Beer on the Beach and Other Priceless Tales
What's your transaction utility?
Posted Dec 10, 2016
What's a cynic? A man who knows the price of everything and the value of nothing.
~ Oscar Wilde
Beggars can’t be choosers.
~ Old English proverb
According to standard economic thinking, you should pay for a good or an experience according to the utility that you get out of it. Utility means ‘use,’ or ‘pleasure,’ or ‘happiness.’ On the one hand, utility is a personal construct; on the other hand, it is a term that is affected by social forces, or rather your perception of them. If, for example, you perceive a product or an experience to be in short supply, you may be willing to pay more for it, and you may indeed enjoy its consumption more. Folk psychology is familiar with the idea of the good deal, or the perception thereof. Richard Thaler (1983) introduced the concept of transaction utility to account for that part of a good’s total utility that comes from your impression that its acquisition is a good (or bad) deal. Assessment of the good- or badness of a deal requires comparisons. Thaler gives several examples, and here is his most famous one, quoted in full:
“You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, run-down grocery store]. He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price you state. But if it costs more than the price you state he will not buy it. You trust your friend, and there is no possibility of bargaining with (the bartender) [store owner]. What price do you tell him?”
Notice that the companion chimes in with a warning that the fancy resort might charge more. This is a slight contamination of the story, but perhaps not critical. Thaler then reports the main result without giving specifics on the method of study [but hey]:
“Not surprisingly, when the two versions of this questionnaire were administered to Participants at an executive development program, those receiving the fancy resort hotel version gave significantly higher responses than those receiving the small, run-down grocery version (medians: $2.65 and $1.50).”
Notice the “not surprisingly.” Thaler’s tapping into folk intuitions to stick it to standard theory. He claims that his result is clean because it “occurs in spite of the following features”:
“1. In both versions the ultimate consumption act is the same - drinking one beer on the beach. The beer is the same in each case.
2. There is no possibility or strategic behavior in stating the reservation price.
3. No "atmosphere" is consumed by the respondent.
4. Care has been taken in oral instructions to make sure that the subjects understand the question and are not answering the related question, "What price do you expect to have to pay?"
These are important points. Are the sufficient to support the claim that the difference between the two median prices reflects a transaction utility and nothing else? Perhaps not. I wonder if it is relevant that the resort has greater overhead costs (rent, insurance, wages) that they pass on to their customers on any product, including those that other, more modest, establishment sells too. If our protagonist knows this, he’s making a reasonable adjustment in his reservation price, i.e., the highest amount he is willing to pay for the beer.
The beach scenario does not reveal the transaction utility, but it sets the stage for it. To our protagonist, getting the beer at the resort for less than $2.65 (in 1983 dollars) is a good deal, and being asked to pay more than $1.50 at the lean-to is a bad deal. In this scenario, there is no strategic exploitation of the buyer’s transaction utility by the seller, although Thaler later gives some instructive examples (e.g., the dreaded fantasy discount creating the illusion of a good deal).
Now consider the inverse problem. Imagine you are a seller – not the would-be buyer in Thaler’s beer tale. Suppose you have professional services to offer, such as legal advice or IT expertise, and you can sell it to a for-profit business and to a NFP business. Will you charge a different rate? Intuition and limited experience say that you would expect less pay from the latter than from the former. This would be so, although Thaler’s condition of equality is satisfied. If in Thaler’s beach story the consumption utility is the same, here the disutility of having to do the work is the same. Yet, you would presumably charge the NFP less because you expect their reservation price (the highest amount they are willing to pay) to be lower than the reservation price of the profit company. If these predictions of others’ reservation prices are accurate, then your willingness to accept (WTA) different pay is not irrational. Or is it? The two companies may be privy to your reasoning – because they can simulate it from experience and perspective taking, and are therefore willing to pay (WTP) more (less) if there is a (no) profit. It’s a chicken and egg thing.
The real puzzle is when the wealthier organizations offer less for your work. Some claim that Mr. Trump, a self-proclaimed master of the business deal and possessor of fabulous wealth, has been stingy paying his contractors fair compensation. Anecdotes are more plentiful here than systematic research. So here is one from the personal experience box; I have observed that some well-to-do schools don’t feel the need to offer an honorarium for colloquia and that some even more well-to-do companies think they can get academic value for free. The crassest version of this strategy is the argument that academics enjoy the experience of giving and they benefit intangibly from the opportunity to hone their presentation skills. The question is: would you, as the seller, charge the fancy place less for your work than the lean-to? Would you expect them to offer less and therefore ask for less?
To bring both these two sides of the coin into view, suppose you are to sell beer to the resort and to the shack. Will you charge different prices? Will you expect the resort to have a higher WTP than the shack? I am inclined to think that the resort will attempt to offer you less than the shack would. Whereas the shack owner may make a low offer based on a plea of hardship and economic marginality, the resort manager may make an even lower offer because she can. Financial power and its derivative psychological power embolden the power-holder to play and bargain hard – because they can. Being rejected by one seller puts nothing in jeopardy. The lean-to vendor can’t say that.
Thaler, R. (1983). Transaction utility theory. Advances in Consumer Research, 10, 229-232.
2 economists submitted a very similar, in parts identical, letter of recommendation for an applicant to a PhD program in psychology. Both feel that the candidate is well qualified for a PhD program in economics. Oh, the elder economist is known, part, for his or her research on moral preferences.