Pricing has evolved from the ancient art of haggling to the application of scientific methods to the micromarket. In a sense we are going back to the unique knowledge of individual customers and products that existed in the old bazaars and town squares – but we’re armed with powerful technological tools of the 21st century. The world of Pricing 4.0 is upon us.
But let’s start at the beginning. In the beginning there was the trade, and the trade saved humanity. Seriously.
Homo neanderthalensis – Neanderthal man – had been occupying the planet for about 200,000 years when our ancestral gene pool, Homo sapiens, showed up on the scene (both species evolved from a common ancestor Homo habilis that had begun to make and use basic tools about 2.5 Ma (million years ago), but their evolutionary paths diverged some 600,000 Ma). Despite what would seem to be a solid first-mover advantage thriving in the harsh Ice Age climate of Europe and Western Asia, Neanderthal man vanished from the face of the earth sometime around 30,000 years ago while the progeny of H. sapiens went on to give the world the Hanging Gardens of Babylon, Magna Carta and How I Met Your Mother. In 2005 academicians Richard Horan, Erwin Bulte and Jason Shogren presented a well-researched argument for why this happened: trade. According to their paper “How Trade Saved Humanity from Biological Extinction: An Economic Theory of Neanderthal Extinction” it appears that our ancestors had particularly honed skills in organizing specialized activities such as tool-making, and trading their goods between different social organizations. As the Ice Age melted and populations grew and migrated, the skills of free trade became an evolutionary competitive edge.
With trade was born the concept of price – you can’t have one without the other. The first trade probably went something like this: I want one of your stone axes and I’ll give you two fur pelts for it. Pricing 1.0 was essentially the fine art of haggling between parties to agree on the relative values of items being exchanged in a trade. The simple mechanics of Pricing 1.0 were effective enough to last for most of human history, from hunter-gatherer societies to the bazaars of the Levant and the Greek and Roman agorae, and onto medieval town square markets.
In the town square every customer was his or her own living, breathing micromarket, and every interaction between that customer and any given product available for sale was unique. Sellers of goods in the market got to know their buyers’ habits, buyers got to know their vendors’ quirks, and everyone kept mental images of successful transactions fresh in their heads so as to have a good basis from which to negotiate in future transactions. The population of customers as well as the daily supply of goods was usually small enough that an average human brain could retain the necessary information to buy and sell effectively without the need for hard-and-fast systems regulating or standardizing the terms of trade.
That all changed very rapidly in the most explosive 250 years ever of human economic activity that started with the Industrial Revolution. Actually the Revolution was just about humans doing what they do so well – specializing and trading – but on technology-fueled steroids enabling massive leaps in productivity. Eric Beinhocker presents in his 2006 book “The Origin of Wealth” (using data estimates from University of California-Berkeley economist J. Bradford DeLong) that world GDP per capita roughly doubled from the era of hunter-gatherers to 1750 CE, then exploded 37 times again in the next quarter-millennium to the beginning of the 21st century. As process specialization became ever more sophisticated so did the financial accounting methods businesses needed to employ to ensure they earned a profit – counting up the cash in the till at the end of the day was not going to do it. From this was born Pricing 2.0: figure out how much it costs to produce 48,000 pins per day (using Adam Smith’s well-known example in “The Wealth of Nations”) taking into account direct labor and materials, administrative fixed costs and distribution logistics – and tack on a little percentage over that to serve as the profit. We of course know this as the cost-plus methodology that even today continues to be used by many organizations.
In the 1970s and 1980s companies in the business of producing, distributing and selling consumer goods realized that the increasing role of technology and science in the fields of operations and finance could also be applied to marketing. By recording each day’s sales transactions into a database, marketing decision-makers could mine the information for clues as to how to better market certain products to certain customers. Popular practices such as customer loyalty programs, combined with increasingly sophisticated third-party data about demographic and psychographic market segments, helped marketers to hone in on ever-more informed answers to the basic challenge of marketing: how to sell the right product to the right customer in the right place at the right price. We can think of Pricing 3.0 as Managed Pricing – a broad diversity of marketing-driven strategies to price certain goods in certain stores in a manner to attract more buyers and increase revenues. The key scientific tool for Pricing 3.0 was the concept of elasticity: how much will a unit change in price affect the quantity demanded?
The successive eras of Big Box discount stores, specialty malls and most recently e-tailing are a long way from those micromarkets in the medieval town squares. For all that we gained since then – gains in wealth, product choice and service efficiency to name but a few – we also lost something. Sellers lost that unique knowledge they possessed in the town square of every individual customer and the particular assortment of factors that led to successful sales. That unique micromarket knowledge was lost in the increasingly complex value chains of increasingly abundant economies. In order to make sense of the opportunities available Pricing 2.0 and Pricing 3.0 approached the market from the top down. Their homing beacon was the average: what is the average customer willing to pay for a dishwasher, or pair of dress slacks, or ketchup, and how can we set the price to attract that average?
The truth, of course, is that no customer is average. Is there a way to marry that unique micromarket knowledge of the medieval town square with the complex realities and efficiencies of our 21st century economy? There is, and it is called Pricing 4.0 – Scientific Micromarketing. Scientific micromarketing goes back to the medieval town square armed with the 21st century weaponry of robust computational processing capabilities and advanced mathematical techniques like Hierarchical Bayesian modeling. In this way Pricing 4.0 comes at the market, not from the top-down perspective of the law of averages, but rather the bottom-up perspective of the market at that most granular level of the interaction between each potential customer and each potential item. Pricing 4.0 is not a gamble based on a presumed “right price” – it is an informed bet based on the odds that the offer of a particular product to a particular customer at a particular price will be successful.
It took 129,750 years (give or take!) to evolve from Pricing 1.0 to 2.0. It took some 220 years to go from 2.0 to 3.0, and about 30 more to arrive at 4.0, the new age of micromarketing. Of course earlier generations never die out completely. Just as there are no doubt still some people using Windows 95, and plenty of Cubans driving their 1950s-era DeSotos, so in many corners of the globe the art of the haggle a la Pricing 1.0 continues to retain its appeal. And many, many of the world’s largest corporations continue to rely primarily on the cost-plus model of Pricing 2.0 despite its extensively documented shortcomings (which are too voluminous to treat in sufficient depth in this posting). But Pricing 4.0 has arrived, and companies grappling with the challenge of truly figuring out their ever-more complex demand environments have the opportunity to begin the journey down this path. It leads us back to the erstwhile town square in a way that the merchants of old could have hardly imagined.