Archive for December, 2010

Dec 16 2010

Grinchonomics – or “how the Economist stole Christmas”

Every year around this time economics students and teachers alike begin looking forward to the long Christmas holiday right around the corner. Two or three weeks of yuletide cheer, mistletoe, snow men, caroling, food, family and… dead weight loss. That’s right, what’d you think this post would be about, the efficiency of Christmas? Come on… it’s the DISMAL science! Not the jolly science!

The tradition of giving Christmas presents has long fallen under the scope of economic researchers who seek to understand more about the rational, or as it turns out, irrational behavior of individuals in society. From an economic standpoint, many of the things that Christmas traditionalists believe are bad, are actually good, while the traditions many believe are good are in fact quite bad from an economist’s viewpoint. Basically, economists are grinches. So prepare to be grinchified…

Are you the kind of person who thinks doing all your Christmas shopping online is cold, impersonal, and against the holiday spirit? Well, Stephen Dubner, co-author of Freakonomics, argues that shopping online is far more efficient than spending days roaming the malls and shopping centers searching for the right gift for your loved ones. Says Dubner about “clicking and gifting” (i.e. shopping online):

See here’s the thing: I like the sound of clicking and gifting, that sounds efficient to me. That’s what we need to bring to the holidays, is more efficiency, less emotion. Let’s get rid of that.

Economists’ disdain for Christmas shopping is not limited to criticizing the inefficiency of spending hours shopping for gifts, in fact the tradition of giving gifts itself is considered economically irrational and inefficient. Sure, you say, it’s the thought that counts. Well, that’s just stupid. A gift giver can think all he wants about what a friend or a loved one may want for Christmas, and end up buying the thing they think the other person wants. But when it comes down to it, each of us only really knows what one person in this world wants, and that is ourselves, that’s right, the royal ME.

So basically, any gift you can buy for someone else will bring them less benefit than a purchase they themselves make; so WHY BOTHER? What it comes down to is self-interest in the end. When we buy a gift for another person, it is ultimately for our own benefit, which as we will see soon, most often exceeds the benefit of the receiver of the gift.

This is what’s known as the dead weight loss of Christmas. From an economic standpoint, Christmas is not “the most wonderful time of the year”, rather it’s “the most inefficient time of the year” (not so catchy as a song lyric, I’m afraid). Dead weight loss is like when,

…my wife’s great-grandma buys me a sweater at $85 and to me it’s worth like $1.50. Because I don’t like it… so that’s $83.50 deadweight loss… And the holidays are jam-packed with that kind of waste.

We’ve all been there, as both the gift giver and the unfortunate receiver of a gift we don’t like or even want. In fact, this phenomenon can be graphed using a basic diagram learned by all high school economic students: the marginal benefit, marginal cost diagram. Look at the graph below and see if you can figure out what it shows, then scroll down and read the explanation.

Basically, what the graph above shows is that the act of giving gifts brings benefits to the gift giver that are not enjoyed by the gift’s receiver. From the ultimate consumer’s standpoint (i.e. from the perspective of the gift receivers), many of the gifts received for Christmas will be valued far less than the amount of money, time and energy that went into choosing and buying them by the gift giver.

In other words, the marginal cost of shopping for and buying Christmas presents exceeds the marginal benefit of those who receive them, hence, the market for Christmas gifts fails since the behavior of private individuals results in a level of Christmas shopping that exceeds the socially optimal efficient level, at which the marginal benefit of the give receivers intersects the marginal cost of gift production. Resources are over-allocated towards Christmas present shopping because it is simply impossible for gift givers to know the precise preferences of those for whom they shop.

That $85 sweater, for instance, may have only been “worth” $1.50 to the poor fellow who received it. The dead weight loss, therefore, is the resources that went towards producing and purchasing a sweater for someone who doesn’t even like it, and all the other possible ways those resources and that money could have been allocated.

Have I ruined your Christmas yet? Well, fear not, there is an economically efficient way to approach the Christmas season and to maintain the beloved tradition of gift giving! That’s right, even the Grinch economists have a solution to this wasteful problem! And it is so simple… it is… CASH! Cash is the ultimate gift, perfect in every way. No time whatsoever is wasted in the process of deciding what to give someone. Simply put your debit card in the ATM machine and your entire season of shopping is done!

Cash is the perfect gift to receive too. There is no chance you will be unsatisfied with what you ultimately “get” for Christmas.  Cash can be spent on the goods from which the receiver himself enjoys the greatest marginal utility per dollar he spends. The dead weight loss above is completely eliminated when cash is given instead of other presents. The marginal benefit of the giver and the marginal benefit of the receiver are the same since the giver can rest assured that the receiver will spend it on something that provides him with the greatest possible benefit.

So there is a happy ending to this story after all! Maybe someday when economic education has truly succeeded we can once and for all do away with the wastefulness and inefficiency of Christmases past and form new traditions rooted in the efficiency of cash gifts. So, students of economics, if you want to make your loved ones happy this Christmas, you now know what to do. In the process, you’ll help make the world just a little bit more efficient!

For more on the dead weight loss of Christmas, listen to and discuss with your class the two podcasts below, from two of my favorite shows, American Public Media’s Marketplace (from which the quotes above are taken) and NPR’s Planet Money.

Discussion Questions:

  1. A market failure in economics exists whenever resources are allocated inefficiently towards the production or the consumption of a certain good. What makes holiday gift giving a market failure?
  2. Why is the marginal benefit of a gift giver often times greater than the marginal benefit of a give receiver? How does this discrepancy result in “negative social benefits” as indicated on the graph?
  3. What is dead weight loss and how does holiday gift giving result in it?
  4. Why are cash gifts more “efficient” than buying presents for others? How would an economist analyze the efficiency of gift cards or gift certificates compared to presents? To cash?
  5. Should we scrap Christmas and replace it with Economistmas? For Economistmas, everyone would get exactly what they want, which is to say, everyone would get money to BUY exactly what everyone wants. Surely you agree this would be far superior to our antiquated traditions rooted in inefficiency and dead weight loss, right?

Author’s note: For the record, I have bought my wife and family the perfect gifts this year! They’re simply going to love what I got them! And no, it is not cash! ;o) Merry Christmas!!

14 responses so far

Dec 08 2010

Why Greed is Good (or how in pursuit of their own self-interest firms do what’s best for society)

Efficiency means more than just producing in the least cost manner. To be efficient a market must also allocate the right amount of resources towards the production of the good or service it provides. Allocative efficiency occurs when land, labor and capital are allocated towards the production of goods and services in combinations that are socially optimal. In other words, the right amount of output of various products is being produced given the demands of consumers in the economy and the costs faced by firms.

Because of firms’ profit maximizing behavior, perfectly competitive markets allocate resources efficiently, neither over nor under-producing the goods consumers demand.

Allocative Efficiency: P=MC

Under the conditions of perfect competition, a market will be allocatively efficient as long as the firms in that market produce at the P=MC level of output. Price is a signal from buyers to sellers, and the price seen by firms signals the marginal benefit of consumers in the market. If the price consumers pay for a product is greater than the marginal cost to firms of producing it, then the message being sent to producers is that more output is demanded. In the pursuit of profits, more resources will be allocated towards the production of the product until the marginal cost and the price are equal. At the P=MC point firms maximize their profits and resources are said to be efficiently allocated.

Graph: Profit maximizing behavior leads to allocative efficiency

Assume that the firm on the right represents the typical firm in a perfectly competitive market. When firms produce at Q1 level of output, resources are under-allocated towards this good, since the price consumers are willing to pay (Pe, determined by market supply and demand) is greater than firms’ marginal cost of production. Notice that when individual firms produce Q1 units, the market supply of Qs is less than the market demand of Qd; there is a shortage in the industry as long as firms produce only Q1 units.

However, firms are unlikely to produce at this socially undesirable level for long because in their pursuit of profits they will increase their output to the quantity at which marginal cost equals the price. When they increase their output to Qf, firms maximize their profits and as a result the shortage in the market that existed when firms produced at Q1 is eliminated, improving social welfare and maximizing the total amount of consumer and producer surplus (the combined areas of the pink and green triangles in the industry graph).

Because of the profit maximizing behavior of self-interested business managers in the competitive market above, resources are more efficiently allocated than they would be otherwise. The price determined by supply and demand in the market signals the benefit society derives from this good, and as long as the price is greater than the marginal cost, the message sent from buyers to seller is “WE WANT MORE!” On the other hand, if at a given level of output marginal cost exceeds the price, resources are over-allocated towards the good. The message sent in such a market is that consumers value the product less than it costs firms to produce, so firms will reduce their output to maximize profits, correcting the over-allocation of resources and restoring a socially optimal level of output.

Allocative efficiency is achieved in a perfectly competitive market precisely because firms will always wish to maximize their profits by producing the quantity of goods at which their marginal cost equals the price.

The article Farmers May Switch Crops Due to Labor Shortage discusses some the effects of rising costs on a perfectly competitive market. Read the extract below and answer the questions that follow.

Farmers may change their crops due to the shortage of immigrant labor. Of all crops, fresh fruits and vegetables are the most labor intensive. Lettuce, strawberries and broccoli all have to be picked by hand. In Arizona, farmers are passing on chili peppers to plant corn, which is harvested by machine.

After 37 years, Ed Curry is not planting green chili anymore because corn can be harvested by machines; green chili can’t.

Curry explains, “It would take about 250 people to pick this year’s chili crop. With immigration tightened up the way it is, well, number one, we just can’t get the labor.”

About seven years ago, Ed Curry was busted for using illegal labor. Today his workers are legal. They go back and forth from Mexico each day, making seven to $8 an hour. Most are in their 50s and 60s. One man is 72 years old. Younger workers can’t get visas or don’t want the jobs. So as his workers age and his workforce dwindles, Ed Curry says he’s thinking about moving some of his operation to Mexico.

“We’re down to survival. Am I going to stay in this or not? And if I’m going to stay in it, I’ve got to do it where there’s plenty of labor and we can be competitive.”

That’s one farmer’s plight. The Western Growers Association based in California represents 3,000 farmers across the region. Its president, Tom Nassif, says farmers need Congress to pass legislation that will allow more workers in, something he says it should have done already.

Nassif says his association polled a dozen members and found more than 40,000 acres had moved to Mexico in the last year or so.

Exercise:

  1. Assuming the market for chili peppers is perfectly competitive, illustrate the effects of the shortage of immigrant workers on the short-run production costs and profits of chili farmers in the American Southwest.
  2. Based on your answer to #1, explain how the chili market will evolve in the long-run in response to the shortage of immigrant workers. How will the market for corn and other capital-intensive agricultural commodities be affected?
  3. Assume the US chili pepper market reaches a new long-run equilibrium following the shortage of immigrant labor. Now demand for chili peppers increases. Use a diagram to illustrate how the profit maximizing behavior of chili pepper farmers assures that there will not be a shortage of chili peppers following the increase in consumers’ demand.

Discussion Questions: In their pursuit of economic profits, firms in a competitive market will, through their collective pursuit of self-interest, inadvertently achieve an allocation of society’s scarce resources that is socially optimal.

  1. Discuss the view that allocative efficiency as defined in this chapter is a socially desirable outcome.
  2. Is it accurate to say that goodness can be achieved through greediness in a market economic system?

10 responses so far

Dec 01 2010

Elasticity Haikus

Published by under Elasticity,Humor

One particularly witty student submitted his Economics Learning Log for our Elasticities unit with the following thoughtful poems.

On Price Elasticity of Demand:

Price may increase fast

Inelastic good’s demand

Stays in place for good

On Cross-price Elasticity of Demand:

Vodka drinkers fear

Russians tax it, prices soar

I’ll drink beer instead

On Income Elasticity of Demand:

Wages cut in half

No more decadent lifestyle

I miss my Rolls Royce

On Price Elasticity of Supply:

Demand for sweets down

Asbestos found in lollipops

Guess I’ll make fewer

Well done, Nick! Keep the haikus coming!

2 responses so far