The Economics of Hooking Up

In honour of Jean Tirole, just announced as the Economics Nobel Laureate for this year, here is the introduction to my Masters Thesis from Spring 2008, which focused on his exploration of the theory of two-sided markets. This concept would come to dominate his research and ultimately lead to his Nobel prize win today.


1 Introduction

A group of men are out on the town, looking for a place to go for the night. They come across two identical nightclubs, on different sides of the street. On the left side of the street, the entrance price is €3. On the right hand side, the entrance price is €5 for men, while women enter for free. Without hesitation, the group of men enter the bar on the right hand side and pay their €5.

From a traditional economic point of view, this choice is irrational. The nightclubs are identical, and therefore utility will be maximised by choosing the cheapest option. This analysis however would be to ignore the intent of the men completely. They are not looking for a nightclub at all- they want to meet women. The nightclub is simply a meeting place with little intrinsic value but as a designated area where men and women can meet each other in a relaxed environment. By charging women less, the nightclub on the right will attract more women and crucially- more men.

This nightclub example is the most accessible and used exposition of the notion of Two Sided Markets, an increasingly explored area in theoretical economics. A two sided market is said to exist if two different types of consumers interact over a common platform. This is easily applied to the opening example- men and women interact in the platform of the nightclub. This definition however is too broad. With creativity, the definition could be applied to almost all markets. For example, employees of a sausage factory could be said to interact with the end consumer over the platform of the sausage firm. Equally it could be said that politicians and voters interact over the platform of the state.

Blanchard and Tirole (2006) define a market as two sided if the platform can affect the volume of transactions by charging one side differently. Using our opening example, we can see that the nightclub on the right can attract more women by charging no entry fee. If men were not charged entry fee also, this could negatively affect the number of women, as the nightclub could be seen as lacking quality. This leads on to a further definition of two sided markets, which is that efficiency can actually be improved by charging one side of the market differently.

The world is full of other examples of two sided markets which discriminate against one side. Shopping malls charge a lease on storeowners, while shoppers can walk around the premises for no charge. Credit card companies charge higher interchange fees to banks in order to offer ‘no annual fee’ contracts to credit card holders. The key point is that even though one side is discriminated against, very often both sides are happy with the arrangement. Men want more women in the nightclub, and see the pricing system as an aid to this goal. Shopkeepers would see a severe drop in business if shoppers were required to pay an entry fee to visit the mall. Banks gain revenue from credit card use, and therefore any incentive created to increase usage would benefit them also.

The analysis of two sided markets is an emerging discipline in economics, with its uses and relevance still to be defined. The research that has been developed so far concentrates on the mishandling of two sided markets by national Competition Authorities when investigating anti-competitive claims in the sector. In these institutions, traditional economic analysis is held as law. It is easy to see how the analysis two sided markets could be misinterpreted in this way. What the nightclub on the right hand side is doing is blatant price discrimination.

To stop the investigation there and impose a fine would be erroneous however, as it would ignore the reason for the price discrimination, and ultimately lead to a suboptimal welfare allocation, where neither side of the market is satisfied, and therefore the platform suffers also.

The focus of this Master Thesis is on this problem, albeit with a focus on the media sector, an industry that is of particular interest to two-sided market theorists. The media industry exhibits a wide degree of examples of two sided markets. There are newspapers that charge a cover price while also charging spot rates to advertisers, while there are also newspapers with no cover price to the end consumer at all. The same goes with pay TV versus Free TV. Also the two sided market model exists in both the old economy of newspapers and magazines as well as the new economy of social networking sites and other Web 2.0 platforms.

Following this introduction, Chapter 2 is a literature review of two sided markets, with an emphasis on practical application in the media sector. Chapter 3 presents a number of processed media cases taken from different Competition Authorities. Chapter 4 offers a critique of these decisions based on the two sided market intuition developed in Chapter 2. This is followed by a conclusion detailing the competence of these Competition Authorities in analysing cases which exhibit characteristics of two sided markets.

 

 

 

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How To Steal Christmas

Recently my attention was drawn to an ingenious deviant of Christmas party game, known as a White Elephant Gift Exchange. In a similar vein to a Secret Santa format (party variant), all guests bring a gift to the party, and then each guest individually (by way of assigning numbers and drawing lots) gets to open one gift that he/she can choose from the pile of other gifts.  The guests agree beforehand to respect certain budgetary (and sometimes thematic) criteria. The novelty arises in that when it is a guests turn to open a present, he or she also has the option to simply take a present that has already been opened instead. Yes, you get to steal presents from people who have already opened theirs. If you like the look of something that has been opened, you can simply bide your time and wait for your turn in order to steal it. Once you steal someone’s gift, they have the option of either opening another package or stealing someone else’s (they cannot immediately steal back ‘their’ gift that you have just stolen, but this can occur later). Thus this chain of treachery, jealousy and confusion continues until the last gift is opened and no more stealing is possible. In ending up with the best gift of all, a White Elephant Gift Exchange offers the distinct possibility of fulfilling the childhood dream of actually winning Christmas. This post will go some way to explaining my thoughts on how to achieve this. As always, I assume the worst in human nature.

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From a theoretical perspective, there are two considerations, ranked as follows:

1)      The quality of the gift you leave the party with.

2)      Your enjoyment in watching other guests steal each other’s presents.

Since it is a game, a lot of the fun is in taking part, yet really the most important part of any game will be in the winning. In this case, winning would involve getting a present that you really like, or (if you are a particularly spiteful person), getting the best present available, regardless of whether you actually wanted it or not. In any case, the behaviour of other guests is also a consideration and it would be preferable from an entertainment point of view for there to be as much skulduggery as possible, and preferably without affecting your pursuit of your desired Christmas gift.

So, with these two goals in mind, a strategy is needed in order to maximise the potential to achieve both. Again, looking at the game from a theoretical view, there are two ways in which an individual can affect the game from the outset:

  • Before the game: Choice of present you bring.
  • During the game when your number is drawn: whether to unwrap, or steal.

An overlooked strategy for success in winning Christmas during a white elephant game is our personal choice of present brought to the table. Remember this can occur long before the game, and therefore there are no excuses for overlooking the importance. The obvious strategy here would be to buy something shite or embarrassing, wrap it up, and bring it along. Someone opens it on the night, wow they are embarrassed, there is laughter for 30 seconds, the game moves on to the next person. No one will steal your shite present from the person who opened it, and you have not really added to the game. Nor will you have furthered your aim of winning Christmas.

I would argue here that an optimal strategy is buying (within the specified game rules) an exceptional present, one that takes into account the preferences of those in attendance, with the knowledge that most would want it. This scenario would guarantee multiple steals, and ensure tension throughout the remainder of the game. Not only that, but if done well, it could distract the majority of guests from following and possibly curbing your pursuit of a desired present. Let them fight over your trinket, while you covertly manoeuvre your way to glory. Therefore it is apparent that plenty can be done before the game begins to ensure a rich bounty come the end of a  white elephant exchange.

This manoeuvring is easier said than done however. The game can be won and lost through poor decision making when it comes to your turn. Choosing to unwrap a gift will yield one of two outcomes: a good gift, or a bad one. If it is a good one, it will be stolen almost immediately. If it is a bad one, you will be stuck with it forever. My recommendation here would be to steal the best available unwrapped present at the time, even if you do not want it. The rationale would be that even if you do not want it, someone will, and will steal it from you eventually. When this occurs you will get to choose again, possibly from a greater selection of unwrapped presents, and just possibly there will be something available that you really want. The point here is that if you steal, people are more likely to steal from you, and if this occurs, you will get to choose more often. With patience, you will get to the gift that your heart desires.

Luck does enter the game at various points. The order in which guests take their turn to receive a present is completely random, and it really does not pay to be drawn early, as there will not be many stealable gifts to choose from, and the eyes of the guests will be around you, resolving to steal anything of even remote quality. Of course, this will just lead to more opportunities or you to observe the possessions of all around you, and plunder the best. The strategy I have laid out here will not win you friends, nor earn you invites for next year’s party. All it can give you is the chance for victory, on this most holy of occasions.  Only with such a strategy can one hope to tame the white elephant. Only with such a strategy can one have the chance to win Christmas, once and for all.

Fight the Dead, Fear the Living: Civil Inattention at the End of the World

As anyone who has reached the age of 30 can attest, the hangovers sure do not get better with age. What make these hangovers almost bearable is the existence of Netflix, and having the unbelievable power of limitless streamed TV shows and movies available while you lie on the couch and hate yourself. After a particularly heavy night last Saturday, my girlfriend and I dragged ourselves out onto the couch at around 2pm on Sunday, and started binge-watching The Walking Dead. The show revolves around a group of people struggling to survive a Zombie Apocalypse, but is far more interesting than that premise sounds. Zombies are slow and stupid, so within a series or two, the zombie threat somewhat stabilises as our survivors learn how to deal with them, and the focus of the show shifts to their interaction with other groups of survivors in this post-apocalyptic world. These interactions rarely end well, and usually involve as many deaths as a zombie attack would have yielded. Maybe I have seen too many post-apocalyptic movies in my lifetime, but I did not find this too shocking. My girlfriend, on the other hand, could not believe that people would be so ruthless to each other when they were all going through this nightmare zombie plague together. They were all human and should help each other survive, she said, why should they act so barbarically to each other? Now, as you may have noticed if you are a regular reader of this blog, I am not the type of person that hears a question and doesn’t at least pretend to know the answer.

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One of the main reasons people congregate together en masse is because more is accomplished when we work together. Human society only really emerged when groups of people stopped wandering around hunting, and made permanent residences where they farmed, growing their own food rather than relying on just killing animals to survive. This led to probably the greatest achievement of the human race, which was how our ancestors removed us from the food chain. When within the food chain, our ancestors survived day-to-day, constantly scavenging for food and living from meal to meal. This is how all other animals on this planet spend their lives. To most animals, the future is merely where the next meal is coming from: it would be pointless to imagine further than that, even if their brains had the power to do so. To us, outside of the food chain, we can imagine tomorrow, and next week, and even do things today that we hope will benefit us years from now. We go to university, invest in the stock market, and commit to a twenty year mortgage.  All of this is backed up by our faith in the power of laws and law enforcers to ensure that society will still be there when this future that we imagine actually occurs.

Further, and I will be blunt; people are not actually supposed to live as close together as we do now. More specifically, we are not supposed to interact so much with people who are not in our own immediate family. Often we forget that we are little more than animals with big brains, but animals nonetheless. Not many animals play well with others of the same species that are not part of their own community. Communities develop from the mixing of two or more families that learn to cooperate, and these communities do not react well to outsiders. This was the same with humans, yet over a period of thousands of years, technological and political advancement have led to the emergence of towns and cities. The idea of a city, with millions of perfect strangers living side-by-side on a daily basis is something that is extremely unnatural  in an evolutionary sense, and one that is unique to humans.

Think of yourself on an elevator when a stranger enters. You both pretend to ignore the fact that you don’t know each other and are trapped in an enclosed space for what can feel like an excruciating amount of time. If you put one of your homo-erectus ancestors in that space with a stranger for the same amount of time, only one of them would be coming out when the elevator doors open again. The awkwardness you feel in the elevator is a kickback to this: your primal urges indicating to you that the stranger is a threat to you. What human society has achieved over the millennia is the strength of will to ignore these urges, and trust that the other person will not harm you, that the hundreds of other people walking down the crowded street with you will not harm you, and will ignore you if you ignore them. This system is known as “civil inattention”, and is once again backed up by the existence of laws and a police force to step in and impose order if it all breaks down.

Back to zombies. I hopefully have conveyed above that two of the main lynchpins of the massively urbanised society are 1) that we have removed ourselves from the food chain and 2) that we can safely live amongst strangers. These advancements are backed up by a system of laws that ensure the safety of all of us in case some deviants may veer from the course of civilised behaviour. In the event of a zombie (or any other kind of) apocalypse, the first thing to disintegrate will be the mechanisms of the state that impose order. The police force and army are not trained to combat the undead, and therefore will be overrun and therefore join them in their quest for brains, swelling the ranks of the walking dead. This precipitates the breakdown of the very fabric of society. When thousands of zombies are baying for your flesh, it is fair to say that we are well and truly back in the food chain. Further, with the breakdown of organised society, no excess food is being produced anymore, and therefore any survivors of the apocalypse must once again scavenge for each meal, living from day-to-day, while at the same time escaping the hoards of zombies who only want to eat human flesh.

Humans are adaptable, however, and this is why we have survived. After a certain amount of time, any survivors will adapt to the situation and forge outposts for themselves, attempting to rebuild a sense of society. Small communities may emerge, but how will they react to outsiders? Any safe haven from the zombie threat has been hard won, and no one wants to give up ground, or share scarce resources. In essence, this reduces the human race to how we were a few hundred thousand years ago, to the level of an animal fighting for territory when confronted with a stranger that is not part of the settled community. Even if the outsider is harmless, it is impossible to ignore the threat, as the times are different and there is nothing to stop one overpowering the other and stealing possessions. What is most unsettling is that even if you don’t believe this, and you believe people would never resort to this, your best strategy for survival would be just to simply assume that everyone you meet will try to kill you and that it is up to them to prove you wrong. Civil inattention is therefore impossible and the collapse of society becomes a mutually detrimental equilibrium in a prisoners dilemma. Survival, from the clutches of zombies and outsiders alike, is the only future in such a world, and therefore thousands of years of our advancement has been destroyed.

I don’t like zombie movies, nor the supernatural in general, yet I liked The Walking Dead. In a similar vein I am not a fan of fantasy, dragons nor magic, yet I have devoured every minute of Game of Thrones and every page of A Song of Ice and Fire. What I find fascinating in all of these is simply the politics involved in societies so vastly different from our own. The Walking Dead in particular makes you realise just how quickly the norms of society could breakdown if just a few hundred million people die, and in the process become zombies that crave the flesh of the living. It really reminds us of how fragile an existence we really live and how far we have come as a species, particularly when lying on a couch all Sunday evening praying for the end of your world.

On Optimal Strategies in Drink Promotions: Towards a Happier Happy Hour

The ‘Happy Hour’ is a cultural institution that exists in bars all over the world. For certain explicit hours of the day, often in the early evening, a bar will offer drinks served at much lower prices than normal, the aforementioned “happy” hour(s). This institution of course has benefits for both customer and the bar itself. The customer obviously saves money and feels good about claiming a discount. The bar gets more customers into the premise than they otherwise would expect at these hours, which hopefully will attract more customers from the street and maybe even some of the Happy Hour crowd stay on for longer once the prices go back up. The exact drinks promotion that is offered during Happy Hour can vary greatly from bar to bar, with conservative establishments offering merely cocktails reduced by a Euro/Dollar/Pound or two, while others can offer free shot chasers with each drink. By far the most common Happy Hour however is the ‘two-for-one deal’, where when you purchase from a limited stock from the bar (usually just beer and certain wines), another of the same drink will be supplied free of charge. This simple Happy Hour rule is widely used all over the world, but it is far from an optimal strategy for the efficient distribution or intake of discount recreational alcohol. This article critiques the two-for-one Happy Hour deal, and proposes a modified variant which is shown to offer extra utility for both the customer and the proprietors of the bar itself.

The fundamental rule of a Happy Hour is that any income earned during those magical minutes is extra income: it is likely the bar would be practically empty without the incentive. The deal attracts customers who otherwise would not exist, based on the promise of reduced price alcohol. In the case of the two-for-one deal, the bar will always lose money on each transaction involving the drinks included in the deal. The hope is that the extra business flowing from the increased number of customers will still mean that the bar is making money at the margins, albeit very incrementally with each extra customer that is getting a half price beer. Ideally though, the bar management want everyone who gets a reduced price drink to still be on the premises after the Happy Hour ends, and willing to pay for a full price beer which would make up for the lost bar income. This hope is not entirely based in reality however, as two-for-one bars generally empty significantly once the deal ends, as all of a sudden the bar is just a bar, with nothing happy about it whatsoever.

On the customer side, the two-for-one deal seems to be a great deal. Going to the deal with a (precisely) even number of friends would mean that for the duration of Happy Hour, each would pay half price for a beer or wine of his/her choice. Not many two-for-one deals venture outside these cheap standard beverage options however, meaning consumer choice is severely limited. Once the deal ends, there is not much incentive to stay in the bar, as the customers simply came for the cheap drinks that do not exist anymore. If the customer is responsible and wanted to go home at a respectable hour, this is fine. Otherwise, it is either a premature end to the evening or the beginning of a search for a new bar. In summary, the two-for-one deal is costly to the bar owner, and but a throwaway gimmick for the customer. The model works, yet it could be so much more.

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An Alternate Model, Incorporating Risk

For the duration of a Happy Hour, all drinks are normal price. A customer queues and orders at the bar, and when the staff bring his bill and drinks, an unbiased coin* is flipped. The customer calls heads or tails. If he is correct, his drinks are free. Otherwise, he pays. All drinks in the bar are available to order, yet he cannot order more than 10 individual drinks at a time.

( *A variant is to have the barstaff roll a numbered dice in a cup, which is emptied on the table. The customer guesses whether the face value is odd or even)

In this model, the incorporation of risk is argued to add a more satisfying Happy Hour experience for both customer and bar proprietor. Whereas in the two-for-one model, the bar loses money on drinks included in the deal at a probability of 1, in this variant the probability of loss in each individual order is reduced by half, to 0.5. The risk is therefore shared with the customer, and therefore the Happy Hour becomes a game of chance between the two parties. What is most interesting from the point of view of the bar proprietor is that the stakes at play are always defined by the riskiness of the customer. Someone who has won a few rounds of a coin toss may get cocky and overextend himself to ordering expensive cocktails or shots, and may end up paying the price. Of course, he is just as likely to get the whole lot for free, but this is the game. The bar will see this act repeated countless times, and the results will even out eventually to a point where the customers and bar share the cost equally. From the bars perspective, it appears to be not much better than the two-for-one deal, yet the difference is that  in this model it is at least an opportunity to win money back, with varied returns due to the different stakes at play. In business, a 50% chance is much better than 0%, especially with the stakes raised. Further on, the model is also argued to offer a greater chance of post Happy Hour (and full price) customer retention than traditional deals.

On the customer side, the advantages of this model over the simple two-for-one are more subtle, yet immediately apparent. If it was not in human nature to get a rush from taking risks, then casinos would be empty, online poker would not involve money, and the international gambling industry would not exist. The simple act of placing a bet on the outcome of an event transforms the transaction into entertainment in itself. This is regardless of win or loss. Winning will produce momentary euphoria which the customer takes back to his friends, while losing will just want that customer to look forward to the next round, just for ‘one more chance’. With greater stakes, the risk of the customer increases, and these high stakes orders could even command the attention of the entire packed bar, just as in a casino. The introduction of risk, with its rewards of jubilation and also deflation, mean that there is raw human emotion flowing in a space where other Happy Hours just have people smiling over cheap alcohol. Here there is more mixing within the bar, more interaction with the staff due to their role in the game, and more camaraderie in the shared experience. I would argue here that all of this conspires to mean that there is a higher chance of customers remaining in the bar once the Happy Hour ends, perfectly content to pay full price. For as well as this hypothetical shared community, there is also the case of those who may have won a large share of their bets, and therefore have “extra”, discretionary income burning a hole in their pockets due to the natural high of winning a high stakes bet. All in all, a much richer experience than sharing the cost of a beer with a friend.

I cannot claim credit for the formulation of this model, for many readers (particularly those who were on Erasmus with me in Tilburg ’05) may recognise the basics from one place or another. I add merely a formal breakdown of the mechanics, as well as a few added constraints (the bar in Tilburg went bankrupt after a year) to prevent revenue losses for the bar reaching a critical level. This Risky Happy Hour has potential as not only a short-term gimmick, but also as an opportunity for a bar to show off its best drinks with the potential (from the customers point of view) of being completely free. Even without this, the bar will make a name for itself among many diverse crowds, from students to working professionals, meaning the opportunity for a much broader client base for the bar, and socialising experience for all involved. The bar may pay for half of the drinks, but due to the distribution of prices on order bets, that is not to say it pays half the bar bill. For a few hours, one night a week, they should take the risk.