Microeconomics for MBAs 49

In certain cases, requiring retailers to charge higher prices price maintenance or allowing them to charge higher prices exclusive territory makes it possible for a manufacturer to benef

Private schools face serious competition attracting customers They have to cover their costs of educating students with tuition payments from parents who have the option

of sending their children to public schools they have already paid for with taxes

Obviously private schools have to treat their customers well if they are to survive But

some of the most successful private schools recognize that treating their customers well

as a group can require mistreating them individually In many respects the education of

children is a collective enterprise in which the best results require that all customers be

required to do things that many would not voluntarily choose to do

Consider the example of a private school in Nanuet, New York that has done very well in part because it has come up with a creative way of mistreating its customers

Love Christian Academy requires that all the parents have monthly meetings with their

children’s teachers and volunteer to work at the school at least one day a year If parents miss, or are even late for, a meeting, they are fined $100 Parents who are fined, or who must attend a meeting on the night of their favorite TV programs to avoid the fine, often

feel mistreated One parent was quoted as “not pleased” with being fined for violating

one of the rules, and some parents have removed their children from the school because

of the strict rules But the school thrives because most parents feel more than

compensated by knowing that their children are attending school with other children

whose parents are actively involved in their education.11

Similarly, few parents want their children spanked at school But if the choice is

between sending their children to a school where none of the students are spanked or to

one in which any student who misbehaves is spanked, including their own, many parents

prefer the latter This is recognized by many private schools that advertise the fact that

they believe in maintaining discipline in the classroom by subjecting unruly students to

an old-fashioned spanking Dr Connie Sims, the superintendent of Love Christian

Academy, makes clear that before students are accepted their parents must accept the

school’s disciplinary policy.12

While no one feels good about his or her children receiving poor grades, many

prefer a school in which that possibility is likely to one in which it is unlikely The

school that holds its students to a high standard of academic achievement and only gives

good grades to those who achieve that standard will have a better reputation than a school that doesn’t So while the students, and their parents, may feel mistreated if they receive

poor grades, they prefer a school with a policy of giving low grades because of the

additional educational value created by that policy

Manufacturers who sell their products through independent dealers often impose

restrictions on the price the dealers can charge for the products or the number of dealers

who can sell them in a given area These restrictions are referred to respectively as resale

price maintenance agreements and exclusive dealing arrangements The effect of these

restrictions is to increase the price consumers pay, and for a long time the conventional

11

See Steve Stecklow, “Evangelical Schools Reinvent Themselves by Stressing Academics” The Wall Street Journal, May 12, 1994: p A1

12

Ibid We want to emphasize that our concern here is not whether or not spanking is the best, or even a good, way of disciplining children The point is that many schools can attract business with practic es that each of their customers would find objectionable if applied only to their children, but which they appreciate when applied to all students

view of policy critics was that the price maintenance agreements and exclusive

dealerships allowed sellers to profit at the consumers’ expense But, as in the previous

examples, a policy that at first glance appears to be mistreating customers may actually

be in the customers’ best interest by allowing them to overcome a prisoners’ dilemma

In certain cases, requiring retailers to charge higher prices (price maintenance) or allowing them to charge higher prices (exclusive territory) makes it possible for a

manufacturer to benefit customers because without these restrictions each customer

would find it individually rational to behave in ways that are collectively harmful

Consider a product on which customers are able to make a more informed choice when it

is properly displayed One example is furniture, which is best examined in a

well-appointed setting containing other pieces of complementary furniture

Another example is sound equipment that consumers would like to evaluate in

sound rooms before purchasing But without the manufacturer being able to impose

some restrictions on the retailer, it is unlikely that the consumer will benefit from such

helpful displays The retailer who went to the expense of properly displaying a product

or having experts on hand to answer questions of potential customers would be

vulnerable to the price competition of retailers who did not provide these services A

retailer with a warehouse and an 800 number could (and many have) run advertisements

suggesting that customers visit retailers with showrooms and experts to decide what they

want to buy, and then call in their order at a discount price

The problem is that while it makes sense for each customer to take advantage of

such offers, if many customers do so they will end up collectively worse off as the

retailers with showrooms go out of business This is clearly an example of consumers

finding themselves in a prisoners’ dilemma So retail price maintenance agreements and

exclusive-dealing arrangements can be thought of as ways of protecting consumers

against their own prisoners’ dilemma temptations By not selling their products through a retailer who refuses to maintain some minimum price, a manufacturer can prevent some

retailers from free riding on the showrooms and expert sales staffs of others If price

competition is not permitted, retailers must compete through the display, service and

sales expertise that make the product more valuable to consumers Similarly, by

providing one retailer the exclusive right to sell its product in a market area, a

manufacturer prevents, or at least reduces the ability of, some retailers to free ride on that retailer’s efforts A retailer with the exclusive right to sell a product in an area has a

strong motivation to provide the combination of display and service that consumers find

most attractive And with each consumer able to secure the advantages of good displays and service only by paying for them, they are no longer in a prisoners’ dilemma

There is no guarantee, of course, that a manufacturer will choose a price (in a

resale price agreement) or a market area (in an exclusive dealing arrangement) that makes consumers better off than they would be without such restrictions on retailers For

example, the resale price agreement could require a price that cost the consumer far more than the extra sales and service is worth Or the exclusive market area could be so large that many customers are inconvenienced by the lack of a nearby store carrying the

product But a manufacturer who makes such mistakes will find itself penalized by

competitors who make better use of these restrictions on retailers Those manufacturers

who strike the best balance between “mistreating” their customers with higher prices and

restrictions on the number of retailers in protecting their customers against the

collectively harmful temptations of the prisoners’ dilemma will expand their market share

at the expense of those who do not

Manufacturer restrictions on retailers will not make sense for all products And

manufacturers should be aware that the use of these restrictions might activate

over-zealous antitrust enforcers even when they do make sense But such restrictions do

provide another example of how you can attract more business with policies that may

appear to harm customers, but which actually benefit them by helping them escape a

prisoners’ dilemma

Why the Customer Is Not Always Right

One of the oldest sayings in business is “The customer is always right.” This seems like

good advice to a firm that wants to succeed in the market place Even if you believe your customers are wrong, don’t disagree with them Give them what they want, or they will

take their business to someone who will There are situations, however, when the only

way to succeed is by being willing to tell your customers that they are wrong, and to give them exactly what they don’t want

Consider the situation faced by firms that are in the business of rating the bonds

of corporations Corporations that want to issue bonds pay firms such as Standard and

Poors, Moody’s, Duff and Phelps, and Fitch to evaluate the safety of those bonds and rate them accordingly A rating of AAA indicates that the bonds are very safe, while a rating

of CC indicates that the bonds are in the category of junk bonds and highly risky A

corporation does not want to misrepresent the safety of its bonds since doing so would, in the long run, reduce its ability to borrow money But there is a natural tendency for a

corporation to give itself the benefit of the doubt and believe that its bonds are safer than

they actually are Therefore, the rating service that followed the advice, “The customer is always right,” would seriously jeopardize its usefulness, and its profitability The rating

service that developed a reputation for yielding to client pressure for higher ratings would cease to have the credibility that its clients are paying for So, in the bond rating

business, corporations commonly give good money for bad ratings

Similarly, corporations hire independent accounting firms to audit their financial

statements and report on the degree to which those statements conform to acceptable

accounting practices and accurately convey relevant financial information The managers

of the corporations who pay for an audit have objectives (rapid promotions, nicer perks, and higher salaries) that differ from those of the stockholders, bondholders, and others

who use corporate financial statements (and who want the highest return on their

investments) So managers can have an incentive to bias the financial statements in ways

that make them look better but are misleading to investors But the accounting firm that

does the audit has a strong incentive to ignore any desire managers may have for a

favorable but undeserved report by being as impartial and accurate in its evaluation as

possible Only by maintaining a reputation for impartiality and accuracy is an accounting

firm able to provide a valuable service to all of its clients

Raising Price to Increase Customer Appeal

One of the best-documented rules of business is that the lower the price charged for a

product, the more of that product consumers will buy Everything else equal, consumers

do prefer low prices to high prices, and it would seem that intentionally charging higher

prices for products than they are worth would be a better way of driving away customers than attracting their business But everything is not always equal, and there are situations

where a business is well advised to charge its customers high prices to cover the costs of

products they don’t value that highly

The benefits a person receives from consuming a good or service are sometimes

significantly influenced by whom the other consumers are Consider a rather extreme

example There are two hotels in the town you are visiting that are identical except for

their customers One is patronized by non-affluent and poorly behaved rowdies who

create loud disturbances all night, while the other is patronized by affluent, well-behaved

folks who are careful not to disturb their neighbors Which hotel would you prefer?

Preferences differ, and no doubt some would prefer the action that is more likely

available at the first hotel But it is a safe bet that most affluent, well-behaved people

would prefer and be willing to pay more for the second

This situation suggests what looks like a profit opportunity for one of the hotel

owners; establish a reputation for catering to the affluent and well-behaved guests by

refusing to rent to anyone else, and then charge premium prices Unfortunately, things

aren’t so simple First, it is not easy to tell if a prospective guest is either affluent or well

behaved, particularly those who make telephone reservations Second, even if you could identify those who are “unacceptable,” refusing to rent to them would probably be a

violation of public-accommodation laws in your state

But there is another way to filter out less desirable customers that, though

imperfect, has the advantage of not being illegal and of getting immediately to your

primary objective Just charge higher prices than the other hotel, even though it is

physically identical The less desirable customers will tend to take their business to the

other hotel, which makes your hotel more valuable to those who can afford to pay extra

to avoid the less affluent and/or unruly guests As indicated, this strategy won’t work

perfectly It does not, for example, screen out rock bands that may be affluent but very

unruly But though imperfect, high prices do have the virtue of generally doing a good

job of screening out less desirable guests, and this is clearly a case where virtue is its own reward

Things are more difficult, however, than indicated so far All hotel owners would like to increase their profits by simply increasing their prices and catering to the well to

do Obviously, not everyone can be successful with this strategy Because of

competition, those who want to attract the well to do to their hotels with higher prices

will find that they also have to provide nicer facilities and more services than are

available at lower-priced hotels So construction and operating costs will increase at

high-priced hotels until the return on investment in these hotels is about the same as the

return on investment in low-priced hotels, as well as in most other investments But

because one of the big benefits to guests at expensive hotels is being in the company of

other guests who can afford to pay high rates, the frills at those hotels don’t have to be

worth what they cost

Indeed, it is widely believed that people pay more for extras than they are

objectively worth at expensive hotels One of the cut-rate hotel chains recently took

advantage of this belief in an advertisement in which a hotel guest is shown holding up a

small bottle of fancy shampoo and asking whether it was worth the extra $20 room

charge If not, the listener was urged to stay at the cut-rate hotel rather than one of the

expensive hotels A clever advertisement, but it ignores the fact that people are getting

more for the extra $20 than the shampoo They are getting a place to stay that screens out those who aren’t willing or able to pay an extra $20 for a small bottle of shampoo.13

We have confined our discussion to hotels so far, but there are other businesses

where the client effect is important in determining how much value consumers realize

from the service The client effect is certainly important for many people when they go

out for a leisurely dining experience People pay a lot of money for a meal in a fine

restaurant, and though the food and service is typically quite good, it seems reasonable to wonder if many people actually value the attention of hovering captains, wine stewards,

and waiters as much as they pay for them Surely some of the benefits customers receive from the high prices at fine restaurants come from the screening performed by those

prices The client effect is hardly a consideration when you grab your food in a paper bag

at a drive-through window At McDonalds or Burger King the price you pay reflects the value you place on the food, not the value you place on screening out undesirable

customers

The business of education is another example of the importance of the client

Students who attend a college with other students who are capable and enthusiastic will

typically get a far better education than those who attend a college with students who are poorly prepared and uninterested, even though the colleges are of similar quality in terms

of faculty and facilities Students learn not only from their classroom experiences, but

also from their after-class interaction with other students This suggests that the high

tuition charges at many small private colleges can be explained, at least in part, by the

value they create as screening devices

We should point out that the screening explanation for high tuition is one that we

find attractive Both of the authors have spent their careers teaching in public universities where the students pay relatively low tuition We have often wondered why so many

small private colleges could charge such high tuition when, generally, most of the

professors at these colleges, at least in the academic fields with which we are familiar,

have published less and are less well known than our colleagues Why would students, or their parents, pay so much more to attend the lectures of these professors when they could

be attending lectures at our universities for far less? We certainly don’t want to believe

13

We don’t want to overemphasize the difference between the costs of providing a package of extras (or frills) at expensive hotels, and the value of those extras to guests Because of competition, hotels are strongly motivated to provide those extras that, for any given cost, provide as much real value to their guests as possible But this is consistent with a hotel being able to realize a competitive advantage by increasing the supply of extras into the range where the extras themselves are worth less to the guests than they are paying because of the screening benefit provided by the extra charge

that our colleagues are not as good at teaching as professors at expensive private colleges Generally speaking, our colleagues are good teachers

In our more serious moments we recognize, of course, that private colleges

typically put more emphasis on teaching than do large public colleges and universities

Competition drives private colleges to provide more services to their customers for the

extra price they pay But it is hard to believe that the value created by the extra emphasis

on teaching at these private colleges is nearly enough to justify the extra tuition charged

Surely much of the extra value is created by varying the higher tuition as a screening

device

The Link between Customer

Abuse and Worker Wages

When bosses repeat the refrain “The customer is always right,” workers may be led to

believe that the unspoken rule is that they should take whatever the customers throw at

them in the way of abuse As we have seen, the bosses’ advice might be a reasonable

working rule, but it is also likely to be advice that the boss doesn’t want employees to

take with complete seriousness The rule overlooks the fact that abusive customers can

make work a form of “hell” for the workers If forced to take excessive abuse, the

workers would, no doubt, demand higher wages to compensate them for this abuse At

some point, as more and more abuse is encountered, it is altogether reasonable to expect that the higher wages the workers require will exceed the value received by the firm from accommodating abusive customers Any tolerably reasonable boss will, at some point,

ask workers to stand their ground and return the “fire” of their customers Otherwise,

firm profits can be impaired

The president of Southwest Airlines understands the (economic) principles at

stake He has been known to write letters to customers who have been abusive to his

workers, telling those customers that they should take their business elsewhere

Southwest may lose some business, but they can also gain a total wage bill that will be

lower than otherwise, and that can more than compensate the company for the lost

business Also, the policy may screen out unruly passengers, thus making Southwest

more attractive to well-behaved passengers

Indeed, if customers are given too much consideration, some will abuse it at the

expense of not just the business, but of customers in general Consider refund policies

Most retail stores allow customers to return merchandise that they feel doesn’t suit their

needs as well as they anticipated Within reasonable limits, such policies benefit all

customers and build goodwill and profitability for the business Some retailers have

pushed those limits, however, with almost no restrictions on refunds Apparently, some

retailers are now having second thoughts as more and more customers are taking

advantage of generous refund policies

For example, Best Buy has stopped giving refunds on certain products unless the customer has a sales receipt, and even then the customer has to pay a “restocking fee” of

15 percent of the purchase price if the package in which the product came has been

opened.14 Before the change in policy, one Best Buy customer received a refund on a

video recorder that he claimed was defective Indeed, it was defective for a reason the

Best Buy repair technicians discovered when they played back the tape inside and saw

the splash of water as the camera fell into a swimming pool and sank to the bottom It

was at the bottom when the recording stopped Wal-Mart has also moved away from its open-ended return policy by imposing on most items a 90-day maximum beyond which

no refund will be made Before this restriction went into effect, a customer got a refund

for a beat-up thermos that Wal-Mart later learned from the manufacturer had been

purchased in the 1950s, long before there was a Wal-Mart Another retailer that has

decided to halt its no-questions-asked policy on returns is the catalog store L.L Bean,

Inc According to a spokeswoman for the firm, some customers were returning clothes

that had been purchased at garage sales or found in the closets and attics of deceased

relatives.15

Most customers are honest, and a largely unrestricted return policy would be

appropriate for them But honest people will be the most supportive and appreciative of

restrictions when a liberal return policy begins to be abused And there is a tendency for the number who take advantage of a generous return opportunity to grow over time as

some of those who do not initially return items that shouldn’t be returned see others

doing so The cost of paying people for fraudulent, or at least highly questionable,

returns is soon reflected in the price that everyone has to pay Imposing strict limits on

all customer returns will seem like mistreatment to some, but it is really little different

than imposing restrictions on the hours of stores in a mall or fines on parents who are late for meetings with their children’s teachers Without such restrictions, each consumer will

have an opportunity to gain by engaging in behavior that is collectively harmful

* * * * * Treating customers as if they are always right, giving them what they want, and

giving it to them at the lowest possible price is standard business advice, and it is

generally sound advice But not always We have examined several situations in this

chapter where, when compared with the standard advice, good business calls for

“mistreating” customers Of course, once the situations have been explained, the

recommended treatment of customers isn’t mistreatment at all Business owners and

managers are well advised to be constantly on the alert for creative ways of “mistreating” their customers There are many more circumstances where such creative “mistreatment” can allow a business to better serve its customers than can be known by any one person

or discussed in one chapter “Mistreatment” often is in the customers’ interest and

translates into economic improvement for customers and a higher value for the firm

Concluding Comments

Treating the public interest and (private) economic theories of regulation separately may

have suggested that one or the other must be the correct theory of regulation In the real

14

Louis Lee, “Without a Receipt You May Get Stuck With That Ugly Scarf,” Wall Street Journal,

November 18, 1996, p A-1

15

Ibid

world, however, the sources of regulation are complex For instance, a combination of

forces probably motivated the regulation of the airline industry Some people were

pursuing the public interest, as they saw it Others, especially those connected with the

airlines, saw an opportunity to protect their markets The precise nature of any particular regulation probably reflects the relative strengths of these two forces, as well as the

extent to which government allows them to be expressed Moreover, these various

theories are not diametrically opposed: For example, both public interest and the private interests may, at times, willy-nilly, promote efficiency or inefficiency Neither approach

has a monopoly on the truth Each explanation mirrors a facet of reality Neither one is

valid standing alone

Probably the most important lesson from the study of regulation is that while the

public interest especially as it relates to the improvement of market efficiency—is a

valid basis for regulation, it can be easily exploited Pretending to pursue the public

interest, promoters of regulation can realize their own interest instead The statistical

studies cited in this chapter indicate a considerable tendency to abuse the intent of

regulation How than can government serve the public interest without allowing a great

deal of freedom for the special-interest regulation to have the government do their

bidding? How can government regulate the regulators, and do so efficiently? These are

the questions that must be addressed by any movement for regulatory reform

Review Questions

1 The economic theory of regulation suggests that firms have an incentive to support

protective regulation Do workers have a similar incentive? Under what conditions

would they support protective regulation, and under what conditions would they

oppose it?

2 Aircraft producers once supported government efforts to hold airfares above

competitive levels Explain their position Should the fare restrictions have led to

more profitable airlines in the long run?

3 Develop a public interest case for the regulation of barbers and beauticians

4 If a regulatory agency determines electric prices on the basis of a fair rate of return on investment,” how might its price-setting standard affect the use of fuels in producing

electricity? Would fuel oil producers favor the fair-rate-of-return method for

regulating electric utilities?

5 In the 1970s, regulatory agencies allowed electric companies to pass on to customers any increases in the cost of their fuel a scheme that reduced companies’ incentives

to reduce fuel consumption and costs Considered in the overall context of

regulation, however, are such fuel adjustments necessarily inefficient? What might

be the alternative to automatic increases based on the cost of fuel?

6 Economists argue that if utilities charge higher prices for electricity during period of

peak demand, consumers will use less electricity then, reducing the strain on

generators Assume again that electric rates are based on the fair-return method of

regulation Will electric utility companies favor the institution of peak-load pricing?

Why or why not?

7 From the data in the following table, plot this natural monopoly’s marginal cost,

average cost, and demand curves on a graph Label the efficient output level Will

the firm actually produce at that level? Why or why not?

Price Marginal Consumers Quantity Cost Will Pay

Competitive and Monopsonistic

Labor Markets

Labour, like all other things which are purchased and sold, and which may be increased

or diminished in quantity, has its…market price

David Ricardo

rofessional football players earn more than ministers or nurses Social workers

with college degrees generally earn less than truck drivers, who may not have

completed high school Professors of accounting typically earn more than

professors of history with equivalent educational background and teaching experience

Even if your history professor is an outstanding teacher, capable of communicating

effectively and concerned about students’ problems, she probably earns less than a

mediocre teacher of accounting

Why do different occupations offer different salaries? Obviously not because of

their relative worth to us as individuals Just as there is a market for final goods and

services—calculators, automobiles, dry cleaning—there is a market for labor as a

resource in the production process In this competitive labor market, the forces of supply and demand determine the wage rate workers receive

By concentrating on the economic determinants of employment—those that relate most directly to production and promotion of a product—we do not mean to suggest that other factors are unimportant Many noneconomic forces influence who is employed at

what wage, including social status, appearance, sex, race, and personal acquaintances

Our purpose is simply to show how economic forces affect the wages paid and the

number of employees hired Such a model can show not only how labor markets work,

but how attempts to legislate wages, like minimum wage laws, affect the labor market

The general principles that govern the labor market also apply to the markets for

other resources, principally land and capital The use of land and capital has a price,

called rent or interest, which is determined by supply and demand Furthermore, land,

capital, and labor are all subject to the law of diminishing marginal returns Beyond a

certain point and given a fixed quantity of at least one resource, more land, labor, or

capital will produce less and less additional output

The Demand for and Supply of Labor

Labor is a special kind of commodity, one in which people have a personal stake The

employer buys this commodity at a price: the wage rate the laborer receives in exchange

P