A Product’s Price Has, & Should Have, Nothing To Do With Its Usefulness
By David Grace (www.DavidGraceAuthor.com)
There is a basic dispute about price between manufacturers of vital products and everyone else who supports the capitalist, free-market, economic system.
Supporters of the free-market system believe that prices should essentially reflect the costs of manufacturing and distributing a product plus the minimum level of profit that competing sellers are willing accept, that is, the free-market, competitive price.
Manufacturers of vital products such as gasoline, pharmaceuticals and the like think that prices should be proportional to how essential the product is to the buyer’s personal health and/or continued business existence, that is, an all-the-market-will-bear monopoly price.
The people who believe that price should be proportional to how essential a product or service is think that they have some kind of a moral right to demand a high price for a good that is extremely useful or vital, e.g. prescription drugs, and a companion moral right of the buyers of products of limited usefulness, e.g. an hour of unskilled labor, to only pay a low price.
Those people are completely wrong.
Contrary to what wannabe-monopolist drug companies and fast-food-company executives wish were true, a product’s high or low complexity or usefulness does not morally justify either a high price or a low one.
Price is an economic issue of cost plus a competitive level of profit not a moral issue involving the words “worth” or “deserve.”
How Prices Are Set
The principal way that prices are set in a capitalist economy is through the market mechanism where competition drives prices down to cost plus the lowest level of profit that a competitive seller is willing to accept.
The market price of a product or service is:
- The lowest price that competing sellers are willing to accept for it, and also
- That buyers are willing and
- Able to pay for it
The Market Price
The market price for a good or service is solely dependent on the bargaining power of the sellers versus the bargaining power of the buyers with a long-term floor equal to the costs of production and distribution.
The greater the bargaining power of the sellers in relation to that of the buyers, the higher the price.
The lower the bargaining power of the sellers in relation to that of the buyers, the lower the price.
The words “fair” “worth” “deserve” and “entitled” have nothing to do with a competitive market price.
The bargaining power of the sellers versus that of the buyers is itself dependent on many factors:
- The larger or smaller the number of sellers
- The larger or smaller the number of buyers
- The extent to which the sellers are acting in concert or in competition — are the sellers independent competitors or a cartel?
- The extent to which the buyers are acting in concert or in competition — are there many independent small buyers or a cooperative representing all or almost all the buyers?
- How badly the sellers need to sell — is the product perishable? Is the seller almost bankrupt?
- How badly the buyers need to buy — will the buyers go out of business or die if they can’t get the product?
- The extent to which supply exceeds demand — is the product so overstocked the sellers will take almost any offer just to get rid of it?
- The extent to which demand exceeds supply — is the product in such short supply that buyers are bidding up the price?
- The cost to produce the product — if the product costs $100 to produce, the everyday price can’t be less than that if the sellers are to remain in business
- The wealth of the buyers — the fewer the buyers who can afford the product, the lower the demand. The lower the demand in relation to the supply, the lower the sellers’ bargaining power.
Goods & Services With A High Intrinsic Usefulness May Have A Low Market Price
Extremely useful, beneficial products like insulin, penicillin, and drinking water have a high intrinsic value because the buyer’s life often depends on having them, but if manufactured by independent sellers in a competitive market (no cartel) they may have a relatively low market price if the costs of manufacture and distribution are relatively low.
Yes, a product that requires rare talent or expensive resources to produce may be in short supply.
If the supply for such a product is small and the demand is high, that imbalance between supply and demand will increase the seller’s bargaining power and that increase in the seller’s bargaining power vis-a-vis that of the buyers will increase the price.
But if the product’s supply is not limited, the fact that manufacturing the product requires rare talent or large resources is relevant to the market price only to the extent that it increases the floor price that must be charged in order for the sellers to be able to remain in business.
If the supply of a vital product, e.g. drugs or gasoline, is not restricted, the product’s free-market price bears no relation to its usefulness or how much people need it. It is only related to the bargaining power of the parties with a floor equal to the costs of production and distribution.
That’s why sellers of useful or vital products, oil refiners and drug manufacturers, want to limit supply and form cartels — so that they can base their price on how essential their product is rather than on the bargaining power of competing sellers and buyers in a free-market, because free-market competition results in a cost plus some level of profit price instead of a monopoly price.
They want to have a cartel so that they can increase their product’s price from a competitive, cost-plus-profit market price to an all-the-market-will-bear monopoly price because a monopoly price for essential goods and services is vastly higher than a competitive market price for those same goods and services.
For people who believe in the free market, a vial of insulin is not inherently “worth” a thousand dollars because it can save a diabetic’s life.
For pharmaceutical companies, a vial of insulin is “worth” the maximum amount of money a monopoly/cartel seller can collect for it, that is, the monopoly price.
Goods & Services With No Intrinsic Usefulness May Have A High Market Price
Suppose a ten-year-old boy chewed a piece of gum, stuck that wad of nasty gun onto a piece of filthy cardboard, framed it, and hung it on the wall of his father’s Madison-Avenue art gallery with a crayon-scrawled price tag of $10,000.
The seller has a monopoly on this item so that increases the seller’s bargaining power. The item is unique which also increases the seller’s bargaining power.
On the basis of utility, complexity, beauty, difficulty of creation, whatever metric you want to use, the inherent value of that framed piece of used gum is zero.
Further suppose that a billionaire saw the framed piece of gum and bought it for $10,000.
- Intrinsic Value: $0
- Dollar Value To That Buyer: $10,000
Price is irrelevant to usefulness. If it were, a Patek Philippe watch would not sell for $30,000.
The Market Price & Unskilled Labor
Suppose that a factory manufactures electric scooters with 400 mostly unskilled workers. It pays $10/hour and its burden cost of labor, including payroll taxes, etc. is $12/hour.
The costs of the labor and materials to manufacture a scooter are $500, of which 20% is labor, $100, and 80% is parts, $400. 8 1/3 hours of labor are needed to build one scooter.
At its current sales level of 100,000 units per year, the company’s overhead costs — rent, utilities, marketing, executive salaries, administrative costs, insurance, etc. — are another $1,000/scooter. It sells the scooters for $2,000 so the company makes a pre-tax profit of $500/scooter.
The United Auto Workers union has already unionized one factory in the area near the scooter plant and that new union contract provides for an unskilled pay rate of $20/hour plus medical, 401k contributions and increased vacation and sick leave pay.
The scooter executives decide that also increasing unskilled wages at their company to $20/hour with a new burden cost of $24/hour should be sufficient to blunt the union’s recruitment efforts at their factory and avoid a union contract which would increase in fringe benefits costs by about a $1 million/year.
This pay hike will double the labor cost per scooter from $100 to $200 and the cost to manufacture a scooter will rise from $500 to $600.
Scenario #1 — Management Raises Its Price To Recover The Additional Cost Without Losing Sales
Management decides to add an Inspection, Factory Detailing, Prep & Delivery fee of $100 for every scooter sold, raising the total revenue per scooter to $2,100 and thus maintaining the original pretax profit at $500/scooter.
Management determines that this $100 “Prep Fee” will not materially reduce sales volume.
The number of units sold remains the same. Profits per unit sold remain the same. Profit per year remains the same. Productivity remains the same.
From the employer’s point of view, doubling the unskilled pay rate costs it nothing and, in fact, it saves the company a million dollars in increased fringe-benefit costs that it would have to pay if it didn’t raise the pay rate and then was faced with a union and possibly a strike.
The market value for unskilled labor is now $20/hour instead of $10/hour because the unionization of a neighboring factory has increased the scooter workers’ bargaining power.
Scenario #2 — Raising The Price Will Reduce Sales
But suppose the company calculates that raising the price by $100 will reduce sales by 5% down to 95,000 units. The loss of 5,000 unit sales X $500 profit/unit = a profit reduction of $2.5 million.
Keeping the price the same will cost the company $100/unit in reduced profits X 100,000 units = $10 million in reduced profits.
If the company stays at $10/hour and the factory becomes unionized and the workers go out on strike, the company will lose 8,333 units/month X $500 profits/unit =$4,166,500/month X however many months the strike lasts no matter what is the eventual outcome of the strike.
If the company increases wages, avoids a strike and avoids additional union-contract fringe benefits, and adds $100 to the cost of each scooter it will only lose $2.5 million.
Essentially, the investment of $2.5 million in increased labor costs will save the company up to $4,166,500/month in profits lost to a strike and save an additional $1 million if it has to eventually accept a union contract.
It is clearly in the company’s best interests to increase wages and also to increase the price to cover the additional labor costs rather than either keeping wages at $10/hour or absorbing those additional labor costs in the form of lower profits.
What Is The Dollar Value Of An Hour Of Unskilled Labor?
The market value of unskilled labor is now $20/hour because the bargaining power of the workers has increased.
By paying an additional $2.5 million in labor costs the company saves over $5M it would lose from a one-month strike and union fringe benefits.
The company makes millions of dollars more profit by paying the higher wages than it would by keeping the lower wages.
From a financial point of view, the dollar value of an hour of unskilled labor is now $20.
The Worker’s Skill Or Training Is Irrelevant
Just as the essential nature of insulin does not mean that the market will set a high price for it, the market value of an hour of a workers’ unskilled labor is irrelevant to how smart the workers are, how simple their skills are, or how hard they work.
Like every other good or service, how complex, sophisticated, or useful an hour of unskilled labor may be is irrelevant to the market price for that unskilled labor.
The terms “fair” or “deserve” have nothing to do with it.
It is as irrational to claim that the unskilled workers’ labor isn’t “worth” $20/hour as it is to claim that Mr. Smith’s bespoke suit isn’t worth $5,000 or that a Rolex isn’t worth $25,000.
A good or service is “worth” whatever a buyer is willing and able to pay and a non-cartel seller is willing to accept, and that price is determined by the relative bargaining power of the buyers versus that of the sellers without reference to any inherent usefulness, skill, complexity or features of the good or service being sold except to the extent that those qualities affect the parties’ bargaining power.
Again, this disconnect between the essential nature of the product and its market price is why drug companies form cartels — it’s the only way they can tie the essential nature of their product to the prices they can charge for them, because without a monopoly or a cartel a product’s usefulness is irrelevant to its market price.
Other Issues Relating To Price In A Capitalist Economy
The Effect Of A High Or Low Price On 3rd Parties
The traditional system of Two-Party Pricing, namely, prices that are set by the buyers and sellers without reference to the effect of those prices on other people and organizations in the economy, cannot factor into the market price the costs and benefits to third parties of a high or low price for a particular product or service.
Those third-party pricing issues are discussed here:
Two-Party Pricing Breaks Down As The Economy Becomes More Complex — Two-Party pricing cannot take into account either the costs or the benefits that the transaction imposes on third parties.
When A Higher Or Lower Price May Be More Efficient For The Economy
There are situations where the market price is higher or lower than the price that would be beneficial/efficient for the economy as a whole. That situation is discussed here:
The Market Price Is Not Necessarily The Correct Price For An Efficient Economy
A Large Imbalance Between The Buyer’s Bargaining Power & The Seller’s Bargaining Power Can Result In A Price That’s Damaging To The Economy As A Whole
The Relationship Between Bargaining Power & Price
The column below contains an overall review of how prices in a capitalist economy are a reflection of the relative bargaining power of the sellers versus the bargaining power of the buyers :
Supply And Demand Are Only Two Of The Many Factors That Affect Bargaining Power, And Bargaining Power, Not Supply & Demand, Is The Main Factor That Determines Price
— David Grace (www.DavidGraceAuthor.com)
