What drives what we pay for things?

What are prices? Who decides prices? Walking down a supermarket aisle, we see a wide variety of complicated pricing schemes; buy one get one free, half price, special offers and the like. These prices seem either carefully calculated – what makes them so specific?

Most people think of a price in terms of how much goods are worth. However, this assertion misses a distinction between ‘price’ and ‘value’. The price that a company charges for a good or service is influenced by a wide variety of factors; for example, competition in a town grocer’s market can decrease the price of vegetables as competitors undercut each other.

In economics, price is often defined as the intersection of supply and demand. This means that companies will set their price when it ‘clears the market’ and the exact amount of goods that they produce will be bought by consumers. There is no excess demand or supply at this price. However, economic models do not often match reality. Sometimes prices are determined by market structure, the larger economic situation or even business objectives.

On a recent trip to Carphone Warehouse, I was looking at cases for the new iPhone 6, when I noticed that all the cheapest models were priced between £12.99 and £14.99. The cases are injection-moulded and I would guess cost less than 50p to make. This profit margin seems extortionate. How can Carphone Warehouse get away with such prices, and why are consumers willing to pay so much?

One possible answer could be the psychology of the market. iPhones are expensive, and people are willing to spend more on a case to protect their phone: the higher the price, the higher the perceived value of the case. People feel that buying a cheap case will be a poor investment, and will not protect their phone in the long run.

This factor might make this product a ‘Giffen good’. This is when a good goes against market convention and the quantity demanded of the good increases rather than decreases when the price is increased.

Another answer is that the cases have an inelastic price. This means that a large change in price will only cause a small drop in quantity demanded. Since the demand for the iPhone case is ‘derived’ from the demand for the iPhone, even if the iPhone case is very expensive, the demand for the cases will not change much, as long as people still buy iPhones. This is true as long as the price of the case is relatively low compared that of the phone.

An additional answer might be that the different manufacturers of cases are colluding to keep to the same high price. If collusion is proven in a market, although this is very difficult, this can lead to legal battles. Perhaps the price is high due to the overheads of the machines that produce the cases. Whatever the reason, iPhone cases are a classic example of market imperfection.