Menu Engineering

Earlier in the semester, my students bravely endured the usual microeconomic approach to understanding consumer choice. You know: budget constraints, indifference curves, and tangencies. Very useful when deployed appropriately, but rather abstract.

To lighten things up—and illustrate some important truths about how consumers actually behave—we then spent a class on the psychology / behavioral economics of consumer choice.

For me, the most fun part was discussing menu engineering. In the usual economic model, people make choices based on prices and the attributes of the goods they can buy. Those things matter in the real world too, but consumers are also influenced by other information. For example, their purchase decisions can sometimes be steered by crafty decisions about what options to include on the menu.

One good example is Dan Ariely’s now-famous experiment with subscription rates for The Economist magazine. In one experiment, his students were offered the choice between paying $59 per year for an online subscription or $125 for print plus online. In a second experiment, they were offered three choices: $59 for an online subscription, $125 for a print subscription, or $125 for a print/online subscription.

Standard economic analysis suggests that the print-only option in the second experiment shouldn’t matter. No one should choose it since they could get print+online for the same price. In practical terms, then, the comparison is the same as the first experiment: online at $59 or print+online at $125. And so standard economics would predict that consumers would make the same choices in the two experiments.

That’s not the way it worked out. In the first experiment, 68% of his students chose the online edition of The Economist and 32% went for print+online. In the second experiment, however, 84% went for print+online, while only 16% went for the online. The good news for standard economics is that no one chose print only. The bad news is that including that option had a big effect on choices. Even though people didn’t want that option, it made the other $125 option look more attractive. In short, it established a reference from which people might decide that the $125 print+online choice was a bargain. So many more of them chose it.

Retailers have understood this psychology for years, of course, while economists are just catching up. But growing interest in behavioral economics has also spawned further innovation in retail, and we are seeing the rise of a new species of consultant: the menu engineer.

Menu engineers advise restaurants and other retailers how to design their menus to encourage customers to buy more and to steer them to more profitable purchases. Consistent with The Economist example, one standard piece of advice is including high-priced items just to make everything else look like a bargain. Menu engineers also recommend that restaurants not use dollar signs; people spend more when they aren’t reminded it’s money. And then there’s a whole science to writing the mouth-watering prose describing each item.

If you have a few minutes, this Today Show interview with a menu engineer is quite amusing.

And for a guided tour of menu tricks, see this piece in New York magazine (ht: Tyler Cowen).

P.S. For completeness, I should note that, according to the Economist entry linked above, the Economist stopped using the three-part pricing system. So maybe it doesn’t work as well in the real world as Ariely’s experiments suggest.

Cupcake Economics

As the New York Times noted a few days ago, cupcakes are hot. I’ve seen shops sprouting around the DC area, and according to the article we are not alone: New York, Los Angeles, Denver, and other cities are also enjoying cupcake boomlets.

I must admit that I don’t know what’s driving the rise of the cupcake. Did Americans finally realize that Krispy Kreme doughnuts are over-rated at best (one man’s opinion)? Was there a technological breakthrough in cupcake production? Has the weak economy lowered rents and labor costs so much that cupcakery is now economically viable?

What I can tell you is that the new cupcake entrepreneurs have a tough road ahead of them. Competition is heating up–good news for cupcake consumers, but bad news for entrepreneurs.

So what is the cupcake entrepreneur to do? Well, the experience of Porche Lovely, who owns a shop in Denver, is instructive:

For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.

So far, the per-cupcake margin is going to pay down start-up expenses. She’s been selling the 2,800 cupcakes a month she calculates she needs to sell to cover her costs — she’s taking only a small salary for now — but she says it’s too early to predict when the store will turn profitable, in part because of the economy and in part because she fears losing business to rival cupcake entrepreneurs.

Ms. Lovely is in the process of rebranding the shop to overcome what she calls “a typical rookie mistake” of underestimating “the power and importance of branding and marketing.” She said she had to do more to tell customers that her cupcakes were made from organic, local and natural ingredients.

Ms. Lovely’s overview of cupcake economics provides a fine illustration of three main points in the economics of competition, which I taught my students a few weeks ago:

  • If you want to stay in business in a competitive market, you’ve got to keep a close eye on costs. You absolutely have to cover your costs to stay in business. (And eventually one of those costs should be a real salary for you, the entrepreneur.)
  • Rivals will eat into your profits. If cupcakes are a good idea, other bakers will follow.
  • To have any chance of making profits in the long run, you’ve got to differentiate yourself. Build a brand and maybe, just maybe, customers will keep coming despite all your rivals.

The Great Eggo Shortage

Today’s microeconomics question, brought to you by the fine people at Kellogg’s: How will Americans respond to the great Eggo shortage?

According to CNN Money.com (ht Michelle):

Grocery stores will be experiencing a shortage of the waffles until mid-2010 due to problems at two bakeries, a Kellogg’s spokeswoman said on Wednesday.

Flooding at an Atlanta bakery during heavy rains in October forced Kellogg, which makes Eggo products, to shut down production temporarily, said company spokesman Kris Charles. Plus, equipment at Kellogg’s largest waffle facility, based in Rossville, Tenn., needs extensive repairs.

“We are working around the clock to restore Eggo store inventories to normal levels as quickly as possible,” Charles said in an e-mail.

Remaining inventory will be rationed to stores across the country “based on historical percentage of business.”

All you armchair economists will immediately recognize that the looming Eggo shortage exists not only because of Kellogg’s production problems, but also because it’s decided to ration the delectable waffles, rather than raise prices.

My question: How will stores and shoppers respond to this shortage? Will grocery stores raise Eggo prices? If they do, will they be denounced as Eggo price gougers? And if not, will there be empty shelves in the refrigerated breakfast section?

And what about consumers? Will they rush out to hoard Eggos today, thus exacerbating the near-term shortage? Will a black market in Eggos emerge?

I’d be interested to hear what you see when you are next doing field research in a grocery store. Of course, in this day-and-age, there’s an even faster way to gauge the Eggo-consciousness of America: check out the stream of Eggo tweets over at Twitter (btw, you can follow me here). Judging by a quick skim of the several hundred Eggo-related tweets in the past few minutes (!), I would say that (a) some consumers will indeed hoard Eggos, (b) some are joking about hoarding Eggos and then putting them up on eBay, and (c) a few consumers are looking at the bottom of their freezers to see if they have any Eggos to sell. Ah, a good old supply response in the face of a shortage.