What Drives Prices? The Secret to Maximizing Your Consumer Dollar

Welcome to another installment of my Understanding the Consumer Products Industry series, where I'm attempting to level the informational playing field between consumers and the companies that sell us stuff.
What exactly drives the prices of the various food and consumer products that we buy? Why are the prices for some products laughably cheap, and in other cases discouragingly expensive? And most importantly, how can we bias our spending towards products that provide real value for our money--and avoid getting ripped off?

Whoa. Talk about starting off with some big questions. But when you finish today's post, you'll understand the key secret to maximizing the value you receive on practically everything you buy.

Everyone else is going to end up spending more money than they need to, and for no good reason.

Drivers of High Prices
Let's start at the conceptual level. Three things drive prices of the consumer goods we buy:

1) Barriers to competition
2) Input costs
3) Current inventory levels.

As we'll soon see, understanding these three price drivers will help you figure our where, and when, to direct your consumer spending most effectively.

Today, however, we're going to cover what I consider to be the most important of these three price drivers: Barriers to Competition. There are interesting wrinkles to the concept of barriers to competition, and those wrinkles can offer exceptional value to consumers willing to think creatively and, uh, out-of-the-boxedly about their spending decisions.

Barriers to Competition Explained
I think most readers can intuitively grasp the basic definition of barriers to competition: they're just things that prevent other companies from entering a market or an industry. It could be a brand with a great reputation (like Coca-Cola or Lindt Chocolate), it could be control over distribution channels (for example, just one or two companies control the supply of commodity spices to your grocery store), or it could be special technology or intellectual property that gives you an advantage in the marketplace (like Wal-Mart's incredible gift for logistics and supply chain management).

Coke is a particularly interesting case here. Paradoxically, it's an example of both significant and nonexistent barriers to competition. If you're only talking about cola, yes, Coke faces very little competition. Essentially the cola industry is a duopoly, offering really juicy profit margins for both major players, Coke and Pepsi. And if you think about it, if a company earns rich profit margins, it suggests that the consumers who buy from them get relatively little value for their money.

Broadening The Context
However, when you think about Coke and Pepsi in the context of all beverages (for example, compared to simple tap water which costs a fraction of a penny per gallon, or other inexpensive drinks like store brand apple juice or homemade lemonade), things look a lot more competitive.

So, here's a trick question: do Coke and Pepsi have high barriers to entry? Yes and no, depending on how broadly you are willing to look for substitute goods.

That's the key. Therefore, the conclusions here for an empowered consumer are these:

Conclusion #1: If you see very limited competition in a market, especially monopoly, duopoly or oligopoly-type situations, you are most likely not getting good value for your money. Look for substitute products.

Conclusion #2: When looking for substitutes, be broad and creative in your search. Look outside the narrow niche that a product occupies.

Conclusion #3: If you see heavy competition in a market, you are most likely getting excellent value for your money. Focus your spending on these types of products as much as possible.

Let's spend a brief moment on conclusion #3. Some industries, thanks to bad luck, happenstance or whatever reason, have laughably low barriers to entry and thus are highly competitive. When you buy products made by competitive industries, most of the value of what you buy consists of value from the product itself, while very little of what you spend goes towards company profitability. Products made by highly competitive industries are usually bonanzas of value for consumers.

For example, there are zillions of companies that make unbranded, commodity-like food products such as canned tomatoes, lentils, rice, dried beans, pasta, etc. But by definition there's only one competitor for branded, unique products like Doritos, Oreos or Haagen-Dazs Ice Cream. Is it any wonder then, that a lousy pint of Haagen-Dazs costs up to $5.50 while a pound of bulk lentils costs 99c?

Tricky Situations
Here's a thought that may ring a bell for long-time Casual Kitchen readers: Occasionally, you'll be faced with a high barrier to competition industry where, initially, you can't seem to find any substitutes. Remember my post series from a while back about the spice industry? In almost all grocery stores, the distribution and retailing of typical commodity spices is under the control of just one or two companies.

This totally sucks for the consumer. After all, if you're making a recipe that calls for cumin, you can't really substitute some other spice or product, right? You're stuck.

Um, no. You're stuck only if you think of substitutes in a narrow and limited way. In this case, you need to think how to substitute who sells you the product.

The apparent lack of competition in the retail spice industry exists only in major grocery stores, which dole out shelf space in the spice aisle to a tightly limited number of companies. In fact, in many grocery stores, there are just two key brands of spices available, McCormick's and Spice Classics (by the way, in a devious example of Mr. Burnsian genius, these two brands are actually owned by the same company).

While there might not be a direct substitute for cumin per se, you can still seek out substitute retailers where you can buy cumin. You can easily find lower-cost substitute suppliers for spices and herbs, such as local ethnic markets in your town, or less expensive retail sources over the internet. In some cases, you can grow your own spices or herbs practically for free in your home or in your backyard garden.

In reality, the commodity spice market--the industry that actually grows and processes the spices we buy--is highly competitive. The barriers to entry exist only in the last step of the retail food chain, in the distribution and retailing of products in our grocery stores.

The Disempowered Consumer
One final point. Imagine the reaction of a consumer with a disempowered mindset when he comes face to face with, say, the spice industry. Upon seeing the high prices in his grocery store's food aisle (ugh, $7 for a one-ounce jar of nutmeg?), he grumbles about it all the way to the checkout counter, mentally shakes his fist at both the grocery store and the spice company, and then lets that irritable demeanor contaminate the home-cooked dinner he makes that evening. Later, he might even leave a scathing comment on some food blog about how the food industry is evil and full of greedy bastards.

Contrast this with a consumer with an empowered mindset, one who has trained herself to look for solutions. She recognizes that in a modern economy there are likely many other retail sources where one can get spices at far more attractive prices, and she seeks those out. Further, she recognizes that if she chooses to pay above-market prices for the spices in her grocery store aisle, she's making an active decision to sacrifice money and value for convenience.

Finally, she won't give her power away to consumer products companies by willingly playing their game on their turf and then complaining about it afterwards.

Readers, if you have a clear idea about the competitive situation for the products you buy, and if you are willing to think creatively and laterally for substitutes, the consumer products industry will never, ever take advantage of you.

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chacha1 said...

Hi Dan! Just wanted to say I love this series already. I am all about the continuing education.

It's a shame that our society does not place a proper value on being an informed consumer. When I look at the bulk of advertising (not to mention product packaging) and see just how misleading it really is - just what producers are able to get away with - it makes me tired.

Because it is really quite difficult to get to the bottom of the various claims that are made. There isn't any clearinghouse of truth, as it were. My solution is, to a large extent, to simply recuse myself and not buy stuff.

But people HAVE to buy food. So thanks.

Daniel said...

Thanks Chacha1! There haven't been all that many comments on this series but the reaction from readers--including you, thank you!--has been quite positive so far.

Today's post covers a lot of ground, so it doesn't leave as much room for reader input as many of my other posts.

But readers, please know that any questions, thoughts, feedback and comments you have are definitely welcome!