Imagine that you have two customers to whom you are selling beef. One is a greasy-spoon hamburger joint and the other is an upscale French bistro that offers a pricey version of steak tartare as one of its gourmet entrees. In figuring out the terms of offer for each restaurant, would you create a profile of an “average customer” based on these two data points and sell a single variation of medium-grade beef at a mid-range price to both the burger joint and the classy bistro? Of course not – you know perfectly well that approach would please nobody and result in two lost sales. Yet that is exactly what sellers in many industries are doing every day – marketing to some notional “average” customer that in reality does not exist. It may seem less absurd when the average is based on thousands or tens of thousands of customers as opposed to two – but it is no less flawed as a marketing approach. Every single customer has a unique set of needs, preferences and priorities. It is your job as a seller to tailor your offers as close as possible to each unique demand curve. Fortunately, technology and science make that daunting challenge possible. Continue reading
Everywhere you look, it seems, people are talking about “physics envy”. This derisive term mocks the attempt of economists and other social sciences practitioners to imbue their disciplines with the equations and mathematical rigor of physics – a rigor that many believe fails when applied to the messy environments of disciplines like sociology or economics. It’s not a new term – economist Philip Mirowski contributed to the Finnish Economic Papers series way back in 1992 with a piece entitled “Do Economists Suffer from Physics Envy?”
Eighteen years later the answer from many observation posts along the byways of public discourse appears to be: yes, they most certainly do, and so do their fellow travelers, business and financial markets experts. After all, we just barely survived the most devastating economic event of our times, deeper and more far-reaching than any downturn since the Great Depression, and all the high priests of the field can do is shake their heads and say “wow, I sure didn’t see that coming.” Distrust of fancy math is rampant in all walks of business life. That presents a real problem for enterprise decision-makers at a time when they need smart quantitative tools – yes, fancy math and all – more than ever. Markets are more complex than at any time in human history. Giant waves of transactional data inundate marketing managers with new information every day. Managers need science to help them gain valuable insights into the markets for their products and services – but how do they know that the growing number and variety of scientific marketing tools out there aren’t infected with the nasty symptoms of physics envy? Continue reading
Businesses want us to view them as fair – there is arguably nothing more important than a reputation for fairness in the daily marketplace of commercial transactions. As business managers what can we do to ensure that decisions we make – about pricing or other actions that are clearly visible at the point of the customer-product interaction – will be seen as fair? Is fairness something absolute, immutable and precisely quantifiable? Or is it situational, capricious and ever-changing? The bad news, perhaps, is that ‘fairness’ is a very elusive notion to pin down with certainty – it’s hard to put fairness in a bottle and label it as such. The good news is that fairness more than anything else is about perception and the relative judgments of your customers and potential customers in varying demand situations. That’s good news because the better you understand the granular contours of your demand environment and the precise needs and propensities of your customers, the more likely you are to understand how to make decisions in that environment that are both fair to the customer and profit-optimizing to your business.
Here’s a test of fairness. Imagine you are lying on the beach on a hot summer day and find yourself craving a cold, satisfying beer. What price would you be willing to pay to quench your thirst? Now imagine two alternative scenarios. In one, the only place within walking distance to buy a beer is the poolside bar of a swanky five-star beachfront hotel. In the other, there is a rather run-down beachfront grocery store that sells beer. Imagine further that both the hotel and the grocery store sell the exact same brand and type of beer. Does your maximum price point change depending on whether you think you are getting the beer from the hotel or the store? Do you think it is fair for two different establishments to sell the same commodity for a different price? Continue reading
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. Continue reading
Large brand-name drug companies – Big Pharma in the common vernacular – are not exactly known for competitive pricing or razor-thin margins. For 2008 the industry was ranked third most profitable in the U.S. according to Fortune magazine, with average profit-to-sales margins of 19.3%. That’s a pretty fat comfort zone compared to the scorched-earth landscape of many other industries…or is it? Until recently Big Pharma was pretty consistent at the #1 spot in those rankings. A look under the microscope reveals some troubles bubbling up in the hitherto happy world of magic molecules and blockbuster brands. These days the whole country seems transfixed by the subject of healthcare, and no matter what does or does not come out of the legislative sausage factory this year, some major trends are afoot that have potentially far-reaching consequences for Big Pharma and may influence the normally lackadaisical approach drug makers have exhibited to the prices they charge for their brand-name drugs – in particular when those drugs reach the end of their exclusivity protection period and go off patent. Continue reading
Two economic developments are currently having a profound effect on the playing field of consumer demand. One is the Great Deleveraging: the painful scaling back of the household debt burden that reached a historical peak, at 133% of household income, in late 2007. The Great Deleveraging means that household dollars that several years ago would have been earmarked for new discretionary spending are instead being diverted to pay down the hangover of old discretionary spending. As fewer dollars chase the same supply of products we would expect some combination of lower prices and/or a reduction in the quantity of products supplied – a reversal of the SKU proliferation that has been a dominant feature of our consumer experience for the past several decades.
At the same time, though, a second major event appears to be unfolding: the emergence of the economics of “free,” or “freeconomics” as provocatively described by Chris Anderson of Wired magazine in his recently published book “Free: The Future of a Radical Price.” “Free” in Anderson’s formulation is the notion that the near-zero cost of doing business online turns upside down the conventional notion of economics as the science of parsimonious choices under conditions of scarcity. The “economics of abundance” in Anderson’s phraseology may filter through the prism of our traditional understanding of markets as being good news for cash-strapped consumers (more stuff for which I don’t have to pay money) and bad news for suppliers of goods and services (“free” doesn’t sound like a price that will shore up my profit margins). Continue reading
Realizing I would be without a wireless connection on my train ride to NYC, I stopped to grab some light reading material at a kiosk in Union Station, where I found a plethora of headlines devoted to capital spending. I know that the loss of $50 Trillion in wealth in the last 18 months led to a severe credit crunch, but wasn’t that old news? Aren’t businesses starting to rebound with the distribution of the $700 Billion in TARP funds that helped prop up banks and car companies, along with another $2.5 Trillion spent to support the struggling financial system? I take a quick look through the daily business headlines, and they continue to reflect a particularly bleak outlook for businesses that are still struggling with low expectations for growth and profits, costly and scarce credit, weak consumer demand and a glut of production capacity. To compound matters, the current administration and Treasury Department will implement extensive financial regulations to curb future financial crises, and banks continue tightening their lending standards for all types of business loans. I hope these measures reduce the risk of another bubble market, but at what cost will these measures reduce the opportunity for many businesses to effectively compete in this economy? One thing is obvious: credit will no longer be a cheap commodity for businesses in the near future, period. But then again, is credit really necessary for businesses to stay competitive? Continue reading
Inflation rates provide a reasonable yardstick for measuring buyers’ purchasing power. By comparing income growth with inflation, we can determine how well buyers are able to keep up with rising product prices. But, there is something that is perhaps much more important in our ever-expanding (or, nowadays, contracting) economy that is unmeasured. Just comparing inflation with income growth does not allow us to see how well consumers are keeping up with rising numbers of products. And this product proliferation not only impacts consumers’ purchasing power, it has deep impacts all the way up the supply chain to the purchasing power of retailers, distributors, and ultimately manufacturers.
If there is a lot more to purchase, or a lot more stuff that can be incorporated into the products you make, each party in this supply chain needs to have the financial ability to entertain such a large set of choices. Looking at income growth and inflation alone conceals the true nature of spending power. It is not as much about whether or not our incomes today are keeping up with the prices of things we bought yesterday. It’s about whether or not our incomes are keeping up with the additional things we can buy. It’s about whether or not manufacturers’ incomes can keep pace with the exploding set of ingredients they can choose to put into their products, and whether distributors can cost-effectively stock and sell an ever-widening mix of products, and so forth. The rate at which these new things emerge is faster than the rate at which incomes grow – and therein lays the crux of the pricing problem (firm birth data obtained from U.S. Census Bureau and Income data obtained from U.S. Bureau of Labor Statistics):
Even though inflation may be growing at a rate that is in line with wage growth, the burgeoning number of items available to consumers (and perhaps even critical to consumers – just a decade ago there was no anti-bacterial lotion, and yet now you can’t walk 10 feet in a hospital without walking past an anti-bacterial gel dispenser) makes consumers have less spending power.
As the weather soured this past weekend, our plans for a long outdoor hike morphed into a long indoor marathon of Monopoly™. There were 5 of us, and figured that given the unexpected rainfall, we might as well dust off the Monopoly board and spend our afternoon keeping dry. To make the game a bit more interesting and reflect the current economic climate, we altered the rules – which we referred to as “recession-rules” Monopoly (as opposed to “normal-rules” Monopoly).
Instead of each player receiving $1500 at the start of the game, we would each receive $1000 (to reflect the $50 Trillion of wealth that has been lost in the last 18 months), and instead of collecting $200 for passing “Go”, each player would collect only $100 (to reflect the massive wage losses seen in the last 12 months). To further reflect the broader economic climate, no loans were permitted in the game (i.e., players were not allowed to mortgage their properties to receive cash from the bank, nor were players permitted to issue loans to one another). With these altered rules, our goal was to see how purchase behavior and wealth would unfold on this artificial economic landscape. The results were rather eye-opening, and sheds light on the fundamental dynamics of price in a down economy.
One startling feature of the game that remained consistent between “normal rules” and “recession rules” was that the price of any property on the board, or the price of any house/hotel was publicly displayed for all to see. This price conveyed essential market information about the value of “the goods”. Yet, despite the publicly known value of a property, property prices always deviated from the stated value once a buyer wished to purchase the property from a player that already owned it. Moreover, different buyers were prepared to pay different prices for the same exact property and in all cases the offered prices were higher than the stated value of the property (i.e., the price paid by the original buyer). This pattern was held true despite the recessionary conditions that were imposed on the game. There are a few important observations to note here:
- Different people were prepared to pay different prices for the same good.
- Those prices were always higher than the stated value of the good.
- Buying & selling still occurred despite lowered wealth levels.
- Buying & selling still occurred despite the unavailability of credit (no mortgages were allowed and no player-to-player loans were allowed).
We observe these same characteristics when… Continue reading
Here’s an interesting market experiment that you can try without leaving your desk. Go to www.pricegrabber.com, choose a merchandise category, and then select a product that has more than a half-dozen or so different sellers. Sort the list by price, and compare the highest price to the lowest. Having just performed this for the HP Laser Jet 1022n laser printer, I see that I have the option to pay as much as $290.00 or as little as $115.00, plus a range of prices in between. That’s a lot of variance for the exact same product. The highest price is almost three times as high as the lowest. Yet all sales have not been captured by the lowest-price seller, nor has the most expensive retailer (which happens to be HP itself) gone out of business. Intuitively, you may already be rationalizing this phenomenon to yourself. People are willing to pay for things like the seller’s brand strength, return policy, warranty, service packages, availability, and so on, which is why different prices are charged. I didn’t bat an eyelash when I saw the price range on the screen, even though it seems to contradict the premise of market-clearing prices in perfectly competitive, transparent markets. We understand the reasons for these differences, but there is a deeper insight to be gleaned from this apparent oddity.
Let’s say hypothetically that this printer has 10 different attributes like the ones mentioned above on which every buyer places a value, even it happens to be zero. There is a segment of the printer-buying population that wants all 10 attributes, including the HP brand name of the seller, and that segment is willing to pay a higher price. No other seller can satisfy all 10 attributes, giving HP a monopoly on that attribute set. But as a seller, HP operates within constraints since other sellers offer the same exact printer at a lower price in return for providing fewer attributes. Thus, HP cannot set its prices as a pure monopolist, because an excessively high price will drive too much of the market to the next lowest price tier. HP’s competitive position is what I call a micro-monopoly (or “Micropoly” if you prefer the conflation, as I do). The explanation for this price dispersion is that every seller of this printer satisfies a unique mix of attributes demanded by a particular segment of the market. For that segment, the seller has a limited amount of micro-monopoly pricing power.
When viewed from this angle, it becomes easy to see why it makes more sense to set prices based on what your customers value rather than what your competitors charge. The reason is that one firm may compete only tangentially with another firm that sells the same products. The obvious question then is what happens when two firms fulfill the same exact mix of attributes. At this point, firms would then compete on price, but I think this logical extension can be somewhat misleading. In the real world, no two firms ever truly occupy the same attribute space. There will always be at least some differences in the total experience and feel that the customer gets from making the purchase, and thus the potential for price differentiation exists. Multiple optimum prices for the same product can exist in the marketplace. A profit maximizing firm’s objective should not be to race to the bottom in a low price battle with competitors, but rather to understand very clearly what its price ceiling is.