Whether consumers, sellers, employers, or the like, we all encounter economic transactions on a daily basis.
One of the most central ways they appear in our lives is in our deciding what we are willing to pay for goods and services, say, at a supermarket or a pharmacy. But what drives our ultimate decision? Let’s look at a few tools that can help us understand. To do this, we’ll turn to an example – one that indulges our sweet tooth.
You’ve just submitted a work proposal you’ve been developing for the past month, secured a great promotion, or maybe you’ve even completed the final module deadline of your HBS Online course! In any case, you’re in the market for a reward – and let’s be honest – with your top tier performance, you deserve it!
You decide that there’s no better way to celebrate then by satisfying your hankering for chocolate. You head towards your local grocery store and beeline toward the candy aisle.
Skimming the shelves, two packages command your attention:
- Gourmet-All-the-Way is organic, and quite frankly, top-notch. It’s made with Madagascar vanilla, is full of dark chocolate antioxidants, and markets an alluring glossy finish that you, as an expert in all things chocolate, know is inherent to a higher quality product. This chocolate is priced at $12.99 for a 10 oz. tin.
- Cheap’o-Choco is quite the opposite. It’s an extremely economical choice – only $5.29 for a 16 oz. bag. The caveat is in the fine print. On the bottom right corner of the bag you see, “made from natural and artificial flavors.” You know this product won’t be as high-quality. Regardless, this standard chocolate is good enough to get the job done .
Cheap'o-Choco: I’m celebrating on a budget!
Debating this choice in the middle of the candy aisle, you start to think a bit more technically about how much you would be willing to pay for each option.
On the one hand, a higher cost for the same (or less!) quantity is tough on the wallet. But, on the other hand, could a higher price mean greater value? Unclear. Let’s unpack this a bit further.
Value – or utility, as economists call it – is an important metric. Utility represents the amount of satisfaction a consumer receives from a good or service. And while it is determined on an individual basis, aggregating this data can provide insight into how much a whole market of consumers might be willing to pay. This, as you can imagine, impacts price-setting practices.
Back to the chocolate. Let’s consider the following two variables: quality and price.
If chocolate quality is irrelevant, then indeed, a larger quantity of chocolate will provide you with more utility. However, if quality does affect your perception of value, then perhaps you would be willing to pay a premium for, or otherwise receive a smaller quantity of, a gourmet brand.
You’ve decided that quality does matter… but not enough to justify a four-fold premium in price. In other words, for this tradeoff to be worth it for you, you would have to receive four times the utility from an ounce of Gourmet-All-the-Way than you would from an ounce of Cheap’o-Choco.
In reality, you only value the gourmet three times as much as the generic option, and thus your decision is made: Cheap’o-Choco will be your celebratory treat. But as you extend your arm toward Cheap’o-Choco, a store associate walking by updates the tag hanging in front of Gourmet-All-the-Way: “Buy One, Get One Free.”
Hmm, now we have to reconsider!
With this deal, the gourmet chocolate becomes only double the price of the Cheap’o-Choco – a tradeoff that not only leaves you with a higher-quality chocolate, but a consumer surplus, too!
As consumers, we encounter situations like this every day. Some deals leave us with greater value than we anticipate, while some valuations prevent us from being able to make a purchase. To learn more tools and better understand the economic factors that affect purchasing behavior every day, enroll in HBS Online's Economics for Managers course today!