By January 25, 2008 3 Comments Read More →

Once Again, Prices are Set by the Market, Not Your Costs

NPR: Airline Prices Depend on Airport

I haven’t harped on this theme for a while, but I was reminded of it from this NPR story on airline prices. The report expressed such confusion (and almost outrage) that airline flight prices are set by the market instead of being based on what the flight costs.

Imagine that — 2 different flights of 600 miles each might actually have different prices depending on where you’re flying from/to. Of course, that’s the free market (or what passes for it in aviation) at work. If you have a discount airline in your city, you’re likely blessed with lower prices. If you’re at a major hub city without a discount airline (say, Cincinnati), you’ll have really high airfares (or you can drive to Dayton).

What the flight actually costs is pretty irrelevant, except for when the airline is calculating their profit/loss statement. It’s irrelevant to the price offered to the customer.

It’s the old mindset at work — that I should be able to set my own price as “Price = Cost + Desired Profit Margin.” That’s just not how most of the world works. This idea that something “shouldn’t” cost so much or that a company should be able to “pass along” increased costs to their customers isn’t very helpful or realistic.

Prices are set by the market. That’s the best lesson I learned in business school. A corollary to that is the Toyota lesson that you can’t arbitrarily raise prices — to reach a desired profit margin you have to reduce your costs (or, as my friend Jamie Flinchbaugh has pointed out, you can change the product so it is valued more by your customers. Arbitrary price increases, above what the market will bear, might eventually drive customers to competitors.

So, I can’t believe I’m defending airlines (I rarely do)… but why do they charge $X for a certain flight? Because they can. Because people are willing to pay $X.

How do you see this concept relating to your business? Do you try to pass along increased supplier costs to your customers, instead of finding ways to reduce other costs to maintain your profit level? Has your company adopted more of the Toyota type mindset of Profit = Price – Cost instead of Price = Cost + Profit?

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Mark Graban's passion is creating a better, safer, more cost effective healthcare system for patients and better workplaces for all. Mark is a consultant, author, and speaker in the "Lean healthcare" methodology. He is author of the Shingo Award-winning books Lean Hospitals and Healthcare Kaizen, as well as The Executive Guide to Healthcare Kaizen. His most recent project is an eBook titled Practicing Lean that benefits the Louise H. Batz Patient Safety Foundation, where Mark is a board member. Mark is also the VP of Improvement & Innovation Services for the technology company KaiNexus.

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3 Comments on "Once Again, Prices are Set by the Market, Not Your Costs"

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  1. Jason Yip says:

    I generally agree with your assessment but if the consumers are expressing a general sentiment that the pricing is unfair, even though they are obligated to pay it (no other choice), it does indicate that there is an opening for an intelligent competitor to change the game by pricing differently.

  2. Mark Graban says:

    Jason – I think what you’re describing is still market driven. Pricing lower, to attract market share, can be done in a Toyota-like way (setting a “target cost” that you have to hit to be profitable at a certain customer price). Or, it’s predatory, as when an airline purposely prices low (and unprofitably) to drive a new competitor out of a market (an example that shows I shouldn’t necessarily be defending airlines!!!).

    If a company says “our costs are lower, so we can charge less” and the market doesn’t require/respond to lower prices, the low-cost company is just giving margin away, right?

    Likewise, if a company can “pass along” increased costs (and the market absorbs that), shouldn’t the company have raised prices earlier?

  3. Mike T. says:

    But how is market competition affected when Government installs a price floor? I have always viewed this as anti-capitalist, yet this event exists in the US.

    In the state of MN (admittedly 2.5 years ago when I last lived there), there was a state-mandated price floor on fuel. They claimed it was to keep the big business from railroading the small business out of business.

    However, like you Mark, I’ve always felt that power would be constantly held in check as other small businesses would enter a market if the price was too artificially high. The price floor takes this system of market-controlled price and throws the theory out the window. Low-cost competitors have no access to this market.

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