Author: Joshua Gans

The law of demand still holds

If you want to make a point that people are spending more and more on things they do not need (for the purposes of conspicous consumption), do you have to use bad economics to justify your case? Surely not.

In today’s Age Sunday Magazine, there was an article about what exorbitant prices people will pay for things. It quoted Clive Hamilton (of the Australia Institute) who has written a book, Affluenza: When Too Much Is Never Enough. He is quoted as saying:

People are prepared to pay more for a product if the price is higher, regardless of intrinsic value. … Economists think a market becomes more limited as the price goes up but today that is just not true.

Now it is true that economist’s tend to believe in the law of demand: as you increase price, fewer people will buy. But this may not be the case for everything. Economists since Giffin have recognised the possibility that in some situations the law of demand may not hold (e.g., if price rises for margarine, people have more to spend and switch from margarine to butter). For other situations, price can be a signal of quality and so firms with high quality goods may not wish to drop prices even when there is excess demand (Joseph Stiglitz won a Nobel prize for that insight, so it is hardly obscure).

However, to say that there has been some fundamental change in the economy so that the law of demand is widely violated is simply not plausible. If so, we would see massive inflation and let’s face it, that is not there. We would not see prices fall in the face of competition but we see that all of the time (e.g., telecommunications and computer equipment).

What is true is that firms are using product differentiation — selling high and low quality versions of a product — to price discriminate. But it is still the case that as they increase price for the high quality product, they reduce their sales of it.

My point is that the law of demand can work just fine and we can still worry about conspicuous consumption leading to problems. For an example see Robert Frank’s excellent book, The Winner Take All Economy (published a decade ago).

Nonetheless, I did find the Age article enlightening on other fronts. For instance, it turns out there is significant demand for Kinder Surprise collections. Before we had children, we engaged in some definitely non-conspicuous, but significant, consumption of these chocolate eggs and have kept most of the toys that came with them. I’ll be digging out the collection this afternoon for a visit to eBay to see if I can be surprised further.

Paying for Serenity

Last night we watched the DVD of Serenity, the movie/next episode of the Firefly television series. That series was cancelled after just 13 episodes but has been a big seller itself on DVD. But the movie was a surprise hit as well. And it was excellent by the way (well above average for an already good series).

What is interesting about this is that Firefly has been able to do what few before it have done: fail on free to air television and make money from a pay per view model. Of course, the biggest prior success for this model was Star Trek (and by this I mean the original series; also cancelled and later making a comeback at the movies).

With the cancellation of The West Wing, fans are lobbying for a similar move to pay per view. Their rationale is based on a simple back of the envelope calculation. It currently costs about $6 million to make a West Wing episode. That means that if you charged $1.99 per episode (as on iTunes) then you could break even with 2 million viewers (downloads). At the time of its cancellation there were an estimated 8 million viewers in the US alone, so the economics seem to stack up. (See this article in Slate for a discussion). Change the cast and use some bargaining power and you lower the costs making the case stronger.

Sadly, however, while this logic seems compelling, there is a really big difference between 8 million viewers who don’t have to pay and 2 million viewers who do. Let’s imagine that there is a price to be paid to watch a program on television (say a generous 20 cents). Then for a 1000 percent increase in price, demand would only have to fall by less than three quarters to make the economics worse. In a crude calculation, that translates to a price elasticity of demand of the order of 0.075; making it one of the most inelastic goods pretty much ever. This seems pretty implausible.

Now, I for one would be happy to pay $1.99 or more to watch the West Wing. But I am not sure the market will. But a West Wing movie, that is perhaps another matter. We will need to wait and see.

An iTunes Index for Exchange Rates

A few weeks ago, The Economist published its annual Big Mac Index. This has been a long-standing exercise by that newspaper to examine how close current exchange rates were to purchasing power parity (or PPP). The idea is to take a standardised commodity that is otherwise locally produced and compare prices across countries. According to PPP, exchange rates should adjust so that in the long-run, the purchasing power of a consumer across countries is the same. Big Mac prices (and perhaps Starbuck’s Tall Latte prices) can, therefore, give an indication as to where PPP exchange rates should be.

One feature of Big Mac prices is that they, of course, build in variation in local costs. Put simply, the price of beef is lower in Australia than Japan and always will be. What one really needs is a standardised commodity that is free of variations in local costs.

It occured to me that iTunes individual song downloads were such a commodity. Like Big Macs their pricing is set by a single firm. But unlike Big Macs we can expect that there are no local variations in costs as for a given song it is the same music company that negotiations with Apple. Hence, all price variation is likely to be demand related.

There are many iTunes stores but only six distinct local currency prices (USA, Europe, UK, Japan, Canada and Australia). The following table is my calculation of the iTunes Index and based on today’s exchange rates what the suggested over or undervaluation of each currency (relative to the US dollar) is:


There are two things interesting to note here. First, apart from Canada, iTunes songs are priced at a premium in other music stores. This echoes my observations about the Australian iTunes music store in The Age (4th November, 2005) where I noted the substantially higher prices for all iTunes products (if they were available) in Australia as compared with the US. Second, there is no relationship between the PPP implied exchange rates under the iTunes and Big Mac indeces. Indeed, there isn’t even a qualitative consistency.

What is interesting about all of this is that I suspect it is the iTunes pricing — something that was fixed but also was set as iTunes rolled out — that is a poor predictor of PPP rather than Big Mac pricing that is flexible and also has a longer-term history. This suggests that iTunes may face some painful pricing reallignment in the future. Certainly, I do not expect exchange rates to adjust to resolve the distortion.

Of course, this might also suggest that it is just the US price that was set poorly. For instance, according to the Big Mac prices, the Australian dollar is overvalued with respect to the Yen but for iTunes, there is no overvaluation or undervaluation.

Nonetheless, if I am wrong and Apple based its iTunes pricing optimally on long-term forecasts of exchange rates, then the iTunes Index should outpredict the Big Mac Index for exchange rate movements as it is free of local variation. I guess time will tell on that one.

The earlier the better

Professor Jim Heckman (University of Chicago and 2004 Nobel Prize winner) presented a very interesting lecture on education policy here at the University of Melbourne. The main insight from his work is how effective (and productive in a social rate of return sense) early childhood interventions are. These are not to improve IQ but to prove the ‘softer’ stuff that allows you to make use of your IQ (e.g., motivation, social awareness, etc). What you experience prior to age 6 (!) is apparently critical in this.

His papers are available on the web. But if I relate these findings to those in an earlier blog about IR reforms, I worry if the cost of those reforms is going to be much greater economically than anyone has appreciated to date. Coupled with the government’s lacklustre approach to childcare and we are working in the wrong direction on this one.

Blog links

I thought I’d just take a second to note blogs of people I know out there:

All different, all with interesting stuff.

Restraining parents

Steve Levitt of Freakonomics fame wrote an interesting paper recently that strongly suggested that car seats did not assist in preventing child fatalities in car crashes any more than seat belts. A link to his article and related findings is here.

Now when I proudly brought this excellent piece of econometric research home as evidence as to how we could free up space in the car, I was informed that our household behaviour would not be changing. Car seats all around until they are well beyond 6 years old. Well, we had the seats anyway (4 or 5 by last count between various cars and ages and a total expenditure of $1000).

I suspect that reaction will be similar. Give parents and option and suggest that it will have a marginal improvement in safety and they will demand it in droves. Get some government regulations and it is entrenched forever.

But one wonders how far this might go. Suppose I developed a cocoon type restraint whereby you took said children, put them in a coffin like structure with a little window to look out of and staked them neatly in the boot of the car or SUV. Now I am pretty sure I could get some engineer to demonstate their safety properties. Coupled with an alluring idea of having the kids out of sight while driving (whine free!) and I think this is a winning product.

Parental demand for safety (subject to wealth constraints) seems to me to be unlimited and as close to inelastic as we are ever going to find. Although against this is the fact that we are yet to see the ‘Safe and Silent Cocoon.’ Nonetheless, an issue of public policy makers interested in consumer protection is how to restrain parental purchases of unnecessary equipment. I for one could use some restraint.

Playing the new IR game

In this week’s BRW, David James considers how the game between employers and employees will change under the new industrial relations regime. He quotes yours truely: “Employers can celebrate, but employees shouldn’t have families.” I apparently go on …

When you change who gets what, it will change people’s lives. Take someone who has four weeks leave, and can take two of those and buy it back. The claim is: ‘You don’t have to buy it back, so how can you be worse off?’ But if I am an employer who sees a benefit in having people work for 50 weeks a year instead of 48, who am I going to hire? I am going to hire the people who sell back the two weeks at a good rate, which basically means people without families. That is going to change the work culture of Australia. I find it ironic that a government committed to family values is enacting this kind of legislation.

You might wonder where to find the game theoretical model underlying these views. For this I need to thank a diligent PhD student of mine — Martin Byford — who worked out the bargaining model to analyse the impact of allowing entitlements to be traded. His paper is available here. Utilising an economic model of bargaining (similar to that in my textbook, Core Economics for Managers), he finds that competition in the labour market can mean that these reforms will leave some workers worse off. More importantly, when coupled with minimum wage laws, these reforms may reduce overall efficiency as well. Sadly and perhaps surprisingly, the trade union movement hasn’t shown much interest in these ideas even if the business press has (another irony!).

Martin and I published an op ed piece in The Age last year on this topic (for the non-economist, it is an easier read than the technical paper).

Externalities happen

My Principles of Microeonomics textbook (with Stephen King and Greg Mankiw) uses a dog ‘mess’ example to illustrate the concept of negative externalities. No solution is proposed.

Click here to see the Freakonomics solution. Costly but perhaps effective.

Rembrandts in the playroom

Last year, in a piece for The Age, I wrote about what appeared to be a change at the Lego company as to how they received user innovations.

That article talked about the Lego Factory concept that had users design new lego sets for a share of the royalties. This was a good example of user-based innovation as described by MIT’s Eric von Hippel in his book Democratizing Innovation.

It turns out that that was just the tip of the iceberg according to February’s Wired. User-based innovation has appeared to have infiltrated the whole innovation process at Lego.

News for Econ Students

News for Econ Students

Just to show that I ain’t that evil, here is another blog with interesting exam ideas and other information for economics students.

I particularly liked this post on price discrimination at Starbucks. I’ll have to ask for a ‘secret’ cappucino the next time I am there.