The Experience Effect: Why prices move down over time? How to predict it?

At the end of this article, we will see one way to predict the price decreases.

The fact that prices move down over time could be the consequence of several causes, as:

• Price alignment (with a competitor for instance)
• New product releases (less value for the “old” product)
• Aggressive low price strategy
• A reduction in production costs thanks to a process optimization
• etc.

In this article, we are going to focus on the last element, the effect of the produced quantities on the production costs (and as a consequence, on prices).

It refers to the effect that firms learn from doing, which means the higher the cumulative volume of production, the lower the direct cost per new unit produced. This is the experience effect.

Top executives are fully attentive to the experience effect of their products because, frequently, more experience leads to more market share…

WHAT IS THE EXPERIENCE EFFECT?

The more you produce the less it costs…

As a definition, “The Economist” said : the more experience a firm has in producing a particular product, the lower are its costs.

Mid-1960s, while working with a manufacturer of semiconductors, Bruce Henderson, the Boston Consulting Group president, noticed that the company’s unit cost of manufacturing fell by about 25% for each doubling of the volume that it produced.

In this case, experience has to be understood as cumulative production.

The experience effect applies not only on heavy industry or technolgy but also on services (plane ticket, cellphone plans, etc.).

Production and sewing automation have had huge consequences on textile production increases (and costs decrease).

WHY PRICES MOVE DOWN?

The experience effect can be explained by 4 different facts:

1. Economies of scale: It refers to the cost advantage experienced by a firm when it increases its level of output. The greater the quantity of output produced, the lower the per-unit fixed cost. Economies of scale also result in a fall in average variable costs (average non-fixed costs) with an increase in output.
   
2. Economies of size: Basically, the more you produce the more you order raw materials to your suppliers. As the quantities increase, it will be easier to negotiate the price with suppliers.
   
3. Learning effect: It is a human phenomenon that occurs because of the fact that people get quicker at performing repetitive tasks once they have been doing them for a while. Thus, workers can do more while keeping the same quality.
   
4. Innovation: Machines and tools’ improvements (standardization and simplification) and technological breakthrough will decrease the cost production per unit.

The main consequence of all these points is to reduce the production cost. Often, but not always, a production cost reduction means a list price reduction.

Nevertheless, some companies and for many reasons can decide to not reduce the list price even if the keep reducing the production cost. Why? Simply because they want to do a better margin.

EXAMPLE

The examples are not easy to find!
Indeed, an experience curve has to show the production costs, but they are sensitive information and most of the time confidential. Thus, companies do not want to share them publicly.

We will take an example that we found on a website which concerns the automotive market.

FORD AND THE MODEL T

In the early 20 century, Ford made a revolution in the automotive sector with its model T. The following chart represents the model T price (and not production cost) as a function of the experience. This is an experience curve.*

We can see on the following chart here below:

*The experience curve is a graphical representation of the experience effect, which shows the cost production evolution as a function of the experience (cumulative production).

HOW TO PREDICT THE PRICE DECREASES?

Once we understand the experience effect and the experience curve, we are able to use it in order to predict the future price evolution.

We will use the previous example in order to demonstrate how the people in the early 1910 could have predicted the price decrease of the Model T.

As we can see on the chart here below, we only (1) (2) need to get the first prices during the first years in order to calculate the 77% curve slope (-23% when the experience doubled) and as a consequence predict (3) the prices for the following years.

This method is so powerful that most of the really high valuable companies in the world use it. However this method has some limits.

THE LIMITS

The experience effect has to be balanced and its user has to keep in mind some essential aspects, as:

• This theory is based on a constant increase in volume regardless of cost, a highly dangerous strategy that can lead to a price war (especially if most of the market shares increase is due to price decline).
• External effects can destroy this theory (competitors new products introduction, a product that will substitute some functions of another product, change in legislation, etc.)
• In some cases, over a certain amount of products, an additional quantity will lead to a substantial cost increase due to the necessity to invest in some new production tools for instance.
• Key factors of success are not inevitably linked to the production costs and prices (luxury industry where the corporate identity is more important)
• etc.

The experience curve is a really simple and highly efficient. Frequently, the experience curve is the foundation of corporate strategies, either for a market leader in a steady market or a start-up in an expending market. Indeed, it is very useful to keep an eye on the experience curve because most of the time the lower on the experience curve, the more market shares… even if, some limits has to be known in order to stay on the right path.

Last but not least, as we have seen in our example, it is very easy to predict price decrease and how fast it is going to happen.