There are a number of surveys that attempt to measure the spending intentions of people in the run up towards Christmas. For example a recent study carried out by YouGov found that people in the UK planned to spend an average of £599 on presents for their family and friends. This represented a 5.8% increase on the previous year. Planned total spending on Christmas was estimated to be a staggering £22 billion.
Respondents to another survey, carried out by the hotel chain Travelodge, stated that on average they planned to buy presents for 12 people. This study also found that the average expected spend on each present was £28.70 – an increase of £1.70 on the previous year. A rather obvious question for anyone interested in economics is whether this is either a sensible or an efficient way of allocating resources. One way to think about how an economist might approach this issue is to ask yourself the following questions after you have opened a present on Christmas day.
• How much money do you think the person who gave you the present paid for it?
• Ignoring the sentimental value, if you had not received this present how much would
you be willing to pay to purchase it?
Exactly 20 years ago the economist Joel Waldfogel posed questions very similar to these to a group of 86 students studying an intermediate microeconomics module at Yale University in the USA. On average the respondents to the questions estimated that friends and family had spent $438 on 
the gifts they had received that Christmas. Unfortunately their willingness to pay for these same gifts was $313 on average. Economists would argue that this is an example of economic inefficiency because the recipients’ valuation of the gifts – as measured by their willingness to pay – was only 71.5% of the price paid by the person who gave them the presents. This means that it is possible to make the person who received the gift better off without making the person who purchased the gift any worse off. This argument can be illustrated with a simple example.
Assume you have purchased a Liverpool football club shirt as a present for Sir Alex Ferguson and it cost you £50! Rather surprisingly Sir Alex likes the shirt but would have only been willing to pay £20 if he was buying it for himself. Imagine now that you have given him £50 cash instead of the shirt. This would not make you any worse off – your cash outlay would remain unchanged. However, Sir Alex would now be able to spend the £50 cash in a way which would give him far more satisfaction than the Liverpool football shirt would have given him. Sir Alex can therefore be made better off without making you worse off. The present in this example generates a deadweight welfare loss of £30. Waldfogel concluded from his later research based on a larger sample of people that, on average, people’s valuations of their presents is about 90% of the money actually spent on them. If this figure is accurate, it suggests that over £2 billion will be wasted in the UK this Christmas.
The size of the deadweight welfare loss depends on how well the person who is buying the present knows or understands the preferences of the recipient. The closeness of age, friendship or family relationship are all likely to influence the accuracy of this knowledge. Interestingly, Waldfogel found that presents from grandparents to grandchildren were the most inefficient: i.e. the difference between the recipient’s valuation of the gift and the price paid for the present was the greatest. The study also found that grandparents were more likely to give their grandchildren cash gifts.
Do economists always advise people to give cash as presents? Thankfully the dismal science can find some positive things to say about giving gifts. The previous analysis can be criticised in a number of different ways. It assumes that the recipients are perfectly informed about all the potential gifts that are available. If the person buying the present can find an item that the recipient was unaware of, then it is possible that economic welfare might be increased. It has also been assumed that the pleasure or value people obtain from an item is not influenced by who has purchased it. It may be the case that people place a greater value on an item when it is a gift from somebody else. In the previous example, perhaps Sir Alex would value the Liverpool shirt at £60 if you had purchased it for him as a present. The analysis has also ignored the possibility that the person buying the present derives pleasure from trying to find a gift that they think the person would like. Perhaps people feel a ‘warm glow’ when they see the happiness of somebody opening their present on Christmas day.
A final interesting economic explanation for buying presents is that they might act as an effective signal in a situation where there is asymmetric information. It can be argued that this is the case in relationships where people have private information about their true feelings towards one another. One way of communicating these feelings is by simply telling someone how you feel about them. However, this might not be an effective signal, as someone who does not have such strong feelings could say the same things as someone who does! However, by taking the time and trouble to buy someone a present that they really like, you are able to signal more effectively how you really feel about them. The signal can be particularly strong if the person buying the present really dislikes shopping. Just giving someone cash, or not taking the time to buy a present the person really likes, might signal that you simply could not be bothered to exert the effort because your feelings are not that strong. The potential consequences of giving your partner money are amusingly demonstrated in the following clip: The Economics of Seinfeld: What’s the right Gift to give; cash?
Perhaps giving presents instead of cash is an economically efficient way of dealing with situations where asymmetric information is potentially an important issue.
Articles
British households plan to spend £820 on Christmas YouGov (11/11/13)
Brits ‘to spend more on Christmas presents this year with average gift costing £28.70’ Daily Mirror (13/11/13)
Christmas shoppers hit the sales in biggest spending spree since the recession began Daily Express (15/12/13)
Bah, Humbug The Joy of Economics: Making Sense out of Life, Robert J. Stonebraker (22/05/13)
What many economists don’t understand about Christmas Quartz, Tim Fernholz (19/12/13)
The Economics of Gifts Greg Mankiw’s Blog (24/12/06)
The case against Christmas presents The Guardian (19/12/13)
Grinchonomics or how the Economist stole Christmas Economics in Plain English (16/12/10)
The true value of the 12 days of Christmas reveals giving cash may be the most cost-effective gift Perth Now, Jessica Irvine (21/12/13)
Questions
- Explain what is meant by the term ‘allocative efficiency’. Use a diagram to help illustrate and explain your answer.
- Draw an indifference curve diagram to illustrate the potential welfare costs of giving presents instead of cash.
- Assess whether giving someone a gift card is more economically efficient than giving them a present.
- Using a simple numerical example, explain how economic welfare could be higher if someone buys a present that the recipient was unaware of. What factors might you have to take into account when carrying out this economic analysis?
- Explain what is meant by the term ‘asymmetric information’. Provide a number of examples to help illustrate your answer.
- What properties must a signal have if it is to successfully overcome problems caused by asymmetric information?
A remarkable event took place in Venezuela on Friday 8th November. Soldiers, on the orders of the president, temporarily occupied a chain of shops run by a leading electrical retailer called Dakar. The shops were forced to cut the prices of their electrical appliances and five managers were arrested and accused of ‘hiking up’ prices.
Unsurprisingly, news of these lower prices spread very quickly and long queues rapidly appeared outside the stores as people hoped to buy plasma televisions, fridges and washing machines at bargain prices. On Sunday 9th November, the president, Nicolas Maduro, gave a televised address in which he condemned the owners of the stores and announced that he was going to ask the National Assembly to grant him extra powers so that he could extend price controls to all consumer goods. He stated that he would next turn his attention to stores selling toys, cars, textiles and shoes.
The use of price controls in Venezuela is not new and dates back to 2003 when they were first introduced by the then president Hugo Chavez. Initially the regulations were imposed on various foods and basic goods. For example, by 2009 maximum prices had been set for cooking oil, white rice, sugar, coffee, flour, margarine, pasta and cheese. Businesses often complained that the maximum prices set by the government were below the costs of production. For example after a maximum price of 2.15 Bolivares was placed on a kilo of rice, producers argued that the cost of producing a kilo of rice was 4.41 Bolivares.
The impact of the maximum prices in Venezuela appears to have been exactly what the theories in the economics textbooks would have predicted – shortages, long queues of people waiting outside shops and a flourishing black market. An article on the shortage of toilet rolls has been discussed in a previous article on this news site: Shortages in Venezuela- what’s the solution? However this has not stopped the Venezuelan government extending the scheme and increasing the number of products that have maximum prices imposed on them. In 2011 Hugo Chavez argued that the policy was required because:
The market has…become a perverse mechanism where big monopolies, the big trans-nationals and the bourgeoise dominate and ransack the people.
Economics textbooks often include some analysis of the impact of price ceilings on a competitive market. The effects on consumer surplus, producer surplus and deadweight welfare are usually discussed. However the potential administrative costs are rarely considered. The Venezuelan case helps to illustrate how in practise these costs could be quite significant.
For example, in April 2012 price controls in Venezuela were extended to a range of 19 products including fruit juice, toilet paper, nappies, soap, detergent, deodorant, toothpaste, baby food, floor polish, mineral water and razor blades. This caused a reduction in prices of between 4% and 25%. However this did not simply mean setting 19 different maximum prices because the goods were all sold in different quantities or different package sizes. For example a tube of toothpaste could be purchased in 4 different sizes – 50ml, 75ml, 100ml and 150 ml. Therefore officials had to set 4 different figures. Nappies were sold in 12 different package sizes ranging from10 nappies/packet to78 nappies/packet. Once again this meant that the administrators had to set 10 different maximum prices just for nappies. In total across the 19 products government officials had to set prices for 616 different individual items!! Companies were given just one month to adjust to the new legislation.
Whenever maximum prices are imposed on a competitive market both frustrated buyers and sellers have an incentive to evade them and trade illegally. Therefore the government established a number of organisations in an attempt to make sure the prices were enforced. One agency is called The National Superintendency of Fair Costs and Prices or Sundecop. Officials from this agency were sent out to 82 retail outlets in April 2012 to try to make sure that firms were sticking to the new regulated prices. They also printed and handed out leaflets to the public informing them of the changes. Another agency is called ‘The Institute for the Defense of People’s Access to Goods and Services’ or ‘Indepabis’. This organisation launched a new strategy in June 2012 in order to monitor compliance. This included the creation of a network called the Friends of Indepabis which would act as an information point for members of the public to report illegal pricing. A new complaints phone line was also introduced.
If president Maduro is granted the power to extend maximum prices to all consumer products, then one can only begin to imagine the extra administrative costs involved with implementing the policy.
Venezuelan president Maduro ‘to expand price controls’ BBC News (11/11/13)
Venezuela sends in troops to force electronics chain to charge ‘fair’ prices NBC News (13/11/13)
Venezuela appliances crackdown spurs uncertainty ABC news (13/11/13)
Venezuela’s government seizes electronic goods shops BBC News (9/11/13)
Venezuelan government sends TROOPS into electronics chain to force them to sell goods at a “fair price” DailyMirror (10/11/13)
Shocher: Price Controls Lead to Shortages in Venezuela Free Advice, Robert Murphy (2/10/13)
Venezuelan Government Action against Overpricing Welcomed by Citizens, Manipulated by Media venezuelanalysis (12/11/13).
Questions
- Explain why a maximum price imposed on a competitive market might generate a shortage. Draw a diagram to illustrate and explain your answer.
- Are there any circumstances when a maximum price would not cause a shortage in a competitive market?
- Analyse the impact of a maximum price on consumer surplus, producer surplus and deadweight welfare loss. Assume the market is competitive and clearly state any other assumptions you have made in your analysis. Comment on the impact of the price ceiling on economic efficiency.
- Illustrate and explain what would happen to consumer surplus and deadweight welfare loss if the available goods for sale were only purchased by the consumers with the lowest willingness to pay.
- Why might a maximum price lead to a flourishing black market?
- The former president, Hugo Chavez, argued that the price regulations were required because “big monopolies… ransack the people”. Using economic theory discuss this statement. Examine the impact of a maximum price on a pure monopoly.
Why are 43 companies in the pub and restaurant sector in the UK donating over a £1 million to an 86 year old Frenchman who claims to work a 70 hour week? Jacques Borel has led an interesting and varied life which has included activities such as helping the French resistance in the 2nd world war and opening the first take-away hamburger restaurant in France in 1961. In 2001 he started a campaign to get the European Union to allow member states to reduce the rate of VAT applied to food and drink sold in the pub, hotel and restaurant industry. Organisations such as JD Wetherspoon, Heineken and Pizza Hut are backing his attempts to persuade the UK government of the benefits of this policy.
VAT is paid when goods and services are purchased and is normally included in the price advertised by the seller. It generates a significant amount of money for the UK government and it is estimated that it will raise £102 billion in 2012-13 – the third biggest source of revenue after income tax and national insurance contributions. It is applied at three different rates in the UK – a standard rate of 20%, a reduced rate of 5% and a zero rate i.e. 0%. This may sound straightforward but in reality the tax is extremely complicated as previously discussed in articles on this website . For example most basic or staple items of food sold in shops are zero rated. However there are some rather bizarre exceptions. For example a packet of potato crisps is subject to the standard rate of VAT whereas tortilla chips are not. The standard rate is applied to a packet of Wotsits whereas a zero rate is applied to a packet of Skips!
The campaign headed by Mr Borel focuses on the discrepancy between the zero-rate applied to most food items purchased from a shop and the standard rate applied to food purchased in restaurants or cafes. For example, if you buy a Pizza from a supermarket then you don’t pay any tax on this purchase, whereas if you eat a pizza in a restaurant the standard 20% rate of VAT is applied. Mr Borel is lobbying the UK government to reduce the rate of VAT paid in pubs and restaurants from the standard rate of 20% to the reduced rate of 5%. One reason why so many UK companies are willing to offer him financial support is because of his success in getting governments in other countries such as Germany, Belgium, Finland and France to adopt this policy.
In a recent radio interview Mr Borel was asked to make his case for the proposed reduction of VAT in the UK. He claimed:
I have a commitment from 125 chains of hotels, restaurants and independents to use 60% of the reduction in VAT to lower prices so that would be a 7.5% decrease in price. When you decrease price by that magnitude you will see an increase in customers of 10-12% and you will be forced to hire new staff. In our best case scenario, we plan to create 670,000 jobs in three years.
When asked in another interview why the hospitality sector should be favoured more than others he replied that:
It would create more jobs in a minimal amount of time…you cannot do that with any other industry.
One obvious drawback of the policy would be the loss of revenue for the UK government. Some estimates have suggested that the loss of VAT receipts would be between £5.5 and £7.8 billion. However it has been claimed that over time the impact of the change on government finances would be zero. In response to the proposed tax cut a Treasury spokesman commented:
Any reduced rates would make a significant impact on revenue and, as a significant proportion of spending in these areas is by UK residents, any increase in activity in these areas would largely be at the expense of other consumer spending.
Webcast
Jacques Borel: VAT cut for pubs Morning Advertiser on YouTube (18/5/11)
Articles
Industry VAT campaigner Jacques Borel appears on Radio Four’s Today and Radio Five Propelinfo (24/4/13)
French veteran in fight to cut pub VAT Financial Times, Christopher Thompson (5/6/12)
The fiscal impact of reduced VAT rates VAT Club Jobs (22/4/13)
Pub and restaurant groups pay 86-year-old Frenchman £1m to convince UK government to cut VAT The Mail on Sunday, Sarah Bridge (20/4/13)
French veteran seeks British jobs boost with VAT Reuters (17/1/13)
Questions
- In his radio interview Jacques Borel claims that if firms pass on 60% of the cut in VAT this would cause a 7.5% reduction in prices. Explain why this is the case. Clearly outline any assumptions you have made in the analysis
- If 60% of the reduction was passed on by firms through lower prices, what do you think would happen to the money generated from the other 40% of the reduction?
- Using a demand and supply diagram illustrate the proposed reduction in the rate of VAT on the hospitality industry. Make sure your diagram is drawn in such a way that it clearly illustrates producers passing on 60% of the tax reduction in the form of lower prices.
- Assuming that the hospitality industry was very competitive, what impact would a reduction in VAT have on consumer surplus, producer surplus and deadweight welfare loss?
- Explain any assumptions you have in your answer to question 3 about the price elasticity of demand and supply.
- Using the figures provided in the radio interview is it possible to calculate the price elasticity of demand. Try making the calculation and clearly explain any assumptions you have made.
- Explain why the reduction in VAT might have no net effect on government finances in the long run?
- What factors determine the price elasticity of supply? What assumption is Mr Borel making about the price elasticity of supply in the hospitality industry compared to other industries when he makes the claim that jobs would be created quickly?
- Outline some of the arguments against cutting the rate of VAT.
Trade is generally argued to be good for economic growth, as it allows countries to specialise in those goods in which they have a comparative advantage and thus produce and consume more of all goods in total. However, trade inevitably leads to winners and losers, especially as countries impose tariffs on imports in order to protect domestic industries. This has been the case in the banana industry.
Banana growers in the former European colonies have long been protected by EU tariffs, helping to prevent competition from their Latin American banana growers. But, now things could be about to change. In December 2009, most of the nations concerned reached an agreement in Geneva for tariffs imposed by the EU to be gradually reduced.
The European Union had imposed no duty on bananas from their former colonies, but had imposed tariffs on banana imports from other countries. This meant that those countries now benefiting from zero import duty could sell their bananas for a much lower price, therefore restricting the other nations (who did have to pay an import duty) from competing effectively.
With the World Trade Organisation in attendance, an agreement was signed that puts an end to this trade dispute dating back over 2 decades. The Director General of the WTO, Pascal Lamy said:
‘This is a truly historic moment … After so many twists and turns, these complicated and politically contentious disputes can finally be put to bed. It has taken so long that quite a few people who worked on the cases, both in the Secretariat and in member governments have retired long ago.’
This trade war has been ongoing for many years and this agreement represents a big step in the right direction. With a fairer playing field in this banana market, countries in Latin America will now be much more able to compete with other nations. As economists argue that trade is good, a reduction in protectionist measures should be seen as a good thing and will benefit the countries concerned. The following articles consider this trade resolution.
Banana war ends after 20 years BBC News (8/11/12)
WTO: Historic signing ends 20 years of EU-Latin American banana disputes 4-Traders, WTO (8/11/12)
EU, Latin America nations mark end of ‘banana war’ Fox News (8/11/12)
Banana war ends after 20 years The Telegraph (9/11/12)
Infamous banana dispute ends Sky News (9/11/12)
Questions
- What is comparative advantage and how does it lead to gains from trade?
- How does a tariff help protect a country’s domestic industry?
- Using a diagram, illustrate the effect of a tariff being imposed on banana imports from Latin America. Is there a cost to society of such a policy?
- Now, show what happens when this tariff is removed by the EU. Who benefits and who loses?
- What is the role of the World Trade Organisation?
- How does a tariff affect a country’s ability to compete with other nations?
Russia and Kazakhstan have been discussing the formation of a trade agreement for some time and an agreement is now in place. From July 1 2010 a customs union between these two countries will be launched. Belarus has also been in talks with the Russian government, but as yet, it will not become a member, due to disputes with Russia. Belarus was hoping that the customs union would free it from export duties on oil, but this has not been the case. The gas dispute between Russia and Belarus has continued, although a meeting is taking place to try to resolve the issue.
President Alexander Lukashenko has said that Belarus will sign the Customs Unions documents if Russia cancels petroleum products duties now and oil duties from January 2011. He said:
“As a goodwill step, we propose removing customs barriers and customs duties on petroleum products now, and we will wait until the beginning of next year regarding oil duties; but the duties must be removed from January 1.”
Although the customs union between Russia, Kazakhstan and Belarus formally began on January 1 2010, it will not work fully until these disputes have been resolved. The following articles consider this agreement and the likely impact on the countries’ negotiations to join the WTO.
Russia, Kazakhstan agree customs union minus Belarus Reuters (28/5/10)
Russia hopeful of settling Belarus gas dispute Reuters (19/6/10)
Belarus to sign customs union documents, if Russia cancel oil duties RIA Novosti, (18/6/10)
Creation of customs union should not hinder Russia’s entering WTO RIA Novosti (17/6/10)
Kazakhstan ‘moving to re-instate Soviet Union’ with customs unions with Russia Telegraph, Richard Orange (11/6/10)
Russia, Kazakhstan launch customs union without Belarus AFP (28/5/10)
Questions
- What is a customs union? How does it differ from a common market and a monetary union, as we have in Europe?
- Russia wants to maintain its tariff on gas and oil supplies. Illustrate the effects of the imposition of a tariff. Does society gain?
- What are the arguments for and against retaining protectionist measures on trade with other nations?
- Assess the likely effects of the customs union on (a) the individual members and (b) other nations. Who do you think will benefit and lose the most?
- What will be the impact of the customs union and its disputes on the accession of these countries to the WTO.
- Is it a good idea for Russia, Kazakhstan and Belarus to join the WTO? What conditions have to be met?
Respondents to another survey, carried out by the hotel chain Travelodge, stated that on average they planned to buy presents for 12 people. This study also found that the average expected spend on each present was £28.70 – an increase of £1.70 on the previous year. A rather obvious question for anyone interested in economics is whether this is either a sensible or an efficient way of allocating resources. One way to think about how an economist might approach this issue is to ask yourself the following questions after you have opened a present on Christmas day.
the gifts they had received that Christmas. Unfortunately their willingness to pay for these same gifts was $313 on average. Economists would argue that this is an example of economic inefficiency because the recipients’ valuation of the gifts – as measured by their willingness to pay – was only 71.5% of the price paid by the person who gave them the presents. This means that it is possible to make the person who received the gift better off without making the person who purchased the gift any worse off. This argument can be illustrated with a simple example.
Do economists always advise people to give cash as presents? Thankfully the dismal science can find some positive things to say about giving gifts. The previous analysis can be criticised in a number of different ways. It assumes that the recipients are perfectly informed about all the potential gifts that are available. If the person buying the present can find an item that the recipient was unaware of, then it is possible that economic welfare might be increased. It has also been assumed that the pleasure or value people obtain from an item is not influenced by who has purchased it. It may be the case that people place a greater value on an item when it is a gift from somebody else. In the previous example, perhaps Sir Alex would value the Liverpool shirt at £60 if you had purchased it for him as a present. The analysis has also ignored the possibility that the person buying the present derives pleasure from trying to find a gift that they think the person would like. Perhaps people feel a ‘warm glow’ when they see the happiness of somebody opening their present on Christmas day. 
A final interesting economic explanation for buying presents is that they might act as an effective signal in a situation where there is asymmetric information. It can be argued that this is the case in relationships where people have private information about their true feelings towards one another. One way of communicating these feelings is by simply telling someone how you feel about them. However, this might not be an effective signal, as someone who does not have such strong feelings could say the same things as someone who does! However, by taking the time and trouble to buy someone a present that they really like, you are able to signal more effectively how you really feel about them. The signal can be particularly strong if the person buying the present really dislikes shopping. Just giving someone cash, or not taking the time to buy a present the person really likes, might signal that you simply could not be bothered to exert the effort because your feelings are not that strong. The potential consequences of giving your partner money are amusingly demonstrated in the following clip: The Economics of Seinfeld: What’s the right Gift to give; cash? 
