Saturday, 23 February 2019

Why summer ice cream prices don't respond to changes in demand

New Zealand has been suffering through a heatwave. One of the effects was a shortage of ice cream, as the New Zealand Herald reported last month:
Hot temperatures have led to such a demand in ice cream and cold drinks that some businesses have had to turn customers away.
Havelock North McDonald's ran out of soft serve ice cream and milkshakes on Wednesday evening, forcing customers to look elsewhere.
A shortage occurs when the quantity of a good demanded exceeds the quantity of the good supplied. Some customers will miss out on the good. We might expect the price to increase to eliminate the shortage. Consider the perfectly competitive market in the diagram below:

Before the heatwave, the demand for ice creams is D0 and the supply is S. The market is in equilibrium with the price P0 and the quantity of ice creams traded is Q0. When demand increases from D0 to D1, the equilibrium should move to the intersection of D1 and S, where the price has increased to P1 and the quantity of ice creams traded has increased to Q1. However, if the price stayed at P0, the quantity supplied remains Q0, but the quantity demanded is QD - there is a shortage (or excess demand).

However, the market diagram above assumes a perfectly competitive market. In a perfectly competitive market, buyers and sellers are price takers - they have no control over the price, which is set by the market (at the intersection of supply and demand). The perfectly competitive market assumes there are many buyers and many sellers, and the sellers are all selling an identical (homogeneous) product. This is not a reasonable assumption for most markets, including the market for ice creams. In most markets, there are a many buyers, but few sellers, or the sellers are selling a differentiated product. That gives the sellers some market power - the power to choose their own price.

The diagram below shows what happens when a firm with market power faces an increase in demand. The firm is profit maximising, so it operates at the profit-maximising price and quantity where marginal revenue intersects with marginal cost - with the original (red) demand curve D0 and (red) marginal revenue curve MR0, this leads to the price P0 and the quantity of ice creams traded is Q0. When demand increases to D1 (and marginal revenue increases to MR1), the profit-maximising price increases to P1, and the quantity increases to Q1. However, if the firm kept the price at the original price P0, then the quantity demanded is QD. There is no excess demand in this case, unless the firm hadn't planned for the possibility of extra sales.

So, regardless of whether we are considering a firm with market power or a firm in a perfectly competitive market, when the demand for ice creams increases, we should expect the price to increase. So, it might be surprising that the price doesn't adjust. Why wouldn't the price adjust?

There are a few reasons that sellers don't automatically adjust prices in response to changes in demand. The first reason is menu costs - it might be costly to change prices (they're called menu costs because if a restaurant wants to change its prices, it needs to print all new menus, and that is costly). The second reason is that changing prices creates uncertainty for consumers, and if they are uncertain what the price will be on a given day, perhaps they choose not to purchase (in other words, the cost of price discovery for consumers makes it not worth their while to find out the price). The third reason is fairness. Research by Nobel Prize winner Daniel Kahneman (and described in his book Thinking, Fast and Slow) shows that consumers are willing to pay higher prices when sellers face higher costs (consumers are willing to share the burden), but consumers are unwilling to pay higher prices when they result from higher demand - they see those price increases as unfair.

Finally, in this particular case, the price of McDonald's ice creams are set at the national level. So, the seller doesn't have control over the price and can't adjust it in response to changes in demand. So, even though the simple economic models might suggest a particular outcome (an increase in price), it is easy to explain why the real world outcome differs from the model.

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