Sunday, December 28, 2014

Are private services inherently expensive?

Imagine you are a promising car mechanic who wants to open a new car repair shop. You would like to provide basic services to low-income citizens at affordable prices. You would charge a bare minimum for your labor, and you would buy used (but decent) replacement parts. This service would be great for people who just want to keep their cars running for a couple more years--nothing fancy, just bare functionality.

Suppose now that your neighbor also wants to open a car repair shop, but he came up with a different business model. He managed to persuade the local government that basic car service is a human right and that it should be provided free of charge to everyone. Since no one can be profitable by providing their service for free, there needs to be some way of funding this "free" service. The government and your neighbor came up with a scheme. The government would collect "the car care tax" from everyone in your neighborhood, regardless of their car care needs and hand the collected money to your neighbor. And, your neighbor would announce that he would provide free basic car service to everyone who needs it.

Now you are facing a problem. Even though you would charge only, say, $15 per hour for your labor and you would buy the most affordable replacement parts, so that, for example, it would cost your customers only $50 to replace their front shock absorber, this would still be much more expensive than $0 charged by your neighbor for a similar service.

You can try to make your service cheaper by charging less for your labor, but even if you provided your labor for free, you still need to buy replacement parts. And, in the long run, you need some source of income. Thus, you can't provide your labor free of charge forever.

So, lowering the price of your service won't make you more competitive compared to your neighbor. You need to provide something different, something that would attract people who would want to pay for car care. You can try providing basic care, but also offer superior customer service to your customers. For example, you could be more polite to your customers than your neighbor; you could provide more timely service; you could provide a warranty on your service etc.

But, would your customers care enough about these extra benefits to pay, say, $50 for them? Maybe some of them would, but it is more likely that most of them would rather receive inferior service free of charge than pay $50 for superior service. Remember, these are people who want bare functionality. They don't care too much about the extras you are willing to provide.

At this point, you realize that you have to focus on a different customer niche. You need people who would not be satisfied with your neighbor's service even if it was free of charge, people who drive newer cars, who want new parts installed, and who also value courtesy and timeliness enough to pay for it. Of course, this kind of service will be more expensive than the "bare bones" service you were planning to provide initially. You abandon your plan to provide basic service and instead open a "high end" repair shop that offers top-quality service for high-paying customers.

Now we have two car repair shops in the neighborhood: your neighbor's shop that provides basic service at no charge to customers, but collects a car care tax from everyone in the neighborhood, and your shop that provides superior care to higher-paying customers.

Looking at this situation without knowing your decision-making process could make one believe that private car repair shops are inherently expensive and that they don't want to provide service to lower-paying customers. But this is an incorrect interpretation. Knowing the unseen decision-making process that was occurring in the background helps us understand that the existence of the tax-funded shop motivated the private shop owner to abandon his plans of providing cheap service. Instead, he decided to provide a more expensive service. In this example, the private shop is not inherently expensive. It's ability to be cheap was prevented by the existence of the tax-funded shop.

I used an example of car repair, but this is not a story about car repair shops. The message here is much more general. We could apply this reasoning to pretty much any product or service, and we would get similar results. The existence of a tax-funded basic service displaces private provision of the same (or better) service and motivates private providers to focus on a higher-paying customer base. This makes private service appear inherently more expensive, but this is only a superficial impression. Understanding the logic of human choices that lead to this outcome helps us understand why we should not be deceived by this superficial impression.

1 comment:

  1. I don't know why I didn't reply to this comment earlier. Probably because it is too unfocused to be addressed properly. However, for those interested in thinking on the topic, here are some ideas: