Have you ever wondered how companies price their products? Have you ever wondered why service charges are so high? As it turns out, pricing a product or service is no secret. First, there is the cost to manufacture the product. Then, there is the cost to distribute the product. The cost of consumer credit plays a role. Most gas stations offer a slightly lower price if you pay by cash. Renting Credit costs money. Taxes on profits play a big role as do government regulations. Labor plays a big part in the cost of any product. Capital is need to buy land, machinery, and buildings. Competition also plays a big part as does scarcity. And lastly, companies must make a profit to survive. Here are some of the items that go into the cost of a product or service:
Raw materials – Let us take oil and gasoline as an example. Oil is worth nothing in the ground. Only until you expend capital, labor, pay taxes, and make a profit does oil have value. In the ground oil only represents opportunity. The quantity available also has an impact on the price. OPEC curtailed production in the 1970s in order to raise their profits. As the price of oil went up from $20/barrel to $140/barrel, companies invested in finding more oil and eventually broke the cartel monopoly. The cost of raw materials represents the capital, labor, profit, and the effect of government regulation and taxes. Competition is what prevents prices from going too high.
Labor – The cost of labor is a big factor in the price of a product. We compete with the rest of the world with respect to labor. Lacking a competitive advantage, like having an abundance of oil, labor is a big cost. Capital can offset labor to bring the cost of a product down. If I invest in labor saving equipment, I can reduce labor and lower costs. Low-cost labor, however, from other countries will always trump high-cost labor for the same product as technology is mostly available everywhere. The difference is in the quality of labor. Most advanced countries have good education programs. To maintain our labor advantage, our education systems must be the best. Companies have no control over taxes, regulations, cost of money, cost of distribution, competition, or the weather. That leaves only labor as the single factor under a company’s control. Now you know why labor costs are always under pressure.
Cost of Capital – To be competitive, companies must continually invest in new machinery, new technology, research, education of the labor force, and land. Whereas labor education is called an expense, the cost of new machinery, research, technology, and land takes capital. You can acquire capital from profits or you can borrow capital and pay interest to rent money. Renting money is an expense and influences product price. Of course, you must pay back the capital, which comes from a company’s future profit.
Taxes – The current corporate tax rate is 21 percent of income calculated before taxes (down from 35 percent rate – from the Obama years). As consumers we also pay the corporate taxes. So, we pay personal income taxes and we also pay the corporate taxes. Some of the profits (after taxes) are distributed to stockholders, who have to pay more taxes on their distributions. The United States is not the lowest taxing country in the world, which is another reason foreign companies can undercut our prices.
Government Regulations – We have to pay for all the government regulations imposed on corporations. Some regulations are needed to maintain minimum environmental standards and some regulations are needed to maintain competition. The government imposes hundreds of regulations each year on industry. As we compete with other nations, government regulations impose undue restriction on U.S. corporations, whereas the competition from other countries (notably China) regulate less and thus have more price benefit. We have to pay for all the government regulation, which give price advantages to foreign countries. Raising the minimum wage raises the cost of some goods. Government regulations should be minimal and least impactful, but they are not.
Profits – Prices depend on many factors. Some of the factors are: taxes and regulations, type of business, competition, management decisions, foreign trade, foreign government intervention, government subsidies, weather, product quality, and the list continues. The fact that business must make a profit to survive in a free market goes beyond doubt. Without profit, no company can survive in a free market. Don’t want a free market? Countries with no free market (Venezuela, Cuba, China, Russia, and 21 other countries that have tried socialism’s planned economies) suffer shortages, lack of choice, inferior products, lack of convenience, and poor quality among other deprivations. What about price gouging? Assume there are two companies making the same product and one of the manufacturing plants burns down. The remaining company now has no competition and can raise prices accordingly. They raise prices to control demand. If they do not raise prices, then a shortage would occur. As the price goes up, there is now more incentive to fix the plant that burned or some other entrepreneur can enter the market. For a short time, prices may raise to control demand, but eventually a high price will encourage other suppliers to enter the market. Services are even more sensitive to competition.
Scarcity – As shown in the previous example, when scarcity exists, prices go up. Demand can exceed supply and prices rise. Demands can be controlled by rationing, raising prices, or lack of availability. Scarcity can also be mitigated by substitution. Wheat, corn, rice, and potatoes can be substituted for each other if a shortage exists in one item. If a farmer has a bumper harvest of wheat and the price goes down, he may plant soy beans the following year. As long as the free market is truly free, things have a way of working out.
Competition – Competition is what keeps prices under control. To some degree you can substitute price for quality, but you can bet that other competitors are trying better your product for an advantage. As an example, paper is graded on brightness as one of its selling factors. Brightness norms dictated an 84 bright sheet of writing paper for many years. One company found a way to raise the brightness to 90 plus. Soon, all the manufactures of writing paper raised their brightness to 90 plus. Competition raised the brightness to a new level and competition forced the other manufacturers to raise their brightness targets. The result was an increase in the quality of writing paper. There are thousands of other examples of competition lowering the price or raising the quality of consumer goods for a competitive advantage. In a socialistic planned economy, there is no competition and prices and quality are static. Innovation in socialistic economies is non-existent because there is no incentive to do better.
A free market will police itself by way of pricing unless acted upon by government edict, corruption, regulations, favoritism, collusion, or laws designed to benefit one competitor over another. This article is a brief description of how prices are set and controlled. There are many other subtle factors that contribute to setting prices. Inflation being a big one. Inflation can only be controlled by not resorting to money printing to finance government spending. Recently, there is reluctance to buy government debt because of lack of confidence in the dollar. Printing money is the only way left to fund government spending. Do we hear a demand to balance the budget and make the government live within its means? It sounds like something a Convention of States can address.
