Windows 7 and Movie DVDs: Examples of Price Discrimination

Apparently Windows 7 (like its predecessors Vista and XP) will give users a choice of multiple versions. See "Windows 7 SKUs announced: your worst nightmare has come to pass" for information about the versions and their distinguishing features.

On the surface, this "choice" gives users the ability to pay only for the features they want. But, what it actually represents, is an example of what economists call "price discrimination". Now, this term sounds bad, but conceptually it's not necessarily a "bad thing". The point I'm trying to make is that the reason for the different versions is not so much to give consumers greater choice, but more simply to maximise the profits of the producer.

In particular, Microsoft is employing a premium pricing strategy. The cost of developing Windows 7 is essentially sunk, and so can be spread out over all the versions (refer: "Pricing Information Goods, Price Discrimination, Pricing Digital Goods"). Therefore, the cost of supplying an additional copy of "Windows 7 Starter" is essentially the same as the cost of supplying an additional copy of "Windows 7 Ultimate" (I'm assuming minimal differences is packaging and number of discs). From the Wikipedia article on price discrimination: "by providing a choice between a regular and premium product, consumers are being asked to reveal their degree of price sensitivity (or willingness to pay) for comparable products." Other examples include bewildering choice of drinks at coffee chains and the pricing of business class airline tickets.

[An aside: "Hey, your an Apple fanboy - what about the two versions of Mac OS X: Client and Server?" The comparison is not really applicable, as these variations are clearly aimed at different types of installation. The Client version actually corresponds to all six flavours of Windows 7: it is intended for an individual's workstation. The Server version is intended to drive backend (i.e. server) systems, and corresponds to the separate Windows 200x Server products.]

For a detailed explanation of how price discrimination increases profits, I suggest you consult Wikipedia or an introductory economics book (e.g. The Undercover Economist or Naked Economics). I'll try giving the gist. In a free market for a product, there is a single price that applies for all units sold. This price represents the point where demand equals supply. Suppliers will continue to sell units of the good as long as the price matches or exceeds the (marginal) cost of producing that additional unit. Now, different consumers value the benefits of the product differently, so some would actually be willing to pay more than the market price if they had to. Those who aren't willing to pay the price miss out altogether. If the seller could charge different prices according to the class of consumers (e.g. by marketing a premium version), it could increase its revenue on the same total volume of sales. This in turn increase profits.

The case of "Windows 7 Home Basic", which is only available in emerging markets, is an example of third degree price discrimination, where "price varies by location or by customer segment, or in the most extreme case, by individual customer".

Those familiar with region coding of movie DVDs should recognise a similarity here. According to Wikipedia: "Price discrimination is especially applicable to movies, because the marginal cost of selling one copy (or viewing) is quite small, giving the seller great flexibility in pricing. There is great disparity among the regions of the world in how much a person is willing to pay for a DVD, and region encoding allows a publisher to sell a DVD for less money in the regions where the demand is low and more where the demand is high."

Note: I haven't mentioned the more contentious issue of Microsoft's predatory pricing through OEM distribution. See "Predatory Pricing - Microsoft's Modus Operandi" for an interesting discussion.

[Adelaide's maximum temperature was only 33.0 degrees Celsius (91 degrees Fahrenheit) today. The temperature continues to fall, but the humidity is increasing.]

Falling Interest Rates: Not Everyone's A Winner

Australia's official interest rate was reduced by 1 percent today: "RBA slashes rates to 3.25pc". Good news for some I'm sure, but for people relying on investment income to pay their bills, it's another shock to deal with. Not only have they seen the value of their investments (e.g. shares and property) fall thanks to the global financial crisis, but in the past few months they've seen returns on their bank deposits plummet.

What irks me is that parts of the media focus only on the "good news" side of the story, and neglect to mention the consequences on self-funded retirees and other people who rely on interest from their money. Remember, people who save money (rather than borrow and spend it) provide the capital needed to finance economic growth.

And the suggestion by some finance experts/talking heads that the Reserve Bank should go even further, citing the near-zero rates in the United States, must surely be joking. They do know what a Liquidity Trap is? The US looks like it's going to suffer a similar fate to that which stalled the Japanese economy in the early 1990s. Investment evaporated, economic activity actually fell even further (i.e. the recession deepened) and deflation set in.

Let's hope governments around the world learn from the lessons of the past. Cutting interest rates to zero won't be enough to get us out of this jam.

[Adelaide's maximum temperature was only 36.3 degrees Celsius (97 degrees Fahrenheit) today. Unfortunately the temperature looks likely to rise before we get a real change.]

Update: About that deflation risk (by Paul Krugman).

Tanks A Lot, AFL

Regardless of whether or not Carlton "tanked" to win last year's wooden spoon, there appears to be a perverse form of incentives working in the Australian Football League (AFL).

Let's see: Carlton finished bottom of the table last year. This automatically entitled them to first pick in the player draft. As an added bonus, the club only has to play last year's top team, Geelong, only once this season. And that match was played at their home ground (admittedly shared with other clubs, but Geelong is not one of them).

With rewards like that, the AFL is not only a fight for the top position, but it looks like a race to the bottom as well.

How do bottom-placed teams fair in the top leagues of the premier football code around the world?
* In the English Premier League, Watford finished bottom and was relegated (along with the two other worst-performing teams).
* In Italy's Serie A, Messina finished bottom and was relegated (along with the two other worst-performing teams).
* In Spain's La Liga, Gimnàstic de Tarragona finished bottom and was relegated (along with the two other worst-performing teams).

Detect a pattern?

Why does the AFL reward poor performance? A team can consistently under-perform for a few years to build up its roster, then suddenly "switch on".

By providing such perverse incentives, the outcomes of matches come under question. Given the level of gambling, er sports betting, in Australia, I'm sure a lot of punters would be concerned by this. Consider this hypothetical: the top team is playing a potential bottom team the week before the finals. The top team must win to secure a home final. A loss for the cellar-dwellers would ensure a last place finish and all the benefits that would accrue. The top team doesn't want any injuries either, but would like a nice hit out to toughen them up. If only the two clubs could conjure a mutually-acceptable arrangement...

I'm not suggesting this has happened, but it could. The threat of relegation would help make sure all teams remain competitive for as long as possible. Resting players or experimenting could jeopardise the club's final position.

The AFL wants to expand from 16 teams to 18 teams. Why not make it 20 teams, but separated into a first and second division? Each team could play each other at least twice, removing the complaints for lop-sided schedules. The threat of relegation and reward of promotion would keep clubs honest and help prevent both mediocrity and the temptation to "tank".

But somehow I doubt the AFL has the guts to do it.

Money as Debt ... as Fact, or Fiction?

"Money as Debt" by Paul Grignon is an interesting documentary about money, banking and debt creation. It points out some facts about money, but unfortunately, it has a few flaws.

Firstly, I want to commend a couple of points where it quite rightly challenges popularly-held views:

1. "Money", as in a currency in our wallets, is not backed by the equivalent amount of gold held by banks or in places like Fort Knox. This is true. (See Wikipedia article: Representative money).

2. Most of the money in an economy is not the result of governments printing notes, but rather from the money creation activities of banks and other credit providers. This is also true. (See Wikipedia article: Money supply).

The general public should be made aware of these common misconceptions, so that people can be better informed about how the economy really works. However, I cannot entirely accept the description of the money creation process as depicted in the video. Nor can I accept the suggestion that the money (or debt) is conjured completely out of thin air.

According to the example in the documentary, a bank can have only $1,111.12 in reserves and use that to loan $10,000 to a borrower. Huh? How can the borrower use the credit (an asset for the bank) when there is no corresponding deposit (a liability for the bank). This would violate double-entry accounting. That's Enron-style voodoo accounting. How does the bank account for the $8,888.88 that has been conjured out of thin air, as the documentary asserts? For the bank to be able to lend out $10,000 it would need to have initially raised that amount of money from somewhere, as either startup capital from investors or deposits from the general public.

While it is true that banks create money, the ratio of 90:1 suggested by the documentary is plain wrong. $1,111,12 cannot create $100,000 of money. If the required reserve requirement ratio is 1:9, then the credit creation multiplier is 9:1. The bank would need $10,000 of initial capital, not $1,111,12. For a more accurate example of the money creation process, check out the description of the Fractional reserve system in the Wikipedia article: Money creation.

The second major issue I have is the idea that debt (and therefore money) exists independently of the real assets in the economy. Again, double-entry accounting suggests this is not possible. Somewhere along the line, a mortgage of say $100,000 requires equivalent assets as collateral. Otherwise the bank shouldn't hand over its depositors' funds to the borrower. That would be irresponsible.

While I accept that these days the traditional (and rather conservative) credit system of banks has been usurped by all manner of credit providers. These sources of credit have much looser regulatory requirements, and I would argue that here lies a potential problem for the economy.

Another concession I would make is that the total debt in the economy may actually exceed the real value of the assets acquired with the money borrowed. Any such mismatch can cause real problems for the economy. Bubbles can lead to prices that have lost touch with the real value of assets. Remember the Tech bubble, the sub-prime fiasco, and so on? If the bubble bursts, borrowers could be in the unenviable position of holding assets worth less than the debt owed to acquire them. These borrowers may no longer be able to meet their obligations, and so could be forced to sell the assets if, for example, the bank forecloses on their mortgage. The flow-on effects throughout the economy can be disastrous, as many people are experiencing as part of the sub-prime crisis.

I must admit I stopped watching the video about half-way through. Therefore I don't know where the argument was ultimately leading. Unfortunately, the two flaws I've identified make me question the documentary as a whole. A basic requirement of a logical argument is that it must be built on premises that are not false. False premises render any conclusion inferred by those premises to be unsustainable.

If the documentary maker wanted to prove that most money is created by banks and other credit providers (i.e. not by governments), and that out-of-control debt creation can cause economic problems, then I would have to agree. But unfortunately he has sabotaged his efforts by introducing serious flaws in his argument. One day if I get time I might watch the rest of it to see what the conclusions are. In the meantime, I cannot give it an unqualified recommendation. I would suggest viewers interested in the issues raised by the documentary seek more authoritative sources before accepting any conclusions presented.