Monday, February 18, 2019

Displaying ignorance is seldom a good thing

Last week I wrote an article titled, "Bait and switch" prices are still going strong".  In it, I made this statement:

What's more, many of the prices charged for goods bear no relation whatsoever to the actual cost of production of those goods - another con game.

I was immediately pilloried by various commenters, both here and on Instapundit (which linked to the article).  A common reaction was to describe that statement as "socialist", and to decry any linkage whatsoever between cost of production and selling price.  I was publicly attacked for my "ignorance" on some other blogs (although I note with some cynicism that when I attempted to post a comment replying to such attacks, that comment was seldom published).

However, those disputing my statement were, in fact, displaying their own ignorance on the subject.  I think it deserves a short explanation, for their sake if nothing else.  BTW, my "credentials" in this discussion are that I've studied economics at undergraduate and graduate level.  I don't consider myself an "economist" in professional terms, but I know enough about the subject to consider myself economically literate at a businessman's level.  I'm not just sucking this stuff out of my thumb.

To begin with, cost of production is only one of many factors that affect the price of an item.  There's an entire field of economics dealing with the subject, and it would be impossible to summarize it here.  For those interested in reading more, try one or more of these sources:

There's a fundamental relationship between what something costs to produce, and the price for which it's sold.  Basically, any businessman wants to make as much money as possible off each product:  but he's constrained by reality.  If he's selling it for, say, a hundred times what it costs him to make it (or buy it from someone who makes it), he's seemingly sitting pretty:  but every other businessman out there will notice that sort of profit margin.  Before long, they'll be selling similar products and undercutting him on price.  In other words, he has to set his price at such a level that the profit margin doesn't tempt others - or, at least, too many others - to enter his market.  The cost of production or acquisition is therefore an indispensable consideration (although, as stated above, not the only one) in the price of that product.

There's also the factor that excessive profit will attract public objection, and possibly political and regulatory intervention.  The past few years have provided some high-profile examples.  Consider, for example the scandal over the soaring price of Epipens, or the fury over the increase in price of Daraprim, both long-established medicines.  In both cases, the cost of production of the product concerned (tiny in relation to what consumers were expected to pay) was repeatedly cited in objections to their outrageous and egregious price increases.  Attempts by executives of the companies concerned to explain their actions went nowhere fast.  Both instances were very clearly "profit grabs", and the public and politicians saw through them and demanded action.  Any business trying to price its product at such excessive levels can expect such pushback, from the buying public at least, and possibly from the authorities if customers make enough fuss about it.  They will, if it's important enough.

Consider also the laws against price gouging passed in several states, that prevent businesses from raising prices on their existing stocks of critical items (e.g. fuel, emergency food supplies, etc.) during an emergency.  One can argue that such laws are misguided, because such increased prices serve to balance the (extremely limited and temporarily irreplaceable) supply with the sudden, vastly increased demand for it;  but that's beyond the scope of this article.  Suffice it to say that the reason such laws were passed is because consumers in those states knew full well that some businesses were making a fortune by charging vastly more for their stock in trade than it had cost them, and they resented it.  That resentment translated into passing laws to prevent and/or punish such profiteering.  Like it or not, the price of the article was legislatively linked to its input cost/cost of production, and that remains the law in those areas to this day.  I don't see it changing anytime soon.

"Pure" laissez-faire economics would certainly postulate that there should be no linkage between the cost of production of an item, and its selling price.  However, there is no such thing as "pure" laissez-faire economics, anywhere in the world.  It's no more than a theory, a pipe-dream, in precisely the same way that "pure" libertarianism would be completely unworkable as a means of running society.  There have to be checks and balances on the "purity" of both concepts, lest their "perfect" theory should run headlong onto the rocks of practicality in day-to-day life.

One such "check and balance" is the concept of a moral and/or ethical price.  Every major religion in the world, and most developed philosophies of life, embody, directly or indirectly, considerations of what is just and unjust in economic terms.  That includes the pricing of goods for sale.  It's generally considered unjust to set an excessively high price for necessities in terms of their actual cost, because people will suffer without them.  Their cost figures into what is considered a "fair" or "just" profit margin in pricing them.  For example, usury (the lending of money at excessive rates of interest) was (and still is) generally condemned as wrong, even sinful.  The modern version of an usurer, a loan shark, is considered a criminal in terms of many civil laws based on such norms.  The Epipen scandal referred to above was said to have "crossed ethical boundaries".  There are many other examples.  Such moral and ethical (and sometimes legal) constraints are a fact of life when setting a product's selling price, and we ignore them at our peril.

I'm not going to waste your time by going into more detail here.  I've provided sources you can read if you'd like further information.  However, let me close by reiterating that its production cost is inextricably linked to the selling price of a product.  That's not socialism, although socialists like to claim it as one of the tenets of their philosophy.  It's basic economic reality.  There are many other factors affecting price, to be sure:  but production or acquisition cost is unquestionably one of them.



McChuck said...

There is no doubt that the drastic price increase on epi-pens and inhalers was a price gouging move by monopolists. This is why we need some government regulation to protect the consumer. (You'll notice that these agencies don't seem to be doing a good job, now are they?)

There is also no doubt that the cost of a drug bears almost no relation to the cost of materials. The materials cost pennies. The research costs billions. The reason new drugs cost so much in America (for the first 17 years) is that we are subsidizing the drug research for the entire world.

For every drug that goes to market, a dozen fail in final trials. For every drug that fails final trials, a dozen fail initial trials. For every drug that fails initial trials, a dozen fail primate trials. And so on, and so on. Each level of testing and research costs exponentially more than the last.

But there is no reason in the world for an existing drug to to have its price increase tenfold overnight. That's just evil.

Glen Filthie said...

You’re an expert in economics too? I’m still in shock from your scholarship on aerodynamics. Who would thunk I could take out the UNMC and the USN ... with toy drones? Your credentials are endless, Pastor!

You charge what the market can bear, Pete. That’s what all your theories boil down too - you’re welcome. There is nothing unfair or dishonest in that. Price gouging occurs when crony capitalists or suppliers monopolize and manipulate the market. They are two entirely different things.

Dad29 said...

Those who decry the US as "capitalist" conveniently forget the US' anti-trust and regulatory bodies, as well as those of the several States. So yes, the US is "capitalist," but it is also very constrained capitalism (with a few exceptions that you mention.)

The arguments about 'price fairness' therefore revolve around "degree," not of substance here. That's a good thing.

MadMcAl said...

Many people conveniently overlook that pure (aka unregulated) capitalism is as bad or even worse than communism.
Unregulated means when big corp sends the Pinkertons to bust a few heads there are no regulations (aka laws) against it.

And of course the dream of every capitalist, a monopoly is a disaster for every body else.

And it is irrelevant why there is a monopoly.
Is it for patent reasons? Well, these monopolies expire.
Because of some nebulous regulations... good luck getting rid of them.
Because of a cult? Well, Apple is learning now that even THAT can be abused to the breaking point.

McChuck said...

MAdMcAl - The Pinkertons were sent to evict striking workers who had claimed the factory was their own private property. (The workers decided they owned the means of production - sound familiar?) The workers opened fire on the barge before the Pinkertons even got off the boat. The clubbed down the Pinkerton men after they surrendered. The militia finally arrived, putting an end to the strike.

The strikers were in the wrong at every single point of the conflict. They're not heroes, but villains.

C. S. P. Schofield said...

I had a visceral negative reaction to this article....which I got over as I read it. But the REASON might be worth examining. I used to sell videotapes and DVDs. One of the repeated conversations I would have was with people who were angry that videos 'cost so much' when it only cost 'X' to make them; 'X' being something very small, amounting to the cost of manufacturing the recording medium and placing the recording on it. Nothing for the cost of the content. Nothing for storage, shipping, storefront, wages. And nothing to cover the cost of all the videos that did not sell. Talking to such people was infuriating. They could not grasp that they had to pay to cover the cost of films that did not sell if they did't want their options to be limited to thing that were SURE to move.

There are aspects of this in the very real scandals you raise. The Epipen issue? Well, the FDA's obsession with never EVER approving anything that has any chance whatsoever of being another thalidomide has made developing and manufacturing pharmaceuticals a very high risk business. Such businesses attract gablers, who (Kenny Rogers to the contrary) tend to be sketchy people. This is a 'cost' of the situation that many people who (rightly) complain about it do not take into account. And as long as it isn't taken into account, the problem will come back.

Ray - SoCal said...

The problem with economics, is 50% of its wrong. The headache is figuring out which 50%.

Price should be set by how much is a person willing to pay. There are usually alternatives, which limits the pricing power. The cost to manufacture usually sets the lower limit on price. Figuring out what the price should be is hard. The usual wholesale discount is 40%. Distributors get a lower mark up, day 10% in the book industry. Publisher / mfg sells at 50% off. Price is often set by volume.

Regulatory Capture is what happens in many products and services, where the government creates a monopoly. Alternatives are not allowed, which is what happened with the Epipens Pen. The fda for a while did not allow an alternative.

Costs are a factor in a business setting a price.

Selling price should include:
Manufacturing cost
Wage costs
Regulatory compliance costs
Inventory costs
Freight in

The us is partially capitalistic, with a lot of government involvement. We are actually less capitalistic in many areas than Sweden or Denmark.

EBook pricing is a good example. Should peter set his selling price at a few pennies? No printing costs? Is $4.99 an excessive profit margin? Or van he price his ebooks at $9.99?

What price point should he use?

Should he make the first in a serious free, and thebitheres $6.99? Assuming the first one is so good, it causes them to buy the next? And what of kindle unlimited?

C. S. P. Schofield said...

Ray makes some good points; a lot of the trouble with 'predatory pricing' is that supply has been curtailed. In the case of 'price gouging' if the State caps the amount the price is allowed to rise, that cuts down on the incentive for people to bring in new supplies...and the supply simply runs out.

Mad Jack said...

I've studied economics at undergraduate and graduate level...

So have other people. I, for instance, have studied any number of things at graduate level. My GPA is still somewhere around 0.25 (zero point two-five). That means I'm no expert in spite of my studies and degrees, or lack thereof.

While there's an indisputable relationship between production cost and retail price, that's only a small part of the picture. For instance, in 1984 I sold personal computers and software. The big deal back then was Lotus 1-2-3, which retailed for $500 ($1,200 in today's dollars), but cost less than $25 per copy to produce. People complained bitterly about this, and when one supposedly learned man (an attorney from a major law firm in town) asked me why Lotus was priced so ridiculously high during a business meeting, I simply shrugged and told him Because they can. What else are you going to use?, and that was that.

That's the real case. No matter the product or the service, the vendor will charge as much as he can get. Drug manufacturers whine about development costs and refuse to reveal their accounting books while the CEO and the Board of Directors write multi-million dollar bonuses to each other, and the consumer tries to decide just how the family can live for another week on church suppers and Ramen noodles.

I don't blame the drug manufacturers. I'd do the same thing myself if I were in their shoes.

My point is that when an item reaches this level, production cost has little to nothing to do with the final cost to the consumer. Yes, the relationship exists. No, the production cost really doesn't matter.

At the other end of the spectrum is food and government subsidies. Whoever wants to open that can of worms is welcome to do so, I'm just pointing out that it exists.

In the middle of this biodegradable junkyard is everything else, which makes up something on the order of 99% of the GDP in the U.S. I'm discounting monopolies for energy production, etc. But there you have it, and these are the products and services where cost of production does matter.

Dad29 said...

Software costs money because a helluvalotta programmers wrote the system before Sale One ever occurred, and a helluvalotta programmers are improving the system.

Cars cost money because--in addition to the obvious--the manufacturers have to cover warranty costs and keep spare parts available for 10 years after production ends.

Just like with the videotapes, most people never think of all that. They just want it for nothing, or near-nothing.

Xoph said...

I'll just say I've done pricing for products and services world-wide and have the commensurate professional education. Peter has an excellent grasp of the subject.

Much of the issue here is one of human relationships and morality. The problem is one of scale. In our families we are communist or socialist. There is social pressure to keep bad behavior in check. We cooperate, put money in the same pocket and support one another. However, as we expand outside the family the relationship that is in the family no longer exists and some people will start looking for the easy profit. Take the money and run. However, the people buying the product feel that there should be limits linked to production costs. As noted above very few people understand overhead costs, or the costs of providing variety. However, note that people buying the product appear to have a closer relationship to the seller, than the seller does to the buyer.

Government intervention doesn't help. Good discussion on drug manufacturing above. Many drug companies can only sell the drugs outside the USA for a percentage over manufacturing costs. Patents only last 17 years, and many of those years the drug is in development. Each successful drug has to pay for 10's who fail. How do you pay for that research? The mechanism the US has is high drug prices. And which countries are subsidizing the research costs that will help their citizens? (crickets)

When companies shifted their focus to profits and the stock price, you set up situations like the epipen. Profits have to come from somewhere and growth has to be constant. Communism, Socialism, or capitalism would work fine if people were perfect, but since we are not this is a moral issue.

I'm very familiar with the arguments for charging all the market will bear. Actions have consequences, customers have memories. Make a guy feel like you screwed him and he will never be your customer again. You've lost the trust necessary to have a commercial relationship. You can make a lot of money quickly and lose repeat customers, or you can set yourself up for a long-term relationship. People don't sic the government on companies who provide a good product or service at a fair price. Everyone defines that word fair differently, and no one seems to want to have a good discussion about what is fair.

Unknown said...

The Epipen increase only happened because there is no competition for the drug.

The patent has lapsed so there should be, but various regulations have specified the brand, not the drug, which makes anyone trying to compete face a very steep road.

Allow for real competition for generics and this sort of abuse will fail.

David Lang

Contrarian View said...

Sorry, Peter, you're still wrong. And blaming us all for our "ignorance" sounds like projection to me. Price is based on value to the customer. Sure, in a longer run competition may drive the price down to a marginal increment over cost, based on the law of supply and demand. But in the long run we're all dead.

McChuck said...

Here's a humorous take on the whole business.