Friday, May 16, 2014

Prices vs Chips

Alternative titles...

"The Tabarrok Paradox"

"In Which Our Hero Tabarrok Throws Opportunity Cost Out The Window"

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In the economics subreddit I saw a link to this NY Times article... Why Unbundling Cable Would Not Save You Money.  When I took a look at the comments on Reddit, I noticed that one of the comments included a link to this video on bundling by the economist Alex Tabarrok.

In the video Tabarrok explains, using diagrams and logic, why bundling cable is a good thing.  His logic doesn't jive though.  I planned on sharing my perspective in a comment, but my best laid plans were foiled...  "Comments on this entry are closed".

And that's the story of how I ended up here.  Pretty exciting stuff...huh?

Let's get down to business.

The flaw in Tabarrok's logic is that it completely ignores the necessity of determining what the actual demand is for the individual components in the bundle.  For example, when I subscribed to cable...Charter had no idea how much I valued the Discovery Channel.  Neither did the Discovery Channel.  But is my valuation relevant?  According to Tabarrok...it really isn't.  Uh, what?

How could the Discovery Channel and Charter and Tabarrok not care what the actual demand is for the Discovery Channel?  In the absence of consumer valuation...how could society's limited resources be put to their most valuable uses?

Tabarrok is basically arguing that we don't need accurate information in order to efficiently allocate resources.  Except, does he really believe that?  Let me consult my magic database...
The most valuable public goods are constantly changing, just as the most valuable private goods are constantly changing.  The signal provided by prices and mobility is therefore of great importance. - Alexander Tabarrok, Market Challenges and Government Failure
Huh.  Hmmm.  Is the Discovery Channel a private good?  Yes.  Is its value constantly changing?  Yes.  So...according to Tabarrok...it's of great importance that the Discovery Channel should have its own price.  But this sure wasn't what he said in his video.  Maybe I should shake my magic database again.  *shake shake*
Of course just because everyone can be made better off by taxation does not mean that everyone will be made better off. Some people want more national defense, some people want less, pacifists want none. So, taxation means that some people will be turned into forced riders, people who must contribute to the public good even though their benefits from the public good are low or even negative. Tyler Cowen, Alex Tabarrok Modern Principles of Economics 
Some people want more Discovery Channel, some people want less, rednecks want none.  I don't know if that last part is exactly true...but bundling cable certainly creates many forced riders.  If consumers aren't given the opportunity to opt out of individual channels...then how can we possibly know what the actual demand is for the Discovery Channel?

Perhaps I can settle things with another *shake* of my magic database...
Voting and other democratic procedures can help to produce information about the demand for public goods, but these processes are unlikely to work as well at providing the optimal amounts of public goods as do markets at providing the optimal amounts of private goods.  Thus, we have more confidence that the optimal amount of toothpaste is purchased every year ($2.3 billion worth in recent years) than the optimal amount of defense spending ($549 billion) or the optimal amount of asteroid deflection (close to $0).  In some cases, we could get too much of the public good with many people being forced riders and in other cases we could get too little of the public good. - Tyler Cowen, Alex Tabarrok, Modern Principles of Economics
Let's try a bit of substitution...
Voting and other democratic procedures can help to produce information about the demand for channels, but these processes are unlikely to work as well at providing the optimal amounts of channels as do markets at providing the optimal amounts of channels.  Thus, we have more confidence that the optimal amount of the Discovery Channel is purchased every year ($2.3 billion worth in recent years) than the optimal amount of Home Shopping Network ($549 billion) or the optimal amount of Epiphyte Channel (close to $0).  In some cases, we could get too much of the channel with many people being forced riders and in other cases we could get too little of the channel. 
Errr...well...that didn't work perfectly...but it worked pretty well.  Just in case though...let's go over it again...

The optimal amount of the Discovery Channel depends on the demand for the Discovery Channel.  If we don't know what the demand is for the Discovery Channel...then how can the supply possibly be optimal?

Basically, we can't say "hey man nice shot" if we don't know where the target is.  Demand is the target by which we measure the accuracy (efficiency/value) of the supply (how resources are used).  We can only say that there's too much or too little of the Discovery Channel if we know what the demand is.

It should be clear that determining demand is fundamentally essential.  So how do we go about doing this?  There are basically three methods.  Consumers can vote or they can spend or they can have their minds read by omniscient government planners.  As Tabarrok indirectly acknowledged in the passage above...the demand information provided by voting (democracy) is not nearly as accurate as the demand information provided by spending (market).  This is because actions (spending) speak louder than words (voting).   Spending is sacrifice...so it reveals values.  Talk, on the other hand, is cheap...so it only reveals opinions.  *shake shake*
Overall, I am for betting because I am against bullshit. Bullshit is polluting our discourse and drowning the facts. A bet costs the bullshitter more than the non-bullshitter so the willingness to bet signals honest belief. A bet is a tax on bullshit; and it is a just tax, tribute paid by the bullshitters to those with genuine knowledge. -  Alex Tabarrok, A Bet is a Tax on Bullshit 
If we use people's opinions to determine demand...then the target will be wrong and resources will be diverted away from far more valuable uses.  This is why spending (deep input), rather than opinions, should be used to create value signals...




If we unbundled cable...then people would be able to share their deep input on the Discovery Channel.  Flowcilitating deep input would create a signal that would communicate to the world the amount of value that society assigns to... *looks at the Discovery Channel website*...shows like #BikerLive.  Remember what I said about rednecks and the Discovery Channel?  I take it back.

If it makes good economic sense to clarify the demand for individual channels...doesn't it also make good economic sense to clarify the demand for individual shows?  Of course.  The information would be even more accurate...which would result in even greater allocative efficiency.

Personally, I finally kicked cable to the curb.  I cut the cord!  Yes!  Now I subscribe to Netflix.  But even though Netflix is far superior in most regards...it's pretty much just like cable in the sense that there's no mechanism for me to communicate how much I value individual movies and shows.  Well...I did give Rake 5 stars.  Man oh man did that clarify demand.  I said that super sarcastically.

Of course I could buy the Rake DVD...that would certainly help clarify the demand.  But shouldn't Netflix give me the opportunity to put my subscription fees where my 5 stars are?  Each month I could take my $9 and divvy it up among the movies/shows that I truly value.  Netflix could then transfer the money (minus their cut) to the producers of those shows.  Why not?

Let's review...
  1. We want resources to be more efficiently allocated
  2. Allocative efficiency depends on accurate information
  3. Flowcilitating deep input provides more accurate information
Flowcilitating deep input?  For example...
  1. Allowing Netflix subscribers to dollar vote for the shows/movies that they value most
  2. Allowing cable subscribers to dollar vote for the channels/shows that they value most
  3. Crowd sponsored results
Let's dig a little deeper.  Here's a comment that I posted on Peter Boettke's blog entry... Quiz for the Austrian Economists Among Us...

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Using a specific example...let's say that the show Firefly was prematurely canceled. Resources were diverted away from the show even though there was sufficient demand. The problem was that the demand was "latent". It was only revealed after the show was canceled. Many people bought the DVD and campaigned on behalf of the show.

As I've argued before...(Hey Mungerfesto, Prices OR Consumer Sovereignty?)...price theory is too narrow. There are certainly situations where we can correctly determine Hayek's "solution" without using prices. The producers of Firefly could have clarified the demand by creating a crowdfunding campaign. This would have allowed each and every fan of the show to decide for themselves exactly how much they were personally willing to contribute/sacrifice in order to keep the show alive. There wouldn't have been one price...there would have been a continuum of "prices". People would have been paying vastly different amounts for the same exact product. It's the same thing with the non-profit sector.

Price theory, as it stands, is not a great prophylactic because it's got a giant hole in it. It doesn't account for the vast majority of situations where we sacrifice in order to try and keep something alive. A better theory would be something like "input theory"...or "positive feedback theory"...or some other better name. Maybe "flowcilitation theory"?

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If cable was unbundled...then individual channels would have their own prices.  But if Netflix was "unbundled"...then there wouldn't be any "prices".  The show Rake wouldn't have a set price.  Each and every Netflix subscriber could spend as much, or as little, as they wanted on the show.  We can call these customized contributions "chips".

If you think about it, this is really fascinating.  It's momentous that here we are at the beginning of the great "Prices vs Chips" debate.

As Tabarrok's bundling video so nicely illustrated...consumers can value the same product differently.  Let's take the Rake Season 1 DVD for example.  On Amazon, the price is $24.28.  Some people would be willing to pay more...while many others would be willing to pay less.  It's a given that far more consumers would buy the DVD if it only cost $1.  Because of this, the revenue generated by this DVD does not accurately reflect its value.  It doesn't show us the value to the right or to the left of the price.  Here's how I've "wonderfully" illustrated this...




As you can see...prices clearly do not convey the large bulk of a product's value to society.  So if prices stand in the way of more accurate information (which we need for allocative efficiency) ...then why don't we eliminate them?

We should all instinctively appreciate that if Amazon allowed consumers to pay whatever they wanted for the Rake DVD...then sales would skyrocket but revenue would plummet.  This is the preference revelation problem.  Given the opportunity, it's logical for consumers to pay far less than their true valuation of the DVD.  Why is their behavior logical?  Because consumers are utility maximizers.  Paying less than they valued the DVD would free up their money to spend on other things.  While this would increase their individual utility...the foreseeable side effect is that the DVD would be undersupplied...which would represent a net loss of total utility.  So it would seem that we are stuck with prices.  Unless...?

Unless...?  Unless the cost is a foregone conclusion.  With Netflix, subscribers are already paying $9 a month...so if they were given the opportunity to allocate their $9, then they wouldn't be able to save any money by undervaluing Rake.  This means that their chips would accurately reflect their valuations.  We wouldn't just see a slice of the demand curve...we would see the entire thing.  Therefore, chips would convey far more accurate information than prices would.

The public sector is just like Netflix.  Taxes, like subscription fees, are a foregone conclusion.  So if taxpayers could choose where their taxes go...then they would have every incentive to honestly convey their values.

Hmmm...I guess the great "Prices vs Chips" debate probably isn't going to be that great.  There's really not much to debate.  As long as the cost is a foregone conclusion, chips will provide far more accurate information than prices can.  This means that chips will result in far greater allocative efficiency.

Here's the grand overview...

  1. Socialism fails because consumers aren't given the opportunity to tell any truth.
  2. Capitalism succeeds because consumers are given the opportunity to tell some truth.
  3. Pragmatarianism would be even more successful because consumers would be incentivized to tell the whole truth.
What do you think?  

What's going on with Tabarrok?  He's sending mixed messages right?  Is it because he's confused by the fact that the marginal cost of channels is zero?  The marginal cost of providing the Discovery Channel is zero...therefore there's no need to determine its priority?  Opportunity cost goes out the window?
The concept of opportunity cost (or alternative cost) expresses the basic relationship between scarcity and choice. If no object or activity that is valued by anyone is scarce, all demands for all persons and in all periods can be satisfied. There is no need to choose among separately valued options; there is no need for social coordination processes that will effectively determine which demands have priority. In this fantasized setting without scarcity, there are no opportunities or alternatives that are missed, forgone, or sacrificed. - James M. Buchanan

Should the Discovery Channel be able to use more or less of society's scarce resources?  How can the answer possibly be correct if consumers aren't given the opportunity to spend their money on this channel?  Yes, they can go to the online store and purchase a bunch of products.  Doing so will increase the channel's influence over how society's limited resources are used.  But no matter how many alternative sources of deep input the Discovery Channel has...the fact of the matter is that its cable revenue doesn't reflect the valuations of cable subscribers.

Just because the marginal cost of providing the Discovery Channel is zero...doesn't mean that the opportunity cost of the Discovery Channel organization is zero.

I want to know how much society values what the Discovery Channel organization is doing with society's limited resources.  It's hard for me to imagine that Tabarrok perceives this information to be inconsequential.  Yet, he doesn't think it's necessary to unbundle cable.  This is the Tabarrok Paradox.  *shake shake*
This, of course, is just the diamond-water “paradox”–why are diamonds, mere baubles, so expensive while water, a necessity of life, is so cheap?–the paradox was solved over a hundred years ago by…wait for it…can you guess?….the marginal revolution. Water is cheap and its value low because the supply of water is so large that the marginal value of water is driven down close to zero. Diamonds are expensive because the limited market supply keeps the price and marginal value high. Not much of a paradox. Note that, contra Graeber, there is nothing special about labor in this regard or “our society.” 
Moreover, it’s good that prices are determined on the margin. We would be very much the poorer, if all useful goods were expensive and only useless goods were cheap. - Alex Tabarrok, BS Jobs and BS Economics
Yeah, I'm pretty sure he doesn't perceive any benefit to unbundling cable because he's too distracted by the fact that the marginal cost of providing the Discovery Channel is zero.  I definitely appreciate that the marginal cost of the channel is zero...but the fact remains that we still need to figure out how much influence the Discovery Channel, as an organization, should have over how society's limited resources are used.  This means that consumers must be able to decide whether or not it's worth it to pay for the Discovery Channel.  In order for this to happen...cable has to be unbundled.

4 comments:

  1. But it's not as if we have no clue when it comes to the question of "how much influence the Discovery Channel, as an organization, should have." We have a very powerful clue: how many people actually watch the Discovery Channel. That information, in turn, shapes how much revenue Discovery can raise from advertisers, and it shapes how much the cable companies and DirecTV are willing to pay Discovery to carry it. I mean, when I was growing up, we never paid anything to watch CBS or NBC, but it seems bizarre to say that this means the price system wasn't working. It is working -- it's just that consumer demand is being mediated through different buyers (advertisers in the pre-cable days, advertisers and cable companies/DirecTV these days).

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    1. How many people stood in line to vote for Obama? How many people slow down to stare at an accident on the freeway? How many people listened to Rebecca Black's song Friday?

      These are certainly clues...but I wouldn't consider them to be especially powerful. They really don't tell us how much of society's limited resources should be shifted to these particular uses.

      In order to shift the optimal amount of resources to particular uses...we first need to quantify/measure the intensity of people's preferences. How much are you personally willing to sacrifice for something? God, as the story goes, willingly sacrificed his only son to save the world. If watching TV is a powerful clue...then what was god's sacrifice?

      In the absence of accurate ranking of particular uses...it's a given that limited resources are going to be diverted away from more highly ranked (more valuable) uses.

      If you get a chance you should read my blog entry on crowd sponsored results.

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  2. Anonymous is right. In cable at least (and Netflix), the bundler can see the demand -- what people are watching (substituting one channel for another, substitution being the very essence of demand curves).

    Asked myself recently why Netlfix is creating its own shows. Because they have to provide content or they lose customers. Is it cheaper to buy/license, or to create that content?

    Viewers aren't voting with their wallets, they're voting with their time. This is arguably a much more accurate (and granular -- show-by-show) measure of demand than pricing individual channels, where viewers have to predict in big overall terms what they're going to want to watch.

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    1. I watched both House of Cards and Rake on Netflix. According to your argument...I demanded both shows equally. But that really isn't true. If I could chip in with my $9/month Netflix subscription fee...then I would give it all to Rake. It wouldn't even be a tough choice.

      So time that people spend watching shows really doesn't convey their valuations as accurately as chips would.

      This is because a chip is a vial of your blood, sweat and tears. It's a unit of your sacrifice. This means that how you allocate your chips on Netflix would be far more meaningful than how you allocate your time.

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