Traditional economic models assume that the utility, or happiness, one gets from consuming an item depends only on how fundamentally useful the item is to the consumer. Under this model, an item’s utility must be independent from the price that the consumer paid for the item, since it’s hard to envision a scenario where the price paid for an item actually affects how useful it is (holding item quality and such constant, of course). Our own intuition, on the other hand, suggests that we get psychological warm fuzzies (or, conversely, cold…uh, slimies?) when we feel like we got a good deal on an item.
Behavioral economists recognize this phenomenon, and they even have a name for it- “transaction utility.” Under the behavioral model, the total utility that that an individual gets from an item is the sum of “acquisition utility” (roughly speaking, what traditional economists just call utility) and “transaction utility.” This model is interesting because it suggests that consumers can be convinced to buy stuff that they don’t rationally like enough to buy by making them feel like they are getting a good deal. (I think I’ve mentioned before how I am convinced that transaction utility is what keeps Christmas Tree Shops from going under.)
Economist Richard Thaler discusses the concept of transaction utility in his paper “Mental Accounting Matters”. In this paper, he gives the following anecdote to illustrate the irrational behavior that transaction utility can cause:
A friend of mine was once shopping for a quilted bedspread. She went to a department store and was pleased to find a model she liked on sale. The spreads came in three sizes: double, queen and king. The usual prices for these quilts were $200, $250 and $300 respectively, but during the sale they were all priced at only $150. My friend bought the king-size quilt and was quite pleased with her purchase, though the quilt did hang a bit over the sides of her double bed.
So let’s think about this- from what we know, we can probably infer that the double size quilt would give the friend the highest level of acquisition utility, since people generally like to have items that fit on the other items they are designed to go on. But the consumer is lured away from that choice by transaction utility, which is likely highest with the king-size quilt, since it had the biggest discount. (More specifically, the king-size quilt has the highest sum, or total utility, even though it probably doesn’t have the highest acquisition utility.)
Now that you are primed with this lesson, let me ask you a hypothetical question: What would you do if you got a coupon that would give you any drink at Starbucks for free? If you answered this, you’ve likely missed the point of the above discussion:
Apparently that is a sexagintuple vanilla bean mocha Frappuccino, and it has a regular price of $54.75. (The container for said drink, in case you were wondering, is a vase that the customer brought from home.) I am very tempted to think that this beverage is the equivalent of the king-size quilt, since what person in his right mind actually finds this beverage to be coincident with rational optimal consumption, even when taking cost out of the picture? That said, I am willing to reconsider my judgment, given the subsequent news that the customer actually drank the whole thing…eventually. In related news, let’s discuss how this beverage and gout medication are likely to be complementary goods.
Tags: Behavioral Econ · Buyer Beware
It’s not often that something I’ve written gets put in the “brilliant and highbrow” quadrant, but here we are:
In related news, the Simpsons book is finally out!
And here I thought my thrilling yet nuanced take on the behavioral economics principles that Simpsons characters exhibit was never going to see the light of day. That said, I must humbly disagree with the New York Magazine editors when they suggest that you “forget Thomas Piketty,” and I will be following up on him shortly. I am told that Homer Economicus is number 13 on Amazon under Microeconomics- now if only we can get the likes of Mankiw and Krugman out of the way…
P.S. Apparently I/we also make house calls, so drop me an email at econgirl at economistsdoitwithmodels dot com if you are interested in arranging a Simpsons talk at your school, workplace, local bar I suppose, etc.
Tags: Administrative · Books · The Simpsons
Many people think of money and wealth as fairly synonymous, whereas economists are careful to point out that money serves a number of specific functions in the economy. Most notably in the context of the discussion we’re about to have, money is the thing that we use to buy stuff. Therefore, people want to hold money, even though it doesn’t pay any interest and other assets do, since they need it to buy all of the cool stuff that they want.
We know that the amount of money in an economy, i.e. the money supply, is set by the Federal Reserve, so how does the supply of money relate to the amount of stuff bought and sold in an economy? Luckily, economists have a handy-dandy identity to describe this relationship:
So what does this mean? Let’s see…
- M represents the amount of money available in an economy (i.e. the money supply)
- V is the velocity of money, which is how many times within a given period, on average, a unit of currency gets exchanged for goods and services
- P is the overall price level in an economy
- Y is the level of real output in an economy (usually referred to as real GDP)
If you think about it for a second, the relationship makes a lot of sense- let’s say, for the sake of argument, that an economy has $100 of money in it. (It’s a small economy, in case that wasn’t obvious.) If stuff in that economy costs $5 on average (i.e. P=5) and the economy makes 60 units of stuff (i.e. Y=60), then, in order to make the transactions happen to sell the stuff that was produced, it must be the case that a unit of currency changes hands 3 times on average (i.e. V=3), since the dollar value of the transactions totals $300 and there is only $100 of money to go around. (In case you’re curious, the velocity of money is thought to be pretty stable in the long run, so changes in the money supply eventually translate to corresponding changes in prices.)
The velocity of money is a very important concept in macroeconomics, even at the introductory level, but it’s a concept that is often less than intuitive for students. Luckily, I stumbled upon this comic that illustrates the concept quite adorably:
(Obviously you have to click to see it full size unless you have superhuman vision.) I get how electronic currency (I mean debit cards, not Bitcoin) is super convenient and efficient, but it’s just somehow not as cute. And this doesn’t even count the sheer hug-worthiness of the fact that my grandpa collected two sets of state quarters for me (apparently there are separate series for the Denver and Philadelphia mints or something) while he sorted change from his condo’s laundry machines and gave them to me as a holiday gift. You’ve gotta admit that a collection of debit or credit cards just doesn’t have the same warm and fuzzy factor, even when the cards look like this:
Sometimes I feel like the world is marketing directly to me.
In case you aren’t already convinced that Janet Yellen is the most powerful woman in the world (or, I suppose, that financial markets are at least approximately informationally efficent), take a look at this:
Okay, so maybe that requires a bit of explanation…today, the Federal Reserve released the statement coming out of its March meeting, and Janet Yellen held a press conference to discuss the Fed’s course of action and answer some questions. Judging by the above picture, I’m going to go ahead and infer that the whole statement/press conference thing started at 2pm. So why was the market unhappy? Let’s go to the statement and see what we can find:
- The Fed still believes that bad weather was at least in part responsible for slow economic activity at the start of the year. (Not everyone agrees with this assessment.)
- Inflation is still below the Fed’s target, and future inflation expectations haven’t really changed.
- The Fed is cutting its asset purchases (read, quantitative easing, or, more generally, expansionary monetary policy) from $65 billion per month to $55 billion per month. (Yes, those still sound like big numbers, but consider that these numbers were consistently at $85 billion per month until recently.) The statement says that the Fed decided to “taper” further because the job market seemed to be in a place where it could recover on its own, and that it expects this amount to still be sufficient to keep interest rates low and inflation moving towards the 2% target.
- The Committee (i.e. the Federal Reserve Board of Governors) wants the world to know that they will keep tapering as the economy improves, but that it is not on a pre-set schedule and reserve the right to do what they want when they want. (Of course, it has this ability regardless of whether it actively asserts as such.)
- The Committee described its current approach as “highly accommodative” and reiterated its commitment to keeping interest rates low, even after the specific quantitative easing program ends.
For context, it’s helpful to know how this statement differs from the January statement and those from 2013 and such…luckily, the WSJ has been stealing my moves and developed a handy tool to track changes across FOMC meeting statements. (Spoiler alert: The Fed appears to be quite adept with cut and paste.) Upon reading the most recent statement, it’s mainly the change in asset purchases that really stood out, so the market’s reaction was likely due to the news of the further tapering. (Update: I had been told that the weak economic performance called the continued taper into question, but my banker friend assures me that the market still expected it, so the reaction was actually to the infamous interest rate “dot charts” that Yellen told everyone to not pay attention to. More on that in a second.) Why is this? Well, less expansionary policy generally means higher interest rates, which means it’s more expensive to invest, which makes businesses less profitable…yes, I know what you are thinking- but the Fed stressed its commitment to keeping interest rates low! Don’t worry, Twitter was a bit confused as well. For example:
In other words, I’m guessing that the Federal Open Market Committee didn’t necessarily expect the world to interpret its statement as as “hawkish” (i.e. stingy with monetary expansion, in this context) as it did. This is probably because the world didn’t ignore the “dot chart” as instructed:
What the hell is that? (Yep, I can hear you asking that from here.) That, my friends, is a summary of where, under appropriate monetary policy, Federal Open Market Committee members and Federal Reserve branch presidents expect interest rates to be in the future. Okay, fine, that doesn’t mean a lot by itself, so let’s compare it to a similar chart from back in September:
Clear as mud, right? Apparently the takeaway is that interest rate expectations have moved up a bit, but why use a sentence when two incomprehensible pictures will do? =P I guess that’s why Yellen kept directing people to the statement rather than the dots, though one can’t help but notice that they contradict each other a bit. (Banker friend points out that the market did in fact notice and decided to believe the dots.)
But the real fun started during Yellen’s Q&A, which went from about 2:45 to 3:30pm. At around, oh, I dunno, 3:05 or so (mainly guessing from the graph above), a reporter asked Yellen to clarify the language in the statement that reads ” The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends…” Specifically, the reporter asked Yellen to define “considerable time,” since it would be nice to know for how much longer we can expect interest rates to stay near zero. Now, this is not the easiest thing, since it’s sort of like asking economists to put a time horizon on the short run versus the long run, but Yellen tried to be helpful and responded with 6 months as her time frame. Apparently the market had assumed that “considerable period” was something much longer than 6 months, since that is the point at which stock prices tanked.
Now, investors may be overreacting to this somewhat offhand comment of course, but at least we can tell from this that people are paying attention. Small victories, right?
Tags: Macroeconomics · Policy
Via a Twitter friend:
It’s funny because it’s true, and I’ve been trying to explain this to people for years. (In related news, economists don’t have a reputation for being particularly romantic.) In case you’re not familiar, sunk costs are costs that you’ve already paid and can’t recover- i.e. you can’t get your money back. Rationally, sunk costs shouldn’t factor into decision making because they are, since they’ve already been incurred, present in every possible outcome and therefore can’t affect the relative appeal of different options. For a Valentine’s themed illustration, consider the following: you purchase a box of chocolates, only to find that all of the chocolates are of the gross coconut-filled variety (seriously, who likes those?)- do you continue to eat the chocolate because, gosh darn it, you paid for it and you’re going to get your money’s worth, or do you chuck the heart-shaped box into the nearest trash can ASAP, saving yourself both empty calories and the pain of choking down substandard goodies? If you’re rational, you’d choose the latter option (or at least find that one person who is apparently keeping the coconut-filled Valentine’s chocolate industry alive and given them a nice gift), since “getting your money’s worth” is only going to make you less happy.
In practice, people are not always good at ignoring sunk costs, even though it would be reasonable to do so. Some empirical evidence:
- People report being less likely to purchase a replacement movie ticket than the original ticket, even though the two decisions are nearly identical (unless one is so cash constrained that the wealth difference between the two choices actually becomes a limiting factor). Sometimes people try to justify their choice by saying “Why would I pay twice to see the movie?” and I counter with “Why would you pay once to not see the movie?”
- People are less likely to attend concert events when they are randomly given a discount on their season tickets after they’ve decided to purchase the tickets.
- People often report being “pot committed”> in poker, when, rationally, whether the money in the pot is your or someone else’s should have no bearing on whether you raise or fold.
- If people were good at ignoring sunk costs, the phrase “throwing good money after bad” would have never been invented.
If you’re curious, you can see more fun with sunk costs in Richard Thaler’s “Mental Accounting Matters.” Thaler even gives a potential explanation for why people tend to ignore sunk costs- in his mental accounting framework, people only explicitly evaluate transactions that are exceptions to the ordinary, so they fail to notice that, for example, they would be paying to not go to the movie and instead only focus on the potential of paying twice to go to the movie. Therefore, it’s not hard to see how ignoring sunk costs could lead to faulty reasoning along the lines of “well, I’ve put so much into this relationship already, I basically have to see this through.” (Like I said, we’re a romantic bunch.)
Isn’t it nice that you can get a valentine and a life lesson in one? I have to admit, however, that this is my favorite nerdy valentine thus far:
Or, if you prefer your valentines to be of the “real” sciences form instead, check these out. Personally, I’m giving this one to my students:
Tags: Behavioral Econ
So, Paul Krugman wrote a blog post that generated the following comment:
Theoretically, it is possible you think about your intended audience. You owe it to the readership of your columns and blog posts (all of whom pay for the opportunity to read them) to identify your intended audience, if you have one. That you may very well have one, or an inchoate one that you do not define for yourself explicitly, is indicated by your use of the rubric “wonkish” for some posts.
Which brings us to today. What is the intended audience of your post which begins,
“David Glasner has a thoughtful post about wage stickiness, a favorite topic of mine. And he is partially right in suggesting that there has been a bit of a role reversal regarding the role of sticky wages in recessions: Keynes asserted that wage flexibility would not help, but Keynes’s self-proclaimed heirs ended up putting downward nominal wage rigidity at the core of their analysis,”?
The intended audience of this introduction must be a group of people who immediately understand what “wage stickiness” and “downward nominal wage rigidity” are. The intersection of that group and the readership of the Times I argue must be tiny.
On one hand, I do sympathize in general regarding the casual use of terminology- I mean, I was more than a little frustrated when I came into the first day of graduate macroeconomics and began supposedly exploring the question “Is money neutral?” and instead pondering what on earth it could possibly mean for money to be neutral…after all, it *does* appear that money really likes to be in Swiss bank accounts, but I at least knew enough to get that that is not the situation that my professor was referring to. (Spoiler alert: Money being neutral means that the amount of nominal currency in an economy doesn’t have an affect on real variables such as physical output, unemployment, etc.) On the other hand, at least some of the terms used above have definitions that can be inferred from just knowing the English meanings of the words, so come on.
Take “downward nominal wage rigidity,” for example. From dictionary.com:
downward down·ward [doun-werd]
moving or tending to a lower place or condition.
nominal nom·i·nal [nom-uh-nl]
(of money, income, or the like) measured in an amount rather than in real value: Nominal wages have risen 50 percent, but real wages are down because of inflation.
Often, wages. money that is paid or received for work or services, as by the hour, day, or week. Compare living wage, minimum wage.
rigid rig·id [rij-id]
firmly fixed or set.
From this, it’s really not a huge leap to infer that “downward nominal wage rigidity” refers to a situation where it’s difficult to adjust wages downwards in dollar terms. I suppose “sticky wages” is less clear as a phrase, but, in context, it’s specifically used to contrast with “flexible wages,” so it doesn’t take a genius to figure out that sticky wages are wages that are not flexible or adjustable, i.e. wages that exhibit (usually downward) nominal wage rigidity. Or, you could, you know, google “sticky wages” and get this. In picture form, sticky wages imply that it’s hard to do this:
Since a wage is just a price on labor, it’s probably not very surprising that prices can be sticky too…I think this sums up the sticky price situation nicely:
Now that we’ve got our nomenclature settled, let’s discuss for a bit why the possibility of (downwardly) sticky wages is relevant to the analysis of business cycles. As it turns out, prices, although somewhat sticky for various logistical reasons, tend to not be as sticky as wages, so prices of output in an economy tend to adjust faster than the prices of the inputs that make that output. Therefore, the typical textbook theory goes as follows: when prices go up due to an increase in aggregate demand in an economy, there is a period of time before the costs of production catch up where it becomes more profitable to produce and producers increase output. Conversely, when prices go down due to a decrease in aggregate demand in an economy, there is a period of time before the costs of production adjust in tandem where it becomes less profitable to produce and producers decrease output. This decrease in production leads to unemployment. If there is downward nominal wage rigidity, this unemployment can persist for a long time. Now, it seems somewhat intuitive that a reduction in nominal wages would solve this unemployment problem, but Krugman actually states that he doubts that such a change would be effective. He does, however, believe that sticky wages exist and have an effect on the economy, but more in this sort of way:
In other words, there must be some force that is preventing wages from adjusting to bring the supply (S) and demand (D) of labor into balance and relieve unemployment. In related news, there really is a meme for everything.