DRI-178 for week of 2-8-15: A Closer Look at Prices

An Access Advertising EconBrief:

A Closer Look at Prices

There is no more important tool in the economist’s kit than the price of a good or service. Microeconomics was formerly called “price theory.” That conveys the correct impression that the theories of household, firm and input behavior are best characterized as processes of price formation.

Basic economics texts painstakingly develop the fundamentals of market pricing. This is necessary; we must crawl before walking, walk before running and run in order to stay in shape. But if all economists did was endlessly draw simple supply and demand curves and point meaningfully to the intersection of two lines, they would spend all their working hours in the classroom teaching undergraduate students. In order to avoid this ignominious fate, economists have had to grapple with the multifarious pricing schemes, strategies and tactics encountered in actual practice.

If market price equates the ex-ante quantity demanded and quantity supplied of a good, how do we explain the existence of sales? In particular, what about the perennial favorite, the after-Christmas sale? What are we to make of the market for coupons, which has been estimated at approximately $1 billion in face value in the U.S.? How should we evaluate the phenomenon of the manufacturer’s rebate, a practice that has proven almost as hard for economists to accept as it is for consumers to handle?

For many years, economists ruminated over these matters in the isolation of scholarly journals. Over the last decade or so, their musings have been publicized in books on popular economics. The idea is to make economic logic not merely accessible, but downright useful, to the masses.

How are we doing? You be the judge.

The After-Christmas Sale 

No class of beginning economics students would be at a loss to explain the origin and purpose of the after-Christmas sale. Everybody knows that retails stores make their bones at Christmas time. They place orders with sugarplum visions of Christmas sales dancing in their heads. Then comes the dawn on December 26th, and all those after-Christmas inventories have to be disposed of. Ideally, this should be achieved before yearend, to keep carryover inventories as low as possible for tax purposes. So, to make a virtue of necessity, the after-Christmas sale is born.

As with many a popular explanation for familiar economic phenomena, the beauty of this one is only epidermal. Sure, anybody can make a mistake – even a retail buyer. But the same mistake? Year after year after year? Buying for the most crucial segment of the store’s calendar year, on which its annual profitability depends? Should we suppose, then, that the professional life expectancy of a retail buyer is exactly one year – hired every January and fired every December 31 after annually misjudging the Christmas demand for the store’s product(s)?

No, this story does not withstand close scrutiny. Something else is at work here. What is it?

Economists believe two factors account for after-Christmas sales. Richard McKenzie identifies the first in his survey of pricing, Why Popcorn Costs So Much at the Movies: And Other Pricing Puzzles. To an economist, the most salient feature of the after-Christmas sale is an identical good, sold at two radically different prices in remarkably close temporal succession. One day, good X sells for price Y. The very next day, the same good X sells for Y – [anywhere from 15% to 75%].

When economists encounter simultaneous price differentials for sales of the same good, they label the practice price discrimination. Economists use familiar words in their own inimitable way, and in this case the word “discrimination” need not be pejorative. (Technically, the practice carries antitrust penalties if sellers use it as a device to impede competition.) Sellers practice price discrimination to exploit differential price-sensitivities among their customers – by charging a higher price to less price-sensitive buyers and a lower price to more price-sensitive buyers, the seller can earn more total revenue than by charging a single price to all buyers.

Why does this tactic increase total revenues? The common sense of it is this: For price-insensitive buyers, the stimulative effect of the price increase on revenue outweighs the slight fall in purchases, while for price-sensitive buyers, the stimulative effect on revenue of the increase in sales caused by a lower price outweighs the effect of a lower price.

If this sounds almost too good to be true, we should hasten to add that this condition does not exist for all goods and services and sellers may not be able to exploit it even if it does. But the possibility is enticing.

In our after-Christmas sale, the general idea of price discrimination applies but the context is atypical. Instead of charging different prices to different buyers at the same point in time, sellers are charging different prices to the same buyers at different points in time. But the motivation is exactly the same – to earn more total revenue than would be earned by keeping price the same throughout. The “different points in time” are these: before Christmas and the day after Christmas (continuing for the duration of the sale, perhaps to Dec. 31).

Why are the different prices charged? That’s the easy part – most people are much less price-sensitive during the Christmas season and much more price-sensitive as soon as Christmas is over. And unlike many contexts, in which it may take keen analysis to distinguish the price-sensitive buyers from the price-insensitive ones, there is no buyer-identification problem to plague sellers. Sellers just change price tags at midnight on Christmas or, more conveniently, at closing time on Christmas Eve.

Viewed in this light, it is obvious that after-Christmas sales are not mistakes. Obviously, sellers want to have enough inventories on hand to take advantage of high-priced Christmas demand, but they do not expect to sell out or even come close. They have factored in the price-sensitive demand after Christmas. Indeed, they look upon the existence of the Christmas holiday as built-in market segmentation. The inherent problems facing any potential exercise of price discrimination are two: first, effectively dividing the market into price-sensitive and price-insensitive buyers; and second, preventing resales of the good or service by the first group to the second. The Christmas holiday solves both problems automatically with temporal separation. People are automatically willing to pay higher prices before Christmas and automatically unwilling to pay more afterwards. And low-price buyers cannot resell to high-price buyers because the high-price buyers already made their purchases first. And, as an extra added attraction, the low price after Christmas will lure new buyers to the product who would never try the product under a single-price policy.

When we turn our attention to other types of sale, we find that price discrimination still plays a big explanatory role. Future EconBriefs will tackle some of these advanced cases. It is certainly not impossible that sellers can occasionally over-order stock and may need to reduce inventories; a sale may well be the expedient means to recover from this error. But we should be wary of imputing systematic errors to experienced market participants. Systematic errors result in insolvency – in which case, the erring seller isn’t around to repeat the mistake.

Coupons

Discount coupons have been around for well over a century. Your parents and grandparents have seen them throughout their lives. Today they can be found in newspapers, magazines, circulars and online. Has it ever occurred to you to wonder why they exist? After all, coupons are costly to produce and distribute – “costly,” that is, in the economic sense that the resources necessary to make and provide them have alternative uses.

The total cost to manufacturers has been estimated (for example, by McKenzie) at around $1 billion for the approximately 153 billion coupons distributed to Americans. (These figures are roughly a decade old and may be somewhat lower today.) If the purpose of coupons is simply and solely to discount the price of the product, might it be both simpler and cheaper to just lower the nominal market price rather than issue coupons?

No, not necessarily. Various arguments bolster the use of coupons. Some of them are transparent. Others are much less clear but just as compelling.

The simplest is the notification effect. Consumers cannot buy a product if they are ignorant of its existence. A coupon is a simple and relatively cheap way of announcing a new product and making it cheap for consumers to try it.

Coupons that reward repeat purchases strive to create brand loyalty. For years, some economists have distrusted markets, doubted the ability of consumers to make rational choices and celebrated the effectiveness of government intervention in markets. They have decried efforts to promote brand loyalty as wasteful, inefficient and downright evil. But it is difficult to see why a repeat purchase should be any more inimical to a consumer than an initial one. Apart from powerful narcotic goods, goods or services do not possess addictive qualities. Once the terms of the coupon have been fulfilled, the consumer is back at square one – but with the added knowledge gleaned from multiple trials of a new product. How bad can this be? It may well be a good thing indeed if the consumer’s brand loyalty reflects a genuine preference – and who is the economist to doubt that?

Still, the most-often cited rationale for coupon issuance is price discrimination. As noted above, sellers want and need to identify and separate the price-sensitive from the price-insensitive among their customers. Coupon distribution is a tried-and-true means to that end.

The term found in economics textbooks to characterize the degree of price sensitivity among buyers is price elasticity of demand. (The rule of thumb among economists is to shun common, ordinary, easily grasped words and phrases in favor of unusual, esoteric, obscure terms – preferably in a foreign language.) Factors conducing to high price elasticity are the existence of copious substitutes for the good, low real incomes and a price that comprises a high fraction of the buyer’s real income.

The collection and use of coupons takes up the buyer’s time. It takes time to collect the coupons – time to hunt them up in their various sources, time to clip and save them, time to gather them again before shopping and dig them up when paying. This time is economically significant. Time has alternative uses. The time of low-income people has a lower alternative-use value than that of higher-income people. And the value gained from the coupon comprises a larger fraction of the low-income person’s real income than it does of the higher-income person’s income, so low-income people rate to gain more from coupon use. For these reasons, we expect low-income people to be more price-sensitive and also to be more avid users of coupons. Thus, coupon distribution is a relatively cheap and effective way for sellers to segment their market into price-sensitive and (relatively) price-insensitive buyers. Thanks to the coupons, the price-sensitive buyers arrange to pay lower prices and the price-insensitive buyers pay the nominal (higher) price.

Since the costs of coupon production and distribution are low on a per-unit of production basis, sellers gain total revenue from coupon distribution even when the costs of coupons are factored into the accounting.

Economist Steven Landsburg, another noted exponent of popular economics in works such as The Armchair Economist and More Sex Is Safer Sex, has made another, related argument for coupons. This is the peak-load pricing argument.

Some businesses face a demand for their product(s) that varies dramatically according to time of day or season. If demand at the highest (peak) time exceeds or strains their capacity, it is in their interest to shift some of this peak demand to off-peak times. Electric utilities are one famous example of this phenomenon. At one point, movie theaters were another case, and this gave rise to twilight-hour movie pricing. These days, though, it’s a rare movie indeed that strains the capacity of a movie theater. Popular bars started the practice of “Happy Hour” to shift some of the late evening clientele to the early evening. Uber has seized upon the idea of charging higher prices during rush hours, something taxicabs should have been done years ago but didn’t.

Landsburg noticed that coupon-clippers are disproportionately retirees, who tend to be low-income, price-sensitive people. They can shop in grocery stores in off-peak times such as mid-morning and mid-afternoon, while full-time workers must shop on their way to or from work. The working population has higher incomes and tends to be less price-sensitive on net balance. Obviously, the opportunity cost of taking off work makes grocery shopping during the off-peak disproportionately expensive for working people. But the coupons do make it more attractive for them to shop in the one off-peak time that is convenient for them – namely, the after-dinner hours. So, by distributing coupons, grocery stores can shift some of their demand from the morning and (particularly) evening rush-hour peaks to the off-peak, thereby lessening their staffing problems and increasing their total revenue and improving their competitive position relative to convenience stores.

Manufacturer’s Rebates

The $1 billion in annual coupon distributions are dwarfed by the estimated $6 billion in the value of manufacturer’s rebates offered annually. McKenzie estimates that “a third of all personal computers and their peripherals, and a fifth of all digital cameras, camcorders, and LCD TVs are sold with rebate offers.” He cites previous research suggesting that the total number of rebate offers approaches 400 million annually.

As most people already know, a rebate offers the return of money expended for a good or service in return for showing proof of purchase. That showing generally demands a fair amount of the buyer’s time and trouble – mailing in a “proof of purchase” (such as a receipt), perhaps accompanied by one or more completed documents, within a specified time period (called the “redemption period”). The redemption period may vary from a week to a year, but once it is exceeded the customer’s rebate privileges are lost.

Given the prominence of rebates on the retail landscape, it is not surprising that they have evolved a unique vernacular. The term lift is defined as the increase in sales stimulated by a given manufacturer’s rebate. Breakage is the percentage of customers who do not seek, or fail to obtain, a rebate during the redemption period. Slippage is the percentage of customers who obtain the rebate but then fail to cash (!) their rebate checks.

The existence of this vernacular implies that there is many a slip between the rebate cup and the consumer’s lip. According to self-styled consumer advocates, the slips constitute “rebate abuse.” Sellers may deliberately – how could it be inadvertent? – specify short redemption periods (say, one week), discontinuous with purchase (perhaps starting three weeks after purchase). The purpose behind such tactics is clear – to frustrate attempts at redemption.

Naturally, this will not endear the seller or the product to consumers. Perhaps, though, the company is on the ropes and facing insolvency; its managers are staging a desperate “hail Mary” promotion to raise cash. The company is willing to risk offending rebate redeemers when facing commercial oblivion. Since the alternative is simply to sell the product for its nominal price, consumers cannot be deemed worse off for being offered a rebate, however strict the terms – unless we consider the rising blood pressure and indignation they suffer upon reading the fine print in the rebate terms as part of their cost.

Natural curiosity leads to the question: What is the average rate of redemption, anyway? Economists believe the average rate may be as high as 40-50 %. The term “average” (or mean, as statisticians call it) is a measure of central tendency. It is useful by itself, but vastly more useful if contemplated alongside the amount of variance around that central tendency. In this case, the variance is huge.

Some rebate offers produce redemption rates at or nearing 100%. McKenzie cites the case of firms producing digital scanners whose rebate offers were universally redeemed – after which the companies went out of business! Before writing this off as colossal misjudgment, we should ponder the not unlikely possibility that the companies were seeking a last-ditch lift from rebates to avoid insolvency, hoping that breakage would be their salvation. In the digital age, fierce competition and low prices have been the handmaidens of technological innovation.

At the other extreme, sometimes the redemption rate is virtually nil. McKenzie quotes one retailer whose comments are quite revealing, if not perceptive: “Manufacturers love rebates because redemption rates are close to none… they get people into stores, but when it comes time to collect, few people follow through. And this is just what the manufacturer has in mind.” As McKenzie notes, this is wrong not just in practice but also in theory. If rebates were really a guaranteed way to increase sales, everybody would use them. The truth is much more complicated, hence more interesting.

By now, readers can begin to appreciate the basic strategy behind rebates. Manufactured products such as computers and printers carry price tags large enough to stimulate price sensitivity among many consumers. It is in the interest of sellers to sort out the price-sensitive from the price-insensitive buyers and charge differential prices. This is not easy; sellers must segment their market and prevent resales by low-price buyers to high-price buyers.

Manufacturer’s rebates perform market segmentation for the same reasons that coupons do. They are attractive to price-sensitive lower-income buyers whose time has a lower value and who therefore are more willing to take the time to comply with rebate terms. Thus, this is the market segment that actually gets the lower price; that is, the market price discounted by the amount of the rebate.

McKenzie also points out that rebates affect – and are affected by – the reputation of the company offering them. This can give them the quality of a “self-enforcing contract.” (The term was first used by University of Chicago economist Lester Telser.) He uses Dell Computers as a case in point. When Dell offers a rebate, consumers take it seriously. They know Dell will follow through on terms because any slip-ups would harm its reputation – something Dell can ill afford. In turn, that makes Dell’s rebate promotions that much more effective in terms of their lift. So even though Dell’s breakage will be minimal, its lift will be maximal – giving it a solid, consistent, dependable return on its rebate program.

Manufacturer’s rebates may be the most controversial of all pricing policies because their terms offer such scope for variation and their results are so variable. Any detrimental effect on consumers resulting from a manufacturer’s rebate cannot help but be small, not to say miniscule. Related complaints are purely emotional – which makes them an ideal topic for the political left wing, which is bereft of intellectual content and must rely entirely on emotive appeals.

Prices and Information

In his Preface, McKenzie quotes the famous passage from F. A. Hayek’s “Economics and Knowledge,” in which the late Nobel laureate describes the value of prices as collectors and transmitters of information. The various pricing practices of sellers put this feature on display. We cannot contemplate any central authority possessing or acquiring the quantity or quality of information that is routinely exchanged by the price system. Sellers have the strongest possible incentive to benefit consumers, while a central authority’s only institutional incentives are political. The more one learns about market pricing, the stronger the case for it becomes.

A future EconBrief will explore the links between market pricing and the evolutionary development of the human brain.

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