Pricing strategy in practice: Cocktail menu edition

One of my favourite topics to teach in ECON100 is pricing strategy. In part, it's because this topic is a bit less about microeconomic theory, and a bit more about practical things that real managers do. That's why I enjoyed reading this article about cocktail pricing, which talks about how real bar managers set prices for drinks.

In the article, there's no pricing where marginal revenue is equal to marginal cost (the theoretical profit-maximising point for the firm with market power). Instead, the managers are making judgement calls about pricing based on their industry experience. For instance, consider this quote:

"I can't say that there's any way to be 100 percent certain that a certain drink will sell better than others," Morgenthaler tells me. "I'm constantly surprised by what is less or more popular on our menus. But with as much experience as I have, I would say I've got a pretty good idea of what's going to sell and what's going to appeal to a more connoisseur crowd."

In other words, the manager is using their market knowledge to set the price. This might involve heuristics (rules-of-thumb, such as the price of a glass of wine being the same as the wholesale price of the bottle - this used to be a common heuristic in the restaurant trade here, but I'm not sure if that still is the case), or it might just involve expert judgment. Cost is an important factor:

A cocktail by nature is a combination, in differing ratios, of a set of ingredients that each have costs, so many cocktail bars spend a lot of time and effort crunching the numbers behind their drinks...

Pour cost is pretty much what it sounds like: the cost a bar incurs by pouring a given cocktail... a bar might decide upon an acceptable range in which its pour costs must fall, given how other aspects of the business factor in, and then calculate the price of drinks based on that range. Between two drinks sold for the same price, the one with the higher pour cost earns the bar a smaller profit...

No matter its size, Cannon points out that "a restaurant will be successful over the long haul if it can pocket"—meaning earn in net profits—"10 cents on the dollar." In other words, for an establishment pulling in $1 million a year in revenue, the owner is fortunate to have $100,000 to show for it after expenses. "That's a tough order," Cannon adds. "Robust liquor sales at solid cost of goods are one of the reasons you can get to that 10 cents on a dollar." Astute cocktail pricing (say, pour costs around 21 percent or less, on average) can be a critical component of a restaurant's overall business strategy and health.

But there can't be any explicit determination of the point where marginal revenue is equal to marginal cost. In order to determine marginal revenue you must know what your demand curve is, which seems unlikely (see the earlier Morgenthaler quote) and if you don't know marginal revenue you certainly can't determine the point where marginal revenue is equal to marginal cost as we do in the textbook examples.

An alternative way of determining the profit maximising price is to use the price elasticity of demand directly (though this only works where the product has elastic demand, i.e. a price elasticity of demand that is greater than one). The formula for the optimal price in terms of the price elasticity of demand (which you can find here, or for a more lengthy explanation see here or the mathematical derivation here) is:

P* = MC[ε/(ε+1)] where ε is the price elasticity of demand (and remember that price elasticity of demand is negative, because as price increases the quantity demanded decreases due to the law of demand - the price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price, and when one of these is negative the other is positive).

For goods which have more elastic demand (i.e. where customers are more responsive to a change in the price), ε is larger (more negative) and [ε/(ε+1)] will be smaller and the price will be a smaller markup over marginal cost. For goods which have more inelastic demand (i.e. where customers are less responsive to a change in the price), ε is smaller (less negative) and [ε/(ε+1)] will be larger and the price will be a larger markup over marginal cost. So, you should charge a lower price (lower markup) if your customers are more price sensitive, and charge a higher price (higher markup) if your customers are less price sensitive.

Of course, this assumes that the price elasticity of demand is constant (which isn't true for a straight line demand curve), but putting that aside it doesn't appear that the bar managers are using an explicit calculation of price elasticity of demand in their pricing decisions either (again, see the Morgenthaler quote above). So, are they getting their pricing decisions wrong?

I would argue (as I do in class on this topic) that the long-term managers we observe in the market are not systematically getting their pricing decisions wrong. The reason is Darwinian. The cocktail bar market is pretty cutthroat - there isn't a lot of margin for error, and a manager who systematically got their pricing decisions wrong is going to lower bar profits either by pricing too high (and having customers go to the competition) or pricing too low (and lowering the per-customer profit making it more difficult to cover rent and staff costs, etc.). A manager who consistently lowers bar profits won't be a manager for very long, so the managers we see (who have been managers for a while) must be the ones who generally price close to the profit maximising point. So, even though these managers are not explicitly using marginal-revenue-equals-marginal-cost or the optimal-price-as-a-function-of-elasticity to determine prices, they must be internalising that through their expert knowledge of the market. And if you talk to bar managers, you can see that they have an understanding of price elasticities (or how their customers respond to changes in price in relative terms), even though they don't use the language of economics.

However, that's not the end of the story, because the pricing of each drink is not undertaken in isolation:

When Cannon and his team revise their cocktail menus, he says they try to price drinks destined for the greatest popularity so that they have the lowest percentage pour costs. For a prospective top-selling drink, "we need to make sure that that one is in a very solid cost of goods range, maybe a point or two below our target, because if a number-one mover that is refreshing and easy to [drink] is priced right, it allows you some wiggle room on some other esoteric things, where the ingredients are more expensive." He adds that, "We'll take a few lumps on this really cool drink that [the bartenders have] created, and it will be great conversation. Meanwhile, the gin sour...this is going to do the heavy lifting for us."

In other words, there are strategic aspects to pricing (as we discuss in ECON100). Sometimes it makes sense to lower the price of a drink, if that drink is going to attract customers who would buy other (higher markup) drinks as well, or who would bring other customers with them who purchase higher markup drinks. The former is the justification for loss-leading (where some products are sold below marginal cost in the hopes of increasing revenue and profits from other products - a common strategy for supermarkets, for instance). The latter is the justification for 'ladies nights' at bars. Again, good managers can be expected to take advantage of opportunities for strategic pricing across the range of product offerings.

And then there's the effect of competition. More bars in the local area will increase competition and lower prices. Customers have more alternatives, so if a bar increases prices (or markups) there will be a greater shift of customers to the competition. This means that customers become more price sensitive when there is more competition, which increases the price elasticity of demand (ε) and lowers the optimal price of drinks. So when there is more local competition, bars should be offering lower priced cocktails.

Finally, bars aren't only offering drinks to customers. They also offer amenity - the atmosphere, music, etc. which customers value. Bars that have attractive more attractive characteristics than their competition will be able to charge a premium for cocktails - again, because their customers are less price sensitive (lower ε, higher optimal price and markup).

So the next time you are drinking a cocktail, spare a thought for the pricing decision-making prowess of the bar manager. They're balancing cost considerations and the price elasticity of demand, as well as strategic pricing and amenity considerations, in determining the price you pay for that Long Island iced tea, whiskey sour, or special creation. And hope they've got the pricing right - otherwise they might not be around the next time you're out on the town.

See also: Fancy a margarita: Why it'll cost you more

[HT: Marginal revolution, back in July]

The living wage is good for employers; unless lots of employers pay a living wage

The living wage is back in the news this week, with The Warehouse Group being held up as an example for other (especially retail) employers in terms of looking after the wellbeing of their workers. From this Bernard Hickey piece in the New Zealand Herald:

The Warehouse is one of a growing number of companies paying a "Living Wage". From August 1, it started paying 4100 of its workers a "Career Retailer Wage" of at least $18.50 an hour. To qualify, they must have full training and 5000 hours' experience. It represents a pay increase of 10-20 per cent.

Warehouse CEO Mark Powell estimated it would cost almost $6 million in extra wages, but it was an investment worth making...

This week, union researchers Eileen Blair, Annabel Newman and Sophia Blair delivered a paper to the Population Health Congress in Auckland on the experience of employers and workers who have adopted the Living Wage, currently $18.80 an hour - 32 per cent above the $14.25 minimum wage.

They interviewed four employers and found a variety of reasons for adopting the Living Wage, including that it was the right thing to do.

But there were more practical reasons, including wanting employees paid enough to buy their products, reducing staff turnover and having staff motivated to produce a great product or service.

You can read the research paper by Brown, Newman and Blair here (pdf), and read more about the living wage campaign in New Zealand here.

I thought a blog post on the living wage was timely given that my ECON110 class has just covered the economics of social security, poverty and inequality, and related policy, so this research provides an interesting kick-off point. As Bernard Hickey points out in his article, Henry Ford introduced a $5-a-day wage at Ford factories in 1914 (although Hickey makes the mistake of buying into the story that this was done so that Ford's workers could afford to buy cars - Tim Worstall and others have already thoroughly debunked that story). The $5-a-day wage might not seem like much, but it was about double the ‘normal’ factory wage at the time. Ford had a huge number of job applications (not surprising - they were the highest paying employer around at the time). Staff turnover fell, absenteeism fell, and productivity rose so much that Ford’s production costs decreased even though they were paying much higher wages.

What Ford had introduced was what we term an efficiency wage, a wage that is voluntarily offered by an employer and is above the equilibrium wage in the labour market. Employers offer these efficiency wages because they know they have positive effects - they attract and retain higher quality employees who work harder for the firm, higher productivity, lower absenteeism and lower staff turnover. Why do all these good effects happen? In the simplest sense, having lots of job applicants and being the first-choice employer for most available workers means you get to choose the best (most productive) workers.

But the good effects go beyond the selection of job applicants, because of the incentives that the efficiency wage creates. If an employee is working for you for a wage that is well above equilibrium, then they have a strong incentive not to shirk, not to take too many dodgy sick days, and generally to work hard for you. Why? Because if they don't and they lose their job, then the best possible outcome for them is that they go back to working somewhere else for a much lower wage. Alternatively, maybe the employees just work harder for their employer because they feel good feelings for the employer who is paying them very well. There is plenty of support for the idea of efficiency wages, including research by myself and Steven Lim and others in Thailand, and there are some good quotes from employers in the Blair et al. research report, like this one:

When you spend a lot of money training someone up you don’t want them to just leave three months later, or six months later; you kind of want them to stick around for a year or two. If they feel like they can earn more money and save up more and then go travel for longer, they’ll stick around a lot longer and the productivity will go up...

Now, the living wage is a good example of an efficiency wage. If you pay your semi-skilled (say, retail) employees $18.80 per hour, you are paying above the minimum wage and well above the equilibrium wage. So I'm not surprised that The Warehouse, and the four employers that Blair et al. interviewed for their study, have seen positive gains from paying a living wage. The alternative for their employees is to work somewhere else for (probably much) less, so working hard for more pay might be an attractive option to them.

What's good for a few employers (and their employees) must be great if all employers follow suit, right? If every employer paid a living wage much higher than the mandated minimum wage, won't everyone be better off? Not so fast. The gains from paying an efficiency wage arise because the alternative jobs for employees pay much less. If every other employer is also paying a high wage, then the employees don't need to work so hard because if they lose their job they can go somewhere else that is also paying a high wage. Same goes for absenteeism, staff turnover, etc. The benefits of the efficiency wage evaporate if lots of employers pay efficiency wages.

So, it's likely that the observed gains for employers from paying a living wage of $18.80 (rather than the minimum wage $14.25) are only sustainable so long as the living wage isn't mandatory for all employers. As Bob Jones rightly points out, forcing employers to pay much higher wages is just going to force those with slender margins (including a lot of small-scale retailers) out of business. This would reduce the number of available jobs for semi-skilled workers. According to the Treasury (quoting an MBIE estimate), raising the minimum wage to the living wage would cost 25,000 jobs. Most of these lost jobs would be in accommodation and food services, and retail trade.

Overall, the living wage might have some positive effects for those employers who offer it. But the idea that it should be rolled out by all employers is clearly being oversold if the gains to employers are essentially those that arise from paying an efficiency wage.

[HT: Tracey from my ECON110(NET) class, for pointing me to the Tim Worstall piece on the Ford $5 workday]

[Update: Fixed broken link]

Try this: The economics of "The Office"

Dirk Mateer and friends (Daniel Kuester at Kansas State University and Christopher Youderian at Pareto Software; Dirk is now at the University of Arizona) have done it again. Their latest contribution to using pop culture to illustrate economics concepts is The Economics of The Office, which I was alerted to by a description of the site in the most recent issue of the Journal of Economics Education. The videos are generally short, easy to use to start a discussion or illustrate a concept in class or lectures, and the variety of concepts (which you can browse through) is broad. Macroeconomics or microeconomics - there's something for everyone there.

On a related note, Dirk Mateer's website is highly recommended for teachers (and students) of economics, especially the media library. See also this earlier post from me on cornering the market for Christmas toys (also based on a video from The Office).

University rankings and signalling

On Tuesday I wrote a post on market-based pricing and the impact on university rankings. But, to what extent do university rankings matter for our graduates? From the NZ Herald on Monday:

Kiwi employers working through a pile of CVs are unlikely to care how applicants' place of study compares on international rankings.

They may have noted last week's media reports on the latest university rankings that showed institutions here losing ground or stagnating.

But the University of Auckland's fall of 11 places on the annual Times Higher Education (THE) rankings won't work against the vast majority of its job-seeking alumni. "Generally speaking, the conversation that we have around university degrees with clients is around a demonstrated ability to commit and complete a degree," said Vanesha Din, a manager at recruitment firm Michael Page Finance.

I've written before on the value of tertiary education as a signal to employers of a student's quality (specifically for economics, see here and here). The article agrees - the value of a degree is a "demonstrated ability to commit and complete a degree". This is a signal of the student's quality as an employee (committed, hard-working, etc.), because a potential employee without a degree can't easily demonstrate those same qualities of commitment and hard work. The ranking of the university doesn't necessarily add much to the quality of the signal. That is, unless everyone that goes for a position has a degree. From the article:

However, the rankings do matter to some employers with senior technical roles including in law, medicine, specialised engineering and financial services.

Every lawyer has to have a law degree, and every doctor has to have a medical degree. So there is no signalling benefit from the degree itself - a student can't signal their quality as an employee with the degree, because all other applicants will have a degree too. The quality of the student then has to be signalled by the quality of the institution they studied at, rather than the degree itself. An effective signal has to be costly (degrees at top-ranked institutions are costly) and more costly to lower quality students (which seems likely in this case, because lower quality students would find it much more difficult to get into a top-ranked institution).

Of course, top students are weighing up the benefits of the higher quality signal provided by graduating from a top-ranked university (rather than a lower-ranked university), against the higher costs of attending the top-ranked university. Sometimes the higher-ranked university won't win out in this evaluation but at the margin, the university rankings will make a difference to this decision, and they should especially make a difference in areas like law and medicine (as in the example in the Herald article).