Inflation for the rich and inflation for the poor

A couple of weeks ago, I wrote a post about Statistics New Zealand's new household living-cost price indexes. Overall, these indexes showed slightly higher inflation for those in the lowest income quintile (the lowest income earners) compared with inflation for those in higher quintiles. Xavier Jaravel (Stanford) has a new paper on a similar topic (using U.S. data). From the abstract:

Using detailed barcode-level data in the US retail sector, I find that from 2004 to 2013 higher-income households systematically experienced a larger increase in product variety and a lower inflation rate for continuing products. Annual inflation was 0.65 percentage points lower for households earning above $100,000 a year, relative to households making less than $30,000 a year. I explain this finding by the equilibrium response of firms to market size effects: (A) the relative demand for products consumed by high-income households increased because of growth and rising inequality; (B) in response, firms introduced more new products catering to such households; (C) as a result, continuing products in these market segments lowered their price due to increased competitive pressure.

More evidence that we should be careful how we interpret the overall inflation rate based on a single Consumer Price Index, and that it is probably appropriate for benefits, superannuation, and the minimum wage to be indexed to the median wage (or a similar measure of income) rather than the CPI.

[HT: Marginal Revolution]

Book Review: Micromotives and Macrobehavior

When Thomas Schelling passed away last year, I mentioned that I hoped to read his 1978 book, "Micromotives and Macrobehavior", soon. I'm happy to say that I have now done so, and I even posted a little snippet from it last week. Overall, I think the book has aged really well. There is one chapter where Schelling is essentially talking about choices over the chromosomes in our children, where the technology is well beyond what he had envisaged as being possible, but if one reads that chapter and mentally replaces every instance of "chromosome" with "gene", it still seems to fit very well.

What is the book about? Schelling sums it up best himself, on p.13 (emphasis in the original):

What this book is about is a kind of analysis that is characteristic of a large part of the social sciences, especially the more theoretical part. That kind of analysis explores the relation between the behavior characteristics of the individuals who comprise some social aggregate, and the characteristics of the aggregate.

Schelling is very good at expressing mathematical models in ways that make them relatively easy to understand. That is not to say that you will understand them if you don't understand basic mathematics (especially algebra), only that people who do understand basic mathematics will quickly pick up the ideas that Schelling is putting forward.

There are a number of contributions that this book makes, that are interesting to the general reader. The first is how people sort or segregate themselves, and may do so based on very weak preferences for not being in the minority. This idea (the so-called checkerboard model of segregation) has underpinned a lot of interesting empirical research on ethnic segregation (which one of my PhD students is currently working on as well in a study of ethnic diversity in Auckland). The second contribution is about how people's choices are influenced by the choices of others (as represented by population-level totals or averages). Do you prefer to do the same things as others, or different? The third contribution is analysis of the multi-person prisoners' dilemma, where the payoff to each player in the game depends on the choices made by many others (recall that in the standard prisoners' dilemma, there are only two prisoners). This contribution defies a simple exposition, so I encourage you to read it for yourself.

I also found this bit interesting (in relation to choosing children's genes):

IQ might be treated as a competitive trait; valuable as it may be for its own sake, it may be construed particularly valuable in a competitive society, whether the competition is based on IQ measurements themselves, on the school success to which IQ may contribute, or on competitive success in one's career. If it were widely believed that the genetic mixtures within most parents made it possible by chromosomal selection to raise the expected IQ of a child by many points above what it would have been by chance selection of the chromosomes; and if it became widely believed in certain social classes that nearly everybody was taking advantage of this opportunity; parents might feel coerced into practicing selection not out of any dissatisfaction with the prospective intelligence of their children, but to keep up with the new generation.

This is really interesting since I think it links to Robert Frank's ideas of competition at least in the short term (see for example here) - while the resources necessary to choose children's genes to select for higher intelligence (or alternatively for other desirable physical traits) are scarce (and costly), this is an option that is only available to the wealthy. And only a few genes might be targeted. The middle class then might desire similar selection for their children, and demand increases. To keep their relative advantage in the gene selection process, the wealthy might select on even more genes (a more costly process), and so on. Some food for thought anyway.

Overall, as I noted above this book has aged really well, is still very relevant to many things, and is definitely worth a read.

Students, rental shortages, and renting over the summer

The simple model of supply and demand teaches us that, when there is a shortage of a good, the price should rise. This is easily explained. As shown in the diagram below, if the current rent (R1) is below the equilibrium rent (R0), the quantity of rental properties demanded (QD1) exceeds the quantity of rental properties supplied (QS1). There is a shortage. In other words, at least some of the tenants who want to rent at the current market rent (R1) miss out on a property. So, what do they do? If they are willing and able to pay a higher rent, they could find themselves a willing landlord, and offer to pay slightly more than R1, to ensure they don't miss out. So, tenants will bid the rent up, until eventually the market reaches equilibrium at R0, where the quantity demanded and quantity supplied are both equal to Q0.

Now, consider this story from the New Zealand Herald from earlier this week:

Student tenants have paid thousands of dollars over summer for empty flats and apartments in a bid to secure their accommodation for 2017 as Auckland faces a growing rental shortage.

Occupancy levels reached a record high at Ray White's city branch with tenants continuing to pay rent when they returned home for holidays rather than lose their accommodation.

"A year ago students would end their tenancy in November, go home for the summer and return in February to rent another apartment," Delanie Horrobin of Ray White said.

"Now they are staying on because they are concerned they won't have somewhere to return to."...

"Our waitlist is at a record high of 50 and it is going to get worse with February and March our busiest months."

Peter Thompson from Barfoot and Thompson said there was inevitable price increases whenever rental accommodation was in short supply.

He said the start of the year was always more expensive as students scrambled to find accommodation and families settled for the school year...

"January is always busiest for us and the shortage means rent increases," Thompson said. "Come March the prices should come down."

Whenever students come back into university cities, the demand for rental properties increases, and shortages become apparent (we see the same stories about rents every January, as I have remarked on many times). Rents go up for everyone, but as in the story above, by March the rents have gone down again.

Why would a student be willing to rent over the summer, when they aren't even there? As noted in the analysis above, we expect the rent to increase when demand is high. And if you consider the rental 'price' as the rent paid over a whole year, this is another example of this (albeit somewhat hidden). If in order to secure a rental property a student tenant now has to pay for 52 weeks of rent instead of 40 (because now they pay for November-March as well as the rest of the year), then the annual rent paid by a tenant for that property increases (assuming it would otherwise be both vacant and un-rented over the summer). And we should expect nothing less from landlords. Why would you rent a property to students for 40 weeks, if there are willing tenants ready to rent for the full year?

Read more:

• January tradition continued... Rent increases again
• A January tradition - complaints about rising rents
• Out-of-control rent increases in Auckland - why?

The rise and fall of craft beer?

I was interested in this long article by Michael Donaldson in the New Zealand Herald last week, entitled "End of the golden age of craft beer" (the Herald also had a follow-up editorial the next day). Donaldson writes:

But despite massive growth in the industry, [Epic brewer Luke] Nicholas fears there's a regression of sorts at work - it's almost as hard now to sell beer as it was back in the day when he was knocking on doors until his "knuckles are bleeding".

"The other day I was trying to figure when we were in the 'golden age' of having the right number of breweries and customers and I think it was 2012 - that was the time before all the me-toos started coming on board.

"Every wannabe homebrewer, every person with money who wanted to buy a brewery, every branding guy who says, 'Look at this double-digit growth, I'm jumping on that.'

"People who are doing that now are already late because things are going to get tough."

That bit struck me because it reminded me of a model that we discuss in some detail in ECON100, based on dynamic supply and demand (or what Steven Lim calls in our ECON100 class 'the cyclical patterns model'). Here's how it works.

Consider a perfectly competitive market, as shown in the diagram on the left below. The diagram on the right will track changes in firms' profits over time. Initially (at Time 0) the market is at equilibrium (where demand D0 meets supply S0) with price P0, and firms are making profits π0. Now say there is a permanent increase in demand at Time 1, to D1 (this increase in demand is the discovery of craft beer by hipsters). Prices increase to P1, and firm profits also increase (to π1). There are no barriers to entry (this is a perfectly competitive market), so the higher profits encourage new firms to enter this market (new brewers flood the market, as noted in the quote by Nicholas above). Supply increases to S2 (more producers) at Time 2. Price falls to P2, and firm profits also fall (to π2). This is where we are probably heading now.

Of course, that's not the end of this little story. Now, at Time 2 profits are low and some firms will exit the market (no barriers to exit because this is a perfectly competitive market). Supply decreases to S3 (fewer producers) at Time 3. Price increases to P3, and firm profits increase to π3. As you can see from the profits over time (in the right-hand diagram), a cycle of high profits-low profits-high profits- etc. is created.

How realistic is this model? If you have a long memory, you may recall something similar in the kiwifruit industry in the 1980s (see for example page 6 of this paper about Katikati). Initially, a few farms made big profits. More farms planted kiwifruit. A few years later, the price collapsed due to oversupply. Many kiwifruit farmers went bust, and investors lost big. There are other similar examples as well, like venison in the 1990s.

All that is required are two things: (1) a perfectly competitive market (or one that is close to it); and (2) some shock to kick things off. In the case of craft beer, is it a competitive market? Remember that the characteristics of a competitive market are: (1) there are many buyers and sellers; (2) all products are homogeneous (the same); (3) information flows quickly and accurately; (4) there is freedom of entry into and exit from the market. The most problematic of these in the case of craft beer is the last one. Is there free entry and exit from the market? Now that craft brewers can simply lease existing plant from other brewers, I'd argue that there probably is low barriers to entry, which makes this market somewhat (but not perfectly) competitive.

There are a couple of other things to take away from the model above. First, a smart player in this market would adopt a 'hit-and-run' strategy. If prices and profits (and the costs of entry) are low, this might be a good time to get into the industry, but if prices and profits are high, this might be a good time to cash out (and bank a large capital gain). Maybe think twice before investing in that new craft brewer, unless you are confident the boom will continue (how confident are you that we haven't yet reached peak hipster?).

Second, the amplitude of the cycles on the right of the diagram gets smaller over time. This is because people are learning, i.e. more people recognising the cycle and trying to take advantage of it, such as by getting out before it hits the peak. Which may go some way to explain the motivations of the previous owners of Emerson's or Tuatara on their decisions to sell out to the major brewers.

Lots of investors got burned in the kiwifruit industry in the 1980s. Will craft beer burn investors next?