Jan 11, 2016

Microeconomics – Scarcity, Price Targeting, and Sandwich Shops in the Mother City


On a cold, winters day at the Waterfront you can buy a flat white and sip away at its frothy goodness as you gaze up at the slopes, peaks and wispy trimmings of Table Mountain. Everywhere you look you will see the principles of Microeconomics at work: merchants in possession of scarce resources using the forces of supply and demand to exploit the scarcity they command, flogging their wares onto wide-eyed tourists. However, the most obvious example of this economic idea of scarcity is found in the form of the mountain that towers above.

There is only one Table Mountain. There is also only one restaurant on the top of mountain, only one curio shop selling its wares, and one cableway to transport you from the base to the peak. There is only one V&A Waterfront, and only some of the restaurants located there have a view of the mountain. While many businesses in Cape Town command some of the scarcity power provided by the mountain (whether it be because they are located on the mountain itself, because they offer a view of the mountain, or simply because they are based in Cape Town – the city of the mountain), the question all of them are asking is this: how can we best convert this ‘scarcity’ into profits?

Generally the more scarce a commodity or resource, the more people are willing to pay to have it (given demand is constant). For example, imagine that on top of Table Mountain there existed a single, lonely sandwich shop. After a long hike up, you and your friends are faced with only one way to replenish your lost kilojoules: the last sandwich left in stock inside the only sandwich shop on the mountain. In that moment, each of you might be willing pay the shop owner a small fortune to have that sandwich all to yourself. Now imagine instead there are four or five sandwich shops around on the mountain, each with many sandwiches available for sale. Sandwiches are no longer scarce, you are instead faced with choice (or in fact, many choices), and you will likely be willing to pay far less for any given sandwich that you would have in the previous scenario.

But, even if you owned the only sandwich shop on Table Mountain, commanding all the scarcity power on the top of Table Mountain, and thus had the potential to charge inflated prices, the question would remain: what should you charge for a sarmie? You could raise the price of a sandwich from the standard R35 to an exorbitant R100. Some people would buy the sandwich, but many other people might not – and will choose to go hungry instead. On the other hand, you could set the price of each sandwich at R15, and sell many more sandwiches than you would have at the standard price – taking advantage of the hordes of tourists summiting the mountain. But, even if you cover costs, you will likely need to multiply your sales significantly to make up for the loss in revenue per sandwich. You therefore face what seems to be some sort of catch-22: bring in lower revenue per sandwich, but sell more sandwiches; or make more revenue on each sandwich, and sell fewer sandwiches.

In a more perfect world, a business would make the most of its scarcity power by charging each customer as much as they are willing to pay. However, in the real world, there is a lack of information about what people are actually willing to pay. It would be great if a sandwich shop owner could charge R20 to people who are not willing to pay much, R30 to the people who are willing to pay a bit more, and R100 to people who are starving and desperate for a sandwich. This way, the shop owner could sell to anyone vaguely interested in a sandwich, and extract the highest possible margin from each person – whether they are big-spenders or misers. But in reality, this won’t work, will it? It’s not like you could put up a price list which says: “Sandwich at R100 – if you’re willing to pay that much. But R30 if you’re not going to buy it at R100”! Luckily, there are ways in which this can be achieved, and in Microeconomics we tend to refer to such strategies as “price discrimination”.

The first type of price discrimination is what is often referred to as “first-degree price discrimination”. This strategy is similar to the example mentioned in the paragraph above: you try to understand each customer and charge them each as much as they are willing to pay. This strategy is stereotypically employed by estate agents and used-car salesman, and usually requires either a lot of skill or a lot of effort, or both. It is therefore most often used to sell items that have a high value relative to the seller’s time – such as houses, art, cars, or also even the odd-bin trinkets sold by street merchants around Cape Town, where these merchants find it worth their time to bargain with tourists. On the other hand, this strategy is not often used to retail items with low value, and would not very likely be an efficient strategy for a sandwich shop owner, or any other food retailer for that matter.

The second type of price discrimination, and perhaps a more common strategy, is group targeting – or “third degree price discrimination”. This is where you offer different prices to members of identifiable groups. A strategy which sets different prices for every person, and charges people the maximum price they are willing to pay, somehow seems a bit unfair, unkind and unreasonable – and unlikely to be successful. However, for some reason, people seem quite at ease when restaurants charge reduced prices for children and pensioners; and it also seems reasonable for tourist attractions to charge locals a lower fee. While we may think this is acceptable because people in groups who pay more are often those who can afford to pay more – we should not for a moment begin to believe this is why they are charged more. Most companies don’t make decisions about pricing because they believe it to be fair or just. Companies instead try to increase their profits and get the maximum value out of their scarcity. They are therefore not interested in who can afford to pay more, but rather who is willing to pay more. For example, when the SAN Parks offers admission discounts at Cape Point for locals, they’re not doing this because they believe the Cape residents to be in a degree of financial turmoil and it is only fair to help them out. They simply know that at a lower price, locals are more likely to come regularly, but once in Cape Town, a tourist is likely to visit Cape Point, regardless of whether the price is high or low.

One of the key ideas behind price discrimination is a concept referred to by economists as price elasticity, or price sensitivity. Price elasticity is a way of talking about how sensitive sales quantities are to changes in price, or, in other words: when we raise (or lower) the price, by how much do our sales fall (or rise)? Tourists visiting Cape Town are less price-sensitive than the locals. This means that if National Parks or the Cableway raise admission prices, locals are more likely to skip a visit to the attraction. At the same time, if the admission price falls, locals are also more likely to visit more than once. The same is true of discounts at coffee shops for locals. Many coffee shops in the Cape Town CBD will offer you a free flat white after every ten purchases – ultimately giving you slightly less than a 10 percent discount on each cup. This is not because coffee shops believe locals (or rather, their regular customers) are poor: the discount instead reflects their price-sensitivity (which may or may not be related to their wealth). Tourists who are new to Cape Town, and here for only a short period, may see only one or two coffee shops and will likely be willing to pay a high price for convenience. Locals, however, will pop out of work at 11am every day, and could walk in any direction to find a coffee. They can buy from several cafés, all of which they are familiar with, all of which are somewhat convenient, and all of which they might enjoy to varying degrees. And they will consequently be far more price-sensitive than tourists, even if they are not poor.

So, in case we’ve lost you along the way, let’s wrap this all up with a brief summary. Scarcity is for sale – the higher the scarcity, the higher the price. However, the same level of scarcity can generate very different levels of profits for your business, depending on which pricing strategy you use. First degree price discrimination is difficult, in part because it requires a lot of information and also because it can be quite unpopular. However, because of its profitability, many businesses still find it worth their while to give it a go. On the other hand, second degree price discrimination – typified by the discounts offered to pensioners, children, or locals – is less profitable, but is far easier to use, and generally quite socially acceptable. There are also a multitude of other price-targeting techniques that combine the best aspects of these two approaches, and are thus often more effective than either pure strategy.

So, if your company is trying to exploit its scarcity power, whether you are a bustling sandwich shop in the CBD, an ill-frequented tourist attraction, an expanding online retailer, or something else entirely, you can be sure that there is a price-targeting strategy that can be used to increase your profits. These principles are rooted at the heart of Microeconomics, and are some of the core tools that GMT+ uses to transform the businesses of the people we partner with.

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*Adapted from Tim Harford’s – The Undercover Economist