December 19th, 2005

Brad @ Burning Man

If the Only Tool You Have is a Hammer ... or Economics

I pay at least some attention to what's going on in academic economics. I'm able to do this because I lucked into having an extraordinarily good high school economics teacher ... which is doubly extraordinary considering that even back then, hardly any high schools were still including a course in economics in their civics or social studies program or whatever they called it. Having had a good grounding in the fundamentals, and having spent the 20-some years since then reading up on the field, I find that I've been equipped with a very useful tool. It's a tool that helps me tackle one of the first questions that any child starts out asking: "Why do we?" It's a question most people stop asking, unfortunately. They figure out, to their lasting disappointment, that the adults in their life don't know why. Worse, they usually find this out when the adults in their lives give them answers to that question ... that turn out to be wrong. So, unfortunately, most people have "learned" that it's impossible to actually know why we do things a certain way. I'm just oblivious enough and self-centered enough that it never occurred to me to learn that lesson. Sure, the adults in my life almost never knew the answers to my question, and sure, a lot of the answers they did give me turned out to be wrong. To me, that was never a reflection on the question, but on the answerer. So yes, when I found out how useful a tool a good grounding in economics can be, I latched onto it with the same fervor that some of you have for other tools, like Dremel rotary tools or Gerber multi-tools or Kline brand electricians' pliers (to pick some of my other favorites).

But there's a famous saying that says, "If the only tool you have is a hammer, every problem looks like a nail." And unfortunately it's true that, by extension, if you're an academic economist who hasn't studied enough other disciplines, you assume that all problems are economic problems, and that the mathematical toolset of modern economics can "hammer" every "nail." Which is why, for all that I love, their "Everyday Economics" column often makes me want to pound my head against the desk. Both Steven Landsburg, who used to write the column, and this new guy, Tim Harford, seem to actually know their stuff on economics. But both of them have written columns in which they applied current economic theory to real world problems, found out that everybody but the economists are doing it "wrong," that even some of the economists are doing it "wrong" (and feeling guilty because their own science tells them what they're doing is stupid, so they can't explain why they're doing what they're doing), and come to the dismal conclusion that everyone is stupid. For example, let me tackle Harford's column from last Thursday, "The Great Xbox Shortage of 2005."

Let's start by outlining the facts from which he's reasoning, all of which I stipulate seem to be accurately reported. Right now there are a lot of people who desperately (and to my mind, incomprehensibly) want to buy a Microsoft Xbox 360, this year's hottest new video game console. Some Christmases, retailers and manufacturers get surprised by unexpectedly high Christmas-season demand for some toy, but this isn't one of those situations. Both Microsoft and the retailers have known for months now that there was going to be huge demand for the Xbox 360. So why didn't Microsoft build enough of them? Because, as Harford correctly points out, demand is cyclical. This month, they need cubic butt-loads of them. Next month, demand will drop substantially, because it'll be too late to get the kids one for Christmas. By May, when they finally work through the backlog of orders, demand will drop like a brick out of the sky; not all the way to zero, but to a relatively tiny fraction of this month's demand. They didn't finalize the design in time to warehouse tons and tons of them. And if they had set up an assembly line big enough to meet the December demand, by June they would have been stuck with the fixed-overhead costs of a factory too big for the demand, and downsizing the heck out of their workforce. So for solid economic and practical reasons, some of you who desperately (and I still scratch my head over this part, but whatever) want an Xbox 360 are going to have a hard time finding one any time in the next couple of months ... at list price, anyway. So far, Harford and I agree.

But it's that last part, "at list price," that has got him convinced that everybody in the world except academic economists are morons. Economics teaches us that the only "fair" way to allocate a scarce resource is to let the market drive up the price. That way, the people who produce the best products have the maximum amount of money to use to create more product, and more to invent more innovative products. And, as Harford points out, thanks to the modern Internet economy, we know with uncanny precision what an Xbox 360 for December delivery is worth. Some of the people who lucked into them and are willing to wait until May to actually play on one (or who just snapped them up as investments) have been selling theirs on eBay, where (he says, and I'll take his word for it because I don't care) prices have converged very closely on a price of right around $700. So people who bought Xbox 360s at $300 are turning around and flipping them to customers who are quite happy to pay $700, and pocketing the $400. That kind of thing drives academic economists totally bug-fuck nuts, because for the life of them they can't think of any reason why those scalpers should have that $400. Why shouldn't Microsoft get that $400? Why not price the Xbox 360 at $700 right out the door, or even at $600 to be conservative, and then cut the price in January, and then cut the price again to the current $300 when the demand drops to the level of supply?

The reason that Harford, like pretty much all academic economists, can't answer this question is not because Microsoft's marketing department are stupid, nor because the toy stores are stupid, nor because the customers are stupid. No, in this case, it's because it is, if anybody, the economists are stupid. Because their spreadsheet models work so well for so many problems, it has never occurred to them to look up from them and realize that there might be more than one tool in the toolbox. And in this case, the correct tool for the job is storytelling. Human beings do not, by default, understand the world through numbers. In fact, we're remarkably ill equipped to do so. The human nervous system can't perceive much beyond two digit accuracy at best, and to the human mind, quantities above one thousand are effectively infinite. No, the default human tool for understanding the environment is the story. We tell each other stories, and well tell ourselves stories. That's how we know what happened, and that's how we hammer out an agreement as to why, and it is from that "why" that we tackle questions like, "So what should we do about it?"

So yes, if Microsoft were to price Xboxes the way farmers price grain and oil traders price oil (in both cases quite successfully, may I add), at say "$600 for December 2005 delivery, $450 for January delivery, $300 for March delivery," there is no doubt that Microsoft would maximize their return on investment. But instead of imagining yourself as a customer, or as an economist, imagine that you were a journalist who had to write a series of news stories about this hot new product. What would the ledes be? December: "Microsoft debuts new gaming system, priced at $600. Is any gaming system worth triple the current price of competing systems?" Yes, there would be people extravagant enough to pay that, obviously, because they're doing so now. January: "Microsoft slashes Xbox 360 prices 25%, citing declining demand. Analysts say that the move was predicted." March: "Today, Microsoft further slashed prices on the Xbox 360. Their gaming console, which debuted last year, has dropped in popularity to the point where Microsoft is now selling them for below the cost to manufacture them, hoping to make up the price difference by selling software."

Now, as an economist, I could make a case why those are reasonable decisions. As a journalist, I could make a case as to why those ledes are perfectly fair and accurate ways to describe, in plain English, the reasoning behind those perfectly rational economic decisions. Any newspaper covering the story would, in fact, be reasonably expected to include at least one quote from a university economist explaining that this is how efficient economies work, and from Microsoft explaining that the price cut was always planned and that no, this doesn't mean that there's anything wrong with the product. But the problem is that a price is more than a number. It's more than just a measurement. It's more than a supply/demand calculation. It's a statement. It's one more sentence in an ongoing story. When you quote an asking price, you are saying, "This is what I think I should be paid for this product." And if a product "is" (now) worth $600 or $600 or $700, and "is" worth $300 or less six months from now, then the story of that value is clear and unambiguous: either the product was over-valued at the beginning of that story, or it "lost" half or more of its value in a couple of months. And no amount of math, and no vast storehouse of successful examples of that math working to best allocate scarce resources, can make that story go away. And that, my friends, is why Microsoft is willing to let those scalpers pocket their $400, why they are in essence allowing a certain number of people who're willing to wait until May to play their Xbox 360 games if it means that the machine in May is "free," paid for by the profit of the sale on their lucky December machines: because if they didn't, they'd have to explain to customers and to shareholders and to market analysts where the missing $300 or $400 in value "went."

(P.S. Apologies of a sort for taking the weekend off. It was busy and I was sleepy.)