Imagine if tomorrow the price of milk doubled and the price of alcohol was cut in half. Would we change our behavior accordingly?

Question: Do supply and demand dictate the market?

Dan Ariely: Yeah. So the standard economic approach is that demand . . . or aggregated demand is the aggregation of what people willing to pay for a product . And the supply has to do with the production cost, and they meet at equilibrium. And this meeting point is being used as a standard starting point for any welfare analysis. And from that you can calculate what would happen if we increased tax, decreased tax, and so on. But these two forces are independent. Now what our experiments show – in particular the experiment in social security numbers and the influence of external forces on decisions – that supply and demand are not independent, but they are dependent. So imagine the following. Imagine that tomorrow they double the price of milk and half the price of alcohol. I would argue that people would start going to work happier and with less calcium, okay? The prices from yesterday would be settled in our mind and we’d change our shopping behavior. But imagine that this change in pricing would also be accompanied by complete amnesia – so any prices you ever paid for milk and for alcohol. Under those conditions I don’t think there would be much change in how we consume milk versus . . . versus alcohol. You know milk is kind of a good deal now at $4.00 per gallon. I think it would still be a good deal at $8.00 per gallon. And wine is a good deal at $20.00 per bottle. I’d say it would be good at $10.00 per bottle. What this suggests – but we have a lot of research to show; it’s not just an anecdote – is that what we based on decision is not just what we . . . the benefit and cost and hedonic pleasure; but also what we did in the past, and the past prices that we encountered. So what does it say about supply and demand? It says that demand depends on supply. If I was born into a world where the MSRP or the suggested price for milk was $4.00, that would be fine. If I was born into a world where it was $8.00, it would be fine. And those are not unique demand curves. They are demand curves that move as a function of what the supply curve is and what the prices are. Now if that’s the case, it means that welfare analysis should be thought of very, very differently. Because it means that when the prices change, people would react vigorously to those. So again if price of gasoline jumped from $1.00 to $4.00 per gallon, people would react vigorously in the beginning. But if it was $4.00 from the start of it, it wouldn’t have even close to the magnitude of effect of the day after the change.

Recorded on: Feb 19 2008