Book Review: Confusing a Fair Lunch with a Free Lunch

The Price is Wrong: Understanding What Makes a Price Seem Fair and the True Cost of Unfair Pricing, Sarah Maxwell, PhD, John Wiley & Sons, Inc., 2008, 240 pgs, $29.95This book is vexing. It's a constant whine and cry of "unfairness" about all sorts of prices in the marketplace—from gasoline and pharmaceuticals to automobiles and airlines. One quickly grows weary of reading people crying victim to the outrageous pricing policies of companies, not to mention the obscene profits these firms are earning. This is one of the most simplistic charges against the free market, aptly described by Max Weber as "kindergarten economics."One expects to hear children cry unfair on the playground, but in a book that is supposed to be a serious exploration of the economics and psychology of pricing, it's just grating.Rather than explaining how and why a price system operates, the book deals almost exclusively with the perception of the fairness of those prices, placing what is often economic ignorance ahead of the reality of how prices are really set in a free market economy.That said, I also enjoyed the book, despite the cognitive dissonance it caused, including the scathing retorts I have written all over the margins of the majority of pages. There are some real gems in this work. Maxwell knows her topic—though not all the economics she should—has done her homework, putting it all together in a very well written, breezy book.There's no way I can convey all of my problems with this work, so I will just highlight what I think are some of the more egregious economic errors Maxwell makes, while also listing what I thoroughly enjoyed about the book.I should also provide this caveat: I think perceived fairness in pricing is an important issue for all businesses to consider. A business is defined by that for which it charges, so the customer better have a clear understanding of the value/price proposition. There needs to be very clear lines of demarcation between a lower/higher price and lower/higher value.In sum, I wholeheartedly agree with Maxwell's mission to explore this topic, as I explored it in my book, Pricing on Purpose: Creating and Capturing Value, especially in Chapter 19.What I LovedChapter two is a history of a "just price," which is very interesting. There's only one problem with it: it states that supply and demand doesn't lead to a "fair price," but as you'll see below, by definition, if a customer and seller engage in a transaction, it's a fair price. She actually includes an essay on pages 142-43 that makes this very point in its last paragraph, undermining the arguments she makes in the rest of the book.Maxwell has an excellent essay on page 80 by Uwe E. Reinhart on the idiocy of health care pricing, utilizing the analogy of what would happen if employers provided a "Clothes Benefit Program" whereby employees had to enter department stores blindfolded. This is a brilliant essay on the perils of why customers aren't price sensitive when they are spending someone else's money on themselves, a lesson taught by Milton Friedman quite brilliantly in his book, Free to Choose.Chapter 14 is an fascinating history on the custom of tipping. She argues in one point in the book about organ pricing. The chronic shortage of organs is not due to a physical shortage (nearly everyone has two kidneys); it is a pricing problem. At a zero price, there will be a shortage. Many economists believe there should be a free market in organs, and at least Maxwell explores this logic.She also has a good chapter on the fairness of paying taxes, though I don't think it goes far enough. For instance, it doesn't point out that the bottom 50% of taxpayers pay about 5% of total federal revenue, while the top 1% of income earners pay nearly 40%. Almost half of the population pays no taxes at all. Is any of this fair?So how does a company price fairly?To put my disagreements in context, it will help to show the social norms of fair pricing, spelled out by Maxwell on page 178:

1. The price should be kept relatively stable over time.
2. The price should be set according to industry tradition.
3. The price should be based on uncontrollable, external forces.
4. The price should reflect the true worth of the good.
5. The price should be determined by unbiased methods.
6. The same price should be charged to everyone, but adjusted for the needy.
7. The method for setting prices should be transparent.
8. The customer should be given a voice in setting the price.
9. The price should be based on the cost of supplies and labor plus reasonable profit.
10. The price should match or beat the competition.

It's Maxwell's thesis that if companies don't follow the above rules, customers will get mad and exact retribution, either by not purchasing or boycotting, which is the price companies pay for not pricing fairly.Numbers 4, 7 and 8 are correct, the latter being achieved by offering a money-back service guarantee. The rest are economically specious, especially numbers 9 and 10, as I will now explain.DisagreementsThe most egregious error in Maxwell's book is her discussion of the economics of a transaction. Using the example of Hillary Clinton's 5,200-square-foot, 7 bedroom, 100-year-old Dutch Colonial house outside of New York City, which the Clinton's purchased for $1.7 million, Maxwell writes: "The $1.7 million price was fair because the exchange was equitable: what they got was equivalent to what they gave."Two pages later she writes: "Clearly, you would not make a purchase if you did not think that what you were getting was worth what you were paying." It gets worse. On page 134, she writes:

...business negotiations involve extensive trade-offs. Price is just one consideration among many. The goal is that both parties come out ahead, to conduct what are called win-win negotiations.

Consumer negotiations, however, differ from business-to-business negotiations because they involve only price. One person's gain is another person's loss. ...These are win-lose negotiations.

This is pure poppycock. All transactions are win-win, otherwise they wouldn't take place at all, something Adam Smith pointed out back in 1776, leaving me to wonder how Maxwell could have an advance degree without knowing this.Further, this idea that business prices are different from consumer prices is nonsense on stilts. Businesses don't buy anything, only us human beings.Both sides profit from any transaction. What you pay is not what you get, otherwise why would you exchange? The whole point of a transaction is the money you are giving up is less than the value of the product you are obtaining. It's not based on equality, but rather inequality.This is such an egregious error—one that Karl Marx made as well with his fallacious labor theory of value—it would normally discredit nearly everything else she writes on pricing.Maxwell writes "fair" has two separate meanings: "acceptable" and "just." A "just" price is a judgment on the part of the customer that the price is justified, free of favoritism or bias; impartial...just to all parties; equitable...consistent with rules, logic or ethics."Then she draws a distinction between personal and social fairness, writing:

It is the difference between a price you prefer because it meets your own personal standards and a price you judge acceptable because it meets society's standards.

Got that? It's all subjective, like value itself (which, by the way, you won't find a definition of value until 58 pages into the book).I personally think the price of Lamborghinis is unfair, but I suppose Maxwell would retort that they are socially fair.If you're as confused as I am about this standard of fairness, you now understand my cognitive dissonance with this book.As pointed out above, she writes that pricing based on demand does not conform to social norms. Is this for real? How else do producers know to allocate resources from low-value uses to high-value uses? How else do customers expect to get discounts if prices aren't set by demand? And, of course, discounts are always "fair" but price hikes based on demand—such as bottled water prices after a hurricane—are always and everywhere unfair.I guess "fairness" is a one-way street, with the buyer being the traffic cop. (In fairness to Maxwell, she makes this point, finally, on page 98).The book opens in Chapter 1 with how customers for gasoline will queue up in line to save .02¢ per gallon. Maxwell claims that customers will act irrationally because they are mad. Why are they mad? The price of gasoline is "unfair." So is "zone pricing" used by the oil companies—basically charging different prices in different neighborhoods based on willingness and ability to pay. So is pharmaceutical pricing. So is airline pricing, especially because of "yield management."Waaaah. Waaaah. My first thought is if customers think the oil and pharmaceutical companies are making too much profits, I have an easy solution for them: BUY STOCK! You'd be ignorant if you didn't purchase stock in companies that can continue to make windfall profits, regardless of any external conditions, or risk.Why don't customers cry unfair against the government's gas tax, averaging around .60¢ per gallon, far more than the profit per gallon the oil companies make—without having to take any of the risks? Doesn't that seem a bit unfair?Pharmaceutical companies are held in special contempt when they charge $5 to $20 (or more) per pill, even if the dosage reduces more costly medical intervention by other means, such as surgery.In May 2000, the late Senator Paul Wellstone claimed, "We have an industry that makes exorbitant profits off sickness, misery, and illness of people, and that is obscene." Yet this is similar to arguing farmers make money off our hunger, when in reality they make money by keeping us from hunger. Drug companies do so by making us healthy.Given the contempt for drug companies, one wonders if people think they'd be better off is the drugs didn't exist at all?As for prices rising after a natural disaster, that's precisely what we want to happen. How else does a market deal with shortages? Is it better that prices stay low but no one can buy the desired product? What's the incentive for truckers to work overtime to deliver needed products to disaster areas if not higher prices? This is so basic you'd think most people would understand it—but they don't, given the appalling lack of economic education in our school system.In How to Be Human Though an Economist, Deirdre McCloskey sums up the role of prices this way:

When I was 25, having studied economics for 6 years, I grasped suddenly that prices are for allocation, not fairness. When I was 28, an assistant professor..., I grasped that prices are only one possible system of allocation (violence and queuing are others) but socially the cheapest. When I was in my thirties I could spot this stuff for myself in actual markets.

When prices are not allowed to fluctuate by the dictates of free markets, by having ceilings or floors placed upon them by laws and regulations promulgated by government, chronic shortages, or surpluses, always result. These shortages and surpluses are not the result of physical scarcity, they are matters of price.Thomas Sowell, one of the nation's most prolific writers and thinkers in the area of the history of economic ideas, explains the role of prices in Basic Economics:

Many people see prices as simply obstacles to their getting the things they want. But high prices are not the reason we cannot all live on the beach front. On the contrary, the inherent reality is that there are not nearly enough beach-front homes to go around and prices are just a way of conveying that underlying reality. ...it is not the prices that cause the scarcity, which would exist under whatever other social arrangements might be used instead of prices.From the standpoint of society as a whole, the "cost" of anything is the value that it has in alternative uses.In a society of millions of consumers, no given individual or set of government decision-makers sitting around a table can possibly know just how much these millions of consumers prefer one product to another, much less thousands of products to thousands of other products. In an economy coordinated by prices, no one has to know.Knowledge is one of the most scarce of all resources and a pricing system economizes on its use by forcing those with the most knowledge of their own particular situation to make bids for goods and resources based on that knowledge, rather than on their ability to influence other people (Sowell, 2000: 7; 10; 14).

On the debilitating effects of price controls, Sowell points out:

Prices rise because the amount demanded exceeds the amount supplied at existing prices. Prices fall because the amount supplied exceeds the amount demanded at existing prices. The first case is called a "shortage" and the second is called a "surplus"—but both depend on existing prices (Ibid: 22)...."shortages" and "surpluses" are matters of price, not matters of physical scarcity, either absolutely or relative to the population (Ibid: 24).To say that prices are due to greed is to imply that sellers can set prices by an act of will. If so, no company would ever go bankrupt, since it could simply raise its prices to cover whatever its costs happened to be (Ibid: 40).Free-market prices are not merely arbitrary obstacles to getting what people want. Prices are symptoms of an underlying reality that is not nearly as susceptible to political manipulation as the prices are. Prices are like thermometer readings—and a patient with a fever is not going to be helped by plunging the thermometer into ice water to lower the reading. On the contrary, if we were to take the new readings seriously and imagine that the patient's fever was over, the dangers would be even greater, now that the underlying reality was being ignored (Ibid: 54).

One reason the Soviet Union collapsed because allocating resources without a price system is difficult, and not very effective. Price controls do not, in actuality, control prices, they control people. Though a price-coordinated economy may have no more total knowledge than one that is centrally planned, that knowledge is distributed in a much more effective manner, as are the decision-making processes of economic agents.The workings of market prices allow each individual to actually possess less knowledge than your ancestors. You can purchase and enjoy food without ever having to learn the trials and tribulations of farming, and you can fly across the continent without even being able to pass a physics exam. As another great Austrian economist, Friedrich Hayek, pointed out: "Civilization rests on the fact that we all benefit from knowledge which we do not possess."A lot of the knowledge we do not possess is that of prices themselves. Of the literally billions of prices that exist in the marketplace, most people are conscious of a relatively small number that directly effect their lives, usually as producers. Most of us are blissfully ignorant of, perhaps, over 90% of the prices that exist in a market economy. Do you know the price of a billiard table, or real estate in the Cayman Islands? Your perception of the "fairness" of the price of these items will not be grounded in reality, but rather economic ignorance.Maxwell actually has a fantastic story on the very failure of a planned economy on page 164, called "A Fair Price Utopia Gone Wrong." This little essay is worth the price of the book, because it describes how there was once a Utopia where prices were set according to a theory of "fair pricing"—where all prices are uniform, all based on cost-plus pricing as well. In fact, this little essay proves Maxwell does understand the above comments, as it actually undermines a lot of her arguments in the book! More cognitive dissonance.Maxwell also has a chapter on the fairness of price discrimination, but again, doesn't cite any economic arguments that this type of pricing is not only ethical, but beneficial for those with lower incomes, such as student pricing, senior citizen discounts, and many other situations.One example Maxwell cites is the Victoria Secret's catalog that contained a $25 discount to those sent to male customers, yet only a $10 coupon sent to female customers. This is classic price discrimination, but Maxwell makes it sound as if it's a sinister plot to exploit women. But males would naturally be more price sensitive with respect to purchasing lingerie, so they need a greater inducement to do so than most women. How does this differ from a coupon offered for Tide? Some people spend time clipping coupons, most don't. Those who do are more price sensitive and need an additional incentive to buy the product.What is a Just Price?The notion of a "fair" or "just" price has bedeviled philosophers, religious leaders, rulers of nations, and businessman for centuries. During the Dark Ages merchants could be put to death for exceeding the communal concept of a "just" price (justum pretium, the right price).In A.D. 301, Diocletian, the Roman Emperor, issued an edict fixing prices for nearly 800 items and punishing violators with death. Severe shortages transpired, as any economist would be able to predict when you put a ceiling on market prices.The problem with a "just" price is who gets to decide what is just? The free market already provides an answer to this question—whatever someone is willing to pay. There is no objective standard for "fair," which is why we have free speech rights, not fair speech rights. You will look in vain to find the word "fair" in our Constitution.An old legal maxim teaches: Emptor emit quam minimo potest, venditor vendit quam maximo potest (The buyer buys for as little as possible; the seller sells for as much as possible). Ultimately, the customer is sovereign, spending his or her money only when it maximizes utility.To believe the free market is imperfect with regard to the fairness of prices is to grossly underestimate your own sovereignty as a customer while putting your faith in some anonymous third party—usually a governmental regulatory agency or the courts—to determine what is "fair."Yet prices contain a wealth of information that no central agency can possibly possess, which is why wage and price controls have failed everywhere they have been tried. If it is immoral for a company to charge premium prices to customers, does it follow it is also immoral for customers to pay low prices?Why is an oil or pharmaceutical company condemned for earning windfall profits when market conditions change, while an individual homeowner who realizes a tidy profit off of a hot real estate market is applauded?Popular movie stars, directors, and entertainment companies can earn above-normal profits without so much as a whisper of public protest. Premium ice creams and chocolates are very expensive and yield profit margins that would have made the "robber barons" of yesterday blush.Very few of us would continue working at 50% of our present salaries. Are we not charging what the market will bear? Why are individuals and corporations held to different standards?Only individuals own stock, ultimately. So bashing certain industries is the equivalent of bashing ourselves.Perhaps it is not so much price that bothers people as it is profits. Profits have a bad reputation because most people simply do not acknowledge where they come from. Profits come from risk.The entrepreneuse gives long before she receives. She pays wages, vendors, landlords and the other costs of running a business in advance of having anything left over (profits). Very few individuals work for 100% stock options, yet business owners, in effect, do exactly this, since profits are only left over after everyone else has been paid.If it were true that profits caused high prices than we should witness lower prices in those countries with no profits, such as socialist or communist countries. Yet the empirical evidence is to the contrary. Even though profits comprise only 10% of national income, they are crucial in allocating the other 90%.Of course, since most enterprises do not make an economic profit, perhaps we should say the pursuit of profit is the necessary ingredient.It is easy for politicians to focus on windfall profits of particular industries at particular times, as if economic cycles were not cyclical. Yet one never hears about windfall losses, such as the airline industry never turning a profit—in effect shareholders and creditors subsidizing passengers—or IBM losing over $15 billion during 1991-1993.Profits are an indicator that a useful social purpose is being filled and needs are being met. In a free market, no profit could exist without people voluntarily entering into a transaction where each receives more than they give up, what one commentator coined "capitalist acts between consenting adults."Both sides profit. Isn't that, ultimately, fair, Ms. Maxwell?