How Product Pricing Works

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Most people think of prices as an extension of a company's greed. In other words, the common perception is that when a given product is expensive, it's because the companies that make it want to get as much profit as they can. In reality, businesses don't have full control over the prices they charge. Prices in a capitalist economy are based on supply and demand, not 'greed.'

Why the Price?

An item's high price is a symptom, not a disease. The real culprit is cost. A company that makes and sells hairbrushes can't arbitrarily set its price at $1000 a brush because no one would buy them; dozens of other hairbrush manufacturers have already set prices lower than that. So an item's price can't exceed the price set by other companies that make that item. A company can only set its price higher than average if it can come up with an explanation—luxury materials, for example, or a product that works faster or more reliably than others.

To stay in business, a company must have a price that is higher than its costs to make that product. Otherwise, it will lose money on every unit it sells. A company is bound to use a price that's similar to its competitors. The only thing that it can control is its costs. So companies use the most efficient and cheapest ways to manufacture and sell their products, to make enough of a profit to thrive.

A company that comes up with a cheaper way to make its product has the option of either keeping the price at the same level or else passing the savings on to consumers by dropping its prices. In practice, companies almost always choose to lower prices. The reason is that lower-than-normal prices without a drop in quality will attract huge numbers of customers who normally buy from competitors. By increasing its market share (the percentage of consumers who buy from one company in particular), it can make much higher profits than it would by leaving the price the same. 

Price and Competition

Of course, the company's lower prices and increasing market share will immediately goad its competitors into lowering their prices in response. Same with penetration pricing. Some of those competitors will find ways to lower their costs and stay in business, while others won't be able to do so and will end up bankrupt. The final result is a lower price overall. So while any one company would love to charge a higher price, as a group the businesses in a given industry force each other to offer the lowest possible prices.

On rare occasions, a group of competitors in the same industry will agree to all charge the same (high) price. This arrangement is called a cartel and is illegal in many countries, the USA included. Not only do cartels put businesses at risk by opening them up to prosecution for breaking anti-trust laws, but they are also inherently unstable. Sooner or later one of the members will 'cheat' and offer a lower price to entice customers, forcing its competitors to do the same.

Sometimes a government or other legal group will intervene by setting an artificially low price on a certain product, as the USA did in the 1970s on gasoline. The result is always a shortage of that product that causes more pain for consumers than the price increase ever could. The artificially low prices cause companies to shift their inventory to other markets where they legally can charge higher prices. Again, this is not because of 'greed, ' but because in many cases the companies simply can't stay in business at those prices, so they have no choice but to find a new market or perish. The only way to truly lower prices is by lowering the cost to make that product. Trying to fix the problem by setting a low price is like dunking a thermometer in ice water and declaring the fever cured.