Micro-Institutions Everywhere: Prices

Today they seem so commonplace. You walk into a supermarket, or a shopping mall, or a gas station, and all of the diverse products for sale have one thing in common: a fixed price, there for all to see. You can walk in, get what you need, pay for it, and walk out without having to negotiate. We take it for granted today but this has not always been the case. Imagine how much longer a simple grocery run would take if you had to discuss the price of every item on your list. This points to a role of prices that many take for granted in our modern economy. Prices convey information.

The information that prices convey is subtle. In a free market, no one really “sets” prices. True, an entrepreneur can charge whatever she wants. But try setting the price of gas at $10/gallon and see how much you sell. Set it at $2/gallon and see how long your supplies last. (If these prices seem quaint, future readers, note the date on this post.) This is what Adam Smith called the “invisible hand” of the market. Smith also pointed out that prices have very little to do with what we might call “value.” Think of how essential water and diamonds are to your everyday life, compared to what you pay for them.

Some small businesses nowadays are doing away with fixed prices, and going with a “pay what you will” (PWYW) model. I encountered this last fall at the Durham Farmer’s Market when I purchased some Irish Soda Bread from a company whose name I do not remember. (Notably, I’ve not seen them at the market since.) When I inquired about price, they told me their PWYW model. I pressed for more information, so they finally gave me a range of $2-6 per loaf. I took the mean as an estimate and paid $4, but left wondering whether I had over- or under-paid. There’s also no way of knowing what the actual distribution of payments looks like. Without a fixed price, I was woefully uninformed.

The Economist recently discussed the PWYW phenomenon, with evidence from a recent set of psychological experiments. Researchers ran three experiments on the price that participants were willing to pay for a photo of themselves on a roller coaster. The main finding is that people’s choice of price is related to concerns about their self-image. The second concerned different levels of fixed prices relative to the PWYW model:

As expected, demand for photos rose when the price dropped from $15 to $5. But it fell again when people could pick their price. Again the researchers suggest that an overly low price can feel unpleasantly parsimonious. In contrast, “when the company sets the price at $5, there is no ambiguity about fairness, self-image concerns disappear and people are happy to pay.”

It would also be interesting to note the amount of time taken to complete the purchase when customers had to name their own price. This is one of the benefits of prices as a micro-institution: I can decide immediately whether the item is “worth” the price being charged, make my decision, and move on. The overall time savings for a national economy are tremendous.

This topic has implications for my views of open source software and PWYW music (both of which I support) that I will have to work out in a future post.

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Note: This post takes a simple, Econ 101 view of prices. The real subject is more complicated, as evidenced by the fact that many brilliant economists since 1870 have spent their entire careers thinking about this problem. The simplicity is an indicator of my relative ignorance on the topic, not of hubris.