From my recent article, The Flaw of Marginal Cost:
The first thing I’ll point out is that I don’t think the market cares what it costs to produce a thing so pricing is never truly a factor of marginal costs. Case in point: Apple products. Apple sells products for significantly more than they cost to build and distribute. In fact, it is so good at it that it has roughly two hundred billion dollars in profits sitting in banks all over the world. Few people care how much it costs to produce an Apple product, the only thing that matters to them is if they can afford it. Because of its ability to produce high quality products in massive scale, Apple is able to set a relatively low initial price point. But, make no mistake, it is Apple that sets the price point, not the market.
Even I have to admit this is one of the most insane paragraphs I’ve ever posted. Yet, though it may look like the ravings of a madman, I’m actually trying to make a point here. Let me see if I can explain it more clearly:
It stands to reason that, for a business, marginal cost is very important. The key is always to find a way to produce the next widget more inexpensively and, preferably, with higher quality. Returning to my Apple example, it is one of the prime innovators when it comes to improving and streamlining its manufacturing and supply chain logistics. Apple doesn’t just innovate when it comes to product design, it vigorously innovates in how that product is built, stored and delivered.
So Apple is always trying to lower the marginal costs for their products. Now, how much of those costs are returned to consumers? Gross profit margins routinely hovering around 40% and almost 200 billion dollars in the bank suggest that Apple returns very little of those savings in marginal costs to consumers. If anything, it has gotten pretty good at extracting all of the benefit of lowering its marginal costs.
Now let’s look at the example of water. If the marginal cost of water rises, many people will use less but those who can easily afford those increased costs will readily consume more, as the California drought example clearly shows. To them, the marginal costs of water don’t matter.
The point that I was trying to make is that, when it comes to goods, the closeness of the price of items to their marginal costs mean absolutely nothing to a consumer. Apple creates products that sell comfortably over their marginal costs. To the consumer, the costs associated with producing the next item doesn’t affect their purchasing decisions at all. The only things that matter are the item’s value, perceived or otherwise, and if they can afford it. What I’m positing is that there is no significance to the consumer how an item is priced in relation to its marginal costs. Indeed, it is its ability to pass on as little of the difference in improvements in marginal costs to the consumer as possible that often determines how profitable a company is. Apple has mastered pocketing almost all of the savings in marginal costs it generates.
Is an item priced very closely to its marginal costs? Is it not? To the consumer, it has no relevance. Hence, the pricing of an item in relation to its marginal cost ultimately is moot. It’s a factor that is important almost exclusively to the business generating the product, not the consumer, who is willing to pay whatever s/he can afford for whatever s/he attributes high utility or value.
Why was that point important in my post, The Flaw of Marginal Cost? For two reasons: 1) to show that water, a product with tremendously high utility and value, is priced relatively far too close to its marginal cost and 2) you can readily identify pricing distortions based on how much utility or value an item has versus how much it is priced relative to its marginal costs.
For instance, it can be argued that every next pair of Nike shoes over the very first pair that any person owns is grossly overpriced. Nike is a tremendously profitable company because every pair of shoes is priced as if it going to be a person’s very first pair. The total utility of a person’s first pair of shoes is very high, so a high price can be charged for them as a result. The marginal utility of the first pair of Nike shoes, assuming it is a person’s only pair of shoes, is also very high but that drops significantly with each next pair of Nike shoes that someone purchases. However, does the price of the next pair of Nike shoes drop in relation to the first pair when you buy them? Absolutely not. In this respect, a price distortion takes place the minute someone purchases their next pair of Nikes and so on. In other words, Nike is always trying to sell the next pair of shoes, not the first. Hence its focus on design and marketing.
Want to identify pricing distortions? Compare a product’s price in relation to its marginal cost relative to its utility or value. High utility or perceived value with low marginal costs and low price? Like water in California, you’re looking at an important resource on the way to eventual overconsumption. How about high perceived value with low marginal costs and a high price? Then you’re looking at Nike shoes and other very profitable high-end mainstream goods. What about low utility, very high marginal costs and a very high price? Then you’re dealing with Faberge eggs, original high-profile artwork, ultra-high end luxury goods, etc.
My main point is that consumers never buy anything in relation to its marginal costs. It’s a concept that, from the consumer’s standpoint, doesn’t have any meaning.