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How Rational Are We Really?

Has it ever bothered you how outrageously high Starbucks and Apple’s prices are compared to their competitors?

Has it bothered you even more that both these companies are arguably more successful than their competitors in spite of their pricing practices?

Well it bothers me, so I set out to get to the bottom of it.

The laws of supply and demand do not explicitly show that there is a price where consumers are “overpaying”, but this is because the definition of the price in this model is how much the consumers are willing to pay. In order to determine if an individual is overpaying, there needs to be context such as how similar products are priced, the circumstances around the purchasing decision etc.

In my opinion, the 3 major reasons people overpay for products are the Anchoring Model, buyer’s preferences and incentives, and the inelasticity of goods.

The Anchoring Model:

The Anchoring Model works off the principle that our minds rely too heavily on the first pieces of information it sees . By manipulating the initial piece of information that consumers receive, price-makers can affect the consumer’s perception of subsequent information. For example, consider two phones that are identical. One is marketed at a price of $800 where as the other is marketed as $800 but is 50% from its initial price of $1600. Even if you wouldn’t normally purchase a phone at $800, you would still feel inclined to purchase the one at 50% off since there is a sense of value created through the “discount”. Using this strategy, companies can convince consumers to pay more than they were initially willing to pay.

As Dan Ariely outlines in this video , Starbucks is able to convert Dunkin Donuts customers into its own through the anchoring process. After walking into Starbucks once, the consumer convinces themselves to walk in each time they pass by Starbucks until they eventually are considered a regular Starbucks customer. Through minor details such as not serving donuts, Starbucks was able to undermine the previous notion of “coffee” established by Dunkin Donuts and implement their own set of standards including prices.

In this case, the decision making is quite irrational. Although the consumer rationalizes to themselves through the discount, this decision is made using misleading information. Personally, in order to circumvent these tactics, I monitor the price of products I’m interested in regularly so I know what I should expect, however, this isn’t always possible and it’s understandable how people may fall into this trap. 

Buyer’s Preferences and Incentives

Another reason people may pay more than they should for a good is a combination of buyer’s preferences and the use of incentives. The sneaker market is a good example of this. Over time, the price of sneakers has increased substantially

Eric Myers, a Northeastern MBA graduate and director at engineering firm INTEGRIS Group said the following.

“Rising sneaker prices can be attributed to a variety of factors: rising costs of labor in China, increased costs for raw material, inflation, and general price increases, yet it appears that the price increases have significantly outpaced these factors over the past decade,”

This is likely due to the nature of marketing and cultural shifts in our society. They have positioned sneakers as what’s “cool” right now and as such the demand curve has shifted right due to a favorable change in buyers preferences, resulting in a higher equilibrium price. Furthermore, through social incentives, individuals will buy expensive shoes in order to fit in with the crowd. As a teenager,  I understand the sentiment of this type of decision making, but that does not make it logical. In this case, the cause of the behavior is irrational, but the results of these decisions follow normal economic models so it can be understood to an extent.

Elasticity

In certain cases, the lack of elasticity of the a good results in people paying more than they need to. For example, coffee is an inelastic good for many since it only takes a small portion of ones income and it is somewhat of a necessity. Due to this, coffee-makers know that they can raise their prices slightly and people will continue to buy coffee. Technically, consumers would be overpaying relative to the previous price, but since a consumer surplus (a difference between the price paid and the price a consumer is willing to pay), they will continue to buy coffee. In this case, the behavior is rational since it doesn’t make sense to stop drinking coffee due to marginal increases in price. 

Overall, in most cases where consumers are overpaying for their products, it is due to irrational decisions making that is primarily based on feelings . However, there are cases, such as the case with elasticity, where overpaying isn’t necessarily irrational.

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Supply and Demand Assignment

With the recent surge of popularity in Bitcoin and other cryptocurrencies, graphics card prices have also surged. People purchase and use large numbers of graphics cards in order to “mine” cryptocurrencies. As the result, the demand for graphics cards has increased causing a drastic increase in price. For example, the Nvidia GTX 1070, a card that should retail for about $380 is being sold for over $700 due to lack of stock.

From an economics perspective, there was a change in the demand determinant, number of buyers. Since the number of buyers increased, the demand curve moved right. This resulted in a shortage, causing an increase in the equilibrium price and equilibrium quantity.

 

supply and demand

 

 

 

Source: https://www.theverge.com/2018/1/30/16949550/bitcoin-graphics-cards-pc-prices-surge