The Craziness that is Black Friday

Retailers seem to be opening their doors earlier and earlier on Black Friday.  Some open at 5 A.M., others at 3 A.M. Toys-R-Us even opened their stores at 10 P.M. on Thursday night!  I've never been shopping that early in the morning and really don't ever plan on it, but having studied economics quite a but maybe I can try to figure out why they insist that midnight is the best time to sell a Barbie.

There is definitely a strategy here that basic knowledge of game theory can help us understand.  On this particular day, consumers tend to be in a crazy buying mood and insist on buying everything they can as soon as they can get it, and the discounts stores offer the public just serve as catalysts to these crazed consumers. Knowing this, stores must compete against each other in order to capitalize on the buyers's moods.

This is where game theory comes in.  Each store offers crazy discounts to get their names out there and draw a crowd of campers outside their doors to attract media attention, but its not really over prices that these stores compete: its all about being the first store open.  Since customers want to go spend their money like its going to catch fire in their pockets, stores must make them selves available to these buyers.  If their competitor is open, the only way they can attract more customers is to lower their prices, which cuts into their profit and they'd rather not do.  But if they open their doors just an hour beforehand, they literally have no competition for an hour and are a monopoly for a brief time period.  By being the first one open, customers line up at your doors, waiting to buy your goods and them move on to the firms that are opening later.  You don't have to offer crazy sales because you're a monopoly; if someone wants to buy a Suzie-Talks-A-Lot at 3 A.M., you're the only one that customer can go to!

Now, every store has the incentive to open just before their competitor. That is why every year the stores open earlier and earlier in the morning, with Toys-R-Us opening on Thanksgiving night. Stores will continue to open earlier each year until an equilibrium is met, that is, when they all open at a time that maximizes their profits for the day.  No one knows for sure what time this will be or when we will reach it, but here are estimates that stores will begin opening on Thanksgiving day.

In game theory, we can think about it this way.  Suppose there are only two stores, Store A and Store B.  If store A opens early and store B opens late, store A gets all the customers and B gets none.  The same is true the other way around, with B opening earlier and getting all the customers.  If the two stores open at the same time, the split the sales 50/50.  As you can see, both stores want to open early to maximize their sales.  Opening early is called their dominant strategy, because no matter when the other company opens, the firm in question will want to open early.  (The payoffs are "open early"= 100% or 50%, "open late"= 50% or 0%.  The company would rather have the first odds, where there's the chance of getting all the customers, and worse case scenario is only half.)

So the reason stores keep opening earlier and earlier is not because they enjoy selling televisions at 2:00 in the morning, but rather because it gives them the best payoff matrix they can manage for that crazy day.

Is it an Oligopoly?

Everyone loves buying how much of a good they want at a price that they feel is fair.  Perfectly competitive markets allow this, because suppliers are forced to sell their goods at the price and quantity determined by the market.  Oligopolies and monopolies, however, don't sell where the supply and demand curves intersect.  They are able to take advantage of the fact that there are few suppliers in the industry and charge a higher price for their product while intentionally supplying less to you, creating a shortage in the market.  When there is a shortage, the good is more scarce and therefor costs more.

Economists have ways of calculating how much control firms have over a market.  For an individual firm, economists calculate the firms "market share," or how much of the market their goods consist of. For example, right now the Google phone controls 27% of the smartphone market and the iPhone has 23%. So between the two firms, they control half of the entire smartphone industry.  This gives them the oligopoly to demand higher prices from you while limiting the amount of phones they release. Remember the limited number of iPhones and shortages when they first came out?

Economists also analyze industries as a whole to see how monopolistic, oligopolistic or competitive they are.  There are two main indexes; 4 Firm Concentration  Ratio and the Herfindahl-Hirschman Index (HHI).  The four firm concentration ratio is exactly what it sounds like, economists just add together the market shares of the largest four firms. Easy as pie.  The HHI index is simple too, it just involves adding up the square of all the market shares in the industry. Again looking at the cell phone industry, the four firm calculation shows us that 94% of the market is controlled by the top 4 firms.  This is a perfect example of an oligopoly, as a few firms control the entire market.  The HHI for the smart phone industry is 2515.  This is on a scale of 1-10,000, with 1 being a total monopoly and 10,000 being perfectly competitive.  As this number is about 3/4 the way to monopoly, we can see that it ranks the industry as being an oligopoly.

Economists love their figures and indexes, it is a great way for us to portray information to each other and the general public in a way that is easy to understand.  In the complex world of market classifications, where the lines between monopolistic competition and oligopoly tend to be very grey, these indexes help us decide what is what.

-Brandon

Game Theory in Action

With the Christmas shopping season coming up, I'm sure everyone's noticed businesses promising price matching guarantees, some even offering to beat a competitor's price by 10-20%.  Theses are sneaky little promises that not only are intended to attract customers, but serve as a threat to other businesses to not drop their prices.

Usually you see these promises from large companies in industries where there are few competitors, called an oligopoly.  The fact that the companies are talking about price change proves that they are not in a perfectly competitive market because in such everyone would accept the market price for the good; no one has the power to change their price without being under cut by the entire industry and being forced out of business.  But since oligopolies have a little market power, they can mess with the price and quantity a little and extract monopoly prices. 

Now, when there are very few companies in an industry, it is easier for them to (illegally) collude, i.e. talk to each other and agree to price their goods higher than normal, earning them more money.  Sometimes businesses don't have to explicitly communicate but rather see each other's prices and gauge their own off of those.  When the whole industry charges higher prices, especially for goods that we can't seem to do without, the suppliers in that industry make a lot more money.  If they sold their goods at lower prices, they'd make less money, and who wants less money??

The guarantees come in to play as a way to keep everyone selling at a higher price.  For instance, Lowes promises to beat any competitor's (Home Depot) price by 10% (as previously linked).  This means that if Home Depot wanted to sale grills at more of a market price (while Lowes was still charging a higher price, therefore stealing business from Lowes and earning tons of extra profit), Lowes would drop to below the new Home Depot price, thereby stealing their customers and putting a major hurt on their competitor.  Neither company would come out ahead in this situation, but Lowes would be minimizing the harm to its business while punishing their competitor for not charging the mutually beneficial higher prices.

You can go into tons of detail on this subject, known as game theory (Industrial Organization, an economics course, focuses on this. Check it out if you're an economics major!).  For the purposes of this website, it is just important to know that oligopolies that are colluding charge a higher that normal price and earn extra profit.  However, there's always an incentive to charge a lower price than your competitors and earn even more profit.  These price guarantees, however, serve as a threat to one another, promising to take down the high-price agreement and drive the industry into market-dictated lower prices with lower profits if one of the companies defect. Its an ingenious idea, offered as a promise of low prices to the consumer but as a promise of high prices to other businesses. Whoever thought up this idea definitely got paid well (and that's why you major in economics :) )

-Brandon

The Economics of Seinfeld

GCSU Alumni (Econ minor) Caroline Rentz alerted me and Brandon to this blog that uses Seinfeld episodes to demonstrate concepts of economics: http://www.yadayadayadaecon.com/

Moral Hazard in the NFL

This article provides a good example of moral hazard through the recent issue of concussions in the NFL.

Demand, Supply Rap

Learn some principles of economics in rap form. The only one I contend with is number 7. I understand this is intended to simplify things but a public choice/government failure line would have complete the song for me. Enjoy!

Invisible Victims

Great example of the unintened consequences of government action from Walter Williams.

Economic Mood Swing

Here's a funny picture that pretty much sums up the economy right now.

Economies of Scope Strikes Again

Another fine example of economics of scope:

http://failblog.org/2010/09/29/epic-fail-photos-business-juxtaposition-fail/

HT: Failblog.org

-Brandon

Do Airplanes Signal When They Merge?

It was reported today that Southwest Airlines is set to purchase its competitor AirTran for $1.4 billion.  Southwest is paying a 69% premium over the stock price of AirTran in the deal, which drove up the stock prices of both companies immensely when the merger was announced.

This type of merger is called a "Horizontal Merger," defined as the joining of two competing firms.  There's also two other kinds of mergers: Vertical (a company buys one of its suppliers, like Dell buying Intel) and Conglomerate (a business buys a company completely unrelated, such as Ford buying Coke-a-Cola).

The reason that such a horizontal merger may work is if there are economies of scale to be realized and if economic efficiency will increase.  Economies of scale means that the marginal cost of running one larger company would be cheaper than running two separate companies.  Think of it as having to pay only one CEO instead of two, they could by less airplanes, etc.

Economic efficiency refers to the merger's effect on society as a whole.  Because the two companies are coming together to form one larger firm, there will be one less company in the industry and the new firm will be that much closer to being a monopoly.  This will give it a little more control over prices and quantities, but not total control because there are still many other large airlines out there. Lets look at this amazing graph: (btw, this graph is just an illustration and does not represent gains or losses from this airline merger)

The area marked "A" is an income transfer from consumers to the new firm and doesn't matter very much.  The area we're interested in is are "B," which shows us the reduction in cost the new company will see due to the economies of scale. If the reduction in cost is larger than the dead-weight loss created by the merger, then creating the larger firm is better for society and increases economic efficiency. You can see here that area B is clearly larger than the dead-weight loss, so this merger is good for the economy.

Is the Southwest/TranAir merger good for the economy? I have no idea, that would take a lot of research and access to data only their upper-level management would have access to. But I make this promise: if an Eta Sigma Alpha student finds the right answer, you'll get 10 HSA points.

Here's a good article about the merger if you want to read more about the actual acquisition: http://bit.ly/cFjhrT