The Indian Economy Blog

September 23, 2006

The Correct Price

Filed under: Basic Questions — Amit Varma @ 12:19 pm

Reuters reports that a court in Finland has determined that “[a] fee of 25,500 euros ($32,000) is way too much for a woman to charge a man for fondling her bosom.”

Apparently, a couple charged “a 74-year-old who suffers from dementia a total of 25,500 euros to enjoy the woman’s breasts on 10 occasions.”

Now, if they’re schmucking a gent who is not competent to make his own decisions, that’s a different matter. But I’m intrigued by the judge’s ruling:

Based on general life experience alone, it is indisputably clear that a 25,500 euro charge is disproportionate to the compensation in question.

I am tempted to ask here what would have been a proportionate charge? 5000 euros? 2000 euros? 80 euros? 2 fricking euros?

My point is that there is no such thing as a fixed “correct price” for anything. The right price for any object is determined by supply and demand, and by what the buyer and the seller agree on. The lady in question has a right to demand whatever price she wants for the fondling of her breasts, and the fondler in question has a right to reject or accept that price. If he wants to fondle only those breasts, or if no other owner of breasts is willing to put them at his disposal, then those breasts, and the consent of their owner, acquire a scarcity value. It would then be surprising if the price set wasn’t high.

People make a similar mistake when they complain about the prices of commodities shooting up after a natural crisis. (I myself have been guilty of this mistake in the past.) But natural market prices are the best possible way to efficiently allocate resources at any time.

Consider, for example, what happens when an earthquake runs through a village and flattens most of it. Just one store with foodgrains in it is still standing. The prices immediately shoot up there. “Greed,” we all scream. “The shopkeeper’s making a profit out of other people’s misery.” We might even support a government regulation that fixes the prices of all his foodgrains.

What happens if such a regulation is indeed passed? Why, the first few people who come there buy up much more than they immediately need, to hoard up in case the crisis continues. And most of the people who come after that find no foodgrains at all. This is inevitable: price controls invariably cause shortages. Had the prices been allowed to rise naturally to reflect demand, though, the first few customers would have bought more prudently, and later customers wouldn’t have gone hungry.

In a similar way, to take a Mumbai example from last year, hotels are bound to raise their prices if the city gets flooded and people in the vicinity are stranded and have nowhere else to go. Is this greed? That’s irrelevant. Consider what the raised prices do: two friends who would have taken a double room for the night for Rs 3000 suddenly find that the room is now Rs 10,000. So they get together with two other chappies, and the four of them take the room. So, instead of two people inside and two people outside in the rain or the lobby, you have four people in the room. Efficient allocation of resources? Yes. Profit for the hotellier? Yes, and so what? Without the profit motive, the hotel wouldn’t be there in the first place.

Another classic example is the price controls imposed on gasoline in the US in the 1970s, which led to shortages that finally disappeared when Ronald Reagan lifted the controls. To read about that, in an excellent short piece in price controls, do read Thomas Sowell’s “An Ancient Fallacy: Price Controls.” (Also read “Price controls” by Sowell, “Four Thousand Years of Price Control” by Thomas Dilorenzo, “What price controls really mean” by Lawrence Reed, and “Price Control Fallacy” by Don Boudreaux. And I’d also recommend Sowell’s excellent primer, “Basic Economics,” for more on the subject.

19 Comments »

  1. Amit,

    In basic economic theory, all demand and supply laws are based on the assumption that consumers make rational choices. Herbert Simon has questioned this assumption of course, with his bounded rationality theory.

    The ruling in this case is of course predicated on the fact that the man was suffering from dementia (I wonder how the case came to court then).

    Even then, though the price mechanism is by far the best (and I would say) only way to allocate resources and ensure the best possible social welfare and allocation of resources (and by now, there is a body of empirical evidence to prove it), it is also important to note that there is evidence that price regulation is essential, and often, even beneficial.

    I suppose what the judge means when he says “based on general life experience”, is that empirical evidence has always shown that the price mechanism has led to a price in a certain range, in similar supply and demand scenarios.

    Comment by Arjun Swarup — September 23, 2006 @ 2:57 pm

  2. “…the price mechanism has led to a price in a certain range, in similar supply and demand scenarios.”

    Scenarios of fondling breasts? Heh. :)

    Comment by Amit Varma — September 23, 2006 @ 9:18 pm

  3. Well put. I was referring to the larger, more legalized industry of prostitution.

    Comment by Arjun Swarup — September 23, 2006 @ 9:57 pm

  4. Well, this doesn’t seem to be a case related to that, it’s just about fondling, not, um, you know. In any case, as I mentioned in the post, the gentleman’s alleged dementia doesn’t concern me, I was simply referring to the judge’s comment about the inappropriateness of the price.

    The general points you raise in your first comment are best answered with reference to specifics, and it’s pointless discussing them in general terms. That is why I gave those illustrations of the harm price controls can do, as well as those links. Would you like to cite some of the “evidence that price regulation is essential, and often, even beneficial”?

    Comment by Amit Varma — September 23, 2006 @ 10:27 pm

  5. Amit,

    You are assuming that in disaster zone there are adequate resources to begin with. IMHO, that might not be the case especially if there is only one shop left, assuming there were more than one in the beginning. To advocate a pure price based rather than need based distribution in such cases might not make that much sense.

    There is little else I disagree with.

    Comment by confused — September 24, 2006 @ 12:42 am

  6. “My point is that there is no such thing as a fixed “correct price” for anything. The right price for any object is determined by supply and demand, and by what the buyer and the seller agree on. ”

    I am with you. Too many economic thinkers want to be a little bit pregnant, i.e., not fully committed to free market principles.

    Comment by Sarat — September 24, 2006 @ 2:00 am

  7. Confused, my assumption, in fact, is that there are not adequate resources: that is why the prices go up.

    Also, as I said, these discussions go nowhere unless we talk specifics. Can you give me an example of such “need-based distribution?”

    (Note that I am not against charity in such cases, whether by the government or NGOs, as long as the shopkeeper isn’t coerced or stolen from in any way; I am simply saying that fixing a price ceiling can be disastrous, and invariably leads to shortages, hurting the very people it is meant to help.)

    Comment by Amit Varma — September 24, 2006 @ 11:52 am

  8. Amit,

    Yes. I am completely with you when you talk of hotels where comfort is not an issue at all.

    However, food to me represents a different problem. With the existing income disparities, if the supply of food is not adequate, it can lead to food being denied to those who have inadequate resources. For example, someone who might not have any cash in hand. In a disaster zone, that is not completely inconceivable. Of coure, it also depends on how timely the government intervention is.

    I don’t think that an rgument can be made that this is an interference in market functions. The real interference was the natural calamity and that is why we are ok with charity in such cases.

    On a side note, our problem with price gouging in disaster zones, comes more from moral abhorrence than sound economic principles. It would be very difficult for any government to ignore it. But then,this is neither here nor there

    Comment by confused — September 24, 2006 @ 7:46 pm

  9. A question for you economists. Why do manufacturers in a completely, or nearly, free market capitalistic economy such as the USA have MSRP (stands for Manufacturer’s Suggested Retail Price)? This is very common with cars here but not other products, and yet cars are one of the most price-elastic products in the US.
    Just curious.

    Comment by Sarat — September 25, 2006 @ 3:01 am

  10. Amit,
    Spoken like a true economist. The belief that mrket price indicates efficiency has been long held as fact, but can be questioned at two levels.

    First, free markets are known to have failures due to natural monopolies, imperfect information, etc. Further, while you claim (correctly) that a market transaction indicates the will of those involved, there are several caveats – people’s preferences are not always obvious, nor do they necessarily act freely or in their own long-term interests. In other words the presumption of ‘rational’ behavior that underlies free market theory does not always hold.

    At another level, we can even question if efficiency is what we want. What if the market outcome is not the most equitable, or what people want?

    My own shallow study of economy taught me one thing – that the field conveniently ignores the normative, for the positive. This is great for resource allocation, but not for wider policy tradeoffs that are called for in life. To completely ignore ethical, moral, and normative concerns is to ignore a large part of what makes us human, and therefore perhaps ‘irrational’. I’d suggest a quick reading of Sen’s Economics & Ethics in this context.

    I will support most examples you suggest as well as the bulk of your argument, but caution against a blind belief that the ‘market knows best’. Because then you put ‘the market’ above those that constitute it.

    Comment by Dweep Chanana — September 25, 2006 @ 3:03 pm

  11. I agree with the general principle that demand-supply matching through the market mechanism is a better way to allocate resources efficiently in many situations. It also captures the informational aspect of prices, as Hayek’s “The Use of Knowledge in Society” suggests.

    However, I believe that it is dangerous to apply the same logic in cases of natural (or man-made) disasters. Several assumptions underlie the theoretical result of a dynamic market equilibrium (perfect competition, rational decision making..) are almost always violated in real markets, and more so in disaster situations. Numerous examples can be cited – the price of “eviction” from New Orleans was so high (ownership of cars, insurance on houses and other assets) that only the reasonably rich were able to escape Hurricane Katrina, leaving those who couldn’t afford these to face tragedy.

    Also, demand-supply matching never happens instantaneously. In disaster situations, providing for basic human needs of all people suffering – clean water, food for survival, shelter – is the primary goal. In such shortage situations, including famines, “rationing” at the lower prices (or sometimes at zero prices) is seen to be a fair mechanism, equalizing all irrespective of their ability to pay. Yes, I can see that “rationing” is a word that will have many people up in arms, and is itself subject to corruption, hoarding, politicking and so on. Coupled with rights to information, and especially in situations where “social pressure” exists, it can work better than a price mechanism. (Also, in severe disaster situations, currency itself may not retain its meaning, putting in question the economic system itself).

    Belief in markets and opposition to price controls in general is one thing; being blinded by these beliefs is quite another.

    Comment by Mihir — September 25, 2006 @ 3:17 pm

  12. Confused, as I said, I love charity, and have no issues with it. But in the absence of charity, allowing supply and demand to determine prices is the best way to ensure efficient distribution and to avoid shortages.

    Sarat, sorry, I’m not competent to answer that question, as I don’t know anything about that aspect of the US economy. But it’s far from free-market heaven, that much I can tell you.

    Dweep, thanks for the insightful comment. Three things: one, can you give me an example of a permanent natural monopoly?

    Two, I don’t believe that all decisions in a marketplace are rational, nor do I think that thsi belief “underlies free market theory” as you put it. And it has little to do in the real-world examples I cited, for example.

    Three, by the market, I mean the people who constitute it. I use the two synonymously and interchangably, and I don’t see why, barring intervention, there could be a difference.

    Mihir, good points. But who assumes “perfect competition” and “rational decision making” while lauding free markets? I don’t, and don’t know of anyone silly enough to do so. Also, I don’t see what New Orleans has to do with the discussion here on prices.

    Also, as I said before, I have nothing against charity in the time of a disaster. But I suspect your support for “rationing” might focus more on intent than outcome. It might be “seen to be a fair mechanism” as you put it, but more relevant than what it is “seen to be” is what it is, and what the incentives involved make it likely to be. Economics should not be based on wishful thinking.

    Comment by Amit Varma — September 25, 2006 @ 4:52 pm

  13. Amit,

    The reason I cited Katrina was this sentence in your original post

    “But natural market prices are the best possible way to efficiently allocate resources at any time.”

    At the time of the hurricane, the “natural price” of eviction could only be paid by the reasonably rich. Clearly, resource allocation by the market prices failed in this situation since many people paid with their lives, injuries, trauma, property damage and so on. I only wanted to point out an “extreme example” to possibly show the limits on the above statement.

    I agree that no one in reality makes the assumptions I stated. My comment only addresses that economic theory of demand-supply and market prices being the “optimal” mechanism of resource allocation rests on these conditions being satisfied. Market prices are an excellent market-clearing mechanism. It is not necessarily optimal.

    “Rationing” just addresses the part where you say the “early buyers” of fixed price goods may buy “excess” quantities and deprive others. By “rationing supply” and simultaneously capping prices, some allocation is possible, especially in situations such as famine. Reputational and other information mechanisms can be utilized to curb black marketing and racketeering in these circumstances. There is of course the risk of these price and quantity controls becoming permanent, after the emergency situation has gone away. That I believe is more a political than economic issue.

    Comment by Mihir — September 25, 2006 @ 6:09 pm

  14. It facinating to see how free market makes things more efficient with very effective utilization of resources.

    Regulations and restrictions destroy this close balance. In other words welfare for both consumer and producer is maximised in free market in absense of regulation and interventions like taxes.

    In the article the judgement on fondling was mentioned, and it was said that the woman may charge whatever amounnt suitable for her (because there is no right price and because of her willingness to supply). But here we also have to take into consideration the buyers willingness to pay. I guess the court verdict is justifiable on grounds that no one would pay thousands of dollars just to fondle breasts..

    Comment by shikhil — September 25, 2006 @ 10:53 pm

  15. Amit,
    First, let me clarify what I’m opposed to in your post. Not the examples you site. However, I do feel that economics gives too much emphasis to efficiency, and ignores much else that is important. In particular, a focus on market price as the correct price, which seems to be the gist of your post is, to me dangerous. Not personally, as I am lucky to be well-off, but for many others that can’t afford the market price.

    Now to your responses:
    ‘An example of a permanent natural monopoly?’
    - Infrastructure? Microsoft Office? Not sure what you imply by permanent?

    ‘Two, I don’t believe that all decisions in a marketplace are rational, nor do I think that this belief “underlies free market theory” as you put it. And it has little to do in the real-world examples I cited, for example.’
    - Rationality ‘underlies free market theory’ in so far as to justify the market price as the ‘correct price’. Because it presumes that the market price was arrived at by people acting in their rational self-interest. If people can agree on a ‘wrong’ price, then we can no longer equate the market price with the best price.

    ‘Three, by the market, I mean the people who constitute it. I use the two synonymously and interchangably, and I don’t see why, barring intervention, there could be a difference.’
    - Precisely my point. Economics is wrong to assume that a market driven by cold, calculated math is the same as people that are anything but. In my view, the market you speak of is not the people that constitute it but a textbook scenario in which people are mostly willing participants. Yet, sometimes they may choose to diverge from its rules.

    Perhaps I completely misunderstand the basics of economic theory.

    Comment by Dweep Chanana — September 25, 2006 @ 10:58 pm

  16. “So,instead of two people in the room and two people outside in the rain or lobby,you have four people in the room.Efficient allocation of resources? Yes.”
    While these four guys are negotiating with the Hotel owner,another person walks in.He offers Rs.12000 for the same room.Now the owner of the hotel has no reason to disagree with this price,so we have one person in the room and four people outside in the rain or lobby.
    When in the developed world price control is being debated even today

    http://www.counterbias.com/705.html

    what else do you expect in India?

    Comment by con man — September 26, 2006 @ 9:16 am

  17. Some prices can never be said to be right or wrong. Like the author of the post posits, it depends on the demand and supply.

    Comment by Alex — September 26, 2006 @ 8:31 pm

  18. Mihir, thanks, good points. But I’ll maintain that the kind of rationing you speak of works only in theory, and I’ll also maintain that politics is inevitable in such matters, and invariably leads to bad economics. Just look at India!

    (Indeed, I’ve seen rationing of medicines in practice in Latur after the earthquake there. An unbelievable black market sprung up for medicines, and the people who most needed it never got it. I travelled through the affected areas in an ambulance with paramedics, and I saw it all first-hand, hospitals being emptied of medicines by black marketeers headed out of the area. Naturally, I’m not saying you should leave situations like to the market: immense charity is required at such times, and it was far more efficiently provided by private NGOs and so on than by the bumbling govt.)

    Shikhil, in the case I cited it seems the buyer paid willingly, and complained later. Of course, his alleged dementia adds an extra angle to the case, and isn’t part of my comment.

    Dweep, thanks for the examples cited, though it’s probably wrong of me to expand on the issue of natural monopolies (which I believe are unsustainable, and MS Office certainly is not a sustainable natural monopoly, just as Windows and IE aren’t, though they were once thought to be). Perhaps we should discuss that larger issue elsewhere.

    Dweep, as I said, I don’t believe that people always act rationally. That is irrelevant, in my view, as long as they act of their own volition. As long as they do that, I don’t believe that anyone has the moral right to interfere with their decisions. This applies as much to trade as anything in a social context.

    But even besides the moral aspect of it, the history of economics shows us that economic freedom and prosperity are closely related. In the context of prices, surely the damage that price controls do cannot any more be disputed.

    As for your third point, we’ll have to agree to disagree, I think.

    Con man, if the scenario you cited was the rule rather than a hypethetical example, then price control would reduce shortages instead of causing and increasing them. Yet, that’s never been the case, has it?

    Comment by Amit Varma — September 26, 2006 @ 9:16 pm

  19. Fundamental to neo-classical economics is the assertion that a free market mechanism allows for efficient allocation of resources through the price mechanism, and any attempt to distort the price mechanism necessarily leads to inefficiencies and black markets. However, this assertion rests on many very questionable assumptions, including perfect symmetry of information.

    As Stiglitz wrote in the 80s and many others have followed, the fundamental problem of asymmetric information where the buyer or the seller knows more than the other, leads to inefficient market allocations. So saying that markets lead to efficient outcomes is a fallacy, in the real world, you never have perfect information.

    Also, forget the problem of efficiency, what about the problem of equity? Economists conveniently relegate equity to the lap of social scientists, but no market interaction can be studied in equity vacuum. In this case, just ask yourself, is it fair that this guy with dementia got duped out of his money? And so, isn’t it fair that the judge awarded him extra compensation on that ground?

    Comment by Arvind Nair — October 4, 2006 @ 11:31 pm

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