Question

Please read "An Economist Sells Bagels" by Steven D. Levitt (you can find a PDF on Google) You can skip the model section (section 3) and focus on the introduction, explanation of the process and the results and please answer the following questions-

1. Is this firm a competitive firm or does it have market power? What trends are there in consumption of bagels and donuts?

2. Based on the evidence presented in the case, are bagels and donuts substitutes or complements? Do sales of one product cannibalize sales of the other? Can you explain why?

3. Why are price changes more costly to make compared to quantity changes? How important are signals in the market in deciding price and quantity changes? What reliable signals is this firm getting?

4. Why would a firm knowingly not maximize profits?

Answer 1

1. The firm studied in "An Economist Sells Bagels" is one of a kind and thus has market power. However, the firm is a unique one in the sense that its payments are based on honor system. The consumption trends as per data are that a total of 80,731 deliveries took place between 1993 and 2005, with an average of approximately 30 bagels and 13 donuts per delivery.

2. Based on the evidence presented in the case study, bagels and donuts are substitute goods. The sales of one product cannibalizes the sales of the other due to the possibility of stock- outs. This is because bagels and donuts are substitutes which offer different degrees of profitability to the firm. When stock of one exhausts, the consumers substitute it by the other. By comparing changes in the data, Levitt finds out that extra donut eaten lowers bagels eaten by .144, and that the cannibalization rate in the other direction is .163.

3. Price changes are more costly to make compared to quantity changes as frequent price changes may cause dissatisfaction among consumers. In this case, it might have even lead to non- compliance of consumers to the honor system. Also, price changes incur menu costs which are cumbersome for the owners.
Although the firm successfully experimented with quantity changes often, this was so because of the presence reliable signals in the market. These signals were in the form of direct mechanism which linked firm's actions to observable outcomes. The firm received daily feedback through sales responsiveness and instantly rectified any mismatch on the quantity dimension. On the contrary, the firm has no direct mechanism for evaluating its pricing.

4. A firm might avoid experimenting with prices to reach the profit maximizing levels due to absence of a mechanism that incorporates consumers reactions in its supply decisions. The activities of the firm seldom provide any useful information in determining the optimal price. Thus, price changes are viewed as costly to make and applied less frequently.