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Pricing and Competition Among Goods

(Part of a series of articles on pricing.)

Last time I discussed how competition between buyers and between sellers reduces the range of possible prices of a good, and that this smaller range is still based on the marginal utilities of the agents involved.

Before it is proper to discuss the pricing of multiple units of a single type of good, it is important to understand the effects of competition between different types of goods.

People do not desire goods qua goods, in and of themselves. People desire goods because they contribute to some purpose — they buy food to maintain life, they buy cars to improve transportation, they buy opera tickets for recreation.

Any single good may be useful for a variety of purposes, but may not be essential to that purpose. For example, water may be used for many different purposes: Drinking, washing, irrigation, hydroelectric power, marine transportation, used as a solvent, used to store thermal energy, etc. For the purpose of drinking, water is absolutely essential and has no substitutes. However, there are ways to generate electricity that do not require large quantities of water, and there are many forms of transportation other than boats. When there are several different ways to achieve the same end, each using different resources, the method that is the least expensive will be preferred over the more expensive options — both utility and cost play a role in determining precisely which goods will be used toward which purposes. In this sense, all goods are in competition with all other goods.

This is an economy-wide phenomenon, much broader than any single industry. It is widely recognized that a higher price of cotton will tend to favor substitute materials such as wool in textile production. There are also alternatives even when there are no direct substitutes. Water may have no substitute in irrigation, but at a high enough price of water, local irrigation would cease and transportation would be used to bring in food from other areas where water (and therefore irrigation) is cheaper. The substitution in this case is local vs. remote production, not water vs. some other irrigant. There are other possibilities too, such as a dietary shift in favor of less water-intensive and therefore less expensive foods.

There is competition even among methods of production. Drinking water may be created by collecting rainwater, digging wells, building a desalination plant, processing it from a river or aquifer, etc. The extent to which any of these alternatives will be employed, along with the possibility of importing water from other areas, depends on the utility and cost of each.

Newly-invented goods are also subject to competition. They compete with already existing goods in the satisfaction of the purchaser's desires. The telephone competed with the telegraph, the automobile with the horse, the television with radio, fluorescent with incandescent lighting, and new drugs compete with existing disease treatments. Differences in cost and utility, as judged by the individuals within the economic system, determine the success of each good. The competitors may coexist (fluorescent and incandescent lights), one may win decisively (telephone over telegraph), or one may be relegated to a niche where it still has an advantage (horses on ranches or for recreation, but not for general travel).

A movement in price of one good relative to other goods changes the competitive balance between them, as the goods are considered for their various uses. Within a particular field of use for a good, if it becomes more expensive than a substitute — either because its price rises or because the substitute's falls — the substitute will be used. By the same reasoning, when a good becomes cheaper relative to others, it tends to be used more intensely and in a greater variety of ways by replacing its substitutes.

It is difficult to go much farther on this line of thinking without directly addressing the matter of pricing in large markets with many units and many traders. However, it is still too early. There are other topics to address first.

Tiny Island