About a year ago, a former student of mine complained to me that they were being ripped off by a large Seattle-based coffee company (that shall go nameless to protect the innocent).
“What’s the problem?” I asked.
The student responded, “Every time I buy a 16 oz iced coffee, I only get about 8 ounces of coffee and the rest is ice. They should be charging me for the smaller size. It’s a rip off!”
“Every time?” I followed up.
“Yes. Every single time.”
This complaint may seem trivial, but underlying it is a much larger problem regarding why our younger generation is skeptical about the benefits of free markets and capitalism – they don’t understand the concept of “gains from trade” and how those gains are distributed. If people increasingly think that large corporations are out to soak them, they become more susceptible to calls for government intervention in the economy. Economic freedom wanes, and we all become worse off.
For this reason, it is important to set the record straight and help people understand the importance of the gains from trade. In doing so, I also will reveal, surprisingly, that sometimes consumers are the ones nefariously “ripping off” those corporate giants.
Understanding Gains from Trade
The concept of gains from trade is a basic building block of economic literacy, but one that is often forgotten, perhaps because it is so simple. Sophisticated college students and professors like complicated concepts, after all.
Gains from trade accrue when two individuals each have something that the other person values more and are able to complete an exchange of those things. When this happens, both individuals are better off (or at least one person is better off and no one is worse off). Voluntary exchange (trade) produces wealth-enhancing gains for society. It is that simple.
Let’s illustrate this with an example from the world of retail coffee where my former student found himself “ripped off.” To protect his identity, I will use myself (Tony) as the hapless consumer squared off against the enormous market power of Barstucks, a fictional coffee company.
Assume I want a cup of coffee in the morning. Fortunately, a nearby Barstucks offers such a beverage. Since Barstucks has something that I want (coffee) and I have something they want (money), the potential for trade exists.
The next question, though, is on what terms will that exchange occur? More specifically, at what price will we trade?
To help us understand if trade is possible and how it produces economic gain, we must introduce the concept of reserve prices (a.k.a. reservation prices). A reserve price is the highest or lowest price an individual is willing to accept in a trade depending on if they are a buyer or seller. A reserve buy price is the highest amount the consumer would pay for an item. For the seller, a reserve sell price is the lowest amount they would accept in order to hand over an item voluntarily.
In Figure 1 below, I am willing to pay up to $5.00 for a cup of coffee. Barstucks has a reserve sell price of $2.00; below that price it will not provide coffee. The difference between my reserve buy price ($5.00) and Barstuck’s reserve sell price ($2.00) represents the total gains from trade, which is $3.00.
The next question is how the total gains from trade get divided between the two parties. If Barstucks sells the coffee to me for $3.50, that faceless corporation keeps $1.50 of value in the gains from trade (the price they sold it at minus their reserve sell price). I also receive $1.50 in the gains from trade because I valued the coffee at $5.00 but only paid $3.50. I would have paid more for the coffee, but I didn’t have to and kept an additional $1.50 in my pocket to buy other stuff with. Yay me!
In this scenario (Figure 1), Tony and Barstucks split the gains evenly. The world is better off because I obtained something for less than what I would have paid for it, and the coffee company received money in excess of the lowest price that they would have sold it for. Everybody is better off; no one was “ripped off.”
However, what would happen if Barstucks offered coffee at a price of $5.00 (see Figure 2)? Since my reserve price was $5.00, I would still buy it. The beverage was offered at exactly the highest price I would have paid for it. I get something of equal value to my $5.00 and don’t share in the gains from trade, but I’m no worse off. Barstucks, on the other hand, captures all $3.00 of the total gains from trade. That may seem “greedy” to some, but again I am no worse off from this voluntary exchange. No harm. No foul. No “rip off.”
To some people, this may not seem fair. Why should Barstucks, a wealthy and powerful corporation, be allowed to keep more of the gains from trade? Shouldn’t we split them evenly?! Or shouldn’t Barstucks sell me the coffee at their lowest reserve price so that I can capture all the gains from trade? I’m a hapless consumer, after all, with little market power. C’mon Barstucks, show a little charity!
Maybe that is what we mean when we say we are being “ripped off” – consumers don’t receive all of the gains from trade, or receive less of the gains than the corporation does. But does this really matter? As long as both parties in the exchange are at least no worse off, is it really an issue of who keeps more of those gains?
Perhaps an even split of the gains from trade is the “fairest” division and deviations from that 50/50 distribution might suggest somebody is getting ripped off. But there is an additional problem. Neither of the parties in the exchange know what the exact reserve prices of the other one is. If that is the case, it is hard to know if we really are splitting them evenly or if one party is getting more. As we shall see next, though, it usually is the consumer who ends up getting more of the gains from trade. Consumers may be “ripping off” corporations!
What If Consumers Are Ripping Off Big Corporations?
Let us assert, for the moment, that a “rip off” is defined as one party getting more of the gains from trade than the other party. I think this is a poor definition of “rip off,” but for argument’s sake bear with me.
Imagine the following scenario (see Figure 3). It is late at night and I need to finish grading student exams by midnight. I’m very tired and really need a cup of coffee. In fact, I would be willing to pay up to $10.00 for some liquid caffeine because I need it desperately. I wander into a 24-hour Barstucks and shout out, “I need coffee, stat! I will pay you ten dollars for it!!” The barista hears me, pours a cup, and then charges me $3.50, just as I was charged that very morning when I wasn’t so desperate. Now that is charity!
I was willing to pay $10.00 for coffee, Barstucks had a reserve price of $2.00, and the barista only charged me $3.50. There were $8.00 of gains from trade to be realized yet the powerful corporation let me keep $6.50 of those gains whereas they only pocketed $1.50. I benefited much more from this transaction than did Barstucks. (I also tipped the barista because that is what I do.)
Did I “rip off” the coffee shop? I did, after all, keep more of the gains from trade for myself. Most people would think this is silly because the big corporation made their profits off of the coffee (which is their share of the gains from trade). But if it didn’t matter that I received more in the gains from trade, why at another time would it matter if the big corporation received more? Both parties benefit in voluntary exchange, so where is the “rip off?”?
It doesn’t seem as if an unequal sharing in the gains from trade constitutes a “rip off.”
Power to the Consumers: Reserve Prices Vary.
If the above scenario seems implausible, let me assure you that it happens more often than you think (see Figure 4).
The problem for businesses is that their reserve sell prices are relatively inflexible and largely determined by the fixed costs of doing business (e.g., coffee beans, cups, labor). But consumer reserve buy prices vary widely. Some people really love coffee and would pay handsomely, while others like it little and wouldn’t pay very much. Some people don’t even like coffee at all!
Moreover, for many goods the reserve buy price of an individual fluctuates over time. I value coffee more in the morning when I need a pick-me-up. Right before going to sleep, however, my reserve price for coffee is zero. Barstucks might not even be able to pay me to drink coffee then because the money they would give me would not be worth the lost sleep I would suffer (a negative reserve price). Of course, if I must stay awake late to grade exams, my reserve price for coffee might be quite high as midnight approaches. Reserve buy prices can be fickle and businesses wanting to reach a broad clientele base must keep their offer prices lower rather than higher so they don’t lose potential customers. This benefits consumers.
If Barstucks was the only coffee shop in town, they would be stupid to raise their price to $5.00 just to capture the gains at my reserve buy price because they would lose all the customers who have lower reserve prices (Figure 4).
This is why I don’t lose too much sleep over “monopoly power” in the marketplace. Since reserve buy prices vary, consumers benefit. Smart monopolists will find ways to reach the widest array of consumers, often by creating different quality levels of products. Once you introduce seller competition (such as NeoBean in Figure 4), each business has an incentive to inch prices down towards their reserve sell price lest another enterprise lowers its price. Consumers win out even more!
Not surprisingly, the vast majority of the time we buy stuff we are not “ripped off.” Consumers engaging in voluntary exchange benefit immensely from the gains from trade.
Why Do Some People Feel Ripped Off?
All of this still leaves us with my unsatisfied former student who felt he was being ripped off by Big Coffee every time he purchased an ice coffee. Every time!
My suspicion was that he felt exploited because he compared the amount of hot coffee in a 16 oz. cup to the amount of coffee in the iced version. But those are separate products. The price of having chilled coffee is having less coffee in the cup. You need a lot of ice to keep coffee cold and must store a batch in the refrigerator so you don’t resort to pouring hot coffee over ice (which results in lukewarm joe).
I further explained to him that if he continually purchased the same beverage day after day, he could not possibly be “ripped off.” He was engaging in a voluntary exchange with full information of what he was getting and what the price was, at least after the second purchase.
I could understand the feeling of being “ripped off” if you tried something once and it didn’t meet expectations. This happens frequently to consumers and we learn. (We also learn that some things are more valuable than what we anticipated!) If we don’t adjust our expectations, the onus is on us for being “ripped off.”
I finally suggested to our irked consumer that he should ask for less ice in the cup and more coffee. He did this. The barista happily complied. The story had a happy ending.
Who Really Rips Us Off?
The mystery of the cold coffee consumer seems silly and trivial. Granted, we all go throughout life feeling at one time or another that we didn’t get a good deal. But if these intermittent irksome feelings become more commonplace and are intensified via social media, the cries become louder for government to “do something!” about “greedy capitalists” (individual businesses) or “capitalism” (our system of economic freedom). Politicians who benefit by pretending to ameliorate even the most minor complaints take action, regulate voluntary transactions, and affect how gains from trade can be distributed or even occur. Regulation makes innovation more costly and lowers our standard of living.
There is an irony to all of this. A person can be “ripped off” if they are coerced to purchase things at a cost above their reserve buy prices. This cannot happen in a free market with voluntary exchange, but it can happen via government intervention and coercion. My taxes go to pay for a large number of services (including regulatory agencies) that I do not value and which deleteriously affect my ability to capture gains from trade. The larger the scope of government grows, the more likely each and every one of us is being asked to pay for things we do not value. That is the real “rip off” and one of the main reasons why AIER remains a critical component to the economic education of our citizens. Drink up and speak out, my friends!