Is What You’re Paying Really What You’re Getting?

Many of you probably think that you spend your money wisely.  That when you buy something, you’re making a rational decision.  You probably think that the price you pay for goods makes sense.  Unfortunately, due to savvy marketing and factors that you probably never even considered, that may not be the case.  It turns out, we’ve all been fooled, and the way we value things may be extremely flawed.  Contrary to the traditional economics perspective, many goods can be, and it turns out, are, overpriced.  

According to supply and demand models of traditional economics, there is a demand curve, and supply curve on a graph. The vertical axis is the price, the horizontal is the quantity.  The intersection of the two lines determines the equilibrium price and quantity.  The factors that normally affect demand are buyer’s income, buyer’s preference/consumer taste, buyer’s expectations, other prices, and the number of buyers. The factors of demand, are cost of factors of production, technology, prices/profits of other goods, seller’s expectations, and number of sellers.

Supply and Demand Graph

It is expected that the price would be at the equilibrium of supply and demand.  If the price was too high, then there would be a larger supply than demand because more suppliers would be willing to supply at that price, but less people would be willing to purchase the good at such a high price. This would result in a surplus.  If the price was too low, then there would be more demand than supply, as more people would want to buy the product, but less suppliers would be willing to produce at that price.  This would result in a shortage.  

Therefore, the conclusion is drawn that supply and demand are separate forces and that the price is a result of the market.  However, according to behavioral economics, in many cases the price actually determines the market.  I know this sounds backwards, but let me explain.

There is a factor which affects the way people value things called the anchoring effect. The gist of the theory is this:

Your first perception lingers in your mind, affecting later perceptions and decisions.”

The article attached to that quote explains that the initial value that you give to an object sticks with you and affects how you value that object. Even simple numbers that we associate with objects can affect how much we’re willing to pay for them.

The author of the article above, David McRaney, also explains how this technique is used to sell leather jackets.  If the initial price is around a thousand dollars you would most likely find this too expensive for a jacket and put it back on the shelf.  But imagine as you are put the jacket back on the shelf after trying it on, an employee at the store tells you it’s on sale for $400. Suddenly the jacket seems like a great deal.  $600 off a great looking jacket!

Leather Jacket Store PhotoHowever, the initial price of the jacket was simply an anchor.  A price that the store wanted you to feel the jacket was worth, and that changed the amount that you would be willing to pay for the jacket. $400 dollars is still a lot of money to pay for a jacket, but because you feel like you’re getting a good deal you’re more likely to buy it now. McRaney explains that this is an actual technique used by salespeople in this industry, and which he has used himself.

This effect is also illustrated by the black pearl market in the 1970s. A man named Salvador Assal attempted to sell black pearls in Manhattan, but there was no market for it at the time, and nobody purchased them.  He decided to place them in the window of a prestigious jewelry store with an extremely high price tag, as well as put them next to diamonds and rubies in ads.  All of a sudden, black pearls were being worn by the most elite in Manhattan.  Because they were presented as a status symbol and as extremely rare, the public adopted that view, and accepted the higher prices. The true value of the pearls became irrelevant.  

“This is all to do with anchoring. You see people cannot decide things in absolute terms, rather they compare it to others” 

Black Pearls for Blog Post.jpg

The conclusion we can draw from this is that anchors can seriously affect people’s judgement and how people value things, which proves that the way people value things is usually not a decision made with consideration for its true value, and therefore not very rational.   Also, this directly contradicts the theory that supply and demand determine the price, but implies rather that the price determines the demand.  But the irrationality doesn’t stop here.

Even a random number briefly associated with the price of a good that has nothing to do with the true value of a it can affect how you might value it.  This article explains an experiment which Dan Ariely conducted demonstrating this concept, named “arbitrary coherence”.  Ariely auctioned off items such as a bottle of wine, a cordless trackball, a cordless keyboard and mouse, and other items.  However, before beginning the auction the MIT students involved were asked to write the last two digits of their social security number as if it was the price of the item being auctioned off.  It turns out that those with higher numbers bid two or three times what those with lower numbers bid.

So even when the MIT students knew that the number was coming from a random source, they still used it as an anchor because they had no other way of valuing the item. This shows just how irrationally people can value things.

So, are things actually overpriced?

Overpriced Blog Post.jpg

Again, according to the theory of supply and demand, the price and quantity supplied is determined by the equilibrium price.  Therefore, it shouldn’t be possible for a good to be overpriced. But it turns out that there are numerous goods which have huge markups but are still bought very often. Examples include text messages (6000% markup), bottled water (4000% markup), movie theater popcorn (1,275% markup), coffee (300% markup) and more. So why do people accept these exorbitant prices? Simply put, anchors and irrational valuation of goods.

Why does it matter that these goods have large markups? Well, a markup is the percentage of payment for a good by the consumer which becomes profit. A markup of some sort is necessary because the aim of a business is to make profit, but when a large mark up occurs, it means people are paying a price that is much higher than what the cost to produce that good was.  This indicates that the good may be overpriced, because businesses don’t typically make markups this high.  Usually, they range from 10% to 100%. However, if the consumers accept such a high price, then the producer can continue to sell with an insanely high markup, which is why I feel it is irrational to buy these goods.  

In fact the price of a good not only affects how we value it and interpret it, it can also affect our satisfaction from that good.  People have a sense that something that costs more is automatically better or of a higher quality. This can be shown through a study which was conducted by the physiologists Fabian Christandl, Detlef Fetchenhauer, and Sebastian Lotz.  For the experiment all the participants were given the same wine. Some were told it cost 3 Euros, the others were told it cost 20 Euros. Those who ranked low on the materialism scale enjoyed both wines the same, and ranked both at an average of 60/100 in terms of satisfaction.  Those with a high materialism scale ranking gave the wines different ratings. (high for the higher price, low for the lower price)  This is completely irrational, but it’s simply the way some of our minds work.

In summary, tactics such as anchoring as well as the irrational way in which people value products results in overpricing.  Although it has been thought that supply and demand determine the price, it may actually be the price which drives the demand for a product in many cases.  Goods such as Starbucks’ coffee, bottled water, and text messages are overpriced because many people have valued them higher than they are truly worth.

So next time you see a seemingly great deal on something, or maybe you feel like you might be overpaying for something, ask yourself:

Is this really worth it?

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