Tuesday, October 04, 2005

Charitable Cost

From Sunday’s Marilyn vos Savant column (not yet available online):
Many companies give away products, such as food or medicine, to the needy: Are these costs passed on to consumers in the form of higher prices?
- John Stratton, Baltimore, Md.

Not if the company wants to stay in business. In a free-market economy, cost doesn’t determine price. Prices are established by market forces – such as the competition and how much consumers are willing to pay.
So cost isn’t a market force? Say what? Cost doesn’t exclusively determine price, but it’s definitely a contributing factor.

Setting aside Marilyn’s bizarre response, what’s the correct answer? The reader’s question is interesting because it’s difficult to classify the cost of giving away output for charitable purposes. It’s probably best treated as a marketing expense, whose purpose is to create good will among consumers. Yet it’s also a production cost, since the output given away has to be produced. The price charged to consumers can be affected in at least three ways.

First, the additional output could affect the marginal cost of production. The usual assumption is that higher output means a higher marginal cost (this is why supply curves are presumed to be upward-sloping), which translates into a higher price. But for something like pharmaceuticals, it’s possible that firms face a constant marginal cost, in which case the added output would not affect the firm’s pricing decision. (Another possibility, though a remote one, is that the additional output would increase total production enough to allow greater economies of scale, thereby pushing down the cost of production and lowering price.)

Second, to the extent that the marketing is needed to boost the company’s total sales – rather than merely increase existing customers’ willingness to pay – the marginal cost of producing and selling more output should include the marketing cost. For example, if giving away one free package of medicine allows you to sell five more packages, and the marginal production cost is constant at $10/package, then it costs $60 to sell an additional five packages and the all-things-considered marginal cost is $12/package.

Third, if the good-will marketing successfully increases consumers’ willingness to pay, the firm can charge a higher price than it would otherwise.

Of course, the fact that charitable giveaways can affect price doesn’t mean the effect is large. My guess is that it’s pretty small. The amount of output involved is probably too small to have much impact on marginal cost, and the expense involved is probably small relative to overall marketing budgets. And in the case of one-time responses to disasters like Katrina, the expense is probably best treated as a fixed -- not marginal -- cost, in which case it should not affect price.

And none of this is intended as an argument against charitable giving by business. Just don’t think the firms will simply absorb the cost. If you want the firms you patronize to engage in charity, you should expect to wind up paying for some part of it.


Amit said...

If there is a single equilibrium price across all the firms selling the product, and if one firm gives to a charity, it increases their marginal cost, which will drive up the price up slightly. However, it will drive up the price for all firms. Since the other firms do not have higher marginal costs, the net effect should be some transfer of profits from the firm giving to a charity to firms not giving to charities.

gt said...

Other factors include quality control, inventory managment, tax consequences.
- arbitrary aardvark