The Holidays-- An Economist's Worst Nightmare

Well, we're coming down the final stretch toward New Years, and I'm sure presents are flying about already. Here's an interesting bit of information that I've come by about the inefficiency of holiday gift giving. Interesting, to say the least. But just to cover my butt in the event someone files a lawsuit against me for plagiarism, all credit for these findings go to Joel Waldfogel. His latest book, Scroogenomics: Why You Shouldn't Buy Presents for the Holidays, is an interesting read. Check out the Amazon page here:


Scroogenomics

Waldfogel also wrote a journal article for the The American Economic Review back in 1993. It's definitely an interesting read as well, and I suggest you check it out. You can find that here: 

Deadweight Loss of Christmas


Waldfogel's results should not be surprising though. How many times have you gotten a gift that you've hated? You simply smile at the gift giver, hoping to conceal your disappointment. Every time this happens, the buyer has paid more for the item than the satisfaction received for it. Say, for example, that my friend buys me this awesome pair of glow-in-the-dark tube socks. Let's assume that he paid $10 for it. However, as soon as I see it, I roll my eyes in disgust. "Glow-in-the-dark tube socks?!?!" I say, "I wouldn't pay more than $1 for those!" And therein lies the problem. According to Waldfogel's findings, people are, on average, only willing to pay 25 cents on the dollar for the gifts they receive during the holidays. Now I don't know about you, but to me that's a pretty big efficiency loss!


So does this mean that we should stop giving our holiday presents? Perhaps not. It is indeed possible to add to the value of a gift if it is worth more to the recipient than what was paid for it by the buyer. This can happen under a couple of circumstances. The simplest is sentimental value. Even a cheap necklace from the dollar store can be worth a lot if it's given to you by the girl that you've had a crush on for the past 30 years. The second circumstance is a function of opportunity. Say that I have an uncle who works for Nintendo and gets unreleased video games for free. He then proceeds to get me a copy which I value at $50 while he pays $0. But if neither of these circumstances apply to you, don't fret. Any type of liquid asset, like cash or gift certificates, make very efficient gifts. Why attempt to value a gift yourself when you could have the recipient value it themselves? So the next time you get someone cash for the holidays and feel bad about it, don't. Just tell yourself that you're promoting economic efficiency. 


But come present time, (whatever holiday you celebrate) do a little experiment. First, write down a valuation of  what you think your gifts are worth. Then look up their prices online. Using this method, you can roughly compare your own satisfaction gained with the prices paid. You can even calculate a rough value for the deadweight loss (by finding how many cents on the dollar you're willing to pay on average for the gifts you receive)! 


See? Isn't economics exciting?

A Novel Approach to Unemployment

 Labor Dept: Available Labor Rate Increases To 10.2%

Steven Levitt meant it when he said in Freakonomics that there's a hidden side to everything.

Democracy--The New Communism Pt. 2

In my last post, I discussed the uses of a "vote market" as a means of increasing economic efficiency. However, what I purposely did not mention is that this kind of "vote market" would not work under the current methods of voting.

As I mentioned, free voting can produce inefficient market outcomes by either providing a specific public good that decreases society's wealth or by preventing the providing of a good that increases society's wealth. Now, if you read that last sentence closely, the problem becomes immediately obvious. How many times do we vote on specific issues? Never! (Well, you sometimes do for issues at the local level, but most of the time you vote for a representative to represent you.)

For example, look at the presidential elections. Instead of voting on each individual issue separately, we instead must vote on a combination of issues, taking the good with the bad. In this case, the inability of voting to prevent the passage a useless good or to insure the passage of a useful good even with the existence of a vote market is yet another source of inefficiency for the economy.

The practice of forcing people to take the good with the bad is not a new one. It is known as bundling in the economic world, and is often used by firms to make a larger profit. Ever seen the video games section at Costco? They sell a video game system and 5 games at a much lower price than the price you'd pay if you were to get these games separately. However, one of the games is usually a complete dud, boring and useless. Yet, because consumers cannot get the entire package for much cheaper elsewhere, many choose to buy these packages because they can "take the good with the bad," at the same time thinking about how great of a deal they got.

How wrong they are. Bundling is a tool used for higher profits, and is un-intuitively bad for consumers.

The same principal holds for voting. Having to choose between two people in a presidential race is in fact giving the consumers (voters and receivers of the public good) the short end of the stick. By forcing people to choose between two bundles of mixed public goods, we are effectively allowing for wasteful spending and economic inefficiency.

Indeed, it is clear that there is much inefficiency inherent in the democratic system that we proud ourselves upon. The concepts of "representative government" and "fair elections" are all alibis for one thing: "economic inefficiency." However, there is a solution, albeit one that requires much reform. I already mentioned the market for votes. But also, we must allow specific issues to be voted upon by the general public.

Now, obviously, this last part produces problems. Up until this point we have been assuming perfect information, that is, the voters know everything about every aspect of the proposed public good. This is, of course, not true in our society. For this plan to work, we need the ability to educate society about the public goods that they are voting on. However, this is not necessarily a bad thing. Education breeds human capital, and human capital breeds efficiency. So investing in education could not only make the political system more efficient, but also make our economy stronger.

The point of all this is not to criticize democracy, per se. It is, instead, to point out the fundamental flaws of a system in which we all promote in our everyday lives. Perhaps democracy in itself is not as inefficient as communism, but our current system certainly has the potential to be just that. However, it is also important to note that potential is not reality, and that America currently is nowhere near as inefficient economically than Soviet Russia or Communist China. But sometimes, it's good to keep yourself humble.

Democracy--The New Communism

In our last discussion of public choice theory, I talked about the relationship between freedom and equality. Today, I'd like to focus on one facet of American life where equality reigns: voting. Ever since the 1960s and the end of the civil right movement, all American citizens have had equal access to voting in public elections. Indeed, Americans often praise free elections, calling them the "staple of modern democracy" or some other fancy mantra praising its success.

However, as economics tells us, equity comes at the price of efficiency. Voting is no different. The fundamental flaw of equal voting is that it fails to take into into account how much something is wanted.

Allow me to give an example. Say, for example, that you have a society of 3 people: A, B, and C. The government wishes to offer a public good that costs $30, and uses a vote to determine whether this good will be offered. Because our society has 3 people, each person will bear $10 in taxes to pay for this public good. Let's assume that A benefits $5 from the public good, that B benefits $5 from the good, and that C benefits $100 from the good. In this case, A and B will vote "NO" to the proposition because their tax burden is greater than their benefits gained, while C will vote "YES" because he receives a benefit of an amount greater than that of his tax burden. If you'll notice, the benefit to society as a whole is $120 while the cost to produce this good is only $30! It doesn't take an economist to say that this good will make society better off. However, as we have already established, both A and B will vote against this proposition; in other words, this public good will NOT be provided because of democracy and equality vote even though it increases society's well being as a whole.

Now consider the exact same case, except now, A values the good at $11, B values the good at $11, and that C values the good at $3. Using the same cost benefit analysis as above, we would arrive at the conclusion that A and B both vote for the public good, yet C votes against. However, note in this case that the benefit to society is $25, while the cost of implementation is $30, a net loss! However, both A and B will vote for this measure, creating the majority needed for its approval even though the measure will decrease society's well being as a whole.

So from this simple model, we are able to conclude that in certain circumstances, fair voting can lead to a public good that detracts from society's well being or block the passage of a public good that will increase society's well being. Just as with communism, the guarantee of equality has detracted from economic efficiency.

So what is the solution? If democracy is to politics what capitalism is to economics, how can we insure an efficient solution to a problem that seems to put democracy more akin to communism?

The answer, surprisingly, is quite simple: allow people to buy votes from each other. In our first case, because C benefits $100 from the public good, he could buy A or B's vote for $10 and still have an economic profit of $80. In the second case,C is suffering a loss of $7, so he will choose to pay either A or B $2 and the measure will not pass.

Does the idea of of buying votes seem unethical to you? You'd not be the first. But from an economic perspective, a well regulated market for votes would be an effective way of allocating resources for public goods... sort of.

I'll explain in my next post.

Circular Flow Model v2.0

Remember how last time I talked about the importance of being able to condense economics into its essence? Remember how I used the circular flow model as an example?

Well, here's what a circular flow model really looks like, with more economic variables factored in. I found it the other day idly browsing through my handy economics textbook. Perhaps now you'll understand the importance of simplicity.

Note: unfortunately, this blogger won't let me upload a full sized picture. If you want to see a larger version of the image with the descriptions, you'll need to actually click on the picture to open it in a new window. 

Breaking Street Date and Game Theory

A self-proclaimed video game connoisseur, I enjoy staying up to date on my latest video game news. One game that I have been following lately is the new Zelda game that was released today, "The Legend of Zelda: Spirit Tracks" for the Nintendo DS. About a week ago, while idly browsing some random video game new site, I stumbled upon an interesting piece of information. Supposedly, the nation-wide franchise corporation 7-11 had broken the street date for the new Zelda game.

Before I continue, I'd like to walk you through the process of a major video game release. Because the release date is the date when the game should be available in stores, the game must be shipped to vendors a week or two prior to the scheduled release date. The vendors then agree not to sell the game until this release date (aka "street date").There are no legal implications involved; compliance with the street date is completely voluntary.

This, of course, is called collusion, and allows us to analyze 7-11's decision with game theory. For simplicity's sake, and so that we can analyze 7-11's decision ceteris paribus, we will divide the involved parties into two firms: "7-11" and "All Other Vendors." The two choices these firms will have will be "Break Street Date" or "Don't Break Street Date." Let us consider first the benefits of breaking the street date. For one, breaking the street date makes you virtually a monopolist for the product until the scheduled release date. This will lead to increased profits and a bit of publicity to boot. However, the costs of breaking the street date is that the company probably won't be entrusted with shipments of another major release.

These findings are summarized below, assigning the arbitrary profits to each firm:

As you can see, the total profits generated from the sales of all copies of the game is $30 million in each case. The only difference is the distribution of these profits. It is immediately clear that both of these "firms" have a dominant strategy. Given that other firms don't break the street date, 7-11 will choose to break the street date. If the other firms do  break the street date, 7-11 will still break the street date to get a profit of $15 million instead of $10 million! The same is true for the other firms as they should theoretically choose to break the street date no matter what 7-11 does. This position is known as a Nash Equilibrium. Once the scenario is reached where both parties have broken the street date, or in other words, have taken their dominant strategy, neither firm has the incentive to change their behavior. Therefore, when one firm cheats by breaking the terms of the collusion, it is in the other firm's best interest to cheat as well, and to continue cheating, until a new collusion is formed... theoretically.

So why is it that 7-11 was the only company to break the street date for this popular game release? There are a few possible explanations. First of all, our model does not take into account the prospects of future profit. As we mentioned before, the company that broke the street date would most likely not be entrusted with another early shipment of a new game. Therefore, once 7-11 decided to break the street date, the prospect of future profits that these other companies would earn from future games sales probably exceeded the benefit of the $5 million of profit gained by following suit with 7-11. Also, remember that our model assumes "all other companies" as a single firm. It is immediately obvious that not all firms would break the street date in unison and this would detract from each firm's ability to generate extra profits.

So there you have it, our discussion of the economics of breaking street dates. This phenomenon is not a novel one; less than a month ago an Australian retailer broke the street date for the new Wii game "New Super Mario Bros. Wii." This phenomenon is not even limited to video games: the same occurs for movies, CDs, and even books.

But in the mean time, if any of you want a brand-spankin'-new copy of the new Zelda, you know where to go.

On Freedom and Equality- A Preface to Public Choice Theory

As the world's single most powerful country, the United States claims itself to be a lot of things. Fair, peaceful, and free, it is the icon and envy of every other country in the world, regardless of whether they admit it or not. This was, at least, the impression that I had as a citizen of China and it is still my impression after living in the United States for what has now been the majority of my life.

However, for all its gusto, the United States is not all that it claims to be. More specifically, I wish to focus on the claim that it provides both equality and freedom. This is nothing new. Everyone know that in America, we are all born with certain "unalienable rights" and that we have the the right to "freedom, liberty, and pursuit of happiness," blah blah blah, all that good stuff.

The problem is, however, that equality and freedom are the complete antithesis of each other, mutually exclusive in their absolutes. This fact is immediately clear upon consideration from an economic perspective. If a government engages in wealth redistribution, in other words the pursuit of equality, it by definition must rob another person of the freedom to use that wealth. This fact holds also from a political standpoint. For an example, we look to slavery, which has guaranteed a social equality of races while limiting our freedom to discriminate and enslave.

One interesting thing about the previous examples is that it shows that freedom and equality both have their uses in different contexts. For this reason, I qualified my original statement saying that equality and freedom are only mutually exclusive in their absolutes. Absolute equality is a scary thing. We call it communism (and everyone hates communism). Absolute freedom is likewise a scary thing. Pure freedom is simply anarchy with a pretty name.

So in the end, the claim that equality and freedom both exist in America is not false, simply misleading. Though they both exist, simply know that they are not compliments to each other and that increased equality comes at the cost of decreased freedom. Government seeks not to guarantee both, it seeks to mediate two opposing forces. As such, an analysis of freedom and equality must exist at a very basic level and cannot be applied at a level like that of an entire country.

Keep all of this in mind when you read my next post about public choice theory.

Mankiw's 10 Principles of Economics... Translated!!!

The Power of Models

The first time that I saw the circular flow model of the economy, I almost cried in disgust. To me, representing the entire economy with a couple of circles and arrows seemed overly-simplified, counter-intuitive, un-useful, and just generally stupid. Did I really need a textbook to tell me that the money I spend goes to business firms? Though rhetorical, I answered my question with an emphatic NO. And though people often call me a contrarian, I venture to say that this mind set is representative of the entire high school population.

However, as the year progressed, this once overly-simplified, counter-intuitive, un-useful, and just-generally-stupid model began to seem intuitive, useful, and, dare I say, even elegant. As I progressed throughout the year, I realized that the economy is not just complex, it's too complex. There are too many variables, too many factors that affect something as simple as a demand curve. The goal of the circular flow model was not to be obvious and useless, it was to condense the entire economy into a manageable package. And to you naysayers, sure, not everything in real life progresses as in the model--I could easily give my money to a friend or donate it to charity--but the ability to look at the essence, the bare minimum of the economy "ceteris paribus" is one that has been useful to me in the course of my economic study.

Indeed, many things in economics are deceptively simple. Take, for example, the economic principal that "people respond to incentives."

"Duh," you say, "that's obvious!" And yes, it is, if you only take the statement at face value. But it is surprising how many times seemingly intelligent people will act in blatant disregard of this principal that is so "obvious." At the same time that we are attempting to lift the economically challenged out of poverty, we hand out unemployment checks and enact tax brackets, which incentivizes the poor to stay poor. This is an example of the law of unintended consequences. But I digress.

The best way to understand the power of models is to look at pure sciences. Most models in pure science are simply theories--they are only accepted because they explain a series of phenomena convincingly and concisely. Some of these models are outright wrong. Yet, they are still used. A perfect example of this is chemistry's theory of the atom. It has been proven that electrons do not line up in perfectly symmetrical rings about the nucleus, yet this model is still taught in every introductory chemistry class across the world for the fact that it demonstrates the concept of atoms in a convincing, elegant, and simple way. In this way, economics is a science. It takes various social phenomena and attempts to explain them through the formulating of theories and models. As such, I see economics as much closer of a kin to science than to humanities.

So the next time that you see the circular flow diagram and roll your eyes in disgust, dismissing its value as overly-simplified,  just remember that its simplicity is not a product of torture, but one of necessity.

Welcome to Functional Economics

Hello all, welcome to Functional Economics, the newest Econ blog on the web run by... students. Yes, you heard right, this blog will be run by students. The intent is that this blog will serve as a forum of economic discussion for Mr. Devine's AP Economics students.

The truth is, economics is a very thought provoking study. The AP curriculum, however, is not exactly, how should I put this, conducive to original thought. A tax here equals a shift here, a movement here equates to an increase there, you get the point. The AP curriculum takes a robust study and condenses it into a black and white experience. This approach does have its benefits, but the truth is that nothing in economics is ever as ceteris paribus as we'd like them to be. And as such, it's important that you get to see the significance of economics outside of this black and white realm of textbooks and aplias.

The result, of course, is functional economics: a blog dedicated to finding the applications of economics in real life, from the decision to skip school to the inefficiencies of democracy. I hope that you will come along for the ride, even help design the ride, for such an experience will undoubtedly allow you to gain an unprecedented insight on the way our mysterious world works.

Throughout the year, Mr. Devine and I will continue to update the site with new posts and ideas, but I hope that we can count on your support and effort to make this blog a success.

And with that, have a nice day and happy blogging!