Wednesday, December 02, 2009

Evil Profit Maximizers Being Nice

It is common to view profit-seeking firms as evil--they do not care about consumers, or worse, they conspire to harm consumers. Many people would agree that it is wrong for firms to raise the prices of goods and services, and that doing so makes them evil.

So I wonder, when confronted with this, would one conclude that these are, in fact, virtuous firms, employing kind, sweet people who love consumers? The research firm iSuppli found that television prices fell 22 percent for Black Friday sales. Why would they do this?

Of course, they are forced to do this by competition. The intense competition for sales on Black Friday forces firms to lower their prices. It's an interesting case in which a simple supply-and-demand model can't quite describe what's going on; we need to think more carefully about expectations, economies of scale, and decreasing cost industries, and how those can affect prices.

A related question: Why doesn't this happen in health care? Again, one could say that maybe health care providers are evil and greedy, whereas providers of consumer electronics are generous and selfless, but that doesn't make much sense. If you're interested in a good overview of the problems with the U.S. system, and why it doesn't behave like the consumer electronics industry, you could do worse than to listen to these This American Life podcasts, here and here.

I linked to this post in my facebook profile, and Justin Coffey had some comments. I think his argument can be summarized as the following question:
If consumers are the people firms really care about, why do managers have a legal duty to shareholders instead?
I think I may have been too subtle in the original post. I was, in fact, not arguing that firms are virtuous and care about consumers for their own sakes. Clearly firms do not care about consumers per se; the goal of the managers of the firm is to make shareholders happy. The original post was intended to point out a contradiction. When firms raise prices, they are denounced as evil. When they lower prices, no one praises them for being virtuous. Why is that? It is because people are inconsistent in how they think about firms.

It turns out that both ways of looking at the behavior of firms are wrong. Firms are not being evil when they raise prices, and they're not being virtuous when they lower them. They are responding to the changing signals of the marketplace in an attempt to maximize profits and please shareholders. That is to say, they're just being self-interested.

To reiterate an argument I've made before, self-interest is neither good nor evil. It can have good or evil effects, depending on the institutional arrangement within which people act. So, for example, if people can pollute without paying any costs for doing so, then they drive their cars too much, operate their power plants too much, and so on. I'd be reluctant to call all drivers and power plant operators (and customers of power plants) evil, though. I'd just say they're responding to incentives. Similarly, when a company lowers prices, I would not call it virtuous. Nor would I call it evil if it raises prices. It is responding to the incentives it faces. In competitive markets, firms are forced to please consumers, for fear of losing profits. The institutional arrangement dictates their behavior. In a non-competitive market--perhaps market dominated by a government-protected monopoly--firms do not work as hard to please consumers, because they do not fear loss of profit to competitors. It's not because they're evil; they're ordinary people like everyone else. It's simply a response to the incentives they face. Expecting people not to respond to incentives is naive and dangerous, as it can create bad policy.

One final point: Higher prices can be a good thing in some circumstances. They may communicate to consumers a reduction in the availability of inputs, or higher prices may tell producers that consumers really like the product and want more of it. It is important to disconnect price changes from notions of good and evil, and instead think about the information conveyed by price changes.

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