Typical shoppers would view you as an annoying know-it-all if you asked if their consumption patterns caused their marginal utilities for the various goods they buy to be in fixed proportions to prices, implying equivalent MU/P for all items purchased. Suppose instead that you asked why they buy certain amounts of particular goods, or why they reject others. They might mumble that some items are “good buys,” while referring to others as “overpriced” or “not worth it to me.” Most of the time, people seem to behave as economic models of demand suggest, even if they don’t understand the jargon economists use to describe their behavior.

See T. Veblen

Goods as Bundles of Attributes

Consumer theory has been expanded recently to consider every good as embodying a variety of utility-relevant characteristics, or attributes. Cigarettes provide oral gratification and give smokers “something to do with my hands”; they are also carcinogenic, stimulate hostility from nonsmokers, and waste time. Sugar Smacks have a certain texture and taste and loads of calories. Rice and potatoes have very similar attributes and are thus substitutes; each is also quite complementary with steak.

 

The complex mixes of attributes embodied in most goods complicate many decisions. For example, even the best-trained doctors and pharmacists may be unaware of drug interactions that can leave tragedy in their wake. Nevertheless, we all must make decisions in an imperfect world rife with uncertainty.

Uncertainty and Imperfect Information

You can never be 100% certain of the attributes of a specific unit of any good, no matter how familiar. You may inadvertantly buy a moldy loaf of your favorite bread or be injured by an exploding cigarette lighter. There is even less certainty about unfamiliar goods that are bought only once or twice in a lifetime. No one who undergoes surgery can ever be certain in advance about the outcome of an operation. Nor, for that matter, can any surgeon. Uncertainty exists because we have only imperfect information about the present and no crystal ball to predict the future.

 

Transaction costs would be minimal in a static world. Constant change drives up the costs of acquiring and updating information. Securing full information would be impossible, any attempt to do so would be prohibitively costly, and some information has only trivial value. The result is that decisions are made in an environment of rational ignorance.

Rational ignorance occurs because people seek information only as long as their expected benefit exceeds their expected cost. Thus, consumers choose to be rationally ignorant of much information.

For example, most goods are available at a wide range of monetary prices, and most people pay more than the lowest monetary prices at a given time. But searching until you were sure you were paying the least possible for a good would probably absorb time and effort worth more than any resulting monetary saving. Similarly, you might spend a lifetime trying to identify the perfect spouse for you from the population of single people. The costliness of search, however, probably accounts for findings that propinquity (nearness, or proximity, in place or time) is a major determinant of whom one marries. Broadening the options available in any decision-making situation can be costly and pose unforeseen problems.

The Bewildering Maze of Choices

Thousands of firms and products fade from the scene every year, but even more thousands are launched. Ever-widening ranges of choice become available as firms attempt to attract huge customer bases to their product lines. This is often held up as a major advantage of market systems; even eccentric tastes and preferences can be accommodated when almost innumerable different goods are available. Typical grocery stores now carry over 15,000 different items; together, the stores in a large shopping mall often offer five times as many.

 

Constant changes in the array of consumer choices drive up is the costs of information required for wise consumer decisions.3 Firms constantly modify products and packaging in hopes of getting noncustomers to sample their goods: “Try our new, improved....” You might be irritated if you searched high and low for a familiar red box of your favorite cereal, concluded that the store was out, and then, on a later shopping trip, discovered that the maker had switched to a blue box.

 

Even more confusion arises when choices are wider. A gourmet may dither for hours over a lengthy menu at a posh restaurant. Some people spend days trying to find the perfect gift for a friend or the perfect suit for a job interview. Selecting goods would be simpler if fewer options were available. You may know people who would have few problems in finding a TV program to watch if fewer channels were available, but who cannot stop pushing the changer when a cable system offers 50 or 60 choices?

 

As more and more Latinos immigrate into the US, many remark that the biggest culture shock is choosing from the millions of options our society offers. Might some people who dislike decision-making feel more comfortable in more regimented societies? For example, the arranged marriages common in traditional societies might reduce the anxiety many people experience when less rigid mating rituals prevail. Career choices might be far less traumatic for some people if they were simply assigned jobs. Social institutions exist, however, that lessen the need to choose. Private schools that require uniforms eliminate concerns about what a child will wear. A military career limits the scope of individual choice. At the extreme, few choices are required of prison inmates. Indeed, some convicts become so institutionalized that they cannot bear life outside prison walls.

 

Most of us, however, enjoy the wide range of options in a market system, and view the cars, houses, or clothes we purchase as expressions of our individuality. We are accustomed to the inconvenience and confusion of shopping or sorting out the activities we want to do. We almost intuitively develop techniques to make reasonable judgments in an environment of rational ignorance.

 

An even greater problem for any type of decision-making is that rational ignorance may yield decisions that seem wrong in retrospect. People try to maximize their satisfaction by balancing expected marginal benefits (e.g., marginal utilities or marginal revenues) against expected marginal costs. Some expectations may prove too pessimistic; a dreaded blind date may turn out to be the person you’ve dreamed about. If people form their expectations reasonably, however, the probability of a pleasant surprise should, on average, be balanced by the probability of a disappointing outcome. This partially explains hangovers, high divorce rates, food poisoning, the spread of AIDS, fatal accidents, and why some people suffering serious illness may be stuck with incompetent quacks and die for lack of information about specialists who might have cured their disease.4

Quality and Prices

Why does anyone ever leave a tip after eating at a restaurant? Why, when shopping may entail driving longer distances, do so many people buy at high-priced stores even if the same brands and items are available at discount stores closer to the customers’ homes? These examples superficially seem to contradict the economic assumption that, after adjusting for transaction costs, people always try to pay the lowest possible prices for any good or resource. Habit plays a role in some cases, but desires for superior service and attempts to avoid unpleasant surprises are also important.

 

That the price people are willing to pay is positively related to the perceived quality of a good or resource is not a secret. Plump red tomatoes sell for higher prices than mushy ones. Renting a room in Aspen during peak ski season costs more than renting that same room in May. But quality differentials in such cases are not a key to answering our questions about tips and premium prices.

 

Economists analyzing close substitutes that differ primarily in quality usually treat the markets as related, but separate. For example, race horses and nags are assumed to be sold in separate markets. A subtle point is that people will pay higher prices as implicit insurance policies intended to ensure quality and avoid mistakes caused by uncertainty and imperfect information. This overturns the notion that higher quality induces higher prices. Instead, the idea is that higher prices induce higher quality. For instance, sellers who receive bribes in the form of premium prices are expected to alter their behavior in ways that satisfy the buyer. This is different from paying a higher price for existing quality.

 

Thus, the prospect of a tip presumably secures faster service at a restaurant, especially one where you are a regular customer. the other reason you tip is because it is deemed as 'socially correct' behavior, and you don't want to appear cheap by not tipping. Premium prices at swanky stores presumably secure better service and easier refund policies when products prove unsatisfactory.

 

In many instances, prices exceeding the minimums necessary reflect attempts to ensure that suppliers help buyers avoid mistakes in contending with uncertainty and imperfect information. But what happens when information available to firms and their customers differ? The next section examines these markets with asymmetric information.