One of the most foundational assumptions in modern economics is that freely agreed upon trades benefit both parties. This seems reasonable, since if one party is getting swindled they are free to back out of the deal. Unfortunately, human interactions don’t work out that neatly.
Let’s start with an example from Dan Ariely’s book Predictably Irrational. Looking online at the prices for the British magazine The Economist, Ariely found that their subscription prices were as follows:
- Online only for $59
- Print only for $125
- Print and online for $125
If you are like most people you probably immediately noticed that print only is the same price as print and online. Your brain registered that print and online together was clearly a better deal. As an experiment, Ariely gave these three options to 100 students at MIT’s business school. As expected, no one chose print only, 84 people chose print and online, and 16 students chose online only. So far this makes perfect sense, the real surprise didn’t come until the next part of the experiment, in which participants were offered two choices, online only for $59 or print and online for $125. If the MIT students are rational (and frankly, MIT students are about as rational as you can get without leaving the human species) then removing a choice that no one wanted shouldn’t make any difference, we should still get 84 for print and online and 16 for online only. But that’s not anywhere close to what actually happened. This time only 32 students sprang for the print and online option while 68 opted for online only.
So what happened? Ariely notes that the human mind likes to compare similar things. It’s tough to compare the value of an online subscription v. a print subscription, but it’s much easier to see that getting both is a better deal than getting only one. Our comparisons are relative, and in this case that relativity may have made us behave irrationally.
One of the common responses I get from economists when I mention that human beings don’t actually behave rationally is that overall human beings come close enough for the models to be useful. Sure, we might make a bad purchase here and there and regret it, but on average we really do buy things (make trades) that increase our well-being. So how does our brains ability to evaluate things (potential purchases) only relative to other similar things play out in the real world?
When bread makers first came out they sold terribly. Then the manufacturers made a bigger model and sales rose rapidly. But it was the smaller original model that was suddenly selling, because now there was a point of comparison. People weren’t sure if they wanted a bread maker or not, but the smaller one suddenly seemed like a good deal and people started buying them. Black pearls didn’t sell at low prices, but once they were suddenly priced exorbitantly they became a must have luxury good. Given a choice of three TVs, or almost any good/service, we will usually choose the middle one. At Restaurants people rarely order the most expensive entree, but will opt for the second highest priced one instead.
I haven’t even mentioned advertising yet, but anyone who has recently seen a commercial can assure you that companies aren’t spending millions and sometimes billions of dollars in order to aid you in making rational choices. Your spending decisions really are influenced by advertising, which is why companies keep doing it. It is for their benefit, not yours. (Btw, I have never yet met an economist who considers advertising to be a market distortion. Apparently distorted consumer preferences are fine as long as it doesn’t interfere with economic growth? This makes sense if your goal is to boost GDP, but not if it is to maximize human well-being, which depends on the economy serving human preferences rather than creating them.)
In addition to the experiment with magazine prices summarized above, Ariely also conducted several others in order to see how willingness to pay could be manipulated. As it turns out, even something like writing down the last two digits of your social security before bidding on an item influences how much you are willing to pay. Ariely concludes,
…as our experiments demonstrate, what consumers are willing to pay can easily be manipulated, and this means that consumers don’t in fact have a handle on their own preferences and the prices they are willing to pay for different goods and experiences…
…whereas the standard economic framework assumes that the forces of supply and demand are independent, the type of anchoring manipulations we have shown here suggest that they are, in fact, dependent. In the real world, anchoring comes from manufacturer’s suggested retail prices (MSRPs), advertised prices, promotions, product introductions, etc.
As a pragmatic matter, markets work fairly well. Certainly better than most other systems human beings have tried throughout history. But the idea that markets, left alone, create desirable outcomes and that any deviation from that should be viewed as a distortion that harms human well-being is simply incorrect. Ariely gets specific about the public policy implications,
If we can’t rely on the market forces of supply and demand to set optimal market prices, and we can’t count on free-market mechanisms to help us maximize our utility, then we may need to look elsewhere. This is especially the case with society’s essentials, such as health care, medicine, water, electricity, education, and other critical resources.
Now, we should be careful here not to make a common psychological mistake. Because evaluating things is difficult, it’s easy to conclude if markets are flawed we should have fewer and/or more regulated markets. That might actually be the case, but we still have to do the difficult work of comparing flawed market outcome to the flawed outcomes of non-market alternatives. That sort of work takes a lot more than a blog post, but what I find so frustrating is that in the U.S. context the debate over public policy usually features one side that starts with the assumption that market outcomes are perfect and any deviation is a disaster. The question of when and how to shape markets is a difficult one calling for careful research and consideration, but first we have to at least start from the basic framework of comparing two or more flawed options.