From 1.0 to 4.0 in 130,000 Years: Pricing’s Extraordinary Adventure from Haggling to Scientific Micromarketing

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. Read the rest of this entry »

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Why Credit Doesn’t Matter to Maintain Competitive Advantage

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? Read the rest of this entry »

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The 5,000 Year Marathon: In the Race to Buy & Sell, Who Wins & Loses? (… Especially When Product Choices Grow Faster than Incomes!)

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.

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The Micro-Monopoly Phenomenon

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.

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The Price You Pay for Not Changing Price

The WSJ ran a story on 3/10/09 on the financial success of McDonald’s Corp. throughout the present recession. Since the company is one of only two DJIA members (the other being Wal-Mart Stores, Inc.) to have ended 2008 by posting a gain for the year, it is perhaps only fitting that the Journal devote a few inches to McDonald’s. The only student to pass a difficult exam rightly deserves a gold star. But amidst the discussion of McDonald’s zeal for succession planning, controlled expansion and keeping a lid on costs in the face of the last year’s commodity price swings, one item deserves more attention than it received: McDonald’s is encouraging individual locations to experiment with prices.

Restaurants sit at the crossroads of both cost and demand volatility. Much to their detriment, companies such as McDonald’s often buffer both their customers and their upstream suppliers from feeling the financial impact of this volatility. Now McDonald’s is at least hinting that it wants out of this arrangement, and our experiences working with multi-billion dollar partners in the food distribution industry points to this being a wise move. We have long observed significant daily fluctuations in food prices across all categories. Couple this with the effect that a strong dollar can have on McDonald’s overseas business, and it quickly becomes clear that understanding how much a customer is truly willing to pay for a menu item is of huge value for a company so proud of its billions and zillions served.

The real question is why don’t more restaurants (or any number of businesses for that matter) treat their price as the valuable asset that it is? It is not overly difficult for a restaurant to approximate a schedule of demand and create several different menus with prices tailored to different Cost of Goods Sold (COGS) environments. For a restaurant grossing $500,000 in revenues annually, every 1% increase in sales corresponds to a $5,000 improvement to the top line (subtracting the printing costs later). In our experiences in food distribution, a 1-2% increase in the organization’s top line can translate into a bottom line improvement of over 8% – an observation that we have seen replicated in numerous industries. Projecting forward a few years, I would be willing to bet that the majority of companies with the highest valuations among their industry peer groups will also be the ones that are trying to actively shape demand through their pricing strategies.

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