For those who don’t like video and just want to read the text, it can be found below.

[Gulnara]

On a recent trip to my beautician – link to her website below – I started negotiating the price of my visit. However, I quickly caught myself doing so and stopped. She understood where I was coming from, as she is also from the former Soviet Union, where such haggling is a normal part of daily life. But that isn’t the case in a country like New Zealand – which is why we both put a stop to it.

So why is haggling culture so different in different countries, and what are the economic consequences of this?

[Matt]

That is really interesting Gulnara. Such bargaining does depend on the expectations of consumers and producers – so bargaining cultures will tend to support individuals bargaining while societies that do not do that will make it costly.

This strategic complementarity implies that both societies with bargaining and those without are “equilibrium” outcomes – where people’s incentive is to do what everyone else is doing. We call these bargaining and non-bargaining equilibrium “states of the world”.

To evaluate these outcomes, we want to think more deeply about price setting and market structure within each of these states. Then we can posit ways to test this with data, and also think about how differences in the data between countries may be due to the acceptance of bargaining.

The two mechanisms we will focus on here are price discrimation and tacit collusion and price discovery.

Price discrimination

Retail stores tend to be monopolistically competitive – especially at the stage where you have already turned up at the store ready to purchase. 

When you are at a store and ready to purchase you have three options:  Don’t purchase, purchase at the ticket price, and haggling.  In the face of haggling the store has its own incentive to haggle back – or to tell you to get bent.

The willingness to haggle on both the customer’s and the firm’s behalf depends on whether it is something they expect other people to do – it feels pretty stink to go and haggle just for the other person, and other customers, to look down their nose at you. However, this is more than just some concern about underlying social judgment – the act of haggling is something the firm would like to be prepared for, and the act of undertaking haggling puts pressure on these other customers to take on the cost of haggling themselves.

This can all be articulated through the concept of price discrimination.

Price discrimination is an interesting issue. A big reason why we viscerally feel uncomfortable with it is because it is discrimination – two people are being charged a different amount for exactly the same product!  This seems fundamentally unfair.

In this haggling case, such discrimination doesn’t work by having a price and marking it up for some and down for others.  Firms, in the face of bargaining, will increase the ticket price relative to a situation without bargaining.  This will make it necessary for customers to negotiate simply to receive the price they would receive in the absence of such bargaining. 

As a result, if you are not equipped to bargain, you end up paying higher prices – and if you aren’t able to negotiate much, this may be due to it being costly for you to negotiate, making the “real price” paid high.

However, there are those that benefit. Customers that are able to buy who wouldn’t have been able to at the non-price discrimination price, those with a low willingness to pay (or low cost for bargaining) will experience lower prices, and the business is able to increase their profits. Overall it might be more economically efficient, depending on how costly haggling is to individuals, but there may be distributional concerns.

If the industry is fully monopolistically competitive, low entry barriers will see the increase in business profits evaporate – so the increase in sales will lead to an increase in benefits to consumers on average, although at the cost of customers who have a high willingness to pay/low willingness to bargain. Furthermore, such entry may lead to excessive product variety as noted in Li and Shuai (2019) Monopolistic competition, price discrimination and welfare – ScienceDirect.

The mixture of price discrimination and search costs doesn’t just hold in the abstract. Bryne, Martin, and Nah (2019) (negotiation_v18.pdf (nyu.edu)) is a recent example of a field experiment testing out this behaviour and its implications. However, these implications and what we think about them does depend on the reason why “willingness to pay” is high and why “search costs” or “the cost of bargaining” may be high.

If it was just on the basis of individuals initial income, this may be quite redistributive – increasing provision of the product  and the welfare of low income individuals.  However, if it was due to the necessity of provision to meet minimum standards (i.e. health care expenses) such bargaining may be quite regressive.

Gulnara, you’ve actually experienced life with bargaining and life without – why don’t you tell us your thoughts.

[Gulnara]

Thanks Matt.

When I was a teenager I was still getting used to being able to shop for myself. At the time I didn’t really understand haggling, and as a result I found it quite exhausting. 

I specifically remember going and purchasing sunglasses from a store in Baku, that I thought looked very cool. 

I went home with them, and my mom asked me how much they cost – I told her and she inquired whether I had managed to get a discount.  When I told her I just paid the ticket price, she laughed and took me back to the store, haggling with them for a discount to be paid back to me. The point of the lesson was to indicate that even if you were willing to pay for a given product, prices had been inflated – and so bargaining was expected.

As I got older, bargaining was active in certain situations – and it became more natural and less costly for me.  Haggling with doctors for medical treatment and check-ups was extremely common, and once I left Azerbaijan to study in Italy, there were constant situations where bargaining was necessary – and expected – to live on my limited student budget.

Tacit collusion and price discovery

[Gulnara]

Now I’d like to change tack a little bit. Although bargaining may be a tool for price discrimination, it also influences the nature of competition in the market.

We recently talked about tacit collusion when chatting about Nurofen prices. Furthermore, an understanding of tacit collusion helps us to understand economic cycles and the recent discussion about price freezes – something we’ve blogged on.

What does this have to do with tacit collusion?  Well when comparing the Rotemberg and Saloner model to the Green and Porter model we noted that a major issue was that of “information”.  Can a firm tell whether their competitors are to blame for changing prices?

If, instead of monopolistic competition, we had firms that were oligopolistic then these strategic interactions become important for the general level of price setting.

Having bargaining, offers an “unobservable” way to cut or increase prices. As a result, your firm’s competitors may be able to observe the ticket price on what you sell – but they cannot observe the full complexity of how you will discount to attract customers.

This view of collusion and bargaining implies two things.

Firstly, with less information about the price set by the other firm, the Green and Porter model – where there are price wars in low demand states – becomes a more believable representation of price setting.  As a result, pricing dynamics over the economic cycle may look quite different in countries with significant consumer bargaining.

Secondly, as it is harder to observe the other businesses’ prices and build up trust for collusion,  it is more difficult for firms to collude!  In countries where bargaining does not occur, firms can loudly commit to a certain level of prices, and thereby find ways to tacitly collude and keep prices higher.  

As a result, profit margins and prices would be higher in countries where bargaining is culturally uncomfortable – countries like New Zealand, Australia, and the United Kingdom.  These example countries are fairly well known for being “expensive” to live in – so consumer bargaining may be one possible explanation.  However, this is an issue we are going to discuss more deeply another time.

Conclusion

To sum up, with price discrimation and tacit collusion, we’ve outlined two of the possible mechanisms that may differentiate market outcomes in countries with active market bargaining and those without.  Both of these arguments appeared to show bargaining in a favourable light – however, they also did point to trade-offs that may reverse this, namely the cost of bargaining, the proliferation of excess product variety, and broader related distributional consequences.

However, there are other possible arguments that can come to mind.  If you have some alternatives of your own, why don’t you pop them down in the comments for us all to discuss!

Thanks for watching and we’ll see you next time.

For those who aren’t keen on listening to videos, I’ve popped the transcript just below

Cheaper medication in winter

[Gulnara]

I’ve been doing a bit of online shopping.  As part of this, I’ve been struggling to figure out what I should stock up on before the next COVID variant hits.

When looking at the price of Nurofen I noticed that there were only a few specials among the varying brands, and the overall discounts were quite small compared to the deals I’m used to seeing during winter.  

[Matt]

Good point Gulnara, this is an observation I’ve made in the past, implying that this isn’t just due to current circumstances.

However, this feels a bit weird – why would cold and flu medication be cheaper in winter than it is in summer? Let’s formalise why this feels weird, and then see if we can provide an explanation.

Demand and price

[Matt]

To formalise our intuition – and start trying to work out why the observed data looks so different – it is useful to build a model. And the best model to start with is our friend supply and demand.

In our discussion of income and price effects we mentioned the idea of a demand curve. 

[Show prezi]

This demand curve tells us that quantity that will be demanded by consumers at different prices.  

Here we are looking at the market demand curve for cold and flu medication.  As we move down and to the right of the demand curve, additional consumers become willing to buy a product – or existing consumers are willing to buy more.  At each price that additional purchase refers to our marginal customer.

Start with the situation where no provider of cold and flu medication is large enough to influence the price with its decision to produce.  In that case we get a market supply curve that represents the marginal cost of production of cold and flu medication.

This marginal cost is shown as increasing in the quantity supplied – why?  Well the more that is sold, the more storage and shelf space is required, the more need their may be for staff to work overtime, and the more risk there is that the machines creating and packing the medication will break down.  The more “scalable” the process is the flatter this curve is likely to be – but the limitations of storage and shelf-space – what are called capacity constraints – point to an increasing opportunity cost from selling more, which makes this type of curve believable.

As it is a competitive market, the price is set where marginal cost equals the price the marginal customer is willing to pay, which is where the supply and demand curves intersect.  Even if competition breaks down somewhat (i.e. monopoly or monopolistic competition) the argument given here still holds – so it isn’t too extreme an assumption.

Cool, so what?

Well we want to think about what “summer” and “winter” are here?  Imagine a world where you only buy cold and flu medication when you are sick – this would be the same world I live in.  Well, I tend to get a cold or flu much more often in winter than summer.

As a result, at a given price I would buy more cold and flu medication in winter than in summer.  We can represent that with a demand curve that shifts to the right in winter.

The names for this are “high demand” and “low demand” states – where winter is a high demand state and summer is a low demand state.  A high demand state leads to the demand curve shifting right – as for a given price the quantity demanded is higher.

Now here the new market price will be higher due to the demand curve shifting right.  This matches our intuition, but not our data!

Gulnara, what is going on?

[Gulnara]

Good question Matt.  To my mind there are six different arguments against this logic.  Let me tell you about five of them, and save the last one as a treat for later.

Firstly, COVID has changed things – and so even though it is summer perhaps it is a high demand time.  

Secondly, perhaps cold and flu medication is a durable good so prices do not change much over the year as lower prices eat into future demand.  

Thirdly, we may have confused average and marginal benefit in this discussion – it may be that the willingness to pay of the marginal consumer is higher in summer than in winter, perhaps because the weather is better so people want to push away the symptoms in order to enjoy the outdoors.  More broadly, summer time customers may be “less sensitive” to price than winter customers.

Fourth (and related to the third), as demand for medication is higher in winter, supermarkets may use it as a loss-leader to attract customers to buy other products. 

Finally, such products are produced at scale and so the average cost of production is higher during summer.

Each of these five arguments are good, but have a fatal flaw.

The first of these arguments may be true of this year, but as this is an observation Matt’s made repeatedly over his long life, I don’t think it quite covers this.

The second argument would make sense if the price never changes. And the ticket price itself is fixed for these products, so that sounds good.  However, it appears that the discount price is lower in winter than in summer.

[show prezi 2]

The third argument is neat, and when combined with imperfect competition it is very compelling, but from personal introspection I don’t know if I’m convinced. Irrespective of the weather I have a given sickness threshold where I will have medication.  This may well be part of the pricing behaviour, but we’re going to move on and look for something else for now.

The fourth argument is quite attractive in some sense, but there is something unintuitive about imagining supermarkets cutting prices when demand for things are high in order to try to sell other products – there needs to be something else here, either about the elasticity of demand as discussed above, the cross-elasticity of demand, or with regards to competition as we will touch on below.

The final argument sounds compelling, however the focus on average cost is misleading.  The “costs of scale” are fixed costs that must be met irrespective of the amount produced, and as a result it is the marginal cost in the short term – which will either be flat or rising with output – that should determine price.

Getting a bit fancier

[Matt]

Moving away from pure ECON101 we might also note that there isn’t necessarily a competitive provision of cold and flu medication in New Zealand. We only have two supermarket chains which face weak competition from pharmacies for these products due to halo effects.  

Halo effects are the idea that if a firm is offering one product people are willing to buy, then people will be more willing to buy other products there – either due to decreased costs of searching as things are all in one place, or because people trust this business to provide a good product.

Supermarkets bundle a lot of goods and services together and so these halo effects are important for understanding the pricing behaviour of these types of firms.

Furthermore, we can look further up the supply chain in New Zealand to see there are a limited number of cold and flu medication brands on the market – as a result, even if supermarkets were competitive, there may be market power in the provision of these products to supermarkets which would lead to changes in the final price to consumers.

Green and Porter 1984 indicates what we may intuitively expect when an oligopoly exists in a market.  

If the firms in the industry follow their own incentives to maximise profit they will compete and drive down the price – leading to all of the firms achieving lower profits.  This is a traditional prisoner’s dilemma.

[Prezi 3]

As a result, if the firms could collude to keep prices higher and act “like a monopoly” they could all be better off – since a monopoly sets prices in the market at the point that maximises industry profit.

The tension here is that each individual firm has an incentive to undercut their competitor a little bit, as the lower price allows them to steal some customers from their competitor and thereby increase their own profits – albeit at the cost of the profits of their competitor.

The question here is how might collusion breakdown if demand conditions change?

Green and Porter 1984 take a situation where the firms are colluding in a high demand state, and then the economy switches to a low demand state – for example the movement from winter to summer.  

[Prezi 4]

If an individual firm sees demand for their product drop there could be two drivers:  Firstly, general demand for the product may have declined.  Secondly, their competitor may have betrayed them and cut prices – thereby stealing some of the individual firm’s demand!

If the firm is uncertain about what the cause of the drop in demand is, then they believe that there is some chance they have been betrayed.  In order to signal that they will “punish firms that renege on the collusive agreement”, our firm will have the incentive to cut prices.

The willingness to increasingly compete in low demand states is needed to ensure that collusion is maintained in the high demand states – by showing to everyone else that the business is serious about punishing firms that defect.

So our intuition and these models all indicate that cold and flu medication prices should fall in summer and rise in winter – which is the opposite of the result we find.  So, Gulnara help me out here – why could this be?

Information

[Gulnara]

This brings us to our sixth argument – tacit collusion and the temptation to cut prices.

Winter and summer are known quantities – we have them in our calendar, and although we don’t know the weather perfectly we have a good idea of what we will be doing during both.

In this way, a large portion of the difference in demand between seasons will be known.  Furthermore, the actual price set by the other firm is observed – it is on the same supermarket shelf, on the website, and in the flyer!  So it would be perfectly observable if competitors were cheating.

When the oligopolists have knowledge of what the other is up to, we get quite a different problem.  Something that Rotemberg and Saloner 1986 discuss.

In this model a high demand state increases the “temptation” to betray your competitors to try to steal the entire market.  Because of this, it becomes difficult to sustain collusion and collusive agreements will break down.

In our example this means that, during winter, there is a surge in demand for purchasing cold and flu medication.  If our medication providers were able to maintain collusion, they would experience a big increase in profits, but the expected benefit from cutting prices (whether your competitor does or not) is now much higher.  As a result, they cut prices and we get some sweet discounts.

Now you might say this sounds dumb – just don’t cut prices!  But the key thing here is that all of the firms are responding to the change in demand conditions – not each other’s actions.  If one firm does not cut prices, it is attractive for the other firm to cut prices.  If that firm did cut prices, it is still the best response of other firms to cut their prices.  Cutting prices is a dominant strategy!

In the oligopolistic setting all firms have this incentive when colluding – however, it is how the “benefit to defecting” compares to the “benefit of maintaining collusion” when a high demand state occurs that drives the result.  Essentially, the arrival of the high demand state has increased the benefit to defecting while keeping the benefit of maintaining collusion (which are expected future profits) unchanged.

Although this sounds like a good explanation it has one issue – the high demand state is supposed to be unanticipated (as demand is modelled as a stochastic process). However, winter and summer are known!

Why does this matter?  If the timing of the high demand state was known, and the oligopolists knew defection would occur in the high demand state, then there would be an incentive to deviate prior to this – changing the timing related to prices, and potentially unravelling collusion overall.

To rescue this model we would need to ask if there is some uncertainty about demand – and there is. The cold and flu season starts, ends, and peaks at different dates each year:  Flu Season | CDC – here medication sellers will know when the high demand state has started, but there is some uncertainty about when it will start before the fact.

We’ve only noticed the strongly discounted prices when I’ve had a cold, which has been once this season has kicked off – as a result, it could be this form of “high competition during high demand states” that is driving the surprising result of lower prices for cold and flu medication in winter.

Conclusion

[Matt]

Although ECON101 supply and demand are powerful tools – they don’t tell us everything.  The counterintuitive behaviour of prices tells us that sometimes we need to dig a bit deeper to understand what is going on – in terms of the cost of production, market structure, and structure of consumer demand.

Contrary to a lot of what you read on the internet, supply and demand is useful and powerful – but we just need to be honest that circumstances can be complex. As a result, keeping an open mind and always disciplining ourselves against the observed data is necessary for doing good economics.

If you are interested in thinking about this a bit more I did a quick google search after writing this script and found some nifty resources – they will be attached below.  I’ll also add a few blog posts Gulnara and myself have worked on that chat about similar circumstances.

Peak-Season Discount Case – Economics – Reed College

Demand, Information, and Competition: Why do Food Prices Fall at Seasonal Demand Peaks? on JSTOR

Why Do Retail Prices Fall During Seasonal Demand Peaks? by R. Andrew Butters, Daniel W. Sacks, Boyoung Seo :: SSRN

For those who don’t want to listen to a video, we’ve popped the script below.

We’ve chatted about why we care about GDP and the different ways of measuring it – be it through expenditure on final items, the value-added in each industry, or the income paid to those providing a “factor of production” such as work time or capital equipment.

In these chats we established that however we measure it, these measures of “expenditure” “production” and “income” all give us the same result for GDP – and this tells us that the amount we produce, the amount we consume, and the amount of income we have are really all the same thing.

This is a powerful result that has been used to say “Supply creates its own demand” or, as the bloke on my t-shirt says, that “demand creates its own supply”. Behind all of this we always need to model a process to truly understand how the macroeconomy works and what trade-offs there are.

[Gulnara]

However, out of context this result is also misleading – and can lead us to get the wrong impression about how society is progressing or the opportunities available to people.  Even ignoring other attributes that economists like to add in – the distribution of income, environmental change, and non-monetary value stemming from your interaction with your community – this perspective can miss important things even in terms of our narrow understanding of monetary incomes.

In this video we are going to think a little bit about that, and see what other measures we can look at from the national accounts that may give us a wider perspective on incomes.

GDP and income

[Back to Matt]

As we noted in a prior video, GDP can be measured by taking all expenditure on final items, taking all income paid to labour, capital, and through indirect taxes, or by calculating the value added in each industry and adding them up.  And each of these measures will give us the same number!

This measure is amazing at helping us understand the use of society’s scarce factors of production, gives us an insight into economic progress in a country, allows us to understand and compare production and incomes between countries, and provides a useful piece of information for asking about policy trade-offs when we use it with economic models.

However, when it comes to cross-country and time based comparisons we immediately run into an issue – prices change through time, and different countries use different currencies.

If we are looking at one country or countries with the same currency everything is in the same “unit of account” which makes it easy to add up – but how do we add up a New Zealand dollar and a Japanese Yen for building a GDP measure?  

When comparing across countries we need to adjust for the fact that different units of the currency can be exchanged for the same goods.  We can’t just use exchange rates here as they don’t give us the full picture due to non-tradable goods and services. Furthermore,these exchange rates can be excessively volatile and as assets currencies may be valued for reasons other than the strict ability to purchase goods and services. 

We aren’t going to focus on cross-country comparisons and therefore those types of measures right now, but will cover it in a future video.

Our focus here will be on the time based dimension. We know that a New Zealand dollar today cannot buy the same number of chocolate bars as a New Zealand dollar could when I was a kid – sadly. As a result, if we construct GDP just by counting the number of dollars spent on these items, then when comparing GDP numbers over time we will end up with a measure that captures both the increase in the price of goods and services as well as an increase in the actual number of them.

The measure that takes “current prices” to calculate GDP – the equivalent of just adding up the number of dollars spent – is called nominal GDP.  While the measure that adjusts for the fact that prices changed and attempts to measure the volume of GDP over time is called real GDP.

Getting from nominal to real GDP involves figuring out a way to remove the price effect, or what is termed deflating nominal GDP for price growth.  The GDP deflator captures the aggregate price effect through time, and by dividing nominal GDP by this deflator we get our measure of real GDP.

As we often care about the amount of stuff available to buy, rather than the number of New Zealand dollars floating around to spend on it, real GDP is normally the measure we are talking about when we talk about GDP as income.  However, both measures are useful and have their place for asking different questions.

To give this all a bit of context, let’s pull up the data and look at these measures for New Zealand.

[R session]

Here we have pulled some data off the Stats NZ website and made some quick and nasty graphs.  This first one shows us New Zealand GDP in nominal and real terms between 2000 and 2020.

Note how nominal GDP starts below real GDP and then climbs above it.  What does this mean?  Well it means the nominal GDP was growing faster than real GDP, which is what we would expect given that prices were rising!

Furthermore, they are equal during 2009 – implying that we are deflating nominal GDP to get real GDP in 2009 prices.

This is the income of the nation, but as we are looking at incomes we might want to know about the incomes per person – or per capita.  As populations are growing that looks like a second graph here.

This shows a similar trend, but you will notice that the lines are a bit flatter (or that the Y-axis increases by a smaller proportion).  This is because the population was growing during this period, so part of the increase in GDP was associated with there simply being more people.  

The real GDP per capita number tells us that, in New Zealand borders, significantly more output is created per person was created in 2020 than was the case in 2000 – 38% more to be precise!  This opens up a world of questions, are we using more inputs (i.e. working more, using more environmental capital, building up more physical capital) or have we just learned how to use what we have in a more efficient way – what is called multifactor productivity growth.

But we aren’t answering those here. Instead we want to ask, is this income?  Over to you Gully.

What is macroeconomic “income”

[Gulnara]

Thanks again Matt.

Describing GDP and income in the way above is typical for an introductory economics course, and feels very natural. However, it is also misleading. To truly think about income we need to ask what income actually is.

In Hicks 1946, John Hicks stated that income was “the maximum value which [a man] can consume during a week, and still expect to be as well off at the end of the week as he was in the beginning.”.  As one of the founders of the post-war “neo-classical synthesis”, and as a famous welfare economist, it is this definition of income that captures what an economist is thinking about when they say “income”.

It is then the equivalence between consumption + savings (potential consumption) and production at the macro level that leads us to view income as essentially GDP.

Income in this economist’s world is “potential consumption”, as it is this ability to consume final goods and services through time that generates wellbeing and welfare.

GDP on the other hand is a measure of the use of factors of production to generate value added/output – the rationale for looking at this is to understand the utilisation of factors of production, especially workers, in market activities. As noted by Matt above, the focus is also on the number of items. 

In this way, much of GDP is the act of creating some value associated with a final product that is consumed – but there may be cases where the factor of production is instead used in order to “maintain how well off they are” or where the residence of the individual who claims the output differs from the residence of the factors of production.  These differences will lead to a gap between our true concept of income and GDP – so let’s talk about them a bit more.

Maintaining assets

[Matt]

Thanks Gulnara.  The issue I want to talk about a bit more is that of maintenance.  

The “gross” in gross domestic product refers to the fact that ALL investment is included in the measure.

If you own a building and you use it to run a business then that refers to a capital item.  You may invest in that building by adding an extra floor, improving the air conditioning with services like www.newcastleairconditioning.co.uk, painting the building, or replacing the showers.  All this investment activity will be measured at once – however, some part of it refers to maintaining the productive use of the asset while some refers to increasing the productive use of the asset.

Why would we need to maintain anything?  Well, time takes its toll on all of us – especially capital assets.  This depreciation in the usefulness of the capital item is sometimes called “consumption of fixed capital”, and GDP includes investment that is solely about keeping the capital item as productive as it was before.

However, if we imagined someone producing something for themselves the decision to repair something doesn’t constitute a new thing for them to consume – so we wouldn’t view it as part of their “income” or an increase in their ability to consume while maintaining their current position.  Instead, this is an expense that is required to keep themselves in that position!

The measure that tries to adjust for this given estimates of depreciation and measures of the capital stock is Net Domestic Product.

[R session]

We will construct Net Domestic Product from the Stats NZ data and graph it here as well.  For this we have subtracted the Stats NZ estimate of “consumption of fixed capital” from GDP, and then used the same deflator to work out a real value.  True Net Domestic Product will look a little bit different, but this gets us close enough to chat about.

So what is this graph showing?

Net Domestic Product moves in a similar way to GDP, but is lower.  This makes sense as we are subtracting an “expense” that isn’t included in GDP.  By taking away the part of GDP that needs to be used to maintain capital equipment we have a more genuine measure of income relative to the definition Gulnara gave above.

This figure grew by 37.7% – slightly less than the growth in GDP over the same period.  Why is it different?  If the capital stock per person has risen, or the types of assets we hold depreciate more quickly – such as computers – then the amount of maintenance that needs to be paid will rise.  As a result, Net Domestic Product growing by less is also consistent with the changing nature of the economy over the past 20 years.

Opening the borders

[Gulnara]

Things become more complex when we open ourselves up to the rest of the world.

Three things happen when we admit there are other countries:

1. Domestic residents can own assets overseas, and so are able to consume things that are produced overseas – similarly foreign residents can own domestic assets, giving them a claim on some of this domestic production that is measured by GDP.
2. Domestic products might be sold overseas (exports), and foreign products may be purchased and consumed domestically (imports).  Imports are part of consumption, and must be funded to some degree by exports.  If the relative price of exports and imports increases , domestic residents can now consume more for the same amount of production.
3. Transfers, such as charitable giving and intermittences, involves residents in one country sacrificing consumption to provide those opportunities to others overseas.

In this way, GDP remains as a measure of what is “produced” within a country – it measures what is made with factors of production within national boundaries.  But this does not immediately mean that it reflects the claim on products for people who live within those borders!

Gross National Product or GNP is the measure that attempts to adjust for the income of domestic residents overseas, and the income of foreign residents that is generated in the domestic economy.  This is very similar to Gross National Income, or GNI – conceptually they should be the same, but in some accounts the residency definition or definition of primary income (income from factors of production) that are included can vary between the two.

However, secondary income (such as the intermittences noted above) are missing in these measures.  Adding in net transfers from above provides a measure termed GNDI (gross national disposable income) as an aggregate income measure.  By capturing all foreign transactions, the construction of this measure also captures changes in the terms of trade as “income” – in a way that GDP does not. (isi_box1_jun_2015.pdf (banrep.gov.co))

Taking GNDI, we run into the same issue that Matt talked about above – there is some investment that is just about maintaining the stock of capital.  Subtracting this depreciation then leaves us with two other measures that you may hear about, NNI or Net National Income, and NNDI or Net National Disposable Income.

Do all of these adjustments change much?  Let’s look at the New Zealand data with Matt!

[Matt on R part and summing up]

For these figures we are going to stick with the nominal data provided by Stats NZ. This is because real figures are not provided, and trying to back out the appropriate price deflators for these different indices will take a bit of time without necessarily adding much value.

With that out of the way, let’s plot everything from the Stats NZ experimental national accounts.

As we can see here there are potentially a few data issues in this experimental series – so I want us to focus on the relativities rather than the individual series shape over time.

GDP is at the top, with GNI and GDI catching up through time.  GNI and GNDI are also very close to each other.  NDI is then significantly lower than the others – which does make sense.

So why is GNI below GDI in New Zealand? Remember that we get from one to the other by subtracting the domestic production that is claimed by foreign residents and adding in foreign production that is claimed or owned by New Zealand residents. New Zealand on average borrows from the rest of the world, and it is the income flows associated with this that explains the gap!

However, the deflator does matter when we want to think about the key differences between GNDI and GDP – namely changes in the relative price of exports and imports, or the terms of trade.  For this we do want to consider how real measures may look different solely on this basis.

Here we get a much sharper change in the relative value of GDP and GNDI than when we looked at the nominal values.  Why is that?  In this instance New Zealand has seen a very substantial increase in its terms of trade – or the price of exports relative to the price of imports – over this period.  When we deflate the two income series, that terms of trade difference shows up as another part of the change in these measures.

Between 1992 and 2021 real GDP per capita rose 58% while real GNDI per capita rose 77% – as a result this is a very significant difference. So how do we think about which income measure to use?

The fact that New Zealand can now buy a lot more imports from the exports it sells is an increase in income in the GNDI sense – and it is not captured directly by real GDP.  How does this work?  If exports remained fixed and more imports were purchased for consumers to consume, then both C and M would increase in the GDP equation – cancelling each other out.

However, this is real income – having people overseas give New Zealanders more products for the same exports is exactly the same as exports becoming more productive in terms of the amount of goods and services available for New Zealanders to use.  As a result, understanding this change is extremely important!

Conclusion

As we’ve noted above, looking at national accounts to get an idea of material wellbeing can be complex – and MOTU has been undertaking work trying to get a more detailed understanding of this in recent years: Motu-Note-21-Material-Wellbeing-of-NZ-Households.pdf

However, by clearly articulating what GDP is, and how it may measure some things we don’t truly see as “income or potential consumption” we’ve been able to work out some alternative measures that already exist in the data to chat about what is happening.  

These measures give us additional information which may change the way we see New Zealand’s productivity performance, inequality within the country, New Zealand’s wealth and income relative to other countries and a multitude of other narratives that are given in the media and common discussion.  However, we’ll leave it here and we would be eager to hear if this perspective is useful in helping you understand a little more about our beautiful little island.

Although I feel some sympathy with her situation, I was worried that I will get dragged all around the place when we do go shopping in the future – and so we’ve gone online to look at Google Maps to figure out where we’ll need to walk. Having a look it appears we won’t have to walk around that far – as the clothing and perfume stores with amazing interior signage projects.

So why is this?

At face value that is quite strange – these firms compete with each other, so wouldn’t they want to be in quite different places to collect different customers? Especially when your location can allow you to differentiate yourself from your competitors.

Take the example when we were talking about loss leaders with toilet paper, it appears important to have your own little place where you can get consumers to shop and it is costly for them to go elsewhere – and if you were placing your firm next to a competitor, it is almost costless for your customers to just jump ship!

So at face value this appears to make little sense – we imagine that these monopolistic competitive firms would want to differentiate themselves from their competitor, and so locate far away from them. So how can we understand what we do observe?

Hotelling’s law

As noted above, the “location” is one way of differentiating a product – if we think differentiating allows you to act more like a mini-monopoly rather than a competitive firm, then it seems like firms have an incentive to do this.

But quite often they don’t on this margin. Why?

This very question led to the development of a concept called Hotelling’s Law after a bloke named Harold Hotelling who published a paper in 1929 on it. He developed a “linear location model” that helped to explain why businesses selling similar goods may locate next to each other.

As I am practicing making online videos for my lectures – due to COVID – I will also talk through this in a video below: