Tuesday, September 17, 2019

Price-fixing in competitive markets

The Economist points to the differences in trans-Atlantic prices in sandwiches and other lunch takeaways. 
In Britain lobster rolls cost £5.99 ($7.31); in America $9.99. In both countries they are filled with lobster from Maine, along with cucumber, mayonnaise and more. Rent and labour cost about the same in London as in downtown New York or Boston. Neither sticker price includes sales tax. Yet a Pret A Manger lobster roll in America is a third pricier than in Britain, even though the lobster comes from nearer by. This Pret price gap is not limited to lobster rolls. According to data gathered by The Economist on the dozen Pret sandwiches that are most similar in the two countries, the American ones cost on average 74% more... The lunch market is local. New Yorkers do not care about prices in London. And they—alongside Bostonians and Washingtonians—are used to their local high prices, for reasons that include bigger portions (though not at Pret) and tipping habits. Londoners are keener on sandwich lunches, which means stiffer competition in that part of the market.
There are two points for consideration.

1. Even in the age of globalisation, the law of one price is hardly a universal feature. Market characteristics are important determinants of pricing. It is important that we bear this in mind before suggesting trade and liberalisation as universal cures for all price 

2. More importantly, Econ 101 teaches that competitive markets lead to efficient price discovery, one which minimises rents. Alternatively, competitive markets are more or less free from rent-seeking. In other words, competition is the antidote to price manipulation. 

The presence of multiple providers deters price fixing (intensive margin). Then there is also the possibility of competition from new entrants if entry barriers are not prohibitive (extensive margin). 

But though the New York or Boston or Washington lunch markets are competitive (on both intensive and extensive margins), they seem to be immune from the dynamics of competition. Even with multiplicity of lunch providers, there seems to be implicit price fixing. Competitors are not creating competition! So what gives?

I am inclined to believe that information and differentiation are important contributors. In the canonical models of competitive markets, there are several providers. These providers operated under conditions of information asymmetry about competitors as well as the market itself. As the market consolidated into a few large chains, the information asymmetry naturally bridged. The plethora of market analyses too minimise information asymmetry. Competitors knew enough about each other and about their buyers and the market itself. The conditions for implicit collusion were created.

The differentiation of the market based the product offering was a further dampener on competitive forces. The number of providers in the market for each differentiated product was even smaller, whereas the buyers were self-selected captive customers. This further lowered information asymmetry. In fact, differentiation may have the dynamic of lowering competition in general. 

This about pricing decisions is fascinating,
Menu pricing starts with a simple rule, says John Buchanan of the consulting arm of Lettuce Entertain You Enterprises, a restaurant group: take the cost of ingredients and multiply by three. Then ask yourself how much customers would expect to pay for a dish of this type, and how much they would expect to pay for it from you. A Pret lobster roll and one from a fancy seafood restaurant are quite different propositions. Lastly, check what the competition charges. “Only a small part of this decision is what I would call scientific,” says Mr Buchanan. “A lot has to do with a subjective judgment of what the market will bear.

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