Separating Equilibrium: Why Expensive Gifts Aren’t Always Proportionally Better

If you want to give a great gift, you do not need to spend tons of money. In fact, I’d say that many times the more you spend on a gift, the less value you will get.

This is not just frugality advice. It is based on a game theory result.

Don’t get me wrong–there is usually a reason that things are priced high. Higher priced products are usually of higher quality, have a better warranty, or give you a perceived pleasure because they are a status symbol. If celebrities enjoy having $100,000+ cars, who am I to tell them how to spend their money?

That said, a higher price does not necessarily equate to a similar increase in value. If you spend twice as much on a luxury product, you are probably not getting twice the value. And that’s because of how companies price luxury goods.

Consider these strange marketplace occurrences:

The introduction of a generic drug increases the cost of brand-name product (pdf)

Wine keeps on rising in price even though the frugal Charles Shaw brand (priced at a mere $1.99) even wins blind-taste competitions

Why do the higher end products cost so much without necessarily giving more value? What makes people buy these things?

It’s a game of scheming companies against consumers who have different price points. I’ll explain the theory through a small example.

An Example Economy

Imagine an economy with ten people who would each pay $10 for wine. In this place, Wino Inc. sells a wine for $10 and makes a $2 profit on it. In equilibrium, everyone buys one bottle so that the company makes $100 of revenue and $20 of profit.

Now let’s change the example slightly. Assume one person becomes “rich,” meaning she desires the best wine and is willing to pay virtually any price for it. Being a smart company, Wino Inc. is aware one customer is now rich but does not know which one. It realizes that it can make more money if it can figure out how to charge the rich customer more.

The company would ideally like to ask each customer “Are you rich?” and charge more to the person who answers “Yes.” Knowing this, the rich customer would lie and the company would have no better information.

So the company needs to use a different strategy to get the rich person to pay. It decides to create a luxury wine for $30, that would yield a healthy $10 profit.

What happens in equilibrium? The rich customer chooses the luxury wine and the remaining choose the regular. The company makes $120 revenue and $28 in profit, and knows which customer is of what type. With this knowledge, the company can market the wine better and potentially even try to get the rich customer to endorse the product so the regular people might try it once in a while.

(Incidentally, this is known as a separating equilibrium. There are other examples, like how movie theaters get different aged customers to pay different prices by requesting IDs.)

But is the luxury wine any better? Maybe, maybe not. We know it costs more to make, and that it is priced higher. But there is no reason it has to taste better.

All the company cares is getting the rich customer to perceive the wine tastes better to maximize profits. The perception can be created through a very high price, good marketing, and other means of exclusivity.

Search for Bargains, and Disguise your Type

Things are much more complicated in the real economy, of course. Not all high end goods are marked up dramatically and rich customers will not necessarily just pay for something since they can afford it.

But companies do try to distinguish customers willing to pay more, a practice known as price discrimination.

Companies do create luxury products that appeal only to rich customers. Consider the Centurion card from American Express, which has amazing service but comes with a $2,500 annual fee, plus a one-time initiation fee of $5,000. Oh yeah, and there is a minimum spending requirement of $250,000. Who else but super-rich could afford or desire this card?

The game theory model suggests two conclusions:

1. Lower end products can be great, if you search to identify what you like

2. When you really want a higher end product, disguise your type and pay less

On point number 1, there is a lot of strange pricing in the food and fashion industry. Most people rely on price as a quality indicator even though quality differences are hard to ascertain. I suggest you do some blind-taste tests and sample on your own because it’s probably worth the long-run savings.

On point number 2, you can get the higher end product if you try to attain it in a way that a rich person might not. For electronics, this means looking at used or refurbished versions a few months after the product came out. This is not always ideal, but it is one possibility.

Of course, I’ve encountered snobbish people who simply cannot accept lower end products have good quality. My friend taught me how to deal with these people.

At one party, my friend featured Smirnoff as the vodka of choice. One guest pointed his nose up at the selection. My friend countered that the vodka packs a surprising taste, and it was even considered the “hands-down favorite” by the New York Times Dining Section among 21 high-end vodkas. It was notably a blind-taste test.

The guest would hear nothing of it, convinced that his tastes were above Smirnoff.

So my friend caved in and took out a bottle of a high-end vodka that was stashed away from the public. The guest was pleased and cheered that “this is what real vodka tastes like.”

Then, before the guest left, my friend showed him one more thing. It was a video of him a few hours before filling an empty bottle of high-end vodka with Smirnoff, specifically to achieve this prank.