Roger Skoff writes about why things cost what they do
In the first part of this article, I wrote about how pricing works, using not only our own industry but others for illustration. I explained that this article is not intended to replace an economics text, but to just touch on, and state in language as simple as I can make it, some of the basic facts of how pricing really works, how it affects the products we buy, and what it might mean for the future of our industry. Here's more:
At the end of Part 1, I had described a hypothetical well-established High-End amplifier manufacturer experiencing declining sales, higher costs of production, and faced with the decision, because of those things, whether to raise his prices or possibly even go out of business. Let's assume that he decides to stick it out and raise his prices; here's what happens next.
The first decision he has to make is whether to just raise the price of his product, the Velociraptor 11 amplifier, or to bring out a new model, entirely. One of the factors to be considered, whichever he chooses, is how he's going to promote it and get people to want to part with more money.
The cheapest thing for him to do is just to raise the price (we'll get to by how much, later), and send a letter out to his dealers saying that, from that point on, his product is going to cost more money. That would accomplish the price increase he needs, but it does nothing by way of promotion. The smart thing to do is to make at least some cosmetic changes (although some performance or component changes, too, would be better), change the name to Velociraptor 12, raise the price as appropriate, and announce it as a brand-new product. That way, he'll have the opportunity to not only meet his financial needs, but have the possibility of new reviews, often the very best and cheapest kind of promotion. (The audio press loves new things and loves to write about them. It seldom, if ever, re-reviews old ones.)
With a "new," more expensive product, though, it will be necessary to decide exactly how new and how different he'll want to make it. The first step in doing that will be to decide on and plan for exactly which market sector the new product will be targeted for. If the Velociraptor 11, the model being upgraded, had an MSRP of (just for example) $2000, and was aimed for the average audiophile, how much can he set the price for the new Velociraptor12 at and still appeal to those same buyers?
That's a crucial decision and can easily turn into a "tail chaser," with raising the price making it necessary to raise the price even further: Here's how that can work:
Let's say that the manufacturer wants to set the price of the new model at $2500, a $500 increase over the old one. He thinks that that will probably cover his need for additional revenues while still keeping his product affordable and appealing to the market sector it's targeted for. Whether that price will accomplish what he wants or not will depend on a number of factors:
For one thing, prices don't exist in a vacuum, so how much are his competitors raising their prices? If he raises his prices much more than they do it could be a problem. And if he raises them less, he might be leaving money on the table.
Another important consideration is that, just because the new amplifiers will be priced at $2500 doesn't mean that his factory will actually get anything like that amount for selling them. The dealers his products are sold through need to buy them for a substantial discount from MSRP. (If they can't, they won't make money selling them, and if they can't make money, why sell them at all?) And, whether it's in-house salespeople, reps, or distributors who sell the new amplifier to the dealers, those people need to be paid, too. So, depending on dealer discount percentages, in-house sales salaries, rep commissions, distributor discounts, or any combination of those, the percentage of any product's price that a manufacturer actually receives in net payment for his products is usually well less than half, and can be as little as only a quarter of MSRP.
And out of just that amount the manufacturer must design, build, package, warehouse, and promote his product, cover all of his fixed and variable costs, and still try to show a profit. And, depending on the times, his costs might still continue rising, he probably needs to build in a little extra margin, as well, so that he doesn't need to come up with the next Velociraptor design too soon.
What all that means is that, if he raises the MSRP of the new model by $500, of that amount he might only be able to spend just $100 or less on making the actual changes to differentiate the new model from the old one.
Will that be enough? It depends on what he intends to change and what the changes are going to cost. If $100 worth of changes won't be sufficient for whatever reason (circuit or component changes or necessary appearance changes or both are going to cost too much), it could be that a $500 price increase won't be enough and that, if the price increase actually necessary is too great, could result in something else entirely.
Before going there, though, let's consider a critical factor in the pricing decision that might otherwise be easily overlooked. That is the manufacturer's fixed costs—the things, like rent, utilities, insurance, loan repayments, business licenses, property taxes, depreciation, internet and contracted promotional costs, and ongoing maintenance expense—that must be paid for, whether or not anything at all is ever sold. They become important to product pricing in that, given price elasticity of demand, the more expensive the new product is, and given a lack of substitute goods, the less of it is likely to be sold. Whatever the fixed cost total is, it's going to have to be divided among a lesser number of sales, making the fixed cost component of each product sold higher, and making more of the price of sale of that product necessary to cover it. To understand this, imagine that the Velociraptor 12 will be the manufacturer's only product, that his current monthly total fixed costs are $25,000, and that he is currently selling 100 Velociraptor 11 amplifiers a month. Given those costs and sales and dividing $25,000 monthly by 100 amplifiers monthly equals a current fixed cost per product of $250. If the higher price of the new Velociraptor 12 drops the number of units sold from 100 to just 80, the new fixed cost per unit will go up to $312.50, and that effective cost increase has to be incorporated into the manufacturer's pricing plan.
What if the number of amps sold doesn't go down, though? What if, despite the price increase, it actually goes UP? [Editor Robinson calls this the "luxury curve," with demand actually increasing with increasing price. Cf. Thorstein Veblen's brilliant analysis of "conspicuous consumption" and "conspicuous leisure" in his theoretically very significant book, The Theory of the Leisure Class (1899).]
In the present High-End audio market, that's not only possible, it's actually happening, and it's the higher-priced goods that are selling best. Does that mean that we're seeing a "Giffen Paradox"—a condition where, contrary to normal price elasticity of demand, as the price of goods goes up, the quantity taken also goes up? That could be, but it's highly unlikely.
Do you remember what I wrote about "the availability of substitutes"—the third pricing factor after supply and demand? As the price of anything goes up, the number of other things that can also be bought for the same amount of money also goes up, so the availability of substitutes always increases as the price does. As proof, consider this: How many products can you choose between for any price up to five dollars? How many are available for any price up to five hundred? When you recognize that a "substitute" doesn't just mean "a thing that can serve the same purpose," but really refers to "what can the same money be used to buy?" it becomes obvious that HiFi is in competition for the customers' dollars with everything else up to the same price, and that a truly High-End HiFi system is not just competing against other High-End HiFi purchases, but, depending on the system, the other contenders might be anything from a toaster to a Rolls-Royce or Lamborghini car, a second home, or rental real estate. That, given the wide variety of customer tastes and preferences might very well be expected to draw money away from HiFi purchases and toward other things, but at this time, very High-End HiFi is still doing well.
Another fact to be considered is that no product of any kind has just a single characteristic that affects its salability. Nobody buys a car just for its ability to get them from place to place; performance, price, operating/maintenance costs, comfort, looks, luxury and prestige value or lack of it always figure in. It's always a mix of values, and as the price increases the mix changes, both in terms of what is offered and what will be the final deciding criterion in making a purchase. With a growing part of very High-End HiFi, it seems that the point of diminishing returns to scale is long past, and affluent buyers are just assuming great performance and may be making more of their buying decision based on looks or bragging rights.
So, what does that mean? Is it a Giffen paradox? No, it it just means that, at any time, but especially during times of high inflation, more affluent people have more money to spend than other people do and are less likely to need it for basics and more likely to have it available to spend on their system and more willing to do so. It could also be that Lamborghinis are inflating faster than High-End HiFi, so we're stealing market from them!
What's interesting, though, is that the more expensive things get, the more expensive they have to get: Higher priced goods have to look at least as expensive as they are, and that means that, in addition to (usually) better performance, they need better cosmetics or better something (including bragging rights) to increase their perceived value in order for them to be able to be sold. Making them better, or fancier, or more braggable must inevitably increase their cost of production (and their packaging and presentation cost), which further drive up their price, and around and around, until it's ultimately that very cycle of increasing price that creates a brand-new market for budget-priced, less flashy, goods. Think of Schiit, Gustard, and SMSL, for example, or any of the other new big-bang-for-the-buck products that are now coming out, and you'll see what I mean.)
In short, "the market" is not just the audio market, but all markets—for anything at all that's competing for buyer dollars. Everything is "the availability of substitutes" and, even in times of rising prices, the seeds are being planted for lower ones. If you think HiFi prices (or the prices of anything else) are too high now, just stick around for long enough and you'll get lower ones. And because our industry is always trying for better sound, chances are, what you buy then will be better, too.
Now you understand why.
