The following is a guest post by Linda Jines — yarn merchant, book titler, and sister of Steve Levitt. Enjoy.
The Office-onomics?
A Guest Post
By Linda Jines
The most recent episode of NBC’s hit comedy The Office offered viewers something extra along with its usual half hour of wry observations about life in Dilbertian corporate America. The episode, entitled “Broke,” included a lesson — an attempted one, at least — in microeconomics.
Some backstory: The Office, currently in its fifth season, is a “mockumentary” about life in a small, stagnant, Scranton, Pa., outpost of fictional paper company Dunder Mifflin. Office star Steve Carell plays Michael Scott, who until this season was the regional manager of the titular office. In a fit of pique, he left to form his own paper company — the Michael Scott Paper Company — which is now foundering, due to his marketing strategy of undercutting competitors’ prices.
In the Thursday, April 23, episode, Michael Scott consults with an accountant to determine how much he might be able to pay someone to make his paper deliveries. He’s told that he can afford to pay a delivery person nothing, as his prices are too low.
“Look, our pricing model is fine,” a Michael Scott employee tells the accountant. “I reviewed the numbers myself. Over time, with enough volume, we become profitable.”
This is where the economics lesson begins in earnest.
The accountant replies, “Yeah, with a fixed-cost pricing model, that’s correct. But you need to use a variable-cost pricing model.”
He goes on to explain, “As you sell more paper and your company grows, so will your costs. For example — deliveryman, healthcare, business expansion … At these prices, the more paper you sell, the less money you’ll make.”
So did the writers for The Office get it right? Is it truly and ineluctably the case that underpricing your product will put you out of business, no matter how many sales you drum up?
I decided to ask the resident expert on all things economic, my brother Steven Levitt.
I recited the accountant’s dialog to Steve (also a fan of The Office, as it turns out) and asked his opinion. He replied:
None of it makes that much sense, really — because usually there’s a fixed cost of setting up a business, and then there’s a variable cost every time you sell one more unit. But usually we think that the average cost per unit sold goes down the more you sell. It is completely possible that a company could go from unprofitable to profitable by charging the same price but selling more. On this one, I side with the Michael Scott Paper Company.
Uh-oh. Based on the accountant’s information, Carell’s character decides to close his paper company (in true Hollywood style, Dunder Mifflin rushes in at the 11th hour to buy him out and rehire him).
So was the Michael Scott Paper Company in the right with their ultra-low-price strategy? Steve replied:
No, I think they were probably charging too low a price, but not for the reason the accountant
said.My guess is they were charging too low a price because most companies that I’ve worked with closely — when you run the numbers — are charging too low a price. I’ve never seen an obvious example — again, with the companies I’ve worked with — of a company charging a price that is clearly too high.
This discussion of low prices was all well and good, but it was time to move it from the theoretical to the practical.
“What if HarperCollins decided to charge just $12.95 for the new Freakonomics book?” I asked.
“That’s a reasonable price,” Steve replied roguishly, “… for the first chapter. But what about the rest of the book?”
and 
. You can also watch it on 
– Ryan,
in theory, fixed costs will never grow in proportion to production due to “doubling”, or simply duplicate the current setup for double the output and same % of fixed cost. So in theory “more you sell more you lose” would never happen. Though they might never move to profitability.
Of course this does not work in real life since scarcity of the resources.
As an accountant I have to side with the accountant! Admittedly the fixed cost per unit will fall as he expands, but of course the costs we think of as fixed aren’t really. They are more likely to increase every so often as he expands his base of operations. Accountants call these ‘step costs’ I guess economists might say that he would go over his maximum efficient scale,
There’s a big problem with the smart economist’s analysis.
The cost curve is not smooth and simple, as he seems to assume is. Sure, for a large large large company that might be the case, but for a very small company, it is anything but.
For example, adding a deliveryman is a big jump in costs. Adding healthcare is a big jump in costs. There are all kinds of rule and regulations that only apply when companies get above a certain size.
So, this is a question of scale. The accountant could have been right for the scale that he is considering, even if Levitt is right the way that economists generally think.
That is, the tiny tiny tiny and unprofitable Michael Scott Paper Company could be about to hit some major increases in costs that would make it even less profitable, with profitability happening so far down the road (i.e. so much growth) that it is inconceivable to the accountant.
The reason why this wouldn’t occur to the smart economist that businesses this stupid don’t get off the ground. Remember, Michael Scott’s stupidity is key to this show, and far beyond what real men and women are capable of.
One could argue that this is part of the WalMart strategy, undercut your competition via loss-leading prices until you run them out of business, and then establish a (quasi-) monopoly for the region/market/item.
In a small business like MSPC, fixed costs are purely theoretical. Any fixed costs expended (improvements on the closet, the bus, etc) cannot reasonably accomodate any needed expansion in business, and require further investment.
Then there’s the growth imperative. MSPC wants to topple Dunder Mifflin, but there’s reams of investment necessary to bring MSPC up to the capacity of Dunder Mifflin (warehouses staffed by Darrells, assistants to the regional managers, etc). MSPC will be continually investing for growth, making profit theoretical as well.
Cash flow is what needed to be discussed with the accountant, that’s the true determinant of proper pricing for a super-small business, not profit/loss. Was Michael pulling a salary? Booking salary payable creates a big deviation between profitability and pos cash flow in a three-person biz. If cash flow from the current pricing supported current operations, THAT’S what should have guided Michael’s decision.
Yes Leland, $13 is too much for a book. Don’t use an overpriced trash meal as justification for something else being overpriced. If I’m going out to eat, I’ll go to a small local restaurant that his higher quality and less expensive. My usual lunch at work is only $0.25-30. I might be convinced to pick up a paperback copy for $6. Even better would be a PDF for $2.50. Of course, it’d have to be DRM-free and not require any sort of registration to buy it, otherwise copyright infringement is a heck of a lot easier.
I think the point is that Michael Scott was treating variable costs as fixed. Likely they are actually step costs: $10 for 0-100 units, $20 for 100-200, etc. The important thing is that they rise with volume.
What the accountant is saying is that his variable costs (when including the step costs) are higher than his selling price, therefore his gross margin is negative. With a negative gross margin, you lose money with every sale.
I thought the negotiation for the buyout was quite brilliant, and hightlighted how seemlingly irrational decisions are made by large corporations….in this instance overpaying for a smaller, weaker competitor.
The CFO of Dunder Miflin said something to the effect of…”we’ve seen your cost structure, and there’s no way you can outlast Dunder Miflin at those prices.”
To which Michael Scott replied, “Your board meeting is coming up, and your going to have to explain to them why your formerly most profitable is now bleeding. The truth is, I don’t need to outlast Dunder Miflin, I just need to outlast you!” …and the CFO immediately acquiesced.
Unfortunately, I have seen these types of decisions made more frequently then one would hope.