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Ordinary discussions of firms tend to focus on market structure. Is this a competitive firm or a monopoly? How does the competitive firm’s behavior compare to a monopoly? In certain contexts, these are important questions. However, if we are starting from first principles, it doesn’t make much sense to start with market structure. Instead, it makes more sense to think about whether a firm is a price-taker or whether the firm sets its own prices.
This distinction makes it a little bit harder to think about market structure. A price-setting firm could be a monopoly, but that is far from universally true. Many price-setting firms are in competitive markets. In fact, if we want to make this discussion more complicated, we could argue that every price-setting firm is a monopoly in a particular way, but at the same time might have a lot of competitors.
Think about a specific example. Wendy’s is a fast food restaurant. In a sense, it has a monopoly. No other fast food restaurant makes a hamburger like Wendy’s. No other fast food restaurant sells a Frosty. But Wendy’s also faces a lot of competition since many fast food restaurants do sell hamburgers and ice cream (and/or milkshakes). Furthermore, there is no reason to think that the only firms that Wendy’s competes with are other firms that sell hamburgers.
Despite its unique brand, it is not obvious that Wendy’s should earn an economic profit. Competition between fast food restaurants will tend to drive up the costs. A worker who works at Wendy’s could just as easily work at McDonald’s or Chik-fil-A. The work is essentially the same. Thus, as more fast food restaurants enter the market, they compete for workers, driving up wages and therefore the average costs of the firm.
Since each of these restaurants is producing differentiated goods, another way that they can compete is by convincing potential customers that their fast food is better than all the other fast food places. This requires a costly dissemination of information, possibly through advertising. Again, this raises average costs. If the advertising is successful, it might also increase demand. However, there is no guarantee. After all, the other fast food restaurants are advertising too. It is possible that competition could dissipate all of the profit even for a price-setting firm.
Nonetheless, there is reason to believe that even in the presence of stiff competition, firms like Wendy’s will receive a significant price premium. To understand why, we might merely want to change our frame of reference.
One of the hallmarks of the UCLA brand of price theory is to think about things in terms of exchange. We can use that as a starting point for thinking about price premiums.
The creation of Wendy’s is an entrepreneurial decision. The entrepreneur sees an opportunity in the market. If we are to believe the marketing that Wendy’s has done over the years, the key difference between their hamburgers and those of their competitors is that they are “fresh, never frozen.” Also, they are square, but that is unlikely to affect the taste. Regardless, there are people out there who will prefer a hamburger from Wendy’s over all competing producers of fast food hamburgers (and maybe all hamburgers).
We might therefore think about Wendy’s and the people who prefer their burgers as being in a long-term relationship. Typically, long-term economic relationships entail the use of something like a contract. A contract could stipulate things like the price that people pay for the hamburger, the quality of the hamburger, a commitment to never to revert to frozen hamburgers, etc. Of course, a contract between Wendy’s and its loyal customers would never occur. The transaction costs of organizing the customers and getting them to agree on terms are likely to be so high that it would preclude the use of the contract. Also, even if a contract was possible, how would things like quality be determined? Customers might have different standards for quality. And an independent arbiter might disagree with customer assessments.
Now, let’s think about the incentives that this creates for fast food firms given that no long-term agreement about quality is feasible and given the possibly of competition eating away all of the economic profit. (Get it? Eating away? Fast food. I’ll show myself out.) We could think of Dave Thomas, the founder of Wendy’s following one of two distinct strategies. In each strategy, Wendy’s would make an effort to establish a brand name and reputation. It invests in “brand name capital.”
Once this reputation is established, the firm could do one of two things. First, it could continue to produce the same quality product that helped it to establish its brand name. Alternatively, it could draw down its brand name capital by gradually reducing the quality of its hamburgers over time. By reducing its operating costs, these reductions in quality could potentially increase profits. Of course, customers will eventually catch on to the fact that the quality of the product is declining. This will wipe out the brand name capital of the firm. The firm will find it in its best interest to do this if the present value of the profits earned by cheating the customers is greater than the present value of profits from operating as it did when it established its brand.
Customers who enjoy Wendy’s would clearly prefer that Wendy’s produce the same quality burgers they enjoy. If contracts were possible, customers could ensure that this would happen by putting terms in the contract that required that Wendy’s pay a penalty equal to an amount that is slightly greater than benefit from cheating. Since contracts aren’t feasible, this isn’t an option. Nonetheless, one might wonder if some sort of market force would emerge to ensure that Wendy’s behaves responsibly.
Ben Klein and Keith Leffler famously argued that this would indeed happen. Repeated interactions between two parties to a transaction can lead to something like an implicit contract. To guarantee that the firm keeps up its end of the implicit contract, consumers can pay a higher price than they otherwise would. If the firm doesn’t perform in accordance with the expectations of the customers, they will lose this price premium. This loss is equivalent to the payment of a penalty if the terms were specified in an explicit contract. The price premium acts as a market force to ensure performance on the implicit contract.
There is evidence to support this view. For example, Jonathan Karpoff finds that firms only seem to be punished for certain types of things that affect their reputation. When firms engage in activities that harm their relationships with customers (that violate the implicit contract), their stock prices decline. This reflects a penalty in the form of a lower value of the firm’s brand. What is particularly important about this literature is that the penalties to the firm’s brand only seem to occur when they violate some implicit agreement with consumers. Firms do not appear to be punished much for other types of behavior that would negatively affect its reputation.
This teaches us an important lesson about brands, prices, and contracts. Even when a firm and its customers cannot sign an explicit contract, market forces will emerge to enforce the type of behavior that would be expected from such a contract.
