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Diseconomies Of Scale, BJ’s Edition…

October 14th, 2009 · 6 Comments
Buyer Beware · Econ 101

Hello, I meant BJ’s the wholesale club…what on earth were you thinking you dirty people? You know, these places:

I’ve posted a few times before about economies of scale, relating the concept to things like whisky and real estate. Technically, the term “economies of scale” refers to the case where production gets cheaper for a firm (per unit) as a firm gets bigger, but I was taking a bit of liberty and using it to apply to bulk discounts in purchasing. We are very used to taking bulk discounts as a given, but this need not be the case. If you think about the supply and demand model, you will remember that increased demand drives up prices, all else being equal. Therefore, it’s quite possible to see diseconomies of scale in purchasing as well, where items get more expensive per unit as you want to purchase more of them. One typical example of this is the stock market- if you wanted to buy a few shares of Ford (not that you should, I’m just giving a hypothetical here), you could just go on E*Trade or whatever and buy your shares at the market price. But say instead that you were an investment bank and you wanted to buy 200,000 shares of Ford. You are likely going to end up paying a higher average price than I would have, since you’ve actually moved the market. In other words, in trying to buy your shares on the open market, you’ve exhausted all of the people willing to sell at the current market price and then need to offer a higher price to get more people to sell to you. (Investment banks often buy and sell in block trades with other institutions for this exact reason, but they still end up paying more than I would for one share.) I find the same problem when I try to buy large quantities of used textbooks on Amazon- I buy all of the cheapest guy’s supply, then have to move onto the next cheapest, and so on.

Now that you realize you can’t assume that bulk purchases are always a good deal, what do you do? One option is to compare the per unit (or per ounce, pound, whatever) prices when you are at the store (it’s often conveniently marked on the price tag on the shelf). Unfortunately, this requires multiple sizes of product to be available for comparison- what do you do if you are at Costco and don’t have this comparison available? Luckily, the folks over at Wallet Pop put together a summary of items to potentially avoid purchasing in bulk:

  • Gasoline
  • Fresh Produce
  • Paper Goods
  • Jewelry
  • “Grey Market” Products
  • Products With Coupons
  • Designer Clothes
  • Credit Cards

Click here to see the full article with analysis and such. (Hat tip to US Economics News) Also, be careful with the receipt-checking guys at the door:

(The cartoons in this post come courtesy of Mike Gray, and I should also thank Costco for holding a cartoon contest, since it gave me a lot of material to pick from. Also, The Consumerist taught me that it’s technically not legal for a store to require you to show your receipt on the way out, though wholesale clubs get you to agree to the procedure in the membership agreement.)

One final point: some of you may have been thinking “If increased demand leads to higher prices, how can it ever be cheaper to purchase in bulk?” Notice above that I specifically put in the caveat of “all else being equal”- in a lot of cases, the increased demand allows the supplier to make investments in capacity, technology, etc. that allow it to produce more cheaply. In the supply and demand model, this would mean that the supply curve changes as well, and the overall effect could be a lower rather than a higher price. I heard one time that the negotiation strategy that Wal-Mart uses with its suppliers is something like this: “Ok, we are going to buy from you at cost, so you are not going to make any profit off of us directly. However, because we are so big, you can now take advantage of economies of scale in your production to have a higher profit margin on the items that you sell to everyone else.” I’m not generally a fan of Wal-Mart, but I have to admit that that is kind of brilliant.

Tags: Buyer Beware · Econ 101

6 responses so far ↓

  • 1 Adam // Oct 14, 2009 at 3:53 pm

    I’d question the logic the Dolans have used to warn people away from gasoline purchases. Most stations around where I live use what is known as zone pricing – the suggested price is a combination of replacement costs, revenue targets, and most importantly, competitor pricing.

    When a station sets it’s price, common practice is for them to survey their market – typically 3-5 stations in the same geographic area, and submit those prices to a central pricing center. The center evaluates the competitors prices, foretasted replacement costs, revenue targets, etc., keeping in mind the general price sensitivity of the area. They then send this price to the station, which is posted on the street.

    There is also a more aggressive strategy in which a primary competitor is chosen, and the station has a directive to stay some amount within that price. An example would be if station X’s strategy is to always be $0.02 below station Y (this would make sense if X, for example, is on a less accessible corner of the street than Y).

    As far as their analysis that the clubs are amongst the first to react with increases in a rising market: this may or may not be true (I haven’t seen any data), but the reason would most likely be that they have a better coordinated response to price volatility because all of the clubs are managed centrally, and since they are usually the low price/high volume retailers in the market, they are also the competitor which most others in the area are forced to react to. Another point to consider is that in retail, you charge based on your *immediate cost of replenishment*, which dictates that you sell each unit at it’s current replenishment cost, regardless of when or how often you actually replenish. Like I said, better coordination may lead to a more perfect following of the market, but it has nothing to do with how frequently a station must be refueled…

    Sorry to get long winded, but I used to manage several stations, and I find the economics of gas pricing fascinating. They’re really very interesting, at least if your a big dork like me…

  • 2 Jason // Oct 14, 2009 at 4:12 pm

    Even if I do pay the same or more per unit, the value of purchasing a large quantity must also be factored in. The fact that I can go to the “wholesale” warehouse and buy a box of 300 diapers once every couple of months or so versus going to the grocery and buying their box of 50 every week is worth almost any price difference that I may unknowingly be paying. Ultimately it is cheaper for me to buy Huggies by the pallet.

  • 3 econgirl // Oct 14, 2009 at 4:20 pm

    @ Jason: Economists have a name for exactly what you are talking about: shoe leather costs. Isn’t that cute? The rationale is that you have to pay for new shoes more often if you are constantly walking back and forth to the store.

    http://en.wikipedia.org/wiki/Shoe_leather_cost

    (Technically the term is used for holding cash, but the idea is the same.)

    As one who lives in a small apartment, I would argue that the effect you refer to could go either way. 🙂

  • 4 econgirl // Oct 14, 2009 at 4:24 pm

    @ Adam: You should know by now that I am a huge nerd, so bring it on…the IO people use gas stations a lot when they talk about things like spatial competition. Gas stations are also mentioned when talking about menu costs because, unlike a lot of other industries, it is very easy (read, cheap) to change the sticker price of the product. (At least it is if you have a ladder.)

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