Thursday, February 7, 2008

Is there an absolute fair price?

I had written once about my thoughts about fair margins while pricing products. I have been trying to get the concept clearer in my head but have not quite been able to do so till now. A few days back I had a rather productive discussion with a couple of my friends regarding the same issue. Productive because it brought a lot more clarity to my thought process regarding this issue.

When you talk about absolute fair price you are making a fundamental assumption that there is a price that can be called an absolute fair price. The definition of such an absolute fair price would be a price that is independent of the actual buyer or seller. Such a price will be the minimum at which the seller should have to sell and the maximum at which the buyer have to buy and would be fair to both the buyer and the seller.

In a perfect market where there is perfect information and market forces are working perfectly, competition and awareness of the customers will ensure that prices will be fair to both the buyer and the seller. Markets are seldom perfect, perfect information is only a myth and hence the above scenario never occurs in real life (at least it wont happen for all the customers at all the places at all times in the given market).

I am more interested in an answer to the question under imperfect market conditions where there is no perfect information and where customers are not fully knowledgeable about the market. The reason why the answer to this question is interesting is that it will give a solid basis of estimation of prices under any market condition and for any customer.

Before I proceed further, I would like to bring to your attention a few extreme scenarios. Consider a situation where a billionaire is convicted by the court and is going to be hanged. His death penalty will be canceled if he can write a letter to the President asking for amnesty. He does not have a pen. He has access only to a single store and the storekeeper, seeing his situation, sells him a 1 dollar pen for 100 Million dollars. The man gladly pays the amount and buys the pen to write his petition. Here there is no competition, the buyer does not have any choices and the seller sells at a price that the buyer can afford to buy.

Now consider another situation where a man walks into a store to buy a pencil. The storekeeper convinces the man to buy a pen, that is available online for 10 Rupees, for 100 Rupees. Here there is competition, the buyer has choices but he is not aware of his choices and is tricked into buying something at a far higher price than if he had been aware of the other cheaper options.

Pricing, as defined as a function of marketing, is an exercise of profit maximization. Prices are fixed between the total costs incurred by the seller and the maximum affordable price for the buyer. The exact value will depend on the market conditions including competition and consumer awareness. This is how it should work under the Capitalistic model of economy.

Earlier I had come to a conclusion that pricing was to be fixed based on the minimum ROI that is still fair to the capitalist and the growth rate expected of the company. The minimum ROI should be the market rate of Interest for the capital as otherwise the capital invested could have been invested in another venture that would have yielded at least the market rates of interest.

Now the expected growth rate is a tricky question. What should be the expected growth rate? Can't the company grow more if the margins are higher? Yes it has to be conceded that high prices might deter growth but still there is that positive slope till the peak. Should the expected growth rate be equal to the growth rate of the country? But then wouldn't a higher growth rate be better for the country?

I could just be a traditional capitalist and play with the prices according to how the rest of the market behaves. For example I could charge a person higher accordingly as he can afford to pay more or accordingly as he is less aware. I could charge as much as my competitors are charging. I could make a killing in areas where there is no competition.

But the socialist in me is pulling me back from doing that. I cannot give two rates to two different people based on their circumstances or their knowledge. I can not bring myself to give two answers to the same question - "What is the price of this product?". When I had stated my intentions of starting a company, people who knew me told I wouldn't survive as a businessman without engaging in malpractices. I said I will. Neither them nor me ever thought of this kind of predicament that I really have to face.

My take on the issue is that, prices should be determined by the costs involved and not the intended profits to be made and that the fair margin should just be a cost. So if we include a fair margin as a cost we have a solution to the problem. Price of the product equals the cost of the product (See also - True Cost of Things) + the Fair margin. Now if we have an equation or a method to find the fair price then we have a fair pricing strategy. But alas!, both the parameters - ie the true cost and the fair margins - are kind of difficult to find, as we have seen, and my pursuit still continues.