More Things That Drive Us Crazy Explained by Economics

Frustration image from BigStockPhoto

So, last week’s post was kind of a rant, getting something off my chest that was bugging me. At least you responded with some very intelligent comments and we had a productive discussion; that was very nice. Thank you, Cat Flaggers!

Still, I feel like after that, I wanted to follow up with something more fun and light-hearted. Then I remembered that you asked me for more posts about things that drive us crazy but are easily explained by economics. So, back by popular demand, here are some more things that businesses do that may make us lose our minds, but only makes perfect sense to them.

Why are there so many freaking types of potato chips? It’s now a whole aisle in the grocery store!

Potato Chip Aisle image from Wikimedia Commons

It seems like there is a new flavor of potato chip every month, and sometimes you just have to wonder why your favorite brand felt the need to produce “Honey BBQ and Jalapeño” or “Sardines and Peanut Butter” flavored chips. This also goes for breakfast cereals, candy bars, sodas, and a host of other products. There are just too many choices! How can you possibly figure out what to buy? It’s overwhelming!

Well, it turns out that there is a very simple reason manufacturers flood stores with seemingly unnecessary variety: Economies of Scope. The idea behind economies of scope is simple – it is cheaper for one firm to make multiple, related products than for multiple firms to do so.

This makes intuitive sense. If you have one company that makes, say, action figures, and another that makes dolls, then the two companies have to each buy or make their own plastic, pay for their own melting machines, make their own molds, operate their own assembly equipment in their own factories, ship the goods out in their own trucks, and so on. On the other hand, a company that makes both action figures and dolls will be able to use the same plastic, the same melting machines, the same assembly equipment, the same factories, and the same trucks for both toy lines. This is a huge cost savings!

This means companies have an incentive to produce as diverse of a product line as possible, so long as the products are closely related enough that they can be made with the same equipment. (This isn’t always as obvious as you think.  Yamaha makes both pianos and motorcycles – these products may seem unrelated, but actually they are made with very similar materials and technology.)

Now, let’s get back to our potato chip example. Let’s say Frito-Lay discovers that there is a market for coffee-flavored potato chips. It won’t cost them very much to use their existing potato-chip-making equipment to make coffee-flavored chips. Just produce something that flavors the chips, and you’re done! Meanwhile, some small, start-up brand that wants to specialize in coffee-flavored chips will be at a competitive disadvantage. They will need to pay for all-new equipment to make the chips, which means their chips will cost more. Frito-Lay can use its size to crush would-be competitors before they are able to even get up off the ground.

And remember, you might not buy the coffee-flavored chips, but someone else will. That’s what Frito-Lay is counting on.

Why are CEOs paid so much? The guy gets to make millions per year while his workers lose their jobs or take a pay cut!

It's awesome to be me!

It’s awesome to be me!

It never seems fair, does it? The CEO of a business gets to make hundreds of millions per year to sit in an office, make some phone calls, go golfing, sail around on his yacht, and show off his super-expensive watch and car. Meanwhile, the ordinary people who, you know, actually do the work get a puny paycheck and maybe some benefits if they are lucky. What’s worse, the CEO can raise his own salary while everyone else gets hosed.

It's almost enough to turn you against capitalism altogether.

It’s almost enough to turn you against capitalism altogether.

Except that is a totally inaccurate picture of what is really going on. First of all, CEOs don’t just sit around and show off how rich they are. They are actually really, really important to the whole company.

The CEO is basically the top manager of the whole company, a manager or managers, if you will. They must decide what the company does, how much money they will do it with, and who is responsible for actually doing it. Let me use the potato chip example from earlier. Did you know Frito-Lay is actually owned by Pepsi? It is. Now, who do you think made the decision for Pepsi to buy Frito-Lay, effectively turning a soft drink company into a soft drink and potato chip company? That was Pepsi’s CEO. And who do you think negotiated the merger? Frito-Lay’s CEO. And whose butts would have been on the line if the merger turned out to be a bad idea that lost both companies a lot of money? Those two CEOs.

The CEO decides what the company’s organization is going to look like, and has a huge role in setting the company’s culture. The CEO of Starbuck’s, for example, is responsible for making sure that every Starbuck’s around the world has the same basic “vibe” – the smooth jazz, the free wi-fi, the cozy feel, the funny names for their coffees. The CEO makes sure that when a customer walks into any Starbuck’s anywhere in the world, they know exactly what to expect.

The CEO hires the top executives that run the company on a day-to-day basis, tells them what to do, and holds them accountable when they don’t do it right. The CEO sets the company’s budget and decides what areas the company is going to invest in and what areas the company is going to drop or let whither on the vine.

In almost every case, if Mrs. Average Employee loses her job, the company can easily find somebody new to replace her. Replacing a CEO is far more difficult, because of the extreme responsibility that the CEO takes on. A good CEO can rake in huge profits for the firm, while a bad CEO can completely destroy a company. Just look at J.C. Penney to see the damage a bad CEO can do.

This means that the stockholders who actually own the company really need to make sure that the person they’ve hired does a good job. This is known as the “agency problem” – how do the stockholders know that the person they’ve hired as their new CEO will actually do a good job, and not just take his paycheck and bail? The best way to address this problem is to give the CEO a stake in how the company performs. The main way this is done is by giving something called “stock options” to CEOs, which in a nutshell make the CEO’s pay dependent on how well the company performs. If the company does well, the CEO’s pay goes up. If it does poorly, the CEO’s pay will go down.

That’s not to say the current system is perfect, though. As mentioned above, if the CEO lays off staff and cuts salaries, profits will go up, and the CEO’s pay will go up as a result. Furthermore, this system encourages CEOs to take huge risks that produce short-term profits, and then bail before the decisions they’ve made blow up in the company’s face. By doing so, they get to reap millions of dollars in rewards and leave the company they managed in an utter wreck, which serves nobody. Fortunately, stockholders of large companies are starting to take action. A wave of so-called “shareholder revolts” have been waged to rewrite the rules of how top executives are hired and paid, in the hopes of discouraging and preventing such behavior.

Gosh! It seems like every time they release a new Whatzit, a line of Whatzit fanboys will line up for days to get it. Don’t these people have a life?

Fanboy and ChumChum image from Fanpop

Now we’re going to diverge slightly from economics per se and enter into the realm of marketing. For decades, marketing, advertising, and business strategy were built around the idea that customers only had a transactional relationship with the companies they do business with. They have stuff. You want that stuff. You buy it, they make money, you have the stuff you wanted. Done and done.

But this purely functional model is gradually being replaced by a different model based on a radical idea – people actually form relationships with brands. Relationships that are in many ways similar to the relationships people have with other people.

It sounds crazy, but think about it. Many car enthusiasts identify with a particular car brand – Ford people and GM people, for instance. Luxury car buyers will often overlook or ignore a functionally superior product because “It’s not a Mercedes”. In technology, we have the same thing – are you a Mac or a PC? You’ll find Sony fanboys, “Nintendistas”, and hardcore Xbox fans in any gathering of video game players. Even restaurants aren’t immune – my grandfather was willing to drive all the way to another state to eat at Cracker Barrel.

From a marketer’s standpoint, this is a gold mine. People will go out of their way to get the brand they want, pay higher prices for it, be more willing to forgive mistakes or problems, and readily try out new products.

So, how does a company get these sorts of customers? Well, there are many ways, but a few things really stand out. Are the products good? Is customer service good? Does the company stand behind its products with a good warranty and a willingness to fix any problems with no hassle or drama? Are their premises neat and clean? When they call the company’s hotline, does a person or a machine pick up? Basically, these sorts of seemingly little things get people to lower their guard, and not be so worried about getting ripped off. They begin to trust the company, and feel like the company has their back.

Now that marketers know this, expect to see more companies trying to build and pander to a die-hard, loyal customer base. And yes, that means having to pass a long line of camped-out customers prior to any new product launch. Sorry.

All information from MBA classes I have been taking.

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One Response to More Things That Drive Us Crazy Explained by Economics

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

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