Sunday, April 24, 2011

False Quantity Discounts and Chocolate Bunnies

Almost two years ago I wrote an article about drugstores offering false quantity discounts. By false quantity discount, I mean that if the price tag said "10 for $10" you didn't need to buy a quantity of 10 to get the discount. You could buy one for one dollar, two for two dollars, eight for eight dollars or any variation thereof. This dishonest and lazy policy struck me as harmful, not so much to customers, but to the retailers' revenues. Under a system of false quantity discounts, assuming customers believe what the price tags say (though I'm sure many are savvy to the policy by now), if a customer chooses to buy fewer than the (false) required quantity, the retailer needlessly loses money on the transaction. These customers are willing to buy the item, but unwilling to buy it in such a quantity that, they think, would earn them a discount. But when they get to the cash register, CHA CHING! they get the discount anyway. These surprise discounts reduce revenue. And the retailers who have their Point of Sale systems set up like this are leaving money on the table. To illustrate the foolishness of such a policy I'll tell you about my shopping expedition to a Rite-Aid the other day. At Rite-Aid there was a sale on chocolate bunnies. "2 for $3" it said:
Knowing there was a chance that this Rite-Aid didn't have a POS system sophisticated enough to handle a real quantity discount, and hungry for a bunny, I bought just one item. And just as I had guessed, this wasn't a real quantity discount, just a re-setting of the price to $1.50 per unit. Here's the proof:

(Disregard that I was also buying earplugs and a glasses case that, as it turns out is not intended for my gender. Chocolate bunny is line three.)
As you can see, not only was it unneccessary for me to buy two rabbits to get the discount, but I also got that one rabbit cheaper than advertised. This begs the question: why would a retailer ever sell something for cheaper than advertised? I've heard of bait and switch, but this is like bait and switch in the customer's favor. The only reason for a policy such as this must be that some retailers choose not incur the costs of implementing and maintaining more detailed POS system that can handle a quantity discount. Not knowing what the costs are, I can't judge whether this is the right or wrong choice. All I know is that such a policy lowers revenue.

So yes, my savvy shopping prevented me from buying an extra chocolate bunny I didn't really need, just to get a discount I would have received anyway. But this article is not about me. This is about the customers who go to Rite-Aid thinking they would need to buy two bunnies to get the discount, choose to buy just one bunny instead, and then get the discount anyway. These customers are willing to give up more of their money, but the retailers who follow this lazy policy are choosing not to take it. What's up with that? I've seen a few drugstores and grocery stores who have POS systems that implement real quantity discounts. I'm sure in the long run this will help them to do better than companies taking the dishonest and lazy path. Dishonest and hardworking? That can work. But dishonest and lazy is not a recipe for success.

Friday, April 8, 2011

Why Bubbles are Bad: The Long Term

Thinking about the word "bubble", describing bouts of speculative mass hysteria by investors creating a self-fulfilling prophesy of rising asset prices out of line with an asset's fundamental value, I've realized that the analogy of "bubble" is not perfect. In one very important way a speculative bubble is more like a sponge. Like sponges, speculative frenzies soak up investment, taking it away from what is truly value-creating. But never mind the metaphors, the point is that when investment gets pumped into one sector that, as it turns out in retrospect, was downright bubblicious, other actually valuable sectors get ignored, and this has significant consequences for the economy in both the short and long term.

I theorize that the amount of long-term havok a bubble unleashes on an economy is directly related to how long that bubble survives. Let me explain. If a bubble is around briefly, it's impact will mostly be limited to those who directly traded in the bubbly asset. But when a bubble thrives for years at a time, as was the case with the housing market in the 2000s, people not directly involved with the buying and selling of the asset have time to react and make fateful long-term investment decisions based on skewed bubble-induced perceptions. When I say the word "investment" I am not just talking about Wall Street. Every person in the world makes investments whenever they sacrifice something in the short term in anticipation of greater value in the future. Going to the gym is an investment. Planting seeds in the ground is an investment. And importantly for our discussion of bubbles, getting an education or putting years of labor into a certain professional field, is an investment. Unfortunately these long term investment decisions are often at the mercy of bubbles.

A bubble with staying power is a huge collective distraction. People gravitate toward numerous bubble-spawned careers, investing their precious years and dollars in them. During the housing and financial bubble of the 2000s, a great number of our best and brightest were whisked away from careers in engineering and medicine, and into the bubbly financial sector. According to The Harvard Crimson, in 2007, 47% of jobs taken by new Harvard grads were with consulting and financial firms. The bubbly influx of cash into these sectors allowed firms to hire extensively, and from the college graduates' perspective, seeing successful financial professionals popping up around them, finance was where the money was. One study of the financial sector by economist Thomas Phillipon at the Stern School of Business, using a statistical model, estimated that on average, bankers in 2006 were overpaid by 40% over what fundamental variables would precict. And wouldn't you like to be overpaid by 40% too? But the carnage occurs once the perceived value of the bubbly asset realigns with its actual value. At this point many of those who had found careers in the bubbly industry get sacked, and having spent years of their lives chasing an economic mirage, it becomes harder for them to contribute to the economy with real value-creating activity. Post bubble, huge sections of the labor force are stuck with skills that are no longer needed. And then what does the economy get? Higher structural unemployment, (the worst kind), and an economy unable to deal with the real challenges of its age.

To give another historical example, the most absurd Monty Pythonesque asset bubble I can think of occurred from 1634 to 1637, when Holland was struck with a collective frenzy for tulip bulbs. This speculative rush elevated the price of some rare types of tulip bulbs to monumental sums of money. The price of the coveted "Admiral Van Eyck" bulb increased from 1,500 guineas in 1634 to 7,500 guineas in 1637, which at the time was the price of a house. Of course a crash in prices followed shortly after. But for those three years, i'm sure it was very lucrative to be in the tulip industry. If such a bubble were to happen today we'd probably see commercials for money-grubbing trade schools on TV saying "Get in on the fastest growing career: Tulip Merchant." It sounds absurd in hindsight. Bubbles always do. But it always seems like a good idea at the time.

I guess the moral of the story is, in all economic behavior, from choosing a stock to buy to choosing a house, to choosing a career: Don't Believe The Hype.


Olivier Blanchard, Macroeconomics, Fourth Edition, 2006, Pearson/Prentice Hall , Pg. 328