Competition is about more than prices

Reliability is one valuable attribute

“Why aren’t Pappy (van Winkle bourbon) and other rare whiskies sold at market prices?” asks Jeremy Horpedahl. There is a constant “shortage” of Pappy, although not because of government-enforced price ceilings. Why don’t liquor stores simply raise prices? Jeremy doesn’t know. And neither do I. But it’s a good question for starting to think about market competition more broadly.

How do firms compete for customers?

Underlying the idea of supply and demand is a world of intense price competition. The most explicit way to see the price competition is through the continuous double auction, as in Vernon Smith’s experiments. People can continuously update their bid-ask prices and these markets (most of the time) converge to the prediction of supply and demand.

A competitive, supply and demand equilibrium attains when the price competition is so intense that no one has an incentive to try to change the market price. In equilibrium, all the buyers and sellers that want to trade find each other and markets clear.

The power of prices to coordinate markets is incredible; it’s almost beyond comprehension, if not for tools of price theory. It is such a powerful and complex process that economists tend to focus almost exclusively on the role of prices.

Price competition is the complete form of competition in these models. Because of this intense focus on prices, economists, such as Jeremy, immediately ask “why doesn’t the price rise when there is a shortage?”

Prices can do it all! Well, not exactly.

When we look out the window, prices are only one part of the competitive process. But let’s not miss the market/forest for the price/tree.

There are lots of other forms of competition. We often talk about quality competition, for example. The general, non-price form of competition I want to talk about today is reliability. I think we can understand lots of forms of competition in terms of reliability.

For example, exclusive dealings contracts can be cast in terms of reliability. Consider a world with two sellers and a single buyer. The buyer can choose who to purchase from each day. This introduces a contractual obligation that increases the constancy/reliability of trade for the seller who wins the exclusive dealing contract. Firms may choose to compete by offering their continued business, instead of competing solely on price day-to-day.

Another important way that sellers compete, besides prices, is through brand names and developing brand loyalty. People often think of brand names as some sign of quality. Apple is high quality and has developed brand loyalty for that quality.

I think the more important role of a brand is, not as higher quality in some absolute sense, but as a form of reliability. Since information about the quality of any product is costly, customers may be hesitant to purchase goods. They may be stuck with a lemon. In response, firms may compete by offering a more reliable product. I’ve always loved Thomas Sowell’s explanation of this in Knowledge and Decisions:

A "Holiday Inn" is not necessarily better or worse than any other hotel. There are undoubtedly many independent hotels that are better and worse (by whatever standard) than the average Holiday Inn, or even better or worse than any Holiday Inn. Moreover, Holiday Inns vary among themselves. Yet the fact that thousands of hotel owners are willing to pay in various ways for the privilege of using this franchise designation means that the economic value of a given physical structure is greater with a Holiday Inn sign in front of it than without it—and that in turn means that millions of travelers are more likely to stop there for some reason. These travelers are also aware that there are better and worse hotels; all that the sign does is re- duce the range of uncertainty as to quality and price. The value of the franchise, and its spread internationally, is evidence that this is no small consideration.

In other words, H̶o̶l̶i̶d̶a̶e̶ ̶I̶n̶ Holiday Inn competes through the reliability of what it sells.

And reliability shows up everywhere. Instead of thinking about reliability completely in terms of quality, we can also think of reliability of price. People like to know in advance the price they will have to pay.

Consider McDonald’s, a true miracle of the modern world. Yes, I know the quality to expect when I go there, but I also know that I can get a meal for a few bucks when I decide to pull off the highway. The price is very predictable too. That’s not true for the local restaurant that I’ve never heard of.

Reliability of price, or price per unit of quality if you insist, is a value to customers and will therefore be one mechanism that businesses can compete on.

I’m still working out how this is exactly related to Josh’s theory for why busy restaurants don’t raise their price when it’s busy. Josh stressed the repeated nature of customers:

Raising prices to capture the extra surplus during a busy Friday night might lower future demand from customers who would have tried the restaurant at a lower price and become a loyal customer or from customers they lose to search.

I’d add to Josh’s explanation that part of the restaurant story is partly about the reliability of price. We have an interesting trade-off in terms of reliability: reliability on price vs. reliability of wait time. For the restaurants, the reliability of price seems to dominate.

Now let’s circle baby to Pappy van Winkle. I think the story is slightly different from the restaurant story.

It seems key that Pappy 20 year is a $200 bottle of bourbon. It’s not something that passerby shoppers are going to “try out,” as Josh had in mind for restaurants. A $200 bottle takes a serious wallet or a serious palate. With that price tag, Pappy is never going to sell at a consistent volume, compared to a bottom shelf bourbon. Now imagine the liquor store raises prices. The problem gets even worse.

Here, lack of reliability on the part of the customers seems to prevent the gains from trade. A liquor store owner may still say they “want” to carry Pappy but just can’t get a bottle. Because of the cost of carrying the inventory, I’m skeptical that they “want” it that bad. It’s probably not a huge profit opportunity for them. Most liquor stores don’t carry $1,000 bottles of anything. It’s going to be too costly at any particular liquor store because the customers are so rare, i.e. unreliable.

Let me conjecture a slightly different role for loyalty than the one Josh puts forward. You’re a liquor store owner. You have certain customers that come in regularly, chat with you, even ask if you have any Pappy in stock. You don’t. But you think you will in 3 months. You give the tip to the regular customers. That regular customer now comes in slightly more often, because of the tip, asking each time for Pappy. In exchange, you’ve implicitly given them a better chance of getting allocated the bottle.

It’s still an open question why you’d compete like this, compared to more explicitly keeping the bottle for the loyal customer. The most obvious answer is that if you promise to hold the bottle for the customer, there is no incentive for them to remain loyal.

I don’t know enough about the bourbon market to conjecture more. As I said at the beginning, I don’t know why Pappy is priced as it is. But it is important to acknowledge the competitive process is about more than just prices. There’s no reason to expect prices to do 100% of the work.