Monday, April 29, 2013

It's All Costs and Benefits

The way economists approach consumer choice theory (why do people buy what they buy at the prices and quantities they do) is really simple. Economic Man (or Woman) goes to a store or website. "What is the most I am willing to pay for this?" thinks Economic Man. "What is the price?" he asks himself. If the value exceeds the price, he buys it. If it doesn't, he doesn't. Simple. Rational.

Nobel Laureate in Economics Daniel McFadden recently argued that economists need to rethink how economists approach consumer choice. Psychology, neurobiology, and other disciplines find a host of things which put our stable, simple world into chaos.
To take one example, the “people” in economic models have fixed preferences, which are taken as given. Yet a large body of research from cognitive psychology shows that preferences are in fact rather fluid. People value mundane things much more highly when they think of them as somehow “their own”: they insist on a much higher price for a coffee cup they think of as theirs, for instance, than for an identical one that isn’t. This “endowment effect” means that people hold on to shares well past the point where it makes sense to sell them.
There are others as well: your loss of happiness is greater if you lose X than your gain of happiness if you acquire X. People prefer a free $10 gift card than to pay $1 for a $15 gift card. There is such as thing as too many choices. It's enough to make economists think people are irrational.

No doubt that people care for other things beyond what you see in our simple model, just like air resistances affects how fast a ball falls but it's so hard to incorporate that at the basic level, you assume it away in intro physics. It's a simplifying assumption. It doesn't require that we redo all of economics or change our fundamental approach.

And this is where these economists get it wrong because most stop there but they shouldn't. None of this demonstrates that people are actually irrational. Rationality is a very low bar in economics: do something when benefits exceed costs. That gets us very, very far. These studies that other disciplines tout are important, not because they undo what we know but because they add to what we know people care about. People derive inherent satisfaction from owning things or getting things for free, just as they value food, sex, and shelter.

Nothing really changes. I guarantee that if you change that $15 gift certificate to $20, $30, or $50, you'll see fewer people willing to indulge in their preference for "free" things. Demand slopes down.

This extends to all areas. Advertising works but it can never brainwash someone into buying something they don't want on some level. Advertising has limits and the fact that you don't buy everything you see advertised to you is a testament to that. I don't like tomatoes and I don't wear makeup. I know this about myself and no matter how many ads I see for either will not change my purchasing patterns. (I've seen thousands of ads for bras; I've never bought one.)

Ads work because they help us economize on other things we find valuable such as time and mental energy. On occasion, I find myself at the store wanting a general thing, like a cracker, but no strong preference on brand name. Then I remember a jingle or a funny commercial and so I buy Wheat Thins or Ritz. This is not irrational; I didn't have a strong preference and making a choice is costly both in time and mind. Costs exceed benefits to make up my own mind so I'll do what's easiest: I'll follow the ad.

That I am describing this everyday purchase in this way does not make me unusual. Quite the contrary, as an economist I'm trained to think like a typical strangers. Time is a real resource people care about. Thinking hurts. So we avoid it if it's cheap to do so. We are rational.

Thursday, April 25, 2013

Unsustainable Pricing

A series of clicks today led me to this YouTube video of Senator Warren's March 2013 congressional hearings on the minimum wage.

At 2:53 she notes as a result of an increase in the minimum wage to $10.10/hour over three years, the price of a fast food meal would rise by four cents.
So instead of it being $7.19 it would be $7.23. Are you telling me that's unsustainable?
Given the context, "unsustainable" probably refers to the restaurant business itself. As in, "if you raise your price by four cents, are you really going to have issues?"

The answer is yes.

There is a nasty consumer habit to believe that the prices we see are given, as if they were determined randomly or granted to us from a deity. But they are the careful, careful decision of business owners and analysts with the sole aim at maximizing revenue. The $7.19 price came from a conversation like this (all prices are post tax):

"How about $7 for the meal?"
"$7 is a bit low; I bet we can up our revenue if we increase by two quarters."
"Our market research tells us our consumers are particular price sensitive, especially given the state of the economy. I wouldn't go higher than $7.05."
"Really? We can definitely go higher than $7.05. I was thinking $7.40."
"No way! Our competitors' are pricing lower than that. We gotta go much lower."
"Our competitors price there for a reason."
"A TV dinner only cost $5. This is our competition."
"It isn't nearly as easy, nearly as good. When we offered a coupon last year, people barely used it. We can afford to go higher. We have investments to pay off."
"How about $7.35?"
"Burger King's $7.25."
"It also's been hitting the airwaves harder than us. Let's drop a little below them and get our customers through price."
"A little bit more; something big enough that they just can't respond."
"$7.17? Has a nice ring to it"
"Maybe...or $7.20"
[Market research]
"$7.19 seems to be the sweet spot."

This is an abstraction, (void of uncertainty which is another factor they consider but I need to go to bed) but it's meant to remind us that firms do not grab numbers from nowhere, especially for firms who tend to sell very cheap food and where customers are very sensitive to price. Warren's thought process seems to be "Well, I'd pay 4 cents more while on my campaign trail" but she is a wealthy individual with very little time and not many alternatives: it's hard to get more insensitive than that.

Many customers, especially when times are tough (and thus when  increasing the minimum wage is most popular), are very price sensitive. This goes double after a lot of time has passed and they can adapt to the 4 extra cents (which, for a family of four and a biweekly meal out totals to $16.64 over the course of a year) in ways such as going to restaurants with fewer minimum wage workers (and thus less of a price increase so at least you get more for your money) to eating at home more to eating less when you do eat out.

At the heart of Warren's question is a puzzle: if an extra four cents is so sustainable, why isn't it already four cents more expensive?

It's because it is. That's the revenue maximizing price.