Why Prices Are Going Up And Market Competition Isn’t Driving Them Back Down

The greater a product’s market concentration the more sellers are able to raise prices

Image by Gerd Altmann from Pixabay

By David Grace (Amazon Page — David Grace Website)

We’ve all been taught that a free market always drives prices down. That’s not true.

The classical theory is that

• (1) each sellers’ top priority is selling more units
• (2) the most effective way to sell more units is to offer a lower price and
• (3) if a seller in a free market raises its price then its sales volume will fall causing it to make less money.

Those ideas are sometimes true and sometimes not true. This column explains why today they are increasingly untrue.

Does A Higher Price Earn A Seller More Money?

If a seller increases the price of its product and the higher price causes the number of units sold to decrease, the seller looks at two numbers:

• (1) how much less money it gets because the higher price has caused it to sell fewer units.
• (2) how much more money it gets from the higher price it charges for the number of units it does sell

Elastic Prices — The Higher Price Reduces Revenue

If the seller previously sold 1,000,000 units per month at $10 each then its gross revenue would be $10,000,000.

If the seller increased the price by $1/unit to $11 each and because of the higher price sales fell to 900,000 units then its gross revenue would fall to $9,900,000, a $100,000 decrease in revenue.

The money lost from fewer units sold was greater than the money gained from the higher price.

When you make less money by raising your price, the old price is said to be “elastic.”

Inelastic Prices — The Higher Price Increases Revenue

If the price went up by $1/unit to $11 each and sales fell to 950,000 units because of the higher price then gross revenue would increase to $10,450,000, $450,000 more revenue.

The money lost from fewer units sold was less than the money gained from the higher price.

When you can make more money by raising your price, the old price is said to be “inelastic.”

Unity Elastic Price

If sales had dropped from 1,000,000 units/month to 909,091 units then the money lost from the drop in sales volume would exactly equal the money gained from the higher price.

In this case the old $10 price would be neither elastic nor inelastic, but rather it would be called the “unity elastic price” or sometimes the “unity price.”

A Market With Many Competing Sellers — Elastic Price

Suppose you have a product, let’s say ballpoint pens, with 10 major manufacturers who all offer similar products and where each has around a 10% market share.

If one of those ten companies raised its price the other nine sellers could easily supply the higher-priced seller’s customers who wanted to change vendors to avoid the price hike.

Because there would be a readily available supply of pens at the old price from other established sellers, an increase in price by one of the sellers would result in a large decrease in that seller’s sales volume.

The seller who raised its price would lose more money from the reduced sales volume than it would gain from the higher price which means that the old price would be elastic.

The market would punish the seller who raised its price thus deterring price increases.

The More Concentrated The Market The More Inelastic The Price

But let’s say that through acquisitions and consolidations the number of sellers dropped from ten to five with each having a 20% market share.

Now, if one of those five companies (20% of the market) raised its price by $.25/unit its customers would want to take their business to another seller, but each of the other four would have to increase production by at least 25% (20%/4 = 5%/20%) to be able to service all the increased-price company’s unhappy customers.

Increasing your factory’s size, your raw materials purchase, and the number of skilled employees by 25% is time consuming and difficult enough, but doing it while each of your competitors are also competing with you for the same specialized equipment and trained employees is even harder.

In practical terms, the other sellers would, in the short term, find it difficult to impossible to fill the needs of all of the customers who didn’t like the higher price, and therefore the drop in sales volume for the seller who increased its price would be less than it would have been if there were nine instead of four other sellers who could have satisfied the needs of all those extra customers.

Due to the limitation of the immediately available supply from other sellers, the drop in sales from the higher price would be lower in that concentrated market than than it would be in a non-concentrated market making the price increase profitable.

A price in a market with ten sellers that would be elastic because of the additional available supply would be inelastic in a market with five sellers because of the lack of an additional available supply.

This ability to increase prices with increasing market concentration continues until you get just a few sellers who will act as a pseudo cartel or one seller who has a monopoly.

When that happens you get the monopoly price which is the price that will generate the maximum level of gross revenue that can be squeezed out of the product’s customers.

The Relationship Between Market Concentration & Higher Prices

There is a direct relationship between

(a) market concentration and (b) the market share of the seller that is raising its price, and

(c) the unity price, namely,

the more concentrated the market and the greater the market share of the company raising its price, the more inelastic is the old price, the higher is the unity price, and the more the seller can charge a higher price.

Two Pricing Strategies

There are two basic pricing strategies:

• (1) a Competitive Pricing strategy where sellers offer a lower price than their competitor’s price in order to increase their sales volume, and
• (2) a Follow-The-Leader pricing strategy where sellers increase their price to match their competitor’s higher price in order to increase their profit per unit sold

The Tipping Point That Energizes Follow-The-Leader Pricing

As the number of sellers decreases,

• (1) the sellers’ market shares increase,
• (2) the unity price increases, and
• (3) we more closely approach a tipping point where sellers switch from a Competitive Pricing strategy to a Follow-The-Leader pricing strategy.

An Example Of The Switch In Pricing Strategy

When one ballpoint pen seller raises its price by $.25/unit the other four sellers weigh their options.

• (1) Competitive Pricing: They can either keep their old, lower price and struggle to increase production to absorb some of the new customers fleeing the higher-priced seller or
• (2) Follow-The-Leader Pricing: They can raise their own price to match their competitor’s new higher price.

Let’s say that the market is 5,000,000 units per month and each of the five companies sells 1,000,000 units.

Let’s say that the higher-priced seller’s competitors can each scale up to produce an additional 125,000 units/month. In that case the seller raising its prices might see its sales volume fall no more than from 1,000,000 units/month to 500,000 units/month.

1,000,000 units at its old profit of $.25/unit = a monthly profit of $250,000

500,000 units at the new profit of $.50/unit = a monthly profit of $250,000.

The price increase does not hurt the increased-price company. The price increase stays in effect.

If the profit of the other sellers is $.25/unit that means that before they recover their costs of increasing their production they each would have an additional $31,250 in profits/month ($.25 profit X 125,000 additional units sold).

On the other hand, if they each increased their price by $.25/unit to $.50/unit profit and they gained zero increased unit sales then they would each see their profit increase by $50,000/month. (Old: $50,000 profit — 200,000 units x $.25 profit. New: $100,000 profit (200,000 units x $.50 profit).

Clearly, it’s better for the other companies to raise their prices and earn an additional $50,000/month than to keep their current lower price and only earn an additional profit of $31,250/month, less the costs of increasing their production capacity.

And notice, if the other four companies also raise their prices the company that first raised its prices does not lose any sales because of the higher price and its profits increase from $50,000/month at the old price to $100,000/month at the new price.

Yes, some customers might reduce their orders but the total sales decrease across all five companies would likely be no more than 10%.

ALL of the five sellers make more money from the price increase. The market does not counteract the price increase. In fact, the market rewards the sellers with higher profits for increasing their prices.

Supply & Demand

While prices may be dependent on supply and demand, supply is dependent on the immediately available additional manufacturing capacity sufficient to satisfy the needs of all of the customers of the largest producer in the event that the biggest producer increases its price.

When that additional manufacturing capacity is not present then there is insufficient supply to satisfy the needs of the largest producer’s customers who wish to switch vendors.

That limitation on supply not only insulates the seller from a huge reduction in sales because of the price increase but it will also likely cause that price increase to spread like an infection to all other producers of that product in the form of Follow-The-Leader pricing.

The Effect Of Market Concentration

Two very important facts stem from there being only five sellers instead of ten sellers serving the entire market:

• (1) Fewer sellers means that the old unity price becomes an inelastic price, that is, fewer sellers means that increased market concentration changes a price increase from being unprofitable to being profitable.
• (2) Fewer sellers means that sellers are motivated to switch their pricing strategy from competitive pricing where the sellers keep the old low price in response to a competitor’s higher price to a Follow-The-Leader pricing strategy where other sellers raise their prices to match their competitor’s new, higher price.

We See This In Our Consumer Prices Today

This is what we are seeing in today’s much more concentrated markets.

Four meat producers butcher and distribute almost all the beef in the U.S. Three producers dominate chicken production and three control pork. In total, six companies overwhelmingly control the market for all the beef, pork and chicken sold in the U.S.

You can see this same concentration in consumer goods from ketchup to disposable diapers, from gasoline to pharmaceuticals.

When six or fewer companies supply 60%, 70%, 80% of the entire United States’ market for a product, that concentration changes prices from elastic to inelastic, increases the unity price, and motivates sellers to switch from a competitive pricing strategy to a Follow-The-Leader pricing strategy.

Is There A Realistic Mechanism That Will Restore Competitive Pricing?

If you want lower prices then you either

• (1) find a way to lower market share for most products to below 10% per supplier or
• (2) eliminate the profit motive for charging higher prices
• (3) find a way to switch sellers from a Follow-The-Leader pricing strategy to a competitive pricing strategy

It’s Almost Impossible To Reverse Market Concentration

For many reasons including but not limited to the economies of scale, I think it is impossible to reverse today’s market concentration.

Prevent The Profit Motive From Driving Up Prices

It is mechanically (not politically) easy, however, to prevent the profit motive from driving higher prices by levying a 100% tax on taxable profits that exceed 20% of deductible costs.

If a seller knows that it will lose all the extra money it might make by charging a higher price to an excess profits tax then it has no motive to increase its price.

Switching Sellers From Follow-The-Leader Pricing To Competitive Pricing

A Follow-The-Leader pricing strategy won’t do a seller any good if all the extra money it might make from those Follow-The-Leader higher prices will be taken away in an excess profits tax.

If a seller knows that it will lose in taxes all the extra money it would gain from a Follow-The-Leader higher price per unit then the only way the seller will be able to earn twice as much in profits next year as it earned this year is to live with the same amount of profit per unit sold and double the number of units it sells.

To double its unit sales it will have to switch from a Follow-The-Leader pricing strategy to a competitive pricing strategy.

Put differently, if Acme sells 10,000,000 units and it makes a profit of $1/unit and it knows that if it raises its price to $2/unit that extra dollar in profit will be taken away in taxes, then the only way Acme will be able to increase its profits from $10,000,000/year to $20,000,000/year will be for it to sell 20,000,000 units next year.

In order to double the number of units it sells a company will need to compete on quality, features and price rather using its large market share to facilitate it and its competitors raising prices by adopting a Follow-The-Leader pricing strategy.

— David Grace (Amazon Page — David Grace Website)

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