GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Munger Problem: Achieve Higher Physical Volume By Increasing The Price?

April 24, 2014 | About:

Achieve Higher Physical Volume By Increasing The Price?

Question:

Now tell me several instances when, if you want the physical volume to go up, the correct answer is to raise the price?

“You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. And nobody has yet to come up with the main answer that I like.”

Answer: There are four categories of answers to this problem. A few people get the first category but rarely any of the others.

  1. Luxury goods: Raising the price can improve the products ability as a “show-off “item, i.e., by raising the price the utility of the goods is improved to someone engaging in conspicuous consumption. Further, people will frequently assume that the high price equates to a better product, and this can sometimes lead to increased sales.
  2. Non-luxury goods: same as factor cited above, i.e., the higher the price conveys information assumed to be correct by the consumer, that the higher prices connotes higher value. This can especially apply to industrial goods where high reliability is an important factor.
  3. Raise the price and use the extra revenue in legal ways to make the product work better or to make the sales system work better.
  4. Raise the price and use the extra revenue in illegal or unethical ways to drive sales by the functional equivalent of bribing purchasing agents or in other ways detrimental to the end consumer, i.e., mutual fund commission practices. [This is the answer Charlie likes most, but never gets]

I found the following problem to be fascinating. From my personal thoughts I was able to come up with the answer luxury goods (I have background experience at Luxottica Retail) as well as an answer that was not provided, although it does relate to number 4. The tactic I thought of (among others) is using stimuli that are addictive, nicotine, etc. to create operant conditioning while slowly raising the price as the social proof factor materializes. If the price is relatively inelastic (determined by observing behavior), the additional funds can be used to market/sell additional product, boosting revenue and creating a lollapalooza effect of marketing, price raises, social proofing, operant conditioning, critical mass, etc. The example is also relatable to pharmaceuticals.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty (2%) can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

Now let us quickly reexamine the problem with the benefit of hindsight bias and frame the questions in such a manner a physicist or algebraist would.

Invert. Always Invert. – Carl Jacobi

When can we lower the price and lose sales volume? How?

  • Products associated with reliability or quality, deterioration of social proof and operant conditioning overtime to competitors.

When can’t we raise the price and increase sales volume?

  • Obviously not everyone would be able to exploit such a pricing process or else the government would step in with price controls. The answer is likely to come from non-regulated or minimal regulated industries.

Of course none of these answers are definite and at best are messy and uncertain.

Why did Max Planck, one of the smartest people who ever lived, give up economics?

“It was too hard. The best solution you can get is messy and uncertain at best.”

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


Rating: 5.0/5 (4 votes)

Voters:

Comments

The Science of Hitting
The Science of Hitting premium member - 2 months ago

I remember hearing Munger discuss this one time, and had since forgot about it; number four gives me a good laugh :) - good article Tannor!

kfh227
Kfh227 premium member - 2 months ago

#4 is funny because my father in law just told me he got his broker to drop his commission to 0.5% from 3% maybe. But then I asked him "What about the 3% cut the fund managers get every year?" After silence, I pretty much decided to keep my mouth shut. At that point I forgot about the possibility of funds paying brokers commisions when they sell a mutual fund to a consumer. Not that I would have mentioned it to my faather in law anyway. I think I once read that a newly created fund can give up to 7% or 8% in commissions to the broker that sells it.

It's just sad. After all the commissions my father in law is paying along with probably doing stocks and bonds, I doubt it that he actually makes any money on a normalized and inflation adjusted basis.

I can't convince him to go to Ameritrade and buy 10 high quality dividend providers at a fair price like JNJ. I never even actually get that far in conversations. How can he outperform a broker after all .... cries

TannorP
TannorP premium member - 2 months ago

Thanks for reading Kfh, Science and everyone else.

Number 4 is funny and 3 reminds me of how a lot of the western world operates after lobbyists get involved, hence the importance of following public policy.

It is disgusting how the financial services sector operates and I wouldn’t find 7-8% very farfetched. The AUM game is a catalytic one, where as new funds are absorbed, a higher absolute MER is provided to the fund manager, which includes marketing.



So fund holders pay an MER (1-2%) with a marketing fee mixed in, in an attempt to attract more assets to manage (which will deteriorate future performance) which in turn are charged an MER. The cycle is one I attribute as "ratchet-up" or catalytic, one that fuels and sustains its self.

What can we do though besides warn others and promote rational investments? It is like dye in a water bowl, once mixed in, it is very difficult to get out without starting new.



- I could rant an easy couple thousand words about the blatant disregard for fiduciary responsibility in the financial services sector, It is best to know, where the incentives are aligned. 



Cheers and thanks for listening,

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Email Hide