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Price makers vs. price takers – what’s the difference and why it matters

We look at what makes a company a price maker versus a price taker, what makes them successful and why it matters to investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

There are lots of ways to categorise a business – defensive or cyclical, income or growth, value or quality. But one that doesn’t get talked about as much as it should is price maker vs. price taker.

A price taker is a company that has little or no control over the price of its products. Miners and oil & gas groups are prime examples. Broadly speaking all iron ore is the same, and the price is set by supply and demand in the market. Low supply and high demand mean high prices, and vice versa. Individual companies have little control over global supply or demand and so they must accept whatever price the market sets for what they produce.

Companies that are price makers are able to influence the price at which their product is sold. Few companies have complete control over the price at which they sell, but lots have some influence. Typically this category includes businesses like consumer goods manufacturers, pharmaceutical companies and certain technology groups. True, as they raise prices, they’re likely to lose customers – but the decision about where to balance sales volumes with prices is in their hands.

But why does this distinction matter?

What does success look like for a price taker?

Just because a company can’t control the price they sell their product for, doesn’t mean they’re totally powerless to influence profits. Revenue is a product of both price and sales volumes, while cutting costs can also help boost profits.

Profit = (Volume x Price) – Costs

A price taker that can grow sales volume without dramatically increasing costs is a potential winner in a steady or rising price environment. This essentially decreases the marginal cost of production for the company – meaning that each new unit is produced at a lower average cost than the one before.

Companies that are able to achieve this kind of volume growth should, over time, take market share from less flexible rivals. This leads to growth in overall profits, even if profit margins stay the same.

However, price takers also have to weather downturns in market price caused by changes in the economic cycle, new supply or disruption to demand. If market prices plummet, revenue is likely to follow suit, and unless costs can be cut, profits will fall or even turn to losses. If prices stay subdued for a long time, that can ultimately drive the company out of business.

Picking a price taker

In practice, picking a winning price taker requires as much judgement about wider market conditions as it does individual companies.

When prices rise, the whole industry tends to benefit. However, the wonders of operating leverage mean weaker players have the potential to deliver better share price returns. Companies with a relatively high cost of production, generating only thin margins could see profits increase rapidly as prices rise.

How operating leverage works and why it matters

However, if prices fall then these weaker players will quickly come under pressure, and could see profits wiped out. Businesses with lower production costs are far better placed in this scenario, especially those with little debt on the balance sheet. These businesses will see profits fall, but have a better chance of emerging from the squeeze fundamentally intact.

This means investors looking to make the most of investments in price taking industries need to be on their toes. Simply taking a buy and hold approach is unlikely to deliver the best results in this particular case.

However, we also think it’s exceptionally difficult to get these kinds of market movement calls correct. No-one saw the global pandemic coming and investors caught in the wrong place when commodity prices collapsed in early 2020 would’ve had a very painful experience.

What makes a price maker?

In order to set the market price of a product, you need a monopoly on its production.

That might sound dramatic, monopoly being something of a dirty word outside the world of family board games, but in reality, lots of businesses enjoy monopolies. Mondelez, for instance, enjoys a monopoly on the production of Cadbury chocolate, Pfizer on sales of its coronavirus vaccine and Dyson on sales of its patented vacuum cleaners.

Some of the products have close substitutes, Galaxy chocolate for example. If Mondelez sets the price of Cadbury’s too high, then its customers might choose to switch. But within certain limits, the group can choose how much to charge for a bar of its product.

Each of these businesses produce something unique, and have the legal right or economic heft to prevent others from copying it – at least for a set period of time.

Picking a price maker

Companies capable of setting their own prices have a number of potential attractions.

For starters, it usually means companies are able to charge a premium for the products. That should boost margins relative to those businesses that can only charge prices set by the market. That in turn provides some support in a downturn. Companies with a 30% profit margin have far greater room for error than companies running on 2% margins.

While these businesses will still see sales volumes fall in a downturn, being able to cut prices gives the company extra strings to pull. Lower prices can boost demand, while lack of direct competition means consumers are often reluctant or unable to trade down to cheaper alternatives.

Crucially as an investor, all this means the direction of the wider economy matters less when choosing which price making business to invest in. While price makers will still fall in a downturn, their ability to ride out periods of crisis means they can be relatively defensive.

When looking for high quality companies in this class, substantial margins, steady growth in sales volumes and strong brand or patent protections are all major plusses. However, the attractions of those traits are well known, and these companies tend to trade on high valuations.

For a good company, a high price might not be make or break, especially for long-term investors looking to hold the shares for years. However, it does increase the risk of overpaying.

What to look for

Considering whether companies are price makers or price takers is a useful way to kick off your research. Depending on the company’s structure, the considerations are different. Some key things to look for are listed in the table below.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Desirable price taker in a rising price environment Desirable price taker in a falling price environment Price maker
Lower margins Lower cost of production High margins
Ability to increase output Low debt Steady volume growth
High margins Long lasting legal protection (e.g. patents and trademarks)
Ability to cut output

These are by no means the only factors to consider when making an investment – not least because valuation is always an important factor. But they offer a useful springboard to help you better understand the businesses you invest in.

This isn’t personal advice. If you’re not sure what’s right for your circumstances, seek financial advice. Remember all investments can fall as well as rise in value so you could get back less than you invest.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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