Wednesday, December 27, 2006

Would You Rather Receive $250 or an iPod?

Telling everyone else how to rationally allocate their money is a pastime enjoyed by economists and non-economists alike. The holiday season, though, always seems to bring about the same piece of advice from economists: give cash, not stuff.

The argument is compelling, at least theoretically. Which would you rather receive as a gift--$250 or an iPod costing $250? If you got the cash, you could always buy the iPod, or you could buy something you liked better. Therefore, the cash must be at least as good as the iPod. Therefore, the cash must be a better gift; QED.

There is at least some empirical support for this argument. From student surveys, economist Joel Waldfogel found that "on average, a dollar that people spend for themselves creates nearly 20 percent more satisfaction than a dollar that someone else spends on them." If this is true of the entire population, Waldfogel estimates that the "deadweight loss of Christmas"--that is, the loss of consumer satisfaction caused by misallocated Christmas gifts--is somewhere between $2 billion and $9 billion per year. (Waldfogel recently wrote a piece about this research in Slate; it was also written up in The Economist a few years ago.)

So why do people give gifts? An answer may lie in a seemingly unrelated area of economics: wages and compensation. Consider the case of Arcnet, a telecom company in New Jersey. Arcnet leases a BMW 3 series for every employee, just as a perk for working there. Why does Arcnet do this? On its website, the firm says, "Even though this is a great place to work with fabulous benefits and great people, the car is a good reason those of us who work here don't have our resumes in circulation. How many of us are ever going to drive this car working for anyone else? The car goes above and beyond anything any employer will ever do for us. We know it and appreciate it." One employee is quoted as saying, "I feel like I won the lottery!"

Now, the same logic applies to Arcnet's BMW offering as to holiday gifts. Suppose it costs $800 per month to lease a BMW 3 series and pay for the other goodies they throw in. Wouldn't Arcnet be able to retain even more workers if it just gave everyone an $800-per-month raise? Then they could lease the car if they wanted to, or get something else they liked better. Yet it's very possible that employees value a BMW more than they would value an additional $800 per month.

Economist Robert Frank suggests that the answer to this paradox may lie in something that goes against the grain of standard consumer theory: people may actually like being constrained to accept a particular gift, rather than being able to "optimally" allocate an equivalent amount of money for themselves. Why? Because sometimes it's nice to get something that your rational self knows you shouldn't choose. As Frank put it in a 1999 New York Times piece, speaking of Arcnet's BMW offer,

Perhaps you'd find it awkward to tell your Depression-era parents that you'd bought a car costing twice as much as a Toyota Camry. Or you may worry that your neighbors would think you were putting on airs if you bought yourself a new BMW. Or perhaps you've wanted to make such a purchase but your spouse insists on remodeling the kitchen instead.

In other words, you can get as a gift something that you couldn't justify buying for yourself, even though you would like to have it.

Both Waldfogel and Frank concentrate on one-way gift giving: Arcnet's employees, after all, don't get Arcnet gifts in exchange for their BMWs. And indeed, if only one person is giving a gift, then cash may very well be king. But if gifts are being exchanged, then a host of new considerations come into play.

Suppose we take Waldfogel's conclusion to heart. To do away with the feared deadweight loss of Christmas, everyone gets everyone cash. Does this make sense? In some cases, almost certainly not--consider the case of a husband and wife who write each other checks from their joint checking account. But more complex issues arise in less straightforward cases. Here are some that I've thought about. Can you think of others?

1. What about parity? If you give someone $20 and they give you $40, what does that mean? Does it in fact make you feel guilty and the other person feel insulted--something that wouldn’t happen if you’d exchanged, say, a $20 necktie for a $40 bottle of wine, both with the price tags removed? (After all, since prices vary from store to store, then in the latter case there’s a non-zero probability that you paid the same amount, even if their worth is different.)

2. What happens when gifts are exchanged more than once? Suppose last year you gave someone $20 cash and they gave you $40 cash; how much should you give them this year? Do you match their $40, or raise it? Does it become like an arms race? (And if, in equilibrium, you give each other the same amount, doesn’t that just leave everyone where they started, but worse off because of the stress and uncertainty?)

3. When non-cash gifts are given, they can be compared on multiple dimensions, making it difficult to say who gave a “more valuable” gift. One may be expensive but standard (jewelry); another might be very inexpensive but heartfelt (a framed kindergarten picture saying “World’s Best Dad”). But cash has only one dimension, making comparisons between gifts easy. Are the benefits of cash in terms of flexibility outweighed by the costs of awkward interpersonal comparisons?


Wednesday, December 20, 2006

Unlikely Experts

Venture capitalists (VCs) are investors who make high-risk investments in young, start-up businesses. Because such start-ups have little, if any, operating and financial history, VCs are often forced to make investment decisions with poor information—and are therefore anxious to get their hands on any bits of information they can. A recent New York Times article reports that many VCs are turning toward an unlikely source for information: their kids.

The article suggests that VCs believe young people are better able to assess new technology and trends than are older people like themselves. There may be merit to this argument, as many new products are designed for the younger generation—for example, social networking sites and mobile gadgets. The article goes on to describe a shift in VC investing research away from strict business and engineering analysis and toward consumer testing. Of course, the extraordinary part is using children's "expertise" to test products and perform business plan and market analysis.

While this notion may be new to the VC industry, it is hardly new in the investment world. Peter Lynch, former manager of Fidelity's Magellan Fund, has touted a similar investing approach in what has become known as the "Invest in What You Know" strategy, or sometimes as "common sense investing." Lynch argues that ordinary people possess keen insight on various products, companies, and industries--insight that can be leveraged. In economic parlance, he suggests that ordinary people possess valuable "local knowledge" that can supplant sophisticated quantitative analysis and help them identify undervalued stocks. A new mother will know more about which diapers are most reliable and which baby food infants like the most, just as a teenager will know more about what features a portable game player needs and how easy and fun a social networking site is to use.

Opinions on the efficacy of common sense investing are mixed, but it's hard to argue with Lynch in light of Magellan's performance under his management. Magellan had only $18 million in assets when Lynch took the reins in 1977, but grew to more than $14 billion in assets by the time he resigned as fund manager in 1990. Under Lynch's direction, Magellan averaged a 29.2% annual return and only underperformed the S&P 500 twice during his 13-year stewardship. There's no way of knowing how much of that is attributable to "common sense" as opposed to conventional research, but it's worth noting that Lynch credits much of his success to being able to "think like an amateur."

Discussion Questions

1. Do you think there is merit to the "Invest in What You Know" philosophy? Should this supplant fundamental analysis and valuation?

2. Lynch touted common sense investing for casual investors in a large, liquid, and relatively efficient market. How applicable do you think this attitude is to VC investing?

3. Magellan consistently outperformed the S&P 500 during Lynch's tenure. However, Magellan had significant exposure to international stocks, while the S&P 500 is a domestic stock index. Is the S&P 500 the appropriate benchmark? If not, what sort of benchmark should be used?

4. Do you think Lynch's success was due more to great skill or luck?

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Monday, December 18, 2006

Free Trade and Economists

For over 200 years, economists have advocated free trade. And for over 200 years, economists have come under attack for defending a practice that is accused of benefiting the richest of the rich and hurting the poorest of the poor. When Harvard economist Greg Mankiw wrote that outsourcing would probably be net beneficial for the United States in the long run (Source: Economic Report of the President, 2004), he was greeted with disapproval from both Republicans and Democrats.

And the arguments against free trade are not limited to the political arena. Journalism has also taken a position against free trade. PBS's Frontline has argued that Wal-Mart sells out American jobs by forcing U.S. manufacturers to abandon U.S. factories and set up shop in China in the pursuit of lower prices and higher profits. CNN's Lou Dobbs Tonight portrays free trade as a war against the middle class. The communication gap between economists and non-economists leaves economists fending off critics of free trade from the left and the right.

William Poole, president of the Federal Reserve Bank of St. Louis, offered his thoughts on the communication gap in a 2004 speech to the Trade, Globalization and Outsourcing Conference. Poole argued that people do not see the full benefits of free trade because they do not understand the interactions and connections across multiple markets in the economy. As a result, the public tends to overemphasize the costs of free trade and underemphasize its benefits. He concludes that the media should report trade issues in a fair and balanced manner that requires three sections in every story: who gains, who loses, and what are the net gains to the country.

However, is resorting to the "net gains" argument sufficient to persuade the general public of the benefits of free trade? Perhaps not. Even if net gains are positive, the benefits of free trade are generally dispersed among the population as whole, while the costs of free trade are concentrated among the few. When news reporters want to find the drawbacks of free trade, they know exactly where to go and whom to interview. Empty car factories in Detroit, Michigan and disgruntled workers in Circleville, Ohio leave lasting impressions on the typical voter. The benefits of free trade come in as lower prices at the store. At first glance, $50 off the price of a TV hardly seems worth firing 5,000 TV-factory workers. However, policy should be made on the basis of aggregate cost-benefit analysis rather than the welfare of a few. Suppose those 5,000 workers each lose $50,000 in annual income due to the outsourcing of TV manufacturing jobs to China; and suppose that 20 million U.S. consumers buy TVs each year.

Net Benefit to Trade = ($50 x 20,000,000) - ($50,000 x 5,000)
Net Benefit to Trade = $750,000,000 per year

Critics would emphasize that a worker who loses her job to outsourcing loses "$50,000 per year," while the average consumer only gains by "$50 per TV." But remember that in aggregate terms, the cost savings greatly outweigh the wages lost. Hence, free trade benefits America more than it hurts. And in the long run, those 5,000 workers would be reemployed in more profitable industries. However, the transition from a TV-factory job to another industry is a difficult one that will require time and hard work. The federal government offers trade adjustment assistance to workers in need of new skills. Economists could probably earn more "morality points" by advocating a more generous trade assistance program.

Discussion Questions

1. Critics of free trade often point to the disparity in wages between the U.S. and China. Some go so far as to say that outsourcing exploits foreign workers. If U.S. firms did not have factories in China, would Chinese workers be better or worse off?

2. Economic prosperity is often correlated with pro-Western ideology. Why would the U.S. have an interest in signing a free-trade pact with Peru?

3. Some people obviously benefit more from free trade than others. How can winners from trade compensate the losers? What role should the government play?


Monday, December 11, 2006

Organic, Fair-Trade, and Local Foods

According to the Associated Food and Petroleum Dealers, a traditional Thanksgiving dinner for 10 can cost as little as $36.70, or $3.67 per person. For some UC Berkeley students, celebrating Thanksgiving means paying a lot more--but buying food that is sustainable, organic, local, and ethical (SOLE).

The Berkeley food revolution seems to be catching on in the commercial world as well. Like the SOLE students, a large group of consumers prefer to buy organic, believing that in doing so they are protecting the environment, helping poor farmers, combating global warming, and leading healthier lifestyles. Especially to high-income consumers, these benefits make it worth paying an extra dollar or two for lunch or dinner. The stellar growth of Whole Foods and Trader Joe's, two high-end supermarkets that sell eco-friendly produce, has forced grocery mammoths like Safeway to introduce their own lines of organic foods. However, as The Economist reports, buying organic, fair-trade, and local foods might not accomplish the intended goals.

At first glance, organic foods seem to be net beneficial to the consumer diet and the environment. After all, humans have been eating organic food for most of history, since before the industrialization of food. However, The Economist argues that the health benefits of organic foods as opposed to genetically modified foods are unsubstantiated; that the production of organic foods is massively inefficient; that paying "fair" prices to poor farmers effectively subsidizes their bad agricultural choices; and that exclusively buying locally grown food sacrifices the gains from trade. In general, the article argues, the benefits of eating organic are exaggerated, and the costs are understated.

Discussion Questions

1. What actions does the article recommend to consumers who want to reduce the effects of global warming?

2. Economists generally agree that "real" free trade is a tide that raises all boats. Explain how the United States and the European Union have promoted protectionism in their agricultural sectors. If the U.S. and the EU were to stop subsidizing their own farming industries, how would world agriculture change?

3. Suppose you wanted to compare the costs and benefits of organic versus conventional agriculture. How would you go about doing that?

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Friday, December 08, 2006

Tiger Conservation Revisited

Can we save wild tigers by selling off the parts of their domesticated cousins? Aplia Econ Blog wrote about a New York Times op-ed by Barun Mitra several months ago (see archived link here). Citing the failure of poacher crackdowns and bans on traditional medicine products made from tiger parts, Mitra argued that legalizing trade in tiger parts would eliminate the strong black-market incentives to poach wild tigers. For example, Mitra wants to legalize the sale of body parts taken from farm-raised tigers in China after the tigers pass away. The Chinese tiger "farms" are zoos of sorts, where tourists pay to snap pictures during feeding time.

The basis for Mitra's controversial proposal? Supply and demand. Legalizing the sale of parts from domesticated tiger carcasses would lead to a sharp increase in the supply of such parts to the traditional medicine market, and a subsequent decrease in the prices of products containing tiger parts. The lower prices for tiger-based products, argues Mitra, could significantly weaken the incentive to poach wild tigers. Revenues from the legal market for tiger-based products could even go toward anti-poaching efforts and habitat conservation.

Not so fast, replies Australian economist Richard Damania.

In a recent NPR story on Mitra's proposal, Damania argues that Mitra forgot to consider the demand side of the market. Follow the link to read NPR reporter John Nielsen's write-up of Mitra's proposal and Damania's rebuttal.

Graph I shows the effect of legalizing the sale of body parts from tiger-farm carcasses in the absence of any demand-side effects. As Mitra suggests, the injection of legitimate supply would lower tiger-part prices and weaken the incentives to poach wild tigers. Damania, however, reminds us that the legalization of a formerly banned product would likely increase the demand for that product, since black-market consumption poses legal risks for buyers as well as sellers.

Graph II shows one possible outcome in the event that Mitra's legalization proposal affects both supply and demand in the tiger-parts market. Because more people demand the legal product, the demand shifts to the right and, in this case, wipes out any downward price pressure from the initial increase in supply.

Discussion Questions

1. Taking the demand-side effects of Mitra's proposal into consideration, how do the potential impacts on poacher incentives change? How would the proposal affect poacher incentives if the demand-side effects were stronger than the supply-side effects? That is, how would the incentive to poach change if the proposal caused a bigger shift in demand than in supply? What if the demand-side effects were relatively weak compared to the supply-side effects?

2. Mitra and Damania echo arguments made whenever policymakers consider legalizing a hitherto illegal good or service that many people view as distasteful, dangerous, or taboo. For example, proponents of legalizing drugs argue that the legal drug trade will be safer than the illegal trade. Opponents argue that legitimizing drug use will increase demand--wiping out potentially positive effects on safety.

How is the market for marijuana different from the market for tiger parts? Do you think the legalization of marijuana in the United States would have a greater impact on the supply side or the demand side of the marijuana market? How do penalties for marijuana consumption differ from those for distribution? How do the differences affect your analysis of legalization in the market for marijuana?

3. According to the NPR story, Damania claims that the cost of poaching wild tigers will always be lower than that of raising domesticated tigers on a farm. According to Damania: "That gap is so wide that it can never be closed, even if you factor in the cost of hunting down a tiger in the wild."

Recall that the tiger farms currently exist to attract camera-laden and somewhat bloodthirsty tourists hoping to see the animals feed on live prey. When the domesticated tigers die, their carcasses are destroyed, since the sale of parts is illegal. Is it accurate for Damania to count the entire expense of raising a domesticated tiger as the cost of providing tiger parts in the marketplace? How do you think the costs of poaching wild tigers compare to the marginal cost of providing tiger parts from a carcass on a tiger farm?

4. As the NPR story suggests, poaching is not the only thing threatening wild tiger populations. Habitat encroachment by humans puts pressure on wild tigers as well. Do you share Mitra's optimism about using proceeds from a legal market in tiger parts to finance habitat conservation? If not, what other types of incentive-based policies might help the tiger?

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Tuesday, December 05, 2006

PlayStation 3 and Arbitrage

Two weeks ago, thousands stood in line to be among the first to get their hands on the PlayStation 3. Surprisingly, many of these people who waited through the cold, rain, and snow did not actually want to keep the PS3. They wanted to buy it for $600 and sell it on eBay for twice the price--a profit-seeking behavior known as arbitrage.

Economists define arbitrage as the act of profiting without bearing any risk. A large shortage is the best indicator of an arbitrage opportunity. A shortage occurs when quantity demanded exceeds quantity supplied--in other words, when the number of PS3's that consumers are willing and able to buy at the current retail price exceeds the number of PS3's available in stores. A shortage implies that there are consumers willing to pay more than $600 for a PS3 who were unable to purchase one because they were too busy to stand in line or too far back in the line. Arbitrage is a means to allocate the PS3's from the initial buyers to the people who want them even more than the original buyers.

Discussion Questions

1. Sony should have forecasted the shortages and price bids on eBay for the PS3 because they sold out of other popular consoles when they were first released (PlayStation, PS2, and PSP). Would it be profitable for Sony to eliminate the "frenzy shortages" by pricing high during the first months and lowering prices afterwards? For example, they could charge $1,000 for the PS3 in November and December, but lower it to $600 afterwards.

2. Sony reports that it costs more than $600 to produce a PS3. Why would it be profitable for Sony to sell the PS3 at an initial loss?

3. Why would a gamer prefer to pay $1,200 for a PS3 on eBay rather than standing in line to buy one for $600?

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