In defence of profiteering

Mark Koyama at Oxonomics points us towards a piece by Tim Harford about the valuable services performed by so-called profiteers. As Koyama puts it

Price gouging communicates valuable information - it signals that there is a real and immediate scarcity.

The effects of "price gouging" is that those whose needs are not immediate do not buy and therefore those who do really need the good, petrol in this case, will be able to get it. A high price sorts people into these two groups. Harford makes the point that

... price-gouging is woefully undersupplied in this market.

Why is this the case? Basically because most retailers are terrified of being accused of profiteering. Well, all power (and profits) to the profiteer I say!

Boudreaux on Obama

Don Boudreaux makes a nice point about the economic reasoning of Barack Obama. Boudreaux writes

According to today's Wall Street Journal, Barack Obama alleges that "Globalization and technology and automation all weaken the position of workers." If this presidential wannabe is correct, then some of the world's most prosperous workers must be the people in that newly discovered tribe in Brazil -- persons with absolutely no contact with the global economy or with modern technology.

Kling on Caplan

Arnold Kling attempts to answer Bryan Caplan's challenge. Kling writes

Let me attempt an answer. I would say that "don't know that you don't know" corresponds to an event for which there is no traded contingent claim. The neoclassical world is one in which there are contingent claims for every meaningful event.

If there is an insurance contract, a security, or a futures market on something, then we know what we don't know. We don't know whether the event will occur, but we know what the market thinks about it.

When there is an event for which there is no traded contingent claim, then we don't know what we don't know. We don't know what we don't know about climate change or a future terrorist attack, and the evidence for that is the lack of any contingent claims market that could be used to draw inferences about climate change.

Pigovian taxes (updated)

In recent years problems such as pollution and global warming have resulted in a renewed interest in issues to do with Pigovian taxes. For example, it is becoming increasingly common to see calls for the addition of Pigovian taxes on the price of petrol. A number of prominent economists, lead informally by N. Gregory Mankiw, from all parts of the political spectrum have made calls for petrol taxes as a potential means of dealing with unpriced externalities. Mankiw has aggregated these concerns in his calls for a "Pigou Club" of economists who identify themselves by their support for a petrol tax.

In a draft paper, Finding the Right Pigou Tax in a World of Imperfect Coasian Bargains (scroll down to find the paper), to be given at the upcoming 2008 International Society for New Institutional Economics (ISNIE) meetings in Toronto, John VC Nye, of George Mason University, calls into question the economic justification for Pigovian taxes. The abstract of his paper reads

This paper calls into question the economic justification for Pigovian taxes and argues that existing empirical work is inadequate to justify the standard policy recommendations. In particular, it calls into question claims that the identification and measurement of a Pigovian externality is a sufficient condition for determining the optimal level of the tax. A claim about the optimal Pigou tax is a joint claim about the size of the externality and about the optimality of observed outcomes, not just the externality. Measuring the size of the observed Pigovian externality – even if done perfectly -- is not a reliable guide to the proper level of the Pigovian tax because in a world of efficient transfers we will still observe some externalities. Hence the debate about externalities should be about whether those compensating factors exist and not about measuring the externality itself. Contrary to received wisdom, we do not have strong evidence that any positive gas tax in the current economy is advisable, let alone information about what its level should be.

Nye goes on to explain

The basic arguments can be outlined as follows:

First, the benchmark Coasian case: In a world of costless bargaining, well-defined property rights, and very low transactions costs, the various parties will negotiate till a jointly maximizing outcome is reached. No taxation is necessary or desirable.

Second, even in a world of positive transactions costs, some Coasian transfers may take place which partly mitigate the harm of the externality. Unless one can fully account for all these transfers – whether conscious or accidental – any estimate of an appropriate Pigovian tax based solely on the size of the Pigovian externality that is measurable will clearly overstate the optimally efficient tax level.

Third, in the presence of regulations (at any level from that of the local community up to the federal government) that have bearing on the supply of the externality causing activity – even if not directly tied to the externality itself – we will need to estimate how different the level of the activity actually is from the hypothetically efficient level. Absent such an estimate, simply knowing the size of the externality itself will give us no clue about the appropriate tax nor its optimal level.

Fourth, even in a strictly Pigovian world in which both the possibility of Coasian bargains and the indirect effects of regulation on the equilibrium supply of the externality-producing good are simply assumed away, the optimal Pigovian taxes are likely to be lower than the standard Pigovian rate if there are other taxes in the economy (Bovenberg and Goulder, 2001). That is, the Pigovian tax rate estimated in a partial equilibrium setting is likely to be supraoptimal in a general equilibrium setting in which a variety of distortionary excises already exist – even if those taxes were not explicitly designed to cope with externalities. Furthermore, taking into account regulations which are substitutes for Pigou taxes – even if indirectly – further moves the optimal tax level away from the standard Pigou solution and makes it likely that applying a straightforward Pigovian tax in addition to existing taxes and regulations is inefficient and even counterproductive.

The single major problem is that the applied Pigou tax literature concentrates on the presumption that TAX = MARGINAL EXTERNALITY or Pigou Externality (PEX). But in actuality what we need to know is the optimal quantity of the good or activity that produces the externality. Absent detailed information about both regulatory distortions and private Coasians transfer, knowing the size of PEX gives us NO clue as to the size of the optimal Pigou tax.

(HT: Division of Labour )

Update: There are interesting comments on the Nye idea in The overestimation of Pigovian taxes posting at The visible hand in economics.

Caplan on radical uncertainty

Bryan Caplan takes the Austrian school to task again. He writes

Austrian economists often attack the mainstream for ignoring something they call "radical uncertainty," "sheer ignorance," or sometimes "Knightian uncertainty." A common Austrian slogan is that "Neoclassical economists study only cases where people know that they don't know; we study cases where people don't know that they don't know."

He then asks that someone from the Austrian school to do at least one of two things

1. Explain his point using standard probability language. What probability does "don't know that you don't know" correspond to? Zero? But if people really assigned p=0 to an event, than the arrival of counter-evidence should make them think that they are delusional, not than a p=0 event has occured.

2. Give a good concrete example.

These seem like good challenges. But what are good replies?

Don Boudreaux on EconTalk

This week on EconTalk, host Russ Roberts talks with his GMU colleague Don Boudreaux. They talk about the recent surge in energy prices and why prices have risen, the implications for America's standard of living and the implications for public policy.

Religion and economic organisation

Explaining economic institutions; firms, guilds, clubs, cooperatives etc, is a core issue for microeconomics. Avner Grief pioneered the use of game theory to study historic economic organisations. His work shows that reputations, repeated relationships, and folk-theoretic interactions fostered the rise of anonymous exchange during the later Middle Ages. But when the mortality rate is high, these mechanisms alone may not be enough to sustain cooperation, and religion can come into play as an additional mechanism which helps shape economic institutions. This is the basic idea behind a new NBER working paper, Religion, Longevity, and Cooperation: The Case of the Craft Guild by Gary Richardson and Michael McBride, NBER Working Paper No. 14004, issued in May 2008.

Richardson and McBride set out to examine the organization of industry in late medieval England. In this era artisanal activity occurred in organizations referred to as craft guilds. Craft guilds were basically groups of self-employed skilled craftsmen with ownership and control over the materials and tools they needed to produce their goods. Guilds were in part small business associations and in part cartels. As Ekelund et al explain

The guild system was an example of government-sponsored cartelization. A local group of producers practicing a particular craft would obtain sanction from municipal authorities to forbid the entry of new competitors into the local market, without first securing, the permission of the guild. These organizations tended to be composed of groups of small independent masters (a sole proprietor) and represented local cartels. They frequently entered into open agreements with one another to fix prices and restrict output, with government approval and support. (p.125)

Ekelund et al also note that

The fact is that the Church did not actively campaign against the system of guild-cartels. (p.125)

These associations of artisans dominated economic activity for centuries.

Explaining the rise, decline and changing nature of guilds has perplexed scholars since at least the time of Adam Smith. Richardson and McBride offer a new theory to explain the nature and development of guilds. Richardson and McBride note that the key to their explanation

... is to understand how guilds convinced members to cooperate, and how exogenous changes in the environment influenced the effectiveness of guilds' enforcement mechanisms. The principal driving forces were the disease environment and religious doctrines.

They continue

Disease influenced craftsmen's ability to cooperate by determining the mortality rate. Folk theorem logic holds that cooperation occurs more readily when individuals care more about the future, which in turn, depends on how long one expects to live. Low mortality rates meant long lives and extensive cooperation. High mortality rates meant short lives and little cooperation. The mortality rate for craftsmen fluctuated dramatically during the Middle Ages, as the introduction of virulent, infectious diseases, such as the Black Death, scourged urban populations.

In such an environment a grave concern would be the afterlife. Religion had an influence on the level of cooperation between craftsmen by emphasising the concept of an afterlife.

The late-medieval Christian church promoted the doctrine of purgatory, which stated that after death, individuals experienced excruciating pain, which purged them of sins in preparation for entrance into Heaven, where one experienced ecstasy. Purgatorial pain could be lessened by the prayers of the living, particularly by pious people who knew one well, such as family, friends, and colleagues. Guilds were organized to provide prayers for the souls of deceased members. Guilds threatened to punish members caught breaking the rules by excluding them from intercessory services. This threat became more salient when belief in the doctrine spread and mortality rates rose, enabling guilds that bundled together religious and occupational activities to sustain occupational cooperation in environments where purely secular associations employing folk-theorem threats could not.

This logic underpins Richardson and McBride's explanation of the development of the guilds in medieval and early modern England. They argue

During the twelfth and thirteenth centuries, when industrial activity initially expanded in towns, urban residents formed organizations focused on secular, economic, and legal concerns. During the fourteenth century, as the doctrine of purgatory spread and the disease environment deteriorated, craftsmen organized increasing numbers of guilds that prayed for the souls of deceased members. Guilds that engaged both in religious and occupational activities proved especially effective at facilitating cooperation. During the sixteenth century, mortality rates fell, religious reformation swept aside the doctrine of purgatory, and new methods of organizing industry evolved.

The analysis of Richardson and McBride links two literatures. One is the literature that employs game theory to study economic institutions and the other the literature that uses club theory to study religions institutions. Richardson and McBride provide one channel by which religion can influence the extent of economic activity. In late medieval England religious belief was one contributing factor in the organisation of industry and the scope and scale of occupational cooperation.

Benjamin Klein's contributions to law and economics

Josh Wright, of the School of Law at George Mason University, has written a piece on the contributions of Benjamin Klein to law and economics. The paper is a chapter for the forthcoming volume "Pioneers of Law and Economics" (Lloyd R. Cohen and Joshua D. Wright eds.). Klein has produced pioneering analysis of the hold-up problem, the theory of the firm, vertical restraints, franchising, and the role of contract terms in facilitating self-enforcement of contractual relationships. Peter Klein has noted

Klein’s 1978 paper with Armen Alchian and Robert Crawford and his 1981 paper with Keith Leffler are of course part of the organizational economics canon. His ongoing debate with Ronald Coase on the GM-Fisher Body case has helped clarify important issues on the role of asset specificity in vertical integration.

Clark on Polanyi and Block on Clark

Gregory Clark, professor of economics at the University of California, Davis, and the author of "A Farewell to Alms: A Brief Economic History of the World", reviews "The Great Transformation" by Karl Polanyi.

Now I'm not sure I see the point in reviewing sixty year-old books, but this review is kinda fun. But not everyone is happy with it. Fred Block, professor of sociology, University of California, Davis, is not impressed with Clark's views. I guess this exchange just illustrates some of the tensions among the social sciences.

(HT: The Fly Bottle)

Effects of high oil prices

Francesco Lippi, professor of economics at the University of Sassari, has an article on VoxEU.org in which he looks at the effects of the recent high oil price. The column, Oil prices: risks and opportunities, points out that

High oil prices are back – more than $125 per barrel. Such prices are associated with the macroeconomic pains of the 1970s, but this column argues that the recent surge may actually be good news for developed economies’ industries. The logic lies in the difference between demand shocks and supply shocks.

Lippi goes on to say

Economic theory suggests that the real effect of an oil price increase depends on its underlying fundamentals. If it stems from a change in supply conditions – as was the case with the Iranian revolution, the first Gulf war, or policy tightening by OPEC – the resulting price increase depresses economic activity, as energy inputs are more expensive. But if higher oil prices stem from increased demand by emerging economies, production in other economies like the US is subject to both a negative effect – due to the higher price of energy – and to a positive effect – greater demand for US goods and services by the growing emerging economies. According to this scheme, the weak relationship between oil prices and the US business cycle in recent years reflects oil demand shocks, while the episodes in the ‘70s and ‘80s can be ascribed to oil supply shocks.

Lippi then refers to a recent paper he co-authored with Andrea Nobili (“Oil and the macroeconomy: a structural VAR analysis with sign restrictions”, di F. Lippi e A. Nobili.) in which they examin the roles of oil demand and supply shocks in US industrial production for the period 1973-2007. The paper aims to identify the oil demand and supply shocks underlying fluctuations in oil prices (deflated by the US CPI). This allows them to estimate the effects of these shocks on the US business cycle. Importantly the identification strategy assumes that oil production and price move in opposite directions following a supply shock, while they move in the same direction following a demand shock.

The analysis shows that over the last 30 years oil demand shocks drive more than half of the oil price fluctuations with, therefore, supply shocks accounting for less than half. The analysis also shows that demand shocks are the main cause of the current price increases.

Lippi then asks: What are the effects of oil shocks?

The effects of oil demand and supply shocks on the US economy are markedly different. The left panel of Figure 2 shows that after a negative oil supply shock (that reduces production and increases the oil price), US industrial production falls (from the baseline trend) with an estimated probability of about 80% one year after the shock (the red line denotes the median response). After an oil demand shock causing a comparable increase in the price of oil, industrial production increases with an estimated probability of about 70% one year after the shock (see the right panel of Figure 2). Despite the “negative” production effect stemming from the higher oil price, the booming emerging economies ultimately lead to an increase in US industrial production the majority of the time.

Figure 2 Response of US production to oil mkt shocks

Note: US industrial production. The figure reports the 16th, 50th and 85th percentiles of the impulse response function distribution.

In Lippi's view the risk and opportunities associated with this can be summarised as

The emergence of new players in the global economy makes some resources scarcer, increasing their cost, but it also offers new trade opportunities. The positive correlation between the price of oil and US industrial production shows that the US economy enjoys a net output gain from these developments. Our study suggests that America’s specialisation in the production of goods not supplied by emerging economies is key to this result. It is the ability – or lack thereof – to innovate and produce goods that are not easily substitutable that determines whether the new challengers represent a risk or an opportunity for industrialised countries.

Quote of the day

Economics is as much a communicable disease as it is a discipline. Economics is a way of thinking about everything and coming to a sense of understanding life better. When you catch it, the way of thinking (by way of learning a few basic but powerful economic principles), it is hard not to see most of life's large and small events as economic puzzles worthy of reflection and solution.

(McKenzie, Richard B. (2008). Why Popcorn Costs So Much at the Movies: And Other Pricing Puzzles. New York: Copernicus Books, p.1)

Local loop unbundling

A new research paper from the New Zealand Institute for the Study of Competition and Regulation deals with the issue of does local loop unbundling stimulate broadband uptake. The report, Catching-Up in Broadband Regressions: Does Local Loop Unbundling Policy Lead to Material Increases in OECD Broadband Uptake? by Glenn Boyle, Bronwyn Howell and Wei Zhang, argues that

Local loop unbundling has been widely promulgated by policy-makers as a significant factor stimulating broadband uptake and therefore an essential component of a developing ‘information economy'. Whilst empirical evidence is sparse, and at best equivocal in respect of a consistent positive and statistically significant effect, a recent study commissioned and published by the OECD does find evidence of such effects. When correcting for omitted variables, correlated data and methodological inconsistencies, our analysis using the models and data from this report instead support the contention that LLU's contribution to the level of national broadband uptake is materially very small, and not statistically significant. Continued advocacy for the policy as a stimulant for broadband uptake on the basis of the OECD-published report is misguided.

A related paper, Regulated Retail Tariff Structures, Dial-Up Substitution and Broadband Diffusion: Learning from New Zealand’s Experience by Bronwyn Howell, asks why does New Zealand exhibit one of the lowest number of broadband connections per capita in the OECD. This paper argues

Despite an apparent absence of supply side impediments to the uptake of broadband, New Zealand has persistently exhibited one of the lowest numbers of connections per capita in the OECD. Whilst geographic, demographic and economic factors may partially explain the disparity, they fail to explain the comparatively low uptake in a country that, in the early 2000s, ranked amongst the top OECD countries in the number of internet users per capita and average usage per account. Demand side factors, however, offer some insights. Using a combination of diffusion theory, two-part tariffs, price discrimination and bundling, this paper proposes that the historic flat-rate tariff for local voice telephony has resulted in substitution from legacy dial-up to frontier broadband internet access in New Zealand occurring at a higher user valuation of both internet connection and usage than if the telephony tariff was set at a level whereby the fixed component recovered fixed costs and the variable usage component was set at marginal cost - the tariff structure that prevails in most other OECD countries.

The New Zealand experience suggests that the extensive use of flat-rate tariffs for the current generation of broadband technologies (e.g. ADSL) may impose similar braking of the rate and timing of substitution to future internet access technologies (e.g. fibre to the home). These effects are exacerbated if the legacy connection is purchased as part of a bundle where customers predominantly value other elements more highly than the internet component. Substitution inertia created by the flat-rate tariff may only be overcome by the development of new applications which are both highly-valued by the majority of users and which can only be feasibly deployed using the frontier technology.

What is free trade?

Don Boudreaux over at Cafe Hayek asks the question: What is free trade? His answer:

Answer: Free trade is an institutional environment in which adult buyers and sellers are free to deal with each other without regard to their nationalities, physical locations, religious affiliations, or any other criteria that officious third-parties would elevate into significance but that the buyers and sellers themselves find irrelevant (or at least sufficiently insignificant so as not to affect their desires to trade with each other).

Economic theory v. political theory

This is from Peter Boettke at The Austrian Economists blog. Boettke writes

... economic liberalism is a practice in search of a theory, while political liberalism was a theory in search of an application. In other words, if you took away all the economists in the world, there would still be mutually beneficial exchange, production through division of labor, and distribution through expected marginal product. Economic life, in short, exists whether we study it or not. Economic association through exchange and production is part of the mundane existence of the everyday life of man. As Adam Smith put it, dogs don't bargain over a bone, but people in all walks of life and in all societies do bargain and trade --- we humans have a natural propensity to truck, barter and exchange as a way of interacting. The experience of economic life exists prior to our effort to study it, understand it, and argue about it.

On the other hand, political liberalism, i.e., the idea of constitutional democracy, is largely a theory in search of an application. Individuals think abstract thoughts about autonomy, freedom, liberty, responsibility, obligation, legitimation, etc., and these are forged into a political doctrine through writing, dialogue, and debate. Political theories exists prior to political practice based on them.

Is this right? Is a fundamental difference between economic theory and political theory that fact that economic life exists prior to economics as a discipline of study while political theory comes before political life? Surely political practice or activity predates political theory and such activity would take place even without an theory of it, in much the same way as economic practice can take place without a theory of it.

Biofuel subsidies and the law of unintended consequences

A new negative for biofuel subsidies. An article, The Clean Energy Scam by Michael Grunwald, in Time magazine explains that

Propelled by mounting anxieties over soaring oil costs and climate change, biofuels have become the vanguard of the green-tech revolution, the trendy way for politicians and corporations to show they're serious about finding alternative sources of energy and in the process slowing global warming. The U.S. quintupled its production of ethanol--ethyl alcohol, a fuel distilled from plant matter--in the past decade, and Washington has just mandated another fivefold increase in renewable fuels over the next decade. Europe has similarly aggressive biofuel mandates and subsidies, and Brazil's filling stations no longer even offer plain gasoline.

But they also note that

An explosion in demand for farm-grown fuels has raised global crop prices to record highs, which is spurring a dramatic expansion of Brazilian agriculture, which is invading the Amazon at an increasingly alarming rate.

and

But several new studies show the biofuel boom is doing exactly the opposite of what its proponents intended: it's dramatically accelerating global warming, imperiling the planet in the name of saving it. Corn ethanol, always environmentally suspect, turns out to be environmentally disastrous. Even cellulosic ethanol made from switchgrass, which has been promoted by eco-activists and eco-investors as well as by President Bush as the fuel of the future, looks less green than oil-derived gasoline.

So like always, government mandates, regulations, and subsidies are doing the reverse of their supposed intentions.

Andeton rejects past

This news report tells us Anderton Rejects Failed Policies of the Past. I guessed that this had to mean he was rejecting socialism, but no. Oh well.

Anderton is quoted as saying

This looks like the National Party policy. National should distance itself from the proposal or come clean. Will National endorse the idea of the biggest tax cuts going for those who need them least?

Doesn't everybody need to have their money returned to them? No matter what their income. Anderton goes on to say

Tax cuts for middle income earners, reducing student debt and more housing affordability are higher priorities for this coalition government and will grow the economy faster than tax cuts for the most affluent New Zealanders.

He is right, the middle class do need a tax cut, just like everybody else. If he wants to reduce student debt then start charging the market rate of interest on it. The greater the rate of interest the lower the quantity demanded for loans will be. As to affordable housing how about removing the central and local restrictions that prevent the expansion of the supply of housing. An increase in supply will lower the price of housing. To increase the rate of growth we need to increase the rate of productivity growth and its not clear how Anderton's objectives will do this. Anderton then says

The priority for tax cuts and other assistance has to be people who can best use the help. If you are likely to spend your next dollar buying your first home, you will add more to the economy than if you are weighing up whether or not to purchase your fourth home. If we spend our next dollar on sending a kid to school with a full tummy and a nutritious lunch, that is better for the overall economy than spending the next dollar on an overseas holiday.

It not clear what buying your first home will have any different effect on the economy than buying your fourth home. In each case a house is bought and sold. Actually as far as the aggregate economy is concerned spending on food or travel have the same effect. If a dollar is spent on food aggregate demand increases by a dollar and aggregate demand increases by a dollar if that dollar is spent on travel. Anderton ends by saying

In the 80s and 90s, under policies proposed by the Business Roundtable, the economy went backwards. We are now undoing the damage. Everything the Business Roundtable has ever advocated turned out to be wrong,” Jim Anderton said. “When the government of New Zealand stopped doing the work of privileged special interests, and began governing for all New Zealand, New Zealand started to turn around.

Its worth noting that the average annual growth rate in labour productivity for the 1992-2000 period was 3.0, for the 2000-7 period it was 1.2 per cent. The graph below gives a longer term perspective. The post 2000 period doesn't look good.

As far as total factor productivity is concerned the average annual growth rate for the 1992-2000 period was 2.6 per cent while for the 2000-7 period it was 0.5 per cent. The importance of this was noted by James Allan in an article in the The Australian. Allan wrote

During the past decade, as a whole NZ has averaged a 3.3 per cent rate, only a tad behind Australia's 3.4 per cent rate. Not bad at first sight, although during that period Ireland averaged 6 per cent and Singapore 5.8 per cent. The problem is that NZ's economic and productivity growth rates have been declining in that period, with its Treasury now forecasting annual growth of only 2per cent during the next couple of years. That's about half of Australia's expected rate, and at least half what would be needed for a fair number of years to have any hope of getting the Kiwis into the top half of the OECD league tables.

Doesn't look like much of a turn around to me.

The government and the law of unintended consequences

The government is here to help. No really it is. We all know that one function of government is to protect us from evil nasty capitalists who just want to rip us off via high prices. Competition laws are used to protect us from such activities.

Given that I recently posted on the high price of popcorn in movie theatres it is interesting to note the affect of competition law on the price of movie tickets. This example is from the US were up until the late 1940s the major movie studios all owned chains of theatres. In the 1940s the studios made their theatres charge customary admission prices and placed restrictions on the showing of their movies in non-owned theatres. As a result the US Department of Justice took the studios to court for monopoly price fixing. McKenize (2008: 93) describes the outcome as

After a series of lower court decisions, the studios were required by the U.S. Supreme Court in 1948 in the United States v. Paramount to divest themselves of their theater chains. The presumption underlying the ruling was that divestiture would lead to greater competition in the theater market and lower ticket prices. However, the exact opposite occurred: In the two decades following the divestiture decision, movie ticket prices rose substantially relative to the general price level. To be exact, between 1948 and 1958, movie ticket prices rose by more than 36% (despite the incentive theaters had to try to substitute concession revenues for ticket revenues), while the consumer price index (CPI) rose by only 20%. Between 1958 and 1968, movie ticket prices rose by almost 69%, while the CPI rose by between 15 and 16%. In short, the Paramount decision probably increased industry costs that showed up in ticket prices that spiraled upward.

So the government's efforts only manged to achieve the very thing it set out to prevent.

• McKenzie, Richard B. (2008). Why Popcorn Costs So Much at the Movies: And Other Pricing Puzzles. New York: Copernicus Books.

Why popcorn costs so much at the movies

One of the great unanswered questions that has baffled economists for eons is Why does popcorn cost so much at the movies? A number of explanations have been offered, none entirely satisfactory.

One answer is that once you enter the theatre, the theatre owner has a monopoly and thus can charge a high price for his popcorn. But as Steven Landsburg has pointed out

Once you enter the theater, the owner has a monopoly on a lot of things. He is the only supplier of rest rooms, for example. Why doesn't he charge you a monopoly price to use the rest room? Why isn't there a monopoly price for the right to proceed from the box office to the outer lobby, another to proceed from the outer lobby to the inner lobby, another to pass through the double doors so that you can see the screen, and another to take a seat?

The answer, of course, is that a rest room fee would make the theater less attractive to moviegoers. To maintain his clientele, the owner would be forced to sell tickets at a lower price. What he collected at the rest room door would be lost at the box office. (Landsburg 1993: 158).

Another explanation is price discrimination. Expensive popcorn makes sense if popcorn lovers are really willing to pay more than other people for their time at the theatre. Everyone comes to the theatre because the ticket price is low but the popcorn lovers pay more for their entertainment by buying the expensive popcorn. Popcorn lovers value the trip to the theatre more than other people and thus, via the popcorn pricing strategy, they pay a higher price. Imagine there are two types of people who go to the movies, one group dislikes popcorn and is willing to pay $20 for the movie. The second group likes popcorn, and will pay $3 for it, and is willing to pay $23 in total - ticket price plus popcorn - for the movie. If the theatre charges $23 for the ticket, only group 2 goes and buys no popcorn. If they charge $20 and have no popcorn, both groups go to the movie but the theatre misses out on the extra $3 they could get from the group 2 types. If the theatre charges $20 for the ticket and has $3 popcorn both groups go to the movie and the theater gets the full $23 from the group 2 types.

The problem with this is, Why don't we see popcorn price wars? One theatre sells its popcorn for $3 so why doesn't some other theater sell theirs for, say, $2.50. The low price theatre could attract all the popcorn lovers and make up on volume what is lost by the price reduction. For the price discrimination story to work the theatre needs to be able to stop competitors from under cutting them, that is, they need monopoly power. But where is the monopoly power?

Landsburg points out another possible answer.

Economists Luis Locay and Alvaro Rodriguez recently gave an ingenious answer to this age-old question, and to me it has the ring of truth. People go to movies in groups. Popcorn lovers often travel with companions who eat no popcorn. The usual argument says that you cannot price discriminate against popcorn eaters without losing them to another theater. The Locay/Rodriguez response is that popcorn eaters cannot go to another theater without splitting up their social groups. If another theater offers cheap popcorn and high ticket prices, the nonsnackers in the group will vote to stay put. Locay and Rodriguez have constructed a complete argument demonstrating that under plausible hypotheses about the way groups make decisions, theater owners have a degree of monopoly power over popcorn lovers who travel with popcorn nonlovers, and can plausibly exploit this power by pricing popcorn high. (Landsburg 1993: 166-7).

The problem here is that the popcorn lover could offer the non-popcorn eaters a sidepayment to go to the low-priced popcorn theatre. A deal something along the lines of: Let's stick to theatres which offer low-priced popcorn, and I'll occasionally pay for your tickets.

Yet another answer is that the high price you pay for popcorn is a fee for cleaning up the mess popcorn eaters make. There may well be something to this.

In a new book Richard McKenzie offers another solution to the problem. McKenzie points out that something has been missed in the explanations given above. He argues that theatres have an incentive to lower the ticket price and increase the popcorn price built into the contracts they have for the movies that they show. These contracts are like a share-cropping type arrangement. McKenzie explains

Theaters often bid for movies in terms of the percentage of their box-office receipts. Theaters regularly bid 70% of their box-office receipts-with their bids sometimes reaching 95% of their box-office receipts-for the rights to show a movie. Theaters could, and have, bid a fixed amount-say, $ioo,ooo-for the rights to show a movie for a multiple-week.engagement. However, because, as entertainment economist Arthur De Vany has argued, the success of a movie is very unpredictable (even when a movie has star power and is a sequel to a successful movie), a fixed amount bid means that the theaters would assume a great deal of risk, which explains why fixed bids alone are rarely used in contracts negotiated between theaters and studios. (McKenzie 2008: 91.)

The relevant point of this contract for popcorn pricing is that theatres have a built in incentive to keep their ticket prices low in order to increase the price of popcorn. If a theatre were to cut their ticket price by, say, $1, they will reduce their ticket receipts by less than $1, may be 30 cents (or in some cases only 5 cents). But they can also raise the price of popcorn by $1, and still keep the total price of their entertainment bundle constant. This strategy means they increase the number of tickets sold, since they cost less, and they get to keep all the additional profits on the extra popcorn sold due to the increase in ticket sales. The profit margin on the extra popcorn sold is greater than the loss, say 30 cents, on ticket sales due to the price reduction.

Eric Crampton when he read this asked: Why don’t film distributors write contracts demanding a share of ticket revenues and a pro rata share of popcorn revenues? He went on to point out that

Right now, the theatre (agent) has an incentive to chisel down the part of the revenues that can be appropriated by the principal and supplant them with non-appropriable revenues. If the distributor instead wrote a contract comprising revenues over both elements, he'd have to do better. Charge a slightly lower rate on ticket revenues and a higher rate on popcorn such that the theatre is indifferent between shunting between different portions of the income stream except to the extent that doing so increases total revenues for both principal and agent.

The distributor would be better off, the theatre indifferent but what happens to the price of tickets and popcorn relative to the McKenzie case? The lower percentage take on the tickets would increase the cost of ticket price reductions to the theatre and the increased percentage take on popcorn would reduce the gain to increasing the price of popcorn. Thus would we see a higher ticket price and a lower popcorn price.

• Landsbury, Steven E. (1993). The Armchair Economist: Economics and Everyday Life. New York: The Free Press.
• McKenzie, Richard B. (2008). Why Popcorn Costs So Much at the Movies: And Other Pricing Puzzles. New York: Copernicus Books.

Misunderstanding economics

Those with a technical bent and who know who Steve Keen is, may enjoy this post by Michael Greinecker at Yet Another Sheep and this one by Gabriel Mihalache at Economic Investigations. They show how some people manage to entirely misunderstand economics.

Monetary history

There is a new book available for preorder for those with an interest in monetary history. The book, Good Money: Private Enterprise and Popular Coinage: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage, 1775-1821 by George Selgin, tells the story of an almost unknown, at least by me, episode in the history of money — British manufacturers' challenge to the Crown's monopoly on coinage.

In the 1780s, when the Industrial Revolution was gathering momentum, the Royal Mint failed to produce enough small-denomination coinage for factory owners to pay their workers. As the currency shortage threatened to derail industrial progress, manufacturers began to mint custom-made coins, called "tradesman's tokens." Rapidly gaining wide acceptance, these tokens served as the nation's most popular currency for wages and retail sales until 1821, when the Crown outlawed all moneys except its own.

Good Money shows that private money - coinage - played a crucial role in fueling Great Britain's Industrial Revolution. In telling his story Selgin challenges many of the beliefs upon which all modern government-currency monopolies are based. He therefore sheds light on contemporary private-sector alternatives to government-issued money. Things such as digital monies, cash cards, electronic funds transfer, and (outside of the United States) spontaneous "dollarization."