Undercover Economist

Eternal enigma

Friends of mine, husband and wife, once argued over the price of a branded packet of lemon slices bought at some convenient corner shop or petrol station. She complained that the slices weren’t worth the price she had paid. He pointed out that she had bought them – albeit grudgingly – knowing exactly how they tasted, and that therefore they had to be worth what she had paid. No prizes for guessing which of them is an economist.

We economists know a lot about pricing, but we tend to be baffled by the way the rest of humanity thinks about it. The package holiday offer, “Kids go free to Disneyland”, is, to an economist, a profitable attempt to charge more to couples with two incomes and no children, who are likely to have more cash to burn. To everyone else, it is an idea waved through unquestioningly.

How a pricing policy is presented clearly matters – which is disconcerting to economists, who can translate all the pricing into mathematical equations and make the presentation irrelevant. It seems to be acceptable to charge a higher mark-up for fair trade coffee, organic bread or lower-emission petrol. It is not acceptable for businesses to say, “we are such fans of exploitative coffee, pesticide-laced loaves and dirtier petrol that we’re willing to discount them and accept a lower profit margin.” Underneath the gloss, the pricing policies are, nevertheless, identical.

The most common puzzle of all, to an economist, is why prices so rarely rise in the face of a shortage. There was a shortage of Wii games consoles last Christmas, Xbox 360s in 2005, PlayStation 2 consoles before that, and so on, yet the retail price remained the same. To secure tickets for a hot concert, you will usually need to go to a ticket tout, because the regular concert promoters wouldn’t dare charge a price that might bring demand down to the level of supply. And when US oil companies raised gasoline prices after Hurricane Katrina, there were howls of outrage – despite the fact that the refining infrastructure was badly damaged and it was self-evidently impossible to supply everyone at the customary lower price.

I have pondered before the very clever explanations economists produce to explain why prices do not rise to equalise supply and demand. Perhaps ticket prices are kept low to encourage a memorabilia-buying younger crowd. Perhaps popular restaurants like to have a waiting list for reservations because it adds to the cachet. Even I am starting to feel that these explanations sound strained: are these side-benefits really enough to outweigh the lost revenue from higher prices?

The intuitive explanation, of course, is that we irrationally object to high prices even when the alternative is rationing, long queues, and uncertainty over whether we can buy what we really want.

That is discomfiting for economists, but we might at least take solace in the idea that even though there is no immediate logic to a belief in the right price, there is at least an evolutionary logic. David Friedman – son of the late Milton Friedman, and a superb communicator of economics – has argued that our ancestors evolved in an environment where most transactions were one-on-one bargains. A hard-wired refusal to accept something other than the customary price would, in such a setting, be an advantage. Anyone who reacts to a price rise with irrational rage turns out to be a strong negotiator.

Our stubborn preference for a just price evolved in a setting that is no longer common; but evolution does not respond quickly, which may be why we still shriek with outrage at price hikes. It would also explain why ticket touts still make a living.

Also published at ft.com.