Tuesday, November 20, 2012

Demand Drives Price

It was my first day in Professor Galster’s Micro- Economics class; I remember walking into the classroom and seeing two things on the chalkboard (yes chalk, no “whiteboards” in those days). First was the professor’s name and the name of the class; simple enough. The second was a quote that has stayed with me over the years and seems more relevant today than ever; “ Demand Drives Price.” At that moment I had no idea at all what those three words meant, or why they were up on the board on our first day of class; yet today I often quote them to my team and to friends as a simple yet profound concept that is often forgotten in business and in life.

An easy way to jump into this idea is to consider a familiar pitfall. When someone asks the price of something they often use the phrase “what does it cost?” Totally understandable from the consumers’ point of view, wanting to know what they would be charged for an item is fundamental. My point is that phrase should NEVER be used in a business context in trying to determine the “price” of an item/product/service. While relevant in the overall economic mix, the “cost” of an item/product/service is almost in-material to the decision of the market price for that said item. This simple example is a good reminder: imagine a moment (hypothetical of course) when you could have at your fingertip three editions of the NY Times, one from last week, one from today, and one from next week. Each edition would have “cost” about the same amount to produce BUT their relative worth would be dramatically different. Today’s edition would bear a market price of $2.00 (it’s actually printed on the paper). Last week’s edition might be used to line the cat-pan, or to light a fire, but you wouldn’t pay anything near $2.00 for last week’s news today. Now next week’s edition is another thing altogether; with all the political/economic/social news that will occur over the next week, if you could buy that edition today it would be invaluable! (Certainly more than the $2.00 printed on the paper) As you can see the actual “cost” of the paper doesn’t impact the relative “price” one would pay, it is entirely driven by the relative “demand” of each edition.

It’s good to take a moment and explore a few of these concepts a little deeper. Let’s start with the definition of “Demand”: An economic principle that describes a consumer’s desire and willingness to pay a price for a specific good or service.

This concept is rooted in the idea of the “consumer’s desire and willingness to pay.” Just as it’s often said that “Beauty is in the eye of the beholder”, so it is true that “Demand” is in the “eye” of the consumer. Recently my wife and I bought a new vehicle and the salesman was extolling the “Navigation system” and how much that feature was worth and why we needed to add the luxury package to the vehicle we were choosing. My wife was so turned off by the NAV system (too much technology is not always a good thing) that we weren’t willing to pay ANYTHING to add it to our vehicle. I am sure that the “Nav System” cost something to produce and install, but it was worthless to us. Our lack of “demand” drove the “price” of that item to zero.

Next let’s look at the definition of “Price”:
The quantity of one thing that is exchanged or demanded in barter or sale for another thing

While we often think of “price” defined by dollars and cents, it’s important to remind ourselves of the definition highlighted above. “Price” is the agreed on payment for the goods and services that one would receive in a transaction. Traditionally it is thought of as the “list price” or the “dead net price” of an item/good/ or service. “Price “, though can take different forms; imagine a college football star that has a breakout senior season. Rather than going undrafted into the NFL, he now is a contender for a first round draft pick that will affect his opportunities, his salary, and potentially his life-long earning potential. “Demand” was increased by his performance and thus the “price” for his future services to a NFL team rose dramatically.

Well by now I am sure that you get the idea that as you think about the marketplace; starts with “demand.” What level of “demand” does your item/good/service generate the marketplace and what “price” are your consumers/customers will to “pay? Then and only then should you look hard at your costs to understand if you have an acceptable profit margin for an ongoing enterprise, or if you need to go back to the drawing board and continue to iterate… Remember, regardless of the market, the era, or the industry, “Demand Drives Price.”

p.s. as I finish this essay a day before the thanksgiving holiday, I want to pass along a somewhat related theorem. If indeed,”Demand Drives Price” as I posit above, a corollary must also be that “those with less should be helped by those with more.” While this wasn’t taught in my Micro-Economics class, it is a profound learning of my adult life. So many of us (and many of the readers of this blog!) have enough to take care of our families AND the ability to help other families in need. My hope this Thanksgiving is that as we sit down for a meal with our families and friends, we can take a moment to be thankful for all that we have AND to turn our attention to the families in need all across the world, the country, and in each of our communities. Whether it’s sending aid to families affected by Hurricane Sandy, or to families impacted by the violence in Syria or Gaza, or possibly the homeless families that live in each of our communities, let us all commit ourselves to take action to help, and to take action NOW, partly because there is so much “need” and partly because we have so much ability to “help”!