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Why "supply and demand" is wrong (cheaper won't win the game)

Discussion in 'General Entrepreneur Discussion' started by australianinvestor, Dec 20, 2007.

  1. australianinvestor
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    australianinvestor Bronze Contributor

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    I'm covering for my Store Manager who had to leave early, so I have a few extra minutes to write another post which I hope will be of value to you :)


    Supply and demand theory is an out-dated model which doesn't work in all circumstances anymore. For those that aren't familiar with it, it really only says that if the supply of a particular product is increased, eg: a million more TVs are made in China this month than last month, that prices you can charge for them will decrease. It is based on the assumption that consumers seek to optimise their purchases and get them at the best possible price.

    Why's that wrong? A few reasons.

    1. It doesn't take into account problems of information. A consumer in Phoenix might not know that he can buy a TV 20% cheaper in Buckeye, AZ (hey, I'm working in my limited knowledge of AZ geography. Woohoo!).

    2. Loyalty and brand value. Supply and demand doesn't account for consumers being loyal to their favourite brands, and thinks they'll swap suppliers as soon as a better deal comes along.

    3. Limitations to consumers' willingness to keep searching. It's unreasonable to think that a customer will evaluate all options before buying. If the TV meets a few key criteria, it's within their budget, and the likelihood of finding something better/cheaper which meets the criteria is low, a sale is made. It's called "satisficing", just an egg-head term for making-do with something that meets your needs well enough so that you stop looking for alternatives. That's why people work in $20K jobs. It's enough (for them).

    "Big whoop", you say. What's in it for you? A little lesson that you'll need to lean in to hear, as it's not one we should announce to the world: cheapest price probably won't win you the game.

    A better option is to charge a higher amount, make sure your product meets the customer's checklist of needs and wants (find out what critical criteria they have in their heads when they are evaluating your products for purchase), price it at the upper end of their budget, and make sure it's easy to find and obtain them. Cutting price is counter-productive. You may get a few extra sales from price-aware customers, but increasing price allows you to minimise the information problem (more money to tell people about your product), increase criticial and desired product features (easier sales because the products meet more decision-triggers), and your profits will be healthier than competitors. Sadly for them, they'll probably cut their price further to encourage more sales and perpetuate the cycle until their business dies or they learn a lesson.

    Oh, and there's the added benefit of increased quality perceptions resulting from higher prices, and decreased overhead (sell 100 units to break even versus 1000 cheap units).


    I had a few interruptions writing this, but I hope it makes some sort of sense, and that you can apply it to your own business thinking :)

    Daniel.
     
  2. Jorge
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    Jorge Contributor

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    How come I never thought of that! :smx4:

    Nice ideas here! rep++
     
    Last edited: Dec 20, 2007
  3. JScott
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    JScott Legendary Contributor FASTLANE INSIDER Speedway Pass LEGENDARY CONTRIBUTOR

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    While I certainly wouldn't argue with your assumption that cheapest price isn't necessarily the best way to market your products (this has been well-known and true for decades), it has nothing to do with "supply and demand theory."

    In fact, I would argue that everything you've written points to the fact that the traditional economic supply-and-demand curves are almost always relevant, not the other way around.
     
  4. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    One of my favorite books from years ago is "Economic Alchemy" by Paul Zane Pilzer.

    He espoused the argument that "supply and demand" doesn't work anymore. But, his take was that the unknown factor was technology. Supply and demand requires a finite system of resources. Yet, technological growth takes what we thought we had x of and creates x times some huge factor. It blows the doors off of supply and demand.

    An example he used was the silicon chip - made from silicon, one of the most widely available minerals on the planet, ie...sand. It's almost infinite.

    As soon as you figure out a market and try to do an old fashioned supply and demand calc on it, there is an innovation that changes everything.

    I remember back when I was in school, we were sure taught that all the natural resources would be gone by the 1980's. There would be no oil reserves, no gasoline...it would all be gone. Then they found out how to get the oil from Alaska, new oil was discovered offshore around the world, and cars became more fuel efficient. (Arguably, they could be a lot more - but compare what they get now to the 1950's cars)
     
  5. Diane Kennedy
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    Diane Kennedy Bronze Contributor

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    Oh, another book recommendation, since this thread was more about "why cheaper isn't better" - "Influence: The Power of Persuasion" by Robert Cialdinni.

    It is a great book about the influences that we might not even be aware of that make us buy.
     
  6. australianinvestor
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    australianinvestor Bronze Contributor

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    I disagree completely! Supply and demand is all (or maybe half) about price! Supply and demand, providing you know a few things like the price elasticity of demand, will tell you how much more or less product you can move in a market depending on how much you change the price. If you reduce the price, the generalised view is that you can sell more. This assumes the things I outlined, like people knowing that you are cheaper, and that they will search for the cheapest price and change brands/suppliers when they find it. A lot of us know the marketing rationale for not selling cheap, but this was intended to show an economic rationale.

    The reason I chose supply and demand to illustrate it is because people seem to justify their price reductions based on supply and demand, but know little of the assumptions it uses.

    What I was trying to say with the post is from heterodox economics. If you google "heterodox economics", there'll probably be a better explanation than I'm capable of, but the main reason for the post was to show people one reason why reducing price doesn't always mean people will buy more.


    :)

    Daniel.
     
  7. WheelsRCool
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    WheelsRCool Contributor

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    From my understanding, supply and demand govern the economy, the thing is supply and demand changes due to technology, for example as stated above, with cars: when fuel-injectors replaced carberators and improved fuel-efficiency a good deal in cars and trucks, the supply of fuel in the world for automobiles essentially was doubled automatically.
     
  8. TNT
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    TNT New Contributor

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    I believe the supply and demand curve works well. It can not be the only thing you use but is a basic princilpe and is a good starting point.

    A basic example is when companies come out with new Games such as the Wii or PS3
    They come in at a high pricepoint knowing that they will only sell a few there to the people who need the latest and greatest( sorry can not remember the term for them been out of my MBA program for a few years) then they drop the price point knowing they will start picking up others in the market and they drop the price more to bring it even more in to the mainstream market.

    If you have taken an econ class then you know there are much more complicated models for pricing than just supply and demand.

    TJ
     
  9. randallg99
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    randallg99 Bronze Contributor

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    supply and demand has withstood the test of time in the free markets over and over again... there is probably no other single theory that is as continuously proven in real world experiences.

    supply and demand applies to all aspects tangible or otherwise: money supply, equities, products, luxuries, resources, commodities, information, etc... the more you want something, the more you are willing pay for it...

    you even argued for the theory in your own post while you were trying to disprove it: >>>Supply and demand theory is an out-dated model which doesn't work in all circumstances anymore. For those that aren't familiar with it, it really only says that if the supply of a particular product is increased, eg: a million more TVs are made in China this month than last month, that prices you can charge for them will decrease. It is based on the assumption that consumers seek to optimise their purchases and get them at the best possible price<<<

    since when did the customer look for the highest price instead of the best prices???

    what if there was a limit placed on how many of the TVs could be made... and conversely, we are seeing the dramatic cheapening of the TVs as the demand as softened. (reason for drop in demand is irrelavant) and the supply increased... the pioneer elite plasma was 10k a few years ago... now it's half.
     
  10. randallg99
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    randallg99 Bronze Contributor

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    >>>A better option is to charge a higher amount, make sure your product meets the customer's checklist of needs and wants (find out what critical criteria they have in their heads when they are evaluating your products for purchase), price it at the upper end of their budget, and make sure it's easy to find and obtain them. Cutting price is counter-productive. You may get a few extra sales from price-aware customers, but increasing price allows you to minimise the information problem (more money to tell people about your product), increase criticial and desired product features (easier sales because the products meet more decision-triggers), and your profits will be healthier than competitors. Sadly for them, they'll probably cut their price further to encourage more sales and perpetuate the cycle until their business dies or they learn a lesson.<<<


    all you did was explain how to create and emphasize strong demand thus strengthening the supply/demand theory
     
  11. JScott
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    JScott Legendary Contributor FASTLANE INSIDER Speedway Pass LEGENDARY CONTRIBUTOR

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    What about the theory of gravity? :)

    Other than that, I agree with everything you said...
     
  12. Jimbo1177
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    Jimbo1177 PARKED

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    I disagree with much of what you say. The model for supply and demand is still very applicable. What you have to remember is that it is a model based on assumptions and preferences. Obviously not every assumption will hold every time, but as a basic model it explains an awful lot.

    As mentioned, price elasticity is another issue that has to be considered. Depending on elasticity, a price increase could either increase or decrease your total revenue. Same goes for a price cut.

    Also, the issue of charging higher prices acts as a signal to consumers telling them that a product is of higher quality than lower priced items. Theoretically, if a product is of lower quality the supplier will be forced by the market to charge a lower price than a firm with a better product.

    Technology is also a key component of the theory of supply. The only way a firm can increase the amount of a product it produces given a fixed input is through improved technology. Virtually any econ text book will list technology as one of the major features effecting the movement of the supply curve.

    So in all, I agree with what randallg99 is saying. The model has been around for a very long time and has withstood the test of time. I think the model is still a very important and relevant model.
     
  13. australianinvestor
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    australianinvestor Bronze Contributor

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    I don't have the time to be able to convert everyone to being a believer, so here's a very brief address of major points raised:

    - An entire branch of economics (heterodox economics) agrees with me on what the limitations of supply and demand are. An intro is here - http://en.wikipedia.org/wiki/Heterodox_economics - with links to probably many more sites which will explain in detail. Note that the supply and demand issue is only one area. You'll have to dig deeper for it.

    - Mainstream thought on supply and demand simply does not explain all supply and demand-related phenomena. It has not "stood the test of time" and so on, although it is definitely embedded in popular culture. Without getting into an academic debate, I'd suggest you read some heterodox economics literature and see why the mainstream view falls down in various areas.

    - I didn't argue for the theory in my own post, I merely stated a simplification of what the theory does.


    Even though I love a good debate (thanks for standing up for your opinions, it's hard to find forums in which people actually argue for a viewpoint), I don't have time to continue this one, and the thread is a long way from doing what I hoped it would do: demonstrate that industrial-age thinking about pricing is no longer the only game in town, and that lowering prices will not always sell more product.

    To add to that last point, for those interested, there's a pricing method economics puts forth, which you may care to google: it's the point at which marginal cost equals marginal revenue. It doesn't apply to many situations, but from what I see from a few people's ideas and posts, it may be of assistance to some. They'll know who they are when they read into it.

    With that said, I think this thread has done the most good it can do before evolving into a heated debate between those of the mainstream persuasion, and those of the heterodox.

    I'm off to reply to a few other posts and prepare for my holiday to "the outback" - I'm going to a remote rural farm a friend owns, where I will do lots of walking, thinking, 4x4ing, life planning, photography and some hunting (his crops get eaten by Kangaroos, so a friend and I will help him reduce their plague-proportion numbers a little). I'll share some photos when I get back. I hope to have some stunning landscapes for you to look at :)

    Daniel
     
  14. Analyzer
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    I see yout point but don't really agree it proves that supply and demand theory is worng at all. I also doubt that this theory will ever change as its part of human nature to try and maximize what you get for you resources (unless the perceive effort its to big, time is also a resource after all). Some of those new fields of economics in the wikipedia article sound a bit like what comunism was some decades a go, a beatiful theory that could work theorically but had no chance at all of ever working in the ral world unless you changed all human nature first.

    As for your points:

    1. This will happen but only temporarily, the guy thats selling cheap tvs in AZ will soon enough start advertising to consumers in Phoenix, if he doesn't do it itself someone will start doing it on ebay. This point has actually become less and less real in recent years, better communication and transport make sure these imbalances don't last for long.

    2. This is exactly what supply and demand is about. A powerfull brand guarantees that you are the only supplier of the product, you have a monopoly. Think about coca cola, people keep buying even if they steadily increase prices. This is the kind of businesses W. Buffett loves, I think they call them consumer monopolies.

    This of course is in line with supply and demand rules. If you're the only supplier charge as much as you like

    3. This is basically the same point as the first. More communication makes this less real, just check price.com

    However this was always a balance between supplier and costumer, the effort the costumer is willing to make must be compensated by savings he might get and his perceived probability of getting it and the sellers extra profit must compensate for his extra effort and probability of actually making the sell
    I will agree with you that for this last point peoples perception of value, available resources and effort vary widely and some people will go to unbelievable lengths to save a couple of bucks while others spend freely without a thought.
     
  15. biophase
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    biophase Legendary Contributor I've Read UNSCRIPTED FASTLANE INSIDER Speedway Pass LEGENDARY CONTRIBUTOR Summit Attendee

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    When I started my 1st ebiz I told a few people about it. The first thing they did was google my product and tell me what the cheapest price was. For example, one was retailing at $89 and my wholesale price was $75. They would tell me that I had no margins and that my store wouldn't work.

    That was true if I was going to be the cheapest priced store. I could sell at $85. But instead I priced my item at $145 and it is selling. So instead of selling 7 to make $70, all I had to do was sell 1 to make $70.

    I told my friends that I don't want the whole market. I just want a piece of the market. Who knows, the person priced at $85 could sell 100 a day, but wasn't aiming to take his 100 sales. I'd be happy with 10% of them.
     
  16. WheelsRCool
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    WheelsRCool Contributor

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    That Heterodox economics theory seems more just like a nice theory IMO, but if it rejects the concept of "rationality" that neoclassical economics is based on, then I think it's academics are spending too much time in theory.

    Economics functions on individualism and rationality. The very reasons capitalism works so well and socialism fails so miserably, are both because humans always ultimately do what's in their best interest.

    Supply and Demand are the most fundamental laws of economics. I cannot possibly see how they could be obsolete. Whenever people try to defy the laws of supply and demand, disaster always results, because they're LAWS.

    It's like gravity. Exactly WHAT gravity is, is theoretical, but regardless, it's still a law that if I jump off of a building, I am not going to fly.

    Supply and demand are no different. People might argue over what makes supply and demand laws, but they're economic laws for a reason.

    As for information, the price system is what transfers information, which is an incredibly complex system. There can be thousands of variables that influence a price, but the price system is the ultimate supplier of information in an economy for supply and demand.

    The prices for things are what tell suppliers the demand and the demanders the supply. It all works itself out.

    It reminds me of a story I read about where a central planner from the Soviet Union (during the Cold War) desperately wanted to know who in the British government knew the specific number of potatoes to import into the country to supply their people, to which the answer was, "No one does."
     
  17. Redshft
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    The 'Law of Demand' is defined with ALL FACTORS BEING EQUAL. In the original post with the 3 reasons arguing the law of demand, factors are no longer remaining equal. You now take into account personal preference, search cost, inferior/normal goods, opportunity costs. Demand/Supply curves also depend on the market...is it a perfectly competitive market, monopoly, oligopoly, etc.?

    In the long term, prices will always function to determine supply and demand and bring a market back to equilibrium.
     

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