Undercover Economist

Not just a matter of taste

Let’s get one thing straight: I only bought Mint Chocolate Baileys as research for this column, and not because I like that sort of thing. I won’t be buying it again. The mint-choc aftertaste is so thoroughly sundered from the initial flavour of the Baileys that it is hard to imagine they once inhabited the same bottle.

But presumably somebody is buying the stuff this Yuletide, along with all the other mutations of everyday consumer goods.

Once there was only Coca-Cola; now we have Diet Coke Plus, which has added vitamins and minerals, and according to a press release from The Coca-Cola Company, joins the “Diet Coke family, which includes the flagship Diet Coke, Caffeine Free Diet Coke, Diet Coke with Lime, Diet Cherry Coke, and Diet Coke Sweetened with Splenda.”

Why are there so many new products, and do they do any good to anyone? Katie Bayne of The Coca-Cola Company has no doubts: “Consumers, including Diet Coke drinkers, are increasingly looking for more beverage options.” That sounds like the kind of thing you start to believe if you work too long for The Coca-Cola Company. But what do you believe if you’re an economist?

Economists try to measure how much consumers are willing to pay for these new twists on existing goods. For example, assume that a customer would be willing to pay £15 for a bottle of Mint Chocolate Baileys, but it retails at just £10. Buying the bottle nets the mint-chocoholic a sort of psychic profit of £5, which economists dub “consumer surplus’’. Supplying a million such mint-choc Baileys lovers would produce a total consumer surplus of £5m.

The trouble is, consumer surplus is invisible: it’s all in the mind of the consumer. Intuitively, Mint Chocolate Baileys would be a more valuable innovation if lots of consumers were willing to pay £20 for it than if most consumers were only willing to pay £11. That is the intuition behind consumer surplus – but of course we do not know how much people really would be willing to pay for Mint Chocolate Baileys – or for any product – if they had to.

The products may seem trivial, but the distortion to economic measurement may not be. If, one year, Baileys sells for £10, and the next year, Baileys sells for £10, and Mint Chocolate Baileys appears on the market for £10.50, is inflation zero? Or negative, since consumers have a new product to choose from? Or positive, since some customers are now paying more for a similar product?

If consumers think new products are very valuable, official inflation measures will be overstated because the buyers are getting a better product for the money. If the new products are nothing more than frills, official inflation measures will be more accurate.

The econometrician Jerry Hausman once attempted to measure the contribution to consumer surplus of one new product: Apple Cinnamon Cheerios. His conclusion was that its existence produced about 27 cents per person per year of consumer surplus – the psychic profit – in the early 1990s, which would be nearly 40 cents per person in today’s money. That is not earth-shaking but it is bigger than most economists expected from a new breakfast cereal.

Hausman’s estimate is disputed by some other economists. But if he is right, inflation in breakfast cereals is lower than it seems: price increases that were measured as inflation are in fact the price consumers willingly pay for a valuable new product.

The broader lesson is that inflation elsewhere may also be lower than official measures suggest.

If so, Diet Coke Plus, Apple Cinnamon Cheerios and even Mint Chocolate Baileys can all take some credit.

Also published at ft.com.