Once you see it, you see it everywhere.
Married couples who’ve left the kids home with a sitter go out to nicer restaurants than childless couples who have the same income.
If you’re travelling abroad and looking across the wine aisle, there’s a lot less price difference between top-tier and mid-tier wine than you’d find here at home. You might be more inclined to pay the smaller bit extra.
And the best New Zealand produce is often destined for export markets.
There is an obvious underlying effect causing all of it. An effect that is, or ought to be, covered in any decent undergraduate course in microeconomics. Indeed, the effect was first explained in an undergraduate textbook.
On NZ Q&A this weekend, Jack Tame interviewed Emily King on food systems. He noted, with some seeming surprise, that the best produce is exported. King suggested that an entire rethinking of food systems might be needed to stop it.
It’s better to start by understanding why this happens. And for that, we need to start with Armen Alchian.
Armen Alchian is arguably the best economist never to have been awarded the Nobel Prize. He made fundamental contributions to price theory. But more than that, it’s hard to think of anyone who better exemplified “thinking like an economist”.
In the early 1950s, Alchian was curious to know what secret materials were being used in America’s hydrogen bomb. Telling the story in 2000, and it really is worth watching the whole interview, Alchian explained how he worked it out by looking at stock market prices. A few companies produced materials that might be useful in the H-bomb, but only one of those saw a substantial lift in its share price after the successful nuclear tests.
He wrote up his results and distributed it to his colleagues at RAND. The paper was immediately suppressed because of its national security implications – he’d uncovered a national secret, just by tracking stock market prices.
The profession had to wait until 1969 for Eugene Fama to independently discover event studies.
That has nothing to do with the price of apples but does explain a bit about Alchian. He’s an economist’s economist who’d just do these little side pieces of work to help better understand the world, and then not worry too much if he had to put the work aside.
And that leads us to the Alchian-Allen effect in price theory – sometimes known as “the shipping the good apples out” theorem.
A normal economist would derive the theorem and publish it in a top journal.
Alchian instead just wrote it into his 1964 textbook with William Allen. A fun obvious implication of some of the basic elements of price theory, explained so undergraduates could understand it.
They put the question as follows.
On NZ Q&A this weekend, Jack Tame interviewed Emily King on food systems. He noted, with some seeming surprise, that the best produce is exported. King suggested that an entire rethinking of food systems might be needed to stop it.
It’s better to start by understanding why this happens. And for that, we need to start with Armen Alchian.
Armen Alchian is arguably the best economist never to have been awarded the Nobel Prize. He made fundamental contributions to price theory. But more than that, it’s hard to think of anyone who better exemplified “thinking like an economist”.
In the early 1950s, Alchian was curious to know what secret materials were being used in America’s hydrogen bomb. Telling the story in 2000, and it really is worth watching the whole interview, Alchian explained how he worked it out by looking at stock market prices. A few companies produced materials that might be useful in the H-bomb, but only one of those saw a substantial lift in its share price after the successful nuclear tests.
He wrote up his results and distributed it to his colleagues at RAND. The paper was immediately suppressed because of its national security implications – he’d uncovered a national secret, just by tracking stock market prices.
The profession had to wait until 1969 for Eugene Fama to independently discover event studies.
That has nothing to do with the price of apples but does explain a bit about Alchian. He’s an economist’s economist who’d just do these little side pieces of work to help better understand the world, and then not worry too much if he had to put the work aside.
And that leads us to the Alchian-Allen effect in price theory – sometimes known as “the shipping the good apples out” theorem.
A normal economist would derive the theorem and publish it in a top journal.
Alchian instead just wrote it into his 1964 textbook with William Allen. A fun obvious implication of some of the basic elements of price theory, explained so undergraduates could understand it.
They put the question as follows.
“How does one explain the larger proportion of good quality relative to poor quality oranges or grapes sold in New York than in California? Why is a larger proportion of the good, rather than bad, shipped to New York? Is it because New York’s population is richer or more discriminating? Possibly; but then why are the oranges and grapes sold even in the poor districts of New York better than those sold in California? The question can be posed for other goods: Why do Asians import disproportionately more expensive American cars rather than cheaper models? Why are “luxuries” disproportionately represented in international trade? Why do young parents go to expensive plays rather than movies relatively more often than do young couples without children? Why are “seconds” more heavily consumed near the place of manufacture than farther away? Why must a tourist be more careful in buyhing leather goods in Italy than in buying Italian leather goods in the United States? Why is most meat shipped to Alaska “deboned”? The answers are implications of the law of demand.”
The answer is simple and obvious. Shipping a mediocre apple costs the same as shipping a good apple. Shipping a top-quality car costs about as much as shipping a mass-market model. Consumers weigh up the relative prices of goods when deciding. And if you live close to where goods are produced, those shipping costs do not factor in.
Alchian gives the example of California grapes. Suppose top-quality California-grown grapes cost 10 dollars per kilo, standard grapes 5 dollars per kilo, and shipping grapes from California to New York costs 5 dollars per kilo. A standard grape in California will then cost half as much as a top-quality grape. But a standard grape in New York will cost two-thirds as much as a top grape: the shipping-inclusive prices there are 15 dollars for the top-tier, and 10 dollars for standard.
A California consumer has to give up two standard grapes for every high-quality grape consumed, but a New York consumer only has to give up one and a half standard grapes for every good one. New York will have relatively greater demand for the higher quality grapes. So California ships the good ones out.
Even consumers with identical incomes and identical preferences will be more inclined toward the higher quality goods in situations where the purchase of a good or service comes with an added fixed cost – like transportation. Or, in the case of parents with children, like hiring a babysitter.
“If they hire baby sitters at, say, $1 an hour [remember that Alchian was writing decades ago!] and are out for four hours, it will cost $4 just to leave the house. Now, add the cost of two movie tickets at $1 each, and compare that total cost with the cost of going to the theater (at $4 per ticket). The theater costs a total of $12, and movies cost $6. The theater, then, costs twice what a movie costs. But if a couple has no children and can avoid the baby-sitter fee, the movie will cost $2 and the theater $8 – a ratio of 4 to 1: the theater is relatively more expensive. In our original question, we did not assume parents will go to the theater more than people who have no children; we said, when young parents go out, they will go to the theater a larger fraction of the time than will childless couples. QED.”
Beautiful and concise. Once you see it, you can’t stop seeing it. And you can’t help but notice when others fail to notice it. It’s been called ‘The Third Law of Demand’ in the literature that followed up on the work that Alchian casually dropped, in narrative form, into an undergraduate textbook.
There is a very good reason that New Zealand’s farmers ship out the best produce. If transporting top quality produce doesn’t cost much more than transporting more standard fare, then our best will always be relatively less expensive, as compared to standard goods, in our export markets.
And these effects work in both directions. New Zealand will import a lot of other countries’ good grapes, or good oranges. Their lower-grade produce will be less likely to be exported.
You could try to undo these effects in some ‘rethinking’ of food systems, but it really wouldn’t be a good idea.
Dr Eric Crampton is Chief Economist at the New Zealand Initiative. This article was first published HERE
1 comment:
Great article
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