Beware Intuitive Econ

Economists have two standard very simple models of product competition: firms can compete on price or compete on quantity.

Early in the Dotcom internet revolution, I remember some people, including even Bill Gates I think, forecasting that since it becomes easier to find and compare prices on the internet, products sold on the internet would have stronger price competition. And since price competition tends to be stronger than quantity competition, that would bring down prices and be good for consumers. Yay internet!

This argument makes intuitive sense, but is dead wrong. And that is the warning of this post: beware simple econ arguments based on intuitions that haven’t been verified in concrete models.

Even in price competition, quantity must also be chosen; price competition is where quantities are chosen indirectly, as a result of the prices. Similarly, even in quantity competition price must also be chosen; quantity competition is where prices are chosen indirectly, as a result of the quantities.

Economists have long had simple models where both price and quantity are chosen explicitly and directly by firms. In these models, what matters is which of these parameters becomes expensive to change first, and which parameters can keep changing more cheaply closer to the last minute of sale.

For concrete examples, consider selling TVs and plumbing services. A TV firm must decide at least weeks before a sale how many TVs they are going to make and deliver then, but they might change the price they offer for such TVs in the last few days before a sale. In contrast, a plumber might pick a price to charge to include in ads many days before customers see such ads and call to get help, but at the last minute the plumber can say “sorry, I don’t have any more openings on my schedule today.”

In models where firms must commit to quantities early, but can keep changing their prices easily until near the last minute, outcomes are close to those in simple models of quantity competition. But if firms must commit to prices early, but can keep changing quantity until near the last minute, outcomes are close to those in simple models of price competition.

So whether firms compete on price or quantity depends more on which of these they must commit to earliest, not which is easier to change at the last minute. Knowing this, once you heard that it would be easier to change prices at the last minute for products sold on internet, you should have predicted that the internet would increase quantity competition and reduce price competition. Which it in fact has.

Economics is general and robust enough to predict things like how selling products on the internet changes competition. But you have to use it right.

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  • http://www.jessriedel.com Jess Riedel

    Data?

  • Joseph Wilks

    contact me shilly

  • Boris V Mirow

    I wonder if the data set this papers are based on is only representative for the early days of the online shopping (1997-2004). Over the last 10 years things have changed. For example, a friend who is producing fashion watches said the hardest decision is how much inventory to allocate to each distributor around the world because if one distributor does an online discount they drag down the prices for everybody, as price comparison bots that scrape daily for global brand pricing immediately recognize the differences….

  • anothereconomist

    Also, check out this paper about how the internet increased prices for rare books.
    http://economics.mit.edu/files/10351

    And this paper on how search costs relate to pricing. What the result is very much depends on the model:

    http://faculty.haas.berkeley.edu/rjmorgan/Information%20Search%20and%20Price%20Dispersion.pdf

  • http://www.kauffj.com kauffj

    We need intuition to develop our priors. If we don’t use our intuition at all, we’ll fall prey to all kinds of spurious correlations.

    This is where I think Austrian economics in particular goes wrong. We need to be willing to subject our intuitions to experiments. Really, we should constantly be trying to invalidate our intuitions and only retain the ones that hold up to scrutiny.

    But clearly we need our intuitions to direct our attention and filter our data. Otherwise we’d all believe Nicolas Cage is causing a few hundred people to drown each year (http://www.tylervigen.com/spurious-correlations#stat5219f9dd2c21ab4297eb2713917482c0).

  • http://EasyOpinions.blogspot.com/ Andrew_M_Garland

    I think the above analysis is flawed. Products compete on factors affecting the buyer, such as price, delivery, quality, features, and ease of return. Quantity isn’t a consumer factor, unless the consumer wants say 1000 of the item.

    Quantity in a production run is significant to the manufacturer. It can achieve lower unit costs and greater profit/unit if it can make more in a run and sell them all. The buyer doesn’t care about the production run.

    All sales factors interact to result in the market price. Manufacturers will adjust their production to respond to that price. When a manufacturer finds that it can make more per run and sell them all, this changes the market price.

    To find the effect of the Internet on prices, one would need to compare prices over time for a product which was not sold on the internet to the price when sold there.

    Many prices plus shipping on the internet are close to the price in a physical store. This doesn’t tell us what factors set that price. Maybe internet availability caused the store to lower its price. Many stores say they will match an internet price.

    My experience is that many items on the internet cost less including shipping than in local stores, along with greater variety. This has to be a tough time for local stores.

  • Robert Koslover

    As a non-economist, I’m still trying to grasp the difference between competing on price vs. on competing on quantity. Is it something like the following old joke?
    ++++
    A man walks into Joe’s Pickles and inquires about prices. “Pickles are two for a nickel,” Joe responds. The man says “But for a nickel, I can get three pickles at Sam’s!” Joe responds, “So, buy your pickles at Sam’s.” The customer looks at his feet and says, “Sam is out of pickles today.” Joe says, “Oh, well when I’m out of pickles, I also sell them three for a nickel!”
    ++++
    So… in the example/joke above, is Sam “competing on price,” while Joe is “competing on quantity?”

    • http://overcomingbias.com RobinHanson

      When a firm competes on quantity, the thing it chooses is the quantity of the product to offer, and then price is determined indirectly via where the total quantity offered by all firms hits the total demand curve.

      • Acharn0

        But that’s not the way prices are set in the real world.

  • Ray Lopez

    I think–but am not sure–that the author meant “quality” not ‘quantity’ in this sentence, and globally: “firms can compete on price or compete on quantity”.

    • http://overcomingbias.com RobinHanson

      I very much meant “quantity”.

      • http://juridicalcoherence.blogspot.com/ Stephen Diamond

        If you ask the average layman about bases for competition, he would say price and quality. What are the implications (if any) of price versus quantity competition on product quality?

      • david brinton

        Let me help. I think you mean what I call, fast dimes vs slow quarters.

        If a business is structured around lower margins, it gets a lot of smaller profit sales (fast dimes). If it is structured around higher margins, it gets fewer larger profit sales (slow quarters).

        Quality has an equal impact regardless of whether the structure is based on fast dimes or slow quarters. However, the product quality or potential time before failure/replacement may impact the decision whether to structure the business around fast dimes or slow quarters.

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  • austrartsua

    **Insert obligatory I’m not an economist preamble here**

    This article is interesting but basically makes no sense. Ok, what on earth is competing on quantity? We all know what competing on price means. This article makes no attempt to explain this other mysterious type of competition… A simple example, perhaps a duopoly, would be nice.

  • William Penfield

    Quantity competition is a new concept for me. The many undoubtedly excellent explanations on the internet tend to go straight to the math of how to figure the Nash equilibrium in a quantity-competitive setting without doing much to explain the concept. For instance, is there a reason why a buyer or seller might desire a quantity over a price-competitive market? If car manufacturers could produce cars like pizzas, would that mean that they would compete on price rather than quantity? Would they want to? Would we want them to?

  • IMASBA

    “since it becomes easier to find and compare prices on the internet, products sold on the internet would have stronger price competition. And since price competition tends to be stronger than quantity competition, that would bring down prices and be good for consumers. Yay internet!

    This argument makes intuitive sense”

    How did it make intuitive sense? It requires one to believe that “price competition tends to be stronger than quantity competition”, but is that really so intuitive, I wouldn’t have assumed this on intuitive grounds, I wouldn’t have ruled it out either but at least to me it wouldn’t have been intuitive.

    Btw, how do you know you’re doing economics “right” beforehand? There’s always a more complicated model out there and you don’t know whether your model is complicated enough until you have real data to compare it against.

  • Acharn0

    I am not an economist, and this wasn’t brought up in my Econ 101 class. I don’t get how firms “compete” on quantity. Why would a consumer choose to buy from one firm rather than another based on the quantity the firm manufactured if the prices were the same? I would care, of course, if the one firm did not have any stock left, but in what sense is that “competing” with the other firm? The initial premise just doesn’t make any sense to me.

    • http://overcomingbias.com RobinHanson

      This isn’t about differences that individual customers perceive. It is about the key choices firms make.

    • imperfectlycompetitive

      https://en.wikipedia.org/wiki/Cournot_competition

      A classic model where two firms choose quantity independently. Prices arise from market clearing. Given market demand, firms can compute best-response functions to the other firm’s quantity choice; equilibrium arises when each firm’s strategy is the best response to the other’s choice.

  • Thomas_L_Holaday

    A link to resources about Quantity Competition would be most welcome. The term elicited a puzzled looks and “do you mean Geffen goods?” from the nearest smart-guy-with-two-semesters-of-undergradate-econ.

  • Camilo Emiliano Rosas Echeverr

    I somehow finished my MBA without ever hearing about “Quantity competition”.

  • http://www.propertarianism.com Curt Doolittle

    I have taught the following:

    1) Price,
    2) Quantity,
    3) Profitability or Debt
    4) Rents (firms like polities accumulate renters)
    5) Adaptation Costs (innovator’s dilemma).

    Why? Decreasing production cycles, increasing distribution of production, the increasing importance of TALENT and innovation service industries. vs capital or credit in manufacturing and distribution companies.

    In a highly efficient market, one can sacrifice profits for talent while larger organizations accumulate internal rents. This is most frequently the reason

    Generally speaking, higher profits incentivize more rents. And while prices are sticky, internal rents are much stickier than prices.

    Generally speaking, adaptation costs vary dramatically from industry to industry: service firms trade out people and production firms trade out people and capital. The difference being that GAP regulation and tax policy obscure the tail of fixed vs human capital, largely because we can finance against the illusion of fixed capital value while we cannot finance against the obvious lack of control over human capital.

    Curt Doolittle
    The Propertarian Institute
    Kiev, Ukraine

  • Daublin

    Can you expand on your claim that price competition is low on the Internet?

    If you look at sellers on Amazon for the same product, they give the superficial appearance of competing very hard on price. There are often a lot of sellers for each item, and their prices often vary. Moreover, Amazon prominently displays the various prices offered, and in such a way that it’s the first and easiest piece of information you can learn about each seller.

  • Tim Tyler

    Price competition and quality competition are not mutually exclusive. Some firms sell high end stuff and compete on quality – others shift mountains of cheap goods – and compete on price. Sometimes the same firm uses both approaches with different product lines. Both approaches are doing pretty well on the internet – as far as I can tell. Robin cites no evidence of the internet lowering price competition. Surely, Bill was right: yay internet!