Monday, 14 September 2009

Value, price, fMRI and consumer surplus

Mark Thoma posts an interesting article from EurekAlert about some Caltech research. The researchers set out to solve the free rider problem by measuring people's real valuation of public goods.

The classic problem with public goods is that if you ask people what the service is worth, they have an incentive to lowball their answer. I may claim that a new railway line, or the NHS, is worth only £10 a year to me. That way, I am likely to pay lower fees or taxes for it, and since I think that lots of other people will put a higher value on it, the government will build the railway and keep funding the NHS regardless of my feelings.

It's the same dynamic as in the tragedy of the commons; no matter what I do, the behaviour of all the other people will determine whether the good is provided. My action won't make any real difference to the outcome, so I may as well act selfishly.

The consequence, however, is that if everyone claims to put a low value on the outcome, the government may ultimately decide not to build the new railway line. Society ends up with less infrastructure than it really wants.

So the Caltech experiment sets out to measure the real value that people put on public goods, in order to work out how much of them should really be provided. In a brilliant example of glossing-over-the-details, they "simply" put people in an fMRI machine and measure their true valuation of public goods.

I do have two quibbles* with the article, but I want to explore a different point so they are in a footnote.

In any case, it apparently worked. The researchers were able to find the real value that people place on public services, and this allows the public to make a fair and economically efficient decision about whether to build a highway and how to make people pay for it.

So far so good. Econproph, a commenter on Mark's post, raises an intriguing question:
In private corporate hands, the same technology could be used by a monopolist or differentiated monopolistic competitor to achieve perfect price discrimination. All our surplus now belongs to the corps.
Scary, perhaps? But let's explore it a bit more.

We need to look at how the relationship between customer and supplier is going to evolve in the future. In the past, these have held each other at arms length. The supplier created a product, placed it on a shelf, priced it, and waited to see if the customer would buy. If they didn't, then the price was cut until they did. If it went too low, the supplier would stop making that product.

Nowadays, most commercial forces are bringing the relationship closer. Information technology allows (and therefore requires) more personalisation of goods and services; competition drives more specialisation and smaller niches.

In this context, if the customer keeps their motivations and valuations secret, they may not get the best product available.

Imagine there are two providers of delicious Russian vodka - brand leaders Ripoff and Stealichnaya - both of which can produce it at a cost of £10 and currently sell it at £15 (the £5 difference is their return on invested capital, and can be maintained due to the fixed costs incurred by any competitor entering the market with no sales volume on day 1).

Now imagine that a typical consumer really derives £25 of value from a bottle of vodka. This means that they gain a consumer surplus of £10 (the value they place on it, minus the cost they pay).

If the individual maintains the pretence of only getting £15 of value, then the story stops here. They secretly get £10 of surplus - maybe a little more in the future if a new type of potato reduces production costs - but that's it.

However, if Stealichnaya finds out the consumer's real valuation they have two choices. They could try to put prices directly up to £25. If we have a competitive market, that won't happen - but admittedly that's a big assumption. Still, let's assume it is true for now. Let's also assume that Ripoff has not got the fMRI data and competitively keeps its price at £15.

The natural course of action for Stealichnaya is to try to differentiate its vodka by adding extra value up to the value of £25. Perhaps they can offer free shot glasses, or send an attractive Russian blonde (of whichever is my preferred gender - let's assume they can figure that out from the fMRI too) to my house to deliver the bottle.

In order to be willing to pay the full £25 rather than buy a £15 bottle of Ripoff, I must gain at least another £10 of consumer surplus from the enhancements. Let's say the enhancements are worth £12 to me; so I am willing to pay £25 for £37 of value, gaining £12 of consumer surplus.

To make this worthwhile for Stealichnaya, they have to be able to offer the enhancements for a cost of less than £10. It's quite likely that they can, especially with their overheads and marketing costs already absorbed in the cost of the original bottle. And if I allow them to understand my desires and personal situation, they have the perfect opportunity to design something of high value to me.

So by revealing my genuine valuation to a supplier, I offer them - provided there's a competitive market - the ability to give me extra stuff which is worth even more to me than the higher price that they now want to charge. The economy as a whole generates extra economic profit, so even the taxman is happy.

Key caveats:
  1. As Econproph says, this does not apply in monopolistic or monopolistically competitive markets. All the more reason to keep markets competitive.
  2. I have glibly assumed that Stealichnaya can easily come up with £12 of enhancements for a cost of £8. This is not necessarily true; but if it isn't, then we are simply left with the old situation where they sell the bottle on its own for £15. I do believe, however, that there is great scope for suppliers to add value in this way.
This is definitely not the end of the story on this subject, and the case for revealing true value is in fact much stronger when a service is custom-designed for the individual consumer. More later when I have time to write up a model for that scenario.

* First, the following quote:
...for decades it's been assumed that there is no way to give people an incentive to be honest about the value they place on public goods while maintaining the fairness of the arrangement.
Rather an overstatement.

Second, how on earth do they measure people's real valuations with a fMRI machine? I can't really see how this is even possible with current technology. Most likely, they used a clever game theoretic design to make people
think the fMRI machine worked, and thus give the subjects an incentive to be honest. Remember that scene from The Wire?

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