Economist's Notebook: Price Elasticity of Demand

We make trips to visit my mother on Bainbridge Island fairly frequently and we take the ferry whenever we can as we much prefer it to the overland route.  A couple of weeks ago my older son and I were taking the ferry after walking over from the train station and while on the ferry we saw the familiar video game console that always catches my son's eye.

This summer it is the retro Pac Man/Galaga combo machine (which led to a good conversation about the state of video gaming when I was his age - the modern version of having to walk 3 miles in the snow which, by the way I also had to do!).  But over the course of a week on Bainbridge we actually took the ferry over a number of times (once to see the King Tut exhibition which is great but incredibly anti-climactic at the end) and we noticed something interesting: no one ever plays the game.  To me this was unsurprising, the price per play was $1 - a sum which my son (and I) thought outrageous.  Now as an economist and a father, there is never a bad opportunity for some teaching so I asked my son if he though they should price it low enough so that the game was constantly played on each trip (10¢ say) if the goal was to maximize revenue.  He said maybe not - good boy, he remembers my lesson of the un-full parking lot!  [To wit: if you see a downtown parking lot less than full in the middle of a business day, can you assume the parking lot owner made a pricing mistake? No.]

But certainly they have mucked this one up.  $1 is so expensive that it almost never gets played.  Compare that to the marginal cost of punters playing it (close to zero) and you understand that the ferry (or the vendor of the machine) have miscalculated the price elasticity badly.  

So I have a suggestion: price it as 25¢ and compare profis. I think you'll find you do better.  

Beeronomics: Anti-Trust

The New York Times comments on the declared intention of Anheuser-Busch InBev and MillerCoors to raise prices on their beers at a time when the economy is in the tank, sales are down and more and more consumers are going for craft beer. They go on to wonder if this is going to set off any anti-trust alarms in the Obama administration. Jeff over at Beervana wonders what the companies are thinking raising prices in the face of declining market share? But economists know that it's all about price elasticity of demand. You may make more money if you give up some sales but charge more. [As an aside, the same principle is true of parking lots. People often wonder why downtown parking lots charge so high a price that they don't fill up - how can it be a profit maximizing strategy to leave unfilled spaces? - the reason comes from the fact that they charge a single price and are responding to elasticities]

Anyway, the fact that the two companies have an 80% market share is part of the economic calculations that go into anti-trust investigations, but it is not the only thing.

One of the most important concepts in anti-trust is the contestability of markets: how easy is it for a competitor to come along and compete against you? And in this the beer market is pretty contestable as shown by the rapid rise of craft breweries. In fact, the very success of craft brewing over the last decade would be exhibit number one in an anti-trust hearing - this success shows that beer is an easy market to get into and thus there is intense competition. Now most of this competition is local and the big breweries have vast economies of scale on the national level, but their ability to rise prices is severely limited by fierce competition in local markets from craft brewing.

Or course this can be seen another way, because another concept in anti-trust that factors in is how we define the market. Are macro-brews and micro-brews really in the same market and thus micros are in fact real competition for macros? (And for that matter are all alcoholic beverages actually part of a single market so that the real share of these companies is quite small?) I have wondered in this blog many times about how high is the cross-price elasticity of micro and macro beer for this very reason, for it is with this figure that we decide how close the markets are. In other words when the price of Deschutes beer rises, how big a bump in the demand for Bud is there?

I have to admit that my sense is that the AB InBev and MillerCoors could make a pretty spirited defense of their case in an anti-trust hearing. They could show how in local markets beer sales are very competitive and that the national economies of scale they enjoy are not easily leveraged in local markets to keep prices artificially high. To me, the decision to raise prices just seems like simple profit maximization - and good news for local craft brewers as it appears there will be more market share to be had.