Microeconomics – Page 3

Economics in Action: Is Groupon Worth It?

Over at the New York Times You’re the Boss blog, Jay Goltz provides a great example of economic reasoning (ht: Jack B). His topic: how should small businesses think about the costs and benefits of participating in daily coupon sites like Groupon? Participants can see big spikes in traffic, at the expense of slashed margins. Is it worth it?

Goltz deploys many of the standard concepts we professor types teach our microeconomics students: distinguishing variable and fixed costs, the importance of thinking incrementally (i.e., at the margin), etc. But, frankly, he does it in a more entertaining way.

Here’s his basic set-up (but check out the whole article for how this calculation works out):

There are eight key calculations you need to consider to determine whether this is a better advertising vehicle than something else you may already be doing

1. Your incremental cost of sales — that is, the actual cost percentage for a new customer. If you are giving boat tours and have empty seats, your incremental costs for an additional customer are next to nothing. If you are selling clothes, your incremental costs might be 50 percent of the sale price. Food might be 40 percent. In any case, don’t include fixed costs that you would be incurring any way.

2. The amount of the average sale. If the coupon is for $75, will the customers spend more that that? I have seen more than one retailer complain that nobody spends more than the value of the coupon. That’s unlikely but I am sure it can feel that way, and that is my point: Keep track.

3. Redemption percentage. You don’t really know until the end, but from my experience and from what I have heard, 85 percent is a good guess.

4. Percentage of your coupon users who are already your customers. I’m sure this number varies tremendously depending on the size of your city, how long you have been around, and the type of business.

5. How many coupons does each customer buy? (The more they buy, the fewer people are exposed to your product or service.)

6. What percentage of coupon customers will turn into regular customers? Again, it can seem as if they are all bargain shoppers who will never return without a discount, but that’s almost impossible. Is it possible 90 percent won’t return? Sure.

7. What is the advertising value of having your business promoted to 900,000 people — that’s the number on Groupon’s Chicago list — even if they don’t buy a coupon?

8. How much does it normally cost you to acquire a customer through advertising? Everything is relative.

DC’s New Mayor Should Say No to Taxi Medallions

I love taxi medallions.

As an example for my microeconomics students, not as policy.

Just last week, I used New York City’s medallion system to show how an entry barrier — the requirement that each yellow taxi have one of a limited number of medallions — could create profits in an otherwise viciously competitive industry.

How much profit? Well, according to the most recent data from the city’s Taxi and Limousine Commission medallions for independent cab drivers traded at between $610,000 and $620,000 in October. If you figure 8% as a reasonable rate of return of this asset, that translates into almost $50,000 in pure profit each year from driving a cab, thanks to the entry barrier.

Good exam question: Who gets that profit? Hint: It isn’t the cab driver, who either has to lay out $600,000+ for a medallion or lease one at perhaps $50,000 per year.

Of course that profit comes at the expense of taxi riders, who face a double whammy: they pay more for the cab rides they can get, and they end up taking fewer cab rides (the latter effect is known as a deadweight loss – society loses the benefit of the cab rides that would have happened without the medallion system).

Given that background, I was horrified to learn from Matt Yglesias that taxi drivers in Washington DC are lobbying Vincent Gray, the city’s new mayor, to introduce a medallion system. Yglesias quotes Alan Suderman of the Washington City Paper thusly:

Derje Mamo, a taxi driver who helped run transportation for the mayor-elect’s campaign, said cabdrivers already are pushing Gray to reshape the Taxicab Commission and allow for the creation of a medallion system. A medallion or certification system would limit the number of cabs operating in the city. Proponents of such a system argue that too many taxis are flooding D.C. streets. ‘He’s got one year, that’s it,’ Mamo said.”

As Yglesias notes, this is a really bad idea. There’s no reason to believe that there are too many cabs on DC streets (except, of course, from the view of cab drivers who hate the competition), and in some neighborhoods there may well be too few. A more plausible concern, as some commenters on his blog note (but I can’t link to because of some glitch), is that current taxi fares might be a bit too low. Taxi fares are still a new thing in DC–until 2008 the city had a zone system that many passengers, myself included, found bewildering–and it may be that the initial levels weren’t set exactly right. If Mayor Gray wants to do something for the cabdrivers, he should ask the Taxicab Commission to ponder whether some upward tweaks to fares might induce some extra supply that passengers would value.

Update: For further discussion, please see this later post.

Behold the Power of Cheese

American cheese policy is full of contradictions. (If it were full of holes, it would be Swiss cheese policy.)

What, you didn’t know America has a cheese policy? Well, we do, as part of our larger dairy policy. And over the years the dairy policy’s failures have led to caves full of uneaten cheese, subsidized cow euthanasia, and, as Michael Moss documents in the New York Times this morning, the creation of a marketing board whose goal in life is to encourage Dominos and Taco Bell to use even more cheese on their pizzas and quesadillas:

Every day, the nation’s cows produce an average of about 60 million gallons of raw milk, yet less than a third goes toward making milk that people drink. And the majority of that milk has fat removed to make the low-fat or nonfat milk that Americans prefer. A vast amount of leftover whole milk and extracted milk fat results.

For years, the federal government bought the industry’s excess cheese and butter, an outgrowth of a Depression-era commitment to use price supports and other tools to maintain the dairy industry as a vital national resource. This stockpile, packed away in cool caves in Missouri, grew to a value of more than $4 billion by 1983, when Washington switched gears.

The government started buying only what it needed for food assistance programs. It also began paying farmers to slaughter some dairy cows. But at the time, the industry was moving toward larger, more sophisticated operations that increased productivity through artificial insemination, hormones and lighting that kept cows more active.

In 1995, the government created Dairy Management Inc., a nonprofit corporation that has defined its mission as increasing dairy consumption by “offering the products consumers want, where and when they want them.”

Dairy Management, through the “Got Milk?” campaign, has been successful at slowing the decline in milk consumption, particularly focusing on schoolchildren. It has also relentlessly marketed cheese and pushed back against the Agriculture Department’s suggestion that people eat only low-fat or fat-free varieties.

The pro-cheese policy thus runs exactly counter to the anti-cheese policy of the Agriculture Department’s nutrition efforts.

The whole article is worth a read for its glimpse into how Dairy Management operates. The organization is private in many regards, most notably the $633,475 in CEO compensation. But it is ultimately financed by the power of the government, which imposes a levy on dairy farmers. The standard argument in favor of this structure is that dairy marketing is a public good, from the perspective of the individual farmers, and that the government role is necessary to coordinate that activity. On the other hand, many industries manage to create trade associations without any government role.

With rising concern about obesity, perhaps now is the time to get the government out of the cheese marketing business? Dairy Management could still exist as a fully private entity, but the government would no longer face a conflict between encouraging healthy eating and pushing quesadillas.

Gender Arbitrage by Multinationals

Economists often argue that market competition can limit some of the economic inequities from discrimination (this idea goes back at least to Gary Becker’s 1957 treatise The Economics of Discrimination). If some businesses refuse to hire well-qualified women or minorities, for example, that creates an opportunity for other businesses to hire those workers at lower cost. Non-discriminatory companies could then gain a competitive advantage over their discriminating rivals. Over time, the success of the non-discriminators could bid up wages to the disadvantaged group of workers.

The practical impact of such competition depends, of course, on the willingness of some employers to be non-discriminatory in their hiring practices. The week’s Economist reports an interesting example of how foreign multinationals are playing that role in South Korea:

Working women in South Korea earn 63% of what men do. Not all of this is the result of discrimination, but some must be. South Korean women face social pressure to quit when they have children, making it hard to stay on the career fast track. Many large companies have no women at all in senior jobs.

This creates an obvious opportunity. If female talent is undervalued, it should be plentiful and relatively cheap. Firms that hire more women should reap a competitive advantage. And indeed, there is evidence that one type of employer is doing just that.

Jordan Siegel of Harvard Business School [and Lynn Pyun of MIT and B.Y. Cheon of Hanshin University report] that foreign multinationals are recruiting large numbers of educated Korean women. In South Korea, lifting the proportion of a firm’s managers who are female by ten percentage points raises its return on assets by one percentage point, Mr Siegel estimates.

You can find the original working paper here. The money quote from the abstract:

Using two unique data sets from South Korea, we show that in the 2000s multinationals have derived significant advantage in the form of improved profitability by aggressively hiring an excluded group, women, in the local managerial labor market.

Perhaps needless to say, the fact that these firms are earning higher profits indicates that there’s still plenty of room to bid up the salaries of managerial women in South Korea.

It’s Back-to-School Season, Time to Lay Your Bets

According to an article over at the Huffington Post (ht Natalie), students at 36 colleges will have a new option when they start classes this fall. Thanks to an outfit named Ultrinsic, students can now bet on whether they will get good grades. Students put up money at the start of the semester and then get payoffs at the end depending on how they do.

Calling it a bet isn’t completely fair, however, since the payoff creates an extra incentive for students to do well. So think of it as a combination of betting (if you think your odds of doing well are better than Ultrinsic thinks) and using a financial incentive to get your future self to study a bit harder. Naturally, Ultrinsic emphasizes the incentive perspective in describing its “Reward” product:

Do you like getting good grades? The right amount of cash should provide you with the needed motivation to pull all-nighters and stay awake during the lectures of your most boring professors. At Ultrinsic.com, you will be able to earn cash while working to achieve your academic goals.

Obligatory note to my new crop of students: all-nighters are generally not an optimal learning strategy.

Like a race track, the company offers packages that pay off not only if you do well on a single course, but also if you perform well in multiple courses or over an entire semester. If a new freshman is really feeling motivated, he or she can also put down $20 up front for the opportunity to win (earn?) $2,000 for maintaining a 4.0 GPA throughout college.

And if students are feeling risk-averse, they can also buy insurance against bad grades. Bomb that final and get a cash reward.

Somehow I doubt many students will want to buy such insurance. Or that Ultrinsic will want to sell it given the risks of moral hazard. Perhaps Ultrinsic will screen for “pre-existing conditions” (like failing a related class) in order to limit the adverse selection. Or just offer such high premiums that only a few extremely risk-averse (or mathematically-challenged) students will apply.

The incentives product, however, seems much more promising. Indeed, it resembles some other efforts to help people modify their own behavior through financial incentives. See, for example, the folks at stikK.com whose service allows users to create their own incentives. For example, you could commit to give $500 to your favorite charity if you fail to lose 10 pounds by Christmas. Even better, you could commit to give $500 to your least-favorite charity if you fail to drop the pounds.

Ultrinsic is just applying this logic to college grades … and kindly offering to take a cut when students fall short.

The Chevy Volt Premium

The other day I noted that Amazon has been tussling with book publishers over the pricing of electronic books. Amazon would prefer a wholesale pricing model, in which it sets retail prices, rather than an agency pricing model, in which the publishers set the prices. One reason that Amazon would prefer the wholesale model is because it would allow it to sell e-books for less than publishers would prefer.

A similar pricing kerfuffle has arisen in the pricing of Chevy’s new plug-in hybrid, the Volt. Auto dealers operate under a wholesale pricing model–they buy the cars and then decide what to charge for them. In this case, however, early demand is so strong that auto retailers are charging more than Chevy (a unit of GM) would prefer. As noted on the Wheels blog over at the New York Times, some dealers are apparently charging $12,000 above the sticker price–$53,000 vs. $41,000–for scarce Volts.

This has miffed GM executives:

By law, General Motors cannot dictate vehicle pricing to its dealers. But Rob Peterson, a G.M. spokesman, noted in a telephone conversation that the company had impressed on sales managers to keep prices in line with the company’s suggested retail price.

“The dealers are independent, for better and, in very rare cases, for worse,” he said. “There are some who have moved in the opposite direction of our request. In response, what we’ve done is to urge customers who have contacted us about pricing discrepancies to shop around, because there are dealerships in their area that are honoring M.S.R.P.”

Bottom line: wholesalers are like Goldilocks, they want retail prices to be neither too hot nor too cold.

Three A’s of E-Book Pricing: Amazon, Apple, and Antitrust

A few months ago, I noted that Amazon and book publishers were tussling over the pricing of electronic books. Amazon had originally acquired e-books using a wholesale pricing model. It paid publishers a fixed price for each e-book it sold, and then decided what retail price to charge customers. Retailers usually sell products at a mark-up above the wholesale price–that’s how they cover their other costs and, if possible, make a profit. Amazon, however, often offered books at promotional prices below its costs. For example, it priced many new e-books at $9.99 even if it had to pay publishers $13.00 or more for them (often about half of the list price of a new hardback).

Several large publishers hated Amazon’s pricing strategy, fearing that it would ultimately reduce the perceived value of their product. They thus pressured Amazon to accept an agency pricing model for e-books. Under this approach, the publishers would retain ownership of the e-books and, most importantly, would set their retail prices. Amazon would then be compensated as an agent for providing the opportunity for the publishers to sell at retail. Under this approach, Amazon would receive 30% of each sale, and publishers would receive 70%.

The strange thing about these negotiations is that their initial effect appears to be lower publisher profits. As I noted in my earlier post:

Under the original system, Amazon paid the publishers $13.00 for each e-book. Under the new system, publishers would receive 70% of the retail price of an e-book. To net $13.00 per book, the publishers would thus have to set a price of about $18.50 per e-book, well above the norm for electronic books. Indeed, so far above the norm that it generally doesn’t happen. … [In addition] publishers will sell fewer e-books because of the increase in retail prices. Through keen negotiating, the publishers have thus forced Amazon to (a) pay them less per book and (b) sell fewer of their books. Not something you see everyday.

Publishers presumably believe that the longer-term benefits of this strategy will more than offset lost profits in the near-term. What they may not have counted on, however, is the attention they are now getting from state antitrust officials such as Connecticut Attorney General Richard Blumenthal. As reported by the Wall Street Journal this morning, Blumenthal worries that the agency pricing model (which is also used by Apple) is limiting competition and thus harming consumers. And the WSJ says he’s got some compelling evidence on his side:

The agency model has generally resulted in higher prices for e-books, with many new titles priced at $12.99 and $14.99. Further, because the publishers set their own prices, those prices are identical at all websites where the titles are sold. Although Amazon continues to sell many e-books at $9.99 or less, it has opposed the agency model because it argues that lower prices, as exemplified by its promotion of $9.99 best sellers, has been a key factor in the surging e-book market.

It’s also interesting to note that Random House decided to stick with the wholesale model, and many of its titles are priced at $9.99 at Amazon.

Of course, higher prices on select books are not enough to demonstrate an antitrust problem. Publishers will likely argue that there is nothing intrinsically anticompetitive about agency pricing, which is used in many other industries. Moreover, there is nothing to suggest that they are colluding on e-book pricing. Also, they may claim that their pricing strategy will allow more online retailers to enter the marketplace, thus providing more competition and more choice for consumers (albeit along non-price dimensions).

The Vuvuzela Externality

Thus far, the top three stories of the World Cup are (3) Germany looks strong, (2) the U.S. got lucky, and (1) the vuvuzela is remarkably annoying.

For those who haven’t tuned in yet, the vuvuzela is a meter-long plastic horn whose name translates roughly as “making a vuvu noise.” And make a noise it does. When thousands of fans start blowing, you’d think a swarm of bees was taking over the soccer stadium … and your living room. Highly annoying.

And that’s not all. According to Wikipedia, the vuvuzelas raise other concerns:

They have been associated with permanent noise-induced hearing loss, cited as a possible safety risk when spectators can’t hear evacuation announcements, and potentially spread colds and flu viruses on a greater scale than coughing or shouting.

In short, the vuvuzela creates a host of externalities. So it’s not surprising that FIFA is under growing pressure to ban them.

I’ve been unable to come up with a market-based approach for dealing with the vuvuzela — there won’t ever be a Pigou club to limit the vuvu noise — and I would personally benefit from such a ban. So I’m all for it.

It is worth pondering, however, whether there are less drastic actions that might address some of the vuvuzela nuisance. Here’s one idea: ESPN and ABC should figure out a way to cancel out most of the vuvuzela noise. I still want to hear the cheers of the crowd and the screams of players who pretend to be hurt, but those are on different frequencies than the dreaded vuvu noise.

I don’t know how technically challenging that would be, but the marketplace is already providing similar solutions for consumers. According to Pocket Lint, you can change the sound settings on your TV, purchase an anti-vuvuzela sound filter, or even build your own filter at home.

Or you can go really low tech and use your mute button.

Web Coupons, Privacy, and Price Discrimination

Suppose you’ve got a successful business, selling your product to a diverse set of customers. Life is good. But you’d like to increase profits even more. What should you do?

One option from the MBA playbook (among many) is to think creatively about your pricing. Maybe there’s a way to distinguish your customers from each other and charge them different prices. Perhaps you can charge higher prices to some of your existing customers without driving them away or charge lower prices to folks who aren’t yet buying from you, or a combination of the two.

Businesses have myriad ways of doing this but, not surprisingly, the web has opened up new vistas. Saturday’s New York Times has an interesting article about the extent to which web coupons can be used to distinguish customers, track their behavior, and optimize marketing and pricing strategies (ht Diana):

The coupon efforts are nascent, but coupon companies say that when they get more data about how people are responding, they can make different offers to different consumers.

“Over time,” Mr. Treiber said, “we’ll be able to do much better profiling around certain I.P. addresses, to say, hey, this I.P. address is showing a proclivity for printing clothing apparel coupons and is really only responding to coupons greater than 20 percent off.”

That alarms some privacy advocates.

Companies can “offer you, perhaps, less desirable products than they offer me, or offer you the same product as they offer me but at a higher price,” said Ed Mierzwinski, consumer program director for the United States Public Interest Research Group, which has asked the Federal Trade Commission for tighter rules on online advertising. “There really have been no rules set up for this ecosystem.”

The web thus offers new ways for companies to pursue the holy grail (from their point of view) of pricing: the ability to personalize prices for each potential customer.

Needless to say, this is sometimes bad news for consumers. After all, increased information can allow firms to jack up prices to consumers that the firms believe are unlikely to stop buying.

Less appreciated, however, is the fact that this can benefit consumers as well. For example, increased information can sometimes help firms offer lower prices to select customers who wouldn’t otherwise choose to purchase.

Without further information, it’s hard to know how such creative pricing will affect consumers in the aggregate. Except that the variety of prices will increase, making more of the marketplace look like the airline industry, in which it sometimes seems as though every seat was sold for a different price.

The Tragedy of the Guacamole

One of the themes of this blog is that economics is everywhere in daily life. Property rights, for example, are at the heart of everyday battles over overhead bins, shoveled-out parking spaces, and food in shared refrigerators.

Continuing in that vein, a friend recently sent me a link to an amusing piece about sharing guacamole. I hesitate to link to it, since this is a family oriented blog, and the piece is decidedly R-rated and NSFW. So I will hide the link under the fold. The basic set-up is that a sort-of-advice columnist named Chris provides humorous answers to reader questions.

In slightly edited form, here’s the bit about sharing guacamole:

[Dear] Chris: My fiancée makes amazing Guacamole, but it leads to the following problem: she only makes one bowl of it, which we then share. The issue is, I like to utilize small amounts of Guac on each chip in order to maximize the amount of time I get to enjoy the sweet green stuff, while she likes to heap massive amounts on each chip, in an effort to eat less chips (which […] I find laughable). This drives me crazy as I always end up with the short end of the Guac stick, and so lately I have been separating the Guac into two equally-sized bowls once she’s made it, in an effort to preserve my fair share. She thinks this qualifies as me being [a jerk] and says I “must have failed sharing in Kindergarten”, but on the contrary, I think it’s her poor sharing that’s lead to the whole situation.

[Dear Letter-Writer:] Well, the obvious solution here is for her to make MORE guac. The other solution? Ask her the recipe, and then begin making it yourself. As head chef of the household, you are in full control of when that guacamole will be presented for consumption. I cook for my wife because it allows me the freedom to eat half of what I’ve made before it even reaches the table.

Furthermore, the strategy of using less guac per chip is fatally flawed. It’s guacamole. All guac is first come, first serve. You must heap as much guac onto one chip as humanly possible (as your fiancée does), only do it at a much faster rate. Think guacamole isn’t a race? IT IS. The faster you eat, the more you get. That’s how it works. And it’s a crucial strategy to exploit when dealing with guacamole, nachos, pizza, wings, and other shared food. Do not hesitate. Don’t even […] chew. You inhale […] until there’s nothing left for her. That’s what I do.

If you were out to eat with your guy friends at a Mexican restaurant, and you ordered guacamole for all to share, would you get [mad] at your friends for digging in too quickly? [Heck] NO. That guac is chum, and you are the sharks. ATTACK ATTACK ATTACK. Never play defense with appetizers.

There you have it, the world’s best explanation of the tragedy of the commons. Garrett Hardin eat your heart out. Let’s just hope we never find ourselves at a Mexican restaurant with Chris.

The letter-writer deserves kudos for endorsing the standard (and effective) economist solution to this problem: well-defined property rights. And his fiancée? Maybe she’s a fan of recent Nobel Laureate Elinor Ostrom.

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