Conventional economic models presume that raising the price of a product will cause it to be used less, as this will dissuade some price-sensitive consumers from purchasing the product. Young economist Jesse Shapiro at the Becker Center on Chicago Price Theory investigates whether distributional and psychological factors might cause product usage to go up as its price is raised, contrary to conventional theory. This question is especially relevent to many global public health organizations considering what price, if any, to charge the poor for drugs, vaccinations, anti-malarial products, and other goods and services.

Many social programs focused on improving health in developing countries require active participation .Unlike a one-time vaccine, products ranging from condoms to insecticide must be used regularly in order to have any health benefit. The crucial role of household behavior in making such products work has led practitioners to search for new ways to ensure regular use among households receiving much-needed health products.

Shapiro went to Zambia to study these issues in the context of the sale and usage of Clorin, a home water purification product. Two distinct effects were studied. First, does charging a higher price target distribution at those who are willing to pay more because they intend to use the product more? Second, does the act of paying more itself induce people to use the product more, due to the sunk cost effect, which might cause people to psychologically justify the purchase price through increased use?

In order to study whether charging more for Clorin results in greater use, the authors designed an experiment that would separate two effects of prices on product use. On the one hand, charging a higher price may help target distribution of the product to those who intend to use it most. On the other hand, the act of paying—or the amount paid—may exert a direct influence on use if households feel they must use a product to make the best use of the money they spent. These two effects—which the authors respectively call the “screening” and “psychological” effects of prices—combine to determine the effect of prices on product use.

The authors find strong evidence that higher prices screen out less intensive users of Clorin. For a given transaction price, increasing the offer price by 10 percent results in a 3.6 percent increase in reported use among buyers.

…

Put differently, the authors find that the screening and psychological effects allow a firm or government to achieve the same level of Clorin use while charging a higher price. This, in turn, means that the Clorin program can produce greater revenue, which can in turn be reinvested in advertising to promote use, or can be redirected to other valuable social programs.

Understanding how these effects work will be very important for organizations looking to maximize the effectveness of their public aid and wondering how much to charge for the services they provide.

Understanding the screening and psychological effects of prices is critical to resolving public policy debates over the appropriateness of user fees for access to social products and services.

Ashraf, Berry, and Shapiros findings have important implications for economics and psychology, as well as for private and public sector industries in which product use is an important consideration.

“Our findings offer a new way to think about the pricing controversy,” says Shapiro. “Charging higher prices for health products does have an obvious downside, which is that fewer people will get access, but the benefit is in targeting the distribution of the product to the people most likely to use it, as well as greater revenue for social programs. These issues need to be weighed against each other when making policy decisions about setting prices.”

Watch the video at the link below to hear Jesse describe his research in Zambia. He also discusses applications to media and advertising, in particular the question of whether giving a publication such as a newspaper away for free induces people to pay less attention to it, thereby reducing the value the audience has to potential advertisers.

Read more: The Economics of Pricing: Can Higher Prices Stimulate Product Use?

The rise of e-commerce has provided companies with rich new sources of information on their customers, based on the clickstreams that users generate as they navigate through a commerce site. This finely grained data brings with it a host of potential new ways to segment customers and tailor a product or service to their specific interests and priorities. Ross Parker has found an interesting example of one such tactic on an online travel site. The site changes the price of a hotel stay displayed to the user based on whether the user sorts the results by lowest price first, or highest price first. The logic seems to be that customers who sort the results from high to low are less price-sensitive than others, and might be willing to pay a higher price for the same hotel room.

The clever idea of travel sites seems to me not to discriminate on any information you provide but rather on information that you request and, crucially, how you request it. Specifically, they know if you have chosen to sort prices ‘lowest first’ or ‘highest first’. This information can be used to the companies’ advantage.

If you sort your search results so as to see the cheapest option first, you’re probably looking for a budget hotel and a good value break. To get your custom, the firm will have to be competitive at the lower end, with headline grabbing rates - ‘Prices from only £x!’. To get you to make them a little more margin, they’ll want to tempt you up the scale a little bit - ‘For only £10 extra you could upgrade to…’. So a pricing structure for this sort of customer would be cheaper for the same reason that student cinema tickets are cheaper: the customer is more sensitive to price.

Conversely, if you sort your search results ‘highest first’, you aren’t looking for a bargain break. You may still want a good deal, but you’ve already indicated that you’re willing to pay for a good holiday and money is not your main concern. So you’d expect prices here to be a little dearer, especially at the top end. Furthermore, you want these people to think that they wouldn’t be saving much going for a cheaper hotel, thus helping them rationalise their choice of a top hotel.

As retailers become increasingly sophisticated at leveraging the massive databases of customer information they already have, can more of these types of tactics be far behind? In many ways the internet is providing the laboratory that economists have never had–a tool for running experiments, which is giving a more thorough understanding of consumer behavior and a venue to gather empirical evidence for new and existing theories.

Read more: Price discrimination in online travel firms

via Marginal Revolution

Would it ever be rational to buy something you know to be overpriced? Research on hedge fund trading during the dot com bubble suggests the answer is yes. Analysis of hedge fund trades on shares of inflated technology stocks shows that sophisticated investors were able to trade profitably even when the stocks were overpriced, by riding the bubble up and selling high through market timing. Stefan Nagel of the London Business School and Markus Brunnermeier of Princeton describe their research:

The premise of counter-trading by sophisticated investors “has been the main argument for why bubbles could not happen,” Nagel said in an interview. Yet, the study’s results importantly support recent theories of the limits of arbitrage. According to these theories, rational investors reasonably refuse to short or trade against even plainly overpriced securities if they believe most investors will continue to act irrationally, such that the security’s trading price will continue to rise. These, of course, are the very conditions of a market bubble.

“There is no evidence that hedge funds as a whole exerted a correcting force on prices during the technology bubble,” Nagel and Brunnermeier write. Indeed, “among the few large hedge funds that did resist the bubble], the manager with the least exposure to technology stocks—Tiger Management—did not survive until the bubble burst.” Nagel and Brunnermeier note in the study that Tiger Management was an example of a classically rational investor. Tiger declined to take major positions in technology stocks, believing them to be overpriced. While Tiger Management was proved right in the long run, its results fell far behind other funds that soared with the “irrational” approach of buying technology issues. Tiger was compelled to close up shop.

“The key to this is that if you feel you can predict what the irrational guys are doing, then it may be entirely rational to buy irrationally priced stocks,” Nagel said. In part, these possibilities arise because of time factors in hedging. Hedge traders generally are unwilling to hold short positions for a long period. Instead of betting on long-run reversal to fundamentals, they may prefer to follow short-run trends in the behavior of “noise traders,” as economists call them. “It seems that the hedge funds did exploit such a predictability during [the bubble],” noted Nagel.

The abstract in their own words:

The efficient markets hypothesis is based on the presumption that rational speculators would find it optimal to attack price bubbles and thus exert a correcting force on prices. We examine stock holdings of hedge funds during the time of the Technology Bubble on NASDAQ and find that the portfolios of these sophisticated investors were heavily tilted towards (overpriced) technology stocks. This does not seem to be the result of unawareness of the bubble: At an individual stock level, hedge funds reduced their exposure before prices collapsed, and their technology stock holdings outperformed characteristics-matched benchmarks. Our findings do not conform to the efficient markets view of rational speculation, but they are consistent with models in which rational investors can find it optimal to ride bubbles because of predictable investor sentiment and limits to arbitrage. Moreover, frictions such as short-sales constraints do not appear to be sufficient to explain why the presence of sophisticated investors failed to contain the bubble.

Read more:

• Stanford Research: Make Day Traders Act Rationally Rather Than Regulate Hedge Funds
• Hedge Funds and the Technology Bubble, by Markus Brunnermeier and Stefan Nagel