Introduction to two-tiered pricing

In response to the question over differences between Wal Mart and Costco, I will introduce a new concept to explain differences in the pricing scheme between a traditional retailer and a discount club. The difference comes from the way prices are set to increase the propensity to consume for customers.

For a traditional retailer, their goal is to price with a difference of the cost and a percentage markup to cover the fixed and variable costs and have a profit. This markup is usually variable and can be none if the firm seeks to engage in loss leading to take out a competitor. Such a phenomenon occurs often with the opening of a new major retailer, since they can spread the losses out over many stores, so the damage to the company overall is negligible compared to the increased market share from removal of competition.

In contrast, a discount club store operates on a different pricing mechanism. By selling near cost, Costco or Sam's Club offers higher savings (known as consumer surplus) compared to the price they would be willing to pay for the same item in a traditional store. As a result, if the discounter only sold at cost, they would go out of business since the profit motive would be removed and they would lose money since the fixed and variable costs would make them lose money. To counteract this reality, the discounter makes up for the difference in consumer surplus by charging a membership fee which creates a small profit and covers the operating costs. As a result, the membership fee is usually tiered to a point where all consumer surplus is removed from all but the highest volume purchasers, so the consumer is not better off shopping the discounter than anywhere else. Naturally, some consumers, such as those with large families gain some consumer surplus, but the pricing including the membership fee precludes most consumers from benefitting economically, so the firm still realizes profit. This type of pricing is known as two-tiered pricing, and is done to ration things for which different classes of consumers have different levels of elasticity.

A Seedy Business Perhaps?

Browsing through the financial stories today I came across a particularly interesting storyi nvolving the largest US seed manufacturer, Monsanto. The United States DOJ is investigating whether their use of patented seed results in antitrust by having users controlled by the seed supplier. For example, the soybean crop in the United States uses 96% Monsanto seeds, so anyone wishing to produce the crop is pretty much reliant on a single supplier. This is called monopsony.

Monopsony is the same principle as a monopoly, but reflecting a single buyer(IE inelasticity in the supply curve) versus the single seller (inelasticity in the demand curve) of a monopoly. Frequently monopsonies arise from issue where government is the sole buyer, such as a universal healthcare system, research funding, and in analysis of labor markets for welfare economics. One example of a monospony would be the labor market in a small town with one major ocmpany, say a Wal-Mart or a mine, for instance. Since the single employer has no outside competition, since there is no store which can compete with the company becuase there is some economic factor preventing competition, the employer can charge below market wages since they have price-making power. This difference in wage at the the output level of the monopsonist is exploitation, since a free(completely competitive) economy would pay a worker W(higher) while the wage taker pays (W(monopsony). In other words, by controlling the ability to hire in a market, the monopsonist firm get more money out of each worker since they know the worker cannot easily leave the market.

If you want to read through an econometric research paper on the topic which reaches the conclusion that Wal-Mart is a monopsonist in rural areas and in the South, while having reducing monopsony power in areas where they facor labor criticisms and competition on the West Coast and Northeast, here it is courtesy of the University of Connecticut.

Wal Mart seeks to expand and crush the last bit of competition in retail

Wal Mart, otherwise known as 'retail cancer' has metastasized by over a thousand percent in the last decade, and keeps growing. It is now publically announcing its intention to destroy what remains of retail in this country through a new expansion campaign called "Project Impact." By creating a more efficient layout and targetting pharmacy and crafts, Wal Mart believes it will take out more businesses and continuing its massive expansion. What to make of a company which is already the largest retailer in the US seeking to expand further?

First, a firm like Wal Mart uses economies of scale to knock out competitors since they use their larger size to cover fixed costs over more and more stores. By doing so, they can expand and sell at a loss to take out competitors by selling at a loss at newly opened stores then making up the cost in other profitable stores elsewhere. The net benefit in terms of lower prices soon become a burden as the loss of jobs caused by smaller competitors closing drains on the local tax base. According to Iowa State University economic research, for each gain in sales from a Wal Mart there is a corresponding loss in sales from competitors. Now, that does not seem so bad, right? People just spend all of their money at one store instead of ten, right?

In theory that would be correct, but in practice no such thing will happen. Let's suppose there are ten local competitors employing 10 people each prior to the opening of the big box store. Those 100 workers all pay taxes to the local area, purchase goods from the other stores, etc. The local box store opens and employs 75 people because they consolidate their staff to be able to cover multiple areas so this one massive store is 25% more efficient than the ten small stores combined (in terms of labor efficiency). Suddenly the same area has 25 people without work and 9 fewer employers. Since there is a correpsonding loss of sales in surrounding areas due to the big box stores, they find it harder to relocate to work, and suddenly are drawing on the welfare state. These 25 workers went from paying taxes to draining tax revenue, so the city becomes worse off on a whole. However, you can save 25 cents on a toaster, so it all works out, right?