By Steven Pearlstein
Sunday, January 17, 2010; B06
The Myth of Fair Value (and How to Take Advantage of It)
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?
In setting prices, social context also matters. The most famous of the games used by behavioralists is the ultimatum game. The researcher puts $10 on the table in front of two subjects. The first is told to propose how he intends to split the $10 between them, with the understanding that the other person has the choice of either accepting the proposed split or vetoing it. If there is a veto, however, neither side gets any money, and the game is over.
In the rational world of theoretical economics, the proposer would maximize his income by giving himself $9 and leaving $1 for the responder, because even at that point the responder would wind up richer than if he exercised his veto. But in real life it turns out that proposers and responders aren't just rational income-maximizers, but are also guided by some sense of fairness. As a result, the average proposal in most Western cultures ends up being somewhere between $4 and $5, and it is rare for a responder to accept an offer of less than $3.
Poundstone, however, tells of more recent research done by Elizabeth Hoffman at the University of Arizona. Hoffman came up with the brilliant idea of doing a variation on the ultimatum game that offered the proposer complete privacy -- nobody would know the split that any one proposer had offered. I won't bore you with how she altered the mechanics of the game to offer this anonymity. What's important is that when she tried it, 60 percent of the offers were "greedy" ones. What matters most to people, it seems, isn't being fair or altruistic so much as being perceived that way by others.
Poundstone recounts many of the most notable experiments by Amos Tversky, Daniel Kahneman, Herbert Simon, Richard Thaler, Vernon Smith, George Loewenstein and Daniel Ariely -- experiments that prove beyond any shadow of a doubt that most of us haven't a clue of what most things are worth in absolute terms. In one experiment, a group of students is quite eager to accept free tickets to a poetry reading when told that each ticket sells for a couple of dollars. But when a second group is told that some students are being paid to attend the reading, almost nobody is willing to volunteer to attend without compensation. In other words, one group is anxious to attend the poetry reading, the other not so much, the only difference being the context in which the offer is presented.
The power of suggestion also extends to negotiation, where the party making the first offer inevitably gets the upper hand, no matter how unrealistic that offer might be, simply because it subconsciously becomes the reference point for all that follows.
Then there's the question of how much you would be willing to pay for a cold bottle of beer brought to you while you're sitting on a beach on a hot day. In one experiment, a group of people said that they were willing to pay as much as $6 for a beer purchased from a bar at a fancy hotel. But when asked how much they would be willing to pay for the very same beer if it was purchased from a small convenience shack, they typically were willing to pay only half that amount.
While the economics profession has come to all this irrationality reluctantly, Poundstone shows that marketers have been using it to their advantage for years. Retailers long ago learned that using 99-cent prices works like a charm when selling some items but not others. And every TV huckster knows how to increase both sales volumes and prices just by throwing in lots of free add-ons that cost very little and that most people wouldn't have purchased anyway. As for those unlimited wireless calling plans, most people would do better paying by the call, but prefer them anyway because there's no pain or guilt associated with making any particular call.
Readable as "Priceless" may be, very little in it is new. The researchers themselves have written books laying all this out, many of them not only just as accessible as Poundstone's but also a good deal more incisive about the psychology behind it all. And at times, the organization of Poundstone's exposition seems haphazard and repetitious. The reader also waits in vain for Poundstone to tie it all together and assess the broader implications for the economy, or the study of economics or much of anything else. "We spend our lives searching for the lowest price, the highest salary, the most money -- numbers by which to validate our happiness," Poundstone says. The problem, he suggests, is that these numbers are neither as precise nor as meaningful as we assume.
It was more than a century ago that Oscar Wilde famously observed that "people know the price of everything and the value of nothing." In "Priceless," we now have the proof.
Steven Pearlstein is a business and economics columnist for The Washington Post.