Bryan Caplan on Pricing and Market Power

by Levi Russell

Previously on the blog, I've shared Bryan Caplan's interesting perspective on monopoly and market power. He recently wrote another post that is at least as interesting as the first one I discussed. Below I reproduce the first half of his post.

In the real world, prices often seem far above marginal cost.  Yesterday, for example, I bought a pair of tweezers for $14.99.  But it's hard to see how the marginal cost - metal, electricity, transportation, miscellaneous - could even reach $1.00.  That's a markup well in excess of 1000%.  If you're steeped in the perfectly competitive model, where price always equals marginal cost, it's easy to feel "ripped off" whenever you make a purchase.

The obvious rebuttal is to point to all the fixed costs of production.  While the marginal pair of tweezers costs pennies to produce, the first pair plausibly costs millions.  Factoring in fixed costs, tweezer producers are probably roughly breaking even.  So how is that a "rip-off"?

But on reflection, this greatly understates what a fantastic deal we consumers get.  To see why, I often invoke my Consumer Gratitude Heuristic.  Here's how it works.  When I bought my tweezers, I asked myself, "How much would it have cost me to make these tweezers all by myself?"  On reflection, the answer is... more than my lifetime wealth!  I'd have to spend years learning the basics of mining and metallurgy to acquire minimal competence.  And after a lifetime of training, I still probably wouldn't have the skill to make a single tweezer as good as the one I bought at Wegmans.  $14.99 versus more time than I have on Earth: that's what I call a bargain.

Caplan goes on to note that this is not an exceptional case. Indeed it isn't; Leonard Reed's famous "I, Pencil" is really a great example of what Caplan is getting at as well. If you're interested in more technical economics on this, I suggest a (tragically forgotten) paper by Armen Alchian (short summary at the end of this FH post) on fixed cost and marginal cost.

Should We Fear Tech-Driven Price Discrimination?

by Levi Russell

Writing at Bloomberg View, mathematician and author Cathy O'Neil walks through several ways in which new retail technology could enhance businesses' ability to engage in price discrimination. I recommend reading her piece, as it makes some good arguments in favor of being concerned. However, I think there are reasons to believe price discrimination either 1) is sometimes beneficial or 2) can be easily avoided.

What is price discrimination? It's the practice of charging people different prices for the same good based on their ability or desire to pay. O'Neil mentions that rules are in place that outlaw this practice, except in the cases of coupons, memberships, or bulk orders. But there are other cases. Senior citizen or military discounts are common. These discounts are based on the general idea that significant segments of these populations have relatively low incomes. Yes, there are well-paid soldiers and many, many people over 65 are quite wealthy, but these discounts apply to enlisted soldiers and elderly retirees on fixed incomes.

Coupons, membership deals, bulk discounts, and discounts for military and seniors are generally thought of in a positive light. People who have lower incomes but more time to cut out coupons will pay lower prices. Those willing to give shopping information to retailers get discounts. Some of us pay higher prices so that soldiers and seniors, who might have lower incomes, can still enjoy goods and services at prices they can afford.

Moving to online shopping, O'Neil explains how retailers collect data on their (potential) customers and are able to prey upon the desperate or cavalier by charging higher prices. Here are some examples with potential solutions in italics:

Retailers collect shopping and other data based on your IP address or browser "cookies."
Clear your browser's cache regularly.
Use the Tor browser, which makes it very, very difficult for you to be identified by websites

Retailers collect data based on user's individual profiles.
Many online retailers allow you to purchase without creating an account.

Personal assistants like Google Home or Alexa might pick up on behavioral cues that allow them to charge high prices.
 Just don't buy one. 

A common theme on this blog is that, as Harold Demsetz pointed out decades ago, comparing the real world with all its faults to a perfect ideal "alternative" isn't necessarily a good guide for policy. So, if advances in retail technology allow retailers to adjust prices based on income or stress or other factors, should something be done to slow these advances? Does it make sense to forego the benefits of improved technology to avoid these potential costs? I don't know the answer to that, but I'm interested in reading your thoughts.

The Poultry Price Paradox - Why Are Turkeys Cheaper During Thanksgiving?

Guest Post
by David Williamson

Over the holiday, Catherine Rampell wrote a piece for the New York Times that raised an interesting question. Why are turkeys cheaper during Thanksgiving when demand is higher? Rampell offers two possible explanations, but I am not totally convinced by either of them. So, I will spell out my concerns with each of Rampell's explanations below and offer a third explanation of my own. Rampell's comments are in block quotes and mine are not.

Explanation #1 (Rampell) - Turkeys are "Loss Leaders"

The most intuitive and popular explanation for a high-demand price dip is that retailers are selling 'loss leaders.' Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups.

This is certainly the most popular explanation, but I worry that it ignores the consequences of competition. The way your store makes money selling turkeys at a loss is by attracting new customers that would normally buy potatoes, cranberries, and pies from your competitors' stores. But why would your competitors allow you to steal their customers? Wouldn't they lower the price of their turkeys in response? If so, wouldn't this cancel your effort to attract new customers and just leave you losing money on turkeys? Also, as an empirical matter, do stores really charge the same or higher prices for potatoes, cranberries, and pies during Thanksgiving? I can't find any systematic data to answer this question, but Kroger (America's largest traditional grocery store) had sales on all these items before Thanksgiving and not just turkeys.

Explanation #2 (Rampell) - Grocery Stores Are Price Discriminating

[P]lenty of economists...argue that it’s actually demand-side forces — changing consumer preferences — that drive these price drops. Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales.

This explanation seems more theoretically consistent to me, but I think it rests on three shaky empirical assumptions. First, a grocery store needs market power to price discriminate. However, even after years of growing concentration, this industry is still pretty competitive (the top four firms account for less than 40% of sales). Second, to preserve its pricing strategy, a price discriminating grocery store needs to prevent others from buying in the cheap market (the Thanksgiving season) and selling in the expensive market (the rest of the year). But how do you stop anyone with a freezer from doing just that? Third, for charging consumers less in November to make sense, it must be that they are more price sensitive during the holidays. But is that true? Rampell gives some good reasons for why it might be true, but I can also see why they might not. Specifically, people tend to be more price sensitive when there are more close substitutes available. I am personally very sensitive to the price of Coke because there are always close substitutes (e.g. Pepsi). But it seems like there are very few substitutes for turkey during Thanksgiving. Would Thanksgiving be the same at your home if you served chicken instead?

Explanation #3 (Me) - The Costs of Stocking Turkey are Lower

My preferred explanation is that because grocery stores are competitive, they must charge prices that reflect the marginal costs of the products they sell. Therefore, if the price of turkeys is higher in July than November, it must be because each turkey is more costly to sell. The tough part is figuring out why. One reason turkeys might be more expensive for grocers to sell in July is that they don't sell very quickly that time of year (i.e. they have low "turnover"). Low turnover means higher costs for grocery stores because every day a product sits unsold on your shelf, you are giving up money you could have earned by stocking something that would sell more quickly. When turkeys start flying off the shelves in November, the cost of stocking each turkeys drops and that is reflected in the price. An advantage of this explanation is that it also implies that we would expect the price of cranberry sauce and pumpkin pie to be lower during Thanksgiving, which I think is the case.

What do you all think? Am I missing something important about Rampell's argument? Am I wrong that higher turnover means lower marginal costs? Are there other reasons why turkeys might cost less to sell and product in November? Your comments are much appreciated. Happy Holidays!