Supermarket structural separation stupidity

This week, the National Party proposed that, if re-elected, it would pursue structural separation of the supermarkets (as reported in the NBR, One News, and the New Zealand Herald). This was interesting timing. My ECONS102 class has just covered firms with market power and monopolies, and one of the regulatory options available to government is structural separation. If this news had broken a week earlier, this would have made a great example for an assessment question. Instead, I'll have to console myself with a blog post.

In short, the proposed structural separation is nonsensical. Foodstuffs is currently comprised of two cooperatives - Foodstuffs North Island, and Foodstuffs South Island. The two cooperatives run three brands of supermarkets: Pak'n'Save, New World, and Four Square. The National Party is proposing to separate the business into two, with Pak'n'Save as one business and New World and Four Square as another.

There are several elements of the proposal that are plain dumb. The first problem with the proposal is that it would require a substantial reorganisation of the two existing geographically-based cooperatives into two nationwide businesses. This proposed reorganisation is somewhat ironic, given that the Commerce Commission declined a Foodstuffs merger into a nationwide business in 2024. Both of the two new supermarket chains would then have to create their own warehousing, logistics, and other backend systems, separate from the other new chain. And the two pre-existing warehousing and logistics (and other systems), which are geographically separated at present, would need to be split up in order to do this. In its own house, the government is busy trying to reduce back-office functions to increase efficiency. And yet, it seems quite happy to generate inefficiency in a private sector business?

Moreover, the cost-benefit analysis that Sense Partners completed for the Ministry of Business, Innovation and Employment demonstrates how sensitive the case is to assumptions about supply-chain costs. The preferred analysis assumes supply-chain costs rise by one percent, generating an estimated net benefit of $2.9 billion over 20 years. However, if supply-chain costs rise by two percent, the estimated benefit falls to around $920 million, and if supply-chain costs rise by more than two percent, the costs outweigh the benefits. That doesn't leave much margin for the proposal to go wrong before society is worse off overall.

The second problem is that this proposal leaves the other major player in the supermarket sector, Woolworths, structurally unchanged. While the proposal would reorganise Foodstuffs into two separate nationwide supermarket groups, Woolworths would be free to continue its current operations, which also includes three brands: Woolworths, FreshChoice, and SuperValue. Admittedly, the two businesses are not structured in exactly the same way. Woolworths operates its Woolworths supermarkets directly, while FreshChoice and SuperValue are locally owned stores franchised through a Woolworths subsidiary. So, there may be good reasons why the same form of structural separation would not be appropriate for Woolworths. But the obvious question then is, if structural separation is the answer to weak competition in the supermarket sector, why is restructuring only one of the two big market players the right approach?

The third problem is that this proposal ignores another, arguably more obvious, form of structural separation that could be enacted, which could be applied symmetrically to both of the large supermarket players. This is to structurally separate wholesale and distribution from supermarket retail. Currently, both Foodstuffs cooperatives and Woolworths benefit from substantial economies of scale in purchasing, wholesale, and distribution. Those economies of scale may themselves create a barrier to entry, because a new supermarket chain that cannot obtain groceries on similarly competitive terms faces higher costs and will struggle to compete effectively.

Structurally separating wholesale and distribution from retail could potentially address that problem by allowing existing and new retailers to access the scale economies of the established distribution networks on fair and non-discriminatory terms, without having to build their own nationwide wholesale and distribution systems. This isn't a new idea (for example, see here and here). Wholesale ownership separation was explicitly considered in a government-commissioned study in 2022, although that analysis raised significant concerns about whether an independent wholesaler would remain viable after structural separation. Despite those concerns, this remains an alternative worth considering, and the Labour Party announced a policy along these lines earlier today. Its proposal would require Foodstuffs and Woolworths to run their wholesale businesses independently from their retail businesses, although it would not require the wholesale businesses to be separately owned.

As I note in my ECONS102 class, structural separation can be an effective way of regulating a monopoly. Typically, it is used with natural monopolies, where increasing competition across the entirety of a sector is not straightforward. For example, in New Zealand we structurally separated the telecommunications backbone (now run by Chorus) from the retail. We also separated electricity lines businesses from generation and retail, although generation and retail were allowed to remain integrated in the so-called 'gentailers'.

Now, supermarket retail itself isn't obviously a natural monopoly, but wholesale and distribution may contain some of the characteristics that we associate with natural monopolies, including high fixed costs and large economies of scale. Regardless, it is clear that to date government's various measures have been largely ineffective in increasing competition in the supermarket sector. So, structural separation may be more effective than what has been tried so far. However, what is being proposed by the National Party is only one possible form of structural separation. The more important question is where in the supply chain separation would do the most to reduce barriers to entry while preserving the economies of scale that keep costs down.

Will AI make personalised pricing a reality, and is that really a bad thing?

Personalised pricing (or first-degree price discrimination) occurs when the seller sells their good or service to every consumer at a different price, as I described in this 2023 post. If executed perfectly, the seller could extract all of the consumer surplus as profits, by charging a price to every consumer that is exactly equal to the maximum the consumer is willing to pay. Fortunately for consumers, such perfect personalised pricing has remained a theoretical possibility.

But technological tools are increasingly helping firms to learn more detailed information about consumer preferences, and that allows firms to home in on consumers' maximum willingness-to-pay. The latest worry for consumers is AI, as this article in The Conversation by Patrick Dodd and Hanoku Bathula (both University of Auckland) notes:

Digital platforms can observe thousands of individual decisions. A ride-hailing platform can see which jobs a driver accepts, when they work and which incentives bring them online. A retailer can see purchases, abandoned carts and responses to discounts.

There is no strong evidence major companies already know everyone’s precise financial breaking point. But algorithmically mediated pay, personalised worker incentives, discounts and consumer offers are already real.

Notice that Dodd and Bathula also take the logic of personalised pricing for consumers, and apply it to gig-economy workers as well. Platforms such as Uber or Lyft or Doordash can increasingly use what they know about their delivery workers' preferences to determine their minimum willingness-to-accept for each delivery. The target is different (minimising how much they pay to the delivery worker, rather than maximising the price they charge the consumer), but the underlying premise of personalised pricing is the same.

Algorithms have been around for a while, though. Dodd and Bathula do not clearly lay out why they think that recent developments in AI make personalised pricing more of a reality than before. Most of what they say about 'algorithms' applies equally to statistical algorithms that have been around for years (decades, even) as to more recent developments in AI and machine learning (AI/ML). So, let me extend their argument more explicitly.

AI/ML dramatically lowers the cost of estimating individual willingness-to-pay. It can combine huge numbers of relatively weak signals about a particular consumer, learn complex patterns from the behaviour of millions of other similar consumers, experiment continually with prices and discounts, and update its estimate each time that circumstances change. That gives firms far richer models from which to estimate each particular customer's maximum willingness-to-pay (or, for their workers, to estimate their minimum willingness-to-accept). Moreover, while older statistical algorithms allowed firms to segment customers into fairly coarse categories, AI/ML allows firms to make predictions for each individual, and in real time. The better estimates from these newer models therefore allow firms to price much closer to the perfectly price-discriminating ideal. It's still not completely perfect, but it is a further improvement on what they were previously able to achieve.

Dodd and Bathula finish their article by noting the unfairness of personalised pricing. Their argument is essentially that there is asymmetry in the relationship between consumers and firms. Firms using algorithms (and now AI/ML) know increasingly more about what consumers are willing to pay, but consumers know very little about what firms are willing to accept.

However, it is worth unpacking that a bit more. Firms that don't know consumer willingness-to-pay can't raise their prices without limit, as consumers with low willingness-to-pay would stop buying from them. In practice though, personalised pricing will never be perfect. Firms may charge higher prices to consumers that they estimate have high willingness-to-pay, while offering lower prices or discounts to consumers with lower willingness-to-pay. So, relative to offering the same price to everyone, personalised pricing need not make every consumer worse off. The high-willingness-to-pay consumers are likely to be worse off, but some low-willingness-to-pay consumers may actually be better off.

Now consider which types of consumers tend to have high willingness-to-pay, and which types tend to have low willingness-to-pay. For many goods, lower-income consumers are likely, on average, to have lower willingness-to-pay, so personalised pricing could result in some of them being offered lower prices. That won't always be true though. Some lower-income consumers with few alternatives or an urgent need may have high willingness-to-pay despite having a low income. Taken together, this means that the distributional effects of personalised pricing are not necessarily straightforward. However, in some instances preventing firms from price discriminating could be making low-income consumers worse off. With that in mind, is it really fairer that firms are not allowed to offer lower prices to consumers with low willingness-to-pay?

I'm not really trying to defend price discrimination here. I'm not keen on personalised pricing for very selfish reasons - I don't want to pay more, even if I am willing to pay more! And like me, most consumers should probably not be keen on personalised pricing. But before we rail against the evils of firms price discriminating, we need to properly consider its distributional consequences. And that means thinking about which groups may be made better off by price discrimination, not just which groups are made worse off.

Read more:

• Surge pricing is coming to a supermarket near you
• What would happen if perfect personalised pricing was possible?
• Personalised pricing is now a step closer with electronic shelf labels

The economics of pricing AFL Finals tickets

In my ECONS101 class, we have a topic that is devoted to understanding pricing and business strategies that deviate from the ideal 'marginal revenue equal to marginal cost' approach to pricing for firms with market power. In particular, I focus part of the topic on firms that price below the short-run profit-maximising price for strategic reasons.

One example is the NFL, which prices tickets for the Super Bowl too low. This is a surprising example to students, because the face value for the cheapest ticket for Super Bowl LX this year was $950. However, we know that this price is too low because the cheapest tickets on the secondary market were selling for around $6,400. That suggests that the NFL is leaving money on the table - they could earn much more if they set the ticket prices higher. Why would the NFL set the price lower than the short-run profit-maximising price for the Super Bowl? One reason may be that they want to maintain a long-term relationship with NFL fans. They want going to the Super Bowl to be an achievable aspiration for fans. Most fans won't be able to pay US$4,000 (plus the travel and accommodation costs) to attend every year, but at that price it is reasonable for fans to believe that they can attend once during their lifetime. If Super Bowl tickets cost over US$10,000, then that aspiration becomes much less achievable. This long-term strategy is also visible through the allocation of Super Bowl tickets. Each team gets an allocation of tickets, 35% of which must go to fans, and that allotment is typically given to the team's season ticket holders (see here).

The Super Bowl is recognisable to my students. However, thanks to this article in The Conversation by Paul Crosby (Macquarie University), I now have another example that is somewhat closer to home (albeit not necessarily more recognisable than the Super Bowl):

It’s AFL finals time – and in a season on track for record attendance, the league’s decision to freeze the price of entry-level finals tickets for an 11th straight year is smart economics...

So why are entry-level footy tickets staying cheap? It’s all about investing in the future – especially when there’s a lifetime of spending at stake...

Finals matches routinely sell out, so standard economics would suggest raising prices.

Instead, entry-level tickets for the AFL’s qualifying, elimination and semi finals, as well as this weekend’s wildcard round, have been frozen at A$35. Entry-level preliminary finals tickets will be $65, unchanged since 2016.

Crosby explains this pricing strategy as arising from fairness and goodwill towards fans, then notes that:

Cheap tickets can be an investment. A full stadium creates value beyond ticket revenue. Crowds generate the atmosphere that makes live sport attractive to television audiences and, in turn, valuable to broadcasters and sponsors.

An AFL supporter will often remain attached to the same club for decades, buying memberships and merchandise, watching broadcasts and eventually bringing their children along. A fan won over by a $35 ticket is worth far more than the profit on that ticket.

Keeping tickets affordable, and occasionally letting kids in free, helps recruit that next generation.

By keeping the price of finals tickets low, the AFL is foregoing short-run profit maximisation in favour of a long-term strategy that keeps fans engaged, keeps them attending games, and may lead to greater revenue and profits overall in the long run.

Crosby compares the AFL's pricing strategy with the approach adopted by music acts, who are increasingly using 'dynamic pricing' to maximise short-run profits from every concert. However, the situations are different in a meaningful way. The AFL can afford to have a long-term focus because it has a revolving cast of star players, while the teams endure. AFL fans typically follow a team, rather than particular players. In contrast, not every musical act is going to be The Rolling Stones, still touring after 60-plus years. For the most part, a musical act is not a revolving cast of musicians (especially for solo acts). A musical act's window for profiting from their talent is much shorter than the AFL, so we might expect to see short-run profit-maximising behaviour from musical acts than for the AFL. It is all about maximising profits over the appropriate time horizon. For the AFL or the NFL, a price that looks too low for today's ALF finals game or Super Bowl may be exactly the right price for maximising profits over the lifetime of a fan.

Customers shouldn't pay less when they use a self-checkout, they should pay more

The New Zealand Herald reported last week:

State representative Nikki Lucas has introduced a bill that would require retail businesses selling food in the state to offer a 10% discount to those who used the self-checkout lane.

“Retail businesses increasingly rely on self-checkout systems to reduce staffing and operational costs by shifting responsibilities traditionally performed by employees onto consumers,” she wrote...

Consumer NZ head of advocacy Gemma Rasmussen said her organisation thought there was validity to the argument in New Zealand, too.

Call me radical, but I think that Lucas and Rasmussen have this backwards. Customers shouldn't pay less when they use a self-checkout, they should pay more. To see why, I'm going to rely on the concept of price discrimination - where the seller sells the same good or service to different groups of consumers for different prices.

Consider two groups of consumers (impatient, and patient), and two options (self-checkout, and regular checkout). The first group of consumers is impatient, and they want to get out of the store as soon as possible, and for that reason they prefer to use self-checkout. This group can be said to have a short time horizon for their purchases. This short time horizon makes their demand for goods less elastic (less sensitive to price). The second group of consumers is more patient, and they are willing to wait. This group can be said to have a longer time horizon for their purchases, which makes their demand for goods more elastic (more sensitive to price).

If supermarkets want to price differently for each group, which group should pay the higher price? The answer to that question is shown in the two diagrams below. Both diagrams show a firm with market power (a supermarket), and each diagram corresponds to one of the sub-markets. The sub-market on the left represents the patient buyers, who have more elastic demand - notice that the demand curve D1 is relatively flat (which means that a change in price will have a big effect on the quantity that these consumers demand). The sub-market on the right represents the impatient buyers, who have less elastic demand - notice that the demand curve D2 is relatively steep (which means that the same change in price would have a smaller effect on the quantity that these consumers demand, than it would for the patient consumers). The marginal cost (MC) is the same in both sub-markets - it doesn't cost the supermarket any more to sell a product to an impatient buyer than what it costs them to sell that same product to a patient buyer. [*]

The supermarket will maximise profits by selling the quantity where marginal revenue (MR) is equal to marginal cost (MC) - this is the standard short-run profit-maximising condition (as I discussed in this post). In the impatient sub-market, the profit-maximising quantity occurs where MR2=MC, which is Q2. In order to sell that quantity in the impatient sub-market, the supermarket should set the price equal to P2. The problem with that high price P2 is that in the patient sub-market, no consumers would be willing to buy the good at all. The supermarket can increase profits if it charges a different price in the patient sub-market from the price it charges in the impatient sub-market. In the patient sub-market, the profit-maximising quantity occurs where MR1=MC, which is Q1. To sell that quantity in the patient sub-market, the supermarket should set the price equal to P1. In other words, the supermarket should charge a higher price to the impatient consumers, and a lower price to the patient consumers.

The problem here is that supermarkets don't know (for sure) which group (impatient or patient) any particular consumer belongs to. But by offering different checkout options, the customers can sort themselves into the impatient (less elastic demand) group and the patient (more elastic demand) group, because the impatient consumers use the self-checkout. In other words, the supermarket should charge a higher price to the users of the self-checkout.

This is an example of menu pricing (or second-degree price discrimination) - where the consumers are presented with a menu of options, and they select the one they prefer.  Crucially, the seller knows that some menu options appeal to consumers with more elastic demand, and other options appeal to consumers with less elastic demand. In this case, there are two menu options - self-checkout, or regular checkout, and the supermarket knows that the self-checkout appeals to the impatient consumers who should be charged a higher price.

So, customers who use a self-checkout right now shouldn't be arguing to lower prices. They should think themselves lucky that supermarkets aren't optimising, because if they were, the prices at self-checkouts would be higher than at regular checkouts.

*****

[*] You could argue that it doesn't cost the same to offer purchase through regular checkouts and self-checkouts. However, how big is the cost difference, really? Let's say that it takes two minutes to scan your items, but would take three minutes through the regular checkout, because the payment process tends to take a bit longer at a regular checkout. With self-checkout, the supermarket would save three minutes of labour. Say that the supermarket pays their checkout staff $30 per hour (somewhat more than the minimum wage). By using the self-checkout, you've saved the supermarket $1.50 of labour in this example (3/60 * $30). Except, that calculation doesn't take into account that the self-checkout is not a zero-labour option. There is usually a checkout person who has to watch over the consumers using the self-checkout. So, the saving is actually a bit less than that. It almost certainly isn't close to the 10 percent discount that Lucas is arguing for. Most of the cost of the items that you buy at the supermarket is the wholesale cost that the supermarkets pay, not the checkout labour cost.

How home loan customers can use switching costs against the banks

Economists often consider switching costs to be a problem for consumers. High switching costs can lock a consumer into buying a particular product, or lock them into buying from a particular seller. Often, the seller extracts additional profits from their locked-in customers by charging them a higher price, or selling them complementary products. However, sometimes locking in can benefit consumers, especially when they can play off one seller against another, where both sellers want to lock the customer in. Consider the example of banks, on which the New Zealand Herald reported last month:

Home loan borrowers are taking cashback incentives to stay with their current banks, as competition continues in the mortgage market.

The focus on cashback incentives intensified through the end of last year, when ANZ offered cash payments equal to 1.5% of loan amounts to new home loan borrowers.

In a competitive environment, banks really want home loan customers, and are willing to pay to attract new customers. Retaining their existing customers is important too, and banks may be willing to pay to keep their customers. However, not all customers will be able to extract the same 'retention payments' from their bank. The bank needs to weigh up how likely it is that they will lose a customer:

Helen Stuart, a mortgage adviser at Compass Mortgages, said she had seen “retention payments” offered by several banks lately, especially when someone had all their lending come off a fixed term...

It is harder to change to lenders when some of the loan is still fixed, because it usually means a break fee has to be paid.

That makes sense. When a bank customer has a fixed rate mortgage, they have to pay a 'break fee' in order to change banks. Their current bank can feel quite secure that the customer is going to stay with them, and so the bank is unlikely to offer a retention payment (or, if they do, any retention payment is likely to be quite small). On the other hand, when the fixed rate on the mortgage expires, the bank customer can change banks without paying a 'break fee', and so the bank would be more likely to offer a retention payment (or would offer a more generous retention payment). Of course, the retention payment itself is likely part of the bank’s lock-in strategy, since cashbacks often come with conditions that make future switching more costly to the customer.

Thinking further:

Jeremy Andrews, of Key Mortgages, said what people could get would depend on how long a customer had had their loan, whether they had taken a cashback previously and whether they had more than 20% equity.

“Some banks will refuse retention cash if the clients are already fixed in and they see it as of no benefit to the client to refinance to another bank. Some examples include if it’d be detrimental either in break fees – they’re already on higher than market rates, or if they would need to move to higher rates in the market, or the legal costs associated exceed any cashback benefit of moving.

So, in general, the bank is weighing up how likely it is that the customer will change banks. If changing bank would lead the customer to end up paying a higher interest rate on their mortgage, the bank infers that the customer is less likely to leave, and the bank will therefore be less likely to offer a retention payment. It is a similar story if legal costs are high - the customer is less likely to move, and the bank will be less likely to offer a retention payment.

Bank customers should be savvy about this though. Any time that they have the 'upper hand', through low switching costs, they could use their position to extract a large retention payment from their bank. This happens when their home loan comes off a fixed rate, and especially when other banks are offering enticements for the customer to switch. Of course, they need to consider not just the retention payment, but the interest rate, break fees, legal costs, the hassle of switching, as well as whether accepting the retention payment locks them in and for how long. If it makes sense overall, then playing off the banks against each other may allow the home loan customer to reverse the logic of switching costs to their advantage.

The Australian government has 'subscription traps' in its sights

As I noted in a post last week, firms are increasingly selling subscriptions rather than products because consumer inertia can make them substantially more profitable. Once a customer starts a subscription, they tend not to cancel the subscription as soon as they should, simply because it requires some thought and attention (as well as a little bit of time) to execute a cancellation of the subscription. This 'customer inertia' is a form of switching cost, which locks customers into buying the subscription. However, sellers can easily amp up the switching cost by making it more difficult (and therefore more costly) to cancel. This makes customer lock-in more effective, and can 'trap' customers into their subscription.

In this article in The Conversation last year, Jeannie Marie Paterson (University of Melbourne) provides a couple of examples of 'subscription traps', each of which represents an instance of the firm increasing the switching costs for the consumer:

One example is when consumers sign up for a service quickly and easily online, but can only cancel on the phone (sometimes needing to ring another country)...

Another example, known as “confirm shaming”, involves requiring consumers to click through multiple screens before they can cancel.

Typically, each of those screens has a message asking consumers to reconsider, often reiterating the service’s purported benefits and even offering new discounts on the price not previously available.

When the switching costs are higher for the consumer, the customer lock-in is more effective (it is harder for the consumer to cancel, or switch). The firm can then profit through selling at a higher price, or by selling complementary goods and services to the locked-in consumer.

It is deceptively easy for a consumer to get locked in as well. I'm sure that you will have been offered the first month free on a subscription. That is how the firms get you. Firms often offer subscriptions at a low price initially (or free), then once the consumer is locked in, the firm can raise the price (this is referred to as multi-period pricing).

However, governments are wising up to the 'subscription traps' that Paterson highlights. She notes that:

Making it hard to cancel – commonly called a “subscription trap” – isn’t currently illegal. But now the federal government has announced a plan to ban subscription traps and other hidden fees.

Since then, the policy process in Australia has advanced, with draft legislation released in early 2026 that would impose disclosure, notification, and easy-cancellation requirements on subscription contracts from 1 July 2027, if the legislation is passed.

It is worth noting that banning subscription traps is not the only policy solution here. Anything that reduces the switching costs will likely be effective at reducing customer lock-in. One example that Paterson notes is:

California’s “click to cancel” rules also mean consumers must be able to cancel using the same method of communication they used to subscribe. And businesses must offer consumers information on how to cancel.

So, if signing up for a subscription requires a single click, then cancelling a subscription must also require a single click. That minimises the switching costs, and minimises customer lock-in. Making subscriptions easy to cancel would allow consumers to retain the genuine benefits of subscriptions (including lower transaction costs and fewer service interruptions) while reducing the unnecessary costs from subscriptions they no longer use. Firms may still be able to offer discounts or reminders to retain customers, but the cancellation process should inform consumers rather than obstruct them. Reducing these artificial switching costs is therefore likely to improve consumer welfare overall.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in
• Why do firms increasingly prefer to sell subscriptions, rather than products?

Why do firms increasingly prefer to sell subscriptions, rather than products?

An increasing number of goods and services that were once sold as one-off purchases are now offered as subscriptions. Newspaper subscriptions and gym memberships have existed for a long time, and 'software as a service' is now commonplace. But the model has spread much more widely: consumers can now subscribe to meal kits (such as HelloFresh), razors (such as Dollar Shave Club), and a growing range of other products. Why are firms that once sold products outright increasingly choosing to sell subscriptions instead?

That is the question addressed in this 2025 article by Liran Einav (Stanford University), Ben Klopack (Texas A&M University), and Neale Mahoney (Stanford University), published in the prestigious American Economic Review (ungated earlier version here). They start by noting that the rapid growth in subscriptions is often attributed to the rise of digital products, and the convenience of a subscription for consumers. However, Einav et al. focus their attention on a third factor:

Because subscriptions are automatically renewed, consumers who are inertial may continue to pay for subscriptions they no longer value... If consumers do not fully anticipate their inertia at sign-up, this may create supply-side incentives to offer subscriptions to exploit inertial consumers, amplifying the growth of subscription offerings.

My ECONS101 students will be familiar with this explanation for subscriptions, because we literally covered this in the lecture today. Einav et al. test for the extent to which inertia matters using transaction data from "a large payment card network in the United States between August 2017 and December 2021". Their final dataset includes over 800,000 accounts, and about 870,000 account-service pairs (each account-service pair is a set of observations of a payment card account that subscribes from one of the ten largest subscription services).

Einav et al. exploit the fact that when a card expires and is replaced, consumers typically have to update the billing information for their subscriptions, prompting them to either update or cancel each subscription. To the extent that card replacement decreases the retention rate of subscriptions, this provides evidence of customer inertia. If consumers cancelled subscriptions whenever they stopped making use of them, then there would be no difference in subscription retention between months with card replacements and months without.

Unsurprisingly, Einav et al. find evidence of customer inertia, and the effects are large and consequential for firms selling subscriptions:

We use the estimated model to perform counterfactual exercises that assess how much more quickly consumers would cancel their subscriptions if there was no inertia, which corresponds to fully attentive consumers (inattention model) or default cancellation every month (switching cost model). We find that seller revenues (or equivalently average subscription durations) are significantly higher due to subscriber inertia with important heterogeneity across services. Specifically, in the inattention model, we find that inertia increases seller revenues by 87 percent on average, with increases that range from 14 percent to more than 200 percent depending on the service. In the switching cost model, inertia raises revenue by 120 percent on average, with a range of 17 percent to 259 percent.

So, there are strong incentives for firms to engage in the selling of subscriptions, and to take advantage of customer inertia in subscriptions. However, many consumers are clearly spending more on subscriptions than they need or necessarily want to. Think about yourself as an example - how many subscriptions do you have right now that you rarely use and probably should cancel? I don't have any, but that's only because writing this post made me think about this and cancel one that I was no longer really using!

Subscriptions can provide important benefits for consumer though, including reducing transaction costs (it is simpler to pay a monthly subscription than to buy goods or services individually over and over), and reducing service interruptions (because a subscription makes it more likely that the consumer won't run out of the good they are buying a subscription for). However, we might still be concerned that customer inertia makes some customers with subscriptions worse off overall. So, Einav et al. then turn to evaluating what the most appropriate policy response is. They focus attention on a rule requiring firms to provide consumers with an active renewal decision at regular intervals. Using their two models, Einav et al. find that:

In the inattention model, we find that requiring active choices at a six-month frequency would reduce the excess revenue from inattention by 45 percent. The switching cost model makes a similar quantitative prediction; moving from default renewal to default cancellation once every six months would reduce excess revenue by 48 percent.

Those are quite substantial effects, which again illustrates just how much consumers are giving away to subscription firms for subscriptions that they no longer make the best use of and should be cancelling. What becomes clear from this paper is that one important reason why firms that previously would have sold products instead prefer to sell subscriptions is that consumer inertia can make them substantially more profitable.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in

Price discrimination in tourism... French tourist attractions edition

The latest development in pricing at French museums should be familiar to my ECONS101 students, or to regular readers of this blog. As reported by the New Zealand Herald back in January:

France is hiking prices for non-Europeans at the Louvre this week, provoking debate about so-called “dual pricing”.

From Wednesday local time, any adult visitor from outside the European Union, Iceland, Liechtenstein and Norway will have to pay €32 ($64) to enter the Louvre – a 45% increase – while the Palace of Versailles will up its prices by €3...

Other state-owned French tourist hotspots are also hiking their fees, including the Chambord Palace in the Loire region and the national opera house in Paris. 

This form of pricing is, of course, known as price discrimination - offering the same product (in this case, museum entry) to different consumers for different prices. Price discrimination works when the seller has consumers with heterogeneous demand for their product. That means that some consumers have more elastic demand for the product (and are more price sensitive), while other consumers have less elastic demand for the product (and are less price sensitive). The seller charges a higher price to the consumers who are less price sensitive.

Why do foreigners have less elastic demand for tourist attractions? As I noted in this post back in 2014, there are two reasons. First, consumers tend to have less elastic demand for goods with few close substitutes. There are few substitutes for visiting the Louvre (or other tourist attractions), making demand less elastic. Arguably, for foreign tourists there are fewer close substitutes to the Louvre. Locals can do all sorts of things with their time, but tourists tend to want to go to tourist attractions while on holiday. Second, the significance of price in the total cost of the good is lower for foreign tourists than for locals. Foreign tourists have usually also travelled a long way at great cost to get to France, so the cost of entry into the Louvre is pretty small in the overall cost of their holiday, making demand less elastic. For locals, the cost of the ticket to the Louvre is probably most of the total cost of attending, so a change in the ticket price would have a greater effect on whether they go (making demand more elastic).

The New Zealand Herald article focuses attention on the ethics of price discrimination, noting that:

Trade unions at the Louvre have denounced the policy as “shocking philosophically, socially and on a human level” and have called for strike action over the change, along with a raft of other complaints.

That criticism is not trivial, because museums are not just profit-maximising firms - they also have a public-access mission, so charging more can look inconsistent with their public access goal. However, it is important to recognise that price discrimination is not illegal or even necessarily immoral, and may provide greater support for the long-term goals of the museum.

Price discrimination is in fact relatively common at tourist attractions (see the links at the end of this post), especially in developing countries but also increasingly in developed countries like New Zealand. And:

Britain has long had a policy of offering universal free access to permanent collections at its national galleries and museums.

But the former director of the British Museum, Mark Jones, backed fee-paying in one of his last interviews in charge, telling the Sunday Times in 2024 that “it would make sense for us to charge overseas visitors for admission”.

Society should want museums to remain sustainable. However, funding purely by taxes doesn't ensure sustainability, which is one reason that museums charge entry fees in the first place. And since museums are charging an entry fee anyway, it is right to consider what is the 'best' entry fee. There is no reason why that entry fee needs to be the same for locals and foreigners. After all, locals likely already pay for the upkeep of the museum through their taxes, so having a lower price for locals (as many tourist attractions do) is in that sense a fairer option. Price discrimination therefore has fairness in its favour, in addition to being a way of increasing profits for the museum, increasing its financial sustainability.

Read more:

• Are tourism operators in NZ missing a trick?
• Price discrimination in tourism... India edition
• Price discrimination and the Great Walks
• Hamilton Gardens' entry fee for tourists as a form of price discrimination
• Te Papa Tongarewa embraces price discrimination, but other tourism operators are still missing the trick

Facebook Marketplace forces a change in TradeMe's business model, but will it succeed?

TradeMe is one of the key examples that I use when teaching about platform markets in my ECONS101 class. But competition from Facebook Marketplace is causing TradeMe to change its business model, and those changes are risky.

The reason why TradeMe is such a good example is that, by attracting buyers and sellers to its platform in the 1990s, TradeMe managed to keep eBay out of the New Zealand market. How did that happen? In a platform market, the firm (in this case, TradeMe) acts as an intermediary that brings together two parties (in this case, buyers and sellers) who would not otherwise interact or easily connect. Buyers using TradeMe create value for sellers, and the more buyers there are, the more value is created. Sellers using TradeMe creates value for buyers, and the more sellers there are, the more value is created. Once TradeMe was set up and had attracted a large share of buyers and sellers, it would be difficult for any other platform to set up in competition with TradeMe. And so, eBay couldn't get a foothold in New Zealand, and TradeMe had an effective monopoly over online auctions for many years.

TradeMe profited by charging a 'success fee' to sellers of goods on the platform. Buyers faced no fees. This reflects the principle that a platform firm (like TradeMe) should set a lower price for access to the platform to whichever side of the market has demand that is more elastic, ceteris paribus. In this case, buyers have more elastic demand for access to TradeMe, as there are many other places that they might go to buy things. Sellers, on the other hand, had more inelastic demand for access to TradeMe because no other place had access to the same quantity of buyers. That is, until Facebook Marketplace appeared.

Facebook Marketplace doesn't charge fees to sellers. And through its links to Facebook users, there are a large number of potential buyers on Facebook Marketplace. And so, there is now a viable (and cheaper) alternative to TradeMe for sellers. And now, TradeMe has finally reacted to this competition, as reported in the New Zealand Herald last month:

Trade Me is removing success fees for casual sellers, in a move that one marketing expert says is probably a response to the growing power of Facebook Marketplace.

Sellers have usually been paying 7.9% of the final sales price of items sold via Trade Me.

But a new fee structure will remove them from next week and site spokeswoman Lisa Stewart said casual sellers would be better off.

It is making other changes at the same time: bank transfers will not be possible and Ping will be offered on every listing alongside cash and Afterpay, with a 2.19% transaction fee for the seller. This provides buyer protection up to $5000 if trades go wrong.

Buyers will also pay a new service fee based on the purchase price, if items are more than $20. This will be 99c for goods sold for $20.01 to $100, $1.99 for sales between $100.01 and $250 and $4.99 for items over $250. Stewart said 44% of trades were under $20.

It was a response to customer feedback and what was happening in the market, Stewart said...

Massey University marketing expert Bodo Lang said it was likely to be in response from growth in the use of Facebook Marketplace, which offers no protection for buyers but charges no fees.

With Facebook Marketplace available for sellers, seller demand for using TradeMe has become more elastic. While the 'success fees' have been eliminated, TradeMe will still profit from sellers through mandating the use of its payment service Ping. And notice that buyers will also now pay a 'service fee' to TradeMe on successful purchases over $20. TradeMe is now leveraging its market power to derive revenue from a complementary good (payment services) rather than the auctions themselves. This change makes TradeMe's business model resemble that of Facebook Marketplace. Meta derives revenue from Facebook Marketplace though selling advertising (on Facebook Marketplace, but also on Facebook), rather than deriving revenue directly from the sales on Facebook Marketplace.

It remains to be seen whether Trademe's new business model will be successful. I question the wisdom of charging a service fee to buyers. They are still the more elastic side of Trademe's platform market, and they have a cheaper option available in the form of Facebook Marketplace. TradeMe is banking on buyers valuing the protection that TradeMe offers them, which Facebook Marketplace does not. However, it isn't clear how much buyers value that protection, and if they don't value it in excess of the new service fee, then they will continue to exit to Facebook Marketplace. And if buyers show an increasing preference for Facebook Marketplace, it won't be long before sellers start to reduce their listings on TradeMe. And if that happens, the market could tip and TradeMe could very quickly find itself in an irreversible decline.

Sellers of natural diamonds are in big trouble

As I noted in yesterday's post, sellers of natural diamonds are in trouble. Lab-grown diamonds are undercutting their market. The problem here is that consumers can't easily tell lab-grown diamonds and natural diamonds apart. The two types of diamonds are perfect substitutes. And when faced with the option of buying one of two products that are perfect substitutes, consumers will generally choose the product that is lower-priced. In this case, that's the lab-grown diamonds.

To see why, consider the diagram of the consumer choice model below. The two goods are X (natural diamonds) and Y (lab-grown diamonds). The consumer's budget constraint is shown by the black line. The budget constraint is relatively steep, which means that the price of lab-grown diamonds is relatively lower than the price of natural diamonds. The consumer's indifference curves are shown by the two red lines, I0 and I1 (with I1 representing a higher level of utility, or satisfaction, for the consumer). The indifference curves are straight lines when the two goods are perfect substitutes (which is the case here). The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, (it's on the highest indifference curve that they can reach, I1), where the consumer spends all of their income on lab-grown diamonds, and spends nothing on natural diamonds. [*] This makes sense, given that lab-grown diamonds and natural diamonds are exactly the same good in the mind of the consumer (they are perfect substitutes), and lab-grown diamonds are relatively less expensive than natural diamonds.

So, how can natural diamond sellers respond to this problem? One way is to lower their prices to match the lab-grown diamond price. That would cause the consumer's budget constraint to pivot outwards and become flatter (just like in this example), and then the highest indifference curve would exactly match the budget constraint. However, lowering prices could easily escalate into a price war, and is unlikely to end well for anyone.

A better option for the sellers of natural diamonds arises when they recognise that the real problem here is not the price, it is that the two goods are identical in the mind of the consumer. If the sellers of natural diamonds can somehow convince the consumer that the two goods are different rather than identical, then they may be able to keep some sales, even if the price of natural diamonds is higher than the price of lab-grown diamonds.

This situation is shown in the diagram below. When the goods are differentiated, the consumer's indifference curves are curves (not straight lines - straight line indifference curves only happen when the goods are perfect substitutes). The highest indifference curve that the consumer can get to is I1'. They will buy the bundle of goods E1, which contains Y1 lab-grown diamonds, and X1 natural diamonds. Even though natural diamonds are relatively more expensive, the consumer chooses to buy some of them.

So, how can the sellers of natural diamonds differentiate their diamonds from the lab-grown diamonds? That is the tricky thing, because there is an asymmetric information problem here. The sellers know whether diamonds are lab-grown or natural, but buyers don't know. The origin of a diamond is private information. Because buyers can't tell the two diamonds apart, they assume that all diamonds are lab-grown [**]. This creates a pooling equilibrium (because all diamonds are pooled together and treated the same). Buyers would only be willing to pay low prices for diamonds, because they assume that the diamonds are lab-grown. Natural diamond sellers don't want to sell their diamonds for the lower lab-grown diamond price, so they drop out of the market. Only lab-grown diamonds would be left in the market. The market for natural diamonds would fail. Economists call this an adverse selection problem. And that is what seems to be happening, since the Financial Times article I referred to yesterday notes that:

By the end of 2024, De Beers had amassed an inventory of unsold diamonds worth $2bn, the largest stockpile since the 2008 financial crisis.

The diamonds are unsold in part because they cannot be distinguished from the lower-priced lab-grown diamonds. How can the natural diamond sellers solve this adverse selection problem? When the informed party (the party that knows the private information) credibly reveals that information to the uninformed party, we call that signalling. To be effective, a signal needs to meet two conditions. First, it must be costly. And second, it must be costly in such a way that the sellers of lab-grown diamonds wouldn't want to attempt the signal.

Unfortunately, it is difficult to identify a signal that meets those two conditions for the sellers of natural diamonds. If they try some recording the chemical signature of their diamonds, those structures can probably be easily copied by makers of lab-grown diamonds. Similarly, microscopically etching a serial number onto each natural diamond is something that makers of lab-grown diamonds can do as well. That rules out branding diamonds. Advertising is not likely to be very effective either, because while advertising natural diamonds and making consumers want them more seems like a good strategy, it won't turn into extra sales if consumers can't tell the lab-grown diamonds and natural diamonds apart. Sellers can often use warranties to signal quality. However, when a good has a warranty, it's quality is eventually revealed to the consumer (because, if the good is low quality, they end up having to claim on the warranty). That isn't the case for diamonds.

So, the natural diamond sellers are not just in trouble. They are in big trouble, unless they can find some way of signalling that their diamonds are natural diamonds (and at the same time hoping that buyers continue to be willing to pay a premium for natural diamonds).

*****

[*] Yes, this model is assuming that the consumer spends all of their budget on only two goods, natural diamonds and lab-grown diamonds. If it makes you feel better, think of it as the consumer spending all of their diamond budget on those two goods.

[**] I'm treating the lab-grown diamonds as if they are lower quality than natural diamonds. That is what the sellers of natural diamonds would argue, anyway, and given that there is a slight price premium for natural diamonds, the buyers seem to think that way too.

Read more:

• Sellers of natural diamonds are in trouble
• Market power and disruption in the diamond industry

Price discrimination (or not) at Parisian restaurants

The Telegraph reported last month (paywalled, but you can read it free from the New Zealand Herald):

Hapless tourists in Paris are being charged as much as 50% more than French customers, the city’s leading newspaper found.

After tourists complained online about being overcharged, Le Parisien sent out a bona fide Parisian to a cafe on the Champ-de-Mars near the Eiffel Tower.

It also dressed up one of its reporters as a typical tourist, sporting a T-shirt emblazoned with the tower, trainers, dark glasses and a baseball cap, and speaking in a passable American accent – albeit with a French twang.

They both sat down at the unnamed eatery and ordered the same dish – lasagne – and drinks, a Coke and water, and discreetly filmed themselves doing so.

The clearly French customer was served a can of Coke for €6.50 ($12.65) and offered a carafe of water with his dish. Meanwhile, the “American” was not offered a small can, only a medium or large Coke. When it arrived, it was half a litre and cost €9.50 ($18.50).

As for the water, the “American” received no offer of a carafe, which is free, instead having to fork out a further €6 ($11.60) for a small bottle of Vittel...

The Telegraph spoke to Joseph, a 21-year-old waiter who confirmed that some of the techniques were widespread.

“In one restaurant I worked I was instructed to bring spring water at €7 ($13.60) a bottle unless foreign customers specifically asked for a carafe,” he said.

This sounds a lot like price discrimination, which occurs when a firm charges different prices to different groups of consumers for the same good or service (and where the difference in prices does not arise from a difference in cost). Price discrimination comes in three forms: (1) first-degree price discrimination (or personalised pricing), which involves setting a different price for every consumer; (2) second-degree price discrimination, which involves the consumer paying a declining price for each additional unit that is purchased; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers.

As I noted in yesterday's post, one form of third-degree is menu pricing. Menu pricing is where the firm offers the consumer different options (that the firm knows appeal to consumers with different elasticities), and consumers select their preferred option. On the menu, items that the firm knows will appeal to consumers with less elastic demand (consumers who are less sensitive to price) are priced with a higher markup (over marginal cost) than items that the firm knows will appeal to consumers will more elastic demand (consumers who are more sensitive to price).

In the case of Parisian restaurants, tourists tend to have less elastic demand for meals and drinks than locals. There are several reasons that we could use to argue this. First, tourists have likely travelled a long way, at considerable cost, to visit Paris. The price of a meal (or some water) at a Parisian restaurant is a very small proportion of the total cost of their holiday. When price is a small proportion of the total cost, demand tends to be less elastic. Second, tourists may have higher income than locals. That means that the price of a meal (or some water) will take up a lower proportion of a tourist's income than a local's, making demand from tourists less elastic. Third, tourists may not know the area well, and are less aware of substitutes (other nearby restaurants), although Google Maps, TripAdvisor and other apps have reduced the impact of this factor. When a good has fewer substitutes, it has less elastic demand. For any or all of these reasons, we may expect tourists to have less elastic demand, and firms that price discriminate would charge them a higher markup (and a higher price).

Now, the Parisian restaurants aren't practicing menu pricing as typically described, because they are essentially removing options from the menu that tourists get to see. The locals, with more elastic demand, are offered cheaper options than the tourists, with less elastic demand. The tourists are generally unaware that there are other options available that would be cheaper (like a carafe of water).

This reminded me of my several trips to Thailand (first during my PhD, and then subsequently), where tourists tend to pay higher prices for visiting various attractions than locals do (a point I mentioned in this 2014 post). The tourist attractions in Thailand hide this fact from the tourists by putting the price for locals in Thai script, so that only those who can read Thai know that the cheaper option exists. Now, the Parisian restaurants have made me wonder about various times in Thailand and China and elsewhere, where I've visited restaurants and received a menu in English (sometimes poorly translated). It's likely that the prices on the English menu are far higher than on the menu in the local language.

All of this suggests that, when we are tourists, we should be a bit savvier about our buying behaviour. The best option is to have local friends who can identify the opportunities for saving, although this won't apply to 'friends' of the type that hang out outside airports or hotels and offer to be a guide. At restaurants or attractions, ask a generative AI app to translate a photo of the local menu or price board, rather than simply accepting the English version. At the very least, we should observe what the locals are ordering and do the same (probably this is good advice generally). Price discrimination is pervasive. That doesn't mean that as tourists we need to just accept it.

Delta Air Lines moves from group pricing to personalised pricing

In my ECONS101 class last week, we covered price discrimination: where a firm charges different prices to different groups of consumers for the same good or service (and where the difference in prices does not arise from a difference in cost). Price discrimination comes in three forms: (1) first-degree price discrimination (or personalised pricing), which involves setting a different price for every consumer; (2) second-degree price discrimination, which involves the consumer paying a declining price for each additional unit that is purchased; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers.

Airlines typically engage in price discrimination (as I discussed here), in the form of group pricing. Specifically, they engage in a type of group pricing known as menu pricing. As I noted in this post:

Airlines don't quite have a menu. However, they do offer a range of options to consumers. Some consumers will buy a ticket close to the date of the flight, while others buy far in advance. That is information the airline can use. If you are buying close to the date of the flight, the airline can assume that you really want to go to that destination on that date, and that few alternatives will satisfy you (maybe you really need to go to Canberra for a meeting that day, or to Christchurch for your aunt's funeral). Your demand will be relatively inelastic, so the airline can increase the mark-up on the ticket price. In contrast, if you buy a long time in advance, you probably have more choice over where you are going, and when. Your demand will be relatively elastic, so the airline will lower the mark-up on the ticket price. This intertemporal price discrimination is why airline ticket prices are low if you buy far in advance.

Similarly, if you buy a return ticket that stretches over a weekend, or a flight that leaves at 10am rather than 6:30am, you are more likely to be a leisure traveller (relatively more elastic demand) than a business traveller (relatively more inelastic demand), and will probably pay a lower price. 

Menu pricing is an imperfect form of price discrimination. The ultimate form of price discrimination would be for a firm to sell to every consumer for exactly the maximum that they are willing to pay. This is a perfect form of personalised pricing (first-degree price discrimination). However, this is difficult for firms to achieve in practice, as consumers don't typically volunteer information on how much they are willing to pay. Nevertheless, firms would still really like to do this, and so estimating consumers' willingness-to-pay is important to firms. If they can achieve that, then the next step is to charge every consumer a different price.

And that brings me to this article in The Verge last month:

Delta Air Lines is leaning into dynamic ticket pricing that uses artificial intelligence to individually determine the highest fee you’d willingly pay for flights, according to comments Fortune spotted in the company’s latest earnings call. Following a limited test of the technology last year, Delta is planning to shift away from static ticket prices entirely after seeing “amazingly favorable” results.

“We will have a price that’s available on that flight, on that time, to you, the individual,” Delta president Glen Hauenstein told investors in November, having started to test the technology on 1 percent of its ticket prices. Delta currently uses AI to influence 3 percent of its ticket prices, according to last week’s earnings call, and is aiming to increase that to 20 percent by the end of this year. “We’re in a heavy testing phase,” said Hauenstein. “We like what we see. We like it a lot, and we’re continuing to roll it out.”

Obviously, Delta thinks that it has enough information about its customers to make this work. It was inevitable that firms would eventually start using artificial intelligence and machine learning to estimate the maximum willingness-to-pay for each of their consumers. This is likely to be just the beginning of a wider trend, given the potential for greater profits for firms. As I note in my ECONS101 class, there is no possible pricing strategy that could be more profitable than perfect personalised pricing. Delta's approach probably isn't perfect, but it is likely to be more profitable than the regular airline group pricing strategy.

[HT: Marginal Revolution]

Read more:

• Price discrimination and airline tickets

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. 

Black Mirror Season 7 illustrates the ultimate version of customer lock-in

[This post contains spoilers. You have been warned.]

I love the TV show Black Mirror. Charlie Brooker (the writer of almost all episodes of the show) is an evil genius. Nearly every episode depicts some dystopian near-future that is just plausible enough to make you both worry, and think. The first episode of the latest (seventh) season, titled Common People, is a perfect illustration of this. It is also a perfect illustration of customer lock-in, albeit at an extreme level. From the Wikipedia description of the episode:

Welder Mike Waters (Chris O'Dowd) and schoolteacher Amanda (Rashida Jones) have been married for three years and are trying to conceive a baby. One day while teaching, Amanda collapses, and doctors discover she has an inoperable brain tumor. Mike is introduced to Gaynor (Tracee Ellis Ross), a representative from tech startup Rivermind Technologies. Gaynor explains that Rivermind can remove the tumor and replace her excised brain tissue with synthetic tissue powered by their servers. While the surgery is free, the couple agree to pay a monthly subscription fee to give Amanda a chance at living a normal life again.

Initially the service seems to help Amanda, but as time passes they find that it has several limitations which can only be bypassed by subscribing to the costlier "Plus" tier, as opposed to their current "Common" tier. Unbeknownst to Amanda, she begins interjecting brief advertisements into her daily speech.

As I describe in my ECONS101 class, customer lock-in occurs when consumers find it difficult to change once they have started purchasing a particular good or service. High switching costs (the cost of switching from one good or service to another, or from one provider to another) are likely to generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products. High switching costs could also, in some cases, prevent consumers from stopping buying the good or service - that is, the switching cost causes the consumers to keep buying the good even if they would want to stop (if there was no switching cost). This is the case for subscriptions, for example (see here or here or here).

In this case, Rivermind appears to have discovered the ultimate form of customer lock-in. The switching cost that Mike and Amanda face if they try to cancel their Rivermind subscription is that Amanda dies (or becomes comatose - the episode is somewhat unclear on this point). That switching cost is obviously very high and provides a strong incentive for Mike and Amanda to keep their subscription going. They are locked into the subscription, which is quite expensive.

Rivermind doesn't just profit from Mike and Amanda through their subscription. Rivermind also engages in a form of multi-period pricing. Typically, firms engage in multi-period pricing by starting new consumers with a low price, and then raising the price once those consumers are locked in. This is what utility firms are trying to do when they offer a discounted rate for electricity or broadband for new customers (for a limited time!). The price is initially low, and then when the new customers are locked in, the price increases (because the discount ends).

Rivermind's approach is somewhat different to the standard case of multi-period pricing. Instead of directly raising the price of the service that Mike and Amanda receive, Rivermind degrades the quality of that service (by introducing advertising). Rivermind then introduces an advertising-free tier that is more expensive (which Mike and Amanda are invited to 'upgrade' to, even though tit is really just a more expensive price for the service they started with). Rivermind then also introduces more tiers of subscription with greater coverage and more perks (and even higher prices).

The Black Mirror episode focuses on the increasingly desperate ways in which Mike tries to keep the subscription going. However, my takeaway is that it illustrates how firms can lock consumers in with switching costs that are non-monetary, and then profit from those locked in consumers. Thanks Charlie Brooker - now you've given me something else to worry about in the dystopian near-future.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in

New Zealand's supermarket sector needs a hero

In yesterday's post, I discussed market power and competition, noting that when there is a lack of competition, firms have more market power, and that means higher mark-ups and higher prices for consumers. An example of a market where there appears to be a high degree of market power is the supermarket sector in New Zealand.

It wasn't always this way. When I was young, I remember there being a large number of different supermarket brands. In Tauranga in the mid-1990s, along Cameron Road between the CBD and Greerton there was Price Chopper (which was previously 3 Guys), Pak'nSave, Big Fresh, Foodtown, New World, and Countdown (and there may be others that I've forgotten, as well as several smaller superettes).

One of the main ways that a market ends up highly concentrated is to start with a market that has some degree of competition, but then some of the firms merge (or take each other over), leaving fewer firms and less competition. In the context of supermarkets in New Zealand, this process is outlined in this article in The Conversation by Lisa Asher, Catherin Sutton-Brady (both University of Sydney), and Drew Franklin (University of Auckland):

The current state of New Zealand’s supermarket sector – dominated by Woolworths (formerly Countdown), Foodstuffs North Island and Foodstuffs South Island – is a result of successive mergers and acquisitions along two tracks.

The first was Progressive Enterprises’ (owner of Foodtown, Countdown and 3 Guys banners) purchase of Woolworths New Zealand (which also owned Big Fresh and Price Chopper) in 2001.

Progressive Enterprises was sold to Woolworths Australia, its’ current owner, in 2005. In less than 25 years, six brands owned by multiple companies were whittled down to a single brand, Woolworths.

The second was the concentration of the “Foodstuffs cooperatives” network. This network once included four regional cooperatives and multiple banners including Mark'n Pak and Cut Price, as well as New World, PAK’nSave and Four Square.

The decision of the four legally separate cooperatives to include “Foodstuffs” in their company name blurred the lines between them. The companies looked similar but remained legally separate.

As a result of mergers, these four separate companies have now become Foodstuffs North Island – franchise limited share company, operating according to “cooperative principles” and Foodstuffs South Island, a legal cooperative.

And so now we find ourselves in a situation with three large supermarket firms, two of which (Foodstuffs North Island and Foodstuffs South Island) are effectively two arms of the same firm, and certainly aren't competing with each other because they operate only on their 'own' islands. With such a lack of competition many people, including Asher et al., are clamouring for change.

Increasing competition in the supermarket sector could take one of two forms. Asher et al. argue that inviting an international competitor into the market will take too long, citing the example of Aldi in Australia, which "took 20 years to reach scale as a third major player in that country". Their preference is 'forced divestiture', breaking up the existing supermarkets into smaller competing firms. Essentially, this would be something of a return to the situation prior to some of the mergers that have characterised the past 30 years of the supermarket sector in New Zealand, but would require a drastic legislative intervention from government.

However, before the government imposes such a dramatic change on this market, it really needs some solid analysis of the impacts of the change. Large supermarket firms benefit from economies of scale in purchasing, logistics and distribution, as well as back-office functions (like payroll, marketing, and finance). If smaller supermarket firms face higher costs because they can't take advantage of the economies of scale available to larger supermarket firms, then breaking up the supermarket chains into smaller chains could lead to even higher prices for consumers. On the other hand, smaller supermarket chains have less bargaining power with suppliers, which might mean that the supermarket suppliers receive better prices (but again, that means higher prices for consumers). Without some careful economic modelling, which has not been done to date, we can't make a clear-eyed assessment of the likely net change in consumer and producer welfare.

And we should be cautious. If forced divestiture starts to gain some political traction, you can bet that the supermarket chains will release some economic analysis that supports a position that breaking them up will be worse for consumers. And consumer advocates might even be able to support their own analyses, showing the opposite. What is needed is a truly independent assessment. And before you raise it, I doubt that we get that sort of independent assessment from the Commerce Commission. They know that their bills are paid by the government of the day, and they may respond accordingly.

Asher et al. ask us to "stop waiting of a foreign hero". What we need is an economist hero, with an independent analysis of the supermarket sector in hand.

Read more:

• The Commerce Commission and the Foodstuffs merger
• The Foodstuffs merger is rejected, so the wholesale market remains an oligopsony

Market power, competition, and the collapses of Bonza and Rex

Last week, my ECONS101 class covered market power and competition (as part of a larger topic introducing some of the principles of firm behaviour). This coming week, we'll be covering elasticity, which is closely related and builds on the key ideas of firm behaviour.

Market power is the ability of a seller (or sometimes a buyer) to influence market prices. The greater the amount of market power the seller (or buyer) has, the more they can raise their price above marginal cost. That is, sellers with greater market power will have a higher mark-up (which is the difference between price and marginal cost).

How do firms get market power? There are several ways, but the greatest contributor to market power is the extent of competition in the market. When firms face a lot of competition in their market, they will compete vigorously on price, and so their mark-up will be lower. When firms face less competition in their market, they don't have to compete on price to the same degree, and so their mark-up will be higher.

Another way of seeing this is to consider the price elasticity of demand. When there are many substitutes for a good, the demand for that good will be more elastic. If the seller raises their price, many of their consumers will buy (one of the many) substitutes instead (because those substitutes are now relatively cheaper). So, firms selling a good that has many substitutes (a good that has more elastic demand) will have a lower mark-up. And if a firm's good has many substitutes, that means a lot of competition.

On the other hand, when there are few substitutes for a good, the demand for that good will be less elastic. If the seller raises their price, few of their consumers will buy substitutes instead (because there are few substitutes available). So, firms selling a good that has few substitutes (a good that has less elastic demand) will have a higher mark-up. And if a firm's good has few substitutes, that means less competition.

Taking all of this together, when a market loses one or more of the competitors, and competition reduces, we should expect to see an increase in prices. A clear example of this is what happened when the Australian regional airlines Bonza and Rex closed down last year. As Doug Drury (Central Queensland University) wrote in The Conversation last November:

In 2024 alone, we’ve seen the high-profile collapse of both Bonza and Rex, airlines that once ignited hopes for much greater competition in the sector. Now, we’re beginning to see the predictable effects of their exit.

According to a quarterly report released on Tuesday by the Australian Competition and Consumer Commission (ACCC), domestic airfares on major city routes increased by 13.3% to September after Rex Airlines halted its capital city services at the end of July.

The collapse of the two low-cost domestic airlines in Australia reduced competition on domestic routes. Unsurprisingly, the lower competition means more market power for the remaining airlines, Qantas and Jetstar. And that greater market power has translated into higher prices for domestic airfares in Australia.

The importance of competition for prices cannot be overstated. As one other example, a lack of competition has been implicated in the perceived high prices in New Zealand supermarkets (a point I will come back to in my next post, but this is a topic I have written about before here). The Commerce Commission is understandably concerned whenever there is a lack of competition, and whenever competition will be substantially reduced by the merger of two or more firms (for example, see here and here about the recently rejected Foodstuffs supermarket merger). When there is a lack of competition, sellers have more market power, demand will be less elastic, and for both of those reasons we can expect prices to be higher.

Licensing of economists, and other fortune tellers

There are certain examples I use in my classes where the origins are shrouded in mystery. They likely come from some obscure note I wrote to myself after reading something online. One of those examples is that there are some states in the US that require fortune tellers to be licensed. [*] I use this as an example of the ridiculousness of occupational licensing, which in many circumstances serves no real purpose other than creating a barrier to entry into the market. After all, what harm could befall consumers from receiving the services of an unlicensed fortune teller, that licensing would help to prevent?

It turns out that the fortune teller example is true. Here's the relevant website with links to the law, as well as this hilarious article which asks the most relevant questions:

How cool would that be to have a fortune tellers license? But then I started to wonder how the licensing process would work. Is there a written examination? Do they hand you a blank piece of paper and expect you to divine the questions and then answer them? Is the test multiple choice or essay? Who grades the essays? Other fortune tellers – kind of like bar exam? Is there a road test? Is reading tea leaves or your palm akin to parallel parking?

I was in New Orleans last month. Walking along Bourbon Street, you see a lot of fortune tellers. I could tell the phony ones. They were the ones that beckoned me over. If they could tell the future, then surely they would have known that I wasn't going to walk over to them, no matter how enthusiastic they waved at me?

Anyway, if fortune tellers are licensed in Massachusetts, does that mean economists should need a licence? After all, economists are regularly asked to tell the future - what is going to happen to GDP, unemployment, interest rates, exchange rates, etc.? Whether economists should be licensed or not isn't a crazy question - there have been calls for that in the past (see here and here). And the consequences of bad fortune telling are likely to be as bad, or worse, when an economist gets it wrong as when a palm reader does. Real risk of harm is the reason that governments license doctors, dentists, and nurses. If there is a real risk of harm from people making poor financial decisions on the advice of economists (or other fortune tellers), maybe they do have to be licensed after all?

[HT: Marginal Revolution]

*****

[*] Although, as it turns out, I have referred to licensing of fortune tellers before, with a relevant link (see here).

Read more:

• Should economists be licensed?
• Should economists have licensing, or a Code of Ethics?