Optimal pricing for bread and circuses

A survey (pdf) by Anthony Krautmann and David Berri has found that most fans in many popular sports pay less for their tickets than conventional economic theory would predict.
 

Which poses the question: are team owners therefore irrational?
 

Not necessarily. There are (at least?) four justifications for such apparent under-pricing.
 

Lots of things in the real world are underpriced. Most popular concerts and sporting contests lose some volume of revenue to aftermarket transactions on sites like StubHub and SeatGeek. It's nearly impossible to get a reservation at some of the most popular restaurants in San Francisco like State Bird Provisions. There's a waiting list for NOMA Sydney that's 27,000 people long.

If you were pricing to maximize revenue, to match supply and demand exactly, you'd boost prices or perhaps auction off all the seats. What would NOMA Sydney have to charge until its waiting list dropped to zero? I can't even begin toguess, but would it surprise you if it was well north of $2,000 a head for dinner?

Given all of that, I was curious to see what this author thought might explain football ticket underpricing.

The first argument is that underpricing tickets leaves more revenue to be gathered through ancillary sales like souvenirs or overpriced concessions. Without data, I'm skeptical. My instinct is that concession and souvenir sales are less elastic with ticket prices than hypothesized.

The second point is that it's better to have a full stadium for team morale and to influence the officiating. But again, you could sell tickets via a mechanism like a Dutch Auction and maximize revenue while still filling the stadium.

The other two arguments are more convincing.

Thirdly, higher ticket prices can have adverse compositional effects: they might price out younger and poorer fans but replace them with tourists – the sort who buy those half-and-half scarves and should, therefore be shot on sight. This increases uncertainty about longer-term revenues: a potentially life-long loyal young supporter is lost and a more fickle one is gained. It also diminishes home advantage: refs are more likely to give dodgy decisions in front of thousands of screaming Scousers than in front quiet Japanese tourists.
 

I went to a couple games at the old Chicago Stadium, during Jordan's early years with the Bulls, and that place was loud. When they moved to the United Center and the ticket prices went way up, the crowd felt different. More wealthy, and definitely not as loud. It could just be the acoustics of the new space, but anecdotally, I saw fewer fans standing and screaming. Also, the rise of the smartphone means more of the dead moments in a game are filled with people scrolling on their phones, quietly.

Fourthly, high ticket prices can make life harder for owners. They raise fans’ expectations: if you’re spending £50 to see a game you’ll expect better football than if you spend just £10: I suspect that a big reason why Arsene Wenger has been criticised so much in recent years is not so much that Arsenal’s performances have been poor but because high prices have raised expectations. 
 

It's hard to lower prices. Some sports teams may have done it at some point, but I've never seen it. You can raise prices when the team is good and on the rise, but those prices tend to stick when the team declines, and that's when stadiums start to empty out.

Saison is the restaurant in San Francisco that feels closest to pricing to match supply and demand. When I first moved to San Francisco, I had a meal there for $79. The next time there, the meal price had jumped over $100. Then the next time, it was up to $149. Later I heard the tasting menu had risen yet again to $248. The last time I went, thankfully on some banker's expense account, the price was $398 for dinner.

The dining room is usually full, but it's usually possible to get a table the same week. It feels like they've finally reached a price that about as close as you can get to where the supply and demand curves meet. Since the number of seats and turns is limited each night, perhaps this is revenue maximizing pricing, but the margin of error is razor thin.

My guess is that optimal pricing is somewhere below the price that matches supply and demand perfectly. Always being sold out adds a feeling of exclusivity, and no one knows how sold out you are, so being just sold out may be as good from a perception standpoint as being having a massive waiting list.

At the same time, I have a sneaking suspicion continuing to raise the price of a dinner would actually raise demand at some high end restaurants. There may be some Veblen-like qualities to restaurant pricing.

Does surge pricing maximize consumer welfare?

Steve Randy Waldman makes one of the more persuasive arguments against surge pricing (a term which may have existed before Uber—the practice certainly did—but which now seems inextricably intertwined with their brand).

I don’t care all that much about Uber’s “surge pricing” — its practice of increasing its usual fare schedule by multiples during periods of high demand. I do, however, care about the damage done by a kind of idiot dogmatism that hijacks the name “economics”. Uber’s surge pricing may or may not serve Uber’s objectives of profit maximization and world domination. It may or may not increase “consumer welfare”. But it is not unambiguously a good practice, either from the perspective of the firm or as a matter of economic analysis. Its pricing practices impose tradeoffs that must be addressed with reference to actual, on-the-ground circumstances. Among prominent academic economists there may well be a (research-free) consensus that surge pricing promotes consumer welfare (ht Adam Ozimek), but that reflects the crude selection bias of the profession much more than actual analysis of the issue. The dogmatism which has arisen in support of Uber’s surge pricing is quite analogous to the case of urban rent regulation, a domain in which there is incredible heterogeneity across localities and nations, both of circumstance and policy, and a wide range of legitimate values that conflict and must be reconciled. (Here’s an interesting case in the news today, in Spain, ht Matt Yglesias.) Almost as a right of passage, economists drone in every intro course that rent controls are bad. By preventing price signals from working their magicks, they prevent the explosion of real-estate supply that a truly free market would deliver. This is stated as uncontroversial fact even while economists who research and opine prominently on housing policy have endlessly documented that housing supply is not in fact price-elastic in the prosperous cities where rent controls are typically imposed. None of this is to say that rent controls are good or bad, or that non-price barriers to construction are good or bad. These are complex questions involving competing values textured by local circumstance. They deserve bespoke analysis, not pat dogma imposed by distant central planners economics professors.
 

...
 

As in the case of rent control, the stereotyped economist’s case for surge pricing is based on a conjectured elasticity of supply. With higher prices, the reasoning goes, more drivers will hit the road, more customers will be served, and the world will be better off. And that’s a good case, as far as it goes. But it doesn’t go very far, without some empirical analysis. It doesn’t justify Uber’s actual practice of surge pricing, which is far from the transparent auction our stereotyped economist seems to imagine. It doesn’t account for the trade-offs imposed by price-rationing (as opposed to time- or lottery- rationing), both between customers and for the public at large.
 

First, how price elastic is driver supply? If we presume that Uber is a Walrasian auctioneer, a disinterested matchmaker of supply and demand, apparently supply is not very elastic. Uber surges prices by multiples, two, three, even four times “typical” pricing in periods of high demand. That’s extraordinary! If supply were in fact elastic, small increases in price would lead to large increases in supply. The supply-centered case for dynamic pricing is persuasive in direct proportion to actual elasticity of supply. Uber’s behavior suggests that the supply-based case is not so strong. Of course, we cannot make very strong inferences about driver supply from Uber’s behavior, because they are not in fact a disinterested Walrasian auctioneer. When Uber surges, it dramatically raises its own prices and earns a lot more money per ride, whether ride supply increases not at all, or whether it spikes so much that drivers end up competing heavily for riders and suffer long vacancies. As a profit maximizer, Uber’s incentives are to impose surges primarily as a function of demand, and say nice things about supply to con economists and journalists.
 

This is one of the paradoxes of surge pricing. It is supposed to attract more drivers to the road, but if you live in SF as I do and have tried to call an Uber at the end of the workday (say 5-8pm), or on a weekend night, you know that Uber will inevitably be in surge pricing. And yet it still happens every day. If surge pricing worked, you'd expect drivers to learn that those are great times to drive to maximize their earnings, and that as more drivers did so surge pricing would wane as supply matched demand.

Perhaps there are still not enough drivers in total to match these spikes in demand. Or perhaps driver supply isn't as price elastic as claimed.

Or perhaps the cost of maintaining even the normal supply of drivers on a Friday night is just higher. Driving in rush hour in San Francisco isn't exactly pleasant work, and more importantly, drivers want to go out on Friday nights, too. The price to get them on the road may just permanently be higher on that night, like how evening movie tickets cost more than matinee tickets, or dinner costs more than lunch at restaurants even if the food is the same, or how Monday morning flights with Friday evening returns cost more to target business travelers. Completely plausible, but different from the story that ride sharing PR departments continue to put out, which is that surge pricing attracts more drivers until supply matches demand.

If that were the case, from a brand perspective, it would be better to just put those higher rates into effect permanently and call them peak rates and call the pricing at other times off-peak rates. Surge pricing is already a dirty word. If for some reason demand was even higher than normal peak demand, then put in surge pricing, and if for some reason it happened to be lower, you could offer a discount off of peak rates (ebb pricing?) and gain some consumer goodwill.

The other argument for surge pricing is, of course, price rationing. That is, by raising prices, we ensure that the scarce resource of Uber drivers goes to those who most need it.

Unfortunately, the argument for price-rationing (as opposed to lottery-rationing, or queue-rationing) of goods as being welfare-maximizing depends (at the very least) upon a rough equality of wealth so that interpersonal dollar values can stand in for interpersonal welfare comparisons. In an unequal society, price rationing ensures disproportionate access by the rich, even when they value a good or service relatively little. There is no solid case that price-rationing is optimal or even remotely a good idea when dispersion of purchasing power is very large. I’ve written about this, as has Matt Yglesias very recently. Matt Bruenig has two excellent posts relating this point to Uber specifically (as well as another post on ethical claims about Uber’s pricing).
 

The service is still scaling (incredibly), so it may not be fair to judge the validity of the price-rationing argument. However, based on the three times I've seen crazy surge pricing multiples for Uber (I'm talking 8X to 9X, for example during a blizzard in NYC the day after the Super Bowl two years ago), price rationing meant Uber was only available to price-insensitive wealthy folks. Great for maximizing Uber's profits, but not exactly what people claim when they say the market is the best way to allocate scarce resources during times of peak demand, for example an emergency. Unless you want to argue that because the wealthy were willing to pay more, they deserved or needed the service more than poorer folks. Pursue that line and next thing you know, you're dancing with a woman in a mask at your masquerade ball and she's whispering in your ear:

There's a storm coming, Mr. Wayne. You and your friends better batten down the hatches, because when it hits, you're all gonna wonder how you ever thought you could live so large and leave so little for the rest of us.
 

Matt Bruenig explains this with a very clear example:

Suppose that, in a given location, 10 people will normally hail an Uber cab, and 10 drivers will normally be cruising about to accept them. Now suppose that, because of an emergency, the number of people trying to hail a cab shoots to 100 people. In response, Uber jacks up prices very high, which has the effect of bringing 10 additional drivers on to the road. That means there are now 20 drivers (a doubling of supply) and 20 of the 100 people trying to hail an Uber cab succeeds in doing so.
 

Under Econ 101 analysis, you say that there was a welfare increase here. See, there were 20 people who got Uber cabs rather than 10 people. But, as I keep pointing out, this argument is not determinative if we assume the 100 people vying for Uber cabs have unequal economic resources. Further, the more unequal the resources are among those people, the more likely using prices like this actually decreases aggregate utility.
 

To see why, consider these two scenarios:
 

Non-Surge

• Rider Demand: 100

• Cab Supply: 10

• Chance of Getting a Cab: 10% for all 100 riders

Surge

• Rider Demand: 100

• Cab Supply: 20

• Chance of Getting a Cab: 100% for wealthiest 20 riders, 0% for other 80 riders

From a glance, you can immediately see that for the bottom 80 riders, the rational preference should be the Non-Surge. In Non-Surge, their odds of getting a cab are 10%. In Surge, their odds of getting a cab are 0%. Don’t let stupid journalists confuse you on this point.
 

Did more cars hit the road in response to the 8x or 9x surge pricing that snowy night in NYC? Without data from Uber, it's impossible to say. Given that Uber has been under a bit of a public relations siege, at least in the tech press and locally here in the Bay Area, if surge pricing increased supply of drivers in any meaningful manner in times where demand outstrips supply, I would've thought they would've released data proving that point.

This isn't to say I'm not a fan of Uber and other ride-sharing services. I love ride sharing, I use Uber and Lyft all the time. They've undoubtedly produced a great deal of surplus consumer and societal welfare, especially in this time of a heavily subsidized price war for market share. What taxi drivers and the government are doing in Paris to fight off Uber is just one more reason I've fallen deeply out of love with what was once one of my favorite places in the world.

And I don't doubt some of the grumbling about surge pricing is just the usual consumer noise greeting any price increases, however reasonable. It would be more bizarre if consumers didn't complain simply as another signal to suppliers of their preferences.

But the argument that surge pricing always maximizes consumer welfare is a more complex one, and not a premise that should be accepted at face value.

When is everyday low pricing the right tactic?

When stores like Wal-Mart, Sam's Club, and Costco began their rapid expansion in the 1990s, supermarkets were thrown for a loop. The limited service, thinner assortments, and “everyday low pricing” of items in these “supercenters” — including foodstuffs — created enormous cost savings and increased credibility with consumers. What was a Safeway or a Stop & Shop to do in the face of such brutal competition?

A new paper from Stanford GSB looks at the strategic pricing decisions made by grocery firms during that period in response to the shock to their local market positions by the entry of Wal-Mart. The paper answers the age-old question in the supermarket industry: Is “everyday low pricing” (EDLP) better than promotional (PROMO) pricing that attempts to attract consumers through periodic sales on specific items? Investigators find that while EDLP has lower fixed costs, PROMO results in higher revenues — which is why it is the preferred marketing strategy of many stores.

The research is also the first to provide econometric evidence that repositioning firms’ marketing approaches can be quite costly. Switching from PROMO to EDLP is six times more expensive than migrating the other way around — which explains why supermarkets did not shift en masse to an “everyday low pricing” format as predicted when Wal-Mart entered the game.

From this article from Stanford's GSB. Ex-Apple exec Ron Johnson can attest to the switching costs of going from EDLP to PROMO pricing; it cost him his job at J. C. Penney.

I'm a Costco regular, but I'll buy groceries at Safeway or other grocery stores sometimes just because or geographic convenience and longer shopping hours. If you have proprietary products, that also allows you to sidestep, to some extent, the EDLP war of attrition.

For commodity products, however, the more retail moves online, the less tenable it is for stores to rely on the sheer convenience of physical store proximity to bypass the EDLP game. The paper above looked at the entry of Wal-Mart, but of course the modern day successor to Wal-Mart as an e-commerce gorilla is Amazon. If you are selling the same commodities as Amazon, it's a brutal game, especially as the eventual customer expectation will likely be same-day delivery AND every day low prices for most retail goods. In that scenario, the findings of the researchers above would not hold. 

Big data and price discrimination

Adam Ozimek speculates that Big Data might bring about more price discrimination.  First degree price discrimination has always been a sort of business holy grail, but it was too difficult to get enough information on the shape of the price-demand curve to make it so.

For some time now, though, this has no longer been the case for many companies, and in fact one company did try to capitalize on this: Amazon.com. I know because I was there, and the reason that was a short-lived experiment is a real world case study of how the internet both enables and then kneecaps this type of price discrimination.

Amazon, until then, had one price for all customers on books, CDs, DVDs (this was the age before those products had been digitized for retail sale). A test was undertaken to vary the discount on hot DVDs for each customer visiting the website. By varying the discount from 10% up to, say, 40%, then tracking purchase volume, you could theoretically draw the price-demand curve with beautiful empirical accuracy. 

Just one catch: some customers noticed. At that time, DVDs were immensely popular, selling like hotcakes, and the most dedicated of DVD shoppers perused all the online retail sites religiously for the best deals, posting links to hot deals on forums. One customer posted a great deal on a hot DVD on such a forum, and immediately some other respondents replied saying they weren't seeing the discount.

The internet giveth, the internet taketh away. The resulting PR firestorm resulted in the experiment being cancelled right away. Theoretically, the additional margin you could make over such price discrimination is attractive. But the idea that different customers would be charged different prices would cause such distrust in Amazon's low price promise that any such margin gains would more than offset by the volume of customers hesitating to hit the buy button.

Ozimek notes this: "The headwind leaning against this trend is fairness norms." What's key to this is that the internet is the world's most efficient transmitter of information, and while it enables a greater degree of measurement that might enable first degree price discrimination, it also enables consumers to more easily share prices with each other. This greater transparency rewards the single low price strategy.

It's not a coincidence, in my mind, that Apple fought for a standard $0.99 per track pricing scheme with the music labels while Amazon fought the publishers for a standard $9.99 pricing for Kindle ebooks. Neither Amazon or Apple was trying to profit on the actual ebooks or digital music retail sales (in fact many were likely sold at break-even or a loss), they were building businesses off of the sale of complementary goods. In the case of Amazon, which is always thinking of the very long game, there are plenty of products it does make a healthy profit off of when customers come to its site, and getting users to invest heavily into building a Kindle library acted as a mild form of system lock-in. In the case of Apple, it was profiting off of iPod sales.

In the meantime, second and third order price discrimination continues to exist and thrive even with the advent of the internet so it's not as if the pricing playbook has dried up.

A skeptic might counter: didn't Ron Johnson get fired from J. C. Penney for switching them over to an everyday low price model? Didn't their customers revolt against the switch from sales and coupons and deals you had to hunt down? 

Yes, but everyday low pricing isn't a one-size-fits-all pricing panacea (as I wrote about in reference to the Johnson pricing debate at J.C. Penney). For one thing, there is path dependence. Once you go with a regular discount/deal scheme, customers create a mental price anchor that centers on that discount percentage and absolute price. It's hard to lift an anchor.

J. C. Penney was trying to go from a heavy sale-driven pricing scheme to an everyday low pricing model, and that's an uphill, unmarked path. Only the reverse path is paved. It's not clear whether the switch would have worked in the long run. Johnson ran out of runway from his Board soon after he made the switch and revenues declined. 

Everyday low pricing tends to work best when you're selling commodities since those items are ones your customers can purchase many places online. At Amazon we were far more interested in dominating one crucial bit of mental math: what website do I load up first if I want to buy something? We were obsessed with being the site of first resort in a consumer's mind, it was the core reason we were obsessed with being the world's most customer-centric company. Anything that might stand in the way of someone making a purchase, whether it be prices, return policy, shipping fees, speed of delivery, was an obstacle we assaulted with a relentless focus. On each of those dimensions, I don't think you'll find a company that is as customer-friendly as Amazon.com.

Ultimately, customers have a hard time figuring out intrinsic value of products, they're constantly using cues to establish a sense of what fair value is. Companies can choose to play the pricing game any number of ways, but I highly doubt Netflix and Amazon will choose to make their stand on the first order price discrimination game. There are many other ways they can win that are more suited to their brand and temperament.

Still, the peanut gallery loves to speculate that Amazon's long term plan is to take out all of its competitors and then to start jacking up prices. A flurry of speculation that the price hikes had begun spun up in July this year after an article in the NYTimes: As Competition Wanes, Amazon Cuts Back Discounts. After the NYTimes article hit, many jumped on the bandwagon with articles with titles like  Monopoly Achieved: An invincible Amazon begins raising prices.

If you read the NYTimes article, however, the author admits "It is difficult to comprehensively track the movement of prices on Amazon, so the evidence is anecdotal and fragmentary." But the article proceeds onward anyhow using exactly such anecdotal and fragmentary evidence to support its much more certain headline. 

Even back when I was at Amazon years ago we had some longer tail items discounted less heavily than bestsellers. However, pricing the long tail of books efficiently is not as easy as it sounds, there are millions of book titles, and most of the bandwidth the team had for managing prices was spent on frontlist titles where there was the most competitive pressure. All the titles listed in the NYTimes article sound to me like examples of long tail titles that were discounted too aggressively for a long period due to limited pricing management bandwidth and are finally being priced based on the real market price of such books. Where in the real world can you find scholarly titles at much of a discount?

The irony is that the authors cited in the article complain their titles aren't discounted enough, while publishers ended up in court with Amazon over Amazon discounting Kindle titles too much. This is to say nothing of the bizarre nature of book pricing in general, in which books seem to be assigned retail prices all over the map, with the most tenuous ties to any intuitive intrinsic value. The publishers set the retail price, then Amazon sets a price off of the retail price. If the publishers wants the discount on their books to be greater they could just increase the retail price and voila! The discount would be larger.

To take another category of products, DVDs, soon after we first launched the DVD store, long tail title like Criterion Collection DVDs were reduced from a 30% discount to a 10% to 15% discount. But just now, I checked Amazon, and most of its Criterion DVDs are discounted 25% or more. If I'd taken just that sample set I could easily write an article saying Amazon had generously decided to discount more heavily as part of its continued drive to return value from its supply chain to customers.

Could the net prices on Amazon be increasing across the board? I suppose it's possible, but I highly doubt that Amazon would pursue such a strategy, and any article that wanted to convince me that Amazon was seeking to boost its gross margins through systematic price hikes would need to cite more than just a few anecdotes from authors of really long tail books. 

It will remain a tempting narrative, however, because most observers think it's the only way for Amazon to turn a profit in the long run.

However, that's not to say big data hasn't benefitted them both in extraordinary ways. Companies like Amazon and Netflix know far more about each of its customers than any traditional retailer, especially offline ones, because their customers transact with them on an authenticated basis, with credit cards. Based on their customers' purchase and viewing habits, both companies recommend, better than their competitors, products their customers will want.

Offline retailers now all want the same type of data on their customers, so everyone from your local drugstore or grocery store to clothing retailers and furniture stores try to get you to sign up for an account of some sort, often by offering discounts if you carry a free membership card of some sort.

Your lobster roll is overpriced

A glut of lobster in the ocean has driven its wholesale price down, yet restaurants have kept lobster dishes on the menu at historical high price points. James Surowiecki explains the many reasons why, including this:

Lobster hasn’t always been a high-end product. In Colonial New England, it was a low-class food, in part because it was so abundant: servants, as a condition of their employment, insisted on not being fed lobster more than three times a week. In the nineteenth century, it became generally popular, but then, as overharvesting depleted supplies, it got to be associated with the wealthy (who could afford it). In the process, high prices became an important part of lobster’s image. And, as with many luxury goods, expense is closely linked to enjoyment. Studies have shown that people prefer inexpensive wines in blind taste tests, but that they actually get more pleasure from drinking wine they are told is expensive. If lobster were priced like chicken, we might enjoy it less.

Restaurants also worry about the message that discounting sends. Studies dating back to the nineteen-forties show that when people can’t objectively evaluate a product before they buy it (as is the case with a meal) they often assume a correlation between price and quality. Since most customers don’t know what’s been happening to the wholesale price of lobster, cutting the price could send the wrong signal: people might think your lobster is inferior to that of your competitors. A 1996 study found that restaurants wouldn’t place more orders with wholesalers even if lobster prices fell twenty-five per cent. As the study’s authors put it, “A low price creates suspicion.” This helps explain one of the interesting strategies that restaurants have adopted to take advantage of the lower price for lobster: they keep the price of lobster entrées high, but add lower-priced items—lobster bisque, lobster mac-and-cheese, a lobster B.L.T—to the menu. That way, they can generate more business without endangering lobster’s exclusive image.

I wonder if lobster prices remain high at seafood markets, or even Costco. They don't have to engage is menu price portfolio construction, but the perceptual illusion that higher priced lobster tastes better still exists.