Wednesday, October 28, 2015

REPOST: Walmart vs. Amazon: Profit vs. Growth

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).  

1 comment:

  1. The battle between Amazon and Walmart has many different sides. When it comes to profits, Amazon is taking a hit to sell more. However, Amazon is trying to take market shares from Walmart. To do this, you have to become more attractive than the competition. Lower price is a great way to attract customers. Yes, Amazon maybe losing potential profits right now, but with the way customers are shopping, online vs. store, and the fact that you can get anything from Amazon in only a few days at a great price; Walmart should be concerned with losing shares and then losing profits later.

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