Why confusing products have high prices

The takeaway: Pricing is information. When information is missing, the price of something may be unfairly high. When information becomes prolific, prices fall, making margins unfairly thin. The only business defenses in our world of increasing information are either to quicken the pace of innovation (to move into areas where pricing information is unknown), or seek to cloud information to protect pricing.

So we cracked the cover to The Road to Serfdom by F. A. Hayek (bear with us, folks) and were reminded of the basic economic concept that pricing is a form of information transfer. Markets, you see, do more than move goods and services around to pay people money; they are actually collective hive minds of intelligence, transferring data on the relative value of things.

Which brings to mind the painful choice of extended warranties. You know, if you bought any big electronics for Christmas, the dissonance of being pitched a warranty by a slick salesperson. Part of you thinks you don't need it; another part worries, well, a neighbor's kid could throw a chair through that flat-panel TV, so maybe, yes?

Margins as friction

Economist Jodi Beggs explains it all with this quote from Richard Thaler and Cass Sunstein:

"The extended warranty is a product that simply should not exist. If humans realized that they were paying twenty dollars for two dollars’ worth of insurance, they would not buy the insurance. But if they do not realize this, markets cannot and will not unravel the situation. Competition will not drive the price down, in part because it takes the salesperson a while to persuade someone to pay twenty dollars for two dollars’ worth of insurance, and in part because it is difficult for third parties to enter this market efficiently."

Shouldn't exist? Well, yes. Most markets have enough competition that a $2 product priced for $20 won't stay alive for long; but a few don't. In the case of warranties, strange services offered only after you've purchased something else in the dark of an electronics store with little competitive information to guide you, the absence of knowledge allows margins to float to the sky. In this case, the friction that blocks comparative value data from competitors creates a sticking point of artificially high margins for the one company pitching the warranty.

The doctor's bill will not see you now

We don't mean to disparage the warranty industry; rather, simply to warn that price gouging of any kind always comes home to roost. Thaler calls this the point when consumers enter a "rip-off" stage of awareness. Healthcare is another vivid example. One could easily suggest the current debate over health reform is the angry reaction of a populous (or at least the liberal side of it) that has awoken to find skyrocketing medical costs are gouging society. Healthcare is really just one example of a broken competitive market; consumers don't pay the bills, insurance companies do, and the individual who receives care has no idea what the procedure, tests and physicians are actually charging. No information, no price competition, no check on rising costs.

The problem for organizations who sell such uncompetitive wares is the Internet, and more recently social media, provides new layers of information that push down on uncompetitive pricing. Your 2,000 peers on Twitter become a virtual Consumer Reports of reviews, warning you when services aren't what they seem. This pressure on margins has been around for a decade, and Chris Anderson has noted it most famously recently in his book Free. (We think Anderson followed the trend line too far; not everything will be priced at zero just as real estate prices in any bubble never reach infinity.)

Really, this push-and-pull is the entire competitive market at work. Companies of all stripes try to disguise their margins in order to raise them. Seeking profits is healthy, because the motive leads to growth and innovation. Yet those goods that are priced too high due to an absence of information will be forced to slide back to reality. As our new tools make value data more transparent, margins will be harder to come by. Competitors will have to respond by either increasing the pace of innovation, or finding new ways to cloud their value. Good luck, and watch out for that guy looking at televisions in Aisle 9 with a cell phone.

Image: Brooks Elliott