Thursday, April 20, 2006

Steve Levitt's Bagel Friend

Steve Levitt has followed up the discussion of the bagel salesman that is in Freakonomics with a NBER working paper that uses the meticulous data collected by Paul Feldman, a graduate-trained economist from MIT who has been selling bagels in the Washington, DC area for 20 years. In Freakonomics, Levitt and Stephen Dubner discuss his data in relation to trust and honesty (Feldman leaves the bagels with a box for payment, and then comes back at the end of the day to collect). Here, Levitt focuses on Feldman's profit-maximization behavior. From the abstract:
Using thirteen years of data representing more than 80,000 deliveries, I find that the company is extremely adept at determining how many bagels and donuts to deliver to a particular customer on a given day. In stark contrast, the company appears to price on the inelastic portion of the demand curve for the entire period, thereby foregoing a substantial share of available profits. I argue that these results generalize well beyond this particular case study: firms are likely to be close to the efficient frontier on dimensions for which there is frequent and informative feedback regarding profits, but absent that feedback, systematic deviations from profit maximization are more likely.

This is a fantastic paper, as the data set is really well suited for seeing how well a firm (Feldman) does in maximizing profits. Although the discussion of optimal pricing in the paper is simplistic (Levitt has to ignore dynamic concerns and customer attitudes towards him, as well as any real analysis of how higher prices would affect the payment rate), it really highlights the way people price in real-life. And it's hard to refute Levitt's argument that pricing is below what would be optimal. (The main argument here is that revenues and profits go up after the price increases that do occur.)

I had a student once that owned a coffee shop, and he told me that he had really only raised his prices once. That price increase was in response to an increase in his rent (a fixed cost, that theoretically shouldn't affect pricing at all, let alone be the only reason for it). I was able to get him to admit eventually that the price increase also corresponded to a price increase (and rent increase) for a nearby competitor too, which allowed me to salvage the lesson on fixed prices not affecting prices, but I think it's pretty clear: firms often times lack (or ignore) the data to make "optimal" pricing decisions.



Anonymous Anonymous said...

I don't get the link to the Seinfeld episode guide. I've never seen one of these bagel guys, but they had one in the film . Great post, by the way.

4/20/2006 8:43 PM  
Blogger Tony Vallencourt said...

Feldman was the name of the bizarro-world Kramer in that episode

4/21/2006 7:37 PM  

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