The economics of pricing LLM tokens

Ethan Ding had a really interesting post on Substack last month, discussing his view on the future costs of tokens for large language models (LLMs), and what that means for the viability of subscription-based generative AI. I want to focus on two aspects of Ding's post. First, this (the lack of capitalisation is Ding's style):

the math has fundamentally broken.

prisoner’s dilemma for everyone else

this leaves everyone else in an impossible position.

every ai company knows usage-based pricing would save them. they also know it would kill them. while you're being responsible with $0.01/1k tokens, your vc-funded competitor offers unlimited for $20/month.

guess where users go?

classic prisoner's dilemma:

• everyone charges usage-based → sustainable industry
• everyone charges flat-rate → race to the bottom
• you charge usage, others charge flat → you die alone
• you charge flat, others charge usage → you win (then die later)

so everyone defects. everyone subsidizes power users.

Ok, so let's look at this prisoners' dilemma. Consider two AI firms (Firm A and Firm B), each with two strategies to choose from (Usage-based pricing, or flat-rate pricing). The game is outlined in the payoff table below. The payoffs are expressed in +'s and -'s, with more +'s obviously being better.

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Firm B chooses usage-based pricing, Firm A's best response is to choose flat-rate pricing (since ++ is a better payoff than +) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Firm B chooses flat-rate pricing, Firm A's best response is to choose flat-rate pricing (since - is a better payoff than --);
3. If Firm A chooses usage-based pricing, Firm B's best response is to choose flat-rate pricing (since ++ is a better payoff than +); and
4. If Firm A chooses flat-rate pricing, Firm B's best response is to choose flat-rate pricing (since - is a better payoff than --).

Note that Firm A's best response is always to choose flat-rate pricing. This is their dominant strategy. Likewise, Firm B's best response is always to choose flat-rate pricing, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where both firms choose flat-rate pricing.

Notice that both players would be unambiguously better off if they chose usage-based pricing. However, both will choose flat-rate pricing, which makes them both worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off).

Ding notes that this is a losing proposition for all generative AI firms, and is the position that they are all in right now. They could try to cooperate and shift to usage-based pricing, but there will always be a strong incentive for the firms to cheat on any agreement and instead offer flat-rate pricing. So, any agreement will not last. Especially since there are other strategies available, which Ding goes on to discuss. The one that caught my eye was this:

use ai as a loss leader to drive consumption of aws-competitive services. you're not selling inference. you're selling everything else, and inference is just marketing spend.

the genius is that code generation naturally creates demand for hosting. every app needs somewhere to run. every database needs management. every deployment needs monitoring. let openai and anthropic race inference to zero while you own everything else.

the companies still playing flat-rate-grow-at-all-costs? dead companies walking. they just have very expensive funerals scheduled for q4.

It makes sense to play the losing prisoners' dilemma strategy, if a firm can use it to be more profitable elsewhere. Using generative AI as a loss leader, and then making more profits by selling complementary services (hosting, data management, monitoring) may be more profitable overall for the generative AI firms.

For loss leading to be successful though, two conditions need to be met. First, the loss leading service should be price elastic. That means that when price is low, many consumers are attracted to the service. That seems likely to be the case for generative AI, because when the price increases, consumers can easily switch to one of the many other generative AI platforms. Second, there must be many other complementary services for the firm to sell. The three suggestions by Ding (hosting, data management, monitoring) are all complements to generative AI (or, at least, to the ways that generative AI is being used right now). So, it seems that loss leading with generative AI may be a profitable strategy for the generative AI firms, even though it means playing out the prisoners' dilemma on pricing.

[HT: Marginal Revolution]

Costco buttering up New Zealand consumers

Overseas, Costco uses a variety of products as loss leaders, including rotisserie chicken (see here). Right now in New Zealand, it appears to be butter. As the New Zealand Herald reported yesterday:

It was organised chaos this week at Costco when another delivery of butter arrived.

This butter is not just any butter – while the other supermarkets are selling a 500g slab for up to $10, Costco’s butter is $9.99 for a kg...

Chris Schulz, a senior investigative journalist at Consumer NZ, said it looked likely that the Costco butter was a loss leader.

“The retailer’s Facebook page is flooded with people speculating when the butter might be back on shelves, debating when to visit, and showing off when they do get it.

“With butter costing at least $17 per kilo elsewhere else, Costco’s pricing makes them look like the ‘good guys’ in contrast to our supermarket duopoly. Once they’re in store, I’m sure many people are picking up roast chickens, cheese, and giant tubs of biscuits too.”

As I note in my ECONS101 class, the ideal loss leading product is one that has a high price elasticity of demand, and lots of complementary goods. Elastic demand means that a decrease in price will increase the number of consumers by a lot. So, loss leading will get a lot more consumers in store. And complementary goods are goods where lowering the price of one good causes the consumer to buy more of the other good. Most supermarket staples that are regularly purchased will be complementary goods, because consumers tend to buy them together on the same shopping trip. So, lowering the price of one causes the consumer to buy more of the other goods on their shopping list.

In this case, by selling butter at a loss (and it must be at a loss, because there's no way that selling butter at half the price of other retailers is profitable), Costco is able to attract many more consumers, who then buy other things that Costco can profit from. The Herald article offers some examples, including this one:

Kaleb Halverson decided to start making the trip from New Plymouth to Auckland to deliver Costco’s 1kg blocks of butter at $9.99 to customers across the Taranaki region.

He only had a few orders at first, but they kept rolling in...

He brings back everything the store has to offer, but said butter is definitely top of the list. “It’s our hot item; at the moment, every order has butter.”

Other popular products are cleaning products and snacks.

Costco sells the butter at a loss, and makes up for it with greater sales of (and profits from) cleaning products and snacks. 

Loss leading with free puncture repairs

Driving to work this morning, I saw an advertisement on the back of a bus for free puncture repairs from Top Town Wheel and Tyre in Te Rapa. Why would a tyre retailer offer to fix punctures for free? As I note in my ECONS101 class, when we see an interesting pricing strategy in the real world, it is likely that it is a strategy that is working for the firm.

In this case, the free puncture repair offer is an example of loss leading, which I discussed with my ECONS101 class a couple of weeks ago. Loss leading happens when a firm sells some of their goods or services intentionally at a loss, in order to encourage more customers to visit them, with the goal of getting those customers to buy other goods and services that the firm can profit from. Offering free puncture repairs, which costs the retailer some staff time and some consumables, will make a loss.

What is the tyre retailer hoping to profit from? Once a customer arrives at Top Town with their punctured tyre looking for a repair, Top Town can easily up-sell the customer to a replacement tyre (which is not free) if the puncture cannot be repaired. That is probably the case fairly often (in my experience, more than half the time when I go to get a puncture repaired, the tyre has been damaged beyond repair). Top Town then profits from the replacement tyre, which they wouldn't have sold if the customer hadn't been encouraged (by the free puncture repair offer) to go to Top Town in the first place.

There is also a soft form of customer lock-in at work here too. Having discovered that their puncture cannot be repaired, the customer could go to a different tyre retailer to get a replacement tyre. However, that involves some additional hassle, time, and effort. Why go somewhere else, when they are already at a tyre retailer? In other words, there is a switching cost here - the additional time and effort required to find and travel to a different tyre retailer represents the cost of switching to an alternative seller. That switching cost, however minor, may lock many customers into buying their replacement tyre from Top Town, rather than going somewhere else. By doing so, they avoid the switching cost.

So, offering free puncture repairs is a smart pricing strategy for Top Town, which likely increases their profits. The surprising thing may be that every tyre retailer doesn't do the same.

Movie ticket prices revisited

I've written a few times about prices at the movies (see here and here). One of the puzzling questions about movie ticket prices is why they are the same for all movies, whether they are blockbusters that will sell out the theatre, or low-rated B-movies that struggle to sell any tickets. That is the question that this recent article in The Conversation by Peter Martin (Australian National University) looks at. Martin puts the answer down to two things. First:

Queues for restaurants (or in 2023, long queues and sold out sessions, as crowds were turned away from Barbie) are all signals other consumers want to get in.

This would make queues especially valuable to the providers of such goods, even if the queues meant they didn’t get as much as they could from the customers who got in. The “buzz” such queues create produces a supply of future customers persuaded that what was on offer must be worth trying.

That makes sense for restaurants, where the queue to get in is quite visible to passing would-be diners. The queue acts to reduce customer uncertainty about the quality of the product. However, it is much less plausible that this effect works for movies. Even if there is a queue for tickets, there is no certainty which movie the customers in the queue are waiting to get tickets for. So, the queue doesn't really provide any information about quality for would-be consumers.

Second, and more plausibly, Martin notes:

Another is the way cinemas make their money. They have to pay the distributor a share of what they get from ticket sales (typically 35-40%). But they don’t have to pay a share of what they make from high-margin snacks.

This means it can make sense for some cinemas to charge less than what the market will bear – because they’ll sell more snacks – even if it means less money for the distributor.

This is a point that I have made before. Since movie theatres are constrained in their ability to profit from ticket sales due to agreements with the movie distributors, it is much better for them to keep the ticket prices low, and instead make money from selling complementary goods (like popcorn and drinks). This could even be an application of loss leading - selling the movie tickets at a loss, in order to increase the number of movie ticket sales, and make even more profits from the complementary goods.

One new aspect of movie ticket pricing that Martin didn't consider is movie theatres charging different prices depending on where the moviegoer sits. As the New York Times reported earlier this year:

Some middle seats at AMC movie theaters will be more expensive than others as part of the company’s new ticket-pricing strategy, announced this week.

AMC Entertainment, the world’s largest cinema chain, said in a news release on Monday that this new pricing system, known as Sightline at AMC, would be in place at all of its United States theaters by the end of the year.

The seats in the front row of the theater will be the least expensive and seats in the middle of the theater will be the most expensive, the company said. However, new prices will not affect showings before 4 p.m. or tickets sold at a special discount on Tuesdays, AMC said.

Notice that this is similar to how tickets to concerts are priced, and is an application of price discrimination. Some moviegoers highly value the seats in the centre of the movie theatre, as they have the best view of the screen. Some moviegoers are willing to pay a premium for those seats (I know I would be). The other seats have less valuable views, and would appeal to more price-sensitive moviegoers. The optimal price is lower for more price-sensitive customers, so charging a relatively lower price for less-preferred seats (and a relatively higher price for the centre seats) makes a lot of sense.

It will be interesting to see whether AMC's new pricing system works (or not). Regal Cinemas' trial of dynamic pricing for movie tickets (which I discussed in this post) was abandoned soon after it was announced (see here). So, we never really got to see if dynamic pricing worked or not. If the AMC system works, we can expect to see it rolled out at other cinema groups in due time. As I note in my ECONS101 class, in a Darwinian sense, the pricing strategies that we see persisting in the real world tend to be those that are working well (and contribute to higher profits for the sellers).

Read more:

• Pricing at movie theatres still defies logic. Or does it?
• Regal Cinemas to introduce dynamic pricing for movies
• The $8 bucket of movie theatre popcorn

Jetstar profits from selling flights, but doesn't only profit from selling flights

Jetstar has been in the news this week for its birthday celebrations. As the New Zealand Herald reported:

Jetstar is marking its 14th year of flying New Zealand domestic routes with fares as low as $29.

The airline is also offering fares from Wellington to the Gold Coast starting at $155.

The low-cost airline launched services within New Zealand on June 10, 2009...

Jetstar’s head of New Zealand, Shelley Musk, said the airline remains committed to New Zealand.

“For the past 14 years we’ve been offering Kiwi customers great-value fares and choice so they can decide how they want to fly."

Aren't Jetstar great? Out of an abundance of kindness towards New Zealand travellers, they're offering really low fares. Or maybe not. As I noted in this post from 2017, airlines are known for taking advantage of having locked-in consumers in order to increase profits. Here's what I said then:

In the usual discussion of customer lock-in, customers become locked into buying from a particular seller if they find it difficult (costly) to change to an alternative seller once they have started purchasing a particular good or service. Switching costs (like contract termination fees) typically generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

In this case, once the airline customer has purchased a ticket from an airline, they are locked into travelling with that airline (and often, they are locked into a particular flight, if they have selected a ticket type that is non-transferable). The airline knows that the customer won't switch to another airline (or flight) if they charged additional fees for complementary services... such as for checked bags, in-flight meals, selecting their own seat, and so on.

This is a highly profitable proposition for the airlines... and this is because customer demand for those extra services is relatively inelastic. Once you have purchased a plane ticket for a given flight, there are few (if any) substitutes that allow you to get your checked baggage to the same destination as you are going. So your demand for checking a bag onto your own flight (if you have a bag that needs checking in) is probably very inelastic. Similarly, if you are not prepared for your flight and buy some snacks to take onto the plane with you (and/or you don't have a meal before boarding and are unwilling to wait until you land to eat), there are no substitutes to buying a meal while in the air. When there are few substitutes for a good or service, demand will be relatively more inelastic, and the optimal mark-up over marginal cost is high. As many of you will have observed, the mark-up on in-flight snacks and meals is very high. It is these high mark-ups that leads these extra charges to be highly profitable for the airlines.

While the extra charges have been increasing, ticket prices have been declining. 

Is that what Jetstar is doing? You be the judge. From the New Zealand Herald article:

“By keeping our starter fares low, customers can choose to add a meal, select a seat or bundle their bags — it’s all about choice.’'...

The airline’s business model is to operate with low costs and maximum ancillary revenue. Before the pandemic, revenue from add-ons such as seat selection, paid baggage and food and drinks grew 38 per cent.

The airline aims for similar growth rates over the next five years as it adds more optional extras and technology to enable buying them easier. It is also getting bigger and more efficient A321 aircraft into its fleet.

Seems to me like it's working well for them. Especially when they can get good press for their 'low fares', while maintaining their profitability through the 'ancillary revenue'. As I note in my ECONS101 class, there are many ways for firms to increase profits, and they need not sell every good and service at its individual profit-maximising price.

Read more:

• How airlines use extra charges to boost their profits

A 30-year waitlist for Kobe beef croquettes, and counting

The next time you find yourself on the waitlist for some product or service, spare a thought for the Japanese consumers waiting 30 years for Kobe beef croquettes. As reported on CNN last week:

If you order a box of frozen Kobe beef croquettes from Asahiya, a family-run butcher shop in Takasago City in western Japan's Hyogo Prefecture, it'll take another 30 years before you receive your order.

That isn't a typo. Thirty. Years.

Founded in 1926, Asahiya sold meat products from Hyogo prefecture -- Kobe beef included -- for decades before adding beef croquettes to the shelf in the years following WWII.

But it wasn't until the early 2000s that these deep-fried potato and beef dumplings became an internet sensation, resulting in the ridiculously long wait buyers now face.

When there is a shortage of some good or service, we usually expect the price to go up (for example, see here). Not only is that not happening in the case of Asahiya beef croquettes, the low price that leads to the shortage is a purposeful business strategy:

"We sold Extreme Croquettes at the price of JPY270 ($1.8) per piece... The beef in them alone costs about JPY400 ($2.7) per piece," says Nitta.

"We made affordable and tasty croquettes that demonstrate the concept of our shop as a strategy to have customers enjoy the croquettes and then hope that they would buy our Kobe beef after the first try."

To limit the financial loss in the beginning, Asahiya only produced 200 croquettes in their own kitchen next to their shop each week.

So, not only are the croquettes being sold at a price that generates a shortage of them, they are being sold at below the cost of production. There are a number of reasons why firms may sell some of their products at below cost, but generally it is because they are a loss leader - the firm sells that product at a loss, and uses it to generate additional customers who then buy other products, which are more profitable. It appears that is the strategy that Asahiya has adopted:

"We hear that we should hire more people and make croquettes more quickly, but I think there is no shop owner who hires employees and produce more to make more deficit... I feel sorry for having them wait. I do want to make croquettes quickly and send them as soon as possible, but if I do, the shop will go bankrupt."

Fortunately, [the business owner, Shigeru] Nitta says that about half of the people who try the croquettes end up ordering their Kobe beef, so it's a sound marketing strategy.

Is it a sound marketing strategy though? You can generate a lot of buzz about your products without creating such a shortage that your customers are waiting 30 years for their purchase. I mean, even now:

Customers receiving croquettes these days placed their orders about 10 years ago.

Surely, they could reduce the size of the waiting list for croquettes from 30 years back to 10 years, or back to one year, and rapidly increase profits? On the other hand, perhaps that would entail a loss of quality, as the article notes:

The cheap price tag of the Extreme Croquettes flies in the face of the quality of the ingredients. They're made fresh daily with no preservatives. Ingredients include three-year-old female A5-ranked Kobe beef and potatoes sourced from a local ranch.

I guess there is a limit to how much you can ramp up production when you use very specific ingredients. But surely, there is scope for the ranch to increase beef and potato production? While loss leading can be a very profitable strategy, there is just so much scope for increasing profits in this case that I'm not convinced that this is a profit maximising business strategy at all. It even makes me wonder, how many other profit-maximisation failures are contributing to the decades of underperformance of the Japanese economy?

Loss leading and the Costco $4.99 rotisserie chicken

In my ECONS101 class, when we cover pricing strategy, we talk about firms making strategic pricing decisions where they may not be profit maximising on one product, but that enables them to maximise profits from other products they sell. The obvious example of this is loss-leading, which is a relatively common practice at supermarkets. Supermarkets sell some of their products at a loss, in order to encourage more shoppers into the store, with the goal of getting those shoppers to buy other products that the supermarket can profit from. In this recent article from The Hustle, we find out that (unsurprisingly) Costco does the same:

Costco debuted its popular, 3-lb. rotisserie chickens around 2000, pricing them at $4.99.

More than two decades later, they're still $4.99.

Despite record-high inflation, supply chain woes, and the rising production costs of poultry, the retailer has refused to raise the price of these prepped birds.

Adjusted for inflation, Costco should be selling its chickens for $8.31.

The Hustle notes the benefits of loss-leading as not simply limited to profiting from other products:

But [John Longo, a professor at Rutgers University] says these chickens serve other important purposes for Costco that go beyond immediate profit:

Value signaling: They reinforce the idea that the Costco brand is a good deal, potentially leading to more membership sign-ups ($60-$120/yr).

Good press: The company's refusal to raise the $4.99 price during inflation makes it look benevolent in the public eye.

I recently wrote about the two-part pricing model of Costco here. Loss leading is an important strategy for Costco, and not just limited to rotisserie chickens. I loved this example (which I have also read elsewhere):

Costco's ex-CEO, Jim Sinegel, was so impassioned about the $1.50 hot dog combo that he once famously told a colleague: "If you raise [the price of the] effing hot dog, I will kill you."

That important. It's highly likely that Costco is doing something similar at its store in New Zealand. I haven't been there. Is it rotisserie chickens? Hot dog combos? Or something else? Certainly, they will be loss leading on something at their West Auckland store.

[HT: Marginal Revolution]

Supermarket toilet paper discounts are part of their long game to attract and retain customers

Yesterday, I wrote a post about the Great Toilet Paper Crisis, using game theory to explain why people are panic buying. However, consumers' behaviour isn't the only behaviour that seems a little strange at this time. Last week, when doing my weekly shopping, I walked past the toilet paper and there was a woman who was just putting her third package of toilet paper into her trolley. She saw me looking at her, and said "What? It's on special!". And you know what? She was right. Pak'n'Save was selling some toilet paper at a discount, at a time when it is in high demand due to panic buying.

On the surface, discounting an item when demand is high makes no sense. Basic demand theory from ECONS101 suggests that when demand is higher, prices should increase, not decrease. Over on The Visible Hand of Economics blog, Matt Nolan recounts a similar story to mine, and offers some suggestions to explain the unusual discounting behaviour of the supermarkets. I want to start by focusing on this potential explanation:

Supermarkets do not sell just one good. As a result, if a special on toilet paper – along with stacks and stacks of toilet paper from wall to wall in the store – will get people in the door, then that also ensures that people will buy OTHER goods and services from the supermarket.

In other words, toilet paper and other supermarket goods are complements, and the discounts and advertising of toilet paper is a way supermarkets can get you in the door to purchase these other goods.

This broad concept has a common name called the “Halo effect“. However, as that post notes this effect is quite unclear as it is the mix of two things, the complementarity of products due to their co-location, and brand spillovers.

In this instance it is just the former we are meaning. In fact there is a better term in this context, where the supermarket may be willing to sell toilet paper at a loss to get people in the door – a loss leader.

Because of the fear of COVID-19, people are trying to find something they can control to give themselves a sense of protection – in this case toilet paper purchases.

Seeing this, supermarkets recognise that people are especially responsive to toilet paper availability and prices and so use these sales to increase demand for their other – higher margin – products.

When I cover pricing strategy in ECONS101, one of the elements of that topic is considering circumstances where a firm is better off deviating from the short-run profit maximising price. One of those circumstances occurs when the firm sells multiple products, and can increase its total profit by selling one or more products at a loss - the so-called loss leader product.

An ideal loss leader product is one that will encourage a lot of extra customers to visit the store. That usually suggests a loss leader product is one that has relatively elastic demand (so that, when price is reduced, it attracts a lot more customers to the store). In a time of panic buying of toilet paper though, it isn't clear to me that demand is relatively elastic. In fact, it is likely that demand is relatively inelastic for goods like toilet paper, hand sanitiser, and other products that people are hoarding right now. People really want these products, and would be willing to pay a high premium to avoid missing out (so they are less sensitive to price - demand is relatively inelastic).

You could argue that, since toilet paper is in short supply, if a particular supermarket has toilet paper and other supermarkets don't, then that would attract customers to the supermarket with toilet paper. But, if that were the case, they wouldn't need the discount to attract customers - they could just post a big sign that says: "WE HAVE TOILET PAPER", and sell at full price (or more!).

So, if it's not loss leading, what are supermarkets doing? Another pricing tactic that firms use is to price low in order to foster a long-term relationship with their customers. Developing a reputation as being a 'fair player' in the market is an important part of that. In this instance, a supermarket doesn't want to be seen as taking advantage of their customers by jacking up the price of toilet paper. And, if raising the price makes the supermarket the 'bad guy', then perhaps they believe that lowering the price makes them the 'good guy': "Not only can customers continue to buy toilet paper from us, we're making it more affordable for them to do so".

Supermarkets are playing a long game here (yes, more game theory, like yesterday's post). Customers tend to be reasonably loyal to their preferred supermarket. If a simple tactic like discounting toilet paper when it is in short supply can encourage some customers to switch, and after switching they become loyal to the new supermarket, then the long-run profit gains may well outweigh any foregone potential profits on the toilet paper.

Of course, if one supermarket engages in this tactic, then it makes sense for all of them to do so. Otherwise, the supermarkets that don't follow suit face the risk of losing long-term customers. So, supermarkets start out discounting toilet paper to attract new customers away from their competitors, but end up discounting in order to retain their existing customers and stop them being lured away.

This is actually an example of a prisoners' dilemma game (see this post for another example). All supermarkets would be better off if they continued to charge full price (or more) for toilet paper, but it is in every supermarket's individual best interest to discount toilet paper to try and steal customers away from the others (or to retain their existing customers, if other supermarkets are discounting). And so, we end up in a situation where the supermarkets are selling toilet paper at a discount, even as the shelves are being left bare.

This is not loss leading, at least not in the normal sense. But it is long-run profit maximising behaviour by the supermarkets.

The $8 bucket of movie theatre popcorn

I can't believe it's over five years since I wrote this post about pricing at movie theatres. I was reminded of it recently when reading this article in The Hustle about the pricing of popcorn:

In March of 2012, Justin Thompson, a 20-year-old security technician from Livonia, Michigan, decided to go to the movies.

Inside, he encountered an atrocity we’re all familiar with: the movie theater concessions stand, with its $8 popcorn, $6 sodas, $5 candy bars.

Left with no alternative, Thompson indignantly bought a treat at an 800% markup.

It's interesting to think about why popcorn is priced so high. In my ECONS101 class, when we cover pricing strategy, we talk about firms making strategic pricing decisions where they may not be profit maximising on one product, but that enables them to maximise profits from other products they sell. The obvious example of this is loss-leading, a relatively common practice at supermarkets for example. Supermarkets sell some of their products at a loss, in order to encourage more shoppers into the store, with the goal of getting those shoppers to buy other products that the supermarket can profit from. It seems that movie theatres are engaging in something similar:

When a theater wants to show a film, it must agree to pay the distributor a percentage of all ticket sales. This percentage is higher during the first few weeks of a film and decreases over time, but generally averages out to ~70%.

So, if a theater sells a movie ticket for $9, its cut is only $2.70 — and that’s without accounting for other expenses.

Theater owners could price tickets higher, but it wouldn’t do them much good since 70% of any increase goes straight to the studios. Instead, they think of movies as a loss leader: their primary goal is to get as many people through their doors as possible, even if it means breaking even (or losing money) on the price of admission...

Unlike tickets, concession sales are not shared: theaters keep 100% of the revenue they generate. And this revenue generates much higher profits.

The Hustle looked through annual reports (2015-2018) from two leading movie chains (AMC and Cinemark) and found that concessions account for ~30% of total gross revenue, yet make up 45-50% of gross profits. 

So, having priced the tickets low in order to get people to go to the movies (although, I leave you to judge whether the tickets are actually priced 'low' or not!), the movie theatre hopes to make profits from the concessions. The most interesting part of the article is this bit on the markups:

Why are the markups highest for popcorn (788%), and lowest for candy (313%)? My ECONS101 class should know the answer - popcorn must have the least elastic demand. That is, moviegoers are less sensitive to an increase in the price of popcorn than they are to an increase in the price of soda or candy.

The reason for that probably comes down to the availability of substitutes. Movie theatres have rules against you taking your own food in from outside (i.e. food not purchased at their concession stand). It's fairly easy to subvert this by bringing things in your handbag or pocket though. However, that works well only for small items (candy), and less so for drinks. Popcorn, on the other hand, you want to consume while it's hot, and it's a lot bulkier, so more difficult to conceal. So, substitutes are most available for candy, and least available for popcorn. The result is that the optimal markup is highest for popcorn, and lowest for candy. And that explains the $8 bucket of popcorn.

[HT: Marginal Revolution]

Read more:

• Regal Cinemas to introduce dynamic pricing for movies
• Pricing at movie theatres still defies logic. Or does it?

Junk food discounts at supermarkets

In The Conversation yesterday, Adrian Cameron (Deakin University, and no relation of mine) and others wrote about junk food discounts at supermarkets:

Half-price chips, “two for one” chocolates, “buy one get one free” soft drinks: Australian supermarkets make it very easy for us to fill our trolleys with junk food...

We looked at supermarket specials over a year to see how healthy they were. The results of our research, published today, show junk foods are discounted, on average, twice as often as healthy foods...

The way supermarkets choose what products are on special each week is complex.

Food manufacturers pay large premiums to have their products featured in supermarket catalogues, at end-of-aisle displays or near the checkout. The arrangements between food manufacturers and supermarkets are often governed by contracts that specify the way products are to be promoted.

Food manufacturers and supermarkets know unhealthy food is often bought on impulse, making price discounts a great way to entice customers to make those impulse choices.

This was quite timely, because last week I covered pricing strategy in my ECONS101 class, and the week before that we covered elasticity. The combination of elasticity and pricing strategy, along with transaction utility from behavioural economics, do a good job of explaining what supermarkets are doing, and why.

Consumer demand for junk food is likely to be relatively price elastic. Most junk food items are relatively inexpensive, so they take up only a small proportion of our income, and that is associated with relatively more elastic demand. They also have many substitutes (there are lots of items to choose from), so our demand for any particular item is also likely to be relatively more elastic. Finally, they tend to be luxury items (in contrast with necessities), which also have relatively more elastic demand.

When demand is elastic, a change in price has a bigger effect (in percentage terms) on the quantity that we purchase. So, a 10 percent price discount on an item with elastic demand will lead to an increase of more than 10 percent in the quantity purchased. That increases revenue for the seller. [*]

This also explains why they would discount junk food items but not fruit or vegetables. Fruit and vegetables are necessity items, not luxuries - they have price elasticities of demand that are less than one (as noted here). So, fruit and vegetable sales do not respond much to a decrease in price, so discounting them would decrease revenue for the seller. Discounting fruit and vegetables is a sure-fire way for a supermarket to destroy their profitability.

However, elasticity by itself doesn't explain discounting, because if it was the only explanation, then the seller would better off to keep the price low permanently. A complementary explanation is transaction utility (as I discussed in this post earlier this year). When we buy an item, we get utility (satisfaction or happiness) from receiving the item (which we call consumption utility), plus we get utility from the transaction itself (transaction utility). If we feel like we are getting a good deal, that makes us happier about our purchase. It doesn't make us any more satisfied with the item itself, but it increases our transaction utility. Higher total utility (consumption utility plus transaction utility) makes us more likely to buy the item. By offering discounts on different items every time, they avoid giving consumers the perception that the price is lower, so each time a discount cycles back to an item, there has been time enough for consumer perceptions about the 'usual' price to reset.

So, if an item has relatively elastic demand (which is true for junk food, but not for fruit and vegetables) and the seller can make us feel good by offering a discount, then it can make sense for them to do so.

All of this is somewhat related to another practice of supermarkets, which is loss leading. That is where a seller sells some products at a loss in order to increase sales of other products. However, it seems unlikely that discounting junk food is an example of loss leading. As the quote above notes, junk food is an impulse purchase. In contrast, the ideal loss-leading product is one that has elastic demand and will therefore bring a lot of customers into the store. Nobody chooses their supermarket based on a discount for their favourite chocolate bar (I think?).

Anyway, none of this behaviour by supermarkets should be a surprise to us. It only takes a little bit of knowledge about consumer behaviour and price elasticity to explain why supermarkets discount junk food and not healthy food. The article finishes with:

Imagine what it would be like to shop at a supermarket where healthier food was on special more often, and with bigger discounts. Where customers were enticed by discounted fruit and vegetables instead of half price chips, chocolate and soft drinks.

You'll have to use your imagination. No such store exists, and if it did, you'd better get in fast because it's not going to last long before it fails.

*****

[*] Economists' usual assumption is that firms are trying to maximise profits, not revenue. For simplicity, I'm ignoring that assumption here. For a supermarket, with high fixed costs and the power to negotiate steep quantity discounts from suppliers, there probably isn't too much difference between maximising revenue and maximising profits.

Read more:

• Transaction utility and the behavioural economics of discounts
• Why we are sucked in by good deals for things we don't need

How airlines use extra charges to boost their profits

Grant Bradley wrote in the New Zealand Herald back in July:

Airline revenue from frequent flier schemes, charging for bags and food has grown more than 10 times in the past decade to nearly $40 billion.

A study of 10 airlines which are among the biggest ancillary earners show that in 2007 it generated US$2.1 billion ($2.87b).

Last year the top 10 tally has leapt to more than US$28 billion.

While base air fares are near historic lows, if passengers want extras they are increasingly being forced to pay for them, especially on budget carriers...

"Low cost carriers rely upon a la carte activity by aggressively seeking revenue from checked bags, assigned seats, and extra leg room seating. Some of the best in this category have extensive holiday package business with route structures built upon leisure destinations," the report says.

None of this should be terribly surprising. The airlines are making use of a simple business strategy that we discuss in ECON100: taking advantage of customer lock-in.

In the usual discussion of customer lock-in, customers become locked into buying from a particular seller if they find it difficult (costly) to change to an alternative seller once they have started purchasing a particular good or service. Switching costs (like contract termination fees) typically generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

In this case, once the airline customer has purchased a ticket from an airline, they are locked into travelling with that airline (and often, they are locked into a particular flight, if they have selected a ticket type that is non-transferable). The airline knows that the customer won't switch to another airline (or flight) if they charged additional fees for complementary services [*], such as for checked bags, in-flight meals, selecting their own seat, and so on.

This is a highly profitable proposition for the airlines (see Bradley's figures above), and this is because customer demand for those extra services is relatively inelastic. Once you have purchased a plane ticket for a given flight, there are few (if any) substitutes that allow you to get your checked baggage to the same destination as you are going. So your demand for checking a bag onto your own flight (if you have a bag that needs checking in) is probably very inelastic. Similarly, if you are not prepared for your flight and buy some snacks to take onto the plane with you (and/or you don't have a meal before boarding and are unwilling to wait until you land to eat), there are no substitutes to buying a meal while in the air. When there are few substitutes for a good or service, demand will be relatively more inelastic, and the optimal mark-up over marginal cost is high. As many of you will have observed, the mark-up on in-flight snacks and meals is very high. It is these high mark-ups that leads these extra charges to be highly profitable for the airlines.

While the extra charges have been increasing, ticket prices have been declining. Airlines can afford to lower ticket prices if they know they will more than make up for the lost profits on tickets with the additional profits from these extra charges. In fact, they could (and may yet) go as far as using economy-class tickets as a loss leading product! Economy-class tickets will be effective as a loss leader if demand for tickets is relatively elastic (so that lowering the price leads to a large increase in the number of ticket buyers), and where there are many close complements (so that the airline will sell a lot of the extra services, which are highly profitable). Both conditions appear to be being met, so airline economy-class ticket prices may have further to fall, but don't expect those extra charges to disappear any time soon.

*****

[*] Note that this is complementary, meaning services that are consumed along with the airline ticket, and not complimentary, meaning free!