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by Arnold Kling
November 28, 2000
Yesterday, we accepted our first delivery from Peapod, an "Internet grocer." The economic issues that will determine whether or not this type of service can succeed have almost nothing to do with the Internet.
Peapod is an example of a comparative advantage "play." They probably are no more efficient than we are at picking and delivering groceries. However, we would rather spend our time doing other things.
In our area, Peapod has a joint venture with Giant Food, a large brick-and-mortar grocer. Peapod supplies the Internet software. Giant supplies the food. I am not sure who does the picking and delivering.
There is a sense in which every business is a comparative advantage play. Every business exists because people will pay the business to do something rather than do it themselves.
However, most businesses have an absolute advantage. When I hire someone to build an addition on my house, the contractor will complete the work in less time than it would take me to do the job. The contractor has an absolute advantage.
About twenty years ago, when I was working at the Federal Reserve Board, an economist colleague built a deck for his house. Apparently, he was fairly skilled, and he may have been able to build it faster than a contractor. That is, the economist had an absolute advantage at building decks.
Nonetheless, I argued that his do-it-yourself approach was indicative of market failure. "If you could work additional hours as an economist and pay a contractor to build your deck, you would be better off," I contended.
Even though the economist may be a more efficient deck-builder than a contractor, the economist should be doing economics rather than building decks. After all, the economist also is more efficient than the deck-builder when it comes to analyzing the costs and benefits of using peak-load pricing for wire transfers.
In fact, relative to the contractor, the economist's efficiency edge in writing memos on pricing issues for the Federal Reserve Board is greater than his advantage in building decks. That is what we mean by comparative advantage.
My guess is that the Peapod model has little or no absolute advantage relative to the model in which people go to stores, pick things off of shelves, and drive them home. The comparative advantage of the Internet-plus-delivery model will be determined by labor market rules, taxes, and the wage distribution.
My friend at the Federal Reserve could not have been paid for working additional hours as an economist there, nor would the Fed have allowed him to "moonlight" elsewhere. That is why he found it profitable to build his own deck.
Many people face arbitrary limitations on the number of hours of work for which they will be paid. These people will tend to do their own shopping rather than use Peapod, because the "opportunity cost" of their time is much lower than their average wage rate.
If I drive to the local Giant Food, pick out my own groceries, and deliver them to my own home, this work earns no income. It does not give rise to any tax liability.
On the other hand, suppose that I work longer and earn an additional $5 to pay Peapod to do the grocery selection and delivery. This $5 will be taxable income.
Because of taxes, including social security taxes, Peapod starts out with nearly a 50 percent cost disadvantage. That is, other things equal, it will cost 50 percent more to have Peapod select and deliver groceries than for me to do it myself.
(As an aside, I am not sure that $5 is sufficient for Peapod to be profitable in the long run. It may be that without a subsidy from the stock market, Peapod would have to charge $30 per delivery. However, for the purposes of this essay, we will assume that Peapod is a rational business model.)
If grocery selection and delivery can be done by unskilled workers earning $6 an hour, and there are skilled workers for whom the opportunity cost is $25 an hour, then the Peapod model may work. Note, however, that in a family, the opportunity cost would be the marginal wage rate of the lowest-earning adult.
Over the past twenty years, trends apparently favor all three factors:
Conceivably, these trends may have made it economical to run a business that is based primarily on comparative advantage rather than absolute advantage. If so, then my guess is that the Peapod model would have emerged without the Internet. If it works, it works using fax machines.