Revenge of the Nerds: How Pricing Really Works in Capitalism

(Part 6 of a series on Political Economy I am writing on this blog. See the series Introduction here. See Part 1 here. See Part 2 here. See Part 3 here. See Part 4 here. See Part 5 here. I recommend reading all prior posts — especially parts 2, 4, and 5 — in the series before reading this piece)

Realizing who keeps making you pay stupidly high prices for things (Screengrab from Revenge of the Nerds film. Source: Waiting for Next Year)

Introduction

Recap

Over the past two posts, we laid out the foundational questions/problems of political economy and then explained how capitalism has a built-in system that answers nearly all of them. This system (money+prices) is both incredibly simple and mind-numbingly complex. We noted how any system that is proposed to replace capitalism must present a system that resolves those foundational problems at least as well as the money+prices system capitalism has.

Central Question

Considering that any system that is proposed to replace capitalism must be equally as (or more) effective as the money+prices system. Which leads us to a question:

How are prices actually set?

Considering that this is arguably the single most important mechanism of capitalism with regards to solving information problems in political economy (and it’s also significantly more complex than you might initially think), we will be engaging with that question today.

How Prices Are Actually Set

This section will cover two topics:

  1. who sets prices?
  2. what factors go into their decisions on prices?

We will not go into different pricing strategies but rather look at who is choosing those strategies and what data they use for whatever strategy they choose.

Who Sets Prices?

Well, the Nerds(TM), of course. Prices do not magically change. Instead, prices are set by humans making “rational” decisions. In every firm, there are Nerds (or algorithms built by Nerds) who decide what the prices of different products the firm offers should be. Sometimes the system they use is a remarkably simple “mark-up” one (“I want a 10% gross profit margin on all goods and services”) and sometimes it’s incredibly complex. But no matter what system is used, each firm relies on its own Nerds to determine its prices.

What Factors do the Nerds Use to Set Prices?

When the Nerds are making their decisions, they need to take into account “objective” and “subjective” factors. These factors can be split up into “internal” and “external” categories.

“Objective” factors are not factors that cannot change; rather, they are factors that cannot be changed by a mere decision. An actual material change (like innovating a new technology or discovering a new deposit of some natural resource) must occur to change these factors.

“Subjective” factors are factors that can be changed by a mere decision. Ex: A firm may decide to change the profit margin its attempting to reach or its expectations about the future based on no material changes but rather on a change in perspective of previously existing and known data.

The “Internal” category has to do with factors that occur within a particular firm.

The “External” category has to do with factors that occur beyond the firm and include the firm’s relationships with other entities (other firms, consumers, the government, etc.)

In the “Internal” category,

“Objective” factors include (but are not limited to):

  • The Firm’s Shutdown Prices (short-term and long-term) of the Company (Ex: “We literally cannot charge less than $X for this good or we will lose money and go out of business”)
  • The Firm’s Capabilities (Ex: “We literally cannot make this good for less than $X. Those are the absolute lowest our costs can be”)

“Subjective” factors include (but are not limited to):

  • The Firm’s desired gross profit margin (Ex: “We want to make 10% profit on every product we sell”)
  • The Firm’s other initiatives (Ex: “We have a pro-environment initiative but it loses us money so we need to incorporate those losses into the prices of other products so we can make up those losses”)
  • The Firm’s particular strategies (Ex: “We sell a lot more to people who set foot inside one of our physical stores. Let’s set the cheapest stuff in the front to attract people to come into the store. We’ll lose money on that cheap stuff, but then they’ll buy the expensive stuff we make profits on and we’ll end up making more money overall”)

In the “external” category,

“Objective” factors include (but are not limited to):

  • The absolute scarcity of the inputs (Ex: “We have the factories necessary to produce 1000 units/day but there just isn’t enough unobtanium out there for us to produce more than 100 units/day”)
  • The preferences of the consumers (Ex: “The consumers prefer good A to good B so if we can produce them for the same cost, good B should still be cheaper than good A”)
  • The policies of the government (Ex: “The government has decided good M produces negative effects on society at large so it is charging a 5% sin tax on every unit of it we sell”)

“Subjective” factors include (but are not limited to):

  • The firm’s expectations about the future (Ex: “We foresee a recession occuring next year and that our profits for that year are going to go down or become losses, so we should price those potential losses into the current prices of goods so we can save the money to weather the recession”)

These factors (amongst others) also direct how each firm makes many strategic decisions. The planning process within every single firm is intense. Consulting firms charge up to exorbitant fees in order to take on these projects for other firms who need assistance. And pricing is one of the biggest category of projects for consulting (especially strategy consulting).

What Makes an Economy “Planned”

Typically, we hear people contrast the “market” capitalist economies of capitalist countries with the “planned” communist economies of the Soviet Union and China. Sometimes we get some nuance about “mixed” economies, especially European Social Democracy economic models, but overall there appears to be an absolute distinction between “markets” and “planning.”

But, we just noted that the Nerds in each firm take all of the above factors and plug them into functions (also created by Nerds) in order to come up with strategic decisions for each firm, which includes setting prices for different goods. In other words, the Nerds within each firm engage in planning! Even within a market economy, planning is present in every single firm, however simple or complex the planning may be.

And yet, there is some qualitative difference between “market” economies and “planned” economies. How do we conceptualize this? In the second part of this series, we deconstructed the notion of the “market” and then built up a better understanding of the concept of the market. We ended with this definition of the market:

A sphere/field, embedded within a moral-political and material framework, wherein the goals of production are met by competition between different entities who have access to the means of production who make decisions regarding those means of production based on some kind of signal

And I believe this presents us with the pathway forward. I believe the key distinction between “market” economies and “planned” economies is competition. In other words, “market” economies embrace competition while “planned” economies eschew it. In capitalism, firms are competing for the money of consumers; firms that can’t compete will fail while firms that can compete will succeed and enjoy profit margins. In other words, the Nerds of each firm are trying to one-up each other as opposed to coordinating.

And, of course, I believe we understand this intuitively. A large number of market failures and other failures of “capitalism” appear to actually have their roots in a lack of competition. In other words, when the Nerds start coordinating, we have a problem. Now, I will not make any claims about whether or not capitalism necessarily eliminates competition within its own markets as big firms crowd out smaller ones and establish monopolies or pseudo-monopolies, but I will simply state that competition is the critical distinction between “market” and “planned” economies. (Of course, this means there is no real distinction between an economy run by the U.S. government and an economy run by Google. Both are run by a single group of all-powerful Nerds. Both are equally bad.)

This ties into the concept of an “economy-wide plan” that usually defines a “planned” economy. There is a small group of Nerds within each firm doing planning. They each have access to less information than a single central planning bureau would. So why does this firm-based planning seem to work better than central planning? Well, as I noted in our previous post on markets:

Consider it a single point of failure: even if everyone is an idiot, chances are at least a few people will accidentally get something right and run successful firms so this colloquial “market economy” seems to beat a system where a small group of nerds (who may also be idiots and/or delusional) try to manage everything.

Wrapping Up

So, we’ve analyzed what it means for an economy to be a “market” economy vs. a “planned” economy. The key distinction is competition. Every economy has Nerds performing planning in every firm, but in a “market” economy the Nerds are competing with one another whereas in a “planned” economy there’s one group of nerds for everything.

I will therefore conclude that it is competition between different firms trying to satisfy the desires of consumers that is what makes capitalism superior to any other system presented so far. It is entirely plausible that an alternative system could express the desires of consumers in a different manner than through spending money, but the key to make this all work is that firms are competing. Without that competition, it all goes to hell.

Which means any system that aims to replace capitalism must incorporate competition in some meaningful way if it is going to lead to similar (or greater) levels of material prosperity as capitalism.

Building Post-Liberal Theory. 🌲 🏴‍☠️.