Pricing like Ferrari

This week my ECONS101 class is covering pricing strategy. Essentially, this topic is about a lot of situations (supported by real-world examples) where firms may choose not to price at the single profit-maximising price. Most of the time, deviations from the profit-maximising price involve the firm pricing at a lower price than the profit-maximising price. The firm might set a lower price in order to generate goodwill and a long-term relationship with consumers, or to sell a greater quantity so that it can take advantage of moving down the learning curve (and achieving lower costs quicker), or to keep competitors out of the market (what economists refer to as limit pricing). The thing about all of those situations is that, by setting a lower price now, the firm earns more profits in the long run. It seems to me to be less clear that firms would want to set a higher price than the profit-maximising price now. Unless they face consumers like this:

Perhaps some consumers are simply willing to buy a good because it has a higher price. That is the basis of conspicuous consumption (which I have written about before here). However, I want to take this in a different direction, because firms can set a high price without needing to rely on conspicuous consumption, even when it seems like a possible explanation for what the firm is doing. Consider this example from the Wall Street Journal last month (ungated version here):

With a list price of $3.7 million, Ferrari’s new “hypercar” was revealed to the public in October with a twist: It wasn’t available for sale.

All 799 units of the low-slung, high-haunched F80 model—the most expensive production vehicle in Ferrari’s history—had been promised to top customers like Luc Poirier.

The Montreal real estate entrepreneur already owns 42 Ferraris. He said he felt “lucky” to be allowed to buy yet another.

“To be chosen by Ferrari for one of their hypercars is a true milestone for any collector,” he said.

Money isn’t enough to buy a top-of-the-range Ferrari. You need to be in a long-term relationship with the company.

By leveraging the rabid fandom of its customers through a business model based on uber-scarcity, the storied Italian company is enjoying a new golden age.

When goods are scarcer, the marginal consumer is willing to pay more for them. This is the 'Law of Demand' working in reverse. If the firm restricts the quantity it sells, then it moves up the demand curve and can sell at a higher price. However, by definition, setting a higher price than the profit-maximising price decreases profits. And, there doesn't seem to be a mechanism where over-pricing their cars gives Ferrari a long-term increase in profits. So, let's consider what they are actually doing.

Consider the market for regular, run-of-the-mill Ferraris. Because there are lots of substitutes for a regular, run-of-the-mill Ferrari, the demand for Ferraris is relatively elastic (shown by the flat demand curve D1). When Ferrari prices its cars, it sets the price so that it will sell the quantity where marginal revenue is exactly equal to marginal cost. That is the quantity Q*, and the price P1. The mark-up for Ferrari is the difference between P1 and marginal cost (MC). 

Ferrari could try setting the price higher than P1, but as noted above, this would decrease the quantity sold below the profit-maximising quantity Q*, and by definition this would decrease Ferrari's profits. So, how could Ferrari increase its profits from selling run-of-the-mill Ferraris? One way is to make demand less elastic (making the demand curve steeper). If the demand curve was steeper, like D0, then the profit maximising price would be P0 rather than P1, and the mark-up on run-of-the-mill Ferraris would be much higher. Selling run-of-the-mill Ferraris would be much more profitable.

If you are a seller, how can a firm make demand for its good less elastic? One of the factors that affects the price elasticity of demand is the number of close substitutes. If the firm can decrease the number of substitutes, or make its good less substitutable by other goods (reducing the number of close substitutes), then demand will be less elastic.

This is what Ferrari is doing by selling its most premium cars only to consumers "in a long-term relationship with the company". If you really want a Ferrari hypercar (or whatever the latest release Ferrari is), then you need to be buying run-of-the-mill Ferraris. That makes other luxury cars less close substitutes for a run-of-the-mill Ferrari, making demand for run-of-the-mill Ferraris less elastic, and allowing Ferrari to set a higher price for run-of-the-mill Ferraris. Since Ferrari sells a lot more run-of-the-mill Ferraris than hypercars, this is likely to be much more profitable for Ferrari overall:

Anyone with a few hundred thousand dollars to spare can buy a regular Ferrari as long as they are willing to wait a couple of years. While the standard models aren’t subject to strictly limited runs, the company still lives by Enzo Ferrari’s scarcity dictum: “Ferrari will always deliver one car less than the market demands.”

Limited-edition Ferraris are even scarcer, and you can’t just walk into your local showroom and buy one. These range from special versions of regular models to the design-oriented “Icona” and, most exclusively, once-in-a-decade hypercars like LaFerrari and the F80.

Such models help keep orders flowing for the company’s entire product range even though they account for a fraction of deliveries—just 7% last year. Collectors had on average bought 10 new Ferraris before qualifying to buy LaFerrari or an Icona, which means icon in Italian, according to Hagerty.

Maybe buying a premium Ferrari is conspicuous consumption, and maybe Ferrari is taking advantage of that. However, it is also using its premium Ferraris to increase the price and profitability of a run-of-the-mill Ferrari.

[HT: Marginal Revolution]