thirst-quenching - but is it fairly priced?

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?

Those questions were at the heart of a study by a team of behavioral economists and reported in the Journal of Business in 1986 (“Fairness and the Assumptions of Economics” by Daniel Kahneman, Jack Knetsch and Richard Thaler).   Participants (playing the role of the thirsty beachgoer) were told where the beer would come from (ritzy hotel or rundown grocery store) and asked what their maximum permissible price would be.  The results were interesting: respondents who thought their beer was coming from the downmarket store were willing to pay a maximum $1.50 while those who were told the beer would be purchased at the luxury hotel were prepared to shell out $2.65.

What’s so fair about that?  We have to assume that, give or take, the procurement cost to each vendor was roughly the same.  The results of the study seem to indicate a calculus in the minds of the respondents that the beer will inevitably cost more if it comes from the hotel, so they were willing to adjust their own demand curves upwards to meet the perceived point of supply, as opposed to boycotting the transaction opportunity because of a perhaps unfair price differential.  Instinctively that makes sense to me.  Putting myself in the position of the parched beachgoer in the shadow of the ritzy hotel I think I would be more likely to go along with the reality of the $2.65 hotel beer than take a principled stand on the arguable unfairness of a 77% markup.  My experience tells me that it’s simply the way these things work, like it or not.  The results of the Kahneman study say largely the same thing: despite a potentially strong case to be made for the unfairness of the hotel’s pricing scheme, most people willingly go along with its reality and adjust their own internal pricing mechanisms accordingly.

Most of us have been somewhere where we have paid much more for something than we would otherwise – the infamous mini bar and local telephone call surcharges in hotel rooms come to mind.  Ordering a bottle of wine in a restaurant brings about the same experience – I know that a particular 2005 Gigondas retails for $18 at the local wine store but I’ll have to shell out $40 for the same quaff over candlelight and soft music at that romantic little cuisine provençale place down the street.  That $8 bag of peanuts or $40 bottle of wine become reference points – prices we anchor in our brains as reflective of actual experience, and call upon each time we are presented with similar transaction opportunities.  In this process a subtle shift takes place; we are no longer focused on the inherent fairness or not of the underlying state of affairs (high markups in restaurants and hotels) but rather on the fairness of any transaction offered to us in relation to its reference point.  So, going back to the sun-baked beach, if someone offers to go buy a beer for me and tells me the only option is from the hotel bar then my brain calls up the reference point of prior hotel-based transactions and I set my maximum price accordingly.  That $2.65 is an imprecise stab at establishing a benchmark for what the hotel bar should charge for my drink, and as long as it is somewhere in that neighborhood I am okay with the purchase.

salamancan scholars found fairness in the micromarket

Luis Saravia de la Calle, a member of what was known as the Salamancan School of the Late Scholastic period in 15th century Spain, stated that “the just price of a thing is the price which it commonly fetches at the time and place of the deal.”  Interestingly the Salamancans strongly influenced the philosophies of later Austrian School thinkers like Joseph Schumpeter, but also seem to resonate with the more recently emergent tenets of behavioral economics avatars like Kahneman (the 2002 Nobel laureate in economics) and the late Amos Tversky.  In this line of thinking fairness is not some arbitrary notion of a justifiable price based on component costs of production and delivery (like a cost-plus model); if it were, then more people would throw down the gauntlet at the prospect of shelling out 77% more for the same beer just because of where it happens to be sold.  It’s more along the lines of de la Calle’s notion of what prevails at the “time and place of the deal” – which is also what we at Sentrana think of as Pricing 4.0 – the intricate configuration of the needs and propensities of each individual customer at the point of interaction with each individual product.

We may not be able to pinpoint the precise meaning of fairness at all times and all places for all people.  But by better understanding the reference points that anchor buying and selling decisions in the micromarket we have an improved chance of achieving results that are both fair and profitable.

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.

the micromarket of yore

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.

For all its impact on the bottom line pricing often seems to be more on the periphery of the activity flow than at the center – an outer rather than a core competency, and sometimes not much more than an afterthought – oh, yeah, we need to stick a price on that now… hmmm, let’s see.   There are three commonly-used methods for firms to price their goods and services, and none of them could be considered the basis for a core competency.   The Old Faithful of pricing methodologies is cost-plus: add up a bunch of direct and indirect costs, slap an arbitrary profit margin on top and voila – that’s the price. Then there’s competitor-based pricing, which many people seem to think is several evolutionary legs up from cost-plus but which Michael Douglas’ Wall Street character Gordon Gekko might have called “a dog with a different set of fleas”.  Why should either bean counters in the accounting department or your competitors be the metronome for what you charge your customers?

The third common pricing method perhaps comes closer to hitting the mark, but it still falls short of a core competency.  In fact it is not really a method per se but more an amalgam of several things – gut instinct, trial and error and maybe some back-of-the-envelope elasticity calculations .  Here the intention is right – try to figure out what motivates a customer to want to pay a certain price and then try to meet it – but the delivery is weak.  Even mid-sized companies in retail or distribution businesses face literally millions upon millions of pricing decisions every day – what product to what customer in what location via what marketing message and selling channel?  The permutations are too staggering to handle in any way other than with technology-aided, systematic rigor.  For a long time the tools did not exist to facilitate this – but as more companies become aware of the tools and best-in-class practices evolve (to borrow another one of those indispensable bons mots from Tom Peters) I expect that we’ll see some migration of the pricing discipline from the periphery to the core.