The cost of production verses what the market will bare.

Factual Questions
1

I remember my economics professors hammering home that producers charge “what the market will bare”, the cost of production has little to do with the sales price. He said as an example that a manufacturer might have two products one which cost $1.00 to produce and one which cost $2.00 dollars to make. However, the company might charge $10.00 for the first product, but only $4.00 for the second if that is what market conditions dictated. Although, I understand the principal this has always been a difficult concept for me to grasp. It was made more relevent when my mother was suffering from stage IV non small cell lung cancer.

One drug that she tried when all others had failed was called Iressa. Even with her insurance paying 50%, the cost for thirty tablets was still around $1,000 out of pocket. I called a buddy who lives in DE and works for AstraZenica to see if he had any ideas for getting the drug cheaper. Anyway, he indicated that Astra Zenica can actually produce Iressa, at a lower cost than Arimidex (a different cancer drug Astra makes and that costs around $400.00 for a thirty day supply) even when you factor in the cost of R&D. However, Iressa is the only “third line” FDA approved chemo agent for lung cancer. He also said that they had done internal studies and decided that even by “pricing the drug beyond the reach of 70%” of cancer patients, they could still earn more revenue from the thirty percent who could afford (or who’s insurance would pay for) the drug.

This is clearly an example of a situation where the market price of Iressa is higher than Arimidex, even though the cost of production may be comparible (or even cheaper for Arimidex). Can anyone think of other more common “every day” examples where a company makes two products that cost the same to produce, but where one is much more expensive (or even where the item which costs less to produce sells for more than the one which is more expensive to make). For example, I have a feeling that those “Mach III/ IV” razors are not much more expensive to make than the standard, double bladed razors, but sell for more than three times as much.

In addition, it seems that this is a concept that many smaller businesses (and older people who have been in business for many years) either don’t grasp or oppose for ethical reasons. For instance, I asked a local lawn- mower repair shop owner why he only charged me $25.00 to install a new blade, when a competing shop charged $70.00 last year. He replied that “it only cost me $8.00 dollars and took less than ten minutes to install”. Clearly, he was basing his “price” on his perceived “cost” rather than doing a survey of “what the market would bare.” Is this a concept only widely accepted by this generation? Did even our American capitalistic, forefathers have a different perspective on this issue?

2

Big businesses (and smaller businesses serious about growing) try to maximize profit. That is their main goal. This is why prices are “what the market will bear” rather than at or slightly above cost.

Your lawn-mower-repair-shop owner was more concerned with being a good neighbor than maximizing his profits, thus the adage doesn’t hold true.

3

Okay, I see what you are saying. However, isn’t there something to be said for earning a good profit without necessarily “maxing out” what the market will pay? When I used to do residential appraisals, I would usually charge around $200.00 when the going rate was closer to $300.00 for a full appraisal (I was only charging $100.00 until my wife laid down the law). My attitude was that if I could earn $200.00 per day then I was happy (and usually I could earn several times that amount, little did I know that the days of full, appraisals were largely coming to an end thanks to updated Fannie/Freedie guidelines). Many of my “fellow appraisers” expressed shock and horror at the time with regard to my prices. My attitude was “bugger off”, If I feel like charging fifty dollars an appraisal and can stay in business that’s my right (and still more than 80% of the world can earn with a hard day’s labor, while my work is conducted in air conditioning).

4

Consider one other example. I would have paid at least $10.00 for a year’s subscription to this website (and I am a poor nursing student who’s every expenditure is analyized by his wife). Let’s say that most others would have also paid at least $8.00 for a year’s subscription to Straight Dope. Well since they only charged $4.95 that means that they left at least nine thousand dollars (assuming three thousand paid subscribers) sitting “on the table” so to speak. On the other hand since they were charging nothing the over fourteen thousand dollars in revenue they generated probably seemed like a good deal. Let say that a complex “retrospective analysis” concludes that profits would have been maximized at a subscription rate of $20.00 per annum (at this rate perhaps only 1500 people would have subscribed in our hypothetical analysis, but the total take would have been thirty thousand dollars). Would this imply that Straight Dope made a bad business decision? I would submit that with this board (and perhaps with drugs such as Iressa) that there are factors that go beyond simple revenue.

5

You actually picked one of the best examples possible to demonstrate the discrepancy between the cost of production and the price charged in the marketplace: drugs. Well done!

I have worked for two drug companies and understand the issues here fairly well.

For all practical purposes the cost of producing an additional pill is zero. The trouble is that the cost of producing the first pill–including all the research–is monumentally high.

The problem is further complicated by the fact that revenues from drugs that a) seem promising after a heavy bout of preliminary research, b) get approved by govt. agencies around the world, and c) succeed in the marketplace must bear the cost of all those that do not. The upshot is that the drug company’s P&L and the price of its products have only an arbitrary relationship.

This creates unhappiness for those who need the products–as in your case. People know that their bottle of pills costs no more to produce than so much Pez–yet still the drug company demands a king’s ransom for your chance to survive.

The pricing of drugs can be described with the following algorithm: charge what countries with price controls will allow (most countries, peanuts), and soak the US. The algorithm for soaking the US is, on the other hand, extremely complicated because the environment is so complex: the consumer wants cheap prices, HMOs want cheap prices, the US Fed Govt wants cheap prices for Medicare/caid/VA patients–and you have to tangle with all of them. Keep in mind that it is illegal to sell at different prices to different organizations (antitrust law) without a reason–such as volume purchases. Then there is competition. Then there are people trying to buy drugs from Canada, where price controls are in place.

At one drug company I worked for, one drug (a pill + injection) had a 1 year course of treatment running at $18k. This sounds similar to what you are dealing with. A drug company will be inclined to charge thus much if it feels it can get a significant amount of insurers to pay for it (usually for a heavy-duty illness without other good options) and if the overall market is small. The calculations are cynical, I agree, but if, say, only 10,000 people are going to use the product,

5,000 users x $20k (absurd price) is $100M, whereas
10,000 users x $1k (reasonable price) is just $10M–1/10 the revenue.

The inelasticity of demand will tend to have this effect. BTW, the company would be happy to sell indigent patients the drug for $1k, if they could preserve the high price for those who would pay it.

But as you suggest, there are many instances in which a product’s cost of production is low while the price is high, and the contrary could be true: the cost of production is high, but the price is low (perhaps even puts contribution in the red). Let’s look at some cases.

Production cost low, price high–ie, high gross margins on a product perceived as expensive yet cheap to produce

  1. The marginal production cost is low, but the overall production cost is high: drugs, etc.

  2. Overall cost is low, but the producer holds a patent, copyright, or other legal barrier to competition: CDs, movies, new inventions, etc.

  3. The product gains scarcity value over time, and the company doles out a demand-specific amount: aged Scotch.

In most cases, however, high prices attract competition. Unless there are hidden costs, as in example 1, or legal or physical barriers to competition, competitors will grab some of that gusto.

Production cost is high, price is low–ie, low gross margins on a product that seems relatively cheap

  1. Competitors are in a price war.

  2. The product is sold as a loss leader: lamb in supermarkets, which I have heard is not profitable but required to attract shoppers with money.

The above is by no means a systematic treatment–just a few ideas. I should point out that it is not always wise to charge as much as one can–the law of unintended consequences can do funny things. When DuPont introduced nylon, it purposely made it cheap–even though it had a patent and could have charged a hefty price for the substance as a silk replacement. Instead of just being used for silk stockings, companies found all kinds of uses for this cheap, strong fiber, and soon the whole world was hooked on it.

Your lawnmower repairman might have made a mistake–on the other hand, he may instinctively know that he can turn more business with that price level. Sometimes a person has two choices: you can work a little for high prices, or work a lot for lower prices. The latter may be a better choice for social reasons, and it can also be a smarter business move in that it increases your customer base while preserving the option of raising prices later. Pricing is complicated stuff!

6

In theory a firm will attempt to maximize profits. In practice, firms often attempt to obtain an acceptable level of profit with a comfortable or less risky existence.

Cost plus pricing is fairly common in some industries.

An examble of pricing independent of cost of production are brand name versus generic labeled products. Some firms sell the SAME product under different names with the brand name bringing a much higher price than the generic one.

7

Can I just be annoyingly pedantic and point out that they’re spelled: versus and bear.

As you were.

8

Roland Deschain titled this thread:
The cost of production verses what the market will bare.

In general, economics makes me uncontrollably sleepy, probably because I was a working member of a family business at age 9. By age 14 or 15, I knew why my father was never going to grow from being a small businessman to being a big businessman - but that’s irrelevant. :stuck_out_tongue:

<grammar pedant>
What is relevant is that using correct English helps to ensure that others take what you write seriously (I thought of using wrong homonyms throughout my response, but decided the OP does not deserve to be mocked).

I readily concede that homonyms are one of the more difficult aspects of the English language. One way of distinguishing them would be if we had a tonal language :cool: (such as Chinese and many other Asian languages), but the experts say that tonal languages are even harder to learn. :eek:

The word “verses” usually refers either to sections of a poem, or subdivisions of a chapter in the Bible (or other holy book). The word “bare” is a synonym for “naked”.

I suspect that the OP is one of those urfortunates who was taught to read by the pernicious “see and say” method, rather than the centuries-tested method of phonics (poor soul!), and for this reason I have (I assure you!) tempered my sarcasm.

For the benefit of those thus handicapped (whatever the reason), but who do not wish to expose themselves to embarassment, I offer the following: Alan Cooper’s All About Homonyms . The site also offers a very long - one hesitates to say comprehensive, as the visitor will see - list of such words. Further, it offers the poem, “An Ode to the Spelling Chequer” on the page link above.
</grammar pedant>

I think Aeschines’s explanation was masterly, BTW.

9

An oft-cited case study in marketing is Smirnoff Vodka, who essentially filled Smirnoff and Popov bottles from the same “tap” but charged $1 more per fifth for the Smirnoff
to appeal to that segment which assumes that price=quality.

“What the market will bare” is not necessarily completely removed from production costs, because if an adequate margin isn’t built into the price, suppliers will cease production. There are some businesses who price to sell volume, some who price for snob appeal, some who price to competition (and those who undercut competition), etc… “What the market will bare” is vague and general, business is specific.

10

I think that one thing you’re leaving out of consideration is that utility is not only measured monetarily. The lawnmower repairman and your experience as an appraiser both show a seller monetarily undervaluing their goods or services, but recouping the utility on the sense of self-satisfaction that comes from having done a good job at a fair – or even cheap – price.

Similarly, I believe the SDMB’s goal was not to make money, but to keep the board in operation. If fiscal pressures hadn’t come to bear I’m sure it would still be free. The aim was to minimize the price subject to the constraint of having to meet operating expenses for some time to come.

Note also that it’s not to meet expenses now, since as expenses go up, this would necessitate raising the rate, which is best done sparingly. A good example is what’s happened with first-class postage; it goes up and up so frequently that it appears to be spiraling out of control. If they had taken bigger steps than one or two cents at a time and taken them farther apart, the impression would be lessened. This also goes to show the other complication in economics that your professors probably weren’t too keen on mentioning: people are irrational. All the theories and statements about “what the market will bear” are abstractions and idealized models. Real humans tend to make decisions that contradict models.

Anyhow, since the goal wasn’t to make money, I wouldn’t say that the SDMB made a “bad business decision” in not charging more because they could have. On the other hand, seeing as how I had pretty much this response typed out at 05:30 I’d say that they made a bad business decision in not charging more so that they board WOULDN’T SEIZE UP EVERY OTHER TIME I TRY TO POST A %@#$%^& MESSAGE!.

11

Another factor in a pricing decision has to do with taking profits now versus taking (hopefully) greater or continued profits in the future. Your lawn mower repairman likely bought himself a customer for life, or at least for a long time to come, by not squeezing every last nickel out of you now.

It can be risky, though, as customers can sometimes have short memories.
RR

12

Just for another take on it all.

A thing is worth what someone is willing to pay for it. Cost of production is irrelevant. It doesn’t matter what a thing costs to make if no one wants it. There is no such thing as intrinsic worth.

People tend to value their lives quite highly and so are willing to pay quite a lot to maintain it.

13

Can I point out – without being accused of leaving GQ territory – that the reason that it’s a corporation’s job to “maximize profits” is because that’s what the owner’s want. For the majority of Americans, that’s you. If you have a 401(k) or a non-government retirement plan, you still own stock. When your balances start going down, it’s not just a crummy market – it’s your companies not doing their jobs.

I don’t think I’m directly related to any pharm companies.

14

Okay, but why can’t they at least be honest about the reason for their price or price increase? When was the last time that a company said “we are raising prices because we believe that the market will support a higher price for our product or service.” Instead they allude to the increased cost of doing business due to higer gas prices, floods in Bangladesh or fungus infestation. If I was CEO of XYZ company and we were going to raise prices I would simply announce “we are raising prices because we believe we can.” If it is an intellectually honest position (and that seems to be the consensus) then people shouldn’t search for other reasons. It never ceases to amaze me how many of my class mates and professors are offended when I reply to the question “so why are you going into nursing” that I want to be a CRNA primarily for the money! Why should I be ashamed to admit a motivation which seems to be the morally requisite position for most companies in the United States?

15

Well almost. Cost of production is relevant in that it provides a floor below which the price won’t go, even if what people will pay is less: the price doesn’t fall, the thing just never gets produced.

16

Easy. Get a copy of the veterinary drug catalog from your sales rep. Compare the prices to the one for MDs.

Because customer good-will is a business asset.

Nobody wants to pay more, even if they have to.

Suppose your friendly lawn-mower repairman charged you $80.00 the next time you take in your Toro. When you ask why the price has gone up, he replies, “I figure you are too lazy to load the mower back into your car and drive anywhere else. So I got you by the balls. Fork over.” He might be responding to the market, but he isn’t building up any good will.

Raising prices when you can is called “good business” when I do it. When you do it, it is “price gouging”.

Of course, when I undercut a competitor, I am “passing the savings on to you!”. When Wal-Mart does it, it is “predatory pricing”.

:shrugs:

Regards,
Shodan

17

Define “rational.”

Ask him if he could have made himself better off by changing his price. Odds are, if you include intangibles and not just dollars, the answer would be “No.” Things to note:[ul][li]“What the market will bear” does not mean “highest price possible.” In fact, it doesn’t really mean anything at all. It is just an excuse one uses to mollify those who don’t like a given price. If we simplify and assume that profit is solely being maximized—the lawn-mower guy may be maximizing in more dimensions than dollar profit, he does spend a third of his life there, after all—and that price is the only variable under the producer’s control that affects revenues (all else held constant), then there is no choice in price to charge unless there are multiple maxima. [/li][li]You mustn’t forget opportunity costs. Your local lawn-mower repair guy may not have given up much for the time & effort spent installing your blade. The other shop may have had to give up something more valuable, e.g. rebuilding a carbuerator (sp?). Those costs have to be taken into account when dealing w/ this sort of thing. Your principles prof. uses simple models to illustrate basic relationships in the same way Galileo might have rolled balls down an incline to illustrate basic relationships. Your job was to understand the methods and concepts, not the “facts.”[/li][li]There are some facts of life, and this is one of them: If it does you more harm than good to do a little more of something, you won’t do it; and if it does you more harm than good to do a little less of something, you will do it; therefore, you will do something until the harm and the good are equalized for that last little bit. This rule is a little more complicated over multiple activities, but it is essentially the same. To claim otherwise is to claim that you would deliberately do yourself more harm than good. Notice the implication of this: If you are going to do something until that last little bit causes as much harm as good, then anything that doesn’t affect the relative harm and good of that last little bit will have no impact on how much of the activity you do. Applied to a profit maximizing business we have,[/li][li]Marginal Revenues Equal Marginal Costs. A profit maximizing business will set a price where profit is highest and that may be a low price, or it may be a high price. If the firm has monopoly power, i.e. a downward sloping demand, then the price will be higher than the marginal revenue. Prozac will cost more than its marginal production cost. Fluxotine will cost less than Prozac.[/li][li]Drugs, 'cos I can’t spell pharmacuticals w/ any confidence, are not an example that is going to enlighten you at all. You might as well simultaneously drop a hammer and a feather and prove that Aristotle was right all along. With third-party payments, marketing, liabiltiy, regulation, patents, outreach, inter alia, you have so many complications that teasing out the basic principles is simply not viable.[/li][li]Assertions that people are irrational are generally overblown. Rats & pigeons are rational. Undergraduate students are rational. Google for “Vernon Smith’s insomnia” and you’ll get a nice little paper that discusses the beginnings of economics as an experimental science.[/ul][/li]
There’s nothing wrong or irrational with doing business in a non-profit-maximizing manner, if we’re assuming profit to simply be dollars. People are complex and things like honor & pride can certainly play a role in non-pecuniary aspects of their decisions, but even those are often motivated by profit. I’ve spoken w/ many small businesspeople who talk about doing the right thing, but it is always clear that they are doing so because an enhanced reputation is good for business. But even in the case of business for pleasure, e.g. I take up painting and decide to try to sell my paintings, one is going to maximize returns—in this case it is the joy of the avocation that is part of the returns.

That is being honest. If a major refinery breaks down, that means less gasoline supply and more stress on the working refineries. It’s not being dishonest to say that gasoline prices went up because a refinery broke down, nor is it dishonest to say that they went down because the refinery went back on line. It’s assumed that gasoline companies are profit maximizers. That doesn’t explain why prices change; it only explains their motives for doing business. When gasoline prices go down, do you think that they’re being lowered to lower profits?

18

Actually, I can do that in this context. When I say in reference to economics that people are irrational, I mean that they sometimes make decisions that don’t maximize their utility, even if you consider psychological forms of utility.

Have you ever had to teach them even something so simple as basic multivariable calculus?

19

I just assumed that he’s discussing the cost of producing erotic poetry. Because no one could intentionally make as many spelling mistakes as Roland does in his thread titles.

20

Pricing can be pretty complicated, thankfully, since it’s my job! There is more to worry about than trying to get the highest price possible.

For your drug, there is a very limited customer set, and people who need it will make sure to get it (most of them at least). Thus, as has been pointed out, you can raise the price without losing many customers.

For new lawnmower blades, a $70 price may very well scare away a lot of customers, who will just carry on with their old dull blade. At $25, you could wind up with many more customers who figure that’s not a big price to pay for a sharp blade. Would you rather have 5 customers a week at $70 or 25 customers at $25?

Similarly, with the SDMB, a price under $5 is throwaway money for most of us, low enough that even the small number of people who couldn’t afford it could find dozens of people willing to pony up the bucks to keep them active. At that price, you’ll get a lot of people willing to pay just because it’s so cheap, raise it to $10 and you would wind up with many fewer customers. The price changes from “one beer” to “one dinner”, that’s a significant change. Since one goal is to keep the membership numbers high, keeping the price low was important.

In my job we recently ran a promotion lowering one of our prices by 15-20%, the customer response was HUGE, we tripled our sales at least and decided to make the change permanent. We could still have gotten the higher price, but the lower price is far more profitable.

It is no doubt true that small business isn’t going to be as sophisticated with their pricing as larger businesses, they can’t afford to hire a guy whose job is just pricing, so they have to make it up themselves. Of course, they are also much more flexible than a big business once they discover something. You can’t imagine the trouble I had to go through to get the above price reduction through our systems, small guys don’t deal with that either. A lot of the time, we’re all just guessing anyway.