Sunday, February 21, 2010

The Economics of Perception (wow, I don't often get this polemical)

"Lisa, I'd like to buy your rock."
-Homer Simpson

Imagine two people, Person A and Person B, in a world where there are only two goods: pumpkins for eating, and yo-yos for entertainment.
Person A is really good at growing pumpkins. His pumpkin growing skills are such that he can grow and harvest a pumpkin for a marginal cost of $1 each. He is less skilled at manufacturing yo-yos, however, and if he were to try, would incur a marginal cost of $5 per yo-yo.
Person B is not so good at growing pumpkins. If he were to try to grow a pumpkin, he would incur a marginal cost of $5. But he's a yo-yo manufacturing maniac, incurring only $1 of marginal cost per yo-yo.
Person B is hungry one day, so he goes to Person A and says, "I'd like to buy a pumpkin." Person A, says, "that'll be $6" and person B responds, saying: "Six Dollars! are you kidding, I can grow a pumpkin myself for cheaper than that!" Before person B can storm off, person A says, "OK I'll give it to you for $4," and B says: "you've got yourself a deal." Person B gets his pumpkin, and person A gets a margin of $3 to use to buy more yo-yos, and produce more pumpkins in the future.
Person A is bored one day, and wants to add a new yo-yo to his collection, so he goes to person B and says "I'd like to buy a yo-yo." Person B, says, "that'll be $6" and Person A responds, saying: "Six Dollars! are you kidding, I can manufacture a yo-yo myself for cheaper than that!" Before Person A can storm off, Person B says, "OK I'll give it to you for $4," and A says: "you've got yourself a deal." Person A gets his yo-yo, and person B gets a margin of $3 to use to buy more pumpkins, and produce more yo-yos in the future.
As in this example, in market economies a buyer will pay a seller a price to do something that is, (taking all costs into account, including opportunity costs) too costly for the buyer to do himself. The price will be greater than or equal to the seller's marginal cost of production (or procurement), and less than or equal to the buyer's marginal cost of obtaining that object through any other means, either through self-production or buying from a different seller. Often, because of the complexity of products, self-production is not an option, so in this case the upper limit on the price a seller can charge will be the price offered by competing producers.
Another factor in determining the price is harder, if not impossible to quantify. This factor is the purely psychological valuation of different goods and services. This value varies from person to person, and within the mind of each individual person, can vary from time to time. If there were a magical brain measuring device to give readings of exactly what people are willing to pay for different items, we could find a measurement of the mean dollar value that a group of people are willing to pay for a good or service. Let's denote this unknowable value with the letter V.
So, if the upper limit of prices is determined by the prices of competitors, what can an individual seller do to make abnormal profits? One method is to try to increase the unknowable value, V, to a level higher than the price of competitors. This can be done through marketing efforts that improve people's perception of your product, without actually changing your product. On an individual level, this can take the form of person to person salesmanship, or on a wider level through mass media advertising. The more the collective perception of value can be shifted upwards through marketing efforts, the higher the price can go.
This is how companies can sell junk for high profits, like the snake-oil diet drugs and herbal "neuroboosters" that can be seen advertised on TV. You'll probably see some zero value junk advertised at the sidebar of this very blog as you are reading this article.
Prohibitions against false advertising are a precondition for a well functioning market. Purely deception based industries are at best zero-sum activities, and at worst they can be truly harmful scams that drag people into economically dangerous situations, as in cases where deceptive contracts tie people to huge outlays of money for nothing valuable in return.
I strongly believe that all purely deceptive industries need to be shut down by regulators, not because I feel a sense of outrage on behalf of people who get duped, but because there are opportunity costs society faces from the existence of such industries. If people can make a living through deception, they will turn away from, (and turn their victims' dollars away from) useful industries. To give a functional definition of "useful", I say that a product is useful to people, if knowing all necessary information about the product, they would still want to use it.
What if Person B comes to Person A looking to buy a pumpkin, and person A says: "I don't grow pumpkins anymore, I produce and sell Neurobooster Pills" and with great salesmanship, sells person B the pills, but they're really just tic-tacs. Is this economic efficiency? In an economy where regulators allow this to happen, resources will be wasted as consumers engage in trial and error to verify the truth. And the capabilities of the information age do not make things better. Today, there is an unprecedented access to information, both true and false. This is the age of tremendously useful online encyclopedias and journals, as well as the age of fake Yelp reviews and SEO tricks. The internet can be both a font of wisdom, and an echo chamber of lies.
Regulators must shut down scam artists, not just to protect their potential victims, but also to lead business people down the path to the real, not just perceived, creation of value, not wasteful industries of subterfuge, salesmanship and fine print.

Remember, if you get scammed, don't just sit there, report it to the Federal Trade Commission.
Check out the FTC website:
There's lots of information on different scams, from job scams (a truly booming industry) to phony diet pills, and using the website it's really easy to report a scam to the FTC. There's even a little cartoon to explain how to report. Don't keep quiet, it's your civic duty to our economy!