MSRP is tacit collusion

Oct 7 JDN 2458399

It’s been a little while since I’ve done a really straightforward economic post. It feels good to get back to that.

You are no doubt familiar with the “Manufacturer’s Suggested Retail Price” or MSRP. It can be found on everything from books to dishwashers to video games.

The MSRP is a very simple concept: The manufacturer suggests that all retailers sell it (at least the initial run) at precisely this price.

Why would they want to do that? There is basically only one possible reason: They are trying to sustain tacit collusion.

The game theory of this is rather subtle: It requires that both manufacturers and retailers engage in long-term relationships with one another, and can pick and choose who to work with based on the history of past behavior. Both of these conditions hold in most real-world situations—indeed, the fact that they don’t hold very well in the agriculture industry is probably why we don’t see MSRP on produce.

If pricing were decided by random matching with no long-term relationships or past history, MSRP would be useless. Each firm would have little choice but to set their own optimal price, probably just slightly over their own marginal cost. Even if the manufacturer suggested an MSRP, retailers would promptly and thoroughly ignore it.

This is because the one-shot Bertrand pricing game has a unique Nash equilibrium, at pricing just above marginal cost. The basic argument is as follows: If I price cheaper than you, I can claim the whole market. As long as it’s profitable for me to do that, I will. The only time it’s not profitable for me to undercut you in this way is if we are both charging just slightly above marginal cost—so that is what we shall do, in Nash equilibrium. Human beings don’t always play according to the Nash equilibrium, but for-profit corporations do so quite consistently. Humans have limited attention and moral values; corporations have accounting departments and a fanatical devotion to the One True Profit.

But the iterated Bertrand pricing game is quite different. If instead of making only one pricing decision, we make many pricing decisions over time, always with a high probability of encountering the same buyers and sellers again in the future, then I may not want to undercut your price, for fear of triggering a price war that will hurt both of our firms.

Much like how the Iterated Prisoner’s Dilemma can sustain cooperation in Nash equilibrium while the one-shot Prisoner’s Dilemma cannot, the iterated Bertrand game can sustain collusion as a Nash equilibrium.

There is in fact a vast number of possible equilibria in the iterated Bertrand game. If prices were infinitely divisible, there would be an infinite number of equilibria. In reality, there are hundreds or thousands of equilibria, depending on how finely divisible the price may be.

This makes the iterated Bertrand game a coordination gamethere are many possible equilibria, and our task is to figure out which one to coordinate on.

If we had perfect information, we could deduce what the monopoly price would be, and then all choose the monopoly price; this would be what we call “payoff dominant”, and it’s often what people actually try to choose in real-world coordination games.

But in reality, the monopoly price is a subtle and complicated thing, and might not even be the same between different retailers. So if we each try to compute a monopoly price, we may end up with different results, and then we could trigger a price war and end up driving all of our profits down. If only there were some way to communicate with one another, and say what price we all want to set?

Ah, but there is: The MSRP. Most other forms of price communication are illegal: We certainly couldn’t send each other emails and say “Let’s all charge $59.99, okay?” (When banks tried to do that with the LIBOR, it was the largest white-collar crime in history.) But for some reason economists (particularly, I note, the supposed “free market” believers of the University of Chicago) have convinced antitrust courts that MSRP is somehow different. Yet it’s obviously hardly different at all: You’ve just made the communication one-way from manufacturers to retailers, which makes it a little less reliable, but otherwise exactly the same thing.

There are all sorts of subtler arguments about how MSRP is justifiable, but as far as I can tell they all fall flat. If you’re worried about retailers not promoting your product enough, enter into a contract requiring them to promote. Proposing a suggested price is clearly nothing but an attempt to coordinate tacit—frankly not even that tacit—collusion.

MSRP also probably serves another, equally suspect, function, which is to manipulate consumers using the anchoring heuristic: If the MSRP is $59.99, then when it does go on sale for $49.99 you feel like you are getting a good deal; whereas, if it had just been priced at $49.99 to begin with, you might still have felt that it was too expensive. I see no reason why this sort of crass manipulation of consumers should be protected under the law either, especially when it would be so easy to avoid.

There are all sorts of ways for firms to tacitly collude with one another, and we may not be able to regulate them all. But the MSRP is literally printed on the box. It’s so utterly blatant that we could very easily make it illegal with hardly any effort at all. The fact that we allow such overt price communication makes a mockery of our antitrust law.

Asymmetric nominal rigidity, or why everything is always “on sale”

July 9, JDN 2457579

The next time you’re watching television or shopping, I want you to count the number of items that are listed as “on sale” versus the number that aren’t. (Also, be careful to distinguish labels like “Low Price!” and “Great Value!” that are dressed up like “on sale” labels but actually indicate the usual price.) While “on sale” is presented as though it’s something rare and special, in reality anywhere from a third to half of all products are on sale at any given time. At some retailers (such as Art Van Furniture and Jos. A. Bank clothing), literally almost everything is almost always on sale.

There is a very good explanation for this in terms of cognitive economics. It is a special case of a more general phenomenon of asymmetric nominal rigidity. Asymmetric nominal rigidity is the tendency of human beings to be highly resistant to (rigidity) changes in actual (nominal) dollar prices, but only in the direction that hurts them (asymmetric). Ultimately this is an expression of the far deeper phenomenon of loss aversion, where losses are felt much more than gains.

Usually we actually talk about downward nominal wage rigidity, which is often cited as a reason why depressions can get so bad. People are extremely resistant to having their wages cut, even if there is a perfectly good reason to do so, and even if the economy is under deflation so that their real wage is not actually falling. It doesn’t just feel unpleasant; it feels unjust. People feel betrayed when they see the numbers on their paycheck go down, and they are willing to bear substantial costs to retaliate against that injustice—typically, they quit or go on strike. This reduces spending, which then exacerbates the deflation, which requires more wage cuts—and down we go into the spiral of depression, unless the government intervenes with monetary and fiscal policy.

But what does this have to do with everything being on sale? Well, for every downward wage rigidity, there is an upward price rigidity. When things become more expensive, people stop buying them—even if they could still afford them, and often even if the price increase is quite small. Again, they feel in some sense betrayed by the rising price (though not to the same degree as they feel betrayed by falling wages, due to their closer relationship to their employer). Responses to price increases are about twice as strong as responses to price decreases, just as losses are felt about twice as much as gains.

Businesses have figured this out—in some ways faster than economists did—and use it to their advantage; and thus so many things are “on sale”.

Actually, “on sale” serves two functions, which can be distinguished according to their marketing strategies. Businesses like Jos. A. Bank where almost everything is on sale are primarily exploiting anchoring—they want people to think of the listed “retail price” as the default price, and then the “sale price” that everyone actually pays feels lower as a result. If they “drop” the price of something from $300 to $150 feels like the company is doing you a favor; whereas if they had just priced it at $150 to begin with, you wouldn’t get any warm fuzzy feelings from that. This works especially well for products that people don’t purchase very often and aren’t accustomed to comparing—which is why you see it in furniture stores and high-end clothing retailers, not in grocery stores and pharmacies.

But even when people are accustomed to shopping around and are familiar with what the price ordinarily would be, sales serve a second function, because of asymmetric nominal rigidity: They escape that feeling of betrayal that comes from raising prices.

Here’s how it works: Due to the thousand natural shocks that flesh is heir to, there will always be some uncertainty in the prices you will want to set in the future. Future prices may go up, they may go down; and people spend their lives trying to predict this sort of thing and rarely outperform chance. But if you just raise and lower your prices as the winds blow (as most neoclassical economists generally assume you will), you will alienate your customers. Just as a ratchet works by turning the bolt more in one direction than the other, this sort of roller-coaster pricing would attract a small number of customers with each price decrease, then repel a larger number with each increase, until after a few cycles of rise and fall you would run out of customers. This is the real source of price rigidities, not that silly nonsense about “menu costs”. Especially in the Information Age, it costs almost nothing to change the number on the label—but change it wrong and it may cost you the customer.

One response would simply be to set your price at a reasonable estimate of the long-term optimal average price, but this leaves a lot of money on the table, as some times it will be too low (your inventory sells out and you make less profit than you could have), and even worse, other times it will be too high (customers refuse to buy your product). If only there were a way to change prices without customers feeling so betrayed!

Well, it turns out, there is, and it’s called “on sale”. You have a new product that you want to sell. You start by setting the price of the product at about the highest price you would ever need to sell it in the foreseeable future. Then, unless right now happens to be a time where demand is high and prices should also be high, you immediately put it on sale, and have the marketing team drum up some excuse about wanting to draw attention to your exciting new product. You put a deadline on that sale, which may be explicit (“Ends July 30”) or vague (“For a Limited Time!” which is technically always true—you merely promise that your sale will not last until the heat death of the universe), but clearly indicates to customers that you are not promising to keep this price forever.

Then, when demand picks up and you want to raise the price, you can! All you have to do is end the sale, which if you left the deadline vague can be done whenever you like. Even if you set explicit deadlines (which will make customers even more comfortable with the changes, and also give them a sense of urgency that may lead to more impulse buying), you can just implement a new sale each time the last one runs out, varying the discount according to market conditions. Customers won’t retaliate, because they won’t feel betrayed; you said fair and square the sale wouldn’t last forever. They will still buy somewhat less, of course; that’s the Law of Demand. But they won’t overcompensate out of spite and outrage; they’ll just buy the amount that is their new optimal purchase amount at this new price.

Coupons are a lot like sales, but they’re actually even more devious; they allow for a perfectly legal form of price discrimination. Businesses know that only certain types of people clip coupons; roughly speaking, people who are either very poor or very frugal—either way, people who are very responsive to prices. Coupons allow them to set a lower price for those groups of people, while setting a higher price for other people whose demand is more inelastic. A similar phenomenon is going on with student and senior discounts; students and seniors get lower prices because they typically have less income than other adults (though why there is so rarely a youth discount, only a student discount, I’m actually not sure—controlling for demographics, students are in general richer than non-students).

Once you realize this is what’s happening, what should you do as a customer? Basically, try to ignore whether or not a label says “on sale”. Look at the actual number of the price, and try to compare it to prices you’ve paid in the past for that product, as well as of course how much value the product is worth to you. If indeed this is a particularly low price and the product is durable, you may well be wise to purchase more and stock up for the future. But you should try to train yourself to react the same way to “On sale, now $49.99” as you would to simply “$49.99”. (Making your reaction exactly the same is probably impossible, but the closer you can get the better off you are likely to be.) Always compare prices from multiple sources for any major purchase (Amazon makes this easier than ever before), and compare actual prices you would pay—with discounts, after taxes, including shipping. The rest is window dressing.

If you get coupons or special discounts, of course use them—but only if you were going to make the purchase anyway, or were just barely on the fence about it. Rarely is it actually rational for you to buy something you wouldn’t have bought just because it’s on sale for 50% off, let alone 10% off. It’s far more likely that you’d either want to buy it anyway, or still have no reason to buy it even at the new price. Businesses are of course hoping you’ll overcompensate for the discount and buy more than you would have otherwise. Foil their plans, and thereby make your life better and our economy more efficient.