Sunday, December 30, 2012

The Grinch Who Mispriced Volatility

In my very first post, I hit on the annual ritual of  Grinch economists explaining the inefficiencies of Christmas (and other) gift giving, and my personal disgust with the concomitant trade in gift cards instead of cash.  (That's my second post this week using the word "concomitant", by the way!)

I even confessed to my personal failure to adequately monitor my accumulated gift card credit risk following the Border's bankruptcy.

In a beautifully titled piece How Terrible Is Christmas? Megan McCardle proposes two arguments in favor of inefficient giving, giving a slightly less Grinch-y approach to economic analysis of gift giving.   Unfortunately, her arguments don't hold up.

First, she argues, building social networks requires inefficient allocation of resources.  Short term, seemingly irrational, commitments of time, money and effort shows commitments to new, long term relationships.  That makes sense.

However, most Christmas gift-giving focuses on existing relationships, not building new ones.  She turns to her own grandmother as an example, but grandmothers cannot buy long term relationships.

In fact, I'd guess Christmas gift-giving etiquette tends toward much more modest gifts for new relationships, to specifically avoid the risk of "over-commitment" to new relationships.

Second, she argues a mistaken notion that "gifts from others have option value..." and she continues:
Having another person buy you a gift stretches your consumption possibilities beyond the limits of your own imagination.  Yes, often they will buy you something you don't like as much as the thing you would have bought.  On the other hand, sometimes they'll buy you something that you like even better than the thing you bought with your own money.  
Here, she has convoluted ex ante possibilities with ex post outcomes. She's acknowledging that "often" the gift will suck, and sometimes it will be great, something you never thought to buy for yourself.

But, the option value depends on the ex ante value, which includes the possibility of Billy the Bass.  The good outcome, expanding your motion activated soap consumption (her example!) is not option's a good outcome.

Here's a thought experiment for Megan's next Christmas: I'll give her $100 cash, or I'll give her something that I will select as an "interesting gift" that has a price of $X randomly selected from Amazon's "Interesting Gifts for $X" list,( which I assume exists!)  She's arguing that X < $100.  That's a mis-priced option.