25 Jan 2012

Externalizing the internality

Behavioral economists have a new twist on the old idea of "internalize the externality" (e.g., include the cost of pollution in the price of gasoline), i.e., "externalize the internality."

By this, they mean call attention to something important that we tend to ignore because it's hard to vizualize internally.

I will be reviewing Ariely's book on these ideas soon, but the important point is that "free" distorts our behavior: we spend too much on "free" things ("buy one, get one free") in the same way that we do not pay attention when a 100 percent price increase is from trivial to "double-trivial," e.g., when water goes from $0.001 per unit to $0.002 per unit.*

Both prices are too cheap to notice (the internality), so we fail to change (externalize) our behavior.

There are two ways around this:
  1. Get people to notice how much water they use relative to their neighbors (like here).
  2. Raise prices to a level that's "noticeable" (e.g., $4/gallon gas) and rebate excess revenue to customers who use less than average volumes (people really notice refund checks!).
These externalizations will change our habits in two ways. First, people will reduce their demand because they are paying attention (wait -- there's a price?). Second, they will reduce their demand if the price is higher (ohhh -- and it's higher!).

Bottom Line: Prices only work when we notice them, so make water prices (and consumption) relevant.

* Residential water often costs $1 for 1,000 liters/250 gallons.