Sunday, 17 November 2013

Two part tariffs: PlayStation4 versus XBox One

Depending on where you live the Sony PlayStation4 is either available or will be soon. Microsoft's Xbox One will follow shortly. Reviewers argue over which is best in terms of graphics, controller and the like, but the general consensus seems to be that they are pretty similar. They are not, however, similar in price! The PlayStation4 is around $100 cheaper than the Xbox. Of course, making like for like comparisons on price is difficult because Microsoft are offering things Sony are not and vice-versa. But, even so it is interesting to explore why Sony might want to come in with a lower price.
      Let's start by supposing Sony has a monopoly - they are the only games console maker. Sony has to set a price to sell the console and a price to sell games. In the parlance of micro theory this is a two part tariff where the console is a fixed cost and the games are a user cost. To make the most money Sony should set the price of games equal to marginal cost and set the price of the console as high as possible. To illustrate, consider the figure below that shows the demand curve of a typical consumer. If the marginal cost of a game is $20 then the games should be sold at $20. That means the consumer will buy 10 games and have a provisional surplus equal to area ABC. This area amounts to $500. Sony, therefore, could charge $499 and extract the entire (less $1) surplus from the consumer. This is the way to maximise profit.

       Now suppose that there are two companies producing an identical product. Selling the console at $499 is unlikely to make much sense any more because Sony's rival can undercut. Ultimately, we would expect the price of the console to be driven down to marginal cost. For example, if the marginal cost of a console is $350 then that's where the price will end up. The average consumer will be $150 better off. Sony and Microsoft only make normal profit (included in marginal cost).
       So, why would it make sense for Sony to charge less than $350? One possibility is to try and recoup money lost on the console by charging more for the games. For example, suppose Sony charges $300 for a console and $40 for games. At a price of $40 the consumer will buy 8 games and have a provisional surplus equal to area CDE. This area amounts to $320. So, if the PlayStation is priced at $300 the consumer is seemingly happy because he gets a $20 surplus. Moreover, Sony is happy because the $50 lost on the console is recouped by the 8x20 = $160 profit from selling the games. Sony is able to make a supernormal profit of $110 per customer.
        The flaw in this plan is whether consumers will go for it. If the PlayStation is priced at $300 and the games at $40 we have seen the consumer gets surplus worth $20. If the Xbox is priced at $350 and the games at $20 the consumer makes surplus $150. The savvy consumer is obviously going to buy the Xbox. Sony's pricing strategy no longer looks so good. Indeed Microsoft could increase the price of the Xbox to $400 and still be the best deal. The key thing to realise here is that: a consumer should value a PlayStation less than the Xbox, even though they are identical products, because it is going to be more expensive to use the PlayStation. The difference in value is equal to area ABDE which is a pretty huge $180.The PlayStation is worth $180 less but only costs (in our example) $50 less.
         But are consumers that savvy? Clearly, the PlayStation looks the better deal if you focus only on the price of the console. My prior, and possibly that of Sony, is that customers will focus on the console price and not pay sufficient attention to the price of games. Basically, the consumer is not going to realise that the high price of the games makes the PlayStation worth less money. If the consumer does not pay enough attention to the price of games then Sony looks a clear winner. They get more customers because of the cheaper console, and they make supernormal profit because of the high price of the games! Not a bad strategy, if it works. 

Saturday, 9 November 2013

Reducing food waste: Time for a rethink?

A report published last week by the Waste and Resources Action Programme (Wrap) showed that British families are throwing away around £60 worth a food a month. This report comes hot on the heels of figures from supermarket giant Tesco showing it generated almost 30,000 tonnes of food waste in the first six months of the year. Apparently 68% of bagged salad ends up in the bin, and 20% of bananas. Clearly, this does not look like an efficient outcome. Which raises questions about why it happens and how we can stop it.
      To most the answers seems obvious - consumers are making biased choices and need help to stop doing so. For example, food journalist Joanna Blytham is quoted as saying consumers are being 'ripped off' by supermarket promotions: "What we could say to consumers is 'wise up' ..... The minute you walk into the supermarket you may be able to get a few bargains but, more likely than not, you'll be nudged into buying stuff you didn't really want or need and it will go in the bin." Consumers, therefore, are buying things they simply do not want. But are consumers really so dumb?
      Consider this quote from Wrap Chief Executive Dr Liz Goodwin: "Consumers are seriously worried about the cost of food and how it has increased over recent years. Yet, as Wrap's research shows, we are still wasting millions of tonnes and billions of pounds." If consumers are seriously worried about the price of food then they have a big incentive to cut waste. Moreover, given that most of us shop at least once a week, we also have plenty of chance to learn from our mistakes (if they really are mistakes). Indeed, waste has been cut dramatically over the last few years. Given the incentives and opportunities to reduce waste, the fact that much waste still remains suggests to me that this is not just about consumers making bad choices.
      In elaborating on this point the crucial thing to recognise is that buying a food is a choice with uncertainty. The family goes out shopping on Monday without knowing whether they will eat out on Wednesday, or what they will feel like eating on Thursday, or how hungry they will be on Friday. The task, therefore, is to choose a bundle of goods that is expected to keep everyone happy. The optimal bundle of goods should almost certainly involve buying food that will be wasted. To give an illustration: suppose you are going for a picnic in the countryside where there are no shops. You estimate what the family will likely eat. How much food do you take? Pretty much everyone (especially those with children) would take more than the estimate. Then you have more food if you need it. You also can have a bit more variety to satisfy your tastes.
      The savvy consumer will, therefore, generate food waste. If they always want to have enough food in the cupboard and they like variety they will buy more food than they probably need. This is the optimal thing to do! Ex-post they end up wasting food, but this is a fair price to pay for having what they want when they want it. And, as a society we are now rich enough to pay for what we want when we want it.       
     Personally, therefore, I think food waste is much more a reflection on consumer preferences than consumer bias. I think consumers knowingly buy more food than they will probably need. If I'm right then we may need to rethink how to tackle the 'problem' of food waste. In particular, the real culprit is uncertainty and not supermarket offers. We need to think, therefore, of ways to reduce uncertainty. This probably means we need to encourage consumers to shop more often, and to make stores more accessible. The big, once a week shop in an out-of-town supermarket is most likely to lead to waste. Regularly picking stuff up to eat on the way back home from work is least likely to lead to waste.
      Interestingly, over the last decade Britain has seen a surge in the number of supermarkets opening small stores in town centres, rail stations etc. In other words, food shopping has become easier and more accessible. I wonder whether that has anything to do with the fall in food waste that we have seen in recent years?     

Saturday, 2 November 2013

Tea party and UKIP: What happened to the median voter theorem?

The median voter theorem is a workhorse of public choice and helps make sense of political manoeuvrings. Informally, the theorem says that if preferences are single peaked then the median voter will be on the winnings side of any majority vote. To say that preferences are single peaked essentially means that the vote is on a 'one dimensional issue' whereby that the closer is the outcome to a person's ideal then the happier they are. This naturally lends itself to talking of left wing, right wing and the centre ground. The median voter is then the person in the middle. And that is why the median voter will always be on the winning side: If the median voter prefers the 'left wing' option then the median voter and everyone to the left will vote for that option and it has a majority. Similarly, If the median voter prefers the 'right wing' option then the median voter and everyone to the right will vote for that option and it has a majority.
      If the median voter will always be on the winning side then political parties are naturally going to compete for the median voter. The median voter theorem is, therefore, very useful in making sense of the two party system that we have in countries like the US and UK. It tells us why the median voter is where the real action is always going to be: this is the vote politicians are competing for. And it also helps us understand why the 'centre ground' shifts over time as the preferences of the median voter evolve.
       Recent events, however, seem to cast doubt on the application of the median voter theorem. In the US we have the unyielding influence of the Tea Party wing of the Republican party. In the UK we have the emergence of the UK Independence Party as a political force. In both cases there is a clear pull towards the right wing: this is a battle far from the centre ground where we would expect to find the median voter. So what is going in? Interestingly, I think we can trace two slightly different explanations for this lurch to the right in the US compared to the UK.
        Looking to the US first: I see the Tea Party as essentially an attempt to move the centre ground to the right. The preferences of voters are clearly not fixed in stone and so an attempt to move the centre ground is not a completely dumb thing to do (if you are at the extremes of the political spectrum). But, it is political suicide from the perspective of the Republican Party because it leaves the centre ground wide open for the Democrats. And, herein lies the big flaw in the Tea Party's approach: the party in power has a lot more leverage to put their view across and move the centre ground. So, the Republicans are probably going to lose on both counts - no power and no shift to the right in the centre ground. The deal that concluded the recent government shutdown seems to illustrate the point nicely. The median voter theorem, therefore, is fine - it is just some in the Republican Party could do with being told about it!
       What about the UK. Here, I do not see much attempt to move the centre ground. Instead I just see general disillusionment in politics. The median voter theorem offers a good explanation for this. Basically, while political parties fight over the median voter everyone else can feel a little disenfranchised. Those to the more extreme right and left will feel most frustrated that 'no one gives them what they want'. This leaves the way open for protest votes such as those currently going to UKIP. I say protest vote on the basis that UKIP has no realistic chance of getting power. Note, however, that if a chunk of the electorate from the right wing of the political spectrum is going to vote for a party with no chance of winning then the 'electoral' centre ground moves to the left. Voters of UKIP, thus, face trading off a vote for something they believe in for an outcome even more removed from what they want. Come election day I have a feeling the UK public will ditch UKIP and the median voter theorem will prove its worth again. But, only time will tell.