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Senin, 24 November 2008

The Law of Supply and Demand Sucks

Adapted from Dan Ariely's Predictably Irrational
Chapter 2: The Fallacy of Supply and Demand: Why the Price of Pearls-and Everything Else-Is Up in the Air

Trade has a very important function in society. It has been practiced since the ancient world. Suppose our world recognizes only two goods, apples and oranges. All of us have our own preferences to apples and oranges. Because of the differences of our preferences, the trade occurs. It is because I like oranges more while you like apples more, I trade my own-grown apples for your oranges. Using this orange and apple world, classic economics believes that free trade can maximize our utility. Free trade can maximize the world's wealth! Unlike the classic school, behavioral economics challenges this belief.

In free trade, the aggregate supply of oranges and apples and the aggregate demand of both are supposed to create an equilibrium. In such condition, using the concept of calculus, any classic economist can readily prove that the total utility (wealth) is maximized. This belief is now fiercely challenged. How come? Dan Ariely proves that demand is no way independent from supply. He conducted social scientific experiments before coming to his 'odd' conclusion. The simple underlying concept he discovered is what he calls anchoring or imprinting. Preferences or demand can easily be manipulated by introducing a sort of anchor.

The anchor can significantly influence our willingness to buy at a certain price level, relatively close to the anchor. If the anchor is high, we are willing to buy at a high price level. If the anchor is low, we are willing to buy the very same product at a low price level. One experiment conducted by Dan to his students was a poetry recitation by himself. For one group, he offered them money for listening to his recitation of short, medium, and long poetries, each having different levels of prices. For another group, he demanded money from them for listening to the same poetries. Different levels of prices too.

The result? Well, the prices offered or demanded by Dan indeed determined the behavior of each group. On the one hand, the group offered the money actually demanded money from the transactions, with different levels of prices according to the length of poetry recited. On the other hand, the group demanded money for listening to the poetry were indeed willing to pay at different levels of prices depending on the poetry length. It was the very same sets of products. The only different was only that one group were offered money and the other were demanded money, both at different levels of prices. The pre condition prior to the transactions functions as the anchor!

Can we change our anchor easily? Dan Ariely conducted another experiment. He invited his executive students to listen to three types of annoying sounds. One group were suggested a ten cents compensation. The second group were suggested a ninety cents compensation. As you may guess, the first group indeed demanded a low level of compensation, in average close to ten cents. The second indeed demanded a high level of compensation, in average close to ninety cents. The story does not end here. The very same people of each group then were invited to repeat the experience, but now with a different anchor, fifty cents. The first anchors, ten cents for the first group and ninety cents for the second group, prevailed regardless the introduction of the new anchor. Even when the first group were introduced the ninety cents anchor and the second group were introduced the ten cents anchor, the first anchors of each group - i.e. ten cents for the first and ninety cents for the second group - prevailed!

Probably you would think that it is irrational. Yes, indeed, we human are irrational. Not randomly, but predictably. We are like baby geese that imprint the first objects they encounter as their mothers. We are like baby geese that stay with the same mothers (the first anchors) although along the way they meet other adult geese (new anchors). How irrational!

Despite the fact that we tend to stay with the same religion because we herd ourselves, a new anchor actually can convert us to another religion if the new anchor really comes with a very different product and perception. The success of Starbucks competing with incumbents, like Dunkin' Donuts, can be attributed with its initial penetration to the market using a very different delivery concept of drinking coffee. It is continental coffee. It is premium, high price. It is served not in small, medium, or large cups, but served in tall, venti, or grande cups. It is not served with donuts but with croissants.

The success of the king of pearl, Asael, in selling black pearls royally out from almost nothing can also be attributed with this anchoring mechanism... Are you ready for this? With an arbitrary anchor! After failing in his marketing effort a year before, Asael came back with a very high price tag for the pearls, penetrating New York's high class market.

Now we know that our preferences can easily manipulated by the introduction of anchors. Now we know that our behavior can be shaped arbitrarily. The anchors can be the manufacturer suggested retail prices (MSRPs) or even arbitrary numbers like the last digits of our own social security numbers. So if your behavior is coherent following some sorts of patterns, do not be proud, since the coherent behavior can be just arbitrarily coherent. This also suggests that we do not really know our preferences and utility. Under this irrational circumstance, in my opinion, it is irrational to believe that free market - the law of supply and demand - merely can maximize our utility, our happiness.

I am not saying that the basic principle of supply and demand is completely wrong. However, an extreme ideology that recognizes governments with no roles whatsoever in the (free) market should reconsider its postulates. As Dan Ariely writes, probably we need to find elsewhere a way to maximize our wealth. Our utility! Our happiness!

Next: Free, Good or Bad?
Prev: Relativity and Rationality

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