Politicians and pundits often declare “It’s Econ 101!” or some similar phrase to defend their policies. But economics is not a one-course discipline. (More)

Mythonomics Part II: Beyond “Econ 101” (Non-Cynical Saturday)

This week Morning Feature looks at common economic myths. Thursday we began with Mike Masnick’s ‘grand unified theory’ for why news, books, music, and movies should be free. Yesterday we gazed into the abyss of supply-side economics, and why conservatives promote it. Today we conclude conclude with why you should be wary when someone claims “It’s Econ 101.”

Once upon a snowstorm….

In a 2010 article at Baseline Scenario titled “What a Little Bit of Economics Does to You,” law professor James Kwak explored a 1986 paper by Daniel Kahneman, Jack Knetch, and Richard Thaler on fairness as a constraint on pricing. That paper began with this question:

A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.

The Econ 101 answer is easy. The snowstorm will boost demand for snow shovels, but the store’s short-term supply is fixed at the number on hand. If the store owner keeps the price at $15, he will run out of shovels and still have customers ready to pay $15 (excess demand). If he raises the price to $25, he will have too few customers ready to pay $25 and be left with shovels sitting idle on his shelves (excess supply). If he raises the price to $20, he’ll sell every shovel he has and no customer ready to pay $20 will be left without a shovel (supply equals demand). Thus, Econ 101 says, raising the price of shovels during a snowstorm will optimize market efficiency.

When Kahneman and his colleagues did surveys in the 1980s, 82% of respondents thought raising the price of shovels during a snowstorm was unfair. But when a professor posed that question in Kwak’s economics class, only half objected:

As the professor said, this is probably because there are a lot of business school students in this class. Business school students are classic Econ 101 robots. They know enough to know that if there is a demand shift, not only is it OK to raise prices, but you should raise prices in order to clear the market. In this case, supply is fixed in the short term, so raising the price won’t increase supply; the Econ 101 argument is that raising the price allocates the shovels to people who will derive more utility from them (because they will pay more), thereby increasing social welfare.

But this rests on a huge assumption: that willingness to pay is the same as utility. Unfortunately, however, this assumption fails in the real world; poor people simply can’t pay as much for snow shovels as rich people, and as a result a price increase will allocate shovels to rich people, not to those who need them the most.* But people who believe Econ 101 only remember the demand and supply curves they saw on the first day of class, so they think firms should raise prices.

Kwak concludes:

More fundamentally, the 1986 paper shows that Econ 101 is diametrically opposed to human beings’ intuitive sense of fairness. Yet public policy largely follows the dictates of Econ 101. Is that a good thing?

* I’m not saying that there is a perfect way to allocate the shovels, just that using price isn’t perfect, and does have inequality effects.

“Price gouging is definitely econ 101 stuff, but it’s one case where econ 101 gets it right”

But “vague[ly] libertarian” economist Adam Ozimek disagrees:

James concedes that he doesn’t think “there is a perfect way to allocate the shovels, just that using price isn’t perfect, and does have inequality effects”. Since we can’t directly measure utility, and willingness to pay is just our proxy for it, no it’s not perfect. But it is the best way best possible way available to allocate scarce resources in this scenario. Notice James doesn’t just not offer a “perfect” alternative, he offers no other alternative that he believes will be better. Willingness to pay may not be a perfect measure of utility and to maximize social welfare, but it sure as s–t is a better than first-come-first-serve.

If James is trying to play our innate sense of fairness against efficiency criteria he should have chosen a more compelling case. Am I really to believe that the $20 price of snow shovels is really pricing poor people out of the market and that they literally can’t pay for them? Because they could afford them at $15, right? Otherwise, the “price gouging” isn’t really an issue since poor people aren’t being priced out of the market.

Ozimek offers no rationale for why, when it comes to allocating shovels during a snowstorm, willingness to pay is a better measure of utility than first-come-first-serve. Even when asked about that in a reader comment, his response is to simply restate his claim in different terms.

But you can make a good argument that first-come-first-serve is the better measure of utility. People who hear of the approaching storm and rush to the store for a shovel probably know they don’t have one. At the very least, they value obtaining a shovel over other storm preparations. Conversely, the person who goes to a department store for extra blankets before going to the hardware for a shovel may well expect to need the blankets more than the shovel.

And while the extra $5 for a shovel may seem trivial to Ozimek, that extra $5 plus the extra $5 for a blanket (because the department store also raises the price for blankets due to the storm) plus the extra $15 for two days’ worth of non-perishable food (because groceries do the same) adds up quickly. If all stores follow Ozimek’s Econ 101 strategy, the wealthy can afford to prepare completely (at snowstorm prices) while the poor have to prioritize and hope they don’t get caught out.

Once upon an earthquake….

Ozimek also adds this:

One other point is that Kwak may be right that “In this case, supply is fixed in the short term, so raising the price won’t increase supply,” but if you allow prices to rise, then it gives stores more incentive to overstock their shelves the next time they anticipate a snow storm. If you prevent them from raising prices, then they won’t have incentive to overstock.

And as proof, he links to this article by New Zealand libertarian Eric Crampton:

I tweeted early on in the quake that I wondered whether supermarkets would implement efficient pricing on water and batteries, hiking prices to meet the surge in demand.

I wasn’t really wondering – they never do. Why? Because most customers aren’t economists. The dairy owner who gives away all his stock by 8am after the quake draws praise; the guy who makes sure there’s something left for folks showing up at 2 in the afternoon, not so much. Businesses know that customers seem to get angry at the store for price hikes but angry at the earthquake for shortages; erring on the side of shortages gives the store fewer hassles.

Crampton then attempts to explain why this imminently rational business decision is actually irrational. He first echoes Ozimek’s unproven assertion that pricing measures utility better than first-come-first-served, and then adds:

Second, it encourages stores to hold excess reserves. Suppose you’re the manager of a supermarket and you have to decide how many bottles of water and packs of batteries to keep in the warehouse. Space in the warehouse has a high opportunity cost, and water does go off over time. If you know that you can’t raise your prices in a crisis because your customers will resent it forever, you’ll keep less water in stock in the back than if you know you can hike your prices.

Third, it encourages folks to stock up before the crisis. Even the guy who lives next door to the grocery store will keep some supplies at home if he reckons that the price would hike in an emergency.

Stocking up on snow shovels before winter makes sense, but there is no earthquake season. Science can predict the relative frequency of quakes at different magnitudes, but we cannot reliably predict specific quakes. So why should stores, or customers, “stock up before the crisis?”

“Things like norms, institutions, make a very big difference”

In fact it was entirely rational for the New Zealand store owners to maintain pre-quake prices for water. The retailers knew that many customers upset by price gouging would stop shopping in stores that price-gouged. Crampton may dismiss the customers’ response as “irrational,” but economics is about human decision-making and humans value fairness. Expecting store owners to behave as if their customers were amoral “rational economic actors” is neither good business nor good science. It’s ideology with equations.

Nobel laureate Paul Krugman discussed that in his interview at Big Think:

There are some people who think if you can’t quite model it using supply and demand then you have to pretend it doesn’t exist. One of the big themes of my book The Conscience of a Liberal is that things like norms, institutions, make a very big difference. […] There’s so many places where Econ 101 doesn’t work. […] Econ 101 might suggest to you that if you deregulate electricity in California it’s going to be just fine. But if you go a little bit beyond Economics 101, you can see that you have actually created an incentive for producers to game the market, and you’re going to get something like the crisis that actually happened.

Store owners can discourage hoarding with per-customer limits. But if Crampton doesn’t get to the store before the water is sold out, the fact that he would have paid more than customers who got there earlier is irrelevant. Money is not the only measure of utility. Time matters too, and the earlier customers prioritized water in responding to the earthquake.

Put another way, should Boston’s wealthiest citizens expect every shop to hold back snow shovels, extra blankets, baby food, etc. for them as a blizzard approaches, no matter when they decide to go to the store? Or should shop owners expect even wealthy citizens to get in line before stocks run out?

For most of us – and most business owners – that answer involves issues beyond “Econ 101.”

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Happy Saturday!