Once upon a time, in a magical kingdom called X…
Person A invents a widget. It’s intended to be used by other people who make things, as part of their finishing process. As widgets go, it’s a good one, and just might be popular. She decides to put copies of it up for sale, as much to find out how well her widget is considered as to realize any income from the sales. Since displaying a widget is a proven way to sell them, she rents a store and prepares her advertising. Before she opens her store, Person A has to set a price for her widget. Being fair-minded, she studies the local widget market and sets a price based on what other people are charging for similar items. She has faith in the quality of her widget, and that enough makers-of-things will agree, and add it to their tool kit.
In another part of Kingdom X, Person B also invents a widget with the same basic purpose as Person A’s, but with a different style of finish. Ideally (depending on what they make), the intended end-users may find it useful to have a copy of both A’s and B’s widgets at hand… thus, A and B are not exactly in direct competition, even though they’re both in the widget business. Person B also rents a store, and gets ready to open it. Like A, B also has to set a price for his product — but unlike A, B decides to price his based on a rate of compensation for the time it took to make the prototype, and the rent he pays for his store, and the cost of advertising in the local media. He takes a guess at how many might sell in a given month, divides his monthly-expenses-plus-compensation figure by that quantity, and arrives at a price which — fortunately for him — is not excessively high. Person B also interprets the phrase “you get what you pay for” to mean that his potential customers will believe in the superiority of his product because the price is a little higher, and be willing to pay it.
It needs to be pointed out that some other factors which might ordinarily influence this pricing exercise are not in operation in Kingdom X. All each of them had to do was create the prototype widget. The copies that are sold materialize out of thin air — i.e., there are no production costs. Delivery is free, too. Also, A and B pay precisely the same amount of rent and advertising fees. Their tangible overhead — a.k.a. “the cost of doing business” — is identical.
(Told you it was a magical kingdom…)
Lo and behold… Another magical kingdom, Z, is founded. Its population is small to begin with, but there are makers-of-things, and more are immigrating every day. Meanwhile, there are almost no widgets to be had there (except some shoddy, outdated free ones). Persons A and B get wind of this, and simultaneously decide to open a branch store in the new kingdom… and this is where the story gets complicated.
Z is an independent kingdom, not a colony of X, and it naturally has its own currency — call it the Z$. However, most (if not all) of the immigrants to Z are coming from X, and a means to change X$ to Z$ is set up for their convenience and encouragement, at a rate of X$1 = Z$2.
Z is also a much less expensive kingdom to live and do business in than X is. In the way these things are calculated, one is permitted to have 3 times as many objects on the same amount of land in Z as in X, for 1/4 the rent (using a well-known third currency as a benchmark to compare the other two).
The result of this situation is: the early merchant immigrants to Z make a public pledge among themselves that they will not charge twice as much for their goods in Z as they do in X — even though the money is only worth half as much — because their overhead is so much lower. Copies still magically appear at no further cost to them, delivery is still free, and so (for the time being) is advertising.
Person A and B move in. They’re both still paying equal rent for their stores in Kingdom Z, so their overhead is still identical. Person A decides that the “conventional wisdom” about pricing is indeed wise, and only changes the currency symbol in her displays. That is: if her widget cost X$500 in Kingdom X, it costs Z$500 in Kingdom Z, even though Z$500 = X$250.
Person B, on the other hand, is still looking to be compensated for each sale in the same amount of that benchmark currency mentioned above, no matter which kingdom the sale takes place in. In doing so, he dismisses the 1:4 overhead ratio and sees only the 2:1 currency exchange rate. Consequently he doubles the numerical value of his prices, charging Z$1000 for a X$500 widget.
All other things being equal — and they are — Person A will see more sales in Kingdom Z because her widget is priced at what the market will bear. Person B will see few sales, if any, because his widget is plainly overpriced for the market, regardless of its equivalence to that benchmark. Chances are likely that B’s venture in Kingdom Z will not last long, while A will probably end up emigrating to Z, and begin to consider her original store in Kingdom X as “the branch”, if she doesn’t close it completely.
The moral of this story: Markets are not math alone. They are psychological. The citizens of X and Z — most of all, people who spend time in both kingdoms — do not think of purchases in terms of some benchmark comparison. They see a number, compare it to what they’re used to paying, and decide if the purchase is worth making. Furthermore, recall that the Kingdom Z customers for those widgets are makers-of-things, who have also evaluated the market for their own goods and decided that the conventional wisdom regarding prices is “good business”; it’s fair to their customers, too.
(There’s a Part 2 to this story…. stay tuned)