August 14, 2016

Dynamic Pricing and Menu Costs - Taking a Shot

When you’re planning a trip to McDonalds for dinner, you have a pretty good idea of how much any item you’re planning on purchasing is going to cost. In fact, you would be pretty surprised if you arrived at McDonalds and an item on the “Dollar Menu” suddenly cost $1.37, or even $0.74. McDonalds keeps its prices fairly stable, and in doing so, two things happen. First, you’re able to decide whether driving your family to McDonalds for dinner today is preferred to going to Applebee’s, or Five Guys, or preparing your own burgers on your backyard grill. The second thing that happens is McDonalds is able to print up signs and advertisements that list the items (usually with a picture that looks much more delicious than what you’ll eventually receive through a drive-through window) along with the prices and how great of a deal you’re getting! These signs and advertisements act to increase demand for McDonalds’ products by informing more people of their availability and luring them into the market.

Wouldn’t it be crazy if the price for a hamburger and fries changed before you got to the restaurant; or if the price changed while you were standing in line? That’s exactly what’s going on at a bar in San Diego, as described in this article. The Blind Burro has adopted a system that allows for the price of the tequila it sells to change at any moment, based on how many people are ordering the brand and, presumably, how much is in stock. Known as dynamic pricing, this method allows the bar to raise the price of tequila brands that are selling well that night, sensing the higher than expected demand for the beverage.

“This is an outrage! They’re taking advantage of their customers!” you may protest. “They lure you into the bar and then jack up the prices, forcing you to pay way more than expected!”

However, don’t forget the flip side to this arrangement. If you’re willing to drink a brand that’s not selling well that night, you’ll be enticed by falling prices and a great deal! Plus, it’s always important to remember that no one is forcing you to exchange your hard earned dollars for tequila or any other drink. In fact, it’s not just “trade” that makes everyone better off (or technically at least no worse off), but rather voluntary trade. This idea hinges on the idea that if you aren’t gaining from the trade, you won’t rationally take part in it. You can always walk away without purchasing the drink.

“If this dynamic pricing idea is so great and economical, why isn’t it more prevalent?” Actually, in a lot of ways it has been around for a while. For example, you don’t always pay one constant price for the goods you buy at the grocery store. The price is adjusted through things like sales and coupons. A more appropriate example in this context may be the infamous Happy Hour (unless you’re in Boston or a handful of other areas where they are outlawed). Even restaurants engage in a similar practice for some items, listing “market price” on a menu for the seafood “catch of the day.”

All of these tactics are a form of what economists call “price discrimination,” which sounds terrible but can actually be quite beneficial in increasing overall surplus. The surplus is increased because people who value the good most highly are able to purchase it, while those who place a low value on the good don’t buy it if the price is too high. Because the amount of each brand of tequila in a bar each night is relatively fixed, the preferences of who buys the tequila matters a lot.

Imagine one shot of José Cuervo Gold tequila were listed on a traditional menu at a price of $3, which is the lowest price that the bar is willing to sell the beverage in order to not entirely give up their profit. The bar has stocked 10 shots worth of this particular brand for the night. Also, imagine that the first guy who walks in wants to buy at least ten shots for him and his friends, and they’re all willing to pay no more than $3.25 for those shots. Luckily, the bar has them in stock, and happily sells him the 10 shots. The consumer gets surplus of $0.25x10 shots = $2.50 and the bar gets no surplus.

Then, 20 minutes later another person walks up to the bar who is willing to pay up to $5.00 for each of those 10 shots, but is turned away because the bar is now out of stock. If the bar had been able to adjust prices, they could have set the price higher (at say $4.50) to start the night. The first person would have been deterred, but the second would have been able to buy the shots! In this scenario, surplus to the consumer would be $0.50/shot x 10 shots = $5, and the bar also gets $1.50/shot x 10 shots = $15 above the minimum price they were willing to sell the drinks for. Of course, without dynamic pricing the bar could still set the price at $4.50, but the bar would then worry that if the second person never walked in that night, it wouldn’t sell any at all. So dynamic pricing allows for the flexibility that increases surplus in this scenario from $2.50 to $20.00!

The question now is whether dynamic pricing will become much more prevalent, infiltrating all sorts of bars, shopping centers, movie theaters, and fast-food restaurants all across the country. I would argue that, even with technological advancements, it would take a lot of time for individuals and businesses to get used to prices changing so frequently. While making some tasks easier, others like planning a vacation would be much harder to budget for. There are some gaps that could be filled by writing contracts and purchasing insurance ahead of time, but these options come at a cost as well. However, I’d still argue that implementing this pricing system in some areas is worth a shot!

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