Friday, September 18, 2009

From the archive: Upward sloping demand curves

As noted previously, the presence of long lines for a variety of goods strikes economists as bizarre. Why don't firms raise prices to reduce the excess demand?

There are a number of explanations ranging from the sales of related products (discussed below in the world cup post) to dodging taxes (by having some off the book side payments) to concerns about consumer reaction to price increases (if consumers think that price increases are unfair they might punish producers) to the fact the individual demand is a function of aggregate demand.

This last explanation is outlined by Gary Becker in his brief "A Note on Restaurant Pricing and Other Examples of Social Influence on Price" in the Oct. 1991 Journal of Political Economy.

Becker argues that these phenomena frequently occur for products (like eating meals in restaurants, watching concerts or games, talking about books, movies, TV shows, or even actors, models, or musicians) which are, at least partially, social activities. If the pleasure of consuming a good increases if lots of others consume it (because people want to fit in or because confidence in the quality of the good increases), then demand increases with aggregate demand. And, with strong enough social interaction effects, demand may increase with price.

Becker goes on to describe a side-ways "S" shaped demand curve that falls, rises, and then falls again. This produces two profit-maximizing equilibria. One has a low price and excess capacity and the other a high price an excess demand. The trick for producers getting to the high price, excess demand equilibria. This involves coordinating demand and explains why firms in these types of industries spend alot of effort and money on advertising and publicity.

This approach also helps to explain why popular restaurants are very small (that is, why places which regularly draw crowds don't increase their supply). Because the market has multiple equilibria and because consumer coordination determines which equilibrium is reached, producers have to worry about consumers deciding that something else is "so hot right now" and disappearing. This fickleness in consumer tastes makes expansion a risky investment. (Suppliers may also not want to increase supply if the size of the line matters. That is, without the long line demand starts to fall.)

I have worked in a lot of restaurants and the busy ones are busy because the service and product provided is more desirable. Does the line make the service appear more desirable or even make it more desirable? I think we can compare the people of the latter to the common misconception of the lemmings.
Have fun waiting in line suckers.
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