The high price of liquor at restaurants has created a popular perception that restaurants break even on food and make huge profits on alcohol. This seems to imply that restaurants have to compete in food service, but can charge whatever they want for drinks. Although restaurants often do break even on meals, their high alcohol prices do not reflect a lack of competition. Restaurants might appear to rake in the money on booze, but drinks also comprise a large part of their costs; that is, the cost of providing a place to linger over a drink.
Why are Last-Minute Airline Tickets So Expensive?
Does price discrimination explain why travelers flying on short notice must pay more for a plane ticket than those who book their trips in advance? The Southwest Airlines website clearly shows the relationship between ticket prices and how far in advance a ticket is bought.24 A one-way flight from Philadelphia to Chicago on December 12, 2006, ranged from $109 for a non-refundable promotional fare purchased twenty-one days in advance to $168 for a ticket bought on the day of the trip. Waiting to buy your ticket until the last day thus raised the ticket price by 54 percent.
Ticket Prices on Southwest Airlines
It may seem that short-notice travelers are charged more because they are more desperate to fly at a particular time than those who make more leisurely plans. But this would need further explanation: exactly how could airlines charge excessively high monopoly prices when numerous competitors exist and the cost of checking fares is so low? Short-notice travelers can consult Orbitz, Expedia, or other websites that compare ticket prices, or simply call someone who specializes in comparing rates—a travel agent. But the large discrepancy in fares for short-notice and advance-notice travelers exists despite the ease and low cost of shopping around for different fares. This should give us pause before immediately assuming price discrimination.25
What airlines are doing, in fact, is charging extra for a particular service—providing a ticket at the last minute. In order to provide this service, airlines must keep “inventories” of seats that are still available at the last minute. As a result, some of these seats can go unsold, and the airlines must be compensated for this loss. This is no different than any other business that stocks inventories—grocery stores, for example, buy more milk than they need in order to ensure that they will not run out. Stores have to throw away unsold milk, and this cost is factored into the price. But consumers are willing to pay a little more if it means that milk will always be available.26
Airlines can easily sell discounted advanced tickets, to the point that they limit the availability of these offers. For airlines to be willing to hold seats for last-minute travelers, they must earn the same revenue from these seats as they do from seats purchased in advance. Just take a simple numerical example from our table for Southwest. Suppose, on average, that just over one-third of the seats set aside for last minute travelers go unsold; assuming that all these tickets could have been sold at the advanced discount “promotional” price. In that case, the last-minute tickets would have to sell for over 50 percent more than the discount price in order to justify offering the last-minute tickets at all.
Why Does the Price Spread Between Full and Self-Service Gas Vary?
Let’s look at one last example of alleged price discrimination. Full-service and self-service gas pumps sell the same gasoline—full-service costs more due to the extra service, not to a difference in gasoline quality. One might expect that the price difference between full-service and self-service gas would be the same for each grade of gas; if a gallon of full-service, regular unleaded costs twenty cents more than a gallon of self-service regular unleaded, then a gallon of full-service super unleaded should cost the same twenty cents more than its self-service counterpart. But this is not the case—the absolute price spread is larger for regular gas than for supreme. AAA reports that for the week of September 25, 2006, the price spread in Rhode Island between full and self-service regular unleaded was five cents per gallon more than it was for the highest octane unleaded.27 Another survey showed that out of sixty-five U.S. cities, fifty had a substantially larger difference for regular unleaded than for premium unleaded (the difference usually being at least at five cents).28
Take a look at prices at your local gas station and you will probably find this disparity. The chart below shows the price differences between full-service and self-service gas at a Sunoco station that I frequent, where regular unleaded had a sixteen-cent spread, while Ultimate only had a twelve-cent spread.
Gas Prices at Sunoco Gas Station at the Chesapeake House Service Plaza off I-95 in Maryland on August 30, 2006
So what explains this discrepancy? Are individual gas stations exercising monopoly power? This hardly seems possible; with so many stations showing clearly marked prices, competition is fierce. But aren’t lower-income customers—who are more likely to purchase regular than premium unleaded—getting swindled?
Once again, what looks like a rip-off is really just the complex workings of an efficient free market. The hidden factor here is that full-service regular gas customers typically buy less gas than those purchasing full-service supreme.29 Consumers of supreme gas tend to have more expensive cars and are generally wealthier than consumers of regular gas. The “time cost” of visiting a gas station is thus higher for supreme consumers—they are losing more money by not working while gassing up their cars. Supreme customers therefore try harder to minimize the time they spend at gas stations. One way to accomplish this is to wait to buy gas until the tank is low and then fill it up completely. Customers of regular unleaded, being comparatively poorer, are likely to buy less gas at any one time and then bear the additional time cost of refueling in the near future. This is especially true in full-service stations, where less wealthy customers are more likely to buy just a few gallons in order to get the “service”—having the attendant wash the windows, check the oil and air pressure, etc.30
Since gas stations sell less full-service gallons per customer of regular gas than of supreme, they need to make up the difference by adding a higher premium to regular gas.
Predatory Pricing—Not as Easy as it Seems
One commonly discussed and particularly vicious method of maintaining a monopoly is through predatory pricing.31 This occurs when a firm slashes prices below its own cost of production, usually in an attempt to drive competitors out of business. A predatory firm doesn’t prevail due to the merits of its business plan; rather, its success depends on its willingness to lose money temporarily in order to shut down its competitors. Though cases are rarely serious enough to reach a courtroom, they certainly get attention when they do. Take the cases of Brown & Williamson cigarette makers and American Airlines: both faced high-profile court hearings over predatory pricing in the 1990s.32 This kind of publicity strengthens a common misperception that powerful corporations can engage in predatory pricing at will whenever they feel threatened by a competitor.
It seems perhaps that our entire economy is not really based on free competition, but rather on the overwhelming power of a few monopolies that can prevent other companies’ entry into the market. However, to the contrary, the strategy of predatory pricing is so riddled with contradictions that it actually ends up creating new incentives for competitors to join the market.33
Even under the best of circumstances for monopolists, predatory pricing is difficult. For predation to work, a predatory firm must not only slash prices, but also expand its output at this low price. If it does not expand production as it lowers prices, the firm will not be able to steal sales from its competitors. According to many economists, even if predators succeed in driving away competitors, the fruits of victory will prove short-lived. To merely recoup its losses from predation, after competitors are driven out of the market a predatory firm has to raise prices even higher than the price had been before the predation effort. But raising prices that high lures new firms into the market, which can easily undercut the predator’s new prices. This then forces the predator to slash its pri
ces yet again in order to drive these new entrants from the market.34 This Ferris wheel of lowering and raising prices makes little economic sense.
In addition, because the predator has to expand its output to hold down prices, the losses incurred from predatory pricing easily exceed any subsequent profits from monopoly prices. The losses to the predator also typically exceed the losses suffered by the victim firms that are driven out.
Furthermore, predation can be overcome by using a tactic employed over 130 years ago by the famous robber baron Jay Gould, whose maneuver, while not carried out against a predatory firm, still demonstrated why predation is so difficult and thus so rare. Firms have always been able to trade in other companies’ stocks. In order to overcome the dominant position Western Union then enjoyed in the telegraph industry, Gould “shorted” Western Union’s stock. Shorting involves borrowing shares in a firm’s stock from a brokerage, selling them, and then repurchasing them later to return to the brokerage. When you short a company’s stock, you are betting that the stock price will fall sometime after you borrow and sell the shares, so that you can buy them back later for a lower price and pocket the difference. In Gould’s case, he shorted Western Union’s stock and then set up his own telegraph lines to compete against the company, making a bundle as Western Union’s stock fell. Gould and his partner made a million dollars each just on the stock deal.35 Not bad for the 1870s.
And this tactic is doubly effective against a predator. Suppose a predator has convinced everyone that it is willing to lose whatever money is necessary to drive out any firm that dares enter its market. Precisely because it is believed to be willing to lose a lot of money, it should never have to lose any; no one would even consider entering its market. While one might think that this strategy will keep firms from entering, actually the exact opposite is true; potential competitors have been given an additional incentive to enter the market because they can make extra cash by shorting the predator’s stock. The more the predator loses from the entry of the new firm and the slashing of its own prices, the more the new firm profits from the lost value of the predator’s stock.36
The irony is that the more committed the predator is to bear whatever cost is necessary to wipe out any potential competitors, the more profitable it is for a new firm to enter the market. In other words, the exact strategy needed to make predation profitable actually ensures its failure.
The Failure of Some Typical “Market Failure” Tales
Stories of everyday market failure are easy to find in popular literature. Calls for public vigilance against unscrupulous business agents, various minor scams, and instances where the market somehow doesn’t function properly have turned a tidy profit for a number of authors and economists. But there is often much more to these cases than meets the eye. Perceived rip-offs and alleged market failures oftentimes merely entail the market working in unexpected ways. Here are a few examples:
A Sour Lemon Story
A new car that was bought for $20,000 cannot be resold for more than perhaps $15,000. Why? Because the only person who might logically want to resell a brand-new car is someone who found the car to be a lemon. So even if the car isn’t a lemon, a potential buyer assumes that it is. He assumes that the seller has some information about the car that he, the buyer, does not have—and the seller is punished for this assumed information.
And if the car is a lemon? The seller would do well to wait a year to sell it. By then, the suspicion of lemonness will have faded; by then, some people will be selling their perfectly good year-old cars, and the lemon can blend in with them, likely selling for more than it is truly worth.
—Freakonomics37
Nice story—except that it’s wrong. In fact, the widespread perception that a new car loses substantial value as soon as a buyer drives it off the lot is really just a myth, as we shall see.
In a market economy, if anomalies like the well-known lemon problem described by Levitt and Dubner occur, they inevitably create a financial incentive for entrepreneurs to solve them.38 Suppose you buy a car for $20,000 and decide for whatever reason to resell it quickly. Assuming nothing is wrong with the car, you have a $20,000 car with just a few miles on it, but according to Levitt and Dubner you can only sell it for $15,000 because buyers believe that people only try to sell a new car so quickly when there’s something seriously wrong with it. What do you do? Do you really sell the car for a $5,000 loss?
Here is the real question: can you convince someone for, let’s say, $4,000 that there is nothing wrong with your car? What about for $500? Could you hire the car’s original manufacturer to inspect the car and certify that it’s in brand new condition? If you could do this for $500, and inform potential buyers about the certification in your advertisements, you could likely sell the car for the full $20,000, earning for yourself $19,500—not $15,000.
There are, in fact, lots of other possible solutions. For example, car manufacturers also allow warrantees to be transferred to new owners. Whether the warrantee is for three years/36,000 miles or five years/60,000 miles, a person who buys a lemon will not be stuck with it, even if he is the second owner. Furthermore, some places allow you to return a used car for a full refund. For instance, CarSense, a certified used car dealer in the Philadelphia area, offers full refunds for cars returned within five days of purchase.39 And of course, these resale companies want to maintain a reputation for screening out any problematic cars.
Luckily for us, the lemon thesis can easily be tested. I analyzed the prices of fifty-five certified used cars—all 2006 models—in the Philadelphia area, comparing the manufacturers’ suggested retail price (MSRP) for brand new cars with the certified used price and the Kelly Bluebook price.40 The Kelly Bluebook price “reflects a vehicle’s actual selling price and is based on tens of thousands of recent real sales transactions from auto dealers across the United States.”41 I looked at forty used cars that were less than a year old, all with about 15,000 miles on them. These were chosen to divine what used cars sell for when they are about a year old. An additional fifteen used cars had been driven less than 5,000 miles on them, averaging 3,340 miles.
One thing immediately became clear: used cars with only a few thousand miles on them sell for almost the same price as when new. (See table on pages 38-39.) The certified used car price was on average just 3 percent less than the new car MSRP. And it was 3 percent higher than the new car Bluebook prices. The Kelly Bluebook further indicates that the private-transaction used car price was only 4 percent less than the new car Bluebook prices.42 One explanation for such a small discount on private transactions—in which buyers can’t even rely on a brand name dealer’s certification—is that manufacturer warrantees still protect buyers.
I called Kelly Bluebook to check if the sample I had was representative and was told that a study of all the cars in their sample would have yielded a similar result; there is surely no 25 percent drop in a car’s price as soon as you drive it off the lot. Even more damning, the price of these virtually new cars occasionally rises even above the MSRP. The Kelly Bluebook representatives claim that in order to maintain strong resale price values and prevent customers from feeling as if the dealer is taking advantage of them, manufacturers often ensure that dealers cannot sell their cars—even the most popular models—at more than the MSRP.
If the lemon thesis had been correct and “the seller would do well to wait a year to sell it,” as Levitt and Dubner claim, then used cars that are about a year old should not sell for much less than those with only a few thousand miles on them. But, indeed, they do sell for a lot less. Cars that are a year old have substantially lower prices. The certified used car price for these older cars was 14 percent lower than the new car MSRP and 8 percent lower than the new car Bluebook prices.
Are Real Estate Agents Really Like Klansmen?
Agents are often better informed than the clients who hire them and may exploit this informational advantage. Real estate agents, who know much more about the housing mar
ket than the typical homeowner, are one example. Because real estate agents receive only a small share of the incremental profit when a house sells for a higher value, there is an incentive for them to convince their clients to sell their houses too cheaply and too quickly... we find homes owned by real estate agents sell for about 3.7 percent more than other houses and stay on the market about 9.5 days longer, even after controlling for a wide range of housing characteristics.
—Steven Levitt and Chad Syverson43
Do Car Prices Plummet as Soon as They Leave the Show Room? Looking at Used Cars Being Sold with about 3,000 Miles (Comparing Manufacturer Suggested Retail Price with Kelly Bluebook Prices and Certified Used Prices for the same 2006 models on September 27, 2006)
Some of us probably feel cheated in life. After all, many experts know more about whatever product or service we are buying from them than we do. Whether it is doctors or lawyers or auto mechanics, we seem to be at the mercy of specialists who have the ability to dupe us.
In Freakonomics, Levitt and Dubner portray America’s free market as a cut-throat environment in which consumers are constantly swindled by so-called experts. Habitually attributing economic anomalies to some kind of scam, the pair don’t seem to realize that market forces exist that punish dishonest behavior. Their distrust of the market is especially evident in their discussion of real estate agents. (Dubner once wrote an article on Levitt entitled “The Probability that a Real-Estate Agent is Cheating You.”)44 Levitt and Dubner are certainly entitled to their opinion, but in asserting that “the Ku Klux Klan [is] like a group of real-estate agents” because both groups use the “principle” of “fear” to take advantage of others, they push the rhetorical boundaries beyond what is tasteful.45
Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't Page 4