Using Demand Signals to Re-Price

A CNBC story indicates that Starbucks repeatedly raised menu prices over the past several years. Initially, this strategy worked well. Higher prices more than offset modest declines in customer traffic, increasing average revenue per transaction. More recently, however, the company's quarterly earnings have shown declining customer visits, and new CEO Brian Niccol has shifted the company's emphasis away from broad price increases and toward improving service, simplifying the menu, and restoring the in-store experience, i.e. product differentiation. While many factors undoubtedly contributed to Starbucks' slowdown, the company's strategic pivot suggests that management believes customers have become increasingly willing to substitute away from Starbucks when prices rise. The available evidence is consistent with demand becoming more price elastic than it was only a few years ago.

Demand elasticity is not a fixed characteristic of a product or brand. Firms may consider premium brands' demand characteristics as permanent, but elasticity depends on the availability of substitutes and customers' willingness to switch. As time passes after a price increase, more consumers become aware that the price has changed, become more willing to experiment with competing brands, and discover acceptable alternatives. With better informed customers, future price increases can trigger much larger reductions in sales than before. The Starbucks experience is less a story about charging "too much" for coffee than about how repeated price increases may inadvertently encourage customers to search for substitutes, making demand progressively more elastic. Every price increase is also an experiment that provides information for future pricing decisions.

Specrtum Auctions Address Economies of Scope

The Federal Communications Commission (FCC) auction can demonstrate economies of scope. The FCC periodically auctions off additional spectrum licenses for advanced services. It recently raised $3.5 billion from recent AWS-3 (Advanced Wireless Services) auctions and expects to raise $30-$6 billion from upcoming Upper C-Band auctions. In telecom, these frequencies are not independent assets; their value is multiplicative. This additional spectrum will allow for greater capacity to handle the exponentially growing demand for wireless data transmission.

Spectrum auctions are usually run as Simultaneous Multiple-Round Auctions (SMRAs). US coverage is divided into many distinct geographic areas that are auctioned simultaneously across many rounds. An aggregation problem arises when a bidder risks winning fragmented licenses that are less valuable without their complementary counterparts. Since transmission has origin and a destination, it is more valuable to win a license in, say, Chicago if the operator can also secure one for Dallas. SMRAs allow bidders to cobble together desired regional capacity by aggregating multiple licenses.

The cell towers, base stations, and cables that link them are huge fixed costs. The ability to defray these costs over more volume reduces average costs. Economies of scale in these fixed costs generate economies of scope across these fixed costs in different regions.

Curating Complements: Apple & USB-C

One of the strongest arguments for industry standards is that they increase competition. A common charging connector means consumers can choose from hundreds of competing cable manufacturers instead of being locked into a single supplier. The resulting competition lowers prices and increases consumer welfare. When the EU required Apple to transition from its proprietary Lightning connector to USB-C in 2023, it illustrated that this logic, while generally sound, is incomplete. The WSJ reports that one independent repair specialist saw Apple iPhone failures associated with poorly designed or non-compliant USB-C cables and chargers. While these failures appear to be relatively uncommon, they highlight an economic tradeoff that is easy to overlook: greater competition among complementors can also increase quality variation. Under the Lightning ecosystem, Apple exercised tight control over accessory manufacturers through its Made for iPhone (MFi) certification program. Consumers paid more for certified cables, but they also purchased into a curated ecosystem with stronger quality assurance. By requiring Apple to adopt the industry-standard USB-C connector, regulators and policymakers may have increased competition, but they may also have exposed consumers to a much broader range of accessory quality.

Firms sometimes vertically integrate to solve coordination and quality-control problems, and not to exploit market power. Apple had strong incentives to ensure that its phones, chargers, cables, and software functioned reliably as an integrated system because failures reflected directly on the Apple brand, regardless of who manufactured the accessory. A proprietary standard gave Apple greater ability to police quality and exclude unreliable suppliers. This is likely the case for many of the Apple iPhone’s complements. An open standard like USB-C creates incentives for lower prices, interoperability, and reduced electronic waste. It also may have shifted more responsibility to consumers, who must distinguish between high-quality and low-quality accessories in a crowded marketplace. In this case, it is unclear if the pre-purchase consumer search costs and post-purchase repair costs were comparable to the competitive benefits from allowing open entry. But the episode demonstrates that a tradeoff could exist.

Can you Go to Jail if your AI Engages in Collusion?

The stereotype of price fixing is fat, cigar-chomping executives meeting secretly in smoke-filled rooms to agree to raise prices. But the Justice Department's recent consent decree with RealPage anticipates that AI collusion may look different. RealPage sold revenue-management software that used confidential pricing information from competing landlords to recommend rents. Although the software generated the recommendations, the DOJ alleged that the system facilitated unlawful coordination among competitors. I had my doubts. Nevertheless, the settlement requires RealPage to stop using certain competitively sensitive data and to change features of its pricing software.

AI can still recommend prices. Firms have used sophisticated pricing software for decades. A broader implication is that firms cannot avoid antitrust liability by outsourcing pricing decisions to an algorithm. If competing firms provide confidential information to a common AI system that helps coordinate pricing decisions, regulators may view the arrangement much like traditional collusion.

This distinction will become increasingly important as companies deploy AI agents to make autonomous business decisions. An AI pricing system that independently analyzes a firm's own costs, demand, and inventory is generally very different from one that relies on competitors' confidential information or otherwise facilitates coordination among rivals. The RealPage consent decree is consistent with antitrust law focusing on economic outcomes rather than how those outcomes were produced.

Use It or Lose It: The Perverse Incentives Draining the American West

If you wanted to design a property rights regime that guaranteed the waste of a scarce resource, you could hardly do better than Western water law's doctrine of prior appropriation. It requires rights holders to put water to "beneficial use" or—after five consecutive years of non-use—forfeit the right. [1] The result is a textbook perverse incentive: a farmer who irrigates more efficiently risks losing the conserved portion of her right, so the private return to conservation is negative even when the social return is big.

Oregon tried to eliminate the perverse incentive with its 1987 Instream Water Right Act that made instream flow a beneficial use. [2] On the Deschutes, conservancies now lease and buy water for the river. [3], but legalizing the trade didn't create a liquid market. Rights are mostly held by irrigation districts rather than individual farmers, so every deal needs board approval, and transaction costs run high: quantifying how much water actually reaches crops through leaky, century-old canals is expensive, and farmers still fear that proving they can conserve invites a future challenge to their right.

In the Colorado River, states face the same problem. If an Upper Basin state conserves, the saved water flows downstream to be consumed by someone else which creates the risk of becoming the baseline for future cuts. [4] Instead, the feds pay farmers billions to fallow fields—a costly government subsidy trying to address the perverse consequences of another government policy. [5]

BOTTOM LINE: any rule tying an asset's ownership to its continuous consumption—budget lines that vanish if unspent, headcount that shrinks if unfilled—will be consumed regardless of value. 

NOTES

[1] Schwabe, Williamson & Wyatt, "Oregon Water Law Questions and Answers" — beneficial use requirement and five-year forfeiture rule. https://www.schwabe.com/publication/oregon-water-law-questions-and-answers/

[2] Oregon Legislature, "Background Brief on Water Rights" — the 1987 legislation adding instream water rights as a beneficial use. https://www.oregonlegislature.gov/lpro/Publications/2004HM_Water_Rights.pdf

[3] University of Oregon School of Law, "Evaluating Instream Flow Programs" — Oregon's 1,100+ instream leases and transfers, including the Deschutes River Conservancy's role. https://law.uoregon.edu/sites/default/files/ai61_ch._22_with_legend1.pdf

[4] High Country News, "Why Colorado River negotiations are so difficult" — prior appropriation dynamics and the interstate stalemate. https://www.hcn.org/articles/why-colorado-river-negotiations-are-so-difficult/

[5] Congressional Research Service, "Management of the Colorado River" (R45546) — federally compensated conservation, including 2.3 million acre-feet paid for with congressionally approved drought funds. https://www.congress.gov/crs-product/R45546

HT:  Claude Fable