Professor McKenzie Discussion Problems and Answers

Week #1 Discussion Problem

Tip Pooling At a restaurant near where the professor for this course lives, tipping servers is common

(generally between 15 and 20 percent of the total bill). The restaurant has two distinct

areas, the bar (or lounge) area where alcoholic drinks dominate people’s orders and the

“casual dining” area where whole meals. Two bartenders serve all customers in the bar.

That is, they each do not have assigned tables and bar stools. A dozen or more servers

attend to the tables in the casual dining area. Each server in this area has assigned tables.

The restaurant’s management has an interesting policy regarding tips. The two

bartenders on duty “pool” their tips and divide the total at the end of their shifts. The

servers in the rest of the restaurant keep the tips that they receive from their assigned

table. In other words, there is no tip pooling in the casual dining area.

1. First and only step in the discussion

a. Why does the restaurant management have tip pooling in the bar and not

the rest of the restaurant?

The problem of tip pooling has many of the incentive problems evident in

“communal property” or “common-access resources,” which can become

real problems when each person’s contribution to the total is

inconsequential and monitoring of all others’ contributions is costly.

(Pollution can occur for this reason.) But with only two bartenders in the

bar, each bartender can reason his/her efforts can materially affect the total

tips collected. Each can also watch the other for shirking (or not working

hard to gain tips), and each can retaliate with shirking.

In the casual dining area of the restaurant, there are a number of servers

who will share in the total tips when tip pooling is the policy. Each has an

impaired incentive to work hard to contribute to the total tips. Each only

receives a minor share of the total tips, and will only get a portion of any

increase in tips due to his/her diligence.

Hence, bartenders will likely agree to tip pooling when there are two (or

few) bartenders. When there are a “large” number of severs, tip pooling

can be a problem for management – and servers.

b. Why doesn’t management have all bartenders and servers pool their tips

and divide the total?

If all bartenders and servers pooled their tips, the prospects of shirking

will increase. Some staff members may naturally be inclined to work at a

slow pace. Others may work at a slow pace because others are doing so,

and each person can reason that the loss of total tips will be shared by all.

c. Management has instituted the tip-pooling/no-tip-pooling policy in the

different areas of the restaurant. Is management’s policy one that the

bartenders and servers would choose if they were in control of restaurant

policy on tips?

Yes, management has likely instituted a policy that is a win-win for

management and bartenders/servers. The bartenders/servers would likely

choose the same policy that management has, because of the win-win.

d. If the restaurant were to expand to where the count of bartenders required

to cover all patrons in the bar increased to, say, a dozen or two dozen

bartenders, how would management’s policy on tip pooling in the bar area

likely change? Would the bartenders likely agree to the policy change?

With a substantial increase in number of bartenders, the problem of

shirking would likely rise. The bartenders would likely press management

for each bartenders being assigned tables and stools and to abandon tip

pooling (at least beyond some expansion of the bar).

e. If management required tip pooling across all bartenders and servers in the

restaurant, what would likely happen to the required monetary earnings of

bartenders and servers both in the short run (during which people cannot

shift jobs) and the long run (during which they can seek?

Initially, the tip earnings of all bartenders and servers would likely fall as

shirking rose, due to the increase in the number of people pooling tips (and

their falling impact on total tips). However, in the long run, such broad-

based tip pooling could cause bartenders and servers to seek employment

elsewhere. If management wants to retain employees with broad tip

pooling (and the resulting increase in shirking), then management would

have to raise workers’ compensation in some form just to keep them under

the rising risk of shirking by all. This required increase in compensation

would likely pressure management to reduce the scope of tip pooling.


Student Choices Consider a hundred students who have been asked to choose one of these two options:

Option A. Students choosing this option will receive a certain payoff of $800.

Option B: Students choosing this option have one opportunity to pull one “ticket” from

a barrel of tickets (which they cannot see). In the barrel 85 percent of the tickets are

worth $1,000; 15 percent are worth $0.

1. First step in the discussion: Which option would you take? (Which option did

other members of your group pick, if you have a group? What is the percentage

distribution of the group in the choices taken?)

To be determined by students and their groups. There is no right or wrong

answer.

2. Second step in the discussion: Suppose that 80 percent of the hundred students

choose Option A and 20 percent choose Option B.

(These two choice options have been given students in experiments classroom

settings, with the percentage of students taking Option A varying between 75

and 85 percent.)

a. Are the choices of either group “irrational” (or “not rational”)? Why or

why not?

No, neither choice is “irrational.” Some students (a majority in this

case) can be “risk averse” and will prefer the sure-thing outcome

($800) to the gamble, which does have a higher expected value ($850 =

[85% x $1,000] + [15% x $0])

b. Is there “money being left on the table” by the choices either group of

students made? Which group? If so, are their choices irrational? Why or

why not?

From the answer to 2a, there is “money being left on the table,” in a

sense. The eighty students who choose Option A receive a total of

$64,000 (80 x $800). If all of these students had chosen Option B, their

total payoff would have been $68,000 (85% x 80 x $1,000)– which

means that $4,000 is, in a sense, being left on the table. However,

choosing individually, the value of the certain payoff of $800 for each

student is greater than the cost (or “disutility”) of their individually

running the risk of getting nothing.

c. If “money is being left on the table,” how might the money be picked up?

Develop at least two ways.

There are at least three possible ways “entrepreneurs” can collect the

“money being left on the table”:

The eighty students could collectively decide to choose

Option B. They can then divide expected total received

($68,000) equally , with each of the eighty students

receiving $850.

Some smart student could sell each student inclined to

choose Option A an insurance policy that provides

protection against getting nothing.

Some smart student (an “entrepreneur”) could offer the

students inclined to choose Option A a fixed payment of

more than $800 (and less than $850), say, $810 to choose

Option B and hand over the “ticket” value (whether

$1,000 or $0). If the smart student gets all (or just a

sizable percentage) of the students inclined to choose

Option A to pick Option B, then the smart student will

receive a “profit” of $40 on each student persuaded to

take the deal.

If one smart student figures out how to make money off

of students inclined to choose Option A, then other

students can be expected to try to do the same. The

competition among the student-entrepreneurs that

ensues should drive up the payments received by the

students inclined to take Option A and drive down the

profits of those student-entrepreneurs making the

buyouts.

3. Third step in the discussion:

a. Suppose that Option A were changed to $600, while Option B

remained the same?

i. How might the distribution of the choices of the hundred

students be expected to change? Why or why not?

In any large group, members (the students) can be

expected to vary in how they assess risk (or their “risk

aversion” will vary). As the Option A payoff falls from

$800 toward $600, more and more students will see the

growing difference in the value of the two options and

will be inclined to take Option B, the value of which has

remained at $850. This suggests that the percentage of

students taking Option A can be expected to fall, while

the percentage of students taking Option B can be

expected to rise.

ii. What applicable economic principle will be at work in

making your prediction of the change in the distribution of

choices?

The applicable economic principle: the “law of

demand” (or the expected inverse relationship between

price and quality, assuming all other relevant forces on

choice remaining constant). With the decline in the

value of Option A, the cost (or price) of choosing Option

B goes down, which suggests more students will choose

Option B.

b. Suppose that Option A remained the same (a sure-thing of $800), but

Option B is changed to the following conditions: Eighty-five percent

of the tickets in the barrel are worth $10 each; 15 percent of the tickets

are worth $0 each. However, students are each given a hundred draws

from the barrel.

i. How might the distribution of the choices of the students

between A and B be expected to change? Why?

Variance of outcomes is importance in choices (because

variance can affect outcomes and the utility of given

choices). The variance in the problem as initially set up is

quite high and stark. The outcome for each student can be

$1,000 or $0. In this new specification of the problem,

students have a chance of receiving either $10 or $0 on each

draw, but they each have a hundred draws. The total value

of all hundred draws can go all the way between $0 (they

draw all $0 tickets) to $1,000 (they draw all $10 tickets).

They can also be expected to draw different combinations

of $10 and $0 tickets. Their individual totals can, for

example, be $400 or $600 or $950. The expected value of

their hundred draws is $850. Since the variance is lower in

this specification of the problem, more students would be

expected to choose Option B.

ii. What applicable economic principle will be at work in making

your prediction of the change in the distribution of choices?

Again, the applicable economic principle: the “law of

demand.” With lower variance for Option B, the cost

(price) of choosing Option B falls. The “quantity” of

Option B chosen can be expected to rise.

Week # 3 Discussion Problem (Note, there are no Professor McKenzie answers for this week)

Gasoline Price Controls As reported in the New York Times on October 30, 2012, Hurricane Sandy, widely

described as a “superstorm,” made landfall on October 29 on the New Jersey coast, but

because the hurricane was a thousand miles in diameter, it wreaked havoc along the

Eastern Coast of the United States from the North Carolina’s Outer Banks up to the

coasts of the New England states.

The storm destroyed thousands of homes and businesses and shut down transportation

systems throughout the region as the storm made its way inland to Ohio and points

beyond. Roads for miles inland were flooded and buried in sand carried inland by the

storm surge. Even the New York subway was closed because of flooding, and emergency

back-up generators at hospitals, businesses, and homes failed after being submerged in

water.

Most important for this week’s discussion problem, Sandy knocked out electric power for

up to nine million residents at its peak (with electricity still not restored for tens of

thousands of residents three weeks after the storm’s landfall). Gasoline refineries and

gasoline distribution terminals along the coast had to be shut down. Available gasoline

supplies could not, for a time, be produced and delivered to gasoline stations. However,

the lack of fuel was of no consequence for many gasoline stations because they had lost

electricity for their pumps.

Reports emerged of people waiting in line for hours to fill their cars or five-gallon

containers at the gasoline stations that continued to operate. Throughout the initial weeks

following Sandy’s landfall, service stations were restricted in raising their prices by “anti-

price-gouging laws” on the books in New Jersey and New York. Governors in both states

warned service station owners that they stood ready to enforce the price laws, with

“gouging” subject to interpretations of local law enforcers (although reports surfaced of

some stations hiking prices by as much as $1 a gallon immediately following the storm’s

passage).

1. First step in the discussion: Assume a competitive market for gasoline for this

problem, and assume for now that the price of gasoline was held everywhere to its

pre-storm price. Given the descriptions of Sandy’s devastation effects outlined above

(and what else you can find on the extent of devastation online),

a. Draw a supply-and-demand graph for gasoline in the region affected by Sandy prior to

the superstorm. Label the curves S1 and D1.

b. In your graph, draw in the supply of gasoline immediately following the storm. Label

the new supply curve with S2. Why did you draw the curve where you did?

c. In your graph, draw in the demand curve after the storm. Label the new demand curve

with D2. Why did you draw the curve where you did?

d. Given the reports of long lines at service stations and the anti-price-gouging laws, what

should be the relative shifts in demand and supply in your graph in the weeks after the

storm hit.

1. Second step in the discussion: Given what you can observe in your redrawn graph,

a. What effect effects do the gasoline price controls have on the quantity of gasoline

available (relative to what it would have been if there had been no price control)?

b. What effect has the controls on gasoline prices done to the quantity of gasoline

demanded (relative to what it would have been if there had been no price control)?

c. What has been the net market effect of the price control?

1. Third step in the discussion:

a. What has the price control done to the “nominal pump price” of gasoline?

b. What has the price control done to the “full price” (pump price plus the value of the

wait time)?

c. Is the full price the same for all people seeking gasoline?

d. Is the pump price above or below the full price?

e. Has the price control made people better off or worse off?

f. Would you expect economists to generally favor anti-price-gouging laws?

1. Fourth step in the discussion:

a. As noted, reports surfaced that some service stations raised their price of a gallon of

gas by as much as $1.

i. Using your supply-and-demand graphs, what would have been the effects of such a

price increase?

ii. Was the price increase all “profit” to the stations that raised their prices? Put another

way, were there greater costs refineries and stations inside and outside the storm area had

to incur after the storm?

b. The federal government released 2.3 million gallons of gasoline from its reserves.

Referring to your supply-and-demand curves, what would you predict would be the

effects of that release of gasoline?


Week #4 was skipped.


U.S. restrictions on the importation of Brazilian ethanol The United States requires gasoline refineries to include ethanol in gasoline, equal to 10

percent of each gallon sold in the country. U.S. ethanol is primarily made from corn

grown in the country.

Brazil is second to the United States in terms of the total volume of ethanol produced

and, because of advanced technology used, is an exporter of ethanol, which is produced

primarily from sugarcane. Brazil also requires refineries to make ethanol to account for

between 10 and 22 percent of each gallon of gasoline sold.

The United States bars the importation of Brazilian ethanol.

All correct alternatives are indicated with an asterisk (*)

First step in the discussion:

1. What does the U.S. ethanol requirement for gasoline do to the (equilibrium)

price of corn in the domestic market?

a. *increases

b. decreases

c. remains the same

d. don’t know (not enough information to say)

Why have you given the answer you have?

The ethanol requirement increases the domestic demand for corn, thus causing

the price to go up. In terms of a supply-and-demand graph, the demand curve

shifts up and to the right.

The process: At the initial equilibrium price, there will be a shortage (with the

quantity demanded increasing with the increase in demand, and with the

quantity supply remaining the same, at least initially). Buyers will bid up the

price, causing the quantity demanded to fall and the quantity supplied to

increase, until both quantities are the same at the new intersection

(equilibrium).

2. What does the U.S. ethanol requirement for gasoline do to the price of corn in

the world market?

a. *increases

b. decreases

c. remains the same


Why?

More U.S. corn will be used in ethanol production, which means the world

supply of corn can be expected to fall, causing an increase in the world price

and less corn consumed in the world.

Please work through the process by which the new equilibrium is

achieved.

3. What does the U.S. ethanol requirement for gasoline do to the price of

popcorn corn in the domestic market?

a. *increases

b. decreases

c. remains the same


Why?

With the increase in the price of corn used in ethanol production, the relative

profitability of growing popcorn will fall, which will cause popcorn farmers to

shift to corn used in ethanol. The supply of popcorn will fall (move up and to

the left), with the price increasing.


achieved.

4. What does the U.S. ethanol requirement for gasoline do to the quantity of U.S.

corn exported?

a. increases

b. *decreases

c. remains the same


Why?

Because of the ethanol-induced greater profitability of growing corn for the

U.S. market, more U.S. corn will be diverted to ethanol, causing the quantity

of corn available for export to decrease.


achieved.

5. What does the Brazilian ethanol requirement for gasoline do to the price of

sugar in the domestic market? In the world market?

a. *increases

b. decreases

c. remains the same


Why?

The Brazilian ethanol requirement can increase the demand for sugarcane and

divert the available supply of sugarcane to ethanol production. The supply of

sugar will decrease, which will cause the price of sugar to rise.


achieved.

6. What does the ethanol requirement in both countries do to the price of

gasoline in both countries?

a. *increases

b. decreases

c. remains the same


Why?

If ethanol were less costly to produce (per unit of energy) than refined

gasoline, the ethanol requirements would not be needed. In their search for

greater profits (and higher stock prices), refineries would move to ethanol.

Hence, we can reason that ethanol must be more costly to produce than

gasoline – because of the requirements. Gasoline with ethanol must be more

costly to price than gasoline without ethanol, which means the supply of

gasoline will decrease and the price will increase.


achieved.

Second step in the discussion:

1. What does the U.S. ethanol import restriction do to the price of gasoline in the

United States?

a. *increases

b. decreases

c. remains the same


Why?

The import restriction would not be needed if U.S. ethanol were less costly

than Brazilian ethanol. Hence, the import restriction increases the production

cost of a gallon of gasoline in the United States over what it would be were

refineries able to import freely Brazilian ethanol.


achieved.

2. What does the U.S. ethanol import restriction do to the price of gasoline in

Brazil?

a. increases

b. *decreases

c. remains the same


Why?

The U.S. import restriction means that there will be a greater supply of

ethanol in the Brazilian economy than would be the case without the U.S.

import restriction. The relatively greater supply would cause the price to be

lower.


achieved.

7. What does the ethanol requirement in both countries do to the price of

gasoline in the world market?

a. increases

b. *decreases

c. remains the same


Why?

The ethanol requirement in both country would reduce the world demand for

crude oil, the price of which can be expected to fall because of the ethanol

requirements. Also, with the United States and Brazil using less crude oil

because of the required ethanol requirement and because of the resulting

higher prices of gasoline in the two countries, there will be a greater supply of

crude oil to satisfy the energy needs of all other world buyers. The world

demand outside of the United States and Brazil falls; the available supply of

crude oil for all other countries increases. Both supply and demand forces on

the world market would push the price of crude downward, which will feed

into a lower gasoline price for all other countries.


achieved.

3. What does the U.S. ethanol import restriction do to the emissions of

greenhouse gases in the United States?

a. increases

b. *decreases

c. remains the same


Why?

If ethanol causes the emission of lower greenhouse gases than gasoline (and

there is debate on this point because corn production is energy intense), then

the lower use of gasoline in the United States and Brazil will lower

greenhouse emissions. Also, the higher price of gasoline in the two countries,

because of the ethanol requirement, can lead to less miles traveled and, again,

to lower greenhouse gas emissions in the two countries.

However, it needs to be noted that the lower price for crude oil on the world

market, and the resulting lower price of gasoline outside the United States and

Brazil, should give rise to some offsetting increase in miles driven around the

world – and more greenhouse gases emitted in places other than in Brazil and

the United states.


achieved.

Third step in the discussion:

1. What does the U.S. restriction on the importation of ethanol from Brazil do to

U.S. exports to Brazil?

a. increase

b. *decrease

c. remain the same


Why?

The U.S. import restriction on Brazilian ethanol will mean fewer external

sales for Brazilians who will have fewer dollars to buy U.S. goods, which

means lower U.S. exports.


achieved.

2. What does the U.S. restriction on the importation of ethanol from Brazil do to

the cost of producing energy in the United States?

a. *increases

b. decreases

c. remains the same


Why?

There would be no need for an import restriction of Brazilian ethanol if it

were more expensive than U.S. ethanol. Hence, the import restriction

increases the price of gasoline in the United States over what it would be with

free importation.


achieved.


Elasticity of demand Suppose that a movie theater faces a downward sloping demand curve for popcorn, and it

increases the price of a container of popcorn from $1 to $1.20, which causes the count of

containers sold to fall from 100 to 90.


1. What is the elasticity coefficient?

Elasticity of demand = - the percentage change in quantity/percentage change

in price = - 10%/20% = - .5

2. Is the demand elastic or inelastic?

Inelastic, as indicated by the elasticity coefficient that is below 1 and as

indicated by the fact that total revenues rise from $100 to $108 with the price

increase.

3. Should the theater consider raising the price of popcorn further?

Yes. A higher price could once again raise the firm’s revenues. The higher

price would also reduce sales, which would reduce costs, making for higher

profits.


1. When a firm faces a downward sloping demand curve, should it ever price its

product in the inelastic range of the demand curve?

No, aside for when the good is addictive or has network effects. Aside for the

exceptions, the firm should raise its price until it moves into the elastic range

of its demand curve.

2. Should the firm ever price it product where its elasticity coefficient is 1?

No, with an exception noted below. The firm may maximize its revenue at the

price where the elasticity coefficient equals 1, but that is not the same as

maximizing profits. The firm can increase its profit by raising the price to

where its demand is elastic (or has an elasticity coefficient greater than 1),

which means its total revenue will decline as it raise it price from where the

coefficient equals 1 to where it is greater than 1. However, its profits can rise

because its costs fall with reduced sales. So long as its costs fall by more than

its revenue, its profits will rise. The firm should stop raising its price when its

revenue falls by more than its costs. (As we will see in following lectures, the

applicable rule is that the firm should continue to raise its price until its

marginal cost equals its marginal revenue.)

The only condition under which a firm will price where the elasticity

coefficient is 1 is when all production costs are fixed, or do not vary with firm

output. (Can you think of a product that fits such a requirement?)

3. When a firm is a monopolist (or the only seller of a product), should it price

its product in the elastic or inelastic range of its demand curve?

The monopolist should price its product in the elastic range (for the reason

given just above).

4. If a firm faces a downward sloping demand curve that has an elasticity

coefficient of 1 throughout its entire range, what quantity should the firm

produce to fully maximize profits?

The profit-maximizing output level is 1. With the elasticity coefficient equal

to 1 at all points on the demand curve, the revenue at all points on the demand

curve, and at all prices, is the same. Why produce more than 1 unit? The firm

gets the same revenue with an output of 1 as with an output of 100, or 1,000.

At an output of 1, productions costs are minimized, which means that profit is

maximized.

5. Should a firm ever charge a price that is below (marginal) cost or that is below

zero (which means the firm pays customers to take the product)?

If the firm produces an addictive good or the sales of its good have

accompanying network effects, then pricing below costs and below zero can

make sense. In the case of addictive good, the added sales can cause

consumers to want more of the good over time, which means that below-cost

and below-zero pricing can increase future demand, with the higher future

price and sales justifying any loss on sales made initially with a below-cost

and below-zero price.

In the case of a good with network effects, greater current sales, induced by

the below-cost and below-zero price, can increase the value all consumers

place on their units bought, increasing demand. The higher demand can lead

to a higher price and higher sales and greater profits. (See video lecture 30

and chapter 6 in McKenzie’s Microeconomics for MBAs, 2nd

ed.)


Wine pouring in bars Tipping servers in bars is common in the United States and many other places around the

world. This typically means that bar patrons leave a gratuity of 15 to 20 percent of the

total bar bill for the bartender(s) (when customers judge the service to be acceptable or

better).

In many bars bartenders are required to first pour ordered glasses of wine into carafes (or

small bottles tapered at the top) and then to pour the wine from the carafes into

customers’ glasses on reaching them at their positions at the bar or at tables surrounding

the bar.


1. If possible, go to a local bar (or restaurant that serves wine) that follows the

wine-pouring procedures outlined above and ask the bartenders why they just

don’t pour the wine directly into their customers’ wine glasses and take the

wine glasses to the customers?

You will likely hear (as the professor has heard) that the carafes are used (in

spite of the greater dish-washing costs) because it helps create a desired

“ambience” in the bar, which could be a partial explanation because the

resulting increase in traffic can more than cover the (very likely small) added

dishwashing costs.

Members of your group could have heard other explanations. Just evaluate

each for their economic reasonableness (or in terms of solving some

management problems and in terms of costs and benefits).

2. Develop your own explanation for the required wine pouring procedures

based on principal-agent analysis.

The owners of the bar are the principals who want to maximize their return by

employing bartenders to pour wine as cost effectively as possible. This means

they do not want bartenders to use firm resources for their own private gain

(unless the bartenders are willing to take a cut in pay). The bartenders, who

are hired agents, want to maximize their return from work by using the

resources at their command, including the bottles of wine over which they

have some control in how the wine is pour. The carafes are used to control

the bartenders’ inclination to over pour their favored customers. It’s harder to

over pour with the carafes (because of their narrow necks) than with the wine

glasses.

3. How might tipping affect wine pouring by bartenders if they poured wine

directly into wine glasses (especially large wine glasses that bars often use to

encourage drinking)?

Bartenders get to know many of their regular customers, including how much

they typically tip. Bartenders can over pour wine for their regular customers

who can be counted on to over tip (or the extent to which they are “big

tippers”). Customers can compensate the bartenders for the extra wine with

an extra tip. Thus, agents can use the principal’s resources (wine) to pad their

pockets, with the principals incurring the added cost for wine.

Because of this principal-agent problems in bars, managers often check how

much wine has been poured in total against cash register receipts. This means

that if bartenders over pour their regular big tippers, they must under pour

other customers just to make sure their over pouring is not detected, and the

under pouring can cost the bar customers and revenues.

4. How might the bartenders’ wine pouring affect tipping?

Needless to say, customers who get more wine than expected, can be expected

to reward bartenders with higher tips, which can cause the bartenders to

extend their over pouring (and round and round until the over pouring is

detectible by managers).


1. What’s the basic problem that the wine pouring procedures are intended to

solve?

Very simply, principal-agent problems, or the cost of the over pouring is

shifted to owners in the form of reduced profits.

2. If bartenders are not required to follow the wine pouring procedures outlined

above, how else might management seek to solve the “problem” you

identified in the previous question?

It should be interesting to learn what monitoring/control systems students find

managers use in bars they visit. One of the most common means bars use to

control over pouring is for the manager to watch what bartenders do. The

professor has seen some bars put a wine glass at the “pouring station” with a

green line around the glass that the poured wine is not to exceed (with the

added requirement that bartenders pour all drinks at the pouring station). Bars

also have cameras aimed at the pouring station to catch offending bartenders.

3. Is the “problem” you have identified a problem in all bars? In what situations

is the “problem” more likely to be found?

The problem of over pouring and over tipping does not appear to be a problem

everywhere. Managers may have few pouring controls in place when they

know they can trust their bartenders, maybe from long years of the bartenders

working at the bar (and their reputations for honest dealing in prior bar jobs).

Obviously, there is no principal-agent problem for bartenders who own their

bars. When they over pour wine for customers, bit tippers of just friends, the

excess wine comes out of their own pockets. It follows that control

procedures are likely used with greater frequency when owners/managers

can’t monitor bartenders, at least not directly and at little cost.

However, keep in mind that some bars will want to use excess pours as a form

of promotion, or to get customers coming back (or to reward frequent

customers). For this reason, the owners of some bars give their bartenders

some leeway in over pouring (and can reward bartenders for effective use of

their discretion on over pouring).


Opportunities and Business Decisions Suppose you are in a crowded restaurant. You overhear a discussion at the next table.

From what you hear, you deduce (accurately) that one of people is the owner of a

prominent upscale nursery in Newport Beach, California where land values are higher

than most other locations in other parts of Orange County, California, and land values in

Orange County are higher than the vast majority of counties in the country (and even in a

number of other counties of Southern California).

The eight or so acres of land on which the nursery sits are especially well positioned, and

are very pricy. The piece of land is within a mile or two of the Pacific Ocean and is on

the perimeter of a major upscale shopping center that is one of the most profitable

shopping centers in the county. The nursery and shopping center are surrounded by

densely packed multimillion-dollar homes. One real estate agent estimates that if the

land were vacant today, it would sell for about $15 million.

You hear one of the people at the close-by table ask about how the nursery can continue

to operate on such a well-positioned and high-price piece of land. The owner explains,

“Well, my father bought the property way back in the 1970s when the area was far less

developed and the land was relatively cheap. If we had to buy the land today, there is no

way we could afford to buy the land and develop the nursery. The land would probably

be used for another shopping center or condo development.”

This restaurant conversation presents an interesting economic/business problem to

ponder, even though there may not be a definitive answer (because we don’t have all the

required details of the nursery’s operations, including its profitability). But then, many

business problems that must be taken up in a course in skeleton form don’t have

definitive answers (because of the limitations of available information). However, such

problems can bring to light concepts and principles and ways of thinking that can be

useful in considering an array of problems where the details may be far more complete.

.

1. First and only step in the discussion:

a. How do you react to the nursery owner’s claim that he could not buy

the land and develop the nursery today and that the land would be used

in some alternative business venture?

One way of looking at the issue is this: If the owner has truly

accurately assessed the real estate market in the vicinity of his nursery,

then he is saying that that he could not “afford” to buy the land today.

Interpreted differently, he is saying that the expected future

profitability of the nursery going forward in time is not sufficient for

him to pay the going price for the land. If the expected profitability of

the nursery going forward were more than sufficient to cover the cost

of the land and nursery facilities (and the differential between the

present value of the nursery’s future profits stream were greater than

the price of the land), then he should be willing to buy the land and

start the nursery. Otherwise, he would be leaving “money on the

table.”

Of course, there is an important caveat to keep in mind: if he could

invest the funds required to buy the land (and cover the cost of the

nursery’s development) in some other business venture that yielded a

higher expected profit stream into the future, then he should not buy

the land. He should invest in the most profitable other business

venture.

b. If the owner has accurately assessed the economic situation of the

nursery, what should he do?

By saying he could not afford to buy the land today, he is saying one

or both of two things: First, the current value of the expected profit

stream of the nursery cannot cover the cost of the land (and other

facilities). Again, if the current value of the profit stream were greater

than the cost of the land (and facilities), he would buy the land today.

Second, he could be saying that the price of the land is so high that he

could sell the land and invest the funds in some other venture that

would be more profitable over time (or he can get a price for his land

that reflects the higher expected profit stream someone else could get

from the deployment of the land in some other use or business

venture).

c. If the nursery owner continues to operate his business, how might you

explain his doing so, in spite of his saying that he would not start the

nursery today because of the high price of the land on which it sits?

By continuing to hold the land and operate the nursery, there is good

reason to suspect (not know) that the owner has not revealed the true

economics of continuing to operate the nursery.

The profit stream might be higher than he let on.

The land could have a lower market value than he thinks.

He gets some non-money value (the pleasure from knowing he

has the premier nursery county that has become a tourist

attraction) from operating the nursery that more than

compensates for the lack of profitability of the nursery.

He might not know of other business ventures that will give

him a higher rate of return on the sale price of his nursery

business.

The owner’s personal (and transaction) costs of selling out and

developing a new business (or buying another existing

business) are greater than any expected gain he might receive.

The owner might also be constrained by the fact that a number

of family members (and investors) may not agree on what

should be done. The owners might not agree on selling out and

on the division of the sale price.

Now that the nursery has been developed on the land and is a

going, profitable business, the owner no longer needs to worry

about the risk of undertaking a new business. There is no

longer the “risk cost” associated with starting a new, untested

business concept. If the owner were to buy the land today at its

current high price to start a nursery today, he would face the

nontrivial risks of failure, with the risk costs elevated by the

high upfront investment in the land and in the development of

the business, which could now be greater than what the risk

costs were back in the 1970s, when competition was less

prevalent and intense.

So-called “behavioral economists” (whose theories will come

up at different points in the course) argue that people are “risk

averse,” which suggests that losses of a given amount (say,

$100) loom larger in decisions in all spheres, including

business, than an equal amount of gains ($100 of losses harbor

more disutility than $100 of gains). Risk (and loss) aversion

implies that people will require a higher sale payment for a

piece of property when they own it than they would pay out of

pocket when they do not own it. So, the owner might demand

$21 million before he would sell the land on which the nursery

sits, but, at the same time, he would not pay the going market

price of $15 million for the land if he did not own it. (Granted,

this line of argument has not been taken up in the lectures –

yet. I briefly and incompletely cover it here just in case some

students (out of the thousands taking the course) are familiar

with the basic tenets of behavioral economics, a basic position

of which is that people do not always act exactly as economists

assume rational people act.)


Monopoly Vs. Perfect Competition Following conventional market-structure theory, perfect competition (a market structure

comprised of many firms and total fluidity in the movement of resources) maximizes

output and market efficiency but reduces economic profit to zero for all firms. Monopoly

(a market structure comprised of a single producer protected by entry barriers) reduces

output below the perfectly competitive level in order to hike its price and generate

economic profits. In the process, a monopoly causes the market to be less than fully

efficient. The monopoly reduces consumer surplus by reducing output and by extracting

monopoly profits.


1. Do you accept the argument that “perfect competition” is all “good” and

“monopoly” (or “monopoly power”) is all “bad”? Why? Why not?

2. Would you want an economy that largely perfectly competitive or largely

monopoly, or some combination?

3. How do you assess barriers to market entry in terms of enhancing consumer

welfare?

4. Would you invest your own resources in the development of a product that

will go into a perfectly competitive market? Why? Why not?

Professors McKenzie and Dwight Lee have addressed all of these issues extensively

in a book titled In Defense of Monopoly: How Market Power Fosters Creative

Production (University of Michigan Press, 2008). Professor McKenzie has excerpter

many of the arguments for an article written for a policy magazine, a major portion

of which is provided below.

TEXTBOOK MONOPOLY

Many economists and antitrust lawyers have concluded that the problem with antitrust

enforcement largely has been a matter of wrongful application of monopoly theory. A

better diagnosis is that a deeply flawed conventional monopoly theory has misguided,

and continues to misguide, enforcement.

All budding antitrust lawyers and economists learn the conventional monopoly

theory, which is almost always depicted with a graph like Figure 1. From such a graph

and underlying theory, four theoretical conclusions, all of which paint monopoly as

nothing less than a source of “market failure,” are drawn:

First, monopolies everywhere lead to curbs on production to achieve higher-than-

competitive prices. That allows a monopoly to collect “rents” — supracompetitive profits

— and impose an “inefficiency” or “deadweight loss” on markets. In Figure 1, the

monopoly restricts production, reducing it from the competitive output level where price

equals marginal cost, to the point where marginal revenue equals marginal cost. That

enables the firm to raise its price to the monopoly price, which is above the competitive

price (and the marginal cost of production). Efficiency in the allocation of resources is

always fully maximized when price equals marginal cost, or so students are required to

repeat in rote fashion.

Second, the monopoly benefits from barriers to competitors’ entering the market and

thus gains pricing power (caused by market dominance, if not just bigness), a practice

that is (conventionally) antithetical to competition and welfare gain. The barriers enable

the monopoly to maintain its supply constraint, monopoly profits, and the deadweight

loss of consumer welfare.

Third, the monopoly achieves rents that are unearned and forcibly taken from

consumers’ “surplus value” (the whole of the area under the demand curve and above the

marginal cost curve in Figure 1).

Fourth, “perfect competition” — a market in which all resources are perfectly fluid

and in which monopoly rents are nowhere achievable — should be viewed as the goal to

which antitrust enforcement presses real-world markets. Then, consumers would get their

entire consumer surplus (including the striped rectangle and triangle in the graph), which

is to say that consumer welfare is maximized.

The conclusion is that antitrust enforcers enhance consumer welfare when they

prevent or destroy barriers to market entry and increase the number of competitors —and

thereby undermine the market power of monopolies.

(Figure 1 is at the end of the article.)

THE REAL WORLD

That’s all nice theory, but it is grossly misleading for several reasons.

From the theory on which antitrust law is founded, one has to wonder why

competitors to a dominant monopoly firm would press for antitrust complaints against a

monopolist when the monopolist acts like one — that is, when it curbs production to hike

its price. Would that not mean the monopoly would be giving its competitors a chance to

gain market share even with higher prices? Would competitors really want their market to

be made even more competitive through antitrust enforcement, as Microsoft’s

competitors indicated they wanted when they proposed the breakup of Microsoft into two

“Baby Bills”? Clearly, William Baumol and Janusz Ordover damned much antitrust

enforcement when they observed, “Paradoxically, then and only then, when the joint

venture [or other market action] is beneficial [to consumers], can those rivals be relied

upon to denounce the undertaking as ‘anticompetitive.’”

Notice also how the theoretical model rigs the debate. Both in Figure 1 and in abstract

discussions of monopoly, the monopolized product and the monopoly itself are subjected

to analysis only after the firm and product have come to dominate the market. Nothing is

said about how the monopoly arose. Could it not have arisen by besting its competition

with a superior product at a lower (or even higher) price?

IGNORING THE GOOD Setting that issue aside, in the market model portrayed in the

graph, any output level below the idealized competitive output level that the monopoly

causes is considered to be detrimental to consumers. Consumers have less to buy and

must pay an inflated price for what they are able to buy because of the monopolist’s

constricted market supply. Thus, the argument goes, consumers lose the potential welfare

gain that goes up in the smoke of the monopoly profits and in the market inefficiency.

Because the good itself and all that went into bring it to market are not considered by the

analysis, the analysis simply assumes that the monopoly has no just claim to any

consumer surplus.

However, products bought and sold in real-world markets do not appear by

assumption, or fall like manna from heaven. Monopolies do not achieve their dominance

for no good reason (unless established by government fiat). Products and their markets

have to be created and developed with significant initial investments. Once those points

are recognized, a monopoly that is alone responsible for achieving its market dominance

will not want to restrict output. On the contrary,

The monopoly expands total output along with the array of available products.

The monopolist does not charge higher prices; it lowers them.

Consumer welfare is not lowered; it is elevated (at the very least equal to the

triangular area in Figure 1 that is above the monopoly price and below the demand

curve).

The monopolist does not produce inefficiently; the identified inefficiency area in

the graph would not likely exist in many monopolized markets were it not for the

prospect of the monopoly profits.

Without the monopoly product, many products of monopoly would not exist in the

first place.

Rents are not an unjustified cash grab, they are likely the impetus for creating the

product in the first place.

When the product is created by the monopoly, the claim that the monopoly has no

just claim on the consumer surplus surely loses at least some of its force.

Of course, a monopoly would not restrict its output and elevate its price if it faced

perfectly competitive market conditions. But if a potential monopolist anticipated

anything close to perfectly competitive market conditions, it would not create the good in

the first place because there would be no incentive to do so. In a market with complete

resource fluidity, a firm would be foolish (and negligent to its stakeholders) to incur the

product and market development costs of a new product because such costs are not

recoverable in totally fluid markets. All prospects for development cost recovery would

be wiped out as numerous producers replicated the newly created product at zero

development costs, forcing price to the marginal cost of production. It follows that where

there are no barriers to entry, product and market development costs cannot be recovered

and “monopolized” products and their markets will not be developed, leaving consumers

less well off.

The idealized competitive price, which equals marginal cost, becomes all the more

absurd as a viable price when marginal cost of production approaches zero, which is the

case for many digital goods. A competitive price of zero is hardly a price that is

sustainable, given product and market development costs in addition to production costs

— unless, of course, the product is a “give-away” that enables producers to charge

monopoly prices on some other product tied to the give-away.

Indeed, in the real world where entrepreneurs create goods, the idealized competitive

price (which equals marginal cost) is hardly a better signal of what products should be

produced because it captures little (actually none in Figure 1) of the value of the product

to consumers. Instead, a monopoly price can more efficiently direct entrepreneurial

energies because such a price captures more of the value of the product than the

competitive price, a point that Paul Romer has made with force. (Remarkably,

economists typically start their classes heralding the mutual benefits from trade going to

trading partners, only to later idealize the perfectly competitive market in which

producers receive no net gain from production while consumers who had nothing to do

with the product and market development get all the gains.)

Paradoxically, the potential for market power over price through the generation of

new products can lead to greater competition in markets than when there is a complete

absence of market power, which is the case under so-called perfect competition. Perfect

competition is far less “perfect” in terms of generating consumer value over the long run

than markets with more constricted resource fluidity.

Think about it: how much entrepreneurial and entrepreneurial effort is being applied

right now to the development of products and markets where there is no chance of

making (directly or indirectly) at least enough monopoly rents to cover product and

market development costs? Indeed, the exact opposite occurs. Firms are constantly

searching for potential products that come with natural entry barriers or harbor the

prospect of being protected by artificially created and continually fortified entry barriers

with, if nothing else, ongoing product improvement. As opposed to being destructive of

consumer welfare, entry barriers in some form and at some level are essential for product

and market creation — and for the advancement of consumer welfare beyond what can be

achieved when products are given.

Antitrust enforcers decry “monopoly prices” because they cause monopoly rents. But

how many consumers and firms would want to deal with firms that make zero monopoly

profits and stand always on the brink of being supplanted by competitors at the slightest

of errant moves? Firms in such markets cannot make credible commitments to do what

they say they will do.

The standard models of monopoly and perfect competition that all antitrust enforcers

learn set aside a reality of markets: the vast majority of new products (and even new

firms) fail. Under such market conditions, the potential for monopoly prices and profits

on the relatively few successful products are absolutely essential, just so that the

development costs of all products — the successful and unsuccessful — can be covered

with some margin left over. Otherwise, firms would not systematically take on the risk

associated with the development of an array of products.

BACK TO MICROSOFT

When the U.S. Justice Department took Microsoft to court in 1998, it chided Microsoft

for having developed its market dominance on the back of “network effects” and

consumer “switching costs.” Network effects mean that the value of the product to

consumers increases as more consumers adopt the product. Switching costs means that

consumers cannot easily move to an alternative product. The Justice Department never

realized that its network-effect/switching-cost arguments together mean that consumers

have a strong interest in the maintenance of the network — and of the network-good

producer, Microsoft, taking strong action to prevent the dissolution of the network

through the entry of alternative producers.

Finally, for sake of argument, let us assume that a firm — call it Microsoft, Apple, or

Google — is the worst of monopolies as conventionally conceived. It constricts output in

order to hike its price and profit to the limit, resulting in the maximum inefficiency in its

market. Is such a firm a drag on the economy, on balance and over the long term?

Conventional monopoly theory offers a resounding “yes.” But not so fast. There can be

an untold number of firms out there busting their organizational butts to create an array of

heretofore unknown products at their own expense because they want to be like the

monopoly that is making monopoly profits.

Paradoxically, monopolized markets can be more creative, competitive, and welfare

enhancing than the most perfect of perfectly competitive markets. Indeed, perfectly

competitive markets would be totally stagnant markets, if they could exist, which is

unlikely because no one would have an incentive to create and develop the products and

their markets in the first place. Moreover, antitrust enforcers who seek to impose their

version of a “competitive” market based on wrongheaded lessons learned from standard

monopoly theory very likely can impose more damage — inefficiency — on the world’s

economy than their targeted “monopolies” ever could do.

Joseph Schumpeter is renowned for coining the term “creative destruction,” a term

most people either misinterpret or do not understand. Schumpeter had in mind a subtle

point that needs to be emblazoned in the corner of the computer screens of all antitrust

enforcers everywhere:

A system — any system, economic or other — that at every given point in time

fully utilizes its possibilities to the best advantage may yet in the long run be

inferior to a system that does so at no given point in time, because the latter’s

failure to do so may be a condition for the level or speed of long-run performance.

The prospect (and the necessary reality) of monopoly power and profits at some level is a

necessary and crucial market force driving so much creativity and competitiveness and,

thus, long-term maximization of resource efficiency and consumer welfare. Particular

products might be protected by barriers to entry from replicators of the product, but new

ideas incorporated in new and improved products cannot be denied. Or as Schumpeter

observed, “The fundamental impulse that sets and keeps the capitalist engine in motion

comes from the new consumers’ goods, the new methods of production or transportation,

and the new markets, the new forms of industrial organization that capitalist enterprises

create.” It does not come from simple price competition, as so many conventional

microeconomics courses wrongly stress.

Unlike the price competition idealized in conventional monopoly discussions,

competition from new ideas incorporated into new and improved products strikes “not at

the margins of the profits and the output of the existing firms but at [the firms’]

foundations and their very lives.” Without including an analysis of this type of non-price

competition, Schumpeter argues, any discussion of markets, even though technically

correct, is as empty as a performance of “Hamlet without the Danish prince,” — a point

that Schumpeter would surely stress to modern-day antitrust enforcers on both sides of

the Atlantic.

# # #

READINGS

Capitalism, Socialism and Democracy, by Joseph A. Schumpeter. Harper, 1942.

The Antitrust Paradox: A Policy at War with Itself, by Robert H. Bork. Basic Books,

1978.

“The Origins of Endogenous Growth,” by Paul Romer. Journal of Economic

Perspectives, Winter 1994.

Trust on Trial: How the Microsoft Antitrust Case Has Changed the Rules of Competition,

by Richard B. McKenzie. Basic Books, 2001.

“Use of Antitrust to Subvert Competition,” by William J. Baumol and Janusz Ordover.

Journal of Law and Economics, Vol. 28 (May 1985).


Pricing Strategies With supply and demand curves, we were able to demonstrate early in the course why

competitive markets have one price that is adopted by all producers. And all producers

charge the same price for all units sold. Such analysis clearly has relevance in

commodity markets (grains, for example). However, in many markets producers are

observed charging different people different prices and different prices for different units

sold to buyers. In this last group discussion problem, you are asked to provide

explanations for observed differences in prices. (You are encouraged to come up with a

list of markets in which the identified pricing strategy is used.)

Don’t assume that the following problems always have clear economic explanations.

Indeed proposed explanations may be, to one degree or another, “speculative,” which is

understandable, given that student groups need to devise explanations without knowing

many institutional details and without time-consuming empirical analyses (which can be

used to test the validity of hypotheses that can be devised from theoretical considerations

but can’t be considered within the timeframe of this course). Also, there could be

multiple explanations for the pricing strategies identified. Student groups should also

seek to think creatively (trying to come up with explanations that escape the professor).

The pricing problems are intended to press students to apply the economic reasoning

developed throughout the entire course. Students should consider all of the following

questions (briefly) but are encouraged to address on selected questions. There isn’t

enough time to address them all thoroughly. Students are encouraged to distribute the

questions within their discussion groups and to swap and evaluate responses devised

within and across student discussion forums.

1. Many movie theaters around the world charge “seniors” (moviegoers over, for

example, sixty years of age) more than they charge younger adults. Why?

Explain why seniors’ break on ticket prices is profitable to movie theaters.

This can be explained by the analysis of market segmentation. The demand

curve of seniors is more elastic than the demand curve of younger adults.

Seniors have more time on their hands to search for the best prices for

entertainment. Their demand may also be lower (which means that the

elasticity of demand at any given price is higher).

Review video lecture 42. Market Segmentation (25 minutes)

2. Movie theaters also charge different prices for different size containers of

popcorn, for example, $5 for a “small” (8 ounces), $6.50 for a “medium” (16

ounces), and $7.00 for a “large tub” (32 ounces with refills). (Similar pricing

strategies are used for sodas and packages of fries at fast food restaurants.)

http://media.merage.uci.edu/merage2/McKenzieVideoCOURSE/42.MarketSegmentation.wmv

Why do movie theaters charge less per additional ounce as customers buy the

larger sizes?

This pricing strategy can be explained by the analysis of imperfect price

discrimination. Movie theaters recognize that in order to sell people larger

sizes of popcorn, they must progressively lower their prices on the additional

ounces. Theaters are, in effect, “walking moviegoers down their demand

curves.” The fact that they must drastically lower the prices of the additional

ounces indicates that the demand for popcorn is highly inelastic. Movie

theaters put a high price on the small container and then include that high

price in the price of the medium and large tub (that is, the medium price is the

sum of the $5 price for the first 8 ounces plus $1.50 for the next 8 ounces.

Review video lecture 41. Perfect and Imperfect Price Discrimination (29

minutes).

3. Name brands often sell their lines of sweaters, jeans, and shirts in upscale

department stores and low-end big-box stores at different prices. When is

such a pricing strategy profitable?

Low-end big-box stores attract customers with more elastic demands than do

upscale stores. Again, this pricing strategy can be understood through the

graphics of market segmentation.

Again, review video lecture 42. Market Segmentation (25 minutes).

4. Airlines charge passenger who book their flights weeks in advance less than

they charge passengers who book their flights just before they want to travel.

Why?

The analysis for this problem is the same as for question 3. All that needs to

be noted is that the airlines have found that customers who book their flights

early have more elastic demands than those who book them days before.

(Some airlines have begun to offer tickets bought the day before departure at a

drastically reduced rate, give that last-minute customers may have even more

elastic demands than customers who book their flights weeks in advance.)


5. People who show up at restaurants with coupons get a break in the price that

is not given to all other patrons?

Again, a pricing problem best viewed through prism of market segmentation.

Those patrons who show up with coupons reveal that they are price sensitive,

which means they have more elastic demands than patrons without coupons.

Those patrons with coupons reveal to restaurants their own elasticity of

http://media.merage.uci.edu/merage2/McKenzieVideoCOURSE/41.PerfectandImperfectPriceDiscrimination.wmv



demand, but they also reveal that customers without coupons have relatively

less elastic demands.


6. National governments impose higher tax rates on peoples’ incomes than

state/provincial governments impose and state/provincial governments have

higher tax rates than local governments. Why?

People have demands for living within governmental jurisdictions. Tax rates

can be viewed as “prices” governmental jurisdictions. They can more easily

move among states than countries. Hence, their demand for living within any

given state/province is more elastic than living within a given country. Hence,

the “price” (tax rate) states can charge is going to be lower than national

governments can charge. People can move even more easily among local

governmental jurisdictions than among state jurisdictions. Hence, prices (tax

rates) of local governments should be expected to be lower than state

governments.

It follows that increases in people and capital mobility across governmental

boundaries can be expected to be a force for keeping tax rates of governments

lower than they might otherwise be.

7. Many retailers sell goods on their web sites for different prices than they

charge at their “brick-and-mortar stores.” Which outlet category – online or

brick-and-mortar -- would you expect to have higher prices?

Another market segmentation problem with the online and brick-and-mortar

markets having different elasticities.

Many students are likely to conclude that the online market segment has a

more elastic demand than brick-and-mortar. This is because people can more

easily (or less costly) compare prices online, which can make them more price

sensitive. However, customers of brick-and-mortar stores can also fairly

easily compare prices by going to their smartphones and taking pictures of

posted UR codes, which can bring up prices for the products from alternative

sellers.

Moreover, for many product categories, the elasticity of demand for online

purchases might be more inelastic (at least for many products). People who

go online may might so because they are highly time constrained. They may

have little time to search alternative web sites and compare prices. They just

want to buy what they need or want as quickly as they can (and move to

projects that have higher values than the value of the savings from extended

searches). (They go to Amazon.com, find their desired item, and hit the “1-

click” button, with some buyers not even taking the time to notice the price!.)


Researchers have found that the demand for online grocery sales is more

inelastic than brick-and-mortar stores, and as a consequence, online prices are

higher. However, keep in mind that the relative elasticities can vary by

product categories, which means relative prices can vary across product

categories, and products.

8. Many retail stores regularly have sales that run for a set period of time during

set seasons of the year. How can sales be explained?

Yet another case that can be analyzed in terms of market segmentation, at

least in part. The short answer to the problem is that buyers differ in their

elasticities and their demands differ at different times of the year.

A sizable group of buyers spend a lot of time watching for bargains – in

announced sales in advertisements! Other buyers pay little attention to prices

– and sales. They may have little time to pay attention to and gather

information on sales. When stores announce sales, the stores draw in a

disproportionate number of price-sensitive buyers who can be expected to

stock up on the sale items. Stores can then sell to price-insensitive buyers on

non-sale days. Admittedly, some price-insensitive buyers will “stumble” into

stores when they have sales. However, such an observation does not destroy

the basic point of sales.

Sales may be seasonal. Again, this can be the case because product demands

increase and decrease over the year. The elasticities of demands can also

change by the season. (Many observers of Christmas gift giving may feel

pressed to have gifts under the tree on Christmas morning, which means

before Christmas their demands can be higher and their demand elasticities

can be lower than after Christmas, which helps explains after-Christmas

sales.) And do note that when demand of any product goes up, the elasticity

of demand at any given price goes down, which means that a demand increase

increases the likelihood of a price increase leading to a higher price.

(As an aside, note that the effectiveness of sales actually generating greater

sales can depend upon buyer’s willingness to “stock up.” Of course their

ability to stock up depends on their storage room, which can depend on the

cost of storage (housing) room.)

For an extended discussion of the reasons for sales, and citations to the

literature, consider reading chapter 13 in McKenzie and Gordon Tullock, The

New World of Economics, 6th

ed. (Springer 2012).

9. Notre Dame University, a perennial football powerhouse with a massive fan

following in the United States (and probably in other [parts of the world), will

play against the University of Alabama for the championship for all major

universities in January 2013. By late November, 2012, Notre Dame had

received had over 100,000 advanced ticket requests for the championship

game, with only 17,000 tickets available for sale by the University. The

difference between available tickets and ticket requests suggest suggests that

its ticket prices are way below "market." As evidence of that, Notre Dame

football tickets in the "secondary market" (now, mainly online sales) ranged in

late November from $1,000 to as much as much $4,300 (for midfield second-

row seats), and ticket prices were expected to go higher as the day for the

game approached. (Such "excess" resale prices have been a common

“problem” for the University.)

Why does Notre Dame continue with its below-market ticket pricing

strategy, which requires that many tickets be distributed by lottery?

Why doesn't the University collect the revenues that are being

collected by resellers by raising University prices for tickets?

After all, the University produces the games and their consumer value, not the

resellers. If the University feels bad about "exploiting" football fans (many, if

not most, of whom are quite well off), then it could raise its ticket prices,

collect the addition revenues, and distribute the additional revenues to the

"poor" (or to any other charitable venture the University or the Catholic

Church deems appropriate).

Moreover, it’s a safe bet that few Notre Dame students would pay the prices

for their tickets charged on the secondary market. But many students will go

to the game with “free tickets.” Why don’t they resale them?

There are probably several ways the questions in this problem can be

addressed.

a. Notre Dame may be held back from charging market-clearing prices

because of religious considerations: University officials simply don’t see

market-clearing prices as “right” and “fair.” Alternatively, the University

may be simply trying to divide the “net gains” from being in the

championship game for between fans and the University.

b. “The logic of queues” might help explain the “below-market price.” See

Perspective 3 that was assigned I Week 2. By holding the ticket price

down, the University has a “stock” of buyers in reserve, and the University

might figure that it wants to have the “stock “ buyers that retail stores have

for wanting to have “inventories” of goods available. The University may

also fear that as it raises its price, it will overshoot the market-clearing

price and end-up unsold tickets – an empty seats (but then this leaves open

the question of why the University doesn’t use past experience with

secondary-market prices as guides for current ticket prices).

c. The University might actually be maximizing its revenues from (at least

two) interconnected sources, donations to the University and ticket sales.

Ticket recipients only have a chance of buying tickets at the announced

“below-market price” if they have previously made some minimum

contribution to the University and/or its athletic program (which can run

into the thousands of dollars). Payments are tickets are not generally tax

deductible; contributions are. By extracting tax-deductible contributions

from attendees getting tickets, then might be inclined to pay more in total.

Notre Dame economics Professor Barry Keating pointed to this line of

argument when asked to this question:

About Notre Dame football tickets...

Surely you are correct at noting the university sells them "below market"

year after year. Of course, the trick is to define the market correctly! My

own "take" is that the university views its total take as the item to be

maximized. This, of course, includes donations.

In order to be in the lottery for tickets alumni must make a minimum

donation to the Annual Fund. Tips are the "price" of a lottery ticket that, if

it is a winner, allows the holder to purchase a ticket (or perhaps two tickets

- they seem to sell in twos). The probability of winning this lottery

increases as the size of the Annual Fund donation reaches certain

thresholds. These thresholds have names in the Development Office. A

gift of more than a certain amount, for instance, would "admit" you to the

Sorin Society and all its privileges. With Sorin Society membership comes

a higher probability of winning the lottery. I don't know this from any

published literature; I am deducing it from observation.

Recall that Notre Dame is private; there is no legislature to run to when

funds are needed. Tuition may cover 20% or 25% of the operating

expenses but donation must cover the rest. The donations must also cover

any capital expenditures over and above operating expenses. That means

Alumni relations are very important; you don't want to annoy your donor

base. If the university were to act economically (rationally as you and I

would see it), they would surely anger a large portion of the alumni. The

university must be doing something correctly here because Notre Dame,

although a small school with relatively few graduates, has one of the

largest and most generous alumni association in the world.

So, maybe the university is charging the true market price; it's simply

collecting part of the revenue in a publicly viewable manner while

collecting an additional portion of the total in a somewhat difficult-to-

measure manner. It is very difficult to separate the single game ticket price

from the "bundled" revenue stream.

d. It might seem odd (or illogical or irrational) for Notre Dame students go to

the game with their “free tickets” when they are not willing to paying the

market-clearing price. Behavioral economists have a direct explanation for

why Notre Dame students go to the game with “free tickets” when they are

unwilling to pay the “market-clearing price”: “the endowment effect.” Read

about the endowment effect in the section below drawn from McKenzie and

Gordon Tulluck’s The New World of Economics, 6th

ed.:

Endowment Effect

Mainstream microeconomic theory posits that rational people

unwilling to pay $200 for a football ticket should be willing to sell such a

ticket she is given, or has bought at a much lower price, if the ticket can be

sold for at least $200. The reasoning is straightforward: people unwilling to

pay $200 for the ticket are saying that they have something better to do with

$200, or else they would buy the ticket. The utility of the something else is

greater than the utility of seeing the game. If people have been given the

ticket, then they still have something better to do with the $200, unless

something has changed. They should sell the ticket and do the something else

that is more valuable to them.

But abundant anecdotal evidence from everyday life suggests that

people’s buying and selling prices often differ, sometimes markedly. We

have taught at big-time sports universities with strong and popular sports

rivals, especially in football. Key games between rivals are almost always

sellouts, with the result being that tickets are often scalped days before the

game for hundreds of dollars. Before the big games, we have asked our

students if they would be willing to pay the known price for scalped tickets,

which, to illustrate the point, is, say, $200. Typically, no students have raised

their hands. We have then asked how many of them would be going to the

game. Many hands go up. We can’t resist asking, “Why? You just said you

wouldn’t pay $200 for a ticket, and you can get $200 for the ‘free’ student

ticket you have. Why not sell your ticket and use the $200 to do what you

would have done with $200 had you not received the ‘free’ student ticket and

had not bought a ticket? Something is amiss.” No doubt the students would

sell their tickets at some price (as, you might remember, Wicksteed postulated

a century ago), but for most, the price would clearly have to be much higher

than $200.

Dan Ariely put our anecdotal evidence to a more rigorous test. He

contacted a hundred Duke University students, half of whom had won the

lottery on receiving basketball tickets to a home game and half of whom had

not. All hundred students had camped out for days to be in the lottery for

tickets. The students who did not have tickets were willing to pay an average

of only $170 for a ticket, whereas the students who had tickets were willing to

sell their tickets for an average price of $2,400. No student who had a ticket

was willing to sell a ticket for a price that anyone who did not have a ticket

was willing to pay.i

To a conventional economist, the students’ buy/sell decisions on sports

tickets are puzzling. Richard Thaler (2000b) argues that we have here is a

general principle: people are commonly willing to pay less to obtain a good

than they are willing to accept as payment on selling the good. He notes that

income effects and transaction costs can explain the differences between

people’s buying and selling prices. Students who are given a ticket are, in

effect, given a real income grant, which results in a higher wealth. Students’

greater wealth might result in a suppression of their need to sell the ticket,

which shows up in a greater price to sell their tickets than the price they would

be willing to pay, absent the wealth represented by the ticket. However,

Kahneman, Knetsch, and Thaler ran an experiment in which they gave coffee

mugs to some subjects in the group. Those who were given the mugs set their

selling prices two to three times the buying prices of those who were not given

mugs. These researchers conclude that people’s difference between “willing

to buy” and “willingness to pay” are “too large to be explained by income

effects” alone.ii The income and wealth effects involved in things like tickets

must be minor, if not trivial, when compared to people’s expected total

lifetime wealth.

Students might not be willing to sell their tickets for the $200 specified

in our anecdote because of the transaction cost of finding a willing buyer and

finalizing the exchange (especially when anti-scalping laws are enforced,

which introduces a risk cost as well). When the transaction costs are deducted

from the $200-ticket price, the net price is lower than what the students would

be willing to pay at maximum for the ticket. But such an explanation can

surely be dismissed, since the enforcement of anti-scalping laws is minimal at

most major college sporting events and the probability of getting caught could

easily be less than a small fraction of 1 percent.

Thaler suggests a more “parsimonious” explanation for the differences

between people’s buying and selling prices, the “endowment effect,” which is

different from the wealth effect noted above.iii

According to Thaler, the

endowment effect is the inertia built into consumer choice processes due to

the fact that consumers simply value goods that they hold more than the ones

that they do not hold (which has an evolutionary explanationiv

).

Thaler traces the endowment effect to a difference (not recognized in

conventional microeconomics) between opportunity costs and out-of-pocket

expenditures, with the former viewed by many consumers as foregone gains

and the latter as losses. Given people’s observed inclination toward loss

aversion, the pain of loss will suppress consumers’ buying prices below their

selling prices. Similarly, their required selling prices can be inflated because

decision weights for gains (implied in the selling price of a good received free

of charge or bought at a lower price) are subjectively suppressed.

To support his endowment effect arguments, Thaler points to an

experiment with MBA students by other researchers (Becker, Ronen, and

Sorter 1974). The students were given a choice between two projects that

differed in only one regard: one project required the students or their firms to

incur an opportunity cost, and the other required that the students or their

firms make out-of-pocket (or out-of-firm coffers) expenditures. “The students

systematically preferred the project with the opportunity cost.”v This finding

suggests that the students should be willing to accept a lower rate of return on

opportunity-cost investment projects than out-of-pocket-expenditure projects

of equal amounts. Similarly, researchers studying the choice of schooling in

the Seattle-Denver Income Maintenance Experiment found that changes in

parents’ out-of-pocket expenditures for school had a stronger effect on

schooling choice than did an equivalent change in opportunity costs.vi

If, as behavioral economists attest, buyers subjectively weigh

opportunity costs as less than an equal dollar amount in out-of-pocket

expenditures, then we have another explanation for the long queues in retail

stores, at movies, and elsewhere.vii

When sellers cut the number of ticket

booths or checkout counters, they can curb their costs and, in turn, lower their

prices, thus lowering buyers’ out-of-pocket expenditures. But, the lower

prices can lead to lines that impose a time cost, or opportunity cost, on buyers.

According to standard analysis, sellers should continue to maintain their ticket

booths and checkout counters so long as sellers can lower their prices by more

than buyers incur in opportunity costs. Sellers have optimized on the length

of their queues when the increase in buyers’ opportunity cost (say, $1) from

the last increase in the length of the queues equals the reduction in the price

(say, $1).

However, if behavioralists are right on the differential weights buyers

apply to opportunity costs and out-of-pocket expenditures, then the dollar

equality suggested above would mean that the line is suboptimal—or too

short. Firms can increase their profits and consumer welfare by increasing the

length of their lines. This is because buyers would subjectively weigh the last

increase in length of the queue (opportunity cost) as less than the last

reduction in price (out-of-pocket expenditures). Hence, sellers should

continue to curb their ticket booths and checkout counters, extending the

length of their queues until the additional subjectively weighted opportunity

costs equal the subjectively weighted reduction in out-of-pocket expenditures.

10. Coursera and any number of other educational platforms that have emerged

relatively rapidly (since 2010) have what seem to be a straight forward pricing

strategy for their MOOCS (“massive open online courses”): Free! This is to

say, very large numbers of students from around the world can take the listed

courses without tuition payments (as you know), at least for now. This means

that the professors teaching the courses get nothing from tuition. While many

of the costs of MOOC are sunk costs (mainly in the form of the computer,

video, and internet equipment investments on the part of the MOOC providers

and in the form of lecture development by professors), there are at least

moderate operating costs that must be incurred by the MOOC platform

providers and their professors. Coursera has had people working away during

the ten weeks of this course, and I (McKenzie) can assure you that I have been

engaged at one level or another in the course from its start in mid-January

(and so have several of my colleagues from Distance Learning at UC-Irvine).

In this last problem, I want to see how you might analyze and assess a pricing

strategy of “free!” for MOOCs.

a. If there are ongoing costs for operating MOOCs, why might MOOC

providers charge you nothing for taking this course? What concepts

considered in this course might be applicable to a pricing strategy of

“free!”?

The concepts of lagged demand, network effects, and experience goods

can be applied to the MOOC providers’ pricing strategy. MOOCs are

new, and not yet fully tested or even fully developed. Much MOOC

development remains experimental (as you have no doubt found) for both

producers (MOOC platform developers and professors) and buyers

(students). In short, many students and potential students have not

“experienced” MOOCs before they take the courses, which means their

demands could be suppressed because they don’t know how to evaluate

the available courses (and what might seem to be a “strange” means of

taking courses). Their demands could be held down for fear of “lemon-

type problems” and for fear that MOOCs are no better than what they’ve

heard about all prior online courses (and criticism, real or imagined, they

hear, coming from administrators and professors who don’t even know

what “MOOC” stands for). To the point, MOOC providers might

rightfully hold their prices to zero (or even below zero) INITIALLY to

pull in students who need “experience” (to see what can be gained). The

expectation may rightfully be that the experience will raise demand with

time (with, supposedly, improvements in people’s assessments of MOOCs

having value). Hence, there can be a “lagged demand.” As students tell

others of their experiences (hopefully, good), there can be “network

effects,” with the perceived value of the MOOCs rising with the number

of students who enroll. The concept of “rational addiction” might also

apply, in that some students might find education “addictive,” leading

them to take additional courses over time (and trying to convince others of

MOOCs’ value).

b. Even when you have to pay Coursera nothing to take this course, has it

been costless?

MOOCs (or on-campus courses) are never costless, or “free.” Education

is one of those goods that can’t be “bought” without work, which almost

always has an opportunity cost. (The time cost of taking MOOCs can be

much higher than any fees that might be charged.) There is no way that

knowledge can be poured into brains; knowledge must be “learned.”

c. Do you expect the MOOC providers to continue to provide their courses

free? Why or why not?

Not very likely from my perspective. At least, I expect some form of

charges (disguised or otherwise) will be imposed. The producers of

MOOCs will, at some point, need to cover their costs (which, in the long

run, are all variable costs, as you learned). They might be able to continue

with zero tuition payments, but only because someone, or some

foundation, gets value out of making charitable contributions – for a time,

to prove the concept. However, if the demand for MOOCs rises with time,

we should expect MOOC developers to start charging – to pull in the

future revenues they anticipated when they set their initial prices at zero.

And they can increase value with payments, or students can have more

surplus value with a charge than without, mainly because the charge can

elevate the value of the courses.

MOOC developers will likely price discriminate when (or if) they start

charging, mainly because they have a world market with transparent

differences in demand and the elasticities of demands in different parts of

the world. And they will be able to price discriminate because, given the

special nature of education noted above, students will find it difficult (or

costly) to move across markets to find a lower price. (No doubt the

potential for illegal copying of video lectures will hold down the prices

that can be charged, because the potential for piracy will increase the

elasticity of demand given markets.)

d. If courses remain free, and professors continue to get nothing in the way

of money payments for providing their courses, what can we surmise

about the provision of MOOCs provided by professors into the future?

I would expect many professors to continue to remain unpaid for their

courses. After all, many MOOCs will be derivative goods that professors

can produce as they get paid for their on-campus courses. Some

professors might incur few to no additional costs for their MOOCs (as

their universities do nothing more that record their on-campus classes).

Also, I can attest that I have gotten something of a charge from being able

to tell colleagues and friends that I teach “tens of thousands” of students

from around the world, and I have taught more students during this class

than I taught in my forty-five years at conventional universities.

However, the supply curve of MOOCs is likely to be upward sloping (with

the lower end cutting the horizontal axes at some unknown number of

courses provided at zero prices. This means that payments to professors in

some way and in some form can cause a rise in the available courses,

which can be desirable by both professors and students. Many students

might, indeed, want required tuition payment, some portion of which goes

to professors, because of the inherent value of having more choices that

will allow students to pick out higher valued courses (and some courses

produced with payments can be expected to have a higher value than at

least some courses produced for free). It is the marginal expansion of

courses, and upgrades of course quality, that will be of interest for some

students.

With professor payments and the marginal growth in the array of courses,

organization can agglomerate available courses into whole “programs”

(MBA programs?), which can be taken, potentially, at a far lower cost

(maybe 5 percent of the cost of many on-campus MBA programs).

But we should not forget the power of market competition. If all currently

operating MOOC platform developers refuse to pay professors and

professors’ work is costly and vital to MOOCs, we might expect new

MOOC platform developers to get a bright idea: Pay professors, which can

induce some to cross MOOC platforms. To hold their professors, MOOC

platform developers not initially paying will feel market pressure to pay

their professors, with the payments feeding into the charges for courses.

e. Some professors who have or will develop MOOCs are also authors of

textbooks that relate to their MOOCs. Other professors are authors of

other books that are related to the subject of their MOOCs. Still other

professors probably have not written books on any level. How would you

rank the three groups of professors in terms of their likelihood of

providing MOOCs (and continuing to maintain their MOOCs once

provided)?

I would order the three groups of professors in terms of their likelihood of

providing MOOCs, from greatest likelihood to lowest, this way:

i. Professors with textbooks.

ii. Professors with related textbooks.

iii. Professors with no books.

Professors with textbooks have the greatest incentives to develop MOOCs,

because they can receive side-payments from the sale of their textbooks.

Professors with related books might find some students buying their

related books just to expand their knowledge, especially since they might

have found their professors adding value (in short, the experience good of

courses can increase their demand for related goods).

Some professors who have no books available (or other potential tie-in

sales) may continue to develop MOOCs for non-monetary reasons already

given. All we can really say is that those professors with books to sell will,

because of the side payments, be more willing than otherwise to develop

MOOCs.

Indeed, the potential side payments from textbook can inspire some

professors/textbook authors now without MOOCs to provide MOOCs for

two reasons, “offensive” and “defensive.” The offensive reason is the

added income. The defensive reason can be the protection of their

textbook income streams. Textbook authors might be induced to develop

MOOCs for fear that if they don’t do so, they might lose textbook market

share from other textbook competitors who develop MOOCs and attract

more adoptions. (One of my marketing colleagues said he would be

developing a MOOC for this very defensive reason.)

f. How might the MOOC providers and professors make money off of

MOOCs?

We have noted the potential revenue from textbook sales for professors.

Professors might devise any number of auxiliary materials not now

known. If programs comprised totally (or in part) are not devised by

MOOC platform providers, then professors (or even outsiders to the

educational establishment, including non-educational businesses) might

get into the business of program development employing the growing

array of MOOCs.

There are probably a thousand and one potential tie-in sales, several of

which your group might have devised.

g. Would you want everyone involved in the development of MOOCs to

make money? If they do make money, what would you expect to happen

in the market for MOOCs?

Many things are done for charitable reasons. No need for money to be

involved in everything people do. Charges can even undermine the value

of some goods (normal sex between spouses, for example). Without

money charges, some unknown number of professors and MOOC platform

developers can continue to give their life to the “cause.” However,

without charges we might expect the count and quality of courses to be

lower than what would otherwise likely be available. After all, the cost of

MOOC development is hardly trivial.

h. What effects might MOOCs have on conventional (on-campus)

universities around the world?

From my perspective of being a long-time university professor, I suspect

that those conventional universities that provide courses with small

enrollments that allow for significant professor-student interactions will

not be severely competitively challenged by MOOCs (although I can

imagine such conventional colleges and universities to see in MOOCs a

technology that be applied to their “small classes,” which can make those

classes more meaningful).

However, those universities that have relied on very large, lecture-hall

classes (with 500 or 900 students in the classes) that offer little to know

student-professor interaction will very likely be competitively challenged.

MOOCs do have drawbacks (little chance for student-professor

interaction, at least that the one-on-one, personal level), but the

opportunity for interactions may be in only a minor way be different from

large on-campus classes. However, MOOCs have some decided pluses,

not the least of which is that the lectures can be slowed and replayed for

note taking. The courses can also be prescreened for quality, and they can

be taught by professors of prominence at elite universities, with the

credentials of the universities and professors increasing the value of

MOOCs.

Can you name other pluses and minuses of MOOCs?

i. Suppose that MOOC developers start charging students tuition,

a. What can be the expected effect of the change in pricing policy?

The counts of enrolled students can be expected to fall (perhaps

precipitously, depending on the elasticity of demand, which will

vary across courses) and depending the charge that is leveled.

b. Would professors want the MOOC platform developers to charge

for MOOCs or just charge for “certification”?

Most students’ first thought is likely to be that all (or most)

professors would want to tap into the revenue streams from courses

charges. That is more likely to be the case for the professors

without the potential for tie-in sales than for the professors who

have textbooks. After all, they will receive a percentage share of

the income stream.

However, the economic interest of professors with textbooks is

somewhat uncertain, especially after little economic reasoning is

applied to the pricing problem. If charges are leveled just for, say,

“certification,” professors with textbooks can reason that they can

share in the revenues, as well as in the sale of textbooks. However,

the certification charge of, say, $100 can mean that the number of

students taking courses – and buying textbooks – can fall. If

students don’t have to pay $100 to receive certification credit, then

they have $100 to buy the course textbook (and other course

materials). All depends on the price elasticity of for taking

MOOCs and on the (cross-) price and income elasticities of

demand for textbooks.

In theory, we can’t say, but professors (and the MOOC platform

providers) can learn from experience, and price accordingly in

future course offerings. To come to the conclusion that theory

alone will not provide a definitive answer doesn’t mean theory is

not useful. Without theory, people can unthinkingly, and

sometimes wrongly, conclude that that charges are always good (or

bad) for professors (as some students in this course have concluded

in addressing this problem).

i Ariely (2008, pp. 129-133).

ii Kahneman, Knetsch, and Thaler (1986).

iii Thaler (2000b, p. 273-276).

iv See McKenzie (2010, chap. 7).

v Thaler (2000b, p. 274).

vi Weiss, Hall, and Dong (1980).

vii For a review of various explanations for queues, see chapter 17.

Professor McKenzie Discussion Problems and Answers

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