The Liberty Papers

I firmly believe that many political problems are born of the average Americans inability — and unwillingness — to try to think and understand the world around them rather than accept conventional wisdom. This is clearly evident in peoples’ lack of understanding of pricing; it is disturbingly evident in the political policies they seek as a result of this lack. It’s clear enough when you hear about “price gouging”, and every economic argument that prices must rise to avoid shortages falls on deaf ears. But it’s the same principle when folks rail in favor of “windfall profits taxes”, as if businesses have the power to just arbitrarily select the level of profits they’ll earn.

Someone should really tell Ford, GM, and Chrysler, because they seem to be having some trouble with this concept!

Given that this is such an important concept, and given that it’s really quite simple, it’s surprising that the simple rules of pricing aren’t more apparent. But it’s not something that most people regularly have to think about. And sadly, because it’s so simple, it is not often explained — which I’d like to change.

The misconception of pricing is obvious. Most people think that prices are determined by a simple formula:

Price = Cost of materials + Cost of labor + Overhead + reasonable profit

It sounds so axiomatic that it is taken at face value. It’s so often true (but for a different reason) that it seems correct. But it’s not that clear.

Pricing is actually determined by the following equation, with a second equation added for clarity:

Price = whatever the market will bear
Profit (or loss) = Price – Cost of inputs – Cost of labor – Overhead

Note the difference between the two. Price is not a PRODUCT of the equation of material/labor/overhead/profit. Price is determined through a wholly different process, and profit or loss is the product of the pricing equation.

Allow me to use an anecdote to explain. As I pointed out a while ago, my wife and her sister recently opened a business making gourmet rice krispy treats. They intuitively understood the reality of pricing, but their logical thought process was all on the wrong model. They initially thought about how much their gifts should cost. Then, as certain costs started piling up, they had that internal desire to raise prices to compensate. But in fact, they started to understand that their initial pricing goals were actually too high, not too low. They realized that the market will only price gourmet gifts around a certain level, and they must adjust their costs to suit. They’ve ended up making some sacrifices that they didn’t want to make in the early term, and will have to defray some business decisions they’d wanted to make until orders become larger and economies of scale develop.

The simple fact is that in the gourmet gift market, the type of people who are buying gifts and the type of occasions they buy them for (birthday, Valentine’s Day, Secretary Appreciation Day, etc) have certain price tags already in mind. They will not buy a gift beyond that level. Conversely, a gift priced too low will not be purchased for it will seem “cheap” to the recipient. It’s a fairly narrow band for this type of product. It doesn’t matter that their product (rice crispy treats) is a new entrant to the gourmet gift market. Their pricing structure has to compete with the existing players.

Of course, they can go against the market pricing. If they price their product too low, they may move more units but will end up working extremely hard for a very slim profit margin. If they price their product too high, they won’t sell very many units but each unit will carry a lot more profit.

It’s the difference between Outback Steakhouse, a fine establishment that I might enjoy on a business trip or a random Tuesday, and my personal favorite steakhouse, Ruth’s Chris, where I might eat once or twice a year. It’s the difference between Honda and Ferrari. You see a lot of Honda’s on the road, but you notice a Ferrari. Premium products can command a premium price, but fewer people are willing and able to afford them on a regular basis. Thus, you see a lot more “regular” products than premium products.

The situation becomes even worse when you start talking about commodity products. The gas you buy at Arco isn’t noticeably different from that you buy at Shell, which is pretty much the same as that you buy at Chevron. Thus, pricing is almost identical across the board. Different stores may have different business models, of course. Many stations will price their gas lower if they have much more full-service convenience store attached, as the profit margins on the convenience store items help to keep them afloat, and the low gas prices entice you to pull into the station (and hopefully, for the station, you’ll walk in and buy a Coke and some Pringles, probably tripling or more the profit they made on your gas). Or, they’ll price gas lower in cash than using a credit card, partially because they must pay a transaction fee on the card, but also partly because you need to walk inside to pay cash (and again, may buy a higher-margin item while inside).

Thus, the pricing equation looks simple and correct, but if you’ve ever had to actually select a price to sell a good, you know that it is one of the most complex parts of business that anyone will encounter. It’s especially difficult in areas where pricing is a lot more opaque. When you own a gas station, you know how much all your competitors in town are pricing their product. When you’re pricing an industrial product that is an input to other production, you typically don’t know what your competitors are charging. Pricing often becomes an educated guess, and there can be thousands or millions of dollars difference over large quantities between how much the customer is willing to pay and how much you attempt to charge. In my business*, some deals may be so tight that $1 move up in price can pay multiple employees’ salaries for a year out of the increased profit, but that $1 move up in price loses the deal to the competition. Like anything else, though, as a producer you’re trying to charge the customer as much as you think they’re willing to pay, but still low enough to win the business.

Thus, a business cannot simply set a price based on the profit they’d like to make. Instead, business run an analysis of profit/loss based on what they expect is the price they can charge, and the costs they must incur to produce. Furthermore, business energy rates in 2019 can also play a part in deducing a final price. If the expected price is too low to make enough of a profit, they don’t engage in the business venture. If the profit is high, they rush into business as quickly as possible. Profits thus also tend towards the “reasonable” over time, because large profits attract new entrants to the market (driving down price), and small profits (or losses) cull participants from the market (allowing price to rise). This again is why the pricing equation appears to be correct, because in an equilibrium point of price stability, the market tends to only allow the “right” number of producers to exist.

This is why GM, Ford, and Chrysler have such trouble. The price for their automobiles is set by the market. They cannot raise their prices beyond this level or they won’t sell enough cars to stay afloat. They can’t lower their prices to move more units because they’re already at a cost structure that is too high for their prices. For them to continue compete, they need to cut costs. And they don’t have a corporate DNA that makes it easy for them to alter their cost structure. Especially not when they can simply go to Congress for regulation to punish their competitors, or as we see this week, a big fat bailout.

This is also why we’ve seen such problems in the airline industry. Airlines were created in the days when travel was a luxury, the only way to schedule a flight was to call multiple airlines on the phone or use a travel agent, and they could differentiate their product on a service model rather than a cost model. The market has changed, and air travel has now become a commodity. With transparent pricing easily comparable on the internet, casual travelers** almost never choose their airline based on a service model. If they save $2 to fly low-cost airlines instead of a “name”, they’ll do so. This is why you see airlines adding things like baggage fees, because they know that they need to increase revenue per passenger, but they cannot increase the fare that shows up on an online search. Many are slowly adopting the Southwest Airlines approach, which is the “sit down and shut up because we’re about to take off” model, delivered with a smile!

This has been a very long explanation for what is a very simple concept. But it all comes down to a single point: Prices are a signal that tell producers what goods and how much of those goods to produce. This doesn’t mean that the prices are always responded to in exact terms, many industries go through feast/famine cycles as inventories wax and wane, particularly when the lag time between deciding to produce a good and it actually reaching the market is long (i.e. semiconductor products, oil, etc). But the political message is clear. Anything that politicians do to artificially modify the price signals in the market will have consequences to production of goods.

Price-gouging laws are a good example. In the wake of a major hurricane, bottled water and portable electric generators tend to see huge spikes in demand. Due to this, the price tends to go up quite a bit. In some ways this signal is taken by consumers as a sign that they should ration their purchases (which helps more consumers get some of a good, rather than few consumers getting all of a good). High prices also offer an incentive to suppliers to deliver more of a good into the affected area, though, which helps to alleviate some of the price pressure while allowing more consumers to get more of the needed goods. If you disrupt the price signal, through a price-gouging law, you tend to see hoarding of goods by those quick enough to get them at low prices, and you see a sustained supply crunch of those goods.

Windfall profit taxes work the same way. When prices of a commodity increase sharply, it creates a signal to producers that they need to work especially hard to produce more of that commodity. Oil companies spend more money on exploration, they are willing to produce oil in wells where the marginal cost of production is far higher than the “easy” wells, and they do everything in their power to increase supply, because they want to take part in those profits. If you institute a large tax on those profits, though, they will refrain from the exploration and production of the higher marginal cost projects. The supply will remain below its potential, and the situation the politicians are trying to achieve — lower commodity costs — will actually end up in the exact opposite.

So if price-gouging laws and windfall profit taxes are such bad economics, why are they so popular? It’s because peoples’ understanding of what drives prices is completely backwards. If I believe that prices are set by “costs + a reasonable profit”, I would naturally feel that an external situation which creates much larger profits without an increase in costs is “unfair”. I would feel that way because my understanding of prices assume that the price of a good is tied to its production cost, and thus to increase prices without a change in those costs is “gouging” your customers. If it assumed, on the other hand, that prices are a function of the market and they are merely a signal to producers to change their behavior, we should be able to understand that short-term increases in prices will result in long-term increases in supply, and that in the long run the equilibrium of all of these goods and services reaches the “right” level.

Pricing seems like an easy and a trivial task. As we’ve seen, though, it’s not easy, and when the politicians get involved, it’s not trivial. For our entire economy to work, pricing has to be allowed to naturally emerge from the market. Any deviation from this natural occurrence results in unintended consequences and reduces the efficiency of the market. It should be noted that many of the areas where government is most actively regulating prices (such as the medical industry) is where we see the market behaving contrary to the wealth-producing tendency it has in all other markets. Pricing is not difficult in concept, but a lack of understanding about its nature can grind our whole system to a halt.

* I personally am in the technical end of the business, not the sales/pricing end. While I understand the impact if a dollar swing either way, I just don’t have the heart to argue with a customer over a dollar — even if that dollar is multiplied a few hundred thousand times. It’s not my personality.

** Note also that one aspect of air travel that is not being cut is frequent-flyer programs. Business travelers are far more capable of loyalty to a specific airline, and the airlines know that they’re willing to pay a bit more for the perks of “elite” status. Business travelers are the remaining cash cow of their industry, and they’re doing what they can to protect that status.