Thursday, January 7, 2016

Marginal Pricing

In a perfect market, each buyer is a price-taker, and pays the maximum amount they deem is fit for a product.   How can this work to your advantage?

In studying anti-trust law, one of the first things we had to study was economics - market equilibrium and also how monopoly markets work.  One of the things that struck me was the professor's statement that in a perfect market, each customer pays the maximum they are willing to pay for a product, rather than everyone paying the same price.

And at first, this strikes some people as odd, as commodities like a loaf of bread or a gallon of gasoline are uniform in price.  Or are they?   The poor man shops around on gas and goes to the generic station and buys 87 octane regular.   The rich man goes to the station that is most convenient, usually a brand-name, and puts 92 octane in his Mercedes.  The poor man buys a loaf of generic store-brand white bread for a dollar or two.  The rich man goes to the artisan bakery and buys a loaf of artisan bread for $15.  We all pay what we can afford

This effect is what I call marginal pricing, although I don't think that is the technical word used by economists.

It also struck me that this fit in nicely with Alfred P. Sloan's "A car for every purse and purpose" philosophy behind General Motors, starting in the 1930's.   GM offered a range of cars, from "the low cost field" of Chevrolet, all the way up to the "fine car field" of Cadillac - with ranges of Buick, Oldsmobile, and Pontiac, in-between.   Often these were the same cars, with minor changes in engines and bodywork.

Some lines, such as Chevrolet and Pontiac, would have only one wheelbase model.   Others, such as Oldsmobile and Buick, would offer cars on the short Chevy Wheelbase (e.g., Olds 88) or on the longer Cadillac wheelbase (e.g., Olds 98).  Fenders and hoods would be modified for each brand, and parts and engines swapped to make "unique" cars for each line.

But by the 1950's, the cars were starting to look alike.  And by the 1960's, they were all (except Cadillac) made in the same plants - General Motors Assembly Divisions - where Buicks would follow Chevies, Pontiacs, and Oldsmobiles, down the same assembly line. By the 1970's, the engines and transmissions were largely identical across all lines.  By the 1980's, the cars themselves were virtually identical, with only minor changes in front and rear fascias.  It no longer made much sense to pay more for a Buick than a Chevrolet, when you were buying the same car.

But manufacturers and retailers have been playing this game for years.   As I noted in an earlier posting, Johnson sold identical V-4 outboards in 85, 100, and 115 horsepower version - the only differences being how the engines were tuned and minor variations in stroke.  The cost of assembling the engines was virtually identical, but the 115 horsepower model was far more expensive than the 85.   They were selling horsepower, not a pile of engine parts and labor.

In a similar manner, a Buick coming off the assembly line behind a Chevy didn't cost much more to make.   Maybe the seats were nicer and the trim cost a little more, but the overall assembly cost was identical, and the incremental cost was negligible.

The theory behind this, for the manufacturer, is compelling.  You build an auto plant and there are fixed costs in running it.  You have to hire people, pay for utilities, the machinery, the land, and so forth.  If the plant sits idle, it is costing you a lot of money and you are making nothing.  So it makes sense to optimize your output by offering products in each price range, so you can serve as many customers as possible.   You may offer a "Sallie Stripper" Biscayne with no radio or heater to serve the poor customer (or fleet market) and then a gussied-up chrome-laded Buick Special to serve the upscale market for Doctors (their slogan back then, "The Doctor's Car").

If supply exceeds demand, maybe you offer more stripped cars to attract more buyers.  If demand exceeds supply, well, then more cars leave the factory fully-loaded, so that people have to pay more (and you make more) on each car.  While options add to the cost of making the car, they often add far more to the price than their incremental cost.

We see this everywhere in our lives.  The local ISP offers internet service at various speeds.  The cost of serving the customer is largely the same (installation, modem, running wires and switching centers, overhead, etc.). The poorer customer merely has his service throttled down a bit, so his speeds are slower.  The wealthier customer or the customer who needs the speed will pay more. The poorer customer or the customer who just wants to check e-mails, will pay less.  An internet speed for every purse and purpose.

Of course, this means that if you are aware this sort of thing is going on, you can take advantage of the system and come out ahead, by intentionally buying below your level of wealth and by minimizing your needs.

For example, in the early 1970's, a young John Delorean was made head of Chevy.  They re-designed the full-sized Chevrolet Caprice to enormous proportions, giving it a grill that looked like a Cadillac. Loaded with power windows, locks, cruise control, and air conditioning, people quickly realized you could buy a car "as nice as a Cadillac" for a lot less money.  The folks at Cadillac were pissed.   But this "product creep" had been going on for a while, with the Caprice brand started in the 1960's to offer a "luxury" model in the low-price field.

Today, cars are a commodity. Almost every feature found on an "luxury" car of the 1970's (power everything, leather interior, etc.) is offered on economy cars today - often as standard equipment.  Air conditioning, once and unheard-of luxury, is now standard on every car sold in America, except the Jeep Wrangler and the Chevy Sonic.  The Japanese started this - realizing it was cheaper to simply put all the options on all the cars, rather than offer thousands of option combinations (as Ford famously did, with its 1960's Mustang) and just give the customer more than they expected.

The game is still played today, though.  GM sells Buicks that are just re-badged Chevies.   Ford does the same with Lincoln.   Chrysler with Dodge.  But now the Japanese have gone American, and they, too, offer "upscale" versions of their basic cars, as Acuras, Lexuses, and Infinities.  You can pay a lot more, but in most cases, you are getting the same car.

And even with the same car, no two consumers pay the same price.  Car prices have been notoriously elastic, with some folks getting a "steal" below dealer invoice, and others paying full sticker price because they either don't know any better, or decide they "have to have" a certain model. And as the model year progresses, discounts, sales, promotions, and rebates are added to discount the car price. And the more heavily optioned the car, the more of an apparent discount can be given.

So each car finds its optimal buyer - in theory - the one willing to pay the highest price, and profit is optimized.

There are two problems with this pricing model, however.  First, as noted above, some clever folks can realize that they can spend a lot less and get the same product, if they buy the "base" model and option it up.  Or, they decide to live below their income level and drive a Chevy when they could easily afford a Cadillac. For the wealthy, this is a sweet deal, as if you are not interested in impressing the neighbors, you can save a lot of dough, which in turn can be invested and make you even more money.

The second problem is the opposite. Unfortunately, the poor often end up being offered the worst sort of deals imaginable.  The mythology of the poor is that, being desperate, they tend to shop in thrift stores and the Dollar Tree, and are very frugal with their money.   And some are, of course, out of necessity.

But in many other transactions, the poor get fleeced, often succumbing to status impulses, and of course, not being sophisticated (and having horrible credit) they are offered the worst prices on goods and the worst terms.

The overpriced convenience store or bodega operates successfully in the poor community.  In the rich community, they have a Trader Joe's or a Wholesale Club which sells products for far less. The poor person buys his liquor in pints in a liquor store with bars on the windows and bulletproof glass.  Five miles away, at the wholesale club, the middle-class buyer can purchase a gallon of better booze for the same price.  The poor pay more, because they are poor, and it is what makes them poor - or poorer.
The rich person buys quality furniture that lasts a lifetime and holds its value (if not in fact, appreciating in value).  The poor person rents-to-own crappy furniture that doesn't outlast the payments. The rich person buys a car and gets the best possible price - as well as the best financing terms - as he has more sophistication and an 800 credit score.  The poor person pays through the nose, often paying more than the rich person, for less car - and paying more in interest than the purchase price.

The marginal pricing effect works, but in reverse.  You would think the poor person would pay less for the Biscayne that the rich man does for the Buick, but when you factor in market sophistication and interest rates, they often come out even, or the poor person even behind.

Some of this may be a recent trend - with the use of the almighty credit score to screw the poor out of every last cent.   Some of it may be as old as the hills.  I read books critical of the auto industry as far back as the 1950's that noted that you are more likely to find a Cadillac parked under a tree next to a hovel than in front of a mansion, as the poor seek status more than the rich, in many cases. And I can say, in Southern Georgia, where "shotgun shacks" nestled beneath the pine trees are quite common, this effect is true - brand-new Chargers and Challengers are often parked next to houses or trailers worth little more than the vehicles parked out front.   In many cases, the cost of rolling stock parked in front of the house, exceeds the value of the house.

Again, if you are smart and think about these things, you can come out ahead.  And the common denominator for both the poor consumer and the rich consumer is status. If you have a high income, you can go and blow every last penny on consumer goods, chasing status, and wonder where all the money went.   Or, you can live below your means and accumulate wealth.  This does mean having people laugh at you for driving a cheap car, instead of an expensive one.   But people like that are shallow anyway, so why bother dealing with them.

Similarly, for the person with a lower income, if you can eschew status-seeking, you can avoid a lot of really rotten shitty deals that take what little money you have and squander it.   Renting to own furniture may sound like fun, but it doubles or triples the cost of the furniture. Similarly, if you are living in a $25,000 trailer home, maybe you should think carefully before you buy a $50,000 pickup truck.  Both are depreciating assets, of course.

And sadly, the rich person is more likely (but not always!) to figure this out, as they have more education and are (supposedly) more sophisticated.   In recent years, however, it seems the "shrinking middle class" is getting dumber and dumber (and hence the shrinking) and chasing after status.   Ordinary people are getting that wild-eyed look in their eyes and saying things like, "leasing a new BMW makes sense!  I get more car for my money!" - and then they blame Obama or the GOP when "someone takes my money away!"

I have found, over the years, that some of the cheapest products I have bought are the most satisfying, mostly because their being cheap means that they seem like such a better bargain, as time goes on. Even if the car doesn't have a three-pointey star on the hood, or some fancy feature you'd never use anyway, you find comfort in the fact you spent hardly anything at all on it, and moreover, you worry less about it getting damaged, stolen, or breaking down.

The poor will continue to make poor choices, I'm afraid.  There isn't much you can do to educate Mr. & Mrs. Redneck about that.  The middle class, however, who went to college - what's their excuse?   You can work this marginal pricing thing to your advantage, and end up with money left over which is how one accumulates wealth in the first place.

Live below your income.   It's that simple.