Economists Do It With Models

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Dilbert Exposes The Logic Of Complements And Loss Leaders…

July 21st, 2010 · 7 Comments
Buyer Beware · Econ 101

When economists talk about supply and demand, they usually discuss prices of “related goods” as one of the determinants of demand for an item. (see here for a video.) Related goods can be either substitutes- things that are consumed instead of one another- or complements- things that are consumed together. In other words, substitutes would be things like tea and coffee, and complements would be things like (hopefully, at least) left shoes and right shoes. More precisely, we can think about complements in one of the following ways:

  • All else being equal, the marginal utility (read, how useful one more of something is to you) of goods gets higher when you own goods that are complementary to them
  • All else being equal, when the price of an item decreases, demand for complementary goods increases

If the relationship is strong enough, it could be the case that the increase in demand is large enough that it would be profitable to artificially lower the price of an item in order to drive demand for its complements. In Economics 101, we usually think about different goods being produced and sold by different companies. In this setup, it is reasonably difficult for one company to subsidize another company’s product in order to increase its own sales, but it’s not impossible. (Just ask Apple and AT&T, for example.) When all the products are sold by the same company, it is much easier. Behold:

In this setup, the car rental company (if you can call it that) is probably either just breaking even or taking a small loss on the rental itself so that it has a captive audience to sell complementary goods to. The logic is that it’s easy and profitable enough to convince people at the point of sale to purchase the add-ons or hope that people will be in a hurry and resort to paying for the fuel fill up that it’s worth using the cars as bait to get people in the door in the first place. Given the exorbitant prices on both supplemental insurance and rental car gas, they’re probably right. As an economist, I’m still perplexed that no one has opened an insurance and gas kiosk in the rental car area, since this person would almost certainly be able to beat the rental car companies’ prices and still be profitable. (Venture capital, anyone?) As a consumer, I’m glad to some degree that this hasn’t happened, since if rental cars ceased to be used as loss leaders, my no-frills rental car would get more expensive.

For the record, I am also Amazon’s worst customer in that I own 50 or so Kindle books and no Kindle. I suppose the lesson to be had is that informed consumers can get good deals when companies are trying to exploit the loss leader strategy…or at least they can as long as not too many people have the same idea.

Tags: Buyer Beware · Econ 101

7 responses so far ↓

  • 1 dWj // Jul 21, 2010 at 4:52 pm

    A gas station near an airport in Florida was being charged with “price gouging” (outside the context of a disaster) recently, presumably attempting to capitalize on what you’ve suggested. (I assume the rental companies have excuses for why they aren’t “price gouging” — aside from the fact that the term is meaningless, I mean.)

    As to that last point, I was thinking recently that a lot of fantasies only make sense in partial equilibrium. More, less, or different price discrimination is often among these. (I was thinking at the time about superpowers; invisibility, or the ability to disapparate from one place and apparate somewhere else, would be somewhat less valuable if everyone were on guard for them.)

  • 2 Mikey D // Jul 22, 2010 at 2:29 pm

    I think you’re amazon’s best customer since the Kindle is their loss leader and the ebooks are comparatively free.

  • 3 Dave // Jul 22, 2010 at 3:36 pm

    Actually, I’m a worse Amazon customer than you. They don’t actually lose money on your e-book purchases (after all, what did it cost to make and ship the book? — not much; and, for now, they only pay standard royalties, which aren’t much). I, however, get free shipping (for $30/year as an AmazonPrime customer), and I extensively use the privilege. Amazon’s sales are equivalent to “special orders” at a regular bookstore — they have to pay an individual shipping charge for every book sold. For cheaper books, the shipping charge typically exceeds the mark-up on the book. Add in the fact that they had to pay a warehouse to store the book and had to pay employees to inventory, handle, box and ship the book, and they cannot make money if they don’t charge for shipping. What they’re hoping, when they sell the AmazonPrime membership, is that the shipping costs they incur will be made up by the $30/year fee. For most customers, that might be true, but I buy so many books, that the $30/year fee is trivial, so they’re probably losing quite a bit of money on me. They would be very happy if I switched from paper books to a Kindle — I’m surprised they haven’t offered me a free Kindle. (Just in case you’re wondering, I worked in a book store for a while after I dropped out of grad school and needed a job. And, yes, I was in charge of special orders, and I *did* figure out a way to make money off of special orders without charging customers for shipping, but it involved eliminating the shipping costs through creative arrangements with wholesalers — something Amazon cannot do because they’re shipping to individual retail customers.)

  • 4 econgirl // Jul 22, 2010 at 5:50 pm

    @ Mikey and Dave: Actually, Amazon does lose money on cheap e-books – what’s important to remember is that they are the retailer of the books but not the publisher, so the marginal cost of providing an e-book isn’t of direct relevance. The fact of the matter is that Amazon pays the publishers between $12 and $15 for a lot of the Kindle books that it sells (or used to sell) for $9.99. You can see more on the topic here:

    http://www.economistsdoitwithmodels.com/2010/05/05/reader-question-so-youre-telling-me-i-have-to-pay-more-to-not-have-a-real-book/

    You can also bet your bottom dollar that there is a large and positive markup on Kindles.

    @ dWj: “price gouging” is SUCH BS. That is all.

  • 5 Dave // Jul 22, 2010 at 6:30 pm

    Thanks for the correction, @econgirl. I had assumed that Amazon.com was simply doing the “publishing” and paying a royalty to the publisher of record.

    A related subject that might make an interesting story: Authors, for most books, get a rather low percentage royalty on the books sold. That’s because the book stores, distributors and publishers take a great risk when they print, distribute and sell books — it’s a significant expense and a very high percentage of books are never sold. So the stores, distributors and publishers demand a high return on their investment. However, with e-books, the cost to do the equivalent of “print, distribute and sell” is rather trivial. So authors are talking about demanding higher royalties from e-books, since the publishers et al are taking very little risk. There might be something in that story that would make a good entry for EDIWM.

  • 6 Greg // Jul 26, 2010 at 6:32 pm

    This made me think; in a 2-good world, would they be substitutes or compliments? Just wondering.

  • 7 dWj // Jul 26, 2010 at 11:14 pm

    In a two-good world, they’re necessarily substitutes.

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