The Higher Tech The Economy, The Less Price Competition It Will Have
A vital product + low excess supplies + a few sellers with large market shares = a free market that will drives prices up, not down
The Inverse Relationship Between The Complexity Of An Economy’s Products & The Level Of Price Competition
The nature of an economy’s products and their distribution channels strongly affect how much power sellers will have to maintain or increase the prices of their products.
The more complex the products & the distribution channels →
— The more concentrated the markets for major goods→
— — The more control sellers will have over prices →
— — — The less free-market price competition will be an effective tool in containing or reducing prices.
This column is an explanation of why that’s the case.
The Fundamental Motivations Of Capitalism
In every capitalist economy:
- Every Sellers’ primary goal is to maximize profits
- Every Buyers’ primary goal is to minimize prices
If the money lost from a reduction in sales because of an increase in price is less than the additional revenue made from that higher price, the price of that product is said to be elastic.
At some point the money lost from a reduction in sales because of an increase in price will exceed the additional revenue made from that higher price. At that point the price has become inelastic.
Every seller want to charge the maximum revenue price, the price just below the point where the additional revenue made from raising the price will be less than the revenue lost from lower sales in response to the increase in price.
That sellers’ preferred price, the maximum revenue price, is the monopoly price.
Buyers instead want the lowest possible price, namely, the cost of materials and labor, plus the amortized cost of overhead, plus a “reasonable” percentage of profit, the competitive-market price.
The battleground between sellers and buyers is in the area between the price the sellers want, the monopoly price, and the price the buyers want, the cost + overhead + a minimal percentage of profit price.
The Key Factor Is The Sellers’ Power To Collect A Higher Price
The fundamental factor that determines each side’s level of success in attaining their goals is the level of the sellers’ power to maintain its current price or to collect a higher price.
The Level Of Additional Available Supply Governs The Seller’s Power To Collect A Higher Price
The principal factor that motivates a seller to maintain or even reduce its price below the current market price is the ready availability in the market of a material quantity of additional supplies of the product at the lowest current price.
The principal factor that allows a seller to maintain the current price or to increase its price above the current market price is the unavailability in the market of a material quantity of additional supplies of the product at the lowest current price.
NOTE: This discussion applies to products whose supplies can be limited, NOT to services with excess capacity, e.g. cell phone services, and pure services, e.g. insurance, whose supplies cannot be limited.
A Concentrated Market
A concentrated market is one where 35% or less of the number of sellers who have at least a 1% market share have a total market share of 65% or more.
For example: 15 sellers have a market share of 1% or more. 35% X 15 = 5.25.
If the total of the market shares of the top 6 sellers or fewer is 65% or greater then the market is concentrated.
Factors That Increase Or Decrease The Availability Of Additional Supply At The Current Price
The level of the complexity and the technology of a product and its distribution channels are the most crucial factors governing the ready availability of additional supplies of that product at the current lowest price. Here is why:
Why There Are Greater Available Supplies Of SIMPLE Products
The simpler and the lower-tech the product and its distribution channels →
- The shorter and more robust is the supply chain →
- — The smaller the number of sellers who have the power to raise the price for a link in that supply chain and thus raise the cost for the end-user product
- — The smaller the number, amount and duration of supply-chain-shortages reducing the supply of the end-user product
- The cheaper and faster is the creation of new manufacturing facilities →
- — The more product in inventory
- — The less time needed to increase production
- — The More Manufacturers In The Market →
- — — The Lower The Concentration Of Market Share In A Few Sellers
- — — The Lower The Ability Of The Sellers To Affect The Availability Of An Increased Supply
When The Profit Motive Causes A Increase In The Supply Of A SIMPLE Product
The profit motive causes an increase in the available supply if
- There are a large number of sellers (e.g. hundreds of small bakeries), and
- None of the sellers controls a material share of the market, and
- The cost in both time and money to increase supply is relatively low (a couple of new ovens and a few new tables and shelves), and
- Distribution channels (a retail storefront or a food truck) are available to any new sellers who might be drawn to the market
- The current price is at or above the competitive price
Why There Are Smaller Available Supplies Of COMPLEX Products
The more complicated and the higher-tech the product and its distribution channels →
- The longer and more fragile is the supply chain →
- — The larger the number of sellers who have the power to raise the price for a link in that supply chain and thus raise the price for the end-user product
- — The greater the number, amount and duration of supply-chain shortages reducing the supply of the end-user product
- The more expensive and the slower the creation of new manufacturing facilities →
- — The less product in inventory
- — The more time needed to increase production
- — The Fewer Manufacturers In The Market →
- — — The Higher The Concentration Of Market Shares In A Few Sellers
- — — The Greater Ability Of The Sellers To Affect The Availability Of An Increased Supply
When The Profit Motive Causes A Decrease In The Supply Of A COMPLEX Product
The profit motive causes a decrease in the available supply if
- There are a small number of sellers (a few large bread manufacturers), and
- Several of the sellers control a material share of the market, and
- The cost in both time and money to increase supply is relatively high (tens of millions and two years to open a highly automated new factory), and
- Distribution channels (supermarket-chain shelf space) are not easily available to any new sellers who might be drawn to the market
- The price is elastic
Sellers Always Want Captive Customers
Captive customers are consumers who cannot buy their desired quantity of the product elsewhere at a cheaper price.
A seller always wants to be able to hold their customers prisoner so that the customers will be unable to escape paying a higher price by switching to a different, lower-priced supplier.
So, while the profit motive causes production capacity to increase when →
- the cost to enter the market is low and
- there are many sellers,
- each of which has a small market share,
The profit motive causes sellers to limit or decrease production capacity for a product →
- whose price is elastic,
- the cost to enter the market is high, and
- the market is concentrated.
The factors that govern whether or not there will be an increase or decrease in the supply of a product in the market at the lowest current price are substantially dependent on the simplicity vs. the complexity of the manufacture, marketing and distribution of the product.
Example: The U.S. Gasoline Refining Industry
Consider the U.S. excess gasoline refining capacity which the oil industry has massively decreased. Over the last fifty years the oil companies have closed many refineries and very rarely built new ones.
Instead of the substantial excess gasoline refining capacity that the U.S. had fifty years ago, now the U.S. has barely enough refining capacity left to meet domestic demand.
The oil companies have reduced excess refining capacity because the industry’s inability to produce additional gasoline reduces the possibility of material price competition, denies consumers the ability to avoid paying an increased price for gasoline, and gives the refiners the power to increase profits by raising prices to the monopoly level because the limited refining capacity means that the consumers have no other source of cheaper fuel.
When California flirted with allowing the market to set electricity prices, energy providers deliberately took power plants out of production so that the reduced energy supply would allow them to increase the price.
Adam Smith Only Saw Half Of The Market-Price Equation
When Market-Price Competition Drives Prices Down
One of the rules of classical economics is that when there are multiple competing sellers offering the same product, the profit motive will always drive the price down to the cost + overhead + base profit level.
Adam Smith made this observation by looking at a market of hundreds if not thousands of small bakeries selling an almost identical, simple, low-tech product whose production could be rapidly increased at a relatively low cost in both time and capital and where none of the sellers’ market shares exceeded a percent or two of the market’s volume.
But this rule that the combination of the profit motive and a free market will drive the price down is only true if
- The sellers have not formed a cartel, and
- There is a quickly available additional supply of the product from existing or new sellers in an amount at least equal to a material percentage of the market share of the seller with the largest market share.
The Other Half Of The Market-Price Equation, When The Market Drives The Price UP
Adam Smith did not and could not know that the market could drive the price up when:
- The product is sold in a concentrated market, and
- The available supply of the product could only be increased after a relatively long period of time and at a relatively high cost of capital, and
- The readily available additional supply of the product is less than a material percentage of the market share of the seller with the largest market share, and
- The current price of the product is elastic
The Free Market Can Both Drive Prices DOWN & Also Drive Prices UP
We need to understand that the market can affect price in two ways:
- Driving the price down toward the cost + overhead + profit level when the sellers are diverse and there is a readily available substantial additional supply of the product at or below the lowest current price, and
- Driving the price up toward the monopoly price for a product whose price is elastic and the sellers are concentrated and there is a low level of easily available additional supply at or below the lowest current price.
How One Large Seller Can Drive The Market Price Up To A Monopoly Price
The key factor is if the large seller’s market-share is materially greater than the industry’s excess production…
**To see an example of how this works, skip to the end of this column.**
What This Means For Us As Consumers
In the nineteenth century we believed that we could always rely on the free market to drive prices down, that the very existence of the Market guaranteed lower prices through price competition.
But price competition is dependent on the ready availability of an additional product supply which in turn is dependent on products where there are multiple sellers in a non-concentrated market.
The history of the 20th and now the 21st centuries demonstrates both an increasing consolidation of sellers, an ever greater percentage of high-tech products which benefit from greater and greater economies of scale, and have less and less readily available additional supply capacity.
The advances in the technology of data management, marketing, and distribution have inevitably driven our economy further into the realm of sellers who either sell complex, high-tech products or who rely on high-technology and the economies of scale to distribute and market their products where there is inherently a low level of readily available additional supply capacity.
This means that a larger and larger share of our economy is operating under conditions where the profit motive drives additional available supplies down, and drives prices up →
- The higher the capital cost, the longer the time frame to bring new manufacturing facilities on line, the larger the economies of scale, the more complex and limited the distribution channels, the more concentrated the market becomes.
- The higher the technology, the longer and more fragile the supply chain.
- — The more concentrated the market and the longer the supply chain, then the smaller the readily available additional supply and the less the products are subject to price competition and the more the sellers of those products can charge close to all-the-market-will-bear, monopoly price.
For many vital products we can no longer rely on the market to always drive prices down. We have now entered an economic reality where for many products we can expect market forces to instead drive prices up.
What Tool Can Replace Free-Market Price-Competition To Keep Prices Down?
In order to control runaway pricing we need a new tool to take the place of the nineteenth century’s free-market, price-competition model, a tool which no longer works for an increasing number of vital products whose prices are elastic such as energy, pharmaceuticals, food, and housing.
One potential tool is an excess profits tax on all profits that exceed a set percentage (20–25%) of costs.
Instead of simply adding the proceeds from this tax to the government’s general fund, those tax receipts could form the endowment for a public banking corporation whose low-interest or no-interest loans would finance business and public projects such as advanced semiconductor, energy, and infrastructure facilities.
**An Example Of How A Concentrated Market Can Drive Prices Up**
If, back in Adam Smith’s day a group of bakers in one neighborhood had formed a cartel and raised their price from the equivalent of $6/loaf to $8/loaf that would attract bakers from other parts of the city to run their ovens an extra couple of hours a day, pack the extra bread into some wagons and sell it in the cartel’s neighborhoods for $6/loaf.
Most of the local customers would buy the cheaper bread and the market would drive the price from $8/loaf back down to $6/loaf.
Now, let’s suppose that a modern city that consumes 100,000 loaves of bread/day which are supplied by four large bread manufacturers who collectively have 95% of the bread market. Each of these manufacturers has a factory full of highly automated, expensive equipment.
Acme, the largest of the four bread sellers, has a market share of 30%, 30,000 loaves/day.
While it costs an individual baker a burden cost of $5 to hand-bake and sell (for $6) one loaf of its artisan bread, it costs Acme a burden cost of only $2 to bake and sell (for $3) one loaf of its mass-produced supermarket white bread.
The other three bread sellers can only increase their production by the total amount of about 7% of the market’s current volume, 7,000 loaves/day.
It would take tens of millions of dollars and almost two years to build a new bread factory sufficient to bake enough bread to supply at least 10% of the daily volume of bread purchases, 10,000 loaves/day.
Acme knows that if it increases its price from $3/loaf to $6/loaf to match the price of the loaves sold by the small bakeries all of its customers will want to buy cheaper bread elsewhere. The question is, how far will sales drop if Acme doubles its price?
Acme knows that the other three bread manufacturers can only supply about 7,000 additional loaves of bread/day.
Acme therefore knows that its customers buying 7,000 loaves/day will be able to find bread elsewhere and that its remaining customers buying 23,000 loaves/day, will be unable to buy bread anywhere else at a lower price. Therefore those remaining consumers will be captive customers who will either have to buy Acme’s $6 bread or go hungry. Acme calculates that only 500 or so of them will elect to go hungry.
Acme determines that the most damage that doubling its price can do is to reduce its sales from a 30% market share, 30,000 loaves/day down to maybe 22,500 loaves/day, a decline of 7,500/30,000 or a 25% reduction in sales.
Lastly, Acme knows that while its sales volume will decline by, at most, about 25%, a 7,500 loaves/day decline, its income will increase from $90,000 ($3 X 30,000) to $135,000 ($6 X 22,500) which means that it will make a huge additional amount of money from doubling its price.
The other three large bread manufacturers immediately learn that Acme has begun charging $6/loaf. Acme’s former customers quickly exhaust the other bread sellers’ inventory and excess production capacity.
This means that the other bread manufacturers’ customers also cannot buy their bread anywhere else if the other sellers also elect to raise their prices to Acme’s level.
So, being profit-driven business people, all three other manufacturers realize that they can now raise their prices to close to $6, perhaps $5.75, and that they will only lose those few customers who stop buying bread entirely, a relatively small loss in sales.
Since they can raise their price with little or no economic penalty, they do.
Acme would like to increase its sales and gain back some of its lost customers so it quickly matches the new market price of $5.75 and some of its old customers return, increasing Acme’s sales from 22,500 up to 25,000.
Because of the tens of millions of dollars and two years in time it costs to enter the market, the expense and difficulty of obtaining distribution channels, the high marketing costs, the entrenched competition, and, at best, a race-to-the-bottom pricing model, few savvy companies would choose to enter this market.
Because this free market is a concentrated market, the market has driven the price up.