Sobering Economics

Applied Economics,
Vol. 36, No. 14, August 2004, Abingdon

Occasionally, economists employ a shtick that makes the dismal science seem a little less dismal. When American economists use The Wizard of Oz to talk about money, for example, they employ familiar images to convey complex economic ideas, reminding us that economics, after all, deals with human behavior.

A particularly novel recent example is an article by Ryan Donnar and Keith Jakee in the journal Applied Economics. Economists at the Royal Melbourne Institute of Technology, Donnar and Jakee use competition in the Australian beer market to highlight their simple yet innovative methodology for measuring people’s willingness to pay for perks. The methodology’s value lies not only in the fact that it doesn’t require fancy statistics and convoluted math but in its potential benefit to the study of industrial organization.

Since the 1980s, two breweries, Carlton and United Beverages (CUB) and Lion Nathan, have become the dominant suppliers of beer in Australia, with a combined market share of more than 90 percent. Even with such heavy industry concentration, competition is intense. Wine and premixed cocktail drinks, such as Bacardi Breezers, have become an easier sell as heavy drinking loses its social appeal.

CUB and Lion Nathan attempted to expand their respective market shares in 2000 by striking deals with pubs that agreed to promote a brewer’s products in exchange for cash and renovations. Agreements that limit a retailer’s choice of suppliers, or "vertical restraints," are outlawed as anticompetitive in many countries — including Australia. However, by promising "extensive" rather than "exclusive" placement of a particular beer, both parties stayed within the bounds of the law.

For economists — and many beer drinkers, for that matter — this strategy violates common sense. Conventional economic wisdom holds that consumers are driven by choice. However, Donnar and Jakee conclude that consumers are, in fact, better off with fewer choices. They calculate the value of the beautified pubs to customers at $68.5 million, noting that patrons enjoyed this benefit without paying more for their beer. Hence, having fewer nut brown, cherry-flavored stouts with a raspberry twist was more than offset by new, buttery, leather chairs.

The global importance of Australian alcohol consumption notwithstanding, Donnar and Jakee’s real contribution is their mechanism for estimating a demand curve that relies on easily obtainable information, rather than complicated data sets and high-powered econometrics. They rely on three readily available variables: the price of beer, the amount of beer consumed, and the sensitivity of beer consumption to price changes. The money that people spend to drink beer in a pub instead of at home is referred to as the expenditure on pubs. All data are available in either business publications or through conversations with experts, in this case a contractor specializing in pub renovations.

The methodology’s simplicity makes it easy to apply to other industries. Take the U.S. airline industry. One could deduce whether consumers are willing to pay extra for that handy phone in the seat in front of them, or whether the airline should pick up the tab for movies on the individual screens. Using an economic approach instead of customer surveys has the advantage of measuring how much people are actually willing to pay for extras, rather than how much they say they would be willing to pay. By looking at airlines’ past experience with these types of improvements, one could even calculate the effects on revenues when carriers pay for meals or offer passengers the option of paying an upgrade charge for an extra two inches of leg room.

Numerous other industries come to mind. How much do customers value the local bank branch in their supermarket? Does a call center that opens at 4:00 a.m. compensate for having only two local banks from which to choose? Economists improve the lives of consumers by giving industries a tool to calculate answers to these kinds of questions. They also remind us that the market does occasionally work in, if not mysterious, at least surprising, ways.