Friday, 12 July 2013

Reference points and Edgeworth Boxes: A tourist's gains from trade

We have just got back from the PET13 conference in Lisbon. On the day of our arrival in Lisbon we were tired and hungry and desperately seeking food. A stroll in the vicinity of the hotel finally revealed a local corner shop selling fruit and essentials, and we were saved. We were also pleasantly surprised by the price. Our expectation was to pay a lot, because we'd bought a lot and because the shop owner was presumably going to rip off the unknowing tourist. It was pleasant surprise, therefore, when the bill came in well below our expectations. 
      In all likelihood the shop owner did add a bit of 'unknowing tourist profit' to the price. But who cares? We, as customers, were very happy to pay the price we did. And the shop owner was presumably happy to charge the price he did. Everyone is a winner. Indeed, this is a textbook story of exchange - a buyer and seller exchange goods for mutual benefit. From a textbook point of view, the really curious thing about this exchange is why it felt so unusual. Any exchange is supposed to be about mutual benefit, but I rarely feel so happy about the price I have to pay in my local supermarket. So, what is the difference between buying goods as a tourist and buying from the local supermarket? 
       On reflection, the answer seems to be about expectations and reference points. To explain, let's start with a bit of textbook basics. The figure below shows an Edgeworth Box diagram. This is the classic way used to illustrate the gains from exchange. From the bottom left upwards we represent the outcome for myself and from the top right downwards we represent the outcome for the shop owner. The initial point is given by the red endowment point. I have no apples and some cash and have a utility of 1. The shop owner has lots of apples and some cash and also has a utility of 1. 
      Can we gain from trade? Yes. The purple 'Edward U = 1' line plots all the outcomes as good as the endowment point from my perspective. Anything above this is a gain for me. The brown 'Owner U = 1' line plots all the outcomes as good as the endowment point from the owner's perspective. Anything below this is a gain for him. If, therefore, I give up some cash for some apples both myself and the owner can gain. Ultimately we can trade to the point where we both have a utility of 2. This representation of exchange perfectly fits our experience in the shop in Lisbon. We bought some apples, and everyone gained.

       Why are things different when I go to the local supermarket? It's tempting to say that its because the price is different, the supermarket has monopoly power etc. But that cannot be the difference. The exchange that takes place at a supermarket is still supposed to fit the story above. I gain from buying apples, and the supermarket gains from selling the apples. My utility still goes from 1 to 2.
    The difference that I experience in the supermarket reflects my expectations. Given that I go to the supermarket every week I take it as given that my utility will be 2 and not 1. Put another way, my 'psychological endowment point' is to have already bought the apples. So, buying the apples doesn't make me feel all that happy. It's just that not buying the apples would make me feel unhappy. On holiday things are different. It's an unfamiliar city and expectations are much less refined. This means that my 'psychological endowment point' is the same as my actual endowment point. I do not take it for granted that I will be able to buy apples at a reasonable price. So, when we did find apples at a reasonable price it felt like a gain. I felt the gain in utility.
        This way of looking at things highlights the important of reference points and expectations. And, it yields a somewhat depressing conclusion: In our routine everyday life it is very difficult to feel pleasure because our expectations are too refined. Buying stuff from my local supermarket, for instance, does not feel as pleasurable as the textbook says it should because I psychologically take as given that it will be done. I can only get pleasure if something unexpected happens such as everything in the shop being half price. But, that doesn't usually happen! So, we are trapped in a world where pleasure is difficult to come by. This is possibly one big reason why buying experience goods (like going on holiday, going for a walk, or going to watch a football match) is known to give more lasting happiness than buying consumption goods (like a car, or the weekly shop). Experience goods are more likely to be surprising.


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