The following is my response to a LinkedIn Answers question pertaining to managerial economics and cost accounting issues surrounding pricing that can be found in its entirety, including other contributors’ answers, at http://www.linkedin.com/answers/professional-development/ethics/PRO_PET/695563-7604647

The original question, posed by Vasco Philip de Sousa, Screenwriter and Historian, was as follows:

Is lowballing acceptable if your client can’t afford to pay?

There’s an interesting project. You love the company. Your really want to do this. But you know you’ll lose money.

The thing is, the client is obviously close to broke. You know this won’t lead to more work, or if it does, it’ll lead to more badly paying work.

Now, a lot of people might think, why would this be unethical? Silly to work for free maybe, perhaps even a bit amateurish, but unethical?

That is, until they see your back balance. If your client doesn’t pay your rent, who will? Will you beg off your friends and families? Will you become, for a time, a burden to the state? Will you be forced to declare bankruptcy when you could have said no to your client and taken better paid work?

And of course, what about your competitors? Doesn’t undercutting them put them out of business too? Aren’t you helping to create a vicious cycle by undervaluing your own work?

Does anyone else see a moral dilemma in charging too little?

Clarification added 9 hours ago:

Thank you, some very good answers here. It’s been worth reading the opinions, experiences and knowledge of others.

I do apologize for all the grammatical mistakes in my question. I think my left brain went on strike. Time for a vacation.

Regards,
Vasco

My response was as follows:

I think this is one of those situations where actually drawing out a Porter’s Five Forces model and itemizing it can actually help you decide where you stand. It’s interesting that you bring it up, because just a couple of months ago, I peer reviewed two papers for the Academy of Management pertaining to game theory, pricing, and strategy.

First, as for undercutting competitors and putting them out of work–I normally dislike bringing economics into any practical discussion because of how theoretical it is and how I have a distaste for applying reductionist models to social science situations–but this, of course, depends on how much of a commodity the product or service is, how closely the competitors can substitute, how active the market is, what their chosen positioning is, what their individual cost structures are, and their own strategic positions (just to name a few). I did have a situation about 15 years ago during my undergrad in the early 1990s, before everyone had a computer, where I provided a word processing service to people who were more comfortable writing out their papers by hand first. Because of how fast I typed, I could charge 75 cents per page, still make nearly $20 an hour, and not feel bad about being overpaid. There was, however, only one real competitor, and after I had taken all her business, she asked if I would raise my prices closer to hers because there was no way she could compete. Now, most jurisdictions have competition laws that would make collusion illegal, but in this case, I did want to be fair and doubled my price, which brought hers down as well but to a level where she was still a viable alternative. Due to my lower cost structure (because I typed faster, I assumed), I otherwise felt I was gouging if I charged the rates she was already charging.

You’re right that in introductory marketing, one problem with promotions such as free giveaways and loss leaders is that customers begin to value the product at the extremely reduced price and are not willing to pay the regular price after the promotional period. In an established market, though, everyone pretty much knows what the product or service is worth (at least to themselves); if your undercutting is below your own cost, then it was a poor decision as far as cost accounting is concerned and it cannot be a long-term solution. If, as you also suggested, it made the difference between bankruptcy and living to see another day, then I think that decision would place servicing debt at a higher priority, since losing money on a single deal is not going to put you out of business, but missing a payment to a creditor can. In cost accounting, this issue is addressed by relevant cost analysis, which would state that the lowest price you should charge for a one-time deal would be the variable costs to you. As long as you meet that requirement, you can evaluate the customer’s strategic position and their willingness to at least meet that price. If you don’t even meet your variable cost then you’re paying them to not pay you to do the work. I’m not even sure a creditor would want to loan to a borrower who would agree to a contract below variable cost and it might be better to try negotiate a later payment date than do that deal, since if your creditors can see a potential for you to make future payments, it would be in their best interests to negotiate another date than for you to do something that might make this payment but would erode your ability to make future payments going forward.

If you’re concerned about the poor competitors you undercut, after you go bankrupt, about the reduced perceived value, then don’t be. If there is a demand for it, the perceived value will eventually work its way to where it should be at the equilibrium between supply and demand, since when you’re gone, the other competitors will not maintain that lower price and the customers will have to pay the real value or find a substitute.

Clarification added 11 hours ago:

If you’re B2B, though, you don’t have to worry much about the poor businesses that are laughing at you for undercutting yourself out of business–most of their analysts will be competent enough to have a good estimate of the value of the product both to themselves and to you as part of their strategic assessment. Your concern about the reduction in perceived value probably applies more to B2C consumer goods where your customers aren’t constantly evaluating their relative strategic positions.

Another thing, incidentally, that competition bureaus don’t like is when you charge less than your variable costs–the lowest price you should ever charge, and even so, only on a one-time deal–by subsidizing with income from another jurisdiction or by playing around with transfer pricing.

Clarification added 10 hours ago:

One more thing I think you have to remember here–and your question gave me the impression that you were mixing the two–was the concept of a business relationship versus a personal one. No one you do business with would expect you to agree to a deal that was even below your variable costs, even for a one-time deal. Personal relationships can be irrational for all sorts of reasons, but in business, ultimately relationships can exist because of values (eg. fairtrade products), because of real or perceived benefit, or because of other strategic reasons. If you even propose selling to another business in a way that hurts your chances to continue, your B2B customer probably already perceives this as a good reason to find another partner since you are either desperate and therefore unreliable or unpredictable or both, neither of which make good business partners along the value chain (in which case they probably could vertically integrate you–buy you out, manage your business better and get better prices at the same time for themselves).