Business Myths

Wise Bread is an interesting blog, which featured an article named 10 Myths Non-Business People Believe About Business by Joshua Ritchie a few days ago. In this article, Joshua refutes some persistent ideas about business that are often viewed as old truths. My general opinion on the article is that it's good, but it looses credibility on some points. Let me give an example.

Myth number 4: "Prices are whatever businessmen arbitrarily decide to charge."

In his article, Joshua turns against the myth that prices reflect greed. When prices rise, it's supposed to be because the selling company wants to squeeze an extra profit out of the product or service. While this is a myth by all means, the explanation he gives is only half the story and actually serves to reinforce another, related, myth.

Joshua argues that, instead of reflecting businesses' greed, prices reflect the cost of producing their product or service. When demand for oil is high, Joshua argues, a gas company has to bid higher for the raw material for their product. Subsequently, they have to rise the gas prices in order to make a profit. This can be true sometimes, but an important piece of the puzzle is still missing.

We have to remember that companies charge whatever they can charge for a certain quantity of goods or services. When our gas company charged $2.50 for a gallon of gas, it was because they expected to sell a certain quantity of gas at that price and that the expected quantity times that price would give them the best profit. If they lowered the price, they'd sell more but still they wouldn't make the same ammount of money (or at least their key figures wouldn't turn out as favorable), and if they raised the prices, they wouldn't sell as much even though each gallon would be more profitable.

This relationship is easy to see if we imagine the extremes; giving out free gas on one end and charging infinitely high prices on the other end. Giving out free gas (charging $0) would make no profit at all even though they'd "sell" fantastic quantities. On the other hand, charging infinitely high prices wouldn't make a profit either, because no one would buy. The optimum is somewhere in between.

Prices on the X-axis, profit on the Y-axis

Now, businesses don't charge prices in the sole purpose of covering their costs. It's the other way around; they take on costs necessary to acquire or maintain sales. No sound company has ever had a business meeting where they've said "OK, we have all of those costs, now what should we do in order to get our money back?". The whole reasoning is backwards.

The real questions to ask yourself when setting the price are:

-- How many units can we sell at a specific price?
-- How much money does that earn us?
-- What are the variable costs of producing that many units?
-- How much is left to cover our fixed costs after variable costs have been accounted for?
-- What are our fixed costs?
-- How much profit is left after fixed costs are accounted for?

The costs that Joshua Ritchie talks about in his article are mainly the variable costs. Depending on the answers to the other questions, they may have a big or small impact. Sometimes they're almost irrelevant. On some markets, raising prices would yield such a drop in sales that this factor outweighs the cost factor. Rising costs may call not for raising prices, but rather for canceling the product if there's no longer room for good-enough profit.

The main point is this: Whenever you feel like saying "This item is over-priced, it can hardly cost a tenth of this much to produce", remember that businesses don't set prices in order to cover costs. They set whatever prices they can in order to maximize profit, or actually to maximize utility (where profit is a main ingredient, but other key figures come to play as well). As long as people are buying and they make a good profit, prices are reasonable.


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