Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't John Jr. (the dot read aloud .txt) 📖

The high price of liquor at restaurants has created a popular perception that restaurants break even on food and make huge profits on alcohol. This seems to imply that restaurants have to compete in food service, but can charge whatever they want for drinks. Although restaurants often do break even on meals, their high alcohol prices do not reflect a lack of competition. Restaurants might appear to rake in the money on booze, but drinks also comprise a large part of their costs; that is, the cost of providing a place to linger over a drink.

Why are Last-Minute Airline Tickets So Expensive?

Does price discrimination explain why travelers flying on short notice must pay more for a plane ticket than those who book their trips in advance? The Southwest Airlines website clearly shows the relationship between ticket prices and how far in advance a ticket is bought.24 A one-way flight from Philadelphia to Chicago on December 12, 2006, ranged from $109 for a non-refundable promotional fare purchased twenty-one days in advance to $168 for a ticket bought on the day of the trip. Waiting to buy your ticket until the last day thus raised the ticket price by 54 percent.

Ticket Prices on Southwest Airlines

It may seem that short-notice travelers are charged more because they are more desperate to fly at a particular time than those who make more leisurely plans. But this would need further explanation: exactly how could airlines charge excessively high monopoly prices when numerous competitors exist and the cost of checking fares is so low? Short-notice travelers can consult Orbitz, Expedia, or other websites that compare ticket prices, or simply call someone who specializes in comparing rates—a travel agent. But the large discrepancy in fares for short-notice and advance-notice travelers exists despite the ease and low cost of shopping around for different fares. This should give us pause before immediately assuming price discrimination.25

What airlines are doing, in fact, is charging extra for a particular service—providing a ticket at the last minute. In order to provide this service, airlines must keep “inventories” of seats that are still available at the last minute. As a result, some of these seats can go unsold, and the airlines must be compensated for this loss. This is no different than any other business that stocks inventories—grocery stores, for example, buy more milk than they need in order to ensure that they will not run out. Stores have to throw away unsold milk, and this cost is factored into the price. But consumers are willing to pay a little more if it means that milk will always be available.26

Airlines can easily sell discounted advanced tickets, to the point that they limit the availability of these offers. For airlines to be willing to hold seats for last-minute travelers, they must earn the same revenue from these seats as they do from seats purchased in advance. Just take a simple numerical example from our table for Southwest. Suppose, on average, that just over one-third of the seats set aside for last minute travelers go unsold; assuming that all these tickets could have been sold at the advanced discount “promotional” price. In that case, the last-minute tickets would have to sell for over 50 percent more than the discount price in order to justify offering the last-minute tickets at all.

Why Does the Price Spread Between Full and Self-Service Gas Vary?

Let’s look at one last example of alleged price discrimination. Full-service and self-service gas pumps sell the same gasoline—full-service costs more due to the extra service, not to a difference in gasoline quality. One might expect that the price difference between full-service and self-service gas would be the same for each grade of gas; if a gallon of full-service, regular unleaded costs twenty cents more than a gallon of self-service regular unleaded, then a gallon of full-service super unleaded should cost the same twenty cents more than its self-service counterpart. But this is not the case—the absolute price spread is larger for regular gas than for supreme. AAA reports that for the week of September 25, 2006, the price spread in Rhode Island between full and self-service regular unleaded was five cents per gallon more than it was for the highest octane unleaded.27 Another survey showed that out of sixty-five U.S. cities, fifty had a substantially larger difference for regular unleaded than for premium unleaded (the difference usually being at least at five cents).28

Take a look at prices at your local gas station and you will probably find this disparity. The chart below shows the price differences between full-service and self-service gas at a Sunoco station that I frequent, where regular unleaded had a sixteen-cent spread, while Ultimate only had a twelve-cent spread.

Gas Prices at Sunoco Gas Station at the Chesapeake House Service Plaza off I-95 in Maryland on August 30, 2006

So what explains this discrepancy? Are individual gas stations exercising monopoly power? This hardly seems possible; with so many stations showing clearly marked prices, competition is fierce. But aren’t lower-income customers—who are more likely to purchase regular than premium unleaded—getting swindled?

Once again, what looks like a rip-off is really just the complex workings of an efficient free market. The hidden factor here is that full-service regular gas customers typically buy less gas than those purchasing full-service supreme.29 Consumers of supreme gas tend to have more expensive cars and are generally wealthier than consumers of regular gas. The “time cost” of visiting a gas station is thus higher for supreme consumers—they are losing more money by not working while gassing up their cars. Supreme customers therefore try harder to minimize the time they spend at gas stations. One way to accomplish this is to wait to buy gas until the tank is low and then fill it up completely. Customers of regular unleaded, being comparatively poorer, are likely to