Wednesday, May 29, 2013

Deriving Value

If you've read a significant amount of economics research you've probably noticed that economists love to reward participants with money.  This phenomenon is not a result of economist's love for currency. Rather it's due to a simple fact, monetary preferences for a rational being are obvious and intuitive.  Any logical being would rather have five dollars than four, rather four dollars than three and so on and so on. On the other hand when economists compensate experiment participants with goods or services another wrinkle is added to the interpretation of results.  Not only do experimenters have to account for preferences for a given decision, but for a given reward as well.

Here's an example. Suppose we constructed an experiment to determine how potential reward affected effort. We give people a simple task in which they have sixty seconds to turn a crank. As they turn the crank a line of lights illuminate indicating levels of reward. After five lights light up they receive a dollar, after ten lights two dollars and so on and so on. Thus we can create a model associating effort and reward rather easily.

However, suppose instead of currency we rewarded participants with fruit. After five lights they'd receive an apple, after ten lights a pear, after fifteen lights a peach etc etc. Now interpreting the participants efforts becomes much more difficult. Does the individual reduce effort after ten lights because rewards have severely diminishing impact on effort, or do they simply not like peaches?

In essence monetary rewards are used so frequently because they have a relatively uniform and predictable valuation between individuals. While a wealthy man may value a ten dollars far less than a middle class man we can usually assume they both value ten dollars more than five dollars and less than twenty dollars.

Outside the laboratory questions of value are rarely so simple. In fact, researchers aren't entirely sure how we determine value for ourselves.

Imagine for a moment that you go to a new restaurant. You're presented a menu with a single item on it that you've never heard of before. You're given a small sample, which is enjoyable, and shown what you would be served if you choose to eat at the establishment.  Assuming you're asked how much you'd like to be charged how would you decide what to pay?

Probably you'd think of what dinner usually costs you at a restaurant. Perhaps you're used to paying approximately fifteen dollars for a meal.  Then you might consider your surroundings. If the eatery featured neon signs and checkered table clothes you are likely to want to pay less than if leather and hardwood are prominent. Of course the taste and presentation of the food probably feature prominently in your decision as well.  Everyone would go through this same process and yet everyone would come to very different conclusions. Many diners would value the dinner at ten dollars while others would pay ten times that amount. So what causes these wildly different valuations?

The core difference generally speaking is experience.  Those who are used to paying more would usually opt to be charged more than those who are used to paying less.  So if past experience is the primary factor in valuation does value just become a constant process of adjusting past evidence to current reality?

One theory of valuation is that value is instilled during youth, primarily by parents. From then on value is simply a continuous process of updating expectations. I remember as a child gas cost slightly under a dollar a gallon. Since then, slowly but surely, gas prices have risen. As has my understood valuation of fuel.  Conversely as a youth computers were rare and valuable commodities which have now become nearly disposable in their commonality.

Their are implications in business for this theory as well. The designer coffee phenomenon that began in the 90s demonstrated this phenomenon clearly. At the time coffee was cheap, quick and grabbed on the go from a gas station or doughnut shop.  Starbucks transformed the coffee experience from fast and cheap to slow and expensive by transforming their product. Had they simply sold a medium coffee like every other corner store it's unlikely anyone would have been willing to pay six dollars a cup. However, by selling a venti double shot low foam latte they caused consumers to separate their value expectations of Starbucks from that of coffee. Although they were selling essentially the same product they differentiated it sufficiently that consumers did not apply their low coffee valuations to the product, allowing Starbucks to successfully demand a much higher price.

There's still a great deal of mystery surrounding how value is created. The presented theory seems plausible and is backed by a great deal of research, but it is not the only theory, nor is it conclusive. In time, with additional research, a consensus on value formation will arise. Until then the discussion of possibilities is half the fun.

Until next week stay safe and rational.

Wednesday, May 22, 2013

Lottery Mania

Last weekend millions of people held their breath to find out if they'd struck it rich. A record Powerball jackpot of nearly $600 million was up for grabs and when the numbers were drawn a lucky Floridian had won. All of this attention on the lottery really made me curious who was buying tickets.

The lottery is one of those contradictions that everyone acknowledges yet still persists. Nearly everybody understands that playing Powerball, scratch off tickets or a local lotto is a bad bet.  Yet the fact is most people knowingly throw their money away regardless (though of course some strike it rich). According to the North American Association of State and Provincial Lotteries 57% of the adult population play some form of lottery each year.  Clearly it doesn't require an abnormal mind or gambling addiction to be drawn into the lure of easy money.

What made me most curious however was the myth that the poor play lotteries disproportionately more than those who can more easily afford such diversions. A small amount of research led to some interesting results which makes another interesting case for being careful with statistics.  

There are of course two sides to this issue. Those who benefit from lotteries would like you to believe that the poor do not play lotteries more than the wealthy. Those who dislike lotteries would like you to believe that lotteries take advantage of those who can not afford them. Both sides are assumably working with similar statistics yet need those statistics to support their case. Here then are both arguments using the same (as far as I know) accurate statistics. This arguments deal strictly with whether lottery purchases disproportionately harm the poor and not with any benefits (such as funding schools or government projects).

The Case Supporting Lotteries

Lower income households are less likely to have purchased lottery tickets in the past year. 

"People with incomes of $45,000 to $75,000 were the most likely to play -- 65 percent had played in the past year -- while those with incomes under $25,000 were the least likely to play at 53 percent. Further, people with incomes in excess of $75,000 spend roughly three times as much on lotteries each month as do those with incomes under $25,000." source

A variety of other factors correlate favorably with the view that lotteries do not prey upon the disadvantaged disproportionately. Lower education individuals play the lottery less than more educated individuals for example. However, most of these factors are simply derivations from the main income statement (higher income correlates with higher education, higher income correlates with lottery purchases and so it is unsurprising that higher education correlates with lottery purchases).

Low Income individuals are also not any more likely than average to play the lottery to excess. Studies in several states have shown that lottery fanaticism is not restricted or overly prevalent at lower income levels.

In essence the poorest play the lottery the least and in no different a manner than the rest of society.

The Case Against Lotteries

Although the lowest income groups play the lottery the least and spend the least on lotteries they spend slightly more of a percentage of their income on lotteries. Census data shows that for each $10,000 decrease in household income, lottery expenditures as a percentage of income increase by .4%. So while lower income individuals spend less on lotteries overall they spend a larger percentage of their income. However, in general this statement holds true for most items. Lower income groups spend a larger percentage of their income on food, housing and energy than higher income groups for example. 

So the lower your income the less likely you are to play the lottery, the less you're likely to spend on the lottery, but the larger portion of your income you are likely to spend. It's an interesting situation where both sides of the argument seem to agree on the relevant facts but both can make reasonable arguments to support their perspective.  The danger lies in holding a bias towards one side of the debate, seeing their argument (which is reasonable) and accepting it without exploring it's counterpart. Now having been given the data from both sides of the debate you can decide for yourself which, if either, is most correct.

More economics next week. Until then stay safe and rational.

Wednesday, May 8, 2013

Three Protections You Didn't Know

This past weekend a discussion brought to mind some of the more unusual protection mechanisms the government uses for certain products.  Everyone knows about agricultural subsidies, but were you aware of some of these lesser known market distortions?

You must possess a federal license to grow and sell peanuts.

During the depression peanut prices began a rapid downward spiral. The federal government wanted to support the peanut farmers without having to spend a great deal of already scarce funds.  In order to stabilize a falling price you must either increase demand (buy the peanuts) or decrease supply. The government opted to decrease supply and began a quota program which still persists. Therefore in order to grow and sell peanuts in the United States you must have a portion of the allocated quota which essentially amounts to a license.

Many of those who possess the licenses do not grow peanuts themselves but instead rent them out to farmers for risk free profits. For decades the license rentals were quite lucrative as peanut farmers in America enjoyed prices as high as 50% more than farmers abroad.  However, as NAFTA was formed Canadian and Mexican peanuts began to cheaply enter the dometic market and drive US peanut prices down.  This peanut price crisis was of course met with additional subsidies for the peanut farmers of America.

The government is a raisin thief.

In 1949 the Raisin Administrative Committee was established in order to regulate the supply and price of raisins. Each year raisin farmers are required to set aside a portion of their crop for the RAC. The RAC then determines based upon what they expect domestic production and demand to be how much of that portion the farmers may sell.  All raisins above what they deem the market can bear are seized and given away or sold by them in non-competitive markets (meaning internationally for the most part). The proceeds of these sales (which are generally far below what domestic sales would bring at the artificially inflated price) are used to fund the RAC with the excess being returned to farmers.

What happens if you don't set aside your raisin tithe? The government fines you for the money you've gained from your illicit raisin sales as well as compliance penalties.

To be fair, the RAC is an organization run by raisin farmers making decisions for raisin farmers. As far as I am able to determine it's a program with generally wide support from those it regulates.  The outcry over it's methods seems to come from a minority of farmers who want to buck the system to make extra cash (which would be substantially less if raisin prices weren't inflated) and non-raisin farmers like myself who enjoy pointing out ridiculous regulations.

American cotton is cheaper because our taxes go to Brazilian cotton farmers.

Like nearly every other agricultural product cotton draws some hefty federal subsidies.  However, unlike many other products another nation took umbrage with our protection of domestic cotton markets.  In particular Brazil brought suit against the United States with the World Trade Organization and won.  The WTO granted Brazil the right of retaliation, which had it been exercised would have been quite interesting.  Brazil could have lawfully chosen to ignore such things as pharmaceutical patents or increased tariffs on many products to protect their own markets from US imports.

Instead the US and Brazil came to a temporary agreement.  While the US attempted to phase out unfair subsidies they would subsidize the Brazilian cotton farmer as well as the American.  Of course ending an agricultural subsidy seems a near impossibility on capitol hill so the agreement is extended every few years with the end result that tax dollars keep flowing towards Brazil.

It seems like it's difficult to find a plant you can grow in America without the governments help.

More economics next week. Until then stay safe and rational.