Value Driven Pricing

For anyone interested in economics as it relates to pricing, check-out this online textbook on Price Theory[1].

The relevant question is basically this: "Am I better off to pay $X for a thing, or not to have it?" The question is the same whether the thing is one more can of Jolt, or one more PalmPilot. Ideally, the independent free choices of buyers and sellers in a market set prices based on the way each player values things, time, money, and intangibles like social good. In a sense, Fashion Driven Pricing is Value Driven Pricing. After all, we describe things people value for perhaps subjective (or even trivial) reasons as fashionable and value drives pricing. QED: Fashion Drives Pricing. Just ask Tommy Hilfiger. Who else gets $17 for a pair of underwear?

There have been other theories of value, notably the Labor Theory of Value which says that the value of a thing is proportional to the labor it took to produce it. This theory is closely associated with Marxism, and I think only one Caribbean dictator and a few Massachusetts academics and politicians still believe it. An argument that huge markups on assemblages of inexpensive parts is somehow irrational or wrong skirts dangerously close to this theory of value.

The "would I rather have the product or the money?" condition doesn't determine the price. There will be a wide range of possible prices within which both parties in the transaction would rather go ahead with it. What happens in practice is that the prices adjust in such a way as to maximize the seller's profit. This usually means that the actual price is nearer to the buyer's "only-just-good-enough" threshold than to the seller's.

Think of it like this: the gap between the two parties' thresholds represents the amount of "slack" available in the transaction: that quantity of value is going spare, in some sense. Generally the seller gets a lot more of the available goodies than the buyer.

So an argument that huge markups is bad doesn't have to have anything to do with Marxist economics. It could be based on the idea that it's unjust for the seller always to get most of the spare value.

(Note that what I'm calling "spare value" has nothing whatever to do with what Marxists call "surplus value".) -- GarethMcCaughan

I'd just as soon assume that when a buyer pays $x and receives a good #g, and a seller accepts $x dollars and delivers the good #g, the good in that transaction was worth $x to both parties, independent of profit or loss on either side. How would one side benefit more or less than either $x or it's equivalent, #g? --EvanCofsky

What about PriceGouging?

See PriceGouging

Let's try a different (but kind of lengthy) approach.

Suppose I am looking for a unusual house in a slow housing market, and I find one I like, and I am willing to spend $300K on it. Suppose after negotiation I am able to buy the house for $250K. I have obtained a good which in some sense is worth $300K to me, and have gotten $50K in extra benefit. The seller was willing to take $250K, so she preferred having that to the house, so presumably she got at least a penny or two of surplus out of it. Voluntary transactions always result in both parties believing they are getting some surplus--that is why transactions happen.

But she may have been willing to sell the house for $200K, in which case she got $50K of surplus too. If we make one change to this scenario, so that she had known I was willing to pay $300K, it is doubtful I would have gotten more than a few thousand of the surplus. Similarly, if I had known she was willing to take $200K for it, I wouldn't have paid $250K. This is why people go to great lengths not to let their counterparts know this kind of information, and it is one reason why you can't easily predict who is going to end up with the surplus. Note that there is nothing magical about the transaction price--it could have been $201K, or $250K, or $299K with nothing in the real world changed except one piece of information in the buyer's or seller's mind.

This is common with transactions involving rarely sold and unusual items, which is why I stipulated a slow housing market--in a good market, there tend to be multiple buyers, they will likely bid against each other and the seller will tend to get most of the surplus. Similarly, I mentioned a unique house; if there are many similar houses, the seller may well have competitors, and may have to match the price of one of her neighbors.

It is also why monopolies or near-monopolies tend to be very profitable--the monopolist knows the consumer has no options, and can price their product to minimize the surplus retained by the consumer. Note that there still has to be some surplus or the consumer will not be willing to purchase the product at all--monopoly power has its limits.

Theory says that profit-maximizing entities will generally (it would say always, but there can be temporal considerations) try to do ValueDrivenPricing, because the value that a product has to a consumer is the highest price he will be willing to pay. But since there is usually at least some kind of tangential alternative, much of the surplus will go to the buyer, because sellers will have to meet each other's prices (you may really, really want a new BMW, and BMW has a monopoly on them, but you could still buy an Audi). The hotter the competition, the less surplus is available for producers. Branding, market segmentation, innovation, etc. are ways for producers to both increase the perceived value of their products to consumers (increasing the total surplus available) as well as differentiating their products from others (reducing competition). Areas where these strategies are effective (technology, designer clothing) tend to be much more profitable than areas where they are not (aluminum, long-distance telephone service).

So in a transaction, both sides will try to get the price which will better it most. The buyer will try to get a low price, the seller a high price. --ec