Tim Harford: The Undercover Economist Cln a sunny day in London you can purchase a cappuccino and sip away as the capsules on the Eye, the capital's landmark Ferlis wheel, rotate high above you, occasionally passing between you and the sun... one of life's simple pleasures. Everywhere you look around the Eye you can see vendors with scarce resources, trying to exploit that scarcity. There is only one coffee bar in the immediate area, for instance. There is also a lone souvenir shop doing brisk business. But the most obvious example is the London Eye it3elf. It towers over the majority of London's most famous buildings and is the worid's largest observation wheel. The scarcity power is clearly considerable, but it is not unlimited: the Eye may be unique, but it is also optional. People can always choose not to go on it. Further along the river, the Millennium Dome is similarly unique, 'the largest fabric structure in the world', boasts the local authority. "I'et the Dome has proved a commercial disaster because uniqueness alone wasn't enough to persuade people to pay enough to cover the vast costs of its construction. Business with scarcity power cannot force us to pay unlimited prices for their products, but they can choose from a variety of stlategies to make us pay more. It's time for the Undercover Economist to get to work and nd out more. The only coffee provider beside the London Eye wields plenty of scarcity power over the customer. It's not innate, but is reected glory from the amazing setting. As we know, because customers will pay high prices for coffee in attractive locations, the coffee bar's rent will be high. Their landlords have rented out some of this scarcity value to a coffee bar, just like the owners of Man hattan's skyscrapers, or railway stations from Waterloo to Shinjuku. scarcity is for rent at the right price. But how should the bar's managers exploit the scarcity they are renting from the London EyeiI They could simply Iaise the price of a cappuccino from 135 to 3. Some people would pay it, but many would not. Alternatively, they could cut prices and sell much more coffee. They could cover wages and ingredients by charging as little as 50p a cup. But unless they were able to increase their sales dozens of times over, they'd not make enough to cover their rent. That's the dilemma: higher margins per cu p, but fewer mm; or lower margins on more cups. It would be nice to side-step that dilemma, by diarging Gp to people who are not willing to pay more and 3 to people who are willing to pay a lot to enjoy the coffee and the view. That way they would have the high margins whenever they could get them, and still sell coffee at a small profit to the skinflints. How to do it, though? Have a price list saying, \"Cappuccino, 3, unless you're only willing to pay BClp'? It does have a certain something, butl doubt it would catch on with the coffee-buying public of London's South Bank. However, for yea rs, the previous incumbent coflee bar, Costa Coffee, appeared to have achieved this. Costa, like most other coffee bars these days, offers 'FairTrade' coffee theirs comes from a leading fair trade brand called Cafedirect. Cafedirect promises to offer good prices to coffee farmers in poor countIies. Fair tIade coffee associations make a promise to the producer, not the consumer. If you buy fair trade coffee, you are guaranteed that the producer will receive a good price. But there is no guarantee that you will receive a good price. For Several years, customers who wished to support third-world farmers and such customers are apparently not uncommon in London were charged an extra 10p. They may have believed that the 10p went to the sthggling coffee farmer. Almost none of it did. Cafedirect paid farmers a premium of between Jl-Clp and 55p per pound of coffee, and that premium was reflected in the price they charged to Costa. That relatively small premium can nearly double the income of a farmer in Guatemala, where the average income is less that $2,Cl0 a year. But since the typical cappuccino is made with just a quarter- ounce of coffee beans, the premium paid to the farmer should tlanslate into a cost increase of less than a penny a cu p. le the extra money that Costa charged, more than 90 per cent did not reach the farmer. Cafedirect did not benet, so unless using the fair tIade coffee somehow increased Costa's costs hugely, the money was being added to prots. The truth is that fair tlade coffee wholesalers could pay two, three or sometimes fourtirnes the market price for coffee in the developing world without adding anything noticeable to the production cost of a cappuccino. Hem use coffee bets make up such a small proportion of that cost customers might have concluded that the extra 10p was to cover the cost of the fair trade coffee, but they would have been wrong. A certain Undercover Economist made some inquiries and found that Costa worked out that the whole business gave the wrong impression, and at the end of 2004 began to offer fair trade coffee on request, without a price premium. But why had it been profitable to charge a higher mark-up on fair trade coffee than on normal coffefr' Because fairtrade coffee allowed Costa to find customers who were willing to pay a bit more if given a reason to do so. By ordering a fair bade cappuccino, you sent two messages to Costa. The first was: \"I think that fair trade coffee is a product that should be supported.\" The second was: \"I don't really mind paying a bit extra.\" Socially concerned citizens tend to be less rareful with their cash in coffee bars, while unconcemed citizens tend to keep their eyes on the price. Perhaps another price list saying, *Ca ppuccino for the concerned 1.35. Cappuccino for the unconcerned 1.75\"? In fact, any well-run business would seek to charge each customer the maximum price he'd be willing to pay and they do. There are three common strategies for finding customers who are cavalier about plice. Let\"s cover two for now and leave the best until last. The first is what economists call \"rst-degree price discrimination\customers to give themselves away, companies have to sell When researching Sainsbury's, my approach was the same as products that are at least slightly different from each other. with M&S: walk into the shop and see what caught my eye. So they offer products in different quantities (a large As you probably know, what catches our eye as we walk into cappuccino instead of a small one, or an offer of three for the the supermarket is no coincidence; it's the result of careful price of two) or with different features (with whipped cream planning designed to throw attractive but profitable products or white chocolate or fair trade ingredients) or even in in the path of customers. What constitutes an attractive different locations, because a sandwich in a station kiosk is product depends on who those customers are. In Tottenham not the same product as a physically identical sandwich in an Court Road the obvious goods were all quite expensive: out-of-town superstore. Tropicana orange juice at $1.95 a litre, Tropicana 'Smoothies' It's reasonable to ask how common this tactic really is. at $1.99 for 100ml, Vittel mineral water at 80p for 750ml, and Because the products are different, you never quite know so on. It wasn't that these products were more expensive in whether the company is using a price-targeting trick or Tottenham Court Road than in Dalston (only the Vittel was), it merely passing on added costs. It could be that it really does was just that in Dalston cheaper substitutes sprang into view cost 10p more to put fair trade coffee in a cappuccino; maybe far more readily. cans of whipped cream are expensive to refrigerate and For instance, I couldn't find inexpensive orange juice in the troublesome to clean and the staff hate using them; perhaps Tottenham Court Road store, but in Dalston, Sainsbury's own large cups of coffee take longer to drink, and so the charge is brand of fresh chilled juice was sitting next to the Tropicana for table-space not coffee - in which case, charging a higher at about half the price, and the concentrated juice was price is not a strategy to get me to incriminate myself, but almost six times cheaper than the Tropicana. Brand-name simply the coffee shop passing its costs through to me. But I pasta was the same price in both shops, but only in Dalston think it's safe to say that companies are always alert for ways was it sitting next to Sainsbury's pasta, which again was to squeeze the maximum advantage out of whatever scarcity almost six times cheaper. The effect was to target the whole power they have, and price-targeting is the most common Tottenham Court Road store at shoppers who are indifferent way to do that. If it looks like price-targeting, it probably is. to prices, but to aim the Dalston stores at shoppers with a Supermarkets have turned price targeting into an art, keener eye for a bargain - while of course giving any price- developing a vast array of strategies to that end. Above the blind Dalston shoppers plenty of opportunity to show their main concourse of Liverpool Street station, there's a Marks true colours. and Spencer 'Simply Food" store, catering for busy Another very common pricing strategy is sale pricing. We're commuters on the way in and out of London. Knowing what all so used to seeing a store-wide sale with hundreds of items we do about scarcity value, we shouldn't be surprised to find reduced in price that we don't pause and ask ourselves why that this shop isn't cheap - even compared with another on earth shops do this. When you think hard about it, it branch of M&S merely 500 metres or so away, at Moorgate. becomes quite a puzzling way of setting prices. The effect of a I picked up five products at random in the Liverpool Street sale is to lower the average price a shop charges. But why store and managed to locate four of them in the Moorgate knock 30 per cent off many of your prices twice a year, when store. Every single one was about 15 per cent cheaper there. you could knock 5 per cent off year-round? Varying prices is a Big salads were down from $3.50 to $3.00, sandwiches from lot of hassle for shops because they need to change their E2.20 to E1.90. But even when such discrepancies come to labels and their advertising, so why does it make sense for light, few City workers would be willing to stray that distance them to go to the trouble of mixing things up? to save 30p. A bold and effective piece of price-targeting One explanation is that sales are an effective form of self- Other supermarkets are more circumspect about their pricing targeting. If some customers shop around for a good deal and policy. Going undercover once again, I made a comparison some customers do not, it's best for stores to have either between the smallish Sainsbury's supermarket in Tottenham high prices to prise cash from the loyal (or lazy) customers, or Court Road, and the large store in Dalston, one of east low prices to win business from the bargain-hunters. Middle- London's less prosperous neighbourhoods. It was harder to of-the-road prices are no good: not high enough to exploit find examples of identical products selling for different prices, loyal customers, not low enough to attract the bargain- although by no means impossible. Does this mean that hunters. But that's not the end of the story, because if prices Sainsbury's doesn't price-target as much as M&S? Not at all. were stable then surely even the most price-insensitive They simply go about the whole process with more finesse. customers would learn where to get particular goods cheaply. So rather than stick to either high or low prices, shops jump between the two extremes.One common situation is for two supermarkets to be leaks or great holes in an otherwise brilliant marketing competing for the same customers. As we've discussed, it's scheme. If you don't deal with them, your plans will be in hard for one to be systematically more expensive than the ruins. other without losing a lot of business, so they will charge The first problem is that supposedly price-insensitive similar prices on average, but both will also mix up their customers may not play the self-targeting game. It's not hard prices. That way, both can distinguish the bargain hunters to persuade price-sensitive customers to steer clear of an from those in need of specific products, such as people expensive product, but sometimes it is more difficult to shopping to pick up ingredients for a recipe they are making for a dinner party. Bargain-hunters will pick up whatever is on prevent the price-insensitive customers from buying the cheaper one. This is not a problem in the case of small price sale and make something of it. The dinner-party shoppers differences; we have already seen that you can get some came to the supermarket to buy specific products and will be customers to pay a modest mark-up in absolute terms, but less sensitive to prices. The price-targeting strategy only the mark-up can be huge in relative terms. works because the supermarkets always vary the patterns of their special offers, and because it is too much trouble to go Some of the most extreme examples come from the to both stores. If shoppers could reliably predict what was to transport industry: travelling first class by rail or air is much be discounted, they could choose recipes ahead of time, and more expensive than buying a standard ticket, but since the even choose the appropriate supermarket to pick up the fundamental effect is to get people from A to B, it may be ingredients wherever they're least expensive. hard to wring much money out of the wealthier passengers. In order to price-target effectively, companies may have to In fact, it is just as accurate, and more illuminating, to turn exaggerate the differences between the best service and the the 'sale' on its head and view prices as premiums on the sale worst. There is no reason why standard-class railway price rather than discounts on the regular price. The random carriages shouldn't have tables, for instance, except that pattern of sales is also a random pattern of price increases - potential first-class customers might decide to buy a cheaper companies find it more profitable to increase prices (above ticket when they see how comfortable standard class has the sale price) by a larger amount on an unpredictable basis than by a small amount in a predictable way. Customers find become. So the standard-class passengers have to do without. it troublesome to avoid unpredictable price increases - and may not even notice them for lower-value goods - but easy The 19th-century French economist Emile Dupuit pointed to to avoid predictable ones. the early railways as an example: 'It is not because of the few thousand francs which would have to be spent to put a roof Try to spot other odd mix-ups next time you're in the over the third-class carriage or to upholster the third-class supermarket. Have you noticed that supermarkets often seats that some company or other has open carriages with charge 10 times as much for fresh chilli peppers in a packet as wooden benches.. What the company is trying to do is for loose fresh chillies? That's because the typical customer buys such small quantities that he doesn't think to check prevent the passengers who can pay the second-class fare from travelling third class; it hits the poor, not because it whether they cost 4p or 40p. Randomly tripling the price of a wants to hurt them, but to frighten the rich... And it is again vegetable is a favourite trick: customers who notice the mark- for the same reason that the companies, having proved up just buy a different vegetable that week; customers who almost cruel to the third-class passengers and mean to the don't have self-targeted a whopping price rise. I once spotted second-class ones, become lavish in dealing with first-class a particularly inspired trick while on a search for crisps. My favourite brand was available on the top shelf in salt and customers. Having refused the poor what is necessary, they give the rich what is superfluous. pepper flavour and on the bottom shelf, just a few feet away, In other flavours, all the same size. The top shelf crisps cost The shoddy quality of most airport departure lounges across 25 per cent more, and customers who reached for the top the world is surely part of the same phenomenon. If the free shelf demonstrated that they hadn't made a price- departure lounges became comfortable, then airlines would comparison between two near-identical products in near- no longer be able to sell business-class tickets on the strength identical locations. They were more interested in snacking. of their 'executive' lounges. And it would also explain why flight attendants sometimes physically restrain passengers Perhaps you are a company director rubbing your hands with from the cheap seats from stepping off the plane before the glee as you read this, planning to deploy a range of clever passengers from first and business class. This is a 'service price-targeting strategies in your own business. Before you get too excited, you'll need to deal with the leaks in your aimed not at economy-class passengers but at those looking price-targeting system. There are two potentially catastrophic on in pity and disgust from the front of the plane. Themessage is clea r.' hep paying for your expensive seats, or next time you might be on the wrong side of the flight attendant In the supermarkets, we see the same trick: products that seem to be packaged for the express purpose of conveying awful quality. Supermarkets will often produce an own-brand 'value' range, displaying crude designs that don't vary whether the product is lemonade or bread or baked bea ns. It wouldn't cost much to hire a good designer and print more attractive logos. But that would defeat the object: the packaging is carefully designed to put off customers who are willing to pay more. Even customers who would be willing to pay five times as much for a bottle of lemonade will buy the bargain product unless the supermarket makes some effort to discourage them. So, like the lack of ta idles in standa rd- class railway carriages and the uncomfortable seats in airport Iou nges, the ugly packaging of 'value' products. is designed to make sure that snooty customers self-target price increases on themselves. Consider a hypothetical organisation, TrainCorp, a passenger b'ain company. TrainEorp owns a train that always travels full. Some of the seats go at a discount of 59 to leisure travellers who booked in advance, to senior citizens, to students or to families. The other tickets cost the full price of 109 and are bought by commuters and other business travellers. This is a fairly standard group-ta rgeting strategy: by giving away a few low-price tickets, TrainCorp restricts supply and acquires the ability to demand high prices by offering tickets to only the buyers with the highest willingness to pay. [It might be protable for TrainCorp just to fence off some of the seats and restrict supply that way, but it's even better for them to fill the spare Seats if they can.] We know at once if we are economists that this is inefficient. In other words, we can think of something that would make at least one person better off without making anyone else worSe off. That something is to find a commuter who was willing to pay a little less than 190, say 95, and who decided to travel by car instead, and offer him a Seat for 90. Where does the seat come from, since the train is full? Well, you take a student who is in no great hurry and was willing to pay a little more than 59, say 55, for the seat and politely throw him off the ham. But you refund the price of his ticket, plus an extra 10 for his trouble. Where do we stand now? The commuter was willing to pay 95 but only paid 90. He's better off by 5. The student was willing to pay 55 for a 59 ticket, so if he'\"cl been allowed to ride, he'd have been only 5 better off. but he has just been given 10, So the student is also happy. And what about TrainCorpi' Well, TrainCorp just transformed a 51.} ticket into a 90 ticket and made a more profitable sale. Even after paying E10 compensation to the student, the company is 90 ahead. Now everyone's a winner; or they would be if TrainCorp adopted this system instead of its group price- targeting sb'ategy. But of course, that's not what happens, because if TrainEorp tried it, commuters who were willing to pay 1lflt'.|I would hang around for the 99 tickets, and students who weren't willing to pay 59 would buy tickets anyway and wait to be paid to get off. The whole affair would tum out badly for TrainEorp, who is the one who gets to set the prices. In case your head is Spinning a little, here's the quickva nd- dirty summary: the group price-targeting strategy is inefficient because it takes seats away from customers who are willing to pay more, and gives them to customers who are willing to pay less. 'i'et airlines and raihvays still use it, because the alternative of individual price-targeting isn't feasible. it, so sometimes pricewtargeting is less efficient than a uniform price; sometimes it's more efficient than a unifom'i price. But we can say more than that Whenever price- targeting fails to expand the number of sales and merely moves products from people who value them more, like commuters, to people who value them less, like students, as in the case of TrainEorp, it will definitely be less efficient than a unifom'i price. IIr'il'l'lenever pricevtargeting opens up a new market without affecting the old market, it will denitely be more efficient than a uniform price. And there's a middle position. A lot of group plice-targeting does a bit of both: it opens up some new markets but also wastefully moves products away from high-value users to low-value users. For example, my book, The Undercover Economist, is published in hardcover at a high price, and the paperback edition emerges later, at a lower price. The aim is to target a higher price at people impatient to hear what I have to say and at libraries. Cine good result is that the publisher will be able to sell paperbacks more cheaply, because some costs will be offset by the hardcover sales, and so the book will reach more people. Cine bad result is that the early version is much more expensive than it would be if there was only a single paperback edition, and some buyers will be put off. That's what life is like in a world of scarcity: when companies with scarcity power by to exploit it, the situation will almost always be inefficient, and equivalently we economists will almost always be able to think of something better. Published in FT Magazine, 22 Ddober 2305