Whole Foods shows us what economists don’t know

Whole Foods is providing the world with a very interesting economics lesson. Immediately after Amazon bought the upscale grocery store chain, it cut prices substantially for many items on the shelves. As a result, sales have boomed by around 25 percent.
Was the price cut a good move? Actually, the real lesson might be how little economics has to say.
Whole Foods’ bottom line will ultimately answer the question, but that will take a while. There have been other instances where a confident new management decided to make a dramatic pricing change, only to find out later that there was a good reason for doing things the old way. A classic example is Ron Johnson, who took over as CEO of department store JC Penney in 2011. Johnson cut prices across the board, substituting low sticker prices for the previous strategy of regular coupon and discount sales. But the new strategy failed—it turned out that JC Penney customers enjoyed shopping at sales and feeling like they were getting discounts. Years later, the company still hasn’t recovered.
So there’s a chance that Amazon will find that people enjoyed shopping at Whole Foods because of the high prices, and the social status they got from frequenting an upscale store. On the other hand, it would probably be unwise to bet against Jeff Bezos when it comes to retail. There’s a good chance that Amazon is doing the smart thing, and that Whole Foods had been leaving money on the table by not cutting prices before.
Interestingly, economics doesn’t shed much light on this issue. In the models students learn in their undergraduate courses, companies don’t make mistakes—they simply act in their own rational interest to maximize profits. Any temporary errors get smoothed out in the long run, as bad managers and inefficient companies are weeded out of the market.
But this is more of a hopeful assumption than a hard scientific fact. A quick glance at the simplest economic model shows how unrealistic it is to expect industries and markets to adjust smoothly and perfectly. In Econ 101, the amount of stuff that gets sold and the price it commands are determined by supply and demand:
Normally, the market is assumed to be at the equilibrium point, where supply and demand meet at a specific price and quantity.
But what if the economy isn’t at equilibrium? What if companies could make more money by cutting their prices and selling more stuff?
The obvious answer would seem to be “Just look at the demand curve, stupid!” If it’s really steep, lower prices won’t boost sales much. If it’s shallow, cutting prices could increase revenue a lot.
But no one actually knows what the demand curve is. They can make rough guesses as to how much people would buy at a different price, using surveys, demographics, and examples from other markets. But in the end, the only way to know the effect of cutting prices is to just try it and find out.
In many markets, this doesn’t really matter. If one rice farmer decides to try cutting prices, the global rice market won’t really be affected. But in markets dominated by a few big players, pricing decisions can make a big difference. And in the US, industries are increasingly concentrated:
This means that companies have increasing discretion, rather than being dictated to by the market.
So introductory economics, with its blithe optimistic long-run focus, has little to teach future corporate managers. Advanced economics has more complicated math, but also tends to assume that corporate decisions are all optimal. If you’re a student hoping to one day be a manager or executive at a company like Amazon or Whole Foods, you¬ won’t get useful decision-making tips from your economics textbook. All you’ll get, essentially, is a blithe assurance that you’ll figure out the right thing to do—and that if you don’t, someone else will compete you out of the market.
So why is economics such a perennially popular major for the up-and-coming white-collar business class? It gives kids a general faith in free markets and a bit of practice using math to solve problems. It teaches them how to think about government policy like minimum wages or fiscal stimulus. But it doesn’t actually teach much about the real workings of business.
Nor is economics the only major where aspiring businesspeople can learn the kind of quantitative skills that are increasingly important in the modern market. Other options, like industrial engineering, operations management, and finance, offer just as much or more of those skills, and often command even higher salaries after graduation.
So while the economics major is now riding high, this is subject to change. If the aspiring business class gets tired of being told that markets will work out just fine, and starts wanting to learn how to actually make markets work, there could eventually be an exodus into more business-themed majors.
So perhaps the lesson of Amazon and Whole Foods is about the limited real-world usefulness of economics itself.

— Bloomberg

Noah Smith is a Bloomberg View columnist. He was an assistant professor of
finance at Stony Brook University, and he blogs atNoahpinion