Sunday, 19 October 2014

Pricing strategy in practice: Cocktail menu edition

One of my favourite topics to teach in ECON100 is pricing strategy. In part, it's because this topic is a bit less about microeconomic theory, and a bit more about practical things that real managers do. That's why I enjoyed reading this article about cocktail pricing, which talks about how real bar managers set prices for drinks.

In the article, there's no pricing where marginal revenue is equal to marginal cost (the theoretical profit-maximising point for the firm with market power). Instead, the managers are making judgement calls about pricing based on their industry experience. For instance, consider this quote:
"I can't say that there's any way to be 100 percent certain that a certain drink will sell better than others," Morgenthaler tells me. "I'm constantly surprised by what is less or more popular on our menus. But with as much experience as I have, I would say I've got a pretty good idea of what's going to sell and what's going to appeal to a more connoisseur crowd."
In other words, the manager is using their market knowledge to set the price. This might involve heuristics (rules-of-thumb, such as the price of a glass of wine being the same as the wholesale price of the bottle - this used to be a common heuristic in the restaurant trade here, but I'm not sure if that still is the case), or it might just involve expert judgment. Cost is an important factor:
A cocktail by nature is a combination, in differing ratios, of a set of ingredients that each have costs, so many cocktail bars spend a lot of time and effort crunching the numbers behind their drinks...
Pour cost is pretty much what it sounds like: the cost a bar incurs by pouring a given cocktail... a bar might decide upon an acceptable range in which its pour costs must fall, given how other aspects of the business factor in, and then calculate the price of drinks based on that range. Between two drinks sold for the same price, the one with the higher pour cost earns the bar a smaller profit...
No matter its size, Cannon points out that "a restaurant will be successful over the long haul if it can pocket"—meaning earn in net profits—"10 cents on the dollar." In other words, for an establishment pulling in $1 million a year in revenue, the owner is fortunate to have $100,000 to show for it after expenses. "That's a tough order," Cannon adds. "Robust liquor sales at solid cost of goods are one of the reasons you can get to that 10 cents on a dollar." Astute cocktail pricing (say, pour costs around 21 percent or less, on average) can be a critical component of a restaurant's overall business strategy and health.
But there can't be any explicit determination of the point where marginal revenue is equal to marginal cost. In order to determine marginal revenue you must know what your demand curve is, which seems unlikely (see the earlier Morgenthaler quote) and if you don't know marginal revenue you certainly can't determine the point where marginal revenue is equal to marginal cost as we do in the textbook examples.

An alternative way of determining the profit maximising price is to use the price elasticity of demand directly (though this only works where the product has elastic demand, i.e. a price elasticity of demand that is greater than one). The formula for the optimal price in terms of the price elasticity of demand (which you can find here, or for a more lengthy explanation see here or the mathematical derivation here) is:

P* = MC[ε/(ε+1)] where ε is the price elasticity of demand (and remember that price elasticity of demand is negative, because as price increases the quantity demanded decreases due to the law of demand - the price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price, and when one of these is negative the other is positive).

For goods which have more elastic demand (i.e. where customers are more responsive to a change in the price), ε is larger (more negative) and [ε/(ε+1)] will be smaller and the price will be a smaller markup over marginal cost. For goods which have more inelastic demand (i.e. where customers are less responsive to a change in the price), ε is smaller (less negative) and [ε/(ε+1)] will be larger and the price will be a larger markup over marginal cost. So, you should charge a lower price (lower markup) if your customers are more price sensitive, and charge a higher price (higher markup) if your customers are less price sensitive.

Of course, this assumes that the price elasticity of demand is constant (which isn't true for a straight line demand curve), but putting that aside it doesn't appear that the bar managers are using an explicit calculation of price elasticity of demand in their pricing decisions either (again, see the Morgenthaler quote above). So, are they getting their pricing decisions wrong?

I would argue (as I do in class on this topic) that the long-term managers we observe in the market are not systematically getting their pricing decisions wrong. The reason is Darwinian. The cocktail bar market is pretty cutthroat - there isn't a lot of margin for error, and a manager who systematically got their pricing decisions wrong is going to lower bar profits either by pricing too high (and having customers go to the competition) or pricing too low (and lowering the per-customer profit making it more difficult to cover rent and staff costs, etc.). A manager who consistently lowers bar profits won't be a manager for very long, so the managers we see (who have been managers for a while) must be the ones who generally price close to the profit maximising point. So, even though these managers are not explicitly using marginal-revenue-equals-marginal-cost or the optimal-price-as-a-function-of-elasticity to determine prices, they must be internalising that through their expert knowledge of the market. And if you talk to bar managers, you can see that they have an understanding of price elasticities (or how their customers respond to changes in price in relative terms), even though they don't use the language of economics.

However, that's not the end of the story, because the pricing of each drink is not undertaken in isolation:
When Cannon and his team revise their cocktail menus, he says they try to price drinks destined for the greatest popularity so that they have the lowest percentage pour costs. For a prospective top-selling drink, "we need to make sure that that one is in a very solid cost of goods range, maybe a point or two below our target, because if a number-one mover that is refreshing and easy to [drink] is priced right, it allows you some wiggle room on some other esoteric things, where the ingredients are more expensive." He adds that, "We'll take a few lumps on this really cool drink that [the bartenders have] created, and it will be great conversation. Meanwhile, the gin sour...this is going to do the heavy lifting for us."
In other words, there are strategic aspects to pricing (as we discuss in ECON100). Sometimes it makes sense to lower the price of a drink, if that drink is going to attract customers who would buy other (higher markup) drinks as well, or who would bring other customers with them who purchase higher markup drinks. The former is the justification for loss-leading (where some products are sold below marginal cost in the hopes of increasing revenue and profits from other products - a common strategy for supermarkets, for instance). The latter is the justification for 'ladies nights' at bars. Again, good managers can be expected to take advantage of opportunities for strategic pricing across the range of product offerings.

And then there's the effect of competition. More bars in the local area will increase competition and lower prices. Customers have more alternatives, so if a bar increases prices (or markups) there will be a greater shift of customers to the competition. This means that customers become more price sensitive when there is more competition, which increases the price elasticity of demand (ε) and lowers the optimal price of drinks. So when there is more local competition, bars should be offering lower priced cocktails.

Finally, bars aren't only offering drinks to customers. They also offer amenity - the atmosphere, music, etc. which customers value. Bars that have attractive more attractive characteristics than their competition will be able to charge a premium for cocktails - again, because their customers are less price sensitive (lower ε, higher optimal price and markup).

So the next time you are drinking a cocktail, spare a thought for the pricing decision-making prowess of the bar manager. They're balancing cost considerations and the price elasticity of demand, as well as strategic pricing and amenity considerations, in determining the price you pay for that Long Island iced tea, whiskey sour, or special creation. And hope they've got the pricing right - otherwise they might not be around the next time you're out on the town.

See also: Fancy a margarita: Why it'll cost you more

[HT: Marginal revolution, back in July]

Thursday, 16 October 2014

The living wage is good for employers; unless lots of employers pay a living wage

The living wage is back in the news this week, with The Warehouse Group being held up as an example for other (especially retail) employers in terms of looking after the wellbeing of their workers. From this Bernard Hickey piece in the New Zealand Herald:
The Warehouse is one of a growing number of companies paying a "Living Wage". From August 1, it started paying 4100 of its workers a "Career Retailer Wage" of at least $18.50 an hour. To qualify, they must have full training and 5000 hours' experience. It represents a pay increase of 10-20 per cent.
Warehouse CEO Mark Powell estimated it would cost almost $6 million in extra wages, but it was an investment worth making...
This week, union researchers Eileen Blair, Annabel Newman and Sophia Blair delivered a paper to the Population Health Congress in Auckland on the experience of employers and workers who have adopted the Living Wage, currently $18.80 an hour - 32 per cent above the $14.25 minimum wage.
They interviewed four employers and found a variety of reasons for adopting the Living Wage, including that it was the right thing to do.
But there were more practical reasons, including wanting employees paid enough to buy their products, reducing staff turnover and having staff motivated to produce a great product or service.
You can read the research paper by Brown, Newman and Blair here (pdf), and read more about the living wage campaign in New Zealand here.

I thought a blog post on the living wage was timely given that my ECON110 class has just covered the economics of social security, poverty and inequality, and related policy, so this research provides an interesting kick-off point. As Bernard Hickey points out in his article, Henry Ford introduced a $5-a-day wage at Ford factories in 1914 (although Hickey makes the mistake of buying into the story that this was done so that Ford's workers could afford to buy cars - Tim Worstall and others have already thoroughly debunked that story). The $5-a-day wage might not seem like much, but it was about double the ‘normal’ factory wage at the time. Ford had a huge number of job applications (not surprising - they were the highest paying employer around at the time). Staff turnover fell, absenteeism fell, and productivity rose so much that Ford’s production costs decreased even though they were paying much higher wages.

What Ford had introduced was what we term an efficiency wage. A wage that is voluntarily offered by an employer and is above the equilibrium wage in the labour market. Employers offer these efficiency wages because they know they have positive effects - they attract and retain higher quality employees who work harder for the firm, higher productivity, lower absenteeism and lower staff turnover. Why do all these good effects happen? In the simplest sense, having lots of job applicants and being the first-choice employer for most available workers means you get to choose the best (most productive) workers.

But the good effects go beyond the selection of job applicants, because of the incentives that the efficiency wage creates. If an employee is working for you for a wage that is well above equilibrium, then they have a strong incentive not to shirk, not to take too many dodgy sick days, and generally to work hard for you. Why? Because if they don't and they lose their job, then the best possible outcome for them is that they go back to working somewhere else for a much lower wage. Alternatively, maybe the employees just work harder for their employer because they feel good feelings for the employer who is paying them very well. There is plenty of support for the idea of efficiency wages, including research by myself and Steven Lim and others in Thailand, and there are some good quotes from employers in the Blair et al. research report, like this one:
When you spend a lot of money training someone up you don’t want them to just leave three months later, or six months later; you kind of want them to stick around for a year or two. If they feel like they can earn more money and save up more and then go travel for longer, they’ll stick around a lot longer and the productivity will go up...
Now, the living wage is a good example of an efficiency wage. If you pay your semi-skilled (say, retail) employees $18.80 per hour, you are paying above the minimum wage and well above the equilibrium wage. So I'm not surprised that The Warehouse, and the four employers that Blair et al. interviewed for their study, have seen positive gains from paying a living wage. The alternative for their employees is to work somewhere else for (probably much) less, so working hard for more pay might be an attractive option to them.

What's good for a few employers (and their employees) must be great if all employers follow suit, right? If every employer paid a living wage much higher than the mandated minimum wage, won't everyone be better off? Not so fast. The gains from paying an efficiency wage arise because the alternative jobs for employees pay much less. If every other employer is also paying a high wage, then the employees don't need to work so hard because if they lose their job they can go somewhere else that is also paying a high wage. Same goes for absenteeism, staff turnover, etc. The benefits of the efficiency wage evaporate if lots of employers pay efficiency wages.

So, it's likely that the observed gains for employers from paying a living wage of $18.80 (rather than the minimum wage $14.25) are only sustainable so long as the living wage isn't mandatory for all employers. As Bob Jones rightly points out, forcing employers to pay much higher wages is just going to force those with slender margins (including a lot of small-scale retailers) out of business. This would reduce the number of available jobs for semi-skilled workers. According to the Treasury (quoting an MBIE estimate), raising the minimum wage to the living wage would cost 25,000 jobs. Most of these lost jobs would be in accommodation and food services, and retail trade.

Overall, the living wage might have some positive effects for those employers who offer it. But the idea that it should be rolled out by all employers is clearly being oversold if the gains to employers are essentially those that arise from paying an efficiency wage.

[HT: Tracey from my ECON110(NET) class, for pointing me to the Tim Worstall piece on the Ford $5 workday]

[Update: Fixed broken link]

Tuesday, 14 October 2014

Try this: The economics of "The Office"

Dirk Mateer and friends (Daniel Kuester at Kansas State University and Christopher Youderian at Pareto Software; Dirk is now at the University of Arizona) have done it again. Their latest contribution to using pop culture to illustrate economics concepts is The Economics of The Office, which I was alerted to by a description of the site in the most recent issue of the Journal of Economics Education. The videos are generally short, easy to use to start a discussion or illustrate a concept in class or lectures, and the variety of concepts (which you can browse through) is broad. Macroeconomics or microeconomics - there's something for everyone there.

On a related note, Dirk Mateer's website is highly recommended for teachers (and students) of economics, especially the media library. See also this earlier post from me on cornering the market for Christmas toys (also based on a video from The Office).

Thursday, 9 October 2014

University rankings and signalling

On Tuesday I wrote a post on market-based pricing and the impact on university rankings. But, to what extent do university rankings matter for our graduates? From the NZ Herald on Monday:
Kiwi employers working through a pile of CVs are unlikely to care how applicants' place of study compares on international rankings.
They may have noted last week's media reports on the latest university rankings that showed institutions here losing ground or stagnating.
But the University of Auckland's fall of 11 places on the annual Times Higher Education (THE) rankings won't work against the vast majority of its job-seeking alumni. "Generally speaking, the conversation that we have around university degrees with clients is around a demonstrated ability to commit and complete a degree," said Vanesha Din, a manager at recruitment firm Michael Page Finance.
I've written before on the value of tertiary education as a signal to employers of a student's quality (specifically for economics, see here and here). The article agrees - the value of a degree is a "demonstrated ability to commit and complete a degree". This is a signal of the student's quality as an employee (committed, hard-working, etc.), because a potential employee without a degree can't easily demonstrate those same qualities of commitment and hard work. The ranking of the university doesn't necessarily add much to the quality of the signal. That is, unless everyone that goes for a position has a degree. From the article:
However, the rankings do matter to some employers with senior technical roles including in law, medicine, specialised engineering and financial services.
Every lawyer has to have a law degree, and every doctor has to have a medical degree. So there is no signalling benefit from the degree itself - a student can't signal their quality as an employee with the degree, because all other applicants will have a degree too. The quality of the student then has to be signalled by the quality of the institution they studied at, rather than the degree itself. An effective signal has to be costly (degrees at top-ranked institutions are costly) and more costly to lower quality students (which seems likely in this case, because lower quality students would find it much more difficult to get into a top-ranked institution).

Of course, top students are weighing up the benefits of the higher quality signal provided by graduating from a top-ranked university (rather than a lower-ranked university), against the higher costs of attending the top-ranked university. Sometimes the higher-ranked university won't win out in this evaluation but at the margin, the university rankings will make a difference to this decision, and they should especially make a difference in areas like law and medicine (as in the example in the Herald article).

Tuesday, 7 October 2014

Market-based pricing of university education and university rankings

How New Zealand's university education sector is funded has been in the news lately. From the NZ Herald last Thursday:
Tertiary students should be charged much more if the Government is unwilling to invest enough to keep universities competitive, the country's largest university says.
University of Auckland vice-chancellor Stuart McCutcheon believes there is a strong case for following Britain and Australia's lead and raising the cost of study.
Fee deregulation or a similar system would allow universities to set their own fees and would likely lead to increases well above the current annual maximum 4 per cent...
...The latest international rankings released today show New Zealand universities losing ground or stagnating...
...Professor McCutcheon said such league tables were the main way international students judged quality, and the downward trend put the funding of universities at risk.
International students - and the high fees they pay - have become increasingly important, with all institutions attempting to increase them after domestic numbers and attached funding were effectively capped.
The funding available to NZ universities on a per-student basis was comparatively very low, Professor McCutcheon said. If the Government would not increase it substantially, then another way needed to be found.
This is timely given that my ECON110 class has just covered the economics of education. There are a couple of things I want to focus on in this post: (1) how university education is funded and the implications of moving to a purely market-based pricing model; and (2) the impact this has on university rankings.

University education in New Zealand for domestic students is part-funded by the government (each institution is subsidised on the basis of the number of full-time equivalent (FTE) students), and part-funded by the students themselves (through tuition fees). Alongside this, the tuition fees that universities are allowed to charge domestic students are capped (as noted above, they're only allowed to increase by 4 percent per year) - this is a price control, albeit a control that moves over time. And to complicate things further, the amount of FTE subsidy that the government will provide is negotiated with each university each year. In other words, universities are essentially limited in the number of students that they are allowed to enrol - a quantity control.

What would happen if the restrictions (on price and quantity) were removed? In ECON110, we describe the optimal level of subsidy for tertiary education, which is described in the figure below. The optimal subsidy would be the subsidy that ensured that marginal social benefit is exactly equal to marginal social cost. Any more subsidy than that and the extra cost (to society) of the additional students would outweigh the extra benefit (to society), and society would be worse off. Any less subsidy that that and the extra benefit of one additional student would be greater than the additional cost, and you should provide more subsidy.

The tricky bit is that education provides positive consumption externalities (higher productivity, lower crime, better outcomes for children of the educated, etc.) so the marginal social benefit (MSB) is greater than the demand (D) for tertiary education. The effect of the subsidy (which is paid to the universities - to keep thing simple we will ignore demand-side subsidies such as student allowances, interest-free student loans, etc.) is to lower the effective cost of providing university education (we show this with the new curve S-subsidy, which is below the supply curve S). If the size of the subsidy is optimal, then it will ensure that the market provides Q0 university places - the quantity where marginal social benefit (MSB) is exactly equal to marginal social cost (MSC). This is ensured because the students pay the low price PC and demand Q0 places at university, and the universities receive PC from the students, which is topped up to PP by the subsidy, leading them to offer Q0 places for students.



Now consider the effect of price and quantity controls. It's not possible for both price and quantity controls to be simultaneously binding on the market. This is because, if the quantity control was binding the price would adjust - the price that universities were willing to accept for each student would fall to below the level of the price control. On the other hand, if the price control was binding, the quantity would adjust  If the price control is binding, it makes the quantity control less likely to also be binding - the quantity of university places that are made available to students would likely fall to below the level of the quantity control. The lack of a binding quantity control is probably the situation we currently observe in most degree programmes other than those that have strictly limited places such as medicine or law. [*]

Let's assume that the price control is binding, but the quantity control is not. This is suggested by Professor McCutcheon's comments. Also, we've recently had a period where the quantity control was binding (we had severely limited spaces a few years ago), and that isn't the case now the sorts of things we observed then (e.g. long waiting lists for all degree programmes) isn't happening now. So, if the price control (in terms of the price paid by students) is binding at PMAX, the quantity of places available at university would be QS. However, at this artificially low price, there is excess demand for places at university - the number of places demanded is QD, but there are only QS places available. Some students, who would like to study at the subsidised price, are excluded. And because the market is operating at less than Q0 (where MSB = MSC), there is a loss of welfare - society is worse off overall.

On the flip side, removing the price (and quantity) controls would allow the market to move to Q0, maximising welfare. More students would go to university, and although they would pay a higher (out-of-pocket) cost for doing so and the government would pay more in subsidies (because there are more students), society would be better off overall.

Where do international students fit into this though? International students aren't subject to the quantity controls, so they don't directly affect the number of places available at universities. However, they do increase the demand for universities' scare education resources. This should push the price of education upwards, but it can't because of the binding price control. This should manifest in additional excess demand - more turned away students. However, it's not clear to me that this (turning students away) is happening in large numbers. So, maybe the degree of excess demand is relatively small.

However, think about the related effects. If the universities aren't bringing in as much income as they would be under market pricing (an effect of the price controls), then they can't afford to employ as many staff (or as high quality staff). Fewer staff means fewer courses (or courses with a higher student-to-staff ratio), and offering fewer courses means fewer places for students. So, perhaps the excess demand is absorbed by offering a lower quality education to all students than would have been obtained with market pricing.

There is a further flow-on effect of this, which should by now be becoming obvious. Lower quality staff means lower quality research output, which flows through into lower international rankings. Higher student-to-staff ratios also lead to lower international rankings (this is one of the dimensions that is taken into account in the Times Higher Education (THE) rankings, for instance - it is their crude measure of 'teaching quality'). So, as Professor McCutcheon notes, there is probably a close link between the lack of market pricing of education and falling rankings of New Zealand universities.

Lower international rankings reduce the demand for a New Zealand-based education by international students. Which lowers the excess demand and probably raises the quality of education for students. So, perhaps there is some dynamic equilibrium between below-marking pricing, university rankings, and international student demand. That doesn't mean we shouldn't be aiming instead for a new equilibrium with market pricing, optimal subsidies, and higher university rankings.

*****

[*] Update: Of course, the quantity and price controls are able to be simultaneously binding. A profit-maximising university will price on the basis of the willingness-to-pay of students, not their willingness-to accept. So, if the quantity control is binding and the number of student places is restricted, students are willing to pay more for their study and this makes the price control more likely to be binding as well. This seems likely for degrees where places are strictly limited, like law or medicine, but less likely for commerce, management, or arts degrees.

Sunday, 5 October 2014

Does working make you happy when you're older?

It turns out that maybe it really doesn't. At least, not according to research that I am completing with Matt Roskruge at NIDEA (the National Institute of Demographic and Economic Analysis, at the University of Waikato). In the journal Policy Quarterly in August (PDF), we wrote about some of our preliminary results. Our key research question was essentially: "Does working make older New Zealanders better off?".

We were interested in this question because labour force participation at older ages has been increasing substantially over time (and because I was funded by MBIE to investigate the effects of labour force participation among older people). To give you a sense of the scale of increase in participation, see Figure 1 below, which shows the labour force participation rate of each five-year age group 55 years and over, across the last five Censuses. This figure is taken from a working paper I wrote (PDF) earlier in the year, which explores a lot of different aspects of labour force participation among older workers in New Zealand.

Figure 1: Labour Force Participation Rate by Age, 1991-2013

Obviously, this is also a really important question, because the New Zealand population is ageing rapidly (see here or here for the national-level, or see some pretty graphic pictures (pun intended!) of the changing age structure at the sub-national level in this report by Bill Cochrane and I for the Waikato Region).

To look at the question of wellbeing and working among older people, Matt and I used data from three waves (2008, 2010, and 2012) of the New Zealand General Social Survey (GSS), which is a nationally-representative survey that collects data on a range of social and economic indicators of well-being. The key question is on life satisfaction (a proxy for overall wellbeing): "How do you feel about your life as a whole 
right now?" Responses are measured on a five-point Likert scale (1 = very satisfied; 2 = satisfied; 3 = no feeling either way; 4 = dissatisfied; and 5 = very dissatisfied). To keep things simple (and avoid having to run ordinal models), we reduced this into a variable that was equal to one if the respondent was very satisfied, and zero otherwise.

Now, there are two key problems to overcome with trying to analyse the relationship between working an wellbeing. First, there is self-selection - people choose whether or not to work, and those who choose to work would likely be those who believe that it will increase their wellbeing. This would lead to a bias in any attempt to evaluate the effect of working on wellbeing. Second, there is an endogeneity problem, because health status affects whether an individual is able to work or not, and also directly affects the individual's wellbeing. We use instrumental variables regression to overcome both problems - using gender as an instrument for full-time work status. Now, I'm not the biggest fan of instrumental variables (see here for example). We think that gender is a good instrument because it is closely correlated with full-time work (men have higher labour force participation than women), and it meets the exclusion restriction because there is no theoretical reason why men should have higher (or lower) wellbeing than women (indeed, from having looked through the literature as part of the Enhancing Wellbeing in an Ageing Society (EWAS) project, there is little consistency in effect of gender on wellbeing). Incidentally, if you are interested in what correlates with wellbeing among older people in New Zealand, read this monograph (PDF) from the EWAS project (or this one (PDF) on people aged 40-64).

What Matt and I found is interesting. We had three groups of labour force status - full-time employed, part-time employed, and not working (which combines the small number of people who reported as unemployed, as well as those who reported as being retired). Figure 2 shows the raw results in terms of life satisfaction, and it looks like those not working have the lowest life satisfaction (smallest proportion very satisfied, and largest proportion not satisfied).

Figure 2: Life Satisfaction, by Labour Force Status

However, one we ran our instrumental variables model, we found that (after controlling for health status) full-time work is associated with significantly lower life satisfaction than either part-time work or not working. Working full-time is associated with an about 49% lower probability of reporting being very satisfied. Those are the results we report in Policy Quarterly. We've been doing some follow-up work since that article, looking at some of the mechanisms through which this might be working.

Is it because wealthier older people don't need to work, so those who are working are doing so because they have to in order to get by? It doesn't seem so - the results are robust to the inclusion of area deprivation (as a proxy for wealth - the GSS doesn't have a direct measure of wealth). Including wealth makes part-time work marginally statistically significant and negative (working part-time is associated with about a 7% lower probability of reporting being very satisfied).

Is it because older workers who are working full-time are dissatisfied with their jobs? If we restrict the sample to only those who are working, job satisfaction is significantly positively related to life satisfaction, but it doesn't make full-time work status any less statistically significant (or any less negative). There's no difference in the job satisfaction-life satisfaction relationship between full-time workers and part-time workers.

Is it because older workers who are working full-time want to work less but for some reason can't? The GSS asked people if they wanted to work more hours, or fewer hours. Wanting to work more hours is associated with lower life satisfaction. Wanting to work fewer hours is not. These results don't differ between full-time and part-time workers, and they also don't make make full-time work status any less statistically significant (or any less negative).

So, it appears to be a fairly robust result - working full-time when you're older makes you less happy. Or maybe less happy older people prefer to work (reverse causality is still a possibility). I know I'd rather be working when I'm older than doing this.

Matt and I are completing the write-up of a working paper on this at the moment. Keep an eye out for it here (it should be up by the end of October). We'll also be presenting on this at the Labour, Employment and Work conference in Wellington in November.

Thursday, 2 October 2014

Why study economics? Sheepskin effects edition

Over at Offsetting Behaviour, Eric Crampton highlighted that economists have higher lifetime earnings than other graduates. The source of this claim is from this Jordan Weissmann article. I've previously written on the reasons why students should study economics (see here and here), and for a lot of prospective students deciding on their majors it really does come down to how much they can earn having done different majors. On this metric, economics does pretty well for the median graduate. However, the key addition from the Weissmann article is that, at the top end of the income distribution for each major, economists earn more than all other majors. Here's why:
So why are econ grads so good at making it rain? Part of it is that the finance and consulting industries like recruiting them, not necessarily for their specific skills, but because they consider the major a basic intelligence test. Granted, we're probably not seeing the effect of Goldman Sachs or Private Equity salaries in these charts, since they only stop at the 95th percentile of earners—but banking is a big industry, and it pays well.
Eric adds a good point which I want to expand on:
Grade-seeking students of lesser abilities drop economics for other majors; those who are left earn their grades.
One of the key characteristics of a degree or diploma is the signal that it provides to prospective employers about the quality of the applicant for positions they have available. Employers don't know up front whether any particular applicant is good (intelligent, hard working, etc.) or not - there is asymmetric information, since each applicant knows their own quality. One way to overcome this problem is for the applicant to credibly reveal their quality to the prospective employer - that is, to provide a signal of their quality. In order for a signal to be effective, it must be costly (otherwise everyone, even those who are lower quality applicants, would provide the signal), and it must be more costly for the lower quality applicants. Qualifications (degrees, diplomas, etc.) provide an effective signal (costly, and more costly for lower quality applicants who may have to sit papers multiple times in order to pass, or work much harder in order to pass). Qualifications confer what we call a sheepskin effect - they have value to the graduate over and above the explicit learning and the skills that the student has developed during their study.

Now, economics may provide a stronger signal of quality (a more valuable sheepskin effect) than other majors. Why would that be? Economics is by no means an easy major for most students. It involves learning calculus and statistics, and developing important critical thinking and logical reasoning skills. All of these things are hard (but ultimately worthwhile, given the returns to an economics major in terms of higher earnings) so, as Eric argues, lower-ability students tend to select themselves into majors other than economics.

When it comes to graduates, employers can't easily tell the difference in quality between economics and knitting [*] graduates in terms of their quality. However, if economics is known (by employers) to be more difficult (i.e. more costly in terms of time and effort) for students, then an economics major would provide an additional signal (over and above that of the degree itself) of the higher-than-average quality of the student.

We could make a similar argument for econometrics (regarded by most students as the most difficult part of an economics major). Top grades in econometrics (or even slightly-above-average grades in econometrics) may provide an additional signal of quality, over and above the signal provided by the economics major (and the degree). Which is why I always strongly recommend to our economics students that they include econometrics in their programme of study. That allows them to take advantage of multiple layers of sheepskin effects.

So, sheepskin effects provide another reason why studying economics is a great idea. If you want to convince employers that you are a top-quality student, it's hard to beat receiving top grades in a more difficult major.

*****

[*] OK, I made that up - we don't have knitting graduates. I don't doubt there are some potential students who would be keen on a Bachelor of Knitting though.