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Sunday, November 13, 2005

Barter Systems and Marketing

I recently came across two companies earning a decent living in the same line of business. It's a line of business that I find unexpected and surprising. Whenever an observation is unexpected and surprising, it's important and it needs to be written down, as Darwin supposedly said (now you know why I wrote the last entry).

Both of these companies are making money by essentially creating their own currency: ITEX dollars and CTE dollars. INLM's explanation for why anyone would want to do this didn't make much sense to me. It makes sense on the surface, but when you really analyze it using economic principles, the argument falls apart. But ITEX identifies a reason in their 10-K that makes tremendous sense:
The ITEX Exchange is especially useful to those businesses where the variable costs of products or services are low such as hotels, media and other service-related businesses. For example, a radio station or newspaper that has not filled available advertising space has lost the opportunity to generate revenue but still has incurred virtually the same costs. In short, businesses can leverage their low variable cost and excess capacity into more purchasing power by accepting ITEX dollars.
This matches up with the conclusion The Armchair Economist reaches when attempting to find out why movie theater popcorn costs so much. They punch holes in all the usual explanations and then determine the pricing structure which theoretically maximizes profits (which resembles how Costco, Sam's Club, etc. do business). But their conclusion for why the popcorn is so expensive is that it allows the theater to serve two different markets. The first market are people who are price sensitive and just want to see the movie. The second market are people who want the full movie experience and are not very price sensitive (people on a first date, for instance). How do you charge a low price to maximize the profits from the first group while still extracting a large amount from the second group? The answer is to identify something, anything, which can separate the two groups. Restaurants have "early bird" specials to do the same thing with old people. It turns out that people like to eat popcorn and drink sodas at the theater. The first group will gladly avoid them (but still buy a movie ticket) if the price of those items is high. The second group will buy them even at high prices so long as you make it seem upscale or differentiated somehow from ordinary sources. So you dress the servers up a bit, have plush carpeting, make the serving sizes large, get the servers to upsell the larger sizes, whatever it takes: extract a large amount of money at the concession stand. (I believe that lately, the first group is disappearing, which would explain why movie tickets themselves have gone up so much, along with stadium seating and better quality sound systems, but it's actually fairly complicted and deserves its own post.) Airlines separate business travelers (who must travel and can pay a lot) from personal travelers (whose travel demand curve is very elastic) by all sorts of methods, which is why their pricing is so weird and complex.

Getting back to the barter systems, the real advantage to this system is being able to serve two markets. My first reaction to this unexpected explanation was that these people shouldn't be using ITEX dollars and CTE dollars (and paying fairly high fees for using them), they should gravitate to some currency such as Mexican pesos or Canadian dollars or something else that's backed by something a bit more solid than a single wobbly company. But the problem is that these might not truly separate the two markets. People would learn to use pesos or Candian dollars. No, this is a delicate system that needs delicate solutions.

My second reaction was to figure that people probably already do this somehow, possibly without even realizing it.

This also would explain why the US dollar has been so widely used all around the world as a universal medium of exchange: people in Elbonia can serve two different markets by dealing in dollars and in elboniars. If you're making good money while living in Elbonia and you want the dentist to actually give-a-damn or you want the restaurant to use edible food rather than floor sweepings, then you might use dollars rather than elboniars. It's sort of the reverse of these barter companies.

I hypothesize that this kind of dual-market system exists in a lot more places that I don't yet know about.

What would identify one? A bi-modal distribution of customers? Two currencies existing where they don't normally exist? Some unexplainably high-priced "extra" or "option"?

How could I test this hypothesis? Compare and contrast with other systems that shouldn't have it or clearly don't have it? Account for all other factors?

What evidence of this did I see in India?

NOTE: ITEX may look cheap but it's actually priced a bit high. Earnings are distorted by a huge gain-on-sale in 2004 and a huge tax benefit in 2005. Free cash flow (and operational earnings) are less than 4 cents a share in 2005 and pretty much zero in 2004. They lost money in 2003 and 2002.

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