Tuesday, July 28, 2009

Prices ARE arbitrary

In "Predictably Irrational" the author talks about how a price can be anchored to an arbitrary number. He sets up experiments where he suggests a random number (your social security number for instance) and then has you assign a price to some object. The astonishing effect (you are meant to be astonished) is that the price people assign is influenced by the random number. Proof positive that people are irrational and prices arbitrary.

He is right, prices are arbitrary, but they are not irrational. Prices are the expression of our individual preferences and those preferences are arbitrary. At it's root all economic activity consists of bartering, i.e. trading. I have something you want and you have something I want. We then negotiate a certain "price", a quantity of one for the other, and trade. There is nothing absolute in this interaction, no set "price". The value I place on the items I am trading is completely arbitrary. Someone else may have totally different preferences and negotiate a completely different "price". In fact, in that simple example both parties value the traded items differently. There is nothing irrational about it.

We go to the store and look at prices and think that those prices reflect some underlying value. Not true. Value is in the eye of the beholder. There is no such thing as an absolute value of anything. Just individual preferences expressed in the form of actions. Not all prices reflect our individual preferences. I won't go and buy a Mercedes for the price charged. Does it mean it is overpriced? Yes and no. It is overpriced to me because I won't pay that much, but someone else will.

Individuals differ in their preferences. Prices reflect aggregated preferences. This means that not all prices will reflect the value that people place on those objects. Some will be high, some will be low. None will be irrational in any meaningful sense.

Another thing to consider is that our preferences are not entirely consistent. Can I say with surety how much an apple is worth to me? What would I give for an apple today, tomorrow, next week? Maybe my circumstances change, maybe I become sick, is the apple worth the same in those situations? We don't know ourselves and our preferences as well as we think. Next time you go to purchase a new flat screen television just try and figure out exactly how many apples it is worth to you?


Geoff said...

That book sounds really interesting. Can I borrow it when you are done?

I'm unsure about whether you are agreeing with the author or not though.

"Proof positive that people are irrational and prices arbitrary.

He is right, prices are arbitrary, but they are not irrational."

Are you saying that the author is suggesting that _prices_ are irrational? Or are you making an altogether different observation?

Adam Freund said...

If I remember, sure you can borrow it. Otherwise you will have to remind me. I don't agree with the author. He is making the statement that because prices are not consistent and can be manipulated (only to some degree I might add) that they are irrational. If you read the book you will see that he uses the results of his narrow experiment to conclude that the free market doesn't make any sense.

If this is not clear, the point I am trying to make is that prices, i.e. the value we place on things is arbitrary because that value is an indivuduals valuation. The mere fact that we trade is proof positive that people don't value things the same way.

Geoff said...

I really think you did a great job on this article. Excellent.

Phillip said...

Solid post Adam.

An interesting example of the pricing scheme is that Coke developed machines that would charge more on hot days than on cold days, which fits perfectly with your point of how personal value varies daily. It was an unpopular measure, so Coke pulled the plug on those machines. I do know that there are times when I would drop 5$ on a frosty cold beverage though -- but it is never irrational.

I am hoping to hear more about this text as I agree with the premise of the title, that we cannot assume a rational actor, but I thought it would be in the context of a somewhat rational actor.

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