What’s the relationship between cost and price?

What’s the relationship between price – the ability to charge for your product – and cost – how much it costs you to produce it?

Price is a function of supply and demand. Notice the word “cost” doesn’t occur there. It is true that cost is, over the long term, a lower bound for price – otherwise you’d go out of business. It is also true that high upfront fixed costs can create barriers to entry and therefore lower supply.

The only case in which price is determined by (variable) costs is in a commoditized market. A market is commoditized when competing products are effectively interchangeable and therefore customers make decisions based solely on price. In commoditized markets, price tends to converge toward cost.

In non-commoditized markets, variable costs have no effect on price. Most information technology companies are not commoditized, therefore variable cost and price are unrelated. That is why there can exist companies like Google and Microsoft that are so insanely profitable. If the cost of producing and distributing a copy of Microsoft Office dropped tomorrow, there is no reason to think that would affect their pricing. The most profitable industry historically has been pharmaceuticals, because they are effectively granted monopolies, via patents, reducing the supply of a given drug to one.

There are two ways people get confused about cost and price – a rudimentary way and a more advanced way. The rudimentary way is confusing fixed and variable costs. People who gripe about the price/cost gap of SMS messages seem to not realize the telecom industry is like the movie industry in that they make huge upfront investments but have relatively low marginal costs. I, for one, have always thought movies are a great deal – they spend $100M making a movie, I pay $12 to see it. It would be silly to compare how much you pay to see a movie to the variable cost of projecting the movie.

The more advanced way people get confused about cost and price is to think that because costs are dropping, prices will necessarily follow. For example, the cost of distributing newspapers has dropped almost to zero. This is not the primary cause of the downfall of the newspaper industry. The downfall of newspapers has been caused by a number of things – losing the classifieds business was huge – but mainly because when newspapers went online and were no longer able to partition the market geographically, supply in each region went up by orders of magnitudes. Once the majority of newspapers go out of business causing supply to go way down, pricing power should return to the survivors.

http://ValuValu.com/ Emmanuel

Good Post, I liked your explanation about Costs and Price being somewhat uncorrelated.

This being said, I think even non-commoditized products compete against each other. Microsoft and Google may offer different products, but the acceptable price of MS Office is partly lowered by the price of Google Docs (free).

indeed, products do not need to be strictly identical for a price war to occur. As shown by XIXth century economist Joseph Bertrand, you only need 2 very aggressive competitors for prices to be lowered at their marginal costs.

As for the pharmaceutical industry, the odd thing is their prices being not constrained by competition nor customers, but by indirect payers. Insurance companies and governments pressure pharmaceutical companies to lower their prices (or abandon their intellectual property after a while), simply to lower their cost of providing health care.

At last, I do not share your optimism for the newspaper industry. Even if a handful of newspapers survive, they’re very, very unlikely to be able to raise their prices again. After all, their price drop is not due to competition between them, but simply their products loosing their appeal.

http://www.cdixon.org chris dixon

Great points. Google docs / MS – this feels more like Google just being willing to subsidize the costs to poke a finger in MS's eye and not true competition.

Do you really think demand for (high quality) news has gone down? If so, what caused it? Feels like a supply problem to me.

ktheory

Right on!

“It is true that cost is, over the long term, a lower bound for price – otherwise you’d go out of business.”

This is misleading. The following is more accurate:

It's true that a firm's total costs (not just the cost of the product), over the long term, must be less than the firms total revenues. Otherwise you'd go out of business.

There a several examples where products are sold (or given away) below cost, even over the long term, and the costs are recouped from other revenue streams. E.g. ad-supported business models, or free commercial software that encourages people to buy more non-free products (the commoditized complements approach).

The Marginal Revolution blog recently had a discussion about costs and prices in the movie industry, and I weighed in with similar sentiments and examples.

Side note: I wonder why having prices well above the marginal cost of production so often feels unjust. We have some innate sense of fairness that thinks it's greedy and wrong to charge more than the per-unit cost. But we have no problem taking things for free.

http://www.cdixon.org chris dixon

Good points. I was definitely over simplifying (trying to keep my blog post short enough that people would read it) but agree with all your points. I write about complements a lot if you are interested.

sfrancis

Taking the movie analogy… how about $4 popcorn? Sometimes variable costs are a decent way to analyze something. If popcorn were priced reasonably, I'd buy it every time I go to the theater. But because it is expensive, I almost never buy any.

Newspapers: even when the supply of newspapers declines, supply will still be high. Because of sites like AlleyInsider and Huffpo and RealClearPolitics, etc… But also because of sites like this one! This could have easily been an editorial in a paper in other eras… but now I get this quality content (and can interact with it via comments!) for free…

@ktheory- Costco has an interesting theory about “greed”. They think that running a good retailer is worth 14%. That as long as their margin isn't more than 14% that customers will trust that they are getting a good, fair price. And that 14% is a reasonable charge for providing good products with a good experience (or at least, the Costco experience).

I think it is a novel way to look at things – over the long run, the market will tell you what kind of margins are sustainable, and what kind of margins will sow distrust with customers.. and finally, what kind of margins will draw undue competition (Microsoft's margins in certain products, for example, appear to be drawing Google, and vice versa).

http://www.cdixon.org chris dixon

newspapers: agree that blogs etc increase supply and make their life even harder.

It's strange that people care about margins in some businesses but not others. Why aren't there outcries about the marginal cost of producing Windows?

sfrancis

PPL don't literally care about the exact margin, its perceived value vs. cost. Costco's premise is that 14% is the “right number” for retailing that won't drive customers away and earns their trust. Maybe they're right? It certainly makes it easier for me to know I'm not overpaying when I buy there – maybe I don't get the best price, but I'm not getting the worst price either.

Just because it works for Costco doesn't imply what the accepted margins should be for other businesses. A higher percentage is accepted and expected in professional services, for example.

Incidentally, I think the high degree of piracy for Windows is an indicator of people thinking that they are being overcharged for something. It isn't the right response, but I think it reflects the lengths people will go to to avoid paying more than they think something is worth.

http://pegobry.tumblr.com/ Pascal-Emmanuel Gobry

Great post. A couple of comments.

1- Software and pharmaceuticals are essentially the same, and if memory serves pharmaceuticals is the most profitable industry but software is #2, and for the same reason: high fixed cost investment, low marginal cost production, monopoly pricing power in the form of patents. (Check out what would happen if I came out with a “generic” version of Windows ie with a reverse-engineered API.)

2- Sure telcos have huge fixed costs but it doesn't mean that SMS pricing isn't crazy, or that all the prices they charge should be at marginal cost (although I hope we get closer to that as they become dumb pipes).

The reason they can charge so much for SMS is not because they have huge fixed costs, it's because the vast majority of SMS users are teenagers who have big price insensitivity because their parents foot the bill (and who are more susceptible to marketing — and treating each SMS as one billable unit is marketing).

Markets where the person who enjoys the service isn't the one who foots the bill are rarely healthy (see healthcare, education).

3- Most importantly. Except in some industries, price is as high as the market will bear, and that's great. But competition should bring it down to marginal cost.

The reason so much stuff online is free is not because startups are started by hippies (the explanation a surprising number of people favor) but because it's so much more competitive. A lot of people say “Well, if Facebook charged $2 per year, by now most people would pay.” Maybe so, but 1- that would kneecap their growth and most of all 2- you can bet within a day you would have three free Facebook knockoffs.

That's what makes the web so exciting — and so hard.

http://www.cdixon.org chris dixon

1) agree, but the difference is in pharma patents matter but in software margins are mostly created by network effects, lock in etc.

2) seems to me the real problem is telco is lack of true competition. if i could buy the iPhone and then shop around for the best carrier based solely on telco service (and without a 2 yr contract) I think prices would be a lot different.

3) agree. but don't underestimate the power of facebook's brand and network effects. I doubt they could charge for their basic service at this point but could probably charge for some upgrades.

http://pegobry.tumblr.com/ Pascal-Emmanuel Gobry

1) Fair enough.

2) You're right about telco pricing overall, I was just talking about SMS
pricing.

3) Sure.

http://arnoldwaldstein.com awaldstein

Important topic Chris. Let's put aside margin and hard goods and channel costs and think about pricing as positioning. A heady topic for those of us who are building services or social gaming or low cost plug ins on top of Twitter or FaceBook. I know this is marketing not finance but something I'd like to see discussed.

http://www.cdixon.org chris dixon

Can you be more specific?

http://arnoldwaldstein.com awaldstein

I'll try.
If you are selling hard goods through a channel, you have cost, channel discounts, your need for margin. Price is pretty well set with some variation.
If you are selling SaaS, you have some sunk costs and the competitive landscape as the eco-environment to place yourself in.
If you are selling, stuff within a virtual world or a plug in for WordPress, or an interactive component of an ad on Facebook, pricing is somewhat arbitrary outside of how you position the product.
Does that help?

http://networkednews.wordpress.com Josh Young

The supply of content produced by newspapers will crater soon enough, sure, but I doubt that the supply of sufficiently close substitutes will diminish enough that newspapers regain significant pricing power. Those days are simply gone, no?

http://www.cdixon.org chris dixon

Probably true. Maybe room for 2-3 newspapers bought primarily for business purposes (WSJ, FT etc)

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kellyford

It's amazing how even supposedly sophisticated multinationals miss some of the fundamental elements in this post. I've worked for companies which insist on initiating pricing discussions based not on what the market will bear, but based on a “fully loaded cost” (including amortized fixed costs for general company overhead) grossed up to meet a minimum margin requirement.

It's easy to see where that type of logic can lead. Depending on the price elasticity of the category/product, far fewer units may end up being sold at this “grossed up” price than the theoretically optimal market demand price. That can cause the company to allocate even GREATER fixed overhead per unit to the product and maybe even raise prices further to continue to meet the margin goals.

And pretty soon you've priced yourself out of business.
http://www.thinkstorm.com Thorsten Claus

Whoever tried to replace parts of an oven knows this: the plastic button on the front panel costs about 10cents for manufacturing. The “Kit” for installation sells for about $9, shipping is also $9. Replacing the whole front and top after a fire is about $400. I talked to some friends in appliance manufacturing. Pricing these spare parts really goes like “consumers can decide to buy a new oven for $1,400 or spare parts for $600, just below a used model for $800-$1,000.”
http://www.thinkstorm.com Thorsten Claus

Whoever tried to replace parts of an oven knows this: the plastic button on the front panel costs about 10cents for manufacturing. The “Kit” for installation sells for about $9, shipping is also $9. Replacing the whole front and top after a fire is about $400. I talked to some friends in appliance manufacturing. Pricing these spare parts really goes like “consumers can decide to buy a new oven for $1,400 or spare parts for $600, just below a used model for $800-$1,000.”
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