[Pricing Nugget #030] In the Eye of the Tree Holder: Who to Blame for High Xmas Tree Prices?

Christmas is around the corner. 

Today, we look into pricing for Christmas trees and find the one to blame for why prices have gone up in the last few years.

[ Spoiler: The theoretical background is solid, but I leave it up to you how seriously you take the conclusion . ]

Studies showed that the price elasticity for natural Christmas trees is -.674.

This means if you increase the price by 1%, the demand goes only down by -.674%.

As the demand decreases by less than one percent (it is less than proportional to the price increase). As the demand change is lower than the price increase, we call this price elasticity inelastic.

Very smart Christmas tree marketing experts conclude: “Okay, the demand is inelastic, so you could raise prices in order to increase your revenue and profits, as the demand will not change so much.”

Maybe that is the reason why prices for Christmas trees have risen in the last few years.

According to the National Christmas Tree Association (it is a real association!), prices have increased from $36 roughly in 2010 to $77 in 2019. This equals an average annual price increase (also known as "Compound Average Growth Rate" - CAGR) of 8.8%. Compared to the average inflation rate in the U.S. for the same time of 1.8%, the price for Christmas tree rose more than fourfold.

And this could be due to smart Christmas tree marketing experts ripping us off. Unbelievable.

But maybe it's less straightforward.

Have you ever heard about Hotelling's rule?

Hotelling was a really smart economist, in particular in the field of microeconomics, and he found out that for exhaustible resources, the value of the stock must be growing at a rate of interest.

To explain what it means, let us apply it to the market for Christmas trees.

The market for Christmas trees has a number of interesting features that allows us to test the theory of optimum resource pricing as proposed by hoteling.

Assume you have an area of land and you planted Christmas trees, and now you have to decide whether you cut them or let them grow for another year.

If you cut them today, you could take the money, bring it to the bank, and get interest income for the next year and you have the opportunity to plant another new tree today instead of next year.

On the other hand, we see that all the trees receive higher prices.

Hotelling argued that there is an equilibrium where the higher prices offset the opportunity costs of lost interest income and waiting for another year to plant a new tree.

Are you up for some trivia?

To test the theory of optimal resource pricing, researchers checked prices for actual Christmas trees in the retail market, as well as for farms. They focused on the type of Christmas tree that is called Fraser's fir (or - as the pros among us call them - Abies fraseri).

People refer to this type as the "Rolls Royce of all Christmas trees".

This is also the most popular Christmas tree in the White House that is usually put up and decorated in the blue room. It has been chosen most often by presidents and/or first ladies.

It grows one foot per year, which makes calculations a bit easier later on. But the growth rate declines with age.

Testing the Hotelling rule for Christmas trees...

To test the theory about optimal pricing for Christmas trees, the researchers made an assumption about a real interest rate. In 1997, the interest rate for loans was between 9 and 10%. For renewable loans, it was one to two percentage points higher. Therefore, the researchers decided that 11% is a reasonable interest rate.

The researchers made two predictions:

First, if growers let a tree grow for another year, the price for this tree should increase by more than 11%. The planting of new trees should deliver an ROI that is above 11% but might converge to 11% from above.

The second prediction is based on the biological growth rate of a tree. As the growth rate of a tree diminishes over time, the researchers hypothesized that on a per-foot basis, the price change is below 11% but increases over time and ultimately converges to 11% from below.

The researchers tested those predictions in the market with actual Christmas tree prices. As you can see, the rate of change in price per tree is, for example, for Christmas trees that increase in size from five to six feet, 31.9%. If you stay in this row, you see that the price change ranges from 23.3% to 31.9%.

The price change for letting a tree grow one more year is at least 23.3% and, thus, higher than 11%. Prediction 1 confirmed (more precisely: not rejected ).

The second prediction is about a price change on a per-foot level. The per-foot price change should start below 11% and converge to 11% from below.

We can see that for very small trees, the price change per foot is actually negative and increases up to a price change of 15% per foot.

Although the per-foot price change is above 15%, the pattern of increasing per-foot price changes is confirmed (at least not rejected ).

By the way, this also explains why sellers usually do not charge Christmas trees per foot because, for older or higher trees, each additional foot becomes more valuable.

Very interesting... what did we learn so far?

A very famous economist tells us about an important rule to explain optimal pricing decisions for exhaustible resources like Christmas trees.

First, it basically tells us that the decision about cutting a tree or letting it grow is an investment decision.

Second, this investment decision takes into consideration opportunity costs that are strongly dependent on the interest rates for alternative investments.

And, third, another team of researchers confirmed this theory empirically.

Okay, the pricing for Christmas trees is related to interest rates, but...

...what happens if the interest rate increases?

The interest income loss from letting a tree grow for another year instead of cutting it today also increases so that the trees that are grown for another year need to deliver even higher prices to offset the increase in opportunity costs.

So if interest rates increase, trees become more expensive; either the price level for all trees increases, or growers focus on growing trees for another year to receive higher prices.

Okay, let us look again at past Christmas tree prices and at your official interest rate as announced by the Federal Reserve Bank, the Central Bank of the United States.

And you can see that in 2015, the Fed announced the first interest rate increase in ten years. The interest rate went up from 0.09% in 2014 to 2.16% in 2019.

So it is more than a 20-fold increase… and it seems like a pure coincidence, doesn't it?

The Central bank appears to be the reason for higher Christmas tree prices .

Today we learned two things:

First, for higher Christmas tree prices, we cannot always blame the smart Christmas tree marketing expert, but nobody less than the Central Bank and its monetary policy and interest rate decisions.

And second, even for not-so-complex products like Christmas trees, there might be a complex chain of effects that underpins prices and the pricing policy.