CHAPTER ONE

The Price of Things

OF THE VARIOUS things I don’t fully understand about my life, one is why I pay what I do for a cup of coffee. I’m a fairly heavy drinker—I took it up when I first quit smoking, to fill the space left behind by my previous addiction. It has since become my main source of sustenance : my breakfast, my lunch, and quencher of urges in between.

Several possibilities cross my path as I commute between home and work every day. There’s the Dunkin’ Donuts across the street from work, which offers a cappuccino for $3.02, and the Illy in-house café on the fourteenth floor, one floor above my office, which proffers cappuccinos for $3.50. The Dean & DeLuca store that opened in the lobby sells a slow yet rich cappuccino for $3.27.

Over the past couple of years I have gravitated somewhat randomly from coffee purveyor to coffee purveyor. While this may appear unremarkable, I find my fickle taste intriguing. My choice of coffee should be a function of the value I get for my money. But the equation is not obvious. Should I even notice the small price differences, trivial amounts when compared with my disposable income? What else, besides the quality of the brew, enters my calculation? My switch from Dunkin’ to Illy probably had less to do with price, or flavor, than with Illy’s sleek brushed steel, a definite step up from Dunkin Donuts’ orange-and-pink, saturated fat aesthetic. Illy also offered meaningful social interactions in the chance encounters with long-lost colleagues from other floors.

Most intriguing of all, there is an undeniable emotional angle to my preferences, which can trump on occasion every other consideration. The best coffee I’ve had in a long time comes from the tiny pie shop on the corner, half a block from my house. It used to sell a superb cappuccino for the unbelievable price of $2.75. I would stop by for a cup as often as I could. Then, a year or two ago, it abruptly raised the price to $3.50. This made me so furious I decided never to drink coffee there again.

I’m not sure what infuriated me so. The friendly barista offered explanations: they were switching to a premium coffee that cost a dollar an ounce; the new cups were bigger; they were using double shots—more than half an ounce of coffee per cup. Maybe I was disappointed at seeing a bargain vanish. Maybe it was a sense of betrayal that the young, laid-back, indie-rock-loving people at the pie shop on the corner could strategize about prices as ruthlessly as Starbucks. I would grumble that rent, wages, and profit make up a bigger share of the price of a cup of coffee than the cost of the coffee that goes into it. Still, my anger made no sense. Their coffee did not cost much more than coffee I bought elsewhere. And it tasted much better. There was something irrational about my boycott. Fortunately, I forgave them. So I’m drinking great coffee again.

BUYING GOODS AND services makes up a large part of modern life. There’s food, clothes, movie tickets, summer vacations, utility bills and mortgage insurance premiums, gas, iTunes downloads, and hair-cuts. The marketplace is where prices acquire their most straightforward definition, determined by a voluntary transaction between a buyer and a seller who expect to benefit from the trade. Yet despite the routine nature of the standard mercantile transaction, consumers’ interactions with prices are fairly complex. This chapter is about this economic interaction, the tango between buyers and sellers as they strive for a deal.

Economists tend to assume people know what they are doing when they open their wallets. They can assess the benefit they will derive from whatever it is they are buying and figure out whether it’s worth their money. It’s hard to overstate the importance of this assumption. It is one of the bedrock principles upon which classical economics was built over the last 250 years. It is often true, and has yielded deep and far-reaching conclusions about human behavior.

But as a general principle, the assumption is misleading in a subtle yet important way. Markets may be the most effective institution known to humanity to determine the value of goods and services to the people who consume them. Still, the price-setting process is by no means a transparent and straightforward interaction between rational, all-knowing calculators of costs and benefits. That’s because market transactions do not necessarily provide people with what they want; they provide people with what they think they want. These two things are not the same. Consumers often have but the most tenuous grasp of why they pay what they do for a given object of their desire. Sometimes they don’t know why the object is desirable at all. Moved by any number of unacknowledged biases, they are easy prey to manipulative devices deployed by those who want to sell them things.

Prices help us understand these cognitive lacunae. They provide a road map of people’s psychological quirks, of their fears, their unacknowledged constraints. Prices—how they are set, how people react to them—can tell us who people really are.

Most of us have heard of the placebo effect—in which a pill with no therapeutic properties relieves a real ailment by making us believe that we are being cured, setting in motion some inner psychological process. A few years ago, psychologist Dan Ariely from the Massachusetts Institute of Technology and some colleagues performed an experiment that uncovered an interesting variant. They told a bunch of students they were getting a new type of painkiller but gave them a placebo instead. Then the researchers made up the placebo’s price. Subjects who were told that the pill cost $2.50 reported much deeper pain reduction than those who were told it was bought on the cheap, at the bulk price of $0.10.

Consider lap dancing. Lust is a reasonable explanation for the popularity of the service, about as close as one can legally get to paying for sex outside the state of Nevada. Yet apparently there are hidden gradations of desire that modulate our willingness to pay. In an exploration of the “gentlemen’s club” scene, psychologists from the University of New Mexico found that lap dancers who were not on the pill made much more money in the most fertile phase of their menstrual cycle.

Dancers can’t charge explicitly for their services because that would run afoul of laws against solicitation. Instead, they rely on “tips,” usually enforced by large, muscled bouncers. In Albuquerque’s clubs, according to the study, the average tip for a three-minute dance is about fourteen dollars.

Perhaps dancers smell more enticing when they are at the peak of their fertility. Maybe they grind their hips more enthusiastically or whisper more alluring nothings. The fact is that dancers who are not on the pill made $354 a night when they were at their most fertile, about $90 more than in the ten days before menstruation and about $170 more than during menstruation.

Dancers on the pill made less money than those who were not, and their earnings were much less sensitive to the menstrual cycle. But perhaps the most interesting finding is that neither dancers nor their patrons have a clue of the effect of the menstrual cycle on their pay. It all happens below the radar.

 

 

THE TASTES IN shopping of my six-year-old are driven by the fictitious character on the label, oblivious to price, flavor, texture, or even the purpose of the desired item. At his behest, I’ve bought Dr. Seuss shampoo, Spider-Man toothbrushes, and Cinderella toothpaste. He alternates between Dora the Explorer and SpongeBob yogurt. His tastes are not unique. A study by the people who make Sesame Street found that young children who are offered a choice between chocolate and broccoli are more than twice as likely to choose the vegetable when it has an Elmo sticker.

Grown-ups are expected to know better. Yet we indulge in more extreme follies, paying often-stratospheric prices for things of debatable value. People will travel across town to save $20 off a $100 sweater but not to save $20 off a $1,000 computer, an odd choice considering that both actions are priced equally: $20 for a trip across town. And, unlike my six-year-old son, who couldn’t care less what toothpaste costs, I may be more willing to buy something if it is expensive than if it is cheap.

Buying wine is an exercise that combines flavor, smell, and other physical attributes with an array of difficult-to-measure qualities—from how well it projects our self-image to whether it brings forth pleasant memories of a European vacation. Americans will pay more for a French wine than an Argentine wine of similar quality, the same grape varietal, and the same age. Simply stamping “Product of Italy” on the label can raise the price of a bottle by more than 50 percent.

Economists will tell you that, other things being equal, people will always prefer the cheaper option. But drinkers like a bottle of wine more if they are told it cost ninety dollars a bottle than if they are told it cost ten. Belief that the wine is more expensive turns on the neurons in the medial orbitofrontal cortex, an area of the brain associated with pleasure feelings.

Wine without a price tag doesn’t have this effect. In 2008, American food and wine critics teamed up with a statistician from Yale and a couple of Swedish economists to study the results of thousands of blind tastings of wines ranging from $1.65 to $150 a bottle. They found that when they can’t see the price tag, people prefer cheaper wine to pricier bottles. Experts’ tastes did move in the proper direction: they favored finer, more expensive wines. But the bias was almost imperceptible. A wine that cost ten times more than another was ranked by experts only seven points higher on a scale of one to one hundred.

Sometimes people pay stratospheric prices for humdrum items because doing so proves that they can. As the price of oil soared to around $150 a barrel in the summer of 2008, Saeed Khouri, a twenty-five-year-old businessman from Abu Dhabi, made it into Guinness World Records for having bought the most expensive license plate ever. Khouri paid $14 million for the “1” tag in a national license plate auction that drew Rolls and Bentley owners from around the kingdom. The number one is, to be sure, a nice digit to have stamped on a piece of plastic attached to the front and back of a car. But it is hard to argue that the number alone merits a premium of $13,999,905 over the standard fee for a regular license plate.

This behavior is surprisingly common, however. Paying high prices for pointless trinkets is just an expensive way to show off. In his famous Theory of the Leisure Class, the nineteenth-century American social theorist Thorstein Veblen argued that the rich engaged in what he dubbed “conspicuous consumption” to signal their power and superiority to those around them. In the 1970s, the French sociologist Pierre Bourdieu wrote that aesthetic choices served as social markers for those in power to signal their superiority and set themselves apart from inferior groups. Anybody can buy stocks. Oligarchs, emirs, and hedge-fund managers can pay $106.5 million for Picasso’s Nu au Plateau de Sculpteur, which sold in only eight minutes and six seconds at an auction in New York in May of 2010. Had Mr. Khouri paid ninety-five dollars for a license plate, he could have been anybody.

Over the last three decades, evolutionary biologists and psychologists picked up on Veblen’s and Bourdieu’s ideas and gave them a twist. The point of spending huge sums on useless baubles is not merely to project an abstract notion of power. It serves to signal one’s fitness to potential mates. Wasteful spending on pointless luxury is not to be frowned upon; it is an essential tool to help our genes survive into the next generation. Sexual selection puts an enormous value on costly, inane displays of resources. What else is the peacock’s tail but a marker of fitness aimed at the peahens on the mating market? It is a statement that the bird is fit enough to expend an inordinate amount of energy on a spray of pointless color.

A diamond ring has a similar purpose. N. W. Ayer, the advertising agency behind “A Diamond Is Forever,” which crafted the marketing strategy for the global diamond cartel De Beers in the United States, persuaded American women to desire big diamond engagement rings, and men to buy one for them, by convincing them that these expensive bits of rock symbolized success. They gave big diamonds to movie stars and planted stories in magazines about how they symbolized their indestructible love. And they took out ads in elite magazines depicting paintings by Picasso, Derain, or Dalí to indicate that diamonds were in the same luxury class. “The substantial diamond gift can be made a more widely sought symbol of personal and family success—an expression of socio-economic achievement,” said an N. W. Ayer report from the 1950s. Today 84 percent of American brides get a diamond engagement ring, at an average cost of $3,100.

In 2008 Armin Heinrich, a software developer in Germany, created the ultimate Veblen good: he designed an application for the iPhone called I Am Rich. It did nothing but flash a glowing red gem on the screen. Its point was its expense: $999. Maybe stung by criticism over its banality, Apple removed it the day after its release. But before it could pull it, six people had bought it to prove that, indeed, they were.

A HISTORY OF PRICES

Value—what confers it, what it means—has captivated thinkers at least since ancient Greece. But the concept then was different from that of contemporary economics. For hundreds of years, the analysis of value began as a moral inquiry. Aristotle was sure things had a natural, just price—an inherent value that existed before any transaction was made. And justice was the province of God.

Throughout the Middle Ages, when the Catholic Church regulated virtually all corners of economic life in Europe, scholars understood value as a manifestation of divine justice. Inspired by Saint Matthew’s notion that one should do unto others only what one would have them do unto oneself, Thomas Aquinas stated that trade must convey equal benefits to both parties and condemned selling something for more than its “real” value.

In the thirteenth century, the Dominican friar Albertus Magnus posited that virtuous exchanges were those in which the goods that were transacted contained the same amount of work and other expenses. This idea was refined into the principle that the inherent value of goods was set by the work that went into them.

The Church gradually lost its grip on society as trade and private enterprise expanded throughout Europe. Religious dogma lost its appeal as an analytical tool. Still, the penchant to view prices through the lens of justice survived the development of capitalism, thriving well into the eighteenth century. Adam Smith and David Ricardo, the two foremost thinkers of the classical age of economics, struggled with the notion of inherent value, which they viewed as a function of the labor content of products, distinct from the market price set by the vagaries of supply and demand. Smith, for instance, argued that the labor value of products amounted to whatever it cost to feed, clothe, house, and educate workers to make them—with a little extra to allow them to reproduce.

But this line of argument got stuck. For one, it had no role for capital. Profits were an immoral aberration in a world in which the only value could come from a worker’s toil. Moreover, it didn’t seem to square with common sense. In Ricardo’s day critics were harsh on the labor theory of value. Some pointed out that the only thing that made aged wine more valuable than young wine was time in a cellar, not work. But before the idea could die, Karl Marx took it to what seemed like its logical conclusion. He used the labor theory of value as a basis for the proposition that capitalists used their leverage as the owners of machinery and other means of production to filch value from their workers.

A product, Marx maintained, is worth all the labor that went into making it, including the labor used to make the necessary tools, the labor in the tools used to make the tools, and so forth. Capitalists made money by usurping part of this value—paying workers only enough to guarantee their subsistence and keeping the rest of the value they created for themselves. This line of thinking could easily lead a thinker astray. Marx concluded that despite appearances, the value relation between different things—their relative price—had nothing to do with the properties of these things. Rather, it was determined by the labor time that went into them. “It is a definite social relation between men that assumes in their eyes the fantastic form of a relation between things,” he wrote.

This shares some of the cool strangeness characteristic of mystic thought, where things are representations of some deeper phenomenon underneath the skin of reality. But it sheds no light on why I find a glass of cold beer so much more valuable than a glass of warm beer on a hot day. I will buy a head of lettuce if its use value to me—because it is crunchy, fresh, and healthy—is higher than its price, what I have to forgo in order to get it. But if some desperate lettuce lover accosts me on my way home to offer twice what I paid, I will sell it to her at that higher price. There is no mysterious relationship between its intrinsic value and its market price. There are just two people who take different degrees of satisfaction from eating lettuce.

There’s a cool trick that teachers have used for years to expose students to the power of this transaction. First they distribute bags with assortments of candies among their students and ask them how much they value the gift—what would they be willing to pay for their stash? Then they allow them to trade candy among themselves. If students are asked again after the exchange to assess the value of their booty, they will invariably give it a higher value than the first time. That’s because trading allowed them to match their lot to their preferences. They traded things they valued less for things they valued more. Nobody worked, yet the value of the entire allotment of candies grew.

The realization that things do not possess an absolute, inherent value seeped into economic thought in the nineteenth century. Marx’s labor theory of value eventually faded into irrelevance as nobody could figure out how his concept related to the prices at which people voluntarily bought and sold real things. Things are costly to make, of course. This puts a floor on the price at which they are supplied. But the value of a product does not live inside it. It is a subjective quantity determined by the seller and the buyer. The relative value of exchanged things is their relative price. This realization lifted prices into their rightful spot as indicators of human preferences and guides of humankind.

TAMING PRICES

Two people will be willing to trade one good for another as long as the perceived benefit from owning one more unit of what they get—the marginal gain—is at least as much as the lost value of what each trades away. This gain, in turn, is determined by the buyer’s endowment of goods: money, time, and whatever else might come into her calculation. The more one has of a given thing, the less one will value having one more. This single principle is the organizing force of markets, which determines the prices of goods and services around the world.

In a market, sellers’ priority is usually to squeeze as much money as possible from buyers. Buyers, in turn, will try to get stuff they want as cheaply as they can. They each operate within a set of constraints: for buyers a budget; for sellers, the cost of producing, storing, advertising, and bringing to market whatever they make. While producers can raise prices if consumer demand for their good grows faster than its supply, consumer demand will wane as prices rise. Above all, producers’ space to raise prices is constrained by competition. In a competitive market consumers can safely assume that prices will be kept in check as rival producers vying for consumers’ custom force them down to their marginal cost, the cost of making one more unit.

There are lots of exceptions to this dynamic, however. To begin with, fully competitive markets are rare. In markets for new inventions, legal monopolies called patents allow companies to charge higher prices than they would in a competitive field in order to recover the up-front cost of their invention. Local monopolies are common—think of the popcorn vendor inside the movie theater. Even in markets for run-of-the-mill products, producers will do their best to keep competition at bay. A tried and tested tactic is to convince consumers that their product is unique, muddying comparisons with rivals’ wares. Another is to lock in consumers with a cheap product that, it later becomes apparent, only works in conjunction with some higher-priced good. Another is simply to hide their prices from consumers’ view.

Unacknowledged motivations cloud the assessments of value that drive our daily decisions. My monthly dues of $58.65 at the New York Sports Club next to the office mean that each of my twice-weekly visits costs just under $7—a reasonable price for a two-hour session, less than what I would pay to see a movie or have a quick lunch. But there are those who will pay much more than I do for a session on the Stairmaster. Paradoxically perhaps, they aren’t the fitness freaks. The uncommitted couch potatoes pay the highest prices. That’s because they are paying for more than a workout. They are buying a commitment-booster too.

A study of visitors to sports clubs that offered monthly subscriptions for just over seventy dollars or single passes for just over ten found that monthly subscribers paid more than they had to. They visited the gym 4.8 times per month, on average, paying some seventeen dollars per visit. Still, having a membership might improve their health, giving them a monetary incentive to work out.

Every day we commit to buying goods and services without paying careful attention to their cost. In 2009, the HP DeskJet D2530 printer might have seemed a steal at $39.99. But the price, displayed prominently on the HP Web site, was almost irrelevant. The more relevant numbers were $14.99 for a black ink cartridge, which prints about 200 pages, and $19.99 for the color cartridge, which prints 165. For those printing photos at home, the crucial number was $21.99 for the HP 60 Photo Value Pack, a set of cartridges and 50 standard sheets of photo paper. At the Rite-Aid drugstore, 50 same-day prints cost $9.50.

The worldwide printing business depends on selling cheap printers and expensive ink. According to a study by PC World, printers will issue out-of-ink warnings when the cartridge is still up to 40 percent full. HP, Epson, Canon, and others have sued providers of cheap ink refills, charging them with false advertising and patent infringement to make them stop. But the best ally of the printer business is consumer ignorance about what they are really paying to print.

Just setting the printer default to “draft” quality would save consumers hundreds of dollars a year. Yet few consumers do. Though many companies still sell cheaper ink refills, refills account for only 10 to 15 percent of the market. That means that 90 percent of printing is still done using ink that, according to the PC World analysis, costs $4,731 per gallon. You might as well fill your ink cartridges with 1985 vintage Krug champagne.

 

 

CONSUMERS CAN ALSO strategize keenly to fit their wants and needs to their budgets. As gas prices surged, drivers drove some 7 billion fewer miles on American highways in January 2009 than they did a year earlier, a decline of about twenty-two miles per person. During a run-up in gas prices between 2000 and 2005, economists at the University of California at Berkeley and Yale found that as the price of gas doubled from $1.50 to $3, families became more careful shoppers, paying between 5 and 11 percent less for each item. The typical price paid for a box of cereal at one large California grocery chain fell 5 percent. The share of fresh chicken bought on sale jumped by half.

But businesses are usually a step ahead. Nobody understands for sure what drove surging prices of agricultural commodities in 2007 and 2008. Analysts have mentioned drought in important growing areas, rising transportation costs and fertilizer prices, the diversion of maize and other crops to produce fuel, and even improving diets in big developing countries like India and China. Whatever the reason, food companies were remarkably adept at protecting profit margins by quietly reducing the size of their portions while keeping the price the same. Wrigley’s took two sticks of gum out of its $1.09 pack of Juicy Fruits. Hershey’s shrank its chocolate bars. General Mills offered smaller Cheerios boxes.

Then, as recession took hold in 2009 and agricultural prices started falling, firms resorted to the opposite tactic: giving consumers more for less and announcing it loudly. Frito-Lay packed 20 percent more Cheetos into each bag, stamping the bags with a “Hey! There’s 20 percent more free fun to share in here.” French’s tried competing against itself to convince customers it offered a killer deal. It launched a twenty-ounce bottle of its Classic Yellow mustard for $1.50, less than the $1.93 at which it sold its fourteen-ounce bottle.

What really tames prices is the presence of more than one producer in the marketplace. If munchers had no other option but Frito-Lay products, the company would have less of an incentive to put more Cheetos into the bag and trumpet it to the world. Had there been no other confectioners around, Hershey’s might have raised the price of its chocolate bars even after shrinking them. But the price of a product must mesh within a universe populated by other brands of sweets and snacks. How well it fits will determine its overall success. This is consumers’ most significant defense against corporations’ power: competition.

The power of competition is writ all over the cost of a phone call. In 1983, shortly after the government broke up AT&T’s monopoly of the American telephone market, AT&T charged $5.15 for a ten-minute transcontinental daytime call. By 1989 it charged $2.50 for the call. Today an AT&T subscriber on the $5-per-month international plan can call Beijing for eleven cents a minute and London for eight cents.

In Britain, it was the government that held a monopoly over telecommunications. But in 1981 the government of Margaret Thatcher allowed Mercury Communications, a private company, to offer competing phone service, and in 1984 it spun off the state-run British Telecom. On February 1, 1982, the rate of a three-minute call from London to New York was cut from £2.13 to £1.49. Today, as long as one keeps each call at under an hour, BT’s international package offers an unlimited number of calls from London to New York for £4.99 per month.

Competition can protect us from runaway printing prices. Fat profits from overpriced ink allow companies like HP to compete by selling printers at less than what it costs to make them. Others employ different tactics. Kodak’s ESP printers are about 30 percent more expensive than similar models, but the ink cartridges cost as little as ten dollars and print about three hundred pages. Regardless of the mix of tactics, the overall price of printing should fall as printer makers vie to win market share.

 

 

CONSIDER WHAT HAPPENS when there is little or no competition in a market. Steve Blank, a former Silicon Valley entrepreneur who teaches a customer development class at the University of California at Berkeley, used to tell his students about Sandra Kurtzig, the founder of a company that in the 1970s designed the first business enterprise software for small companies that could run on microcomputers rather than huge mainframes.

When she walked in to make her first sales pitch, Ms. Kurtzig had no idea of what to ask for her system, so she mentioned the biggest number she thought a rational person would pay: $75,000. But when the buyer wrote the number down without flinching, she realized she had made a mistake. “Per year,” she added quickly. The company man wrote that down too. Only when Ms. Kurtzig added maintenance at 25 percent per year did the buyer object, so she cut it to 15 percent. According to Mr. Blank, the company buyer said, “Okay.” Ms. Kurtzig could do this because she was offering a unique service in a specialized industry with few competitors, and thus had great freedom to set her prices. But where there are many rivals it is impossible to achieve this kind of market power. The mere threat of competition can move companies to respond. Indeed, for many years the threat that Southwest Airways would start flying on a given route would prompt other carriers to lower fares on that route, to preemptively buy customers’ loyalty.

Walmart drove supermarkets to despair when it expanded into groceries in 1988, offering prices 15 to 25 percent cheaper than the competition. The opening of a Walmart supercenter caused sales at other grocers in the neighborhood to fall 17 percent, on average, according to one study, amounting to $250,000 worth of forgone revenues each month. To remain in business, its rivals were soon forced to follow its lead. A study of retail prices in 165 cities across the United States between 1982 and 2002 found that the opening of a new Walmart in the long run forced rivals in the area to cut prices on products like aspirin, shampoo, and toothpaste by 7 to 13 percent.

Like most businesses, Walmart cuts prices only when there are competitors around. One study found that it charged 6 percent more in Franklin, Tennessee, where it had virtually no competition, than in Nashville, where it had to compete with rival Kmart. Critics argue that Walmart decimates communities, forcing local retailers into the ground. The company’s relentless push for the cheapest products has driven many suppliers to relocate to low-cost China, contributing to the decline of American manufacturing. Still, Walmart’s competitive drive has definitely benefited Americans in their roles as consumers. Its impact has been so powerful that, according to one study, the Department of Commerce overstates American inflation by about 15 percent because the sample it uses does not include Walmart’s low food prices.

KEEPING COMPETITION AT BAY

In 2005 Detroit’s automakers—General Motors, Ford, and Chrysler—used a novel tactic to unload their bloated inventories and revive their flagging finances. They offered customers an unprecedented deal to buy a car at the same discounted price they usually reserved for employees. When GM launched its “Employee Discount for Everyone” program in June, sales jumped 40 percent. When Chrysler launched its “Employee Pricing Plus” in July, it sold the most cars ever.

But upon closer inspection, the promotions weren’t such a great deal. A study by economists at the University of California, Berkeley, and the Massachusetts Institute of Technology found that many cars could have been purchased for less before the employee discount program was launched. For a majority of GM and Chrysler models, and a substantial share of Ford’s, customers paid more in the two weeks of the promotion than they could have in the two weeks before its launch. They were simply told they were getting a bargain and they believed it.

If competition is a consumer’s best friend, corporations’ favorite countervailing strategy is to keep consumers from figuring out where they can get the best available deal. Unlike the competitive utopia described in economic models, where consumers can effortlessly compare competing products to make their choices, the real world is plagued with what Nobel laureate George Stigler called search costs. It is difficult for consumers to find out what a given product costs in all the shops in town—let alone everything available on the Internet. It is even tougher if the goods are not identical. This is a shortcoming that businesses can exploit.

For many companies, evading competition is a question of survival. Makers of everything from cars and computer chips to shoes and TV sets experience what is known as increasing returns to scale: each additional microchip costs less to make than the preceding one. Companies can obtain raw materials and parts more cheaply the more they buy. They also share the cost of investments in machinery and the like among more products, reducing the cost per unit. This dynamic presents companies with a challenging conundrum: competition, when operating properly, would drive the price of TV sets and microchips relentlessly down until they were barely above whatever it cost to make the last one. If this were to happen, makers of chips and TV sets would go out of business. At that price, they wouldn’t be able to recover all their costs. Fortunately for them, there are ways to wriggle free to some extent from competition’s constraints. One of the best-known techniques is to make it difficult for customers to understand where they can get the best value for their money.

At the Fairway supermarket in Brooklyn where I take my son shopping on weekends, the pricey organic section is segregated from everything else, lest a price-conscious shopper decide to get the cheaper plain cereal this time. Similar items are strategically placed far from each other across the vast space, discouraging price comparisons. There’s fancy fresh cheese at a counter on my way in and cheap packaged varieties on my way out. There are at least two different sections for cold cuts and for olive oil. Prepared pasta sauces of different brands seem to be peppered throughout the store. Even fruits are segregated.

Frequent sales and markups also serve as tools to keep customers from working out where the cheapest box of cereal is sold. A study in Israel of four similar products sold across a range of stores from 1993 to 1996 found an enormous variation in prices. Not only did the same can of coffee or bag of flour cost more than twice as much at the most expensive store as at the cheapest; it wasn’t always cheapest in the same store. Retailers kept moving the prices around to keep shoppers on their toes.

Even the Internet, a technology that was meant to empower the twenty-first-century consumer by allowing us to compare prices around the world at the click of a mouse, can cloud consumers’ understanding. Online retailers of computer chips will muddle product descriptions and offer dozens of different versions to make it tough to comparison shop. They add large and hidden shipping and handling costs, surround products with a cloud of add-ons that have to be stripped out, and offer low-quality products to lure customers to their Web sites and, once there, get them to upgrade.

Some retailers have even figured out how to trick the shop-bots used by price search engines to make them think they are giving the product away for free and appear at the top of the search rankings. Rather than foment transparency, the Internet has encouraged retailers to cheat. Whoever offered a decent product at a fair price would be buried under a pile of “cheaper” superspecial offers by less honorable rivals.

SEARCHING FOR FOOLS

The killer tactic to identify and reel in the highest-paying customer in a crowd remains the auction. Auctions are designed to find the customer who places the highest value on whatever item is on the block. Daniel Kahneman, the Israeli psychologist who won the Nobel Prize for economics for researching the behavioral quirks that can lead our economic judgment astray, called auctions a tool to “search for fools.” That’s why sellers love them but buyers don’t. A 2006 poll of private equity firms found that 90 percent of them preferred to avoid auctions when buying a company, but 80 to 90 percent favored using them when selling one. The fabled American investor Warren Buffett never omits the warning in Berkshire Hathaway’s annual report: “We don’t participate in auctions.”

They are not necessarily a bad deal for buyers. But buying at auction can be tricky when the value of what’s for sale is unknown. For instance, consider a government auction for the right to exploit the airwaves or drill oil wells. If all the bidders know what they are doing, chances are the average bid will reflect the value at which the average oil company or telecommunications firm could profitably exploit the rights. But that means that the winning bid—which will necessarily be above average—will exceed this value. If this is the case, the odds are high that the winner will lose money. That’s why it’s known as the winner’s curse.

The auction, however, is not the only technique available to lure high-paying consumers. In fact, corporations have many subtle and elegant ways to segregate them according to their willingness to pay and exact a higher price from those who value their items most.

Consider, for a moment, how people shop. According to a study of Denver shoppers, families that make more than $70,000 a year pay 5 percent more for the same set of goods than families making less than $30,000. Singles without children pay 10 percent less than families with five members or more. Families headed by people in their early forties pay up to 8 percent more than those in their early twenties or late sixties. Retirees are much more careful shoppers than middle-aged people. They search dutifully for the best deal and end up paying nearly the same amount for the same product. People in middle age, by contrast, buy more carelessly. The prices they pay are thus all over the map.

These patterns arise because of differences in the way people value time and money. Time is relatively more valuable to the rich, who already have money, than for the poor who don’t. A janitor in New York making $11 an hour will likely prefer an extra $20 than an extra hour of leisure. A lawyer who makes $500 an hour, by contrast, would probably choose the free time. This affects how each of them will shop. The lawyer will be less inclined to spend hours comparison shopping and instead will pay the first price she sees. The janitor, by contrast, will be more willing to spend a little time to clip coupons, shop around, and get a better deal.

The value of our time also rises with age. That’s because wages increase as we proceed on our careers, gain expertise, and acquire seniority. The number of hours in the day, by contrast, does not. As any parent will admit, time actually contracts when one has children competing for attention with household chores, shopping expeditions, and a job. Time is at its most scarce and expensive around age forty-five, when wages and job responsibilities peak while families still have children living at home.

Companies exploit these differences. They charge more for basic staples in supermarkets in rich neighborhoods than in those frequented by lower-income shoppers. Rebates and coupons allow them to sell the same good at two prices—one for poorer coupon clippers and another for the rich who couldn’t care less. The technique can be used to discriminate between all sorts of people with different costs of time.

 

 

PEOPLE DIFFER ALONG dimensions beyond age and wealth. Companies try to target these differences to sell their product to as many customers as possible, extracting from them the maximum price they are willing to pay. Examining the 2008 Zagat restaurant guide for New York City, two economists discovered that restaurants rated as romantic or with a good singles scene charged up to 6.9 percent more for appetizers and up to 14.5 percent more for desserts, relative to the cost of the main course, than did restaurants classified as good places to have business lunches. The reason, they surmised, could well be that couples—if they liked each other—would linger and order an appetizer, perhaps a dessert. It would be unromantic for either to make a fuss about the price. So a restaurant could charge them relatively more for these “romantic” items on the menu.

The technique—called, appropriately, “price discrimination”— is ubiquitous. What else is the student discount at the bookstore, or the cheap matinee ticket on Broadway? Books are published in pricey hardcover months before their paperback edition to capitalize on those who can’t wait to read it and will pay more to get it faster. Apple launched an eight-gigabyte iPhone at $599 in June of 2007, to capture the early adopters who would pay anything to be among the first to have one. Two months later it dropped its price to $399.

Airlines are masters at selling seats on a plane at vastly different prices. They honed their techniques over more than thirty years trying to fill flights that cost the same to operate whether they are empty or full. In 1977, American Airlines was the first carrier in the United States to try the gambit, offering cheaper “Super Saver” tickets that required advance purchase and a minimum stay of seven days or more to lure price-conscious leisure travelers. Price variation exploded after airfares were deregulated in 1978, setting off intense competition as airlines strove to fill as many seats on their planes as they could. For a quarter century their most famous technique was the Saturday-night stay rule, used to segregate price-conscious tourists from business travelers who could expense the ticket and would pay anything to get home before the weekend. Today airlines have up to twenty different prices for seats on the same flight, depending on when and where the ticket was bought, how long the trip will last, and several other dimensions. Tickets with restrictions on the days of travel cost about 30 percent less than unrestricted tickets. Travelers who buy their ticket less than a week in advance pay 26 percent more than those who buy it at least three weeks ahead of time. Passengers who stay over a Saturday night pay 13 percent less.

It’s a profitable tactic. A study of thousands of pop acts from 1992 to 2005 found that concerts that offered different ticket prices for different sections earned 5 percent more revenue than those that didn’t, drawing a more lucrative mix of fans with cheap tickets in the nosebleed section and expensive seats in the front rows. Discrimination works better in cities that are richer and for artists who are older because they generate a more diverse audience: older and wealthier fans who have followed the band since the early days and young new ones who will go hear a band of old-timers provided tickets are cheap. It is now the norm: In 1992 more than half of all gigs sold all seats for the same price. By 2005, only about 10 percent did so.

Some schemes to charge consumers according to their willingness to pay don’t work. In the late 1990s Coca-Cola experimented with a vending machine that would automatically charge more for a Coke on warm days. But when Coke chief executive Doug Ivester revealed the project in an interview with the Brazilian news magazine Veja, a storm of protest erupted. The Philadelphia Inquirer slammed the idea as the “latest evidence that the world is going to hell in a hand basket.” An editorial about the idea in the San Francisco Chronicle was titled “Coke’s Automatic Price Gouging.” Pepsi saw the opening and announced it would never “exploit” its hot customers. Ivester defended the plan. He told Veja, “It is fair that it should be more expensive. The machine will simply make this process automatic.” Still, Coca-Cola dropped the idea.

The Internet is likely to bring price discrimination into every corner of our lives. In September of 2000, Amazon.com was caught offering the same DVDs to different customers at discounts of 30 percent, 35 percent, or 40 percent off the manufacturer’s suggested retail price. Amazon said the differential pricing was due to a random price test. It denied that it was segregating customers according to their sensitivity to price, which could be gleaned from their shopping histories recorded on their Amazon profiles. But ever since the incident, consumer advocates have warned that the reams of personal information that people give away when they search, shop, and play on social networking sites online will allow companies to finely tune their prices to fit the profiles of each customer. The less price sensitive, for instance, would be offered pricier versions of articles at the top of a search list. Bargain hunters could be presented with cheaper alternatives first.

The practice isn’t evil. Companies prone to economies of scale in competitive businesses often depend on it to raise their average unit price in line with their average unit cost. If they sold everything at the marginal price—the price it cost to make the last single unit—they would not be able to cover their fixed costs and would go out of business. And it can be beneficial to consumers. If Cokes were all sold at the same price, a consumer who would have appreciated a Coke on a mild autumn day if it had been slightly cheaper won’t buy it, forgoing what, for him, would have been a profitable acquisition. Allowing Coca-Cola to charge more on hot days and less on mild days would allow more consumers to indulge their taste for a Coke.

Still, price discrimination alone cannot rescue a flawed business model. Airlines prove that it does not even guarantee profitability. For all their efforts at price management, competition has pushed airfares down by about half since 1978, to about 4.16 cents per passenger per mile, before taxes. Most of the major carriers have spent some time in bankruptcy. In terms of operating profits, the industry as a whole spent half the decade from 2000 to 2009 in the red.

PROTECT US FROM WHAT WE BUY

The understanding of humanity as a set of rational beings able to accurately evaluate costs against benefits, striving to maximize their well-being, remains immensely popular among economists. It is a bedrock belief of the conservative movement in the United States: if we understand our own preferences better than anybody else does, there is no reason for the government to butt into our decisions. It has powerful corollaries. We can’t be second-guessed. If we buy something for a given price, it must be worth at least that much to us. The market price of any given thing is the best approximation the world has of the thing’s real value to society.

The belief is not empty. It provides a reasonable approximation of real people in many situations. For instance, it provides a satisfactory explanation of why we prefer things we choose to things other people choose for us. Joel Waldfogel, an economist at the University of Pennsylvania, approached a bunch of university students and asked them to compare the value of presents they received with things they had bought themselves. To make the answers comparable, he asked for the minimum amount of money they would demand to give the items up. A total of 202 students responded, providing hypothetical prices for 538 things they had purchased themselves and 1,044 items they had received as gifts. Mr. Waldfogel found that people value what they bought about 18 percent more, per dollar spent, than what they got as a present.

As we will see in subsequent chapters, the model of rational humanity is a powerful tool that can help us understand the behavior of men and women in many walks of life. Yet, at the end of the day, belief in the inerrant ability of our choices to communicate our preferences is inconsistent with how we actually behave. As some of the prior examples might suggest, people often make decisions about prices and values that, upon careful consideration, are inconsistent or shortsighted. We change our minds and rue our actions only minutes later. We knowingly overindulge. We prize what we have more than what we don’t.

Students of Duke University, for instance, said they were willing to pay up to $166, on average, for a ticket to the big basketball game—when Duke was one of four teams vying for the championship. But those who had a ticket said they wouldn’t sell it for less than $2,411. Economists who trust human rationality see credit as an optimal tool to smooth consumption over our life cycle, allowing us to consume more when we earn less and pay it back later. The rest of us know credit cards can be dangerous. One study found that basketball fans in possession of a credit card would pay twice as much for tickets to a Boston Celtics game as those who had to pay in cash.

And we are often simply inveigled by prices. In the 1960s, the California businessman Dave Gold discovered that charging $0.99 for any bottle of wine in his liquor store increased sales of all his wines, including bottles that had previously cost $0.89 and even $0.79. He left the liquor business, launched the 99 Cents Only chain of stores, and made hundreds of millions. Since then, companies of every stripe have lured us by slapping $0.99 on the price tag. Steve Jobs revolutionized the music industry by persuading us to pay $0.99 for a song. Evidently, the number convinces us we are getting value for money.

Surveying the landscape of our idiosyncratic decision making more than fifteen years ago, Kahneman, the Nobel Prize-winning psychologist, suggested that the government should intervene to curb our tendencies toward the less than rational. We should consider, he wrote, “some paternalistic interventions, when it is plausible that the state knows more about an individual’s future tastes than the individual knows presently.” Jenny Holzer, an American artist of the 1980s who built her reputation projecting self-evident “truisms” on buildings, building them out of neon signs, and stamping them on T-shirts, addressed the very same human vulnerability on the shiny surface of a BMW race car, emblazoning it with the phrase “protect me from what I want.”