A Pricing Model

No one can build a model to either determine or predict prices, despite the useful information that prices provide. Attempts to predict prices will always prove fruitless.

Knowing prices in advance would prove useful to owners and managers in all businesses. Imagine the profitability a company that could accurately predict the future prices of its products. I will show that the best that we can do is interpret price patterns in order to make subjective judgments about market opportunities.

I will step through three different levels of models and explain their relative usefulness:[1]

  • Events
  • Patterns of Behavior
  • Market Structure

Events

Models to Determine Prices

Despite what they teach in basic economic classes a person cannot predict individual prices by finding the intersection of supply and demand curves. If you think about this for about 12 seconds, you will realize that no one has ever seen a supply or a demand curve. Economists draw these curves, after the fact, in an attempt to explain the behavior of buyers and sellers.

The fact remains that buyers act based on their scale of preferences and sellers must make reasoned guesses about what buyers might pay for their products. Business schools teach managers to make sophisticated models to develop offering prices based on their cost structure. That exercise, however, provides no guarantee that buyers will pay that price.

Patterns of Behavior

Models to Interpret Prices

Over a period of time patterns develop that indicate the prices upon which buyers and sellers agree. These patterns do not provide any prediction, but, based on the assumption that the past is an indication of the future, these patterns do provide some useful information.

Rising Prices

A pattern of rising prices provides significant useful information for entrepreneurs. A pattern of rising prices indicates relative shortages in a particular market and the possibility for profitable opportunity. If buyers willingly pay more and more for a good, it indicates that they have relative difficulty in finding that good. Entrepreneurs can exploit that opportunity. (See diagram below.)

Rising Prices

Declining Prices

Declining prices, on the other hand, indicate relative excesses in a specific market. Depending on the steepness of the decline entrepreneurs might decide to reallocate their capital to more profitable opportunities. (See diagram below.)

Declining Prices

Market Structure

Pricing Causal Loops

An accurate model of the market structure would provide the most accurate prediction of market prices. In the diagram below, I have sketched a conceptual model of a simple market structure. Briefly it would operate in the following sequence:

  1. Increases in production lead to increased inventory.
  2. Increased inventory leads to a reduction in production. These two steps create a balancing process. Additional reinforcing processes influence these two steps.
  3. Increased efficiency leads to reduced prices and increased production.
  4. Reduced prices lead to increased sales
  5. Increased sales reduce inventory leading to increased production.

If a modeler knew all these variables, he could accurately predict the behavior of the system.

Causal Loop

This model, however, has one fatal flaw. It represents a human system in which people act based on subjective judgments. As described in the section above no one can predict individual prices. We don’t know until after the fact what buyers will voluntarily pay for the goods in question.

When attempting to build models of markets, modelers make the mistake of assuming the patterns of behavior represent the mental models of buyers. (I.e. they confuse the map for the territory.) Prior to 2008 house prices rose consistently year after year for several decades. Market watchers mistakenly assumed that that trend would go on “forever.”

The preferences of individuals can shift suddenly, changing the structure of the market, creating entirely new patterns of behavior. No one can predict when these shifts in preferences will occur. No one can know when prices will change.

Conclusion

No reliable model for pricing can exist. Patterns of behavior provide the most useful models for interpreting market behavior. Rising prices generally signal shortages. Falling prices generally signal abundance. But, market participants must view these patterns with great caution.

In a free-market, buyers can shift their preferences relatively swiftly. But, in markets subject to intervention outside forces work to distort those preference scales, causing price distortions, misinformation, and the misallocation of resources.

  1. I base my statements on an assumption of no intervention in the market. I assume, for the sake of discussion, that fiscal redistribution, regulation, and monetary policy have no influence on market pricing.