Some companies have built a business model based on the idea of offering a product at a lower cost than all of their competitors.
At the opposite end of the spectrum, other companies have made a name for themselves by offering products that are more expensive than competitors.
Two perfect examples of the different businesses that operate at the opposite ends of the cost spectrum are Costco Wholesale Corp. (COST, Financial) and Ferrari NV (RACE, Financial).
Two different businesses
Costco's business model is built around the principle of offering customers more for less. Its stores are stripped back, and everything is offered in bulk sizes. This helps the company keep costs as low as possible while providing customers an unrivaled level of pricing. The annual membership fee is another part of the business model, which helps it keep costs low.
At the other end of the spectrum, Ferrari is the quintessential luxury brand. The company manufactures a set number of cars every year, and for some models, the waiting list can be several years long. And even if you do have enough money to buy one of the luxury automaker's cars, you might not necessarily gain access to one. The company has declined buyers in the past based on their reputation.
The organization is also notoriously aggressive when it comes to enforcing the power of its brand.
You might assume that if a company is turning down customers, even if they have enough money to pay the exorbitant prices it commands for its products, that it doesn't want the business.
But this is all part of the business model.
While there is always going to be a market for low-cost operators such as Costco, there's also always going to be market for higher-priced luxury goods because consumers generally associate a high price with quality.
Charlie Munger (Trades, Portfolio) explained this concept in a talk given at UC Santa Barbara in 2003.
Munger on pricing power
He started explaining the principle by presenting a question that he said he had asked two different business schools in the past:
"I say, '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?'"
The billionaire went on to explain that the second part of this question was always met with stunned silence, though there are some cases where this has been the case:
"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."
That was just one example. Another example was the mutual fund industry. As Munger explained, it was quite common in that industry to raise prices and use the extra funds to "bribe" the agents selling the fund to customers. High prices create the illusion of scarcity and quality.
Meanwhile, with more agents touting the product, it becomes the crowd favorite.
Put simply, investors should never overlook the power of prices in both the luxury and discount markets.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Searching for Advice in a Crisis: Lessons From Seth Klarman​
- Learning From Warren Buffett's Early Investment Strategy​
- Learning Charlie Munger's Investment Strategy Through a Case Study
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