Business Cases: The Chicago Board of Trade

Jim West

Around the world, commodities are bought and sold on “exchanges,” markets organized in a specific location, where buyers and sellers meet to trade. But it wasn’t always like this.

The first modern commodity exchange was the Chicago Board of Trade, founded in 1848. At the time, the United States was already a major wheat producer. And St. Louis, not Chicago, was the leading city of the American West and the dominant location for wheat trading. But the St. Louis wheat market suffered from a major flaw: there was no central marketplace, no specific location where everyone met to buy and sell wheat. Instead, sellers would sell their grain from various warehouses or from stacked sacks of grain on the river levee. Buyers would wander around town, looking for the best price.

In Chicago, however, sellers had a better idea. The Chicago Board of Trade, an association of the city’s leading grain dealers, created a much more efficient method for trading wheat. There, traders gathered in one place—the “pit”—where they called out offers to sell and accepted offers to buy. The Board guaranteed that these contracts would be fulfilled, removing the need for the wheat to be physically in place when a trade was agreed upon.

This system meant that buyers could very quickly find sellers and vice-versa, reducing the cost of doing business. It also ensured that everyone could see the latest price, leading the price to rise or fall quickly in response to market conditions. For example, news of bad weather in a wheat-growing area hundreds of miles away would send the price in the Chicago pit soaring in a matter of minutes.

The Chicago Board of Trade went on to become the world’s most important trading center for wheat and many other agricultural commodities, a distinction it retains to this day. And the Board’s rise helped the rise of Chicago, too. The city, as Carl Sandburg put it in his famous poem, “Chicago,” became:

By 1890, Chicago had more than a million people, second only to New York and far out-pacing St. Louis. Making a better market, it turned out, was very good business indeed.

1. In Chapter 3 we mentioned how prices can vary in a tourist trap. Which market, St. Louis or Chicago, was more likely to behave like a tourist trap? Explain.
2. What was the advantage to buyers from buying their wheat in the Chicago pit instead of in St. Louis? What was the advantage to sellers?
3. Based on what you have learned from this case, explain why eBay is like the Chicago pit. Why has it been so successful as a marketplace for second-hand items compared to a market composed of various flea markets and dealers?

Business Cases: Medallion Financial: Cruising Right Along

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Back in 1937, before New York City froze its number of taxi medallions, Andrew Murstein’s immigrant grandfather bought his first one for $10. Over time, the grandfather accumulated 500 medallions, which he rented to other drivers. Those 500 taxi medallions became the foundation for Medallion Financial: the company that would eventually pass to Andrew, its current president.

With a market value of over $250 million in late 2012, Medallion Financial has shifted its major line of business from renting out medallions to financing the purchase of new ones, lending money to those who want to buy a medallion but don’t have the sizable amount of cash required to do so. Murstein believes that he is helping people who, like his Polish immigrant grandfather, want to buy a piece of the American dream.

Andrew Murstein carefully watches the value of a New York City taxi medallion: the more one costs, the more demand there is for loans from Medallion Financial, and the more interest the company makes on the loan. A loan from Medallion Financial is secured by the value of the medallion itself. If the borrower is unable to repay the loan, Medallion Financial takes possession of his or her medallion and resells it to offset the cost of the loan default. As of 2012, the value of a medallion has risen faster than stocks, oil, and gold. Over the past two decades, from 1990 through fall 2012, the value of a medallion rose 450% compared to 330% for an index of stocks.

But medallion prices can fluctuate dramatically, threatening profits. During periods of a very strong economy, such as 1999 and 2001, the price of New York taxi medallions fell as drivers found jobs in other sectors. When the New York economy tanked in the aftermath of 9/11, the price of a medallion fell to $180,000, its lowest level in 12 years. In 2004, medallion owners were concerned about the impending sale by the New York City Taxi and Limousine Commission of an additional 900 medallions. As Peter Hernandez, a worried New York cabdriver who financed his medallion with a loan from Medallion Financial, said at the time: “If they pump new taxis into the industry, it devalues my medallion. It devalues my daily income, too.”

Yet Murstein has always been optimistic that medallions would hold their value. He believed that a 25% fare increase would offset potential losses in their value caused by the sale of new medallions. In addition, more medallions would mean more loans for his company. As of 2012, Murstein’s optimism had been justified. Because of the financial crisis of 2007–2009, many New York companies cut back the limousine services they ordinarily provided to their employees, forcing them to take taxis instead. As a result, the price of a medallion rose to an astonishing $713,000 in August 2012. And investors have noticed the value in Medallion Financial’s line of business: from August 2011 to August 2012, shares of Medallion Financial have risen 26%.

1. How does Medallion Financial benefit from the restriction on the number of New York taxi medallions?
2. What will be the effect on Medallion Financial if New York companies resume widespread use of limousine services for their employees? What is the economic motivation that prompts companies to offer this perk to their employees? (Note that it is very difficult and expensive to own a personal car in New York City.)
3. Predict the effect on Medallion Financial’s business if New York City eliminates restrictions on the number of taxis.

Business Cases: The Airline Industry: Fly Less, Charge More

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The recession that began in 2008 hit the airline industry very hard as both businesses and households cut back their travel plans. According to the International Air Transport Association, the industry lost $11 billion in 2008. However, by 2009, despite the fact that the economy was still extremely weak and airline traffic was still well below normal, the industry’s profitability began to rebound. And by 2010, even in the midst of continued economic weakness, the airline industry’s prospects had definitely recovered, with the industry achieving an $8.9 billion profit that year, with continued profitability in 2011. As Gary Kelly, CEO of Southwest Airlines said, “The industry is in the best position—certainly in a decade—to post profitability.”

How did the airline industry achieve such a dramatic turnaround? Simple: fly less and charge more. In 2011, fares were 14% higher than they had been the previous year, and flights were more crowded than they had been in decades, with fewer than one in five seats empty on domestic flights.

In addition to cutting back on the number of flights—particularly money-losing ones—airlines implemented more extreme variations in ticket prices based on when a flight departed and when the ticket was purchased. For example, the cheapest day to fly is Wednesday, with Friday and Saturday the most expensive days to travel. The first flight of the morning (the one that requires you to get up at 4 A.M.) is cheaper than flights departing the rest of the day. And the cheapest time to buy a ticket is Tuesday at 3 P.M. Eastern Standard Time, with tickets purchased over the weekend carrying the highest prices.

And it doesn’t stop there. As every beleaguered traveler knows, airlines have tacked on a wide variety of new fees and increased old ones—fees for food, for a blanket, for checked bags, for carry-on bags, for the right to board a flight first, for the right to choose your seat in advance, and so on. Airlines have also gotten more inventive in imposing fees that are hard for travelers to track in advance—such as claiming that fares have not risen during the holidays while imposing a “holiday surcharge.” In 2011, airlines collected more than $22.6 billion from fees for checking baggage and changing tickets, up 66% from 2010.

But the question in the minds of industry analysts is whether airlines can manage to maintain their currently high levels of profitability. In the past, as travel demand picked up, airlines increased capacity—added seats—too quickly, leading to falling airfares. “The wild card is always capacity discipline,” says William Swelbar, an airline industry researcher. “All it takes is one carrier to begin to add capacity aggressively, and then we follow and we undo all the good work that’s been done.”

1. How would you describe the price elasticity of demand for airline flights given the information in this case? Explain.
2. Using the concept of elasticity, explain why airlines would create such great variations in the price of a ticket depending on when it is purchased and the day and time the flight departs. Assume that some people are willing to spend time shopping for deals as well as fly at inconvenient times, but others are not.
3. Using the concept of elasticity, explain why airlines have imposed fees on things such as checked bags. Why might they try to hide or disguise fees?
4. Use an elasticity concept to explain under what conditions the airline industry will be able to maintain its high profitability in the future. Explain.