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Mental Model: Veblen Goods

September 2, 2010 By 5 Comments

In today’s installment of our mental models catalog, we are going to discuss Veblen goods, which are a special type of item that would appear, at first glance, to violate the law of supply and demand relationships to prices.

Charlie Munger Mental Models

Veblen goods are those that consumers want to buy more of the higher prices rise because they are really purchasing a status symbol that sends a message to friends, family, coworkers, peers and competitors: "I am better than you." I personally subscribe to the belief that it is rooted in reproductive signaling theory.

Veblen goods are a type of commodity, product or service for which demand increases the higher the price climbs because buying a Veblen good is seen as a status symbol, giving the purchaser social cachet.  For example, a $10,000 Birkin bag from Hermès is attractive to international celebrities precisely because they want to be noticed.

If the bags were suddenly available at Macy’s for $995 each, many, if not most, of the existing buyers of Birkin bags would not want to purchase them even if they were exactly identical in every respect.  (For those who truly just appreciate the craftsmanship, these products are not Veblen goods because they would still buy them.)

The reason?  When someone buys a Veblen good, they are really buying an item that says, “I am better than you because I can afford this and you cannot.”  It is deeply rooted in human psychology and something known as signaling theory.   Studies have shown that people enjoy a product or service more if they believe it is more expensive.

The Austrian School of Economics denies that Veblen goods exist because the entire underlying belief is that people and entities act rationally and economize their resources.  Buying an item due to a higher price doesn’t fit with this model.  Frankly, common sense tells you the Austrian School is point-blank wrong because anyone who has ever watched a group of suburban housewives showing off their new homes or rich lawyers bragging about their yachts knows that the thing they talk about is how much they paid not the product itself.

Veblen goods are related to Giffen goods, positional goods, behavioral economics and signaling theory.

Understanding how Veblen goods work can result in significantly higher profit margins for luxury retailers, jewelers and those selling products that could fit into the realm of a status symbol.  If you want to increase sales, raise prices, don’t lower them.  It is counter-intuitive.

Related posts:

  1. Mental Model: The Dunning–Kruger Effect
  2. Mental Model: Satisficing
  3. Mental Model: Gaslighting
  4. Mental Model: The Thief Among Us
  5. Mental Model: Calibration Errors
  6. Mental Model: The Illusion of Choice
  7. Mental Model: Social Loafing
  8. Mental Model: Goldovsky Errors
  9. Mental Model: The Drunkard’s Search
  10. Mental Model: The Micawber Principle

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  • Frat Man

    Hi Joshua. Thank you so much for all your help in answering my questions. Because I’m generally responsible with money and do my own investments, sometimes my friends ask me for stock advice, which always puts me in a squirmy situation (if an investment sours, I don’t want to be blamed/lose a friend). My strategy has always been to buy common-sense stocks: i.e. XOM, BRK, CVX, CLX, PG, JNJ, KFT, CL, MCD, WMT, etc. and just watch the dividends increase. But generally speaking, I’m no financial genius- I just monitor earnings, wait for the current or future P/E ratio to hit a sweet spot, make sure the payout ratio of the dividend is sustainable, and then I buy. I’m not really good at delving through annual reports, just because I can’t understand half the jargon in there, and even then, I’m sure they can goose the earnings a bit to satisfy Wall Street’s quarterly estimates. So anyway, long-story short, one of my friends asked me if he should buy Cincinnati Financial. I usually only buy large-cap stocks I’m familiar with, and told my friend thus. But he still wanted me opinion. And since I don’t want to be “on the hook” for this investment, I thought I’d go to you. What are the five to ten criteria that are the most important to you when purchasing a stock? And how much of it is beyond numbers- i.e. hunches and gut feelings? I have read most of your work on about.com, but I was wondering if you could really boil down the numbers you consider to be of the utmost importance. Thanks!

    • http://www.joshuakennon.com Joshua Kennon

      Frat Man: You probably shouldn’t have an opinion on 99% of stocks you research. Benjamin Graham said you don’t have to know a man’s exact weight to know he’s fat or a woman’s exact age to know she’s old. Finding value is the same thing; you see an opportunity, it is rare, and you take it if you can afford the risk and it won’t do damage to your standard of living if it goes bust.

      With banks, it comes down to a few really important figures: Total reserves and actual write-offs. A bank sets aside so-called reserves for loans it *THINKS* will go bad. So if we thought $20 million worth of loans wouldn’t get repaid, we’d write that off on the income statement EVEN BEFORE WE LOST A PENNY, lowering profits. Buried in the 10K, we’d have something showing actual net write-offs, which is the amount that ended up going bad. During recessions, conservative banks might take big reported hits by over-reserving and then when things get better, they will “release” the reserve because actual charge offs were much lower. This all goes into the profit column quarters, or years, later and can help them shoot their stock price higher.

      Likewise, tangible capital relative to liabilities matters a lot, too, as does the source of that capital. I wouldn’t touch a bank stock unless I was able to understand all of those figures. That means your friend, unless he is capable of performing that kind of analysis, is gambling not investing.

      Another option for people who want to gamble in “sectors” of the economy, like banks, is focused ETFs, which have all the risk of being concentrated in a single area of the economy and market. For example, the Bank SPDR ETF (https://www.spdrs.com/) owns a bunch of bank stocks but you buy them under a single ticker symbol. Right now, Citigroup makes up 10% of the holdings but it contains Wells Fargo, Bank of America, Suntrust, Fifth Third, Regions Financial, US Bancorp, JP Morgan Chase, etc.

      As a rule, I never tell anyone if I think something is a good or bad investment. I can’t help you or your friend at all in this regard and cannot make any recommendation. In fact, I think your caution about trading in things you don’t understand is wise! If something is outside of my circle of competence, I run. I may study it to learn for the future, but I don’t feel any pressure to “get it” before time runs out.

      From the little you mentioned, though, I’d say someone who can’t tell whether a loan-loss-reserve-to-net-charge-off ratio is conservative or not within 3 seconds is probably speculating and it will be sheer luck if they make a killing or lose their shirt. If your friend is pushing you for an answer, he will just as likely blame you if things go wrong (and you get no benefit) or he will praise himself for bringing it to your attention (and you get no benefit). So you have NOTHING to gain by talking to him about the stock and everything to lose. Don’t do it. Just change the subject if he asks again or say you have no idea. The danger is not in what you don’t know but failing to recognize what you don’t know. That is where the big money is lost most of the time.

  • Gilvus

    What’s your take on Veblen goods? Would you purchase them?

    • http://www.joshuakennon.com Joshua Kennon

      Yes, sometimes. It comes down to two questions:

      1. Do I want the item anyway for its own utility? For example, I always buy the newest, best Apple products. To some people, they are overpriced status symbols. To me, who made a lot of my early money working 18 hours in front of a computer screen, they are far superior tools that I could use because of some of the features built into the operating system that weren’t available in Windows that made my life easier. What is a Veblen good to someone else wasn’t to me. They saved me hours of my life and, as you know, I think time is the most precious commodity. It is far more precious than money.

      Likewise, I buy shirts that are comfortable to me, even though that means I have most of them made to my specifications. I don’t care what anyone else thinks it is entirely and wholly for me. Certainly, those shirts have a Veblen goods price component but I like them better so I buy them.

      2. Do I wish to take advantage of signaling theory? It is a very powerful mental model (signaling theory) and it can lead to a lot of business success. Lawyers in certain areas of law, such as divorce law, are likely to be able to charge higher prices if their offices are in the best skyscrapers with the most expensive books and the most expensive cars. By purchasing and displaying Veblen goods, these lawyers are signaling to their potential clients, “Yes, I’m rich, which means I am successful. And if you want to win your case, you want me on it. Pay my price and you have a better chance of winning.”

      The same can work in reverse. If you walk into the office of a down-to-earth businessman who spent his lifetime building an empire that he is considering selling, he drives a Ford and wears sneakers, and you are in a pair of $800 shoes with Italian cut suits, you may send the signal of “slick banker from the city – not to be trusted”.

      I think the interaction of signaling theory and Veblen goods has not been adequately explored. There is a lot of rich wisdom there that I might write about in the future, now that I think about it …

      • Gilvus

        Behavioral research is difficult because giving a survey to someone makes them a “human test subject.” I’ve been warned repeatedly to not step on the ethical review board’s toes.

        Ever consider getting a guest columnist? Maybe you could ask Dr. Stanley (of “Millionaire Next Door” fame) to share his thoughts. He’s been researching the wealthy since before either of us were born…