Standard Price for Video Games

I read an interesting article on IGN the other day (link here) about the pricing system in place for video games. The idea presented is that because different games present the player with varying degrees of value, the price of video games should be set based on the content to players, instead of simply using the standard $60 price tag.

There are a few problems with this idea. First, and most importantly, is determination of the inherent market value of any given video game. The author is clearly mixing up the concepts of ex ante data and ex post data. The concept is pretty simple. Basically, the final verdict (reviews, message board feedback, etc.) on the quality of a video game doesn't come out until after the game is released. Therefore, data regarding the value of a game is ex post data, being released after pricing decisions are already made. The decision to set a certain price for the game, however,  is made before the game is released. The data available at the time pricing decisions are made are called ex ante data, or data that forecasts into the future. In other words, from the perspective of the developer, it's rather difficult to gauge the quality of a game and to set the price accordingly without empirical data  about the game's quality which only becomes available after the game is released.

I realize that at this point, people will argue that developers are, in fact,  able to gauge the quality of any said game, due to the fact that they are the ones who made it. However, it is exactly this that creates the problem. Most developers spend so much time with the games that they are creating and become so accustomed its ebbs and flows that any apparent flaws in the game probably go unnoticed. I realize that there are play testers and beta phase tests, but the people in these tests are usually experienced gamers themselves, likely able to automatically adjust to the most unintuitive ideas. That said, I wouldn't be surprised if developers of most of the shovelware out there believe that the games they have created are actually quite superb.

Another problem with this model of value-based price setting is the fact that in many cases, value does not reflect sales. There are many good games that have flopped (see: Okami). On the opposite side of the coin, there have also been a number of not-so-good games that have sold extremely well (see: Wii Music, Wii Play). In these cases, the success of a game depended not on quality, but rather on marketing, something the author fails to take into account. In this way, video games are very similar to movies (and I might note that you don't really see a huge price differential in the DVD price or ticket price of a good movie and a bad one).

The final problem with the author's analysis of video game pricing lies in the role of price in signaling. Let's assume, for a minute, that there are only two classes of game: good games and bad games. Good games are priced at $100, and bad games are priced at $50. Do you see the problem? If price becomes an indicator of the quality of a game, what is stopping the developer of a bad game to up their price to $100 in an attempt to make their game look like a good game? It is true that in the age of the internet, the role of price in signaling is decreased. There are now much more credible ways of finding out the quality of any given video game, through internet reviews and such. However, pricing undoubtedly does act as a signal, and will have at least some effect on the pricing decisions of game makers.

So while in theory the concept of pricing games based on quality is a good one, it is a bit impractical in the real world. It may work for guaranteed hits like Fallout or Call of Duty, but for the rest of the gang, the status quo is probably a much safer option.

The Case Against Inflation

I've always been an adamant inflation hawk, squawking away about the need to reduce the money supply and the fact that the potential for inflation is huge with the fed expanding its balance sheet from 800 billion USD to 2.4 trillion USD is a little over a year.

However, it's sometimes nice to consider the opposite side of the argument, to be the so called "two armed economist." I do, in fact, sometimes bash the fed for keeping interest rates too low for too long. However, after a bit of research, I can see why it has been hesitant to do so.

First is the issue of the Taylor Rule. The Taylor Rule Equation, at its core (without smoothing and error) is:

FF = a (I - I*) + b (Y - Y*)

In plain English, the federal funds rate depends on the inflation gap I (inflation; it is usually symbolized by the Greek letter pi, but I can't type that) minus I* (the inflation target) and the output gap Y (Real GDP) minus Y* (Natural rate of output). If we consider the state of the current economy, we can see that by all calculations, expansionary policy is necessary. Inflation is below the fed's implicit target (around 2%) and output is WAY below its natural rate. In fact, the Taylor rule suggests that the Fed should actually lower interest rates. However, this obviously is not possible with the Fed Funds rate at 0-.25%.

The second telling sign against inflation is the poor capacity utilization numbers right now. Capacity utilization is basically how much of our current resources are being used up. For comparison, think about it like the percentage of rooms that are being used in a school. Usually, US capacity utilization is around 90%, but now, they are a mere 70% (ish). Anyone who studies Keynesian theory knows that in recessions, due to low capacity utilization, the aggregate supply curve is horizontal and will have few upward price pressures even in the case of an increase in demand.

So for these two reasons, I can definitely see the case for dis-inflation. I still think that the risk for inflation is higher and that we're more or less in a liquidity trap at the moment (see: Japan), but then again, I've been wrong before.

Grade Inflation: An Analogy

I remember taking economics last year, when some of my peers had trouble grasping the concept of inflation. What was inflation? How did it work? The whole concept of money itself was so confusing and new that few people could intuitively understand the basic principles underlying inflation. To try to make understanding inflation (arguably the most important concept in Macroeconomics) a bit easier, I provide you the following analogy:

Instead of money, consider the points system that many teachers use. The system works something like this: different assignments (homework and tests) are worth different amounts of points. At the end of the semester, the teacher adds up all of your points and divides by the total number of points possible to get your percentage and thus your grade.

Let's take a look at an example. Let's assume that Mr. Devine assigns 5 pieces of homework that are worth 10 points each and a test that is worth 50 points. You turn in all your homework, but get a 40/50 on your test. Your grade is 90/100 = 90%.

Now, let's introduce some inflation. Suppose that Mr. Devine now changes the system so that homework is worth 100 points and tests are worth 500 points. Your still turn in all of your homework, but this time, your test score is 400/500. Your final grade is 900/1000 = 90%.

If we think about the total number of points as equivalent to the money supply, the connection to inflation becomes clear. The value of a single point, in our example, went from 1/100 = 1% to 1/1000 = .1%. The reason for this decrease in value was an increase in the supply of points. In monetary policy, an increase in the supply of money in the economy decreases the value of a single dollar. See the connection?

Our analogy also shows us an interesting fact about inflation. If all prices are flexible and increase by the same amount, inflation has no effect on output. As you saw, the only thing that changed was the number of points in the system; your grade was the same. In other words, with price flexibility, nominal prices can change, but relative prices remain the same.

Now, let's consider a slightly different case. Suppose Mr. Devine kept the value of tests to be 50 points, but changed the value of homework to 100 points. You, doing the same amount of work, get 500 points for homework and 40/50 points on the test. When we calculate your grade, the calculation is 540/550 = 98%.

So what happened? Your grade jumped by 8%! The key here is that relative prices changed. This is very similar to the mechanism by which inflation actually promotes growth in economy. Keynesian theory states that prices are fixed in the short run, but in actuality, different prices have varying degrees of flexibility. For example, food and oil prices can change and fluctuate rather quickly, but housing prices cannot change very fast. As a result, the level and composition of your economy's output changes. "Oh, but that's not a bad thing," you say, "after all, my grade went up 8%!" However, the changes in relative prices causes some inefficiencies.

Let's consider for a moment the incentive structure this creates. Homework is worth 100 points, yet the test is only worth 50 points. Will you spend more time doing your homework or studying for the test? Any rational student would choose to spend his time doing his homework (he could get a 0 on his test and still keep an A). However, if we take a step back, we conclude that it is probably just as important that the student studies for his test as it is for him to do his homework, for the sake of learning. This, in econ-speak, is what we call a misallocation of resources. You should be spending your time studying, but instead you spend more time on homework.

This, when applied to US macroeconomic policy, can have debilitating effects. If prices in one sector grow disproportionately to the rest of the economy, *coughhousingcough* more economic resources will go toward that sector, depriving other markets of economic activity. This creates what we call a bubble, a rise in prices that outstrips the market's fundamentals. And as we all know, bubbles pop.

So while it may seem good at first glance that our economy has inflation, it is actually something that needs to be heavily moderated in the interest of efficiency. I suppose that's why we have the Federal Reserve, right?

Economics: The UN-Dismal Science?

I recently read an interesting post on Marginal Revolution (link: Are Economics Students Happier?) regarding a recent study on the happiness of students studying Economics compared to other social sciences. The journal itself can be found here; it's very interesting if you want to get a feel to what modern experimental behavioral economics is all about.

At any rate, the authors concluded that:

"In our sample, studying economics has positive effects on self-reported well-being while studying social sciences has negative effects on individual well-being compared to economics. This is good news to anybody involved in teaching economics. Additionally, an important finding is the strong positive effect of income on subjective well-being. Despite the findings of modern behavioral economics that well-being depends on more than money, an increase in income is still an important driver for individual life satisfaction, at least for low income levels. We also found that happiness is also positively affected by positive career perspectives, which may also be interpreted as a measure of future income. Furthermore, we found it interesting that more conservative students appear to be less happy in our survey. To conclude, while income and future job chances are the main drivers of happiness for students in our sample, studying economics also increases students’ life satisfaction."

So studying economics might make you a happier person. Somehow, the dismal science just got a bit brighter.

Monetary Theory and Policy

I found this lecture absolutely fantastic (especially the portion about the Taylor Rule). If you're taking AP Econ right now, this will put everything you've learned about the Federal Reserve in context. Don't doubt yourself; I think you'll actually understand most of this. The professor takes a very beginner friendly approach to his explanation of monetary policy.

And if you're on the Fed Challenge team (like me), this is an absolute MUST WATCH!!!

Microeconomics Rap

The first thing that I thought when I saw this one was, "Another one?!?!?!??!" There's been way too many of these popping up lately, but this one is pretty funny. It makes me wonder what Mr. Devine's AP classes could do if they had a project like this... (I vote for a fed rap, in case anyone's listening :3)

Anywho, credits to Economists Do it with Models for the find.

A System Without Incentives Pt. 3

Reading some posts the other day, I realized I never finished my series of posts on the economics of procrastinating as a senior (oh the irony). The final reason for senioritis I have today doesn't really apply to me, per se, but I know that it definitely has a great deal of an effect on the effort put forth by my peers.

3. There is no GPA difference between AP classes, honor's classes, and normal classes.
Yeah, that's right. Our school doesn't have a weighted GPA. Ever hear of the kid who breezes through senior year with four credits of gym and two blow-off electives? That's our school. I'm personally taking five AP classes (I enjoy the challenge), but a person with the former schedule would likely have no GPA difference from someone with the latter GPA (in fact, the latter schedule might end up with a lower GPA, because the difficulty of the courses is greater).

Unsurprisingly, I prefer the weighted system over the unweighted system (5.0 scale for AP classes 4.5 for honor's, and 4.0 for normal classes). Not only would this make the grading system more fair, it would also incentivize students to take higher lever courses for a chance to improve their GPA.

So there you have it, the three reasons for senioritis. Now if you don't mind, I'm going to go not do my homeowork :P

Dr. Arthur Laffer Presentation

After much delay, here it is. You won't find a summary of this presentation anywhere else, as there were one 130 people in the room, and none were part of the media (as far as I could tell). Anyhow, here it is!

Dr. Laffer and I, after his presentation on the state of the economy

I had the distinct honor of sitting in on one of Dr. Arthur Laffer's presentations about a week ago (credit to Mr. Devine for getting me in). I was, coincidentally, the only high school student in a room full of investment managers and corporate big wigs (I was sitting next to a financial adviser from JP Morgan). At any rate, suffice it to say that this was a very rare (and amazing) opportunity for your run-of-the-mill high school senior.

I will below outline the contents of his speech from the notes I took. There may be some holes, and I apologize if anything's missing (I know that for one segment I was so enraptured by Dr. Laffer's presentation that I forgot about notes), but I will attempt to recreate his presentation as accurately as possible, paraphrasing and quoting Dr. Laffer when necessary. But more than anything, please keep a keen eye on Dr. Laffer's distinct sense of humor, which I will let you draw your own conclusions about.

Dr. Laffer was supposed to arrive for the presentation at 12:00PM, but his flight was delayed. We ended up waiting for an hour, and his presentation started a bit past 1:00PM. As a result, his lecture was slightly shorter than it otherwise would have been. Anyways, at around 1:15PM, Dr. Laffer walks in with his signature smile apologizing that he was late but saying that it wasn't his fault.

Dr. Laffer began by asking the audience how we manage to survive with both Granholm AND Obama. Way to set the tone for a presentation, eh? He continues to point out that there can be "no economic growth with raising taxes, protectionist policies, and a federal reserve that is printing money like crazy." He acknowledges that we have been seeing "green shoots" in the economy, but then goes on to outline 3 reasons why these green shoots will not translate into sustainable growth.

Reason 1: The accelerator effect (Dr. Laffer calls it the "Free Fall Effect.")
I'll admit that I'm not too familiar with this. I'll do some more research later, but I'll summarize what Dr. Laffer said. The idea is that a small investment will lead to a larger increase in GDP. Therefore, a small population increase will lead to a large increase in construction (...somehow). At any rate, the point of this is that in the short term, GDP growth goes down sharp, and goes up sharp. Dr. Laffer described our situation as a "Dead cat bounce." He also stated that this signals that recent growth growth "won't be here in 2011."

Reason 2: The Fed's Expansionary Policies

Dr. Laffer noted that the Fed's balance sheet has surged from $840 billion to over $2.2 trillion. He also cited the fact that bank reserves have grown from $800 billion to over $1 trillion. The Fed has engaged in some risky policies such as quantitative easing. In every introductory economics course we learn that an excess supply of money leads to an increase in aggregate demand and inflated prices. This is why Dr. Laffer believes that oil prices are at $70 per barrel when they should be at around $40 per barrel.

However, Dr. Laffer believes that the Fed will be forced to reverse its expansionary policy soon, similar to what happened in 2000. Dr. Laffer said that in 2000, due to a fear of a run on banks from Y2K, the Fed expanded the money supply. However, once it realized that the world was not going to end and that there would be no run on banks, the Fed contracted its policy. They "took the punch bowl away and took back the punch from those who already got it." In Dr. Laffer's opinion, as soon as the Fed ends its expansionary policies, we will descend back into the depths of recession.

Reason 3: The Tax Boundary Effect
This effect was the focus of Dr. Laffer's presentation, and what I found the most interesting. Dr. Laffer noted that President Obama was purposely allowing the Bush Tax Cuts to expire rather than renewing them or raising taxes through a tax bill. The idea is that on January 1st 2011, we are going to have an across the board tax rate increase. The highest marginal personal income bracket, the capital gains tax, and business taxes will all increase significantly.

Keeping in mind that businesses "can change the location, volume, composition, and timing of their income," the logical conclusion is businesses will be incentivized move profit from 2011 into 2010. This creates temporary growth in 2010 while sacrificing growth in 2011. Dr. Laffer claimed that this would move 3-4% of 2011 GDP growth and move it into 2010.

At the same time, these tax hikes don't generate the intended effects, as America's richest people know how to evade these high taxes. Dr. Laffer cited Warren Buffet and Bill Gates, who have most of their wealth in unrealized capital gains, for which the tax rate is 0%.

Dr. Laffer then proceeded to talk about the 1981 Tax Bill that he himself wrote, which progressively lowered taxes over the course of a few years. The measure evidently led to four consecutive quarters of positive GDP growth following a recession and led to a two year upward trend in GPD growth.

At any rate, the end result is the same. Come 2011, the tax increases will take effect, and businesses will be disincentivized to make profit. As a result, the economy will spiral back into recession, and President Obama will have to face the wrath of an unhappy public opinion. In his words, "we will have an economic collapse similar to the 2008 collapse. The train will go off the tracks."

He then proceeds to bash President Obama a bit, beginning by calling President Reagan the "Real President." He talks a bit about the recent extension of unemployment benefits ("If you pay people to not work, do I need to finish the sentence?"). He mentions how unnecessary the bailout of GM was, saying that "bankruptcy only reorganizes." He then proceeded to talk about the stimulus package, saying that "there is no stimulus in the stimulus package," due to the fact that stimulus for one person means a tax for another. He then comments on the midterm elections, saying that he hopes that republicans don't make any headway so that the Obama administration will take full responsibility for his failures. Indeed, Dr. Laffer joked, "It took Carter to produce Regan. Just imagine the great president that will come after Obama."

That, for the most part, was Dr. Laffer's presentation. He then proceeded to take a few questions. I'll summarize his thoughts about those too. He fielded a question about unrealized gains in social security and medicare (or something to that effect), but a lot of that blew over my head (there was a lot of jargon involved), so I won't include that question here.

1. Do you believe that government can create a "green economy"?
Dr. Laffer's answer, unsurprisingly, is no. He thinks that the whole concept of "energy independence" is ridiculous. He says that the idea of energy protectionism doesn't make any sense. "The logic that we can punish terrorists by not trading with them is crazy; otherwise North Korea would be a bustling capitalistic nation." Besides, the notion that we will stop trading with a nation because we are afraid that that nation will stop trading with us doesn't make much sense from a logical standpoint either. Dr. Laffer did not mention anything about the legitimacy of a carbon tax or a carbon credit system.

2. Where do you see Fed policy in the next year?
To sum up Dr. Laffer's beliefs in a sentence, Dr. Laffer basically said that the Fed is stuck somewhere between a rock and a hard spot. "I don't know why Ben Bernake would want to run for reelection. The guy's a great economist and a great professor, but I don't think they can pull it off. If I were him, I would go to the administration and say 'I'm very honored that you chose to renominate me, but I can't see myself getting the economy out of this recession.'" His view is that if the Fed keeps going with its expansionary policy, we'll see high inflation and unchecked growth. If the fed pulls back, we'll settle back into the depths of recession. It's a lose-lose situation.

3. What would you do if you were in charge of the economy?
Dr. Laffer's answer to this question was very interesting. His answered was two pronged. If given the choice, he said, he would simple "do nothing." "These guys don't get it," he said, "I've learned that panicked and drunk people lead to bad outcomes. The bottom line is that panicked politicians make stupid decisions." However, he said, if he DID have to do something, he would take the $3.6 trillion dollar yearly budget (with tax revenues of $2.2 trillion) and have a one and a half year federal tax holiday. The bottom line, Dr. Laffer said, is that there's "no alternative to economic growth."

My overall reactions to the presentation were very positive. His economic analysis was solid, and made a lot of sense even to a high school economics student. I would, however, have liked to see a few more numbers, or at least support for how he made his predictions (Moving 3-4% of 2011 GDP into 2010? Who came up with those numbers?). I also thought the presentation was a bit too politically charged, too much focused on bashing the current administration.

But then again, It's Arthur Laffer.

A Supply Side Solution to Michigan's Ailing Economy

So I recently wrote a paper for a scholarship on how to fix Michigan's economy. I thought it'd preface my blog post about the Arthur Laffer presentation, so I'm posting it here. Enjoy :)

"The current economic outlook for Michigan is rather bleak, with unemployment peaking at a staggering 15.8% of the total workforce, more than double of unemployment figures in January 2008 (BLS).  In 2009 alone, 300,000 jobs were lost in the state of Michigan. In this same time period of January 2008 to present, the civilian labor force has decreased 3.39%, signaling an increase in the number of discouraged workers in Michigan. Meanwhile, Michigan’s government is facing record deficits, with $1.6 billion of projected deficits for FY10 alone. It is clear that we need to make reforms to fix Michigan’s economy. 

The proposed solution to Michigan’s economic woes is perhaps not as revolutionary as one might expect. The policy solution outlined is, in majority, embodied by the school of economic thought known as supply side economics. Championed by famous economists of the 1970s (e.g. Arthur Laffer) and brought into practice by President Reagan (coining the term “Reaganomics”), supply side economics operates upon the fact that firms who hire workers for production cause a proportional increase in income in the economy. This is called Say’s Law. As these workers who receive income are also consumers, production side incentives create certain effects on demand. In other words, supply side factors “trickle down” into demand. 

Unfortunately, Michigan’s business tax code is somewhat less than ideal. The Michigan Business Tax (MBT) is composed of a Business Income Tax of 4.95%, a Modified Gross Receipts Tax of 0.8%, and an extra Surcharge Tax of 21.99%. 

According to a study by the Anderson Economic Group, the effective business tax rate as a percentage of profits for the year 2008 ranked 22^nd in the nation. Similarly, Michigan’s “State Business Tax Climate Index (SBTCI)” assigned by the tax foundation was 5.35, ranking Michigan 17^th in the nation. To the average reader, these numbers may not seem so bad, as 22^nd and 17^th in the nation are both well above the national median. However, a more in depth analysis of these numbers can be very enlightening. 

Contained within Michigan’s  SBTCI is its Corporate Tax Rating, which ranks an uncompetitive 48^th. No matter what one’s economic philosophy, the fact is that corporate taxes are one of the largest factors in many business decisions. A review of the economic literature involved will prove this. In a 1982 study, Newman showed that tax differentials among states were a major factor for the movement of industry to southern states. Harden and Hoyt concluded in 2003 that corporate taxes have the largest negative effect on the rate of growth in employment. Also, according to a 2001 study by Agostini and Tulayasatheien, for “foreign investors, the corporate tax rate is the most relevant tax in their investment decision.” 

In other words, high corporate taxes significantly hinder economic growth. Paired with supply side ideals, the two point to a powerful economic tool. The solution is simply to lower corporate tax rates. However, at a time of record deficits, a tax cut must be accompanied by a spending cut. As part of the current Michigan Business Tax, a wealth of tax credits is offered to businesses. Michigan’s government can start by cutting these tax credits, as they only serve to decrease the negative impact of a poorly-written tax code. 

The aggregate of these reforms should lead to a tax code that includes: a uniform corporate tax rate of 6.0%, continuation of Michigan’s Modified GRT Tax (a Value-Added Tax (VAT) in econ-speak, a highly efficient tax), and the elimination of most of Michigan’s tax credits that only serve to unlevel the business playing field. 

As stated previously, the solution presented is far from revolutionary. However, they are elegantly so. A few simple policy changes can lead to a number of changes that improve Michigan’s economy.

The most obvious effect of a corporate tax cut is that businesses have more profit as a percentage of revenue. Noting this as an important business incentive and keeping in mind that states are in a constant state of competition with surrounding states, businesses will unquestionably decide to relocate from an area with high tax rates to an area with low tax rates. The influx of business will significantly increase the amount of skilled labor in the workforce and will help to lay the foundation for the economy in the long term. 

Also a result of this effective increase in business income, firms will begin to hire more workers. However, as the economy does not exist in isolation, wages paid to workers by definition leads to a mirror increase in total income of the economy. Given this extra income, consumers will undoubtedly spend a portion of it, which increases demand for products in the economy. This increase in demand will lead firms to supply more of their goods, hiring workers in the process. Rinse and repeat. 

As evidenced above, decreasing corporate tax rates leads to more economic activity. This is nothing short of a blessing from a deficit reduction standpoint. The additional economic transactions provide a larger tax base for existing taxes. While it is slightly preposterous to claim that a decrease in taxes will lead to an increase in tax revenue, a corporate tax cut will in part be funded by the increase in economic activity involved. 

As you see, the suggested solutions will solve a host of Michigan’s economic problems and, with the necessary deficit reduction measures, come at little cost to Michigan’s government. All of these proposals are sound economic fact; the only obstacle lies in political attainment."

Economics, Philosophy... Cows?

Sorry the post about my meeting with Dr. Arthur Laffer is so late... It's taking me a bit longer than I expected to write it. I did meet him, and the post will be up soon. Further details will have to wait until the actual post.

In the mean time, I read a very interesting post on Marginal Revolution yesterday (link here: Philosophical Cow). Here's an excerpt:

"Suppose that you are a cow philosopher contemplating the welfare of cows.  In the world today there are about 1.3 billion of your compatriots.  It would be a fine thing for cows if all cows were well treated and if none were slaughtered for food.  Nevertheless, being a clever cow, you understand that it's the demand for beef that brings cows to life.  How do you regard such a trade off?

If each cow brought to life adds even some small bit of cow utility to the grand total of cow welfare must not beef eaters be lauded, at least if they are hungry enough?  Or is the pro beef-eater argument simply repugnant?"

The scene is reminiscent of the "push-man-onto-train-tracks-to-save-three-innocent-children" scenario. More precisely, it is the little theoretical concept usually used in Philosophy classes to disprove rational thought. If you have the choice to push a man onto the train tracks to save three innocent children, killing the man in the process, any economist will tell you to push the man off (three lives for one is clearly beneficial for society). However, many people probably couldn't bring themselves to do so given the choice.

I suppose this is why behavioral economics has arisen, taking into account the fact that people don't always think rationally.

Perhaps you couldn't picture yourself as the cow, but faced with one of these situations, what would you do?

So Evidently I'm Meeting Arthur Laffer Tomorrow

To say that I'm excited would be an understatement. I'll keep you updated :)