The Price of Everything Read online

  Walmart drove supermarkets to despair when it expanded into groceries in 1988, offering prices 15 to 25 percent cheaper than the competition. The opening of a Walmart supercenter caused sales at other grocers in the neighborhood to fall 17 percent, on average, according to one study, amounting to $250,000 worth of forgone revenues each month. To remain in business, its rivals were soon forced to follow its lead. A study of retail prices in 165 cities across the United States between 1982 and 2002 found that the opening of a new Walmart in the long run forced rivals in the area to cut prices on products like aspirin, shampoo, and toothpaste by 7 to 13 percent.

  Like most businesses, Walmart cuts prices only when there are competitors around. One study found that it charged 6 percent more in Franklin, Tennessee, where it had virtually no competition, than in Nashville, where it had to compete with rival Kmart. Critics argue that Walmart decimates communities, forcing local retailers into the ground. The company’s relentless push for the cheapest products has driven many suppliers to relocate to low-cost China, contributing to the decline of American manufacturing. Still, Walmart’s competitive drive has definitely benefited Americans in their roles as consumers. Its impact has been so powerful that, according to one study, the Department of Commerce overstates American inflation by about 15 percent because the sample it uses does not include Walmart’s low food prices.

  KEEPING COMPETITION AT BAY

  In 2005 Detroit’s automakers—General Motors, Ford, and Chrysler—used a novel tactic to unload their bloated inventories and revive their flagging finances. They offered customers an unprecedented deal to buy a car at the same discounted price they usually reserved for employees. When GM launched its “Employee Discount for Everyone” program in June, sales jumped 40 percent. When Chrysler launched its “Employee Pricing Plus” in July, it sold the most cars ever.

  But upon closer inspection, the promotions weren’t such a great deal. A study by economists at the University of California, Berkeley, and the Massachusetts Institute of Technology found that many cars could have been purchased for less before the employee discount program was launched. For a majority of GM and Chrysler models, and a substantial share of Ford’s, customers paid more in the two weeks of the promotion than they could have in the two weeks before its launch. They were simply told they were getting a bargain and they believed it.

  If competition is a consumer’s best friend, corporations’ favorite countervailing strategy is to keep consumers from figuring out where they can get the best available deal. Unlike the competitive utopia described in economic models, where consumers can effortlessly compare competing products to make their choices, the real world is plagued with what Nobel laureate George Stigler called search costs. It is difficult for consumers to find out what a given product costs in all the shops in town—let alone everything available on the Internet. It is even tougher if the goods are not identical. This is a shortcoming that businesses can exploit.

  For many companies, evading competition is a question of survival. Makers of everything from cars and computer chips to shoes and TV sets experience what is known as increasing returns to scale: each additional microchip costs less to make than the preceding one. Companies can obtain raw materials and parts more cheaply the more they buy. They also share the cost of investments in machinery and the like among more products, reducing the cost per unit. This dynamic presents companies with a challenging conundrum: competition, when operating properly, would drive the price of TV sets and microchips relentlessly down until they were barely above whatever it cost to make the last one. If this were to happen, makers of chips and TV sets would go out of business. At that price, they wouldn’t be able to recover all their costs. Fortunately for them, there are ways to wriggle free to some extent from competition’s constraints. One of the best-known techniques is to make it difficult for customers to understand where they can get the best value for their money.

  At the Fairway supermarket in Brooklyn where I take my son shopping on weekends, the pricey organic section is segregated from everything else, lest a price-conscious shopper decide to get the cheaper plain cereal this time. Similar items are strategically placed far from each other across the vast space, discouraging price comparisons. There’s fancy fresh cheese at a counter on my way in and cheap packaged varieties on my way out. There are at least two different sections for cold cuts and for olive oil. Prepared pasta sauces of different brands seem to be peppered throughout the store. Even fruits are segregated.

  Frequent sales and markups also serve as tools to keep customers from working out where the cheapest box of cereal is sold. A study in Israel of four similar products sold across a range of stores from 1993 to 1996 found an enormous variation in prices. Not only did the same can of coffee or bag of flour cost more than twice as much at the most expensive store as at the cheapest; it wasn’t always cheapest in the same store. Retailers kept moving the prices around to keep shoppers on their toes.

  Even the Internet, a technology that was meant to empower the twenty-first-century consumer by allowing us to compare prices around the world at the click of a mouse, can cloud consumers’ understanding. Online retailers of computer chips will muddle product descriptions and offer dozens of different versions to make it tough to comparison shop. They add large and hidden shipping and handling costs, surround products with a cloud of add-ons that have to be stripped out, and offer low-quality products to lure customers to their Web sites and, once there, get them to upgrade.

  Some retailers have even figured out how to trick the shop-bots used by price search engines to make them think they are giving the product away for free and appear at the top of the search rankings. Rather than foment transparency, the Internet has encouraged retailers to cheat. Whoever offered a decent product at a fair price would be buried under a pile of “cheaper” superspecial offers by less honorable rivals.

  SEARCHING FOR FOOLS

  The killer tactic to identify and reel in the highest-paying customer in a crowd remains the auction. Auctions are designed to find the customer who places the highest value on whatever item is on the block. Daniel Kahneman, the Israeli psychologist who won the Nobel Prize for economics for researching the behavioral quirks that can lead our economic judgment astray, called auctions a tool to “search for fools.” That’s why sellers love them but buyers don’t. A 2006 poll of private equity firms found that 90 percent of them preferred to avoid auctions when buying a company, but 80 to 90 percent favored using them when selling one. The fabled American investor Warren Buffett never omits the warning in Berkshire Hathaway’s annual report: “We don’t participate in auctions.”

  They are not necessarily a bad deal for buyers. But buying at auction can be tricky when the value of what’s for sale is unknown. For instance, consider a government auction for the right to exploit the airwaves or drill oil wells. If all the bidders know what they are doing, chances are the average bid will reflect the value at which the average oil company or telecommunications firm could profitably exploit the rights. But that means that the winning bid—which will necessarily be above average—will exceed this value. If this is the case, the odds are high that the winner will lose money. That’s why it’s known as the winner’s curse.

  The auction, however, is not the only technique available to lure high-paying consumers. In fact, corporations have many subtle and elegant ways to segregate them according to their willingness to pay and exact a higher price from those who value their items most.

  Consider, for a moment, how people shop. According to a study of Denver shoppers, families that make more than $70,000 a year pay 5 percent more for the same set of goods than families making less than $30,000. Singles without children pay 10 percent less than families with five members or more. Families headed by people in their early forties pay up to 8 percent more than those in their early twenties or late sixties. Retirees are much more careful shoppers than middle-aged people. They search dutifully for the best deal and end up paying nea
rly the same amount for the same product. People in middle age, by contrast, buy more carelessly. The prices they pay are thus all over the map.

  These patterns arise because of differences in the way people value time and money. Time is relatively more valuable to the rich, who already have money, than for the poor who don’t. A janitor in New York making $11 an hour will likely prefer an extra $20 than an extra hour of leisure. A lawyer who makes $500 an hour, by contrast, would probably choose the free time. This affects how each of them will shop. The lawyer will be less inclined to spend hours comparison shopping and instead will pay the first price she sees. The janitor, by contrast, will be more willing to spend a little time to clip coupons, shop around, and get a better deal.

  The value of our time also rises with age. That’s because wages increase as we proceed on our careers, gain expertise, and acquire seniority. The number of hours in the day, by contrast, does not. As any parent will admit, time actually contracts when one has children competing for attention with household chores, shopping expeditions, and a job. Time is at its most scarce and expensive around age forty-five, when wages and job responsibilities peak while families still have children living at home.

  Companies exploit these differences. They charge more for basic staples in supermarkets in rich neighborhoods than in those frequented by lower-income shoppers. Rebates and coupons allow them to sell the same good at two prices—one for poorer coupon clippers and another for the rich who couldn’t care less. The technique can be used to discriminate between all sorts of people with different costs of time.

  PEOPLE DIFFER ALONG dimensions beyond age and wealth. Companies try to target these differences to sell their product to as many customers as possible, extracting from them the maximum price they are willing to pay. Examining the 2008 Zagat restaurant guide for New York City, two economists discovered that restaurants rated as romantic or with a good singles scene charged up to 6.9 percent more for appetizers and up to 14.5 percent more for desserts, relative to the cost of the main course, than did restaurants classified as good places to have business lunches. The reason, they surmised, could well be that couples—if they liked each other—would linger and order an appetizer, perhaps a dessert. It would be unromantic for either to make a fuss about the price. So a restaurant could charge them relatively more for these “romantic” items on the menu.

  The technique—called, appropriately, “price discrimination”— is ubiquitous. What else is the student discount at the bookstore, or the cheap matinee ticket on Broadway? Books are published in pricey hardcover months before their paperback edition to capitalize on those who can’t wait to read it and will pay more to get it faster. Apple launched an eight-gigabyte iPhone at $599 in June of 2007, to capture the early adopters who would pay anything to be among the first to have one. Two months later it dropped its price to $399.

  Airlines are masters at selling seats on a plane at vastly different prices. They honed their techniques over more than thirty years trying to fill flights that cost the same to operate whether they are empty or full. In 1977, American Airlines was the first carrier in the United States to try the gambit, offering cheaper “Super Saver” tickets that required advance purchase and a minimum stay of seven days or more to lure price-conscious leisure travelers. Price variation exploded after airfares were deregulated in 1978, setting off intense competition as airlines strove to fill as many seats on their planes as they could. For a quarter century their most famous technique was the Saturday-night stay rule, used to segregate price-conscious tourists from business travelers who could expense the ticket and would pay anything to get home before the weekend. Today airlines have up to twenty different prices for seats on the same flight, depending on when and where the ticket was bought, how long the trip will last, and several other dimensions. Tickets with restrictions on the days of travel cost about 30 percent less than unrestricted tickets. Travelers who buy their ticket less than a week in advance pay 26 percent more than those who buy it at least three weeks ahead of time. Passengers who stay over a Saturday night pay 13 percent less.

  It’s a profitable tactic. A study of thousands of pop acts from 1992 to 2005 found that concerts that offered different ticket prices for different sections earned 5 percent more revenue than those that didn’t, drawing a more lucrative mix of fans with cheap tickets in the nosebleed section and expensive seats in the front rows. Discrimination works better in cities that are richer and for artists who are older because they generate a more diverse audience: older and wealthier fans who have followed the band since the early days and young new ones who will go hear a band of old-timers provided tickets are cheap. It is now the norm: In 1992 more than half of all gigs sold all seats for the same price. By 2005, only about 10 percent did so.

  Some schemes to charge consumers according to their willingness to pay don’t work. In the late 1990s Coca-Cola experimented with a vending machine that would automatically charge more for a Coke on warm days. But when Coke chief executive Doug Ivester revealed the project in an interview with the Brazilian news magazine Veja, a storm of protest erupted. The Philadelphia Inquirer slammed the idea as the “latest evidence that the world is going to hell in a hand basket.” An editorial about the idea in the San Francisco Chronicle was titled “Coke’s Automatic Price Gouging.” Pepsi saw the opening and announced it would never “exploit” its hot customers. Ivester defended the plan. He told Veja, “It is fair that it should be more expensive. The machine will simply make this process automatic.” Still, Coca-Cola dropped the idea.

  The Internet is likely to bring price discrimination into every corner of our lives. In September of 2000, Amazon.com was caught offering the same DVDs to different customers at discounts of 30 percent, 35 percent, or 40 percent off the manufacturer’s suggested retail price. Amazon said the differential pricing was due to a random price test. It denied that it was segregating customers according to their sensitivity to price, which could be gleaned from their shopping histories recorded on their Amazon profiles. But ever since the incident, consumer advocates have warned that the reams of personal information that people give away when they search, shop, and play on social networking sites online will allow companies to finely tune their prices to fit the profiles of each customer. The less price sensitive, for instance, would be offered pricier versions of articles at the top of a search list. Bargain hunters could be presented with cheaper alternatives first.

  The practice isn’t evil. Companies prone to economies of scale in competitive businesses often depend on it to raise their average unit price in line with their average unit cost. If they sold everything at the marginal price—the price it cost to make the last single unit—they would not be able to cover their fixed costs and would go out of business. And it can be beneficial to consumers. If Cokes were all sold at the same price, a consumer who would have appreciated a Coke on a mild autumn day if it had been slightly cheaper won’t buy it, forgoing what, for him, would have been a profitable acquisition. Allowing Coca-Cola to charge more on hot days and less on mild days would allow more consumers to indulge their taste for a Coke.

  Still, price discrimination alone cannot rescue a flawed business model. Airlines prove that it does not even guarantee profitability. For all their efforts at price management, competition has pushed airfares down by about half since 1978, to about 4.16 cents per passenger per mile, before taxes. Most of the major carriers have spent some time in bankruptcy. In terms of operating profits, the industry as a whole spent half the decade from 2000 to 2009 in the red.

  PROTECT US FROM WHAT WE BUY

  The understanding of humanity as a set of rational beings able to accurately evaluate costs against benefits, striving to maximize their well-being, remains immensely popular among economists. It is a bedrock belief of the conservative movement in the United States: if we understand our own preferences better than anybody else does, there is no reason for the government to butt into our decisions. It has powerful corollaries. We c
an’t be second-guessed. If we buy something for a given price, it must be worth at least that much to us. The market price of any given thing is the best approximation the world has of the thing’s real value to society.

  The belief is not empty. It provides a reasonable approximation of real people in many situations. For instance, it provides a satisfactory explanation of why we prefer things we choose to things other people choose for us. Joel Waldfogel, an economist at the University of Pennsylvania, approached a bunch of university students and asked them to compare the value of presents they received with things they had bought themselves. To make the answers comparable, he asked for the minimum amount of money they would demand to give the items up. A total of 202 students responded, providing hypothetical prices for 538 things they had purchased themselves and 1,044 items they had received as gifts. Mr. Waldfogel found that people value what they bought about 18 percent more, per dollar spent, than what they got as a present.

  As we will see in subsequent chapters, the model of rational humanity is a powerful tool that can help us understand the behavior of men and women in many walks of life. Yet, at the end of the day, belief in the inerrant ability of our choices to communicate our preferences is inconsistent with how we actually behave. As some of the prior examples might suggest, people often make decisions about prices and values that, upon careful consideration, are inconsistent or shortsighted. We change our minds and rue our actions only minutes later. We knowingly overindulge. We prize what we have more than what we don’t.