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.

The problem many corporations frequently suffer from is fractured pricing policies where disparate departments within the organization have conflicting rules regarding pricing strategy. This is often a result of unimpeded change within each department, where every manager relies on their own gut instincts at pricing based on their limited view of the ever-changing picture of customer demand. In addition to this proliferation of pricing policies with the potential to impact the market’s demand, other departments in the organization are also making demand-impact decisions, such as advertising and product mix. These practices are often left to chance because most leaders A) don’t realize the problem exists, B) are currently surviving this economy with a meager profit that is most often derived from a “survivalist” measure like cost cutting, layoffs, and running tighter operations, etc., C) are consumed by the sheer volume and complexity surrounding marketing decisions due to the proliferation of advertising channels, products, customers, and supplier networks, or D) if they realize there is a problem, they aren’t aware of what solutions may exist. What these business leaders don’t realize is that they’re leaving enormous profits on the table all the while giving competitors the opportunity to lure their customers away with the “right” price.

To help shed light on the problems these business leaders are facing, I reflect on a quote from John Wooden – one of the most respected college basketball coaches of all-time with 10 NCAA basketball championships during his tenure at UCLA – where he said, “Before you can lead others, you must be able to lead yourself.” This brilliant insight by a legendary sports icon can also serve as an invaluable business axiom: you can’t lead your market until you lead your organization. Simply put, companies – especially those struggling in this economy – should turn their attention inward. Doing so will require new thinking, advanced technology and a change of focus towards effectively generating growth organically (as opposed to via manic serial mergers and acquisitions) for your firm. Forget about the credit crunch (i.e. insufficient investment capital, the dried up commercial-paper market, etc.), falling consumer demand and other external factors that you can’t control.

I believe that in order for companies to be profitable in this economy, they need to adopt both an enabling technology and decision-making infrastructure to help them determine the optimal prices, marketing mix, and product assortments that will maximize revenue and profitability. Successful implementation requires leadership from the executive suite and bottom-up support from the people who work in all functions throughout the organization. Technology is a necessary component and must be able to serve the firm across its organizational silos in ways that allow each part of the organization to achieve optimal productivity and profitability, taking into account both departmental and firmwide objectives. Visibility throughout the organization is also essential, where the stewards of each of the demand and supply levers in effect have the ability to discover previously unknown or misunderstood elasticities – this can lead to a virtuous loop of discovery and profit.

Times like these require business leaders to move past temporary measures to be successful in both the short and long-term – to not only help their companies survive this downturn, but also to be visionary and lead their market! The insight a company requires to effectively manage their marketing decisions should be robust and holistic – not only do they need optimal prices, but also recommendations on products for customer penetration (cross-selling), optimal deals and promotions and guidance to curtail customer churn. These organizations that are able to not only manage, but also execute their ever-growing array of marketing decisions will have the ability to drive their markets, rather than being driven by them, and will be better positioned to continue leading their markets when the economy returns with vigor, as they will be more adept to discover, view, analyze and act upon the opportunities present in their demand environment. I can only assume that the shrinking credit supply, weak consumer demand and other external factors will likely be with us for some time, but they are of little relevance to any business leader looking to grow their firm organically, and seek to embody John Wooden’s principles in the process.

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.

This spending power is a 2-dimenional thing, but we have tended to focus on only one of those dimensions – i.e., we’ve levied most of our focus on inflation versus income growth, and have not focused as much on product variety versus income growth.  Today, there are many more things to buy both directly and indirectly (for instance, when we purchase a car today that contains twice as many parts as a car from 20 years ago, we are indirectly purchasing “more things”) and this breadth of choice bites deeply into our spending power.

It is not just whether or not the prices of things that we bought 20 years ago have grown in pace with our incomes, its whether or not the sheer number of products and the total global value of those products have kept pace with the total global value of our incomes. And by this measure, spending power has failed to keep pace.  The obvious response as a seller is to flock to everyday low pricing – but, this “obvious” response actually fails to respond to the right problem (which is one of burgeoning product assortment).  Price reductions alone will not bring spending power up to the levels of power we had just a generation ago.  And the problem is only going to worsen, for innovation will continue to accelerate and the diversity of goods and services offered in the global economy will continue to mushroom.

So, what’s a pricing manager to do in the face of this shrinking spending power headwind?  First and foremost, recognize the strong interplay between your marketing efforts and your pricing.  Every dollar invested in marketing will impact the prices that you can charge for every product in every market (or, for B2B vendors, sales & marketing dollars directly impact the prices that you can charge for every product that can be sold to every customer – so, if you have 100,000 customers and 50,000 SKU’s, you have 5 Billion customer-item combinations that you need to understand).  Marketing effectiveness and pricing excellence are joined at the hip, which means that marketing managers and pricing managers must couple their decisions optimally.  This is especially true now because your marketing voice is drowned out each day by more than 3,000 other voices.  The chart below shows the sharp rise in advertising expenditure in the U.S. alone (data obtained from Coen Structured Advertising Dataset):

Secondly, recognize the strong interplay between your product assortment and your pricing.  In the face of ever-widening product choices, being able to identify the right bundles of products for the right customers or customer segments is pivotal to combating ever-narrowing spending power.  Remember, everyone’s Achilles heel in this race to sell is the explosion of assortment mixes.  If the crux of the problem is product assortment, then therein lay the solution.  Identifying which products to co-sell with other products, and what price that entire combination should have for every single customer or within any single market is the key to winning this race.

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.

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.