Got Lobster?

It’s a good thing I don’t have to watch my cholesterol, because after moving to the Maine seacoast last July, I simply cannot get enough lobster. Though I haven’t had to worry about the health cost of consuming lobster, I have been paying attention to changes in the dollar cost over the course of the season. Monitoring prices doesn’t get any easier for this lobster-loving Mainer because every day on the way to my son’s school, I drive by a sign advertising the current price.

The start of the lobster season coincides with an increase in the demand for lobster as summer vacationers head to the Maine beaches. In York, Maine, alone, the population triples during peak season then drops back down again once the school year begins. An increase in demand means upward pressure on price, while an increase in supply means downward pressure on price.

As lobster season came to a close in the summer of 2012, however, word on the street was that there was a surplus of lobsters. With quantity supplied larger than quantity demanded, downward pressure dropped lobster prices to an astonishingly low $2.99/pound for chix (lobsters weighing between 1 and 1.24 pounds), making lobster in southern Maine cheaper than a good steak at the time.

As lobster season ended and the bitter winter set in, the per-pound price of lobster started to tick upward. This is consistent with the basic model of supply and demand—once lobster season was over, supply decreased which put upward pressure on prices and demand decreased which put downward pressure on prices . Over the last year, it appears that supply changes have been more drastic than demand ones, thus the same good that had cost roughly $3 per pound in the summer cost nearly $10 per pound by March 2013 simply because of changes in supply and demand.

Between summer and winter, supply changes outweighed demand effects in the market for Maine lobsters (as evident in the large increase in price), so I am hopeful that lobster prices will drop in the coming months as supply increases so that I can enjoy my favorite butter conduit once more!

Discussion Questions

1. Using a supply and demand diagram, illustrate the shifts in demand and supply after the lobster season ends. Be sure to pay attention to the magnitudes of your shifts so that the equilibrium price rises as described in the article.

2. If lobster fishermen have a bad catch this summer, what would you expect to happen to the price of lobster in Maine in July?

3. How do fluctuations in the market price for lobster affect other markets for food products such as steak and chicken?

Time is Money

The other day I took my car to the mechanic for what I thought would be a quick maintenance appointment. However, I was sadly mistaken when my bill came in at a whopping $800. Because my knowledge of cars is pretty much limited to things that can be done from the driver’s seat, whatever fluid replacement, alignment adjustment, or component repair the mechanic recommends, I usually pay for with resignation. After reviewing my itemized bill, I wondered whether it really should have cost $30 in labor to replace my windshield wipers, whether my something-or-other-belt really needed to be replaced, or whether I could have perhaps gotten a cheaper set of new tires at Costco. It’s possible (if not quite likely), that a more informed consumer could have saved hundreds of dollars on the same transaction. And yet, it’s unlikely that I’ll do anything differently the next time I go in for repairs.

In many aspects of life, there are ways to save money by becoming more informed about what we’re buying or by learning how to do something ourselves rather than paying for the good or service. For example, a friend of mine learned how to fix guitars because, as a musician, this will save him from having to pay for a lifetime of professional repairs. Personally, I like to cook, and thus I save money by preparing my lunch at home rather than buying it at work. However, my musician friend doesn’t like to cook and therefore spends more money on pre-made lunches than I do, and uses the time he saves by not cooking to engage in activities more valuable to him.

This illustrates one of the fundamental principles of economics: we gain from specialization in the face of scarcity because everything has an opportunity cost. In this case, the opportunity cost of becoming more informed about cars is the time I spend learning about cars rather than doing other activities I enjoy. Given the limitations of time and money, no one can become an expert in everything. To be truly self-sufficient would require a return to our hunter-gather roots when we spent the majority of the day finding food, and even then you might want to assign someone to gather the berries, someone else to prepare the meal, another to build shelter, etc.

A common misperception is that economics is aimed solely at maximizing profit. However, a classic application of economics is the study of how people choose to spend their money and time given the limitations they face in order to maximize utility, or a person’s level of happiness. Because there are not enough hours in the day to find the cheapest way to do everything ourselves, we decide to spend our time either doing things we enjoy (that is, that directly give us higher “utility”) or getting paid to do things we are particularly good at (that is, tasks in which we have a comparative advantage). With the money we earn from working, we can then pay others to get the rest of what we want or need.

Discussion Questions

1. What are some of the things you choose to “specialize in” that others pay for? What are some of the things you pay for that perhaps you could do yourself? Are there other reasons for specializing in something besides being good at it or enjoying it?

2. The exact opportunity cost of an activity can be hard to determine, since it is not easy to put a “value” on your time. How is the opportunity cost of time different for someone who earns a fixed salary versus someone who can always choose the number of hours he or she works?

How Much Does It Cost To Make Cookies?

“Buyers know what goods cost.” Some version of that assumption comes up in the very first weeks of just about every introductory econ course. It becomes one of the few assumptions that we make to build the model of consumer demand. But every once in a while, life gets in the way and asks “Is that something you really can assume?”

I had to test that assumption recently. I just moved and after unpacking, I was in the mood to make dessert for myself. Of course, I hadn't brought many kitchen supplies with me, so that quickly posed a problem. To make cookies, I needed to buy some wooden spoons, measuring cups, and a cooling rack. None of those are hard items to find, and I happened to live just minutes away from a shopping center that had a regional grocery store, a Wal-Mart, a Target, and a regional department store. I knew that all four stores should have what I want, so the question of where to go really came down to where it would cost the least. And that’s when I realized that one of the most basic assumptions of microeconomics didn't hold true. I didn't know which store would be the cheapest, or even what the prices of the goods should be!

I had some free time on a Saturday and a strong enough curiosity that I wanted to sample prices from each store. Here’s what I found:

STORE	WOODEN SPOON (Dollars per spoon)	COOLING RACK (Dollars per rack)	MEASURING CUPS (Dollars per cup)
GROCERY STORE	$1.50	$4.50	$1.22
WAL-MART	$2.97	$2.99	$1.32
TARGET	$2.03	$3.67	$4.97
DEPARTMENT STORE	$12.00	$7.00	$7.50

I was also shocked by the spread in prices. While I did expect to see some markup at higher-end stores, the range was wider than I expected. I was also surprised that there wasn't one store that had the cheapest prices, across-the-board, for all the goods.

When economists create models, the goal is to make a few assumptions about the world to describe the “typical” human response and show how that response leads to a “general” outcome. My behavior in this case is not what economists would call “typical.” (My friends might even call it weird!) But even for the typical consumer, are the assumptions of the supply and demand model always appropriate?

In a lot of cases, the classic supply and demand model does gives accurate results, but sometimes the assumption that consumers know the distribution of prices isn't appropriate. In those cases, it’s important to understand how behavior will change if an assumption is violated. The classic model does not involve consumers looking for prices, they just know them. As economists, we often say we are assuming “complete information.” When consumers don’t have complete information the market price typically doesn't match the equilibrium price the model predicts. Most of the time the market will be inefficient (contrary to what the model suggests) and both producer and consumer surplus will be lost.

Throughout economics, every conclusion that we draw from a model depends on the assumptions that are used to build that model. Whenever I learn about a new model, I always list the assumptions made and focus on how the results change if the assumption would be removed. Understanding the relationship between assumptions and results is the critical step to applying what we learn from theory and using it to understand what happens in the real world.

DISCUSSION QUESTIONS: 

1. When I was getting my information I found that stores rarely carry the exact same goods. (Even if they are the same brand, the packaging might be different. It’s why I calculated my information in per unit prices.) Since I was able to find the goods in multiple locations, but they were not identical, which market structure is the most appropriate to describe kitchen supplies: Monopoly, Oligopoly, Monopolistic Competition, or Perfect competition? Why?

2. While my shopping behavior was a bit different than most people for kitchen supplies, people do “search” when they buy certain goods. Name some items where the supply and demand model isn't as appropriate as a consumer search model would be. Why is it more appropriate to think about consumers searching for these goods?

3. An important part of search theory talks about the cost of searching. Suppose I didn't live near a shopping center and the stores were all 20 minute drives apart. How do you think that distance (and the opportunity cost associated with traveling between them) would change my behavior when I search? How would it change the pricing behavior of the stores?

Assumption Corruption

A famous economics joke says it best: A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let’s smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let’s assume that we have a can-opener..."

Though the above example is meant to be extreme, all economic models are based on underlying assumptions. They may pertain to variety of things such as the market structure, pricing mechanism, location, time lags, frictions, mathematical properties, etc., and they are used to simplify economic relationships.  An important assumption that drives many popular economic models is that of perfect information. In particular, models rely on the assumption that the prices of all goods and services are known.

As I was recently perusing the latest status updates of my Facebook friends, I noticed the following post: “How much do you pay a 14-year-old high school freshman as a mother’s helper a few days a week?”

As an economist, one might be inclined to quickly answer “whatever the market price is for that service!” However, it is clear from this post that that information is not actually known to the buyer.

While the internet has clearly helped to alleviate this information gap, it can still take time to gather all the relevant information necessary to make an informed decision. Sometimes, the cost of obtaining this information becomes so high that consumers decide not to research at all. For example, if you want to buy a hair dryer, a quick internet search may result in the same model offered at different stores for different prices, so you still wouldn’t know the relevant price for your needs without more digging.  

Even though the famous supply and demand model does not completely reflect the real world (since it assumes, among other things, that prices are known), this is not meant to imply that economic models are worthless. It would be impossible to model every detail of the “real world”; rather, it's important to make sure the assumptions are appropriate for what you are trying to analyze. For example, if you’re trying to model the effects of an increase in fuel price on consumers’ demand for SUVs, assuming perfect information for prices does not invalidate the results that it will decrease the demand for this good; it merely simplifies the model into something tractable. But in general, you’ll want to ask yourself the following questions when you examine an economic model: Are the assumptions of this model reasonable? Would changing the assumptions affect the result in a drastic way?

In short, be careful not to become a victim of assumption corruption, but don’t let fear of assumptions keep you away from using models at all either!

Discussion Questions

1. Another popular assumption is that agents act rationally and are utility-maximizers. How can this assumption still be valid in the presence of people volunteering their time or donating money?

2. Consider some other assumptions for the supply and demand model, such as price-taking behavior or the competitive hypothesis. How would relaxing those assumptions change the results of the model, if at all?

3. Why do we study economic models that don’t perfectly match our experience in the real world?

4. What are some other markets where the assumption of perfect information does not hold true in the real world?

Crime, Society, and Me

A few months ago, my car was burglarized; the side window was broken and my iPod taken. I had to pay $230 for the window repair and although the 2-year old iPod Touch may only have been worth $100, having it stolen was nonetheless very upsetting. On top of that, my husband had to spend $30 and two hours at a carwash cleaning up glass shards. At the end of the day, this crime incident cost my family about $360, not including the loss of time and music stored on the iPod.

Surprisingly, economic theory provides some comfort. According to the economic theory of crime and law enforcement advanced by economist Garry Becker in his famous 1968 article “Crime and Punishment: An Economic Approach” (www.jstor.org/stable/1830482), the societal cost of this crime is lower than the cost to me personally. Becker modeled societal losses from crime as the difference between damages brought about by criminal activities and gains to offenders, which can be summarized as follows:

Social Losses = Damages brought about by criminal activities - Gains to offenders

The complete theory accounts for the cost society bears to maintain the legal system and law enforcement, and also makes a number of important assumptions (for instance, that gains from crime are subject to diminishing returns). However, more importantly, the theory acknowledges that the person who stole my iPod is a member of society too, so although I lost a total of $360, not all of that value was truly lost. When formulated this way, the economic theory of crime enables law enforcement to calculate the “optimal” sanction. That is, when determining the level of resources to devote to crime prevention and punishment, society must weigh the benefit of reduced crime against the costs of law enforcement, incarceration, etc. If this equation ignores the gains to offenders, then the calculated level of punishment will be too high.  Assuming the burglar can get $100 for my iPod and ignoring the value of the time spent on cleaning and the sentimental value of the lost music, the loss to society equals only $260. The optimal level of punishment for such a loss should therefore be lower than that associated with a true $360 loss.

Moreover, had the burglar been more skillful and stolen the iPod without breaking the car window, my loss would be exactly equal to the burglar’s gain. Certainly, I still would be upset, but in a larger scheme, this event would not create a noticeable effect on societal welfare. Well, the IRS would be unhappy about the situation too, although for a different reason. I can deduct my losses from the next year's taxes whereas, it is highly unlikely the burglar will ever report the gain as a taxable income.

Discussion questions:

1. If my burglar’s income is lower than my income and assuming diminishing returns to income, could this crime incident be viewed as a welfare improving redistribution of wealth?

2. Why wouldn’t societies be better off by increasing expenditures on law enforcement to such a level that there would be absolutely no crime?

3. Would societies be better off by adopting maximum punishment for all types of crime, violent and non-violent property crimes alike?

Who Pays for Online Discounts?

The other day I woke up, looked in the mirror, and decided it was time for a haircut. Rather than picking up the phone and calling the salon where I’ve gone in the past, I checked my email, typed “haircut” into the search bar, and was rewarded with a half a dozen email offers from San Francisco salons selling haircut vouchers at 25%, 50% or even 75% off the regular price. All but one offer had since expired, but I was nonetheless amazed that businesses were offering such steep discounts with such regularity.

Traditional coupons seem to have withstood the test of time as a profitable marketing scheme, but the success of any discounting strategy depends on how coupons are used by both new and existing customers. A primary reason firms offer coupons is to attract new customers, in hopes that after experiencing the quality of the product or service, those who were initially only willing to pay the coupon price will later return and pay the full price. Regardless of whether coupons are offered online or delivered in the mail, however, some will invariably be used by existing customers who would have otherwise paid the full price. Thus, although coupons may generate additional revenues from new customers, they also may reduce revenues from existing ones. While I have been drawn to many new hair salons by their coupon offerings, the widespread availability of these offers has made me far less likely to become a repeat customer. Even if I particularly like a cut at one salon, I’m generally willing to take my chances on the next deal to save 50%.

Fortunately for firms, some customers willingly pay the full price to avoid the hassle coupons entail. This enables firms to separate consumers into two groups based on their willingness to pay, a technique known as price discrimination. If a salon can use coupons to gain customers who are willing to pay less (but instead willing to expend the effort required to use a coupon), and still charge a higher price to customers who are willing to pay more (but won’t bother with coupons), then it can increase the volume of its sales without having to lower the price on all sales. Thus, while it may seem that firms should want their coupons to be as easy to use and widely accessible as possible, the lower the “cost” of  acquiring and using coupons, the less ability the firm has to continue charging the full price to some customers.

Admittedly, there are other factors to this new online market for coupons that may counteract the difficulties presented above; some people buy coupons but never cash in on the services, some of the “discounts” may actually reflect artificially inflated original prices, and not everyone is willing to take a chance on a new salon for each new haircut. In the long run, the market will likely determine whether or not this particular variation of discounting survives, but until then, I’ll continue to take advantage of half-off haircuts.


Discussion Questions

1. How might the analysis above be different for different types of goods and services? Is there a difference between offering deals on things people buy impulsively versus things that people buy regularly?

2. How does the fact that people actually have to purchase many of these deals in advance of using them (as opposed to simply clipping a coupon that you may or may not end up using) affect the market? How might this benefit or hurt the firms offering deals?

3. How strong is the psychological component of coupons? That is, how might consumers respond differently to a regularly priced car wash for $30 versus a coupon offering a $60 car wash at 50% off? What does economics have to say about these different price schemes and how they should affect the market outcome?

4. Suppose there are only two hair salons, how could you use game theory to model their payoffs when they each must decide to offer a coupon or not?

Hunting for a Cheaper Easter Egg

Easter egg decorating was more expensive than usual in Europe this year. According to the Wall Street Journal, the annual spike in egg prices—due to their use in Easter food and decorating—was much higher than usual. Compared to the same time last year, prices were up by more than 75% across the European Union and had more than doubled in Poland, Bulgaria, and the Czech Republic.

What’s different about this year? The beginning of 2012 marked the deadline for implementation of a European Union regulation, first issued in 1999, mandating larger cage sizes for hens. Because egg producers have to buy new cages and then use more space to house the same number of hens and produce the same numbers of eggs, the average cost of producing eggs has increased (assuming that having a larger cage doesn’t increase the number of eggs each hen lays). Consequently, some producers have exited the industry, and the remaining producers require higher prices to produce the same number of eggs.

The graph models the consequences of these demand and supply shifts in the egg market, with D1 indicating the normal, non-Easter demand and S1 indicating the supply without a regulation on cages sizes. “D Easter” reflects the increased demand due to Easter, and “S Reg” reflects the shift in supply due to the regulation on cage size.
Note:
P1: price of eggs outside of Easter season without a regulation on cage sizes
P2: price of eggs during Easter season without a regulation (i.e. what prices would have been during previous Easters)
P3: price of eggs this Easter season—that is, with a regulation on cage sizes
P4: price of eggs outside of Easter season with a regulation on cage sizes

The increased demand for eggs at Easter shifts the demand curve to the right, increasing the price of eggs from P1 to P2. The regulation shifts the supply curve up and to the left, causing a further increase in price (about 75% in this model) to P3. As Easter demand recedes and the demand curve shifts back to normal, the supply curve remains shifted, keeping prices, at P4, above what they were in previous years and, according to this model, above even what they were in previous Easters. The exact price and quantity changes will depend on the size of the demand and supply shifts and the elasticities of the demand and supply curves.

While the hens and those concerned with their welfare indubitably appreciate the improvement of their cages, which now have perches and more bedding, better conditions for chickens means higher egg prices for humans. As always, there’s no free lunch, even (perhaps especially) when it includes eggs.


Discussion questions:

1. How much extra would you pay for an egg produced by hens who got to live in better cages?

2. Assuming that all parts of Europe experience equal shifts in supply (which may or may not be true), what do the larger increases in price in Poland, Bulgaria, and the Czech Republic suggest about elasticity of demand for eggs in those countries relative to Europe as a whole? What other explanations are there for the higher price increase in those countries?

3. California Proposition 2, passed in 2008, requires egg producers in California to provide more room for hens starting in 2015. However, the proposition does not require that California retailers only sell eggs produced in California. What do you think will happen to egg prices in California, egg production in California, and egg production in neighboring states?

Kicking through the Ceiling

In the sports world, it has become cliché for people to say that every second counts. However, we expect that phrase to apply on the field, not to the teams trying to get there. Recently, a friend of mine wanted to register his team for a local kickball league. The registration was online only, starting at noon. He had a problem with his credit card that slowed him down, and by 12:02, all the spots in the league were taken and his team was shut out.

Rather than seeing his misfortune as a sign of kickball’s growing popularity, or the quick typing skills of other kickball managers, the first thing that came to my mind was that the market for league entries must be distorted. The league uses public fields that also need to accommodate other sports and high schools, so time on the fields is limited. Since the kickball league will only have a fixed number of hours on the fields, and since the season needs to accommodate a set number of games, it’s fair to think about the supply of league space as fixed, or perfectly inelastic. Most importantly, even at very high market prices, there is no way to add additional teams to the league.

If limited space were the only constraint on the market, then we could find the equilibrium for the market at the intersection of supply and demand, and thus know the equilibrium price where there are exactly as many teams willing to pay as there are spaces in the league. However, since the league filled up so fast, and teams (like my friend’s) that are willing to pay more than the $500 entry fee are unable to join, it appears that there is an artificial price ceiling in this market. Since the league is publicly run, it is likely that someone decided on a “fair” price to charge, so that entries in the league would be open to people of varying incomes. Unfortunately, price ceilings create shortages, that is, they force some people who desperately want the good to go without it. When goods do not sell for the unrestricted equilibrium price, people who value the entries the most do not necessarily receive them. Thus, the shortage caused by a binding price ceiling will end up lowering society’s total welfare.

Can economic theory suggest a solution that would still offer entries at the “fair” price, but also make sure the entries go to the teams that value them the most? Suppose that the league entries were still given out the same way, but once initially purchased by a team manager, an entry could be resold to a team that did not sign up fast enough, if both parties agree. Teams that got entries and value them at least as much as the equilibrium price will hold on to their entries, but teams that were too slow to purchase them initially will be able to buy them from teams who value them less than the equilibrium price. In terms of the final price and quantity of entries, making the league entries tradable will achieve the same result as removing the price ceiling altogether: the market price for the tradable entries will rise to the unrestricted equilibrium price, and the teams that value them the most will end up in the league. However, setting a lower price initially allows some teams the opportunity to buy that otherwise wouldn’t be able to get them. Society’s total welfare is maximized by either making the entries tradable or removing the price ceiling, the only difference is who earns the surplus. As you can see, there are different ways to maximize society’s welfare. Some can be more complicated than others, but they can accommodate different concerns about fairness.

DISCUSSION QUESTIONS:

1) Currently, the market mechanism used to allocate kickball league entries is first-come-first-served. What behaviors does this sort of mechanism encourage?

2) If league entries are tradable and originally given on a first-come-first-served basis, who would attempt to get the initial entries? Is there a chance people who do not want to have a kickball team might apply for a slot? Under a tradable permit system, does the way the entries are initially allocated affect who receives the most welfare?

3) The Coase Theorem is a public economics result that applies to markets where governments want to reduce pollution. It says that the most efficient way to reduce pollution to any desired level is to give firms in an industry permits to pollute the desired amount, and then allow the firms to trade the permits. Consider the similarities between a fixed number of kickball league entries and a fixed amount of pollution by an industry. What results would you expect to see in the market for pollution permits? What effect would creating that market have on society’s welfare?

Tricky Tax Timing

After my husband signed a contract in October 2011 to work for a Maine hospital, they asked him if he preferred to get his signing bonus immediately or some time in 2012. The seemingly obvious answer was to get the money as soon as possible. As an economist’s spouse, my husband knows that a dollar today is worth more than a dollar tomorrow. However, after completing our 2011 taxes, we discovered that the answer to this question is not as simple as it seems.

While any economist will tell you that the present value of a dollar today is worth more than receiving that dollar in the future, the reverse of this is also true—spending a dollar tomorrow is cheaper in present value than spending a dollar today. To see this, consider the formula for computing future and present values:

Future Value = Present Value x (1 + Interest Rate)^{Number of Periods}
Present Value = Future Value / (1 + Interest Rate)^{Number of Periods}

If we take the money in 2011, we have to pay taxes on it by April 15, 2012; on the other hand, if we take the money in 2012, the tax payment would be delayed by a year, but we’d also get the bonus later.

Further complicating this was our state of residence. In 2011 we were residents of Pennsylvania, so accepting the signing bonus in 2011 meant that we had to pay taxes in Maine as nonresidents (which came out to about 5.5% of the bonus and required that I file taxes in that state when I normally don’t have to). We also had to pay taxes in Pennsylvania as residents (roughly 3%, but you can deduct the Maine payment so you aren’t fully double taxed), and in local taxes to Williamsport, PA (at another 2%). However, if we had waited to accept the payment in the middle of 2012, we would only pay taxes on this income in Maine as residents next April (roughly 8-10% depending on our joint income next year) and not need to file in Maine in 2011.

We were making less money in 2011 than we will in 2012, so we are in a lower federal tax bracket for our April 2012 filing. Our dilemma is whether or not that break plus the value of getting the money today is enough to compensate us for the additional tax liabilities of receiving the money in 2011. Our inability to foresee that taking the money in 2011 would result in a complicated tax situation might have lead us to make a suboptimal decision. Thus, before quickly jumping on the present value bandwagon and taking the money immediately, it’s important to make sure you have complete information about all future consequences of present-day choices.


Discussion Questions:

1. Another factor that led us to take the money immediately is that we plan to use it to pay down some of my husband’s high-interest rate medical school loans. Does this make our decision more or less rational if the interest rate on his loans is above what we could earn in an interest-bearing account? What if the rate on his loan is below what we could earn in interest?

2. Suppose that we received the signing bonus from a hospital in New Hampshire instead, where there is no state income tax for residents or nonresidents. How does this affect our optimal decision?

3. Suppose we were adopting several kids and I was planning to quit my job to become a full-time, stay-at-home mom, putting us in a lower tax bracket in 2012. How might this affect our decision?

Land or Dishes? Dishes, please!

On a recent visit to the Los Altos History Museum with my daughters, I found myself hoping that one day they will appreciate my favorite exhibit: a replica of the wheel-of-fortune used by the Los Altos Land Company in the 1930s. During the Great Depression, the company had a difficult time selling plots in the sparsely-populated apricot orchards that later became Los Altos. That land is now part of the Silicon Valley and among the 100 wealthiest communities in the country, but nobody could have predicted that success back then. To offload the property, the struggling company conducted a promotional contest that took place in San Francisco movie theaters. Participants could spin the wheel to win free stuff, including a choice between a set of dishes and a plot of land in Los Altos. A plot of land was about the price of a set of dishes back in the day and according to the exhibit, most people chose the dishes.

What determined this choice? Economic utility theory tells us that the choice between land and dishes is determined by the marginal rate of substitution between them. However, without more information about the consumer, we cannot deduce the winner’s utility function from owning one more set of dishes or one more plot of land by simply knowing that the prices are equal.
Asset pricing theory—an economic theory that attempts to understand the prices of uncertain payments—can give us more insight into the matter. Land and dishes are assets with different properties. Although both could be viewed as durable goods, the set of dishes qualifies as a consumer good, whereas land is largely treated as investment. This allows us to view this scenario as the choice between consumption and investment (or saving); a decision between the two is determined by the relative prices of the two goods, the utility of the consumption good, future returns on investment, and the rate of future discounting (or the degree of impatience). Even without assumptions about the impatience and preferences for fancy dishes, the seemingly naïve choice of the dishes was fully rational given that investment in farm land did not promise great returns at the time.

Now suppose that the lottery winners knew that in 40 years the area’s booming economy would lead to skyrocketing land prices. As a rational economist, if I was a winner at such an event, would I choose dishes or land? My first reaction is: “Of course in this case, I would pick the land!” On the second thought, however, I realize that there is a very good chance that I still would choose the dishes. In troubled times like the Great Depression, both the perception of risk and the demand for liquidity increased, making the dishes a clear winner. Because a set of dishes could be considered a durable good, it could serve as an asset functioning as a store of value. Also, it is easier and less costly to sell or exchange dishes than a plot of land, thus making dishes a more liquid asset than land. Thus simply knowing in 1931 that the Los Altos land would appreciate in a few decades does not imply that it could be immediately converted into cash when needed. In tough economic times, survival today is often more important than planning for the future. Therefore, I would likely choose in favor of current consumption despite the high expected return on investment.


Discussion questions:

1. What piece of information about the dishes and the plot of land is critical in my decision-making?

2. Suppose that land is as liquid as the dishes. How would this affect the choice between the land and the dishes?

3. Would the same economic reasoning apply if it were a dinner instead of the dinnerware?

4. What would be your choice today if you were presented with a similar set of alternatives? Justify why this choice is the same as or different from most people’s choice for dishes in the 1930s.