Which Volunteer Activity Do You Value More?

Option 1: Working in the local soup kitchen for a day to all the cleaning, sweeping and other physical labor. You likely will be on your legs all eight hours and do some back-breaking work including clean-ups you don’t normally do.

Option 2: Working for the same soup kitchen to help set up their email marketing system to get better communication with their sponsors and tie that back to a reporting dashboard to see contribution levels and history. You likely will work 8-10 hours from the comfort of your office with no physical labor what so ever.

If you picked Option 1, think about this for a second. You are not the best dishwasher or a cook. You hardly can lift a 20lb bag of flour without help. You slow down everyone around you. On the other hand you are an expert digital marketer and works as a growth hacker for a startup that is growing 350% a year thanks to your work. You can put all that to work for the soup kitchen as well.

Taking it to other extreme, you could hire someone to do far better job than you do to help with soup kitchen’s labor needs.

From an economic perspective it creates lot more value to have you contribute with skills you are best at vs. skills you are worst at.

And yet why do we see all volunteer activities -individual and company organized – take pride ONLY in activities that involve physical labor?

You better not bake your costs into pricing

The Atlantic boldly declares, “prices are people”.

“Baked into the price of everything we buy is the rising cost of advertising, accounting, legal services, insurance, real estate, consulting, and the like — jobs performed by the high-wage workers of our modern economy,”

Quoting data on our food spending, they say increasing share of our spending goes to services (wages to people that is) while less and less goes to commodity producers. Hence their case, baked into price is people cost. They explain to us that is why hand-made handbags are more expensive than the mass-made.

Just think about the $629 you just paid for the new iPad 4G, 32 GB.  Was it priced high because it is made one at a time using US labor, costs Apple a lot to pay those high-wage geniuses who work at Apple stores or because of their rising cost of advertising?

You can see how naïve Atlantic’s argument is and that how it completely misses the mark on economics and marketing front.

First the economic point – customers are not going to keep buying products when the manufacturers keeps adding their rising cost to the price. Demand is a function of price. Not only demand moves with price, the entire demand curve may shift (as they do in case of economic shocks). On the flip side, look at the farmer’s share as the price they charge for the products they delivered. Their pricing power keeps going down because of excess supply and practically no product differentiation.

Next the marketing point – customers are not paying to offset your costs. They are paying to fulfill their needs –utilitarian or hedonistic. It does not matter to them what your costs are or how you are allocating them.  When was the last time you were at a coffee store and paid separately  for employee salary or the decorative lighting?

It is not the cost that comes first, it is the price that comes first. Apple and Starbucks don’t bake their cost into pricing. They find the price customers are willing to pay for the value they get and deliver the product at cost that is profitable to them. In case of Apple, insanely profitable prices and costs. There are many customers who are not willing to pay Apple prices, Apple simply chose not to target them.

Shoppers brandishing their newly purchased iPa...
(Photo credit: Wikipedia)

It is not the salaries of Apple Store Geniuses that is baked into each iPad. To target those customers who are willing to stand in line and hand over $499 to $799, Apple has to hire the Geniuses. The  experience is part of the product. Apple is willing to pay higher wages the Geniuses demand because, one they cannot deliver the same customer experience with someone willing to take lower wages and two it can still make profit at these wages.

Prices are not people. People costs do not determine prices.

Hope you are not taking economic insights or worse pricing advice from such articles.

Other readings:

  1. If you think organic produce is priced higher because of costs
  2. Why is iPad 3G priced $129 more than Wifi but Kindle 3G is only priced $50 more
  3. What is the difference between Apple and a drycleaner? (password: iPad2)

Mental Accounting and Other Errors in Home Buying

English: An icon from the Crystal icon theme. ...
Image via Wikipedia

Homeownership –  the American Dream. The one that contributed significantly to the Great Recession and is still responsible for the slow recovery we are seeing. There is some change in this love to own a home, among some demographics,  but not much to call it a shift.

To explain why we still prefer buy vs. rent will take a book, so let us keep it brief and look at the errors we commit in our thought process. There was an article in The Washington Post that wrote about a research that found, “Average American’s don’t think like Economists”.

That explains a lot about our love for buying homes.  I should add, when it comes buying or selling their own homes most economists don’t think like economists.

  1.  The Seller pays all the realtor fees– The first thing any realtor will tell a prospective homebuyer is, “you don’t pay me anything, the seller pays me“. Conflict of interests aside, how does the seller really pay? It does not come from a different pot the seller has. The seller pays by including it in the price of the house.A moment’s reflection will convince  you that the day you sign the 2564th document they thrust in front of you during closing, you are down 5-6%. In other words even if you sold the house the next day you will lose 5-6% of the price you paid.
  2. Rent is down the toilet – Rent is an expense. By extension every expense we make is down the toilet. Besides this ignores the fact that your interest payments, most of your monthly mortgage payments are just that in the first few years, are down the toilet too. Interest is the rent you pay to use the bank’s capital to buy the house.
  3. Interests are tax deductible, rent is not – True and this could be used as a another point to bolster the case, “rent is down the toilet”.  First there are limits on mortgage interest tax deductions. Second, renters indirectly get the advantages of the tax deduction.
    When you rent a home or apartment recognize that they are owned by somebody who is paying mortgage interest on that property. Because of the tax deduction the cost to own is reduced and hence  more are willing to get into the renting business. As more such owners buy to rent it out, the supply of rental properties increases and hence the price decreases. If there were no deductions fewer people may own rental properties and the decrease in supply will push up rent. Either way renters get part of the benefits of mortgage tax deduction.
  4. Prices will always go up –  There is enough data published by Case-Shiller that says prices don’t go any faster than rate of inflation. We all suffer from optimism bias, ignoring the downside and giving higher likelihood to favorable scenarios.
    Even if it did, what does it mean to us to take advantage of the new higher prices? We need to sell the house first. Where would we live then and what would be the costs? If your home price went up so did the whole neighborhood, city,  and state. Unless you are ready to move to a low-cost state there is no upside to the home price increase.
  5. Opportunity cost of down payment – This is huge for those buying houses in Bay Area. When you sink 20% of the price of the home in one illiquid asset you are losing out on the opportunity cost of investing the same capital in any diversified fund.
    While realtors tell you, “when stock market goes down you are left with nothing to show for but even when your home prices go down you have a place to live”, you need to ask
    – will my mortgage payments stop? No.
    – Is my down payment safe? No, that is wiped out with just 10-20% down swing in home prices.
    –  will i still have job in the same neighborhood? Unlikely.
    If the stock market is wiped out, will be home market be any better? They are not completely uncorrelated. At least you get diversification when you invest your down payment in a broader market.
  6. Locking in my “rent” for next 30 years – This is usually stated as post-purchase rationalization, “at least I know what my payments will be for the next 30 years”.  If the economy goes south, you are liable for the same level of payments even if the market prices for rent are lower.
    If indeed rent goes up, then you need to realize that you are maintaining the same quality of life at a higher cost even though there is no additional money flow. In other words you could rent the home out to take advantage of higher rent and reduce your standard of living by renting a lower quality place for you.  The net is there is no advantage in locking in payments.
  7. Unlocking  equity – Homeowners repeat this phrase as if it were a self-evident truth. They speak as if they sold part of the house and cashed out without really giving up that part of the house. The basic accounting equation is
    Assets = Liabilities   + Equities
    When you buy the home it is added to the asset column at the price you paid and the mortgage you took is added to the liabilities. The down payment is added to equities column. The two sides of the equation are matched.
    When market price for homes goes up it does not really do anything to the asset side unless you are doing mark-to-market accounting (which we don’t). If we did that then the assets column will go up. The increase in left side of the equation is balanced by adding the same amount to the equities column.
    What you do when you take out a home equity loan is move some or all of that increased equity to liabilities column.
    The net is, you are liable for the additional loan you take out.  It is not like you are issuing new stocks to convert the asset class to cash.

There you have it, the seven errors in our thinking that leads us to prefer buy over rent.

Other articles:

  1. Home Staging – Why our willingness to pay is higher with staged homes?
  2. Ignoring the downside – Prices will always go up
  3. Slow decline in home prices – why prices are slow to fall
  4. Home Prices – Value gap

If One Price is Good, Two are Better – a Fallacy? Gross Generalization?

I end many of my posts with the line,

If one price is good, two are better.

It is written in the blackboard I use in my Twitter and WordPress profile pictures. Is it just a tag-line? Worse, is it a gross generalization or a fallacy?  In a previous article I wrote about the 1% price increase fallacy, and I frequently write articles on gross generalizations by other authors. Shouldn’t I look at my own tag-line  even if I don’t give it the same level of scrutiny I give to others?

First and foremost – Yes it is a tag-line and there are situations where it is not true.

Origins of this statement: It is rooted in price discrimination which was first written about by the economist Pigou.  He did not use these exact words. I am reluctant to claim full ownership of this statement. I am convinced I have read this before but my searches come up empty, so I own it for now.

The claim I make is weaker than the claim made by general price discrimination theory. My claim stops at two prices, requires that “one price must be good, i.e., there is a market for the product at a given price”, and does not imply scaling or generalization.

Pigou and later economists used more formal quantitative methods to prove the merits of price discrimination.  Pigou laid out three specific pre-conditions for price discrimination to be more profitable than a single price:

  1. Different customers must value the various versions differently. This means customers’ needs and the value they get from the product must be different.
  2. There must be no arbitrage opportunity.
  3. The products must not be commodities or easily substitutable – products must add unique value to customers.

It is easy to see why (1)  is true for most products.  If it is not true today then everyone will buy a product at any price. Since that isn’t the case we can accept (1) to be true.

For most products we develop and market there is no arbitrage opportunity. This is especially true for digital goods and webapps.

Finally, your product is a commodity only if you let it be.  The most common refrain I hear about webapps is, “if you don’t make it free your competitors will”. If your webapp adds no unique value or easily substitutable then  it is a commodity. But does it have to be that way? Isn’t that why we have marketing, value-messaging and positioning?

So for most of the cases the three preconditions for practicing price discrimination hold true, leading me to repeat,

If one price is good, two are better!

Note: You can read my articles on 4 Costs of versioning and how to design and price the versions. I offer three versions of these articles all priced differently.

Making a living out of wordonomics

There is a proliferation of made up words that tack on the word onomics to a brand name., all inspired by Reagonomics and Freakonomics. All these initiated by the brands themselves. This of course an attempt to position the brand as most suitable for the current economic conditions. Examples include

  1. 3conomics  (Wendy’s 3 meals under $3 deal)
  2. Suaveonomics
  3. DiGiornomics

Does this help the brand to associate with something that is not doing so well?

Why position your brand for tough economic conditions? So are the products the equivalent of what economists call Giffen goods?

When the economy improves will people switch from your brands to what they perceive as better brands?