Things that Drive us Crazy – Explained by Economics!

Screamer image from Deposit Photo

It seems like sometimes businesses around the world are conspiring to see how long it takes to make their customers scream, with maddening practices and outrageous prices. Except it turns out that these businesses are only doing what makes economic sense for them to do.

Now that I’ve finished the first quarter of my MBA program, I can say with confidence that there are very good reasons that businesses behave the way they do, even if they drive the rest of us crazy. Here are just a few of the things I’ve learned in my classes so far.

Why do cable and satellite TV companies force me to buy 8,000 channels if I only ever watch six?

HDTV image from 123RF

Right now, on Sunday I will watch NFL football on Fox, CBS, and NBC and sometimes Mythbusters on the Discovery Channel. On Mondays I will watch Top Gear on BBC America. The rest of the week, I will sometimes watch NBA basketball  on ESPN or TNT, and the rest of my TV viewing time is spent on the Discovery Channel, the National Geographic Channel,  H2, BBC America, the Military Channel, the Science Channel, and occasional peeks at what’s on HBO or AMC. So, I could get by with just 13 channels. Besides, I don’t watch TV as regularly as I used to, anyway; I spend far more time every day on YouTube. Yet cable companies don’t let us pick our channel a la carte, do they? We have to buy hundreds and hundreds of channels all bundled together. What is going on? It turns out that there is an economic reason for this plan, and like almost all of the things I’m going to talk about, it has to do with maximizing profits.

First, there is a concept in economics called “willingness to pay” (WTP). It is, literally, how much a consumer is willing to pay for a product. Everybody has their own WTP – you might be willing to pay $15 for a product, but someone else wouldn’t touch it for more than $5, and yet another customer might be willing to shell out $25 for that same product! Companies know this, and they accept that for any price they set, they will lose some customers because the product is too expensive for them, while other customers will think they’ve bought a bargain. That “bargain” – the difference between a customer’s WTP and the price they actually paid – is called “consumer surplus”.

And companies hate that knowledge. All companies want to maximize their profits, and the ideal way to do that is to charge every customer their exact individual WTP. That way, everybody buys, and nobody walks away with a consumer surplus because the company has taken all of their customers’ offered money. Unless you are one of those creepy companies that monitors every online purchase that everyone makes, there is just no way to do this in the real world. So, companies must do the next-best thing, and try to find ways to extract as much consumer surplus out of their customers as possible.

My money! Mine!

My money! Mine!

So, to use an example from my economics class, let’s say a cable company had 1,000 customers. Let’s say 400 of these customers would be willing to pay $20 for the Discovery Channel and $2 for VH1, while 600 customers would be willing to pay $11 for Discovery and $10 for VH1. If the cable company charged for channels a la carte, they would end up charging everybody $11 for Discovery (which everyone would buy) and $10 for VH1 (which only 600 customers would buy), earning a total of $17000.

OR… they can bundle the two channels together for $21. Everyone would buy the bundle, because they are all getting both channels either at or below what they would be willing to pay for the two channels individually. The company would then make $21,000!

Of course, this was a severe simplification – the real picture would look very different. Even so, the basic idea remains the same, by forcing you to buy a whole bunch of channels you don’t really want in order to get the few you do, the cable company is actually earning more money per customer than if they sold channels individually.

I just paid $60 for my Whatzit. Why do I now have to pay a whole bunch of hidden fees to use it?

Frustration image from BigStockPhoto

Again, Whatzit Corp. is just trying to suck up your consumer surplus… they’re just doing it in a far more direct way.

So, the trick here is that Whatzit Corp. actually sold you their product at cost. They made a grand total of exactly $0 on your purchase. But that’s just fine by them, because they know that now you are going to have to pay their fees, and it is in the fees where they will make their money.

Pictured: Hidden fees.

Pictured: Hidden fees.

In fact, if the company is smart, the amount of the hidden fees will be as exactly equal as possible to the consumer surplus of an average customer. There is some math involved in calculating this, and it assumes the company has a good idea of its customers’ behavior, but it is not an arbitrary number.

Product A and Product B are pretty much identical, so I was going to buy the cheapest. But they cost exactly the same! What’s going on?

Nook vs Kindle image from Gadget Review

Think about this from the point of view of the makers of products A and B. If both products start out at, say, $200, then Product A could cut its price to $190 and everybody would buy Product A. Then, if Product B lowered its price to $180, everybody would buy Product B. These two companies would be engaging in a “price war”, with each one trying to capture more customers by being the cheaper product.

There are two ways this scenario can work itself out. In a Bertrand-type situation, the two companies just keep cutting prices until they can cut no further, i.e. selling both products at exactly what it costs to make them. This situation benefits customers, because it guarantees the cheapest price. From the company’s point of view, though, this situation is terrible because nobody is making a profit.

The more common outcome, then, is a Cournot-type situation, where both companies decide to control how much of the product they manufacture. By the laws of supply and demand, this will mean that the price of the two products will be based on how many of these products are actually available for purchase. The amount of Product A that is placed on the market will be based on how much Product B is made, and vice-versa.

Of course, actual collaboration between the makers of Product A and Product B is illegal under U.S. law. It is also, however, economically unsustainable. If the makers of Product A and Product B agree to fix the amount of each that is put in production in order to give everyone the maximum price, the temptation is really, really strong for Product B to decide to cheat and cut its price just a little, netting it a huge increase in sales. Then Product A will retaliate and cut its price, starting the price war all over again.

It turns out, thanks to a useful mathematical model known as Game Theory, we can figure out how much of Product A and Product B the two firms will produce in a Cournot-type situation, and how much money each firm would make. It turns out the two companies would make less than they would if they tried an illegal collusion, but far more than the nothing they would earn in the Bertrand-type situation.

Why are gas prices always so high? Don’t they realize what an impact this is having on the economy? And my wallet?

Gas Prices image from Brother Peacemaker

Let me introduce you to an economic concept called “elasticity”.

Not that kind of elasticity!

Not that kind of elasticity!

If you make a product, and you lower the price on that product, you will gain more sales but will be making less on each sale. If you raise the price, you will lose sales, but you will gain more money per sale. Is it better to raise or lower prices, or keep them the same? How can you tell?

It turns out, economists have developed a measure for just this type of situation: elasticity. If a small change in your price creates a huge change in the demand for your product, that is said to be “elastic”. In this situation, it is better to lower your prices and attract as many customers as possible. If a large change in your price has almost no impact on the demand for your product, that is said to be “inelastic”. In this situation, it is better to raise your prices because you won’t lose many customers and you will more than make up for your losses in the increased profits per sale.

As you might have guessed, gasoline is very inelastic. Everybody depends on it, there aren’t very many good substitutes, and while you might drive less when gas prices go up it is a very rare person who will give up driving entirely. Oil companies can keep raising gas prices and raising gas prices and there is not a thing we can really do about it.

Of course, there are other essentials to daily life in the modern age – electricity, running water, telephone service, and so on. These “utilities” are extremely inelastic, which is why the government steps in an places strict rules on providers of these utilities to keep them from raising prices on all of us indefinitely. Yet gasoline and oil have never been deemed worthy of this level of regulation by the U.S. government. So, the prices just keep climbing and we keep devoting more and more of our income to paying them.

And speaking of rising prices…

I just got my bill from the hospital. What the heck?

Hospital bill image from The Accounting Student

If you think gasoline is inelastic, let me introduce you the medical industry. Prescription medications and medical procedures are as close as we have come to a “perfectly inelastic” pricing situation. You don’t really have an alternative to purchasing these products, except maybe dying. So pharmaceutical companies can get away with things like a 1200% price increase.

The only defense against these high prices is to buy health insurance or participate in government-run programs like Medicare and MediCal, in order to pool your costs with everyone else who participates in these programs. Many countries have gone so far as to set up a nationwide single-payer insurance plan that covers every citizen in order to further spread the costs so each individual patient pays less. (Though there are weaknesses to the single-payer system, too. I’m not going to go into all the ins and outs of the health care industry and my own opinions on them here; that would take at least two whole blog posts.)

Developing new medicines and medical procedures is expensive, and that research has to be paid for somehow. Otherwise, the company will not earn a profit and go out of business, which doesn’t benefit any patient. So, it looks like for the time being, we’re just stuck with high medical bills.

Taking MBA classes has opened my eyes to a whole new way of looking at things. Learning why businesses do what they do has helped explain so many of these otherwise perplexing situations.

Information from my Managerial Economics class.

3 Responses to Things that Drive us Crazy – Explained by Economics!

  1. Steve G. says:

    Econ 101 – nicely done. And, as I write this, you have a perfect 100% agreement amongst all voters (i.e. me) that we’d like to see more of these type of posts. 🙂

  2. Pingback: More Things That Drive Us Crazy Explained by Economics « Cat Flag

  3. Pingback: Even More Things That Drive Us Crazy (Explained by Economics) | Cat Flag

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: