Wednesday, April 28, 2010

Why rising house prices and rising oil prices are different

Casey Mulligan has an interesting post today lauding the return of rising prices in the housing market, saying:
The housing crash is the single most important factor that started this recession, so it would be nice to know when it will end.
I initially wondered whether an increase in the price of an important durable good could improve individual well-being. Usually, we think of price increases as making consumers worse off. Consider a standard good: gasoline (or apples or iPads if you wish).

In the diagram, the plotted point is the initial choice of the household. Then, the price increases. On account of the price increase, the household can no longer afford its original favorite bundle. Indeed, the price change means that all of the shaded gray region is unattainable. This is unambiguously bad for the household because an increase in the price does not expand consumption opportunities, and therefore, can make the consumer no better off.

Given this standard case, Casey Mulligan's praise of rising housing prices is strange. But, if we think a little about what is different in the housing market, Mulligan's claim that housing price increases can be a good thing turns out to be well-founded (even for reasons beyond this post). The difference is ownership. In the housing market, plenty of people own the product, and that ownership has a significant effect on the household's consumption opportunities.

If the price of housing increases, household wealth increases if you own a house. If the household cashes in on a seller's market by selling and downsizing, this price increase affords greater consumption opportunities. That wasn't a possibility with gasoline, and it is all due to ownership. Here's a simple diagram illustrating the difference.

A household can always stay in their house, which means the original favorite choice is affordable.* Also, as with the case of gasoline, if the household spent as much as it could on housing, it could buy less housing. That is, we still have a gray area of lost consumption opportunities. But, because of ownership, households have a stake in price increases, and because households can cash in on a seller's market, they now have a yellow region of expanded consumption opportunities.**

Contrary to our first-graph intuition, price increases can be good for consumers if they own (and can sell) a significant amount of the product. This offsetting effect is called an endowment effect. There are plenty more complicating factors to this market that are worth discussion, but the ownership aspect is one that is often overlooked.

*In my simple model of housing, people own their houses outright, and there are no property taxes and other variable assessments that increase with the price. Reality is more complicated as these factors combined with an expensive mortgage may force a household to give up their current consumption bundle to stay in their house. But, the forces I highlight above are forces that act in the real world, and abstracting from messy details allows us to see them more clearly.

**Interestingly, the second diagram is almost exactly the graph that an economist will -- by default -- use to analyze the effect of a wage increase on labor supply. In that case, a worker owns his time and sells his time to the firm at the market price. In supplying labor, a worker cannot sell negative time, so there is no gray region of lost consumption opportunities due to a wage increase.

Saturday, April 24, 2010

Teaching or Research: Which is more important?

As part of my graduate program in economics, I have a teaching requirement: At least 5 quarters of teaching assistance while I pursue my Ph.D. This is a relatively new requirement, and it isn't especially burdensome for the average student.

On the other side of the spectrum, we have a significant research requirement: A dissertation that not only produces original research, but also sets an agenda for our future research as young economists.

If it isn't clear from the description, I think it is fair to say that my program puts more weight on research than on teaching. This isn't uncommon for Ph.D. programs in economics, but it raises a question, which is the poll question of the week:

How much weight should be put on teaching in a Ph.D. program in economics?

(a) 0 percent
(b) 10 percent
(c) 30 percent
(d) 50 percent
(e) more than 50 percent

That's the poll. Vote early and often, and tell your students and professors to vote. I'm interested in hearing what you have to say.

Wednesday, April 21, 2010

iPad economics

Last year, I wrote about how I dislike Apple products, yet still like the fact that Apple exists as a competitor to Windows. Now, that post is only half true (OK maybe 1/4 true). In our search for a new laptop and desktop, we actually considered purchasing a Mac. I even touched the MacBook Pro's intelligently designed multi-touch touchpad. I liked it, but I have concluded that -- although the Mac technology is nice -- it's not worth paying a premium (for me).

On another dimension of Apple, I am intrigued by the iPod Touch. The handheld technology is really interesting, and if I won one in some contest, I would be happy about it. I like the idea of internet in my pocket, and of course, I am a fan of the "there's an App for that" commercials. At some point in the not-too-distant future, I might consider buying one. On the other hand, I am not on the verge of buying the iPad, which is like a giant iPod Touch.

The fact that people of my type are not very interested in buying an iPad speaks volumes about the economics of the iPad. Apple faces an intriguing problem, and by studying it, we can learn some interesting economics.

Product differentiation and market power

In many respects, Apple made a lot of things better by developing the iPad. It has a bigger screen, better graphics, interesting book-reading features, and some artist sketch programs. In economic lingo, these changes to the product relative to others already on the market are called product differentiation.

Differentiating your product is one way to enhance market power. If your product is the only one that has such-and-such feature and consumers value that feature, your company can charge a premium. This is what Apple is trying to do with its iPad. They're marketing it as everything that is in the iPod Touch, but better and more.

Where else are you going to get a giant iPod Touch? There's a price for that.

Pricing over time

Now, you might wonder why Apple bothers to introduce a product that is a blown-up version of one of its other successful products. Aren't many of the sales of iPads going to be lost sales from iPods? I don't think so. This has to do with two features of the iMarket: durability of the product and impatience of some consumers.

Apple designed its customer base to be "eager at the beginning" by introducing the iPod at a high price, and then slowly bringing the price down to expand the customer base. The most eager, most impatient consumers are the ones who line up on the first day. As the price drops, less eager and more patient consumers become the new iPod customers. Now, consumers like me (who are on the fringe of Apple's market) are the only ones left without an iPod Touch.

The fact that we consumers sort over time based on how much we value the product implies that Apple can charge different types of consumers different prices (indeed, that's why they start high, and predictably lower their price). An important constraint on this exploitation of consumers is that every type of consumer has the option to wait. Apple has to price to ensure that waiting isn't the best option. Otherwise, they won't make any sales.*

iProduct durability: a Problem?

Another consideration is the vibrant resale market for iTechnology. Apple faces a tradeoff: Greater durability is valued by the consumer (and can lead to a higher price), but greater durability means that the resale market is likely to be a stronger check on the company's pricing. The company can control this problem in one of three ways:

(1) They can make a less durable product to sabotage the resale market. For iTechnology, it would be a bad idea because less durability means poor quality. As Apple is branded on high quality, this isn't a good option.

(2) Apple can control the total number of iPods on the market in their pricing over time (as above). So, that high initial price reflects that a strong resale market would result if there were more used iPods available.

(3) At regular intervals, Apple can introduce new, slightly better products that supersede the old ones. If you want the new features, you'll have to buy the new iProduct. This is a big reason why textbook companies introduce new editions of textbooks. If you want the new exercises (which might be assigned for your class), you'll have to buy the new book.

Of these options, Apple appears to use (2) and (3) in conjunction with one another. The introduction of the iPad is like a dramatic version of (3).

Back to Different Types: The iPad

The economics of Apple tells us that the type of consumer who is excited about the iPad is someone who bought an iPod years ago. By now, they are thirsty for a new technology from Apple, and the iPad is just good enough to draw this type of consumer into the market. Is this new product going to steal current iPod Touch consumers away? That's not likely.

Based on the start-high-go-low pricing strategy, the same kind of sorting over time that took place for the iPod will take place for the iPad. For the most part, current consumers who are contemplating an iPod are the type who were turned off by the high iPod price. Given this, they're not likely to be in the market for an iPad for a while -- at least until the price drops.

A final comment is that the iPad is not better on all dimensions. In fact, it is too big to put in your pocket, which takes away one of the best features of the iPod (portability). Only consumers who value the new features or the novelty of the new iProduct will come to the market. On this dimension, the reaction of consumer reviews is muted, as this CNET video demonstrates.

The name is funny, too. Jokes aside, the iPad is another interesting product from Apple that I probably never will buy. Then again, one of these days I'll have to find out what all the fuss is about Apple products. Maybe I'll start with the iPod Touch.

*This is a simple idea, but sometimes simple ideas are powerful. There is an entire literature on durable goods pricing that establishes this fact, and studies other elements of monopoly pricing of durable goods. It was started by one of my favorite economists, Ronald Coase.

Saturday, April 17, 2010

Poll: Why help someone out?

Today, on our way to the car repair shop, our car stalled and stopped on Lake Shore Drive. If you are unfamiliar with Lake Shore Drive in Chicago, it isn't a casual side street by the lake. Lake Shore Drive is a busy highway with 3 to 4 lanes in each direction.

Needless to say, we were in a bad situation because our car was blocking one of the three lanes of traffic. But, the situation allowed me to see how willing people were to help our situation. The woman who was driving behind us stopped and offered her assistance. She gave us the number of her uncle's towing company, but unfortunately, the tow truck couldn't get there for an hour. On hearing this, she called 911 to get us off of the highway, at least. The dispatcher coordinated with city services to send a truck to "get us off of the road."

After she realized that we would be safe, she left. Shortly thereafter, the police arrived to help avert any collisions with our car as we waited for the city services truck to show up. They were less helpful, asking questions like "Do you have gas in it?" after I clearly told them that the battery light was on before it stalled.

Then, the city services tow truck arrived, and hooked our car up to the truck. Usually, city services is only called in to clear the lane of traffic. That is, once they moved our car to a parking lot, we would normally have been on our own to arrange to get our vehicle to the repair shop. But, because the guy noticed that we were from Montana (by our Montana license plates), he was especially helpful in assisting us to find a repair shop.

He made several calls, and he looked up the locations of various repair shops in our Chicago phone book. Eventually, he found a place that could get us in right away and fix our car problems. Without his assistance, we would have ended up at a lot worse repair shop, and we would have had to pay much more.

That whole experience got me wondering. Would he have been so helpful if our license plate said Illinois? Was he helping two young kids from Montana because it was the right thing to do? That brings me to my poll question of the week:

Why help a stranded couple from Montana on the road?

(a) It is the right thing to do.
(b) It makes me feel bad to do otherwise.
(c) They might pay me for my help.
(d) I didn't help. I honked! They were blocking a lane!

Vote early and often, and tell your friends to vote. If you have friends in the towing business, tell them to vote as well as your alderman. The poll is open for a week. I am interested in hearing what you have to say.

Wednesday, April 14, 2010

An April 15th Perspective

Casey Mulligan has a great piece on the downside to simplifying our tax code. Here are a couple of excerpts:
But it’s easy to overlook an important side-effect of tax complexity burdens — and the taxpayer anger created by them. Such aggravation helps sustain the sizable and energetic group of Americans who want their government to get by with less.

As President Obama’s head of the National Economic Council, Lawrence Summers, once wrote, “A better tax system may lead to more wasteful spending.” Even Professors Robert E. Hall and Alvin Rabushka, longtime advocates of simpler tax code, concede that a simpler tax makes it much easier for advocates of larger government spending programs to be successful. (See p. 48 of their book.)
Here's how he concludes:
So we could eliminate some of your perennial mid-April frustration by replacing the income tax with a simpler and more efficient tax code, but in that case be prepared to send a greater fraction of your income to the United States Treasury.
Most people would like a simpler tax code (who loves figuring out how much they paid?), and I don't know many people who like the idea of paying taxes. Mulligan points out that there is a tradeoff between the two. It's true that people might be willing to pay more for a simpler tax code. How much more they would willingly pay is an empirical question.

Given this tradeoff, what is the optimal tax code complexity? How much higher would taxes be if we had a simpler tax code? Would it be worth it?

Saturday, April 10, 2010

Poll: Should a computer monitor be tied to your computer purchase?

Some economists study the effects of potentially anti-competitive practices (and what to do about them). The classic anti-competitive practices are monopolization, conspiracy to fix prices, and forming a cartel. But, a lot of other business practices -- called "bad acts" -- have fallen under the scrutiny of antitrust law.

It is an interesting question whether tie-in sales (linking the purchase of one product to the purchase of another) should be a bad act. To see why, consider two examples.

Example 1: A firm produces two products: Accounting machines and punch cards for accounting machines. The firm is the only firm to produce accounting machines because it has a patent, but the punch cards can be made by anyone in a competitive industry (and can be used in other less-popular purposes). In this case, allowing the firm to tie punch card sales to the sale of the accounting machine will allow it to have significant market power in punch cards, as well as in accounting machines. If tying the sales of punch cards to machines leaves no room for other competitors, the company could achieve and exploit more monopoly power. That's the idea of a bad act.

Example 2: A firm produces two products: Shoes and shoelaces. Imagine that the firm is the only firm to produce shoes, but there's a competitive market for shoelaces. As in the previous example, the shoe company can foreclose its competitors by (literally) tying in the sale of the shoelaces to the shoes. But, wouldn't it be a hassle for the consumer to independently contract for shoes and shoelaces when he could just buy the whole package?

To a lesser extent, this argument applies to the first example. It might be really convenient to have a stock of punch cards come with the purchase of a new accounting machine. On the other hand, if the consumer has a strong preference for some other type of punch card, it is inconvenient to have to buy some of the type you don't want. Viewed in this light, it comes down to whether it is more convenient for the consumer on average to purchase both products together.

This brings me to my poll question of the week, and it relates to a personal example. We recently bought a new computer on special from Dell. One of the conditions of the special was that the computer came with a Dell monitor. We didn't really need the monitor because we already had a better one from our previous computer, and I imagine that this is a fairly common situation: In my experience, computers tend to wear out before monitors do.

One could make the strong case that monitors and computers are separate products. In fact, I have seen other retailers start to move to a model where they sell the computer separate from the monitor.* So, that brings me to my question:

Should a computer monitor be tied to your computer purchase?

(a) Yes
(b) No, but it should be an option.
(c) No. It should be sold separately.

The poll is open for a week, so vote early and often (on the sidebar -->). Tell your friends, your tech-support gurus, your customer service representatives, and your antitrust officials to vote. I'm interested in hearing what you have to say.

*Ten years ago I can imagine that this was the same debate over printers and computers. By my fuzzy recollection, computers used to always come with a printer. Now, it is one of the many "accessory" options one can choose. From this casual observation, it seems that the whole computer industry is "untying."

Wednesday, April 7, 2010

Why do bees die after they sting?

Jeff Ely has an interesting answer to the question here. He starts by reposing the question as an economic question:
There are two ways to phrase the question. First, why would a bee sacrifice its life to sting me. Second, why would Nature design the bee so that it dies after it stings? The answer to the second question is that after stinging the bee’s life is not worth living. The answer to the first is that it wasn’t worth much before either.
This answer is similar to the economics of rational suicide (depressing, I know). According to this theory, one reason to commit suicide is that it is no longer worth living. If life gets too bad, the person opts out.* A statement of the rational analysis of suicide is given here by Gary Becker and Richard Posner.

Their purposive behavior approach gives insight into the economic behavior of what they call "miserable" people. More than just an analysis of suicide, they are able to explain why people in desperate situations would rationally take more risks. The Becker and Posner suicide argument is that "miserable" people use suicide as a way to opt out of a bad outcome in a gamble. This opt out ability implies that the downside of gambles isn't as bad for people in desperate situations relative to the upside.

I would like to conclude by demonstrating that the creators of Lost know their economics of rational suicide (spoiler alert). On last night's episode, we encounter a suicidal Charlie Pace (one of the important characters in the show). He walks across the street without regard for whether cars will run him over. Later in the episode, he grabs the steering wheel from the passenger seat, causing his car to crash perilously into the harbor.

Why would he do this? On last night's episode, Charlie reveals that he had recently seen events in his alternate reality (or flash sideways). In his alternate reality, he had found true love (with Claire, another character on the show). Relative to his present drug-abusing life, he found his life no longer worth living.

In his present reality, Charlie is dealt with as a drug-abusing and mentally unstable individual (which he surely is). As a society, we might even say that Charlie needs protection from himself. But, that's where the storyline surprises us. We find ourselves hoping that Charlie can "flash-sideways" to his alternate reality to be with Claire. Given the broader perspective, the creators of Lost take a surprisingly Becker-Posner approach: He has a better option, and the theory helps us understand his risky behavior.

*We typically focus on mental illness or the immorality of suicide, and those points are important. But, it turns out that assuming that the individual is mentally ill does not allow for a well-founded economic analysis. Saying that suicide is caused by mental illness is like allowing the individual to change his preferences. It might be true that people's preferences change, but economics attempts to explain how changes in opportunities lead to changes in behavior. This is because with changes in preferences, we can explain any behavior. Therefore, a central tenet of economic analysis assumes stable preferences (or at least preferences that cannot change arbitrarily).

Friday, April 2, 2010

Poll: Should a business make concessions in the event of a mistake?

Businesses make mistakes. Here are three such examples:

1. A department store clerk may accidentally get a customer the wrong size shirt, or leave the ink tag on. In this situation, some stores have the policy that a discount should be applied to remedy the inadequate customer service.

2. A computer company may ship the wrong computer. In this event, one major computer company has the policy that they will exchange the wrong computer for the right one. Aside from free shipping on the new order (and return labels), there are no concessions.

3. An item may get damaged in transit. From experience with a damaged product, I'm familiar with Amazon's policy on this. No questions asked, they will ship a replacement item overnight. No charge, but very convenient.

4. My wife's Mary Kay agent accidentally forgot her order. When my wife called this to her agent's attention, the agent offered her six months of free makeup.

So, that brings me to the poll question of the week.

When the inevitable mistake happens, how should a business deal with it?

(a) Pretend it didn't happen.
(b) Just fix the problem by providing the initially requested product/service.
(c) Fix the problem, and provide a concession.

The poll is on the sidebar, and it is available for a week. Please vote early and often. Tell your friends to vote, and if you're on hold with a customer service agent, tell him to vote too. I look forward to seeing what you have to say.