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Tuesday, August 12, 2008

"He Must Own the Building!"

I hear this often, in reference to a shop owner who keeps a low-traffic shop open in a high-traffic area. People say, "He must own the building, otherwise he couldn't afford the rent!"

It's the economic fallacy of confusing money costs with real (opportunity) costs. It doesn't matter whether or not the man owns the building -- it's costing him just as much to run the business there either way. Let's say he's making $1500 a month in a site that could (or does) rent for $2500. I f he rents he is obviously losing $1000 per month. But if he owns, he could rent the space for $2500 instead of drawing $1500 profit from it -- for a loss of $1000! It's the same result.

The truth behind this mis-perception is that to subsidize a money-losing business takes some wealth -- and owning a building is one form that wealth could take. Additionally, the building owner may be able to hide his loss from himself" more easily than most -- the $2500 he could have gotten doesn't show up on his books anywhere.

13 comments:

  1. Gene, I've thought about this for a totally long time and I've concluded it's obvious that the people you are quoting are quite right, and you are quite wrong.

    You are simply reading a stupid interpretation into a simple statement. Yes, viewed as an opportunity cost, he "affords" loss just the same. But what people are saying is, er, exactly what you just did: an owner could hide the loss he's taking much easier than someone who has to pay the market rent to a different party each month.

    Deliberately misinterpreting other people's remarks so as to make them sound stupid is child's play. And all too often, YOUR play.

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  2. Silas,

    Are you saying that those people's predictions are actually correct, or merely that Gene's criticism is invalid? I think they are wrong: A low-traffic place is not a clue that the person running it owns the building. And Gene explains why.

    Gene:

    This reminds me of my favorite econ grad school horror story. The UAW was trying to unionize us grad students, and NYU was sending around its big administrator people to try to get the students to vote no.

    So the provost or somebody came to talk to the econ PhD students. He asked, "Why are you so unhappy? What can we do to make your package more attractive?"

    People said they wanted subsidized housing, like Columbia PhD students got.

    "OK we can do that," he said, "but then your stipend checks would have to go down. There's a pile of money we can give you, and right now we are giving it to you in a check. If you want subsidized NYU housing, then we'll have to lower the amount of the check."

    One of the better students in our class apparently (I wasn't there) said, "No, because NYU owns these buildings, it doesn't cost you anything to lower the rent."

    And remember, this guy was getting a PhD in economics. I can only imagine what happened when this guy talked to the Fine Arts department...

    (Now Silas go ahead and defend the student. I'm curious to see your skills.)

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  3. Bob: First of all, of course I can defend the student, even and *especially* if you were to claim he actually understands economics. It's simple: he's making an argument that would appeal to a non-economist. He "gets it", and he's betting they don't.

    Second of all, many economists forget to ditch the unrealistic assumptions when they stop applying. Not *all* instances of "not working" imply "forgoing your wage rate over that time". Pedestrian application of opportunity cost theory would say that if I took a two week vacation, I'm forgoing two weeks worth of wages. But I can't actually find work in my line for just two weeks!

    As for your question directed at me, my focus was on showing how it's not an economic fallacy, but rather, a simple way of expressing the analysis Gene just gave. While the opportunity costs are the same whether or not you own the building, the loss is more hidden in one case -- you know, like Gene just said -- and that is exactly the sentiment being expressed that Gene casually assumes isn't there.

    As for what the best assumption about the ownership status is? Well, whenever I see such a building (or more generally, a building on real-estate that can't possibly be earning enough business to justify operating there), I just assume isn't being used for money laundering: "Oh, oh yeah IRS man, we, like, you know, TOTALLY got TONS of business this year, that's like, TOTALLY how we got our profits."

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  4. There are many possibilities aside from ownership here.

    The shop owner could have a very long lease, where the owner of the building does not have the skill to induce the shop owner to be bought out.

    There could simply be a case of entrepreneurship error where a shop owner did not understand the poor traffic his business would generate, and he will be gone when his lease is over.

    Finally, in a small shop, a shop owner who is not making money, may renew a money losing lease if he is receiving some sort of psychic income from the business, and he has the funds to pull it off. (For a person of above average wealth it would not be hard to pull off. If he is losing a grand a month, that is only $12,000 a year.)

    I know businesses in each of these three categories.

    The most interesting is a candy cigarette shop stuck in the top levels of the Bonaventure Hotel in LA. It is no man's land, and anyone passing buy has to wonder how the place survives. It survives beacuse the business keeps getting flipped to new owners. In the last five years there have been four different owners.


    BTW:I recently spent some time in NYC after really only a few in and out vists over the prior 20 years, before that I lived in Mnahattan for approximately 10 years.

    What was amazing is that after 20 years there seemed to be four businesses types that still were operating at the same locations:

    Delis

    24 Hour Diners

    Newstands

    and

    Strp Clubs (Despite all the new strip clubs, Scores etc. They still have that guy on Broadway, LOL, passing out flyers for some club. There were also two other clubs that seemed to be there 20 years ago)

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  5. "an owner could hide the loss he's taking much easier than someone who has to pay the market rent to a different party each month."

    Yes, he can hide it -- from himself -- but I believe people really think (as the owner mistakenly does) that it's economically less costly to operate that business in that place if the business owner is also the building owner -- yes, business owners often make that mistake, which is PART of what the armchair analysts are noting, but so do the armchair analysts, and that's the fallacy at play. Of course, it's an empirical matter as to just how many of such commentators fail to recognize the opportunity cost angle, and I doubt either of us are about to undertake the research necessary to determine that percentage. But my impression -- after all, this is just a blog, and not a scholarly paper! -- is that most such people actually think the building owner is not losing money, since he gets his rent for "free".

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  6. I agree with Gene's comment above. And Silas, I assure you, that guy from my program was not being coy. He didn't get the opportunity cost issue at all. He wasn't an economist, he was a mathematician. (I'm not saying that as a criticism of him, but rather of the system in which someone who would puzzle over Hazlitt's book can get a PhD in economics from a top-20 school.)

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  7. Anonymous8:52 AM

    I think the most compelling reason for Gene's explanation is this: In the hypothetical that the man on the street offers, the landlord is assumed to know what the market rental rate is, and to evict the incumbent tenant-occupant if he can't pay that amount; whereas, when the same occupant is the the owner he should be expected to have the same knowledge of the market rental rate as the landlord in the comparison case. And, so long as he does have the same knowledge, then his obliviousness to the opportunity cost of renting his building to someone else at the market rate, rather than occupying the space himself, is irrational (assuming, that he's trying to maximize net money income).

    Araglin

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  8. I thought of a related example. In college my roommate and I had a silk screen t-shirt business. He would often "steal" from our inventory, and the issue was, how much was that costing us?

    At first I thought he was costing us the amount we were selling the shirts for, while of course he wanted to argue that he was only costing us the wholesale price, plus our two minutes of labor to print the logo or whatever on an additional shirt. So is was like $8 versus 20 cents.

    But I realized he was right, because the demand for our shirts (featuring the date of an upcoming frat party or something) was very elastic. Like, after we print up the 50 that the frat orders, nobody else is going to pay much at all for that particular shirt.

    My objection was that he was using historical cost, which was indeed wrong. But a correct forward-looking measure also reduced to the same thing, since we could always buy more from the wholesaler and there was a limited market for the finished product.

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  9. "Deliberately misinterpreting other people's remarks so as to make them sound stupid is child's play. And all too often, YOUR play."

    Sure, Silas, you're reluctant to take a thread personal right away.

    Did you ever wonder why you've been kicked off of so many sites? They're all just mis-interpreting you're innocent remarks, po boy!

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  10. @Bob: Thanks for giving an example of an uncareful assessment of opportunity cost (which I had warned about) and how you corrected it. See the end of this post for my response to Genes characterization of the people who make the alleged fallacy.

    As for the student: again, I try to avoid shooting fish in a bucket by going with the least charitable interpretation of a remark. So I think what he is saying is, "Yes, the school hands you cash with which to compensate the students. But you can still spend the cash on benefits for us *and* lower the price of the rooms." That is, the room subsidy is not mutually exclusive with spending the "bucket of cash". In contrast, you would in fact have to pay from the bucket of cash -- rather than merely forgo some market rent -- if it were a third party renting out the rooms.

    And yes that means he was demanding more than they offered. I just think his argument got "lost in translation".

    So, what's the error in that defense?

    @Gene, I did not "make it personal". I listed a characteristic of the statements you've made in the past, and that can be substantiated. Did you already forget your attribution to me of stupid beliefs? And it is something I have noticed quite often from you. But I never criticized you as a person, just your actions. For example, I did not say that you "need help" or "have serious personal problems".

    You know, like you've done to me. That kind of thing.

    Do you want to know why I get banned? Because being wrong hurts. And so it makes people mad at the very helpful person who pointed out their error. I suspect that that emotion led you to make the false accusation you just made of me.

    People like to dress it up in all kinds of excuses: "Oh, you made relevant criticisms, but you were just so *mean* and *rude* about it." BS. Being shown to be out-of-the-ballpark wrong will hurt no matter how you're informed of it.

    Now, about your empirical claim, here is how we could test it:

    Ask these people: "If he were renting, is he being foolish to stay in business? If he actually owns the building, is he being foolish to stay in business?"

    If you are correct -- that they genuinely the costs as being fundamentally different -- their answers would be yes and no. If I'm correct, their answers would be yes and yes. So, if you think those same people would see the foolishness of having a poor business while you own the building, you agree with my perspective.

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  11. Yes, and it is clear to me that they DO think it makes more sense to stay in business if you own the building.

    And you know, I'm wrong all the time, and have it pointed out to me all the time. Jeez, I've circulated 15 or so academic papers, and done amd masters, and am nearly done with a PhD. Do you know how many times it's been opinted out I'm wrong in the course of that process?

    No, what doesn't hurt, but what is annoying as hell, is to have someone who doesn't understand the situation being discussed arrogantly mouth off about how dumb my analysis is. THAT, I don't get in my PhD program.

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  12. "But I never criticized you as a person, just your actions. For example, I did not say that you "need help" or "have serious personal problems"."

    Those things can be substantiated as well, Silas -- like by all the other people who have kicked you off of their sites.

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  13. No, what doesn't hurt, but what is annoying as hell, is to have someone who doesn't understand the situation being discussed arrogantly mouth off about how dumb my analysis is. THAT, I don't get in my PhD program.

    Good thing you didn't go to Chicago!

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