First, regardless of whether there is a perception effect or not, let me discuss an interesting point that arose in our conversation.

Veblen effects occur when consumers care explicitly about prices of goods. The main examples are luxury goods. With Veblen goods you get an upward sloping demand curve—consumers prefer to have a good that is scarcer to a good that is more available. I haven’t studied the specifics of this effect much, but I believe this paper is the main reference.

In my micro class last fall, Dr. Slutsky noted that the primary analysis of Veblen effects assumes that consumers care about relative prices.

In standard demand analysis, absolute effects don’t matter. Double all prices and everything stays the same and no one cares. –This is no longer true if we allow for right digit effects (as “19.99” pricing is apparently called in the literature). If we increase all prices by 5 cents then consumption is going to change significantly. Hence absolute effects matter.

I’m not sure what the implications of this are, but I thought this relationship between the analysis of Veblen goods and the analysis of right digit effects was interesting; they essentially fit into the same framework—consumer preferences depend on prices.

As a side note, I drew up what I think a demand curve would look like given right digit perception effects:

I’m not sure if people actually estimate the shape of demand curves to such an extent but this would be one test of the perception theory.

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Admiral’s first post on Stigler’s text discussed the evolution of preferences over time. Consider an even smaller scale: the evolution of a single consumer’s preferences. Perhaps such perception effects exist only in the early stages of a consumer’s preferences, that is, when they are still young. Or perhaps they appear as consumers age? Allowing perception effects to appear and disappear, rather than arguing that they are always present, is a much stronger argument.

So in the aggregate, we may see 19.99 pricing remain at a relatively constant level, but it is targeting a small, changing, subset of consumers.

So how would preferences change to remove or allow such perception effects? It follows from decision costs. If the brain starts out with a bias towards towards the first few digits on the left, consumers can perhaps (indirectly) train themselves to remove this bias as they gain more experience in the marketplace. Similarly, as one grows older and mental capacity diminishes, the bias may resurge.

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Here is some research I dug up related to this debate. I couldn’t find any research in strictly economics journals though, all of it comes from marketing research. I haven’t read these studies yet so I can’t comment on their quality. For now I want to mention them for reference only.

Keith S. Coulter and Robin A. Coulter. “Distortion of Price Discount Perceptions: The Right Digit Effect” Journal of Consumer Research: August 2007.

Robert M. Schindler and Patrick N. Kirby. “Patterns of Rightmost Digits Used in Advertised Prices: Implications for Nine-Ending Effects” The Journal of Consumer Research, Vol. 24, No. 2 (Sep. 1997), pp. 192-201 (article consists of 10 pages) Published by: The University of Chicago Press

Hooman and Estelami. “The computational effect of price endings in multi-dimensional price advertising” Journal of Product & Brand Management (1999). Volume: 8, Issue: 3, Page: 244 – 256. Publisher: MCB UP Ltd

Second, the psychological explanation is much, much, much stronger and it is certainly related to what Mark highlighted. [[ MATERIAL OMITTED. ]]
Third, I think that the recent tax salience papers (but mostly Chetty, et al (2007)) combined with that neurolinguistics research would indeed make for a pretty paper that would inform our discussion quite a bit. But that’s me.

I also agree that we’d need to investigate the bargaining explanation in the auto market and the real estate market a little further. What Mark makes a lot of sense: If too many firms incorrectly signal precision, then consumers will figure things out and the gain will be eliminated.

Second: We can discuss “rationality” and related topics in more depth later, but briefly…. “rational” is not well defined in economics. Everyone seems to have a different definition of what it means for consumers to be rational. For me, I say a consumer is rational if they attempt to do what’s best for them given their constraints. That is, a rational consumer will not knowingly do something that’s not in their best interest.

This definition allows for all kinds of behavior that others term “irrational” to be rational. This kind of behavior can arise from calculation costs, complex preferences, or whatever. The main point is that a rational consumer does what’s best for them, given their limitations.

I strongly believe that all consumers are always rational under this broad definition. Furthermore, I think it is likely impossible to prove that consumers are not rational under this definition, and it must be taken as an axiom. I have no problem with this. Anyway….

Back to the topic though, above and beyond this broad definition, I do believe calculation costs are relatively low for most consumers, although I haven’t seen any data. I really just don’t think consumers are fooled by this pricing scheme. Besides, we really need to see the data. Well…I was about to say that I think most goods are not priced right below a whole number. But then I went to my local grocer’s weekly ad…lol. Anyway.

I suppose my argument is quite weak and I’ll have to work on it, but my intuition just says that the psychological explanation is wrong: people can round 21.99 up to 22. They know that 21.99 is almost 22 dollars. They don’t think it’s 21 dollars or 21.50, or 21.95. But again, maybe it comes down to calculation costs? This leads into a general equilibrium problem I think, but perhaps I should end my rambling now and gather my thoughts for a bit.

The “19.99” pricing practice may relate to impulse buying (which is not irrational, but I don’t want to get too much into my thoughts on that here).

Admiral, you cite “recent research into consumer perception of prices,” do you have any specific papers in mind? Are you referring to the tax salience research? I’m not sure that research informs our question about “19.99” pricing too much.

P.S., Megan McArdle recently mentioned the psychological explanation for this practice, although only in passing, and she doesn’t give any evidence either way.

If anything, the first explanation that should be dismissed is #2. That explanation would only accommodate a new sales tax if the good was in the $1-$2 range, not for the vaaaaaast majority of goods which are not in that subset of priced goods. I think explanation #1 makes sense and I think that the explanation for Wal-Mart’s pricing sounds about right. Instead of imprecise pricing, in which they would lose profit, they go for the exact lowest they can go while maximizing profit.

I dare say you’re giving the average consumer too much credit. I am so often frustrated by the irrationality of the average consumer, but then that’s what I get for being an economist. Often when you look at a price, the first thing you notice is the first couple of numbers. Or at least I do. And I think that something being in the ‘teens’ in price rather than the ‘twenties’ (for the 19.95 price example) is not something that would convince someone on a conscious level, but subconsciously it might just be enough to grab their attention that little bit more and, at the margin, make slightly more of a difference than that simply attributable to a 5 cent price difference.