Calling a Cost a Cost: NY Anti-Free Speech Edition

Seems the State of New York is going to the Supreme Court for another of its protectionist regulatory policies. Yesterday the US Supreme Court granted a petition to hear the case of Expressions Hair Design v. Schneiderman. As the WSJ explains, at issue is whether New York’s regulations concerning credit-versus-cash retail prices constitute a First Amendment speech violation.

The problem stems from the fact that the State of New York has attempted to have its cake and eat it to by ignoring economic rcredit-card-1520400_1280ealism and prohibiting retailers from calling a cost a cost. The State prohibits retailers from charging customers a fee for using a credit card, but allows retailers to give customers a discount if they use cash. A group of hair salons, led by Expressions Hair Design, sued the state for infringing on its right of free commercial speech. The salons won their initial case, which was reversed on appeal. Now SCOTUS will have an opportunity to weigh in.

The Cost of Using Credit
From an economic perspective, the issue is fairly simple. Credit card companies charge vendors a fee every time a consumer pays with plastic. How much depends on the credit card company, whether the transaction is run as debit or credit, and the amount of the transaction. But typically, the fee is around 2-4% of the amount of the purchase. This reduces the amount of revenue retailers receive when the customer uses plastic. Put another way, when customers choose to use plastic, it raises the retailer’s cost of doing business for that sale.

In a free economy, retailers could choose one of three options: 1) force the credit card user to pay the additional transaction fee, which raises the price at the point of sale, 2) charge the same price for all buyers, implicitly charging cash users more for the product to subsidize the costs of the plastic users, or 3) pass the transaction fee savings on to cash users by giving them a discount. The only economic difference between 1 and 3 is what the sticker price is relative to the price actually paid. In #1, credit card users pay more than the sticker price; in #3, cash users pay less than the sticker price. In #1, the credit card fee is made explicit by adding it on just for those consumers who use plastic. In #3, the sticker price includes (i.e., hides) the cost of using a credit card and by default is the price everyone pays unless they are aware of the cash discount. In either case (1 or 3), the retailer is price discriminating between cash and plastic users. Or the retailer could simply post two sets of prices, one for credit and one for cash, which would then beg the question of “why the difference?” And that is where the NY regulations become a problem.

The NY regulation prohibits retailers from choosing #1 but allows them to choose #3. In other words, the regulation allows retailers to price discriminate, but only if they present it as a discount for cash users rather than a surcharge for credit card users. In short, NY allows the exact same price discrimination between two sets of consumers, but restricts the speech of retailers in how they are allowed to describe that price difference. As Expressions Hair Design argues in their complaint, this places a burden on the business in how it is allowed to explain or justify what is otherwise a perfectly legal two-price pricing system since the regulations make it illegal for employees to explain that the difference between the cash price and the credit price is due to the cost of the credit transaction. It would be like passing a law prohibiting a restaurant from explaining the cost of its steaks went up relative to its pork chops because the price of beef rose.

Framing matters
Why would the State of New York prohibit credit card surcharges but not prohibit cash discounts? Consumers respond to price signals, so how those signals are presented matters. If consumers are charged an extra fee for using their credit card, it makes the cost (price) of using the credit card very obvious to the consumer and she is more likely to change her behavior by using cash instead. This would be bad for the banks that make a significant amount of money on credit card swipe fees. Not surprisingly, banks support laws prohibiting explicit credit card surcharges. However, as noted in #2 above, charging cash and plastic users the same forces cash users to subsidize the purchases of plastic users, which also tends to penalize lower income persons relative to wealthier shoppers. So allowing retailers the opportunity to provide cash discounts is socially superior to not allowing differential pricing. However, the NY’s prohibition on calling a cost a cost and explaining the price difference for what it is, is not only an infringement on speech, but unjustifiable as anything other than an attempt to mislead consumers and protect credit card issuers.

Thursday’s Interesting Reads

A couple of interesting articles came across my screen today.

The first, by Alex Tabarrock over at Marginal Revolution, corrects a popular misconception about the relative bargaining power of workers. He points out the problems (both conceptually and factually) in framing employment issues as “firm versus worker,” which focuses on the threat of worker unemployment. He also shares a nice chart from the St. Louis Federal Reserve illustrating how this perception of employers having control over employment relationships is quite incorrect. One of my favorite lines/points:Buyers don’t compete against sellers, buyers compete against other buyers (and sellers compete against other sellers). See how that’s important in this context.

The second, by Andrew Flowers at FiveThirtyEight Economics, reports on a recent study by Montazerhodjat and Lo (MIT) that argues how the Food and Drug Administration (FDA) should change its one-size-fits-all approach for approving drugs to take into account the opportunity cost of making the wrong decision. This idea isn’t at all new to economists. Currently, the FDA uses the same standard for all drugs, regardless the severity of the consequences of making the wrong decision (in the trade-off between Type 1 and Type 2 errors). Montazerhodjat and Lo’s study (available here) is pretty technical, but Flowers’ piece does a great job of summarizing the economics and the results in a much more lay reader-friendly way.

Happy reading!

Markets, Incentives and a Krugman (et al.) Fail

Pity the poor teenager taking an AP Economics course whose father is an economist. Especially when the local school district has adopted a text that is based on Paul Krugman’s Economics (3rd ed., coauthored with Robin Wells). Even more especially when the father-economist has a fundamental disagreement with much of what Mr. Krugman has become since surrendering his academic credentials for political punditry. Yeah, that’s my lucky kid.

So of course, I had to thumb through the text. I suppose I shouldn’t have been too surprised to find on only the third page of Module 1 a gross error in explaining the trouble with command economies. After explaining the failed history of command economies, the text asserts (p. 3):

At the root cause of the problem with command economies is a lack of incentives, which are rewards or punishments that motivate particular choices.

Where to start? How about with the simple fact that incentives always exist, no matter the type of economy. And there were plenty of incentives in the former Soviet Union (the textbook example of a command economy–literally in this case). I remember the late Nobel Prize-winning economist James Buchanan sharing the story of his visit to Moscow shortly after the fall of the Soviet empire during which he was surprised to learn of a market for burned out light bulbs — because people could use them to steal working light bulbs from their workplaces when they couldn’t get light bulbs in the stores. People responding to incentives. It’s The Basics 101. The problem with command economies is not a lack of incentives–but a lack of incentives that are based on the wants of consumers themselves and a lack of incentives for innovation or efficiency. In short–the absence of the incentives created by a free market economy.

More importantly, the focus on incentives misses the point in a way that has significant implications for what the text goes on to say about economic policy. At the root of the problem with command economies was the lack of information available to decision-makers about the wants and desires of an entire population of individual consumers with different tastes and preferences and about the conditions of scarcity and desires in dispersed local markets across the society’s economy. As F.A. Hayek (another Nobel Prize winner) explained, the fundamental role of markets is to discover and reveal information based on the complex interactions of individuals across product types and geographic space.These interactions result in prices that reflect the relative scarcity and value of goods across society. Those prices create incentives, and those incentives are fundamentally important in guiding individuals to use their resources in ways that innovate, create value, and serve consumers. But the incentives are secondary–derived from the information discovery role of the market that cannot be replicated in a command economy.

Why is this such an important distinction? Because of the way the text goes on to describe the objective of policy making. After (fairly accurately) explaining how prices create incentives, the authors state (p. 3):

In fact, economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective; a plan that gives them a financial incentive to do so is more likely to succeed.

The implication? All we need to do is create incentives (implicitly, in the form of taxes, fines or subsidies) to create financial incentives for manufacturers (or people) to do what we want them to do. But this line of argument ignores the more fundamental question of determining whether the plan makes social or economic sense in the first place. What is the economic basis for whether we uses fines or subsidies and how large they should be? At what point, if any, would doing nothing be economically more efficient than doing something? By taking away the fundamental information function of the market and jumping immediately to incentives, we skip the whole messy discussion of the information requirements by legislators, bureaucrats and policy makers in coming up with “the plan” to begin with. All we need to do is trust the omniscience and beneficence of policy makers to know what the “right price” is–and to set arbitrarily the incentives to get the outcomes we want. But that’s exactly why command economies fail.

The root problem of a command economy is not that there are no incentives, but that there are socially inefficient incentives. The incentives are socially inefficient because it is impossible for a central authority to know the value individual citizens place not only on existing goods and services, but on the latent value of potential goods and services that can only be discovered by innovation and experimentation–and a central planner cannot think beyond her own imagination in the realm of possibilities. And it’s not only true of Soviet-style planned economies, but of any central decision-making authority–including the US federal government–even in the context of a heavily market-dominated economy.

Note: AP Economics students (and teachers), remember….the correct answer on the test may not be the right answer in reality. Answer the questions from the textbook based on the information in the textbook. But in your real life as a consumer of information and participant in the market place of ideas and politics, be sure to get to the fundamentals rather than the superficial.

SCOTUS Rejects USDA’s Raisin Cartel

A couple years ago I posted (here) about a lawsuit progressing through the courts concerning the USDA’s raisin marketing order. The Raisin Administrative Committee (RAC) basically sets a quota on the amount of raisins that can be marketed in a given year as a way of maintaining high-priced raisins. The RAC requires produ799184_1280x720cers to turn a portion of their crop over to the RAC, which then markets the “excess” raisins to other countries or uses.

Today, the US Supreme Court ruled in Horne v. Department of Agriculture that the USDA-sponsored Raisin Administrative Committee’s process amounts to an unconstitutional governmental “taking”. Apparently the decision is limited to the raisin program and it opens the doors to other ways for the USDA to control the raisin market, but the decision also raises questions about the constitutionality of other agricultural commodity programs.

 

Bye-Bye Bookstores

When you read a story about a local bookstore going out of business, you kind of expect the culprit to be lost business to on-line retailers (e.g., Amazon), e-book sellers (e.g., Amazon’s Kindle or Apple’s iBooks), or maybe, just maybe, a large brick-and-mortar bookstore (e.g., Barnes & Noble ). And while it may make one sad, at least one can understand the consequences of competition.

What you wouldn’t normally expect is that the store’s loyal customers and local citizens voted to shut it down–without even knowing it. But apparently that’s exactly what happened to the beloved Borderlands Bookstore in the Mission District of San Francisco according to the Bay Area’s ABC 7 News. As a result of the voter-approved increase in minimum wage, the bookstore can’t afford to remain open and has announced it will close at the end of March.

“You know, I voted for the measure as well, the minimum wage measure,” customer Edward Vallecillo said. “It’s not something that I thought would affect certain specific small businesses. I feel sad.”

The San Francisco Board of Supervisors seemed to have expected it though, but they forwarded the initiative to the voters nonetheless:

“I know that bookstores are in a tough position, and this did come up in the discussions on minimum wage,” San Francisco supervisor Scott Wiener said.

Apparently Wiener takes comfort that it was the will of the people, with 77% voting in favor of the increase. But this just really points out a problem in what is often a democratic-wannabe, spineless-republican form of government. Legislators pander to interests and ideas they know are bad for the economy, but pass the buck on responsibility by “letting the voters decide”.

And while Jonathan Gruber was mocked for saying Obamacare supporters had to hide the details because of the stupidity of the American voters, time and again local (and state-wide) referenda on things like minimum wage give credence to his claim. The average voter either has no clue about how markets really work or is tremendously myopic in thinking through the consequences of the policies they support…most likely, both. (Although, if voters were more economically competent, Obamacare supports would have had even more reason to hide the details.)

So the chickens have come home to roost in San Francisco. If you go there, plan to leave your heart…and your money…but don’t plan on enjoying the beloved local bookstores. Or the many other small, local businesses that can ill-afford an arbitrary (in this case, 50%) increase in their labor costs. Because that’s what minimum wage laws do.

The Price and Quality of Wine, Part II

After my previous post on the relation between the price and quality of the top red wines and the top wines under $50 in Vivino’s 2014 “People’s Choice” rankings, I got curious about the price-quality relation for the top white and sparkling wines. And I must say, i was a bit surprised.

For the Top 100 white wines, there is actually a moderate correlation between the quality rankings and prices; with a correlation coefficient of 0.51. Price isn’t a perfect signal for quality. In fact, the seventh best white wine cost only $27, just more than half the average price of $52.48. But price and quality are at least somewhat related overall, with the top five wines ranging from $244 to $404 and 21 of the last 25 wines below $50. As expected, the variance in price relative to the average was less than for the reds (std dev of 63.84).

However, if you’re looking for sparkling wine, it’s much safer to let price be your guide in judging quality. Price and quality rating have a correlation coefficient of 0.715, suggesting a fairly strong correlation between the two. This is completely opposite the case of the reds (recall, the price-quality correlation for those was just 0.053). And while the range of the Top 100 sparkling wine prices was considerable, from a high of $476 to a low of $10, the variance was lower relative to the average than for either the reds or the white (std dev = 95.779, average = $126.78)

Now, there are some caveats one should make about inferring too much from such a simple comparison. But the basic lesson is pretty straight-forward: if you’re shopping for quality sparkling wines, let price be your guide–at least in an ordinal sense. You’ll have to judge for yourself how much the additional quality is truly worth (i.e., is the quality of a top 10 wine five times better than the quality of the lowest 25, as their price difference would suggest?). If shopping for whites, price is a bit less reliable a guide, but not wholly unrelated. If shopping for reds, however, be careful about reading too much into the quality of the wine from the price on the bottle.

The Price and Quality of Wine, 2014

The makers of the Vivino app, which allows wine lovers to rate and share reviews of wines, produced their Top 100 lists for 2014. According to their website, over 13 million users rated over 3 million wines. Based on those reviews, they produced lists of the Top 100 reds, whites, sparkling wines, and “Under $50” wines. The lists included the average price reported by their users (another feature included in the app). Naturally, I thought it would be interesting to see how well prices correlated with the quality rankings.

I started with the Under $50 category because, seriously, if I’m going to buy a bottle of wine it’s going to be under $50 unless I’m hosting a Nobel Laureate wine connoisseur, or I’m out for dinner at a nice restaurant on someone else’s dime. Besides, there are WAY too many good wines under $50 to spend more than that for most purposes. Using the ranking score (from 1 to 100), the reported prices have a positive correlation, as one would expect (higher ranked wines have higher prices; lower ranked wines have lower prices), but it’s a pretty weak relationship (0.2075).* This suggests that while a higher price wine may be higher quality, don’t count on it. That ought to make you feel better about grabbing that less expensive bottle for your neighbor’s New Year’s party. The average price of wines on the list was $35.03, which is still higher than you might buy for an evening at home, but the cheapest wine was just $11 (Wild Rock’s The Infamous Goose Sauvignon Blanc Marlborough 2013 at #97) and only one wine hit the $50 cap (Pago De CarraovejasRibera del Duero Crianza Tinto 2009 at #31).

I was going to stop there, but decided to look at the Top 100 red wines as well. Since there was no cap on the prices, one might expect some very expensive, highly rated wines to push the expected correlation. However, it’s quite the opposite. The correlation coefficient between rank and price is a mere 0.0528, which means virtually NO relationship between quality ranking and price. Of course, the standard deviation was much larger relative to the average price (std dev = 803.5; average = $549.30) than it was for the lower priced wines (std dev = 10.53, average = $35.03). The highest priced wine on the list was $5,455 (yes, that’s right, Pétrus’ Pomerol 1982 at #36) while the lowest was just $81 (Concha y Toro’s Don Melchor Cabernet Sauvignon 2009 at #82). So if you’re looking at wines in the $100+ range, there is a good chance that relative prices tell you next-to-nothing about the quality in the bottle.

One thing that may affect the weaker relationship is the context in which the most expensive wines are likely purchased. I would suspect a good percentage of these were purchased in restaurants, where mark-ups can be quite high and varied across establishments. And one wouldn’t expect a large number of the highest priced wines to be purchased, even among the 13 million Vivino users, so there may a good deal of variance in reported prices and quality that is masked in the reporting of averages. Perhaps the good people at Vivino would be willing to share more of the data for a more thorough analysis.

I opted not to take the time to do the exercise for the Top Whites or Top Sparkling Wines. For one, I generally prefer reds. I would hypothesize that the correlation is probably just as low for the whites and sparkling, but I suspect the variance in price would be lower for each of those than for the reds, since reds are generally better for aging and therefore may have some appreciated (or potential) time value built-in that the whites may not. If you decide to check it out for yourself, please post a follow-up in the comments!

So you want to make sure you’re getting a good bottle of wine at a good price? Crowd-sourcing quality using apps like Vivino (or Untappd for craft brews) is likely a much more reliable source than just relying on price. Of course, a knowledgeable friend or local wine seller wouldn’t hurt either.

* Note: I edited the post to make the correlations more intuitive (higher quality, higher price positive correlations) rather than the negative numbers that resulted from the actual ordinal rank score. I also added in the names of mentioned wines along with a link to the wine’s profile on Vivino.com).