A Pragmatic Look At Market Pricing

Market Pricing Both Efficiently Allocates Scarce Resources And Increases The Scarcity Of Those Same Resources

DavidGrace
Sep 24, 2013 · 17 min read
Image by Robert Pastryk from Pixabay

By David Grace (www.DavidGraceAuthor.com)

It’s Not About “Fairness”

Supporters and opponents of Market Pricing usually line up on ideological grounds.

The left wing thinks it’s “unfair” to charge all the market will bear irrespective of the cost of producing the product.

The right wing thinks that prohibiting the owner of property from selling it at the highest price he can get is unfair.

Fairness Is A Moral, Philosophical Criteria, Not An Economic One

The problem with those sorts of arguments is that fairness is a moral issue not an economic one.

Arguing moral questions is a waste of time, always ending in “Is so!” “Is not!” You might as well debate who’s the prettiest person or what’s the best flavor of ice cream.

Fairness, like beauty, is in the eye of the beholder.

From a public policy point of view, we need to be concerned with what works best to promote a useful, productive, and efficient economy and society.

Capitalist principals promote profit incentives for entrepreneurs as a means to encourage efficient production and competitive pricing. These goals – preserving the profit incentive while also providing products at the lowest possible prices – are worthy goals for any economy.

Ideas of fairness should be expressed via the university philosophy department or the pulpit, not through public policy.

A Thought Experiment

Against that background, let’s investigate market pricing with a thought experiment. The simplified parameters of our experiment are:

  • The site for our experiment is a fictional town in the middle of a desert.
  • The sole source of water is from an underground aquifer whose volume in various scenarios either (i) exceeds demand or (ii) is less than maximum possible demand.
  • The burden cost of delivering the water to the user via pumping stations drilled into the aquifer is a flat one-cent per gallon irrespective of volume, that is, for this experiment we will assume that almost all costs of supplying the water are variable costs.

Scenario One — One Supplier — Unlimited Quantity — Monopoly Pricing

  • There is one and only one water source for the town, a well owned by the Acme Water Company which is located on the only site suitable for drilling access to the aquifer.
  • The quantity of water that Acme can pump far exceeds any possible demand, that is, there is more water available than would be used if the water were sold at cost.
  • Since Acme can produce all the water it needs at a low cost and it has no competition it sets the price per gallon based on extensive market research which had determined the price point where demand becomes inelastic, that is, it sets a per-gallon price that yields the maximum gross income, otherwise known as the Monopoly Price.

Put another way, demand falls more slowly than the prices increases resulting in an increase in gross revenue as price increases. Eventually, a price is reached where sales fall faster than the price increases and gross revenues then begin to fall on the reduced volume.

The price-point where the lost revenue from the decrease in sales volume exactly equals the increase in revenue from the higher price is the point where demand changes from “elastic” to “inelastic.”

This price generates the highest total revenue and is the Monopoly Price

Scenario Two — One Supplier — Limited Quantity — Market Pricing/The Auction Price

  • There is one and only one water source for the town, a well owned by the Acme Water Company which is located on the only site suitable for drilling access to the aquifer.
  • The quantity of water that Acme can pump is less than the amount that would be consumed if the water were priced at cost.
  • Since we need to balance supply with demand we know the price will increase at least until supply matches demand. Since the seller has a monopoly, if the monopoly price is higher than the Market Price, then it will charge the the Monopoly Price.

Scenario Three — Multiple Suppliers — Unlimited Quantity

  • There are two water sources for the town, a pump owned by the Acme Water Company and a pump owned by the Baker Water Company. Both pumps draw water from the same underground aquifer. The water from the two companies is identical in purity, taste and other attributes.
  • The quantity of water that each company can pump far exceeds any possible demand.

Scenario 3A — Price Competition Between Acme & Baker — Market Pricing/The Profit & Overhead Price

Acme and Baker compete on price. The price to the consumer stabilizes at some level based on costs of production and the lowest level of profit each company is willing to tolerate.

This is a Market Price whose floor is the cost-plus-profit or “Profit & Overhead” (P&O) price.

Each company’s sales volume and the corresponding profit each company earns is dependent on non-price competitive factors such as service plans, financial terms, marketing, promotions, loyalty programs, late fees, termination fees, etc. plus any unique cost savings one company may be able to put into practice.

Scenario 3B — Market Division Between Acme & Baker — A Cartel

Market Allocation By Acme & Baker

Acme and Baker agree (illegally) to divide the market by some objective standard, e.g. geography, volume; alphabetical by customer name or some other scheme that illegally allocates the market between the two suppliers so that each becomes a monopoly supplier to its customer base.

This strategy merely converts the single monopoly of Scenario 1 to two smaller monopolies, each of which will set a Monopoly Price for their market segment in the same way that Acme sets its Monopoly Price in Scenario 1, namely at the price point that maximizes gross sales revenue.

Explicit or Implicit Price Setting By Acme & Baker

Either by an explicit (illegal) agreement or by simply watching what the other one does Acme and Baker both charge the same price per gallon and compete on other factors such as late fees, service plans, refund policies, minimum orders, marketing gimmicks, and the like.

In this situation the size of the pie, that is the market, is fixed by the demand level at the identical price points both companies set, but the allocation of that pie between Acme and Baker varies depending on the effectiveness of their non-price competitive strategies.

Both Acme and Baker know that if either of them begins to compete on price then a price war will ensue and that both of them will suffer lower net profits from the reduced prices. Each resists the temptation to regain lost market share by reducing prices below the explicitly or implicitly set level.

They both agree on charging the monopoly price.

Summary Of Scenario 3B

The effect of Acme’s and Baker’s cooperation either in market allocation or explicit or implicit price setting is, for the purposes of pricing, essentially the same as merging the two suppliers into one monopoly supplier.

This is the same as in Scenario 1 where there is a single monopoly supplier. As in Scenario 1, the common price or the price in each allocated market will be the one that research has shown will result in the maximum level of gross revenue – Monopoly Pricing.

Scenario Four — Multiple Suppliers — Limited Quantity

  • There are two water sources for the town, a pump owned by the Acme Water Company and a pump owned by the Baker Water Company. Both pumps draw water from the same underground aquifer. The water from the two companies is identical in purity, taste and other attributes.
  • The quantity of water that Acme and Baker can pump is less than the amount that would be consumed if the water were sold at cost.
  • Acme and Baker are each limited to a quantity equal to one-half of the aquifer’s maximum daily supply.

The fact that there are multiple suppliers has no effect on price when the quantity of water available is limited.

Lowering prices will not increase either company’s net income because they can already sell more water than they can supply. Because they are not able deliver any additional product to any additional customers that might otherwise be attracted by a lower price there is no incentive for either of them to lower the unit price.

This is essentially the same situation as in Scenario 2 where the supplier (or in this case suppliers, plural) is supply-limited so that lowering the price will only leave greater unsatisfied demand rather than generate increased revenues.

If Acme & Baker have entered into a cartel agreement they will charge the Monopoly Price.

If Acme & Baker have not entered into a cartel agreement then the price charged by both Acme and Baker will be the price at which supply is balanced with demand – the Market Price.

What Have We Learned So Far?

When Supply Exceeds Demand

  • When there is more than one supplier and also the supply exceeds demand and there is no cartel agreement we will have a classical Market Price whose floor will be a Profit & Overhead price.
  • In the scenarios where supply exceeds demand and there is one supplier (or several cooperating suppliers) the pricing model will be maximum revenue pricing or Monopoly Pricing.

When Demand Exceeds Supply

  • So long as demand exceeds supply and there are multiple competing suppliers without any cartel agreement, the pricing model will be the Market Price which will always exceed the profit and overhead price.
  • In all scenarios where demand exceeds supply and the profit motive has caused the producers to enter into a cartel agreement we will see Monopoly Pricing, i.e. the price at which gross revenues are maximized irrespective of production costs rather than Market Pricing where an auction price balances supply with demand.

The Profit Motive Disfavors P&O Pricing

The supplier’s profit motive least favors P&O Pricing because P&O pricing returns the lowest level of profit to the supplier.

Conversely, P&O Pricing is the most desirable pricing model from the consumer’s point of view because (with limited exceptions) it provides the lowest prices.

Under classic capitalist theory:

  • the consumer benefits from price competition under the P&O pricing model;
  • producers are attracted to a market by the promise of profits, and
  • the desire for increased profits encourages producers to adopt more efficient methods of production and to increase supply.

However, if given the opportunity a producer will always choose to use the Monopoly Pricing model.

If the Monopoly Pricing model is unavailable the producer will usually find the Market Pricing model the next most profitable assuming that demand is high enough to keep the market price higher than the P&O price, namely, when

  • the product is a necessity;
  • cheaper acceptable substitutes are not available, and
  • supply does not exceed demand.

Where Market Pricing Breaks Down

The classic capitalist model of the economy is grounded in the belief that, by default, the available supply will be greater than demand and that competition among various competing suppliers will drive the market price down to the P&O price.

When supply is so great that the market price is far below the P&O price you get “boom” and “bust” supply scenarios, lots of bankruptcies and the government may try to step in and “fix” the problem with things like farm price-support schemes.

When supply is limited and the market price is above the P&O price you create a negative-feedback loop where the profit motive encourages producers to enter into cartels or adopt other schemes that will reduce supply (e.g. reducing the number of flights, taking plants out of production, closing facilities for “maintenance”) to even further reduce the product’s supply and thus increase the market price.

The more vital the product, the more likely that a further contraction of supply will increase gross revenues by driving up the market price while costs/unit remain unaffected.

This will continue so long as there are a limited number of producers, no one breaks ranks, and there are material barriers for market entry for new producers.

A limited supply of a vital product provides an incentive for a continued reduction in supply until the market price equals the monopoly price.

When the number of suppliers is limited by factors such as restricted distribution channels, high costs of entry (gasoline refining, pharmaceuticals), technological hurdles, patent/IP restrictions, supply or component unavailability, a market which by its nature can only support two or three suppliers (e.g. credit card issuers), or when the supply of a vital product is otherwise limited, then P&O Pricing will be quickly displaced by either Monopoly Pricing or Market Pricing that is far above the P&O price.

The Market Pricing model for vital products such as water, gasoline, flour, milk, lumber, copper, etc. can be extremely profitable for the suppliers and very costly to the consumer.

For the market price with competing sellers to materially rise above the P&O Price, supply must be limited or the sellers must enter into a cartel agreement.

If supply exceeds demand, and suppliers have not entered into a formal or informal cartel, producers will be forced into P&O Pricing which is, from their point of view, undesirable.

The profit motive urges suppliers to move to Monopoly Pricing (supply limited by one or more cooperating producers) or Market Pricing (supply limited by other factors) whenever possible.

An example of a market that has seen a drastically reduced supply and a shift from P&O Pricing to Market Pricing is gasoline.

Sellers have drastically reduced refining capacity over the last thirty years and the resulting limitations on supply have increased the Market Price far above the P&O Price, to their vast profit.

How Else Could We Allocate Scarce Resources?

Market Pricing does serve an essential purpose – the allocation of scarce supplies. There are supply allocation alternatives to Market Pricing, but there are no good supply-allocation alternatives.

Rationing

During wartime, governments have resorted to rationing systems. These systems are fraught with problems – forgery, re-selling, and black markets to name only a few.

Short of some short-term emergency situation, rationing is not a system that anyone wants to use to allocate scarce resources.

Lotteries

Lotteries are another option, but they have their own problems, not the least of which is that the winners will often re-sell their tokens at the market price. We see this in sports/concert tickets, for example.

A lottery system still results in market pricing. It’s just that it’s one a step removed from the producer.

Instead of the producer gaining the extra money derived from the increased price due to a limitation in supply, the lottery winner gets the extra money by reselling the ticket.

This is worse than pure Market Pricing because it does not reward producers for supplying a product, and it also breeds anger and contempt for the entire system while at the same time not offering any offsetting social or economic benefits.

Objective Test Allocation

In limited circumstances a “rational” allocation method might be adopted. This is how organ transplants are supposed to work.

This sort of a system, however, is unworkable for most products and, in the end, is merely a variation of the rationing scheme.

If I get on an allocation list for gasoline then, essentially, I’m part of a rationing system with all the black market and other problems such a system entails.

Random Factor Allocation

Random allocation factors can be tailored to specific products. For example, gasoline could be sold to cars whose license plates end on an odd number on certain days and ones that end in even numbers on other days, but that sort of system is also filled with problems – siphoning gas from your car and selling it to your neighbor, switching plates, and bribing retailers, to name only a few.

Also, this only shifts the market-price bonus from the producer to the person who possesses the random attribute on any given day.

The Market-Pricing Paradox —Market Pricing Both Efficiently Allocates Scarce Resources And Increases The Scarcity Of Those Same Resources

So we’re back to using Market Pricing to allocate scarce resources, but we’re still stuck with the problems of Market Pricing.

Market Pricing

  • does not provide an incentive for the producer to increase the supply of scarce resources, but rather
  • actually gives the producer an incentive to reduce the supply of scarce resources.

Today the last thing the oil industry wants is increased refinery capacity. A material increase in supply would drive the market price down toward the P&O price which would drastically reduce the refiner’s profits.

A rational economic and social system would use a mechanism where the profit motive encouraged producers to increase supplies of scarce resources and thus reduce prices, but Market Pricing’s incentives operate in the opposite direction.

Market Pricing’s incentives promote a reduction in supply and an increase in prices.

The paradox is that while you need Market Pricing to allocate scarce resources, Market Pricing provides an incentive to the producers to continue to keep those resources scarce in order to maintain or increase those higher prices.

Because of multiple factors, other producers will likely not enter the market to expand supply. Not the least of those other factors is the unattractiveness of spending hundreds of millions, perhaps billions of dollars to enter a market in competition with well-funded, established companies with extensive distribution channels and millions of existing customers when the reward, if you succeed, will be getting stuck selling your product under the low-profit P&O pricing model.

A Solution To The Market-Pricing Paradox

There is an answer to this Market-Pricing paradox – an excess profits tax.

Before the juxtaposition of the words “excess” “profits” and “tax” starts you muttering about socialism and left-wing nut-jobs, take a breath and let’s look at the numbers.

Scenario Five – One Supplier – Limited Supply – Excess Profits Tax

  • There is one and only one water source for the town, a well owned by the Acme Water Company.
  • The quantity of water that Acme can pump out is less than the amount that would be consumed if the water were priced at cost, that is, at a low price demand for water will exceed the supply.
  • Since we need to balance supply with demand we allow the price to increase until supply matches demand. Essentially, the supply is auctioned off to the highest bidders – Market Pricing.

Maximum supply is 1,000,000 gallons per day. Costs are 1 cent/gallon. Demand is such that the market price for those 1,000,000 gallons is 5 cents per gallon.

The City has imposed an Excess Profits Tax as follows: the burden cost of production is 1 cent per gallon and a level of 50% profit over the burden cost of production is deemed reasonable, therefore, all of Acme’s income under 1.5 cents per gallon is tax free.

The difference between a price of 1.5 cents per gallon and the price charged is taxed at 99%.

Acme’s Daily Numbers at 1,000,000 Gallons/Day, $10,000 in costs.

Price/Gallon - Gross Sales — -- Costs — — Taxes -— Profit

1.5 cents ——-$15,000 —-—$10,000 —--0 — — — $5,000
2.0 cents ——-$20,000 — — $10,000 — $4,950 —-$5,050
2.5 cents ——-$25,000 ——$10,000-—$9,900 —-$5,100
3.0 cents ——-$30,000 ——$10,000—$14,850 —$5,150
5.0 cents ——-$50,000 ——$10,000—$34,650 —$5,350 – Market Price

6.0 cents — — -$60,000 — —$10,000 — $44,550 — -$5,450

While the market balances supply with demand at 5 cents per gallon the higher price of water does not materially benefit Acme.

The profit motive to restrict supply and thus further increase the price has been taken away by the tax.

Under this mechanism Acme has no motive to reduce supply.

In fact, the only way Acme can increase its profits is to increase supply.

Without the tax, Acme has no incentive to increase supply. In fact, without the tax Acme has a motive to decrease the supply.

If Acme can increase supply to 2,000,000 gallons and the market price falls to 2.5 cents per gallon, Acme’s profits increase from $5,150 at a 5 cent/gallon market price to

Price/Gallon — Gross Sales — — Costs — — Taxes - — Profit

2.5 cents — — -$50,000 — — $20,000 — $19,800 — $10,200

Motivated by the desire for higher profits, Acme expends additional (tax deductible) capital to widen the underground channel inside the aquifer and increases the daily supply from 1,000,000 gallons to 2,000,000 gallons.

When the volume doubled the market price fell from 5 cents per gallon to 2.5 cents per gallon, but Acme’s profits increased from $5,150/day to $10,200 per day.

Obviously, Acme will need to recoup its capital investment, but a substantial portion of that cost is an amortized deduction against these profits taxes so, essentially, the City and Acme will share the costs of the increased production while the consumers will benefit from the lower prices and Acme will benefit from the higher profits derived from the higher volume of product. Everyone wins.

At the market price of 5 cents per gallon for 1,000,000 gallons and no excess profits tax Acme would make $40,000 per day.

Without the tax, if Acme increased the supply to 2,000,000 gallons and the market price fell from 5 cents to 2.5 cents its gross revenue would be $50,000 and its costs at 1 cent per gallon would be $20,000. Its profit without the tax would be $30,000 instead of $40,000.

Without the tax, by increasing the supply Acme actually would lose money.

Without the tax, Acme would make $10,000 per day less profit by doubling the supply and seeing a fifty-percent reduction in price.

Without the tax, market forces combined with Market Pricing give Acme a strong profit incentive to keep the supply limited.

In fact, if the supply fell to 800,000 gallons and the price increased to 6.1 cents per gallon Acme’s gross sales revenue would be $48,800 and its costs would be $8,000 giving it a profit of $40,800, a higher profit than the $40,000 it would have earned by delivering a million gallons at 5 cents per gallon.

Not having an excess profits tax hurts consumers in two ways, a double whammy,

  • a lower supply of water being available AND
  • a higher cost per gallon.

And we haven’t yet considered the effects on the City’s economy of less water and less money available to the citizens to spend on other goods and services offered by other businessmen.

Without the tax, Acme is actually motivated to refrain from spending any money to increase the supply.

Since the capital investment needed to increase the supply is tax deductible, the existence of the tax actually encourages Acme to make the tax-deductible investment to increase the water supply.

Without an excess-profits tax, the producer will make more money by reducing the supply of a limited-supply product, that is, the producer will make more money by selling fewer units at a higher per-unit price.

The profit motive gives producers an incentive to reduce supply and increase price because when smaller quantities are produced costs decrease until the point where

  • fixed costs negate the benefits from reductions in variable costs, and
  • the number of units sold drops faster than the price/unit increases.

Put another way:

Market Pricing gives producers a profit motive to keep supplies low when society wants the market to give producers a profit motive to keep supplies high.

The profit motive causes producers of products in limited supply not only not to spend any money to increase supplies but actually to affirmatively act to reduce supplies.

BUT, if there is an excess-profits tax coupled with tax deductions for expenditures that will increase the supply, the profit motive will encourage producers to increase supplies which increased supplies will lead to lower prices for consumers.

If an excess profits tax is imposed, consumers of products in limited supply will see an increase in supplies and a reduction in prices .

Holding True To Capitalist Principals

From an objective, capitalist, point of view we all should want an economic policy is that uses market forces give producers a profit motive to provide goods and services at the lowest possible prices.

From a capitalist’s point of view, whether Acme’s profit is $10,200/day or $40,000/day is irrelevant.

As capitalists, all we care about is that the market (not the government) incentivizes producers to produce good products at the lowest possible price.

Capitalism’s Promises

Also, as capitalists we expect free market forces to produce lower prices, not higher ones.

Capitalism does not promise that any particular business will see a doubling of its profits at the expense of doubling the price to consumers. Just the opposite.

Capitalism promises us that market forces will give producers a profit motive to lower prices and increase supply, not the other way around.

Market Pricing of products in limited supply without excess profits taxes delivers:

  • incentives to reduce supply;
  • prices that are higher than those that would prevail if the free market were allowed to work as it was intended.

Market Pricing of limited-supply products coupled with excess profits taxes delivers exactly what the capitalist system promises:

  • prices set by the free market (not the government);
  • market-based rewards to entrepreneurs; and
  • price efficiency to consumers.

Capitalist Principals Require A Fix For Market Pricing’s Flaws

If you believe in the principals of capitalism then you need to accept excess-profits taxes in the same way that if you believe in the principals of capitalism you need to accept anti-trust/anti-price fixing laws.

Both are required for the capitalist system to work as its supporters intend.

If you warp the rules so that the capitalist system doesn’t work as promised, you are giving ammunition to those who want to destroy it.

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Graduate of Stanford University & U.C. Berkeley Law School. Author of 17 novels and over 200 Medium columns on Economics, Politics, Law, Humor & Satire.

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