Friday, May 15, 2015

Walmart vs. Amazon: Profit vs. Growth

Optimal pricing in a simple one product, one firm, one price world involves a simple tradeoff: higher prices mean more profit on each good sold, but fewer goods sold. The MR=MC calculus can be expressed in terms of margins an elasticity as:

 (P-MC)/P=1/|elasticity|

Simply put it says that the optimal margin should equal the inverse demand elasticity.  So for example, if you demand elasticity is -2, then your optimal margin is 50%.

Retail outlets usually have much lower margins:  Amazon's margin is 4% and Walmart's margin is 8%.  (For comparison, a traditional grocery store or gasoline vendor has 10% margins).  The Financial Times wonders whether Walmart's move into online makes sense:


Initially the Walmart offer will only be available in a few US markets, but if it goes national, Amazon’s US retail margins, already under 4 per cent, could come under pressure. Amazon and its investors seem perfectly comfortable with low returns, though. 

A trickier question is how much pain Walmart is willing to tolerate. Its US margins are 8 per cent and it mints cash. Competing properly online may well mean sacrificing some of that. Capital investment, as a proportion of sales, at Amazon is more than double Walmart’s. It is traditional to fault Amazon for sacrificing profit to growth. Perhaps Walmart should take some heat for sacrificing growth for profit.

In other words, Walmart is following the traditional MR=MC profit maximizing strategy, while Amazon is producing where MR<MC (it is selling too much), and is thus sacrificing some profit for bigger output (and hopefully future profit).  

15 comments:

  1. Simply put it says that the optimal margin should equal the inverse demand elasticity. So for example, if you demand elasticity is -2, then your optimal margin is 50%. buy verified amazon reviews

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  2. Optimal pricing in a simple one product, one firm, one price world involves a simple tradeoff: higher prices mean more profit on each good sold, but fewer goods sold. Buy Amazon No Votes

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  3. I completely believe growth is better and far more profitable in long run, it might be good to get profits temporary but as per long run is concern, it is definitely grow that’s the wish of every person and if we have ability to grow then profits will also come. I am working in Forex industry with high profile broker OctaFX, it’s an regulated company with 8 USD no deposit bonus, so anyone can start trading from that and so far I have made over 200 profits from it!

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  4. The very first point to be made in discussing Walmart and Amazon, is that neither is simple, offering a single product, location, or price. This is definitely a complex pricing decision so higher prices equaling more profit per good but less total goods sold is not necessarily the case. A lower price, even if it means less profit margin, is the best way to move more items. Walmart already has a lower profit margin than is optimal, at only 8%, however is that low enough to compete with Amazon, who has a margin of only 4%? Amazon certainly seems to be sacrificing profit in favor of expansion, but will the expansion be enough to cover the missed profit due to low margin?

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  5. I find it interesting that investors are still focused comparing Amazon with Walmart. For the retail business, it does make sense to compete on profit margins. However, with Amazon’s future, its biggest growth opportunity is its powerful cloud computing web services better known as AWS. In the first quarter of 2015 alone, it has reported $265 million of operating income with nearly 17% profit margins. While the retail business will continue to be the face of the organization, the money is going to be in AWS and its growth potential. That is one area that Walmart will be one step behind, unless it can leverage its supply chain technologies to a broader customer based outside of retail.

    So from an economist point of view, now that’s what we would call a grand economic profit opportunity!

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    1. References:
      http://www.forbes.com/sites/georgeanders/2015/04/23/amazons-web-services-delight-16-9-margins-more-joy-ahead/

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  6. One aspect of the Amazon vs Walmart discussion is how they both achieved their respective dominance. It was by completely dominating the competition. While Walmart still is the achiever in the big box all-in-one store for the lower price tier merchandise shopping consumer market, Amazon has penetrated extensively into multiple consumer tier markets. In fact, nearly anything you may want to purchase is available through Amazon.

    With thank you to James Munro’s recognition of Amazon’s immense computing empire, offering cloud based services, with significant profit margins, there is recognition of Amazon’s impending future growth beyond merchandise markets. They have achieved a respectable command of the aggregate (market) demand for their goods and services.

    One only has to look at the changes in individual buying patterns. Rather than spend time searching for the “best deal” by going to various websites, or to stores themselves, or to go to price comparison active web-searching sites (apps), I generally have learned to go to Amazon first, where product description, availability, best price algorithms are already in place and active, to find the product of interest.
    I think Amazon decided to achieve world domination is more important than having a short term (current) situation where their marginal revenue (MR) is equal to or barely exceeding their marginal cost (MC). And they are obtaining customer loyalty and “first go-to” reflex, which will pay off handsomely in the future.

    Lee Lichtenstein

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  7. Pricing is a powerful but oft-neglected tool (Froeb ET all, pg. 67, 2014). So I have found myself shopping at the new (or at least new to me) retailer Five Below. It is a rather simple but brilliant concept, every single item costs $5 or less; a real bargain. The merchandise quality is much better than the local $1 store which includes niche merchandising such as an extensive selection of cell phone cases and accessories. You are not going to find a $5 Otter Box here, but you will find a close and comparable substitute.
    If you have not been here then you are missing out, it is true lesson in pricing. All day long the cell phone case aisle is packed with as many people that can fit in the allotted space. At $5 a pop it is simply impossible to buy just a single case. People are actually standing in line to fill a basket up with cell phone cases in different colors or styles. Of course while you are there you might as well fill another basket with complementary products like chargers or blue tooth speakers and while you are at it why not buy some other items like old DVD’s or video games; all which have a selection of complimentary items of their own. It’s amazing, the name should be changed to the $85 store because that is what you wind up spending.
    Price elasticity measures the sensitivity of quantity to price (Froeb ET all, pg. 72, 2014). They also are geniuses at luring you into the store. For example the Sunday circular will highlight a premium product like Star Wars action figures. You will go to the store and for certain the action figures will be present and abundant, why not buy 10 at this price and while you are there fill a basket with cell phone accessories. Once again they should change the name the to the $85 store.
    JG
    Froeb, L.M., McCann, B.T., Ward, M.R. & Shor, M. (2014). Managerial Economics: A Problem Solving Approach. Mason, Ohio: Southwestern Cengage Learning.

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  10. Regarding Amazon and MR MC, you have to remember that Amazon is a multi-headed behemoth and not sacrificing some revenue might be well worth it if the knowledge and/or benefit gained helps them elsewhere in their business. For instance, most people look at Amazon Prime for the free shipping but Prime also gets you free Amazon Prime Video access which there they can upsell video rental, purchases, etc. and make more revenue and profit at little cost. So what looks like a MR less than MC in one product area probably leads to a MR greater than MC in another. In these cases they ultimately average out and I am sure they benefit!

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  11. Amazon and Wal-Mart have somewhat different business strategies. Wal-Mart’s model captures customers in communities throughout the United States in a variety of aspects. Wal-Mart focuses on providing an all out experience (suggested by Lee Lichenstein) and a one-stop shop for items that are necessary for your everyday life. Berliner (2015) from NPR implies that Wal-Mart is trying to engage consumers on purchasing their groceries within their store to create a larger consumer base. One might surmise that this will ultimately create additional foot traffic and random purchases to increase their bottom line as an entity. After reading Froeb’s post, Wal-Mart’s higher margins could be attributed to the companies focus on providing convenience for their consumers such as: refrigerated products, unique array of products, the tangible experience amongst others pertinent factors, etc.

    Ultimately, I believe that Amazon’s business strategy is to build its customer base extensively. As the next several generations become more computer savvy and inclined to purchase products over the Internet, it will continue to grow. Eventually, Amazon may add additional services once attaining greater levels of economies of scale to support such a low margin to consumers. In order to combat this, Wal-Mart will continue to offer services that are less attainable from online vendors to show it is different than its competition as well as expand its online purchasing power.

    Over time, I imagine Amazon’s near zero margins could either pay off handsomely or prove to be not worthwhile depending on the retention of its consumers and the prices they continue to offer. A business operating at a level of MC>MR will not maintain viability unless bringing in capital through some other type of avenue as “Jim O” suggests in prior commentary. It is actually a unique way to earn capital and one that could prove successful. Ultimately, I believe that greater elucidation is needed to understand consumers purchases as well as their value on going to an actual store rather than buying online and vice versa. What is the threshold to sway customers to the store or to the Internet? Additional market research would be interesting to understand the psychology of consumers related to these aspects as online purchases become more common and store visits less common.

    Reference

    Berliner, Uri. (2015). Why Wal-Mart Is Betting Big On Being Your Local Urban Grocer. NPR. http://www.npr.org/sections/thesalt/2015/04/04/396890106/why-wal-mart-is-betting-big-on-being-your-local-urban-grocer

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