Sunday, 23 March 2008

A different view of price formation

Well, I decided I'd better get Dan Ariely's book Predictably Irrational after being fairly impressed with his talk at LSE last week. I'm already a fair way through it and it's proving to be quite a fun read. A slight criticism would be that I think his version of 'traditional economics' is a bit of a straw man.

There's been nothing ground-breaking for me yet, though it's useful to hear how some of the insights from behavioural economics have demonstrated in experiments. For example the accounts of various experiments focusing on the impact that anchoring has on our view of prices really do get across the point that a lot of the time our ideas of what is 'cheap' or 'expensive' are pretty arbitrary. Therefore I think he is right to argue that the irrational way we respond to prices should make us think more about price formation.

Here's an excerpt from towards the end of the second chapter:

"[A]ccording to the standard economic frameowrk, consumers' willingess to pay is one of the two inputs that determine market prices (this is the demand). But as our experiements demonstrate, what consumers are willing to pay can easily be manipulated, and this means that consumers don't in fact have a good handle on their own preferences and the proces they are willing topay for different goods and services.

"Second, whereas the standard economic framework assumes that the forces of supply and demand are independent, the type of anchoring manipulations we have shown here suggest that they are, in fact, dependent. In the real world, anchoring comes from manufacturers' suggested retail prices, advertised prices, promotions, product introductions, etc. - all of why are supply-side variables. It seem then that instead of consumers' willingness to pay influencing market prices, the causality is somewhat reversed and it is market proces themselves that influence consumers' willingness to pay. What this means is that demand is not, in fact, a completely separate force from supply."

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