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?

Not-so-sunken costs?

I recently had to decide between going to a concert for which I’d already bought a ticket and attending a dinner party with friends. Initially I was compelled to “get my money’s worth” by going to the concert (it was too late to sell the ticket to someone else), in spite of the fact that I would have preferred to go to the dinner (if I hadn’t bought the ticket). According to the economic theory of sunk costs, however, choosing to go to the concert under these circumstances would have been irrational.

Once a good or service has been paid for, the future costs and benefits of actually making use of the purchase should be compared to the future costs and benefits of alternative options—the cost of the purchase, paid in the past, is “sunk” and should not factor into the decision. Suppose that neither the dinner nor the concert would cost me any additional money, but I predicted the enjoyment I would get from the dinner would exceed the potential enjoyment from the concert. Because the expected future benefit minus the (nonexistent) future cost of the dinner exceeded that of the concert, I chose to go to the dinner.

Choosing to ignore sunk costs, however, is not always easy, in part because it can be difficult to distinguish situations in which the cost is truly sunk from those in which it shouldn’t be written off entirely.

Suppose instead I had been asked to bring a bottle of wine to the dinner. In that case, the fact that I had already bought the ticket meant that I was choosing between a concert that would cost no additional money, and a dinner that would cost me the price of a bottle of wine (say $15). Though I would have had a definite preference for going to the dinner and paying $15 for wine over going to the concert and paying $20 for a ticket, it could have been the case that I preferred going to the concert (at no additional cost) to going to dinner (and spending additional money). Although the $20 I’d spent on the ticket was gone either way, it had made one of the options free without affecting the cost of the other option. This would be particularly meaningful if I had a monthly budget for semi-luxuries like concerts and wine, and having spent $20 on the concert, I couldn’t justify spending $15 on a bottle of wine.

The moral of the story is that while you should never consider the “sunk cost” in itself when making decisions, it is relevant to consider how the sunken payment may have altered your current set of options.

Discussion questions:

1. Think about how this kind of analysis would be important to a company that has already invested considerable capital in a project, but later finds a different project that would have been better to invest in. When deciding whether to abandon the first project to invest in the second, how should the money already invested in the first project affect or not affect the decision?

2. Can you think of examples of sunk costs in your life that you might be tempted to not ignore because it can be difficult psychologically to not use things you’ve purchased?

NFL Concessions Meet Economic Tradeoffs

While at the Patriots-Steelers NFL game earlier this season, I made a classic economics observation: tradeoffs are everywhere. It was partway into the second quarter, and dinner time was approaching. Because our seats were up in the highest section possible, this meant short lines at the concession stands, but the quality of food available was poor. The economist in me couldn’t help but see the natural connection to consumer theory, specifically indifference curves.


Indifference curves express how much utility, or happiness, comes from various combinations of goods. Any two points along the same indifference curve must represent two combinations of goods that make you equally happy. Additionally, points on different indifference curves represent different levels of happiness. In terms of the shape of indifference curves, economists make standard assumptions, such as more is better and averages are preferred to extremes. However, consider what the indifference curve mappings would look like if the goods being represented are quality of food and queue length (that is, the length of time you expect to wait in line .)


In this case, a long queue length is undesirable (economists call this a “bad”).That means that if you’re going to tolerate a longer line, the food quality must improve for you to be equally well off; this translates graphically into the increasing shape of the curve above. Also, for any given queue length, a higher quality of food makes you better off, so the level of happiness represented by IC2 must be higher than that of IC1. Finally, because averages are still better than extremes, the bowedness of the curves must be in the northwest direction. This is illustrated on the following graph:


A and C are two possible consumption bundles, while B represents the average of this bundle. Because B is preferred to A and C and you know that consumers are happier with better food and shorter lines (the southeast direction), the curve must be bowed in this way.


As you can see from the graph above, the choice as to whether or not it makes sense to travel throughout the stadium for better food is a simple consumer choice problem. My optimal decision rests on the relative happiness I get from higher food quality versus not waiting in line. What did I choose? A simple burger with french fries in exchange for a short line, so I could watch Brady and the Patriots blow it!


Discussion Questions:

1. What if instead of modeling “queue length” on the vertical axis, you want to show the indifference curves between “food quality” and the “amount of the game you watch from your seat.” How would the shape of the indifference curves change? Which direction represents a higher level of happiness from one curve to another?

2. Suppose that the value of watching the game diminishes because your team is crushing the opposition. How would this change the shape of your indifference curves between queue length and food quality?

3. What if averages are no longer better than extremes? How would that alter the shape of the indifference curves shown above?

A Biter's Market

Halloween always brings back a lot of wonderful memories for me. Like so many kids, trick-or-treating may have been my favorite few hours of the year. And while costumes and free candy are always appealing, there was also some thrill to the hunt. At least for me, just getting the candy was satisfying, regardless of if I liked a particular treat, or if I already had more candy than I would ever be allowed to eat! If an economist assumes that kids get some utility from “the hunt,” or at least that it is costless to kids to continue to go to houses for as long as they are allowed, then the result is that kids will get as much candy as is offered to them, regardless of how much or little they value it. If kids end up with a bunch of candy, many people are concerned about the health effects associated with eating it all. One interesting attempt to work with the fact that kids will get candy but reduce their consumption has come from a very interesting program where dentists offer to buy Halloween candy back from their patients. By offering a monetary incentive, these dentists are accepting that kids will gladly gather as much candy as possible, but perhaps their consumption can be changed if they are given more incentives than just a promise of “healthier teeth.”

Most economists would look at this program and talk about how its organizers are trying to incentivize kids by increasing the payoff of an otherwise less desirable choice. At the frontier of current research, economists are developing models to analyze the fairest and most efficient way to do this. Some economists may also suggest that this program’s goal is to influence a child’s preferences so that she will make different (healthier) decisions in the future. However, the ability of programs to change preferences is currently an open question in economic research.

Discussion Questions:

1. What other sorts of behaviors might dentists want to subsidize? What are some other examples of when a healthcare provider tries to encourage a healthy behavior?

2. Why might a program, like the one above, be unsuccessful at reducing candy consumption?

3. How much money would you need to be paid to sell a pound of Halloween candy? How much candy would you sell if you had five pounds? What about fifty pounds?

4. Do you think the amount of money a child already has will influence his or her decision to sell some candy? In what way?

5. Right now, anyone choosing to sell candy can pick which treats they sell. How do you think participation in the program would change if the pound of candy was selected randomly from all the candy collected trick-or-treating? What if the most dentally damaging candies were priced higher?

Digital Distribution Meets the Video Game Market

GameStop and EB Games have always been the major players in the used video game market when it comes to retail sales. Given their level of success, it was only a matter of time before other major players, such as Amazon.com and Toys "R" Us, entered the market. But how does this affect the long-term profitability of retailers, game publishers, and game developers?

The short-term motivation of retailers such as GameStop buying and selling used games is that they share none of the profit with developers of the game. Game publishers and developers only receive a payment for the sale of brand new games and are thus negatively affected by the growing used video game market, especially during bad economic times when sales are already lower than desired. Although buying used games instead of new titles might only save consumers $5-$10, some GameStop stores also allow you to return used games within 7 days if they don’t work properly or you simply don’t like the game, an option unavailable if you pay for a new game.

Incentives play a crucial role in economic analysis. Properly aligned incentives can promote desired outcomes in the short run and long run. From the perspective of video game developers, the lost revenue from video games trading hands multiple times in the used market is evident. As an increasing number of retailers realize the gains from entering this market, video game developers will experience decreasing gains from the production of new games.

This provides publishers with the incentive to consider other mediums of distribution, in particular digital distribution. The video game market is not the first entertainment industry to delve into a more technical solution. In the music industry, CDs are being replaced by iPods and MP3s thanks to Apple's iTunes. In the movie rental industry, we have gone from renting at our local store to mailing in movies through services such as Netflix or Blockbuster to downloading movies directly to our TV through the internet or cable services.

Therefore, it is not surprising that the video game market is heading in this direction, especially with the growing popularity of the used video game market. Since its inception, the Nintendo Wii has offered games from older consoles for purchase through the Wii Marketplace. Because the Wii offers free Wi-Fi, Nintendo can bypass the middle man of in-person and online retailers. In addition, Microsoft has begun to experiment with this option by offering smaller-scale, arcade-like games for purchase using Microsoft points that can be purchased in the Xbox Live Marketplace. They also offer free demos of newly released games in hopes of attracting additional sales. The drawback with Microsoft is their Xbox Live internet service is not free, so only users with a paid account can access these services.

Discussion Questions:

1. From the consumer perspective, what would your indifference curves look like for these two goods? Do you believe a used game is equally as good as a new game? How would this affect the demand for used video games?

2. What kind of incentives, if any, could a video game developer provide to GameStop to encourage them to sell new games over used ones?

3. How will the growing popularity of releasing and purchasing video games through an individual console change the market structure of video game retailers? How does this compare to the success of the iPod and MP3s in general?

(How) Are Men and Women Different?

The subject of differences between men and women has always been a touchy one. Economist Lawrence Summers stepped down last year as president of Harvard, for example, after he touched off a firestorm by speculating that the differences between the achievements of men and women in academia might be due in part to differences in ability.

Suppose we posit that men and women are completely identical in their ability: or more specifically, that the distribution of ability is not dependent on gender. Even under such circumstances, there are two reasons that we might expect different outcomes among men and women: (1) institutional factors, such as discrimination, cause a woman to obtain a lesser outcome than a man of similar ability; or (2) women, for whatever reason, make systematically different choices than men, perhaps because their preferences are systematically different.

In a forthcoming paper in the Quarterly Journal of Economics, economists Muriel Niederle and Lise Vesterlund use an experiment to test the second hypothesis. Specifically, they split participants (usually college students) into groups of two women and two men. They then offered each of them a simple task: adding up series of five two-digit numbers. After a few rounds of practice, the participants were given a choice. If they selected the "piece rate" option, they would earn $0.50 for each correct calculation they made, no matter how the others in their group performed. If they selected the "tournament" option, they would earn $2.00 for each correct calculation—but only if they had the most correct calculations in the group.

What happened? About three-quarters of the men in the experiment chose the tournament option, compared to about one-quarter of the women. Indeed, most of the men who in fact had performed worst in the group chose the tournament option, and most of the women who in fact had performed best in the group chose the piece-rate option. In other words, mistakes were made by members of both genders: the men were too competitive, and the women chose the competitive option too seldom.

Niederle and Vesterlund conclude by saying:

It is generally agreed that ability alone cannot explain the absence of women in male dominated fields. In natural settings, issues such as discrimination, the amount of time devoted to the profession, and the desire for women to raise children may provide some explanation for the choices of women. However, in this paper we have examined an environment where women and men perform equally well, and where issues of discrimination, or time spent on the job do not have any explanatory power. Nonetheless we find large gender differences in the propensity to choose competitive environments… Much may be gained if we can create environments in which high-ability women are willing to compete.

Discussion Questions

1. If Niederle and Vesterlund's conclusion is correct, does this mean that "winner-take-all" competitions are inherently discriminatory against women? Why or why not? If they are, what, if anything, should be done to correct the situation?

2. Academia is one area in which there exists intense interpersonal competition for top jobs—for example, tenured positions at top universities. Steve Levitt of the University of Chicago recently called for the elimination of the tenure system. (Greg Mankiw responded that he's not surprised that Levitt, as a winner of the prestigious John Bates Clark Medal and co-author of the bestseller Freakonomics, places a relatively low monetary value on job security.) If we accept Niederle and Versterlund's conclusion, would eliminating the tenure system result in more women in academia, or fewer?

3. Many economists, when faced with a problem that some call a "market failure," like to recast the problem as one of "missing markets." For example, Ronald Coase famously showed that the problem of externalities could be resolved by allowing the affected parties to bargain with one another. Is there any way to recast the inefficiency shown in Niederle and Versterlund's experiment—i.e., the fact that women shy away from competition while men compete too much—as a problem of missing markets? If so, what market is missing?

Quality, Choice, and Growth

Two articles in the New York Times this week are nicely complementary. Each looks at long-term trends in the U.S. economy, and in particular what Americans have chosen to spend their money on as they became progressively richer over the past few generations. And each argues that quality improvements have been a major force in driving American consumption patterns.

In the first, David Leonhardt argues that Americans face a tradeoff between better health care and other consumption goods. While he states that the health care system is indeed in crisis, he doesn't worry that increases in health care spending outpace inflation. We get what we pay for, in his view; and although Americans now pay, on average, $5,500 more per year on health care than they did in the 1950's, that's a small price to pay for the increased quality of life we now enjoy.

Robert Frank makes a similar point in an article titled "The More We Make, the Better We Want." He points out that we could now afford the lifestyles of our grandparents with only a fraction of our current income, but we choose not to.

Both articles illustrate a central element that drives economic growth: the insatiability of human desires. When Adam Smith wrote The Wealth of Nations, it was an easy argument to suggest that scarcity is a defining principle of life -- for one thing, just getting enough calories to survive was a challenge for a majority of people. But in an era when obesity is a bigger problem for Americans than hunger, it's reasonable to ask why we continue to work so hard. In the words of Keynes (that Frank quotes), "A point may soon be reached, much sooner perhaps than we are all aware of, when these needs are satisfied in the sense that we prefer to devote our further energies to noneconomic purposes." Clearly that point has come and gone, and yet here I am at work. Why?

Frank argues that the answer to this question lies in the understanding of what "basic needs" are. A theme running through much of his work is that people define their needs in relative terms, rather than absolute terms. Thus everyone might want a "good house in a safe neighborhood," but that might mean something very different in Los Angeles than it means in Baghdad. If the rest of society is driving a Camry, then, almost nobody is going to be happy driving a Model T.

Leonhardt argues that the answer to this question lies in the fact that technology--and in particular, medical technology--extends the boundary of what is possible. Living a healthy, full life means something very different in 2006 than it did in 1950, but taking advantage of modern medicine costs money.

1. Suppose you're in the market for a car, and you know that you want something like a Honda Civic. You come upon a brand new 1980 Honda Civic that had never been driven. You could save a lot of money by buying that car rather than a 2006 Civic. You work an hourly job and can choose how many hours you work. Suppose that if you bought a 2006 Civic and worked for 40 hours a week, you could afford to spend $400 per week on other goods. If you bought the 1980 Civic, you could either choose to still spend $400 on other goods and work fewer hours, or you could continue to work a full 40-hour week and spend more than $400 on other goods. Which of these options would you choose?

2. Suppose you meet a genie who offers you a choice: you can live in the 1950's and earn more than 90% of people, or live in the present and earn the average wage. Which would you choose? What if it were the year 1900? Or 1500? (Before you answer, you might want to pause and think a moment about indoor plumbing.)

3. Suppose a medical research project could extend life expectancy from 80 to 100 years. How much should we, as a society, be willing to pay for that project? What about one that extended life expectancy to 120 years? Or 140? Perhaps an easier question to answer might be: how much would you be willing to pay to extend your own life expectancy? What current consumption would you give up to live an additional year?

College Drinking and GPA: 4.0 or Fewer?

In 1995, Christopher Buckley gave a speech at the Yale Daily News banquet. Afterwards, he wrote an angry op-ed in The New York Times called "Bombed in New Haven." Said Buckley at the time, "We knew how to party in my day, too." But:

The scene that greeted me in the dining room at the New Haven Lawn Club was out of a putsch in a Munich beer hall, minus the brown shirts and funny salutes. The leaders were bellowing so loudly that you had to shout to converse with your dinner partner. At one table, a fifth of vodka was being passed around and glugged from. At another table, a woman was slumped over her boyfriend, unconscious. Well, they had been drinking since 5 in the afternoon. Apparently the trend these days is to "front-load," that is, go to a party before the event and get so tanked that you will feel no pain later on. Or be aware that there is a guest speaker.

Of course, college students are used to being lectured about how excessive drinking is risky to one's health. According to economists Michael Kremer and Dan Levy, though, it may also be dangerous for one's GPA.

Kremer and Levy examined how alcohol use among college students affects academic performance. In short, they asked: What happens to a student's GPA if they are randomly assigned to a roommate who drinks? Read the abstract, introduction, and conclusions (skip the technical mid-section) of Kremer and Levy's research paper to find out. (Note that the authors get at a deeper economic question in the paper: Do peers influence the way people form consumption preferences?)

1. What happens to the college GPAs of young men who share dorm rooms with frequent drinkers? Is the effect stronger for male students at the top (high high-school GPA) or bottom (relatively low high-school GPA) of the GPA distribution?

2. What happens to the college GPA of a young man who drank frequently in high school when he is assigned to a dorm room with a fellow drinker?

3. How does the GPA effect of rooming with a drinker play out over time? Do Kremer and Levy find that the effect on GPA is stronger in the first year of college or in the second or subsequent years?

4. Do the authors find any evidence that a drinking roommate affects the college GPAs of young women?

5. Suppose a university establishes substance-free housing. How will this affect GPAs of students who self-select into the substance-free dorm rooms? What types of students will end up rooming together in the not-so-substance free dorms? How might such segregation impact the average GPA at the university?