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I’m not sure if there’s a formal name for this fallacy, but it’s pervasive in almost all financial reporting: the sticker price has nothing to do with the cost

by orev 5y ago

I’m not sure if there’s a formal name for this fallacy, but it’s pervasive in almost all financial reporting: the sticker price has nothing to do with the cost of materials; it’s driven only by how much people are willing to pay. As a manufacturer, if the cost to produce something is higher than what customers are willing to pay, then you simply don’t sell it. There are commodities where this doesn’t apply as much because there’s enough competition keeping downward pressure on the price so it floats just above the actual raw materials price, but other than that, this concept applies to most products.

redorb 5y ago
I've worked at a company now for 14 years - where we change what it cost plus a margin to make a fair living. Other competitors have started to 'charge based on the value made by the product'. We're winning by becoming the more 'fair and honest value' brand. I think 'looking into customers wallets' and charging them for the value they will create with your product is a bit lame. I understand my opinion is in the minority of at least other high level managers or owners of companies.
EGreg 5y ago
But of course, the money surplus has to go SOMEWHERE... and eventually someone would defect, and take a loss to make up on volume. I have asked wholesalers this (who produce cars, lighters, etc.) and they say that they have a licensing agreement and can just kick out retailers who sell below MSRP too much. So those retailers would have to then get the goods from other retailers.
- RustyConsul 5y ago
  >kick out retailers who sell below MSRP too much i've worked alot in a bunch of company's when i was selling NSN's and mostly it works by your volume. You can sell at whatever price point you want but this is your price based on volume. Jobber: 500, at $1.30 distriibutor: 1000, at $1.20 wholesale: 10000, at $1.10 partner: 1000000, at $1.00 Sometimes it makes sense to sell some inveentory at a loss to ensure you maintain the 'bucket' and happens all the time.
simulate-me 5y ago
I don’t know if you’ve even seen a supply and demand graph, but there is a price a supplier is willing to sell at, and a price the buyer is willing to pay. The supplier’s price is based off of their costs. Saying the price is only determined by the buyer makes no sense.
- Clent 5y ago
  Economists love their supply demand graph. This article is saying the graph isn't enough. This seems obvious on its face, reminds me a friction in physics, where you can ignore it until you cannot. But physics is not incapable of measuring the friction. The concern is if economists able to account their model's friction.
  - doubled112 5y ago
    We assume iced tea is sold in a spherical can in a vacuum in economics too?
- kbelder 5y ago
  And yet... points Arizona Ice tea. Unchanging price, changing costs. I think what everybody is missing is the 'tends' qualifier. Price tends to rise with increased demand; price tends to drop with increased supply. It's true, but simplified, and can be influenced by a near infinite amount of other factors, like most other behavioral laws.
  - simulate-me 5y ago
    > Arizona Ice tea. Unchanging price, changing costs. This just means the demand curve is very price sensitive, but it doesn't mean the supply curve doesn't exist. There is an element of survivorship bias to all of this. Products on the market exist because there is a point the supply and demand curves intersect. It's totally that the price people are willing to pay for Arizona ice tea will be less than the cost to produce it, at which point Arizona ice tea will cease to exist.
Kranar 5y ago
The fallacy is you stating something that's just plain wrong. The basic law of economics is that price is determined by BOTH supply and demand, whereas your statement is that price is determined only by demand. The cost to manufacture a product is one of the key components that determines the supply of a product; the higher the cost to produce, the lower the supply and hence assuming demand doesn't change then the price will increase. Of course demand may not stay the same, could increase or decrease.
- garbagetime 5y ago
  I think the point he was making is that change in supply doesn't necessarily lead to a change in price. I don't know if that's what they teach in basic economic s, but it's certainly true.
  - Kranar 5y ago
    The post I replied to doesn't mention supply either directly or indirectly, rather it states the following: "[prices are] driven only by how much people are willing to pay." Emphasis theirs. That statement is false, prices are a function of both supply and demand and supply is a function of manufacturing costs. The cheaper something is to produce, the more of it one can produce and hence the greater the supply.
    - OJFord 5y ago
      I think that quote is fine if you read 'how much people are willing to pay' as meaning the whole order book (as it were) - i.e. how many people are willing to pay how much. The price is usually (an attempt at) optimising profit, where that may mean selling for more dollars to fewer people. Ceteris paribus a reduction in the cost of supply doesn't change that calculation. (Though, as the economist in my family says, 'ceteris never bloody is paribus'!)
      - Dylan16807 5y ago
        > I think that quote is fine if you read 'how much people are willing to pay' as meaning the whole order book (as it were) - i.e. how many people are willing to pay how much. It's really not though. If I give you the full detailed order book of a secret product and ask you to set the price we should use as a company, you won't be able to do it. You need at least a rough idea of the production cost first. If people will buy 10x as much at $100 compared to $200, then we should probably price at $100 if our cost is $40, and we should definitely not price at $100 if our cost is $120. If you want to set a price off of one data lump, you need to replace the revenue numbers in that order book with margin per unit.
bko 5y ago
Cost definitely impacts the price. In a perfect competition, the price would be the marginal cost to produce an additional unit. This would result in maximizing the revenue. Even in a monopoly, the price is where the marginal cost and marginal revenue intersect, but the price charged would be the average revenue. In both cases cost impact the price charged. There are other things that affect price, including consumer demand. But cost is absolutely a factor. Saying "the cost is what people are willing to pay" is a tautology and not very useful. http://www.sanandres.esc.edu.ar/secondary/economics%20packs/microeconomics/page_122.htm http://www.sanandres.esc.edu.ar/secondary/economics%20packs/...
- ncmncm 5y ago
  Except there is no perfect competition, and none for Arizona Iced Tea: only Arizona sells it, no one else. They are, of course, engaged in competition with Pepsi, and also with water, food, and rent. If they were to raise their price, some number of people may decide they don't need any Arizona Iced Tea.
  - bko 5y ago
    Right. The two extremes are perfect competition and monopoly. The truth lies somewhere between the two. In both cases supplier costs affect price
    - ncmncm 5y ago
      No. At monopoly, cost has zero effect on price. Except, the cost of a substitute might, where the substitute participates in a real or regulated market. So, price under a rail monopoly may be bounded by the cost of trucking.
      - Dylan16807 5y ago
        > No. At monopoly, cost has zero effect on price. Only if that monopoly is actively being substantially abused. If you're only slightly taking advantage of a monopoly, then your price is mostly tied to normal supply and demand rules.
benp84 5y ago
Counterexample: Suppose I'm selling a product with zero cost and I've determined the profit-maximizing price to be $1.00. This means profit as a function of price is maximal and therefore the slope is zero, i.e. raising the price by 1% makes sales go down by 1% and vice versa. Now suppose my cost to produce goes from zero to $0.99 per unit, which drops my profit to $0.01. Now that 1% increase in price that only drops sales by 1% is well worth it because my profit per unit doubles. The profit-maximizing price is now likely well over $1.
- ddingus 5y ago
  Then one must still consider demand and how buyers value the product. Max profit becomes far more complex! A second order view might be: Say at $1.99 one gets X sales, Y sales at $2 (and yes, that is a real thing), Z at $3, $5 etc... Clearly, selling for the $5 maximizes profit per unit sale, but if volume is more than double at $3.99, overall profit will be maximized by far higher unit sales. The buyers will weigh product benefits vs their time, liquid dollars and competing products. Fewer of them see a favorable value proposition at $5 than do at $3.99. Maybe more see it at $2.50, but not enough more to make more profit over the life of the product. And a third order strategy could be: One layer above that is time. Early on, if the product is well differentiated, has a strong value proposition, max money may in fact linked to a price ramp downward. Start at $5, then drive new sales at $4.50, etc, until late in the cycle to sell against competition, one is selling down at $1.99. While this is being done, cost reductions and other product enhancements can keep margin high.
- OJFord 5y ago
  Or perhaps even clearer: go to the other limit, cost of $1; drop in sales while going from break even to profitable.
jedimastert 5y ago
I think what would be closer to the truth is that the worth of the product to the customer is independent of the cost of manufacture of the product.
- orev 5y ago
  Yes, this is what I (thought) I was saying, but you seem to have expressed it more clearly. Thanks. However, the fallacy I’m referring to is related to how they report on these things, usually saying something like “the price of the materials went up, therefore the price to the consumer will also go up (by some corresponding amount)”. In reality, the price will only go up if the seller thinks the consumer will pay it. It makes one wonder if this type of article is a move by the company to preemptively plant the justification for the price increase in the public consciousness.
- tomrod 5y ago
  Correct. This is why supply is modeled separately from demand. Supply shocks affect prices differently from demand (typically, preference) shocks as well.
bluedino 5y ago
Remember when Walmart had the vending machines in the front of the store? Sam's Cola was 25 cents while Coke/Pepsi were a dollar.
deleted 5y ago
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deleted 5y ago
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WalterBright 5y ago
The cost of materials is often only a small part of the final cost - there's the cost of manufacturing and all the other costs of running a business. Grossly underestimating these other costs is a major reason why new businesses fail.
throwaheyy 5y ago
It’s not so much a fallacy as it is a further relationship between prices and supply or demand, called elasticity. A change in prices will produce differing marginal changes in demand for different goods/services, depending on many factors such as whether the good is an essential or a luxury, the availability of substitutes, competition in the marketplace, and others. This relationship is part of the information used when deciding MSRP, so it’s not entirely unexpected that an increase in costs doesn’t translate to an increase in retail price, if profit margins allow it.

by orev 5y ago

redorb 5y ago

I've worked at a company now for 14 years - where we change what it cost plus a margin to make a fair living. Other competitors have started to 'charge based on the value made by the product'. We're winning by becoming the more 'fair and honest value' brand. I think 'looking into customers wallets' and charging them for the value they will create with your product is a bit lame. I understand my opinion is in the minority of at least other high level managers or owners of companies.

EGreg 5y ago

But of course, the money surplus has to go SOMEWHERE... and eventually someone would defect, and take a loss to make up on volume. I have asked wholesalers this (who produce cars, lighters, etc.) and they say that they have a licensing agreement and can just kick out retailers who sell below MSRP too much. So those retailers would have to then get the goods from other retailers.

RustyConsul 5y ago
>kick out retailers who sell below MSRP too much i've worked alot in a bunch of company's when i was selling NSN's and mostly it works by your volume. You can sell at whatever price point you want but this is your price based on volume. Jobber: 500, at $1.30 distriibutor: 1000, at $1.20 wholesale: 10000, at $1.10 partner: 1000000, at $1.00 Sometimes it makes sense to sell some inveentory at a loss to ensure you maintain the 'bucket' and happens all the time.

simulate-me 5y ago

I don’t know if you’ve even seen a supply and demand graph, but there is a price a supplier is willing to sell at, and a price the buyer is willing to pay. The supplier’s price is based off of their costs. Saying the price is only determined by the buyer makes no sense.

Clent 5y ago
Economists love their supply demand graph. This article is saying the graph isn't enough. This seems obvious on its face, reminds me a friction in physics, where you can ignore it until you cannot. But physics is not incapable of measuring the friction. The concern is if economists able to account their model's friction.
- doubled112 5y ago
  We assume iced tea is sold in a spherical can in a vacuum in economics too?
kbelder 5y ago
And yet... points Arizona Ice tea. Unchanging price, changing costs. I think what everybody is missing is the 'tends' qualifier. Price tends to rise with increased demand; price tends to drop with increased supply. It's true, but simplified, and can be influenced by a near infinite amount of other factors, like most other behavioral laws.
- simulate-me 5y ago
  > Arizona Ice tea. Unchanging price, changing costs. This just means the demand curve is very price sensitive, but it doesn't mean the supply curve doesn't exist. There is an element of survivorship bias to all of this. Products on the market exist because there is a point the supply and demand curves intersect. It's totally that the price people are willing to pay for Arizona ice tea will be less than the cost to produce it, at which point Arizona ice tea will cease to exist.

Kranar 5y ago

The fallacy is you stating something that's just plain wrong. The basic law of economics is that price is determined by BOTH supply and demand, whereas your statement is that price is determined only by demand. The cost to manufacture a product is one of the key components that determines the supply of a product; the higher the cost to produce, the lower the supply and hence assuming demand doesn't change then the price will increase. Of course demand may not stay the same, could increase or decrease.

garbagetime 5y ago
I think the point he was making is that change in supply doesn't necessarily lead to a change in price. I don't know if that's what they teach in basic economic s, but it's certainly true.
- Kranar 5y ago
  The post I replied to doesn't mention supply either directly or indirectly, rather it states the following: "[prices are] driven only by how much people are willing to pay." Emphasis theirs. That statement is false, prices are a function of both supply and demand and supply is a function of manufacturing costs. The cheaper something is to produce, the more of it one can produce and hence the greater the supply.
  - OJFord 5y ago
    I think that quote is fine if you read 'how much people are willing to pay' as meaning the whole order book (as it were) - i.e. how many people are willing to pay how much. The price is usually (an attempt at) optimising profit, where that may mean selling for more dollars to fewer people. Ceteris paribus a reduction in the cost of supply doesn't change that calculation. (Though, as the economist in my family says, 'ceteris never bloody is paribus'!)
    - Dylan16807 5y ago
      > I think that quote is fine if you read 'how much people are willing to pay' as meaning the whole order book (as it were) - i.e. how many people are willing to pay how much. It's really not though. If I give you the full detailed order book of a secret product and ask you to set the price we should use as a company, you won't be able to do it. You need at least a rough idea of the production cost first. If people will buy 10x as much at $100 compared to $200, then we should probably price at $100 if our cost is $40, and we should definitely not price at $100 if our cost is $120. If you want to set a price off of one data lump, you need to replace the revenue numbers in that order book with margin per unit.

bko 5y ago

Cost definitely impacts the price. In a perfect competition, the price would be the marginal cost to produce an additional unit. This would result in maximizing the revenue. Even in a monopoly, the price is where the marginal cost and marginal revenue intersect, but the price charged would be the average revenue. In both cases cost impact the price charged. There are other things that affect price, including consumer demand. But cost is absolutely a factor. Saying "the cost is what people are willing to pay" is a tautology and not very useful. http://www.sanandres.esc.edu.ar/secondary/economics%20packs/microeconomics/page_122.htm http://www.sanandres.esc.edu.ar/secondary/economics%20packs/...

ncmncm 5y ago
Except there is no perfect competition, and none for Arizona Iced Tea: only Arizona sells it, no one else. They are, of course, engaged in competition with Pepsi, and also with water, food, and rent. If they were to raise their price, some number of people may decide they don't need any Arizona Iced Tea.
- bko 5y ago
  Right. The two extremes are perfect competition and monopoly. The truth lies somewhere between the two. In both cases supplier costs affect price
  - ncmncm 5y ago
    No. At monopoly, cost has zero effect on price. Except, the cost of a substitute might, where the substitute participates in a real or regulated market. So, price under a rail monopoly may be bounded by the cost of trucking.
    - Dylan16807 5y ago
      > No. At monopoly, cost has zero effect on price. Only if that monopoly is actively being substantially abused. If you're only slightly taking advantage of a monopoly, then your price is mostly tied to normal supply and demand rules.

benp84 5y ago

Counterexample: Suppose I'm selling a product with zero cost and I've determined the profit-maximizing price to be $1.00. This means profit as a function of price is maximal and therefore the slope is zero, i.e. raising the price by 1% makes sales go down by 1% and vice versa. Now suppose my cost to produce goes from zero to $0.99 per unit, which drops my profit to $0.01. Now that 1% increase in price that only drops sales by 1% is well worth it because my profit per unit doubles. The profit-maximizing price is now likely well over $1.

ddingus 5y ago
Then one must still consider demand and how buyers value the product. Max profit becomes far more complex! A second order view might be: Say at $1.99 one gets X sales, Y sales at $2 (and yes, that is a real thing), Z at $3, $5 etc... Clearly, selling for the $5 maximizes profit per unit sale, but if volume is more than double at $3.99, overall profit will be maximized by far higher unit sales. The buyers will weigh product benefits vs their time, liquid dollars and competing products. Fewer of them see a favorable value proposition at $5 than do at $3.99. Maybe more see it at $2.50, but not enough more to make more profit over the life of the product. And a third order strategy could be: One layer above that is time. Early on, if the product is well differentiated, has a strong value proposition, max money may in fact linked to a price ramp downward. Start at $5, then drive new sales at $4.50, etc, until late in the cycle to sell against competition, one is selling down at $1.99. While this is being done, cost reductions and other product enhancements can keep margin high.
OJFord 5y ago
Or perhaps even clearer: go to the other limit, cost of $1; drop in sales while going from break even to profitable.

jedimastert 5y ago

I think what would be closer to the truth is that the worth of the product to the customer is independent of the cost of manufacture of the product.

orev 5y ago
Yes, this is what I (thought) I was saying, but you seem to have expressed it more clearly. Thanks. However, the fallacy I’m referring to is related to how they report on these things, usually saying something like “the price of the materials went up, therefore the price to the consumer will also go up (by some corresponding amount)”. In reality, the price will only go up if the seller thinks the consumer will pay it. It makes one wonder if this type of article is a move by the company to preemptively plant the justification for the price increase in the public consciousness.
tomrod 5y ago
Correct. This is why supply is modeled separately from demand. Supply shocks affect prices differently from demand (typically, preference) shocks as well.

bluedino 5y ago

Remember when Walmart had the vending machines in the front of the store? Sam's Cola was 25 cents while Coke/Pepsi were a dollar.

deleted 5y ago

[deleted]

deleted 5y ago

[deleted]

WalterBright 5y ago

The cost of materials is often only a small part of the final cost - there's the cost of manufacturing and all the other costs of running a business. Grossly underestimating these other costs is a major reason why new businesses fail.

throwaheyy 5y ago

It’s not so much a fallacy as it is a further relationship between prices and supply or demand, called elasticity. A change in prices will produce differing marginal changes in demand for different goods/services, depending on many factors such as whether the good is an essential or a luxury, the availability of substitutes, competition in the marketplace, and others. This relationship is part of the information used when deciding MSRP, so it’s not entirely unexpected that an increase in costs doesn’t translate to an increase in retail price, if profit margins allow it.