by Robert Litan
Before beginning the chapters in this part, some readers may be tempted to ask a different, but important question: If the economic ideas surveyed in this book are so good and valuable, why are economists even necessary to think them up? One answer, which economists trained in the University of Chicago’s Department of Economics would give, is that ordinary people are smart enough to figure out by themselves the good ideas they need to make money and they don’t need to consult economists to help them to do it. Firms and their customers know what’s in their best interest or act as if they know. That’s a good answer for a lot of ideas, but I also believe an incomplete one.
Not everyone who has no economic training, or who hasn’t read or hired someone with this background, came to every idea laid out in this part on their own, nor could they be expected to. That would be like saying that ordinary people, without training in science, could be expected to come up with all of the discoveries that scientists in all kinds of disciplines have made over the centuries. To believe this to be true reminds me of the old joke about what an economist, presumably one trained in free market economics at Chicago, said when he or she was told there was a $20 bill on the sidewalk: “No, that can’t be, because if it was there it already would have been picked up.”
But we all know there are plenty of $20 bills, some even larger than that, that are left on sidewalks all the time, just as there are ideas remaining to be discovered, or at least widely implemented, in both the physical and social sciences (and many economists think they are leaders of the pack among social scientists). You will find some of those ideas in the remaining chapters of this book, beginning with the chapters in this part.
Chapter 3
The Price Is Right
One of the earliest television shows I watched as a young child was The Price Is Right, hosted for many years by Bob Barker. I loved the show so much that occasionally I would feign illness to stay home from school (exactly how will remain a secret) to watch.
At this writing the show is still on and I suspect it will remain a television staple for years to come. There may be a few readers of this book who haven’t seen The Price Is Right, but for those who haven’t, the format is quite simple. Three contestants are chosen from the audience to participate in a two-round contest in which they are shown various items and asked to guess the price of each. A key rule is that a contestant automatically loses if the price is too high, but the contestant closest to the right answer on the low side wins a prize. The prizes are larger in the second round than in the first, and typically the winner from the first two rounds plays a guessing game one final time, by themselves, for one large prize.
Ask people in business and they’ll tell you that after coming up with a product or service to sell—a task whose difficulty I do not want to understate—the first decision they must make is to figure out what price to charge. They are like the Price Is Right contestants, with one big difference: When businesses set prices it is not a game; it can be a (business) life or death decision. As one of the most respected and thoughtful entrepreneurs I’ve met, Norm Brodsky (with his coauthor Bo Burlingham) has underscored in the best popular book I’ve ever read about entrepreneurship, Street Smarts, it’s much easier to lower prices on things that aren’t selling than to raise them even if they are.1
That is because when businesses set a price, they are setting customers’ expectations about the nature of the product or service. Is this a luxury item, in which case a higher price can act like a status symbol? Or is this a product or service very similar to many others in the marketplace where customers carefully compare prices on comparable items, something that is far easier to do in this age of the Internet than ever before? If all consumers need to do is check their phone or their personal computer, or go to a search engine and find the best price at the most convenient location or by ordering online, then you’d better set price at or below the market if you want sales. In either event, unless prices for all goods and services are rapidly rising, prices tend to be sticky, so getting to the right price quickly, in most markets, is important.2
Of course, if you’re selling something that already is well known, the market—the combined interactions of lots of buyers and sellers—will reveal the price, and that’s what you’ll charge. Actually, you may set the price at a slightly lower level if you think you can capture more sales that way. Or perhaps you’ll charge a bit more, if you can differentiate your product or service with a little something extra that no one else, or perhaps only a few of your competitors, is offering.
What happens if you are an entrepreneur or an executive at an established firm introducing a new product or service? How do you know what to charge for something that hasn’t been tried yet?
Here’s what the economics textbooks will tell you, which often is not enough, or is at least less than satisfying. At a minimum, you will want to charge enough to cover at least the costs of manufacturing, or what economists (and accountants) call short-run variable or marginal costs. These are the costs associated with selling just the extra one or perhaps several items. Examples include the materials that go into making a product, but maybe not much else, not even the cost of workers. In the very short run, employers won’t change their workforce to make one more or less widget or to see one more or one less customer. Over a bit longer run, labor costs are variable, and so it may be appropriate to allocate the average amount of additional labor required to produce an extra item to the variable cost side of the ledger.
Of course, if all you’re doing is trying to cover your marginal costs, you won’t stay in business very long, because to get it started, you or any business typically had to lay out money for fixed costs—rent, equipment, and so forth. Plus, if you’re really being rational, you’ll want to count as a fixed cost the “cost of capital” or what you and other funders (friends, family, angel investors, or in the rare case, venture capitalists) expect to earn on their investments, given the amount of risk involved (I’m not counting bank debt as a source of funds, unless your business is well established and it has access to a bank loan; many entrepreneurs use mortgage or credit card financing, but are not in a position to get an ordinary commercial loan unless they pledge personal assets to secure it).
So, ideally, you’ll want to charge a high enough price to generate a return on capital, after covering variable and fixed costs. You won’t know what the price is, however, unless you also make some projections about the amount you hope to sell—the number of widgets, or the number of customers or clients (in case you’re in the service business)—over some reasonable period of time. Add up all the costs, divide the volume expected, and you’ll have the cost per unit, and hence the price. Sounds easy, until you begin the guesswork of how well your product or service will sell, something you may not know for a long time. That’s why the best you can do is price by trial and error, or you can fix a price and add more value to the product or service over time and hopefully convince customers to buy it.
The latter strategy is one that Michael Bloomberg and his company has used to price its service, financial information. Bloomberg didn’t consult an economist about the strategy, but over time he found it really worked. I start with his example, even though it runs counter to the central objective of this book: to convince you how important economists are or can be. The story introduces a degree of humbleness that economists should have but often don’t.
The Bloomberg Way of Pricing
Even if I hadn’t gone to work at a Bloomberg company, I would not have hesitated to call Michael Bloomberg and the company he and his colleagues built a true American success story. Born to a middle class family in Massachusetts, Bloomberg went to college at Johns Hopkins (a school he had barely heard of in high school), studied engineering, and had a very successful career at Salomon Brothers trading bonds until, at the age of 39, he was unexpectedly and summarily let go in the wake of a company reorganization.
Though he left the company with $10 million, surely enoug
h for most anyone to retire on, Bloomberg had other ideas and ambitions. From his experience as a bond trader, he knew how opaque that market was—there was (and still is) no equivalent of a New York Stock Exchange or NASDAQ for bonds—so anyone who wanted to buy and sell bonds had to get their quotes and complete their trades through intermediaries like Salomon. In the language of economics, this was a market imperfection that Bloomberg realized could be fixed in a profitable way.
He did so by building what has become known as the Bloomberg terminal, which, in the days before the Internet, was a personal computer-like device with limited capabilities that was connected through a private line into a data center that provided up-to-date feeds of bond quotes. Over time, thousands of additional features—in the forms of commands—were added to the offering, including quotes and offers on an expanding array of financial instruments (equities, derivatives, and foreign exchange) and increasingly sophisticated analytic tools (such as the Black-Scholes-Merton options pricing formula, which is discussed in Chapter 8).3
The strongest markets for the Bloomberg terminal are financial traders, in commercial and investment banks, and institutional buyers of securities and financial information. Along the way, Bloomberg realized that quotes and prices of financial instruments were not enough: It would be critical to add a financial news operation to the offering, since traders wanted not only the prices but the information that induced markets to change the prices of these instruments. Over time, under the direction of its founder, Matt Winkler, Bloomberg News became one of the leading sources for news of any kind in the world.
One other important feature of the Bloomberg terminal makes it a very valuable feature for customers: the chat function. Invented before instant messaging became a big hit outside the financial world, Bloomberg discovered, largely by accident, that traders valued the short bursts of characters Twitter users (who came much later) would recognize as abbreviated tweets that the terminal would transmit in real time between traders and other terminal subscribers.
I mention this brief history without noting price. It was and remains a fundamental philosophy of the company that the price of the terminals does not vary from customer to customer—there are no discounts, except for nonprofit universities and for purchasers of more than one terminal. The one-price policy was meant to provide simplicity for the company’s sales force, and also to let all customers know they were getting the same deal and no one else was getting a special one.
Bloomberg has also charted a different technological path. In an age when virtually all information services providers, in any field, offer their customers data and information through the Internet, housed increasingly in the cloud, from its start the main Bloomberg terminal (unlike some of Bloomberg’s other recently acquired or launched vertical businesses) has continued to provide data, analysis, tools, and chat services through dedicated private communications lines accessed through proprietary terminals on a subscription basis. This has turned out to be an advantage in the age of cyber threats, relative to individual websites and even to companies relying on the cloud. In addition, even with rapid broadband connections, there is some latency (or lags) in Internet responses. Fast responses to commands over private dedicated networks give Bloomberg terminals an important advantage in the world of financial transactions, where milliseconds count.
The importance of these various non-price means of competition appears, at least on the surface, to violate one of the first rules about market economies elaborated in the second chapter—the centrality of price signals in a market economy. On closer inspection, however, this is not the case.
That is because while the nominal price of the Bloomberg terminal essentially has remained flat in real (or inflation-adjusted) terms, its services (and those of its subsidiaries, or verticals) are continuously augmented with new information and functions. This means that the quality adjusted prices of the Bloomberg offerings decline over time, an approach that is central to the company’s efforts to differentiate itself from its competitors. My personal experience with a Bloomberg business reinforces this lesson, and also demonstrates how ideas with economic content can be thought up and implemented without a lot of formal economic training.
It’s now time to evaluate cases where this isn’t always true, where economists and their ideas have had a much more direct causal impact on how businesses have developed and prospered. In particular, I want to focus on the surprisingly large number of transactions in the modern U.S. economy that are based on a very different type of mechanism for setting prices: some variation of an auction.
Auctions
Auctions as a means of setting prices and allocating ownership have a long history. Auctions were used as early as 500 B.C. in a way that would be considered abhorrent today: selling women as wives. Auctions also were used in Roman times for selling off war plunder. In America, Pilgrims auctioned off crops, livestock, slaves, and even entire farms. Even today, individuals and lenders routinely use auctions to sell property, while upscale auction houses sell collectibles.4
A common theme runs through these uses: Most of them tend to be for items in limited supply and thus are unique. But auctions were also used for fungible financial instruments, such as shares of stock, which until relatively recently were sold on the floors of exchanges through what was called the open-outcry system. A single auctioneer, namely the specialist, would match multiple buyers and sellers on a running basis throughout the trading day, with prices moving up or down depending on the balance of purchase and sale orders. Today, as noted in Chapter 1 and discussed in more detail in Chapter 12, all but the very largest buy and sell orders for stocks are matched electronically by computers, while futures and options contracts (to be discussed in more detail in Chapter 8) are still sold and bought by human beings.
Outside of these seemingly unusual contexts, one wouldn’t think of auctions as being the standard mechanism for setting prices in any economy. Nonetheless, one pioneering economist (more accurately, a mathematician) in the nineteenth century, Leon Walras, imagined the prices of all the goods (he wasn’t thinking about services) traded in the economy being set through a series of hypothetical auctions. Walras calculated that economies would be in equilibrium when prices of all goods had iterated, through an auction-like procedure, to their market-clearing prices, or the highest price at which all goods offered would be sold. To this day, many economics textbooks and journal articles reference the Walrasian auctioneer in some fashion.
It turns out, however, that the best-known auction system—where items for sale are sold at the highest prices—is only one of many different types of auctions discussed in the economic literature that have found their way into actual use. Moreover, with the introduction and increasing popularity of the Internet, the costs of conducting auctions have gone down dramatically, so auctions are now used in many more contexts.
In much of the rest of this chapter, I describe different types of auctions, how they came to be, and how a number of them are now the pricing method of choice in a number of markets. Chapter 11 expands on auctions, in a very different setting—where a government entity requires the use of an auction because it is the most efficient way to allocate a limited resource (for example, the electromagnetic spectrum) while earning revenues for the government.
Airline Seats
In this age of constant, though often irritating (but cheaper) air travel, I’ll bet this has happened to you at least once. You arrive at the gate for your flight and are about to begin the boarding process, and then one of the attendants announces that all of the seats for the flight have been sold and he or she begins offering travel vouchers for future flights so the airline can get excess travelers off the plane. The vouchers go quickly and often for not much money if there are more takers than slots available, but I’ve been on flights, and I’ll bet you have too, where the gate attendants have raised the voucher price until all the seats are reassigned.
The auction itself seems like such a natu
ral way to clear the market in airline reservations, but it actually is a relatively recent practice, dating from the late 1970s when American Airlines first introduced the idea, after receiving a green light from the agency that used to regulate airline fares, the Civil Aeronautics Board (CAB). Before then, airlines randomly bumped passengers on overbooked flights, and in the process generated a lot of ill will. To avoid that outcome, airlines deliberately did not fill their planes and thus flew with less capacity than they do now, a circumstance that made customers more comfortable, but reduced profits for the airlines. To compensate, airlines had to raise prices higher than they otherwise would be to cover the cost of partially empty planes.
If you’ve read this far, you’ve already guessed where the airlines got the idea for auctioning overbooked flights—yes, from an economist. Actually, any economist could have told them to do this, but it took a bold one, Julian Simon, to raise and actually push the idea, and another economist to allow the airlines to implement it.5
