Econ 101: How We Are Like Wheat Farmers

Q from an independent hearing aid specialist:{{1}}[[1]]I found this question in a Letter to the Editor, entitled “Profiting From Hearing Aid Sales.”  It was published, but unanswered, in an industry journal[[1]]

“I have minimum overhead… so perhaps my prices are lower than average.  However, if Costco is purchasing their aids for the same price that the VA pays (the price of which I have seen), they are making more gross profit than I am when I sell a pair of hearing aids!  … Does it really cost $600 or more for the manufacturer to ship a hearing aid to me versus to Costco or the VA?

A.  Wow. Where to start?  Addressing RR’s statements and question could easily fill a full semester of Microeconomics.  No, make that two semesters.  But, let’s give it a try in the next few posts by considering Price, Quantity Supplied, Supply Curves and what is meant by “Supply and Demand” in a competitive market.  I’ve bolded some terms that are common Econ-speak in hopes of bridging the communication gap.

Let’s start by asking RR to share those Cost numbers with the rest of us.

Dear RR:  If you are reading this, would you please send in those wholesale cost figures ASAP? Hard data is always welcome on this site. Plus, I imagine a number of private practitioners would welcome knowing what they’re up against.

While we wait for RR to respond, perhaps a realistic starting point is to address RR’s main concern literally and rationally:

Dear RR:  No problem!  If you want the same gross profit as Costco and the VA, all you need to do is raise your sale price.

To which RR would undoubtedly respond:

Dear HHD:  Are you nuts?  If I charged $600 more for hearing aids that my competitors,  I couldn’t sell any and I’d go broke. You may be an economist-in-training but you are not ready for prime time.

Right. But we’re a poor little start-up and I’m the best they can afford here at HearingHealthMatters! Which brings us to the first, bitter pill of competitive market economics:

• Bitter Pill #1:  Single firms cannot influence Price (P) in competitive markets.

RR runs a small business (a firm) and it is true that he sets his prices, at least in principle.  For this post, we’ll make the likely assumption that, as a dispenser, he bundles hearing testing into his hearing aid price.  But it is also true– as he is quick to point out– that if he prices higher than surrounding practices, he won’t sell many units. His profit (price x # of sales) will be negative.  In reality, he must accept the “prevailing market Price” (Price)  in order to stay in business – another bitter pill.

• Bitter Pill #2:  RR and all his competitors are Price Takers.

Typically, economists use the Farmer to illustrate a Price Taker.  He buys the seed, grows the wheat, and sells it at the market Price, which may or may not cover the cost of the seed and his variable costs. He gets a high Price if the wheat Supply is scarce; a low Price if the wheat Supply is abundant.  Profitability for the farmer depends mainly on external factors (e.g., weather; cost of seed, equipment, labor) beyond his control.  But, the Farmer can help out by running an efficient operation to keep his costs as low as possible.  Another bitter pill.

• Bitter Pill #3:  It costs RR money to sell a hearing aid.

RR has rent to pay, whether he sells a hearing aid or not.  That’s a fixed cost and we won’t consider it further because he’s on the hook for it no matter what.  But RR can choose whether to keep the lights on 5 days a week. Let’s say he chooses to work one day a week to save electricity.  He sells a hearing aid on the day he works, so we can say that his Variable Costs (VC) are the cost of 8 hours of electricity, his cost of goods (COG), and whatever weekly salary he gives himself.  That worked pretty well, because those costs summed up were less than the Price he changed for the hearing aid.  So, he decides to work two days and he sells 2 hearing aids.  We can say that his Marginal Cost (MC) to sell the second hearing aid is the cost of an additional 8 hours of electricity and 1 COG.  Another bitter pill.

• Bitter Pill #4:  Every hearing aid RR sells adds to his cost of doing business.

Not so bitter when you consider that RR made more money from his second sale than it cost him to sell it. He sold that second aid for the Market Price, so his additional revenue — his Marginal Revenue (MR)– is exactly the hearing aid Price.  That’s important to remember — in a competitive market where RR is a Price Taker, his MR will always be the same as Price:  MR = P.  So long as his Marginal Revenue is greater than his Marginal Cost (MR > MC) he forges on.  But, he begins to notice that his marginal costs are going up with every additional sale he makes.  That’s the next Bitter Pill.

• Bitter Pill #5.  Marginal Cost (MC) increases as more product is sold.

What?  Not fair! How’s that work?  Well, RR is so busy selling that he goes full time; then he hires staff; then staff demand healthcare benefits; then he has to move into bigger quarter with higher rent; then … you know the drill.  At some point, RR figures out that the Marginal Cost to sell the next hearing aid is MORE than the Marginal Revenue he gets from selling it:  MC > MR.  Recall that MR = P, so another way to say this is that the price RR is able to charge for each hearing aid is less than it costs him to sell it.  Time to backtrack.  Very bitter pill.

• Bitter Pill #6:  Repeat Bitter Pill #2 — Price Takers accept Market Price.

This is SO unfair. Marginal Cost goes up with every sale but Price stays the same (or goes down if you recall the Demand Curve).  Seriously?  Economists understand this and blithely tell us that this is how it goes in a free market.  RR and the rest of us hit the spreadsheets late at night till we find that next, thankfully final, bitter pill.

• Bitter Pill #7:  Maximum Profit is the point where Marginal Cost is the same as Marginal Revenue. MC = MR.

Since Marginal Revenue for Price Takers is the market Price, another way to say this is that RR has to stop selling when the cost to sell the next unit exceeds the price he can charge for it, AND that he must sell units as long as marginal revenue is even a penny more than marginal cost.  That is what is meant by maximizing profit.  To recap, RR’s profit is maximized when MC = MR = P.

All of which brings us back to RR’s original question and wraps up today’s post.   RR’s COG is $600/aid more  than some of his competitors.  Because he’s tacitly accepted the Price Taker role, his Profit is lower too.  Even though he’s pushed his other costs down as much as he can, at some number of sales he is going to hit the point where MC = P.  That number of sales is the Quantity that he can Supply (Q_s) at the given Price, and it is almost certainly a lower Quantity than the  Q_s  of his big competitors with lower marginal costs.  Over and out.

Next week, the Supply Curve.  Eventually, an answer to RR’s real question, which is why the manufacturers charge different Prices to different customers.  Hint:  Could it be that manufacturers are not Farmers like the rest of us out toiling in the fields?

Photo courtesy of art quid