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.

Fortunately for business decision-makers, fair pricing and optimal pricing are not at odds with each other but can comfortably coexist.  Over the course of the coming weeks my colleagues at Sentrana and I will be approaching the rich topic of fair pricing in a series of exchanges on this blog.

debating the age-old question of fair price

What is a fair price?  This question has perplexed humanity throughout history.  Leading thought output of the ages, from Aristotle’s Nicomachean Ethics to the Summa Theologicae of  Thomas Aquinas, Pierre de Fermat’s probability proofs and Adam Smith’s classsical economics, have all weighed in with considered opinions on the fairness and justness of alternative ways to price economic goods and services, and the debate continues today.  A series of letters exchanged between Blaise Pascal and Pierre de Fermat in 1654 is often regarded as a primal cause of the development of modern probability theory: this exchange was actually an attempt to establish a scientific basis for the notion of fair price.  In his paper “The Unity and Diversity of Probability” Rutgers professor Glenn Shafer shows how these letters created hypothetical games of value that we today can recognize as the application of probability methods to defend a price as ‘fair’ under conditions of uncertainty.

Uncertainty is the 800-pound gorilla in the room when it comes to price-making decisions.  Buyers and sellers operate from positions of considerable uncertainty in approaching transactions with each other: buyers have only partial information about the features of what they are buying such as quality, reliability, service support and the extent to which a given offered price may be reasonable in relation to these features, while sellers have a limited perspective on what demand exists for their products and what combination of levers such as price, assortment and marketing could influence that demand.  Buyers thus face the risk of inequity in their exchange – paying more than the intrinsic worth of the object acquired, while sellers face the risk of their transactions being unprofitable and, if persistently so, driving them out of business.

Having worked for a number of years in the investment industry I offer up a useful model from this corner of the economy for dealing with uncertainty.  In the investment world uncertainty commands a price: investors demand more compensation, in the form of return on investment, for assets that exhibit higher levels of short term volatility.  Participants widely view this as fair: it is not thought ‘unfair’ that an investor in, say, a 5-year U.S. Treasury note earns a dependable return of 5% whereas someone who takes a punt on the shares of a small-cap biotechnology company may potentially earn over 25% in the same time period.  There is more likelihood that the value of the biotech shares will plunge in the wake of unexpected news or that the company will go out of business than there is of the U.S. government failing to honor its legal obligations to bondholders.  A capitalist economy offers the potential for greater rewards to the investor willing to assume greater risk.

what matters is the customers who don't come

How is this concept analogous to the uncertainty faced by businesses that sell in markets for real (i.e. non-financial) goods and services?  I thought about that the other day while dining out at one of my favorite Northern Italian restaurants, located in a trendy urban area chock-full of good eats.  As I looked around the dining room on a late September Tuesday evening it occurred to me that the uncertainty this business experiences on a daily basis is plainly visible: the number of empty seats during peak dining hours.  Restaurant patronage is a notoriously fickle notion to quantify and is subject to considerable fluctuation in real time.  I wondered about the methodology through which this restaurant’s owner translates the uncertainty of empty seats into the revenue model. It seems to me that the real art to the formulation of this model is not based on the tables that have patrons sitting at them, but rather the ones that are empty.  The hard part of revenue calculation is not figuring out what the average occupied table will spend on any given night – it is dealing with the uncertainty of those empty tables.

Now in theory, the owner could simply build an ‘uncertainty factor’ into menu prices as a partial compensation for the prospect of empty tables.  In practice this is unlikely, and the reason why it is unlikely brings us back to the concept of fairness.  Prospective restaurant patrons (including yours truly) are very unlikely to be sympathetic to the notion that they should have to pay a higher price for the verze e luganega because it helps the owner’s revenue model – to us patrons, that is an unfair offloading of the owner’s problem onto us.  We don’t even have to explicitly know the owner’s motivation.  Discerning customers have plenty of access to comparative information – from other restaurants in the area, our social networks, Internet reviews and so forth – to form strong perceptions of the fairness or unfairness of prices at any given spot.  We will wield our verdict of ‘fair or unfair?’ with much self-righteous certitude in making future dining out decisions.

So what is a ‘fair’ way for our poor restauranteur to manage uncertainty toward a more profitable outcome?   Rather than accepting empty tables as a given fact of life the owner can try to figure out intelligent ways to fill them.  Who may be walking by the restaurant in the late afternoon, or working in a nearby office building and considering an after-work dining outing with colleagues?  What combination of factors might entice these and other prospective patrons to choose this establishment over numerous other choices?  Is there a way to figure out attractive deals that would lure certain prospective customers and to surgically target each such customer with a unique offer?  Yes – it is possible through scientific micromarketing techniques that optimize at the granular level of the customer-product interaction.  The next question – if it is possible, is it also fair?

All those centuries of debate on the notion of fairness and justice in economic commerce now come back into this discussion.  Paul Krugman expressed a concern about this in a New York Times op-ed piece titled “What Price Fairness?” all the way back in October 2000, when price optimization methods were in a much, much earlier stage of development.  His remark (related to the notion of dynamic pricing in general) was that while it may be “arguably good for the economy,” dynamic pricing is also “…unfair: some people pay more just because of who they are.”  Sitting in the restaurant, I imagined a hypothetical case where the gnocchi with sweet basil pesto, which I ordered for the menu-listed price of $14.50, was being enjoyed by the gentleman at a nearby table for $11.30 simply because the restaurant’s micromarketing system contacted his iPhone with a targeted discount offer just before he left his office just down the road.

Is that unfair?  I don’t think so.  Who wins and who loses in this scenario?  The gentleman who receives the offer wins – he gets the opportunity to enjoy a dining experience targeted to his personal preferences.  The restauranteur wins by filling a table that would otherwise be empty, reducing uncertainty and improving the nightly profit intake.  I am still enjoying the gnocchi I ordered at full price and am no worse off than I would have been otherwise; having already concluded that $14.50 is a reasonable price for the dish and ordered on that basis.  On a broader social scale the notion of micromarket pricing does not discriminate between the two of us in a way that I would deem unfair.  I have my own set of preferences that may benefit me with a different offer set on a different day.  In fact, were I to be made aware of the circumstances under which the gentleman got his gnocchi for a lower price, I may well be inclined to leave my own contact information with the establishment in anticipation of future benefits.

There is a road ahead before scientific micromarketing becomes a more accepted feature of B2C commerce situations like that of my hypothetical imaginings while dining out (no doubt helped along by the delights of a 2003 Castello di Camigliano Brunello).  And I expect that a vigorous debate about the question of fairness versus optimality will be part and parcel of this journey.  At day’s end, though, I believe the two are fundamentally compatible.