The Economics Network

Improving economics teaching and learning for over 20 years

Student essays from the Economic Naturalist writing assignment

Provided by Wayne Geerling, LaTrobe University with grateful thanks to all the students who contributed.

Why would a consumer spend up to $4,000 on a fixie bike when a standard one is much cheaper?

Given the option of purchasing a road bike from Target for $99 that comes equipped with 18 speeds, brakes and front suspension support or a basic “fixie” bike for an average $1,000, which comes with none of the aforementioned items, which would you prefer? Interestingly enough, many of Melbourne’s younger generation are choosing the latter option.

A fixie bike is a bicycle that has no freewheel, meaning it cannot coast; the pedals are always in motion when the bicycle is moving. Fixie’s are associated with a young, hipster crowd; each individual rider identifies with other fixie riders because they ride the same bikes and a fixie culture is established. This fixie culture has created a lucrative market where suppliers are able to mark up the price of certain bikes and purchasers willingly continue to purchase.

The vast amounts of money spent on purchasing, but mostly modifying, a fixie bike is well in excess of what most young “Melbournites” would spend on the average consumer good. Having ownership of a luxury item such as a fixie allows the rider to attain a certain social status within friend groups, work atmosphere and the society that he or she rides.  A luxury item, economically speaking, is defined as a good or service where demand increases more than proportionally as income rises.

The social status attached to riding a fixie bike does not, alone, explain why consumers are willing to pay such hefty amounts of money for them. The niche market theory provides further clarification: specific demand requirements such as price, quality, demographics, etc, dictate the need for a specialised market to materialise. A successful niche market will have higher prices and a smaller market share than its competitors but be more profitable in the same product category. As outlined, niche markets depend less on the price of a good and more on the specific needs of the consumer. These needs can extend to brand recognition and other assets that the consumer wants to be associated with (e.g. prestige, environmentally conscious consumers, etc). The needs of fixie riders include brand recognition, the ability to modify the bike and make it a reflection of themselves, and social association.

Various literature, including websites and newspaper articles note that many consumers see appeal in the hardened image of riding without brakes (it is also worth noting that it is illegal to ride a bike without brakes in Australia).  In economic terms, this intended projection of image is called signaling: when one party conveys a certain image of itself to another party. In the case of fixie riders, they are signaling to other riders, and the general public, that they are young, fashionably conscious, hardened riders.

The decision to purchase a fixie can also be justified with a cost/benefit analysis: purchase if MB > MC. The benefits of riding a fixie bike include the increased social status and belonging to the fixie culture. A fixie can also provide the same benefits as a standard bike: exercise & cheap transportation. The costs of purchasing a fixie bike include the purchase of a bike (ranging from $600-$2000) and the modifications (a further $60-$2,000). The consumer’s marginal willingness to pay plays a major role here. According to the laws of economics, a consumer cannot be duped into spending too much money on their bike of choice, as they will only spend up to a point where MB = MC. If a buyer values a bike at $2,000, then he/she will pay not a cent more.

Purchasing a fixie bike may seem like an irrational choice for those who do not delve beneath the exterior motives of the rider. In reality, the underlying benefits gained through buying a luxury item, such as a fixie, provides recognition and many other intrinsic benefits to the rider. Although the price may seem excessive compared to a standard road bike, after careful research and the application of economic reasoning, it is apparent that a fixie is not just any bike. It is a “lifestyle changing” purchase.

How should one overcome the perils of online dating?

Diana had been on OasisActive for over a month now and had yet to find a mate. Initially, Diana had a choice between two dating websites: OasisActive and eHarmony. She choice OasisActive because the opportunity cost was lower, as it is a free dating site (OasisActive’s comparative advantage). What she didn’t consider was that incentive of satisfying materialistic needs such as sex would not motivate men to register for eHarmony, as consumer price discrimination favours Oasis and features younger women – a trait valued by men. There was also greater information asymmetry in choosing OasisActive over eHarmony. Diana had attempted to attract a like-minded mate by listing “No Casual Sex” on her profile. This turned out to be a perverse incentive as it encouraged men to be deceptive about their intentions in order to increase their supply of sexual intimacy.

It was clear that whilst her opportunity cost for using OasisActive over eHarmony was lower, it had also reaped less net benefit. Her initial cost-benefit calculation had been incorrect. So Diana began to think, I’m still single, and the variable costs are mounting. She had made a large emotional investment into online dating. Diana knew she was dealing with sunk costs but was irrationally driven to wait for her marginal benefit to exceed her marginal cost to regain a feeling of value and worth.

As an economics student, she had also begun to realise she was in a very competitive market. She had been realistic about her purchasing power; she was attractive, though not supremely beautiful and she knew she needed to contend with women who were willing to lease instead of buy and who had maximised their total utility – at least in terms of superficial looks. Because OasisActive offered few metrics to measure compatibility, search and rejection costs accumulate, increasing marginal cost. Diana began to wonder; “at what point does my marginal benefit exceed my marginal cost and make this worthwhile?”

Diana was right to re-consider the costs and benefits of dating. She had dealt with much immorality in what should be an amoral market. After all, OasisActive is known as a dating site for youth and considering the time constraints, social commitments and friendship networks of such youth, how many want to commit to a serious relationship? Nevertheless, it seems the expectations of men and women entering the market seem to differ. Expectations are high, the quality of the product is low but the supply is high and equilibrium is therefore difficult to strike.

Men on OasisActive have lower standards for gratification and were less inclined to fall into emotional intimacy as their rational intellect prevailed over their emotional mind. In this way, men possess market power as they are price-setters. Women, searching for traits that are rarer amongst the male population on the website, are price-takers as they must reassess their willingness to pay in order to find a mate. What Diana realised is that this perfectly illustrated scarcity and shortage; men who fulfil the higher expectations of women naturally attract more attention. As a rational agent, Diana knew that her hopes of finding this man were unlikely; after all, efficient market hypothesis states that all the good ones are either taken or gay.

After a while Diana realised that her profile views were growing less frequent. Diana considered that by allowing searches by profile picture, the website was incentivising a superficial interaction between buyers and sellers and creating barriers to entry for women who did not post an attractive picture. Suddenly, her chat window opened – somebody was talking to her. After a few minutes of talking, however, she quickly cottoned on that this man was using game theory, and moreover, he had a dominant strategy! It didn’t matter what she said, the man was duly sympathetic and excitable at the times when he should be. He seemed so nice. When she questioned him about this, he became defensive. “Argh, she thought. This site is a perfect example of market failure!”

Diana had rejected guys who asked for sex before, and they quickly began to berate her and call her unsavoury names. Although she knew this was a technique to reduce her self-worth and therefore her purchasing power, she couldn’t help but feel terrible afterward, a negative externality.

Why does steroid usage lead to an inefficient outcome for society?

Active, social young adults are especially prone to the influence of social norms, expectations and values systems as projected by their peers, parental figures and the media. It is no coincidence that Australia’s mainstream media is more concerned with idealistic images of beauty than with realistic representations of the human body. Media agencies are rent-seeking, trying to bolster private economic growth through political manipulation. They are reliant on advertising revenue for profit. The products sold in the advertising are driven by consumer need, therefore magazine publications have an incentive to ensure consumers believe they have a problem that needs fixing. This creates an obvious negative externality in perpetuating a social problem of low esteem.

Perhaps more than any other Generation, Generation Y (aged 18 – 29) is impatient and wants quick results. The quickest and easiest way to bulk up quickly is with anabolic steroids. Arguably, the greatest issue with confronting the popularity of the drug is the moral hazard involved. Steroids deliver instantaneous results with minimal short-term risk and thus, present great benefit at low cost to people looking to build fast muscle. What results, however, is an inefficient allocation of resources whereby growth is maximised early but habits for maintenance of those gains are not established. In this way, performance enhancers such as steroids do maximise utility but also incentivise lazy workout habits. So whilst short-term gains are good, the long-term risks of using steroids inevitably contribute to a dependence on government-funded health care.

It is also inefficient on a fiscal level whereby cash is fed into the black market – giving dealers market power, who can then price gouge – and not into the private sector, to nutrition companies who can then further invest in research and development to yield better quality produce. If this were to be a government regulated market through decriminalisation, information asymmetry would be reduced by rule of law and competition will drive the price down. If governments were to control the supply of performance enhancing drugs, taxation could be used to supplement government revenue.

As steroid abuse is potentially addictive, it is possible that a percentage of heavy users of steroids would have perfectly inelastic demand for the good. The government has made steroid use available through prescription, which some addicts are using to obtain quality-controlled goods. Although the government is signalling that steroid use is not condoned, they still offer market access for steroids legally for legitimate medical reasons. Through screening for loopholes and access to corrupt doctors, the system is adversely selected by addicts who are able to circumvent the system. This, however, is the only mechanism preventing drug dealers from possessing scarcity power, even if it does, in some way, act as a perverse incentive. On a personal level, it could be that wealthier steroid abusers stockpile the drug from prescriptions and experience free-riding from addicted, less financially stable friends.

Whatever the case, it can be assumed that the market for steroids is populated by people serious about fitness or muscular development. If young people where to consider the benefits of health and nutrition education, they would be able to up-skill, gain employment within the sector, raise capital to build muscle and receive discounts on health products. Furthermore, it is ironic how irrational behaviour leads people to choose low-hanging fruit instead of healthier, more sustainable substitutes to muscle growth.

Despite the trade-offs and opportunity costs – including reduced health at older ages for dependant users -, steroids still apparently deliver strong return on investment. Revealed preferences theory proves that social welfare is not considered, and that marginal benefit clearly outweighs marginal cost. This goes some way to explaining how the market for steroids is still active. The greatest consideration, however, is the impact steroid abuse has on society.

There are many negative externalities associated with steroid abuse, such as improper disposal of needles polluting the public sphere. The broader problem, however, is that it is counter-intuitive to efficient level of crime. Steroids are of more value to patients in rehabilitation than to recreational users, so the commodities, or resources, are inefficiently allocated in the market (where marginal social cost outweighs marginal social benefit). The side-effects of the drug such as steroid-induced rage may lead to statistical discrimination against the body-building community and could have permanent effects on the hedonic treadmill due to its hormone adjustment. Another consideration is that income inequality contributes to steroids being used in higher-income areas, where physical health is an affordable hobby. This could potentially lead to segregation between recreational performance-enhancing drug addicts and psychotics or depressants in different socio-economic regions. Whatever the perspective, economically, steroid use is an inefficient outcome for society.

Eggspensive Taste: Why do eggs that cost 95c a dozen to produce sell for up to $9.00?

How is it that supermarket’s are able to sell eggs at such a mark-up price? A dozen eggs can sell for anywhere from $2.39 to $9.00 in a supermarket in Melbourne (All prices quoted in this essay are based on figures obtained from Coles supermarket in Greensborough on 10 October 2010). What causes such a price differential and why do people pay for the more expensive eggs? The answer lies in the economics of everyday life.

It costs a Victorian farmer approximately 95c to produce a dozen eggs. Current wholesale prices being paid to farmers are up to $1.60 per dozen. On shelves in local supermarkets, eggs cost anywhere between $2.39 for the no frills home brand eggs to $9.00 for homestead laid, free range eggs. Supermarkets are able to artificially inflate prices using many techniques, such as product placement, packaging, branding, asymmetrical information and signalling.

The first thing that is obvious when you walk up to the egg section is the abundance of varieties available. The supermarket singles out those who place a high opportunity cost on their time by the way the eggs are placed on the shelf. Customers who are relatively insensitive to prices won’t take time to compare and are likely to grab the box that is easily accessible with packaging that quickly appeals to them. It should come as no surprise then that those with the highest prices and mark-ups are located at eye level in easily accessible spaces.

The way in which different eggs are packaged signals different things to groups of customers. The cheapest options are found in egg cartons with the basic information printed in black with little or no colour, whilst the more expensive eggs are more vibrant and eye catching. These design techniques have no impact on the quality of the eggs in the box; however it signals to the consumer that the eggs are of differing quality. This is targeting customers with varying levels of willingness to pay.

Packaging style is not the only way in which prices are gouged by the supermarkets. Labels on how the egg was produced and under what conditions are used to increase the buyer’s willingness to pay. Supermarkets price target different segments, which are more sensitive to certain situations. Eggs labelled as being “locally produced” attract a mark up of 66%. The eggs that donate 20 cents a box to charity cost the customer an extra $2.60 to buy. Eggs produced to RSPCA standards attract an 88% mark up. Each product is aimed at a different consumer, and is designed to identify and exploit that customer’s marginal willingness to pay.

Asymmetrical information plays a large role in the ability to impose such large and seemingly arbitrary mark-ups. A dozen caged eggs cost approximately 95c per dozen to produce. Barn laid eggs cost 25% extra to produce, and free range eggs 50% more. Supermarkets charge mark-ups of up to 109% for barn laid eggs and 276% for free range! The average customer will be unaware of the production costs and therefore be more willing to accept that they must be so much more expensive.

 Customers will purchase eggs that have been laid free range for two dominate reasons: they object to chickens being caged or they believe that free range eggs are of higher nutritional value or quality. Whether it has been laid by a chicken in a cage barely big enough to fit the chicken or on a farm with kilometres of open space, the end product is simply an egg. Research done by the US Department of Agriculture found that there were no nutritional benefits to free range eggs. As you are able to inspect eggs before purchasing, the quality is assured, regardless of whether they are free range or caged. Therefore, supermarkets are effectively putting a price solely on your conscience.

With all of these techniques the supermarkets strive for perfect price discrimination, where the buyer will be charged the highest price they are willing to pay for a product. Leakage occurs when customers who are willing and able to pay a higher price for eggs choose the relatively inexpensive home brand eggs. But what is the loss to the supermarket? They still make a profit margin off these eggs, even if it is less than the mark up on their ‘premium’ eggs.

So how can a supermarket openly display such price disparity, yet customers willingly choose the more expensive products? Although they cannot practice perfect price discrimination, what they do is employ economic techniques such as signalling, information asymmetry and price targeting in order to identify those customers with the highest marginal willingness to pay, and increase profits as a result. If you feel ripped off in the knowledge that you paid $9.00 for eggs that are for all intents and purposes the same as eggs less than a third the price, next time choose differently.

The Market is Amoral: Should you buy the last can of Coke on the shelf?

What the hell is ‘amoral’?

Amoral is a neutral term which infers that something is neither good nor bad. Economic markets are amoral; they are a ‘forum’, for lack of a better term, where goods and services can be traded. Markets vary - they can be good, bad and sometimes ugly, for example the market for renewable energy or volunteering in Africa may seem saintly compared to the crack cocaine markets of inner city Ghettoes, or the gun market in Mogadishu. Although both of these sit at opposite ends of the moral spectrum they both operate in exactly the same way: they are simply offering different goods or services. If we accept Mr. Paul Zak’s inference that almost all people do have some altruistic moral fibre then why are gun merchants selling arms to child soldiers?

Why do they feed Paris?

One of the most important ten lessons in economics is that people respond to incentives, so if a person sees an incentive in selling an AK-47 to a pre-pubescent child, they generally will. The market answers the question of “who feeds Paris?” and incentives answer the question of ‘why’. People seek to maximise their utility; they do so by selling their labour or commodities to the market. In the more eloquent words of Charles Wheelan “these guys don’t care about upscale diners in Paris. They care about the wholesale price of fish”[1]. Markets organise themselves through people’s patterns of behaviour and this behaviour is governed by an incentive: for a person to be better off than they were before.

I guess at this point you are probably asking “what does this have to do with the last can of Coke on the shelf?” People face trade-offs every day; the money a person spends on a can of Coke could have easily been spent on a chocolate bar or a cigarette lighter. Therefore, if someone buys a can of Coke it is safe to assume that this product was the most important thing to them at the time. Now imagine this was the exact same case for a separate person, only with one problem: two people want a can of Coke more than anything else that is the same price and in the near vicinity; however, in this case there is only one left. By Smithian logic the best possible thing for the market is for both actors to behave in a self-interested manner, but will this lead to the best possible result for the market?

Let us assume for a moment that the market is founded on a different basis to Smith’s self-interested perspective, maybe one of “morality”. Morality is an elusive term so we will substitute it with ‘altruism’ to make it easier. Would the market be better off if this were the case? The simple answer is ‘no’. If both parties vying for the can of Coke acted altruistically, which is to say they both sacrifice their own want for that delicious beverage, making it available to the other. In this scenario there is an asymmetry of information - neither party knows the value of the Coke to the other person. The best approach for both people now would be to send a ‘signal’. They reveal information to the other person and as a result the ‘receiver’ adjusts his consumption behaviour. If, for a number of reasons, any information is ‘not received’ (misinterpreted, poorly sent) then we have what is called a ‘separating equilibrium’.

Let’s play the Moral Bayesian game!

Sending signals sounds much simpler than it actually is. The problem is that much of the information sent, even in a rather simple scenario of trying to quench your thirst for caffeine cola, is incomplete. Put simply (or at least attempting to) both players (the two Coke consumers) are trying to understand the ‘nature’ of the other; however, there are too many factors which can be ‘misinterpreted’. Essentially, the only information that both people have is that the other is going to act altruistically and as a result questions begin to arise like how thirsty are you? Have you had a hard day at work and would a Coke make it better? These are potentially all categories of information which need to be revealed for both people to establish who wants that can of Coke more.

Acting morally could lead to negative externalities.

Let us now imagine that both players do not arrive at a conclusion. Instead they both decide not to purchase the Coke because of the quaint idea that one will benefit at the other person’s loss. In effect they are in collusion, but it is a cooperative pact that is actually not ideal for all parties involved. Before you think this is turning into a Dostoyevsky novel with 70 characters, I will assure you there is only one more person involved in this transaction. That person is the one selling the Coke of course. As a result of the two people deciding not to purchase the Coke due to altruistic tendencies, the shop owner loses. Actually, everyone loses. The two individuals who want to buy the Coke incur the opportunity cost of the time it takes to learn the ‘value’ of the other and the shop owner does not sell his can of Coke.

If this was how an altruistic market operated (in very simple terms) then it would most likely fail due to the large part that asymmetry of information would play. Fewer transactions would occur because of consumer altruism and a change of incentives, which basically means people are no longer trying to make themselves better off than others. This may have a positive effect on markets mentioned before, like drugs, however how would this affect everyday markets? For one, you would definitely be paying double for almost everything. In other words next time you are at the shop and staring at the last can of Coke on the shelf, just buy it. Unless of course you derive more benefit from allowing a nice young lady, or large under-caffeinated fridge with a head, to purchase it.

[1] Charles Wheelan, Naked Economics: Undressing the Dismal Science, W.W. Norton and Co. (New York), 2002, p 12

"Why are motorbikes exempt from paying fees on toll roads in Victoria?"

While it may seem like a pointless loss of revenue for CityLink[2] to not charge bikers for their use of toll roads, it makes economic sense to leave them exempt from the fees, which, for a 24 hour pass, ranges from $4.70 (car) to $21.25 (heavy commercial vehicle). Motorbikes cause less congestion than cars and emit much less pollution from their considerably smaller capacity engines. Cars are charged by way of e-tags kept inside the cabin. An e-tag for motorbikes would have to be weatherproof and the costs involved in developing such a device may be too great.

Some might argue that motorbikes, regardless of their size, still contribute to the traffic congestion dilemma. Any “crowding out” effect that people may contend is basically negligible. Even if there has been an increase in the numbers of riders using toll roads, traffic congestion has not become considerably worse. In fact, it may have taken motorbike traffic off public roads and spread it out over both public and toll roads, creating improved traffic flows across all metropolitan areas.

The typical motorbike has a much smaller engine than even a small car. Hence, the pollutants emitted by motorbikes are far less than those emitted by cars on average. In order to reduce pollution, providing free travel on toll roads for motorbikes is a strong incentive for commuters to make the change. Improving air quality became pivotal for CityLink when the smoggy air in both its tunnels appeared to be worsening. A rational way of reducing the poor air quality was to allow free travel for vehicles that contribute very little to the pollution. This, along with some improvements to the ventilation, eradicated the thick smog.

Cars are chargeable via a simple e-tag that gets scanned at each toll gantry along the CityLink. It needs direct line of sight with the sensors and has variable beeps to indicate different things to the driver. An e-tag for motorbikes would need to be able to resist the elements and still somehow communicate with the gantry sensors and the rider. To develop a different e-tag capable of doing all these things would increase overall costs of production for CityLink. Given the relatively small impact bikers have on CityLink's efficiency in reducing traffic congestion, it appears that e-tags for motorbikes would lead to marginal costs being greater than marginal benefit (MC > MB).

Furthermore, to maintain marginal profits after developing motorbike e-tags, CityLink would have to raise prices, deterring car drivers and most bikers. Bikers' demand for CityLink is quite elastic since there wouldn't be much difference riding on CityLink or public roads during busy periods. These price increases would then impose a negative externality on the car drivers who now face higher prices for the same good. The opportunity cost for bikers returning to public roads after fees are implemented reduces very quickly. In this sense, not only is the positive externality of not charging riders being the reduced congestion and pollution but also the lower prices charged to car drivers!

To some it may seem unfair that bikers get a “free lunch” and they will argue that a free-rider problem may ensue as a result. While the bikers may essentially be getting an actual free ride on toll roads, this case is not leading to any significant negative effects. As mentioned earlier, there is no overuse of the good and it can’t lead to any underproduction from lack of funding because the capital has already been funded and constructed. By eliminating this free-rider situation, the entire system will suffer as a result. For once, a free-rider situation is beneficial.

To conclude, while there are certain arguments promoting fees imposed on motorbike riders, it would simply be a poorly judged trade-off to charge them. Motorbike fees would raise CityLink’s prices across the board and it would see very little usage by riders given their highly elastic demand for toll roads. The costs involved in producing vastly different e-tags to those already in cars would be a huge cost - one that’s best off being avoided as the return on this cost is very low. Given the agility and small size of motorbikes, they don’t increase traffic congestion and have little reason to be charged as they don't sit behind traffic but simply ride through it. While it may be seen as a free-riding issue, these riders using the toll roads are not over-using them and only very minimally “crowding them out”. All in all, the current system of free travel for bikers is Pareto inefficient in that by making one party better off, other parties are not seriously worse off.

[2] CityLink is a 22-kilometre automated tollway in Melbourne, which is divided into two sections: the Southern and Western Links. It connects the Tullamarine Freeway, the West Gate Freeway and the Monash Freeway. CityLink roads are clearly marked with blue and yellow tollway signs.

Why are designer denim shorts so expensive?

As the weather has been changing for the better recently, I have been on a regular hunt for shorts. Picky as I am, I have been browsing through many shops in order to find the ideal pair to be included in my summer apparel wardrobe. During my search, I stumbled upon something my inner economist found peculiar: the price of so-called “designer denim” shorts costs anywhere from $150-$250![3] Since denim shorts use roughly half the amount of fabric as a pair of jeans, one could rationally assume the price would reflect this. Seeing as this is clearly not the case, why exactly is it that designer denim shorts are so expensive?

Many apparently 'obvious' reasons why designer clothing is more expensive than the alternative generic brands initially come to mind. Often, I have heard: “designer clothes are equal to prestige and exclusivity”, “they provide a better fit”, “the quality of the materials is higher”, “remember that much time is spent on the innovation and designing process”, etc. And while there is definitely some truth to all of those statements, I would like to argue that other factors also contribute to the higher price. After all, denim is denim and there is only so much that you can do with the design of shorts.

We are dealing with a standard market. The designer firms wish to make profits (and attempt to maximise these) by delivering goods we want to buy and we, individuals, simply want to maximise our utility. By applying market theory, the answer to my posed question is simply: the reason these shorts are set at the price they are is because the consumers’ marginal willingness to pay for them equals or exceeds their value (marginal benefit > price). Thus, the interesting question now becomes: what utility is it that consumers derive from denim designer shorts? And why is their willingness to pay so high?

Appearance and being fashionable explains some of it. For example, men who wish to date attractive women would be very interested in increasing their ‘purchasing power’. By wearing more expensive, designer clothing it could be argued that men improve their physical appearance and thus signal a higher 'value'. As designer clothes do signal values like prestige and exclusivity, they do send a clear message to potential dates: I am wealthy and fashionable. Since women generally regard men with higher incomes and higher social status as more desirable marriage partners, men can take advantage of this signaling and consequently their marginal willingness to pay for designer shorts rises.

Another reason relates to the pursuit of happiness. The research of Robert Frank has proven that being rich does not necessarily equal being happy due to the fact that our expectations and aspirations adjust over time. Nevertheless, having certain positional goods, for some, is important for a general sense of self-value and level of contentment. Some people simply feel happier if their relative position to others is better. Unfortunately, a relative position implies that you can only get ahead if somebody else falls behind. As consumption is important in relation to relative position, people wishing to have this ‘higher’ status must continue to buy designer clothing. This again affects one’s willingness to pay.

Lastly, I think it can be argued that designer companies try to create scarcity in the minds of the consumers through advertising. The different labels are in need of some degree of market power to actually sell their products at above normal economic profits. They achieve this by differentiating themselves through price, design, advertising, etc. This differentiation is so important because, if excluded, denim shorts could be categorised as a fairly homogenous product, i.e. shorts are shorts. If consumers think the same way, then firms’ profits would be under threat. Many labels supply denim shorts. If, for example, Generic Shop B undercut its competitors, Design Shop A would quickly lose all of its customers, and a bidding war would start between the shops selling denim shorts, eventually driving the price down to where price equals marginal costs i.e. no economic profits.

Therefore, labels try to create a perception of premium value and, to an extent, a sense of scarcity through proactive marketing efforts essentially saying: “There is only one company that delivers, for example, “Diesel Shorts” and these are worth much more than the next best alternative”. These branding efforts create the perception of premium associated with the product in the mind of consumers. Consequently, the designer products become price inelastic for consumers and the designer companies are able to capitalise on this by reaping above normal economic profits.

[3] Denim is the rugged cotton twill textile that jeans are made of.

Does McDonald’s three minute Drive-Thru Service lead to better outcomes for society?

McDonald’s restaurants have been at the frontier of the fast-food industry in adapting their service to better suit their customers’ preferences. The competitive nature of the industry forces them to be dynamic. Hence, they recently introduced a three minute timer on Drive-Thru meal orders. If a customer’s Drive-Thru order takes longer than three minutes to fulfil, that customer will receive a free burger on their next visit. This seems fair enough: waste a customer’s time, then make it up with a freebie. However, the overall effects on society are ambiguous.

A McDonald’s employee would ideally like to uphold their three minute promise to signal to their superiors that they are an efficient and more valuable worker. The manager can use the number of free burgers each employee is giving away (among other metrics) as a form of screening to decide which employee is more valuable to the restaurant. The better employees may be rewarded to provide the incentive for increased labour productivity while other employees may be reprimanded or fired for poor performance. These improvements in labour should, in theory, increase McDonald’s overall profit.

On face value, this policy should make McDonald’s restaurants better off financially and improve their consumer image. Customers whose Drive-Thru order is too slow would receive a free burger, but not immediately: the burger is claimable on their next visit. When they return to the restaurant to claim their burger, they might come with a friend who in all likelihood will make a purchase. The customer who claims their free burger might make an additional purchase, say chips and coke. These extra items are complementary goods to the burger because they are normally consumed together. McDonald’s would generate a tidy surplus on these goods, as they otherwise would not have been sold. In this case, the extra trade and profit generated more than covers the cost of supplying that one free burger. Assuming customers return to claim their free burger, McDonald’s increases its market power over rivals (provided they do not imitate).

The Drive-Thru Promise is not a perfect, flawless policy. It has many drawbacks which can be traced back to the law of perverse incentives where unintended or undesirable outcomes result from a policy’s implementation. For instance, say an employee must fulfil a customer’s order, but is running out of time. That employee would prefer not to give a free burger as it will reflect poorly on their performance. Hence, there is an incentive to deliver an order on time, even if it is not ready. By using marginal cost-benefit analysis, the employee will determine if it is worth the risk of being caught undercooking a customer’s meal or leaving items out of the order just to get the meal in the customer’s hands before the time is up. McDonald’s would not condone its employees behaving in such a way, yet their policy has the potential to lead employees to act in their own best interests, which will be at the customer’s expense.

The customer is not always worse off as a result of perverse incentives. McDonald’s assumes that consumers will continue to buy from their store, with only the odd free burger when a meal is late because of understaffing or a busy front counter. Yet the Drive-Thru promise night cause consumer habits to change. Drive-Thru customers may try to rort the system in order to increase their chance of receiving a free burger. A customer could drive slower, fiddle with their money and make complex and confusing orders in the hope that the order will take longer than three minutes to fulfil. This customer sees a free burger as maximising their utility, or their enjoyment, and will act in a way that allows them to achieve this. However, if every customer decided to employ this strategy, McDonald’s will be giving away too many free burgers (possibly causing a decrease in profit) and will have to either increase the price of their products or scrap the policy altogether. This is known as tragedy of the commons where multiple agents, while acting individually in their own best interests, cause a long-term outcome which is bad for society (and not initially intended).

McDonald’s is the first franchise in the fast-food industry to implement a three minute Drive-Thru policy, giving them a first-mover advantage over other restaurants. The actual effectiveness of this policy really depends on where customers and employees draw the line in terms of how much utility a free burger brings them. If consumption and supply habits do not change, the policy’s only effect should be positive: an increase in sales volume.

How has the contraceptive pill contributed to the split in the relationship market in Western societies?

Some modern luxuries we have taken for granted, such as cars, mobile phones, even the contraceptive pill. The contraceptive pill has long been voiced as a liberator of women, allowing frequent sexual experiences without the unintended (negative) externality of becoming pregnant, therefore lowering the cost of premarital sex. Over time it has come to light that some perverse incentives from the regular use of the contraceptive pill have split the unitary relationship market from one in which you find a long term partner into two: a sexual market and a relationship market. Other factors may also be responsible for this split but here I will mainly concentrate on what extent the contraceptive pill has split the relationship market.

The relationship market has extensively been considered as a place of courtship for people considering finding ‘the right person’ and settling down. This does not exclude sexual activity but places the emphasis on establishing a deeper connection and possible long term future relationship. Over time though, there has been a greater emphasis on sexual activity without the ‘strings’ of any type of relationship attached, basically one night stands/sexual partners. This split puts some strain on the aforementioned relationship market as there are now more options for both men and women to indulge in either market, though the levels of scarcity and bargaining power for either sex are different across the two markets. In the sex market, women are found to have a higher bargaining power as men are the majority of consumers in this market. The relative scarcity of women in this market means that men have to engage in higher sunk costs like buying new clothes, spending money on drinks for girls and taxi cabs for the ultimate product: sex. Whereas in the relationships market men have the higher bargaining power because of their scarcity as they are filtering out to stay in the sex market longer. With this understanding, we can look at how the contraceptive pill has attributed to the split in the relationship market.

The contraceptive pill has lowered the cost of having premarital sex by all but eliminating the possibility of falling pregnant, encouraging a split within the relationship market. The commodity most in demand in the sex market is sex and when men have a higher willingness to pay, women hold the bargaining power and can be a little more picky, creating personal, pardon the pun, barriers to entry. A woman in the sex market will determine what age bracket, occupation, physical attractiveness and other qualities she will be willing to exchange her goods for. At any given point in time, women of similar appeal to a man, may find themselves in an oligopoly situation where to remain competitive they have to lower their standards but only slightly to accommodate for outside competition. In the relationship market, it is men with the bargaining power and women who make compromises to fulfil their desires of starting a family and being in a committed relationship. Even though the contraceptive pill may have encouraged the split in the relationship market, other factors in human development should also be taken into consideration.

Over the last 50 years, women have gained unprecedented ground when it comes to rights and independence from men and the development of the pill contributed to this freedom by taking away the possibility of falling pregnant. Other factors that may have also contributed to this split are the sexual revolutions of the 1970’s and women being able to hold more prominent jobs in society, both of which have led women to consider having children at a later age.

As much as the pill may have encouraged a split in the relationship market, it was a contributing factor to a wider set of events. This miracle of modern science was supposed to liberate women from what was once an undesirable set of circumstances and be enjoy the freedom of promiscuity as practised by men but instead has encouraged a perverse incentive by enabling the split of the relationship market.

Why are soft drink cans sold on aeroplanes half the size yet double the price of those sold in supermarkets?

In today’s globalised world, aeroplane flying has become a part of everyday life for most Australians. With flights going cheap and the increased ease of booking a ticket, more people are flying in the air than ever before. Recently, while onboard a flight from Melbourne to the Sunshine Coast, something caught the attention of my ‘economic brain’. The woman beside me ordered a soft drink as well as a ham and cheese sandwich. Although the sandwich looked nice enough, it was the small soft drink can that caught my attention and made me ponder the question, “Why are soft drink cans sold on aeroplanes half the size, yet double the price of those sold in supermarkets?” Although some answers to this question may be obvious, my ‘economic brain’ went to work and came to the conclusion that several economic concepts were at play and they give some insight into why passengers pay so much for so little.

Onboard three out of four domestic flight carriers within Australia, food comes at an additional cost to the price of the ticket. This is one of the consequences of buying a cheaper ticket: you are paying for the seat and nothing else. Once onboard the flight, food and beverages are available to passengers at a price. Looking at the in-flight menus of both Jetstar and Virgin Blue, a 200ml soft drink can will cost a passenger $3.00[4]. A standard soft drink can sold in a supermarket is 355ml and can vary in price from $0.70 cents to $1.50. There is a vast price difference between these two scenarios (buying in a supermarket v on a plane), which can be explained by the scarcity of the soft drink, pricing policies, willingness to pay, the existence of a captive audience, price gouging and relative market power.

There is only a small amount of space onboard an aeroplane that can be allocated for food and beverages. This exacerbates the level of scarcity. Flight carriers stock small cans in order to increase the quantity of cans without having to increasing the holding space of the scarce resource. Unlike supermarkets, the cans cannot be sourced from other locations such as storerooms and external warehouses, meaning there is only a finite supply for any given flight. Given this constraint, soft drink cans have a relative long shelf life, meaning the airline does not have to sell the cans within a certain flight and they can be rolled over to other flights. Airlines exploit this relative shortage by engaging in price gouging, setting prices that are higher than that of a competitive market. The airline becomes a de-facto monopoly once the plane is in the air. As there is no alternative supplier and the audience is a captive one, in theory, airlines are able to charge a price equivalent to a customer’s highest marginal willingness to pay, extracting all consumer surplus.

A consumer’s demand on a flight is less sensitive to price, hence, willingness to pay is much higher than when buying from a supermarket. In this situation, the passenger is not being “ripped off” by the airline because if their willingness to pay is lower than the price they are being charged, they will not buy the good. If they do buy the good, it confirms that the value the passenger places on the soft drink is at least equal to the price charged – in this case, much higher than for a comparative can from a supermarket.

Onboard the flight from Melbourne to the Sunshine Coast, the woman who sat next to me bought a can of soft drink, even though she was hesitant to pay the price at first. Many people would argue the price charged was extreme, but my ‘economic brain’ came to the conclusion that the price is in fact reasonable given the laws of supply and demand at work.

Why are mobile phone calls more expensive than landline calls?

For many Australians, mobile phones have become an indispensible everyday tool. Many rational consumers might wonder why a mobile phone call is relatively more expensive than a fixed landline call. There are dozens of factors that determine retail telecommunication pricing structures. Many consumers dismiss high call costs as a form of being ‘ripped off’ without considering various factors. The following essay explains some of the reasons behind relatively high mobile phone call costs with the aid of various economic concepts.

An attractive component of many mobile phone contracts is the provision of a ‘free’ (or heavily discounted) handset – effectively acting as an incentive. Some consumers fail to realise that these handsets are hardly ‘free’ – there is no such thing as a free lunch. The provider recovers the cost of subsidising the handset through call rates that are greater than what they otherwise would be.

Mobile telecommunication providers encounter significant and immediate fixed costs in the provision of their services. Unlike landline copper network infrastructure that was built many decades ago (by Telstra’s government owned predecessor– Telecom Australia), mobile phone companies have been forced to build mobile phone reception towers and related infrastructure in a relatively short period of time (since the 1990’s) and must continue to build them as demand continues to increase. The cost of building this infrastructure runs into hundreds of millions of dollars and must be recovered from the consumer. Some of the high mobile phone call cost is reflected by the fixed costs incurred by the company.

Some consumers may believe that mobile phone calls should be billed per connection (as is the case for local landline calls) as opposed to a timed tariff. These consumers may not understand that wireless capacity is a scarce resource; there are a limited number of calls that can be supported in a particular geographic area. It is inevitable that some consumers would exploit untimed calls and unnecessarily prolong their conversations whilst tying up scarce wireless access to the detriment of those that really do need to make a call. To ensure that consumers are able to have access to the network when required, the pricing structure needs to reflect the fact that such access is a scarce resource.

There are relatively few mobile phone networks in Australia. This concentrates the mobile phone market into only a few companies, thereby creating an oligopolistic market. There could be an argument that these networks exploit their market power and keep their mobile phone call rates artificially high due to lack of greater competition. This means that such companies effectively engage in price gouging. The steady rise of mobile phone users and the increased integration of these devices in our everyday lives demonstrate to the mobile phone companies that the demand for their services is probably inelastic. Inelastic demand for services provides a perfect opportunity for the extraction of consumer surplus. Mobile phone companies know that consumers will continue to value the benefits of mobile telephony and continue to pay relatively higher prices, even if the prices appear to be unreasonably high.

Greater competition is difficult to achieve in this industry due to barriers of entry, three of which particularly stand out:

  • There are significant up-front fixed costs involved in establishing a viable mobile phone network. Many individuals / companies do not have access to such capital.
  • Due to the technical nature of wireless telephony, there is limited wireless spectrum that the government can auction off to these companies. The scarcity of wireless spectrum significantly raises the cost of the relevant bids / licenses.
  • Australia may not have enough consumers to provide the large customer base necessary to make a mobile phone telecommunications venture viable.

Finally, there may be a case of asymmetric information. A standard SMS message sent over the two largest mobile phone networks in Australia costs a consumer 25 cents. How is an ordinary consumer to know if this reflects the true cost of sending a SMS message? It is possible that the mobile phone companies know that the consumers cannot know what the true operating costs are and therefore exploiting this ignorance.

There is no question that mobile phone services are becoming increasingly important in our everyday lives and similarly that mobile phone calls are comparatively more expensive than fixed landline calls. The above has demonstrated that this cost difference can be at least partially explained through subsidies, fixed infrastructure costs, inelastic demand, asymmetric information, concentrated market power, barriers to entry, price gouging and scarcity.

Why do some people choose to exceed speed limits whilst others do not?

Despite a saturation of government campaigns and tough penalties, some motorists consciously choose to exceed speed limits. Many people label such drivers as irresponsible ‘hoons’ that seek an adrenaline rush from travelling at high velocities. Whilst this may be true for some drivers, this widely held view is a simplistic interpretation of the complex decision making process that many drivers, possibly unknowingly, undertake prior to exceeding the speed limit. Economic theory is a useful tool in explaining why some motorists choose to do this – as will be demonstrated below. A seemingly simple issue has a surprisingly complex economic explanation.

In many cases, exceeding the speed limit allows people to arrive at their destination sooner. This can represent a time saving that ranges from minutes to hours. Driving at the speed limit represents an opportunity cost – the extra time required to obey the law is time that is lost that could be used for the pursuit of other activities. If this were the only consideration, most motorists would consistently ignore the speed limit. Motorists caught speeding are usually fined – this is a (literal) cost that many take into consideration. Given the opportunity cost of time and the potential cost of a fine, motorists (often on a subconscious level) assign a value to any potential time saving gained through speeding. If the benefits of saving a certain amount of time outweigh the costs of potentially getting caught and paying a fine, the driver is likely to exceed the speed limit.

Some motorists choose to exceed the speed limit because they seek the thrill of travelling at high velocities. Whilst such drivers are not necessarily a mutually exclusive group from the category of drivers that are intent on saving time, for the purpose of this essay it is assumed that they are. High speed driving for thrill seeking purposes can be considered a high risk activity that significantly increases the chance of injury or death should the driver lose control of the vehicle. Armed with this knowledge, the driver performs (an often subconscious) calculation where the benefits of a high speed thrill are weighed against the costs of injury or death. If the driver values the thrill greater than their life, he/she may decide to exceed the speed limit.

Some drivers may employ marginal analysis when considering whether they should exceed the speed limit. Freeways often designate speed limits of 100km/h or more. Many drivers appreciate that if they were to be involved in a crash at that (legal) speed, the chance of survival is relatively low. Therefore, some drivers may reason that by exceeding the speed limit by (for example) 10 km/h to bring their speed up to 110km/h (for one of the reasons outlined above) may not significantly impact on their chance of survival in the event of a crash. Given that governments tend to install fixed speed cameras along freeways, one can assume that this form of marginal analysis is quite common amongst some motorists.

Exceeding the speed limit carries many negative externalities on other members of society. Aside from noise and air pollution, speeding motorists may endanger the lives of other road users. Many decades ago, the government tried to combat these externalities with mandatory fines. Some motorists that are on relatively high incomes and choose to exceed speed limits may have an inelastic response to generally high fines that are indexed for inflation each year; other motorists will continue to speed no matter what the monetary cost is. In response to this, the Victorian government introduced a demerit point system where traffic offenses, including exceeding the speed limit, are penalised with the accrual of demerit points as well as being fined. Once a threshold is reached, the driver may have their driving license suspended for a prescribed period. The demerit point system affects all motorists equally (i.e. irrespective of income). Assuming that most motorists regard their drivers license (right to drive) as precious, there is a significant disincentive for the vast majority of drivers (that wish to legally drive) to exceed the speed limit.

It is inevitable that some drivers will elect to exceed the speed limit. Assuming that they are rational economic agents, a complex economic assessment will occur prior to any decision to break the law. Drivers may consider the opportunity cost (time) of travelling at the speed limit, or perhaps they value the thrill of excessive speed more than their life, or maybe the driver decides that when driving at a legal high speed, the marginal cost of increased death or injury is negligible compared to the benefits. It should be noted that the vast majority of drivers do not exceed the speed limit as they are deterred by fines and demerit points. Regardless of a motorist’s decision in relation to excessive speed, it is certain that economic considerations are involved – often without them even realising.

Was my decision to live in Reservoir rational?

Being a student is not the most profitable profession. Therefore, the cost of rent was a major factor when I was deciding where to reside during my period of study exchange at La Trobe University in in Melbourne.

Having done my research from Denmark, I had it narrowed down to two options:

  1. Stay in Fitzroy/Carlton (F/C): close to the city but 15-20 kilometres from La Trobe University

  2. Stay in Reservoir/Bundoora (R/B): close to La Trobe University but far from the city.

There were, as there are with everything in life, trade-offs involved in each choice. Rent in Bundoora was roughly $40/week cheaper than the places that I had found in F/C, and I was quick to opt for a house close to La Trobe under the impression that I was saving money this way. Having had my inner economist awakened, however, I now want to take a closer look at this decision.

It is now apparent to me that I did not include all of the relevant costs when deciding between the alternative housing situations. Internet, food and utilities are all going to be roughly the same, both in normative price, as well as in usage level. On top of that, seeing as I have a job in the central business district [CBD] and go to university, in either scenario I would have bought a monthly zone 1 concession ticket (transport costs will be the same). What I really failed to take into account, and what would turn out to tip the 'rational scale' against me, was money spent on going out.

Being a young university student, I enjoy the odd night out in the city now and again. These nights tend to occur roughly once a week (4 times a month on average) and usually amount to approximately $100 per night for alcohol and a souvlaki. The problem though is: by the time I get to my 4 am souvlaki, the only means I have of getting home is taxi. Through empirical evidence from my own past, I can conclude that a Saturday night taxi ride from the city to home costs roughly $40 (or $160 per month). This shows that, based purely on the cost of nights out on the town and and taxis home, it is unclear whether my original rationale on choosing accommodation was correct.

Another aspect relevant to my decision is my propensity to consume 'going out', as a function of my housing situation. There are two factors to consider here. Lets assume that I only go out in 'downtown' Melbourne, which is in close proximity to F/C. This means that the marginal cost of going out is lowered, as I need only travel a short distance both to and from the city. Therefore, I now  have an incentive to consume more of 'going out'. However, my consumption of 'going out' is also, consciously or unconsciously, a function of my disposable income, that is, the amount of money I have left every month after rent and other fixed expenses are paid. Having more fixed expenses every month might make me more cautious about going out every single weekend of the month and I might cut down from 4 to 3 nights instead. Yet my housing decision’s effect on my propensity to consume “going out” is ambiguous.

Since the financial implications are equivocal, we can quickly look to the “other” costs associated with the trade-offs. For one thing, either housing situation may impact on my study and thus, my grades. Living in F/C would require a 40 minute tram ride to university each morning versus a 10 minute bus ride from R/B. This means that my marginal cost of going to university would increase, and I would have less incentive to go than would be the case if I lived in R/B. If we assume that my grades are a function of my attendance rate of lectures, this could be the tie-breaker I have been looking for in this analysis. But wait! Another argument comes to mind, which tips the scale back to the vague centre. Because I am an exchange student, the grades that I get whilst at La Trobe will never show up on my transcript from the Copenhagen Business School [my home institution]. They will simply be transferred and shown as Pass/Fail. This practically removes my incentive to want good grades and with it, the negative weight of the fall in lecture attendance if I were to choose F/C.

I am almost a little disappointed to say it, but after the analysis of direct financial and non-financial costs and benefits of either housing situation, it would appear that what it comes down to is in fact a question of practicality. If I were to ensure that I never take a taxi home from the city alone after a night out (which is not unlikely as I share a house with two housemates who are also fans of the Melbourne nightlife), I would significantly lower the financial costs associated with living in R/B. That small practical point actually tips the scales in favour of R/B and confirms that my decision to live in Reservoir is, in fact, rational indeed.

Will the new red P-plate driver restrictions decrease or increase road safety?

In 2007, 12% (39) of drivers killed in Victoria were aged between 18 and 20, even though this age group represents only 8% of Victorian licence holders. As a reaction to these statistics the government introduced new road user restrictions in the form of a red and green P plate system. The idea essentially was that while driving on a red P plate, drivers were restricted to having only one passenger aged between 16 and 21. Will this actually decrease or increase road safety?

The legal implications of these new restrictions give young drivers the incentive to get their licence sooner as they can no longer rely on friends for lifts and multiple car pooling. The increased incentives of having your license sooner along with owning your own car will also result in more young inexperienced drivers on the road. These drivers are considered inexperienced as they have only had to complete a minimum of 120 hours of supervised driving and in a lot of cases the hours are forged by parents so that their children can sit for their license test. This increase in adolescents getting their license and choosing to drive will result in higher negative externalities of smog, road congestion and pollution. More importantly though is that with a higher proportion of young inexperienced drivers on the road simultaneously, we can logically expect an increase in accidents and an overall decrease in road safety. This is due to not only the level of experience of these P plate drivers, but also the peer pressure to drive dangerously that results when multiple friends are driving simultaneously (as they can longer car pool due to the new restrictions) to the same destination. One needs only to drive on the roads during holiday season to witness this first hand.

Using Insurance premiums and TAC statistics as a basis, it can be justified that young drivers are more likely to be involved in accidents. The reasons inexperienced P plate drivers take more risks can be explained using Rational Choice Theory (RCT). RCT looks at how individuals weigh up the perceived marginal costs and benefits of their actions and choose a type of behaviour where MB > MC. The benefits of driving dangerously are overstated in the minds of these drivers as the bragging rights and perceived acceptance among peers (just spend a few hours in the car park of a McDonalds or a suburban shopping centre late at night) is considered greater than the marginal cost of serious injury, fines, repairs and death. A general consensus among young drivers is that they are immune to these costs. This belief lowers the MC of their actions, resulting in a rational choice in their mind to drive dangerously.

When the rational choice for P-plate drivers is to drive dangerously, combined with the incentive to be on the road sooner, a decrease in road safety is likely. The government’s decision to restrict the amount of passengers a red P-plate driver can have will have no effect on reducing accidents. Instead the perverse incentive to drive sooner will lead to an increase in driving related accidents.

The biggest problem is that there are limited incentives for young drivers to drive safely. The government’s current restriction doesn’t offer any incentives for young drivers to drive safer; all it does is increase the marginal benefit of driving sooner and does nothing to increase the costs of driving dangerously. The list below poses some potential solutions to increase road safety by increasing the incentive to display safe driving behaviour and/or increasing the costs of dangerous driving.

Increase costs of dangerous driving

  • Increased police presence at shopping centres, fast food outlets and other areas that attract a high density of young drivers
  • Increased fines for dangerous driving, and increasing police powers to fine on the spot and/or seize vehicles
  • Increased costs of purchasing high powered vehicles creates a greater incentive to purchase vehicles more economically friendly
  • Increased education on the costs and perceived benefits of dangerous driving lowers the MB of dangerous driving, as education creates an understanding of the danger they pose to the community and lowers the social acceptance from peers.

Increase benefits of safe driving

  • Lower insurance premiums for young drivers who have taken more hours of practice
  • Reduced registration costs for drivers who demonstrate good road etiquette and safety
  • Safe driver rewards program
↑ Top