When The Free Market Drives Prices Up Instead Of Down — Virtual Cartels
We can no longer depend on the free market to deliver low prices. New tools are needed to deliver Cost + Overhead + Profit prices
By David Grace (Amazon Page — David Grace Website)
People think that the free market always means price competition which always drives prices down to a Cost + Overhead + Profit level.
It’s true that for products with
- (1) A large additional available supply and with
- (2) Many independent sellers
the free market does indeed drive prices down. That’s Adam Smith’s pricing observation based on the actions of the baker and candlestick maker.
But, it’s not true for vital products with
- (1) A limited additional supply available from
- (2) Sellers who are not participating in the price increase.
Let’s start at the beginning: The free market’s profit motive.
Above All Else, Sellers Want More Profits
Every mature business’ primary goal is to increase its net profits.
There are basically two ways to do this:
- Lower prices in order to sell more units at a lower profit per unit, or
- Increase prices and sell fewer units at a higher profit per unit.
Will A Seller Make More Profits By Lowering The Price Or Raising The Price?
The two factors that determine whether a business will employ a strategy of
- Pursuing the sale of more units at a lower price per unit or
- Pursuing the sale of fewer units at a higher price per unit
are:
- 1) How badly do the customers need the product? (Strength Of Demand) And,
- 2) How much additional product is available to consumers from other sellers at the current price? (Quantity Of Supply)
Is There A Large Available Additional Supply Of The Product?
If there is a large quantity of additional units available from other sellers at the current price, any one seller raising its price will not be successful and sellers generally will have to increase their profits by lowering their prices and selling more units.
In that situation, the free market’s profit motive will drive prices down to the Cost + Overhead + Profit competitive price.
Is There A Low Available Additional Supply Of The Product?
But, if there is limited quantity of additional units available from other sellers at the current price — if other sellers will be unable to fill the needs of the customers seeking to flee a high-priced seller — then, yes, the seller raising its price will make more money by raising its price and selling fewer units at the higher price.
Moreover, if a large seller successfully raises its price, then the other sellers will realize that the lack of available additional supply at the current lower price means that their customers will also have no other producer who can satisfy their needs and that therefore these other sellers will also elect to increase their profits by raising their prices.
The market’s profit motive will therefore drive the price of vital products up when one seller (or a group of sellers acting together) who have a large market share, successfully raise their price.
I discuss in detail how this works here:
The Key To A Price Increase Yielding More Profits Is The Unavailability Of Additional Units Of The Product At The Current Price
For a price increase to make the seller more money, there has to be insufficient inventory available from other sellers to satisfy the needs of a substantial percentage of the customers of the seller that is seeking to increase its price.
The key factor, then, for a seller considering making more money by raising its price on a vital product is whether or not there is sufficient product available from other sellers (supply) at the current, low, price to satisfy a significant percentage of its existing customers’ needs (demand).
A seller’s ability to make more money by raising its price will be a point on the following continuum of the availability of additional supply from sellers who are not participating in the price increase.
The Types Of Products That Are Likely To Have Limited Additional Available Inventory
Products that
- Have a high capital cost to manufacture and/or
- Have a long lead time to manufacture and/or
- Have a long supply chain and/or
- Contain components that are in limited supply and/or
- Have limited distribution channels and/or
- Have components that are subject to intellectual property restrictions and/or
- Have a low excess manufacturing capacity and/or
- Are manufactured by a small number of sellers
are likely not to have enough additional units from other sellers available at the current price to satisfy the demand of the customers seeking to flee the seller that is raising its price.
Thus, customers of those types of vital products will have no alternative but to pay the higher price or do without, and, knowing this, the other sellers will be motivated to also raise their own prices to match the new higher price.
The More Complex The Product, The More Likely The Market Will Be Able To Drive The Price Of That Product Up
For the vital products in a high-tech economy — energy, drugs, medical care, housing, meat — that
- (1) do not have large inventories, and have
- (2) a few sellers that control a majority of the market,
we can no longer rely on the free market to keep the prices of those vital products at what we call the competitive level, that is at the Cost + Overhead + Profit level.
Just the opposite.
For those vital products with a limited additional available inventory and a few large sellers (or large group of small sellers acting in the same way), the free market’s profit motive drives prices up, and consumers — and every single person and company is a consumer of something — need a new and different tool to drive prices back down from the monopoly/cartel price to the Cost + Overhead + Profit price.
I go into the details about the vulnerability of vital high tech products to price increases here:
But Now It’s Not Just Products With A Few Sellers That Are Subject To Increasing Prices
A group of sellers working together to raise prices would be an illegal cartel, so people might think that a product that has many small sellers will not be subject to the market forces driving the price for that product up.
Before the internet that might be true. Today it is not true.
A Virtual Cartel
A software product called YieldStar tracks rents, vacancies and demand, and advises landlords on how much they can increase their rents to maximize their revenue.
This type of product, one that tracks market demand and prices, allows dozens, hundreds or even thousands of individual sellers to act in unison like a virtual cartel. By following the software’s suggestions, each seller independently raises their prices like a swarm of birds following the single leader at the head of the flock.
As soon as a few of the larger landlords raise their rent (as soon as the leaders of the flock turn in a new direction), most of the remaining landlords (the rest of the flock) instantly see the change and also raise their rent. None of them are doing anything illegal because unlike members of an illegal cartel, they are not meeting and jointly agreeing to raise prices.
But the result is the same as if they had met and agreed — an increase in price by all the sellers using the software, all the members of the flock following the path of the lead bird.
The desire of the sellers using the software for more profit coupled with the low availability of additional units from the sellers not using the software, results in the price increasing toward the cartel/monopoly price, a virtual cartel, but without the “meet and agree” requirement of an illegal cartel.
When all the sellers of a product have instant access to an algorithm that monitors demand, sales and prices, they are all able to mirror each other’s price increases and any seller can charge, day-by-day, a higher price.
That means that a much larger number of products are subject to the free market’s profit motive driving prices up instead of down.
We Can No Longer Count On The Market To Lower Prices
After WW II people felt as if antibiotics could do anything. They thought that if you got sick you just took penicillin and you would get better.
And, people thought that if you wanted lower prices, you could just make sure there was a free market and low prices would automatically result.
But as time went on we learned not only that penicillin would not cure every ailment, but that sometimes more penicillin made things worse.
People are now starting to realize that not only does the market not always guarantee us a low price, but that sometimes the market’s profit motive actually results in a higher price.
In the same way that we need tools other than antibiotics to cure disease, we need new tools other than the market to deliver low prices.
The fundamental, vital, fact to be gained from this situation is that consumers can no longer depend on free market competition to deliver low prices and that we need new tools to drive prices down from the monopoly price to the competitive Cost + Overhead + Profit price.
A New Tool
One of those new tools is using tax policies to make it more profitable for sellers to lower prices and sell more units and more costly for sellers to raise prices and sell fewer units.
I outline how that might work for sellers of physical products here:
I will soon publish a new column where I propose a tax policy that will encourage landlords to charge lower rents for residential units.
— David Grace (Amazon Page — David Grace Website)
