What’s your daily brew for the morning?
Is it: Instant coffee like Maxwell House or Nescafe? Home brew made from your Keurig? Or for those who appreciate the finer things in life, a cup of joe served with a smile from your local Starbucks barista, Dunkin Donuts employee, McDonald’s team member, or Subway sandwich artist?
As a frugal consumer, it really puzzles me when I see somebody spending $1.96 for a grande coffee from Starbucks when they could get a similar quality medium coffee for $1.69 from Dunkin Donuts.
Is it possible for a good, in this case Starbucks, be overpriced? Is buying a coffee at that price rational? If it’s not, why do we pay it?
To answer those questions, we must know how supply and demand influence price, and how to define rational behavior.
Supply and Demand
Traditional economists define the law of supply and demand as “the effect the availability of a particular product and desire for that product has on price.” Essentially, low supply and high demand cause an increase in price, while a high supply and low demand leads to a fall in price. The price and quantity at which supply equals demand is the equilibrium point. On a supply and demand graph, supply is an upward sloping line because an increase in price (paid by consumers) cause an increase in quantity supplied. Demand is a downward sloping line because an increase in price (charged by suppliers) results in a decrease in quantity demanded.
There are many factors that affect supply and demand and they are called supply/demand determinants. Supply determinants include cost of factors of production, technology, prices/profits of other goods, seller’s expectations, and number of sellers. Demand determinants include buyer’s income, buyer’s preferences/consumer taste, buyer’s expectation, price of other goods, and number of buyers.
Now that we understand the basics of how the equilibrium price is determined by supply and demand, we can answer the question: can a good be overpriced?
An overpriced good would have a price of P1 on following supply and demand graph. It has increased from the equilibrium price (P*) and the quantity demanded and supplied would have changed to Q1 and Q2 respectively.
This graph indicates a surplus of Q2-Q1. Suppliers are producing more goods than consumers are willing to purchase at the increased market price. This overpriced good is inefficient for the economy, and this price cannot be sustained for a long period of time (by suppliers). As a result, producers will reduce the price and cut back on production to meet the demands of the market. Consumers respond to this lowered price by purchasing more. ”In a competitive market, this process continues till the market reaches equilibrium.”
Therefore, according to these supply and demand models, a good cannot simply be overpriced and the only way to increase the price of a product without affecting the market equilibrium is by increasing demand or decreasing supply. This is often accomplished by changing consumer tastes and preferences to increase demand.
Investopedia defines rational behavior as: “making choices that result in the most optimal level of benefit or utility for the individual. Most conventional economic theories are created and used under the assumption all individuals taking part in an action/activity are behaving rationally. Rational behavior does not necessarily always involve receiving the most monetary or material benefit because the satisfaction received could be purely emotional.” By this definition, purchasing a coffee from Starbucks for $100 can be rational as long as the consumer values the benefits of that coffee more than $100.
However, it goes beyond that simple conclusion. To determine if a decision is rational, you often have to remove any emotional factors and base your evaluation on only the available facts. An irrational decision is one that lacks rationality, or is less logical than more rational options.
To dive deeper, I would like to discuss how human rationality is bounded (imperfect, and sometimes even irrational), and how our daily decisions are easily and often influenced. So sit back with your favorite cup of joe and enjoy the show.
According to BusinessDictionary.com, bounded rationality states that all decisions are made under three unavoidable limitations:
- There is often “limited and often unreliable information” regarding all the options and their consequences.
- The human mind is limited and may not be able to process all available information.
- There is a limited amount of time to make the decision.
As a result of these restrictions, most, if not all rational choices regarding complex decisions, are satisfactory, and not optimized. This concept, introduced by Herbert Simon is called “satisficing” (satisfy+suffice).
Regardless, even if we were able to gather all the available information regarding the pros, cons, alternatives, and consequences of buying a coffee from Starbucks, our brains would not be able to process it all and it shouldn’t have to. Thankfully, we learn from a summary of Thinking, Fast and Slow by Daniel Kahneman on BrandGenetics.com that there are two types of thinking:
- Intuitive thinking
- Rational thinking
Although rational thinking is “slow, deliberate and systematic” and is extremely limited, intuitive thinking is “fast, automatic and emotional”. A simple economic decision like choosing where to buy a coffee is easily made using intuitive thinking.
However, intuitive thinking is based on heuristics and biases. Today we will be focused on heuristics. To read more about biases affecting intuitive thinking, please click here.
So if you decide to go to Starbucks because it feels like the right decision, you’ve been influenced by the affect heuristic (if a decision feels good, it’s the right decision). If you choose to revisit Starbucks because you can easily recall your last visit to Starbucks, but can’t remember the last time you had Dunkin Donuts, you were influenced by the availability heuristic (things we easily remember are more important than things we can’t). If you step halfway into a Starbucks to try a free sample, look at the menu and realize how expensive the drinks are compared to Dunkin Donuts, but still choose to buy a coffee from the green-aproned barista, you’ve been persuaded by the commitment heuristic (if you’ve already invested in a decision, you should see it through).
These are just some examples of heuristics that can greatly sway your decision. However, there is one extremely common heuristic used by businesses and by (behavioral) economists to argue that humans aren’t always rational decision makers. It’s the anchoring effect/heuristic. Anchoring is defined as “the use of irrelevant information as a reference for evaluating or estimating some unknown value or information” by Investopedia.
Therefore, “the first impression matters”, and with coffee, there are many outlets for people to develop an anchor for coffee. Compared to outlets like Dunkin Donuts, McDonalds, and convenience stores, Starbucks is simply charging more for a similar product. Nonetheless, there is still a huge demand for frappucinos and macchiatos, and the company continues to succeed. Since going public in 1992, their stock has increased over 16000%, beating the S&P 486% return in the same time period.
So how did the twin-tailed mermaid attract so many customers (aside from her elegant flippers)? By opening stores that had a different ambiance, different food offerings, different store appearance, and even different drink sizes, Starbucks was able to disassociate themselves from price anchors set by other coffee-selling chains. Furthermore, “repeated visits to Starbucks served to establish a NEW anchor price for high-end coffee products. Each purchase of $4 coffee strengthened that new anchor point.”
Compared to large coffee that costs $1.89 at Dunkin Donuts, a Starbucks venti coffee that costs $2.07 might seem overpriced. However, compared to the $4.95 grande pumpkin spice latte, that once overpriced drink is a great deal!
There are a couple more economic/marketing concepts used to influence consumer decisions. They are the framing effect and psychological pricing.
The Framing Effect states that how information is presented influences consumer choices. For example, 10% customer dissatisfaction sounds much worse than 90% customer satisfaction, and a gym membership that costs $1.28 per day sounds much more economically sound than $39 a month. Although both phrases mentioned above contain two statements that deliver the same objective information, one sounds subjectively more positive. However, a study conducted by David R. Mandel for the American Psychological Association reveals that “a significant majority of participants made rational decisions by classical rational-choice criteria in traditional risky-choice framing problems.”
Psychological pricing takes advantage of consumers’ emotional side to encourage sales without significantly reducing prices. There are five types of psychological pricing strategies:
- Charm Pricing: By reducing the leftmost digit by one (usually done by reducing the price by 1 cent, $3 lowered to $2.99), consumers perceive the price as a lower tier than before. According to an experiment by the University of Chicago and MIT, when different women’s clothing items were priced at $34, $39, and $44, the $39 item was the most popular.
- Prestige Pricing: By rounding up prices (i.e. $99 up to $100), the price is more easily processed and “encourage reliance on consumers’ feelings.” The decision is based on feelings rather than cognition.
- Buy One, Get One Free: This strategy takes advantage of consumer greed. Logic is “tossed to the wind” and the consumer is most concerned with getting the free item. This strategy is modified to best suit financial/sales goals (buy one, get three free).
- Comparative Pricing: Offering two similar products side by side makes one product seem much more attractive (this is a similar concept to anchors). Surprisingly, this best works with luxury items, especially clothes. An expensive tuxedo beside a cheaper one is perceived as higher quality.
- Visually highlighting the different prices: Changing the font, size and color of signs that indicate a current sale price will convince customers that this is a cheaper price, and a much better deal.
All of these psychological pricing strategies make consumers FEEL like they’re getting a good deal, and may motivate them to buy something they don’t need, or something more expensive than necessary.
So to answer the question: Are the prices we pay for goods rational? Can a good be overpriced? I would say that according to the laws of supply and demand and the evidence previously provided, the prices we pay are rational, and that nothing can be overpriced (as seen earlier).
Although humans are not perfectly rational, meaning we don’t always make the MOST objective logical choice, we possess bounded rationality. Despite our limitations, humans process the available information to the best of our ability in the time given to make the decision that provides the most benefit. We satisfice because we have no better option under those circumstances.
Although some behavioral economists would argue that techniques like heuristics, the framing effect, and psychological pricing cause us to make irrational decisions, traditional economists could say that they simply change the consumer’s preferences and tastes, one of the demand determinants, to increase demand.
Visiting Starbucks instead of Dunkin Donuts may seem irrational to some, but to others, it provides them with the most emotional value at the expense of economic value. If the markup was so great that nobody would buy it, Starbucks would be going out of business. Instead they are consistently growing and appealing to those who appreciate the experience, not the coffee or the price.