Bryan Caplan  

Why Don't Dying Firms Raise Prices?

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"Demand is more elastic in the long-run than the short-run."  It's a textbook truism.  Implication: Raising prices is often a bad idea even if profits instantly rise.  In the long-run, demand will get more elastic, and the price-gouging firm will discover that its behavior was penny-wise and pound-foolish.

This all makes sense, but there is an awkward implication: Once firms realize that they're dying, they ought to raise prices.  By the time long-run demand elasticity kicks in, they'll be out of business.  Why not opportunistically take advantage of the situation?

Yet as far as I can tell, this almost never happens.  When firms are on their last legs, they tend to cut prices, or at least hold them steady.

What gives?  Is the textbook truism false?  Is this a corporate governance problem - the current CEO never wants to admit that the end is nigh?  Or what?

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COMMENTS (28 to date)
Radford Neal writes:

It seems even more puzzling to me. Does a dying firm always know that their pricing strategy is optimal (even in the long term)? Raising prices to the level where you could survive if sales go down only slightly seems like it's worth a try. Maybe your customers are more loyal than you think!

I wonder this about restaurants, for instance. Some of them go out of business even though they seem to be reasonably popular, and don't have prices that are obviously too high. Why don't they try raising prices if they aren't making enough to pay the rent?

Dave Tufte writes:

Ooh, I think you may have missed the forest for the trees.

Perhaps almost all businesses are dying almost all the time. So the prices you're observing are already higher than they should be.

This certainly seems to be the case with Wal-Mart's competitors.

Michael Long writes:

The reason may relate to why the firm is dying. That usually is the result of inferior products and/or service. Under those circumstances the only way to sell more is to lower prices in the hopes of attracting more customers. Certainly a customer isn't going to pay more for an inferior product.

Eric Rall writes:

1. The sample of dying firms suffers from selection bias: management teams who make rational economic decisions are likely to be under-represented relative to the overall population of firms.

2. I expect dying firms are stuck with high fixed costs, along with a declining customer base that isn't large enough any more to reasonably amortize those fixed costs. Raising prices will likely shrink your customer base further, making the fundamental problem worse. This is particularly problematic for firms whose products have become commodities.

3. By the time a firm is clearly dying, the best case scenario may be to return 60 cents on the dollar to creditors rather than 40 cents. In this situation, managers aren't likely to care enough to suffer the grumbles of customers faced with price increases.

4. Your advice would be good advice for firms that are solvent but illiquid (to tide them through temporary cash flow difficulties), but not for firms that are insolvent (which would merely be postponing the inevitable). The former may raise prices but never be perceived as dying because in hindsight their troubles appear relatively minor, or may find ways of bridging the gap without raising prices.

Grieve Chelwa writes:

Perhaps because firms almost always overestimate their likelihood of success more so when they are facing tough times? A case of what cognitive psychologists call Survivorship Bias.

Nathan Whitehead writes:

My guess is that it's related to cash flow. Lowering prices increases revenues at the expense of profits. Turning inventory into cash quickly can help the short term prospects of the company. The company is literally buying time and taking a gamble that things will change before it goes bankrupt.

Tim Worstall writes:

My take on it, supported by no evidence whatsoever, is that very few management teams are willing to admit that a business is dying. Thus very few of them do that rational thing of soaking the remaining customer base for as long as they can get away with.

This is closely related to but not quite the same as the way that management teams will thrash around trying to find a new business for an old company to go into. When it might well be that the best tactic is to simply sweat that old business and retuirn the money to shareholders.

As an example, all the profit at AOL is currently coming from the old subscriber base. All the money being spent on Huff Po etc has yet to produce any return. It might well have been better (arguable, but perhaps) to simply soak those old dial up customers for another 5 years or whatever and to have returned the profits to investors. Let them spend on new companies if they wish.

Aaron Zierman writes:

Might it be different with firms that sell products that have a large number of substitutes?

If a consumer can obtain the exact same product from another company across the street, how much more elastic will the demand be? Just because demand is more elastic in the long run does not mean that it is necessarily inelastic in the short run.

For example, if gasoline is selling at $1 more/gallon at gas station A than at gas station B across the street, how much business will gas station A get? Probably none, unless by mistake.

Also, I think this would have to do with failing companies trying to turn inventory into liquid assets as quickly as possible.

Curt Doolittle writes:

Firms rarely trade commodities and benefit from the anonymity associated with commodities. They work in a network of established customers and distributors all of whom are more knowledgable about the relative strength of the firm in relation to its competitors than are members of the firm itself. (Yes, really.)

If your failure is an internal one ( a well known tech harware manufacturer had incentives to keep costs down which later nearly killed the company as venors started absndoning the paltform because it was too difficult to learn the many minor differences) then if your brand supports the price you can do it and use the money to correct the problem.

But the real problem is this: a very. Small number of people in any organization provide the entire marinally competitive difference, and if those people feel the company will fail they will leave. (We have pretty good data on this now. ). If knowledge of even short term failure leaks into the organization itself the consequences for quality, priductivity, retention, access to credit, will produce a deterministic result.

Firms do raise prices in duress. (Microsoft prior to Vista for example. ) I advise it all the time in order to prune unprofitable customers when companies are under duress. You just cant get away with it for that long.

Positivistic error/error of induction: assuming quantities contain sufficient information for other than commodities, when commodities are unique in this condition.

Mark writes:

Nathan Whitehead has the most obvious answer.

A firm never operates on the inelastic portion of its demand curve. Therefore, when times are tough and the firm is struggling with a cash flow problem, it needs additional revenue to make payments and delay/avoid bankruptcy. Since it operates on the elastic portion of its demand curve, by lowering its price it immediately increases revenue in hopes of forestalling looming bankruptcy.

Raising its price would do the opposite--decrease revenue--compressing the time needed to find solutions to its problems.

Becky Hargrove writes:

A quick take from a (former) small business person. One's price set says "This is who I am." By the time the business is in trouble, the issue is no longer who we are, but how much time do we have left.

John B writes:

The question assumes all firms are the same and only have one product and takes no account of product life cycles.

Single product firms go out of business because their product, or maybe narrow range to one sector, has/have reached the end of their life-cycle and have been overtaken by other firms who have innovated.

Generally as volume sales of a product line diminish, a firm will increase the price to make its continued production profitable and in effect to kill off the product, usually by offering a lower cost/better replacement.

The rationale of a diminishing business cutting prices is to get rid of inventory if not at a profit then to turn the stock into cash.

If a business is in terminal decline, then you can be sure it is not just a matter of how it prices its products that is the cause or will be its salvation.

Daublin writes:

For retail companies, it is probably more profitable for a dying company to have a close-out sale and liquidate inventory.

For service companies with low inventory, they may as well strive to survive until the very end, and then just stop once it looks hopeless.

In both cases, the *time* of the management team and especially the investors is important to consider. They all want to move on to something with more prospects.

Mike W writes:

Your point should be explained to will not allow prices for the dying US Postal Service to be raised.

Glen Smith writes:

Surviver bias and identity are big ones. Some are likely in an industry were raising prices is not really an option. In retail, I've seen a price increase strategy implemented more often in the back end (for instance, reduction of post-sale customer service or only offering it to people who pay the premium but unadvertised price), turning from a consultive selling strategy to a more "get them to buy the most stuff whether they need it or not" approach and likely certain forms of business development.

Yancey Ward writes:

I doubt the assertion that a firm knows it is dying. As they say, "Hope Springs Eternal".

Michael writes:

The market demand curve is not the firm's demand curve. A dying firm does not face a long-run curve.

Zach writes:

I think the story is on the supply side. Say I have tickets to a football game that I am trying to scalp (I do not want to attend the game). What price am I willing to accept a week before the game? What price am I willing to accept five minutes before the game? My tickets will be useless in five minutes: I will take whatever you give me.

Likewise for a dying firm, in a short period of time they will be out of business, and the longer they hold onto inventory the worse. If they are a retail store, for example, they may not be able to pay their lease at the end of the month and so they "need to" completely sell out of their product before then. The price they are willing to accept is decreasing as time approaches the lease running out.

Demosthenes writes:

Pretty sure the truism is about the planning horizon of consumers, not firms.

Jay Hancock writes:

Major metropolitan newspapers have taken the Caplan prescription. They know they are dying. They have been substantially raising prices — not just nominally but especially in real terms when accounting for deteriorating quality. Publishers have figured out that there is extraordinary inelasticity of demand among certain hard-core readers. Maybe these folks really really like the crossword puzzles. Publishers have decided that newspapers have a certain lifespan regardless of the price charged or the quality of the output, so they are extracting as much cash as they can as fast as they can.

another Bob writes:

In the software product business, dying companies (sales revenue is no longer growing) that have an installed base are acquired (often by CA, Inc.). The acquirer then raises the price to Customers of product support, reduces operational costs and cuts back on development efforts and costs.

The acquirer is operating in the 'inelastic' portion of demand. The acquirer is careful to raise support costs to just below the considerable cost to the customer of replacing the 'dying' product.

So, at least in this instance, the business is following your advice.

Andrew writes:

Wouldn't raising prices signal to your customers, investors and competitors that your firm is "dying"? Wouldn't this cause your "death" to be quicker than it would be without this signaling?

Elliott Leung writes:

Raising prices alludes to the fact that the company is taking a gamble on staying in the competitive market. If a company acknowledges the fact that they are dying, they might as well gain some quick cash by liquidating their inventory rather than increasing prices and driving away customers who know that the company clearly cannot last. It is a psychological effect; people tend to buy things when they are cheap, regardless of the quality of the item (mostly true, but not always true). Raising prices decreases total revenue and if that revenue is lower than the total cost, the firm will inevitably shut down.

John Fembup writes:

When companies are in trouble, the universal cry of the sales force is "reduce our prices".

So - don't underestimate the influence of the VP of Sales and the relationship between Sales, Finance, and the CEO.

Maurizio writes:

They don't raise prices because, if this could increase profits, they would have done it already. What am I missing?

Mike H writes:

I am almost positive someone else mentioned this. My guess is dying firms hold out hope.

The golf course next to my house went out of business recently, but they were holding big sales all last year.

I think delusion plays a large role. The managers always feel they might save it, so they go to the grave cutting prices.

Also, I find it hard to believe that their few loyal customers wouldn't balk and a big price jump.

But I'm not an economist, so what do I know?

Jeremy, Alabama writes:

1. Most business owners probably don't know that "Demand is more elastic in the long-run than the short-run."

2. When your business fails, in most cases an incremental difference in assets does not make much difference to your outcome: you're ruined and you move into your parents' basement. You may as well try a Hail Mary by dropping prices, instead of a going-out-of-business strategy of raising prices.

Seth writes:

Because most won't realize they are dying.

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