Wednesday, February 22, 2012

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.

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