I keep receiving emails that Star Wars Squadron is only $2.50. Wild! I love Star Wars, and when I was a kid I loved flying around all the planes and stuff.

But why such a big special? And why are lots of computer games on a big sale now?

I mean surely this is the time when demand is high (a lot of people are on holiday) and computer games are a durable good (you pay up front, and then consume them over time).

As a result, this must be the time when people are most willing to pay for it – and the incentive to discount must be pretty weak because if you sell a game to someone now, you can’t sell it to them again in the future. For more fun, try link slot games where you can enjoy exciting gameplay and chances to win.

So let’s have a think about why this may be going on – and I promise not to talk about tacit collusion this time. Instead lets talk price discrimination.

A tale of three consumers

Imagine we have three people who all get excited when they see the following image.

One of these people is a 16 year old from a high income family, and a social network of friends in a similar position. Access to a new game depends largely on payment by your parents due to the need of a credit card – even if you’ve gone off to earn the money yourself.

In terms of time you have plenty of time to play games where you would otherwise be practicing hand stands and breaking windows. As a result, such purchases tend to occur when you are able to access them as an external gift – such as during a birthday or at a game launch when you can point out your mates have gotten it.

In this situation, your demand does not really vary with prices, and you are exceptionally impatient about having the game at release.

Another person is a 21 year old university student with fairly strong credit constraints. Although your time is a bit more constrained than at 16, you still do have a variable amount of leisure time – focused specifically at study breaks. Furthermore, others that you will play with are available at similar times – so individuals will coordinate on games.

This combination of factors means that demand can vary quite sharply with price, as groups of students coordinate on different games on the basis of their price.

Finally you have a 35 year old professional with a family, significant work commitments, and some disposable income. Their network is also similar people. Work and child requirements are not so coordinated, and as a result there is less coordination between people about playing together.

Furthermore, you have very limited free time – which means that you don’t really expect to get too much value from a game, as you doubt you’ll have much time to play it. However, you do have significantly more income.

This type of consumer has relatively low price elasticity … but for a game that is multiplayer focused also has a much much lower value for the game.

All three of these individuals would enjoy playing the game – but they differ in the opportunity costs they face from doing so.

• 16 yos: Material resources are available at fixed times, and plenty of time. So the opportunity cost is associated with the specific time of purchase (a form of limited material resources).
• 21 yos: Have limited material resources, but plenty of time. As a result, the key opportunity cost is other things they could spend money on.
• 35 yos: Have material resources, but no time. As a result, the opportunity cost is more associated with not having time available.

Price discrimination and our Steam sale

Our firm is selling a piece of software online. The marginal cost of doing so is close to zero.

As a result, in a perfectly competitive industry the price would collapse to zero. However, such an industry wouldn’t be sustainable – as no-one would make these games. So some amount of market power exists which generates the revenue to cover fixed costs as well.

We know that the game seller is setting marginal revenue equal to marginal cost – to sell an extra unit they have to cut the price to everyone, and they do this until the “extra dollars” they get become zero.

If they had to set the price and leave it, then we can look at our three groups to figure out the price:

1. If we only sell to 16 year olds we can set the price pretty high!
2. If we include the 21 year olds we run into the issue they can’t pay as much – so we have to sell at a lower price for both.
3. If we include the 35 year olds, then they aren’t willing to pay much at all – so we have to set the price very low to cover all of them.

So the seller will compare marginal revenue and cost, and determine what group is the marginal group. They will only sell to that group and the groups willing to pay more, and the groups with a lower willingness to pay will not receive the product.

Lets picture that the price was $50, and it was only sold to 16 year olds in this instance.

This is “inefficient”. Why? Because it costs $0 to provide the game, people like the 35 year olds do have a small positive value from the game, and yet there is no transaction between the game seller and the 35 year old!

Ohhh no, lost gains from trade!!

So why not charge them less based on the age on their passport? Well we can’t age discriminate. Steam offering different prices based on a persons age would lead to manipulation and is illegal.

But instead we can achieve this by changing prices through TIME – based on when the game is released, and when it is discounted.

A $2.50 sale after Christmas – when the 35 year old is on leave from work, everyone else is getting gifts, and they have had some fun playing with their kids toys – is pretty appealing. If the retailer has already saturated the 16 year old and 21 year old markets, then they are really just servicing 35 year olds when they do this sale.

When the game was released it was $50. The game was advertised, and in some places sold with, a joystick. A lot of 16 year olds love spinning their ship around and around to annoy their friends when playing with them (speaking from experience) – so there is significant value from buying at release when there are a lot of people to do this to, friends and people online. This was in October 2020.

In the three years inbetween, there were plenty of sales – as well as a lot of negative reviews regarding bugs and a lacklustre story. Whether these things matter I don’t know, as I’ve never played or watched the game, but for our price sensitive 21 year olds it will have taken a number of school holiday sales to convince them to give it a go. $20 or $30 sales may have worked for this group.

If this is a correct description of the market, through time based price discrimination the retailer can charge 16 year olds who want the game at launch $50, our 21 year olds who are willing to delay $20, and the relatively disinterested 35 year olds $2.50 – providing the game to a set of different groups who value it, and making the highest profit.

Now we can’t just randomly set the prices lower at different dates as it is a durable good. If everyone knows it will be $2.50 on a certain day, then why would they pay $50!

• It is uncertain if, and when, the game will become $2.50 – hell it took 3 years!
• People may value having the game early – or more specifically, coordinating when they have it to play with other people. The people who value games in this way will pay more for receiving the game at an earlier date.

As a result, the ability to price discriminate is limited by the ability for a high paying type (16 year olds) to tag themselves as a different type (i.e. a 35 year old). If the $2.50 sale was one month after release, the 16 and 21 year olds would likely delay the purchase by a month.

But look at when the $2.50 sale has occurred – three years after game release, at the start of January, after Christmas when middle aged people who don’t commonly buy games are sitting around thinking about their youth.

Great time to convince them to drop half the price of a coffee on something they will never open or use … after customers that were willing to pay a bit more have already paid.

It’s Boxing Day – and I’ve already used up the idea of discussing the now largely missing Boxing Day sales. And the idea that Boxing Day is increasingly lame is common across years.

So instead the focus of today will be on a different industrial economics topic – the state of competition in Australia. Specifically, does the lack of Boxing Day sales tell us something about the level of competition in Aussie?

For this I’ll be borrowing heavily from a Research Note on the topic by my stellar e61 colleagues Dan Andrews, Elyse Dwyer, and Adam Triggs (now of Mandala). I’ll also be relying on this paper by Jonathan Hambur from the RBA.

However, all misunderstandings and inappropriate comments are my own.

Competition in Australia

Yelling that businesses aren’t competitive enough is a great way to get attention, and push for “getting something for nothing”.

What do I mean? If firms are very uncompetitive then we know they are generating an economic rent – and that this rent could be redistributed to someone (consumers, workers) without undermining economic activity.

As most of us are consumers, the unfairness associated with being charged what we view as too much makes this narrative pretty appealing – and a variety of thought leaders who want to persuade us love nothing more than packaging up ideas we find appealing, and repeating them to us ad nauseam.

However, that doesn’t mean there isn’t some truth to concerns about competition. In fact, it is in the interest of people who are earning economic rents to pretend that daring to tax these rents, or reduce barriers to entry, will undermine some magical value they create – and will use the language of productivity and innovation to make us scared of doing anything.

So given that public narratives are tarred with ideology, lets step back and work things out for ourselves – by looking at some data.

When looking at the State of Competition, the e61 authors focused on the degree of concentration in Australian industries – specifically they focus on the market share of the four largest firms in every Industry Group (3-digit industry code).

There are two graphs I’d like to focus on – noting that the Research Note adds a lot more detail if you want to give it a read!

The graph above shows that these concentration ratios are higher in Australia than the US – so Australian industry groups tend to have a greater share of sales that occur among only four firms. Now this could be partially the result of Australia’s smaller markets.

But then we come to the graph below – concentration ratios have risen across a number of industry groups ESPECIALLY retail sales and mining. As our focus today is on retail sales, this tells us that retail sales activity has become more concentrated among a small number of firms.

The other paper tells us that this rising concentration has also been associated with rising margins earned by firms. However, when compared to other countries that increase in margins has been a bit smaller. Margins in Australia are high – but it isn’t clear that this has been a worsening issue over the past 20 years.

What do bad sales tell us about competition?

So Australian industries are concentrated, margins in Australia are fairly high, and judging by my shopping attempts today Boxing day sales are lame. But does this actually tell us anything?

Concentration alone is actually not telling us as much as we hope. It is possible to have 100s of reasonably sized companies in an “industry” but for each to have significant market power – due to the spatial or product dimensions varying between firms. On the flip side it is possible to have a single firm but very little market power (effective competition).

Margins are also tricky, as the necessary return for entry to the industry depends on risk and the needed return to also meet fixed costs – post Global Financial Crisis there has been in lift in both uncertainty and regulation, both factors that require higher margins to incentivise entry.

But does firms reluctance to provided good boxing day sales mean there is a competition problem?

Intuitively this makes sense – businesses look like they are colluding (even if tacitly) to avoid giving me a cheap Xbox.

However, what is boxing day? It is a period when everyone is off work and goes out shopping – there is a huge surge in demand, and people have the time to shop around.

Given this description, this is when a firm with market power would price discriminate by cutting prices to attract these customers who are relatively more willing to substitute between firms. While more competitive firms would simply face a lift in demand and thereby charge higher prices.

So what is it – are the bad boxing day deals a sign that competition in Australia is stronger than in the past, or is it a sign of a competition issue?

Tacit collusion – a tale of two models

OK so we are going back to our description of Boxing Day in 2019, and one of our favourite descriptions of Oligopoly collusion traditionally.

The difference is that this time we are focusing on whether Boxing Day is telling us anything about competition – specifically, does it tell us if retailers are tacitly colluding in setting their prices during Boxing Day?

If we accept the Green and Porter (1984) model of tacit collusion and competition, then firms collude until they think other firms are cheating (a trigger strategy). During Boxing Day the stores are full up, and so there is no need for sales – but as soon as demand drops, firms think that this is because other businesses have “defected” and stolen customers. As a result, the sales will kick off when the stores are not so busy.

In this world, the disappearance of Boxing Day sales is consistent with collusive behaviour – but we’d expect to see some big New Year sales.

If we buy the Rotemberg and Saloner (1986) model of tacit collusion and competition, then tacit collusion breaks down during high demand states – as firms face an out-sized incentive to try to steal customers. In this model, a collusive equilibrium would involve situations where there are big sales following observable increases in demand – like Boxing Day.

We all know what Boxing Day is – as a result, the second model appears more appropriate for understanding whether we generally have collusion. But if we buy this model, it would suggest that one of two things must be true:

1. Competition has increased and as a result there is no long tacit collusion that falls apart on Boxing Day.
2. Competition has declined, and as a result retailers can maintain tacit collusion even when the reward for reneging is huge.

Teasing out the difference between these is pretty tough. When it comes to the service station industry, David Byrne from University of Melbourne has shown that tacit collusion has increased among petrol retailers, with a related e61 event study reinforcing this.

But without more information we just can’t say which way things have gone among retailers in general – such is the nature of industrial economics!

Sorry, no conclusions for today. If it makes you feel better take this post and demand your local retailer reads it – in order to avoid doing so they’ll probably give you a discount

For those who don’t like video and just want to read the text, it can be found below.

[Gulnara]

On a recent trip to my beautician – link to her website below – I started negotiating the price of my visit. However, I quickly caught myself doing so and stopped. She understood where I was coming from, as she is also from the former Soviet Union, where such haggling is a normal part of daily life. But that isn’t the case in a country like New Zealand – which is why we both put a stop to it.

So why is haggling culture so different in different countries, and what are the economic consequences of this?

[Matt]

That is really interesting Gulnara. Such bargaining does depend on the expectations of consumers and producers – so bargaining cultures will tend to support individuals bargaining while societies that do not do that will make it costly.

This strategic complementarity implies that both societies with bargaining and those without are “equilibrium” outcomes – where people’s incentive is to do what everyone else is doing. We call these bargaining and non-bargaining equilibrium “states of the world”.

To evaluate these outcomes, we want to think more deeply about price setting and market structure within each of these states. Then we can posit ways to test this with data, and also think about how differences in the data between countries may be due to the acceptance of bargaining.

The two mechanisms we will focus on here are price discrimation and tacit collusion and price discovery.

Price discrimination

Retail stores tend to be monopolistically competitive – especially at the stage where you have already turned up at the store ready to purchase. 

When you are at a store and ready to purchase you have three options:  Don’t purchase, purchase at the ticket price, and haggling.  In the face of haggling the store has its own incentive to haggle back – or to tell you to get bent.

The willingness to haggle on both the customer’s and the firm’s behalf depends on whether it is something they expect other people to do – it feels pretty stink to go and haggle just for the other person, and other customers, to look down their nose at you. However, this is more than just some concern about underlying social judgment – the act of haggling is something the firm would like to be prepared for, and the act of undertaking haggling puts pressure on these other customers to take on the cost of haggling themselves.

This can all be articulated through the concept of price discrimination.

Price discrimination is an interesting issue. A big reason why we viscerally feel uncomfortable with it is because it is discrimination – two people are being charged a different amount for exactly the same product!  This seems fundamentally unfair.

In this haggling case, such discrimination doesn’t work by having a price and marking it up for some and down for others.  Firms, in the face of bargaining, will increase the ticket price relative to a situation without bargaining.  This will make it necessary for customers to negotiate simply to receive the price they would receive in the absence of such bargaining. 

As a result, if you are not equipped to bargain, you end up paying higher prices – and if you aren’t able to negotiate much, this may be due to it being costly for you to negotiate, making the “real price” paid high.

However, there are those that benefit. Customers that are able to buy who wouldn’t have been able to at the non-price discrimination price, those with a low willingness to pay (or low cost for bargaining) will experience lower prices, and the business is able to increase their profits. Overall it might be more economically efficient, depending on how costly haggling is to individuals, but there may be distributional concerns.

If the industry is fully monopolistically competitive, low entry barriers will see the increase in business profits evaporate – so the increase in sales will lead to an increase in benefits to consumers on average, although at the cost of customers who have a high willingness to pay/low willingness to bargain. Furthermore, such entry may lead to excessive product variety as noted in Li and Shuai (2019) Monopolistic competition, price discrimination and welfare – ScienceDirect.

The mixture of price discrimination and search costs doesn’t just hold in the abstract. Bryne, Martin, and Nah (2019) (negotiation_v18.pdf (nyu.edu)) is a recent example of a field experiment testing out this behaviour and its implications. However, these implications and what we think about them does depend on the reason why “willingness to pay” is high and why “search costs” or “the cost of bargaining” may be high.

If it was just on the basis of individuals initial income, this may be quite redistributive – increasing provision of the product  and the welfare of low income individuals.  However, if it was due to the necessity of provision to meet minimum standards (i.e. health care expenses) such bargaining may be quite regressive.

Gulnara, you’ve actually experienced life with bargaining and life without – why don’t you tell us your thoughts.

[Gulnara]

Thanks Matt.

When I was a teenager I was still getting used to being able to shop for myself. At the time I didn’t really understand haggling, and as a result I found it quite exhausting. 

I specifically remember going and purchasing sunglasses from a store in Baku, that I thought looked very cool. 

I went home with them, and my mom asked me how much they cost – I told her and she inquired whether I had managed to get a discount.  When I told her I just paid the ticket price, she laughed and took me back to the store, haggling with them for a discount to be paid back to me. The point of the lesson was to indicate that even if you were willing to pay for a given product, prices had been inflated – and so bargaining was expected.

As I got older, bargaining was active in certain situations – and it became more natural and less costly for me.  Haggling with doctors for medical treatment and check-ups was extremely common, and once I left Azerbaijan to study in Italy, there were constant situations where bargaining was necessary – and expected – to live on my limited student budget.

Tacit collusion and price discovery

[Gulnara]

Now I’d like to change tack a little bit. Although bargaining may be a tool for price discrimination, it also influences the nature of competition in the market.

We recently talked about tacit collusion when chatting about Nurofen prices. Furthermore, an understanding of tacit collusion helps us to understand economic cycles and the recent discussion about price freezes – something we’ve blogged on.

What does this have to do with tacit collusion?  Well when comparing the Rotemberg and Saloner model to the Green and Porter model we noted that a major issue was that of “information”.  Can a firm tell whether their competitors are to blame for changing prices?

If, instead of monopolistic competition, we had firms that were oligopolistic then these strategic interactions become important for the general level of price setting.

Having bargaining, offers an “unobservable” way to cut or increase prices. As a result, your firm’s competitors may be able to observe the ticket price on what you sell – but they cannot observe the full complexity of how you will discount to attract customers.

This view of collusion and bargaining implies two things.

Firstly, with less information about the price set by the other firm, the Green and Porter model – where there are price wars in low demand states – becomes a more believable representation of price setting.  As a result, pricing dynamics over the economic cycle may look quite different in countries with significant consumer bargaining.

Secondly, as it is harder to observe the other businesses’ prices and build up trust for collusion,  it is more difficult for firms to collude!  In countries where bargaining does not occur, firms can loudly commit to a certain level of prices, and thereby find ways to tacitly collude and keep prices higher.  

As a result, profit margins and prices would be higher in countries where bargaining is culturally uncomfortable – countries like New Zealand, Australia, and the United Kingdom.  These example countries are fairly well known for being “expensive” to live in – so consumer bargaining may be one possible explanation.  However, this is an issue we are going to discuss more deeply another time.

Conclusion

To sum up, with price discrimation and tacit collusion, we’ve outlined two of the possible mechanisms that may differentiate market outcomes in countries with active market bargaining and those without.  Both of these arguments appeared to show bargaining in a favourable light – however, they also did point to trade-offs that may reverse this, namely the cost of bargaining, the proliferation of excess product variety, and broader related distributional consequences.

However, there are other possible arguments that can come to mind.  If you have some alternatives of your own, why don’t you pop them down in the comments for us all to discuss!

Thanks for watching and we’ll see you next time.

For those who aren’t keen on listening to videos, I’ve popped the transcript just below

Cheaper medication in winter

[Gulnara]

I’ve been doing a bit of online shopping.  As part of this, I’ve been struggling to figure out what I should stock up on before the next COVID variant hits.

When looking at the price of Nurofen I noticed that there were only a few specials among the varying brands, and the overall discounts were quite small compared to the deals I’m used to seeing during winter.  

[Matt]

Good point Gulnara, this is an observation I’ve made in the past, implying that this isn’t just due to current circumstances.

However, this feels a bit weird – why would cold and flu medication be cheaper in winter than it is in summer? Let’s formalise why this feels weird, and then see if we can provide an explanation.

Demand and price

[Matt]

To formalise our intuition – and start trying to work out why the observed data looks so different – it is useful to build a model. And the best model to start with is our friend supply and demand.

In our discussion of income and price effects we mentioned the idea of a demand curve. 

[Show prezi]

This demand curve tells us that quantity that will be demanded by consumers at different prices.  

Here we are looking at the market demand curve for cold and flu medication.  As we move down and to the right of the demand curve, additional consumers become willing to buy a product – or existing consumers are willing to buy more.  At each price that additional purchase refers to our marginal customer.

Start with the situation where no provider of cold and flu medication is large enough to influence the price with its decision to produce.  In that case we get a market supply curve that represents the marginal cost of production of cold and flu medication.

This marginal cost is shown as increasing in the quantity supplied – why?  Well the more that is sold, the more storage and shelf space is required, the more need their may be for staff to work overtime, and the more risk there is that the machines creating and packing the medication will break down.  The more “scalable” the process is the flatter this curve is likely to be – but the limitations of storage and shelf-space – what are called capacity constraints – point to an increasing opportunity cost from selling more, which makes this type of curve believable.

As it is a competitive market, the price is set where marginal cost equals the price the marginal customer is willing to pay, which is where the supply and demand curves intersect.  Even if competition breaks down somewhat (i.e. monopoly or monopolistic competition) the argument given here still holds – so it isn’t too extreme an assumption.

Cool, so what?

Well we want to think about what “summer” and “winter” are here?  Imagine a world where you only buy cold and flu medication when you are sick – this would be the same world I live in.  Well, I tend to get a cold or flu much more often in winter than summer.

As a result, at a given price I would buy more cold and flu medication in winter than in summer.  We can represent that with a demand curve that shifts to the right in winter.

The names for this are “high demand” and “low demand” states – where winter is a high demand state and summer is a low demand state.  A high demand state leads to the demand curve shifting right – as for a given price the quantity demanded is higher.

Now here the new market price will be higher due to the demand curve shifting right.  This matches our intuition, but not our data!

Gulnara, what is going on?

[Gulnara]

Good question Matt.  To my mind there are six different arguments against this logic.  Let me tell you about five of them, and save the last one as a treat for later.

Firstly, COVID has changed things – and so even though it is summer perhaps it is a high demand time.  

Secondly, perhaps cold and flu medication is a durable good so prices do not change much over the year as lower prices eat into future demand.  

Thirdly, we may have confused average and marginal benefit in this discussion – it may be that the willingness to pay of the marginal consumer is higher in summer than in winter, perhaps because the weather is better so people want to push away the symptoms in order to enjoy the outdoors.  More broadly, summer time customers may be “less sensitive” to price than winter customers.

Fourth (and related to the third), as demand for medication is higher in winter, supermarkets may use it as a loss-leader to attract customers to buy other products. 

Finally, such products are produced at scale and so the average cost of production is higher during summer.

Each of these five arguments are good, but have a fatal flaw.

The first of these arguments may be true of this year, but as this is an observation Matt’s made repeatedly over his long life, I don’t think it quite covers this.

The second argument would make sense if the price never changes. And the ticket price itself is fixed for these products, so that sounds good.  However, it appears that the discount price is lower in winter than in summer.

[show prezi 2]

The third argument is neat, and when combined with imperfect competition it is very compelling, but from personal introspection I don’t know if I’m convinced. Irrespective of the weather I have a given sickness threshold where I will have medication.  This may well be part of the pricing behaviour, but we’re going to move on and look for something else for now.

The fourth argument is quite attractive in some sense, but there is something unintuitive about imagining supermarkets cutting prices when demand for things are high in order to try to sell other products – there needs to be something else here, either about the elasticity of demand as discussed above, the cross-elasticity of demand, or with regards to competition as we will touch on below.

The final argument sounds compelling, however the focus on average cost is misleading.  The “costs of scale” are fixed costs that must be met irrespective of the amount produced, and as a result it is the marginal cost in the short term – which will either be flat or rising with output – that should determine price.

Getting a bit fancier

[Matt]

Moving away from pure ECON101 we might also note that there isn’t necessarily a competitive provision of cold and flu medication in New Zealand. We only have two supermarket chains which face weak competition from pharmacies for these products due to halo effects.  

Halo effects are the idea that if a firm is offering one product people are willing to buy, then people will be more willing to buy other products there – either due to decreased costs of searching as things are all in one place, or because people trust this business to provide a good product.

Supermarkets bundle a lot of goods and services together and so these halo effects are important for understanding the pricing behaviour of these types of firms.

Furthermore, we can look further up the supply chain in New Zealand to see there are a limited number of cold and flu medication brands on the market – as a result, even if supermarkets were competitive, there may be market power in the provision of these products to supermarkets which would lead to changes in the final price to consumers.

Green and Porter 1984 indicates what we may intuitively expect when an oligopoly exists in a market.  

If the firms in the industry follow their own incentives to maximise profit they will compete and drive down the price – leading to all of the firms achieving lower profits.  This is a traditional prisoner’s dilemma.

[Prezi 3]

As a result, if the firms could collude to keep prices higher and act “like a monopoly” they could all be better off – since a monopoly sets prices in the market at the point that maximises industry profit.

The tension here is that each individual firm has an incentive to undercut their competitor a little bit, as the lower price allows them to steal some customers from their competitor and thereby increase their own profits – albeit at the cost of the profits of their competitor.

The question here is how might collusion breakdown if demand conditions change?

Green and Porter 1984 take a situation where the firms are colluding in a high demand state, and then the economy switches to a low demand state – for example the movement from winter to summer.  

[Prezi 4]

If an individual firm sees demand for their product drop there could be two drivers:  Firstly, general demand for the product may have declined.  Secondly, their competitor may have betrayed them and cut prices – thereby stealing some of the individual firm’s demand!

If the firm is uncertain about what the cause of the drop in demand is, then they believe that there is some chance they have been betrayed.  In order to signal that they will “punish firms that renege on the collusive agreement”, our firm will have the incentive to cut prices.

The willingness to increasingly compete in low demand states is needed to ensure that collusion is maintained in the high demand states – by showing to everyone else that the business is serious about punishing firms that defect.

So our intuition and these models all indicate that cold and flu medication prices should fall in summer and rise in winter – which is the opposite of the result we find.  So, Gulnara help me out here – why could this be?

Information

[Gulnara]

This brings us to our sixth argument – tacit collusion and the temptation to cut prices.

Winter and summer are known quantities – we have them in our calendar, and although we don’t know the weather perfectly we have a good idea of what we will be doing during both.

In this way, a large portion of the difference in demand between seasons will be known.  Furthermore, the actual price set by the other firm is observed – it is on the same supermarket shelf, on the website, and in the flyer!  So it would be perfectly observable if competitors were cheating.

When the oligopolists have knowledge of what the other is up to, we get quite a different problem.  Something that Rotemberg and Saloner 1986 discuss.

In this model a high demand state increases the “temptation” to betray your competitors to try to steal the entire market.  Because of this, it becomes difficult to sustain collusion and collusive agreements will break down.

In our example this means that, during winter, there is a surge in demand for purchasing cold and flu medication.  If our medication providers were able to maintain collusion, they would experience a big increase in profits, but the expected benefit from cutting prices (whether your competitor does or not) is now much higher.  As a result, they cut prices and we get some sweet discounts.

Now you might say this sounds dumb – just don’t cut prices!  But the key thing here is that all of the firms are responding to the change in demand conditions – not each other’s actions.  If one firm does not cut prices, it is attractive for the other firm to cut prices.  If that firm did cut prices, it is still the best response of other firms to cut their prices.  Cutting prices is a dominant strategy!

In the oligopolistic setting all firms have this incentive when colluding – however, it is how the “benefit to defecting” compares to the “benefit of maintaining collusion” when a high demand state occurs that drives the result.  Essentially, the arrival of the high demand state has increased the benefit to defecting while keeping the benefit of maintaining collusion (which are expected future profits) unchanged.

Although this sounds like a good explanation it has one issue – the high demand state is supposed to be unanticipated (as demand is modelled as a stochastic process). However, winter and summer are known!

Why does this matter?  If the timing of the high demand state was known, and the oligopolists knew defection would occur in the high demand state, then there would be an incentive to deviate prior to this – changing the timing related to prices, and potentially unravelling collusion overall.

To rescue this model we would need to ask if there is some uncertainty about demand – and there is. The cold and flu season starts, ends, and peaks at different dates each year:  Flu Season | CDC – here medication sellers will know when the high demand state has started, but there is some uncertainty about when it will start before the fact.

We’ve only noticed the strongly discounted prices when I’ve had a cold, which has been once this season has kicked off – as a result, it could be this form of “high competition during high demand states” that is driving the surprising result of lower prices for cold and flu medication in winter.

Conclusion

[Matt]

Although ECON101 supply and demand are powerful tools – they don’t tell us everything.  The counterintuitive behaviour of prices tells us that sometimes we need to dig a bit deeper to understand what is going on – in terms of the cost of production, market structure, and structure of consumer demand.

Contrary to a lot of what you read on the internet, supply and demand is useful and powerful – but we just need to be honest that circumstances can be complex. As a result, keeping an open mind and always disciplining ourselves against the observed data is necessary for doing good economics.

If you are interested in thinking about this a bit more I did a quick google search after writing this script and found some nifty resources – they will be attached below.  I’ll also add a few blog posts Gulnara and myself have worked on that chat about similar circumstances.

Peak-Season Discount Case – Economics – Reed College

Demand, Information, and Competition: Why do Food Prices Fall at Seasonal Demand Peaks? on JSTOR

Why Do Retail Prices Fall During Seasonal Demand Peaks? by R. Andrew Butters, Daniel W. Sacks, Boyoung Seo :: SSRN

According to the media, NZ shoppers have faced this as well. 

“Some customers have taken to social media to complain that prices of items like soap, meat and fresh veggies have increased sharply.”

However, supermarkets kept denying the fact. It’s hard to judge the case from my experience, as Matt and I were lazy and were primarily eating outside before the lockdown. However, Stats NZ provides data here – so let’s look at the latest release on the Food price index to figure out whether the customers are right.

Spending on groceries

Before looking at this, let’s think about the what has happened.  Fear around COVID and the quarantine by the end of March will have driven down demand for going out to restaurants, travelling, and going to movies – but driven up demand for groceries. 

Why? People were keen to stock up in case they couldn’t get food, and as they aren’t eating out people now need to get more of their food from supermarkets (our case).

Stats NZ’s electronic card spending data indicates that this was indeed the case in March. 

So we know that grocery store demand surged, so what does that mean for prices?

The food price index

Our initial economic intuition tells us, high demand in goods drives up prices as willingness to pay of consumers rises. This is reinforced by the fact that supermarkets were hitting their capacity constraints as noted by the comments around toilet paper.

But then this didn’t happen.

Stats NZ March food price index shows that grocery store food prices rose 0.2% in March relative to February when adjusted for seasonal variation. 

The “real” figure is likely a bit larger, as supermarkets dialled back their “promotions” during the COVID crisis – and these deals are often not included in price statistics.  Even so it looks like supermarkets haven’t increased prices in the face of rising demand, limited competition, and capacity constraints. Why??

Why haven’t supermarkets increased prices?

There are two clear categories for why they would not have increased price – the relationship between the price now and demand in the future, and imperfect competition.

For the first, the price supermarkets set now will influence demand for their store in the future.  There are reputational effects from changing the price (goodwill) which are likely heightened during a pandemic, there are consumer expectations of prices which are anchored to the price now, and for franchise owners there is also the difficulty in getting them to coordinate prices with each other if you intend to significantly change the way products are priced.

In the current situation, supermarkets don’t want to get a reputation of not being kind – or of being price gougers – so will be sensitive to increasing the price.

The second is competition.  If the two supermarkets were hypercompetitive and also had no market power over their wholesalers/suppliers then they would be forced to change prices with changes in supply and demand.  But they haven’t. As a result, they could have market power in either of these markets.

On the sales side this could be a situation of tacit collusion. When demand is high supermarkets compete more to capture a share of the “high reward”, leading to a breakdown in tacit collusion that normally exists. Arguably, this idea is supported by the drop in grocery prices during December (Christmas).

Combining the concern about looking like bad people, and an increase in competition between supermarkets to get these new customers, it makes a lot of sense that they haven’t increased prices when faced with a surge in demand.

However, if demand remained higher forever, then these explanations suggest that eventually prices would rise – they only work because this is a temporary “high demand” or “high reputation cost” state.  If restaurants are closed for a year expect to see more upward pressure on grocery prices.

Although I feel some sympathy with her situation, I was worried that I will get dragged all around the place when we do go shopping in the future – and so we’ve gone online to look at Google Maps to figure out where we’ll need to walk. Having a look it appears we won’t have to walk around that far – as the clothing and perfume stores with amazing interior signage projects.

So why is this?

At face value that is quite strange – these firms compete with each other, so wouldn’t they want to be in quite different places to collect different customers? Especially when your location can allow you to differentiate yourself from your competitors.

Take the example when we were talking about loss leaders with toilet paper, it appears important to have your own little place where you can get consumers to shop and it is costly for them to go elsewhere – and if you were placing your firm next to a competitor, it is almost costless for your customers to just jump ship!

So at face value this appears to make little sense – we imagine that these monopolistic competitive firms would want to differentiate themselves from their competitor, and so locate far away from them. So how can we understand what we do observe?

Hotelling’s law

As noted above, the “location” is one way of differentiating a product – if we think differentiating allows you to act more like a mini-monopoly rather than a competitive firm, then it seems like firms have an incentive to do this.

But quite often they don’t on this margin. Why?

This very question led to the development of a concept called Hotelling’s Law after a bloke named Harold Hotelling who published a paper in 1929 on it. He developed a “linear location model” that helped to explain why businesses selling similar goods may locate next to each other.

As I am practicing making online videos for my lectures – due to COVID – I will also talk through this in a video below:

So it is Christmas. How about this year I don’t:

• Make the case for why we should give cash instead of gift.
• Warn about not undertaking time inconsistent behaviour on Christmas day.

Honestly, I used to do the same thing every year.

My way of precommiting to that was to time this post to go up on … Boxing Day! The presents are given, the inappropriate behaviour is done, and now we are ready to go shopping.

But those big sales back when I worked in retail appear to be largely gone. Why?

Why was there a sale?

Back in the day I worked on checkout at the Warehouse, it was great times with great people. So what was the commonly known motivation for Boxing day sales?

It started with overstocking. In the lead up to Christmas a retailer will make a large amount of their profit for the year (specifically based on higher margins), however there is significant uncertainty about what they will sell. As a result, retailers would build up extra stock to make sure they could sell the higher margin products at that time – but that would leave them with stock that just didn’t sell.

As a result, Boxing day was about clearing out that stock – usually at close to cost.

However, then consumers knew there would be a sale on Boxing day. Because they expected a sale, there would be a large number of customers available on the day – in other words, expectations of a good deal leads to consumers being in the location.

As consumers have appeared at the store they have taken on the cost of going to the shops and are looking to shop.

When I was working I very much saw this coming into place as I worked. Suddenly retailers were not just “building up stock” of products that didn’t sell, they would ensure they had extra stock of EVERYTHING to sell on Boxing Day.

With lots of customers available in the shopping area, and a lot of competing firms about, part of the story became about trying to get the customers to come shop at your store – rather than your competitors. As a result, big sales were taking place on popular items in order to get the pool of customers to shop with us!

Where has the sale gone?

So Boxing day is just a day out with lots of advertising nowadays – I hardly ever see a good deal anymore. So what has happened?

This reminds me of models of tacit collusion.

Essentially, high competition had given us a Rotemberg and Soloner style competition for consumers. The “large pie” associated with the huge number of consumers wandering around looking to shop offered a tempting reason to try to undercut competitors – generating a price war.

However, in this style of game there is the possibility for retailers to all improve their profitability by agreeing not to fight. Yes the “reward” for fighting is greater with high demand, but given the prisoner’s dilemma that involves an agreement would make the oligopolistic retailers better off.

And as a result, it appears that is what has happened. Boxing Day sales are not longer the event they used to be.

Will this change?

Tacit collusion is sensitive.

The reduction in Boxing Day sales happened after the recovery from the Global Financial Crisis. In that way, the reward for undercutting your rivals has been lower than it was previously – as consumers may be more averse to spending.

If that is the driver, then one day the sales might be back.

However, it could be that the nature of products have changed. As noted here an increasing number of durable products are being replaced by services. The big Boxing Day sales often involved cheap overstock durable products that were sucking up space. If underlying demand for these has gone away, the Boxing Day sale itself may be gone.

Anyway, I’m off to go shopping – Merry Christmas all you beautiful people, and economists!

Imagine being able to print your own currency.

Click a button, add a few zeros and voila you’ve increased the money supply.

The Reserve Bank can do it, and, believe it or not in a similar vein so too can Air New Zealand.

Our national carrier doesn’t have control over the New Zealand dollar, but it does control the supply of New Zealand’s second biggest currency – the Airpoints Dollar. 

Airpoints Dollars conform to the standard definition of a currency – they are a medium of exchange for goods and services, they can be used to store value through time, and they are a quotable unit of account.

Air New Zealand operates a fixed exchange rate policy for its currency, where one Airpoints Dollar can be redeemed for one New Zealand dollar worth of flights.

Furthermore, in addition to being a currency, the Airpoints Dollar loyalty scheme also adds to Air New Zealand’s bottom line.

Air New Zealand is the sole institution with the ultimate authority to issue the Airpoints Dollar currency and back-of-the-envelope calculations show that the value of the airline’s loyalty scheme could be around $400 million.

At first brush, this valuation of Air New Zealand’s money printing prowess may seem a little far-fetched, but bear with me. The remainder of this article outlines how I arrived at this rough valuation and describes how an airline can generate revenue from a loyalty scheme.

Valuing Air New Zealand’s Airpoints programme

Although Air New Zealand releases detailed information regarding the profitability of the various parts of its air operations, unfortunately our national carrier is somewhat cagier when it comes to its Airpoints loyalty scheme.

Air New Zealand chooses not to report on the profitability of its loyalty scheme, but the airline does regularly divulge the number of Airpoints members and how much these members’ outstanding balances are worth.

As at 30 June 2013, the Air New Zealand Airpoints programme had more than 1.4 million members, up 17% from a year earlier.  These members had outstanding Airpoints Dollar balances valued at $236 million (recorded as revenue in advance), compared to $234 million in June 2012.

This growth in outstanding balances appears modest, but bear in mind that the purchasing power of Airpoints Dollars was boosted over the past year by falling domestic airfare prices.  Using airfare price information from Statistics New Zealand and passenger numbers data from Air New Zealand, I estimate that the real purchasing power of the Airpoints Dollar money supply increased by just under 10% over the past year.

However, although it is interesting to understand how the supply of Airpoints Dollars to members has evolved recently, this information is still not enough to even crudely value how much the Airpoints scheme is worth to Air New Zealand.

In order to derive such a valuation, I need to have an idea of how much profit the loyalty programme generates.  With Air New Zealand not releasing such detailed profit information, I was forced to get an idea of potential profitability by looking across the Ditch at Qantas.

In the year to June 2013, Qantas’s loyalty scheme generated A$260 million of Qantas group’s A$372 million EBIT.

With the rumour mill abound that Qantas is set to sell off its successful frequent flyer scheme in an effort to raise cash and stabilise the airline’s balance sheet, some analysts have used these profit flows to value the Australian national carrier’s loyalty scheme at up to A$2.5billion.

Given that Qantas’s loyalty scheme has 9.4 million members, this valuation equates to a value of around A$265 per member.  If one assumes that Air New Zealand’s Airpoints programme is equally as profitable as Qantas’s loyalty scheme and has a similar profit outlook, then the same valuation multiple could also be applied to Air New Zealand’s 1.4 million Airpoints members.

This methodology would suggest that Air New Zealand’s Airpoints programme could be valued at just over $400 million. Not bad considering that the total market value of equity in Air New Zealand in its entirety currently sits at $1.8 billion.

How can a loyalty scheme be worth so much?

Many of you may wonder how a scheme that involves creating a currency out of thin air, that is redeemable for flights, can be worth so much.

To get to the heart of this issue, one must understand that, like Qantas’s loyalty scheme, Air New Zealand’s Airpoints programme generates profits in several key ways.

Firstly, the carrot of loyalty points earned by flying with Air New Zealand is a mechanism for attracting customers in the first place and retaining their loyalty.  Thus an Airpoints member will be more likely to purchase flights through Air New Zealand rather than competitors.

Secondly, Air New Zealand can also utilise its currency issuing authority to create additional Airpoints Dollars and sell them to third parties such as credit card companies, hotels, car rental firms, etc. These third parties can then use the offer of Airpoints Dollars as a way of attracting and retaining their own customers.

Other more minor sources of value for Air New Zealand are related to the length of time between when the Airpoints dollars are sold and when they are redeemed for flights. During this period, the airline has free use of the capital and can consequently reduce its funding costs.

Furthermore, there is also a subset of Airpoints members who fail to redeem their Airpoints Dollars before they expire. Air New Zealand can keep the cash received from issuing these particular Airpoints Dollars without ever having to provide a service in return.

Although the basic framework of Air New Zealand’s Airpoints programme is broadly similar to Qantas’s loyalty scheme, it would be difficult at present to come to more rigorous conclusions regarding value than I have outlined in this article.

However, if Qantas does indeed sell off its frequent flyer scheme then intense interest from the investing community may force Air New Zealand’s hand to divulge more detailed information regarding its Airpoints scheme in future sharemarket briefings.

• Why are the prices different between these gyms?
• Are they “extracting surplus” from me – in other words overcharging me?

To think about this, I want to talk about competition – specifically an idea called monopolistic competition.

What is monopolistic competition?

It is a market with a combination of monopoly and competitiveness, but with key distinctions. In monopolistic competition market there is a monopolistic firm and many substitute firms with low barriers of entry. In monopolistic competition, the price change of one firm doesn’t affect the price of another. Product differentiation is a key element of the market.

You would say that oligopoly and monopolistic competition overlap in many ways, however the main distinction in monopolistic competition is that there are very low barriers for the substitute firms  to enter, where as in oligopoly the barriers are moderate/medium. Another difference is that if a firm sets different price in oligopoly, it makes other firms to react, whereas in monopolistic competition price changes by firms do not affect each other

What is monopoly and monopolistic competition then?

A monopoly is a market with a solo firm, where the barriers to entry are very high. A monopolistic competitive firm is ALSO a solo firm, but the barriers to entry of close substitutes are low.

The fact it is close – not perfect – substitutes is important. In this case if the firm increases its price it does not lose all of its customers, as a result in the short term the relative demand curves faced by the firm are given as follows.

In this case, due to the product being “different” in some way the demand curve faced by the firm varies from perfect competition. How could the product be different?

• Branding and perception of quality
  • According to https://gymequipmentbuyers.co.uk/ you should trust in the machines offered in the gym
  • A belief that having the Les Mills brand in your pocket will give you greater gains
• Tangible differences in the services/product offered
  • Location
  • Quality of gym machines
  • Direct network effects (where my friends go)

These differences can also lead to differences in “costs”. But the price difference occurs because the differing gyms CAN charge different prices and without losing or gaining all of the customers in the market – in the case of perfect competition this would not occur.

So having close substitutes (what econs will call a market with heterogeneous goods) can help explain why Les Mills charges a different fee than my prior gym.

Costs and our monopolies

However, we haven’t worked out whether they are taking advantage yet. To figure that out we need to compare a monopoly with a monopolistically competitive firm.

If Les Mills is a monopoly, and would make “normal profits” if it was perfectly competitive, what can we say? From the lecture slides for introductory economics at Victoria University of Wellington comes the following graph:

The monopoly earns a margin above marginal cost and also receives supernormal profits – profits in excess of what is required to supply the market. Such profits are coming straight out of my consumer surplus!

The same type of argument would hold for a monopolistically competitive firm at face value. They will charge a “markup”, but does that imply they make supernormal profits too?

Lets go a step further.

The long run: Entry and exit

In case of monopoly when we introduced the average cost (AC) curve, we can see that, the firm sets prices that are higher than average cost (AC) which allows it to make a supernormal profits.

However, in monopolistic competition our “mini-monopolies” have some close competitors to the product they offer. Economists call these close substitutes. If these close substitute firms lower their prices, this shifts the demand curve to the left for the firm we are looking at, and we get a different intersection between AC and demand curve.

In this case, firms make normal profits only – as the close substitutes keep entering until all supernormal profits are gone. This is what the “low” barriers to entry refer to.

Graphically this would see the demand curve for the firms product shift to the left until it just touches the AC curve once – this is the point where economic profit is zero, and economic profit for all other levels of production will be negative.

With Les Mills are there close substitutes? In my view there is:

• Doing exercises outside or with groups of friends,
• The use of “exercise apps”,
• Other gyms which offer varying “quality-price” trade-offs,
• Other Les Mills!

Most importantly, if a Les Mills gym tried to set a higher price that would incentivize the entry of additional substitutes whose costs of entry are relatively low (outside group fitness classes, phone apps) leading to an eventual reduction in demand for Les Mills memberships. If you are consider to work out at home and save as much as you can, you might also want to get the Best nootrpics to boost your health.

To sum up my thoughts , I have recently joined Les Mills , a monopolistically competitive firm. There exist other substitute gym clubs in Wellington but the price charged by Les Mills is higher due to the better  amenities it provides.

Looking across this blog I’ve seen monopsony discussed in terms of the labour market and in terms of migration and monetary policy.  However, I want to focus on concentration indices (as a proxy for monopsony) and wages.

My friend Chris Ball discussed this at NZAE this year and it has shown up on VoxEU and the OECD recently.  Specifically, I want to consider this point from Chris’s conclusion:

Income growth is generally higher for those in more concentrated industries after adjusting for differences in underlying characteristics. As outlined in Chapter 4 this result is subject to a number of caveats, but even so this is a surprising result because the first principles analysis of monopsony would predict income growth should be lower for those in concentrated markets.

So why could this be?  My guess is that concentrated labour markets may also have market power in product markets therefore:

1. Concentrated markets may have higher productivity growth, allowing them to pay higher wages.
2. Concentrated markets may be subject to greater X-inefficiency due to the incentive for owners to deal with principle-agent problems through contracts, as a result managerial staff may be able to extract greater surplus from the firm – which constitutes labour income.

I am looking forward to more interesting New Zealand work on this issue, as it is something that could be especially important for a small economy far away from the rest of the world like NZ.