Saturday, August 28, 2010

Poll: Is offering a "no kids" section a good idea for airlines?

This morning, I watched an interesting report on to family seating in airplanes. Here is an excerpt from a related article on the web:
Of the 2,000 respondents in the unscientific poll, 70 percent want to sit "as far away as possible from children." And about a quarter of non-parent respondents went one step further saying that they would prefer flights that are free of children.Of parents, 45 percent say they don't want to see a families-only section on planes because they don't want to sit next to "other people's horrors," the website says.

"As a relative new mum myself I can still remember that feeling of dread when you found yourself seated next to a baby on a long flight," says Skyscanner's spokeswoman Mary Porter. "However since regularly flying with my one-year-old, I am much more aware of what a stressful and often embarrassing situation it can be for parents."

She opines if passengers are willing to pay extra for child-free flying, "perhaps the solution is a premium adults-only section, rather than a pre-allocated families section."
Charging different prices to different segments of a market is price discrimination, a potentially profitable strategy (which I have written about before). Even though it can be a profitable strategy, it is not always profitable -- especially if charging different prices to customers puts people off.

With a hot topic issue, this means that there is a tradeoff from extracting extra revenue from premium seating, and offending families (which would potentially push that segment to other airlines). That brings me to the poll question of the week:

Is offering a separate "no kids" premium section of seating on the airplane a good idea?

(a) No. It would cost too much.
(b) No. It would offend families, and reduce revenues.
(c) Yes. It allows price discrimination.

The poll is open for a week, so vote early and often. Get your friends (and families) to vote as well. I'm interested in hearing what you have to say.

Wednesday, August 25, 2010

Thoughts from a winery tour

Last week, I took a winery tour with my wife's family. We all hopped on a wagon that weaved throughout the vineyard. As the tour went on, we sampled the wines that were produced from those very vines. As the proprietor of the winery gave the tour, it was a wonderful view into the inner workings of a winery. I left the tour fully impressed by wine economics. Here are some of the highlights:

Wine Costs and Wine Varieties

For this particular winery, it costs $3200 per acre to maintain the vineyard. That's the same number regardless of whether the acre produces a ton of grapes or ten tons of grapes. The winery is in Michigan where some varieties do well, but others (notably southern European varieties) do not. In other words, nature limits the selection of grapes, which limits the selection of wines at this winery.

To mitigate this limitation, wineries in this region have been working with a breeding program at Cornell University that is trying to mimic the flavor characteristics of the European varieties while instilling heartiness of the American varieties. They do this by breeding American grapes with European grapes, and they have had some success. On our tour, we tasted an American Traminer wine from the winery that tasted just like the popular European wine Gewurztraminer.

The proprietor told us that his ability to used the heartier grape allowed him to profitably sell wine at a price of $12 for Traminer versus $16 or $17 for Gewurztraminer.

Blending: Why do it?

Throughout the tour, the proprietor mentioned the practice of blending where the decision is made to mix the wines from various grapes to create a new, blended wine. He told us that there were three reasons to blend: to cover up "sins," to achieve great quality, and to achieve consistency.

Covering Sins. According to the proprietor, they try to not blend to cover a bad taste very often, but you have to do what you can with what you have. That makes sense, but the other two reasons were more interesting motives to blend.

Making Great Wine. Our tour guide told us that blending is where the vintner (wine maker) can demonstrate his talent. Any fool can make wine: Just crush up some grapes and dump some yeast on it. But, excellent wine can be made from the right blend of different wines.

At this stage in the tour, we had our chance to try the winery's Meritage variety. There's no Meritage grape, but there is a Meritage Association in California that certifies the use of the term to denote premium, quality, blended American wines made from grapes of the Bordeaux variety. Basically, Meritage is an organized effort of American wineries to compete with European Bordeaux wines. To have a Meritage variety, the vintner must blend from Bordeaux grapes, and of course, pay dues to the Meritage Association.

The proprietor also described how his Meritage-labeled wine was different every year. To make this credible to the consumer, the winery offers a different vintage every year. In other words, Meritage 2001 is a different wine than Meritage 2002. The proprietor told us that making different vintage wines is nice because he can use the Meritage variety to do the absolute best that he can with the grapes he has that year. He enjoys the freedom to express his wine-making creativity. It's his opportunity to make great wine.

Blending for Consistency. This particular winery has a blended wine called Capriccio, which is a less-bitter-than-most red wine. Because this blend has been popular for its flavor characteristics in the past, the proprietor wants to maintain that flavor as best he can. So, he blends the wines to have the same flavor every year. Even if he could modify the wine to have what he thought was a better flavor, he doesn't. With this blend, he wants to be consistent. After all, he gets to have his creative fun with the Meritage label.

There were plenty of other memorable moments from the winery tour, but those could be the fodder for another post. If you have a chance to take a tour of a winery, do it. Not only is it interesting, but as our tour guide said, "wine is a social lubricant." So, you're sure to have a good time.

Friday, August 20, 2010

Poll: What do you think about discount- for-information programs?

Today, I received a call from Costco (where we do most of our grocery shopping) about some eggs that we bought a few weeks ago. It turns out that we bought some of the eggs that are thought to be contaminated. The message told us this fact and it told us that we could come in for a full refund (a whopping couple of bucks). Even though the message was automated, I was impressed that our grocery store was so proactive about the recall.

The only reason Costco knew to contact us is because they keep disturbingly meticulous records of our shopping history. Today, I was grateful, but it goes to show how much our grocer knows about what we buy and when.

I could not help wondering the extent to which Costco uses this information to target our pocketbook. If I were Costco management, that is the first thing I would do with the information. The ability to build goodwill by notifying customers of their recall rights.

That brings me to my poll question this week:

How do you feel about club promotions (like Costco or discount cards elsewhere) that give you discounts in exchange for the ability to track your purchase history?

a. Not good. They know too much.
b. Great! This means they will have my favorite products in stock.
c. Indifferent. They cannot do much with my information.

As always, the poll is open for a week, so vote early and often. I am interested in seeing what you have to say, but like the grocery sttore I won't know unless you tell me.

Wednesday, August 18, 2010

When does it pay to burn money?

Yesterday, a student of microeconomics brought me an excellent game theory question to discuss. The topic was credible commitments (which I previously wrote about here and here). I don't want to spoil the question for others who get the joy of working this problem, so here's the problem with context changed:

Suppose there are two firms in the smart phone industry: an incumbent and a potential entrant. The incumbent can charge a high price or a low price. The potential entrant can enter or stay out. We also know the following facts about the incumbent's profit:
  1. If the potential entrant enters, the incumbent gets 10 from charging a high price, and 5 from charging a low price.
  2. If the potential entrant stays out, the incumbent gets 60 from charging a high price and 55 from charging a low price.
That is, no matter what the entrant does, the incumbent wants to charge a high price. A strategy like this (best regardless of what the other player does) is called a dominant strategy. The incumbent in this setup has a dominant strategy to charge a high price.

So, what about the entrant? Here's what we know about him:
  1. If the incumbent charges a high price, the entrant gets 25 from entering (0 from not entering).
  2. If the incumbent charges a low price, the entrant gets -20 from entering (0 from not entering).
This is where the problem gets interesting. If the incumbent charged a low price, he could deter the entrant from entering (ensuring a choice between 60 and 55 instead of 10 and 5). BUT, we already deduced that no matter what the entrant does, the incumbent has a dominant strategy to charge a high price. In other words, no matter how much talk there is of the incumbent charging a low price, the entrant won't believe him.

Given these payoffs, the equilibrium is that the entrant will enter, and the incumbent will charge a high price. The entrant gets 25 while the incumbent gets 5... to the dismay of the incumbent.

So, what's an incumbent to do? He knows the game and understands that he has a dominant strategy that is detrimental to profits. One possibility is to credibly change his payoffs. Here's what I would do:

Sign a contract with some advertising agency that is contingent on setting a high price. In exchange for one worthless ad, the incumbent would pay 6 (I didn't put units on my payoffs, maybe it is millions of dollars) to the advertising agency. The important feature of the contract is that it would only run if the incumbent's price is high.

This seems like a dumb contract for the incumbent to sign. After all, the incumbent would be spending money for the purpose of decreasing payoffs. But, it's not so dumb when you look at the strategy behind it. With the contract, the incumbent's payoffs are as follows:
  1. If the potential entrant enters, the incumbent gets 4 from charging a high price, and 5 from charging a low price.
  2. If the potential entrant stays out, the incumbent gets 54 from charging a high price and 55 from charging a low price.
Under the contract, the incumbent has a dominant strategy to charge a low price! Now, the entrant believes the incumbent when he hears rumors of a low price. The outcome of the game is that the entrant does not enter while the incumbent charges a low price. Instead of making 5 (as in the equilibrium without the contract), the incumbent makes 55, a vast improvement.

An alternative would be for the incumbent to just burn 6 units of profit if he ever sets a high price. But, notice that threatening to hold a "profit bonfire" upon setting a high price doesn't quite do the trick. That's because once the time comes to hold the bonfire, the incumbent will want to substitute monopoly money for the real profits. The entrant knows this, and for this reason, the entrant won't believe a simple threat to burn money.

This need to convince the entrant of incentive compatibility is why the incumbent must go to great lengths to take the burning of profits out of his hands. Hiring the ad agency accomplishes this task. It doesn't usually pay to burn money, but if a company needs to credibly commit to a dominated strategy, burning money the right way might be a good idea.

Friday, August 13, 2010

Poll: Is the Air & Water Show a Positive or Negative Externality?

When I went downtown the other day, I was greeted by the roar of airplanes that were flying surprisingly close to the skyscrapers of downtown Chicago. I immediately knew that it was the annual Air & Water Show, which takes place every August in Chicago.

I understand the Air & Water Show is a big event that draws people downtown to watch the spectacle of planes doing tricks and flying in formation, but I had to wonder how the show affected workers downtown. People were undoubtedly working on a Thursday afternoon at 1:30 pm. Yet, this was a time when planes noisily swooped past these offices and weaved in and out of skyscrapers. If I were a high-powered executive with a deadline, I don't think I would be happy that the Air Show was flying by my window.

On the other hand, there were plenty of tourists roaming the streets who got to enjoy a free air show. It may have been a good thing for them.

In economics, these costs and benefits that are experienced by bystanders are called externalities. If it is a bystander cost, it is a negative externality; if it is a bystander benefit, it is a positive externality. Externalities are a form of market failure. That is, we don't expect the market will produce the right amount of good that has an external benefit or cost. That's because individuals account for private benefits and costs (not external) when making their decisions. At the end of the day, the market produces too much of products that have negative externalities and too little of products that have positive externalities.

So, that brings me to the poll question of the week.

For you, is the Air & Water Show a positive externality or a negative externality?

(a) positive
(b) negative

As with all polls, this one is open for a week. Vote early, often and on the sidebar. Tell your friends and Blue Angels to vote. You should even tell your noisy neighbor if he can hear you over the noise he's making. Whatever you do, please vote. I'm interested in hearing what you have to say.

Wednesday, August 11, 2010

Is this a car advertisement for economists?

Here's the text of the ad:
Can utility be a poster? Can utility keep you up at night, dreaming? Can utility put thoughts in your head? Depends on what you mean by utility. The new Cayenne Utility Hybrid, born from Porsche intelligent performance to be lighter, more agile, more efficient. More Porsche than ever.
Here's the video:

For the non-economists who read this blog, economists define utility to be something like happiness (and we assume that individuals maximize utility). Viewed in this light, the poster yields some amount of utility, so do the dreams that keep us up all night. Even "thoughts in my head" can add to my overall utility (if they are good thoughts).

But, what is not seen in this advertisement is the foregone utility of these actions (the price isn't stated either, but that's a different story). The poster of a car takes up space that could be used for some other decoration (maybe a mirror to make the space seem bigger). Staying up all night dreaming likely means that you will be tired for your morning meeting tomorrow. You'll be less effective and you might not get that promotion. Finally, just thinking "happy thoughts" might mean that you will take less precaution against bad outcomes. That is, there are cases where putting good thoughts in your head isn't optimal (such as "my car is so awesome that I can drive recklessly up a winding road in the mountains" just like the commercial).

So, is this an advertisement for economists or something different? Depends on what you mean by utility.

Saturday, August 7, 2010

Why do you buy branded products?

Depending on industry, companies expend a great deal of resources on branding. The nature of these expenditures and their effects have important implications for how firms compete. For example, Coke and Pepsi have enormous advertising budgets, which have established widely-recognizable and appealing brands. These brands are so recognizable and have such great appeal that it is hard for any other competitors to profitably enter the soft drink market.

These reputation effects are important in other industries as well. For example,
  • Pharmaceutical companies expend money to cater directly to doctors (a practice called detailing), but they also advertise directly to consumers. Both activities cultivate their brand.
  • Textbook companies maintain a brand with professors and other academic buyers as providing rigorous review of book content before the professor even sits down with the book.
  • Cleaning products (such as soaps, detergents, and stain removers) are often branded while generic store brands are available.
  • Even cereal manufacturers invest a great deal of money to brand their product in an effort to differentiate their cereal from the other cereals out there.
These branding efforts would not be successful if consumers were willing to go with the unbranded alternatives (after the patent expires, of course). As an alternative to branded soda or cereal, try the generic store brand. As an alternative to the leading book published by a textbook company, try a self-published book.

If branding is successful, consumers are reluctant to try the generic counterpart. This reluctance means paying more. So, there's a tradeoff that comes with buying branded products. They're better (or at least perceived to be better), but they are also more expensive. That brings me to my poll question of the week.

Why do you buy branded (rather than generic) products?

(a) I don't. Generic products are just as good for a lower price.
(b) It depends on the product. Some branded products are better than the generics. Others are not.
(c) There's no substitute for quality. Branded products are just better.
(d) Branded products have their reputation on the line. I like being able to hold my products accountable.

As always, the poll is open for a week. So, vote early and often (on the side bar). Tell your friends and your favorite brand spokespeople to vote. This includes Mrs. Butterworth, Mr. Clean, the Old Spice Guy, the Brawny man, Justin Case, the Aflac duck, and any other brand leader you adore. Regardless of how many people you tell, please vote. I eagerly await your responses, eagerly.

Wednesday, August 4, 2010

Pondering complements

Here's an economics question to ponder:
Tony has two uses for milk: to complement regular coffee and to complement espresso. When he drinks coffee, he uses just a splash of milk. When he makes espresso, he steams nearly a cup of milk to go with the drink. Because he uses so much more milk with his espresso, a price increase in milk causes Tony to consume more coffee and less espresso. Are coffee and milk complements or substitutes?
The answer is substitutes. If this surprises you, you're probably not alone. This is a tricky question that exposes the way that economists define complements and substitutes.

Although we loosely describe complements as goods that are "consumed together," that's not the definition of complements that you'll see in a microeconomics text. Two goods are complements when an increase in the price of one leads to a decrease in demand for the other. This definition is roundabout, but it is best way to know what we really mean by the word complements.

After all, our grocery basket includes a lot of goods when we exit the store. For all the grocer knows, you will drink that bottle of wine while eating the Lean Pockets with the ketchup and mustard that you bought. Yet, it is unlikely that all of those goods are complements with one another. A clearer example is hamburger and rib steaks. I might buy both in my weekly shopping trip, but for me, they're likely to be substitutes (especially for low enough price of rib steaks).

This isn't merely a pedantic point. An economist with data on prices and quantities needs a definition of complements that can be observed in the data. The economist (like the grocer) doesn't get to see the consumer put ketchup on his Lean Pockets before he eats, but he can see what happens to Lean Pocket demand when the price of ketchup goes up.

Back to the question I posed, why are milk and coffee substitutes for Tony? As the price of milk increases, Tony will consume more coffee as a means of substituting away from milk consumption. They are substitutes that are consumed together.