Business-margins vs. volume; why low taxes are good for a government, demand functions

As a general rule in business, as you lower prices of your goods, your profit margin (net margin of profit, as a percentage of revenues) goes down but you more than make it up by selling higher volume. This happens because people are more likely to buy or buy more of a product when it gets cheaper; or the demand of a product goes up with a decrease in price.

Conversely, if you raise prices of a product, people find alternatives, or simply do not buy as much of it-they have a thousand other products to buy with their money.

Walmart operates at a low profit margin of about 3%. A small kiosk has a very high profit margin, maybe 50% or even 100%. Who makes more money? If the profit margin percentage is the measure, the kiosk seems to make more money. But the kiosk won't sell much volume at those high prices. Your total profit is normally proportional to the total revenue, which is the volume of goods sold multiplied by price, and since your goal is to increase your total profits, you must never forget to consider volume when you consider setting prices for your goods. Volume of goods sold does not increase linearly as you lower prices, it increases in a power law or exponentially as you lower prices (how it does exactly is not known to anyone...more on this below). The key to a successful business which gives you large dollar profits is high volume, low prices or low profit margins. It is better to sell 1000 oranges at $1 each than sell 10 oranges at $10. Assuming oranges cost $0.50, your total profit in the first case is $500, whereas in the second case, only $50.

I often hear people complain about higher prices (sometimes disguised as inflation, covered in detail here). Any time a business raises prices they give up volume. The reason the McDonald's burger costs $2 and not $20 is because they won't sell much volume at $20.

A good businessman friend of mine, Rajesh Santlani, once said to me-if you want to make money, operate at low profit margins, and sell high volume. For success in a business, the name of the game is volume . It is as true for governments (taxation) as it is for businesses-if the governments ran themselves as a good business, and you can think of the government as a large non-profit or zero-profit business in one sense, they should lower taxes as a percentage of the value of goods, and never increase them.

Let us say the government increases the sales tax on a consumer good from 10% to 12%. Politicians often vote for these kinds of increases, because they think of this as easy money; they forget to consider that if the volume of goods sold goes down by more than 20%, the government will actually take in less money than before. For example, for a $100 value of goods sold, the net tax collection was $10 in the original scheme, and if the volume of goods sold decreases to $70, the net collection will be $8.40, which is less than before.  The net tax collection goes down when the percentage of tax is increased.

Assuming that a government wants to increase its total tax collection revenue, which would mean the net dollar amount collected by the taxes to support the government, the best strategy is the same as a strategy for a large business-lower the tax percentage and try to get more volume of goods to tax.

This is also true in taxation on imports. Keeping taxes on imports low (as a percentage of the value of goods) increases the volume of imports, and it is a good idea to keep trying to lower the taxes if a government wants to collect more total taxes at customs. Often times the clamor of nationalists and "buy home made products" clouds this policy, and imports are taxed highly; they effectively kill the volume of imported goods in the  country, to the great disadvantage of the government itself, who could pick up more total taxes if they kept the percentage of taxes low. This also hurts the consumer, who is left with less choices of goods in the home market.

Demand functions and how price and volume of goods sold vary with each other

From what I have said above, we can model an approximate demand function. If "V" is the volume of goods sold and "P" is the price:

V is proportional to 1/P^2

or V = K/P^2 where K is a independent of P.

With this formulation, the Revenue, R, is:

R= PV = K/P

which agrees with the observation that revenue goes up as the price decreases.

The volume of goods sold can go up slower or faster as price decreases, but will always increase as price decrease, so we can say, in general:

V = K/ P^n , where n>1

This relationship between price and volume is independent of the number of actors in the marketplace, competition or monopoly power, etc. Even if there is only one company which has a complete monopoly over selling a product, as this company decreases prices, it will find that it can sell higher and higher volume. Therefore, even for this monopoly it makes sense to lower prices to increase profits. The common theory that only in the presence of competitors prices go down is flawed; a smart monopolist still comes out ahead if it lowers prices. However, monopolies are lazy and do not always act in their own best interest, and do have a tendency to maintain or raise prices.

Business school and finance types will talk about stuff like price elasticity of demand and prices, Giffen goods (goods whose demand go up as their price goes up), etc. They have little experience in running a business in real life, and do not realize that businesses, especially the stable large ones, have a simple rule of success-to lower prices constantly and increase the volume of sales to increase their total revenues and profits. They do not pay much attention to maximizing profit margins-as long as they are profitable even at a very low, e.g. 1% profit margin, they will keep selling their goods. Because the goal of a good business is to take in large and increasing amounts of net total profits (in dollars or euros, or whatever), not to maximize profit margins.