Friday, September 21, 2012

Economic logic, part II

The examples I gave in the last entry were clear-cut:  I'm pretty sure that, from the point of view of maximizing your personal pleasure (which is what economics is about), you should not consider the cost to the vendor in your calculations (unless for some reason hurting the vendor was part of your calculations -- but in that case, you would almost certainly be better off not buying from him at all).  The examples in this entry still puzzle me; I'm not sure where the correct logic lies.

The first is from The Armchair Economist by Steven Landsburg, which I thoroughly recommend to everyone.  I found myself agreeing with almost everything in it, but one case still leaves me puzzled.  Suppose you are going to a show of some sort and have bought 2 tickets at $50 apiece for you and your guest.  When you get to the show, you can't find the tickets.  Should you buy more, or should you be unwilling to buy them because you don't want to pay for the same thing twice?  What about if you had not bought the tickets, but found that you had lost $100 on the way to the show?  Landsburg says (to the best of my recollection) that most people would not buy the tickets again because they had already budgeted that money for entertainment, and would not want to exceed their budget.  On the other hand, most people would be willing to go ahead and buy the tickets with, say, a credit card, even if they had lost the $100 earmarked for buying tickets.

Landsburg pokes fun at this "mental accounting," but somehow, I find myself agreeing in principle that I would not re-buy the tickets even though I would spend the money if I had lost cash.  I'm probably just being stubborn here, but I wish I could grasp the logic strongly enough to appreciate it more viscerally.

Here's another case which may or may not be related, but it puzzles me in a similar fashion.  Suppose you go to the grocery store to buy a can of green beans.  On the shelf are two types of cans, a store brand for $0.75 and a name brand for $1.  You know there is very little difference in quality between the two; which would you buy?  Now suppose you go to another store to buy a large television.  There are two sets of the same size and resolution that you want, one off-brand for $999.74, and one name brand for $999.99.  Which do you buy?  My gut is to buy the cheaper green beans but the more expensive television, on the grounds that $0.25 out of $1000 is negligible, whereas $0.25 out of $1 is a large fraction of the total price.  But I can't get over the fact that it's the same $0.25 either way.

Now, there are many other factors that one could bring into this, such as the fact that the television is supposed to last longer and therefore the name brand might be worth more even if you can't see any difference in picture quality.  I want to ignore those factors as much as possible and treat the two commodities as sharing all the same basic properties except for price.  I suppose you could imagine that you are buying a truckload of green beans for $999.74 or $999.99.  My sense is that, even in that case, no one would care about the extra quarter in one case, but virtually everyone would prefer the more inexpensive single can (assuming, as we have, that they two cans are the same quality).

Even though the total price difference is a quarter in either case, one could say that, in buying the more expensive green beans, one is creating the potential for spending a lot more money in the long run, since presumably you buy more green beans than televisions in your life.  That makes sense to me, but only with the caveat that it is a mental shortcut:  in general, you should buy the less expensive item of the same quality, even if the price difference in absolute terms is negligible.  For an individual can of green beans, I can't see why the $0.25 you save on the cheaper brand should count for any less than the $0.25 you save when buying a whole truckload of the cheaper brand.

Thursday, September 20, 2012

Economic logic, Part I

The discipline of economics is founded on the idea that people are rational, at least to the extent that they will buy less of a good the more it costs.  But people are not always rational, of course (see, e.g., Dan Ariely's Predictably Irrational).

Some economists, such as Ariely, think our enduring irrationality is a blow against traditional economics.  I don't agree, but that is a topic for another entry.  What I'm interested in is some examples of apparently irrational purchasing behaviour that I have observed.

For example, I once heard someone discussing what toppings to put on a pizza.  "If I'm going to pay for extra toppings, I like to get meat so it's worth the money," he said.  At first, that seems to make sense:  all toppings typically cost the same, but meat is obviously more expensive than, e.g., mushrooms or onions.  But if you think about it, you're not trying to get the most expensive toppings for your money; you're trying to get the pizza you will enjoy the most for your money.  Imagine someone saying, "Green peppers are my favourite topping, but I want to get pepperoni because it costs more."  That doesn't make sense, but that is essentially the same logic the guy was using.

You might try to qualify this by saying that, other tastes being equal, you should prefer the meat topping, but that doesn't help.  What you are really saying is that you would rather the pizza place make less money from their sale to you even though it provides no benefit to you.  The only way this could make sense was if you were talking about a topping, such as lobster, which is so much more expensive than the other toppings that you rarely get to eat it.  But then what you're really saying is that lobster pizza has more value to you because you get it more rarely.  That's consistent with the basic principle of economics, which is that goods have a decreasing marginal value.  Even though in absolute terms you might prefer green pepper, lobster might have a higher value because you eat green peppers all the time and lobster almost never.

I have been subject to the "minimize profit" fallacy myself in one similar case.  I read that restaurants typically make little profit off of the most expensive items on their menus, because if they charged as much relative to the cheap items (such as vegetarian or chicken dishes) for fancy meats such as veal and lobster, no one would buy them.  For a while, I was caught in ordering the more expensive items because I thought I was getting a better "value" out of them, even though the extra cost rarely corresponded to extra enjoyment on my part.