded Economy' diagram was vastly superior to the 'Doughnut' diagram around which the book is framed. Here's the relevant diagram:

Systems thinking, and sustainability, are not new ideas for the 21st Century. They are grounded in 20th-Century thinking, but that doesn't make them any less important. We need to recognise all of the trade-offs that we make in our decisions, individually and collectively. The embedded economy model helps to make more of those trade-offs (especially those that occur at an earth-systems level) more explicit. However, we don't need a doughnut to tell us this.

Doughnuts are great for a quick sugar hit, but fail to provide adequate nutrition and we can't live on doughnuts alone. That's an appropriate metaphor for this book.

Sunday, 18 August 2019

Always be a new customer - price discrimination and 'loyalty taxes'

Price discrimination is one of the most pervasive pricing practices that firms use. It involves the seller the seller selling the same product to different consumers for different prices, and where those differences in prices don't reflect differences in cost. Specifically, the seller should charge a higher price to consumers who have less elastic demand (consumers who are less price sensitive, and those who are less likely to go elsewhere), and a lower price to consumers who have more elastic demand (those who are more price sensitive).

Some of the examples seem really perplexing, until you think about them in terms of the price elasticity of demand. For instance, consider the example of Delta Airlines charging a higher price to its frequent fliers than to those who are not frequent fliers (one of my favourite examples to use in my ECONS101 class). That seems to make no sense, until you realise that frequent fliers are less likely to go elsewhere, because they want to keep accumulating air miles. That means that the frequent fliers have less elastic demand than other consumers do, and a price-discriminating airline should be charging them a higher price.

Given how common price discrimination is, I was interested to read this article in The Conversation last month, by Allan Feis (University of Melbourne), about what he refers to as 'loyalty taxes':
A “loyalty tax” occurs when discounts are offered to new customers while longer-term customers pay more. Often this involves increasing premiums at the first and subsequent renewals...
Our research last year showed, on average, customers renewing their insurance policy paid 27% more than new customers. Our most recent data indicates the gap has risen to 34%. This translates to hundreds of dollars for the average home and contents insurance policy.
Loyalty taxes appear to be widespread in Australia. The Australian Competition and Consumer Commission concluded from different pricing inquiries that loyal customers of both banks and energy providers end up paying more. It also demonstrated the price difference for insurance in northern Australian – with one insurer on average charging renewing customers 15-20% more than new customers.
In Britain, regulators have calculated that customers are, by their fifth renewal, paying about 70% more than a new customer. The Competition and Markets Authority estimates the total cost of loyalty taxes in five British markets – mortgage, savings, home insurance, mobile phone contracts and broadband – to be about £4 billion (about A$7 billion) a year.
Translating this British estimate to the equivalent sectors in Australia (taking into account differences in population and GDP), the cost to consumers could be as high as A$3.6 billion, or at least $140 a year per person. This estimate does not include the energy sector, where evidence suggests the practice of charging longstanding customers more is rife.
Loyal customers are, by definition, less likely to go elsewhere. Common sense suggests that companies should look after these customers, especially if the cost of acquiring new customers exceeds the cost of keeping existing customers (apparently, five times as much). However, maybe that heuristic is breaking down, especially if loyal customers are profitable in the short term, because their less elastic demand means that firms can charge them a higher price until they leave.

In my ECONS101 class, we also talk about customer lock-in, where customers find it difficult or costly to change provider once they have started buying from one. The cost might be monetary (such as a contract termination fee), or it could simply be the time and effort required to find a new seller. One way a firm can increase the number of locked-in consumers is to offer a low price initially. Once the consumers are locked in, it makes sense for the firm to raise its price to those consumers. This is referred to as multi-period pricing.

'Loyalty taxes', as described by Feis, cover both of these situations (price discrimination, and multi-period pricing). It is difficult for consumers to avoid the loyalty tax if it arises from multi-period pricing (especially if they are locked in by a contract termination fee), but less costly to avoid price discrimination, if firms are simply charging loyal and long-term customers a higher price.

The take-away message from this for consumers should be: make sure that you regularly change suppliers, for electricity, broadband, insurance, etc. If you're not locked in by a contract, you should be checking for alternatives on a regular basis (and there are government-provided services available to help, like whatsmynumber in the case of electricity providers in New Zealand). If the firms are only giving better deals to new customers, you should be aiming always to be a new customer.

Saturday, 17 August 2019

Junk food discounts at supermarkets

In The Conversation yesterday, Adrian Cameron (Deakin University, and no relation of mine) and others wrote about junk food discounts at supermarkets:
Half-price chips, “two for one” chocolates, “buy one get one free” soft drinks: Australian supermarkets make it very easy for us to fill our trolleys with junk food...
We looked at supermarket specials over a year to see how healthy they were. The results of our research, published today, show junk foods are discounted, on average, twice as often as healthy foods...
The way supermarkets choose what products are on special each week is complex.
Food manufacturers pay large premiums to have their products featured in supermarket catalogues, at end-of-aisle displays or near the checkout. The arrangements between food manufacturers and supermarkets are often governed by contracts that specify the way products are to be promoted.
Food manufacturers and supermarkets know unhealthy food is often bought on impulse, making price discounts a great way to entice customers to make those impulse choices.
This was quite timely, because last week I covered pricing strategy in my ECONS101 class, and the week before that we covered elasticity. The combination of elasticity and pricing strategy, along with transaction utility from behavioural economics, do a good job of explaining what supermarkets are doing, and why.

Consumer demand for junk food is likely to be relatively price elastic. Most junk food items are relatively inexpensive, so they take up only a small proportion of our income, and that is associated with relatively more elastic demand. They also have many substitutes (there are lots of items to choose from), so our demand for any particular item is also likely to be relatively more elastic. Finally, they tend to be luxury items (in contrast with necessities), which also have relatively more elastic demand.

When demand is elastic, a change in price has a bigger effect (in percentage terms) on the quantity that we purchase. So, a 10 percent price discount on an item with elastic demand will lead to an increase of more than 10 percent in the quantity purchased. That increases revenue for the seller. [*]

This also explains why they would discount junk food items but not fruit or vegetables. Fruit and vegetables are necessity items, not luxuries - they have price elasticities of demand that are less than one (as noted here). So, fruit and vegetable sales do not respond much to a decrease in price, so discounting them would decrease revenue for the seller. Discounting fruit and vegetables is a sure-fire way for a supermarket to destroy their profitability.

However, elasticity by itself doesn't explain discounting, because if it was the only explanation, then the seller would better off to keep the price low permanently. A complementary explanation is transaction utility (as I discussed in this post earlier this year). When we buy an item, we get utility (satisfaction or happiness) from receiving the item (which we call consumption utility), plus we get utility from the transaction itself (transaction utility). If we feel like we are getting a good deal, that makes us happier about our purchase. It doesn't make us any more satisfied with the item itself, but it increases our transaction utility. Higher total utility (consumption utility plus transaction utility) makes us more likely to buy the item. By offering discounts on different items every time, they avoid giving consumers the perception that the price is lower, so each time a discount cycles back to an item, there has been time enough for consumer perceptions about the 'usual' price to reset.

So, if an item has relatively elastic demand (which is true for junk food, but not for fruit and vegetables) and the seller can make us feel good by offering a discount, then it can make sense for them to do so.

All of this is somewhat related to another practice of supermarkets, which is loss leading. That is where a seller sells some products at a loss in order to increase sales of other products. However, it seems unlikely that discounting junk food is an example of loss leading. As the quote above notes, junk food is an impulse purchase. In contrast, the ideal loss-leading product is one that has elastic demand and will therefore bring a lot of customers into the store. Nobody chooses their supermarket based on a discount for their favourite chocolate bar (I think?).

Anyway, none of this behaviour by supermarkets should be a surprise to us. It only takes a little bit of knowledge about consumer behaviour and price elasticity to explain why supermarkets discount junk food and not healthy food. The article finishes with:
Imagine what it would be like to shop at a supermarket where healthier food was on special more often, and with bigger discounts. Where customers were enticed by discounted fruit and vegetables instead of half price chips, chocolate and soft drinks.
You'll have to use your imagination. No such store exists, and if it did, you'd better get in fast because it's not going to last long before it fails.


[*] Economists' usual assumption is that firms are trying to maximise profits, not revenue. For simplicity, I'm ignoring that assumption here. For a supermarket, with high fixed costs and the power to negotiate steep quantity discounts from suppliers, there probably isn't too much difference between maximising revenue and maximising profits.

Read more:

Tuesday, 13 August 2019

African Swine Fever, China and demand for New Zealand beef

In my ECONS102 class this week, we've been discussing international trade. Having spent a lot of time going through the various ways that governments can intervene in markets with international trade, and the deleterious effects of those interventions, doesn't leave a lot of time for interesting questions about market dynamics in markets with international trade. So, I thought I would take a moment here to do so, motivated by this New Zealand Herald article from last month:
African Swine Fever has played a part in China overtaking the United States as the biggest market for New Zealand beef, the Meat Industry Association (MIA) said...
Demand for New Zealand red meat in China had been growing before the disease arrived in Asia a year ago, but Ritchie said its onset had altered the world supply/demand dynamic.
"We have been lucky in the sense that there has been that buying demand for protein in recent years," he said.
"Right now, with the impact of African Swine Fever in China, they are talking about potentially a 25 to 30 per cent cut in production, so that has to be extraordinarily significant given pork's position as the biggest meat and with China representing about 50 per cent of the world's pork market," he told the Herald.
"Clearly, the alternative proteins have been caught up in that, and demand there has such a huge impact on the world's meat markets," he said.
China has seen a large decrease in the supply of pork, due to African Swine Fever. This raises the price of pork. Beef is a substitute for pork, and when the price of pork increases, some consumers will switch to buying beef. This increases the demand for beef. Now, China is an importer of beef, and how that increase in demand affects the market for beef is shown in the diagram below. If China was not able to trade for beef, the market would operate in equilibrium, where the price of beef is P0 and the quantity of beef traded is Q0. The increase in demand (from D0 to D1) would raise the price of beef from P0 to P1, and increase the quantity of beef traded from Q0 to Q1.

However, China is able to trade for beef on the world market. In other words, they can buy beef from the market by paying the world price for beef, which in the diagram is PW. The world price PW is lower than the Chinese domestic price P0, because China has a comparative disadvantage in beef production - they can produce and sell beef, but only at a higher cost than other countries (those other countries have a comparative advantage in beef production). In other words, the rest of the world is willing to supply China with beef at the price PW. We represent this with the kinked (red) supply curve S+imports (the supply of beef to the China market, once we account for imports). Now, Chinese consumers only have to pay the lower price PW instead of P0, so they will buy more (QD). However, Chinese beef suppliers have to compete with the lower world price PW, so they will sell less (QS). The difference between QD and QS is the quantity of beef imports.

When demand increases from D0 to D1, that doesn't affect the Chinese beef suppliers any more. They are already supplying as much as they wanted to at the low price PW. The Chinese consumers will increase the quantity that they purchase though, to QD1. The difference between QD1 and QS is a larger quantity of beef imports.

Now consider how that will affect New Zealand, as a beef exporting country. This is shown in the diagram below. New Zealand has a comparative advantage in beef production, so the world price PW is above the New Zealand domestic price that would obtain if there was no trade (P2). In other words, New Zealand can produce and sell beef at a lower cost than other countries. The rest of the world is willing to demand New Zealand beef at the price PW. We represent this with the kinked (red) demand curve D+exports (the demand of beef from New Zealand, once we account for exports). At the higher world price of PW, New Zealand beef suppliers are willing to supply more beef (QS3), and New Zealand beef consumers are willing to purchase less beef (QD3), than they would at equilibrium. The difference between QS3 and QD3 is the quantity of New Zealand beef exports.

When Chinese demand for beef from the world market increases, this pushes up the world price of beef (the Chinese economy and population are large enough that an increase in demand from China is enough to shift world market prices - this would not be the same for New Zealand in most markets!). We won't go back to our earlier diagram on the Chinese market and make this change, but in the New Zealand market, the world price increases from PW to PW1. The D+exports curve moves up to D+exports1. Now, New Zealand consumers have to compete with a higher world price, so they reduce their beef purchases to QD4. New Zealand beef suppliers increase their production to QS4, to take advantage of the greater profit opportunities from the higher world price. New Zealand exports of beef increase to the difference between QS4 and QD4.

So, we can see how Chinese demand for beef translates into impacts on the New Zealand economy. New Zealand beef exporters will be better off, and beef exports increase, but New Zealand beef consumers can expect to see higher prices. I wonder - are we already seeing higher beef prices at New Zealand stores?

Monday, 12 August 2019

Book review: The Case Against Education

I just finished reading Bryan Caplan's The Case Against Education. The subtitle is "Why the education system is a waste of time and money". You might wonder why I would read such a book, given that I work in the higher education sector. Isn't it a book that argues against the very thing that I do? Indeed, I think my in-laws raised their eyebrows on seeing the book on our coffee table.

Caplan writes well, and is contrarian by nature, so I thought this might be an eye-opening read. The book covers both high school and university-level education (as well as graduate school, but there is less data available at that level). Essentially, Caplan argues that there are two private benefits to education that lead to a wage premium for those with more education: (1) an increase in the student's skills and knowledge (or human capital); and (2) a signal to employers that the student is worth employing (because they are intelligent, conscientious, and conformist).

None of this is particularly new, even the idea of signalling, and I have blogged about it before in exactly this context. What is new about Caplan's argument is that he breaks down how much of the education premium relates to human capital rather than signalling. He extensively reviews the literature (not just in economics, but also in educational psychology and sociology), and he contributes his own analysis based on US General Social Survey data. From this, he arrives at shares of 20% human capital and 80% signalling. That suggests that most of the benefit of education is in its ability to sort students into those who are more (or less) worthy of employment, and much less benefit derives from the skills and knowledge they are supposed to be being taught. As Caplan notes:
Most of what schools teach has no value in the labor market. Students fail to learn most of what they're taught. Adults forget most of what they learn.
And that is the inconvenient truth in the whole education sector (that might have made a good alternative title for the book, if it wasn't already taken!). The education system is not teaching skills and knowledge that students are going to make use of in the labour market. Caplan takes particular aim at clearly non-vocational subjects like the arts, music, history, social studies, civics, and physical education. The end result is that many (less able) students would probably be better off not going to university, and doing some vocational education instead (Caplan is rather more bullish about the value of vocational education).

Caplan isn't done there though. If 80% of the private gains to education are from signalling, then there is a strong case against public funding of education. While society gains from increases in students' skills and knowledge, society gains virtually nothing from signalling, since that is simply a way of sorting good and bad future employees. So Caplan argues that the social gains from education are much lower than the private gains, and therefore the costs to the public of funding education could outweigh the benefits (and certainly in the case of low-ability students). Here I think Caplan over-plays his hand, but he does a good job of making his case, even if I may not agree with it entirely (or at least, I haven't yet been able to bring myself to agree with it entirely). He even addresses social justice, which I was expecting him to have left alone (as many economists in the same position would have):
Yes, awarding a full scholarship to one poor youth makes that individual better off by helping send a fine signal to the labor market. Awarding full scholarships to all poor youths, however, changes what educational signals mean - and leads more affluent competitors to pursue further education to keep their edge. The result, as we've seen, is credential inflation. As education rises, workers - including the poor - need more education to get the same job. Where's the social justice in that?
Many readers will disagree with the points that Caplan raises, but it would do good for more people to be engaged with these ideas. There is a growing Assurance of Learning Industrial Complex, driven by accrediting agencies such as those that accredit business schools, engineering schools, and so on. If education is mostly signalling, then the majority of assurance of learning is little more than an educational equivalent of the mechanical Turk.

Caplan's libertarian values will also not appeal to many readers, who might be appalled by his willingness to engage with the idea of promoting child labour. However, he does base the policy prescription on his data and analysis - if vocational skills are mostly learned on-the-job and not in school, then if the goal of education is to provide children with vocational skills, then it would be more effective to have them working rather than at school learning history or physical education.

Overall, this was an interesting read, and my ECONS102 students can expect to see me pick up on a few of Caplan's less-outspoken ideas when we get to the economics of education later this semester. Recommended for teachers (and especially economics teachers)!

Read more:

Tuesday, 6 August 2019

How to get licensing of the legal marijuana market wrong

This article from Politico caught my attention last month:
What’s happening to [owner of The Reefinery in Los Angeles, Greg] Meguerian is a window into one widespread side effect of marijuana legalization in the U.S.: In many cases it has fueled, rather than eliminated, the black market. In Los Angeles, unlicensed businesses greatly outnumber legal ones; in Oregon, a glut of low-priced legal cannabis has pushed illegal growers to export their goods across borders into other states where it’s still illegal, leaving law enforcement overwhelmed.
Legal marijuana and illegal marijuana are substitutes. That should not be a surprised to anyone. They are not quite perfect substitutes (goods that are, in the eyes of consumers, identical), because illegal marijuana does come with social or moral costs such as the stigma of buying an illegal good, or the risk of being fined for making an illegal purchase. However, they are close substitutes, and so if you make one of them relatively more expensive, some (many?) consumers will switch to purchasing the others:
“Cannabis consumers are rational economic actors,” Hudak, the Brookings... expert, said. “They’re probably going to pick the cheaper option. In a lot of states, that would mean black market cannabis.”
No surprises there. One of the major costs for legal cannabis businesses is the cost associated with complying with licensing and other regulations. And that creates a problem:
High startup costs, licensing fees, and taxes make it hard for cannabis businesses to compete with unlicensed dispensaries that get equal billing on Weedmaps, the Yelp of cannabis. Los Angeles, for instance, is estimated to have more than 1,000 dispensaries, according to some advocates, but only 200 of them are licensed. This means the vast majority are illegal businesses.
If you increase the costs of doing business for the legal cannabis businesses, they will have to raise prices. Higher prices shift some consumers to the illegal cannabis businesses, and therefore make the illegal businesses more profitable. That encourages more illegal cannabis businesses to set up. If you're going to make a product legal, why on earth would you set it up in such a way that encourages the illegal trade in that product? But, that appears to be what is happening.

Part of the problem is the mix of state and federal laws in the US, where individual states have legalised, but marijuana remains illegal at the federal level. States respond to this by creating byzantine licensing regimes, and that raises costs for the legal businesses. To make matters worse, because banks can't legally deal with the marijuana businesses in case they are prosecuted for breaking federal laws, this adds an additional layer of cost to the marijuana businesses. So, how to solve the problem? The article notes:
[California Bureau of Cannabis Control spokesman Alex] Traverso’s solution is much like the approach favored by advocates in Massachusetts and Oregon: Make the market legal at both the state and the national levels...
Traverso, of California Cannabis Controls, says federal access to banking would lower startup costs and provide a financial buffer for new small businesses, encouraging more to switch to the legal market. 
At least in New Zealand we don't have separate federal and state law-making bodies that could create conflicting laws. However, we can only hope that if marijuana is legalised following the upcoming referendum, we will create a licensing regime that is sensible.

[HT: Marginal Revolution]

Sunday, 4 August 2019

Land seizures, security of property rights, and efficiency in Ihumātao

In my ECONS102 class this week, we'll be talking about property rights. One of the key points in that part of the topic is discussing the characteristics of efficient (that is, economic welfare maximising) property rights. For property rights to be efficient, they need to have four characteristics. They need to be:

  1. Universal - all resources are privately, publicly, or communally owned and all entitlements are completely specified;
  2. Exclusive - all benefits and costs accrued as a result of owning and using the resources should accrue to the owner whether directly or indirectly;
  3. Transferable - all property rights should be transferable from one owner to another in a voluntary exchange; and
  4. Enforceable - property rights should be secure from involuntary seizure or encroachment by others.
For the weekly assignment in that class, I was going to assign a question about the current standoff in Ihumātao, which has been widely covered in the media over the last several months and has come to a head in the last couple of weeks (see this New Zealand Herald story as one example). My initial thought was that I could ask a simple question about how land occupation by protestors affects the efficiency of property rights. The straightforward answer is that land occupation reduces enforceability, and therefore property rights become less efficient and therefore less valuable - if your property rights are being encroached upon (and are therefore both less secure and less exclusive), then you would be less willing to have those rights. In a sense, this provides a simple explanation for why Fletcher Building may have become willing to sell the land at Ihumātao.

However, as with many things, the issue isn't quite that simple. As I was thinking about this potential assignment question, I began to consider the original land seizure by the Crown in 1863. If I asked about how efficient property rights are, some students might consider that the original land seizures as reducing the efficiency of property rights. And they would have a valid point. Obviously, if the Crown is seizing land, then that makes the property rights a whole lot less efficient. So, land occupations that result in the return of the property to its original owners could increase the efficiency of property rights, if you took a longer run perspective. At that point, I decided the assignment question was a whole lot more difficult that I had anticipated. But also, the question had become a whole lot more interesting.

What happens if land seizures are only being executed against one population group, and not others? Then the group subject to land seizures would have less efficient property rights than other groups. Consequently, the group with inefficient property rights would be willing to pay less to hold onto land (including any land that hadn't been seized!), or willing to accept less to sell their land, compared to groups with more efficient property rights. This disparity has important implications.

In the absence of market failures, economists accept that markets maximise economic welfare. Nobel Prize winner Friedrich Hayek argued that markets are efficient because goods are transferred to those who value them the most. In the case of land, we would expect land to be transferred to those who valued it the most, being those who could make the best use of the land (whether that be for farming, forestry, housing, infrastructure, or cultural values). If land seizures directed against one group (but not others) makes the targeted group willing to pay less for land, then the market would eventually transfer land away from that group, and to groups that are willing to pay more for it. However, the difference in willingness-to-pay is being driven (in part, if not entirely) by the difference in the security (and efficiency) of property rights for the targeted group. The transfer of land is not towards those who value it more, except as a result of the land seizures.

For many years, I've been wondering if there was an economic argument for redress for Crown land seizures from Māori, aside from the ethical and moral arguments that are already pretty clear. I haven't thought through all the implications here, but I think that the efficiency of property rights probably provides a basis for making such an argument.

Friday, 2 August 2019

Stop whining; Netflix doesn't care if you're going to cancel your subscription

In the New Zealand Herald yesterday:
Reaction to Netflix's incoming 19 per cent price hike amongst Kiwi subscribers has been immediate and passionate.
Many have taken to social media to announce their imminent departure from the streaming service and to question the value for money proposition offered by their subscription.
The price across of all Netflix plan will increase. The basic plan will now cost $11.99 a month, the standard $16.99 and the premium plan $21.99 a month, increases of 4 per cent, 13 per cent and 19 per cent respectively...
Long term subscriber Cameron Anderson seemed to capture the general mood of the nation to the price hike news writing, "Well, it's been fun netflix, years of support, but I think I'll have to cancel my subscription".
Despite all the wailing an gnashing of teeth (see the full article for more of the same), Netflix isn't going to change its mind. When a firm raises its price, some consumers will stop buying from it. That's called the Law of Demand. It will come as zero surprise to Netflix that some consumers will cancel their subscriptions. Jumping onto social media to whine about how it's unfair and therefore you're going to cancel your subscription changes nothing.

And you know why? Netflix doesn't care. Enough people will keep Netflix and pay the higher price, to more than offset the lost revenue and profits from the small number of subscribers who cancel their subscriptions. Netflix has already factored this in when they made the decision to raise the price.

The diagram below illustrates this point. It shows a firm with market power. The original subscription price is P0, and there are Q0 subscribers at that price (Q0 is the quantity demanded at the price of P0). Netflix's producer surplus (its profits, excluding any fixed costs) at that price are shown by the rectangle P0CHF (that's the area between price and cost, for the quantity they have sold). The problem for Netflix is that P0 doesn't maximise profits. Profits are maximised at the quantity where marginal revenue is exactly equal to marginal cost. That's the quantity Q1. Netflix has too many subscribers to maximise profits. It should raise its price to P1, where the quantity demanded (the number of subscribers) is exactly equal to Q1. At the profit maximising quantity, the producer surplus is equal to the rectangle P1BEF. It should be obvious that the area P1BEF is bigger than the area P0CHF. Netflix's profit increases. [*]

By raising the price to P1, Netflix loses the area of producer surplus GCHE, which is essentially the profit they were previously receiving from the people who cancel their subscriptions. But they gain the area P1BGP0, which is extra profit from the people who keep their subscriptions and now pay the higher price.

So, people can whine about it all they like. Netflix is simply engaging in the sort of behaviour that we expect a firm with market power to engage in. Incidentally, Netflix has this market power because so many consumers rushed to subscribe to them and let competitors like neighbourhood video stores close down. Now those other competitors are gone, there's no going back (at least, not easily). If consumers didn't want this to happen, why give Netflix so much market power to begin with?


[*] Of course, it is also possible that Netflix over-shoots the profit-maximising price, and has actually set a price that is higher than P1. In that case, profits would be lower than at the price of P1, but may still be higher than they were at P0. It seems to me, though, that Netflix is more likely to still be under-priced even at the new, higher price. If it priced too high, then it leaves open too much opportunity for lower-priced competitors. In this, maybe I've been influenced by Jeff Bezos' views, as explained in the book The Everything Store (which I reviewed earlier this week).

Tuesday, 30 July 2019

Sea level rise, coastal flooding, and house prices

In my ECONS102 class last week, one of the things we discussed was hedonic pricing - the idea that the price of some goods (such as houses or land) reflects the sum of the values of all of the characteristics of the good. In the case of property, if the property includes a dwelling, the price will reflect the quality and size of the dwelling, number of bedrooms, bathrooms, whether it has off-street parking, and so on. But the price also reflects the access of the property to local amenities, such as good schools, public transport, and so on (for example, see this post from 2017), as well as the property's risks of damage due to environmental disasters such as earthquakes or floods.

In the case of risk, properties that have a higher risk profile should have lower prices - a higher risk profile is a negative characteristic for a property. Two new research articles provide some relevant evidence.

First, this article by Allan Beltran, David Maddison, and Robert Elliott (all University of Birmingham) published in the Journal of Environmental Economics and Management (sorry I don't see an ungated version), looked at the impact of floods on property prices in the UK. They used data on over 12 million property transactions and nearly 5 million properties over the period from 1995 to 2014. Interestingly, their method looked at 'repeat sales'. That means that they essentially looked at property's prices before, and after, a flood event. Some properties were directly affected by flooding, while others weren't. They found that:
...in the immediate aftermath of inland flooding the average price of property in a postcode entirely inundated is 24.9% lower. For incidents of coastal flooding the corresponding figure is 21.1%. These results moreover emerge from a comparison of inundated and non-inundated properties all within the floodplain. Such discounts are however short-lived; property affected by inland flooding typically recovers after 5 years and in just 4 years for coastal properties. The time for price recovery differs markedly for properties in different price-quartiles. For properties affected by coastal flooding in the highest price-quartile, the property price discount disappears after only 1 year whereas for properties in the lowest price-quartile the discount remains statistically significant for up to 6-7 years.
So, floods reduced house prices, but the prices rebounded so that there was no net negative effect within several years. Interestingly, the effect was slightly lower for coastal flooding, and disappeared quicker. That is, people were quick to return to demanding coastal property soon after coastal flooding. That should be a bit of a worry to us, given that sea level rise is likely to be one of the enduring effects of future climate change.

Which brings me to the second article, by Asaf Bernstein (University of Colorado at Boulder), Matthew Gustafson (Pennsylvania State University), and Ryan Lewis (University of Colorado at Boulder), published in the Journal of Financial Economics (ungated earlier version here). This article provides more direct evidence on the effect of sea level rise on house prices, using data from over 460,000 property transactions of properties in the US that would "be inundated following a 1-6 foot increase in average global ocean level". Their analysis is not based on repeat sales, and neither is it based on actual sea level rise (it is projected future sea level rise). The latter point means that, if there are negative impacts on property prices, then buyers are factoring in future sea level rise in their decisions about buying. They find that:
...SLR exposed properties trade at a 6.6% discount relative to comparable unexposed properties. We further break this into exposure buckets, with properties that will be inundated after one foot of global average SLR trading at a 14.7% discount, properties inundated with 2-3 feet of SLR trading at a 13.8% discount, and properties inundated with 4-5 and six feet of SLR trading at 7.8% and 4.4% discounts, respectively.
Interestingly, it is non-owner-occupiers would are more likely to apply a discount to the property:
We find that the SLR exposure discount is concentrated in the non-owner occupied segment of the market. On average, exposed non-owner occupied properties trade at a 10% discount, relative to comparable non-exposed proper- ties, while exposed and unexposed owner occupied properties trade at similar prices.
In other words, owner-occupiers likely underestimate the negative impacts of sea level rise on their homes. They also found that owner-occupiers with stronger beliefs regarding climate change did apply a discount in buying coastal property.

These two papers, taken together at face value, should probably worry anyone who is concerned about the future impact of sea level rise and coastal flooding on people living near the coast. Coastal property is at risk in many (perhaps most) areas. Holding all other factors constant (such as the quality of housing, access to amenities and services, etc.), the value of these properties should be decreasing relative to less vulnerable property (or at least, not rising as quickly). It appears that is not the case, and in fact following flood events (which should make it abundantly clear to potential purchasers that these properties are vulnerable to coastal flooding and sea level rise), property prices are rebounding quickly to their previous levels. On top of that, it appears that it is owner-occupiers (and in particular climate-change-naive owner-occupiers) who will face the brunt of these future impacts.

I don't know that this leads to a strong case for regulation of coastal property in some way, but at least it suggests that coastal property owners (and potential buyers of coastal property) must become better informed about the risks. The specific vulnerability of coastal property to inundation and flood events probably needs to be communicated to potential buyers for every coastal property transaction.

Sunday, 28 July 2019

Book review: The Everything Store

At the end of 2017, I read and really enjoyed Brad Stone's book The Upstarts (which I reviewed here). So I looked for other books by the same author. It turns out, I already had one on my shelf that I hadn't read - The Everything Store. The book tells the story of Jeff Bezos, and in particular of the rise of Amazon, initially as an online bookstore, and later as an online purveyor of almost everything (hence the title).

As he did for Uber and AirBnB in The Upstarts, in this book Stone does an excellent job of chronicling the history of Amazon. The key players (and there are many) are all included and their contributions to Amazon are noted in some detail. Stone includes lots of anecdotes that help you to really feel the relentless pace of development of the company over the years including, surprisingly, that they briefly toyed with the idea of calling the company Relentless (indeed, the web address relentless.com still takes you to the Amazon homepage today!).

Many of the details in the book, I had already read elsewhere over the years. However, there were still many stories that were new. I hadn't quite appreciated Bezos's total dedication to low pricing, but this quote in relation to Amazon Web Services (AWS) captures it well:
Bill Miller, the chief investment officer at Legg Mason Capital Management and a major Amazon shareholder, asked Bezos at the time about the profitability prospects for AWS. Bezos predicted they would be good over the long term but said he didn't want to repeat "Steve Jobs's mistake" of pricing the iPhone in a way that was so fantastically profitable that the smartphone market became a magnet for competition.
The comment reflected his distinctive business philosophy. Bezos believed that high margins justified rivals' investments in research and development and attracted more competition, while low margins attracted customers and were more defensible.
In its determination to capture customers through low prices, Amazon has driven hard bargains with its suppliers, and the book contains lots of stories to that effect. It has also driven hard bargains with its employees, and if the book is missing one thing, it is the lack of stories from the front line. I guess that many readers would not have appreciated it in a business book, but I wanted more than a few isolated anecdotes about "top-grading of employees" (where managers grade employees along a curve, and "dismiss the least effective performers"). Even those few anecdotes only appeared towards the very end of the book. However, despite their absence, there is no doubt from reading the book of the challenges that working for Jeff Bezos presents. He appears to be a hard taskmaster.

The book doesn't lack humour though, such as the story of the missing pallet of Jigglypuff Pokemon toys in one fulfilment centre:
The group was looking for a single box inside an eight-hundred-thousand-square-foot facility. "It was very much like that scene at the end of Raiders of the Lost Ark," Rachmeler says. She dashed out to a nearby Walmart to buy a few pairs of binoculars and then passed them out among her group so they could scan the upper levels of the metal shelving....
After three days of exhaustive searching, at two o'clock in the morning, Rachmeler was sitting, spent and dejected, in a private office. Suddenly, the door flew open. A colleague danced in, and Rachmeler briefly wondered if she was dreaming. Then she noticed that the woman was leading a conga line of other workers and that they were jubilantly holding above their heads the missing box of Jigglypuffs.
I guess it wasn't all bad news for the employees of Amazon. It has made a large number of them (not least Bezos himself) fabulously wealthy. For a company that was originally "conceived in 1994 on the fortieth floor of a midtown New York City skyscraper", Amazon has certainly come far. And this book does a great job of showing you just how far it has come.

Saturday, 27 July 2019

You can pay a subsidy with a tax, but it won't eliminate the deadweight loss

The government's new plan for incentivising a switch to electric vehicles (EVs) is interesting, as reported in the New Zealand Herald last week:
The Government is signalling its intention to slash the price of imported electric and hybrid vehicles by up to $8000 in a bid to make greener cars cheaper for Kiwis.
But it is also planning to slap a new fee of up to $3000 on the import of vehicles with the highest greenhouse gas emissions.
The Government has today opened a six-week consultation period before it introduces new legislation in Parliament later this year...
The Government is proposing discounts of up to $8000 for zero-emission new imported vehicles, such as electric vehicles (EVs).
That number would be $6800 for plug-in hybrid electric vehicle (PHEVs) and $4800 for hybrids.
The level of the discount depends on the total net emissions of the vehicle...
A used Mazda Axela, which is one of New Zealand's most popular imported vehicles, would cost $7200 after an $800 discount.
But a new Land Rover Sports V8 would be slapped with a $3000 high-emissions fee.
A $22,000 Toyota Hiace would cost an extra $1400 after the fee was applied.
Genter said the policy would be cost neutral – meaning the money gained through the fees from higher emitting vehicles would offset the subsidies provided to the lower emission cars.
A specific excise tax on the sale of a good, such as high-emission vehicles, will raise revenue for the government, but it also creates a deadweight loss - there is some economic welfare from the market for those vehicles that is lost, because fewer of them are being traded. This is illustrated in the diagram below. If the market were left alone, it would operate with a price of P0, and Q0 high-emission vehicles would be traded. When the excise tax is imposed, we represent that with the new curve S+tax. The price the consumer pays for a high-emissions vehicle increases to PC, but the effective price for the seller decreases to PP (which is the consumer's price PC, minus the amount of the tax paid to the government). The quantity of high-emissions vehicles decreases to QT.

However, now think about economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle P0ED.

Once the tax is imposed, the consumer surplus decreases to ABPC, while the producer surplus decreases to the area PPCD. The government gains the area of tax revenue, which is the rectangle PCBCPP (this rectangle is the per-unit amount of the tax, multiplied by the quantity of taxed vehicles). Total welfare is the sum of all three areas (consumer surplus, producer surplus, and government revenue), or ABCD. Notice that total welfare with the tax is lower than it is without the tax, by the area BED. That is the deadweight loss of the tax - lost economic welfare as a result of the tax reducing the quantity of high-emissions vehicles traded.

So, we lose economic welfare in the market that is taxed. Does that mean that we gain welfare in the market that is subsidised? Actually, it doesn't. The diagram below shows the effect of a subsidy on the market for EVs. If the market were left alone, it would operate with a price of PA, and QA EVs would be traded. When the subsidy is introduced (and assuming it is paid to the importers of EVs), we represent that with the new curve S-subsidy. The price the consumer pays for a high-emissions vehicle decreases to PE, but the effective price for the seller increases to PF (which is the consumer's price PG, plus the amount of the subsidy paid to the seller by the government). The quantity of EVs increases to QS.

Now consider the areas of economic welfare. Without the subsidy, consumer surplus is the area FGPA, and producer surplus is the area PAGH. So, total welfare without the subsidy is the area FGH. With the subsidy, the consumer surplus increases to the area FJPG, while the producer surplus increases to the area PFKH. The government subsidy is the rectangle PFKJPG (this rectangle is the per-unit amount of the subsidy, multiplied by the quantity of subsidised vehicles). The subsidy is negative welfare - it reduces total welfare, because the government could instead use that subsidy money to pay for schools, roads, etc. So, it has an opportunity cost (it is not free money). Total welfare with the subsidy is the sum of consumer and producer surplus, minus the area of the subsidy. This is tricky because all the areas overlap, but if you work it out you'll find that total welfare is now FGH-GKJ. So, total welfare with the subsidy is lower than without the subsidy, by the area GKJ - the subsidy also creates a deadweight loss.

Now, combining the two markets, it is clear that the government could use the revenue that it raises from the tax on the high-emissions vehicle market, to pay for the subsidy on the EV market. However, that only pays the subsidy - it does nothing about the deadweight loss in either market. [*] So, while the policy may be cost neutral from a government fiscal standpoint, it clearly isn't cost neutral for society as a whole.


[*] Now, you could argue (rightly) that the high-emissions vehicle market has a negative externality, and so too many high-emissions vehicles are traded relative to the welfare-maximising quantity. So, a tax on that market would actually increase total welfare (once you factor in the externality). However, that still leaves the deadweight loss in the EV market.

You could also argue that the EV market has a positive externality, since EV use reduces the number of high-emissions vehicles, and so too few EVs are traded relative to the welfare-maximising quantity. So, a subsidy on that market would actually increase total welfare (once you factor in the externality).

However, you couldn't argue that both of those things are true, since you would be double-counting the externality. Either there is a negative externality of high-emissions vehicles, or a positive externality of EVs, but there can't simultaneously be welfare increases for both of those things.

Friday, 26 July 2019

Mark Kleiman, 1951-2019

Normally on this blog I only mark the passing of famous economists, but I'll make an exception for Mark Kleiman, who was a professor of public policy at NYU, and was most famous for his work on drug policy. In fact, I referenced a blog post by Kleiman in a post last year on the economics of fentanyl.

Gabriel Rossman at National Review has an excellent article that captures some of Kleiman's key contributions:
Market failure and high transaction costs are policy successes when the commodity is poison, and so good policy means encouraging bad market design. For instance, Kleiman favored a noncommercial approach to marijuana decriminalization precisely because he expected nonprofit or state-operated dispensaries to be less efficient than for-profit firms, and in particular less likely to grow the user base through advertising and make intense use more convenient. The billboards advertising dispensaries, and even marijuana delivery, that saturate Los Angeles are exactly what Kleiman thought sensible decriminalization should avoid.
But just as good market design has to be careful, so does deliberately bad market design. A major argument in Against Excess is that if you make selling drugs risky by locking up drug dealers (or encouraging them to shoot each other over territory), you build in a risk premium to the price, which draws in suppliers who don’t mind risk. The better approach is to create a deadweight loss so you don’t encourage more supply. For illegal drugs, make it a time-consuming hassle to score. For legal drugs like tobacco and alcohol, impose stiff excise taxes. In both cases the consumer faces costs that do not benefit, and therefore encourage, sellers. These costs might not discourage addicts in the short run, but long-run demand is relatively “elastic”: Increased costs from hassle or taxes can discourage potential users from starting and encourage existing addicts to quit.
Those are insights that I have used in my ECONS101 and ECONS102 classes. Rossman also highlighted some additional contributions that I probably should make more use of:
Jointly tackling mass incarceration and crime was the aim of his most famous book, When Brute Force Fails. At a theoretical level, the book is an argument that Gary Becker’s economic theory of crime must be radically reconceptualized in light of behavioral economics. Becker argued that deterrence was the expected value of punishment, defined as the probability of punishment times its severity, which has the practical upshot that we can achieve deterrence by punishing infrequently but severely. However, behavioral economics suggests that people aren’t good at reckoning unlikely-but-severe outcomes — and if ever there were a group of people who live for the moment and ignore the future, it would be those who are either intoxicated or addicts looking to score. (Contrary to popular myth, relatively few prisoners are incarcerated for non-violent drug offenses, but many violent and property offenses are committed while intoxicated or to acquire money for drugs.) This implies that a ten-year prison sentence won’t have much more of a deterrent effect than a five-year sentence would. In practice, extremely long sentences serve not to deter crime, but to induce plea bargains and incapacitate criminals throughout their prime-offending young years — and beyond.
When Brute Force Fails is an important book not just for contributing to a theoretical dispute, but also for its empirical evidence and practical solution: mild but extremely consistent punishments, the opposite of Becker’s approach.
Given that I make a lot of use of Becker, and of behavioural economics, the juxtaposition of the two seems like something that would work well in future.

You can read more about Kleiman in this article by German Lopez on Vox, and here is the New York Times obituary.

[HT: Marginal Revolution]