The Undercover Economist Part 2
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So here's my advice: if you want a bargain, don't try to find a cheap store. Try to shop cheaply. Similar products are, very of-ten, priced similarly. An expensive shopping trip is the result of carelessly choosing products with a high markup, rather than wandering into a store with "bad value," because price-targeting accounts for much more of the difference between prices than any difference in value between one store and another.
Mix it up!
Another very common pricing strategy is sale pricing. We're all so used to seeing a storewide sale with hundreds of items reduced in price that we don't pause and ask ourselves why on earth stores do this. When you think hard about it, it becomes quite a puz-zling way of setting prices. The effect of a sale is to lower the average price a store charges. But why knock 30 percent off many of your prices twice a year, when you could knock 5 percent off year-round? Varying prices is a lot of ha.s.sle for stores because they need to change their labels and their advertising, so why does it make sense for them to go to the trouble of mixing things up?
One explanation is that sales are an effective form of self-targeting. If some customers shop around for a good deal and some customers do not, it's best for stores to have either high prices to pry cash from the loyal (or lazy) customers, or low prices to win business from the bargain hunters. Middle-of-the-road prices are no good: not high enough to exploit loyal customers, not low enough to attract the bargain-hunters. But that's not the end of the story, because if prices were stable, then surely even the most price-insensitive customers would learn where to get particular goods cheaply. So rather than stick to either high or low prices, shops jump between the two extremes.
One common situation is for two supermarkets to be compet-ing for the same customers. As we've discussed, it's hard for one to be systematically more expensive than the other without los-ing a lot of business, so they will charge similar prices on average, but both will also mix up their prices. That way, both can distin-guish the bargain hunters from those in need of specific prod-ucts, like people shopping to pick up ingredients for a cookbook recipe they are making for a dinner party. Bargain-hunters will pick up whatever is on sale and make something of it. The dinner-party shoppers come to the supermarket to buy specific products and will be less sensitive to prices. The price-targeting strategy only works because the supermarkets always vary the patterns of their special offers, and because it is too much trouble to go to both stores. If shoppers could reliably predict what was to be discounted, they could choose recipes ahead of time, and even choose the appropriate supermarket to pick up the ingredients wherever they're least expensive.
In fact, it is just as accurate, and more illuminating, to turn the "sale" on its head and view prices as premiums on the sale price rather than discounts on the regular price. The random pattern of sales is also a random pattern of price increases-companies find it more profitable to increase prices (above the sale price) by a larger amount on an unpredictable basis than by a small amount in a predictable way. Customers find it troublesome to avoid unpredictable price increases-and may not even notice them for lower-value goods-but easy to avoid predictable ones.
Try to spot other odd mix-ups next time you're in the supermar-ket. Have you noticed that supermarkets often charge ten times as much for fresh chili peppers in a package as for loose fresh chilies? That's because the typical customer buys such small quan-t.i.ties that he doesn't think to check whether they cost four cents or forty. Randomly tripling the price of a vegetable is a favorite trick: customers who notice the markup just buy a different veg-etable that week; customers who don't have self-targeted a whop-ping price rise.
I once spotted a particularly inspired trick while on a search for potato chips. My favorite brand was available on the top shelf in salt and pepper flavor and on the bottom shelf, just a few feet away, in other flavors, all the same size. The top-shelf potato chips cost 25 percent more, and customers who reached for the top shelf demonstrated that they hadn't made a price-comparison between two near-identical products in near-identical locations. They were more interested in snacking.
Admittedly, for some people the difference in flavors is important. Some will notice the higher price for salt and pepper flavor and, irritated, pay anyway. Others will prefer the different flavors and count themselves lucky that they have inexpensive tastes.
But this is an example of a universal truth about supermarkets: they are full of close (or not so close) subst.i.tutes, some cheap, some expensive, and with a strong random element to the pric-ing. The random element is there so that only shoppers who are careful to notice, remember, and compare prices will get the best bargains. If you want to outwit the supermarkets, simple obser-vation is your best weapon. And if you can't be bothered to do that, you really don't need to save money.
Reality check number one: Does the company really have scarcity power?
It's time for a reality check. When we talk about big companies it is easy to get carried away with notions of how they are infinitely powerful and we are infinitely gullible. Not true.
Remember that no company has power unless it has scarcity, and often that scarcity is something we give them through our own laziness. Nothing is stopping us from walking down the street or driving from one store to another; certainly nothing is stop-ping us from a bit of mental arithmetic when buying chilies, or from glancing around for two seconds when buying potato chips.
Every store has a tiny amount of scarcity power, if only because it's an effort to walk out and go next door. But some have more scarcity power than others, which is worth thinking about when estimating the risk of being waylaid by price-targeting strategies.
For instance, what is the answer to the question we posed in the previous chapter: why does popcorn cost so much at movie theaters? Is it for the same reason that wine is expensive in res-taurants? We know that the first-glance answer in both cases is, "Because once they get you in the door they can charge whatever they want." We also know that this first answer is probably not true. Customers may be dumb, but they're not that dumb. People expect to be charged a lot for wine in restaurants and for pop-corn and candy in movie theaters before they walk in the door.
Now we have a better answer: it's likely to be a price-targeting strategy. Moviegoers who are sensitive to price will bring their own snacks from home, or go without. People who are not sen-sitive to price-perhaps because they're on a date and don't want to look stingy-will simply pay for the overpriced popcorn. Very clever.
This is a much better explanation, since in many towns there is only one movie theater, and even in towns with more than one, there is often only one showing the film you want to see.
This gives a theater a lot of scarcity power, and if the manager is smart he'll want to exploit that power to the full.
Yet the same story doesn't ring true for pricey wine at restau-rants. The typical restaurant has less scarcity power than a movie theater because in most towns there will be a variety of alterna-tives. Whenever there is little scarcity power, prices need to re-flect costs. Yet even the most ordinary restaurants seem to charge a lot for wine. A better explanation is that one of the big costs in a restaurant business is table s.p.a.ce. Restaurateurs would there-fore like to charge customers for dawdling, but because they can-not do that, they charge higher prices for products that tend to be consumed in longer meals: not just wine but also appetizers and desserts.
We go to a movie theater to see a movie and to a restaurant to eat, so is the truth also that we always get gouged on "options"? Not at all. One option available in both movie theaters and in restaurants is the option to use the restrooms; this is always an option provided free of charge. Tap water is also free in restau-rants. It is not the option that invites the gouging, it's the lack of price sensitivity that allows a business with scarcity power to prac-tice price-targeting.
Reality check number two: Can the company plug leaks?
Perhaps you are a company director rubbing your hands with glee as you read this, planning to deploy a range of clever price-targeting strategies in your own business. Before you get too ex-cited, you'll need to deal with the leaks in your price-targeting system. There are two potentially catastrophic leaks or great holes in an otherwise brilliant marketing scheme. If you don't deal with them, your plans will be in ruins.
The first problem is that supposedly price-insensitive customers may not play the self-targeting game. It's not hard to persuade price-sensitive customers to steer clear of an expensive product, but sometimes it is more difficult to prevent the price-insensitive customers from buying the cheaper one. This is not a problem in the case of small price differences; we have already seen that you can get some customers to pay a modest markup in absolute terms, but the markup can be huge in relative terms, just by wrapping some chilies in a plastic bag, or moving a bag of potato chips up onto the top shelf. When it comes to more substantial buying decisions it is not always so easy.
Some of the most extreme examples come from the travel in-dustry: traveling first cla.s.s by train or air is much more expensive than buying the coach-cla.s.s seats, but since the fundamental ef-fect is to get people from A to B, it may be hard to wring much money out of the wealthier pa.s.sengers. In order to price-target effectively, firms may have to exaggerate the differences between the best service and the worst. There is really no reason at all why coach-cla.s.s train cars shouldn't have tables, as they typically don't in the UK, for instance, except that potential customers for first cla.s.s might decide to buy a cheaper ticket when they see how comfortable coach has become. So the coach-cla.s.s pa.s.sen-gers have to suffer.
There is a famous example from the early days of the trains in France: It is not because of the few thousand francs which would have to be spent to put a roof over the third-cla.s.s carriage or to upholster the third-cla.s.s seats that some company or other has open carriages with wooden benches. . . . What the com-pany is trying to do is prevent the pa.s.sengers who can pay the second-cla.s.s fare from traveling third cla.s.s; it hits the poor, not because it wants to hurt them, but to frighten the rich. . . . And it is again for the same reason that the compa-nies, having proved almost cruel to the third-cla.s.s pa.s.sen-gers and mean to the second cla.s.s ones, become lavish in dealing with first-cla.s.s customers. Having refused the poor what is necessary, they give the rich what is superfluous.
The shoddy quality of most airport departure areas across the world is surely part of the same phenomenon. If the free departure areas became comfortable, then airlines would no longer be able to sell business-cla.s.s tickets on the strength of their "ex-ecutive" lounges. And it would also explain why flight atten-dants sometimes physically restrain coach pa.s.sengers from stepping off the plane before the pa.s.sengers from first and busi-ness cla.s.s. This is a "service" aimed not at economy-cla.s.s pas-sengers but at those looking on in pity and disgust from the front of the plane. The message is clear: keep paying for your expensive seats, or next time you might be the wrong side of the flight attendant.
In the supermarkets, we see the same trick: products that seem to be packaged for the express purpose of conveying awful qual-ity. Supermarkets will often produce a store-brand "value" range, displaying crude designs that don't vary whether the product is lemonade, bread, or baked beans. It wouldn't cost much to hire a good designer and print more attractive logos. But that would defeat the object: the packaging is carefully designed to put off customers who are willing to pay more. Even customers who would be willing to pay five times as much for a bottle of lemon-ade will buy the bargain product unless the supermarket makes some effort to discourage them. So, like the lack of tables in coach-cla.s.s trains and the uncomfortable seats in airport lounges, the ugly packaging of "value" products is designed to make sure that snooty customers self-target price increases on themselves.
The most surprising examples of all come from the world of computers. For instance, IBM's "LaserWriter E," a low-end la-ser printer, turned out to be exactly the same piece of equipment as their high-end "LaserWriter"-except that there was an addi-tional chip in the cheaper version to slow it down. The most effective way for IBM to price-target their printers was to design and ma.s.s-produce a single printer, then sell it at two prices. But of course to get anyone to buy the expensive printer they had to slow down the cheap one. It seems wasteful, but presumably it was cheaper for IBM to do this than design and manufacture two completely different printers. Intel, the chip manufacturer, played a similar game by selling two very similar processing chips at different prices. In this case, the inferior chip was actually more expensive to produce: it was made by taking the superior chip and doing extra work to disable one of its features.
Software packages often have two or more versions: one has full functionality (the "professional" package), and the other sells to the ma.s.s market at a considerably reduced price. What some people don't realize is that the professional version is typically designed first, and certain features are disabled for the ma.s.s-market version. Despite the high price of the professional ver-sion, it's the cheaper version that actually has an extra up-front cost for the developer, and of course both versions are sold on CDs, which cost the same to manufacture. Computer hardware, and in particular software, has a strange cost structure because of intensive research and development costs, and relatively low manufacturing costs. At the height of the Internet bubble, giddy gurus were claiming that the different cost structure changes everything-but, as we've seen, the basic rules of making money in the hi-tech business are not so different from the rules for train operators or coffee bars.
The first "leak" in a price-targeting strategy, then, is that rich customers may buy cheap products, unless the products are de-liberately sabotaged. The second "leak" is a particularly difficult one for companies using a group-target strategy to plug: their products may leak from one group to another. The risk is that the customers who are being offered a discount buy the product and then resell it at a profit to the customers who are being charged a higher price. Up until now, we've mostly been discussing ser-vices that can't be resold (like a bus trip or a visit to Disney World) or products that are probably too much ha.s.sle to resell (such as a sandwich or a cup of coffee). That's not coincidence. Services and convenience products are the most fertile grounds for price-targeting strategies, because they don't leak. The really great pricing tricks take place on airlines, in restaurants and c.o.c.ktail bars (not many bookstores have a "happy hour"), in supermar-kets, and at tourist attractions.
In contrast, some products are inherently leaky: they're expen-sive, easy to transport, and nonperishable. The obvious examples are digital media (CDs, DVDs, and software) and pharmaceuti-cals. Companies go to tremendous lengths to plug leaks, which in an age where Internet shopping allows us to order products from anywhere in the world are becoming increasingly difficult to pre-vent. For instance, the DVD industry agreed on a system of re-gional coding so that DVDs bought in the United States would not work in Europe. But that system is being circ.u.mvented by an alliance of customers and DVD-machine suppliers who willingly equip machines to read a DVD from anywhere in the world.
If your instincts are anything like mine, it all seems like a pretty shabby trick. But the same popular opinion that despises the DVD industry for trying to sell their products at different prices in different markets also believes that the big pharmaceutical com-panies should supply drugs to poor countries at discounted prices. Confusingly, our moral intuitions seem to be sending us contra-dictory messages.
Maybe the story is as simple as this: when it's an important product like a treatment for HIV/AIDS, the most important thing is to get it to the poor; when it's as trivial as a DVD, our irritation at being ripped off is the dominant emotion. But that doesn't quite add up: DVDs make it to very poor areas, and surely we should be at least somewhat pleased that the poor get to watch movies in bars and village halls across the developing world? Or, conversely, shouldn't we be even more outraged that the phar-maceutical companies are overcharging for crucial treatments in the developed world? An economist cannot solve these ethical conundrums, but economics can unwrap them so that at least the ethical question becomes clearer.
When price-targeting is a good thing Here is a thought experiment.
Imagine a hypothetical pharmaceutical company called PillCorp, which has developed a uniquely powerful new treatment for HIV/ AIDS. a.s.sume that it doesn't engage in any price-targeting and charges the same price across the globe. PillCorp will set the glo-bal price so that the gain in sales from cutting the price exactly balances the loss of margin from a price cut. For example, say that PillCorp cut prices and reduced their margins by half. Unless they doubled sales this would reduce profits. They could raise prices and double their margins, but if sales dropped by more than half that would also reduce profits. PillCorp will maximize profits by pricing at the point where either a price cut or a price increase would slightly damage the bottom line.
The price will be high, because people in rich countries will pay a lot for an effective treatment, and there is no point in los-ing customers who are paying thousands of dollars in an effort to pick up customers who are paying pennies.
That looks like bad news. PillCorp is using its scarcity power to charge a high price for a life-saving drug. As a result, people in poor countries don't get the drug. People are dying because of PillCorp's greed.
Actually, it's only half bad news. People are also living because of PillCorp's greed. PillCorp developed the life-saving treatment because it was encouraged to do so by the hope of a lucrative patent. Pharmaceuticals are very expensive to research and de-velop, and somebody has to pay the bill. The current system is that public and private insurers pay, and since the United States is easily the largest market, innovation is driven by and largely paid for there.
Although PillCorp is making money by selling its drug at a high uniform global price, they could be doing better and so could everybody else. Economists don't just have in mind a shrug-your-shoulders-life's-like-that-sometimes "could be better." We mean something more precise: PillCorp could be making more money and serving the world better.
Say that a year's supply of drugs for one customer costs $10 for PillCorp to produce, and retails at $1,000. For rich customers willing to pay-or who have insurance that will pay-that's not really a problem. Each year of treatment transfers $990 from those living with AIDS to those who produced the treatment. But a taxi driver in Cameroon might be willing to pay only $50 a year for treatment; beyond that, he'd rather buy food, or gas for his taxi. Because of PillCorp's global price policy, the taxi driver loses out on the treatment, and PillCorp loses out on the chance to make some profit. But if PillCorp were able to make a one-time discount to the taxi driver and sell him the treatment for any price between $10 and $50-say $30-everybody would be better off. The taxi driver gets treatment for $30 when he was willing to pay $50. PillCorp receives $30 in revenues for a $10 pill-a profit of $20.
That is what economists mean when we say a situation "could be better." If we can point to a change that could make at least one person better off, and n.o.body worse off, we say that the cur-rent situation is inefficient, or, in everyday language, that it could be better. (We also say that the current situation is efficient if every change that could make at least one person better off will also make somebody else worse off. It doesn't mean that an effi-cient situation can't be improved; it's just that there is no costless way to improve it.) Now imagine that PillCorp practices price-targeting, continuing to charge $1,000 in rich Western countries but supplying people in developing countries, like the Cameroon taxi driver, for $30. Suddenly, a whole new market opens up for PillCorp: the new discount allows the company to acquire millions of new customers at a profit of $20 a year, but at the same time, it still makes all the sales it used to make in rich countries.
This a.s.sumes the cheap pills don't "leak" back, which in practice is a ma.s.sive concern for pharmaceutical companies. The current leakage of cheap drugs from Canada is a problem for drug companies who want to take advantage of the high willingness to pay in the United States, but who also sell to Canadian health care providers who refuse to pay high prices for drugs. The risk, if the leakage continues, is that American providers simply refuse to offer discounts to Canada any more.
The example should also make us realize that the greater price transparency brought about by the Internet and other improve-ments in communications occasionally has a downside: a com-pany with scarcity power may be discouraged from offering discounted products because they are more likely to leak.
PillCorp's dual-pricing policy creates a much better situation. Customers in rich countries are no worse off. Shareholders in PillCorp are better off. And people living with HIV/AIDS in poor countries are also better off. To use the business-school jargon, this is a win-win situation, or as an economist would say, a clear improvement in efficiency.
This doesn't mean the new situation is perfect; it just means that it is unambiguous progress from the previous situation, where PillCorp's scarcity power was causing a huge inefficiency . . . and huge loss of life in poor countries. Perhaps we are outraged to see the poor denied drugs that cost pennies to produce, not be-cause that is unfair (many things are unfair) but because it is also so wasteful of life.
When price-targeting is a bad thing PillCorp's new price-targeting program was a win-win affair. But sometimes price-targeting is a losing proposition all around.
Consider another hypothetical organization, TrainCorp, a pas-senger train company. TrainCorp owns a train that always trav-els full. Some of the seats go at a discount of $50 to leisure travelers who booked in advance, to senior citizens, to students, or to fami-lies. The other tickets cost the full price of $100 and are bought by commuters and other business travelers. This is a fairly stan-dard group-targeting strategy: by giving away a few low-price tickets, TrainCorp restricts supply and acquires the ability to demand high prices by offering tickets to only the buyers with the highest willingness to pay. (It might be profitable for TrainCorp just to fence off some of the seats and restrict sup-ply that way, but it's even better for them to fill the spare seats if they can.) We know at once-if we are economists-that this is inefficient. In other words, we can think of something that would make at least one person better off without making anyone else worse off.
That something is to find a commuter who was willing to pay a little less than $100, say $95, and who decided to travel by car instead, and offer him a seat for $90. Where does the seat come from, since the train is full? Well, you take a student who is in no great hurry and was willing to pay a little more than $50, say $55, for the seat and politely throw him off the train. But you refund the price of his ticket, plus an extra $10 for his trouble.
Where do we stand now? The commuter was willing to pay $95 but only paid $90. He's better off by $5. The student was willing to pay $55 for a $50 ticket, so if he'd been allowed to ride, he'd have been only $5 better off. But he has just been given $10, so the student is also happy. And what about TrainCorp? Well, TrainCorp just transformed a $50 ticket into a $90 ticket and made a more profitable sale. Even after paying $10 compen-sation to the student, the company is $30 ahead. Now everyone's a winner; or they would be if TrainCorp adopted this system instead of its group price-targeting strategy.
But of course, that's not what happens, because if TrainCorp tried it, commuters who were willing to pay $100 would hang around for the $90 tickets, and students who weren't willing to pay $50 would buy tickets anyway and wait to be paid to get off. The whole affair would turn out badly for TrainCorp, who is the one who gets to set the prices.
In case your head is spinning a little, here's the quick-anddirty summary: the group price-targeting strategy is inefficient because it takes seats away from customers who are willing to pay more, and gives them to customers who are willing to pay less. Yet airlines and railroads still use it, because the alternative of individual price-targeting isn't feasible.
OK, so sometimes price-targeting is less efficient than a uniform price, as in the case of the train; sometimes it's more efficient than a uniform price, as in the case of the HIV/AIDS drugs. But we can say more than that. Whenever price-targeting fails to ex-pand the number of sales and merely moves products from people who value them more, like commuters, to people who value them less, like students, as in the case of TrainCorp, it will definitely be less efficient than a uniform price. Whenever price-targeting opens up a new market without affecting the old market, as with PillCorp, it will definitely be more efficient than a uniform price.
And there's a middle position. A lot of group price-targeting does a bit of both: it opens up some new markets but also waste-fully moves products away from high-value users to low-value users. For example, this book is published in hardcover at a high price, and then the paperback edition emerges later, at a lower price. The aim is to target a higher price at people impatient to hear what I have to say and at libraries. One good result is that the publisher will be able to sell paperbacks more cheaply, be-cause some costs will be offset by the hardcover sales, and so the book will reach more people. One bad result is that the early version is much more expensive than it would be if there was only a single paperback edition, and some buyers will be put off. That's what life is like in a world of scarcity: when companies with scarcity power try to exploit it, the situation will almost al-ways be inefficient, and-equivalently-we economists will al-most always be able to think of something better.
I say "almost" because a company, which is able to practice per-fectly individualized price-targeting strategy, would never miss a sale: rich or desperate customers would pay a lot, poor or indiffer-ent customers would pay very little, but no customer willing to pay the cost of production would be turned away. The situation would be efficient.
Being realistic, though, it's most unlikely that any company would have so much information about its customers as to be able to make such perfectly efficient sales. The company would need to peer into the heart of every possible customer and find out how badly he or she wanted the product; it would need a supercomputer to operate the cash registers. That just isn't plausible. But perhaps it makes you think. What if you could plug every customer's preferences into a supercomputer? What if you had all the information you needed to never miss a sale? Would the world be a better place?
Something else may have caught your attention. When PillCorp changed its global pricing policy, it did something that was not only profitable but also both efficient and fair. Can we say anything more generally about when private greed will serve the public interest? For the answers to all these questions, and more . . . read on.
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Perfect Markets and the "World of Truth"
You might not expect Jim Carrey films and economics to have much in common, but in fact there is much we can learn from the rubber-faced comedian. Consider the film, Liar, Liar, which tells the story of Fletcher Reede. As a result of his son's birthday wish, Fletcher Reede finds that he is compelled to tell the truth for twenty-four hours. This is problematic for Fletcher because he is a lawyer-or a liar, as his son understands it-and hilarity predictably ensues as a horrified Fletcher incriminates himself by helplessly blurting out truthful answers to every question he is asked. They don't make as much of a feel-good movie, but free markets are just like Fletcher Reede's son-they force you to tell the truth. Yet while the results were humiliating for Jim Carrey's character, we will discover that a world of truth leads to a per-fectly efficient economy, one in which it is impossible to make someone better off without making someone else worse off.
In this chapter we'll see what truth means in economic terms, how it leads to efficiency, and why efficiency is good. We'll also explore efficiency's shortcomings: how efficiency isn't always fair, and why we have taxes. As we'll see, taxes are like lies: they inter-fere with the world of truth. But I'll reveal one way in which taxes can be implemented, which is both fair and efficient. This could be good news for seniors struggling to pay their winter heating bills, but bad news for Tiger Woods.
Imagine if you will that Fletcher's son gets his birthday wish, not just for his smooth-talking dad but for the whole world. So, let's buy a cappuccino in the world of truth. Before frothing up the half-and-half for you, the barista looks you up and down and asks: "What's the most you're willing to pay for this coffee?"
You'd like to lie and pretend that you don't really want it, but the truth just slips out: "I'm in caffeine withdrawal. Fifteen bucks."
With a smirk, the barista prepares to ring up the extortionate sum, but you have a few questions of your own: "How much did those coffee beans cost?"
"How much did you pay for the plastic lid and the cup?"
"How much does it cost to raise a cow, and how much milk can you get from one?"
"How much did the electricity cost for the refrigeration, heating, and light in here?"
Now it is the barista's turn to have a Fletcher Reede moment. No matter how she tries to evade the questions or froth up the cost of the cappuccino, she cannot tell a lie. It turns out that the cappuccino costs not fifteen dollars, but less than one. The barista tries to haggle, but you have one more killer question: "Are any other places within thirty yards selling coffee like this?"
"Yes . . . " she moans, her head thudding to the counter in a gesture of abject defeat.
You walk out of the shop with the coffee safely in your possession for the bargain price of ninety-two cents.
Prices are optional, which means they reveal information There's a basic truth incorporated into any system of prices. That truth comes from the fact that stores and consumers do not have to buy or sell at a given price-they can always opt out. If you'd been willing to pay only fifty cents for the coffee, n.o.body could have forced you to raise your offer or forced the barista to drop the price. The sale simply would not have occurred.
Of course, you sometimes hear people complaining that if they want something-say, an apartment on Central Park West-then they have to pay the exorbitant asking price. That's true, but although prices sometimes seem unfairly high, you hardly ever have to pay them. You could always use your money to buy an apartment in Harlem or a house in Newark or a million cups of coffee instead.
In a free market, people don't buy things that are worth less to them than the asking price. And people don't sell things that are worth more to them than the asking price (or if they do, it's never for long; firms that routinely sell cups of coffee for half of what they cost to produce will go out of business pretty quickly). The reason is simple: n.o.body is forcing them to, which means that most transactions that happen in a free market improve efficiency, be-cause they make both parties better off-or at least not worse off- and don't harm anyone else.
Now you can begin to see why I say that prices "tell the truth" and reveal information. In a free market, all the buyers of coffee would prefer to have coffee than the money the coffee cost, which is shorthand for saying they prefer coffee to whatever else they might have spent ninety-two cents on. That is, the value of the product to the customer is equal to or higher than the price; and the cost to the producer equal to or lower than the price. Painfully obvious, perhaps, but the implications turn out to be dramatic.
It may seem trivial to say that in a free market we know customers value coffee more than the money they pay for it. Yet it's not quite as trivial as it looks. For a start, this "trivial" piece of information is already more than we can say about anything that is paid for outside the market-for example, Was.h.i.+ngton DC's hugely controversial new baseball stadium. The Montreal Expos baseball team agreed to move to DC on the condition that the DC government subsidize the cost of a new stadium. Some say the subsidy will be $70 million, others that it will be far higher. Maybe this is a good idea, and maybe not. It's not clear how we decide whether this is a good way of spending taxpayers' money.
When decisions are made inside a market system there's no such controversy. If I decide to pay $70 for a ticket to see a base-ball game, n.o.body questions whether it's worth it; I made my choice, so obviously I thought so. This free choice produces in-formation about my priorities and preferences, and when mil-lions of us make choices, market prices aggregate the priorities and preferences of us all.
Perfect markets: Thetruth, the whole truth, and nothing but the truth So the trivial piece of information that in a free market customers value cappuccinos more than the money they pay for them is not so trivial after all. But we needn't stop there.
Imagine now that the coffee market is not only free but ex-tremely compet.i.tive, that entrepreneurs are always starting new firms with fresh ideas and entering the market in an attempt to undercut the inc.u.mbent companies. (Profits in a compet.i.tive in-dustry are high enough only to pay workers and persuade entre-preneurs that their money isn't better off in a savings account-no higher.) The compet.i.tion will force the price of coffee down to the "marginal cost"-the cost the coffee bar incurs when making one more cappuccino, which we may remember is just under a dollar. In a perfectly compet.i.tive market, the price of coffee would equal the marginal cost of coffee. If the price were lower, firms would go out of business until it rose. If the price were higher, new firms would enter or old firms would expand their output until it fell. Suddenly, the price is not conveying a vague fact ("this coffee is worth ninety-two cents, or more, to the buyer, and it cost the coffee bar ninety-two cents, or less") but a precise truth ("this coffee cost the coffee bar exactly ninety-two cents").
What if other industries were also perfectly compet.i.tive? That would mean that for every product, the price equaled the mar-ginal cost. Every product would be linked to every other product through an ultracomplex network of prices, so when something changes somewhere in the economy (there's a frost in Brazil, or a craze for iPods in the US) everything else would change-maybe imperceptibly, maybe a lot-to adjust. A frost in Brazil, for ex-ample, would damage the coffee crop and reduce the worldwide supply of coffee; this would increase the price coffee roasters have to pay to a level that discourages enough coffee drinking to offset the shortfall. Demand for alternative products, like tea, would rise a little, encouraging higher tea prices and extra supply of tea. Demand for complementary products like coffee creamer would fall a little. In Kenya, coffee farmers would enjoy b.u.mper profits and would invest the money in improvements like aluminum roof-ing for their houses; the price of aluminum would rise and so some farmers would decide to wait before buying. That means demand for bank accounts and safety deposit boxes would rise, although for unfortunate farmers in Brazil with their failed crops, the opposite may be happening. The free-market supercomputer processes the truth about demands and about costs, and gives people the incentive to respond in astonis.h.i.+ngly intricate ways.
That may seem like a ridiculous hypothetical scenario. But economists can measure and have measured some of these ef-fects: when frosts. .h.i.t Brazil, world coffee prices do indeed rise, Kenyan farmers do buy aluminum roofing, the price of roofing does rise, and the farmers do, in fact, time their investment so that they don't pay too much. Even if markets are not perfect, they can convey tremendously complex information.
Governments-or any organizations-find it hard to respond to such complex information. In Tanzania, coffee is not produced in a free market, and the government, rather than the farmers, receives any windfalls from high coffee prices. Historically, the government has failed to spend the money sensibly, blowing too much on unsustainable salary rises for civil servants, and failing to realize that the price spike was temporary.
To appreciate why markets do such a good job of processing com-plex information, first think about the customer. We know that he won't buy a cappuccino unless he values it more than any-thing else he could buy with the same money. But what else could he buy with the same money? In our world of truth, he could buy anything that costs the same as, or less than, a cappuccino. If he chooses the coffee he's saying that of all the things in the world that cost the same as coffee, he would like coffee to be made.
Elsewhere, of course, there are other people spending their money not on coffee but on movie tickets, bus fares, or under-wear; and there are others choosing not to spend their money at all and to put it in the bank instead. All of these competing de-mands pull producers to respond. If people want computers, then manufacturers will build factories, hire workers, and buy plastics and metals, which will be diverted from other uses to go into computers. If people want coffee instead of underwear, then more land will be devoted to coffee and less to other uses, like parks or housing or tobacco farming. Lingerie shops will be replaced by coffee shops. Of course, start-up companies will borrow money from banks, and interest rates will rise or fall, depending on the balance between the number of people wanting to save and the number of people wanting to borrow. Interest rates are just an-other price: the price of spending today instead of next year. (You might have thought that interest rates were set by central bank-ers like Alan Greenspan at the Federal Reserve or Mervyn King at the Bank of England. Actually, Greenspan and King chair com-mittees that set "nominal" interest rates. True interest rates are interest rates after inflation-set by the market in response to the central bankers.) The changes don't stop there. The ripples in the price system continue outward. They whip through some parts of the economy at tremendous speed and cause slow but powerful seismic s.h.i.+fts in others, like education or technology. For example, if there aren't enough trained workers to produce computers, manufac-turers like Dell and Compaq will have to train them, or raise wages to poach them from other manufacturers like Apple and Gateway. As the wages for skilled workers rise, people will see that it's worth taking time off and paying to go to college. Manu-facturers' interest in producing cheaper or better computers will give a boost to research labs and engineering schools. Higher demand for plastics will raise the price of the raw material-crude oil-which will in turn encourage those who use oil for energy to switch to cheaper subst.i.tute fuels or to invest in energy-saving technology. And so it continues. Some of these effects will be tiny. Others will be enormous. Some will have an instant effect. Others will not be realized for decades. But in the world of truth- the world of perfect markets-all of them will have an impact.
What is the result of a set of perfectly compet.i.tive markets interconnected like this?
Companies are making things the right way. Any company that wastes resources, over-produces, or uses the wrong technol-ogy, will go out of business. Every product is produced in the most efficient way.
Companies are making the right things. The price of a prod-uct equals the cost to make it. The price also reflects the terms at which customers can trade off one priority against another. (Two cups of coffee cost the same as one Danish; which would you prefer?) The price is a direct line of communication from what products cost to what customers prefer, and back again.
Things are being made in the right proportions. If too much coffee were being produced, manufacturers would cut prices; and if too little, prices would rise. Either way, the situation would correct itself. In the compet.i.tive market, price equals cost; there is no incentive for anyone to produce less (giving up profitable sales) or to produce more (creating products that cost more than anyone is willing to pay). The compet.i.tive rule-price equals cost equals value to the consumer-keeps things efficient.
Things are going to the "right" people. The only people who buy products are the people who are willing to pay the appropri-ate price. Let's say I confiscate a cappuccino from Axel and give it to Bob. In the world of truth, this is wasteful. Axel was willing to pay for coffee, and Bob was not, which means Axel values cof-fee more than Bob, and my confiscation is inefficient. Notice that here I am equating "right" with "efficient," an a.s.sumption we'll examine and challenge shortly.
The Undercover Economist Part 2
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