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Haute Horology: Breaking the Law (of Demand)

In prior articles I have discussed the unorthodox role of prices in luxury watch markets. For example, since watches can serve as a highly convenient source of portable liquidity, when prices go up the liquidity benefit from a watch is greater because you can carry around more value on your wrist. This means that, at least along one dimension, buyers might be more inclined to buy a watch as prices go up.

The watch market, then, serves as an exception to the prevailing notion that as a product gets more expensive people buy less of it, otherwise known as the law of demand (a law which tends to hold for almost any product). In this article I will explore additional reasons why the law of demand doesn't apply to luxury watches and, further, show that many features of the luxury watch market can be explained by nontraditional consumer behavior. Fair warning: I have steered clear of the math which we economists use to investigate markets but that will have to end here. I will relegate most of the math to an appendix which I will offer elsewhere.

The TL;DR:
  • Luxury watches are an indicator of social position. For such goods a higher price signals greater social status which can strengthen demand. This is called a Veblen effect.
  • Veblen effects mean that luxury manufacturers can not follow the standard practice used to maximize profits. Instead they pursue adequate capacity to achieve profitability.
  • To preserve Veblen effects haute horologists must avoid a pooling equilibrium in which their products are perceived as fundamentally the same as low cost products..

Guilded Age Insights for Guilded Watches

The Guilded Age refers to the years after the United States Civil War and prior to the beginning of the 20th century, roughly 1870-1900. As an undergraduate I studied those years in a history class taught by Professor Geoffrey Blodgett. He was a masterful lecturer, every word he spoke had been carefully chosen over decades of teaching.

His description of Henry George's writings during the Gilded Age was particularly memorable. George, like many of his contemporaries, was stunned by the rapid accumulation of wealth during the Gilded Age.
Henry George, c1885
He pondered whether this wealth was truly meaningful or, like gold guilding covering a worthless material, it was simply a flashy exterior with nothing real behind it. George was particularly interested in whether a rapid increase in land value was warranted.

As an undergraduate at Carleton College from 1874 to 1880 a young man name Thorstein Veblen studied Henry George's work.
Thorstein Veblen
It no doubt influenced his own thinking on the wider role of wealth in society.

Veblen became an economist and developed the concept of "conspicuous consumption" in his book Theory of the Leisure Class.

The idea behind conspicuous consumption is that the enjoyment one experiences from certain products is not entirely determined by the direct impact of the product on the individual who consumes it. For most products an "internal return" is the most important: if I eat an apple it is the taste I experience and the apple's health effects on me that determine my enjoyment of the apple. In contrast, a product like a fur coat could keep me warm but there are far less expensive materials which achieve equivalent warmth. So why spend extra money on fur?

Veblen's notion is that when you consume a product, the impact it has on those around you is part of the benefit you receive. We can refer to this as an "external return." When you wear a fur coat it keeps you warm (the internal return) but also people who see you may know that it is made from the hide of the endangered red bellied honey badger (the external return). And you might know they know. It may impress them. You might be happier when people are impressed by you.

So when others know that a product you have is expensive or rare then there is an impact on social status, real or perceived. Sometimes we also refer to these types of products as "positional goods." They signal, or perhaps establish, your position in society relative to others. They also signal, potentially, that you have been financially successful which, in turn, can make it easier to have still more success. If anything, positional goods are even more prevalent now given the rise of social media and the ability to display your rare product to a virtually limitless audience.

The luxury fashion industry is almost completely populated by "Veblen goods" in which the external return is extremely important. In 2019 a Hermes Lindy 20 women's handbag retailed for $41,500. The internal return from this product is no different than a plastic bag that Walmart gives out for free. They both carry stuff. The Walmart bag probably generates a better internal return in that it is lighter and waterproof. I guess organizing pockets and zippers are maybe worth $50. But at the end of the day almost all of the value of that Hermes bag comes from its positional attributes. It is a Veblen good.

Veblen Says Wrist Check

There is no doubt that at least some portion of a watch's value is determined by Veblen effects. It is fair to say, though, that watch functionality also varies with price. Achieving COSC certification for a movement requires a level of engineering quality and precision which can not be achieved without significant manufacturing costs, for example.
A chronoscope, used to measure accuracy
In addition, spending more on a luxury timepiece does provide you with the opportunity to buy a watch with more complications, thereby increasing the internal return from a watch. A watch which is more expensive because it has the date, a rotating bezel for tracking elapsed time, and lume for low light legibility is not purely about status. It is about function.

Setting that aside for a moment, though, luxury horological manufacturers devote significant resources towards cultivating a reputation for exclusivity. Marketing budgets and prominent brand ambassadors from the elite ranks of sports and entertainment are all about establishing that, by purchasing a certain timepiece, you have achieved a roughly equivalent elite status in society. And perhaps nothing makes a product more rare or exclusive than price. It is a very small portion of society which has sufficient resources to buy an $8,000 Rolex not to mention a $20,000 Audemars Piguet timepiece.

This means that setting a high price is one of the easiest ways to achieve exclusivity and establish your brand as one which ranks high in the positional game. Marketing and advertising can provide a gloss of Veblen effects but, when push comes to shove, actual Veblen effects are, by and large, driven by price. Provided the external reward is important enough among consumers then we would expect to see that as luxury watch prices increase the demand for watches actually rises, exactly the opposite of the law of demand.

Haute or Not?

I'll now present a model of the watch market which incorporates the existence of Veblen goods. I will assume that there are two types of watches distinguished by quality: haute horology watches which are subject to Veblen effects (think AP or Patek) and not-so-haute watches which follow the standard law of demand (think Casio or Citizen). In Figure 1 I have given an example of two demand curves: the blue for haute horology and the red for not-so-haute:
In the graph quantity is measured in thousands. The haute demand curve slopes upward due to the positional nature of luxury watches: as price increases a watch is more exclusive and, therefore, more are purchased. The not-haute has the opposite slope because it is a more standard product: as price increases fewer watches are purchased. The actual equations I used for these curves are in an appendix.

Let me offer some background on how you maximize profits if you run a company in a traditional market without Veblen effects. When I teach profit maximization I ask students to imagine a simple question: should you produce one more of whatever it is you are producing? To be more concrete, if you are running Jeager-LeCoultre should you manufacture one more Reverso? The answer is actually pretty simple. Producing one more Reverso has only two outcomes which matter for Jeager-LeCoultre. The first is the impact of that new watch on the company's revenues (or income). Because we are talking about a small change in Reverso production and the corresponding change in revenue is pretty small we refer to this as marginal revenue (MR). A medium Reverso Duetto on a leather strap in steel with an automatic movement sells for $10,100 as I write this. So that is the marginal revenue (possibly, more on this later).

But marginal revenue does not tell us if we should make the additional watch because we should only do so if the new watch is good for profits. And to know that we have to know the cost of producing our next watch. We refer to this as marginal cost (MC). I have no way of knowing how much it costs to produce a single Reverso. To know that I would have to have internal data from Jaeger-LeCoultre on the value of machining time, the value of the time required to assemble an in-house movement, the value of the materials which go into the Reverso and many other things. But let us assume that the marginal cost of producing one more Reverso is $5,000.

Now our decision is easy. If we make the additional Reverso then we earn $10.1K. The additional Reverso also creates a financial drain of $5K. So of course we make one more Reverso! That single Reverso earns us $5.1K in profits! So now we have to decide if we want to make a second additional Reverso. In fact we will keep increasing our production of Reversos so long as marginal revenue is greater than marginal cost because doing so generates profit. We will stop expanding production once marginal revenue is equal to cost because then there is no more profit to squeeze out of the Reverso line. And that is our profit maximization condition: marginal revenue is equal to marginal cost (MR = MC). When we reach that point we can't do any better by expanding production (and we wouldn't want to cut production because then we'd lose profit).

So how does marginal revenue behave in the watch market since it is so important in determining if we're making the right number of watches? With traditional demand, such as in the not-so-haute watch market segment, as we make more watches then the price falls. Consumers will only buy more if price is lower. This means that marginal revenue is always below price because we won't be able to earn as much as the current price for the next watch we produce. We can calculate marginal revenue and I've done so for the not-so-haute watch demand I described earlier. I added it to the graph, it is the purple line (the appendix has more details about this).
For Veblen goods marginal revenue acts very, very differently. In order to produce and sell more product a manufacturer needs to raise prices. This means that marginal revenue is always higher than price. If Blancpain can sell 250 units of the Fifty Fathoms reference in titanium at a price of $14,700 then in order to sell one more unit the manufacture must increase exclusivity. But selling more makes it less exclusive! So the price must go up to something like $15,000 in order to sell watch number 251. I've calculated marginal revenue for the haute watch demand described earlier and added it to the graph. It is the green line.

With these results in hand we can now describe how profit maximizing watch manufacturers will behave.

Bifurcated Balance Wheels

As described earlier, traditional companies achieve maximum profits when their marginal revenue equals the marginal cost of producing. What are some reasonable assumptions regarding the cost of watch production? I think it is safe to say that, for many reasons, the cost of producing a single Citizen watch is far far lower than the cost of producing a single Patek. So for the sake of our example let's assume that the marginal cost of a haute horology timepiece is $4000 while the marginal cost of a not-so-haute watch is $35. In Figure 2 I have added each of these marginal costs to the graph and they appear as a flat line (corresponding to the idea that the marginal cost of production is constant).

We can now see some clear results from this model. First, there are two very different looking market segments. Among not-so-haute watch producers who face a standard law of demand marginal revenue equals margin cost at approximately 1.42 million units. The price of a non-luxury watch is then $395 and the manufacturer makes a tidy profit of $360 per watch. Our model predicts that the "mass produced" watch industry is large in scale with low prices and a reasonable rate of profit. We can then compare this with the luxury watch segment.

Go Big or Go Home

The existence of Veblen effects completely turns the pursuit of profits on its head. If luxury manufacturers pursued standard practice then they would choose to produce approximately 143,000 units (at this quantity marginal revenue equals marginal cost). But then the price of a watch would be $3,500 and watches would be produced at a loss of $500 each! Manufacturers would close and luxury watch production would end. For reasons outlined in the appendix, when there are Veblen effects the standard strategy of producing at marginal revenue equal to marginal cost actually generates the lowest level of profits possible.

Fortunately there is another option. By increasing prices of luxury timepieces the industry can sell more units, because of Veblen effects, and begin to erase losses. There is a "break-even," minimum level of production at 286,000 units such that the cost of producing each watch is just covered by the revenue it produces. And any production even greater than that amount will generate more profits still. So, for example, if haute horology capacity is 500,000 units per year then that is exactly where the industry will land. The price of a luxury watch will be $4,750 and the industry will earn $750 in profit per watch.

Surviving or thriving in haute horology, then, is a question of building out industry capacity to an adequately high level and then producing at full capacity. With low prices and low capacity there will not be enough profit for the industry to survive.

We've seen, then, that Veblen effects underlie a number of features of the watch industry. First, the industry is bifurcated into two segments. One features low cost of production and traditional demand and supply behavior. Profit maximization is no different than any other industry. There is a large volume of production and prices are comparatively low. Second, the industry has a luxury segment which plays by very different rules. Costs of manufacturing are high as are prices. High prices actually create large demand and the industry as a whole must establish an adequately large capacity so that it can meet this demand. Traditional profit maximization principles are tossed out the window in this market segment.

Hemingway's Tautology

According to legend Ernest Hemingway once observed that the rich are different than you and me because they have more money. I expect that if we asked Hemingway about the watch industry he might say "A Rolex is different than a Citizen. It costs more." We have seen that price is actually the principle way that we can distinguish a Veblen brand from more traditional brands. It is important to note, though, that watch manufacturers often sit astride both market segments. As I write this the Swatch Group sells Swatch branded timepieces at Walmart for about $40 and also sells Breguet Classique Complications reference 3795 for $240,600 (not at Walmart).

We economists call this a separating equilibrium. Consumers understand that there are two distinct types of watches and they don't conclude that they're getting a huge discount on a Swatch because the same company sells $240k watches. Even though these watches are made by the same firm the brands help establish this separating equilibrium by differentiating the perception of the timepieces. Swatch started in 1983. Breguet, the man, was born in 1747. Many brands are successful at straddling the two market segments. In 2018 Richemont create Baume, a comparative low cost watch brand which operates alongside haute horology house Vacheron Constantine. Rolex offers the comparatively accessible Tudor brand.

Our earlier analysis suggests that maintaining this separating equilibrium is vital for the survival of luxury watches. If consumers begin to perceive that there really isn't any difference between watches with high and low costs of production then we move into a pooling equilibrium. There is only one price for a watch. Even if this price ends up being the average of the price in the two market segments, $2,575 in the case of our example, the luxury watch market will cease to exist because this low price does not cover the cost of producing luxury timepieces.

This insight helps us understand the recent "war" against grey market sales of excess timepieces, as reported by Tony Traina of Rescapement. Manufacturers are even taking the extreme step of purchasing back excess units and destroying them in a bid to maintain high prices. This preserves Veblen effects in the luxury segment and averts the pooling equilibrium which would be so harmful to luxury manufacturers. Equally important to maintaining the separating equilibrium is marketing efforts and brand ambassadors.


The luxury watch industry has survived many disruptions, including the "quartz crisis" of the 1970s and the present emergence of smart watches. What is often under-explored is the role of Veblen effects in driving this survival. The positional role of luxury watches and the fact that high prices can engender exclusivity means that low cost alternatives are, effectively, a completely different product following completely different rules. We see, then, that Veblen effects are more than a tangential part of the watch industry. Rather, they are a driving factor behind much of its outcomes.


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