Pricing Power

Why this matters

Supply and Demand measured how buyers react to price across a whole market. Competition and Market Structure showed how the number of competitors limits what any one can charge. Put the two together for a single company and you get pricing power: its ability to raise prices without losing so many customers that the increase does more harm than good. Investors pay close attention to it because it decides what happens to a company's profits when its costs rise, and costs rise in every inflation.

Where it comes from

Pricing power is inelastic demand for one company's product. The things that make a customer slow to leave are the same things that made eggs and petrol inelastic, applied at the level of a brand or a supplier.

• Few good substitutes. A patented medicine, a unique location, or a product that rivals can't match. If the nearest alternative is clearly worse, a price rise doesn't send customers to it.
• A small share of the customer's budget. A 10% rise in a $5 monthly item is noticed less than a 10% rise in rent, even if the customer could switch.
• Costs of switching. Software built into a company's operations, equipment that needs a particular supplier's parts, or data that's hard to move. Leaving costs more than the price rise.
• Trust and brand. Where buyers can't easily judge quality, a familiar name is worth paying for.
• Rivals who follow. In an oligopoly, a price rise holds if competitors raise theirs too, and fails if one of them doesn't.

Its absence has a recognizable shape too: a product like its competitors', sold to buyers who compare on price, in an industry with spare capacity. Producers of commodities, in the sense of Supply and Demand, have almost none. They take the market price.

The test: costs go up

Pricing power is hard to see in calm times, when nobody is raising prices much. It shows up when costs jump and every company has to decide whether to pass the increase on.

Both start with revenue of 1,000 and cost of goods sold of 600, a gross margin of 40%. Then the cost of making each unit rises 10%.

	Company A: raises prices 10%, loses 2% of volume	Company B: raises prices 3%, loses 1% of volume
Revenue	1,000 × 1.10 × 0.98 = 1,078	1,000 × 1.03 × 0.99 = 1,020
Cost of goods sold	600 × 1.10 × 0.98 = 647	600 × 1.10 × 0.99 = 653
Gross profit	431, up 8%	366, down 8%
Gross margin	40.0%, unchanged	35.9%, down 4.1 points

Company A passed the whole increase on and barely lost customers, so its profit grew with inflation. Company B could pass on less than a third of it before customers objected, and its profit fell.

Over a few years of rising costs, the difference compounds. A company that can't pass costs on doesn't just earn less. Its margin is squeezed every year the costs keep rising, which is why inflation tends to separate businesses with pricing power from those without it.

The rest of this lesson is for members

Still to come in this lesson: Seeing it in the reports, Profits, prices, and the 2021 inflation, Limits, the key takeaways, and 2 quiz questions with explanations.

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