Every since I was a little girl, I’ve seen everyone around me – friend, strangers, and family members fall for this. Hell, I’ve even seen myself fall for it even though I know better. From clothing to food, we humans Keep. On. falling. For. The. Same. Trick. OVER AND OVER AGAIN! Yep, we’re extremely irrational – emotions could affect us, a little bit of irrelevant information could affect us from buying things.
Us irrational buyers effect the demand portion of the supply and demand graph, causing a shift in the graph. According to our wants, the companies selling the goods and services bend to our will and produce as much as we, the buyers desire.
What is this effect?
Anchoring effect describes the common human tendency to rely too much on the first piece of information offered (the “anchor”) to the buyer when making decisions.
This is why places like Pacific Mall in Toronto can still stay open, despite all the haggling. No seller would ever put the selling price of a product lower than their production cost, just because you as a buyer convinced them that you should have the item for a lower price. Eventually, every buyer gets tricked into believing that they got an excellent bargain from their purchase. Information asymmetry is the first reason buyers never get a good deal. This only occurs when one party knows more about a product than the other party does. In the case above, it’s when the seller knows more about a product than the buyer.
We DO NOT pay a rational price for goods.
Given the level of asymmetry or ‘unevenness’ in the knowledge of the transaction between the buyer and seller, this is where anchoring effect comes in.
Dave Ariely, the James B. Duke Professor of Psychology and Behavioral Economics at Duke University conducted lots of research, one being him reading a poem to his students and telling them he would do poetry readings of varying lengths (short, medium and long). He asked half his students if they would hypothetically agree to listen to him if they were paid $10 and the other half if they would pay him $10 for the honor of listening to him. They were then left to bid for each section. Those who had been offered money, offered on average $1.30 for a short poetry reading, $2.70 for a medium and $4.80 for the long reading. Interestingly those who had been asked if they would pay Ariely offered a dollar for the short, about two dollars for the medium and just over three dollars for the long reading. The initial offer not only anchored how much they would pay but also whether they would pay or be paid. This is called arbitrary coherence,as the initial price is randomly chosen (arbitrary) and in turn affects future prices (coherence).
Materialistic? Non-materialistic? Which one are you?
I’m definitely more on the materialistic side.
The more the person values luxury goods, the more materialistic they are, since they’re higher on the materialistic scale measuring material values.
Economic psychologists documented in their recent studies that materialistic and non-materialistic people view the world differently from each other. They also studied something called the “labeling effect”, a term used by psychologists and marketers which describe the effect people evaluate products based on external cues, such as a product label, a server’s recommendation and/or the price – rather than the quality of the product.
These researchers conducted a study where a group of people were shown 2 bottles of wine, one cheaper than the other, but in fact they were the exact same wine in 2 different bottles. When asked to grade both wines, materialistic people graded the cheaper wine significantly lower than the expensive one.
But this is a basic human tendency called confirmation bias, where we interpret the world in a way that fits with our preexisting views. This means that we need something to compare an object to, for a price. In the case above, the confirmation bias is seen as materialistic people giving a low score for the cheaper wine.
I know you’re reading this. The fact that you are reading this journal right now says things about who you are. You may be a teacher, a student, or an extremely confused foreigner who has somehow managed to find their way onto this website. Don’t worry, if you’re among the last number, there are a surprising number of you. Sit back, relax, and welcome to The Sleepy Canadian.
Strike that, wrong blog. That belongs to someone else. My apologies.
Without a further ado, I would like to begin this journal by saying that we’re all dumb. Idiots. Perhaps we may qualify as just under remotely intelligent. Thankfully, as I am behind a screen, I am safe from any mobs and pitchforks that may be hurled my way. Regardless, I should clarify.
We—human beings—are irrational.
Our choices, actions, and purchases all reflect this. We are motivated by irrational thinking, and will pay absurd prices on certain goods. Oftentimes, our irrational behaviour is predictable to an extent and factored into the demand curve. Through intentional supply or price tampering, a good may be overpriced even with the irrational nature of the demand curve accounted for, although human irrationality may contribute to the good being overpriced.
TL;DR Irrationality affects the demand for goods, but this doesn’t always make them overpriced.
Before the final assertion about irrational prices and overpriced goods, it is necessary to first confirm that humans are irrational.
It is safe to presume that anyone who may be reading this journal is likely more intelligent than its author. Although I cannot deny that my intellectual inadequacy may have led to several personal anecdotes relating to irrationality, the fact remains that human beings are not rational creatures. We are bound to emotions, morals, and are subject to a variety of cognitive biases. Even in the subject where we should be most rational in, money, humans consistently fall victim to these biases.
The anchoring effect is a cognitive bias in which we, as pitiful human sheeplings, focus heavily on the first morsel of information provided on a topic, and base future judgments on it.
For instance, let’s say I show you a piece of fine art, like a brown shoe, and tell you its current market value is $5000. Then, I offer you a deal of $2500 and free shipping, across the remarkable distance between my hands and yours.
It’s a great deal: 50% off, plus free shipping. Thinking of owning one of these artful masterpieces and adorning your wall with a muddy shoe, you buy it. It seems worth it. But is it really?
The original cost, $5000, serves as an anchor for the rest of the discussion. As the first piece of information on the shoe, it becomes the de-facto testament in regards to its value. Thus, the 50% discount on an item as valuable as a brown shoe is amazing in that context.
In reality, the shoe is worth a fraction of that amount and I walked away with thousands in profit.
Think this is impossible? Think you would never fall for something like this?
Retail stores, clothing being a big one, often operate with this tactic. The “sale” price will be the regular price, and the “regular” price will be marked up to provide the illusion of a discount. The larger the price difference, the happier the consumer will be, regardless of the actual value of the product.
Other examples of cognitive biases and similarly irrational economic activities include the paradox of choice, the mere exposure effect, and the sunk cost fallacy. I’ll whip through them in quick paragraphs.
The paradox of choice is the mental barrier that arises when someone is confronted with too many options. In 2000, psychologists Sheena Iyengar and Mark Leppar conducted a study on the topic using jam. They set up two tables: one had 24 varieties of jam, and the other had six. Although the larger display garnered more attention, customers were ten times more likely to buy at the smaller table. Too many options actually reduced spending.
The mere exposure effect is the increase in trust placed in something or someone based on familiarity. The more we see something, the more we trust it. Advertising works on this principle. There’s no rhyme or reason to liking Pepsi more than Coke just because you saw more advertisements for Pepsi, but that’s how it works.
The sunk cost fallacy is when a greater investment in something makes it harder to stop investing in it. This is observable in gambling, as well as projects and other mediums where the investment is time rather than money. The behavioural economist Dan Ariely states that this fallacy is due to an individual’s tendency to focus on losses before gains. The innate loss aversion of the mind hinders rational decision making.
Most importantly, there is no escaping these cognitive biases. Self-awareness does not make any individual any more astute in future decisions.
Factoring in Irrationality
So humans are irrational. So what?
The irrationality that humans express will affect demand curves. In large swaths of the population, it may even be a predictable shift. In order to match this, suppliers will increase or decrease the quantity supplied to eventually reach an equilibrium price. How then, is it possible for any good to be overpriced? Do we pay more for goods than we should, and are they overpriced?
The clearest example of paying excessive amounts compared to competitors or production cost is one of the demand determinants, Buyer’s Preferences. Brand loyalty is one case of buyer’s preferences. Aspirin and off-label aspirin contain the exact same chemical content, but most will purchase the branded aspirin despite a price difference of $6.29 to $1.99. Many over-the-counter medications feature similar purchasing trends. This is predictably irrational due to the advertising campaigns for the branded products and the labeling effect, which will be explained in the following paragraph.
Another instance of irrational preferences is the labeling effect. Higher prices make materialistic individuals value the good more. When given two identical bottles of wine and being told that one costs more than the other, the subjects of the experiment will evaluate the expensive wine to be tastier. If the individual was highly materialistic, then the “cheaper” wine’s evaluation sank further. In this case, consumers pursue highly priced goods because of their price; they assume that the cost validates the product’s quality.
Both of these examples will be factored into the demand curve as one of the demand determinants. This means that even given an irrationally high cost for a good, like aspirin, the good is not truly overpriced because the supply and demand align to set that price in an ordinary market. Many consumers would consider their coffee purchase, for instance, to have a consumer surplus despite the large profit margins.
These alone are not egregious examples of overpriced goods. It can be argued that they are simply a part of the natural equilibrium under Buyer’s Preferences. What then, is for sure an overpriced good?
Really Overpriced Goods
The answer lies in price fixing and monopolies. To a lesser extent, this is also present in oligopolies. I believe that while a good being overpriced because of irrationality can be debatable due to non-price competition, artificially inflating that price is usually what makes a good overpriced.
This would include the financially sound but morally defunct actions taken by many pharmaceutical companies. Newly produced or uniquely modified drugs allow companies to hold a monopoly, allowing for total price control. In addition, due to the inelastic nature of live-saving drugs, the prices can skyrocket without demand dropping. This has happened time and time again, from Martin Shkreli at Turing Pharmaceuticals to more recently, with Marathon Pharmaceuticals. In fact, Marathon Pharmaceuticals outdid Shkreli’s 5000% price increase with a 6000% price increase—which was approved by the U.S. Food and Drug Administration.
Earlier, I mentioned that natural supply and demand curves would incorporate many irrational demand preferences in a normal market. An example of when this leads to an overpriced good is the Supreme brand, which has made some headlines over its ludicrous price mark-ups. Here, the sheer level of demand is irrational due to the near-cult following of the brand. Supreme maintains their high prices through a combination of irrational behaviour and extremely limited supply.
Both monopolized pharmaceutical goods and products like Supreme are overpriced goods; they feature supply or price fixing that drastically alter the market equilibrium. The irrational behaviour of consumers contributes in some cases (like a brick costing over a hundred dollars), but is not a required factor.
In the end, we don’t really pay rational prices for the goods we purchase. Our minds are routinely tricked by companies who manipulate our cognitive biases. That being said, although we act irrationally, the “overpriced” goods we purchase are often well within our willing spending range, leaving both sides of the transaction satisfied. In this regard, what is “overpriced” will vary and depend on a case-by-case basis. Irrationality may contribute to an item becoming overpriced, but does not guarantee it.
Extreme scenarios, such as Supreme and pharmaceutical companies that feature price gouging due to price or supply fixing are definitely overpriced though. Bricks should never cost that much.
Hopefully the mere exposure effect won’t convince you to buy some bricks for a few hundreds dollars. Just chisel out the logo on your own.
Picture this, you’re on your way home from school and you feel the sweltering heat as you recall this morning hearing forecasts of 38ºC and today being the hottest day of the year. Every time you try to swallow your saliva it’s as if there’s a wall preventing it from going down. The inside of your throat feels like a new scratching post for your kitty, Mr. Whiskers. As you wince in pain, you finally enter your local grocery store. Once inside, you search intently for a bottle of water. You look up and see ‘Isle 3: beverages, water, sports drinks’. You scan the shelves and you see a no-name water bottle priced at $1.00/bottle and right beside that is ‘Fiji Water’ priced at $3.00/bottle.
At this point, three things are probably going through your mind.
I need this water NOW.
How can prices be so irrational that things can be drastically different in costs when they serve the same purpose? They’re bothjust water. and
If I was at home, I could just get this for free, how are they getting away with selling this?
You purchase the dollar bottled water, quench your thirst and decide to stay in the grocery store for 2 reasons.
To take shelter from the scorching heat. and
To further investigate this pricing matter.
Thus you begin to wonder, are the prices for goods rational or can they actually be overpriced such as the ‘Fiji Water’ you saw earlier? There has to be more to this than is what just meets the surface if they’ve been doing this for decades.
This idea of pricing and what consumers will actually pay for certain goods revolves around behavioural economics. The idea of rationality and irrationality. As Dan Arley puts it:
It’s interesting how there are many different conclusions depending on how you view things and where you start in regards to rationality and irrationality.
The economic concept of the anchoring effect plays a role in the price decisions consumers make. Anchoring is the idea where people are unable to make decisions in plain terms, instead, they use comparisons. In the grocery store example, the anchor was the free tap water. As a result, you are so used to having water for free that the $1.00 bottle seemed like a rational price to pay for the situation you were in, versus the irrational price of $3.00.
Arley, a behavioural economics conducted research in regards to anchors and found that anchors play an extremely important role in consumer price decisions. If the original anchor is low, there will be lower bids, which is fairly evident when you purchased water. In his experiment, he asked people to use the last 2 digits of their social security numbers to bid for wine. Arley found that,
In reality, if you allow people to produce a higher price in mind, then this will make others pay as much as treble the price. People with high social security numbers paid up to 346% more than those with low numbers. As Arley quotes from his book, “Predictably Irrational”;
As you can see from Arley’s example, the price of goods can vary from rational to irrational as easily as people change their perspectives.
Expensive or Expens-NOT:
Now the question is, why do people buy overpriced things when they can buy a cheaper alternative instead? Are these goods priced rationally?
As “Investopedia’s: The Psychology Behind Why People Buy Luxury Goods” states:
“It’s well known that people don’t behave rationally, and considering the enormous consumer debt Americans have, consumers clearly don’t always act in their best financial interests.”
Materialism comes into play when explaining expensive purchases. If a person values luxuries in life, admires people who own expensive things such as cars, homes, clothes or finds happiness through buying expensive items, the more materialistic that person is. This results in the labeling effect. Products are evaluated based on external cues such as labels, recommendations, and prices instead of the product itself.
This study revealed that if you are on the lower end of the materialistic scale you value “expensive” and “cheap” products on a fairly similar scale. Whereas, people on the higher end of the scale valued the “expensive” and “cheap” things more differently in 2 extremes.
As a result, this solidifies the idea of the confirmation bias.This is when you value an expensive item, you expect it to have a higher quality and a cheaper item to be bad.
This explains is how designers such as Louis Vuitton, Supreme, Gucci, Apple and many other companies are able to sell their products at insane prices and continue to have consumers lineup when they release new products. The consumer expects it to be worth the price they buy it at. They acquire these materialistic concepts through these irrational, overpriced purchases but rejustify themselves into rationality through their own happiness and other feelings.
This aspect is where supply and demand determinants play a role in prices and quantities that are set. In this aspect, the demand determinant that is important in keeping these name brand companies on the market is buyer’s preferences/consumer’s taste. This is the idea of finding happiness or just wanting to purchase expensive things. This causes the demand curve to shift to the right increasing demand. This results in an increase in price and quantity.
As a result, these goods may not be priced rationally and seem overpriced, however, emotions and feelings may explain otherwise and counteract these arguments to justify irrational spendings.
On the other side of things, the notorious king of overpriced goods are the pharmaceutical companies. The infamous, Martin Shkreli was able to take advantage of the monopoly, super inelastic aids drug by putting a 5000% markup price from $13.50 to $750.00 overnight.
In conclusion, are the price of goods rational? In my opinion, the answer to this question is that it varies to certain extents, but in general for goods considering the amount of inflation that is occurring, it is rational. As long as people use the anchoring effect and turn a blind eye to the mark-ups companies are making on their products, then this irrationality can seem rational. As long as these ideas can be explained and backed up with the happiness the products/goods bring anything, in theory, can be a rational price to pay. However, personally, I do believe that the name brand, ‘hype-beast’ clothing that is trending nowadays are definitely blown out of proportions and ARE overpriced goods as well as anything you can get for free.
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