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.

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.

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.

Beware of sharp predictions (especially about popcorn)

In a recent Slate article (click here), Steve Landsburg puzzles as to why some hotels bundle internet access for free but movie theatres never bundle popcorn for free. He writes: “… in the real world, popcorn, unlike wireless Internet, is never free.” Landsburg goes on:

 

It’s logically possible that by pure coincidence the
numbers at every movie theater in the world all work out the same way,
while the numbers at hotels work out one way half the time and the
other way the other half. But “pure coincidence” theory is even less
satisfying than the “differential greed” theory. There must be
something I’m missing that makes popcorn essentially different from
Internet access. I remain stumped.Well, here in Australia we can
help him out as the ‘real world’ is different: popcorn is sometimes free.
If you go to those ‘first class’ options such as Director’s Lounge or Gold
Class, the popcorn is free. Of course, your ticket price is higher.

Put here is a more straightforward possibility. Here is a link to an offer I received yesterday from Hoyts. If you pay for your tickets with Visa, the popcorn is free.

So the economic theory that predicts that we should sometimes see free popcorn is correct. It is just Professor Landsburg’s casual observation of the real world that caused a conundrum.