Wednesday, December 31, 2008

Gifts and the deadweight loss

It is estimated that in the US, an average of $150bn is spent on gifts every year during the year-end holiday season (though this year, it may be far less!). It is estimated that the Indian consumers splurged over Rs 40000-45000 Cr this year on various categories of gifts - mithai and dry fruits, garments, consumer durables, gold, silver, automobiles, electronic goods, and ofcourse crackers - in the period between Dussehra and Diwali.

But gifts throw up a major, albeit hidden, economic problem. Eco 101 teaches us that a transaction is efficient if the total economic surplus is maximized. In other words, both the producer and consumer surplus should be maximized. In the case of gifts, the respective surpluses of the gift giver and the gift recipient should be maximized. While the gift givers are naturally happy with the gifts they are gifting, the gift recipients are less likely to be as happy. This arises because of the varying preferences of individuals and the information asymmetry prevalent between the donor and the recipient.

This problem is widely prevalent in the commonest of gifts - toys, clothes, shoes, bags, jewellery, books, consumer durables etc. Given the vast variety available and the equally numerous tastes of individuals, unless the gifter is aware of the specific preference of the recipient, there is a strong probability of gifting some thing that does not maximize the utility of the recipient. In fact, with many of the aforementioned items, the probability of a sub-optimal utility transaction is very high.

With food gifts, there is an additional health risk. The most frequently gifted food items are sweets and dry fruits, whose consumption imposes significant health costs on the recipients. Typically the higher end gifts like automobiles and expensive ornaments do not suffer as adversely from this problem. Despite the possibility of lower total surplus, the deadweight loss is likely to be smaller.

Corporate gifts are a different matter altogether. In such gifts, the utility to the gift giver is much higher than the utility to the recipient. In fact, these transactions can be justified solely in terms of the utility derived by the giver. Further, the types of items given as corporate gifts is more impersonal, standardized, (like diaries, pens etc) and only rarely individual-specific. But despite this, here too the deadweight loss is significant.

In 1993, Prof Joel Waldfogel wrote a very influential paper on The deadweight loss of Christmas. He estimated that the typical $50 Christmas gift is valued by the recipient at between $35 and $43 due to the deadweight loss arising from differences in the respective tastes of the donor and the recipient. He had however specifically excluded sentimental value from his calculations.

One way of reducing the deadweight loss is by making the gift fungible, so that the recipient can transact it if he finds a better choice. This can be achieved if the shops take back sold goods, or if the gift is a shopping coupon or voucher in your favorite shop. In fact, gift vouchers and its electronic version, gift card, have become a very popular method of gifting materials, and has been aggressively promoted by major retail stores. Tim Harford offers his tips on buying Christmas gifts. There are even websites that sells gift cards and also helps swap different types of gift cards.

More than $25bn worth gift cards were sold in the US in the last season, up 34% from the previous year, thereby making gift cards rival apparel as the most popular present. Retailers like gift cards because they see it as an interest free loan from the customers and also because it has been found that the recipients usually spend more than the amount on the card ("uplifting" spending). In fact, of the total of $70 bn spent by consumers on gift cards in 2007, 58% said they spent more than the gift card amount when they used it.

But doubts remain about its effectiveness. According to a new survey, a quarter of all gift vouchers are never used by the recipients - providing windfall profits for the stores. In 2007 alone, one US chain, Best Buy, has chalked up a profit of $19m (£9.5m) from unclaimed gift cards. However, the economic slowdown which has opened up strong possibility of issuing retailers going under, thereby defaulting on their gift cards, poses a problem for the gift cards market this year.

The most ideal solution to eliminating any deadweight loss would be to gift money! But here we are likely to run into social mores and offend cultural sensibilities. In case of corporate gifts, cash gifts will be tantamount to open bribery! Or else, the gifter should be asking the recipient about their choice, in which case it loses the significant characteristic of a gift.

The silver lining in this mad gift race is that the economy benefits by way of increased consumption and hence production, and so on. Whether the total utility is increasing or not is a different matter. Gifts are therefore an example of increasing deadweight losses contributing to the economic growth!

Update 1
See also this from Joel Waldfogel.

1 comment:

Albert said...

This is a very informative article. Thanx for posting it! I would like to say that while speaking of corporate gifts you've made a good point. The value for the gift is more for the giver than the receiver. It means business to him. For instance, we chose the iPod this year. We also booked it at a special price at But more than the price what influenced us into buying it is it's uniqueness as a corporate gift. After all, the underlying objective is to get noticed by the clients so that they give more business to us. So in this case, the price of the iPods were outweighed by the long term dividends it may draw.