Everything You Think You Know is Wrong

Thursday, September 3, 2009 | Bob De Dea

"Only free men can negotiate. Prisoners cannot enter into contracts." -- Nelson Mandela

"The free man is he who does not fear to go to the end of his thought." -- Leon Blum

In The Atlantic magazine last week, Richard Posner wrote of "the fatal flaw of economics." Two British economists, in an unprecedented letter to Queen Elizabeth II, spoke of the inability of analysts to foresee the financial meltdown as "a failure of the collective imagination of many bright people."

In other words, nobody could say what they saw, much less predict the future.

Posner suggests that standard economic theory does not take into account "messy realities that don't lend themselves to expression in mathematical models or are intractable to formal analysis."

In our first article in this series, "How Not to Get Suckered into Anything," I made the bold statement that the traditional approach to economics may just be pie-in-the-sky. It's built on the assumption that we are rational beings who are capable of making the right decision, and acting in our own best interests, by carefully weighing our options and choosing according to our likes and dislikes.

But the new discipline of behavioral economics is troubling the waters by showing us how far afield we can go when it comes to our application of judgment and our process of decision-making.

Adam Smith Got it Wrong

If something goes awry in the market -- if something irrational occurs out of the blue -- the idea that market forces will come in to correct the imbalance is a central tenet of historic economic thinking.

But is it still a useful way to look at markets?

I'm going to go out on a limb here and say, emphatically, "No longer."

Here's a picture of how the market is supposed to work:

Production at each price point (SUPPLY) is contrasted to
the willingness to purchase at each price point (DEMAND).

Supply and demand, it is assumed, are independent of one another. They battle it out to arrive at the market price for a commodity, security, service or product.

In part one, I pointed out, however, how easy it is to manipulate the consumer into a particular anchor price. Common anchors are the Manufacturer's Suggested Retail Price, a sale price, an introductory price, an advertised price, or the initial public offering (IPO) price.

You might recognize that all of these are supply-side variables.

As a result, "instead of consumers' willingness to pay influencing market prices, the causality is somewhat reversed, and it is market prices themselves that influence consumers' willingness to pay. What this means is that demand is not, in fact, a completely separate force from supply."¹

The Way We Were

The truth is that memory, not preference, determines the relationship between supply and demand. Here's an illustration, courtesy of Dan Ariely, a professor of behavioral economics at Duke University.

Milk vs. Wine Consumption: Current
Cost	Gallons per Year Consumed
$3/gallon	20
$10/bottle	5

If we were to tax or otherwise affect the price of these two beverages so that there was an increase in the price of milk and a decrease in the price of wine, we might find our consumption changed to something like this:

Milk vs. Wine Consumption: Supposed
Cost	Gallons per Year Consumed
$6/gallon	15
$5/bottle	15

Now, let's say we induced a state of amnesia in the populace, so that they didn't remember the previous prices for milk and wine. It's likely that their consumption would not be noticeably affected. In other words, the demand for both items would remain the same.

But because we DO remember what each used to cost, we are sensitive to the price changes and -- here's the most-important part -- it's not because our true preferences or our need for the products (i.e., level of demand) have changed. It's just the way we perceive the new price in light of the old one.

Of course, over time, people do adjust to new prices. (Bottled water or caramel macchiatos, anyone?) So, despite what we think would happen were the price of gasoline to approach worldwide levels, in time a $6-per-gallon price tag may not help to curb demand.

Necessary Evils and Good Government

If we were completely rational beings, supply and demand would work flawlessly. Given that we're not, the free market is not entirely free of influence by "baser" or less-desirable behavior.

For example, since we know that stock prices are fairly arbitrary, the value of a security is quite literally the aggregate perception of the investing world, heavily influenced by the big players manipulating the public's perception, because they can.

That's why regulation is necessary, to protect us from inefficiencies and the incessant greed that can overcome rational behavior.

A limited free enterprise is certainly more-desirable than a completely unregulated market free-for-all because, as we've seen, the market can never quite be trusted to self-correct completely.

Admittedly, we would hope that any regulation of the market is itself thoughtful and reasoned. (Is this too much to ask?)

Nothing From Nothing Leaves Nothing

Speaking of free, how about that offer we talked about that you just couldn't pass up? A buy-one-get-two-free promotion, a 30-day free trial, a buy-something-get-10-other-things-free with it deal -- it truly costs you zilch, nada, zip, nothing.

Or does it?

If reading about getting something free increases your heart rate, you're not alone. Zero, it turns out, is "an emotional hot button -- a source of irrational excitement."²

Another experiment for your consideration:

If you saw a booth set up in a public place with the above signs, which would you go for?

If you're like 73% of the people who saw this display, you would probably opt for the greater value -- 15 cents for a fine Swiss Lindt truffle. If you're like the other 27%, you'll opt for the Kiss.

Now, what if the prices were changed?

Cost-benefit analysis (a foundational idea in standard economic theory) says that the customer will behave the same if the price differential is unchanged. In other words, the difference in the cost between two items, as long as the difference remains the same, should be irrelevant.

But look what happens when the 14-cent difference is maintained but the price of one item drops to zero:

So much for cost-benefit analysis, huh?

If something is truly free -- like a used couch on the sidewalk -- it's usually a no-brainer. We assess the condition and the design and, thus, the value ... and we decide whether we want it. Trouble begins when a free item is compared to another similar item, as in the example above.

The beauty of behavioral economics is that such irrational judgments are, believe it or not, predictable, which means that the field of economics is due for an overhaul.

An overhaul that won't be free, but one that should prove enlightening, to say the least.

(Please let us know what you think about Bob De Dea's article.)
Rate his article here »

Bob De Dea
Chief Investment Officer
<>