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ECONOMICS

Book World: Steven Pearlstein reviews Priceless by William Poundstone

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By Steven Pearlstein
Sunday, January 17, 2010

PRICELESS

The Myth of Fair Value (and How to Take Advantage of It)

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By William Poundstone

Hill and Wang. 336 pp. $26.99

Cost. Price. Value. These words are often used interchangeably. We tend to assume that, in competitive markets, the price for purchasing something is roughly aligned with the cost of producing it, plus a modest profit. And because we presume that markets do a pretty effective job at matching supply with demand, or incorporating all that is known about a particular asset, or divining that sweet spot between what people are willing to sell something for and what others are willing to pay for it, there's a tendency to equate market price with intrinsic value.

All of these assumptions, in fact, are fundamental to the way most economists understand the world. They are the foundation for measuring output and productivity. And they are the key variable in most economic models, from the simplest supply and demand curves to complex macroeconomic models. But how would all that change if cost and price and value weren't so tightly aligned? What if some market participants were at a dramatic information disadvantage relative to other? Worse yet, what if buyers and sellers were heavily influenced by totally extraneous factors or emotional demands that somehow got in the way of their maximizing their economic self interest?

What would happen is that economics as it was traditionally understood would be turned upside down and inside out.

Indeed, that's exactly what has occurred over the past two decades as economists have come to understand and acknowledge that markets are a lot less than perfectly competitive, and economic actors a lot less rational, than economists had always assumed.

Much of this work now goes under the banner of behavioral economics, which has been the subject of a number of best-selling books in recent years, as well as a number of recent Nobel prizes. Much of behavioral economics, in turn, has focused on the seemingly crazy ways in which people and prices interact. In his new book, "Priceless," William Poundstone offers a thoroughly accessible and enjoyable tour of this research.

Although not an economist, Poundstone is an engaging intellectual historian who traces the development of behavioral economics from its roots in the 1960s in a discipline called psychophysics, an offshoot of psychology. Over the years, the raw data for this research have come mostly from laboratory experiments, which usually involved asking groups of randomly selected graduate students to play games in which they decided at what price they were willing to buy or sell something, or to chose from a set of gambles, each with a different risk and payoff.

The most important of the early insights was that there was a law of diminishing returns to money -- that to most human beings, the pleasure of finding a $50 bill lying on the street was not, in fact, five times the pleasure of finding a $10 bill. From there it was only a short leap to determining the price at which people are willing to buy or sell something. What matters most, it turns out, is not the absolute price but the relative price -- how it compares to something else we know about. If that top-of-the-line Prada bag in the window is going for $1,100, then this other one here must surely be worth $400. Or are both prices absurd?


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