I suspect that the price changes would make a huge impact on demand if people remembered the previous prices and noticed the price increases; but I also suspect that without a memory for past prices, these price changes would have a trivial effect, if any, on demand. If people had no memory of past prices, the consumption of milk and wine would remain essentially the same, as if the prices had not changed. In other words, the sensitivity we show to price changes might in fact be largely a result of our memory for the prices we have paid in the past and our desire for coherence with our past decisions—not at all a reflection of our true preferences or our level of demand.
The same basic principle would also 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 with their anchor, would be flabbergasted by the new prices, and so might pull back on their gasoline consumption and maybe even get a hybrid car. But over the long run, and once consumers readjusted to the new price and the new anchors (just as we adjust 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. Moreover, much as in the example of Starbucks, this process of readjustment could be accelerated if the price change were to also be accompanied by other changes, such as a new grade of gas, or a new type of fuel (such as corn-based ethanol fuel).
I am not suggesting that doubling the price of gasoline would have no effect on consumers' demand. But I do believe that in the long term, it would have a much smaller influence on demand than would be assumed from just observing the short-term market reactions to price increases.
ANOTHER IMPLICATION OF arbitrary coherence has to do with the claimed benefits of the free market and free trade. The basic idea of the free market is that if I have something that you value more than I do—let's say a sofa—trading this item will benefit both of us. This means that the mutual benefit of trading rests on the assumption that all the players in the market know the value of what they have and the value of the things they are considering getting from the trade.
But if our choices are often affected by random initial anchors, as we observed in our experiments, the choices and trades we make are not necessarily going to be an accurate reflection of the real pleasure or utility we derive from those products. In other words, in many cases we make decisions in the marketplace that may not reflect how much pleasure we can get from different items. Now, if we can't accurately compute these pleasure values, but frequently follow arbitrary anchors instead, then it is not clear that the opportunity to trade is necessarily going to make us better off. For example, because of some unfortunate initial anchors we might mistakenly trade something that truly gives us a lot of pleasure (but regrettably had a low initial anchor) for something that gives us less pleasure (but owing to some random circumstances had a high initial anchor). If anchors and memories of these anchors—but not preferences—determine our behavior, why would trading be hailed as the key to maximizing personal happiness (utility)?
SO, WHERE DOES this leave us? If we can't rely on the market forces of supply and demand to set optimal market prices, and we can't count on free-market mechanisms to help us maximize our utility, then we may need to look elsewhere. This is especially the case with society's essentials, such as health care, medicine, water, electricity, education, and other critical resources. If you accept the premise that market forces and free markets will not always regulate the market for the best, then you may find yourself among those who believe that the government (we hope a reasonable and thoughtful government) must play a larger role in regulating some market activities, even if this limits free enterprise. Yes, a free market based on supply, demand, and no friction would be the ideal if we were truly rational. Yet when we are not rational but irrational, policies should take this important factor into account.
* The price the highest bidder paid for an item was based not on his own bid, but on that of the second highest bidder. This is called a second price auction. William Vickrey received the Nobel prize in economics for demonstrating that this type of auction creates the conditions where it is in people's best interest to bid the maximum amount they are willing to pay for each item (this is also the general logic behind the auction system on eBay).
† When I've tried this kind of experiment on executives and managers (at the MIT Executive Education Program), I've had similar success making their social security numbers influence the prices they were willing to pay for chocolates, books, and other products.
* The result was not due to wealth, taxes, or other financial reasons.
* To ensure that the bids we got were indeed the lowest prices for which the participants would listen to the annoying sounds, we used the “Becker-DeGroot-Marschak procedure.” This is an auction-like procedure, in which each of the participants bids against a price randomly drawn by a computer.
* We will return to this astute observation in the chapter on social and market norms (Chapter 4).
* I am not claiming that spending money on a wonderful cup of coffee every day, or even a few times a day, is necessarily a bad decision—I am saying only that we should question our decisions.
CHAPTER 3 The Cost of Zero Cost
Why We Often Pay Too Much When We Pay Nothing
Have you ever grabbed for a coupon offering a FREE! package of coffee beans—even though you don't drink coffee and don't even have a machine with which to brew it? What about all those FREE! extra helpings you piled on your plate at a buffet, even though your stomach had already started to ache from all the food you had consumed? And what about the worthless FREE! stuff you've accumulated—the promotional T-shirt from the radio station, the teddy bear that came with the box of Valentine chocolates, the magnetic calendar your insurance agent sends you each year?
It's no secret that getting something free feels very good. Zero is not just another price, it turns out. Zero is an emotional hot button—a source of irrational excitement. Would you buy something if it were discounted from 50 cents to 20 cents? Maybe. Would you buy it if it were discounted from 50 cents to two cents? Maybe. Would you grab it if it were discounted from 50 cents to zero? You bet!
What is it about zero cost that we find so irresistible? Why does FREE! make us so happy? After all, FREE! can lead us into trouble: things that we would never consider purchasing become incredibly appealing as soon as they are FREE! For instance, have you ever gathered up free pencils, key chains, and notepads at a conference, even though you'd have to carry them home and would only throw most of them away? Have you ever stood in line for a very long time (too long), just to get a free cone of Ben and Jerry's ice cream? Or have you bought two of a product that you wouldn't have chosen in the first place, just to get the third one for free?
ZERO HAS HAD a long history. The Babylonians invented the concept of zero; the ancient Greeks debated it in lofty terms (how could something be nothing?);