Tuesday, September 21, 2010

Intangible services

Neoclassical economics presents a pretty simple theory of the equilibrium price of a manufactured good. This theory also extends to a theory of the wage for skilled and unskilled labor. We postulate production and demand curves, and the equilibrium price is the point where supply equals demand. The supply curve is influenced by factors governing the cost of production and therefore the level of profit created at a given production level and price, and the demand curve is influenced by subjective consumer preferences. An increase in demand for a good pushes up the price, thus triggering more production; and the price falls to a new equilibrium.

Wages are affected by this calculation because labor is a factor of production, and demand for labor at a given wage is influenced by the marginal product of labor. If the marginal product is greater than the wage the employer will hire another worker, increasing demand for labor and marginally increasing the wage. The equilibrium wage is the point at which the marginal product equals the wage.

Labor is not a homogeneous substance; the marginal product is affected by skill, intensity, and experience. So we should expect different wage curves for different segments of the labor force, with the wage rate for unskilled and inexperienced workers at the lowest level.  But because specialized labor is somewhat elastic in supply (through additional training) we would expect some degree of convergence between skilled and unskilled labor rates over moderate time periods.

How does this theory apply to intangible services where the quality of the product is difficult to measure? I'm thinking of a college education; how does a consumer decide between the education offered at a private university like Rice and the lower-cost alternative at UT-Arlington? But let's think of simpler examples -- for example, architectural services, family lawyers, or studio musicians. What are the factors that influence the price a supplier can charge in the marketplace?  Why do each of these sectors embody significantly tiered price structures?

Take architectural services. There is a wide range of fees charged by architectural firms, ranging from one-person firms designing single-family homes to multi-city firms charging much higher fees. There is demand for architectural services regionally and nationally. There is good information about suppliers and rates at the national level. And the supply of services is somewhat elastic -- more students will enter architecture school when the incomes they can expect are high. So why doesn't the simple logic of supply and demand imply convergence of prices for this service that is reasonably consistent and related to the cost of production of the service? Why are some elite firms able to retain a significant and permanent price premium? In other words, why don't we witness the commodification of architectural services along the lines of the auto industry, where firms compete aggressively on price?

I suppose some of the factors that stabilize this sort of multi-tier price system in services are fairly obvious. These might include brand and reputation; quality and prestige of professional service providers within the various firms; and depth and quality of referral networks.

Consider this thought experiment. RUNOFTHEMILL is an architectural firm of 30 professionals in the Rustbelt. TOPOFTHELINE is a firm of 200 professionals in San Francisco. Detailed quality assessment by the XYZ consulting firm estimates that RUNOFTHEMILL completes a wide range of midsize projects at roughly the same level of quality as TOPOFTHELINE. However, TOPOFTHELINE charges roughly twice what RUNOFTHEMILL charges for a project of comparable size. What are the mechanisms that preserve the price differential between the two firms? Why are rational business organizations willing to pay the premium to have their buildings designed by TOPOFTHELINE?

First, it is possible that TOPOFTHELINE has succeeded in positioning itself in the marketplace as a provider of superior quality. By hypothesis, this is untrue; but if potential buyers are persuaded of the quality advantage, they may choose TOPOFTHELINE over RUNOFTHEMILL in spite of the premium. This seems to be an inverted version of the "market for lemons": because the actual quality of the good is difficult to measure, the purchaser is forced to turn to other indicators as possible signals of quality. And this may lead the purchaser to pay more for the service than necessary.

Second, TOPOFTHELINE may have pursued a deliberate and successful strategy of recruitment of architects from the most respected schools in the world, whereas RUNOFTHEMILL may pay lower fees and may recruit equally capable but less prestigious professionals. Prospective clients may take the prestige of the staff as an indicator of the quality of the product, and may therefore be willing to pay the premium.  The observable prestige of the professional staff may serve as a surrogate for the inferred quality of the service.

Third, TOPOFTHELINE may have a brand that conveys significant prestige on its projects.  A company whose corporate offices are designed by TOPOFTHELINE may gain from that prestige, and the gain may justify the premium in spite of the additional cost.

Finally, it may be that the market for architectural services is highly segmented as a result of the networks of referrals that exist involving the two firms. TOPOFTHELINE exists in a network of premiere organizations, both providers and purchasers; and referrals and endorsements for TOPOFTHELINE support premium prices for its services. RUNOFTHEMILL has completed equally high-quality projects, but for a second tier of companies and consumers; so its referrals more or less automatically steer its services towards a tier of companies that are more likely to compete on price. So RUNOFTHEMILL's referrals generate lower average fees.

Several of these factors are inherently irrational grounds for accepting a price premium.  If purchasers had full information about quality and price, they would not pay a premium for the pedigrees of the professional staff, and they would not restrict their purchasing horizon to suppliers recommended by other elite firms.  Instead, they would go with the Walmart strategy: get the best product for the lowest price. So far, however, it seems that the markets for advanced and specialized services are fairly sticky when it comes to price, quality, and prestige.

1 comment:

Siyuan Song said...

The causes of the "irrational" decision-making process in the essay could be summarized as specialization from the buyer's perspective and differentiation from the seller's perspective. Specialization of all kinds of industries makes it impossible for companies to evaluate the quality of products of other industries professionally before using them. Differentiation of companies in the same industry drives them to become unique in any aspect as long as the aspect could gain competitive advantage.