by Robert Litan
In January 1930, about three months after the infamous stock market crash, Frank Ramsey, having suffered from chronic liver problems, entered Guy’s Hospital in London to have an abdominal operation. He never went home. Developing jaundice after the operation, he died shortly thereafter. He was 26. Economists to this day speculate about the professional greatness Ramsey would have achieved had he lived a normal life span.
The central notion at the core of Ramsey’s contribution—that firms should be permitted to price discriminate according to consumers’ sensitivity to price—is actively now used and accepted in many markets, even those served by more than a single producer. Before I show you this to be the case, I want to be clear what I am not referring to: the tendency of firms to charge different prices for essentially different, although related products because some of them come with different, more highly valued features. Think of fancier hotel rooms within the same hotel carrying a higher price than standard rooms, or first-class airplane tickets with wider seats and better service that cost more than those in coach.
The price discrimination on which I focus instead is the difference in price for the same room or the same coach seat or the same cruise ship cabin that firms charge depending on when you book the reservation. As one of the architects of airline deregulation, former dean of the Yale Management School and distinguished law professor Michael Levine has demonstrated in considerable detail, these situations have two major things in common: (1) they each involve the delivery of a service that has “common costs” that must somehow be recovered, ideally at the maximum profit possible, and (2) the booking or departure times are fixed according to a preset schedule.28
For example, an airplane or cruise ship has many seats, all made possible by investment in the vessel itself, plus all of the fixed costs of the crews who steer and maintain it. These costs do not vary if one extra passenger boards (except perhaps minor cleaning costs, and perhaps some snacks if the passengers are lucky). In addition to figuring out how to charge passengers to cover these costs, the firms also confront another challenge: The reservations for available seats are made at different dates and times. Should passengers who book early (typically leisure travelers) be given a relative discount, in the hope that those who book at the last minute (often business users) will want to pay more? The main challenge confronting each of the firms providing these services is to figure out what to charge each customer in order to maximize the firms’ profits.
You will learn more about Levine in Chapter 9 but, for now, all you need to know is that he was one of the first academics, government officials, and then business executives to wrestle with these problems in a very real business setting. Shortly after airline fares were fully deregulated in 1979, he was recruited to run Continental Airlines. At the time, it was a risky move, because historically people who ran airlines were former airline pilots, not trained lawyers who also had a deep understanding of economics. Levine brought his technical experience gained in government, combined with economic training after law school under the tutelage of future Nobel Prize winner Ronald Coase of the University of Chicago (who we will meet in later chapters), to Continental and to the airline industry more broadly. His key innovation: He began the process of charging different prices for the same seats (or seat equivalents) to different customers depending on their likely sensitivities to prices. This explains why today prices of airplane seats and hotel rooms can and do change continuously, often within each day and certainly within a week in the case of airlines. Increasingly sophisticated yield management, or what are sometimes called dynamic pricing programs, are now in place throughout both industries, a clear example where an economist had a powerful impact not only on their own business but also in other industries.
Much later in his career, after teaching at a number of leading law schools and serving for a time as dean of the Yale School of Management, Levine developed his more general theory about pricing in industries with common costs and fixed allotments. Levine’s analogy to the pricing of different parts of a cow for meat is highly instructive: Why is it that hamburger is cheaper than prime rib or other parts of the animal? It is not simply because there may be more of the former than the latter; the different prices reflect differences in consumers’ tastes that are reflected in differences in willingness to pay for certain cuts of meat. Likewise, travelers manifest similar differences when they book a cruise ship or plane reservation at different times. Levine credits Frank Ramsey with inspiring dynamic pricing in competitive settings, not just in elasticity-based pricing by a monopolist.29
Another variation of Ramsey pricing, also widely in use, is peak load pricing by utilities, which charge more for electricity when overall demand is high—say during the summer afternoons when air conditioners are running full blast seemingly everywhere in hot climates—than when it is lower. In part, peak load prices may reflect the higher costs of fuel to power electric generators than during base load periods, but they also reflect differences in willingness to pay. The more price-sensitive consumers respond to these price differences by adjusting when they use their appliances, and that is precisely why peak-load pricing promotes energy efficiency.
Until Levine and other economists showed the generality of charging on the basis of consumers’ price sensitivities, it was widely assumed that only monopolies could engage in price discrimination. Instead, Levine and others showed that the presence of price discrimination should not always be taken as evidence of monopoly power, and that, in fact, it was more likely evidence of the common cost problem that many firms in a variety of contexts confront, since virtually all firms have fixed costs they need to recover in order to remain profitable. Levine, in particular, however, demonstrated this to be a widespread problem, not one limited to special circumstances. Other economists, such as William Baumol, whom you will meet in the next chapter, have also demonstrated this.30
It is well recognized that price differentiation can only work if users being charged higher prices cannot arbitrage their way to lower prices—that is, being able to buy a low-priced item and immediately turn it around and sell it as a high-priced one. Arbitrage is a lot easier to do when selling physical commodities, which is why we don’t see much price differentiation for goods. Furthermore, if price-insensitive users can pose as price-sensitive users to whom low prices might be charged, then even providers of travel services might find it difficult to engage in price discrimination.
The Bottom Line
Prices are among the most important—some will say the most important—signals in any economy. In purely competitive markets, with well-established products and services, firms have little or no choice about what prices to charge. The market tells them, although perhaps first through trial and error.
For new products and services, however, firms have a lot more choice, and this is where economists have proved their worth. Not in all cases, to be sure, such as the Bloomberg terminal, where an entrepreneur decided on a pricing strategy and his successors (when Bloomberg was serving as mayor of New York) stuck with it, with remarkable success.
But in other contexts, such as Internet search, and in more conventional physical markets for services in limited supply, such as the travel industry, economists have had important and, I would argue, powerful effects on how business is conducted. Indeed, without the innovations of economists (and engineers acting like them, in Google’s case), certain businesses would not have grown as rapidly as they did, and may not even have survived to this day. If you’re searching for the trillion dollars of value I promised you in the title of the book, you’ve found much of it here in this chapter about pricing like an economist.
Here are some key practical takeaways from the successful use of economic ideas in pricing:
Where you don’t know what price users will pay for your service or commodity, consider an auction, such as a Vickery or second price auction.
If you have excess demand for a service with limited shelf life, such as a plane t
icket, also consider an auction to clear the market.
Even if you’re not a monopolist, there may be a way to engage in price differentiation, if customer arbitrage is difficult or expensive.
Notes
1. Norm Brodsky and Bo Burlingham, Street Smarts: An All-Purpose Tool Kit for Entrepreneurs (New York: Portfolio, 2010).
2. Alan S. Blinder, Asking about Prices: A New Approach to Understanding Price Stickiness (New York: Russell Sage Foundation, 1998). Price and wage stickiness, at least downward, is a fundamental tenet of Keynesian economics, and is a topic of seemingly never-ending controversy among many macroeconomists.
3. Michael Bloomberg and Matthew Winkler, Bloomberg by Bloomberg (New York: John Wiley & Sons, 1997). The material about pricing is drawn from this book and my own experience at Bloomberg Government, an information services subsidiary of Bloomberg LLP.
4. Mike Brandly, “Mike Brandly, Auctioneer Blog,” Mike Brandly Auctioneer Blog, http://mikebrandlyauctioneer.wordpress.com/auction-publications/history-of-auctions.
5. Julian L. Simon, “An Almost Practical Solution to Airline Overbooking,” Journal of Transport Economics and Policy II, no. 2 (May 1969): 201–202.
6. Julian L. Simon, “The Ultimate Resource,” American Journal of Physics, 53, no. 3 (1985): 282.
7. The metals were copper, chromium, nickel, tin, and tungsten.
8. Julian L. Simon, “The Airline Oversales Auction Plan,” Journal of Transport Economics and Policy 28, no. 3 (September 1994): 31–23.
9. “Auctions for Overbooking,” Wall Street Journal, June 8, 2010, http://online.wsj.com/article/SB10001424052748703303904575293011757655060.html.
10. Jan Dennis, “Airline Overbooking Policy Well Known and So, Too, Should Be Its Creator,” News Bureau, University of Illinois, August 3, 2009, www.news.illinois.edu/news/09/0803overbooking.html.
11. Steven Levy, In the Plex: How Google Thinks, Works, and Shapes Our Lives (New York: Simon & Schuster, 2011).
12. Steven Levy, “Secret of Googlenomics: Data-Fueled Recipe Brews Profitability,” Wired.com, May 22, 2009, www.wired.com/culture/culturereviews/magazine/17-06/nep_googlenomics?currentPage=all. The rest of the personal material about Varian I obtained in a personal interview with him on July 15, 2013 (and through earlier conversations I had with him during the course of our careers). In the interest of full disclosure, I wrote a white paper on behalf of Google with Hal Singer in 2012, defending one of Google’s search practices.
13. In 2012, Google’s advertising revenue accounted for almost $44 billion versus $31 billion in revenue from Google websites. See: “2012 Financial Tables,” Google Investor Relations, July 10, 2012, http://investor.google.com/financial/tables.html.
14. William Vickery, “Counter-speculation, Auctions, and Competitive Sealed Tenders.” Journal of Finance 16, no. 1 (1961): 8–37, http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1961.tb02789.x/pdf.
15. Hal R. Varian, “The Economics of Internet Search,” Rivista di Politica Economica (November–December 2006): 177–191. www.rivistapoliticaeconomica.it/2006/nov_dic/pdf/Varian_eng.pdf.
16. For this reason, the Google ad auctions are not pure Vickery auctions. For a technical explanation, see Hal R. Varian, “Online Ad Auctions,” American Economic Review 99, no. 2 (2009): 430–434. http://pubs.aeaweb.org/doi/pdfplus/10.1257/aer.99.2.430.
17. Some investors who bought the stock on the first day were also caught up in a computer glitch that prevented trades in the stock from being completed for several hours on the NASDAQ exchange on which the company’s shares were listed. At this writing, several class action investor lawsuits are still pending against NASDAQ over this incident.
18. For a thorough overview of these techniques, see Hal. R. Varian, “Big Data: New Tricks for Econometrics,” The Journal of Economic Perspectives 28, no. 2 (Spring 2014): 3–28.
19. For more information about this platform, see www.globaldairytrade.com.
20. See www.cranberryauction.info. The economists who assisted in establishing both this auction platform and the earlier one for milk, which they also manage, are from CRA International, a firm I discuss briefly in Chapter 5, and with which I previously have been affiliated as a senior consultant (but not on auction-related matters). I am grateful to Brad Miller at the firm for providing me with this information.
21. Aki Ito, “Stanford Economist Musters Big Data to Shape Web Future,” Bloomberg.com, www.bloomberg.com/news/2013-06-26/stanford-economist-musters-big-data-to-shape-web-future.html.
22. “Jay Walker,” Speakers Platform, www.speaking.com/speakers/jay-walker.php.
23. Scott Case, “Interview on Jay Walker and the Origins of Priceline,” interview by Robert E. Litan, June 2013.
24. Unpublished memorandum provided by Walker to the author.
25. D. H. Mellor, “Cambridge Philosophers I: F.P. Ramsey,” Philosophy 70 (1995): 243–262.
26. Frank P. Ramsey, “A Contribution to the Theory of Taxation,” Economic Journal 37, no. 14 (1927): 47–61 www.uib.es/depart/deaweb/webpersonal/amedeospadaro/workingpapers/bibliosecpub/ramsey.pdf.
27. John Maynard Keynes, “Frank Plumpton Ramsey,” Essays in Biography (New York: Harcourt, Brace and Jovanovich, 1933).
28. Michael E. Levine, “Price Discrimination Without Market Power,” Yale Journal on Regulation 19, no. 1 (2002): 1–34.
29. Ibid.
30. William J. Baumol, “Predation and the Logic of the Average Variable Cost Test,” Journal of Law and Economics 39, no. 1 (1996): 49. See also Levine, 6–8. I was privileged to work with Baumol and my colleague Carl Schramm in writing Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity (New Haven: Yale University Press, 2007).
Chapter 4
Minimizing Costs
If you’re running a business or just running your life, you don’t have to be an economist or take a course in economics to understand how to cut costs. It’s a matter of choice and arithmetic. What things and services do you believe are essential to carry out the business, or to live the life the way you want? What are you willing to pay for them? If you’re on a budget—most people are and so are all businesses in one fashion or another—then controlling costs is one of the most important things you regularly do or should do.
Of course, not everyone is successful in this endeavor, which is why some people and businesses go bankrupt—they live beyond their means. As a nation, the United States has lived beyond its means for years, borrowing from foreign governments and individuals to maintain a level of spending that cannot be financed solely by domestic incomes.
There is nothing inherently wrong with this imbalance if the borrowed funds are used productively, that is, put to work earning more income in the future, whether by expanding the ability to produce more goods and services or, in the case of individuals, through the acquisition of skills that will command a premium in the labor market. Borrowing for professional school, putting aside whether the school has done a good job of minimizing its costs, generally (though not always, just ask a lot of recently minted lawyers) is a good investment for those who earn their degrees. Borrowing to finance more and bigger houses, as many did during the years running up to the financial crisis, did not turn out to be such a good investment.
I digress on purpose, since the simple lesson of the last paragraph bears repeating precisely because through the years it so often has been ignored. The main subject of this chapter, minimizing costs, is a close cousin of the maxim to live within your means, with a twist: here I am going to tell you how certain techniques for minimizing costs have been developed by economists or experts in related disciplines and are now widely used in business. Because these techniques are not obvious to the untrained eye, nor are they typically taught in introductory courses in economics, they are fitting subjects for this book.1
Optimization
Economists have a lot of favorite words and optimization is one of them. The word is uttered in the context of constraints—the fanc
y word for saying that there is no free lunch. Firms seeking to maximize profits are really engaged in optimizing their performance given the constraints of the demand for their products and their costs.
Actually, costs are not a given, but something to be optimized, or actually minimized, on their own. Mathematicians and mathematically oriented economists have developed techniques to help firms do this with precision rather than relying on hunches. Here’s a short history, in plain English, of the field.
The Diet Problem
One of the earliest uses of the specific optimization tool on which I focus in this chapter—linear programming—was to solve the diet problem, which is an easy way to begin to understand the power of the technique. The diet problem is to find the way to minimize the cost of food subject to the constraint that the diet meets an individual’s minimum daily nutritional requirements. Later versions of the problem added another condition, one of diversity, so that one doesn’t end up eating only one or two foods.
To solve this problem first requires some information about key inputs: the cost of individual items of food per serving (such as corn, milk, bread, and so forth) and the nutritional content of the servings of these items (amounts of particular vitamins and calories). If the diversity constraint is added, then one must add the maximum number of servings per item in a day. Since the costs and outputs rise in a linear fashion as the food variables increase—one pound of butter costs twice as much as half a pound, and so on—this is a linear programming problem: The total cost of the menu is the objective function that one wants to minimize, while the constraints are the minimum acceptable daily nutritional values and the ceilings on the quantities of the different food items needed to ensure diversity.