Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (5 page)

Alcohol and coffee also have other costs. Restaurants typically stock all types of liquor, incurring real inventory costs. They also have to throw out many cups of coffee over the day to insure freshness. All these are real costs, just as much as the cost of the alcohol or coffee itself.

The high price of liquor at restaurants has created a popular perception that restaurants break even on food and make huge profits on alcohol. This seems to imply that restaurants have to compete in food service, but can charge whatever they want for drinks. Although restaurants often do break even on meals, their high alcohol prices do not reflect a lack of competition. Restaurants might appear to rake in the
money on booze, but drinks also comprise a large part of their costs; that is, the cost of providing a place to linger over a drink.

Does price discrimination explain why travelers flying on short notice must pay more for a plane ticket than those who book their trips in advance? The Southwest Airlines website clearly shows the relationship between ticket prices and how far in advance a ticket is bought.
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A one-way flight from Philadelphia to Chicago on December 12, 2006, ranged from $109 for a non-refundable promotional fare purchased twenty-one days in advance to $168 for a ticket bought on the day of the trip. Waiting to buy your ticket until the last day thus raised the ticket price by 54 percent.

It may seem that short-notice travelers are charged more because they are more desperate to fly at a particular time than those who make more leisurely plans. But this would need further explanation: exactly how could airlines charge excessively high monopoly prices when numerous competitors exist and the cost of checking fares is so low? Short-notice travelers can consult Orbitz, Expedia, or other websites that compare ticket prices, or simply call someone who specializes in
comparing rates—a travel agent. But the large discrepancy in fares for short-notice and advance-notice travelers exists despite the ease and low cost of shopping around for different fares. This should give us pause before immediately assuming price discrimination.
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What airlines are doing, in fact, is charging extra for a particular service—providing a ticket at the last minute. In order to provide this service, airlines must keep “inventories” of seats that are still available at the last minute. As a result, some of these seats can go unsold, and the airlines must be compensated for this loss. This is no different than any other business that stocks inventories—grocery stores, for example, buy more milk than they need in order to ensure that they will not run out. Stores have to throw away unsold milk, and this cost is factored into the price. But consumers are willing to pay a little more if it means that milk will always be available.
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Airlines can easily sell discounted advanced tickets, to the point that they limit the availability of these offers. For airlines to be willing to hold seats for last-minute travelers, they must earn the same revenue from these seats as they do from seats purchased in advance. Just take a simple numerical example from our table for Southwest. Suppose, on average, that just over one-third of the seats set aside for last minute travelers go unsold; assuming that all these tickets could have been sold at the advanced discount “promotional” price. In that case, the last-minute tickets would have to sell for over 50 percent more than the discount price in order to justify offering the last-minute tickets at all.

Let’s look at one last example of alleged price discrimination. Full-service and self-service gas pumps sell the same gasoline—full-service costs more due to the extra service, not to a difference in gasoline quality. One might expect that the price difference between full-service and
self-service gas would be the same for each grade of gas; if a gallon of full-service, regular unleaded costs twenty cents more than a gallon of self-service regular unleaded, then a gallon of full-service super unleaded should cost the same twenty cents more than its self-service counterpart. But this is not the case—the absolute price spread is larger for regular gas than for supreme. AAA reports that for the week of September 25, 2006, the price spread in Rhode Island between full and self-service regular unleaded was five cents per gallon more than it was for the highest octane unleaded.
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Another survey showed that out of sixty-five U.S. cities, fifty had a substantially larger difference for regular unleaded than for premium unleaded (the difference usually being at least at five cents).
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Take a look at prices at your local gas station and you will probably find this disparity. The chart below shows the price differences between full-service and self-service gas at a Sunoco station that I frequent, where regular unleaded had a sixteen-cent spread, while Ultimate only had a twelve-cent spread.

So what explains this discrepancy? Are individual gas stations exercising monopoly power? This hardly seems possible; with so many stations showing clearly marked prices, competition is fierce. But aren’t lower-income customers—who are more likely to purchase regular than premium unleaded—getting swindled?

Once again, what looks like a rip-off is really just the complex workings of an efficient free market. The hidden factor here is that full-service regular gas customers typically buy less gas than those purchasing full-service supreme.
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Consumers of supreme gas tend to have more expensive cars and are generally wealthier than consumers of regular gas. The “time cost” of visiting a gas station is thus higher for supreme consumers—they are losing more money by not working while gassing up their cars. Supreme customers therefore try harder to minimize the time they spend at gas stations. One way to accomplish this is to wait to buy gas until the tank is low and then fill it up completely. Customers of regular unleaded, being comparatively poorer, are likely to buy less gas at any one time and then bear the additional time cost of refueling in the near future. This is especially true in full-service stations, where less wealthy customers are more likely to buy just a few gallons in order to get the “service”—having the attendant wash the windows, check the oil and air pressure, etc.
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Since gas stations sell less full-service gallons per customer of regular gas than of supreme, they need to make up the difference by adding a higher premium to regular gas.

One commonly discussed and particularly vicious method of maintaining a monopoly is through predatory pricing.
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This occurs when a firm slashes prices below its own cost of production, usually in an attempt to drive competitors out of business. A predatory firm doesn’t prevail due to the merits of its business plan; rather, its success depends on its willingness to lose money temporarily in order to shut down its competitors. Though cases are rarely serious enough to reach a courtroom, they certainly get attention when they do. Take the cases of Brown & Williamson cigarette makers and American Airlines: both faced high-profile court hearings over predatory pricing in the 1990s.
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This kind of publicity strengthens a common misperception that powerful corporations can engage in predatory pricing at will whenever they feel threatened by a competitor.

It seems perhaps that our entire economy is not really based on free competition, but rather on the overwhelming power of a few monopolies that can prevent other companies’ entry into the market. However, to the contrary, the strategy of predatory pricing is so riddled with contradictions that it actually ends up creating new incentives for competitors to join the market.
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Even under the best of circumstances for monopolists, predatory pricing is difficult. For predation to work, a predatory firm must not only slash prices, but also expand its output at this low price. If it does not expand production as it lowers prices, the firm will not be able to steal sales from its competitors. According to many economists, even if predators succeed in driving away competitors, the fruits of victory will prove short-lived. To merely recoup its losses from predation, after competitors are driven out of the market a predatory firm has to raise prices even higher than the price had been before the predation effort. But raising prices that high lures new firms into the market, which can easily undercut the predator’s new prices. This then forces the predator to slash its prices yet again in order to drive these new entrants from the market.
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This Ferris wheel of lowering and raising prices makes little economic sense.

In addition, because the predator has to expand its output to hold down prices, the losses incurred from predatory pricing easily exceed any subsequent profits from monopoly prices. The losses to the predator also typically exceed the losses suffered by the victim firms that are driven out.

Furthermore, predation can be overcome by using a tactic employed over 130 years ago by the famous robber baron Jay Gould, whose maneuver, while not carried out against a predatory firm, still demonstrated why predation is so difficult and thus so rare. Firms have
always been able to trade in other companies’ stocks. In order to overcome the dominant position Western Union then enjoyed in the telegraph industry, Gould “shorted” Western Union’s stock. Shorting involves borrowing shares in a firm’s stock from a brokerage, selling them, and then repurchasing them later to return to the brokerage. When you short a company’s stock, you are betting that the stock price will fall sometime after you borrow and sell the shares, so that you can buy them back later for a lower price and pocket the difference. In Gould’s case, he shorted Western Union’s stock and then set up his own telegraph lines to compete against the company, making a bundle as Western Union’s stock fell. Gould and his partner made a million dollars each just on the stock deal.
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Not bad for the 1870s.

And this tactic is doubly effective against a predator. Suppose a predator has convinced everyone that it is willing to lose whatever money is necessary to drive out any firm that dares enter its market. Precisely because it is believed to be willing to lose a lot of money, it should never have to lose any; no one would even consider entering its market. While one might think that this strategy will keep firms from entering, actually the exact opposite is true; potential competitors have been given an additional incentive to enter the market because they can make extra cash by shorting the predator’s stock. The more the predator loses from the entry of the new firm and the slashing of its own prices, the more the new firm profits from the lost value of the predator’s stock.
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The irony is that the more committed the predator is to bear whatever cost is necessary to wipe out any potential competitors, the more profitable it is for a new firm to enter the market. In other words, the exact strategy needed to make predation profitable actually ensures its failure.

Stories of everyday market failure are easy to find in popular literature. Calls for public vigilance against unscrupulous business agents, various
minor scams, and instances where the market somehow doesn’t function properly have turned a tidy profit for a number of authors and economists. But there is often much more to these cases than meets the eye. Perceived rip-offs and alleged market failures oftentimes merely entail the market working in unexpected ways. Here are a few examples: