Back to Overview
Review Question


Quality And Price

In the late 1960s, a large department store in Madison, Wisconsin had a special sale on electric knives. Although they were priced very low, surprisingly, few knives sold. The store then raised the price a little and the knives quickly sold out. What could explain this strange phenomenon, which clearly is not what a demand curve says should happen?

The most likely explanation for this event is that people often make judgments about the quality of items based on their prices. High-quality items usually are expensive and low-quality items are cheap. Thus, when people see an item that appears unusually cheap, they suspect that the item has low quality. In the knives example, people may have thought that something was wrong with the knives because the price was so low. When the store raised the price a bit, people no longer thought that the deal was too good to be true.

Quality often depends on price. For example, consider how parents would act if they had won a free vacation and had to hire someone to watch their baby. Would they seek out the cheapest care available? If they love their baby, they should be reluctant to act this way. Those who are willing to work for very little indicate that they are unable to get higher wages. They will probably provide low-quality child care. This is a case of adverse selection.

Suppose, however, that our couple has found someone whom they trust to watch their baby and are negotiating the price. Should they try to negotiate for the lowest price they can get? Maybe not. Maybe the effort the babysitter will take will depend on how much she is paid. People have perceptions about what is fair and often work less if paid less and work harder if paid more.

If all parents find that lowering price decreases the quality of services they get, then even if there is a surplus of people wanting work as babysitters, price may not decline. Such a market would not act as supply and demand suggests, but would have an equilibrium price that is not market-clearing.

A number of economists have argued that this influence of price on quality is important in labor markets and have called the prices or wages in these markets "efficiency wages." The wage is efficient not in the sense of economic efficiency, but in the sense that it is the best price from the viewpoint of individual buyers or sellers in the market. The babysitting case mentioned previously has two reasons that an employer might prefer to pay a price higher than the market demands. A third reason can exist if higher wages cut turnover. If time is needed to train employees, then high rates of turnover cut productivity. Hence high wages, not low wages, may result in the lowest costs for the employer.

A similar situation may exist in the market for loanable funds. Banks are major sellers in this market. Suppose that there is a decrease in the supply of funds that they have to lend. A supply and demand model suggests that price, which in this market is the interest rate, will rise and force out some of those who want to borrow money. Banks, however, have to wonder what sort of customer is left at high interest rates. Perhaps there is a problem of adverse selection, that higher interest rates leave only those borrowers who are willing to take big risks. If higher interest rates increase the riskiness of the loans the bank makes, it may find that the higher default rates reduce profits. In this case, the bank will find that the best course of action will be to limit the rise in its interest rates and ration funds among borrowers. In this market, there will be a shortage of funds at the equilibrium price. The bank will tell some people willing to pay the interest rate that they cannot borrow because the bank does not have funds available.

Efficiency wages (and prices and interest rates) are important when one looks at how economic systems adjust to equilibrium. This topic has been of considerable interest in macroeconomics, where adjustment problems are considered more seriously than they are in microeconomics.

We finish this set of reading by looking at dangers in auctions.

Back to OverviewReview QuestionExploreNext
Copyright Robert Schenk