Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (4 page)

To conclude, although consumers may feel that they’re being ripped off when they see gas prices spike after a hurricane or realize that drugs are being sold far cheaper in foreign countries, there are in fact very subtle market mechanisms at play that increase supplies and eradicate market distortions. In these situations, the free market is working, and it’s ultimately working far more efficiently than any government-mandated controls would.

Ben Stein, the actor and economist, perhaps summed it up best when he wrote, “Yes, I loathe the speculative premium in energy prices. Yes,
I wish that I did not have to pay as much when I fill up my car. But the idea that there is a conspiracy at work, the idea that Congress can make it better by regulation—that’s insanity. To let the free market, the best economic idea of all history, work its magic—that’s good sense.”
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And indeed it is.

Now let’s focus on whether consumers are being ripped off by the pricing of some everyday products. Many people, when they feel they’re being charged “too much” for an item, will instinctively denounce “corporate greed”—these corporations just can’t seem to get a break. Of course, it’s a bit mysterious how a corporation could charge unjustifiably high prices when a competitor could easily steal their sales by undercutting their prices. The most common retort to this observation is to cite corporations’ alleged “monopoly power.” To paraphrase H. L. Menken, such answers are all too frequently simple, neat, and wrong.
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“Monopoly power” is really just another form of corporate conspiracy theory.

Contrary to popular opinion, monopolies are rare and difficult to maintain, and the few real monopoly situations that exist tend to benefit consumers; in some cases, such as with pharmaceutical companies, they literally save lives. What’s more, the kind of allegedly nefarious pricing schemes that monopolies employ—such as price discrimination—often increase the availability of products or services and spur innovation.
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“Price discrimination” is a malevolent-sounding phrase used by economists to describe certain pricing anomalies. Price discrimination is said to occur when a firm charges various people different prices for the same product or service, and these price differences can’t be explained by differences in production costs. Price discrimination in certain instances allows firms to maximize profits by charging the highest
prices to consumers who most value a product and are willing to pay the highest prices for it.

So is this necessarily a bad thing? Price discrimination frequently allows firms to produce more and increases society’s total wealth. This is especially true for monopolies that make large investments in research and development or in infrastructure; if they are not allowed to price discriminate, the firms will simply have to charge a uniform high price in order to recoup their R&D costs. This would place their product out of reach for the poor or others who can’t pay the high price.

Take pharmaceuticals again. Producers are given temporary monopolies in order to launch new drugs. Medicines are very costly to develop, test, and get approved, but cheap to manufacture. And once a drug is put on the market, it’s easy for other firms to reproduce it. If any company were allowed to copy another firm’s drugs, the original manufacturer would never recoup its R&D costs. Without the profits they can gain from their temporary monopolies on new drugs, companies would not be able to invest millions of dollars to develop new ones. So without monopolies, we would no longer get many new drugs, including the most vital, life-saving medicines.
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Let’s look at Reyataz and Emtriva. These drugs stop HIV from replicating and thus help to prolong HIV victims’ lives—often for many years. Many Americans can afford to pay a lot for these drugs; indeed, rich HIV sufferers would probably be willing to pay almost anything for them. But poor Americans and much poorer Africans can only pay very little for the drug, while others can probably afford some mid-level price. When manufacturers lower the drugs’ price for poorer HIV victims, they are engaging in price discrimination. Although it might not seem “fair” to charge different customers various prices for the same drug, price discrimination is clearly a good thing here; poor victims can get their drugs, while the companies can still make a profit by charging higher prices to wealthier sufferers.

The inherent problem with price discrimination, however, is that customers buying a product at a cheap price can profit by reselling it to those being charged a higher price. This is a problem faced by manufacturers of the aforementioned HIV drugs, which are sold cheaply in Africa but then sometimes resold in Europe, the U.S., or other countries where the drugs are sold for more. This is an important downside of lowering prices for poor consumers; drug companies risk creating competitors from among their own customers and thus reducing their profits on new drugs.

Other industries in which monopoly situations are created through the use of patents or copyrights face similar problems—monopolies are simply difficult to sustain, even when firms’ monopoly positions are legally protected. The publishing industry is a case in point. This industry functions similar to drug manufacturing—publishers must pay much more for the development of a book (the writing, editing, and marketing) than they do for the printing of each book, which may only cost a few dollars per copy. Although a book, once on the market, would be easy for a competitor to reproduce, publishers are protected from this competition through copyrights.

Ever wonder why a hardcover book is so much more expensive than its later paperback edition? It’s not the difference in printing costs, which is minimal. Part of the answer is that those most keen on buying a book will want it as soon as it is released, and will be willing to pay a higher price for it. But another, less apparent factor is that by the time a paperback edition comes out, there is already a secondary market in the resale of the hardcover edition. Readers who want the book are already paying less than the bookstore price by buying it secondhand. So the publisher must lower the price of its later editions in order to compete with the new market created by its own customers. Thus, even monopolies face competition.

Such secondary markets are particularly evident on university campuses. Any college student knows how easy it is to avoid paying monopoly
prices for textbooks. You may see a lot of new copies when a textbook is first assigned, but by its second semester in use, many—if not most—of the books in use will be resold ones from the previous semester. While it might be pleasant to imagine students keeping textbooks their entire lives and eagerly refreshing their knowledge every few years, this seldom is the case; the vast majority of students resell their books as soon as their course ends. This creates large, extremely well-organized markets for secondhand books that sell well below the original price. And these secondary markets have really exploded in recent years thanks to
Amazon.com
and myriad other websites that create national—and even international—marketplaces for these transactions.

Monopolies are often forced to compete with these secondary markets, but sometimes the firms find ways around them. Take a totally different example. Allerca is a small California biotech company that has developed a hypoallergenic cat—that is, a feline genetically designed not to produce the protein that makes some people itch and sneeze. These cats cost $3,950 (plus a hefty $900 for shipping). In order to forestall the creation of a secondary market by customers who buy the cats and then breed them themselves, Allerca simply neuters all the cats it sells. Like pharmaceuticals, given the high cost of developing these cats, competition from a secondary market would eliminate the incentive to develop animals like these in the future.
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Although monopolies and price discrimination can both have beneficial effects, differences in prices don’t always—or even normally—indicate that either of these situations is occurring; price differences are frequently attributable to differences in quality or costs that may be invisible to consumers.

Not long ago, some neighbors of mine contracted to have their driveway repaved. A few days before the job, the paving company owner came to the neighborhood to see if he could line up more business. He offered to do my driveway for $2,000, but I wasn’t interested. The neighbors across the street agreed to pay $2,100. Then, on the day of
the paving, the paver unexpectedly rang my doorbell again and offered to do the job for only $1,200. I haggled him down to $1,000.

Was the paver engaging in price discrimination? It might seem so, since I was charged a lower price than our neighbors for the same service. But what goes unseen here is the likely difference in cost for the paver to add my driveway to his list. It was well over ninety degrees, and the owner wanted to let his employees go home early before they were overcome by the heat. Since he didn’t have time to take all his equipment to another job in a different neighborhood, he offered to pave my driveway at a lower price so he could have one more job before sending everyone home. It would not cost him much to add one more job in the same neighborhood, and without it he would be stuck with the extra asphalt.

Here’s another example of pricing that seems discriminatory but is not. My family and friends who frequent restaurants with me have to endure my annoying habit of asking restaurant owners and managers why they do things the way they do. A restaurant near my house charged a couple dollars more for a special takeout Thanksgiving meal for two than they did for two single portions of the same meal. Is this price discrimination targeting customers so blinded by love that they can’t see they will save money by buying two single portions? Hardly. The owner explained that the meal for two includes more than twice as much food as the single portion. The meal is usually ordered by a couple, and the man typically eats more food. It wouldn’t make sense to increase the size of single portions because the price would have to be raised, and customers won’t want to pay more for extra food they don’t need.

It may seem that price discrimination is also at work in the sale of colas. It’s an interesting anomaly that colas tend to be priced at or below the cost of seltzers. For instance, on
Amazon.com
, six-packs of Seagram’s Seltzer Water in 12 fl. oz cans recently cost $3.85. The drink is produced by Coca-Cola,
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which sold its Diet Coke in the same size six-pack for just $1.99.
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Why on earth would Diet Coke, with its added flavoring and sugar substitute, sell for less than seltzer, which is merely carbonated water? Was this just an anomaly?
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Could this be price discrimination? Are seltzer drinkers being charged higher prices in the belief that they tend to have higher incomes than cola drinkers? This is unlikely; if big profits can be made on purely carbonated water, we should expect other firms to have entered the market, eventually driving down the price. The real, although not readily apparent, explanation is that water quality and carbonization levels have to be higher when pure seltzer is not masked by cola flavoring.
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Now that we’ve established that high prices aren’t always attributable to omnipresent, sinister monopolies or to unfair price discrimination, let’s take a look at some expensive items that are the subject of particularly frequent consumer complaints. Are these cases of price discrimination, monopoly power, and corporate greed? Or, can market forces explain these pricing schemes?

Are you curious why restaurants charge substantially higher prices for dinner than for lunch? While the size of the dinners are often slightly larger, meal size alone cannot explain the price difference. The knee-jerk answer is that restaurants charge more for dinner simply because they can. In a sense, this is true; restaurants, like any business, will charge the highest price the market allows in order to maximize profits. But if this holds true for dinner, why not for lunch?

This may seem like another case of price discrimination—supposedly, dinner customers are charged more because lunchtime diners typically work near the restaurants they frequent and are more familiar with the local eateries than are dinner customers, who more often travel to other neighborhoods to dine. Thus lunchtime customers could more easily switch to another establishment if a restaurant raised its lunch prices. But this explanation doesn’t work, for dinners are more expensive than lunches even in cities such as New York City and
Washington, D.C. where dozens of restaurants are crammed into a few square blocks, with prices posted at the front door.
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It is easy to compare prices in these neighborhoods, and finding the cheaper dinners is not a problem.

So if price discrimination is not at work, and monopolies clearly are not functioning in areas with so many restaurants, how do we explain the price difference? There is a simple answer totally consistent with competitive markets: dinner patrons linger over their meals longer than lunchtime customers, who usually face more severe time constraints.
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In addition to the cost of the food, the price of a meal has to cover the rental cost of the table. The more leisurely the pace at which people enjoy a meal, the more money a restaurant loses by not selling meals to additional customers at that table. Anyone who regularly frequents restaurants has surely come across waiters who subtly rush patrons with little maneuvers like clearing the table before all the diners have even finished eating. In the restaurant business, time is money.

This time cost of the table also explains why certain kinds of drinks are so much more expensive in restaurants than in stores. Restaurants charge particularly high prices for coffee, tea, and wine because people either linger over these items or linger longer over meals that include them. The mark-up is highest for beverages that people linger over longest. That’s why wine typically has a larger absolute mark-up than beer, and why both have larger mark-ups than soda.
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