Monday, October 29, 2018

What is the elasticity of demand facing Whole Foods?

In the FTC's 2006 suit to block the merger of Whole Foods and Wild Oats, former colleague Dave Scheffman argued that the simple pricing model of Chapter 6 implied that the merged firm would not find it profitable to raise price:
In his decision, the Judge cited a break-even analysis (sometimes called "critical loss") that asks how much quantity a monopolist could afford to lose and still want to raise price. With retail margins of 40% (FTC complaint, p.21), a 5% price increase would require a quantity loss of no more than 11.1% to be profitable [11.1%=5%/(5%+40%)]. Citing marketing studies showing that customers shopped at Whole Foods as well as other grocery stores, former FTC Chief Economist and colleague David Scheffman argued that the actual quantity lost would be greater than 11.1%, presumably to stores outside the category.

Implicitly, Professor Scheffman was using the (P-MC)/P=1/|elasticity| to infer an elasticity of -2.5.  We can compare this elasticity to the the one we computed from the pricing "experiment" after Amazon purchased Whole Foods for $13B.  Amazon's pricing algorithms (presumably they used algorithms to compute prices) reduced prices by 30% and foot traffic increased by only 3%.  If foot traffic is a proxy for sales, then we can calculate a price elasticity:


 elasticity = (%change in Q)/(%change in P)=(+3%)/(-30%) = -0.1

Either this elasticity estimate is way off (foot traffic is a bad proxy for sales), or Amazon is trying to accomplish something other than the short-run profit maximization of chapter 6. 

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