Australian financial Review

Australian financial Review

Question 1: On April 24, 2013 a factory collapse in Savar, Bangladesh killed more than
1,100 workers. Most of these workers were employed by factories producing garments
for Western markets, including Australia. Such tragic incidents have led to a concerted
effort by some retailers to sell ethically-produced clothing.1 These retailers are essentially
betting (hoping?) that consumers will appropriately value such clothing. Is there any
evidence to support this? A study conducted by the research firm McCrindle found that
eight out of 10 Australian consumers are willing to buy a product that has a charitable
component over one that does not as long as the price between the two are similar.2 This
need for prices to be similar highlights the challenge faced by many socially conscious
retailers. As long as a garment produced in a safe workplace costs more than a similar
garment produced in an unsafe workplace, the retail price for the former will always be
higher. This may explain why, when it comes to buying ethical clothing, Australian
consumers “do not put their money where their mouth is”.3
Motivated by the behaviour of Australian consumers referred to above, consider a
1By ethically produced I mean garments that are produced in safe workplaces. In other words, I
am leaving out concerns about the use of sustainable production methods in the worldwide garments
industry. All of our conclusions about how to induce consumers to switch to garments produced in safe
workplaces also apply to a scenario where we are interested in inducing consumers to buy garments
produced using sustainable methods.
2As reported in Carmody, Broede, 2014. “Australian shoppers prefer ethical and Fairtrade products:
study.” Smart Company, May 30.
3Han, Misa, 2016. “Slow fashion a poor fit for mainstream consumers.” Australian Financial Review,
April 22.
1
model where a consumer must decide how much of a garment to buy. Suppose that this
garment comes in two varieties: (a) a low quality variety that is produced in an unsafe
factory overseas and (b) a high quality variety that is produced in a safe factory overseas.
Let us suppose that this consumer’s preference for the two varieties can be represented
by the following utility function:
u = XL + XH (1)
where XL = 0 is the number of units of the low-quality variety that she purchases and
XH = 0 is the number of units of the high-quality variety that she purchases. Let the
price of these varieties be PL and PH respectively and let this consumer’s income be I.
(a) [2 marks] Suppose that PH > PL. How much of each variety will this consumer purchase?
Use a diagram with XH on the horizontal axis to explain.
To see whether we can induce this consumer to buy more of the high-quality variety,
now suppose that the consumer’s utility not only depends on her purchase of each variety,
but also on her reputation in society. This means that we can now write her utility
function as follows:
u = XLR + XH (2)
where
R = D + vXH (3)
represents her reputation in society. This reputation is an increasing function of the
amount of the high-quality variety that she purchases. In other words, in this model,
the consumer’s decision to purchase the high-quality variety is motivated by both the
utility that this decision will provide as well as the enhancement to her reputation. This
means that purchasing XH allows this consumer to engage in “virtue signaling”. That
is, it allows her to signal to the rest of society that she is a socially conscious consumer
that buys ethical garments. We will assume that buying the low-quality variety does not
affect her reputation.
In this model, D represents this consumer’s baseline reputation. It is her reputation
if she chooses to not purchase the high-quality variety at all. In contrast, v represents
the increase in her reputation from a one unit increase in the her purchase of XH.
(b) [10 marks] Suppose that PH = 2 and I = 20. Using this information as well as (2) and
(3), find this consumer’s optimal consumption of each variety. The optimal consumption
levels should be a function of PL, D, and v.
Now suppose that a group of socially conscious retailers develop a campaign to induce
more consumers to purchase ethical garments. The key element of their campaign
will be to attach a label to their garments that will certify that the garment has been
produced in a safe workplace overseas. The advantage of this symbol is that it will allow
a consumer to signal to society that she is socially conscious. That is, the symbol will
allow the consumer to enhance her reputation by purchasing the high-quality variety.
2
(c) [4 marks] Let us assume that the use of this symbol increases this consumer’s v from
0.5 to 1. You can also assume that D = 3, PL = 0.5, PH = 2, and I = 20. Use a
diagram with XH on the horizontal axis to illustrate this consumer’s indifference curve
for both values of v. Can you infer from this diagram alone whether the higher v makes
this consumer better off or not? Explain. [Hint: when drawing the diagrams for this part
you can assume a fixed value of u = 130.13.] (d) [2 marks] One way to measure the magnitude of the effect of a change in v on XH is
to calculate an elasticity. Specifically, define the elasticity of XH with respect to v, e
v
, as
e
v =
Percentage change in XH
Percentage change in v
Calculate this elasticity when v changes from 0.5 to 1. You can continue to assume
that D = 3, PL = 0.5, PH = 2, and I = 20.
Another way to increase the consumption of XH is to tax XL. This tax will raise
the price of XL, PL. We can measure the impact of such a tax using the elasticity of XH
with respect to PL. Let this be defined as
e
PL =
Percentage change in XH
Percentage change in PL
(e) [3 marks] Calculate this elasticity when PL changes from 0.5 to 1. Here you can
assume that D = 3, v = 0.5, PH = 2, and I = 20. Compare this elasticity with the one
you calculated in part (d). What does this imply about the effectiveness of a tax on XL
relative to exploiting a consumer’s desire to engage in virtue signaling?
(f) [4 marks] State and explain two limitations of this model that might lead you to be
unconvinced that virtue signaling is more effective than the tax