Rahul Nakhe

Roll No. 2542

Executive MBA - I

Critique of Case Study

AN ECONOMIST SELLS BAGELS: A CASE
STUDY IN PROFIT MAXIMIZATION
By Steven D. Levitt

Introduction
Steven D. Levitt, professor in the Department of Economics in University of Chicago
takes the case of Donut and Bagel delivery business and analyzes the extent to
which the decisions of this business are consistent with profit maximizing choices.
His results indicate that the customer feedback or response is very useful tool in
making effective profit maximization decisions.
Profit maximization is fundamental goal in economics. The information inadequacy,
data constraints and operational complexities make it difficult to assess if the firms
are achieving optimum profits.
In order to set prices, a firm needs to know its marginal cost of producing the good,
as well as the elasticity of demandhow responsive customers will be to changes
in prices. Following points should be considered while pricing the products in order to
maximize profit:

not setting prices below marginal cost (the cost of producing a product);

not choosing a price at which demand is inelastic (which implies that a price
increase will raise profits for certain); or

stopping production when marginal revenue exceeds marginal cost.

Levitt estimates that the firm sacrificed 30 percent of its potential profit through
mispricing though the quantity to be delivered each day was estimated perfectly. He
suggests that the absence of feedback (along with the inherent difficulty of the
problem) makes it possible to sustain long run deviations from optimal pricing by an
otherwise sophisticated decision maker.
The author thus hypothesize that the systematic deviations from profit maximization
are more likely due to the absence of feedback. The firm under consideration has the
prices on inelastic portion of the curve forgoing substantial part of profit. The author
then generalizes it to all other firms.
Article Summary
Profit maximization is of critical importance and is one of the most fundamental
assumptions in economics. The author analyzes the extent to which the decisions of
the bagel and donut delivery business are consistent with profit maximizing choices.
According to him, there are several reasons why the bagel and donut delivery
business would be a leading candidate to maximize profits.

First, the service the firm provides is very simplewith only one line of
business and two products,marginal cost is easily observed.

Second, the firm gets frequent and detailed signals of demandeach day, for
each customer, the owner chooses the quantities of bagels and donuts to
deliver; later that day, the owner observes the amount of goods that go
uneaten and the revenue collected.

Third, the owner has studied economics and has 20 years of experience as a
professional economist.

Fourth, the owner both makes the decisions and is the residual claimant on
the profit flows; there is no principal-agent problem at work.

It purchases bagels, cream cheese, and donuts wholesale, which it delivers to local
businesses in the morning. Payments are done on honor system and the company
does not charge to offices to which it delivers. Revenues accrue solely from the
payment of bagels and donuts.
To develop the econometric model Levitt makes certain assumptions:
1. Price is taken as fixed in the short run, with the quantity delivered adjusted
on a daily basis in response to anticipated fluctuations in demand
2. The marginal payment rate is identical for bagels and donuts and it is
equal to the average payment rate (i.e. the marginal consumer is as
honest as the average consumer).
3. At the posted price and marginal payment rate, the revenue from the sale
of the good exceeds the marginal cost.
The firm can test for profit maximizing behaviour along two important dimensions of
decision making:

the choice of quantity and

the choice of price.

Based on the above two variables, an objective of profit maximization and the
constraints as explained further a model is developed. Using econometric models,
Levitt analysed the optimal quantity that should be delivered to each customer,
based first on a particular price for only one good. The estimates were determined by
the posted price of a bagel, the degree of underpayment on the honour system, the
marginal cost, and the observed probability that all the bagels delivered are eaten.
Levitt analysed the degree to which the firms actions, on average over the course of
a year, correspond to the predictions.
In contrast to the quantities supplied (which vary for each customer on a delivery-bydelivery basis), there is little price variation. There are only four price changes over
the entire sample (three for bagels, one for donuts). After each price increase, the
quantity of the goods delivered and consumed fell. The payment rate also declined.
These declines, however, did not significantly offset the increased revenue
generated by the higher price, so profits rose substantially.

Critical Analysis:
While modelling the firms decision problem, Levitt does not consider the cost
parameters including wages and operational costs. Since the effect of pricing and
quantity on the profit are being examined and then we maximize it with an
econometric model so it is logical to neglect the cost parameter.
The author has neglected the seasonal variations. In December, as author has
mentioned the demand is very less. We can accommodate the seasonal variation in
the model however since it is constant every year and for which the demand has
been estimated quite precisely by the owner of the firm we can ignore these
seasonal variations.
The author has opted for degree of cannibalization over cross elasticity for the
reason he mentions, If demand for one of the goods at a particular office on a given
day exceeds the quantity delivered of that good, I assume that the good in short
supply is rationed randomly among the consumers demanding the good. This
assumption implies that the firm is not able to price discriminate between those
consumers who will substitute towards the other good in case of a shortfall of their
preferred product and those who will not. But still it does not completely justify
neglecting cross elasticity of demand in this present case because elasticity is the
measure of the well celebrated demand curve. For the above mentioned statement
author has used residual demand.
Approach towards Modelling:
While modelling author has perfectly captured the variables and used the regression.
I agree with the procedure author has implemented. Regression and correlation
appropriately measure the combined effect of the variables on the output and obtains
the one variable when the other one is fixed.
Author has estimated the time series regression equation as:

Now let us analyse the procedure step by step and try to incorporate our deductions
and assumptions.
Modelling the Firms Decision Problem
1. The decision problem when demand is known with certainty
Author mentions the three possible strategies:
i.

Deliver donuts and bagels exactly as per demand

ii.

Only deliver bagels

iii.

Only deliver Donuts

Author has reached to the conclusion that delivering both is more profitable
strategy though delivering only high mark-up goods is optimal.
2. Uncertain demand with only one product
Assumptions made: Price is fixed

The greater the mark-up over the marginal cost, the lower is the equilibrium
probability that the last unit of the good supplied will be purchased.
The author develops the first order equation based on the simple case, at the
profit maximizing point, the marginal cost of providing a unit of bagel or donut
must exactly offset the expected marginal revenue.
3. Uncertain demand with two products
Now, author introduces the second product in the first order equation derived
in the above case.
The basic idea behind it is, With the introduction of a second good, when
there is a shortfall of one good, some of the demand will transfer to the other
good, as long as there is a sufficient supply of that second good to satisfy the
incremental demand.
Conclusion obtained by the model and arguments:
The only deviation from the result of the model and the actual performance occurs
solely because of miss-pricing. The demand is known precisely based on the data.
Hence the quantity part of the profit maximization model cannot be further optimized.
If a particular office has demand for 20 donuts and 30 bagels, then the firm has to
serve those much. The only scope to vary the supply is when to that particular office
each day let us say 5 donuts and 5 bagels are being un-eaten. So the firm can
supply 15 donuts and 25 bagels.
Importance of feedback:
The author has aptly explained the importance of feedback and the conclusion
obtained is very logical. The pricing strategy that we can derive using the Levitts
analysis and conclusion is, we can reduce the prices in December to accommodate
seasonal variation. We can reduce quantity of both the item so as to minimize the
uneaten items. Also, increasing the prices would be very beneficial for the firm as the
price set is in in-elastic part of the demand curve. That would give the firm optimum
profits.
Conclusion
The author has analysed the bagel and donut selling business very well in order to
maximize profit. The selection of firm, collection of data, data modelling technique for
profit maximization and assumptions behind same and the conclusion are
convincing.
In my opinion, pricing is the important aspect in the profit maximization. Firms should
maximize their profits by finding the optimal price by charging different customers
different prices and observing whether profits increase. The miss-pricing can lead
the firm to loose substantial part of the profits over the time.