Freakonomics Discovers Alchian's and Allen's "Oranges Principle"
By David Henderson
Anyway, there were a few houses I worked on where we got J-grade lumber, which is lumber that is destined for Japan. It is a grade above A-grade that you can’t even buy at a lumber yard. You have to know someone at the sawmill and buy it directly from there. The J-grade lumber is perfect. You don’t have to check for anything because it is all straight and knot-free. You could make beautiful furniture with it if you were inclined. We were making houses that were designed to last at least 100 years at least. It’s unfortunate then, that all the best lumber is going into houses that will be demolished in 38 years.
I think the argument was that the cost of shipping the lumber was at least the cost of the lumber itself, so it made sense to buy the best lumber possible considering the high transport costs. Maybe it has something to do with currency differences as well or maybe it takes less lumber to build the smaller houses. Regardless, the best lumber in Canada (and likely the U.S. northwest) goes to Japan so they can throw it away in 38 years. Thank you, capitalism.
This is from a blog post by Stephen J. Dubner, over at Freakonomics. Dubner is quoting a commenter named Kevin. The post is titled, “Why Use the Best Lumber in a House That Won’t Last?”
This fact would not have surprised the late Armen Alchian or co-author William Allen. Introductory textbooks in which the authors lay out new theoretical insights that have not already appeared in academic journals are rare. University Economics, by Alchian and Allen, first published in 1964, was rare. They gave no name to their insight and so we graduate students at UCLA, where Alchian and Allen taught, called it the “oranges principle.” The idea is that the cost of shipping low-quality oranges is the same as the cost of shipping high-quality oranges. Say the price of a high-quality orange in Florida is PH and the cost of a low-quality orange in Florida is PL. Obviously, PH > PL. But let the cost of shipping to Minnesota be X. Then the price of a high-quality orange in Minnesota is PH + X. The price of a low-quality orange in Minnesota is PL + X. PH/PL > (PH +X)/(PL + X). Therefore the relative price of a high-quality orange in Minnesota, relative, that is, to the price of the low-qualty orange in Minnesota, is lower than the relative price of a high-quality orange in Florida relative to the price of a low-quality orange in Florida. That’s why a disproportionately high percentage of oranges tend to be shipped out.
The same goes for lumber. Notice that Kevin, although probably not an economist, almost gets there by talking about the shipping cost.
UPDATE WITH NUMBERS
A reader on Facebook pointed out that I can make the point clearer with numbers. Imagine high-quality oranges sell for $2 a pound and low-quality oranges sell for $1 a pound, all in Florida. Transportation cost to Minnesota is $0.50 per pound. The relative price of high-quality to low-quality oranges in Florida: 2/1. High-quality oranges are twice as expensive. The relative price of high-quality to low-quality oranges in Minnesota: 2.5/1.5, or 5/3. High-quality oranges are only 67% more expensive.