Bastiat’s Bastions

Let me start by saying that I am not very fond of the author of the article I’ll be writing about. In my opinion, Mr. Gross knows just enough economics to be dangerous.

Click here for a previous rant on an article he wrote about pick-your-own apple orchards. In that article, Mr. Gross suggests that apple consumers can’t be trusted to make wise decisions.

In his current offering in Slate and Newsweek, Mr. Gross is writing about Apple’s decision to cut the price of the iPhone. In this article, he suggests that producers can’t be trusted to make wise decisions – remarkably Apple’s consumers are quite capable decision makers.

So, apple consumers are incapable, but Apple’s consumers are not. That is an interesting distinction. However, in fairness, I should point out that it may be easier to sell articles this way. It is a lousy way to do economics, though.

What fundamentally is going in the iPhone situation is what is called price discrimination. There are many different varieties of price discrimination. In order to engage in any form of price discrimination there must be at least two things that happen. First, a firm must have market power, and second, the firm must be able to identify groups of consumers with different willingness to pay (or have the consumers identify themselves). Firms that sell unique products or are large relative to the market are often price searchers – they have market power. iPhones clearly fit the bill. As a result, Apple will have some pricing latitude.

One strategy Apple might have chosen is to charge only one price for the iPhone (and never lower this price). If Apple would have chosen this strategy, it is quite likely that they would have charged a price below $599.

A second strategy would be for Apple to engage in price discrimination. The insight is that different consumers have different willingness to pay for products. Suppose there are only three consumers:

Consumer Willingness to Pay
A $700
B $600
C $500

In a perfect world for Apple, they’d somehow get A to pay $700, B to pay $600, and C to pay $500. This is called perfect price discrimination. Practically, this is difficult to do. How could you get people to reveal this information?

One thing that comes to mind is to start out by offering a price of $700. Only consumer A would purchase the good. Then, wait a while before lowering the price to $500. At this point, both consumer B and consumer C will purchase the good. While the firm didn’t get everyone to pay as much as they were willing, they still get more revenue than by charging any single price. This is exactly what Apple is doing.

What Mr. Gross is wrong about is (at least) two things.

First, this type of pricing is not novel. (Is that a pun? Keep reading.) This type of pricing has gone on for a long time, though there is some suggestion that this is a new twist for Apple’s pricing strategies, a point I’ll touch on below. Second, the subsequent lowering of price is not an indication that something that has gone wrong, but is part of the profit-maximizing profit strategy by the firm.

How do the prices of tickets at the regular movie theatre compare to those at the second-run (dollar) movie theatre? How do the prices of the “it” fashion this year compare to prices of that same fashion on the rack next year?

So let’s watch Mr. Gross get stuff wrong:

Check out this data on the use of incentives by auto manufacturers in August. The Japanese automakers don’t offer much (Toyota’s average was just $849), while the Big Three U.S. automakers each offered incentives of more than $3,000 per car. Is it any surprise they’re having such great difficulty turning profits on their U.S. operations?

Does this tell me that US automakers are stupid? Or does it tell me that US automakers are engaging in more price discrimination than Japanese automakers. If Mr. Gross wanted to examine the wisdom of these pricing strategies, he should be comparing what profits would be at GM without price discrimination to what they would be at GM if there were price discrimination (ceteris paribus). As GM has the option to choose only one price and stick to it, and they do not, they must believe they have higher profits as a result. I assure you that they understand this at GM.

Fire sales have a way of freezing consumer decisions. Once they know that retailers are likely to slash prices, many tend to delay purchases. Why buy an SUV tomorrow if you know it will be reduced in price at the end of the season? And once you start discounting, it’s very hard to stop.

I wholeheartedly agree. The optimal timing between price decreases is a difficult one. But the waiting is precisely how the companies separate the consumers into groups. Take his example of car sales. Everyone knows that the sale is coming at the end of the season. And yet, not all people wait until the end of the season. Those who are itching to get the new phone (or car or movie) pay the high price. Those who wish to wait, pay less.

To make it up to angered iPhone customers, Apple had to offer a $100 credit to early iPhone buyers. To assuage customers angered by large discounts on a single product, in other words, Apple is effectively now discounting all its products. Think different, indeed.

Let’s not get carried away, and let’s not double count. They sold 1 million phones for an extra $200. They then offered a $100 credit to a portion of these folks that paid the extra $200. Not all of these people will redeem these rebates, and the rebate will necessarily induce consumers to do some shopping at iStores. The cost of these $100 rebates are not anywhere near $100 to Apple. To say that they are discounting all their products is double counting.

What surprises me here is that consumers are so up in arms about it. Why no complaints about cars, fashion, or movies?

The answer to this question is that there is something snobby (an economics term) going on here. Some consumers seem to be purchasing iPhones as a status symbol. The iPhone is a badge that says “I am trendy” or “I am wealthy enough to spend $600 on a phone”. The price cut bothers these people because now, everyone is wearing the badge – the club is not so exclusive. If goods have snob features, pricing is more complicated, but that is a post for another day. Consumers might feel as though they were deceived – that is where the fact that Apple doesn’t typically discount products becomes interesting. Was an implicit contract broken by the price decrease? Was it that Apple never had a product where they have so much pricing latitude? I don’t know.

One last point… If Mr. Gross is so smart, and these firms so dumb, we surely wouldn’t expect him to engage in this pricing strategy, right? Let us get back to novels. Hardcover prices exceed paperback prices. But of course, the paperback doesn’t get released until several months after the paperback. Sound familiar? (The cost difference for binding is very small.) It is price discrimination.

Mr. Gross wrote a book that was published in May of 2007. The list price of the book is $22.95, hardcover. You can buy it new now on Amazon for $15.61. If Mr. Gross believes what he is arguing, we wouldn’t expect a paperback that sells for $7.99 to be on the way now, should we?

–CT

As you may have heard by now, WalMart will no longer sell Louisiana grown Cypress Mulch in its garden centers. Here are two articles in the Baton Rouge Advocate on the subject.

Wal-Mart drops state’s mulch: Coast advocates cheer store, by Amy Wold, Advocate staff writer
Sep 6, 2007, p. 1A.

Wal-Mart to stop selling cypress mulch from

By Cain Burdeau, Associated Press Writer, Associate Press, Sept. 5, 2007.

Political pressure is being applied by several so-called environmental groups. Is there a real problem cypress harvested for mulch? Well, the idea is that these trees keep the wetlands where they grow from becoming open water when they are over-harvested, or clear cut. This was certainly a problem with clear-cutting cypress a decade ago. But what is going on now?

There can be problems now, but let’s see what they are and the conditions where these problems occur.

Suppose you own some swampy low land that has cypress on it. If you harvest that cypress you may pocket the value of the cypress sold, but what happens to the value of your land? The land without the cypress is worth less than the land with it because a new owner would not be able to sell the timber. To keep from losing land value, timberland owners replant. Basically, they harvest their land at a rate so that the timber grows at about the same rate that they harvest. In other words, it is profitable to them to practice sustainable forestry. Now in the

When the landowner is the public, the incentives are different. Politicians have a hard time collecting the value from the land in the future, and they surely cannot sell it. Politicians can, however, make deals with logging companies to harvest trees from public land, and can, at times do so at values less than the values of the trees. Usually, governments regulate the logging activities on their lands, but if those regulators can be influenced with favors, bribes or campaign contributions, the regulations may not be enforced as intended.

Also, to the extent that cypress lands provide protection for the rest of us, there may be some sort of “positive externality” from growing, but not from harvesting, cypress trees. In this case, landowners may not have sufficient incentive to keep their land in the cypress growing business, and may be more likely to develop their land into other uses.

In a series of journal articles, I, along with Tom Dalton and Leon Taylor, explored how Polynesians on Easter Island over-harvested palm trees in a predator-prey type cycle (many other economists have written on this topic, starting with James Brander and Scott Taylor (1998, American Economic Review). This predator-prey cycle led to a decimation of the

What is noted in the Advocate articles is that by boycotting or by WalMart not selling cypress mulch from

My Economics 255 students will recognize that the issue with over harvesting cypress is much the same as the busted myth in our readings book by Madariaga on why recycling paper really does not save trees (pp. 81-82). The story there is clear. By recycling paper, the demand for harvesting trees for paper is reduced, reducing the price of trees and reducing the incentive that timberland owners have for planting trees, so recycling paper reduces the number of trees at any one time. By taking away the demand for cypress for mulch, as the well-meaning, but mis-informed environmentalists have done, cypress stands are likely to disappear faster than they would if mulch and other byproducts of cypress lumber could still be marketed.

-MC