Farnam Street helps you make better decisions, innovate, and avoid stupidity.

With over 350,000 monthly readers and more than 88,000 subscribers to our popular weekly digest, we've become an online intellectual hub.

Mental Model: Raising prices and increasing consumption

Other things being equal when the price of a good rises, the quantity demanded should fall. Economics refer to this as the law of demand. Because there are many counter-examples to this law it’s more of a quick rule of thumb.

Giffen goods are ones which people consume more of as the price rises, thus violating the law of demand. The name comes from Sir Robert Griffen, who first proposed this paradox from his observations of the purchasing habits of the Victorian era poor.

Alferd Marshall, explains it like this:

a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.

But this exceptions to the “law of demand” can be more broader than food or even inferior goods. Often a price can act as a quality indicator. More mischetvious people could rasie prices and use part of the profits to bribe the purchasing agent (like Visa). Amazon does this. Brian Zen does this. Mutual Funds do this. Bribing the purchasing agent is actually fairly common once you open your mind to it.

In his speech “Academic Economics Strengths and Faults after Considering Interdisciplinary needs,” Chalie Munger explained:

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.

* * *

A real world example of what Munger was talking about:

Sanjay Bakshi offers a great real-world example of how Brian Zen, from Zenway bribes the purchasing agent.

(Brian) wants me to recommend to you, as my student, his online investment course which has helped “people with limited means to become millionaires and multi-millionaires.”

Dr. Zen will charge you $800 to sign up. He promises to pay me $400, if you do.

You will, I hope, recall the connection between Dr. Zen’s offer and Mr. Charlie Munger’s example of “bribing the purchasing agent”.

…How, then, does one go about selling a high-priced product derived out of something so cheap? That’s simple. One uses, the reward super-response tendency and the associated incentive-caused bias (whose bread I eat, his song I sing) which it produces– Mr. Munger’s terms – by pricing the product high and offering a very significant part of the sales proceeds to people like me having access to “captive audience” like you.

There is nothing illegal about Dr. Zen designing his business model in this manner. After all, seeking profits is the essence of capitalism, isn’t it? But I doubt it very much – if the fathers of value investing – Mr. Graham and Mr. Buffett – would approve of the marketing strategies used by Dr. Zen, for promoting products created out of their knowledge, which they generously shared with the world, without any profit motive involved.

When Wal-Mart pushes its suppliers to lower their prices, and then passes on these low prices to its customers, and yet is able to earn a respectable return on capital, it’s an example of a positive-sum game which benefits civilization as a whole. Wal-Mart does not make money off its customers – it makes money with them. But when someone pushes a high-priced product using as ammunition, mouth-watering commissions offered to people who are in a position to influence others, it largely becomes, at least in my view, a zero-sum game. You’re not making money with your clients anymore- you’re making money off them. And, this aspect of capitalism is not very good for civilization.

You can read more on Griffen Goods at wikipedia.