Buyer and seller – one market price, two perspectives

(featured image: abby_mix07/Flickr CC BY NC SA 2.0)

Markets enable prices to reach a level that satisfies both sellers and buyers, but that doesn’t necessarily mean that they see that price in the same way

Do you know what a kilo of brown rice costs, a 350g pot of salt, or a pack of four sponge wipes? If you are like me (and I do the weekly shop!), in all likelihood the best you can do is give a pretty wide price range for these products. As long as the price is within that range, you’d put these items in your trolley without giving it more thought.

You trust that the price is reasonable, because you assume the supermarkets compete with each other in an open, free market, where overpricing items in comparison with their rivals will lose them customers. And so do we all. Even for items that we buy more frequently than salt or sponge wipes, and whose price we know well, we rely on the market to tell us what they cost: there is no ‘right’ price for a pint of milk or a loaf of bread. Supply and demand find an equilibrium, and anyone trying to make excessive profits will quickly be undercut by someone who is happy with a more reasonable margin.

The buyer’s perspective

This is the case for low-cost items like these groceries, but also for more expensive goods and services costing tens, or even hundreds of pounds. But our assumption that the market price is a fair price can end up being challenged when we see it broken down into its constituents.

HOW MUCH for cleaning? (photo: via twitter)

A little while ago, an economist of my acquaintance had hoped to get away for one night in celebration of his birthday, and checked out what was available on AirBnB. Even more than for brown rice or dishwasher detergent, the typical consumer can only guess what a fair price for a night’s accommodation would be, dependent as it is not only on the destination city (and where exactly in that city), but also on the date.

He found an option with a pretty decent rental price for one night of $199 (£144, €167), but that was not the whole picture: on top of that there was the AirBnB service fee ($49), the tax ($41) – and the cleaning fee, which turned out to be an eye watering $150. Even AirBnB’s helpful notice that this price was still a good deal “less than the average nightly rate for the last 60 days” did not do much to sugar that pill.

Now most economists, and even most behavioural economists, would generally tell you that, in a transaction, it is the total price that matters. If the benefits exceed that amount, then the transaction can go ahead. Its components should not matter at all.

However, the cleaning fee here stood out like a very sore thumb. We make decisions based on more than just the numbers, and that is why we might find the total price of $439 much more acceptable if it was composed of $299 for the accommodation $50 for the cleaning, and reject this identically priced arrangement. That’s just how we roll. Nobel Economics laureate Richard Thaler puts it succinctly: we are “humans” with idiosyncratic preferences and feelings, and not “econs”, dispassionate creatures that narrowly focus only on material costs and benefits.

Is it irrational to reject a transaction, not because the total price outweighs the benefits, but because it is revealed that a particular component of it is, in your eyes, excessive? For “econs”, yes, but not if you adopt the “human” vantage point: doing business with someone who appears to take advantage of us would be deeply unpleasant, no matter how enjoyable the actual stay might be.

So it seems that acquiring additional information can alter our viewpoint significantly. But does this decomposition tell us everything, or is there still more that can influence our view? How do things look like from the seller’s eyes?

The seller’s perspective

As it happens, an actual AirBnB host responded to the original tweet, explaining that he uses the cleaning fee “to encapsulate all the one-off costs of a booking”. Doing so discourages 1-night stays (which take just as much effort as longer ones), without eliminating the option altogether: someone who is really, really keen still has the option of paying the fee.

This is an interesting, and economically quite plausible, position to take. Pricing almost always comprises both fixed and variable elements, but hospitality is particularly exposed to the imbalances that might arise. In retail, the sales volumes are usually so high that fixed costs can be spread over many sold items and become relatively insignificant – the transportation component of the price of a pot of salt is a small fraction of the cost of the actual salt. Hotel rooms and AirBnB properties, however, can be let for one night to one guest and for seven nights to the next, with the same fixed cost per stay. In a hotel with many rooms, the average duration of a stay will generally be fairly steady, which makes it sensible to allocate the fixed costs on a per-night basis. That doesn’t quite work for a host with a single AirBnB property, though.

And as a guest, we don’t immediately realize this challenge. We tend to evaluate the price in light of the value we get in return – a night’s stay – and both the magnitude of the fixed cost, and the complexity of recharging, it are hidden to us.

Might guests be underestimating the cost of cleaning? (photo: Matilda Wormwood/Pexels)

Is the amount this particular host charged excessive? Maybe disclosing the actual one-off costs might address would-be guests’ suspicion. Of course, not all of these are really out-of-pocket costs that can be itemized, like hiring a cleaner. Some manifest as effort, time and hassle for which the host wants to be compensated. “But hey, is all that not part and parcel of the business of letting, which should simply be incorporated in the price of the stay?”, I can hear you ask.

This may feel intuitively fair, but it makes poor economic sense. By design, this approach would reduce the total cost of short stays, and increase that of longer stays. As a result, the total revenue of a shorter stay would no longer cover its full fixed cost. More longer stays would thus be needed to subsidize that shortfall, but as this approach would make them relatively more expensive, there would be fewer of them. At the same time, the cheaper shorter stays would become relatively more attractive, and hence tilt the balance in the wrong direction – thus further increasing the total shortfall for the host.

Even more information, in particular the seller’s angle, does indeed add more nuance: splitting off the fixed cost in this way is both a fairer way of pricing (without subsidy) and economically more sensible. As a guest, you may still think the fixed cost fee is too high, and go elsewhere, just like the host can decide to deter guests who only want short stays.

Yet, even here you can trust the market to regulate matters: a host whose cleaning fees are truly excessive will see his custom melt away, and will be encouraged to lower the charges until supply and demand are back in balance.

About koenfucius

Wisdom or koenfusion? Maybe the difference is not that big.
This entry was posted in Behavioural economics, Cognitive biases and fallacies, Economics, Emotions, Psychology and tagged , . Bookmark the permalink.

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