Here is a link to a $745 t-shirt: (source)
Are you going to buy it? If no, why not? Does it seem, maybe, a little too expensive?
How did you decide it was too expensive? If you had a billion dollars in the bank, would it still be too expensive? Or what if every other t-shirt in the world cost $1000? Or what if the entire world were out of t-shirts and this was the last one left? Would it still be too expensive?
Determining a good price for the products we buy is essential to managing our finances. It sounds insane to buy a t-shirt for that much, and yet, people obviously do, or else Gucci would go out of business. The question is not so much what we will spend our money on (we can just look at sales numbers for various products to find that out), but rather why we spend our money.
Just as consumers must determine good prices in their own best interest, so too must businesses. A good price is essential, even synonymous, with a good business. If a certain product is priced too high or too low, the business will either go bankrupt or miss out on potential profits. But what goes into determining that price? Why is a jug of milk $5 and not $10? Why is a t-shirt at Wal-Mart just $10 and a t-shirt at Gucci $700?
We know prices aren’t just random. In this article, I intend to explain the basic theory behind how businesses and consumers work together to determine the price tag of the goods and services they make and use.
1) Supply and Demand
Economies are driven by two things: supply and demand. The supply is only relevant if there is demand for it, and the demand is only relevant if there is supply for it.
For example: let’s say that someone makes a t-shirt with a third sleeve on it, and the marketing campaign is, “Hey three armed people! Annoyed about all these two-armed-only shirts? Here is the solution for you!”. So they make one million 3 sleeved shirts and put them on the shelves at clothing stores. But then, there is no one who has 3 arms, and thus, no demand for them, so they sell nothing. What you have is a bunch of supply with no demand, and you’ve created absolutely no value. All the people who worked to make the shirts? All the people who transported them? All the people who provided the materials for them? All the people who advertised for them? They can’t get paid, because no money came in. Or, if they do get paid temporarily before the company goes bankrupt, it’s purely out of the losses of the owners.
Let’s consider an example of the other way around (demand with no supply): let’s say there are tons of people who would love to have a flying car. Unfortunately, there is no way to actually create a flying car, and thus, no supply. So, someone could start a flying car company, and there would be tons of potential customers, but if they can’t come through with the flying car, then they will go bankrupt instantly.
It’s easy to see that supply and demand must both exist for a company to develop any value. Businesses rely on their ability to develop supply that meets the demand of consumers. In terms of how it affects pricing, the simple rule is that the demand must be sufficiently high and the supply must be sufficiently cost-effective so as to ensure the product can be sold for a higher amount than it costs to make it. The benchmark determinant to pricing is that there must be a profit for the business. No matter what else is happening, a business must generate a profit, or at least break even in terms of costs and revenue. In order to maximize profit margin, businesses must work to minimize the cost of supply and maximize the cost of demand i.e. lower costs for themselves and increase costs to the consumer.
There is a simple rule that increased supply results in lower price while increased demand results in higher price. This is, however, not a major contributor to determining the actual price of goods and services, because supply is essentially unlimited in a properly functioning economy.
Let’s say that McDonald’s launches a new, never before seen sandwich, that they name “The Super Burger”. It costs them $5 to make, so they just need to sell it for higher than that to make a profit. But people love it, and there is very high demand; so high that they can sell it for $15 and people will still buy it just as much. If they were the only company that had this type of burger, they could keep making a $10 profit/burger. However, Wendy’s comes along and makes “The Amazing Burger” that is basically the exact same burger. It also costs them $5 to make, so they only need to sell it for more than that in order to make a profit. But to draw demand to their store instead of McDonald’s, they choose to sell it for $10/burger, thus making a $5 profit/burger. If McDonald’s continues to sell their product at $15/burger, they will have no demand, because all the demand will go to Wendy’s. To gain the demand back in their favour, they lower the price to $9/burger. Wendy’s then lowers their burger to $8. Eventually, this price war causes them both to sell their burger at $6, thus limiting their profit to $1/burger.
The important thing to realize from this analogy is that pure supply and demand would’ve resulted in a $10 profit/burger. But competition caused the price to go much lower, and profit margin caused it to stabilize above $5.
We now have three rules: a price must match demand, must be competitive with other suppliers, and must maintain a profit margin.
The McDonald’s vs. Wendy’s analogy works great to explain the pricing of certain types of products, but how then can Wal-Mart charge $10 for a t-shirt while Gucci charges $700? Shouldn’t the competition for a nearly identical product result in the prices becoming more even?
The fact is: they aren’t identical products. Sure, the material is the same, it’s the same shape, and it costs a similar amount to make. But the difference is all about branding. Wal-Mart is branded as being cheap. The brands have no weight behind them. Gucci, on the other hand, is branded as luxurious. It’s a designer brand that’s been marketed to convince people that it’s incredible. You’re not just wearing a shirt; you’re wearing a brand. And some people will pay $690 more for the brand.
Gucci and Wal-Mart are not in direct competition to one another, because they are marketing to different consumers. A wealthy person who loves designer fashion will never step foot in Wal-Mart to look for clothing. A low income person with no interest in fashion will never visit the Gucci store to seriously shop. Wal-Mart is really in direct competition with other businesses that are going for the same market- Superstore, Target, Winner’s, etc. Wal-Mart needs to stay competitive with those stores while also maintaining a profit margin and sufficient demand. Gucci is in direct competition with businesses that are going for its same market- Guess, Armani, Fendi, etc. Gucci needs to remain competitive with them while maintaining profit margin and sufficient demand.
Companies have all sorts of means by which they can create their brand, and these are all a huge aspect of marketing. Nike, Reebok, and Adidas, for example, pay high profile athletes millions of dollars to wear their products and appear in commercials. They attach the sport star to the brand, and thus create demand and can increase the price. Nike is not the same as some no-name brand that makes the exact same shoe, because Nike is the only one with Michael Jordan and Tiger Woods attached to it.
If consumers are looking for practical utility of their cost to goods ratio, they will not let marketing/branding affect their purchasing decisions. Just because Sidney Crosby appeared in a Tim Hortons commercial doesn’t make Tim Hortons have better food or better prices. And yet, they still pay Sidney Crosby to appear in their commercials, knowing that attaching his name to it will increase sales.
Simply put, we can already see from these brief examples that pricing can be significantly affected, or completely changed, by branding. Marketing can shift the demand to an entirely new demographic, and thus shift their product’s identity and their business competition.
The cost of goods and services is determined by supply and demand, competition, and marketing/branding. It may seem arbitrary in its end result, but it can always be traced back to these three things in some form. The ability for businesses to generate high sales volumes at profitable prices is essential to creating economic growth, not only for the business itself, but for society as a whole.
Effective businesses create tons of jobs for everyone along the supply chain, as well as provide quality products at good prices to consumers. Consumers have a major say in what they pay for goods and services, and they will, as a whole, always pay what they consider to be a price they are happy with paying. This combination of product supply and product consumption ensures that individual’s needs and wants are met while also providing work to tons of people.
As long as business law and government regulation works to ensure healthy competition between businesses, maintain worker’s rights, ensure consumer satisfaction, and administer low enough taxes so as to not excessively burden businesses, the supply and demand can continue to operate in a way where prices are able to make businesses profitable and consumers happy.