Tuesday, June 30, 2015

How are prices determined? The case of statistical consultants

How are prices determined? AnnMaria De Mars offers advice to statisticians on how to price their services. It comes down to this

 So, that’s it, decide a fair rate based on what the market is paying, where, based on objective criteria, your skills and experience fall compared to the general population of whatever-you-do and figure in what non-monetary requirements you or the employer have .” 

Dr. De Mars’ offers good advice and good economics. This is pretty much what I tell students regarding how businesses set prices, except I throw in a little economic terminology. She essentially describes a price that is a function of the price elasticity of demand. The price elasticity of demand is the percentage change in the quantity demanded in response to a one percent change in price. Other things equal, when the price of a good increases people buy less of it. Consequently, the more inelastic the demand for the product you sell, the greater your ability to mark up the price above the cost of production.

What determines elasticity? Elasticity is determined by the availability of close substitutes. The more close substitutes for the good you sell (the more elastic the demand), the less control you have over the price; the less close substitutes there are for the good you sell (the more inelastic the demand), the more control you have over the price. In other words, if you are pretty much like the other statisticians out there you need to charge what they are charging; you can only charge more if you can convince people that you are superior in some way. And, in the long run, you can probably only convince people that you are better than others if it is true. In other words, businesses that do not generally follow De Mars’ suggestions are unlikely to survive.

Understanding how prices are determined also provides a better understanding of business strategy. I tell students that if they plan on starting a business they should aim to be a monopolist. The essence of being a monopolist is that you are the only seller. To be the only seller, you need to convince customers that other goods are not a substitute for yours, and you need some barriers to entry, things that keep people from copying what you do. Fortunately for statisticians, they already have somewhat of a barrier to entry in that most people think that math is a lot of work and not much fun.

The other good point that she makes is that people should not just focus on the money. A lot of people think economists are totally focused on money. Nothing could be further from the truth about good economics. Economists assume that people maximize utility, which means satisfaction. People can get satisfaction from a lot of different things.

Two related things:

2. One of De Mars’ daughters has done an extraordinary job of demonstrating that none of her competitors provide a close substitute for what she does.  

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