The impact of the 2023 Bud Light boycott on alcohol purchases

When a consumer stops buying a particular product for some reason (for example, if a product becomes unavailable), do they switch their spending to another product within the same category, or do they reallocate their spending across all available goods and services? The consumer choice model (or the constrained optimisation model for the consumer) suggests that the consumer should reallocate across all possible goods and services, rather than transferring the exact proportion of spending to the closest substitute product.

This recent article by Aljoscha Janssen (Singapore Management University), published in the journal Economics Letters (ungated earlier version here) provides an interesting test of that expected response. The context is the 2023 boycott of Bud Light in the US:

The boycott began in early April 2023 after Bud Light partnered with a transgender creator, prompting calls from conservative media to avoid the brand... Viral content amplified the message, and the manufacturer responded with advertising that emphasized traditional Americana themes... Sales declines emerged not only in conservative areas but also in regions without strong ideological leanings...

Janssen uses data from the NielsenIQ Consumer Panel from 2021 to 2023, which tracks spending by between 40,000 and 60,000 US households. Janssen drops households that did not buy alcohol, and then categorises the remaining households into three groups based on Bud Light purchases: (1) 'Bud Light households' (that purchased 18 litres of Bud Light in both 2021 and 2022); (2) 'Bud Light-dominant households' (that purchased at least twice as much Bud Light as other beers, in addition to purchasing at least 18 litres of Bud Light in both 2021 and 2022); and (3) 'Non-Bud Light beer households' (that purchased at least 18 litres of light beer in both 2021 and 2022, of which less than one-third was Bud Light). Janssen reports that:

In the full sample there are 34,470 alcohol-purchasing households; 585 qualify as Bud Light households and 439 of those are Bud Light-dominant, while 5130 are non-Bud Light beer households.

Janssen analyses monthly purchase data using a difference-in-differences approach, essentially comparing the difference in purchases between different treatment and control groups before and after the Bud Light boycott in April 2023. In practice, the comparisons show very similar results for the impact on Bud Light purchases, purchases of other beer, and total alcohol purchases. Specifically, Janssen finds that:

Across all designs, treated households reduce Bud Light by roughly 160 ounces per month (34%–37% of their pre-boycott Bud Light volume)...

Households partially replace Bud Light with other beer: other-beer purchases rise by 70–90 ounces per month. The offset is meaningful but incomplete relative to the Bud Light shortfall...

Net of substitution, total ethanol declines by about 3–4 fl-oz per month among treated households, a 5.5–7.5% drop. Converting with 0.6 fl-oz per U.S. standard drink, this equals roughly 5.0–6.7 drinks per month per treated household...I find no significant changes in wine or spirits, indicating that switching is almost entirely within the beer category.

So, the boycott led households on average to purchase less Bud Light (as you might expect from a boycott). They bought a greater quantity of other beer products, but the increase in other beer purchases was less than half the decrease in Bud Light purchases, meaning that consumers substituted to other non-beer products. Consumers also didn't switch entirely to other alcohol products, as total alcohol purchases declined. Instead, some spending appears to have shifted away from alcohol altogether. In other words, consistent with the consumer choice model, when consumers stopped buying (or reduced their purchases of) Bud Light, they reallocated their spending across all goods and services, not just switching their spending to the closest substitute to Bud Light (other beers).

Does this offer anything meaningful for advocates of reduced alcohol consumption? Probably not in any direct sense. These were fairly unusual circumstances, and consumer boycotts of particular alcohol products are uncommon. It is hard to imagine advocates or policymakers being able to engineer similar boycotts on a regular basis in order to reduce alcohol consumption. However, the findings do suggest a broader possibility. Interventions that reduce purchases of particular alcohol products, especially those associated with high levels of alcohol-related harm, may lead to at least some reduction in overall alcohol purchases, rather than consumers simply switching one-for-one to the nearest substitute. That said, this study is about purchases rather than consumption, and more evidence from other types of interventions would be needed before drawing firm policy conclusions.

Sellers of natural diamonds are in big trouble

As I noted in yesterday's post, sellers of natural diamonds are in trouble. Lab-grown diamonds are undercutting their market. The problem here is that consumers can't easily tell lab-grown diamonds and natural diamonds apart. The two types of diamonds are perfect substitutes. And when faced with the option of buying one of two products that are perfect substitutes, consumers will generally choose the product that is lower-priced. In this case, that's the lab-grown diamonds.

To see why, consider the diagram of the consumer choice model below. The two goods are X (natural diamonds) and Y (lab-grown diamonds). The consumer's budget constraint is shown by the black line. The budget constraint is relatively steep, which means that the price of lab-grown diamonds is relatively lower than the price of natural diamonds. The consumer's indifference curves are shown by the two red lines, I0 and I1 (with I1 representing a higher level of utility, or satisfaction, for the consumer). The indifference curves are straight lines when the two goods are perfect substitutes (which is the case here). The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, (it's on the highest indifference curve that they can reach, I1), where the consumer spends all of their income on lab-grown diamonds, and spends nothing on natural diamonds. [*] This makes sense, given that lab-grown diamonds and natural diamonds are exactly the same good in the mind of the consumer (they are perfect substitutes), and lab-grown diamonds are relatively less expensive than natural diamonds.

So, how can natural diamond sellers respond to this problem? One way is to lower their prices to match the lab-grown diamond price. That would cause the consumer's budget constraint to pivot outwards and become flatter (just like in this example), and then the highest indifference curve would exactly match the budget constraint. However, lowering prices could easily escalate into a price war, and is unlikely to end well for anyone.

A better option for the sellers of natural diamonds arises when they recognise that the real problem here is not the price, it is that the two goods are identical in the mind of the consumer. If the sellers of natural diamonds can somehow convince the consumer that the two goods are different rather than identical, then they may be able to keep some sales, even if the price of natural diamonds is higher than the price of lab-grown diamonds.

This situation is shown in the diagram below. When the goods are differentiated, the consumer's indifference curves are curves (not straight lines - straight line indifference curves only happen when the goods are perfect substitutes). The highest indifference curve that the consumer can get to is I1'. They will buy the bundle of goods E1, which contains Y1 lab-grown diamonds, and X1 natural diamonds. Even though natural diamonds are relatively more expensive, the consumer chooses to buy some of them.

So, how can the sellers of natural diamonds differentiate their diamonds from the lab-grown diamonds? That is the tricky thing, because there is an asymmetric information problem here. The sellers know whether diamonds are lab-grown or natural, but buyers don't know. The origin of a diamond is private information. Because buyers can't tell the two diamonds apart, they assume that all diamonds are lab-grown [**]. This creates a pooling equilibrium (because all diamonds are pooled together and treated the same). Buyers would only be willing to pay low prices for diamonds, because they assume that the diamonds are lab-grown. Natural diamond sellers don't want to sell their diamonds for the lower lab-grown diamond price, so they drop out of the market. Only lab-grown diamonds would be left in the market. The market for natural diamonds would fail. Economists call this an adverse selection problem. And that is what seems to be happening, since the Financial Times article I referred to yesterday notes that:

By the end of 2024, De Beers had amassed an inventory of unsold diamonds worth $2bn, the largest stockpile since the 2008 financial crisis.

The diamonds are unsold in part because they cannot be distinguished from the lower-priced lab-grown diamonds. How can the natural diamond sellers solve this adverse selection problem? When the informed party (the party that knows the private information) credibly reveals that information to the uninformed party, we call that signalling. To be effective, a signal needs to meet two conditions. First, it must be costly. And second, it must be costly in such a way that the sellers of lab-grown diamonds wouldn't want to attempt the signal.

Unfortunately, it is difficult to identify a signal that meets those two conditions for the sellers of natural diamonds. If they try some recording the chemical signature of their diamonds, those structures can probably be easily copied by makers of lab-grown diamonds. Similarly, microscopically etching a serial number onto each natural diamond is something that makers of lab-grown diamonds can do as well. That rules out branding diamonds. Advertising is not likely to be very effective either, because while advertising natural diamonds and making consumers want them more seems like a good strategy, it won't turn into extra sales if consumers can't tell the lab-grown diamonds and natural diamonds apart. Sellers can often use warranties to signal quality. However, when a good has a warranty, it's quality is eventually revealed to the consumer (because, if the good is low quality, they end up having to claim on the warranty). That isn't the case for diamonds.

So, the natural diamond sellers are not just in trouble. They are in big trouble, unless they can find some way of signalling that their diamonds are natural diamonds (and at the same time hoping that buyers continue to be willing to pay a premium for natural diamonds).

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[*] Yes, this model is assuming that the consumer spends all of their budget on only two goods, natural diamonds and lab-grown diamonds. If it makes you feel better, think of it as the consumer spending all of their diamond budget on those two goods.

[**] I'm treating the lab-grown diamonds as if they are lower quality than natural diamonds. That is what the sellers of natural diamonds would argue, anyway, and given that there is a slight price premium for natural diamonds, the buyers seem to think that way too.

Read more:

• Sellers of natural diamonds are in trouble
• Market power and disruption in the diamond industry

Food price rises and consumer choices

This week my ECONS101 class has been covered constrained optimisation, with a particular focus on consumer choices. So, I was interested to see this article by Puneet Vatsa and Alan Renwick (both Lincoln University) in The Conversation yesterday, talking about food price rises:

The rising price of food has been making headlines for the past decade. But prices have not been rising consistently across all food groups – and this has major health implications for New Zealanders...

Although food price increases have been noticeable over the long term, the change in relative prices — the cost of one food category compared to another — often goes unnoticed. Nevertheless, these relative price changes are crucial as they influence consumer choices, often subconsciously.

Our new research examines Stats NZ data between 2014 and 2023 on the price of 85 food items collected from 560 retail outlets – supermarkets, greengrocers, fish shops, butchers, convenience stores, restaurants, and outlets selling breakfast, lunch, and takeaway foods – in 12 urban areas.

Between July 2014 and March 2023, prices of some sweetened, processed foods and drinks such as boxed chocolate, ice cream, soft drinks and sports energy drinks have risen by around 14%. At the same time, price of some fruits and vegetables have risen by around 45%.

When sweetened processed foods are cheaper relative to fruits and vegetables, people tend to buy more of the former. This can lead to poor dietary habits, increasing the prevalence of obesity and related health issues.

Changes in relative prices are something that we can examine theoretically using the consumer choice model (otherwise known as the constrained optimisation model for the consumer). I've used this model to describe consumer choices before (see here and here), but this application is slightly more difficult, as the price of both goods is changing over time. I'm not going to go into the basics of the model. It has two components - budget constraints (which I explain here) and indifference curves (which I explain in some detail here).

Consider a model of consumer choices, where the consumer can choose between two goods: sweetened processed foods (S) and fruits and vegetables (F). This model is shown in the diagram below. The consumer has income of M, the price of sweetened processed foods is PS0, and the price of fruits and vegetables is PF0. The consumer's budget constraint is shown by the straight, downward sloping line. The slope of the budget constraint is equal to [-PF0/PS0] (which is the relative price of the two goods). The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, which is on the highest indifference curve that they can reach, I0. That bundle of goods includes S0 units of sweetened processed foods, and F0 units of fruits and vegetables.

Now consider changes in prices. The price of sweetened processed foods increases (to PS1), and the price of fruits and vegetables increases (to PF1), but the increase in the price of fruits and vegetables increases by more than the increase in the price of sweetened processed foods. The consumer's budget will not be able to buy as much as before (their income is still equal to M [*]), so the budget constraint will move inwards. The budget constraint will also become steeper, because the relative price has changed. The price of both goods has increased, but the price of fruits and vegetables has increased by more than the price of sweetened processed foods. So, the new slope of the budget constraint, which is equal to [-PF1/PS1], must be a larger number (because PF is increasing faster than PS), meaning that the budget constraint is steeper.

This change is shown in the diagram below. The new budget constraint is the red line - it is steeper and moved inwards from the original black budget constraint. The consumer can no longer buy the bundle of goods E0, because it is outside the budget constraint (the consumer cannot afford to buy E0 anymore). The consumer's new best affordable choice is the bundle of goods E1, which is on the highest indifference curve that they can reach now, I1. That bundle of goods includes S0 units of sweetened processed foods, and F0 units of fruits and vegetables.

Notice that the consumer buys less of both goods, but the impact on the quantity of fruits and vegetables is greater than the impact on the quantity of sweetened processed foods, which is what Vatsa and Renwick found in their research. [**]

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[*] To make life a bit easier, we're assuming that the consumer's income has not changed. Effectively, this reflects an assumption that the price of both goods is increasing faster than incomes have increased, which is probably not too far from recent experience in New Zealand, where food price inflation has been higher than wage inflation.

[**] It is also possible to draw this diagram in such a way that the impact on the quantity of fruits and vegetables is less than the impact on the quantity of sweetened processed foods. The only difference in the diagram would be the placement of the new highest indifference curve I1 and the new best affordable choice E1, which would be further to the right on the diagram. I'll leave that as an exercise for any interested reader to do for themselves.

Carbon taxes are not a costless way to boost the economy

Economists recognise that any choice we make comes with an opportunity cost - for every thing that we choose to do, we are giving up the opportunity of doing something else. This is memorably captured in the acronym TANSTAAFL - There Ain't No Such Thing As A Free Lunch. So, I was interested to read  this article in The Conversation last week, by Mona Mashhadi Rajabi (University of Technology Sydney), about carbon taxes:

A new study has found that a carbon tax, accompanied by “revenue recycling”, can produce both environmental and economic benefits for Australia.

Revenue recycling means money reaped from a carbon tax would be redirected back into the economy. This means the money accumulated from the tax would be redistributed between different stakeholders in the economy without increasing the government’s revenue.

To be more specific, the tax income should be used to support consumption, invest in new research and development projects, and subsidise energy saving and pollution reducing programs. Using this approach makes the tax more politically appealing to companies and other opponents.

So far, so good. But this bit is more than a little surprising:

My study recommends that in the first year, all the tax revenue would be used to support consumption. However, the amount of money allotted to investment would rise from the second year as the carbon tax rate increases. It is estimated that about $57 billion would be available for new technologies over 13 years under this carbon tax.

Imposing a carbon tax would also provide a financial incentive for industry to reduce its fossil fuel use. It would motivate the sector to shift to low-carbon technologies as they would bear a smaller tax bill and reap larger profits.

My study concludes Australia could reduce carbon emissions by 35% while GDP would increase by 0.286% by 2035 and new jobs would be created in research and development. Following the recommended carbon tax design, Australia’s transition to a low-carbon economy would be accelerated, which would benefit both the economy and the environment.

This appears to describe a policy choice with no trade-off. That is, there is no opportunity cost. If the government can tax carbon, pump that money back into the economy to support consumption, and increase consumption and output (GDP), then someone ought to be shouting this from the rooftops. Rajabi is describing a route to infinite consumption. Because, having increased consumption and GDP, the government can then raise taxes again, increasing consumption and GDP by more, and then raise taxes again, increasing consumption and GDP by even more. Repeat this process over and over again, all the way to infinite GDP. Of course, that makes no sense.

To see why, let's consider what happens when you tax a product, and give all of the tax revenue back to consumers as additional income. We'll start with the basic consumer choice model (or the constrained optimisation model of the consumer), as shown in the diagram below. We are using some made up numbers, but the example works the same with other combinations of numbers. The diagram shows the budget constraint for a consumer with income of $1000, choosing between buying carbon goods (with a price of $1), or all other goods (AOG, also with a price of $1). The consumer can choose to consume anywhere on their budget constraint or below it (this is the feasible set). The budget constraint runs from a bundle of goods with no carbon goods at all, and the consumer spending all of their income to buy 1000 AOG, to a bundle of goods with no AOG at all, and the consumer spending all of their income to buy 1000 carbon goods. The slope of the budget constraint is equal to the relative price of the goods (the price of carbon goods, divided by the price of AOG), which is equal to 1 ($1/$1). The consumer is trying to get to the highest possible indifference curve, which is the indifference curve I0 (for more on indifference curves, read this post). They buy the bundle of goods E0, which contains 500 of AOG (costing $500) and 500 carbon goods (costing $500).

Now consider what happens when carbon goods are taxed. Let's assume that the tax is so high that it doubles the price of carbon goods [*]. The effect of this change is shown in the diagram below. The consumer's budget constraint pivots inwards to the red line, and becomes steeper. The slope of the budget constraint is now equal to 2, which is the new relative price of the goods (the price of carbon goods, divided by the price of AOG, which is now $2/$1). If the consumer were only buying AOG (and no carbon goods), they could still buy 1000 AOG. However, if they were only buying carbon goods (and no AOG), they could now only buy 500 AOG. The consumer can no longer afford the bundle E0 - it is outside the feasible set (outside the budget constraint). Instead, the consumer will consume the bundle of goods on the highest indifference curve that they can reach on the new budget constraint. That is the bundle E2, which is on the indifference curve I2, and contains 600 of AOG (costing $600), and 200 carbon goods (costing $400). Notice that the consumer is still spending all of their income, but they have been made much worse off (they are now on a lower indifference curve, meaning that they get less utility from their consumption).

Now let's see what happens if we recycle the tax revenue back to the consumer. The budget constraint remains steep (because the relative price of carbon goods and AOG is still equal to 2), but moves outwards parallel to the previous budget constraint. It doesn't move out all the way to E0 though. At E2, the consumer was paying $200 in carbon tax, so their income goes up by $200, to $1200. The new budget constraint, shown in blue, extends from the point where they spend all $1200 on AOG, buying 1200 AOG, to the point where they spend all $1200 on carbon goods, buying 600 carbon goods. The consumer can now do better than the bundle of goods E2, and reach a higher indifference curve I1, by buying the bundle of goods E1. That bundle contains 700 AOG (costing $700), and 250 carbon goods (costing $500). However, notice that even after the tax revenue has been recycled to them, the consumer is not as well off as they were before the tax was introduced. They may be spending more ($1200 instead of $1000), but their utility is lower.

This demonstrates that there is a cost to this policy. The consumer pays it in the form of lower utility. To be fair, in a sense Rajabi is correct. The consumer is now spending more than before ($1200 instead of $1000), so consumption has increased. But that is an increase in nominal terms. The price of carbon goods has gone up. If we think about the value of the goods that the consumer is buying, at the original (non-taxed) prices, they are only buying $950 worth of goods now (700 AOG worth $700 and 250 carbon goods worth $250), compared with $1000 before the tax was introduced. Or if we think about the value of the goods that the consumer was buying before the tax was introduced, but valued at the new prices, they were previously buying $1500 worth of goods (500 AOG worth $500 and 500 carbon goods worth $1000), but now they are buying $1200 worth. Either way, they are now buying a total bundle of goods that is worth less - the consumer's real income has decreased.

Of course, most people who advocate for 'revenue recycling' are not arguing that every taxpayer would receive back exactly what they paid in the tax. Many prefer that the 'carbon dividend' would be paid only to low income households. That would change the analysis somewhat. First, there would be high-income households for which the analysis looks much like the second diagram - a carbon tax with no offsetting dividend. These households would be unambiguously worse off with the tax. Second, there would be low-income households for which the analysis looks like the third diagram, but with the increase in income from the revenue recycling being much larger. In theory, these low-income households would be better off as a result of the carbon dividend. In other words, the tax would redistribute income from high-income taxpayers to low-income taxpayers. However, it still wouldn't increase the real value of consumption or GDP overall. It would simply redistribute who is doing the consumption spending.

Overall, we can conclude that it isn't possible to simply pump up the economy endlessly by taxing carbon goods and recycling the tax revenue to consumers as additional income. Any analysis that shows this is possible is clearly missing something important. There ain't no such thing as a free lunch.

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[*] In reality, this would require a tax of more than 100 percent, because a tax raises the price that consumers pay, but producers share the burden of the tax, so the whole tax amount is not passed onto consumers as a higher price. For more on this, see this post. However, for simplicity we will assume that the entire tax is passed onto the consumer in the form of a higher price. This assumption would affect the exact numbers from the example, but not the overall conclusion.

Constructing an indifference curve

When I was writing my previous post that applied the consumer choice model (otherwise known as the constrained optimisation model for the consumer), I noticed that in this earlier post applying the same model, I had promised a more detailed discussion of indifference curves. Some sixteen months on, it must be time for me to make good on that promise. So, here's the explanation that I have developed over a number of years, that I use to explain indifference curves in my ECONS101 class.

We'll start by limiting ourselves to one application of the constrained optimisation model - the model for consumer choices. Next, we need some assumptions. We'll assume that the goal of the consumer is to maximise their utility (their satisfaction, or happiness). We'll also assume that the consumer is only buying two goods, Good X and Good Y. And finally, we'll assume that more of each good is always better than less (so, having more of a good will always increase the utility of the consumer). [*]

We can represent the possible bundles of goods that the consumer might choose to consume in a diagram, as shown below. Consider one bundle of goods roughly in the centre of the diagram, Bundle B, which includes XB of Good X, and YB of Good Y.

Now, let's compare Bundle B with other bundles of goods that the consumer might choose. That is shown in the diagram below, by separating the diagram into four quadrants using dotted lines. Now, think about the comparison of Bundle B with bundles in those other quadrants. All of the bundles of goods that lie in the grey shaded quadrant up and to the right of Bundle B must be better than Bundle B (in the sense that they provide the consumer with more utility). That's because those bundles of goods either contain more of Good X, more of Good Y, or more of both goods. And more is always better (higher utility) than less. Next, all of the bundles of goods that lie in the grey shaded quadrant down and to the left of Bundle B must be worse than Bundle B (in the sense that they provide the consumer with less utility). That's because those bundles of goods either contain less of Good X, more of Good Y, or less of both goods. And because more is always better, less is always worse.

What about the other two quadrants? The bundles of goods in those quadrants are not obviously always better, or worse, than Bundle B. To get our head around those, let's draw a big circle around Bundle B, as shown in the next diagram below. Now, think about what happens in the comparison of bundles of goods, as we move anticlockwise around the circle, starting with Bundle D. Bundle D must be better than Bundle B (because Bundle D has more of Good X than Bundle B). That is also true of every bundle of goods as we move around the circle to Bundle E, which is also better than Bundle B (because Bundle E has more of Good Y than Bundle B). Then, we continue around the circle to Bundle F, which is worse than Bundle B (because Bundle F has less of Good X than Bundle B). Somewhere along the way between Bundle E and Bundle F, we moved from bundles of goods that are better than Bundle B to bundles of goods that are worse than Bundle B. So, somewhere along that part of the circle is a bundle of goods that is just as good as Bundle B (because it provides exactly the same amount of utility to the consumer as Bundle B does). Let's say that bundle is Bundle A.

Now, let's go back to our circle. Bundle F was worse than Bundle B. That is also true of every bundle of goods as we move around the circle to Bundle G, which is also worse than Bundle B (because Bundle G has less of Good Y than Bundle B). Then, we continue around the circle to and back to the start at Bundle D, which we recall is better than Bundle B. Somewhere along the way between Bundle G and Bundle D, we moved from bundles of goods that are worse than Bundle B to bundles of goods that are better than Bundle B. So, somewhere along that part of the circle is another bundle of goods that is just as good as Bundle B (because it provides exactly the same amount of utility to the consumer as Bundle B does). Let's say that bundle is Bundle C.

Now, we could repeat this exercise for other circles that are larger, or smaller, than the circle we drew above. And in every case, we would find that there are two bundles of goods on each of our new circles that are just as good as Bundle B - one bundle in the top left quadrant, and one bundle in the bottom right quadrant. If we then draw a curve that joins up all of those bundles of goods that are just as good as Bundle B (because they provide exactly the same amount of utility to the consumer as Bundle B does), we would have a curve that we call the indifference curve. That is shown in the diagram below, and is labelled I0.

It's called an indifference curve because the consumer is indifferent between any of the bundles of goods on that curve, because all of the bundles of goods on the curve provide the consumer with exactly the same amount of utility). If we gave the consumer the choice between Bundle A and Bundle B, they wouldn't care which one they were given - they are indifferent between those two options. Similarly, if we gave the consumer the choice between Bundle B and Bundle C, they would be indifferent. And if we gave the consumer the choice between Bundle A and Bundle C, they would be indifferent. And the same for any other bundle of goods on that indifference curve I0.

So, now you can see where we get indifference curves from. They are a necessary feature of all constrained optimisation models, not just the constrained optimisation model for the consumer. For example, in my ECONS101 class, we also briefly look at the constrained optimisation model of the worker, and the constrained optimisation model of the saver, and both of those feature indifference curves as well. Now, you may be wondering why we draw indifference curves as curves, rather than straight lines. I'll address that point in my next post.

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[*] If this assumption didn't hold, and having more of a good made a consumer worse off, it wouldn't be a good, it would be a bad. We can draw indifference curves for bads. The same principles apply, it's just that higher utility is not up and to the right anymore.

Fuel price increases revisited, and the Law of Demand

Last week, I posted about the incentive effects of a fuel price change, noting that:

When the price of petrol went up on 1 July this year, it created an incentive for people to consume less petrol.

Now that I've covered the consumer choice model (or the constrained optimisation model for the consumer) in my ECONS101 class, it's time to revisit what happens when the price of fuel goes up, from the perspective of a fuel consumer. I'm not going to go through the basics of the consumer choice model here though, as I did that in this post about kūmara prices last year, so refer to that for the basic setup of the model.

The consumer choice model for the fuel consumer is shown below. The consumer can choose to buy a bundle of goods that includes some quantity of fuel (measured along the x-axis) and some quantity of 'all other goods' (AOG; measured along the y-axis). The starting point for our consumer is shown in black. The straight line that runs from M/Pa to M/Px0 is the consumer's budget constraint when the price of fuel is low (Px0). The consumer is trying to get to the highest possible indifference curve, which is the indifference curve I0. The consumer buys the bundle of goods E0, which contains X0 fuel.

Once the price of fuel goes up (to Px1), the budget constraint pivots inwards (shown by the red budget constraint, which runs from M/Pa to M/Px1). The consumer can no longer buy the bundle of goods E0, because it lies outside the consumer's budget constraint (it is outside the consumer's feasible set). Now, the highest possible indifference curve that the consumer can reach is the red indifference curve I1. The consumer buys the bundle of goods E1, which contains X1 fuel.

So, this model shows that when the price of fuel increases (from Px0 to Px1), the consumer decreases the amount of fuel that they buy (from X0 to X1). That is the Law of Demand, which is one of the most robust findings in economics. And it is clear that the consumer choice model demonstrates the same incentive effect of the fuel price increase that I discussed in my post about fuel prices last week.

Read more:

• The incentives associated with an anticipated fuel price change

It's good to be different, or why firms differentiate their products

This week in my ECONS101 class, we are covering the decision-making of firms with market power. When firms have market power that means that they have some control over the price of their product. Some firms gain market power through barriers to entry into their market - there is something that keeps competitors out of the market. However, most firms don't benefit from barriers to entry. Instead, most firms derive market power from differentiating their product from the products sold by their competitors. In this post, I'll demonstrate why it is that firms differentiate their product, using the consumer choice model, and assuming that there are only two firms (one firm selling Good X, and one firm selling Good Y).

Before we get that far though, let's consider what would happen if we had two firms selling identical products (what we refer to as perfect substitutes). In that case, the consumer is indifferent between the two firms' products. Since they are identical, the consumer doesn't care which firm they buy from. In that case, the consumer will obviously buy from whichever firm is selling their product for a lower price, and will buy nothing from the firm that has the higher price.

This situation is shown in the diagram below. The consumer's indifference curves are shown by the two red lines, I0 and I1 (with I1 representing a higher level of utility, or satisfaction, for the consumer). The indifference curves are straight lines when the two goods are perfect substitutes (so the consumer doesn't care about how many of each good they have, only how much they have of both goods in total). The consumer's budget constraint is shown by the black line. The budget constraint is relatively steep, which means that the price of Good Y is relatively lower than the price of Good X. The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, (it's on the highest indifference curve that they can reach, I1), where the consumer spends all of their income on Good Y, and spends nothing on Good X. This makes sense, given that Good Y and Good X are exactly the same good, and Good Y is relatively less expensive than Good X.

Obviously, the situation in the diagram above is not good for the seller of Good X. How could they respond? One thing that they could do is lower their price to match the price of Good Y. That would cause the consumer's budget constraint to pivot outwards and become flatter (just like in this example). They could even make their price lower than the price of Good Y, capturing all of the market. Of course, there is little to stop the seller of Good Y from then lowering their price as well. This sort of a price war is not good for either seller, and could continue until neither seller is able to make any profit at all (which is the case in a perfectly competitive market).

A better option for the seller of Good X arises when they recognise that the real problem here is that the two goods are identical in the mind of the consumer. The two goods are perfect substitutes. If the seller of Good X can somehow convince the consumer that the two goods are different rather than identical, then they may be able to keep some sales, even if the price of Good X is higher than the price of Good Y.

This situation is shown in the diagram below. When the goods are differentiated, the consumer's indifference curves are curves (not straight lines - straight line indifference curves only happen when the goods are perfect substitutes). The highest indifference curve that the consumer can get to is I1'. They will buy the bundle of goods E1, which contains Y1 of Good Y, and X1 of Good X. Even though Good X is relatively more expensive, the consumer chooses to buy some of it.

So, how do firms differentiate their products? There are many ways, but one of the most common is through branding. By branding their product, firms demonstrate that their product is different in at least a superficial way to the products of their competitors, setting it apart in the minds of consumers. For example, petrol sold by petrol stations from different chains is the same good, regardless of which chain it is purchased from. The petrol stations are differentiated from each other by their branding (as well as by their locations, and by the additional services that they offer in addition to petrol). Supermarket brand cornflakes are often the same cornflakes that are in the boxes of leading brands, just in a different coloured box. And so on.

There are lots of examples. Some firms are good at differentiating themselves, while others are not so good. Ceteris paribus (holding all else constant), the more differentiated a firm's product is from its competitors, the more market power it will have. And that makes the example in the photo below difficult to understand. This photo was taken at the Chapel Downs shopping centre in Flat Bush in January (although the situation there has been the same for many years [*]). You may need to zoom in to see the detail in the photo. However, let me explain what is going on. I've circled the names of three stores. The one on the left is called No 1 Supavalue Supermarket. The one in the middle is called Supavalue Supermarket. The one on the right is called Super Value Supermarket. To be clear, all three stores are in the same shopping centre. This is NOT how you differentiate yourself from your competitors.

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[*] I took this photo during fieldwork, that I have been repeating in January each year for the last fifteen-plus years. The situation I describe here has been present for most of that time. I only captured it in a photo this year.

Kūmara prices, consumer decision-making, and the Law of Demand

Yesterday I posted about kūmara prices increasing, and the impact of that on the markets for kūmara and potatoes. This week, my ECONS101 class will be covering constrained optimisation, and the main application of the general constrained optimisation model that we will be looking at is the consumer choice model. So, it seems timely to look at the effect of kūmara prices on consumer decision-making, using that model.

Consider the decision-making of a single consumer. [*] The model is shown in the diagram below. The consumer can choose to buy kūmara (measured along the x-axis) or 'all other goods' (AOG; measured along the y-axis). All of the points within the space on the diagram are combinations of kūmara and AOG, which we will refer to as bundles of goods. Now, the consumer's choice of how much of each good (kūmara and AOG) they will buy is constrained by their income (M). This is represented on the diagram by the straight-line budget constraint. The budget constraint starts at a bundle of goods with only AOG and no kūmara at all. At that point (at the top of the budget constraint), the consumer is spending all of their income on AOG, and nothing on kūmara. The maximum amount of AOG the consumer can buy is M/Pa (where Pa is the price of AOG). At the other end of the budget constraint is a bundle of goods with only kūmara and no AOG at all. At that point (at the bottom of the budget constraint), the consumer is spending all of their income on kūmara, and nothing on AOG. The maximum amount of kūmara the consumer can buy is M/Pk0 (where Pk0 is the price of kūmara). Now, the consumer can afford any bundle of goods (kūmara and AOG) that is on the budget constraint or underneath it (we refer to this as the feasible set). Now, for reasons we won't go into here, the slope of the budget constraint is equal to -Pk0/Pa (the relative price of the two goods). Any bundles of goods outside of the budget constraint cost too much for the consumer to afford. Next, we assume that the consumer is trying to maximise their utility. We represent utility on the diagram using indifference curves. So, the consumer is trying to get to the highest possible indifference curve, while choosing a bundle of goods that is in the feasible set. That happens at the bundle of goods E0, which is on the highest indifference curve I0, and which includes K0 of kūmara and A0 of AOG. The consumer can't get to any higher indifference curve than I0, because any higher indifference curve than I0 wouldn't be touching the budget constraint (and so there would be no bundles of goods on the higher indifference curve that are within the feasible set). That is the basic setup of the consumer choice model, and it shows what the consumer will buy given their income (M), the prices of the goods (Pk0 and Pa), and the consumer's preferences for the two goods (shown by the indifference curves).

Now, consider what happens when the price of kūmara increases (as discussed in yesterday's post) from Pk0 to Pk1. The budget constraint is affected first. If the consumer was only buying AOG and no kūmara at all, then the change in the price of kūmara would not affect them. The point at the top of the budget constraint remains the same. However, if the consumer were only buying kūmara (and no AOG at all), then they would now be able to buy less kūmara. This is represented by the new point M/Pk1, which is a smaller quantity of kūmara than M/Pk0. The budget constraint pivots inwards and becomes steeper. The steeper budget constraint makes sense, because its slope is now equal to -Pk1/Pa, which is a larger number (in absolute terms) than -Pk0/Pa (and larger numbers mean steeper slopes). The problem for the consumer is that they now can't afford the bundle of goods E0, because it is outside of the new feasible set (it is outside the budget constraint - the consumer can't afford to buy E0 any more). Instead, the consumer will choose the bundle of goods on the highest indifference curve that they can now reach. That is the indifference curve I1, and they will buy the bundle of goods E1, which includes K1 of kūmara and A1 of AOG.

In the consumer choice model, after the price of kūmara increases, the new bundle of goods that the consumer chooses to buy contains less kūmara. So, consumers will respond to the increase in the price of kūmara by buying less kūmara. This is what economists refer to as the Law of Demand, one of the most important empirical regularities in economics.

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[*] I haven't explained all of the moving parts of the consumer choice model here. In particular, I'm leaving a detailed discussion of indifference curves for a future post. However, if you need a bit more detail, try this explainer.

Costco and two-part pricing

This week in my ECONS101 class, we covered pricing strategy. One pricing strategy that many firms use is two-part pricing. A firm uses two-part pricing when it splits the price into two parts (there is no mystery in why it is called two-part pricing!): (1) an up-front fee for the right to purchase; and (2) a price per unit. If the consumer wants to buy any of the product, they must first pay the up-front fee. We can think about two-part pricing first by contrasting it with a profit-maximising firm with market power that is pricing at a single price-per-unit, as in the diagram below (for simplicity, I'll use a constant-cost firm).

The firm with market power selling at a single price-per-unit selects the price that maximises profits. This occurs where marginal revenue is equal to marginal cost, i.e. at the quantity QM. To sell that quantity, they set the price at PM. The producer surplus (profit) the firm earns is the rectangular area CBDF.

However, if the firm switches to two-part pricing, then they can charge an up-front fee for consumers to access the market. The maximum that consumers are willing to pay to access the market will be equal to their consumer surplus (the difference between what the consumer is willing to pay, and the price that they actually pay). The consumer surplus is the consumer's economic rent - it is the surplus they receive from having the opportunity to buy the good or service. So, the maximum that the firm could charge as an up-front fee is the amount of consumer surplus. With the price set at P0, this is the area ABC, in which case profits (combining the original producer surplus plus the up-front fee) would now be the combined area ABDF.

The firm can do even better than that. Profitability is all about creating and capturing value. So, if the firm can create more value (by increasing the consumer surplus), they can capture more profit (by increasing the size of the up-front fee). So, by lowering the price to PS, the consumers would be willing to buy the quantity QS, and would receive consumer surplus equal to the area AEF. By setting the up-front fee equal to AEF and the per-unit price at PS, the firm then increases their profit to be all of the area AEF.

That brings me to my example, Costco, which will shortly open in New Zealand. As this article in The Conversation last week by Megan Phillips (AUT) notes:

Multiple delays and a NZ$60 entry cost have done little to quench enthusiasm for New Zealand’s first Costco, with New Zealanders lining up for more than 90 minutes recently for a chance to buy a membership to the store.

A members-only warehouse retailer, the store will sell a wide range of products including food and grocery items, clothing, electronics, furniture and more. Commentators and people familiar with the brand have claimed the store will disrupt the duopoly that currently dominates New Zealand’s grocery sector.

But to enter the warehouse you must pay a membership fee, set at $60 a year or $55 if you own a business.

Clearly, Costco is employing a two-part pricing strategy here. Notice that the $60 membership fee doesn't entitle customers to anything other than the right to purchase other goods from Costco. The membership fee is the first part of the two-part price, with the second part being the price-per-unit that customers pay when they buy goods in the store.

Now, Costco is deviating a little bit from how we described two-part pricing above, and that is Costco's attempt to overcome one of the problems with two-part pricing. The problem is that two-part pricing only works when the firm has homogeneous demand for their product (to see why, read this earlier post which explains the problem in detail). This means that all consumers have roughly the same demand for the product. This is unlikely to be the case for Costco, because they sell an enormous range of products, and their consumers likely have very different preferences from each other. When demand is heterogeneous (consumers have very different demands or preferences), then two-part pricing tends to encourage low-demand consumers to stop buying (because they don't want to pay the membership fee when they don't buy very much at all), while high-demand consumers buy more but end up spending less in total (because of the lower second part of the price, as per our earlier diagram).

However, Costco has found a way for two-part pricing to work even with heterogeneous demand. Notice that the membership fee is only $60 per year. Consumers will baulk at the membership fee only if their consumer surplus is likely to be less than $60 per year. This is unlikely to be the case for many. This is quite different from the diagram we drew earlier, where the firm increases profits by driving up the size of the up-front fee as much as possible.

So, why have a membership fee at all, if it is set so low? There are a number of reasons why Costco might implement the membership fee. First, it gives Costco customers a feeling of exclusivity. It makes them feel like they are part of a special club. As Phillips notes in that article in The Conversation:

That said, Costco has a massive following. One fanatic even tattooed the Costco’s private label brand (Kirkland Signature) on himself, and other loyal shoppers have proposed or even tied the knot in the warehouse.

The adoration seems to be building in New Zealand with 70,000 followers on a local fan page.

A loyal customer base is quite valuable and profitable for firms. Loyal customers have more inelastic demand for products, allowing prices to be slightly higher. However, Costco maintains its low prices in spite of the opportunity, because its reputation as a low cost store is important for maintaining customer loyalty.

Second, because it requires a membership to buy products from Costco, Costco knows who all of its customers are. It knows what they bought, and when, and how much they were willing to pay (or, more accurately, it knows they were probably willing to pay a bit more than they actually did pay). And Costco knows what their customers didn't buy as well, especially for products prominently on sale.

All of this customer purchase (and non-purchase) data is valuable for developing future pricing strategy. It's the main reason why supermarkets have loyalty cards (it's not out of the goodness of their hearts). And retailers have barely scratched the surface in terms of what is possible with their customer data. As I discussed in my ECONS101 class today, it may not be too long before retailers remove price stickers from their products and from the shelves, and ask customers to scan a QR code or use an in-store app to find the price. When that happens, you will know that the retailer has adopted personalised pricing (first-degree price discrimination). Costco isn't there yet either, but give it time.

Alarmism about global food prices misses an important part of the story

I was surprised when I read this article in The Conversation this week, by Alastair Smith (University of Warwick):

Global food prices shot up nearly 33% in September 2021 compared with the same period the year before. That’s according to the UN Food and Agriculture Organisation (FAO)‘s monthly Food Price Index, which also found that global prices have risen by more than 3% since July, reaching levels not seen since 2011.

The Food Price Index is designed to capture the combined outcome of changes in a range of food commodities, including vegetable oils, cereals, meat and sugar, and compare them month to month. It converts actual prices to an index, relative to average price levels between 2002 and 2004. This is the standard source for tracking food prices – nominal prices, as they’re known, which means they’re not adjusted for inflation.

While nominal prices tell us the monetary cost of buying food in the market, prices adjusted for inflation (what economists call “real” prices) are much more relevant to food security – how easily people can access appropriate nutrition. The prices of all goods and services tend to rise faster than average incomes (though not always). Inflation means that not only do buyers need to pay more per unit for food (due to its nominal price increase), but they have proportionately less money to spend on it, given the parallel price increases of everything else, except their wages and other incomes.

Back in August, I analysed the FAO’s inflation-adjusted Food Price Index and found that real global food prices were actually higher than in 2011, when food riots contributed to the overthrow of governments in Libya and Egypt.

The idea that "the prices of all goods and services tend to rise faster than average incomes" is flat out wrong. If it were true, then real wages would be declining, and so would living standards. But they're not (see the figures on pages 31-32 of the latest ILO Global Wage report for data covering 2006-2019). It gets worse though. On his blog (which The Conversation article links to), Smith wrote (emphasis in the original):

Sadly, while more precise than previous accounts, this messaging still misses the simple statistical observation that obliterates the relevance of this coverage. Reviewing the “real” price of food over time – expressed as an index relative to a base year, rather than the nominal value in currency, which makes comparison harder due to inflation – the only relevant way to capture today’s status of global food prices is to say that:

‘It is on average harder to buy food today in 2021, than it has been since 2012, and in fact for most of the noughties, the entire decade of the 1990s, and the 1980s; most of the 1970s, and every year of the 1960s! Food is more expensive today than it has been for most of the modern recorded history’.

Not only is it wrong, it's alarmist and wrong. It doesn't even take much economic sense to see why it is wrong. Consumers' decisions about how much food to buy depend on three things: (1) food prices; (2) the consumers' incomes; and (3) the consumers' preferences. If consumers' preferences haven't changed, then the amount of food that consumers buy depends on prices and their income.

If food prices go up, then consumers will buy less food. This is essentially the argument that Smith makes. However, if consumer incomes go up, then consumers will buy more food (because food is what economists call a normal good - that's a good that, by definition, consumers buy more of when their income increases). So, if food prices go up and consumer incomes go up, then consumers may buy less food, or they might buy more food. It crucially depends on how much consumers respond to the change in price, and how much they respond to the change in income. I'll come back to this point using an economic model a little bit later in this post.

But first, on his blog Smith has a figure that demonstrates that the Global Food Index (which tracks the real price of food, and is available here) is about 16.7 percent higher in 2021 than it was in 1961. However, global real gross national income (GNI) per capita (a measure of income per person) more than doubled between 1971 and 2019 (see the World Bank data here). Here's a graph that compares both series (GNI per capita, and Global Food Index) in terms of increases relative to 1971 (when the GNI data series starts). It is clear that incomes have risen far more than food prices over that time. So, it's hard to see how the data supports a claim that "It is on average harder to buy food today in 2021, than it has been since 2012... most of the 1970s, and every year of the 1960s!". Such hyperbole is completely unwarranted.

The comparisons that are made do matter. Food prices in 2021 are 21 percent higher than the average of 2014-2016, but incomes haven't grown nearly as much over that time period (GNI per capita increased by 8.8 percent from 2014-2019, and won't have grown enough in the past two years to match the food price increase). That change over recent years might support Smith's rhetoric (although the alarmist tone is arguable), but his use of the longer time period clearly does not. However, it's not really global food prices that matter for the destabilisation of societies, but local food prices in those societies. Smith could have crafted a much more compelling story by focusing on local changes rather than global.

Anyway, now we come to the economic model I promised earlier (which is the consumer choice model, and useful for ECONS101 students). This model is illustrated in the diagram below, which shows food on the x-axis, and 'all other goods' on the y-axis. The consumer buys a bundle of goods that is made up of food, and all other goods. When the price of food is low (PF0), the black budget constraint applies. The optimising consumer's best affordable choice is the bundle of goods E0, since it is on the highest indifference curve the consumer can reach (I0), while remaining within their feasible set (on the budget constraint). The consumer is buying F0 food. When food prices increase (to PF1), the budget constraint pivots inwards to the blue line and becomes steeper. The consumer can no longer afford the bundle of goods E0 (it is outside of the feasible set), so their new best affordable choice is the bundle of goods E1, since it is on the highest indifference curve the consumer can now reach (I1), while remaining within their new feasible set (i.e. on the new budget constraint). The consumer is worse off, because they are now on a lower indifference curve (which means that they receive less utility, or satisfaction, from their consumption), and they buy less food (F1).

When the price of food increases, there are really two things going on for the consumer. First, there is a substitution effect. Food has become relatively more expensive than all other goods, so the consumer buys less food (and substitutes some of their consumption to all other goods instead, because they have become relatively cheaper). Second, there is an income effect. The consumer's real income (or purchasing power) has decreased - they can afford to buy less in total than they could before. Since food is a normal good, the consumer buys less of it (and since the composite 'all other goods' is also a normal good, they also buy less of all other goods as well - the income effect explains why the increase in the price of food causes the consumer to buy less of all other goods, as well as less food). [*]

However, we are not done. Remember that, in addition to increasing food prices, consumer incomes have increased. If we compare the 1970s with today, the increase in income is far larger than the increase in food prices. This is illustrated in the diagram below (which also shows the situation from the diagram above). The red budget constraint shows the combined effect of the increase in prices to PF1 (the budget constraint becomes steeper) and the increase in consumer income to M2 (the budget constraint moves outwards, parallel to the budget constraint with the new food price). The consumer could have kept buying the bundle of goods E0. They won't though, because they can now reach a higher indifference curve (I2), by buying the bundle of goods E2. The consumer is much better off than before, because they are on a higher indifference curve (which means that they receive more utility, or satisfaction, from their consumption), and notice that the net effect is no change in food purchases at all (the consumer still buys F0 food).

Now consider the change over the more recent period from 2014-2021. This is shown in the diagram below. The food price has increased and consumer income has increased, but the increase in consumer income is now much less (to M3). The consumer cannot continue to buy the bundle of goods E0, because it is outside of the feasible set. Their new best affordable choice is the bundle of goods E3, since it is on the highest indifference curve the consumer can now reach (I3), while remaining within their new feasible set (i.e. on the new budget constraint). Their utility has decreased, as they are now on a lower indifference curve than before, and they buy less food (F3) than before.

Changes in food prices do matter for consumer utility (or satisfaction), and a big decrease in utility will make consumers unhappy. Perhaps a big decrease in utility will make consumers unhappy enough to cause civil unrest. However, food prices are not the only thing that matters for consumer utility. Consumers' incomes matter as well, and if consumer incomes increase faster than (or at least keep pace with) food prices, then it is difficult to see why that would be problematic. Focusing on food prices alone misses an important part of the story.

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[*] We could show the income and substitution effects on the diagram, but it isn't necessary for us to do so in order to explain them.

Coke Zero, Coke No Sugar, and the problem of getting customers to change products

The Morning Bulletin reported recently:

In a suburban Sydney supermarket, a women approaches the wall of red that is the Coke aisle.

She picks up a bottle of Coke No Sugar, the new brand the US giant is hoping will win over consumers wary of calorific carbonated drinks.

After a few seconds she puts it down and picks up a Coke Zero instead, the very product Coke No Sugar was supposed to replace. The shelves are stacked with Zero - it's hard to even see No Sugar.

This one interaction, witnessed by news.com.au, illustrates the big problem Coke has - persuading fussy shoppers to forsake Zero in favour of No Sugar.

While in some overseas markets, Zero is no more, in Australia it's stubbornly hanging on taking up far more shelf space than its successor.

Indeed, Woolworths has told news.com.au they want to continue stocking Coke Zero "due to customer demand".

Coke wants us to stop drinking Coke Zero, and switch to Coke No Sugar. However, that creates a problem. To see why, consider a very simple consumer choice model, where the consumers can choose to consume Coke Zero (on the x-axis) or Coke No Sugar (on the y-axis), as in the diagram below. [*] The prices of Coke Zero and Coke No Sugar are the same, so the budget constraint has a slope equal to one (actually -1, since it is downward sloping). Assume the price of both drinks is Pc (though the actual price is not important to this example). The consumer is currently buying the bundle of goods that is on their highest indifference curve (I1), and that bundle is the corner solution E1, where the consumer buys only Coke Zero and none of Coke No Sugar. Coke wants the consumer to buy the bundle E0, which is at the other corner (where the consumer only buys Coke No Sugar, and no Coke Zero). The problem is that the bundle E0 is on a lower indifference curve (I0). Forcing consumers to switch to Coke No Sugar would make them worse off (by making them consume on a lower indifference curve).

The problem is that the consumer in the diagram above views Coke Zero and Coke No Sugar as substitutes, maybe even close substitutes, but not perfect substitutes. Perfect substitutes are goods that are, in the consumer's view, identical. They don't care which of them they have. An example that I use in my ECONS101 class is red M&Ms and blue M&Ms. The consumer probably doesn't care at all about the difference in the colour of M&Ms (unless they're Van Halen); they only care about the total number of M&Ms. With perfect substitutes, the indifference curves become straight lines. In the case of the consumer in the diagram above, the indifference curve would be identical to the budget constraint, and the consumer would be equally happy with any bundle of goods on the budget constraint, including both E0 and E1. In other words, the consumer would be perfectly happy to switch from only drinking Coke Zero to only drinking Coke No Sugar.

So, Coke's job is to convince consumers that Coke Zero and Coke No Sugar are perfect substitutes. That seems to me to be a difficult task, since if the two products were identical, why replace the old one with the new one at all? And many consumers probably feel the same way. So Coke is probably left in the uncomfortable position of having to make its customers a little bit less happy, if it really wants to get rid of Coke Zero.

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[*] In this very simple model, we are ignoring that the consumer can buy other products as well as Coke Zero and/or Coke No Sugar. You can think of it as assuming that consumers have a fixed budget for those two varieties of Coke.

Preferences over statistical and economic significance

It's been a couple of years since I read Ziliak and McCloskey's "The Cult of Statistical Significance", but I must have put aside this paper by Erik Thorbecke (Cornell) at the time to read later (I don't see an ungated version, but it appears it might be open access), and I just ran across it again last week. In the paper, Thorbecke looks at Ziliak and McCloskey's argument that economics researchers should focus more on economic significance (what Z&M term "policy oomph"), and less on statistical significance (I reviewed the Ziliak and McCloskey book here, a couple of years ago).

What struck me about Thorbecke's paper though was that he demonstrated the difference in preferences between economists with a greater preference for economic significance, and economists with a greater preference for statistical significance, using indifference curves. Which is timely, given that we only recently covered the consumer choice model in ECON100. Here's the key figure from his paper:

The two 'goods' over which economists preferences are defined in this model are economic significance (on the x-axis) and statistical significance (on the y-axis) (for more on the distinction, see my earlier post on the Ziliak and McCloskey book). The upper panel (A) shows economists with a greater preference for statistical significance. Notice that the indifference curves are relatively flat. We know from ECON100 that the slope of the indifference curve is equal to the ratio of marginal utilities (-MUx / MUy). In this case of economists with a greater preference for statistical significance, the marginal utility of x (economic significance) is relatively low and the marginal utility of y (statistical significance) is relatively high (since these economists would prefer more statistical significance, rather than economic significance), so -MUx / MUy is a small number (i.e. a flat curve).

The lower panel (B) shows economists with a greater preference for economic significance. Notice that the indifference curves are relatively steep. In this case of economists with a greater preference for economic significance, the marginal utility of x (economic significance) is relatively high and the marginal utility of y (statistical significance) is relatively low (since these economists would prefer more economic significance, rather than statistical significance), so -MUx / MUy is a large number (i.e. a steep curve).

Notice that, despite the difference shapes of the indifference curves, both groups of economists would prefer more economic significance and more statistical significance. That is, both groups prefer indifference curves further up and to the right. They just differ in terms of which of those two 'goods' is more important.

Where's the budget constraint? I don't think there is one, at least not in the sense of a continuous line like we see in the basic consumer choice model from ECON100. However, there may still be a trade-off between economic significance and statistical significance in the 'preferred' model that we report in any given research paper. And the economists with the preferences in Panel (A) would be more likely to prefer the model with more statistical significance, while the economists with the preferences in Panel (B) would be more likely to prefer the model with more economic significance.

Who is right, of the two groups of economists? They both are. In the model, the two groups of economists make decisions based on their own preferences, maximising their utility (by attaining the highest possible indifference curve - the highest level of utility). In his paper, Thorbecke concludes:

Ultimately, the determination of economic importance is an issue that can only be approached within a specific context and should be left to the (subjective) judgments of individual researchers.

Which would be based on the shape of their individual indifference curves.