It’s counterintuitive that falling prices can be bad. After all, nobody ever complained about stuff being cheaper. The problems, though, are twofold. First, if prices fall across the board, so too will wages — but debts won’t. Borrowers will have a harder time making their payments. More of them will default. And defaults will push down prices and wages even more. This so-called debt deflation is basically a doomsday machine for mass bankruptcy — and it’s exactly what happened in the 1930s. The other way of thinking about why deflation is so toxic is that it effectively increases interest rates just when we want to reduce them. What matters for borrowers is the real interest rate: that is, the interest rate minus inflation. But falling prices mean inflation is negative, so real interest rates go up. Again, bad for borrowers.
Actually, falling prices aren’t bad at all, especially if they are coming down after having been artificially inflated. This is how the market clears itself. Will some get hurt by this? Yes, especially those who foolishly bet on the bubble expanding indefinitely. But this was always a bad bet from the beginning; declining nominal prices merely reveal this fact.
Now, it is generally true that lower prices will lead to lower wages, all things being equal. But, as long as there are generally efficiency gains in labor, the rate of decline in regards to the price of goods should be greater than the decline in regards to the cost of labor. As long as production efficiency is realized in some way, declining wages should not be a problem because they generally will not decline as much as product prices. Caveat: this analysis is predicated on the assumption that there is no expansion in the money supply. Monetary inflation complicates analysis considerably, at least in terms of nominal price, but does not invalidate the fundamental point.
That debts won’t deflate is theoretical nonsense. In the aggregate, debt will most certainly deflate because a certain number of people will inevitably default on their loans. Others may settle their loans in lieu of default. The practical outcome is that deflation will hit debt. And those that get hit the worst by deflation will be those who most encouraged the bubble by loaning to those who caused it.
The conclusion that this will lead to some sort of doomsday scenario is absurd on its face, for it is obvious that aggregate demand will never be zero. Humans always want something, and they will pay to get what they can. And so, while it is most certainly true that practical aggregate demand will decline considerably in the wake of deflation, it is simply farcical to even suggest that aggregate demand will go to zero, or even be cut in half.
Ultimately, deflation is the markets way of cleansing itself, allowing misallocated resource to be used more effectively. Once the market begins to clear, prices rise again until there is once again an optimal mix of resource usage. Trying to prevent nominal deflation from occurring only encourages the continued misallocation of resources, and makes the inevitable pain worse, while also allowing for the possibility of rampant inflation. Thus, preventing deflation is nothing more than a lose-lose proposition, and a fool’s errand to boot.
Some people would rather rub a raw onion in their eye then try to understand economics. That is unfortunate because the basics of economics are not that hard to understand. The fact is that you and I and everyone else use economics every day of our lives. It is liberating to understand why economic things happen, in the same way that it is liberating to know why a car takes longer to stop on ice or gravel. The essence of politics is the use of economic law to manipulate the behavior of citizens to the will of the politicians. Political motivations become more understandable in that light, though no more moral or justified.
Economics is merely an attempt at understanding the basic laws that work in our lives. It seeks to define and simplify our knowledge of the forces that affect us so we can make appropriate decisions. We similarly use the physical principles of gravity, momentum and force every day of our lives. In both economics and physical sciences, there are relatively few laws, which can be applied in understanding very complex systems. Unfortunately, many modern economists actually add confusion and complexity by repudiating simple economic laws, substituting complex macro-economic theories, mathematical models and personal policy preferences.
With that said, the basic laws of economics are truly straight forward and powerful, and arise from the way that humans act and make decisions. Because the logic of human choice hasn’t changed, the economic laws that governed ancient societies are the same ones that govern our lives today, as well as all future civilizations of any time. We can relate to historical characters from any place on the globe because they acted like we do. Their wisdom and their follies are reflected in our experiences today. All that has changed over time is the technology we use to satisfy our needs and wants.
One of the key concepts in economics is that incentives matter. Humans take specific actions to achieve specific goals. If the incentives change, it will affect the means and the ends chosen by the actors. Related to this is the idea that choices are made at the margin. The law of diminishing marginal utility implies that the higher the quantity of a good a person has, the lower the marginal utility, or value, the next available unit holds for that person. If you are dying of thirst in a desert, you would pay almost any price for the first cup of water. You wouldn’t value the fifth cup nearly as much because your thirst would be quenched. You would value the 1000th cup of water much less because you can’t carry it and it does you little good. It’s marginal utility is very small.
The fact that the current market price for a good is $1 doesn’t mean that everyone is willing to pay a dollar. Some people would have a higher marginal utility and be willing to pay more, while others wouldn’t buy it unless it was cheaper. It only means that, at that price, the number of buyers at the margin, those willing to pay at least $1, are about equal to the number of sellers at the margin, those willing to supply it for $1 or less.
This is typically stated as economic laws of supply and demand. If the price of a specific good is lowered, buyers will be enticed to purchase more. We see this in every day life as retailers so often use discounts and sales to move inventory. If the price is raised, the quantity demanded will be less. On the other side of the coin, suppliers are in business to make profits. It will be difficult to make a profit if prices are too low, and very little will be supplied. As prices increase, it becomes easier to earn money, thus suppliers produce more, and new competitors are drawn to the market. Supply increases with increasing prices.
The incentives for buyers and sellers are at odds, and for every good in a particular market at a point in time, there will be a price where the number of willing buyers about equals the number of willing sellers. Any price above that point will produce an excess of sellers, a glut of goods. Any price below it will produce an excess of buyers, a shortage of goods. That simple relationship is one of the most powerful keys to understanding economic phenomena, whether it is Hurricane Katrina shortages or gluts of labor, more commonly called unemployment. Prices, demand and supply are all mutually dependent and reflect the market environment at a particular time. Imposing an artificial limitation on any of them will have inevitable unintended consequences, often very powerfully.
With this understanding, it is possible to comprehend the bulk of the phenomena occurring in society, and in politics, on a day to day basis. There is a lot more to it, of course. A very important aspect of economic laws and concepts from an overall point of view is that they can help to understand why an economy progresses or regresses over time.
The laws of comparative advantage and division of labor are related and work together in determining the level of productivity and prosperity of an economy. Comparative advantage means that any person, organization or geographic region has specific advantages, whether that is because of natural resources, innate skill, education and any number of other characteristics. If the actors concentrate on those things that they are most productive at and pay other people to do the things they less productive at, everyone will be better off overall. A typical example may be an attorney who may have better secretarial skills than any secretary available. But since attorney’s make a much higher hourly rate than secretaries, the attorney will be better off by doing attorney work than secretarial work. The secretary likewise would probably be better off leaving attorney work to the attorney and concentrating on the areas where relative skills are the highest.
Division of labor is the recognition that everybody has only 24 hours a day. It takes a great deal of time and effort and the right tools to be highly productive in any endeavor. Nobody cannot develop all of the skills and purchase all of the tools needed to be highly productive at all types of activities. People or geographic regions that try to be self sufficient will lead a very poor, difficult life and work very long hours.
A surgeon may be very good with his hands, but will probably hire someone to do his plumbing, carpentry, auto repair and so on. He could probably develop some low level of competence in each of those areas, but in order to do that, he would probably sacrifice very valuable time at which he is most productive. In an advanced society, there is a strong tendency toward specialization because it leads to higher productivity and a higher standard of living.
Because people who specialize are generally more productive, they have more income with which to buy the goods and services of other people. Most people in modern society outsource most of their requirements to other people or businesses. They outsource their food requirements to grocery stores and farmers. They outsource their automobile needs to car manufactures. They outsource their homebuilding needs to experienced carpenters, and so on. By building a high level of competence in one area, you are able to trade with others for the things for which they have built a high level of competence. That is what trade is all about. We outsource our requirements to others who are more highly qualified in those areas, and thus, both sides reap the benefit.
If you define progress in society as that state of affairs where people have to work less hard for less hours in order to provided for themselves and their families, then the higher the level of division of labor and the more people can apply their comparative advantage, the more quickly they will progress to a higher level. The wealth of a society comes from people producing more than they consume. Over time, that wealth can be used for capital investments that enhance the productivity of participants, and thus, further raise their income and standard of living. Societies that restrict trade and inhibit capital accumulation and specialization are those that remain in perennial status of less developed countries.
The laws of economics hold many important lessons on a day to day basis. You can try to disobey them, but it is similar to disobeying the law of gravity. You can step off a tall building and think you won’t fall, but your funeral will be just as sure as if you realized you would fall and die. The most critical lesson that economics can give is that actions have consequences. Good intentions and powerful politicians don’t make a bit of difference. The more we can gauge the true consequences without sentimentality or blinders, the more likely we are to make decisions which avoid the pitfalls and lead us to our goals, as individuals and as a society.
“There is more than one way to skin a cat.” That old saying it is a very appropriate basis for understanding resource economics.
People use particular resources only for the services they provide, not because of any intrinsic value of the resources. People use copper because it conducts electricity or heat, is malleable or displays many other useful qualities. Petroleum is used because it powers vehicles, provides heat, light and power, and can be transformed into a huge variety of plastics and useful chemicals. Iron, gold and, indeed, all physical resources, have certain measurable characteristics which human ingenuity can use to solve the many problems of living healthy, comfortable lives.
Gasoline is only one means to an end. Before the advent of internal combustion engines, there were other modes of transportation which people used, because they were the best, most efficient choices at the time. Horses, mules and wagons provided local transportation services for a long time. The horse was valuable primarily because of the service it provided. When motor vehicles took over their role, horses became less scarce and less valuable, even though their numbers declined.
Whale oil was used for lighting before kerosene. It was very scarce, and thus, very expensive. The dawn of kerosene as a cheap, plentiful substitute for the service of providing light made whale oil too expensive, and it quickly lost out to the new, more efficient rival. Cheap electricity subsequently took over the lighting role played by kerosene.
The idea of scarce resources only makes sense when there is a human use for them. Before the beneficial properties of oil were discovered, nobody ever considered petroleum scarce. It was, rather, a considerable nuisance wherever it was found. The instant that people discovered the valuable products that could be made from it, it became a scarce resource.
A resource is only scarce if there is not enough to provide for all of the demand for its useful properties. Scarcity is relative. It is a function of how much is readily available in relation to how many people want it and the size of the problems it solves. Whale oil may be very rare these days, but most people would not say there is any scarcity of it. We have no need for it because its useful properties have been provided much more efficiently and cheaply by substitutes.
If you want to know how scarce a good is, you only need to look at its price. That is the most reliable gauge of scarcity. In the absence of intervention in the market, the more scarcity, the higher the price. Diamonds and platinum are very expensive because there aren’t enough of them. Their physical characteristics make them very desirable, so people are willing to pay a high price for them. If new sources of supply were found and they became readily available, the prices would drop, not because they were less useful, but because they became less scarce, relative to the demand for their useful qualities.
With that in mind, one of the most fascinating phenomena related to human civilization becomes more understandable. Even as there are more people using more resources year after year, there is less and less scarcity. While prices of resources may fluctuate significantly in the short run, in the long run, there is a very real trend toward falling prices and less scarcity of virtually all resources. There is no credible reason to believe that that trend will suddenly reverse.
That may not be the case in every geographic area for every resource at every time. In some places, resources such as water may become more scarce. From an overall perspective, however, there is no less water in the world than there was a million years ago. The only water we have lost has been from transporting it out of our atmosphere with the space program. The same goes for virtually every other chemical substance on earth. Humans need to locate where there is plenty of usable water, or to efficiently purify it or transport it to other places where they want to go. The problem with water is that people typically think that it should be provided cheaply or for free by government, and thus, market prices do not guide responsible action.
Declining scarcity of resources, even as they are used, makes sense when you recognize that it is not the resource itself, but rather its useful properties, that people buy. If one resource gets too expensive due to scarcity, people use less of it or develop more efficient methods of getting the same benefits. The higher price makes it more profitable, and the higher profits draw competitors to develop more of the resource. The higher price also makes alternative ways of providing for human needs more attractive.
The opposite dynamic occurs in the case of high availability and low prices. Producers develop more efficient methods of production and distribution so they can remain profitable. Those improvements carry over into times of greater scarcity, and the net result is that prices continue to fall over time while long term scarcity declines.
We see those opposing processes happening on a continuing basis. In the case of petroleum products, higher prices encouraged more conservation efforts, more efficient technology and increased exploration and development. It also made alternative forms of energy more profitable and promoted their development. There is less scarcity of oil lately, due to lower demand, and thus, significantly lower prices. Producers are trying to become more efficient in order to stay profitable. Society benefits because the cost of energy is less than it would have been had the consumer and producer improvements not been made over time.
Some day it is possible that petroleum could become the whale oil of tomorrow, becoming too expensive for economical use. But there is more than one way to skin the cat of heating, lighting, transportation and manufacturing needs. The most efficient forms of energy will ultimately win out, and in the long run, the cost of energy will continue its long and relentless trend to less scarcity and lower prices, just like every other form of natural resource throughout the course of human civilization.
As an impartial observer, I’ve often wondered why, when I go to a restaurant in a group and order a dish, do they bring my order along with everyone else’s, and then serve my food that I ordered to everyone on the table! For example, if I order six dumplings, and there are six people in the group, the waiter will casually give each person a dumpling, and I get only one. Whereas I ordered six thinking that I would eat all of them. As a result, my hunger is not satiated.
Also, if I want to eat well, I must have the dishes that others have ordered which I may not like. My wife says that this is good etiquette, and that my not understanding this simple fact highlights my lack of social graces. As a person with a suspicious mind however (and a game theory one at that!), I have a different take on the issue.
When a group goes to a restaurant, either they all share the bill equally or each pays for themselves. It is considered less awkward and simpler if the group (all things being equal), split the bill equally. This means that as an individual, when I want to order something on the menu, the price of whatever I order drops proportionately to the number of people on the table. For example, if an item I want (say king prawns) costs $50, then I will only have to pay $10 if my group has five people.
Now I have no control whatsoever on what other people order. By not ordering anything expensive, I can’t guarantee that others will do the same. Therefore, it is in my best interests to order everything I want without looking at the price since I will never again get an 80% discount! True, others may share my meal, but in an expensive restaurant, you’re usually not paying for the raw materials of the food itself but for the ambiance, the nicely dressed waiters, etc.
Image Credit: Matt and Kim Rudge
Since we assume that each person in the group is rational and is thinking just like me, they will order expensive things too, and so the total bill turns out to be extremely high. A variation of the prisoner’s dilemma actually.
Of course, if it was decided beforehand that each person will pay for what they order, then I will be much more circumspect about what I decide to eat. I can’t afford to pay $50 for 5 shrimps!
Knowing this, it is in the restaurant’s best interests to ensure that everyone shares the bill equally, since only then will each person go berserk with their orders. Therefore, they must operate in such a way that it becomes very difficult to gauge who has eaten what.
One of the ways to do this is to serve everyone’s dish to everyone under the cloak of “etiquette”. In fact, I won’t be surprised if they invented the practice in the first place since and started calling it Good Manners. Good Manners it may be, but it’s also good business sense.
Of course, if you’re a greedy person and want to sample expensive food that you would never normally eat, you must get into a group of people you don’t know very well and who are not very well off. You must then convince them to go to an expensive restaurant so that you will be the only one to order expensive food and make them share the bill. I would assume you can only do this a couple of times before your group started to feel the pinch.
Sometimes however, a person’s personality can be so captivating and charming that others forgive them. Or say you’re a beautiful woman in the company of four men, they will not only forgive you, but fall all over themselves in fighting over your bill. You can then show how independent you are by paying “your share,” when actually you’ve shifted over all the expensive food’s cost to your lackeys!
We learned a few pricing strategies in a previous article about how to make customers self-select and get them to pay as much as they are willing to pay for your product. However, it assumes that all of your customers value your product equally. In reality, your product will be valued differently by different people.
Let’s assume you’re selling jeans and business trousers. The trousers will be of lesser value to a teenager and the jeans, say, will be of lesser value to an office-goer. Ideally, you want to be able to sell to both of these people. But if you set a high price for jeans, then the office-goer will not buy it, and if you set a high price for the trousers, then the teenager will not buy it.
As usual, our most direct strategy will never work. Namely asking the customer what they are willing to pay for it! No. We crafty game people need a more subtle approach.
So what are we looking for in such a strategy? We want to arrange things in such a way that both the office-goer and the teenager will buy both products for as much as they are willing to pay for each. To illustrate this, we need to plug in some numbers.
Jeans – Value to teenager: 100. Value to Office-goer: 50
Trousers – Value to Teenager: 50. Value to Office-goer: 100
Image Credit: inju
Ideally, we want the teenager to pick up both the jeans and the trousers for 100 and 50 respectively, spending a total of 150. We want the office-goer to buy the jeans and the trousers for 50 and 100 respectively. We want both to spend 150, and we want to net 150+150 = 300.
Clearly setting a single price for the garments isn’t going to do us any good since then either the teenager or the business person will end up either not buying it, or paying a lower price than they are willing to pay for it. The strategy to follow is that of bundling.
Bundling means that we package both the garments together and sell the bundle for 150! We wrap them nicely in a plastic bag and indicate that the two are inseparable. Now both the teenager and the office-goer can buy the bundle for a price of 150, paying as much as they would normally be willing to pay for each item. Our net gain is 300, and the office-goer as well as the teenager need never know of our clever manipulation.
There are several instances where certain items are worth different values to different people, and in situations like this, bundling can be very effective. If you remember the days of Nintendo, you would see (and you still do) cartridges that have something like 10,000 games in 1 at a reasonable price. How was this possible? The idea was that some people like certain games more than others. The best way to sell them was to put all the games together and hope that there will be something in the bundle for everyone. Selling them separately meant that almost no one would buy each game individually, but by bundling them, you ensure that you sell all of them.
This approach really works well for software since it is so easy to replicate. For bundling to work, you need to be able to manufacture the goods cheaply as well as have the goods be of varying worth to different people. When used properly , it can be a very effective strategy even for physical goods, just like the jeans and trousers example above.
In 1911, Dr. Miles Medical Co, a maker of relaxants and other medicines, sued a distributor, John D. Park & Sons Co., for selling at cut rate prices. The company lost the case when the Supreme Court held that it was trading too close to cartel-like trading. The judgment in the case Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911) became a precedent in antitrust law and came to be known as Dr. Mile Rule. Under that rule minimum prices manufacturers set on what dealers can charge customers for their products are deemed as illegal per se under the Sherman Act, no matter what evidence might be presented.
This precedent has now been revered by the Supreme Court in Leegin Creative Leather Prods. v. PSKS, Inc., 127 S. Ct. 2705 (2007). The Supreme Court in a 5-4 decision held that minimum pricing pacts between manufacturers and retailers could benefit customers under certain circumstances and should be considered on a pact by pact basis. The pact could foster competition by giving retailers enough profit to promote a brand or offer better services. The Supreme Court upheld the manufacturer’s right to enforce minimum prices on its own products.
Before this judgment, a manufacturer would be violating the antitrust law by punishing or discriminating against a retailer who sells at cut rate prices. This judgment gives the manufacturers new powers and can change the face of discount retailing in the United States. Manufacturers can now require retailers to abide by minimum pricing pacts or have their supplies cut off.
This ruling has in effect allowed price fixing to make a comeback. It undermines the free market by limiting the consumer’s power to decide for himself whether to buy at rock bottom prices from a no frills retailer or pay the full price at a retailer offering better services and other benefits. From a consumer’s point of view, it is very difficult to prove that such minimum price fixing pacts are anti-competitive.
The judgment has failed to consider one important aspect of retail trade – competitive environment. A uniform price might not work for all retailers.
This judgment will most probably result in many manufacturers fixing the minimum price at which the retailers must sell their products. This could feed inflation. Among the dissenting judges, one judge estimated that legalizing price setting could add $300 billion to consumer costs every year.
Manufacturers have welcomed this decision. Many manufacturers look upon discounts as tarnishing their image. Many have used this decision to get price fixing allegations against them dismissed. Cendant Corporation, the owners of Avis and Budget rent-a-cars, was facing price fixing allegations in a case filed in the U.S. District Court in Anchorage, AK, filed by one of its franchisees. The very next day after the Supreme Court’s ruling, Cendant asked the court to dismiss the allegations. The court dismissed the allegations citing the Supreme Court judgment.
Welcome to the new era of legalized price fixing.
Setting a price on your product or service can be one of the most difficult decisions a marketing manager can make. Different people value your product differently. Most of the time, it is impossible to get accurate information regarding the percentage of your target market that are willing to pay a certain price for it.
However, even with perfect information, the pricing question can be very vexing. Say you know full well that 30% of the population is willing to pay a substantially higher price for your product. Setting the value at this higher price means that you lose out on the remaining 70% of your market who are not willing to pay that price. Setting a lower price means that you have wasted the spending power of that 30% who will now pay a lower price than what they were willing to pay.
What we need is a way to charge a higher price for those who are willing to pay more, and a lesser price for those who are willing to pay less. Simply ask each customer how much the product is worth to them, and charge them on that basis!
However, your customers might throw a fit if they realize that they are being charged simply because they are willing to pay more. No one likes to feel that they are paying more than another person who is getting the same service. In addition, customers will have a strong incentive to lie. Just because I’m willing to pay a high amount for a service doesn’t mean that I wouldn’t like to pay less for it.
The way to achieve this differential pricing is to identify customers who are willing to pay less for your product based on their behavior and charge less when you observe that behavior being followed.
Image Credit: washed up
One example is computer gadgetry. When a new computer gadget comes out, those who will only pay a lower price for it (the cheapskates) will not buy it immediately. When it comes to computer gadgets, cheapskates always feel that the prices will come down several months later. Therefore the best strategy for a company that is bringing out a new computer gadget is to charge high prices when the product comes out and deliberately lower those prices for the cheapskates later on.
Those who pay a high price for the gadgets will get bragging rights and the knowledge that they are the first adopters of the technology.
In most cases however, it is very difficult to identify the cheapskates. Fear not. Certain strategies exist that make the cheapskates identify themselves. This is called self selection. Using certain strategies, your firm can cause the cheapskates to unknowingly reveal their true colors. You can then charge them accordingly.
Image Credit: agthom
The strategy cannot be as simple as, “Whoever says that they are too poor to afford this product will get a 15% discount.” If it’s that easy, then everyone will follow it to get the discount. The idea is to make the cheapskates work for their discount. Those who are willing to pay a high price for the service are usually price insensitive and will not bother to go through the extra effort to get a lower price.
For example, several restaurants charge lower prices in the afternoon. Most people enjoy going to a restaurant in the night when they can party with their friends as part of a later plan to enjoy the rest of the evening. However, by offering lower prices at a time of the day when it’s slightly inconvenient, you invite the cheapskates to get your meals at a lower price. There’s no danger of your richest clients coming at this time simply to save a few bucks. For them, it’s simply not worth it. But you manage to get others who would not normally have come to your restaurant.
By making the cheapskates reveal themselves, you cause them to self select and are free to charge them lower prices. The self selection is always implicit instead of explicit. It’s never mentioned that lower prices are being charged for the sake of cheapskates. Pretty sneaky, huh?