Comparison Shopping

Summer School

In the summer between my third grade and fourth grade years in elementary school, my mother returned to teaching. In order to prepare herself for developing a curriculum and practice creating and executing lesson plans, she gave me homework to do each morning before I could go outside and play. Yeah, it was kind of a drag.

There’s one lesson she taught me that has been perhaps the most valuable economics lesson I’ve ever received. I was given a list of groceries and was tasked to write down the prices at the two neighborhood supermarkets. The first store was pretty routine. I wrote down prices and my mother selectively picked out items and put them in the basket. I recall sulking a lot.

The big reveal came when we went to a second store, where my mother had already received the circular promoting the items on sale. We went to record the prices of the same items as the first store. Now I was the one asking the questions. Why does the same thing cost a different price at the second store? Why were we choosing name brands for some items and generic store brands for others?

My mind was still spinning when my mother took her pocketbook out of her purse. She proceeded to go thorough the cart and point out all the additional savings she’d secured by using coupons. Needless to say, we ended up saving a lot of money. Could I have the money we saved? No. I could not. At best I might have gotten a candy bar out of the deal.

Then we checked out, and the price was more than the sum of all the items. 'Hold up!' I remember thinking, 'They’re trying to rip us off!' Turns out some of the items were taxable. Soda cans in Michigan have a ten cent deposit. A quick reconciliation would show that we were indeed charged the right price.

The difference between the retail prices and the net cost of the goods after discounts taxes and deposit is an elementary example of the difference between gross and net prices, and it’s really all you need to know about similar economic terms like nominal prices and real prices if you substitute the notion of price adjustments for inflation, which I promise to cover in a future article.

Bulk Discounts

Large savings can be made with retail prices by buying in bulk. For instance, if you were to purchase your laundry detergent at the laundromat, you’d end up paying a markup somewhere in the neighborhood of 1,000% if you’d simply bought a big box or bottle of detergent at the supermarket. This is no accident. When you’re at the laundromat, your willingness to pay is tempered by the immediacy of your need. If you take the time to plan ahead and bring your own detergent, your succeptibility to price gouging is significantly lowered. The elasticity of prices and the willingness for a competitor to pay premiums on top of otherwise discounted goods speaks to the asset specificity of the detergent. The laundromat owner figures you’re there and believes that the price hike is justified given either the convenience of the overpriced detergent or the unwitting consumer’s inability to determine a “fair price” for the detergent. In effect, a fair price is just about anything anyone is willing to pay, and no matter how overblown the charge, each unique transaction reflects the market price.

Buying in bulk is arguably the easiest way to understand scale economies (AKA economies of scale). It’s also a very simple way to introduce the concept of cost accounting. Both ideas trace back to one of the most important innovations of the industrial age, the assembly line made famous by automobile pioneer Henry Ford. With the assembly line, Ford was able to capture the efficiencies of the most famous concept in economics, the division of labor. In his seminal treatise The Wealth of Nations, Adam Smith, the most important economist that has ever lived put to words the concept that would change the world. When an individual specializes in a particular facet of the production process (i.e. putting the lugnuts on a wheel), he’s able to produce at a much higher level than if they were to build an entire car all by himself.

As long as there are differences in the product offering, there are no perfect substitutes for the Ford Model T. There always remains a degree of market power in the hands of the seller insomuch as Ford can differentiate their cars from the other manufacturers’ offerings. This is no doubt factored into the sticker price of the automobile. The great efficiencies of the assembly line and division of labor allowed Ford to price their vehicle in the reach of average consumers and pay his workers $5 a day, an especially lucrative wage that was practically unheard of at the time. There were limits to Ford’s market power, evidenced by Ford’s own words, who boasted that the Model T was available in any color the consumer wanted, “...as long as it was black.”

The cost of production is lowered significants by the efficiencies created in improving the process by having individuals and teams specialize. That savings is used to create a cost advantage over competition with less efficient means of production. As competition increases, the bulk of those savings are realized by consumers in the form of lower prices. This is the purest form of efficiency. One of the only things all economists agree on is that efficiency is a good thing.

When products are available in large quantities, the price per unit is almost always lower. As long as the item in question is non-perishable, the savvy consumer will choose to stock up on the lower per unit package, so much as the storage of those non-perishable goods does not create costs for holding that household inventory.

The Willingness to Walk Away

The imbedded lesson here is that suppliers, producers, and retailers have wiggle room incorporated in their sticker prices. If you’re willing to ask, especially on big ticket items, typically salespeople are willing to cut you a deal. Sometimes all it takes is to ask, “Is that the best you can do?”

My professor at The Ohio State University literally wrote the book on negotiations.

Roy Lewicki and his co-writers have shown that by simply establishing a bottom line before engaging in a negotiation leads to more favorable outcomes for the consumer. The efficiencies created by competition can be captured by the consumer if only he’s willing to walk away when the switching costs between one supplier and another are sufficiently low enough. The point here is no small one. Competition lowers prices, but only to the degree that the consumer is willing to take his business elsewhere. If the threat to change suppliers isn’t credible, the place you’re standing at is likely to call your bluff.

The Ability to Walk Away

My friend Brian is a master of car shopping. When he looks for a new car, he takes a test drive, he finds out what he likes, and then goes home. He does his research. He sleeps on it. He decides exactly what he wants, and he decides what he’s going to pay for it. Then he writes several different car dealerships specifying exactly what he wants and what he’s willing to pay. He declines offers to travel to different dealerships and negotiate in person. He doesn’t want to talk to anyone on the phone. He takes the lowest written offer, and he always wins, hassle-free guaranteed.

This realization did not occur to Brian without some forethought and not without a few missteps along the way. In a particularly notorious example, Brian worked out a trade in on an old beat up car that was dying. It was dying, then it died. It died on the way to the dealership, so he needed a tow. He called the dealership and explained his situation. Understandably, his trade in value went from $1000 to $500.

He got a tow to the dealership, and suddenly the terms of his new car offer began to creep away from him. He was less enthused about the deal that was on the table, so he walked out the door. Then it hit him: He had no ride home. He tucked his tail between his legs and walked back in to sign the less-than-favorable deal. From that moment on, he never walked into a dealership until he had a deal in writing ahead of time. He helps his friends and family buy their cars, too, and he generally makes the world a better place.

The Meta of Manifest Destiny

I found myself writing this article in a hotel room in Grand Junction, Colorado in the midst of a cross-country trek to a job interview. I was on a tight schedule. My car broke down at a gas station that shared a parking lot at an EconoLodge... across the street from a car garage. Considering the vast wilderness between this point and my previous stop, the gods could not have smiled more favorably on the Ambidextrous Economist. When the garage opened the next day, they could have exercised their market power something fierce. Instead, the proprietor took mercy on me. I couldn’t exactly shop around. I was a price taker at that point. My car wasn’t going anywhere without the garage’s benevolence.

Instead of hammering me for the apparent asset specificity of my problem and my situation-dependent willingness to pay, they got my car on the road in 90 minutes, road-ready to handle the long stretch of desert wilderness ahead. Just because someone can charge you more for their services, it doesn’t mean they will. Why? It helped my cause quite a bit that I promised to write them a favorable online review. This brings about another aspect of the efficiencies inherent in the World Wide Web: The ability of consumers to stand up for themselves collectively, lowering the individual consumer’s monitoring costs for service providers' performance. This is the beauty of increased competition by a markedly visible hand. Efficiencies are created through the sharing of information. When previously market power and information asymmetries allowed automobile service stations to charge customers untenable amounts and create hold up problems, now there are checks and balances the savvy consumer can pull out of the ether.

AE - 08.31.2011

The Ambidextrous Economist will do you one better... ACT NOW and he'll toss in free shipping for your free question sent to AmbidextrousEconomist@gmail.com.