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Saturday, March 19, 2005

Where does value come from?

A restaurant in New York City offers food with no prices. The owner asks that you pay her what you think the meal was worth.

The story describes a few free-rider instances, but for the most part people do pay something. According to the story's writer:
The pay-what-you-like policy has caused a certain amount of anxiety among diners, much as the pay-what-you-wish policy at, say, the Metropolitan Museum can cause crises of conscience in the face of a ticket-taking docent?s all-knowing gaze. Only the gauche or exploitative would interpret such an invitation as an opportunity to feed for free; the problem, for the civilized remainder, is the lack of an established code of behavior to follow.

The story's author seems to confuse price with total value. I could imagine some people have trouble determining exactly how much they value a meal, although in principle's class we act as if everyone knows exactly how much they value products.

Most immediately the problem from the point of view of the customer is similar to the tipping problem. Transients should pay nothing because there is no reputation effect, nor is there any concern about whether the restaurant will be there next week. However interesting the customer's problem is, I wonder about the implications of the firm soliciting revenues in this fashion. Why do firms post prices?

If all customers paid their true valuation then the outcome is no different that the perfectly discriminating monopolist. However, this is typically an expensive proposition and asking for voluntary revelation of true value not likely to be successful. Therefore, it is usually more profitable to post a price and sort customers on whether their value is greater or less than the posted price. If no one purchases the product at a posted price then either the firm must lower price or face its demise.

Those who purchased might have done so at a higher price, and this is why firms are interested in their price elasticity of demand. If demand is inelastic, the firm can raise price and increase revenues. If demand is elastic, if the firm raises price revenues will fall.

Posting prices seems to be a relatively efficient sorting mechanism (if only because almost every firm does it), but the restaraunt owner used an interesting way for the nascent firm to determine whether they have a product people are willing to pay for. It might not seem profit maximizing at first, but I wonder.

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