This post is a tribute to Armen Alchian who passed away today, February 19, 2013.
I always wondered why cinnamon sticks look the way they look here in US. Back home, in the grocery store I usually shop, they always came as a bag full of chipped bark! In US they are nicely rolled up and longer pieces of bark. Apparently this is not limited to cinnamon but extends to almost all the spices or other goodies that come from far off places to the American markets. Why, do you think this is the case?
I stumbled on the answer while I was browsing random text books for the course I will be teaching next semester. It is called the Alchian-Allen law, after the two authors that first thought about it. The story goes somewhat like this. Suppose, in Srilanka, cinnamon sticks come in two qualities, one nice long rolled up barks (high quality) and the other just chips of the bark (low quality) and suppose the high quality stick costs $2 a piece and the low quality one costs 50 cents a piece. The relative price ratio of the high quality to low quality cinnamon then is 4. Further suppose that to transport these sticks to a store in New York city, it costs $1 per piece irrespective of the quality. Now the high quality cinnamon costs $3 whereas the low quality one costs $1.50 implying a relative price ratio of 2. It means the high quality cinnamon is relatively cheaper in US than in Srilanka. As a result, US consumers will consume more high quality cinnamon than the Srilankan consumers. However, because cinnamon is generally costly relative to other goods in US, consumers here on the whole will consume less cinnamon than consumers in Srilanka or for that matter than those in India.
Isn’t that neat? Well, if you are smart you already might have figured that out but if you are a bit slow like me, suffice it to know that its a simple application of the law of demand. Consumer theory tells us that quantity demanded of a commodity is a function of its relative price and not the absolute one. That is precisely what we see here happening. The neat trick is to realize that adding a fixed charge lowers the relative price in the foreign markets and that causes the consumers there to demand more of high quality stuff than low quality stuff. Thus, in general foreign places end up consuming higher fraction of the high quality good but their overall consumption is less than where the good originates.
This is indeed a remarkable result and holds for a lot of commodities that are traded over long distances. As Eaton et.al say, examples of relative price effects are infact quite numerous. To mention a couple, Americans drink less of French wine than French but the proportion of expensive wine is higher or the New Yorkers consume fewer grapes than Californians but a higher proportion of high quality grapes.
This neat trick of fixed charges can work beyond explaining the effects of transportation charges. Consumers who prefer hand tailored suits to ready-made ones mostly also choose more expensive quality cloth because the fixed tailoring charges lower the relative price of expensive cloth. Tourists tend to spend on restaurants in your city much less than you do but most of their spending goes on good restaurants and so on. At the risk of generalization, it also explains why the world outside the Indian subcontinent prefers less spicy food but a richer variety of Indian food than the plain simple home cooked Indian food. It now might be a habit but its emergence can be explained with the Alchian- Allen law!
I will leave it you to figure out other such examples. As a hint let me tell you that this law has another name- shipping the good apples out!
Eaton, Eaton, and Allen (2005), Microeconomics, Pearson Cananda, 6th Edn. Chapter 4.
PS: Other than the cinnamon sticks one, all examples are from this chapter.