David R. Henderson  

The Economics of Self-Imposed Price Ceilings

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About once every two weeks, I drive to Costco for my favorite fast food per dollar: the famous Costco hotdog. It's priced, along with a soda with free refills, at $1.50 plus tax. In Sand City, California, my local Costco, the tax-inclusive price is $1.62.

A few years ago, a former student was visiting and he had interviewed at Costco. I told him that I thought the $1.50 price was hard to justify and, presumably, led to losses. I suggested that Costco, even it wanted to have a "Schelling point price," could set it at $1.85 and, therefore, even in very high sales-tax localities, the overall price would still be below the magic number of $2.00. And, I said, Costco would probably make substantially more money on hot dogs.

My friend grinned and told me that in his conversations with Costco executives, he had learned that many new executives, when they first started at Costco, would make similar proposals and get nowhere. It turns out that James Sinegal, the co-founder of Costco and, until recently, CEO, had a strong belief in keeping the price at $1.50. No one could talk him out of it.

So what to do? Cut quality. I've noticed two changes, one that happened about 5 years ago or more, and the other that happened more recently.

Once you get your hot dog, you go over and put on your own condiments. Until about 5 years ago, these condiments included relatively fresh sauerkraut. You turned a crank and the sauerkraut came out. About 5 years ago, the sauerkraut was gone. I learned, about a year after it disappeared, that if you asked for it, you were given a little plastic container of sauerkraut. About 2 years ago, I noticed that the sauerkraut in the plastic containers was kind of old. So I started asking for it fresh, but that takes the server time to go back to the fridge and get it. So that's two incremental cuts in quality.

While in the hot dog line a few weeks ago, I was pointing this out to a friend and he noted that no longer were the hot dogs the high-quality Hebrew National brand. Instead, they are Kirkland, the in-house Costco brand. Another reduction in quality.


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CATEGORIES: Business Economics



COMMENTS (20 to date)
Thomas writes:

The sauerkraut crank was gross. As are the relish and onion cranks. Blame the customer if you want.

Costco covered the change from Hebrew National in their in-house publication a few years ago. See link above. Their take is that using a Kosher dog was a mistake, motivated by the contingent fact that Kosher dogs were higher quality than regular non-Kosher dogs back when the food courts opened. Moving from Kosher to non-Kosher isn't a loss for those of us who don't keep Kosher.

I noted that Costco did switch from Coke to Pepsi. Maybe that's the beginning of the reduction in quality.

Ken P writes:

$1.50 is a pretty catchy price. Many entrepreneurs like to focus on price as a way of forcing cost conscious innovations. It maintains competitiveness.

Meanwhile, QuckTrip has the roller dogs priced at two for $2.29 in my city. My choice is the jalapeƱo cheddar. They have sauerkraut , chicago style relish, salsa and other toppings, but no free soda.

eric falkenstein writes:

I like most hot dogs. Eating a Costco hotdog reminds me there's a difference in quality between a good and bad one.

David R. Henderson writes:

@eric falkenstein,
Just to make sure I understand you, you don't like the Costco hot dog?

Greg G writes:

Customers do not form their opinions about the pricing structure of retailers by doing comprehensive price comparisons of many products. None of us has time for that. Instead we use heuristics. We tend to notice anomalies and draw general conclusions from them.

The pricing of the Costco hotdog is not primarily about making money on hotdogs. This discussion is good evidence that it is about quickly and effectively creating the impression that Costco is a place where you will find things priced lower than you expect.

Greg G writes:

A follow up here to the point I made above about how customers form their opinions about pricing and self-imposed price ceilings:

For many years I owned an operated a store that sold men's work clothes and shoes. In the beginning we sold a lot of Hanes underwear and made good money on it. As time went on we sold a lot less of it and had to lower our markups due to fierce competition from big box stores.

There came a point where we sold very little of it but I continued to stock some due to a mistaken belief that my customers would want me to provide something more of a one stop shopping opportunity. I thought I needed to carry it as a convenience for my customers even though it had become my lowest margin item.

Then one day I overheard two customers talking while looking at my Hanes underwear display. One was saying to the other, "What a ripoff. Look how much they charge for Hanes underwear."

I did a little research and quickly found that (for obvious reasons involving volume discounts) I could have bought Hanes underwear cheaper at Wal-mart at retail than I could buy it from my wholesale distributor.

The item I had been selling at the smallest margin had been the one doing the most to create the impression that we were overpriced. Needless to say my Hanes underwear inventory went on closeout immediately and I revised my ideas about how retail customers form their opinions about pricing and convenience.

Dan writes:

The day Costco raises the price of its hot dog is the day the Fed doves can no long lie about inflation being contained.

Frankly I find Costco's pricing noble but ultimately self defeating. Quality has declined and my frequency of consumption at their deli has declined from once a week to once a month, if that.

Andrew writes:

It's a good thing I am not an economist because I would probably mention that the "price" of the CostCo hot dog has increased. But then again, if I was a Macroeconomist I could say that nothing has changed in the aggregates.

Dan writes:

Along with what Greg G has written ...

If customers conclude that Costco is selling an inferior deli products, no matter the cheap price, that will hurt their brand. Consider that if Costco ultimately decides to raise its deli prices it will be very difficult to convince customers that in return for higher prices they will be getting better quality. Pricing information is transparent. Quality information is opaque. Once customers notice the quality has declined it will be difficult (ie expensive) for Costco to convince them that quality is improved.

The irony is that Costco branding is not that it is a low price outlet but that it sells quality merchandise at an attractive price. The deli experience is a contradiction to the company's overall brand. Does management realize this?


RPLong writes:

I noticed the first big dip in quality when the Alberta beef mad cow scare happened. I think that was the supply-chain impetus that lead to all the other changes. That's my theory, anyway.

It's worth noting, though, that sanitary conditions are worse at older Costco stores. If you walk into a newer warehouse, the quality is much more in-line with the good old days.

libertarian jerry writes:

Dan's point about inflation is the real story. In order to stay competitive in pricing quality and size are compromised. Walk into any supermarket and see how the price of a product stays the same but the ingredients and package sizes are degraded. Soft drinks and other beverages and snacks that were once sweetened with sugar now use the cheaper fructose corn syrup. Ice cream that used to be packaged in 1/2 gal. sizes are now reduced to 3 Quarts. Coffee that used to be in 1 pound containers are now reduced to 10 or 11 ounces. Bite sized candy bars that were once packaged 10 to a pack are now reduced to 8 packs. The items that are reduced in size,but stay more or less the same price is endless. "Loss leaders" such as Costco's $1.50 hot dogs may still be around,but everything else in the store will have gone up in price. This happens not because the products cost more but because the purchasing power of the dollar has plummeted due to over printing. What we have in America is classic monetary inflation. An inflation,or devaluation of the currency,which will eventually cause the destruction of the "dollar" and create economic chaos.

Jessie writes:

Get your facts straight. I'm tired if all these internet articles that make assumptions and pass them off as facts.

Maybe you should have asked Costco why the kraut is behind the counter and why they changed the hot dogs . Because you were wrong on both accounts.

Also you might want to get a subscription to Consumer Reports. Kirkland brand is regularly tops in quality and definitely in price. Refering to it in a negative way shows your ignorance.

gwern writes:
The pricing of the Costco hotdog is not primarily about making money on hotdogs. This discussion is good evidence that it is about quickly and effectively creating the impression that Costco is a place where you will find things priced lower than you expect.

As a kid, I always assumed it was part of making Costco a 'destination' - the same way we would get really excited about going to Ikea to play in the ballpit and eat weird Swedish food, we would be excited to go to Costco and decide whether we wanted a hot dog or sausage or churro. We'd leave quite happy.

The day Costco raises the price of its hot dog is the day the Fed doves can no long lie about inflation being contained.

Dan, I was unaware that the Fed doves claimed that inflation was exactly 0.0000000% and so one would never ever see any price increase in hot dogs.

Costco Employee Speaking Privately writes:

I am a current Costco HQ employee not authorized to speak on behalf of Costco but I would like to offer a personal perspective based on public information promptly, pending a real Costco spokesperson weighing in. Costco still sells only high-quality hot dogs.

Costco built itself the world's finest hot dog manufacturing plant several years ago because Con Agra foods (Hebrew National brand) and Sara Lee (Sinai 48, etc) refused to sell to Costco-- the world's largest purchaser of kosher hot dogs-- more hot dogs to accomodate Costco's growth. Costco even offered to sign long-term contracts which would basically guarantee suppliers financing to expand their plants but they declined.

Literally unable to keep serving kosher dogs to all its customers due to supply limitations (and unwilling to disappoint Costco members by serving kosher dogs at some warehouses but not others) Costco decided to make its own high-quality hot dogs, compensating most customers for the lack of kosher certification by making the dogs a bit larger, and putting Costco's reputation for quality foods* on the line. Costco's current dogs really are well- made, and except for the intangible benefit of kosher certification compare favorably in all respects to the old kosher dogs.** Since Costco is now vertically-integrated and has tremendous buying power, Costco can keep the retail price of its hot dogs very attractive.

Costco still retails kosher hot dogs for off-premises consumption. Costco also sells the same hot dogs in packages under the Kirkland Signature brand that it serves in its delis. If you compare those products you should find them both of excellent quality.

I'm sorry to hear that putting the sauerkraut behind the counter diminished the value proposition of the Costco hot dog for you. Costco had discovered that sauerkraut wasn't much demanded and it was hard to maintain freshness of that condiment out on the sideboard. Other changes to promote freshness and food safety in recent years have included replacing the ketchup and mustard pumps to use vacuum-sealed bags of condiments and improving various behind-the-counter processes. If you've run into problems locally with deli staff handing out stale kraut, you might want to let the warehouse manager know so remedial measures may be taken. As for the added delay of having to ask for kraut, that is a form of quality reduction which I'm sure Costco regrets, but hopefully the Costco deli hot dog still seems like a good value overall to you.

*Decades ago a newborn Costco hadn't yet earned its current reputation for quality so demonstrating Costco's quality commitment by serving more costly kosher hot dogs seemed like a good idea. Today most people recognize based on long experience that Costco itself is a quality food supplier.

**Costco's delis never had kosher kitchens and Costco never claimed to comply with kashrut as opposed to secular good kitchen practices. Though Kirkland Signature dogs are not kosher, neither are they chopped liver :-).

Eric Evans writes:

I have no problem with a loss leader, but it seems kind of odd that they would make changes on a loss leader that a customer would perceive as making it less valuable. Particularly Costco.

Erik writes:
Dan's point about inflation is the real story. In order to stay competitive in pricing quality and size are compromised. Walk into any supermarket and see how the price of a product stays the same but the ingredients and package sizes are degraded. Soft drinks and other beverages and snacks that were once sweetened with sugar now use the cheaper fructose corn syrup. Ice cream that used to be packaged in 1/2 gal. sizes are now reduced to 3 Quarts. Coffee that used to be in 1 pound containers are now reduced to 10 or 11 ounces. Bite sized candy bars that were once packaged 10 to a pack are now reduced to 8 packs. The items that are reduced in size,but stay more or less the same price is endless. "Loss leaders" such as Costco's $1.50 hot dogs may still be around,but everything else in the store will have gone up in price. This happens not because the products cost more but because the purchasing power of the dollar has plummeted due to over printing. What we have in America is classic monetary inflation. An inflation,or devaluation of the currency,which will eventually cause the destruction of the "dollar" and create economic chaos.

This isn't because of inflation. It's profit maximizing. These companies have done extensive research on consumer habits and discovered that most people don't pay enough attention to notice a small reduction in size or quantity, or look at the list of ingredients every time they purchase an item (or ever for that matter). If we have "classic monetary inflation" from "over printing," as you say we do, we would see the cost of all goods and services rising very quickly. But, we don't. That's because the (historically low) level of inflation we are experience right now has very little to do with money printing. Most of it has to do with simple supply and demand. The dollar is doing just fine. Stop listening to Peter Schiff and other economically illiterate, perpetual doomsayers.

libertarian jerry writes:

Eric......................Profit maximizing? Google John Williams Shadowstats to get the true,full picture of inflation in America. Your thesis of "historically low" inflation is government and Main Stream Media propaganda. Why is gasoline $4.00 a gal.or quality hamburger $3.75 a pound when they were half that price 10 or 12 years ago? Why do the same automobiles that sold for 15K ten years ago now cost 25K? If you think there is low or no inflation then you are living in a fool's world.

Dan writes:

Repeat after me: There is no inflation, there is no inflation, there is no inflation. Does any believe that if we say it enough it will be true?

Anyone who has been a consumer the past 10 years knows for a fact that a dollar earned today has less purchasing power than a dollar earned a decade ago. Is that not inflation? The debate should be over the measure of it. That it exists is self evident to anyone who is paying attention.

Consider that just a few years ago it was common for Walmart to sell 2 regular size candy bars for a dollar. Now the candy bars are smaller and the best deal is 3 for two dollars. In addition the price of items in my company's vending machine have climbed between 30% and 50% in the past decade. Oh, but that is just supply and demand?

Also consider that it used to be common to buy a combo meal at your favorite fast food hamburger shop for $5, burger, fries & drink. The going price for that meal is now between six and seven dollars.

But there is no inflation!

If all the food vendors in North America are pricing their menu higher than it begs the question of why Costco is not. Either Costco is losing more per serving or it is finding ways to cut costs on the food it serves. Some of those cuts invariably reduce the quality of the customer experience.

My quip about Costco raising its deli prices is that if it were to do so it would be noticed because they have been fixed for so long. Anecdotal evidence matters a lot in building the narrative of the economy and a Costco hot dog jumping 20% in price will be like the cost of gas going over $4 a gallon.

Erik writes:

I didn't say there was no inflation. Of course there's inflation. I meant that lowering the amount of ice cream in a container, or the number of candy bars sold in a package, or using HFCS instead of real sugar is largely because of profit maximization. Inflation is a small part of that, but not nearly all of it.

What I was saying about inflation is that if we were experiencing inflation from too much money printing, like you said, the prices of everything would be going up at a rate similar to the increase in the money supply, but that's not happening. We're seeing some prices go up quite a bit, like the oil, car, and meat prices that you mentioned, because of increased global demand. The economies of billions of people around the world are developing into middle class economies, increasing their demand for oil, car manufacturing inputs, etc... Beef prices are going from a decrease in supply due to recent droughts in beef producing states. None of this means that the dollar is anywhere near collapsing.

Erik writes:
Google John Williams Shadowstats to get the true,full picture of inflation in America. Your thesis of "historically low" inflation is government and Main Stream Media propaganda. Why is gasoline $4.00 a gal.or quality hamburger $3.75 a pound when they were half that price 10 or 12 years ago? Why do the same automobiles that sold for 15K ten years ago now cost 25K? If you think there is low or no inflation then you are living in a fool's world.

According to shadowstats, inflation has averaged about 8% a year for the past 30 years (that would mean an average price increase of about 1000% percent). Right... And it's the "government and Main Stream Media" that's spewing unreliable inflation propaganda. If you're so sure of the imminent (or current) hyperinflation, sell everything you own and buy gold. Good luck with that. "Everyone is entitled to his own opinion, but not his own facts."

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