In the brief account that follows, Sandeep Baliga provides a glimpse of life in the neighborhood in which I grew up. Although what follows resembles an “urban fable,” it seems true to life.
What lessons about justice and entrepreneurship does it suggest? Who or what is the Leviathan”?
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James is an alley-mechanic – he and his team of five workers repair cars in an alley behind a church on the South Side of Chicago. James rents the space from the church pastor for $50/day. James has been doing business there for twenty years or so. Then, along comes Carl, another alley mechanic. He sets up a garage close to James. Carl hires some homeless people to hand out flyers offering discounts to motorists arriving at James’ repair shop.
James is ticked, to put it mildly. James thinks he has property rights to car repairs in the area – he pays $50/day for this right. He asks the pastor to adjudicate. The pastor is well-known in the neighborhood and often acts as a mediator in contractual disputes. The pastor finds in favor of James. But Carl is not from the neighborhood and does not acknowledge the pastor’s authority. He continues to compete with James.
James turns to an informal court that has developed in the neighborhood. The court arose to settle disputes between rival gangs but it grew to act as a general arbiter of contractual disagreements in the local underground economy. Again, the court finds in favor of James. Again, Carl ignores the determination of the “court” as it has no authority over him. Finally, the pastor is forced to use old-fashioned contract enforcement – violence. He hires a gang of thugs to beat up Carl and his crew and drive them out. End of story
(Source: Talk by Sudhir Venkatesh at the Harris School, University of Chicago)
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Sandeep Baliga is an Associate Professor of Managerial Economics at the Kellogg School of Management, Northwestern University. He is a co-editor of the Berkeley Electronic Press Journal of Theoretical Economics.
Here is an excerpt from an article written by Joshua Gans for the Harvard Business Review blog’s “The Conversation” series.
I especially appreciate Gans’s insatiable curiosity to consider unorthodox thinking and the insights only it can generate. Judge for yourself.
To read the complete article, check out the wealth of free resources, and sign up for a subscription to HBR email alerts, please click here.
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This post is part of Creating a Customer-Centered Organization.
The title of this post surely seems somewhat strange.
Surely any self-respecting business should be in the interest of making as much profit as possible, and the temptation might be to extract as much as you can from each customer interaction. But we know that such views can be too short-term. In many situations, while you could rip off a consumer when they first walk through your door, if you want them to come back, you need to them to be happy with the outcome — including getting “value for money.” This problem is as real for consumer-centric organizations as for corporations looking for opportunities to share value beyond their shareholders (as Michael Porter and Mark Kramer recently discussed in the pages of HBR).
Sharing value is perhaps a straightforward proposition when it comes to not dumping pollutants into the environment or skimping on product quality in ways that harm your customers’ health. But how does it work with regard to rip offs? That is, how exactly do you price so that you consumers feel happy and come back for more?
Northwestern University economist Jeff Ely addressed this question in a series of (somewhat technical) blog posts. Ely was concerned with situations in which some consumers value a firm’s product more than others, but the firm can only supply so many consumers. Which is to say, there isn’t enough product to go around, a classic rationing problem. Ely’s example used a popular restaurant, but it could apply equally to, say, a Broadway show. It could also apply to companies who launch new products to long queues (ahem, Apple) rather than pricing high to early adopters.
Firms do not usually consider having a scarce but desirable product a problem. Firms that want to make profit should run an auction and offer their product to the highest bidders. But as Ely pointed out, that means pitting your customers against one another with a result that those who actually get the product will pay a high price while others miss out entirely. In that situation, those who end up with the product might not be left with much value, and may feel ripped off, even though they chose what to pay. In the long run, the firm may face issues if they need to dip again into that customer pool. They clearly like the firm’s products but may have ill feelings about having paid so much. Perhaps this isn’t an issue for a Broadway show, whose customers tend to be one-offs, but for a local restaurant it is real.
One way to resolve this is to just set a price. If you really cared about the value consumers get, you’d price at cost and ration randomly amongst those willing to pay more than cost for your product. But for any firm, this is a heroic amount of sharing of value. Your consumers get as much as possible but you just cover costs.
You could charge more than cost, but this creates another dilemma. When there are lots of consumers with high values around, you’ll sell out. But what happens if those consumers aren’t there? Set a price and you are left with spare products. For a restaurant or concert venue, the extra seats do not paint a pretty picture.
Ely suggests that firms could deploy a hybrid between a price and an auction: hold an auction but cap the maximum bids that can be made. When demand is high, you’ll end up rationing but no one will be ripped off. But when demand is low, your price will effectively drop and you’ll still be able to sell out. You use the auction precisely when your consumers have power — so enable them to exercise that power.
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To read the complete article, please click here.
Joshua Gans is an economics professor at Melbourne Business School and a visiting researcher at Microsoft Research (New England). All views are his own. While writing this post in a café, the owner randomly gave him a free cookie.