The Price of Everything (5 page)

Two people will be willing to trade one good for another as long as the perceived benefit from owning one more unit of what they get—the
marginal
gain—is at least as much as the lost value of what each trades away. This gain, in turn, is determined by the buyer’s endowment of goods: money, time, and whatever else might come into her calculation. The more one has of a given thing, the less one will value having one more. This single principle is the organizing force of markets, which determines the prices of goods and services around the world.

In a market, sellers’ priority is usually to squeeze as much money as possible from buyers. Buyers, in turn, will try to get stuff they want as cheaply as they can. They each operate within a set of constraints: for buyers a budget; for sellers, the cost of producing, storing, advertising, and bringing to market whatever they make. While producers can raise prices if consumer demand for their good grows faster than its supply, consumer demand will wane as prices rise. Above all, producers’ space to raise prices is constrained by competition. In a competitive market consumers can safely assume that prices will be kept in check as rival producers vying for consumers’ custom force them down to their marginal cost, the cost of making one more unit.

There are lots of exceptions to this dynamic, however. To begin with, fully competitive markets are rare. In markets for new inventions, legal monopolies called patents allow companies to charge higher prices than they would in a competitive field in order to recover the up-front cost of their invention. Local monopolies are common—think of the popcorn vendor inside the movie theater. Even in markets for run-of-the-mill products, producers will do their best to keep competition at bay. A tried and tested tactic is to convince consumers that their product is unique, muddying comparisons with rivals’ wares. Another is to lock in consumers with a cheap product that, it later becomes apparent, only works in conjunction with some higher-priced good. Another is simply to hide their prices from consumers’ view.

Unacknowledged motivations cloud the assessments of value that drive our daily decisions. My monthly dues of $58.65 at the New York Sports Club next to the office mean that each of my twice-weekly visits costs just under $7—a reasonable price for a two-hour session, less than what I would pay to see a movie or have a quick lunch. But there are those who will pay much more than I do for a session on the Stairmaster. Paradoxically perhaps, they aren’t the fitness freaks. The uncommitted couch potatoes pay the highest prices. That’s because they are paying for more than a workout. They are buying a commitment-booster too.

A study of visitors to sports clubs that offered monthly subscriptions for just over seventy dollars or single passes for just over ten found that monthly subscribers paid more than they had to. They visited the gym 4.8 times per month, on average, paying some seventeen dollars per visit. Still, having a membership might improve their health, giving them a monetary incentive to work out.

Every day we commit to buying goods and services without paying careful attention to their cost. In 2009, the HP DeskJet D2530 printer might have seemed a steal at $39.99. But the price, displayed prominently on the HP Web site, was almost irrelevant. The more relevant numbers were $14.99 for a black ink cartridge, which prints about 200 pages, and $19.99 for the color cartridge, which prints 165. For those printing photos at home, the crucial number was $21.99 for the HP 60 Photo Value Pack, a set of cartridges and 50 standard sheets of photo paper. At the Rite-Aid drugstore, 50 same-day prints cost $9.50.

The worldwide printing business depends on selling cheap printers and expensive ink. According to a study by
PC World,
printers will issue out-of-ink warnings when the cartridge is still up to 40 percent full. HP, Epson, Canon, and others have sued providers of cheap ink refills, charging them with false advertising and patent infringement to make them stop. But the best ally of the printer business is consumer ignorance about what they are really paying to print.

Just setting the printer default to “draft” quality would save consumers hundreds of dollars a year. Yet few consumers do. Though many companies still sell cheaper ink refills, refills account for only 10 to 15 percent of the market. That means that 90 percent of printing is still done using ink that, according to the
PC World
analysis, costs $4,731 per gallon. You might as well fill your ink cartridges with 1985 vintage Krug champagne.

 

 

CONSUMERS CAN ALSO
strategize keenly to fit their wants and needs to their budgets. As gas prices surged, drivers drove some 7 billion fewer miles on American highways in January 2009 than they did a year earlier, a decline of about twenty-two miles per person. During a run-up in gas prices between 2000 and 2005, economists at the University of California at Berkeley and Yale found that as the price of gas doubled from $1.50 to $3, families became more careful shoppers, paying between 5 and 11 percent less for each item. The typical price paid for a box of cereal at one large California grocery chain fell 5 percent. The share of fresh chicken bought on sale jumped by half.

But businesses are usually a step ahead. Nobody understands for sure what drove surging prices of agricultural commodities in 2007 and 2008. Analysts have mentioned drought in important growing areas, rising transportation costs and fertilizer prices, the diversion of maize and other crops to produce fuel, and even improving diets in big developing countries like India and China. Whatever the reason, food companies were remarkably adept at protecting profit margins by quietly reducing the size of their portions while keeping the price the same. Wrigley’s took two sticks of gum out of its $1.09 pack of Juicy Fruits. Hershey’s shrank its chocolate bars. General Mills offered smaller Cheerios boxes.

Then, as recession took hold in 2009 and agricultural prices started falling, firms resorted to the opposite tactic: giving consumers more for less and announcing it loudly. Frito-Lay packed 20 percent more Cheetos into each bag, stamping the bags with a “Hey! There’s 20 percent more free fun to share in here.” French’s tried competing against itself to convince customers it offered a killer deal. It launched a twenty-ounce bottle of its Classic Yellow mustard for $1.50, less than the $1.93 at which it sold its fourteen-ounce bottle.

What really tames prices is the presence of more than one producer in the marketplace. If munchers had no other option but Frito-Lay products, the company would have less of an incentive to put more Cheetos into the bag and trumpet it to the world. Had there been no other confectioners around, Hershey’s might have raised the price of its chocolate bars even after shrinking them. But the price of a product must mesh within a universe populated by other brands of sweets and snacks. How well it fits will determine its overall success. This is consumers’ most significant defense against corporations’ power: competition.

The power of competition is writ all over the cost of a phone call. In 1983, shortly after the government broke up AT&T’s monopoly of the American telephone market, AT&T charged $5.15 for a ten-minute transcontinental daytime call. By 1989 it charged $2.50 for the call. Today an AT&T subscriber on the $5-per-month international plan can call Beijing for eleven cents a minute and London for eight cents.

In Britain, it was the government that held a monopoly over telecommunications. But in 1981 the government of Margaret Thatcher allowed Mercury Communications, a private company, to offer competing phone service, and in 1984 it spun off the state-run British Telecom. On February 1, 1982, the rate of a three-minute call from London to New York was cut from £2.13 to £1.49. Today, as long as one keeps each call at under an hour, BT’s international package offers an unlimited number of calls from London to New York for £4.99 per month.

Competition can protect us from runaway printing prices. Fat profits from overpriced ink allow companies like HP to compete by selling printers at less than what it costs to make them. Others employ different tactics. Kodak’s ESP printers are about 30 percent more expensive than similar models, but the ink cartridges cost as little as ten dollars and print about three hundred pages. Regardless of the mix of tactics, the overall price of printing should fall as printer makers vie to win market share.

 

 

CONSIDER WHAT HAPPENS
when there is little or no competition in a market. Steve Blank, a former Silicon Valley entrepreneur who teaches a customer development class at the University of California at Berkeley, used to tell his students about Sandra Kurtzig, the founder of a company that in the 1970s designed the first business enterprise software for small companies that could run on microcomputers rather than huge mainframes.

When she walked in to make her first sales pitch, Ms. Kurtzig had no idea of what to ask for her system, so she mentioned the biggest number she thought a rational person would pay: $75,000. But when the buyer wrote the number down without flinching, she realized she had made a mistake. “Per year,” she added quickly. The company man wrote that down too. Only when Ms. Kurtzig added maintenance at 25 percent per year did the buyer object, so she cut it to 15 percent. According to Mr. Blank, the company buyer said, “Okay.” Ms. Kurtzig could do this because she was offering a unique service in a specialized industry with few competitors, and thus had great freedom to set her prices. But where there are many rivals it is impossible to achieve this kind of market power. The mere threat of competition can move companies to respond. Indeed, for many years the threat that Southwest Airways would start flying on a given route would prompt other carriers to lower fares on that route, to preemptively buy customers’ loyalty.

Walmart drove supermarkets to despair when it expanded into groceries in 1988, offering prices 15 to 25 percent cheaper than the competition. The opening of a Walmart supercenter caused sales at other grocers in the neighborhood to fall 17 percent, on average, according to one study, amounting to $250,000 worth of forgone revenues each month. To remain in business, its rivals were soon forced to follow its lead. A study of retail prices in 165 cities across the United States between 1982 and 2002 found that the opening of a new Walmart in the long run forced rivals in the area to cut prices on products like aspirin, shampoo, and toothpaste by 7 to 13 percent.

Like most businesses, Walmart cuts prices only when there are competitors around. One study found that it charged 6 percent more in Franklin, Tennessee, where it had virtually no competition, than in Nashville, where it had to compete with rival Kmart. Critics argue that Walmart decimates communities, forcing local retailers into the ground. The company’s relentless push for the cheapest products has driven many suppliers to relocate to low-cost China, contributing to the decline of American manufacturing. Still, Walmart’s competitive drive has definitely benefited Americans in their roles as consumers. Its impact has been so powerful that, according to one study, the Department of Commerce overstates American inflation by about 15 percent because the sample it uses does not include Walmart’s low food prices.

In 2005 Detroit’s automakers—General Motors, Ford, and Chrysler—used a novel tactic to unload their bloated inventories and revive their flagging finances. They offered customers an unprecedented deal to buy a car at the same discounted price they usually reserved for employees. When GM launched its “Employee Discount for Everyone” program in June, sales jumped 40 percent. When Chrysler launched its “Employee Pricing Plus” in July, it sold the most cars ever.

But upon closer inspection, the promotions weren’t such a great deal. A study by economists at the University of California, Berkeley, and the Massachusetts Institute of Technology found that many cars could have been purchased for less before the employee discount program was launched. For a majority of GM and Chrysler models, and a substantial share of Ford’s, customers paid more in the two weeks of the promotion than they could have in the two weeks before its launch. They were simply told they were getting a bargain and they believed it.

If competition is a consumer’s best friend, corporations’ favorite countervailing strategy is to keep consumers from figuring out where they can get the best available deal. Unlike the competitive utopia described in economic models, where consumers can effortlessly compare competing products to make their choices, the real world is plagued with what Nobel laureate George Stigler called search costs. It is difficult for consumers to find out what a given product costs in all the shops in town—let alone everything available on the Internet. It is even tougher if the goods are not identical. This is a shortcoming that businesses can exploit.

For many companies, evading competition is a question of survival. Makers of everything from cars and computer chips to shoes and TV sets experience what is known as increasing returns to scale: each additional microchip costs less to make than the preceding one. Companies can obtain raw materials and parts more cheaply the more they buy. They also share the cost of investments in machinery and the like among more products, reducing the cost per unit. This dynamic presents companies with a challenging conundrum: competition, when operating properly, would drive the price of TV sets and microchips relentlessly down until they were barely above whatever it cost to make the last one. If this were to happen, makers of chips and TV sets would go out of business. At that price, they wouldn’t be able to recover all their costs. Fortunately for them, there are ways to wriggle free to some extent from competition’s constraints. One of the best-known techniques is to make it difficult for customers to understand where they can get the best value for their money.