Imagine if the Price of Haircuts was Determined by Supply and Demand

A simple thought experiment shows how far the real world diverges from marginal pricing theory.

Imagine if barbers or hairdressers really determined the price of their service by supply and demand dynamics and in an auction-like market.

Imagine you went to get a haircut in such a world. You enter the store. If you were the only customer in the store, then you and the barber would engage in a mutual haggling process by which you negotiate a price for the haircut: you would give a lower price and the barber his higher price, and the haggling would continue until a price would emerge on which you could both agree.

Now imagine you went to get a haircut and there was a crowd of people in the store. At this point, the barber would auction off the next haircut or sequence of haircuts, and you would competitively bid against other clients. In the latter case, when the bidding was complete, all who wanted a haircut would have bid successfully for one, and all those who did not like the price offered would have left. The market – at least in a minor sense in the particular store – would have cleared, and supply offered at the relevant time period would equal demand.

It is likely that the price of haircuts would really fluctuate considerably in relation to demand and supply in such a world.

Simple reflection on how you really pay for haircuts reveals that this scenario is irrelevant for how the price of haircuts is normally set in the real world.

In reality, you enter a store and the prices for services are usually given in a list. The price is fixed and most probably based on the store’s total average costs plus a profit mark-up, and probably with reference to competitors’ prices too (and the internet is filled with sites advising small business-people like hairdressers how to calculate such prices just like this one). The price, then, is an inflexible cost-based, mark-up or administered price.

It is unlikely you can just haggle over the price. Instead of attempting to clear markets by price adjustments, barbers leave their prices unchanged and simply serve clients in the order in which they arrive: costumers simply wait their turn, as they read magazines or whatever (e.g., the last time I went for a haircut I read a National Geographic and the wait didn’t really bother me!).

In this sense, excess demand happens all the time in the hairdressing business, but although some people may grumble at having to wait their turn, nobody sees it as some disastrous economic “problem” where fixed prices lead to economic inefficiency and shortages. And who would want to live in a world in which you could never be sure what the price of a haircut would be every time you wanted to get one? By contrast, the real world tends to fix prices and to reduce uncertainty – and people prefer this world.

If a barber sees that he has long lines of costumers over a period of time and expects that this demand is going to last, he will hire more help: in essence, he will ramp up production and either (1) adjust his mark-up price to cover the new labour costs, or (2) might actually leave prices unchanged, if he already has a sufficient profit margin.

We live in a world where, in market after market, conventional supply and demand dynamics and auction-like markets are generally irrelevant to price setting.

What explains how we set prices in many markets is tradition, economic and social convention, and institutional development, not tidy supply and demand curves.