Monday, September 2, 2013

Elastic prices

This may seem dated since it was actually written a few years ago, but the pricing principles remain unchanged through out history and are no less true today than 5,000 years ago.

The news is reporting that gasoline prices may drop in the wake of hurricane Irene.

Demand was down over that weekend because people hunkered down till the storm passed. Remember that the cost of the product and the cost to deliver to the customer did not change. The only thing that could change the price at the pump is profit.

While some very rare situations exist where some product gets sold for less than it cost, no one sells at a loss! The discounted price due to low demand is still making money for everyone in the supply chain. The question is not profit or loss but how much profit.

The frequent swings in gasoline prices appear to be caused by trying to squeeze out the last fraction of a percent of profit from the market or dropping the price because of low sales.

If your price is not tied to the cost of production you’re not a businessman, you’re a used car salesman in the classic cartoon sense. You know the guy I’m talking about, the one who tries to get you to pay $3,000 and finally settles for $2,500? Where would the extra $500 bucks go if you hadn’t haggled? Why into profit of course.

Anybody think that salesman was loosing money at $2,500? Not a chance. He was accepting less profit. That 500 bucks represents his estimate of your ignorance; what you might be willing to pay over the real worth of that used car simply because you don’t know any better. Why do I consider the $2,500 the “real” value? Because that’s what the dealer eventually accepted and that’s what that product should have been priced at all along.

Ever been in one of those store that always have a $109 dollar price tag marked down to $49 and your wife says “XYZ store has them at that price all the time”? No one in the history of the real world has ever paid the tag price for that particular item. It’s a phony price that is artificially inflated to make the markdown to the everyday price seem good. The stores that do this are trading on the customer’s ignorance and gullibility to buy simply because the tag says sale.

As my dear old sainted daddy used to say, “I don’t mind him making a profit, I just don’t want him to make his whole month off of me”.

After the hurricane passed, gas prices rose at many stations because only a few had power to pump gasoline and those few had to supply all the customers formerly supplied by many closed stations.

The often-cited justification for “elastic” pricing is that if something is in short supply and demand is up then rising prices would entice more suppliers to enter the business increasing supply relative to the demand and driving prices back down into some equilibrium.

In this case the shortage was not caused by a shortage of the product but rather by a delivery problem – no electricity, thus no pumps to get existing stocks from the ground into the car’s tanks. No outside force could enter the supply chain and add supply to the system. And if you think those higher prices would cause some stations to get generators to power their pumps, by the time they could get generators to their locations, the utility company had the power back on.

I still don’t understand why raising the price to the end user (and the profit to the seller) is a fairer system of deciding who gets the product than holding the price static and using odd or even license plate buying days.

How about the guy who can afford the higher prices but only wants to be sure he has fuel IF he needs it and the guy who’s wife is about to have a baby but doesn’t have that extra 20 cents per gallon? 

Capitalism is often touted as being a “great” method of allocating capital but as the previous example shows not nearly good enough at allocating resources.

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