Prices without markets
Do prices reflect value — and if they don’t, should they?
Cynics, Oscar Wilde said, know the price of everything, and the value of nothing. That’s as may be, but do you know the difference? The price of something is easy: it is the amount of money one party pays to another party in return for a good or a service. It is clear-cut, unambiguous and quantified.
The price for the same item may differ from one transaction to the next: a beer in a swanky bar may well cost somewhat more than the same beer from a beach shack, and printer paper bought by the box is most likely cheaper per page in a single ream. But after a completed transaction, there is no discussion about the actual price.
Value is a different affair. We can try to express it in money as well, using economists’ concepts of willingness to pay (WTP) and willingness to accept (WTA) as proxies for the value in the eyes of the prospective buyer and seller respectively. The long-running television show Wheeler Dealers (perfect fodder during idle lockdown moments) illustrates how this works.
In each programme, car trader Mike Brewer seeks out an old car to renovate, which his wizard mechanic companion (formerly Edd China, currently Ant Anstead) then fixes. The hope (and aim) is to sell the car on at a profit. At the very end of the show, a prospective buyer offers an amount of money below the asking price. Then there is some (pretend) haggling, and usually the sale is concluded at an amount in between; although sometimes they settle for either the offer, or the asking price. Does this tell us something about the value in the eyes of either party?
To the buyer, the value of the car will be at least equal to their initial offer; a sane person would obviously not offer to pay more than that. How it is derived, we can only guess (but hang around, there is more to say about this in a few paragraphs). To the seller, with similar logic, the value will be no more than the asking price (but at least the total cost of the renovation, as the seller will not want to incur a loss).
But both parties, if they do their homework, will also consult the market. If you know at what price similar transactions have concluded, you can calibrate your WTP or WTA, and avoid a costly mistake. If you’d make a good profit by selling at £7,000, but you know that this kind of car sells for £10,000 you’d be a fool not to raise you WTA to that level. Likewise, if your budget for a classic car you really fancy is $10,000, but you find that they typically change hands for around $7,000, you’d feel miffed if you had stuck to your original WTP.
Are WTP and WTA a good proxy for the true value of something, then? It may well be for sellers. WTA is like a reserve price in an auction — if that price is not reached, the seller keeps the item. If they later agree to sell at a lower price, they are not selling below their value, but discovering that their true value was not as high as they imagined.
But for the buyer, it’s is not so straightforward. How much would you be willing to pay for a litre of water? Let me remind you that without enough water (around 2 litres per day), we would probably be dead in less than a week. And we don’t just use it for drinking — it is just as essential for cooking, and for keeping our house, our belongings and ourselves clean. Surely, something so crucial to our welfare will be more precious to us than diamonds (which we can happily do without)? In the UK, a litre of water, delivered at a tap of your choice, costs around 0.3p — not a lot, you’ll agree.
Now let’s compare that, not with diamonds, but with petrol. Even with rock bottom oil prices, a litre of petrol in the UK costs more than £1 — more than 300 times the price of a litre of water. Since our species first emerged, we have depended on water to survive and prosper, and indeed to evolve to conquer the world. But we never needed petrol. So, surely, water is the more valuable of the two. Would that be reflected in our WTP — would we happily pay £1 or more for a litre of tap water?
Thankfully, we don’t have to contemplate that eventuality. Water is, in most places where people live, in abundant supply, so that all our demand can be met at the low, low price we pay. Should any supplier try it on and test how valuable we really find water, competition will soon force them to adjust their prices to what the market will pay. That even applies for mineral water, selling at 200 times the price of tap water — but not 1000 or 10,000 times.
Pay by contribution
Which brings us to an idea that pops up every so often, including now, when our society is, shall we say, a little disrupted. The so-called key workers: nurses, garbage collectors, shelf stackers and delivery drivers — the people who keep us from going sick, hungry or crazy in this lockdown… don’t they contribute more to society than CEOs, financial traders and soccer stars? Should, as an opinion video on the BBC website suggests, “bin men (and women) be paid more than bankers”?
There is a tempting logic to the proposition. Even sidestepping the difficulty of establishing the actual contribution of a worker, our intuition would seem to tell us that bin (wo)men are considerably more valuable to our life than bankers. But isn’t that just like water and diamonds? It is not because something is more valuable to us than something else, that we are prepared to pay more for it.
This is known as the paradox of value. Adam Smith, the spiritual father of modern economics, attempted to resolve the paradox by separating the value in use (the utility we enjoy while consuming a good or service) and the value in exchange (the price in a transaction). As we saw earlier, they can influence each other, but they can still differ markedly. The utility we derive from the consumption of a good or a service is generally not dependent on supply and demand. The price, on the other hand, is very much a function of relative supply and demand — and this is what is behind the core of the paradox. We confound stuff that is inherently valuable to us because it provides utility, with stuff that is expensive because it’s scarce (and hence appears valuable).
Would it be beneficial if the price of water or of garbage collection reflected better the value it represents? Imagine governments raised taxes on water the way they do on alcohol, and made water — being more valuable — more expensive than whisky or gin. It is not easy to see how this would make anyone better off. Households would need to divert money that is spent on other things to pay for water. This would be welfare reducing, and one wonders what the government could do with the additional water tax revenue that would provide enough compensation.
What if refuse collectors were given a pay rise that put them on a par with bankers? Governments are the principal buyer of their services (on behalf of the tax payer) so they could actually make this happen. But here too it is unclear where the net benefit would arise. Like for households and more expensive water, the pay rise would require a cut in other expenditure, and hence a drop in overall utility.
It would also disrupt the labour market. Everyone with suitable qualifications would want to become a bin person: the wage rise signals the supply of labour is scarce. But, of course, it is not — on the contrary, there are suitable candidates in abundance, and it’s the jobs that are scarce. Huge numbers of entirely qualified people would be chasing a small number of highly paid jobs. How would the lucky candidates be selected? It’s easy to see how corruption might start tempting the recruiters. Would the unlucky ones demand similar wages elsewhere? If they’re successful, life might become much more costly (and eventually even the bankers would earn more too). If not, we might see rising social tension. Trying to set prices outside the market, without taking into account relative demand and supply — price controls, if you like — is fraught with unintended consequences.
But perhaps the most compelling argument against pricing goods, services or work according to the value they contribute is not that it is impossible to beat the market. It is in our own choices and behaviour. If we, as consumers of water or waste collection, feel we want to pay a higher price that more accurately reflects the value these represent to us, we are free to do so. Nothing stops us making extra payments to our water supplier, or handing out money to the bin men and women.
And we don’t — because it doesn’t make us better off.
Originally published at http://koenfucius.wordpress.com on May 15, 2020.
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