Thursday, March 10, 2011

Explicit Contracts versus Implicit Contracts

We were very brief yesterday in discussing the Okun piece so I thought I'd offer an example that you are all aware of which is in the spirit of the type of insurance I was talking about yesterday. It is the guaranteed tuition plan. At the time it was enacted, the history of tuition increases made people think of this as imposing caps on what they'd have to pay. But in the environment we are entering now, where cost cutting seems paramount, do note that the plan also produces a floor on revenue qua tuition. Note that the plan does not restrict at all tuition differences across cohorts, which has been rising at above the general rate of inflation. But also note that Illinois now has the highest in-state tuition in the Big Ten (when counting in surcharges that various colleges charge). That may dampen future increases.

This plan comes with the force of law, which in the language here means it is an explicit contract. This is possible, of course, because it is done in the public sector.

When turning to the private sector the question is whether firms can, via implicit contracts, effectively achieve the same sort of outcome - giving more certainty to consumers of their products that prices will be flat over time, and likewise to employees with respect to wages. Of course firms cannot differentiate buyers like universities can differentiate students via the time they enter. But the question is whether they can make commitments to price rigidity and whether such commitments are actually a good thing for business.

Let me give some examples. There are a variety of products where there is a durable purchased that in some sense gives access to a service and then there are variable inputs that are purchased over time to accompany the service. Examples include printers (the durable) and paper and ink (the variable inputs), eReaders (the durable) and books and magazines (the variable inputs), portable music/video players (the durable) and the songs and videos (the variable inputs). This list can be lengthened substantially, with the same general division in mind.

Now think of a fully rational consumer who wants to understand the "total cost of ownership" of one of these things. The purchase price of the durable is available to the consumer up front. But what should the consumer think about the future price of the variable inputs, which is a necessary thing to know to determine total cost of ownership. And then notice that the industry has changed in this regard.

If you look at VHS players as a historical example, Blockbuster and other movie rental stores represented a downstream business that was not linked to the upstream sale of player business, at least not directly. But now Apple has the iTunes Store, Amazon has its store, and at least in printers I know HP markets its own ink cartridges. The vertical integration enables more possibilities for commitment to the sticky prices in the variable input part of the market.

I just went to the iTunes store to have a look see. I don't buy current rock and roll but I did look at some new listings for their prices. Individual songs seemed to be either $1.29 (which I take to be their new price) or $.99 (which is what I remember from the last time I bought music there). There isn't price variation from artist to artist, regardless of which song is more popular.

Likewise, I also took a look at the Amazon store of the price of Kindle eBooks. There is more price variation there than at iTunes. But going through the New Releases link for the last 30 days, the striking thing is how many books are at the upper bound of $12.99. (The upper bound used to be $9.99).

So it isn't that prices are perfectly rigid over time, but surely they are much more sticky than would be the case in auction markets. That result is pure Okun.

1 comment:

  1. I should add something here, not about the observation that the variable input prices tend to be sticky. The issue is whether that is risk aversion or something else (simplicity for example) and does it matter which explanation is chosen.

    Okun wants to say that what is happening in the product markets is similar to what is happening in the labor markets with regard to implicit contracts.

    When it is wage income that we're talking about, I think risk aversion is a good explanation. I'm hard pressed to talk about having focal prices of $1.29 for a song download instead of small fluctuations around that as explained by risk aversion per se. But if you add that fluctuations can mask price trends and buyers want to understand such trends to determine the total cost of ownership, then the two go hand in hand.