joy of imperfection, The

Markets revisited

By the same token, one of the great challenges to teachers is to help students to build up and retain an analytical toolkit that will help them to produce for themselves 'answers' that not only will satisfy their own curiosity to a reasonable extent but will also withstand the scrutiny of other people's scepticism and, best of all, excite interest and enquiry in those fellow students for whom apathy has been, until then, the order of the day.

One of my favourite posers for a class is "If, as economists would have us believe, consumers are rational beings who seek to maximise the satisfaction they derive from consumption, then why are some consumers willing to pay Ln for a product, when the same product is available for, say, L0.85n elsewhere?" .

In this abstract form, this potentially fascinating conundrum will probably remain a 'turn off for some students until three things have happened.

Firstly, they need to understand the connection between the "If .." and the "then". That's fairly easy to establish. Most will rapidly grasp that for a consumer to maximise satisfaction from spending a given income involves him/her in paying as little as possible for any one purchase, so that as many goods and services as possible can be bought ie the opportunity cost of any one purchase is minimised by buying it as cheaply as possible.

If, at no additional cost to themselves, everyone is willing and able to buy a product where it is cheapest, then there will eventually be only one market price for that product; namely, that cheapest price. So why is that position so seldom reached? Why do different prices for the same product continue to prevail? Those are key questions.

Secondly, the conundrum needs to be couched in contexts with which students are familiar, and with reference to products that interest them and/or which they themselves consume and for which a range of prices obtain eg CDs, chocolate bars, bottled water, cinema tickets.

Thirdly, the question may need to be restated in a form that hits them directly eg "Why did you go to see Zing it Like Zola at the Majestic when it was cheaper to see it at the Essoldo?

Are you irrational, or what?"

For me, market imperfection came to mind again very recently when, in the course of 24 hours, I saw the same frequently-traded product for sale in two places only 50 miles (or 1 hour) apart, but with the price in the one retail outlet being five times the price in the other. Some members of this journal's exalted readership may not find that fact astonishing; but it surprised me, particularly in this day and age, with many of the barriers to local monopolies and market imperfection having been either weakened or dismantled altogether in recent years.

Having set the scene, the rest of this article suggests some of the most fruitful lines of enquiry into "How can this be? Why might a retailer set a price that is different from that set by other retailers? How can different retailers get away for so long with setting different prices from each other for the same good or service?". The factors are presented in no particular order of importance or of likelihood of their being a major or main source of a disparity in any one case.

1 Retailer innocence/ ignorance: The seller is insufficiently aware of the price at which other retailers are trying to sell the product, and has no cheap or easy way of finding that information. Also, his/her perception as to the nature and/or worth of the product is awry. In these circumstances, his/her asking price is based on a combination of (a) a standard mark-up, linked to the price at which the seller has obtained the product and (b) the seller's (misinformed/misguided?) perception of what a typical customer is likely to be willing to pay.

2 Retailer local monopoly: The seller is well aware of the price at which the product typically sells elsewhere, but is sufficiently free of local competition to be in a position to 'charge what the market will bear' ie the selling price is related not so much to the retailer's costs as to local incomes and tastes. The retailer is relying on somebody coming along who either is unaware that the product can be obtained more cheaply elsewhere or who lacks the will or the means to take advantage of that fact.

There is an important distinction between 'will' and 'means'. Some people know that a product is cheaper elsewhere, and would like to take advantage of that fact, but are not in a position to do so eg the rural poor, who lack cars, public transport and kindly, considerate neighbours. Others have the means (eg a car) but lack the will; they can't be bothered or don't consider it worth the time/money/effort to buy elsewhere.

3 Disparities in the value that different consumers place on money: There are wide discrepancies in people's disposable incomes. The amount that people are willing to pay for an item is often linked rather more to the proportion of their income that the price represents than to its actual price. Thus, a 40p orange will seem easily affordable to some people, and unaffordable to others. A consumer's perception of 'dear' is related not only to a view on what a product might have cost to produce and make available for sale, but also to his/her own ability to afford it. Retailers in prosperous areas can therefore afford to risk setting prices that are higher than those looked for by retailers in areas where incomes are low. Consumer affluence and lethargy will do the rest.

4 Disparities in retailers' costs etc: A retailer's asking price reflects not only the cost to the retailer of buying-in that product but the size of the contribution that the retailer requires the product to make towards the covering of business overheads and to the overall profitability of the business. Different retail outlets have different overhead costs that are reflected in prices charged. They may also have different levels of ambition regarding profits and the return on capital employed, and this will be reflected in the size of the mark-up they deploy. They may also have different cash flow requirements - one retailer can allow the item to remain unsold for a considerable time, and so prices it accordingly, whilst the other sees the item mainly as something that is taking up shelf space and tying up cash, and wants to move it on as soon as possible.

5 Absence of regulation or control of the market place: The product is being sold in a market over which no body exerts effective control or influence. Thus, there is not a dominant manufacturer or provider who is in a position not only to insist (covertly and probably illegally) on resale price maintenance couched in the guise of 'recommended prices', but also to refuse to supply retailers who are unwilling to 'conform'. Nor is there a regulatory body or 'watchdog' with a remit to monitor and prevent either overcharging or predatory pricing. Nor is there a buyers' cartel intent on forcing all suppliers to supply at the same low price.

6 Consumer

innocence/ignorance: Some consumers are willing to pay high prices because they have no 'feel for the market': they have little or no knowledge of prices elsewhere, and little or no concept of what might constitute a reasonable price.

This is one form of 'market friction' and 'imperfect knowledge' that has diminished dramatically in recent years. It would be hard to overstate the extent to which modern consumers are better placed than their forebears to obtain market data. Nearly all of them can read and most have access to newspaper advertisements, to leaflet drops through doors, to telephones and to specialist retailer directories. Increasing numbers have access to the Internet, and the ever-increasing wealth of price information available on-line. There is less and less excuse for many consumers to claim that it was lack of information that obliged them to pay more than they wished to pay or might have paid.

7 Consumer desperation:

Consumers sometimes pay up 'here and now' because they have reached desperation stage and time is running out eg the dog won't stop barking for his supper, and it is more important to silence him than to delay purchase by buying dog food more cheaply elsewhere. This action constitutes rational consumer behaviour, by the way. Peace has its price and its value, and can sometimes be worth paying that bit extra for.

8 Consumer/producer immobility and the cost of search and find:

For consumers it is one thing to know that prices are cheaper elsewhere; it is quite another to be in a position to take advantage of that fact. There are very real costs (in both time and money) associated with searching, finding and obtaining, and these may nullify any price advantage. And so the price differences remain.

There are also costs for sellers in looking to place items in markets where higher prices obtain. On one occasion, an Aberdeen antiques dealer said to me of something I was hoping to buy from him: "I could get twice this price for it in London, you know." "OK, you go and do that, then!" I replied. He was right, of course; he could have done. But he didn't. He sold the item to me; and both he and I knew why.

Not all 'searches' and pursuits of lowest prices are as straightforward as they may first seem, however. Every Sunday afternoon, one of my elderly friends used to make a 60-mile round trip into the countryside in his car in order, so he said, to buy a dozen cheap free range eggs.

In summer this pursuit appeared to be rational; he and his wife enjoyed the outing, which was part of the package and worth paying for too.

In wicked winter weather, however, his conduct appeared irrational, if the trip really was solely in pursuit of cheap eggs, as he claimed.

I noticed, however, (but was careful not to say) that in winter his wife did not accompany him on these trips. I formed the view that what at first looked like irrational consumer behaviour on his part was in fact wholly rational given what appeared to be the real reason for his taking himself out of the house. I also gained the impression that his wife placed a similar value on her husband's absence; so both were rational consumers, and the eggs continued to be cheap at the price.

9 Transport/delivery costs: It is not enough for consumers to discover where goods are cheapest and how to obtain them from that source without having to visit the source themselves. They need free delivery too.

Mail order often looks comparatively cheap until the costs of postage and packing are included. With valuable goods, there is the additional cost of insurance. Little wonder, then, that pet shops, for example, manage to survive at a local level and that their pricing is not standardised. A bird in the hand is worth two in Shepherd's Bush, often literally. Has anyone ever bought an exotic goldfish or the like using mail order? If so, at what extra cost for P&P?

On the other hand, there are some economic activities in which the costs of delivery have been reduced dramatically, and a formerly huge market imperfection has thereby been virtually removed.

Thus, for example, 20 years ago it was important to publishers that their proof readers and editors were comparatively close at hand. So, other things being equal, London-based publishers tended to place their work with nearby freelancers, who could get away with charging a rate higher than their rural counterparts. Not any longer; e-mail has changed all that. With editing and proof reading, what matters more these days is not where one lives but how good one is at doing the job. Charging a premium price because of geographical proximity is a dying art.

The same is true for some other services. Legal advice, for example, can come 'down the line'. Services that consist largely of 'providing information and/or advice' can now base themselves almost anywhere that has a good, cheap phone line. With differences in delivery costs virtually removed, consumers can shop around not only nationally but globally in search of best value. It seems very likely that price differences will increasingly reflect for the most part the differences in perceived service quality and reputation and not delivery costs.

10 Products are similar, but not identical, in fact or in the eyes of the potential consumer: There's more to a film than the film itself. The total experience is the product, and consumers differentiate between cinemas in terms of what they offer besides the film.

The same argument goes for a measured glass of branded cider in a particular pub, and for the particular retail outlet in which you buy that branded dress, that branded coat, that branded bottle of perfume, that branded pair of contact lenses; and even for that branded seat on an aircraft flying between Luton and Paris. The price charged reflects not only the product bought but other elements that go with that purchase eg the ambience of the retail outlet, the service element and the conditions to the purchase, including attached forms of payment, and rights to cancel, postpone, return, or exchange.

That concludes my 'target of ten' factors that lead to a range of prices for the same product. A good class will between them suggest them all, and look to the teacher to embellish them. If you feel that I have missed something really vital, then do write an article that makes your case.

In the 'price difference' experience I met last week, the main factors that explained the marked price discrepancy were 2, 3 and 6. There was also a little of 10, but it was 'inverted'; the subtle differences that existed between the two products should have narrowed the gap in their respective prices, not widened it - the cheaper one was actually the more desirable. As for 4, there were marked differences in the overheads of the two retailers, but again they were inverted: the 'high pricer' had overheads that were less than those of the 'low pricer'.

And which of the two retailers, you may ask, had the product priced 'about right', if they were profit maximisers looking to make a sale that day at the best price they might reasonably expect?

The answer is 'Neither of them'. The cheap one was marked at half the typical market price, as I understood it to be, and the other at 2.5 times that price; it failed to sell on that day. Unsurprisingly, I bought only the cheaper one, and (joy of joys) at a price rather less than I would have been willing to pay if I had been required to do so.

And, finally, who was probably the main 'victim' of my bargain purchase, given that I was buying a secondhand item that the retailer had 'bought in'? And what part did market imperfections, and imperfect knowledge in particular, play in bringing about that scenario?

Clearly, the joys and pains of market imperfections are not confined to economics classrooms. It's in the classroom, however, that the real joy of teaching the key ideas is to be found, year after year, within contexts that are continually changing.

Copyright Economics and Business Education Association Summer 2003
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