(7.3) The general theory of prices

A preface to prices

This section concerns how prices are set by individuals engaged in voluntary exchange, like one person buying a used car from another or people buying and selling corn in a futures market. First, though, I feel the need to remark that most prices are not just set by buyers and sellers, but are influenced by government policies. Such policies include minimum wages, taxes, and various regulations like housing codes. This is nothing new. Even the first democracy in ancient Athens would set the price of figs by a democratic vote.

Video 1—Voting on fig prices in Ancient Athens

(A) Prices emerge from voluntary purchases

Susan Warren charges $75 to clean the house of Sherry Bush, but that is not a price, because Susan broke into Sherry's house and cleaned it without permission. Although Susan left behind a bill for $75, that was not a "price" because Sherry did not voluntarily pay it. Perhaps Sherry would value the cleaning more than $75 and would have gladly paid the price, if given the choice, but the fact that she was not given a choice means we do not know whether the cleaning was worth more than or less than $75 to Sherry.(S1)

If it had been the case that Susan hired Sherry to clean the house for $75 then we would know that Sherry values it more than $75. Otherwise, she would not consent. Anytime a buyer makes a purchase they do it because they value the good or service more than the price, and so real, negotiated prices will always be equal to or less than the consumer's value for the good.

Apparently, Sherry was willing to clean the house for $75, which means she could earn more cleaning that house (assuming she was paid) than her next best alternative. Perhaps in the amount of time it took to clean Susan's house Sherry could have cleaned someone else's house for $50. Sherry would only be willing to accept a price equal to or greater than her opportunity cost, and so price is always greater than opportunity cost of $50.

From this we see that any price resulting from a voluntary transaction between a buyer and seller will be less than or equal to the buyer's value and greater than or equal to the seller's opportunity cost. Where price actually resides between those two bounds then depends on other considerations, discussed below.

Figure 1—A General Theory of Prices

(B) The struggle for negotiation power

When Tibetans have finished gathering yartsa (a larvae that has been eaten by a fungi, thought by the Chinese to cure disease) they approach a potential buyer and begin negotiations. The potential buyer spends all day establishing different prices with various sellers, and they can be easily identified by their long sleeves which extend far beyond their hands.

The negotiations begin by the buyer insulting the worms, to make it seem they are an inferior product. He will remark, "I've never bought such bad worms...The color's no good, it's too dark...I'm going to lose money on these." These insults communicate that he places a low value on the worms, regardless of how much he actually values them. Of course, the sellers know this, and expecting him to insult the worms before they begin negotiating, the insults have little impact on the minimum price they are willing to accept. Every market has its formalities, emerging from a long history of social interactions between buyers and sellers.

Before they begin the negotiation, the buyer has an idea of the absolute maximum price he will pay for the yartsa—this is his value for the product. The seller has an idea of the absolute minimum he will accept, and this minimum will probably be equal to the price they believe other buyers will pay—the opportunity cost. The actual negotiated price will be above the seller's opportunity cost and below the buyer's value. Where the final price is resolved between these two extremes depends on the negotiating power of the buyer and seller.

The manner in which they negotiate a price is strange and fascinating. The buyer holds out his arm, with the long sleeve dangling off the end of his hand. The seller inserts his hand inside the buyer's sleeve, and within this sleeve where no one can see, they use their fingers to negotiate the price. It's almost like sign language, except no one can see the fingers. It might look like a thumb-wrestling match. Sometimes, if the buyer does not have this long sleeve, they drape a cloth over their hands, as shown in the picture below.

Figure 2—Tibetans Negotiating Yartsa Prices Through Their Fingers(F1)

Everything is communicated by touch, and however it works, it works well. When the price is settled the buyer passes the money through the sleeve. Thus, only the buyer and the seller know the agreed-upon price. This allows the buyers to exploit their negotiating power and pay lower prices to certain people, but the seller is also able to charge some people higher than others. Because all prices are secret, no one can say, "But you paid so-and-so more than that," or, "But you sold it to so-and-so for much less."(F1)

Both firms and consumers are in a perpetual struggle for the upper-hand in negotiating prices, and we are not just talking about instances when buyers and sellers directly interact, like the Tibetans above. The haggling over prices can occur through direct negotiations, like with yartsa, or indirectly through purchasing behavior. Every item you decline to buy at Walmart is your way of saying, "This price is too high. Lower it, and I might consider buying it."

Video 2—Buyer and Seller Haggling in Life of Brian (1979)

Though it is counter-intuitive, sometimes a seller can obtain a higher price not by tougher negotiating, but by leaving the price solely to the discretion of the buyer. Concert Window is a firm that broadcasts live music sessions, with some artists strumming their guitar and singing in front of their laptop, while others jam in a studio, and it used to charge $5 per ticket. Then they learned that when people were given the option to pay whatever price they wanted, the average ticket price went up. Why? Hard to say for sure, but perhaps charging people a fixed price of $5 per person communicated that the average cost was less than $5. However, when the buyer was allowed to name their own price they did not know what the average cost was, and feeling an intimate connection to their musicians, they volunteered to pay to make sure the artist was rewarded appropriately.(R2)

Figure 3—Concert Window lets you name the price!

(C) Price discrimination

Firms have always used tactics to charge different people different prices, thereby exerting more negotiating power over some than others. When firms charge different prices to different individuals or groups of people, that is called price discrimination. When you go to the theatre and get a student discount, this is not charity. What the theatre is really doing is charging wealthier people more money for tickets. When grocery stores offer coupons in the mail, they are really trying to charge higher prices to those who are too wealthy and busy to spend time cutting out coupons from the daily paper.

Figure 4—Dilbert on price discrimination

With the advent of the internet, firms now have an unlimited number of tools to not only charge different groups of people different prices, but to go beyond groups of people and charge prices uniquely tailored to the individual. Airlines and other online retailers now collect data on how you shop online, and use that information to determine the value you place on a good. The more you value it, the higher the price you will be offerred. You might have noticed that the price of a plane ticket or Amazon item can depend on how you are browsing the webpage. If the airline believes your browsing habits suggest you are buying a ticket for a vacation, they will offer you a lower price than if it appears you are buying a ticket for an important business meeting. Safeway recently introduced a new program called "Just for U", where they use your shopping history to determine the price they should offer you for a good. They, and every other major retailer, is using information about you not only to figure out what you want and make your life better by selling it to you, but to also determine whether they have more negotiating power and can charge you a high price, or whether they must offer you a low price.

Video 3—Stephan Colbert On Target's Price Discrimination

Fear not. This does not mean the online consumer is getting shafted. The internet often works in favor of the consumer. Websites now allow you to tell it where you wish to fly and it will show you the different ticket prices offerred by various retailers. This ignites price wars, where online retailers feel they must offer the lowest prices possible or they will lose business to other people. The point is that the internet has not given producers or consumers more negotiating power, it simply changes how those negotiations take place.

Price discrimination is now universal in college education, so much so that the official tuition rates charged by universities are meaningless. In reality, universites offer students a price that equals the tuition and fees minus financial aid. What they do is offer more financial aid to the students they want the most (those with high ACT scores) and whose parents make little money. While news reporters constantly tell us that the cost of a college education is rising much faster than inflation, they are giving us false information. What they really mean is that the official tuition rate plus fees is rising faster than inflation, but they do not tell us that financial aid is also rising faster than inflation. In fact, when you look at the actual price students pay for a college education, it hasn't changed since 2001.(G2)

(D) The Quakers hit on a grand idea

Some of this discussion may seem strange because you are not accustomed to negotiating with people directly over price. Yard sales, auctions, houses, and cars are exceptions, but most of your purchases are conducted in an atmosphere where you simply observe price and then decide whether to buy or not.

We don’t like negotiating with people because the process is uncomfortable and we always have this nagging thought that, “I might have paid too much”. If given the choice, we often prefer to shop in pressure-free settings where the same price is posted for all. We take these opportunities for granted, because in the past one had to haggle over almost everything one purchased. One never took the first price the seller suggested, because it was assumed that this price was higher than the price they were willing to accept.

Then came the Quakers, who valued honesty to such an extent that they refused to take oaths, claiming an oath suggested they would not tell the truth without an oath (they often went to jail over this). So honest and reasonable were these individuals that they did not care to negotiate, and simply stated a “fair” price to begin with. There was no use negotiating, because the Quakers immediately volunteered the lowest price they would accept. Because of this, parents could send their child to a Quaker merchant knowing he would not attempt to take advantage of the child, and would charge the child the same price as the parents. This made purchasing from Quakers fruitful and pleasant, and as a result, Quaker businesses flourished in the seventeenth and eighteenth centuries. Others eventually copied this practice, such that today negotiating is relatively rare.(B1)

The Quakers earned such a good reputation in their business dealings that non-Quakers sought to profit from their honesty. Most of us know of the Quaker Oats, but wrongly assume that it is a Quaker-owned company. It is not, and it never was. The company founders chose the Quaker name and placed a picture of a Quaker on their products because it suggested to consumers that the product was made with integrity.

There are many ways to increase profits other than negotiating higher prices. As Concert Window and the Quaker community have demonstrated, sometimes it is better to not negotiate at all.

(E) Prices are all in the head

The general theory of prices, shown above in Figure 1, thus says that price will be (1) above the seller's opportunity cost, (2) below the buyer's value, and (3) between the two extremes, depending on each party's negotiating power.

There is a fourth factor though, (4) social, ethical, and psychological considerations, although it could be said that this factor largely impacts prices through its effect on negotiating power. Still, I list it as a separate item to highlight the idea that because prices are determined by humans, they are influenced by social norms and psychology.

A buyer might feel it their moral duty to pay poor widows a higher price for their used cars, out of empathy—although car dealerships in the U.S. do the opposite, and make much of their money on the vulnerable elderly.(R1)

Grocery stores do not charge more for turkeys around Thanksgiving, even though that is when consumers value them the most. In fact, they tend to sell turkeys at or below cost! The reason is that they believe consumers will feel they are taken advantage of if the price of turkeys is jacked up at the precise time they need it the most. Consumers become angry, and seek nicer stores. Stores may do this out of altruistic or self-interested reasons. After all, the good-will created by low turkey prices at Thanksgiving will reward the store throughout the year, as it earns and retains loyal customers.

To make the negotiations easier, the Tibetans might use whole numbers, whereas to exploit the nature of the brain, retailers in the U.S. prefer to charge $X.99 for everything. Retailers excel at psychological tricks that increases the price you will pay for the good without increasing its real value to you. For instance, retailers often do not want to present consumers with many choices, because we get discouraged from having to choose from among many varieties. Instead, they like to place a superior product next to an inferior product, making you think you found a good deal, when the inferior product was never expected to be sold in the first place.

For some reason people are psychologically drawn to the idea of a "sale" where items are placed at, say, 40% off. 40% off what? How was the non-sale price decided? The ordinary shopper rarely asks whether that initial price ever really existed if a store always has everything marked down, and they rarely wonder if the non-sale price was made high just so it could be marked down by a large percentage. These shoppers are playing the fool while believing they are getting a good price. The same goes for coupons. As a Macy's chief financial officer once remarked, "People love these coupons. They love thinking they got us."

The psychological power of the sale or coupon was made clear when Ron Johnson became CEO of J.C. Penney. Before Johnson, Penney only earned 1% of its revenues from items not "on sale". Johnson believed people were too smart to think the markdowns meant anything, and he transitioned the store to eliminate much of its sales and, instead of sales, simply set low non-sale prices. It didn't work. Penney suffered considerable losses, and Johnson lost his job.(V1)

Don't interpret this to mean consumers are always vulnerable to psychological manipulation by retailers. If anything, the opposite is true. Sellers in a competitive market place must aggressively provide consumers with more value than their competitors, because if they don't they will lose business to sellers who do. In cases where sellers do have power over consumers it is often due to regulation. Nobody likes to buy a car, because car dealers make it a miserable experience for us. Why, then, do these dealership not lose business to other dealers who treat buyers better? Because government regulation has made it almost impossible to become a new car dealer. So next time a car salesperson takes all the fun out of buying a new car for you, don't blame capitalism or free enterprise, blame government! (G1)

(F) Print on demand (about negotiating power)

Purchasing a plane or a concert ticket online now comes with an added convenience. Instead of waiting for your ticket to arrive in the mail you can print it from your computer. This convenience adds value to you, otherwise it would not be an option. The cost of providing this service is almost zero, or might even be negative since it saves the company postage. So if the convenience of printing tickets on demand provides consumers with value and is basically free for the company, why does the airline give you this convenience for free but Ticketmaster charges you a high price (I think $2.50 is high, at least)?  

Figure 5—From Ticketmaster's Website

The answer has to do with negotiating power. Airlines are in a very competitive industry, which means they must work extra hard to keep consumers happy. They provide this service for free because if they didn't they would lose customers to other airlines. Ticketmaster, on the other hand, has something close to a monopoly for concert tickets. You either buy your tickets from Ticketmaster or you don't go to the concert. Ticketmaster can charge you a price close to the maximum price you would pay, because it doesn't have to worry about you going to a competitor.

Regardless of what type of good we are talking about, prices are determined by these four factors, and they can be used to explain almost any pattern of prices.

(G) Crop prices (about opportunity costs)

On December 26, 2014, the wheat growing in the U.S. would not be available for harvest until the summer but people were already buying and selling that wheat. The table below shows futures prices on this date. The $6.14 price for July 2015 means that on December 26 of 2014 a buyer and seller agreed to exchange wheat in July of 2015 at a price of $6.14. Likewise, people were agreeing to exchange wheat in December of 2015, at an agreed upon price of $6.33.

Wheat in the U.S. is planted around October and harvested around June. Notice that between harvests the price of wheat tends to rise. People were trading September wheat at a price of $6.24, but sellers required a higher price for December wheat.

The explanation for this price rise is simple. In order to have wheat available for sale between harvests one must store some of the wheat from the last harvest. Storing wheat costs money, and the longer wheat is stored, the greater the storage costs. As the cost of this wheat rises between harvests the minimum negotiated price also rises often leading to higher prices.

People will only store wheat year-round if they are compensated for their storage costs, and so the price of wheat often rises between harvests to compensate people for storing wheat for us. Otherwise, bread would be plentiful in August but unavailable in January.

Figure 6—Wheat futures prices on December 26, 2014(C1)


Futures contract price
($ / bushel)

July 2015


September 2015


December 2015


The increasing storage costs between harvests only means that the minimum negotiated price will rise. If the value of the wheat to buyers, or the relative negotiating power of buyers and sellers changes, it could be that wheat prices fall between some months between harvests. The futures prices on March 31 of 2004 demonstrates this. Between March and May the U.S. is not harvesting any additional wheat, and if any wheat is to be available in May of 2004 it must be stored. Yet, if you stored wheat between March and May you would incur higher storage costs but a lower price for the wheat.

So long as price begins higher than cost, price can fall even as costs rise.

Figure 7—Wheat futures prices on March 31, 2004


(B1) Brinton, Howard H. 1964. Friends for 300 Years. Pendle Hill Publications.

(C1) Chicago soft red winter wheat futures prices. Settlement prices on December 26, 2014. Accessed December 28, 2014 at http://www.cmegroup.com/trading/agricultural/grain-and-oilseed/wheat.html.

(F1) Michael Finkel. August, 2012. "Tibetan Gold." National Geographic magazine. Photographs in Figures 1 & 2 were by Michael Yamashita and accessed on August 2, 2012 at http://ngm.nationalgeographic.com/2012/08/tibetan-mushroom/yamashita-photography#/08-family-harvesting-worms-670.jpg.

(G1) Glinton, Sonari. February 19, 2013. "Why Buying a Car Never Changes." Planet Money podcast. National Public Radio. Accessed February 19, 2013 at http://www.npr.org/blogs/money/2013/02/19/172402376/why-buying-a-car-never-changes

(G2) Goldstein, Jacob. May 11, 2012. "Figuring Out The Real Price Of College." Planet Money podcast. National Public Radio. Accessed May 11, 2012 at http://www.npr.org/blogs/money/2012/05/11/152499671/figuring-out-the-real-price-of-college

(R1) Roberts, Russell. June 9, 2008. "Cole on the Market for New Cars." EconTalk podcast. Library of Economics and Liberty.

(R2) Rodgers, Jeffrey Pepper. June 19, 2014. “Your Favorite Musicians, Straight From Their Laptop To Yours.” all tech considered [podcast]. National Public Radio. Accessed June 3, 2014 at http://www.npr.org/blogs/alltechconsidered/2014/06/19/323674748/your-favorite-musicians-straight-from-their-laptop-to-yours.

(S1) Staedter, Tracy. January 15, 2013. "'Cleaning Fairy' Arrested for Shoveling Snow." Discovery News. Accessed January 25, 2013 at http://news.discovery.com/human/life/cleaning-fairy-arrested-for-shoveling-snow-130125.htm#mkcpgn=rssnws1.

(V1) Vanderkam, Laura. November 2-3, 2013. "Must Act Now." A review of the book Bargain Fever by Mark Ellwood. The Wall Street Journal. C10.