Real Businessmen Respond to Quantity Signals, Not Price Signals
Update: “Lord Keynes” provides a great explication of Kaldor’s theoretical work on this subject.
Back in the day when I was running a high-tech conference company, we had a favorite (and actually rather cruel) interview question:
“What’s the best price for a conference?”
There was only one right answer:
“The price that makes us the most money.”
That answer encapsulates the position of almost every business trying to sell real goods and services. You have to choose a price, and you have little or no idea what sales differences will result from different choices. The implications are enormous — no other decision affects profits so powerfully — and you’re basically shooting in the dark.
Every business or product-launch plan I’ve ever seen has a huge dartboard right in the middle of it: How much, how many, will we sell? (“Well, it depends what we charge…”) In some businesses there are ways to do controlled tests of different prices and see how sales respond — Amazon being a brilliant example, and we did a a bit of it using direct mail with split runs — but most businesses (i.e. all of Amazon’s producers/suppliers) don’t have that luxury. You have to just choose a price with your best guess, based on various scraps of hard-to-interpret historical-sales and market data. It’s incredibly frustrating.
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Which brings me to the point of this post: most producers are dealing (at least in the short term whose length varies with the type of business) with a fixed-price market. Once they’ve set their price, they can’t go changing it all over the place.
So: They’re not receiving any of the market’s supposedly informational price signals. They’re receiving quantity signals. That’s the information that producers derive from the market. Then maybe they change the price, and get more quantity signals. But again, those signals are always hard to interpret because you don’t generally have a controlled test to know whether the price is what drove quantity changes, or whether it was something(s) completely other.
Price is fixed, while quantity is very flexible. i.e. Analysts expected Apple to sell five million iPhone 5s in its first weekend. They sold nine million. Did the price go up? No. They rousted workers out of bed in China and filled the goddamn orders. When one of our conferences wasn’t selling well we couldn’t just lower the price, cause we’d piss off everyone who’d already signed up. If sales were good and it looked like we might sell out (there was simply no more room for hotel employees to place chairs), the last thing we were going to do was raise the price and risk stomping on that success. It’s very difficult for producers to derive prices signals from the market.
This is utterly unlike the market for financial assets, where price is infinitely and instantaneously flexible, while quantity — i.e. the number of Apple shares outstanding — is pretty much fixed and unchanging. (When you buy my Apple shares, the quantity or supply of saleable Apple shares is unchanged.)
In the market for financial assets, the price signal is (almost) everything. In the market for real goods and services, the quantity signal is (almost) everything.
There are lots of places to go with this thinking, but I’ll leave that to my gentle readers for the moment.
Thanks to Mike Sankowski for prompting this post.
Cross-posted at Asymptosis.
You are talking about the principle of an anchor in behavioral economics. Once the price is set, the consumer judges the product according to that price.
Dan Ariely writes that he started a class by reading a poem, then separated the class into two groups. One group he said that he would be reading poetry that night and asked how much they would pay to hear him read.
To the other other group, he asked how much he would have to pay them to hear him read.
The first group responded with prices that the would pay.
The second group responded with prices that they would receive.
It was the same product… him reading poetry.
It was all how you presented the product that gave social value context.
In product startup and from what I experienced, it usually was the fixed costs and variable costs which set the basis for what the price would be. If demand increased, there was the possibly of adding greater capacity (chairs) by adding additional hours in addition to a one shift plan. If demand was not present, then one was faced with the aspect of not covering manufacturing fixed costs plus variable costs and could only do such for a short period. Adjustments would have to be made to sell the product if one hoped to remain in business. I guess this too could be called reacting to quantity demand.
Then you add the middle man, say Walmart and you can pretty much kiss your control of pricing in the butt. Unless you have the confidence of say Simplicity Equipment who told Walmart where to go after one year and their demands for lower pricing.
When it comes to retail, darn few manufacturers have control of the pricing for their products.
Even when trading securities, when I want to sell, I usually specify a price and see whether demand for the quantity in question exists at that price. If it doesn’t, I might lower my price or wait and sell later. In other words, I set a price and wait for a quantity signal. I’m not alone. I remember when Carl Icahn bought out Marvel Comics. He set a price and determined how many shares were available. He was doing the same thing, just at a larger scale.
The price of labor might not fit this — haven’t really thought it through — just an abstract thought.
Then there’s Sy Syms — every item on the sales floor for X many days is reduced X much: an educated consumer is our best customer. 🙂
Right and Amazon is Sy Sims times infinity. But Sy and Amazon don’t share their pricing insights with suppliers. Can get glimpses by monitoring Amazon’s price changes for your products, but without the results data, it’s rather like reading a Ouija board in Cyrillic. Hard or impossible to interpret when trying to choose your next price change. See the update above on Kaldor’s theorizing.
Prices are administered. Shocking I know.
Why do economists have such a hard time digesting this one readily observable fact?
And, another thing. There is no actual market, for most goods and services. It is, at best, an often misleading metaphor.
So, we have prices, which are administered, and markets, which are not markets, and which, not incidentally, do not clear, and economics is helping us understand this world, how, exactly?
If economists are to be taken seriously, they really need to work on telling the truth about the most basic facts of economics and business. Thanks for taking a small step in this direction.