Nation of Beancounters

Behavioural Economics has Less to Say About Supply and Demand than It Thinks

Posted in Uncategorized by Navin Kumar on July 15, 2010

I’m re-reading Dan Ariely’s Predictably Irrational and I’m thoroughly enjoying the insights into human behavior. Nonetheless, I’m becoming increasingly skeptical of how much value the field of behavioral economics is adding to the understanding of how economies behave.

In a chapter titled “The Fallacy of Supply and Demand”, Ariely talks about anchoring. When a person is asked to think about a fairly random number (say, the last two digits of his Social Security number), he will end up “anchored” to that number and it influences his future choices. A person whose last two digits are 89 will bid higher in an auction than a person whose last two digits are 14. He’s conducted quite a few experiments of this kind.

He presents a few real life examples, such as James Assael’s marketing of black pearls: he priced them outrageously high and published photos of them next to precious gems, anchoring peoples view of their value higher than their pure appearance warranted (the first time he tried to sell them, they bombed).

Experimental validation, check. Real-world examples, check.

But what is his submission at the end of it?Ariely is a bold man. He presents his idea as a shot at nothing less than the theory of demand and supply.

This [the theory of supply and demand balancing to create a price] is an elegant idea, but it depends centrally on the assumption that the two forces are independent …  as our experiments demonstrate, what consumers are willing to pay [which is what determines the demand at each price] can be easily manipulated, and this means that consumers don’t in fact have a good handle on their own preferences and the prices thay are willing to pay for different goods and experiences.

…Anchoring comes from manufacturer’s suggested retail prices (MSRPs), advertised prices, promotions, product introductions etc.- all of which are supply side variables. It seems then that instead of consumer’s willingness to pay influencing market prices, the causality is somewhat reversed and it is market prices themsselves that influence consumers willingness to pay…demand is not, in fact, separated from supply.

The idea that advertising creates supply is hardly a new one, but I really wonder if it’s as easy as Ariely believes it is. The sheer number of new products and restaurants that bomb as well as the old marketing joke “We know half of all advertising expenditure is wasted. We just don’t know which half” suggests otherwise. This, however, is a topic for another day.

The true test of any theory, however, is in it’s falsifiability. Theories expound a set of predictions about how physical or social entities will behave and if any of these predictions are false, the theory is false. So if apples start floating to the moon, the theory of gravity will have to be revised.

Ariely, boldly puts forward some real-world implications: he believes that since anchoring plays such a huge role, a change demand due to a change in prices depends upon our knowledge of the previous price. If the price of milk is doubled, but we don’t remember the initial price (due to a bout of amnesia), we’d continue to buy the same amount.

The same basic principle would apply if the government one day decided to impose a tax that doubled the price of gasoline . Under conventional economic theory, this should cut demand. But would it? Certainly, people would initially compare the new prices, and so might pull back on their gasoline consumption and maybe get a hybrid car. But over the long run, and once consumers readjusted to the new price and the new anchors (just as we adjusted to the price of Nike sneakers, bottled water, and everything else), our gasoline consumption, at the new price, might in fact get close to the pretax level.

The problem with this is that real life observations are exactly the opposite: people are slow to change their behavior and consumption in the short run (when Ariely expects them to be shocked into buying a hybrid) but in the long run, their behavior changes. They consume less fuel. Walk down the road instead of using a car. Stop buying SUVs and start buying Priuses. In Geek, we say that elasticities of price (the amount by which demand changes in response to price changing) are greater in the long run than in the short run. This is one of the reasons that OPEC couldn’t keep the prices of oil high. They cut oil production  in the 1970s resulting in a quadrupling of oil prices and an enormous accumulation of wealth and political power for themselves. But as people changed their behavior, demand fell, resulting in the oil glut of the 1980s.

Another counter-example can be drawn from international economics: the J curve. When a country starts importing more than it exports (in a fixed exchange rate) it runs the rick of running out of foreign exchange to pay for it’s exports. Thus it may devalue it’s currency – making it’s currency (and therefore it’s goods) cheaper to foreigners and imports expensive for it’s citizens. This, it is hoped, will ease improve the balance of payments (the difference between the exports and imports, which must be met by building up or running down ForEx reserves in a fixed exchange  rate system).

It is hoped that by encouraging foreigners to buy cheap domestic goods and by discouraging citizens from purchasing now-expensive foreign goods, the demand for foreign currency will go down and therefore the ForEx reserves will not be run down. It does so, eventually, but the demand for ForEx initially increases.

This happens because people are slow to change their buying behavior. They continue to purchase expensive foreign goods but since they are now more expensive, they have to pay more for them. Thus the amount of foreign currency required increases. Eventually, habits change and the pressure eases.

If Ariely was right about people’s memory of prices being the main driver of their behavior, one would expect oil demand to go down quickly and then slowly rise after an increase in prices. One would expect demand for foreign goods to decrease immediately and then rises slowly after a devaluation. This does not happen, which means that while the anchoring heuristic, while doubtlessly extant, does not play as large a role in real life as Ariely imagines. Inertia seems to be far more influential.

Perhaps, a note should be made on things like Nikes, Macs, bottled water and black pearls. All of these are more advertisements of wealth and social status than functional goods, which is why advertising and perception affects them so much. I doubt anchoring will affect something like the demand for oil or staplers.

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