The Office-onomics?

The following is a guest post by Linda Jinesyarn merchant, book titler, and sister of Steve Levitt. Enjoy.

The Office-onomics?
A Guest Post
By Linda Jines

The most recent episode of NBC’s hit comedy The Office offered viewers something extra along with its usual half hour of wry observations about life in Dilbertian corporate America. The episode, entitled “Broke,” included a lesson — an attempted one, at least — in microeconomics.

Some backstory: The Office, currently in its fifth season, is a “mockumentary” about life in a small, stagnant, Scranton, Pa., outpost of fictional paper company Dunder Mifflin. Office star Steve Carell plays Michael Scott, who until this season was the regional manager of the titular office. In a fit of pique, he left to form his own paper company — the Michael Scott Paper Company — which is now foundering, due to his marketing strategy of undercutting competitors’ prices.

In the Thursday, April 23, episode, Michael Scott consults with an accountant to determine how much he might be able to pay someone to make his paper deliveries. He’s told that he can afford to pay a delivery person nothing, as his prices are too low.

“Look, our pricing model is fine,” a Michael Scott employee tells the accountant. “I reviewed the numbers myself. Over time, with enough volume, we become profitable.”

This is where the economics lesson begins in earnest.

The accountant replies, “Yeah, with a fixed-cost pricing model, that’s correct. But you need to use a variable-cost pricing model.”

He goes on to explain, “As you sell more paper and your company grows, so will your costs. For example — deliveryman, healthcare, business expansion … At these prices, the more paper you sell, the less money you’ll make.”

So did the writers for The Office get it right? Is it truly and ineluctably the case that underpricing your product will put you out of business, no matter how many sales you drum up?

I decided to ask the resident expert on all things economic, my brother Steven Levitt.

I recited the accountant’s dialog to Steve (also a fan of The Office, as it turns out) and asked his opinion. He replied:

None of it makes that much sense, really — because usually there’s a fixed cost of setting up a business, and then there’s a variable cost every time you sell one more unit. But usually we think that the average cost per unit sold goes down the more you sell. It is completely possible that a company could go from unprofitable to profitable by charging the same price but selling more. On this one, I side with the Michael Scott Paper Company.

Uh-oh. Based on the accountant’s information, Carell’s character decides to close his paper company (in true Hollywood style, Dunder Mifflin rushes in at the 11th hour to buy him out and rehire him).

So was the Michael Scott Paper Company in the right with their ultra-low-price strategy? Steve replied:

No, I think they were probably charging too low a price, but not for the reason the accountant
said.

My guess is they were charging too low a price because most companies that I’ve worked with closely — when you run the numbers — are charging too low a price. I’ve never seen an obvious example — again, with the companies I’ve worked with — of a company charging a price that is clearly too high.

This discussion of low prices was all well and good, but it was time to move it from the theoretical to the practical.

“What if HarperCollins decided to charge just $12.95 for the new Freakonomics book?” I asked.

“That’s a reasonable price,” Steve replied roguishly, “… for the first chapter. But what about the rest of the book?”


Imad Qureshi

Very interesting. About Steve's joke on $12.95 a chapter. through this website he has developed quite loyal customers (if you would call us customers. I am assuming few authors of this blog get paid for blogging here) because they bring in lot of eye balls to this website (higher ad revenue). If not its still great marketing for their next book. In a mature market of books Steven has differentiated his product. I think he should be able to successfully charge a higher price for his next book (though not $12.95 a chapter) and also a higher cut from publishers.

DG Lewis

"I've never seen an obvious example... of a company charging a price that is clearly too high."

Would you be interested in some Yankees' premium seats?

Ryan

You are ignoring the crucial fact that the accountant explained that as they sell more paper, the Michael Scott Paper Company will find it necessary to hire more works (such as the delivery man) and will need to start covering health care and other costs. Although these aren't "variable costs" as we usually use them, the accountant was correct in the sense that the "fixed costs" grow as the company grows.

I side with the accountant.

Mike

I see prices that are too high all the time. "More than the other guy," assuming similar time to acquire, reliability, etc., is the definition of "too high."

And if $12.95 is "too low" for the next freakonomics book, they're pricing themselves out of at least one customer. HarperCollins should take a lesson from Valve's game sales, where substantial price cuts resulted in exhorbinant sales revenue increases.

sarahmas

Dude... you have to give spoiler warnings! I have 3 weeks of the Office on my DVR and now I know what happens. Boo, Freakonomics!

Leland Witter

I think that we could make the allowance that the accountant is right if we consider the short term and assume that they aren't capitalized sufficiently to get to the long term.

They can only afford a closet for an office and a used Korean church bus as a delivery vehicle. If they based their slim profit margins on those costs, then they likely wouldn't be able to afford a delivery person or anything else in the short term. Unless they could somehow dramatically increase sales to get to a lot of volume quickly, they wouldn't be able to cover costs long enough to ramp up to profitability.

Hmm, sounds like a pretty common scenario, actually.

Leland Witter

@Mike - Really? $12.95 is too much for the new Freakonomics book?

Compared to say, a burger and soft drink at Chili's? A couple of drinks at a decent bar? Four cups of coffee at Starbuck's?

spence

I agree with Mike...$12.95 is pushing the limits of what I'd pay for a book. There's always the public library.

YX

-- Ryan,

in theory, fixed costs will never grow in proportion to production due to "doubling", or simply duplicate the current setup for double the output and same % of fixed cost. So in theory "more you sell more you lose" would never happen. Though they might never move to profitability.

Of course this does not work in real life since scarcity of the resources.

Rachel Eden

As an accountant I have to side with the accountant! Admittedly the fixed cost per unit will fall as he expands, but of course the costs we think of as fixed aren't really. They are more likely to increase every so often as he expands his base of operations. Accountants call these 'step costs' I guess economists might say that he would go over his maximum efficient scale,

ceolaf

There's a big problem with the smart economist's analysis.

The cost curve is not smooth and simple, as he seems to assume is. Sure, for a large large large company that might be the case, but for a very small company, it is anything but.

For example, adding a deliveryman is a big jump in costs. Adding healthcare is a big jump in costs. There are all kinds of rule and regulations that only apply when companies get above a certain size.

So, this is a question of scale. The accountant could have been right for the scale that he is considering, even if Levitt is right the way that economists generally think.

That is, the tiny tiny tiny and unprofitable Michael Scott Paper Company could be about to hit some major increases in costs that would make it even less profitable, with profitability happening so far down the road (i.e. so much growth) that it is inconceivable to the accountant.

The reason why this wouldn't occur to the smart economist that businesses this stupid don't get off the ground. Remember, Michael Scott's stupidity is key to this show, and far beyond what real men and women are capable of.

Read more...

deeznuts

One could argue that this is part of the WalMart strategy, undercut your competition via loss-leading prices until you run them out of business, and then establish a (quasi-) monopoly for the region/market/item.

Darren

In a small business like MSPC, fixed costs are purely theoretical. Any fixed costs expended (improvements on the closet, the bus, etc) cannot reasonably accomodate any needed expansion in business, and require further investment.

Then there's the growth imperative. MSPC wants to topple Dunder Mifflin, but there's reams of investment necessary to bring MSPC up to the capacity of Dunder Mifflin (warehouses staffed by Darrells, assistants to the regional managers, etc). MSPC will be continually investing for growth, making profit theoretical as well.

Cash flow is what needed to be discussed with the accountant, that's the true determinant of proper pricing for a super-small business, not profit/loss. Was Michael pulling a salary? Booking salary payable creates a big deviation between profitability and pos cash flow in a three-person biz. If cash flow from the current pricing supported current operations, THAT'S what should have guided Michael's decision.

Read more...

Mike

Yes Leland, $13 is too much for a book. Don't use an overpriced trash meal as justification for something else being overpriced. If I'm going out to eat, I'll go to a small local restaurant that his higher quality and less expensive. My usual lunch at work is only $0.25-30. I might be convinced to pick up a paperback copy for $6. Even better would be a PDF for $2.50. Of course, it'd have to be DRM-free and not require any sort of registration to buy it, otherwise copyright infringement is a heck of a lot easier.

Blake

I think the point is that Michael Scott was treating variable costs as fixed. Likely they are actually step costs: $10 for 0-100 units, $20 for 100-200, etc. The important thing is that they rise with volume.

What the accountant is saying is that his variable costs (when including the step costs) are higher than his selling price, therefore his gross margin is negative. With a negative gross margin, you lose money with every sale.

R

I thought the negotiation for the buyout was quite brilliant, and hightlighted how seemlingly irrational decisions are made by large corporations....in this instance overpaying for a smaller, weaker competitor.

The CFO of Dunder Miflin said something to the effect of..."we've seen your cost structure, and there's no way you can outlast Dunder Miflin at those prices."

To which Michael Scott replied, "Your board meeting is coming up, and your going to have to explain to them why your formerly most profitable is now bleeding. The truth is, I don't need to outlast Dunder Miflin, I just need to outlast you!" ...and the CFO immediately acquiesced.

Unfortunately, I have seen these types of decisions made more frequently then one would hope.

hal

I have seen the alleged "WalMart strategy" (#12) in action in the former airline business.

Delta once flew from Mobile, AL to Atlanta, GA for $479 round trip - a "princely" sum. So the Mobile business community asked another airline (Valu-Jet) to enter the market. Valu-Jet asks for a guarantee in the form of a $100,000 subsidy for the first year. The businesses pony up and Valu-Jet starts service with $179 round trips. Delta immediately drops its fare to $179. Customers look at the price equality and overwhelmingly choose Delta on the basis of perceived higher quality for the same price. Soon Valu-Jet is flying empty planes roundtrip to Atlanta, and at the end of the year quits flying the route altogether. Delta promptly raises its fare to $479. Another small example of the free market (free of regulation).

Want to see a giant enormendous example? Look at your cable bill. My community has two broadband providers, cable and DSL. Neither competes on pricing. Both "compete" on ever more fanciful full-package offerings (no unbundling or cafeteria menu) in an attempt to raise the level of inconvenience for changing. My local government-owned utility is both capable and willing to provide service at half the corporate robber-baron prices, including providing some subsidization (in the form of "profits") for other services, but will be legislatively prohibited by the "bigs" swinging their clout in the capital.

While it's fun to watch The Office, and I do so regularly, it is farcically inaccurate on the larger issues involved in our economic system. We delude ourselves into thinking there is real competition and that we pay fair value for most important commodities. Any corporation worth its salt (funny, salt used to be the actual measure of wealth) makes regular payments to create protectionist legislation and preserve the bigs' dominance over the smalls.

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Hmmmmm

"The reason why this wouldn't occur to the smart economist that businesses this stupid don't get off the ground. Remember, Michael Scott's stupidity is key to this show, and far beyond what real men and women are capable of."

Don't be too sure of that. Travel consolidators in NYC routinely sell tickets below cost on the theory that volume will help them make money. They last 3 to 6 months on this idea before closing up shop. Meanwhile the competitors have to take a price hit or lose the business.

After all you are only as profitable as your least dumbest competitor.

Paul

Regarding the price of books, I've often wondered why the price of good books is so low. If someone is going to spend (even conservatively) $100 of their time reading a book, why should another $10 on the price matter to the rational consumer if the book is even 10% better than a cheaper one? I'm a frugal student, and even for me, the limiting factor on the number of books I read is my free time, not my bank account. I can't recall ever not reading a book because it was too expensive.

Matt

I think the accountant was referring to the overhead costs. The paper cost is always a variable cost. But such a small company would have variable overhead which grows as the company sells more paper.

So, if they kept the same overhead and sold twice as much paper, they might make money, but selling twice as much paper means they'd be working 80 hours a week instead of 40.