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How To Spend It
Have you ever read that FT supplement and wondered how and why the mix of products is changing with increasing income inequality? Anna Yurko tackles this question:
The distribution of consumer incomes is a key factor in determining the structure of a vertically differentiated industry when consumer's willingness to pay depends on his income. This paper computes the Shaked and Sutton (1982) model for a general specification of consumers' income distribution to investigate the effect of inequality on firms' entry, product quality, and pricing decisions. The main findings are that greater inequality in consumer incomes leads to the entry of more firms and results in more intense quality competition among the entrants. This is due to the elasticity of consumer demand for quality being higher in more inegalitarian economies. More intense quality competition among firms causes them to locate their products in higher ranges of the quality spectrum, closer to each other, decreasing the degree of product differentiation. Competition between more similar products tends to reduce their prices. However, when income inequality is very high, the top quality producer chooses to serve only the rich segment of the market, and the low price elasticity of demand of these consumers allows him to charge a higher price. The conclusion is that income inequality has important implications for the degree of product differentiation, price level, industry concentration, and consumer welfare.
My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments. More concretely, there is often more profit from serving the very top, who will always pay more for something just a wee bit different or a wee bit better. So stay away from producing the mid-level cheeseburger, where price elasticity of demand will kill your profits. You can't charge the rich very much for it, and the presence of the poor keeps the price down for the middle class. Here is the paper. Anna is currently a job market candidate at the University of Texas, here is her CV.
Posted by Tyler Cowen on December 31, 2007 at 05:04 AM in Economics | Permalink
Comments
Kudos to Anna for the fine paper and the
important empirical work but I don't know
why economists spend so much time on the
obvious.
I will add that the way to determine quality
is very important here as well. FOr some
products and services, quality is easy to
determine for others not so. In such a
situation the demand-supply curves for
quality signaling mechanisms also warrant
attention.
Posted by: sa at Dec 31, 2007 9:36:56 AM
This seems consistent with the idea that a larger inequality of income is often translated into a much smaller inequality of utility. So the rich consistently pay much more for products that provide relatively marginal improvements in function. They fly first class at three times the price. They buy $2000 laptop computers whose function is all but indistinguishable from $500 models. They buy luxury cars that cost twice as much as a Honda but are less durable and reliable. They spend thousands on Viking ranges that cook no better than ordinary stoves. And so on.
It used to be (when I was a kid in the 60's and 70's) that the rich had many things that the poor and middle class could not afford at all -- second cars, clothes driers, air conditioning, color televisions, air travel, and then later personal computers, VCRs, microwaves, and CD players. But now increasingly the case that what the rich buy are 'gold plated' versions of the same things virtually everybody has.
This seems like a trend that is quite independent of income inequality, however, but rather is a function of the nature of modern 'miracle' goods -- which tend to have the property that the cost of production is low compared to R&D and other fixed costs. Which means once you've invented and perfected the new thing and built the plant to produce it, you want to crank out as many as you can. Therefore, once something like this has been invented it's almost inevitable that it will become a mass market item.
Take that dynamic and overlay it with income inequality and funny things happen, like intense competition to create brand cachet that will enable a company to demand premium prices for what are *necessarily* very marginal improvements in functionality (since the underlying miracles of, say, digital photography or flat-screen displays are inherently mass market phenomena).
Posted by: Slocum at Dec 31, 2007 9:58:30 AM
"My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments."
This seems reasonable. If you wander the aisles of your local Whole Foods you won't see much in the way of price competition.
However it is only half the story. If you head on over to your local Walmart you'll see plenty of products that employ low price as a differentiating feature.
It appears that the consumer economy is bifurcating. Suppliers can move up and compete on quality and design, or move move down and exploit economies of scale to compete on price.
This is probably in part due to increasing income inequality, although it is unlikely to be the whole explantation. Plenty of wealthy people shop at discount retailers for the simple reason that for many mundane purchases the quality of products available at Walmart is good enough.
In fact the existence of discount stores may be critical to the success of premium retailers like Whole Foods. Shopping at Walmart (or Target, Costco etc) allows consumers to spend a lower proportion of their disposable income on mundane purchases, freeing up disposable income for expenditure on the luxury items sold by high end retailers.
Posted by: Deepish Thinker at Dec 31, 2007 10:13:44 AM
"How To Spend It" is not a section of the newspaper I am in any position to look at.
Posted by: HeShootsAndScores at Dec 31, 2007 10:25:52 AM
This seems pretty plausible, but I'd like to play supply-side devil's advocate. Corporatist economies tend to have high taxes, highly regulated labor markets, and strong welfare states, all of which implies low income inequality. Likewise, they have strong industrial policy which implies high barriers to entry and little product differentiation.
Posted by: Gabriel Rossman at Dec 31, 2007 10:55:07 AM
Let's hear it for immigrants to the US.
Posted by: Dave Barnes at Dec 31, 2007 10:57:18 AM
slocum: "So the rich consistently pay much more for products that provide relatively marginal improvements in function. "
My guess is that you are not aware of those who are rich but who choose not to spend their incomes or wealth on expensive status goods. Many wealthy peaple drive Honda Accords, shop for bargains at Kohl's, and fly economy class.
Many luxury goods provide utility that just cannot be described as "marginal improvements" over the economy offerring. For example, within 8 miles of my home are four golf courses with great variation in greens fees. I have played all four. To the avid golfer, the experience at the economical and midrange municipal courses just does not compare with that at Jerry Jones luxury Cowboys Golf Club.
Likewise, few would agree that a four-day Disney World vacation is comparable to two weeks in France or Italy.
I agree that SOME high-income families waste a lot of money on status goods. But my experiences with dozens of high-income individuals leads me to believe an equal number spend their money wisely.
Posted by: John Dewey at Dec 31, 2007 11:41:45 AM
When wealthy people value goods for their prestige value, it creates an opportunity for improving the efficiency of the tax system.
In particular, "diamond goods" are ideal candidates for zero-deadweight-loss taxation.
To take an extreme case, suppose the utility of a larger diamond is entirely due to the fact that it is expensive, and thus signals the bearer's (and/or giver's) wealth. In that case, a large proportional tax will simply shift the signalling schedule -- a $40,000 diamond will still provide the same signal, although it will weigh less on the wearer's hand. Whether $0 or $20,000 of that cost goes to taxes makes no difference to the utility of the diamond.
Assuming the government can provide services with utility greater than zero, funding them with taxes on "diamond goods" is a pareto improvement.
Posted by: A student of economics at Dec 31, 2007 11:42:06 AM
re Diamond good. Yes! I propose a luxury tax on boats. Let's see how that works out.
Posted by: Tom at Dec 31, 2007 12:04:45 PM
In a small city in China (600,000 in the city proper), my friend saw a box of four mooncakes selling for more than $250. Most mooncakes can be purchased for less than $1. The box was nice, but not that nice.
Posted by: 8 at Dec 31, 2007 12:19:19 PM
You write "My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments."
This is inconsistent with the model, where quality competition is associated with MORE intense price competition, not less. "More intense quality competition among firms causes them to locate their products in higher ranges of the quality spectrum, closer to each other, decreasing the degree of product differentiation," In the Shaked and Sutton model this paper is based on, closer products <==> more intense price competition.
Posted by: Steven Joyce at Dec 31, 2007 12:24:41 PM
John Dewey: My guess is that you are not aware of those who are rich but who choose not to spend their incomes or wealth on expensive status goods. Many wealthy peaple drive Honda Accords, shop for bargains at Kohl's, and fly economy class.
Oh, I'm perfectly aware of such people, kind of being one myself. But many other people in with similar incomes behave otherwise and think people like me are odd. And they convince themselves that the big premiums they are paying are essential, for example...
"To the avid golfer, the experience at the economical and midrange municipal courses just does not compare with that at Jerry Jones luxury Cowboys Golf Club."
When you get when you pay to play the high-priced courses is not much better fairways and greens, but rather the chance to rub shoulders with other rich people and the experience of being catered to.
Likewise, few would agree that a four-day Disney World vacation is comparable to two weeks in France or Italy.
Comparable how? I know a lot of people who both prefer Disney vacations and spend a lot more on them than we have on trips to France and Italy. Were you under the impression that Disney World is a cheap trip?
A student of economics: When wealthy people value goods for their prestige value, it creates an opportunity for improving the efficiency of the tax system.
In particular, "diamond goods" are ideal candidates for zero-deadweight-loss taxation.
So says Robert Frank. But I believe that sort of leveling would come at great expense to the 'production system'. I like to have all those rich diamond buyers working 50 and 60 hour weeks. As far as I'm concerned, letting them have their diamonds (which interest me not in the slightest) is a trivial price to pay for the benefits that are produced by keeping them on their (highly productive) hamster wheels. Would they spin the those wheels just as fast with high marginal tax rates in order to be able to buy smaller diamonds? Sorry, don't believe it. Don't go killing those golden hamsters.
Assuming the government can provide services with utility greater than zero, funding them with taxes on "diamond goods" is a pareto improvement.
Assuming the productivity of the economy is not harmed. Which is dubious.
Posted by: Slocum at Dec 31, 2007 12:34:00 PM
The high end implications of this paper may be obvious, but the implications for the middle of the market are perhaps far less so.
There will always be a place for low cost providers, and in a growing market of well of people there will be an increasing place for that extra bit of quality, or at least perceived quality. But that middle quality, middle price segment of the market looks to be increasingly difficult to make gobs of money in, and that I think is the highlight of the story here.
Posted by: happyjuggler0 at Dec 31, 2007 12:34:35 PM
Slocum: you missed the point of the diamond goods tax. It is NOT a high marginal tax on work or capital. It's a specific tax on prestige goods. If they are valued for their price, rich diamond buyers would work just as hard to stay on their "on their (highly productive) hamster wheels. " whether the tag read "3.2 carats" or "2.6 carats". Let's face it, its not the the intrinsic weight of the stone that provides utility, its what it symbolizes. And this is true for many other goods, to varying degrees.
In fact, by taxing diamond goods, we could LOWER marginal tax rates on work, including tax rates on the very richest citizens, if that's your preference. No golden hamsters are killed, or even slowed down a bit by a diamond tax. The point is not to "level" wealth at the expense of the "production system". It's simply a more efficient way to fund government than say, taxing labor and capital, on the margin.
That said, there could be adjustment costs moving from one system to the other. If you do it abruptly, there will be a one time shock to the production of the diamond goods (or yachts, as actually happened). Of course, if that market is competitive, then the long run profits are unaffected for suppliers, just as utility is unaffected for buyers.
Why would you prefer to have taxes on the marginal product of labor and capital, when such taxes are typically distortionary (unlike diamond taxes)?
Posted by: A student of economics at Dec 31, 2007 12:57:34 PM
I thought "Trading Up" was a great book talking about these issues.
... but my first thought today was similar to Slocum's. Everybody (Trading Up) reaches for the "luxuries" they can afford. Sometimes these luxuries are decided by consensus, for signaling, rather than for their performance or reliability. Maybe in the vast swath of the middle class that is the main driver.
Posted by: odograph at Dec 31, 2007 1:04:02 PM
ASOE: I agree with you, except if you are trying to analogize boats and diamonds, which surely are not at all alike. Are you asserting that the value of a boat lies only in its price?
Posted by: Cliff at Dec 31, 2007 1:10:01 PM
I probably shouldn't have lumped boats in with diamonds. I did it because "Tom" did, which was a mistake.
For most boats, there's a very substantial increase in intrinsic utility with price. Prestige is probably not that big a factor, so they are not "diamond goods".
For a few boats, like Larry Ellison's 452.75ft yacht (who's specs were changed just in time to make sure it was a bit longer than Paul Allen's yacht), the prestige factor probably is the dominant factor. In fact, most of his spending, on the margin, may well go to such goods and services.
Posted by: A student of economics at Dec 31, 2007 1:26:16 PM
ASOE,
What's to stop the wealthy from simply shopping overseas for their luxury goods (and services I might add)?
Also, as has been pointed out, unless it is done carefully you'll simply have a boycott of the envy tax, and the only people hurt are the "working class", not the rich consumers with high elasticity.
Posted by: happyjuggler0 at Dec 31, 2007 2:10:17 PM
slocum: "When you get when you pay to play the high-priced courses is not much better fairways and greens, but rather the chance to rub shoulders with other rich people and the experience of being catered to. "
First, I doubt that you have played both the high-priced and low-priced courses in Texas, Tennessee, Louisiana, and Arizona, or you would never have made this statement. I can't speak for other states, but my bet is that one would see the same variation in quality. I am positive the high priced courses in Florida also have much better fairways and greens than the low price course in the four states I listed.
Many of us consider the "experience of being catered to" a significant improvement in quality. If you do not, that is fine. But your original statement was about "products that provide relatively marginal improvements in function". What is a "marginal improvement" is very obviously different for you than it is for those of us who pay four times as much to play a high-priced course.
I have "rubbed shoulders" with other rich folks at the municipal Grapevine Golf Club, where greens fees are $32 on weekends. I don't need to go to the Cowboys Golf Club and pay $150 greens fees to do so. But I still play at the more expensive course when I need to treat myself to the best available conditions.
Posted by: John Dewey at Dec 31, 2007 2:40:46 PM
slocum: "Were you under the impression that Disney World is a cheap trip? "
Not at all. But a four day Disney vacation is an affordable family trip for at least 85% of U.S. households. A two week vacation in a European city is not. To me, the European vacation meets your definition of luxury good. To me, and to most of the wealthy, the European vacation would represent much more than "relatively marginal improvements in function" over the Disney trip.
Slocum, the problem I have with your original argument is that you project your value judgments on the habits of the wealthy. That's the only way you can make your conclusion about the rich paying more for a "much smaller inequality of utility".
Posted by: John Dewey at Dec 31, 2007 2:52:23 PM
Wouldn't it be easier just to look at the disposable income of the mean family versus inflation?
Posted by: Jarick at Dec 31, 2007 2:53:45 PM
Yeah, explain to me why we have to drive my $22K Toyota Camry and not my girlfriend's $45K BMW whenever it snows?
JD & Slocum-of course the luxe courses are going to have better conditions than the local muni track. No financial pressure to send off 200 foursomes per day to spike up the greens! But are the greens that much better at The Country Club than at Ponkapogue?
I call it the Handbag Effect. The marketers at Coach, Prada, Kate Spade, etc. hit upon the perfect storm of faux cache, selling a pocketbook for literally thousands of dollars. It's so infiltrated the culture that last Christmas I saw a UPS driver still in his uniform at Macy's dropping $650.00 for a bag! (Full disclosure-I was dropping $35.00 for a Coach change purse, cheap bastard that I am!)
But according to something I read online last spring, the luxe item CAN'T be a luxe item if the UPS driver is buying it, so the backlash has begun, with some of the new luxe items being logoless.
That'll show those dirty proles...
Posted by: Brutus at Dec 31, 2007 3:55:30 PM
brutus: "But are the greens that much better at The Country Club than at Ponkapogue?"
I do not know those courses. I do know luxury golf courses in north Texas. The layout, the bunkers, the greens, and the fairways at the Cowboys Golf Club, or at Colonial Country Club, or at the Preston Trails Golf Club are head and shoulders above that of the typical municipal golf course. The avid golfer knows the difference and understands why the prices vary.
brutus: "No financial pressure to send off 200 foursomes per day to spike up the greens!"
When did you last play golf, brutus? Grass-damaging spikes have been prohibited from quality golf courses for about a decade.
Posted by: John Dewey at Dec 31, 2007 4:23:02 PM
Johnny Walker Black Label in Japan was expensive and sold well. People liked to give them as gifts, the price being a significant aspect of the value of the gift. Being willing to spend a lot of money demonstrated "sincerity". When the company dropped the price to increase sales, to the contrary, sales dimninished. The gift value of the booze declined with the price. A 100$ bottle is an impressive gift. A 50 $ bottle is less impressive, even if the contents of the bottle are the same.
Posted by: Jive_Turkey at Dec 31, 2007 11:53:10 PM
Slocum sez:
"But now increasingly the case that what the rich buy are 'gold plated' versions of the same things virtually everybody has."
Perhaps in basic consumer electronics, hardly anywhere else.
In most cases difference is obvious to the rich and not-so-rich.
One may consider a 3000 sq ft house in hot and dusty Central CA the same as a similar house on a beach in Santa Monica. But most reasonable people will disagree.
4 days family vacation in Cancun, planned 6 months in advance, is not the same as deciding on Thursday to spend weekend shopping in Milan and getting there by private jet.
Even a good public school is not quite the same as a top private school plus private lessons in languages, music and arts.
Run of the mill suburbian hospital/docs are not bad, but easy access to the very best specialists is immeasurably better.
Perhaps one likes to clean and/or one likes to cook. But most people would really love to have a maid, a butler and a personal chef.
Perhaps at some level of wealth a saturation is achieved. Perhaps a family with $100M could live just as well as a $1B family.
But there is usually a huge difference in lifestyle between middle class and $100M family.
Posted by: mik at Jan 1, 2008 5:51:56 AM
