Friday, April 24, 2015

Why the Free Market Economy Does Not Serve the Consumers - One Example

I've heard a lot of people talk about how, if we leave the market free and let companies compete for profits without any regulations, consumer choice will lead to the best products succeeding over their competitors. This idea has always seemed incredibly naive to me, given how many real-life examples there are of the free market economy screwing over the consumers in so many different ways.

Take one hypothetical example. Imagine there are two appliances arriving on the market at the same time, made by two different companies. These two appliances do exactly the same thing, they do it equally well, and they both sell for $25. However, Appliance A is less durable, lasting about 2 years. Appliance B, on the other hand, is made to last 10 years. Clearly, Appliance B is better for the consumer, since buying one Appliance B gives you the same results as buying five Appliance As. But will Appliance B win out?

Let's say that the first year, both appliances sell equally well - 1,000 copies of each appliance is sold, meaning both companies receive an income of $25,000. Let's also say, to make this simpler, that these 2,000 consumers are the only people who will ever want either appliance. So the second year, no one buys any more of either appliance.

On the third year, however, the 1,000 people who bought Appliance A need to get a replacement, because their appliance broke down. Some of them may be dissatisfied with how long it lasts, or have friends who got Appliance B and say it's still going strong. But others may not know that Appliance B lasts longer, and would rather go with what they know than take a chance on an unknown product. So let's say that half of the people buy another Appliance A, and half buy an Appliance B instead. That's 500 sales for each company, for an income of $12,500 and a cumulative income of $37,500.

On the fifth year, the consumers who bought a second Appliance A once again need it replaced. Once again, half of them buy another Appliance A, and half buy Appliance B. That's 250 sales for each, $6,250 income and a cumulative income of $43,750.

Seventh year, same thing. Each company sells 125 appliances, earning $3,125 for a cumulative income of $46,875.

Ninth year, we have an odd number of people buying, so let's say 1 person buys neither Appliance B or Appliance A. That gives both companies 62 sales for $1,550 and a cumulative income of $48,425.

At this point, 1,938 people own an Appliance B, and only 62 own Appliance A. Despite this, both companies are raking in equal profit, having both sold 1,937 appliances. However, it's unlikely that their production costs are the same, since more durable machines are usually more expensive to make. So, if Appliance A costs $10 per unit, and Appliance B costs $15 per unit, then it cost Company A only $19,370 to make all their appliances, leaving $29,055 as pure profit. In contrast, Company B has spent $29,055 on their appliances, and their profit margin is only $19,370 - a lot less profit.

Appliance A - lasts 2 years - $25 price - costs $10 to make
1st year - 1,000 sold - $25,000 price
3rd year - 500 replaced with same - $12,500 - cumulative $37,500
5th year - 250 replaced with same - $6,250 - cumulative $43,750
7th year - 125 replaced with same - $3,125 - cumulative $46,875
9th year - 62 replaced with same - $1,550 - cumulative $48,425
sold 1,937 copies - cost $19,370 - $29,055 profit

Appliance B - lasts 10 years - $25 price - costs $15 to make
1st year - 1,000 sold - $25,000
3rd year - 500 switched from A - $12,500 - cumulative $37,500
5th year - 250 switched from A - $6,250 - cumulative $43,750
7th year - 125 switched from A - $3,125 - cumulative $46,8759th year - 63 switched from A - $1,575 - cumulative $48,425
sold 1,937 copies - cost $29,055 - $19,370 profit

Of course, this is an oversimplified example. Some people may argue that word-of-mouth will increase Appliance B's sales after the 3rd year, as people hear that Appliance A only last 2 years and Appliance B lasts longer. But by the 3rd year, Company A has spent $15,000 and Company B has spent $22,500 on production costs, resulting in a big difference in profits already. So this effect would have to be pretty dramatic to turn around the trend.

In addition, because they have more money, Company A could start competing more aggressively than Company B. Probably the easiest way for them to compete would be to drop the price of Appliance A. If they sold it for $15, they'd still earn $5 per unit, and at the same time increase their sales - most people's buying decisions are affected more by price than by durability. Company B would not be able to fight back, because if they sold Appliance B for $15, they wouldn't make any money.

Company A can also afford a bigger advertising budget - and advertising works. If you give people a choice between a product they've never heard of and one they saw an advertisement about, people are significantly more likely to pick the advertised product. This is true even if they don't consciously remember the advertisement. So the fact that Company A can spend more money on advertising will almost certainly lead to more sales.

Sadly, there are many real-life examples of this, all around you. Buildings built in the Middle Ages, before the rise of free market economy, are often in better condition now than buildings only a couple hundred years old. My father's handmade desk and stool have lasted 20 years, while store-bought furniture last only around 5 years at most. Pretty much every non-consumable product you buy could have been made much more durable, but instead it falls apart after only a short amount of time. It's not that companies can't build things to last - they simply have no incentive to do so.

2 Comments:

Blogger Stephanie Crist said...

Ettina,

An effective free market relies on the same ingredients as an effective democracy--an educated voting/consumer base.

Companies get away with making and selling inferior products because consumers are not being educated about effective buying decisions. Those consumers who take the time to educate themselves do far better than those who don't. But both buying and investing in one's education are choices. Many people make bad ones.

8:17 AM  
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12:27 PM  

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