Tuesday, 27 December 2016

The supply-and-demand puzzle that is the Boxing Day sale

In basic supply-and-demand models, if there is an increase in demand the equilibrium price rises (ceteris paribus; which means 'all else being equal'). However, Boxing Day is the biggest shopping day of the year - so we know demand is high. Why are prices so low then? Surely they should be higher?

Helpfully, the New York Times had a good article last month about the price of turkeys in the lead-up to Thanksgiving in the U.S., which illustrates a similar point:
According to government data, frozen whole-turkey prices drop significantly every November; over the last decade, retail prices have fallen an average of 9 percent between October and November.
That trend seems to defy Econ 101. Think back to those simple supply-and-demand curves from introductory micro, and you’ll probably remember that when the demand curve shifts outward, prices should rise. That’s why Major League Baseball tickets get most expensive during the World Series — games that (theoretically, anyway) many more people want to see. Similarly, airline tickets spike around Christmas...
The most intuitive and popular explanation for a high-demand price dip is that retailers are selling “loss leaders.” Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups. Likewise, Target offers a big discount on select TVs on Friday, which will ideally entice shoppers to come in and buy clothes, gifts and other Christmas knickknacks on that frenzy-fueled trip.
That is the supply-side explanation of what’s going on. But plenty of economists disagree, and argue that it’s actually demand-side forces — changing consumer preferences — that drive these price drops...
Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales. Perhaps, during the holidays, the composition of consumers changes; maybe only rich people or people who really love turkey buy it in July, but just about everybody — including lower-income, price sensitive shoppers — buys it in November. Or maybe everyone becomes more price-sensitive in November because they’re cooking for a lot of other people, not just their nuclear families.
Count me among the economists with a preference for demand-side explanations, especially for Boxing Day sales. The discounts are so widespread that loss-leading seems extraordinarily unlikely as an explanation. To me, the most likely explanation for the low prices on Boxing Day is that consumers have more price elastic demand then. To see why that leads to lower prices, consider the diagram below (which is the profit-maximising diagram for a firm with market power - note that this is a constant-cost firm to make the diagram a bit easier). The black demand curve (D0) is associated with the black marginal revenue curve (MR0). With this demand curve the firm profit-maximises where marginal revenue (MR0) meets marginal cost (MC), at a quantity of Q*. The profit-maximising price (the price that leads to exactly Q* being demanded) is P0. Compare that with the red demand curve (D1), which is associated with the red marginal revenue curve (MR1). The red demand curve is more price elastic (flatter). With this demand curve the firm profit-maximises where marginal revenue (MR1) meets marginal cost (MC), which is still at a quantity of Q*. The profit-maximising price (the price that leads to exactly Q* being demanded) is P1. Note that when demand is more elastic (for a product with the same cost), the profit maximising price will be lower (the mark-up over marginal cost is also lower).

Why would demand be more elastic on Boxing Day? Consider the factors associated with higher (more elastic) price elasticity of demand. Are there more, or closer, substitute goods available? Arguable. Do consumers have longer time horizons? Perhaps (especially if you compare with shopping the day before Christmas). Is there a higher significance of price in the total cost to the consumer? Doesn't seem to fit. That leaves as a possibility that there is a higher proportion of income spent on the good. [*] If consumers spent a large proportion of their income on gifts and food for Christmas, that leaves a much smaller budget constraint for shopping on Boxing Day, which should lead to more elastic demand. That is, consumers with less money left over for shopping on Boxing Day will be more price sensitive, and retailers respond by lowering their prices to attract those price-sensitive shoppers. [**]

Finally, the NYT article had an interesting comparison between frozen turkeys on Thanksgiving (high demand and low price) and roses on Valentine's Day (high demand and high price), which is worth sharing:
There are a few possible reasons why market forces are different for roses and frozen turkeys on their respective holidays. For one, the loss-leader strategy really only works if you’re a multiproduct retailer, says Chevalier. Florists sell only flowers; they’re not willing to take a loss on the one thing they sell in the hope that you’ll buy a bunch of other stuff, since you’re not likely to buy anything else.
More important, roses — like airline seats or World Series tickets — are what economists refer to as “supply inelastic.” It’s costly to ramp up rose production in time for peak demand, since the roses must all be picked (and for the most part, flown in from Colombia and Ecuador) in the single week preceding Valentine’s Day.
Which is also why you see the biggest discounts on Boxing Day are on items that the retailer can easily hold back for the day, like electronics. Which I admit I took full advantage of!


[*] Alert readers and economics students will notice that I have ignored two other factors that are associated with more elastic demand: (1) narrower definition of the market; and (2) normal goods (compared with inferior goods). Both of these factors compare different goods, so don't make sense when comparing elasticity for the same good on Boxing Day and not-on-Boxing-Day.

[**] Another alternative is that the composition of shoppers is different on Boxing Day from other days, with more low-income (and hence, price-sensitive) shoppers shopping on that day. Unless I see some evidence of this, I'm going to discount it as an explanation.

No comments:

Post a Comment