Unsustainable Pricing

A series of clicks today led me to this YouTube video of Senator Warren's March 2013 congressional hearings on the minimum wage.

At 2:53 she notes as a result of an increase in the minimum wage to $10.10/hour over three years, the price of a fast food meal would rise by four cents.

So instead of it being $7.19 it would be $7.23. Are you telling me that's unsustainable?

Given the context, "unsustainable" probably refers to the restaurant business itself. As in, "if you raise your price by four cents, are you really going to have issues?"

The answer is yes.

There is a nasty consumer habit to believe that the prices we see are given, as if they were determined randomly or granted to us from a deity. But they are the careful, careful decision of business owners and analysts with the sole aim at maximizing revenue. The $7.19 price came from a conversation like this (all prices are post tax):

"How about $7 for the meal?"
"$7 is a bit low; I bet we can up our revenue if we increase by two quarters."
"Our market research tells us our consumers are particular price sensitive, especially given the state of the economy. I wouldn't go higher than $7.05."
"Really? We can definitely go higher than $7.05. I was thinking $7.40."
"No way! Our competitors' are pricing lower than that. We gotta go much lower."
"Our competitors price there for a reason."
"A TV dinner only cost $5. This is our competition."
"It isn't nearly as easy, nearly as good. When we offered a coupon last year, people barely used it. We can afford to go higher. We have investments to pay off."
"How about $7.35?"
"Burger King's $7.25."
"It also's been hitting the airwaves harder than us. Let's drop a little below them and get our customers through price."
"$7.24?"
"A little bit more; something big enough that they just can't respond."
"$7.17? Has a nice ring to it"
"Maybe...or $7.20"
[Market research]
"$7.19 seems to be the sweet spot."

This is an abstraction, (void of uncertainty which is another factor they consider but I need to go to bed) but it's meant to remind us that firms do not grab numbers from nowhere, especially for firms who tend to sell very cheap food and where customers are very sensitive to price. Warren's thought process seems to be "Well, I'd pay 4 cents more while on my campaign trail" but she is a wealthy individual with very little time and not many alternatives: it's hard to get more insensitive than that.

Many customers, especially when times are tough (and thus when  increasing the minimum wage is most popular), are very price sensitive. This goes double after a lot of time has passed and they can adapt to the 4 extra cents (which, for a family of four and a biweekly meal out totals to $16.64 over the course of a year) in ways such as going to restaurants with fewer minimum wage workers (and thus less of a price increase so at least you get more for your money) to eating at home more to eating less when you do eat out.

At the heart of Warren's question is a puzzle: if an extra four cents is so sustainable, why isn't it already four cents more expensive?

It's because it is. That's the revenue maximizing price.

Black Swans and Evolution

Nassim Taleb argues that financial reform should take a page from nature and add redundancy to protect against "black swans," his name for unexpected, very rare events.

Let me summarise my ideas of how Mother Nature deals with the Black Swan. First, she likes redundancies. Look at the human body. We have two eyes, two lungs, two kidneys, even two brains (with the possible exception of company executives) - and each has more capacity than is needed ordinarily. So redundan cy equals insurance, and the apparent inefficiencies are associated with the costs of maintain ing these spare parts and the energy needed to keep them around in spite of their idleness.

Let's be careful. Some of those extra parts are not redundant; the "two brains" are different parts of the same brain and one is not a perfect substitute for the other. Our "extra eye" is not idle; two eyes allow depth perception and losing one is more than losing some insurance (though it's far better than losing both).

But it's more than that: a black swan is a very rare event. If losing an eye or a kidney is a black swan (and I think it is), then it is unlikely to happen before someone reaches maturity or even in their lifetime. And redundancy's costly. Energy devoted to a second, idle, organ is energy not devoted to keeping the body alive. Exactly how much this is, I admit, I don't know. But anything more than one redundant organ is very rare across across all animal species despite that all organisms exist in very different environments and places in the food chain.

It's more likely that these pairs are evolutionary hold-overs from a common ancestor who faced either a black swan kind of problem but the extra organ was very cheap to grow and maintain (unlikely as "black swan" again implies there's time, on average, to reproduce and pass on your genes) or the problem was more common than a black swan (though is still not "common") and the organ was less cheap to grow and maintain.

Despite it all I agree that some redundancy in the financial market is a good thing and to be sure, we already have some of that (competition between banks, credit unions, etc) and much of what he suggests I support. But a riskless world is not optimal and I wouldn't go so far as to ban complex financial products.

Not All Yale Students Are Hippies

Tanya and I are at some coffee shop in New Haven and I noticed on patron has a quote attributed to John Maynard Keynes on her laptop:

Capitalism is the extraordinary belief that the nastiest of men, for the nastiest of reasons, will somehow work for the benefit of all.

Apparently, this quote isn't from Keynes, but it's a good sentence nonetheless and reminds me of this quote from F.A. Hayek's The Fatal Conceit:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

(It occurs to me this person might think the quote is sarcastic but I hope not. That would ruin my title.)

On Solow On Posner On the Economy

Nobel Laurette Robert Solow wrote a review of Richard Posner's new book about the economy. In a surprising move, Posner blames market failure--not government failure--for the recent problems. In an unsurprising move, Solow agrees with him. I don't.

Both point out that the market is not perfect and there's no denying it. You'll be hard pressed to find any economist who thinks businesses, and even whole markets, make mistakes. But the temporary or systematic failure of a firm, or the temporary failure of many firms (i.e. the market) does not mean there are inherent problems with the system. On the motivations of engaging in investments investors knew little about, Solow writes

Why did I do such a risky and, as it turned out, stupid thing? Well, it had worked in the past, and made a lot of money for many people. If I had backed off, others would probably have continued to make money for a while. I would have looked like a fool, and very likely an unemployed fool.

Add "until now." And lots of banks didn't do it: Pittsburgh National, Wells Fargo, JP Morgan Chase, and Bank of America (the last one did, but only after the crisis begun). Now they look like geniuses. Believing firms are so mindless, myopic, and systematically prone to being duped violates basic economic principles of rationality.

Imperfections and information asymmetries always exist. People understand that and people adapt to it. They don't adapt instantly and they don't do it perfectly, but they adapt as well as they can. Solow and Posner seem to agree unless we're talking about regulators. One cannot point to information asymmetry as a key problem and then call for non experts to correct it.

That is not to say regulation never has its place, but the issue is one of costs and benefits. What is less costly to society: the costs of establishing and maintaining the regulation plus the good opportunities regulation renders impossible or the occasional, but vary painful, market corrections that come with no regulation. The answer is not obvious, especially when you consider that people will adapt to the rules. There are many ways around regulation (creating a false sense of security), many ways to game the system (making regulation more costly), and many reasons to embrace prudence when you know one's going to save you if you screw up. The essential mechanism of market self-correction doesn't go away when errors get big, though the additional time it takes to fix itself (increased by uncertainty in the political climate) might fool even famous judges and Nobel Laurettes that it disappears completely.

Life Follows Death

During his inaugural address, President Obama rightly reminded us that it is the risk takers that ensure a better tomorrow. Yet he paradoxically argued that the current economic slowdown is the fault of greed and the market needs a "watchful eye." One cannot have both. Risk takers have to fail; otherwise it would not be risk. Pointing to mistakes as evidence of too much risk, of a need to remove bad decisions, necessarily curtails the capacity to make the right ones. We cannot have growth without bankruptcy nor more than we can have evolution without extinction.

Traffic Patterns and the Left Lane

Frustrated in DC traffic, a friend of mine wondered why, in the States, people drive in the city about as much in the left lane as in the right while in Europe, the left lane is traditionally held exclusively for people going very fast and passing. This is an excellent question and I think I have the solution.

Americans have low car taxes, free parking, few tolls, and relatively cheap gas. Not surprisingly, we have more cars compared to our European counterparts and traffic is thus much worse. With crowded streets, drivers learn it's far better to drive in the left lane if they're planning to turn left, even if the turn isn't for miles. No one wants to miss a turn because they never could claim a spot in the correct lane. Thus people drive in one lane as easily as they drive in the other.

The same can be said of interstate traffic, though the story's slightly different. With so many cars on the road, there's greater likelihood that the right lane will have an unusually slow driver. Constantly passing in and out of the right lane to avoid these drivers might induce the faster car to simply stick with the left lane, even though an even faster car will likely be stuck behind it soon. Thus we see very fast cars weaving through traffic, blazing a sort of third lane.

The Emperor's New Grub

LA central planners, lead by Jan Perry, put a moratorium on new fast food outlets in south LA (one of LA's poorest neighborhoods). The policy is to encourage more grocery stores and sit-down restaurants. She cites health reasons and claims there simply aren't a lot of choices in that part of the city.

What she really means to say is that she doesn't like what the poor eats and they should be forced to choose what she wants. It clearly never occurred to Perry that this poor (little money to eat at nice restaurants), working (no time to prepare their own food) neighborhood of LA enjoys fast food for a good reason. Forcing them to swap their preferences for hers is ghastly arrogant and morally reprehensible.

If Jan Perry wants more food choices in South LA she should start a restaurant, not ban others.

HT: Jon Cell

The Island of Doctor Hayek

For the third homework assignment I asked my principle of microeconomics students the following question:

Suppose anyone could legally practice medicine regardless of their educational background. Keeping the ideas of emergent order in mind, explain the implications of such a change. Would this change be desirable or undesirable? Explain why or why not.

The vast majority (about 70%) claimed this would be, "of course," disastrous. It reminded me of F.A. Hayek's observation:

Much of the opposition to a system of freedom under general laws arises from the inability to conceive of an effective co-ordination of human activities without deliberate organization by a commanding intelligence.

To see what I mean, here's a sampling of the responses:

...there would be a significant decline due to a lack of knowledge ad resources to apply appropriate medical treatment. This would cause a decrease in recovery, trust in the medical professionals, an increase in malpractice suits, and inappropriate treatment...

The quality of healthcare would plummet. The doctors [sic] offices would be jam packed with people who may not even need medical attention.

Without medical schools people would learn how to practice medicine directly from other doctors....without the proper tests and knowledge from medical school many doctors may be ill-informed and overall perform more poorly than they would of if they learned all the rules and regulations from medical school.

There's no doubt, as I mentioned to the class, that decentralized order is messy. In this case, people will surely suffer and even die by the hand of someone with less knowledge than a typical doctor. But so much of the chaos mentioned here wouldn't happen. The danger of medical malpractice and the desire to get a good doctor will make true quacks few and far between. A "jam packed" waiting room would encourage entry or prices would increase. Medical schools would still exist and, because good doctors are still in demand, people would still attend. More might attend because you don't need to finish to practice medicine.

Most of the reasons people go to a doctor are routine concerns. Do you really need a veteran doctor to give you a physical? Or tell you that you have the flu? You're either wasting his time or spending too much on him. As Arnold Kling argues, this "Crisis of Abundance" is one of the big reasons health care costs are so high. You don't need experts on every little cough and sneeze.

Yet students rarely mentioned any benefits such deregulation would bring and some mentioned the lower salary of doctors as a negative (though in reality only the bad doctors would see their wages fall, as per the compensating wage differential, a concept that was covered in the question right before this one).

It's not obvious if this institutional change is desirable or undesirable. But the relative metric is comparing the costs of the risk and additional suffering thanks to quacks with the benefits of getting the same job done for less. And since the costs are temporary and rare (bad doctors don't last long) and the benefits are permanent, I personally lean to the favorable interpretation.

Order At A Bargain

This week on EconTalk Allan Meltzer poetically reminded us that

A country that won't experience a small recession will end up having a big one.

Free markets are messy things and it won't be perfect all the time. Nothing will be perfect all the time. We must remember that slowdowns and corrective recessions are the price we pay for the benifits of a dynamic and enriching society. And we're getting a damn good deal.

If You Build It, They Will Ride

Paul Krugman claims Americans face a paradox as we adapt to higher oil prices and away from our suburbia lifestyle.

Public transit, in particular, faces a chicken-and-egg problem: it’s hard to justify transit systems unless there’s sufficient population density, yet it’s hard to persuade people to live in denser neighborhoods unless they come with the advantage of transit access.

This is not really a big problem if you remember your marginalism. Extend a single rail line through a residential area. If oil prices are as high as everyone says they are, people will move to that area. Apartment buildings will replace townhouses (and if you're smart, you bought some of that land around the rail before the construction was announced).

Firms solve this problem all the time. Wal-Mart constructs its stores in the middle of no where. It doesn't fret about the low population density (it prefers it, actually) because it knows people will come to it. Same goes with any large scale project that people will want. Assuming, of course, they want what you're building.

Capitalism 101

Tonight on The Daily Show John Oliver and Jon Stewart jokingly argued that China's use of lead paint in toys is an example of how "they do capitalism better than we do." Not bothering with oversight or quality control, the Chinese factories (and the American consumer) can save a great deal of money.

If only they knew how much they were joking. Contrary popular belief, capitalism is not merely about reducing costs but reducing costs while still providing people with something they want. And this is why capitalism works. It's not that bad decisions won't happen, it's that they won't be rewarded. And already we see capitalism working as Chinese factories become less popular and are put under pressure to raise their standards. It's a loss for the manufacturer, but yet another victory for markets.

Tell Me the Secret of the Hurricane

Tonight during my introductory economics class, I made mention of the story of Hurricane Fran after it swept through Raleigh, NC in 1996. In the aftermath of Fran, power was out, trees were down, and the heat was devastating.

In nearby Goldsboro four guys decided to rent a refrigerator truck, loaded it with ice and chain-sawed their way to the city center. Once there, they charged the locals $12 a bag--more than 10 times what it cost them to buy it. Anti-gouging laws took effect and the police arrested the men. (The trucks were impounded and turned off. The ice melted.)

We discussed how the pricing mechanism will sort out those who want ice for cold drinks and those who want it for their insulin or to ward off heat stroke. Prices do that. They are not perfect, but it is far better than a first-come-first-serve basis, where the fast or the healthy or the merely well placed get ice, leaving nothing for those that need it.

But the most powerful element of the pricing mechanism is that it creates the incentive to increase the supply and bid it down. At $12 a bag, others in Goldsboro have a reason to send more ice there and sell it for $11 or $10. Still, that's a high price and encourages yet more to come: $9, $8, $7. Lower, and lower. It's a strange paradox in economics: The only way to guarantee low prices is to allow sellers to charge high prices. But when you understand the role and power of incentives, it makes perfect sense.

For the full and deeper story, see this EconTalk.

The Future Is Slippery

Last night on The Daily Show, Jon Stewart mentioned the rise of the price of oil during the Memorial Day weekend. To paraphrase, he asked why, on this most predictable of demand increases, don't oil companies increase production to compensate? Implying, of course, that they are colluding to restrict supply on purpose.

First, oil prices are actually slipping as the Memorial Day weekend approaches. But this could just be a strange fluctuation. It could also be overcome in the US by American demand. What else is going on?

The second point is much more subtle. It takes months for any oil company to respond to a change in demand. That means to prepare for this weekend's surge in gas use, companies have to estimate today's increase in gas consumption back in winter. Not only could a lot happen in the mean time (as it always does), it's very easy to get the initial estimate wrong. So to play it safe and compensate for the cost they must bare by trying to predict the future, they sometimes get it wrong. It's not that they aren't adjusting to the prices, they just aren't doing it perfectly. But that hardly means they are colluding. It just means they are human.

Remaking A City

Mike Mills sent me an email containing this link about Google establishing a server farm in Lenoir, NC. Lenior used to be a city of furniture makers but the rise of China has out competed them and the town entered a decline. Because of this decline, unemployment rose, land values fell and the free market kicked in.

Because of these low land values and lake of people looking to become employed again, Google decided it would place a new server farm there. A server farm is basically a building full of computers that run Google programs (their search engine and so forth) all over the world.

Mike correctly stated that there's "A lot of blogrich material" in the article and that's no exaggeration. But beyond the very cool overarching theme of spontaneous order, I noted one other item I really wanted to point out:

The city offered Google some pretty sweet tax breaks to encourage them to come in. Like the only Libertarian on the city council (who was also the only one to vote against Google's entrance), I'm not too fond of special treatment. However, I also recall the words of Milton Friedman: "I am favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible."

Hidden Exchange

In one of my classes, we read about how various stateless societies functioned economically without money or prices as we are familiar with. There were various methods of exchanged discussed, but this one I found to be the most interesting.

Herodotus discussed the trade relations between the Carthaginians and African tribes several hundred BCE. It went as follows:

The visiting traders (or perhaps better, would-be traders) appeared at some point in the vicinity of the area occupied by their hoped-for trading “partners,” with the goods they wished to exchange, and signaled their presence. The visitors placed their goods on the ground and went into hiding. In due time those with whom they wished to trade brought their goods, which in turn were placed on the ground, after which they disappeared. The visitors then returned to the place where the goods were displayed and if they were satisfied with the offerings of the “host” group, took them and returned home, leaving their own in exchange. If not satisfied, they left the host’s offering and their own goods untouched and disappeared again, thus indicating rejection of the initial offer. The hosts were then expected to adjust their offerings, or withdraw them and depart. In this technique the visitors would normally not be adjusting the amounts that they offered; they merely accepted or rejected the host’s offerings. Further, the visitors, in refusing the host’s first offering, were courting failure of their expedition and even impairment of continued relations with those who had goods that they needed.

F. A. Hayek called the pricing system a “marvel.” After reading about societies without an explicit pricing system, I agree with him that much more.

The World Wide Way?

Today I discovered the Global : Ideas : Bank, a website dedicated to posting users' random ideas for the world to see and discuss.

I was almost going to put it aside and sign up later (so I could comment) when I saw this entry (safe to say I signed up soon after):

The Problem:
Most of the time when we are surfing internet, we face the problem of find the information we need(What we are looking for).
The Social Invention:
A standard layout for website should be created which enforce the new website development to follow that standard layout. I than way [I think this way (?)] we will alway find the information more quickly and without any sort of hasle of search again and again.

Also some sort of engine can be develop which shows the information on the web site in a consist manner (Embebed with the internet browser). [sic]

Very fitting that just minutes before I had re-read The Idea Trap.