Friday, 4 September 2009

What's a cup of tea worth? (updated)

Many economic historians would argue that living standards stagnated for millennia before the Industrial Revolution. New work by two economists attributes that conclusion to a measurement error in real wage indices. In their view the introduction of new goods such as coffee, sugar, and tea to England in the 1700s and 1800s dramatically raised living standards – perhaps more than 15%.

This is the conclusion of work by Jonathan Hersh and Hans-Joachim Voth summarised in an article at entitled Coffee, consumer choice, and the consequences of Columbus. They write,
The problem of accounting for new goods is not new. Both the Stigler Commission (1961) and the Boskin Commission (1996) noted that there is a new product bias in the Consumer Price Index. This occurs when new products are either not added to the CPI or are included only with a long lag. There are now several approaches to deal with these problems; we use one that is particularly suited to the challenges of our dataset.

One method pioneered by Hausman (1996) looks at the welfare gain from the introduction of Apple-Cinnamon Cheerios, a relatively marginal improvement of the art of breakfast cereals. He still finds a welfare gain equivalent to 0.002% of 1992 consumption expenditure. Other scholars have looked at gains from the introduction of the minivan (Petrin 2002), online booksellers (Brynjolfsson et al. 2003), and satellite TV (Goolsbee and Petrin 2004), finding significant gains. Most of these methods rely on household level data for adoption rates and price variation across consumers – data requirements that are exacting in an historical context.

Greenwood and Kopecky (2009) introduce a method that makes less stringent demands of the data. Their approach is more macroeconomic and requires aggregate data on prices and take-up rates of a new consumption item. When working with historical data, this is an advantage. They calculate welfare gains by estimating the value of the first unit of a new good. Effectively, they ask which degree of preference for the new good can be inferred from changes in consumption patterns in the aggregate, given a known path for quantities consumed and prices. It is their measurement approach that we implement with our historical data.

Equivalent variation (EV) is the amount of additional income you would have to give to a consumer so that his or her welfare without the new good is equivalent to that obtained with the good. Our results for 1850 show a gain of 8.0% for sugar, 7.9% for tea, and 1.5% for coffee. Combined, this implies that the average Englishman’s welfare was improved by 17% through the addition of these three goods alone. At a technical level, the reason why we find such a large gain is that English citizens consumed much more tea, sugar, and coffee even when the price had only fallen by a little, shortly after the introduction of the good. This means that the reservation price – the price that would set demand to zero – is quite high. Consequently, towards the end of the early modern period, when prices were much lower, consumers could reap a huge windfall. They could buy goods they valued enormously for a song.

Our analysis is complicated by the vagaries of the data. Smuggling for some of the goods was rife. Data is particularly scattered in the early years of adoption. Tariff changes and wars influenced volumes consumed. We attempt to account for all of these factors and find that our results are unaffected. As a further robustness check, we adopt an alternative “short-cut” method suggested by Hausman and find welfare gains of 13.5% for sugar and tea alone.

We think of our results for tea, sugar, and coffee as a lower bound on the discoveries’ overall effect. They stand pars pro toto for a wider range of “new goods” that arrived on European shores as a result of overseas expansion. The addition of tomatoes, potatoes, exotic spices, polenta, and tobacco transformed consumption habits in even more fundamental ways than did sugar, tea, and coffee. If the rise in consumption of all of these colonial goods was measured accurately, welfare gains for European consumers after 1492 would have been even larger than our findings suggest.
Hersh and Voth conclude their column by noting
There is a broad consensus that living standards stagnated for millennia before the Industrial Revolution. Only after the “Malthus to Solow” transition (Hansen and Prescott 2002, Galor 2005) did welfare start to increase. Clark (2007) concluded that the average Englishman in 1800 lived no better than their ancestors on the African savannahs. We argue that stagnating long-run real wage indices partly reflect measurement error. Life in early modern Britain got better – much better. By the 18th century at the latest, consumption habits had undergone a profound transformation. Previously unmeasured welfare gains added at least 15% to the income of Englishmen by 1850.
So a good cup of tea has more going for it than you may think.

Update: Eric Crampton covers this article here, while the Economist does so here.


Crampton said...

Dammit that was my queued post for tomorrow.

Paul Walker said...

Hi! Take that Crampton!

Anonymous said...

I don't think this paper challenges the received wisdom as much as they think it does. For instance, Clark's line about an Englishman in 1800 being no better off than his African ancestors - he doesn't deny that there were improvements in real incomes along the way, it's just that they were eroded over several generations. The best known example is after the Black Death; an Englishman in 1800 was worse off than one in 1400 by a great margin.