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Present-Maximising Advice For Young Economists

Christmas is a time for family, food and – of course – presents. But rumour has it that the best presents only go to the “nice” kids, with “naughty” ones finding nothing more than a lump of coal under the Christmas tree. Fortunately for them, Frontier is at hand. Our stock-in(g)-trade is applying economics – sometimes in unusual ways – to help clients put forward their best case to stakeholders and policymakers. So this year, we thought we’d try to help your children turn their regulatory regime from threat to opportunity. Leave this bulletin on the kitchen table at your peril.

He’s making a list, Checking it twice; Gonna find out who’s naughty or nice…” The tune may be jolly, but the message is much less jovial: only kids who meet a certain – unspecified – level of “niceness” can expect to get Christmas presents. Bad behaviour will receive a frosty reception in winter wonderland. Be good or Yule be sorry.

Will parents do as they say? Or can you work on the premise that it’s all a big bluff?

Santa, Scrooge and the Grinch – it sounds as if they’re all in it together, running a regulatory regime with high performance hurdles for Christmas present pay-outs. But will parents do as they say? Or can you work on the premise that it’s all a big bluff? After all, no self-respecting child wants to munch greens or do the washing-up unnecessarily.

Until recently, the answers to these questions were as shrouded in mystery as the location of Santa’s toy factory. But a recent survey – carried out for Walmart by market research firm GfK – has finally thrown up the data that enables Frontier to bring rigour to the debate¹. This survey, in which over a thousand children and parents were quizzed on a wide range of Christmas issues, indicated that 78% of parents would buy their little treasures the same presents, however bad their behaviour. Not surprising, perhaps, when – as any public policy economist will tell you – children’s happiness at Christmas has a positive externality for their parents. (Who wants to spend Christmas with Mr Grumpy?). However – as ever – we try to help our clients reach evidence-based conclusions.

78% - Percentage of parents would buy their little treasures the same presents, however bad their behaviour.

And the evidence from this survey is that our junior client base still faces the 22% risk of a sanctions regime. So how can you mitigate this? Here’s the good news: economics has some useful tricks up its Christmas stocking.

GAMES PARENTS PLAY

The biggest danger you face is benchmarking.

Let’s assume that your parents are in this tiresome performance-measuring 22% minority. How will they go about it? The biggest danger you face is benchmarking.

You may think it’s bad enough having a goody two-shoes for a brother or sister, but – to make things worse – your parents may use your sibling as a measuring-stick for your own behaviour. And, if your parents have a fixed budget constraint for Christmas presents (a fair bet in these troubled times), your sibling’s angelic behaviour may directly result in you losing out.

This creates what economists call a Prisoner’s Dilemma – a pernicious situation in which you and your sibling both have an incentive to behave well, even though you would collectively be better off if you both behaved badly. The diagram in Figure 1 illustrates the dilemma.

In this illustration, we assume that parents have 20 points’ worth of presents to award to their two children. The parents declare that they will give all the presents to the child who keeps the cleanest bedroom, or split the presents evenly between them if they are equally tidy.

Two equally mucky rooms, and each child gets a 10-point present. Two spotless rooms will also guarantee each child a share of the presents. However this will also cost them 5 points’ worth of effort, reducing the net gain for each to only 5 points – who wants to be putting things in boxes when they could be playing computer games or watching TV?

 Source: Frontier Economics

So, as Figure 1 shows, any sensible pair of siblings would prefer an outcome where they can both stay untidy (the bottom-right box) to an outcome where they both have spotless bedrooms (top left). However, this comfortably messy outcome is also unstable: if Alex is bound to be scruffy, Stephanie has every incentive to start hoovering. That way she gets all the presents for just 5 points of effort. And if Alex spots this, he then needs to start clearing up to salvage his hopes of something under the tree. Both children will end up scrubbing their rooms clean, even though they are both worse off as a result.

...if Alex is bound to be scruffy, Stephanie has every incentive to start hoovering.

A win for your parents? Hang on: experimental game theory suggests a way out of your dilemma. Alex should make it clear to Stephanie that if she so much as picks up a sweet paper, he will retaliate with a similarly sycophantic act of cleanliness. This threat, if executed with discipline, should keep Stephanie in line, thereby allowing both to collude by behaving equally badly (all this puts a new spin on the phrase “one good turn deserves another”). The more siblings you have, however, the trickier it becomes to co-ordinate this strategy, given the powerful incentives to “cheat” your way to a present with a sneaky clear-up.

Insights from psychology add richness to textbook economics, like cranberry sauce on a good turkey roast. In recent years, big advances have been made in understanding how our supposedly rational choices are “nudged” by other influences. This research offers some handy hints to kids willing to show a bit of Christmas cunning. Key influences on parents’ behaviour to be aware of include:

SORTING OUT SANTA

Be wary of New Year resolutions to drop bad habits: chances are that December stress and mulled wine will wipe these commitments out of your parents’ memories.

Finally, don’t make things worse for yourself. Beware of making exaggerated claims for your behaviour under cross-examination in Santa’s Grotto. Many a company has got into trouble misleading the regulator. And even the soppiest parent may be provoked by hearing you give an unwisely positive response to Santa’s probing question as to whether you’ve been an awfully good boy all year. Claim shyness and don’t answer.

Take the same cautious approach to forward commitments. If forced to sing “Once in Royal David’s City” at the school carol concert, hum through the lines that would otherwise sign you up to the proposition that “Christian children all must be, Mild, obedient, good as he”. Be wary of New Year resolutions to drop bad habits: chances are that December stress and mulled wine will wipe these commitments out of your parents’ memories, but why take the risk of disappointing them? (One experienced seven-year-old reports that when pressed by his family to say what he was prepared to give up, he simply said he was giving up listening.)

Above all, encourage your parents not to expect too much – however unfashionable rational expectations theory has become. The more realistic your parents’ expectations, the less of a failure they’ll feel, the less they’ll bug you – and the happier a Christmas you’ll all enjoy. Which, of course, along with a great New Year, is what we at Frontier want to wish all our clients, senior and junior, past, present – and future.

¹Walmart Talking Holiday Toys Survey, 2012

At the 9th Ministerial Conference in Bali, the World Trade Organisation (WTO) agreed on new rules to simplify customs procedures and facilitate trade. It also agreed certain issues relating to trade in agriculture and matters of interest to the WTO’s poorest member countries.

The main focus has been the Agreement on Trade Facilitation, which represents the most significant extension in multilateral trade rules in 15 years. The implementation of these new rules, coupled with investments in improving customs administration, is expected to generate a significant boost to global trade. Research indicates that every dollar spent on improving the regulatory regime affecting trade in the WTO’s poorer countries can increase trade by nearly $700 in these countries.

The benefits of rules on trade facilitation reflect the fact that as traditional obstacles to trade – such as tariffs and other border measures – have decreased, red tape and administrative inefficiencies have become major impediments. This is especially important in a world in which globalised supply chains have become the main driver of trade; around 60% of global trade involves intermediate products, and 30% of world trade involves transactions between affiliates of the same multinational corporation.

Frontier (Australia) works with clients on a broad range of trade policy and related matters. This includes modelling trade policy measures, advising on trade negotiations, trade facilitation and customs reforms, litigation, and transport logistics.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

The Australian Energy Market Operator (AEMO) today released the 2014 National Electricity Forecasting Report (NEFR) Action Plan. The plan outlines actions to address all of the main findings and recommendations from the independent peer review by Frontier (Australia) of the 2013 NEFR, as well as additional improvements identified by AEMO's internal review.

Frontier’s independent review focused on the methodological issues involved in the selection, development and implementation of the econometric and statistical models for forecasting energy consumption and maximum demand. Frontier recommended specific improvements to assist AEMO’s ongoing commitment to enhancing its forecasting methodology and transparency.

Frontier (Australia) regularly advises public and private clients on forecasting methodologies requiring advanced econometric and statistical techniques.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

Frontier (Australia) today announces the promotion of James Allan to Director.

James joined Frontier in 2004 and leads the market modelling practice of the firm. He has advised policy makers, regulators and industry on all aspects of energy markets in Australia and Asia and also advised on issues in water, competition, telecoms and industrial processing. Predominantly, James's work involves the analysis of utility markets using and enhancing Frontier’s suite of utility market models, including WHIRLYGIG, WHIRLYGAS, SPARK, STRIKE and SPLASH. More recently, James has been involved with the development of new optimisation models and integrated economic modelling systems for the firm's clients.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

How The Unconscious Mind Affects Purchase Decisions

Most people have bought products on an impulse that they did not need – the new gadgets in the kitchen cupboards, the exercise equipment in the garage or the unworn clothes in the wardrobe. Often it is easy to see why a product does not get used, but why do people buy these things in the first place? In this email we explore five ways in which the unconscious mind can trigger unwanted purchases.

The unconscious mind affects the behaviour of consumers: under the influence of basic evolutionary drives and the marketing tactics that play on them, it’s easy to feel compelled to buy something that later does not get used. People do not tend to remember their bad purchase decisions. Like a gambler who only remembers the wins, the feel-good buzz that comes from spontaneously buying something that turns out to be a great buy leaves a much greater impression in people’s memories than the product that was bought in the same way but never used.

So what’s going on inside consumers’ heads when they buy on impulse?

1) LOVING SHOPPING

The simplest explanation is that some people just derive an enormous amount of pleasure – or utility  – from acquiring something new. And since consumers not only pay for the product, but also for the pleasure they experience from the purchase, an economist could argue that it is still worth its price – even if it never gets used. But why do people value new things more highly in the first place? The explanation could be traced back to consumers’ childhoods. Children are often conditioned by their parents to feel good about something new being handed to them. Looking back a couple of generations ago makes clear why this was an understandable sentiment. But if consumers indulge themselves (or their children) too often, novelty becomes the goal and potentially more important than the actual value of the product.

If consumers indulge themselves (or their children) too often, novelty becomes the goal.

2) THE LOSS AVERSION SWITCH

Buying a product on discount rather than for its full price makes obvious economic sense. However, discounts only save consumers money if they would have bought the product anyway.

Retailers have learned that consumers are very susceptible to the loss aversion switch – the innate concern to avoid feeling bad in the future. A discount that won’t last forever switches the unconscious focus to the fear of missing out on a deal. It may feel like saving money but consumers often fail to see that the discount was the reason that made them buy the product in the first place

3) TWISTED HEURISTICS

Consumers do not have the time or means to make their purchase decisions in an economically rational way. They would need to cross-reference every product with every other product available in the market on price, product composition, reviews and maybe even the quality of customer service supporting it. Even if all the information was available in comparable formats it would take hours to buy even a cup of coffee.

People use heuristics – unconsciously held rules of thumb – that help make quick decisions.

So instead people use heuristics – unconsciously held rules of thumb – that help make quick decisions that generally work out well. Consumers may have learned that bigger packages are generally better value than smaller ones – and trust this heuristic rather than compare prices. Retailers can play on these heuristics by packaging up products as bulk buys, or including ‘free’ extras. Heuristics tell the consumer that these deals must be good value, and so they go with their feeling rather than researching any further.

4) THE DESIRE TO SAVE

A susceptibility to ‘value’ and apparent discounts isn’t just down to the loss aversion switch; many people have an innate desire to save. Marketing messages often focus on how much money consumers could save by buying and using a product. Thousands of years ago, knowing that it was important to store up food and wood for the winter would be the difference between life and death. These days, most people in this part of the world no longer need to worry about their day-to-day survival, but the evolutionary drive remains.

While saving can be the economically rational thing to do if the discounted future value of money or time is higher than today’s value, the strong psychological drive to save can cause consumers to react to the idea of saving even if it is not beneficial to them.

5) ROSE-TINTED LENSES

Finally, we have a psychological bias towards optimism. Most people believe themselves to be better than average looking, better than average drivers, better than average parents… Clearly, they can’t all be right.

... they may think they will start to exercise if they buy that new Ab-Toner.

Rather than look back and evaluate past actions, people tend to look to the future with an idealised view of what it might be like. They may think they will start to exercise if they buy that new Ab-Toner and start cooking grand dinners if they buy the latest kitchen gadget. In reality, they are likely to be deluding themselves.

Ultimately, there is little doubt that retailers can take advantage of the role the unconscious mind plays in shaping our behaviour. However, if consumers come to learn that they are being taken advantage of in an unfair way, the risk is that a new heuristic is formed… “Don’t trust retailer X”.

On 30 August the Australian Energy Regulator (AER) released its Draft Rate of Return Guidelines. The AER is responsible for setting the regulated tariffs charged by gas and electricity networks in eastern and southern Australia.

A key element in the process of setting regulated tariffs is the determination of the rate of return that the networks are allowed to earn on their regulated assets. In December 2012, following recent changes to Australia’s electricity and gas rules, the AER launched its Better Regulation programme, which is designed to improve the AER’s approach to regulation. As part of the programme, the AER will publish guidelines on its approach to determining the rate of return for energy networks in mid December 2013. The AER has invited interested parties to comment on the Draft Rate of Return Guidelines by 11 October.

Frontier Economics (Australia) advised the AER on certain aspects of its Draft Rate of Return Guidelines.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

The Australian Competition and Consumer Commission (ACCC) today announced it would allow Woolworths to acquire three Supa IGA supermarkets in Queensland. The ACCC concluded that this acquisition would not lessen competition in either the local or statewide markets.

Frontier (Australia) advised lawyers for Woolworths in their submissions to the ACCC on this matter.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or Richard York at richard.york@frontier-economics.com.au, or call on +61 (0)3 9620 4488.

Why The Carbon Price Will Have A Limited Impact In Reducing Electricity Emissions

The Australian Government’s recently announced carbon pricing scheme – based on a cap and trade system – has divided the main political parties and the community. The looming federal election (scheduled for 7 September 2013) will again be largely fought over which party has the best policy for meeting Australia’s 2020 greenhouse gas reduction target (which has bipartisan political support for 5% reductions below 2000 levels).

Much of the policy debate in Australia has supported a cap and trade scheme – seen as necessary (and some believe sufficient) to achieve Australia’s emission reductions target.

The debate needs to consider the likely effectiveness of the Australian Government’s carbon pricing scheme in terms of its contribution towards reducing greenhouse gas emissions given current policy and market settings. This paper examines this issue, particularly in light of changed market and policy conditions.DOWNLOAD FULL PUBLICATION

The Australian carbon pricing scheme, based on a cap and trade system, has divided the main political parties and the community. Australia has a target to reduce greenhouse gas emissions by five per cent below 2000 levels by 2020. But the parties are divided on the best policy to achieve this target. The issue will have a high profile in the run up to the federal election which takes place next month.

This paper from Frontier (Australia) examines some facts around the likely effectiveness of the Australian Government’s carbon pricing scheme, in terms of its contribution towards reducing greenhouse gas emissions. Frontier finds that the Australian Government’s carbon price is likely to result in only a small reduction in electricity sector greenhouse gas emissions, and considerably less than expected in 2011.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

Federal Government Claims Carbon Price Success

On 8 May 2013 the then Minister for Climate Change, the Hon Greg Combet declared that “…. the carbon price mechanism that the Government has implemented is working. It is doing what it was intended to do and that is to cut our greenhouse gas emissions. In fact, the data from the independent agencies demonstrates that emissions in the National Electricity Market fell by 7.7 per cent in the first nine months of carbon pricing”.DOWNLOAD FULL PUBLICATION

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