January 7, 2008

Price Gouging? Think not.

After having read the 8 chapters of Undercover Economist, but focusing on the first five, I find some of the insights very interesting at least to me. Despite some of the remedial nature of some of the book, I found unique and interesting the idea of the passing of profit margins among so many different parties. I liked the part where the coffee sellers were analysed. It discussed and dispelled the common misconception that prime-location coffee shops are "ripping us off."

Coffee that san be purchased at busy, crowded areas, like train stations, wherein people are in a hurry demands a higher price than other coffee at any quantity. This is because in such pell-mell circumstances, the costumers are effectively willing (but not neccesrily super excited about having) to purchase and pay for more services than other wise. Coffee in busy, rushed areas is more valued and price-shopping is either not possible or easy for buyers in this areas. For all these reasons coffee in these kinds of areas can (and probably will) fetch higher prices.

This begs the question. Does that mean that customers will be charged higher prices just because they can be? The answer is most likely so. But What I liked about the book was that I was surprised to find out that it is probably not the coffee shop charging this premium, and likely also that the coffee shop's profits may well be razor-thin. Because the station manager (whose job is likely to include raising revenue for the station) knows that things like a coffee shop there can charge exhorbinent revenue so it extracts these premiums revenues from the coffee shop in the form of higher rents.

What I took away from reading these passages was about how it is now my belief that, perhaps, this chain continues. Perhaps the people to whom the train station is accountable, perhaps their landlords, or their tax collectors probably. This makes me wonder how deep this chain goes. It makes me wonder if the train station can even keep any of the high profits it forces the coffee shop to earn. I wonder that with so many immediate suppliers all supporting and offering inputs goods to subsequent steps with the end result being coffee upon which a premium can be added whether or not it is even possible to discount. I wonder with such a high number of profit seeking links in such a chain if it is even possible to avoid charging for these convienience and locational charges, or if there are too many links in this train station that at least one of them will price-discriminate and thereby force each subsiquent link to do so as well.

Either way, the coffee shop, while price discriminating, is not gouging after all, a coffee shop so located is in fact offering more servicesthan an average coffee shop, in the way of locational convienience, they are merely now charging for them.

4 comments:

Douglas Loeper said...

So after reading this post I had a couple of questions that may or may not be issues with the post. You say:

"This begs the question. Does that mean that customers will be charged higher prices just because they can be? The answer is most likely so. But What I liked about the book was that I was surprised to find out that it is probably not the coffee shop charging this premium, and likely also that the coffee shop's profits may well be razor-thin. Because the station manager (whose job is likely to include raising revenue for the station) knows that things like a coffee shop there can charge exhorbinent revenue so it extracts these premiums revenues from the coffee shop in the form of higher rents."

This seems to be inconflict of my interpertation of Mr. Harford's writing.

If I read this right you imply that the premium on the coffee is primarily based on the cost of the rental space being acquired, and earlier in your text because of the busy location of the rental space. My understanding of situation is that the higher rent can be charged because they can sell more coffee at a higher price in that location and not the other way around. The reason they're willing to pay a high rent is because of the profit they realize, that profit is realized because the landlord passes that rent on in the form of exclusiveness for their product type - a Starbuck's would never pay premium rent for shop location #5 at the exit of super busy trainstation if Dazbog had a lease in location #6. The coffee shops are charging a premium for their coffee but it's not because of the high rental cost or solely because of the high traffic frequency but because they acquire some of the scarcity power of the landlord and they have a mini-monopoly in a high traffic buying area.

Mr. Harford writes: "The willingness to pay top dollar for convenient coffe sets the high rent, and not the other way around". (Harford 10).

With this being true I believe the argument for your 3rd paragraph then loses some soundness because the conclusion is based on the premises that the signal of pricing is passed on from producer(landlord,seller) to consumer(lessee,buyer) and not the other way around.

To put this into prespective use the same reasoning that was presented in Harford's book but apply it to coffee. Would Starbuck's charge less if the rent was lower but traffic was the same? Would they give it away if the rent and materials were free? (Not that the landlord would rent it for less but let's suppose). They would lose producer surplus to the consumer, and because of the monopoly status that the coffee seller has due to the scarcity/exclusitivity they are offered by the landlord they can price not at market equilibrium but at a premium price set by a monopoly market.

Larry Eubanks said...

As I read the essays posted on Harford's discussion of coffee, I'm inclined to suggest that maybe what I think is the essential idea in Chapter 1 might have been missed.

In my view, Chapter 1 is scarcity value. Douglas you might think about the analysis in your comment in view of scarcity value. And, think also about location, location, location, as they say in real estate. Much of undergraduate economic analysis really doesn't consider the location of economic activity. The discussion in Chapter 1 about coffee is really a discussion that considers the location of economic activity. One thing I suggest you consider is that in many ways every location is unique, and that uniqueness may well imply some monopoly power.

Douglas Loeper said...

Prf. Eubanks,

So I make sure I have all my ducks in a row, and I know exactly what parts I’m misinterpreting and I don’t get things mixed up let me break this down into different points so you can comment on the soundness of each.

1) The price of coffee sold by the coffee company isn’t set by or a reflection of the rent the coffee company pays for their location. The highest rent they are willing to pay is set by how much they can price their coffee at in any given location and how much they can sell at that location. I.E; the sales potential of the coffee company is sending the signal to the landlord and not the other way around. This was my main point in response to what I thought was a faulty premises on the part of the blogger ‘w atkinson’ who wrote: “But What I liked about the book was that I was surprised to find out that it is probably not the coffee shop charging this premium, and likely also that the coffee shop's profits may well be razor-thin.” When I read this it seemed that there was the implication that that pricing is passed forward and not backward.

2) The higher price and more coffee that the coffee company can sell at a prime location (one which in turn commands more rent) is due to both the location of the retail area (a busy travel area for busy people who are willing to pay for convenience) as well as the fact that they have low or no direct competition for their product in that area. The high premium for the coffee isn’t possible if you exclude either of these factors, both are necessary for the higher premium to be charged. If you take away the premium selling aspects of the location (a lot of people willing to pay high coffee prices) then you get a coffee seller who will find a location that meets their business model on their pricing for a larger market area. If you take away the lack of competition then the coffee seller will eventually drop their pricing until profit hits zero and either they or their competitors will drop out of the market place (barring forms of collusion). This shows that the lack of either element drops the price the seller can ask for the coffee and this sends the signal back to the landlord to maintain the scarcity of their product (retail space) to command a higher price.

3) The aspect of the premium price of the coffee that is controlled by the lack of competition in #2 is an example of the power of scarcity. The landlord has power of scarcity because they have a limited supply of premium retail area and they maintain that scarcity and pass it on to the renters by giving them exclusivity for their product. An example of this would be concessions at a ballpark where the concessions are typically ran by a single vendor who bids highest for the contract. The opposite of this would be a scenario at the exit area for a train station - if there were spots for 4 retail stalls and all 4 were leased to coffee sellers could the coffee sellers still sell their coffee at a premium price if the overall traffic was the same in the area? I believe the answer is no because that seller would no longer have a monopoly in that market (the market for coffee in the buying area between the train station and the consumer’s destination). The market changes and principals of a competitive monopoly begin to come into play.

4) As I reread w atkinson’s post I believe there may have simply been some confusion on the interpretation of the essay by myself. As mentioned in #1 I took this passage “But What I liked about the book was that I was surprised to find out that it is probably not the coffee shop charging this premium and likely also that the coffee shop's profits may well be razor-thin.” To mean the blogger thought the price was being passed forward from landlord to coffee shop. However this point is immediately followed by “Because the station manager (whose job is likely to include raising revenue for the station) knows that things like a coffee shop there can charge exhorbinent revenue so it extracts these premiums revenues from the coffee shop in the form of higher rents.” This implies that the blogger is expressing the concept shown in the book. Anyhow that is really where my confusion stems from, it almost seems as though these two parts contradict each other.

Anyhow thanks for your time in reading and responding to this.

Larry Eubanks said...

The suggestion I was hoping to make in my first comment was encourage you to more simply and directly consider your analysis. Your 4 parts for an answer doesn't seem to me to simplify. Of course, I didn't directly ask you to simplify. But my pointing to location and suggesting every location is unique was my camoflaged way of hinting at how to simplify.

Keep in mind, economic analysis of markets doesn't usually say something like: "Hey, this is the result of demand," or "Hey, this is the result of supply." Markets have buyers and sellers and market equilibrium outcomes are the result of the choices made by all buyers and all sellers simultaneously. This means that trying to break a lot of stuff out into things like your numbers is dangerous and may well lead to misunderstanding.

The key concepts in all this coffee stuff are 2, I think: scarcity value and locations are unique. Because each location is unique, each location is likely to have a scarcity value. But, this scarcity value is not with respect to any economic activity. Some economic activities will earn more at certain locations than at others. Different activities will compete to be located in different locations. Scarcity value means higher willingness to pay, other things constant.

Now, who is it that owns the unique location? The person who owns the real estate parcel. Who is going to be able to capture the scarcity value, or the monopoly power, of a unique location? The owner of the parcel. While the owner of the coffee shop is going to make at least a normal economic profit, he or she is unlikely to gain much more profit than this because there are others who are willing to pay to be the economic activity at that unique site. The scarcity value, or monopoly value, of a great location will mostly be captured by the person who owns that parcel of land.

I think this is one of the most important lessons from Harford's discussion. While some parts of Will's essay offered a bit more complexity that I think advisable, the key idea he said he learned fit well with what I've just described as the important lesson.