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?

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?

Househunters Meets Econ

A famous quip suggests that if you could teach a parrot to say "supply and demand," he could replace 90% of the world's economists. However, what economics is really about is analyzing the decisions people make in the face of scarcity and uncertainty. While the supply-and-demand model does have a wide variety of applications, it also comes with a laundry list of assumptions that give the model its power and tractability. One of these assumptions is complete information about the prices and quality of various goods. But one thing is for sure—in the housing market, there is certainly imperfect information about current and future market conditions.

For example, last week I found myself in an interesting predicament while house hunting. I was faced with two options: I could make an offer on a house currently on the market (going forward we’ll call this House A), with the belief that it was priced-to-sell and thus would likely be unavailable in the coming weeks. Or I could wait a month for more houses to come on the market, thus foregoing House A and incurring additional costs, like the effort to find new houses on the market and travel time to look at houses. This situation is exactly the type of scenario studied by search theory economists.

Search theory is a branch of economics that models markets with search frictions. In this case, “frictions” are the unknowns about what kinds of houses will come on the market in the coming months. You are faced with the choice of either accepting the good you’ve found today (House A) or throwing that choice away and paying a cost to find another choice tomorrow (House B). With some standard assumptions regarding utility and the distribution of houses on the market, the optimal way to shop is to use a reservation strategy; this means that you continue to shop until you find a house that makes you equally or more happy than that of the “reservation house”. This is the house that makes you exactly indifferent between continuing to search and buying it.

Thus, you can imagine my excitement surrounding house hunting. Not only is it fun to peruse the web and schedule showings, but house hunting is a great example of where supply and demand falls short, making room for more appropriate economic models like search theory. In most cases, consumers don’t know with certainty where goods can be found, how much they cost, and if they’re available; rather, they must spend time and money searching for these goods. When people ask me what kind of economics I like to study, my typical response is “the economics of shopping.” Search theory is simply the economic tool I use to describe it.


Discussion Questions:

1. How would you expect the time you have to search for houses to factor into the characteristics of your reservation house? In other words, do you think your level of pickiness will change if you had 3 months left to search versus 12 months?

2. Suppose that you didn’t have to worry about losing a housing option if you decide to search another day. Search theorists called this having “recall” over previous draws. How do you think this affects your “reservation house” if you’re searching over an infinite time period. How about a finite time period such as 12 months?

3. How has the internet alleviated search frictions in the housing market?

4. What other markets might be better explained using search theory as opposed to the standard theory of supply and demand? Why?

Towards Gasoline Market Efficiency

For the past year or so, I’ve been using the same website to save money on gasoline. The parent site of the one I use is Gas Buddy. Commuting to work I spend about $130 per month on gas, or roughly $1,550 per year. There are several reasons for this. Gasoline is one of my biggest work-related expenses, California gas prices are consistently among the highest in the nation, and I’m also an economist. I feel impelled to fill up at the station offering gasoline at the cheapest price, without going significantly out of my way to get there, of course.

Economic theory would typically classify a local gasoline market as a competitive market, yet, I often see differences of 20-25¢ per gallon for the same gasoline grade among nearby stations. Why does the standard model of competition not seem to apply here? Because most consumers probably accept the notion that gasoline of the same grade is nearly identical regardless of the station, competition should drive prices to the same competitive market clearing price. However, gasoline retailers often try to differentiate their product through methods such as affiliated credit cards, which give the holders a discount when they purchase gas with the card from a retailer that is part of the corporate chain. Another strategy they use is to offer a discount on a car wash to consumers who have purchased gas at their station. Nevertheless, it doesn’t seem like such differentiation would be important enough to keep the market from a perfectly competitive equilibrium.

What else might explain these facts? One possibility is that some gas stations employ a strategy of luring customers into their stores with gasoline sold below cost, to sell them high margin convenience goods. Another possibility is that some stations enjoy location advantages that allow them to command higher prices, such as the first station located off of a high traffic freeway exit. Nevertheless, the explanation that I prefer is that gasoline consumers do not have all of the information regarding prices of gasoline in surrounding areas. Websites like Gas Buddy help alleviate this informational deficiency in a nearly costless way thanks to its gas price maps and price lists. As more people use the site, the local gasoline markets covered should theoretically approach a perfectly competitive equilibrium.

Where does the website get its price information? People who are interested in either winning gas cards or making the gas market more efficient have accounts on the site and post gas prices there. Although there are obvious benefits to the information provided by Gas Buddy, there may also be drawbacks to the site. Besides the obvious damage to the profits of gas station companies, there are likely to be people who misuse the information. For example, imagine the user who drives several miles out of his way to fill-up on gas that is only 5 cents cheaper per gallon than the nearest station. This person may save $.75 or so, but environmental costs of the extra driving distance, the cost of the additional gasoline used and vehicle wear, and the value of the person’s extra driving time are likely to sum to significantly more than $.75. So, while getting the cheapest gas is great, remember that there are more to costs than just retail prices.

Author’s note 10/19/09: During her review of this post, Kasie Jean mentioned the possibility that consumers may have gasoline brand loyalties. The author found this unlikely but later received advice from a trusted mechanic regarding the benefits of Chevron with Techron gasoline. The author owns no securities issued by the Chevron corporation.


Discussion Questions

1. Now that you are aware of a gasoline price website, would you use one to locate the cheapest nearby gas prices? Why or why not?

2. Think about the characteristics of perfectly competitive markets. Do you believe that gasoline markets are perfectly competitive? If not, what are some aspects, besides those described above, that keep them from perfect competition?

3. In 2007, a study concluded that the optimal tax on gasoline was $2.10 per gallon. What is your opinion of this conclusion? Do you think that gas price websites would be viewed more if gasoline taxes were significantly higher?

4. In what other ways has the internet made markets more efficient or perhaps less efficient?

The Peculiar Economics of Ratings

Recently, Michelin released a new Red Guide for San Francisco. For those who are not foodies, Red Guides are Michelin’s ratings for restaurants and hotels. Their hotel ratings tend to be ignored, while the restaurant ratings are the subject of a great deal of interest and speculation, particularly in France, where the addition (or worse yet, removal) of a “star” can make or break a restaurant. The Michelin guide also raises some interesting economic questions. The peculiar economics of ratings systems has two sides—the consumer side and the supplier side.

Consumers use published ratings as an information-gathering mechanism, a way of economizing on the costly actions associated with determining the quality of a product that they wish to purchase and consume. This is especially true for goods characterized as experience goods--that is, goods for which the consumer cannot easily ascertain the product’s quality prior to purchase. It's also true for durable goods like cars, or for goods that can only be purchased once, like a college education.

The more expensive a good is, the more incentive a buyer has to invest in information gathering. A meal at the local diner may not warrant the time, money, and effort needed to determine the restaurant’s rating. For a trip out of town or a visit to an upscale restaurant, such an investment may be useful, especially because it can help to reduce the risk of a disappointing experience.

Consumers want clear, objective information from a ratings guide. Advertising cannot convey the same kind of information, since it is (appropriately) perceived to be self-serving. Yet, how much faith can we place in the (presumed) objective information from ratings services, like Michelin or the Zagat’s? Is there a potential problem with these ratings guides that can affect the quality of the information they produce?

Sellers clearly can benefit from a favorable rating in these guides--for many restaurants, it can mean a significant boost to their revenues and provide an avenue to other revenue sources (a great rating could pave the way for the chef to write a cookbook, or these days, have their own TV show). Such a system may create perverse incentives for restaurateurs. A restaurant could alter its menu offerings, change the décor, or upgrade the wine and beverages list to improve their rating, but these changes may change the qualities that originally contributed to the restaurant’s popularity among consumers. Further, this can contribute to a restaurant version of an “arms race” to be the top-rated restaurant in a given city. This may be trivial, but the same logic applies to all sellers who compete for ratings rather than consumers. It is not as trivial, for example, in the case of colleges and universities who expend resources to boost their US News rank, or in the case of schools and teachers who “teach to the test” as opposed to teaching valuable academic skills.

1. What determines how much consumers are willing to spend on a restaurant guide for a city? Would this differ between local residents and visitors?

2. How do consumer ratings differ from advertising? When could advertising provide more useful information than a ratings guide?

3. Some people decry products that are supposedly shaped to win the favor of critics; a great example of this is that many people argue that winemakers produce wines to appeal to the tastes of the powerful wine critic Robert Parker. What’s the flaw in this logic?

4. Whose ratings are more valuable—those of expert reviewers like Michelin or the accumulation of opinions from regular diners?

5. When the Michelin ratings were published, many in San Francisco objected to the rankings. Some commentators argued that the taste of the Michelin writers was different than the taste of Californians. Since not everyone's preferences are the same, does it make sense for there to be one "accepted" ranking system? Would your answer be different if the good in question were surgeons rather than restaurants? Why?

Harold Elder is a Professor of Economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's Masters and Ph.D. programs.