The Spirit of Giving

Merry Christmas!

Joyeux Noël!

Sheng Dan Kuai Le! (圣诞快乐!)

Wishing you an enjoyable day, and a happy holiday season spent with good people, surplus amounts of food and drinks, and a large number of gifts!

One idea that is firmly associated with Christmas is gift giving. This is a central part of the Christian tradition, and also has an important place in broader Western culture, which retailers are obviously happy to encourage and embrace.

The festive season’s spirit of giving provides us with a nice opportunity to revisit basic notions of “value”, “price” and “cost”.

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We can think of “value” as the benefit provided by a good or service to the end user.

Economists typically interpret this as the consumer’s “willingness of pay“. That is, the maximum amount that a consumer would be willing and able to pay for a good or service. This allows them to introduce the idea of “consumer surplus“, which is the difference between willingness to pay and the actual price level. And the notion of consumer surplus leads to the idea of “gains from trade“; the idea that both consumers and producers can be made better off if they are allowed to trade freely.

Christmas gives us a chance to re-examine this mainstream interpretation of “value”.

It is evident at this time of year that a gift’s value is often totally disconnected with how much the recipient would have been willing or able to pay for it.

Factors that might affect the value of a gift include:

  1. The strength of the relationship between the giver and receiver of the gift;
  2. Whether or not the gift is a surprise;
  3. How well the gift matches the recipient’s needs and interests;
  4. The message on the card;
  5. The decorations surrounding the gift (Xmas tree, stockings, reindeer, Nativity scene);
  6. The colourfulness of the packaging;
  7. How fun or difficult the packaging is to rip open; and
  8. The atmosphere, experience and ritual of opening gifts together with family and friends.

Christmas is a time of year when people go to great lengths to maximise the value of what they give to others, so much so that it shatters mainstream Economists’ interpretation of “value” as “willingness to pay”.

Next we can consider “price” (what a firm receives from a customer (who may or may not be the end user) in exchange for a good or service) and “cost” (what the firm needs to pay for inputs that are used to produce it).

When I studied Economics as an undergraduate at Sydney University (under such luminaries as Kunal Sengupta, Tiho Ancev, and Don Wright) it was explained to me that firms aim to maximise profits. They can do this by adjusting price and quantity in order to increase the distance between total revenue and total cost. At a minimum, I was told, they will never set a price which is lower than the average cost of producing one extra unit (that is, price will never be lower than variable cost).

At Christmas, people spend significant resources (time, money, effort, imagination) to purchase or create gifts which they then give away for free. People tend to hunt for the best “value” gift that they can find within a given budget. That is, they seek to maximise the gap between “value” and “cost”, not “price” and “cost”.  Christmas shoppers will often hunt for a bargain, but if they stumble upon a remarkable gift which exceeds their budget they will often buy it anway.

“This is far too expensive! Meh, it’s Christmas! I’ll put it on my credit card!”

Your response might be that a firm is not a family, and so this Christmas analogy is invalid.

But is it?

What would the world be like if firms thought of consumers like family members?

And, more to the point, how did many of today’s most valuable technology firms become billion dollar companies? Think of Whatsapp, Twitter, WeChat, and Facebook. They did it by trying to provide value for as many end users as possible, and only afterwards did they find a business model to sustain and grow the firm.

Merry Christmas!

Joyeux Noël!

Sheng Dan Kuai Le! (圣诞快乐!)

Image: Tom Spencer

Mankiw’s 10 Principles of Economics

Economics is about decision making in situations of scarcity

ECONOMICS is the study of how individuals, firms and government make decisions to manage scarce resources.  What does this mean exactly?

Professor Greg Mankiw teaches economics at Harvard University and is the author of a popular economics text book called Principles of Economics which is used at many Ivy League schools. Mankiw’s status within the economics profession makes him uniquely well placed to help us understand the basic principles of economics.

Set out below are Mankiw’s 10 Principles of Economics:

How People Make Decisions

1. People face tradeoffs: To get one thing, you have to give up something else. You may have heard economists say “there is no such thing as a free lunch”. What they mean by this is that, for example, you might get a free bowl of soup at the student co-op, but the soup is not free because you have to give up 35-minutes waiting in line to be served.

2. The cost of something is what you give up to get it: Making a decision requires comparing the costs and benefits of alternative courses of action. The cost of one option is not how much it will cost in dollar terms, but rather the value of your second best alternative. For more explanation, see understanding the cost benefit analysis.

3. Rational people think at the margin: People make decisions by comparing the marginal benefit with the marginal cost. For example, you might buy one cup of coffee in the morning because it helps you start the day, but you might not buy a second cup because this gives you no extra benefit (and costs another $3).

4. People respond to incentives: Behaviour changes when costs or benefits change. For example, if your hourly wage increases then you are likely to work more (unless of course your income is already too high).

How People Interact

5. Trade can make everyone better off: Trade allows people to specialise in what they do best. By trading, each person can then buy a variety of goods or services. For example, you may be a skilled management consultant. Money you earn through your consulting work might be used to build a house even though you may not have the skills to build the house yourself.

6. Markets are usually a good way to organise economic activity: Individuals and firms that operate in a market economy respond to prices and thereby act as if guided by an “invisible hand” which leads the market to allocate resources efficiently. For example, if there is an oversupply of wheat on the world market then individual farmers will lower the price they charge until they can sell all of their wheat.  Lower wheat prices will also likely reduce the total quantity of wheat that farmers decide to produce. Market prices are able to adjust to equate supply and demand without the need for any central planning.

7. Governments can sometimes improve market outcomes: Sometimes a market may fail to allocate resources efficiently, and government regulation can be used to improve the outcome. Market failures can occur due to the existence of public goods, monopolies and externalities. For example, an electricity supplier might have a monopoly. Government regulation may be required to ensure that the supplier does not abuse its market power.

How the Economy Works

8. A country’s standard of living depends on its ability to produce goods and services: A country whose workers produce a large number of goods and services per unit of time will enjoy a high standard of living.

9. Prices rise when the government prints too much money: Printing money causes inflation. When a government prints money, the quantity of money increases and each unit of money therefore becomes less valuable. As a result, more money is required to buy goods and services. For more explanation, see quantitative easing.

10. Society faces a short-run tradeoff between inflation and unemployment: Reducing inflation often causes a temporary rise in unemployment. This tradeoff is the key to understanding the short-run effects of changes in taxes, government spending and monetary policy. For more explanation, see the Phillips curve.