7 Deadly Sins of Pricing

I have experience of setting and optimising pricing within the overall commercial strategies of Vodafone, Orange, Eurostar, T-mobile, South West Trains, Thorn EMI and other leading organisations.
This blog is intended to provoke discussion and stimulate the development of  better pricing strategies.

Sin 1  –  Knowing too little about pricing

Unfortunately pricing theory is taught ‘just a little’ to students of finance, economics and marketing.    About as dangerous as a 1 day course in medicine.

So . . . .   The 1st and biggest sin is believing what you were initially taught works in real life!

For completeness let’s check what your textbook probably told you. . .

Pricing Elasticity of demand (Ed ) is a figure (e.g. -0.5) that describes how demand for a good or service varies with a small change of price

In a formula

Change in quantity
____________________     =   Ed = -0.5
change in price

So if  price changes by 1% ; demand moves 0.5% in the other direction

Classically an essential like the antidote to a lethal virus or, for some, the latest (but only the latest) iPhone will be price insensitive or inelastic over a small range.  This may indicate an Elasticity of -0.1 or less.  Less exotically a similar factor applies to how much salt you buy for your food .  In both cases however you buy only what you “need” and pay whatever it costs.

On the other hand tourism is said to be elastic with an elasticity of -2 to -4.   A price increase is thought to cut demand sharply.  Business travel is more inelastic.

That is all you need to know . . .  if you want to know nothing useful about pricing.  It is therefore the first of my 7 sins.

Please read on 🙂

Sin 2 – Retail  presentation and context  confuses elasticity

So you go to an outlet to buy some wine,  Wines vary in price but generally have retail pricepoints ending in 49p or 99p.  You see a huge range of wines at £4.99.

The pricing manager of Wine A decided to use elasticity theory and cunningly sell their wine for £5.10,  collect “an easy extra 11p a bottle with only a tiny change in price that no one would really care about”.

Meanwhile the pricing manager of wine B, who has another cunning thought, prices theirs at £4.90 to ” Stand out and capture a higher volume than the competition”.

Now here in real life I am NOT going to be able to use a formula to tell you exactly what happens here.   There are whole load of ifs and buts:

  • Customer 1 may now perceive the £5.10 Wine A as a higher Quality  £5.xx wine and try it in preference to her usual £5.49 bottle.   We just hope it’s not undercut another more expensive wine from the same supplier’s range.
  • Customer 2 is looking for a brand they recognize at £4.99 and therefore misses the £5.10 Wine A completely this week.
  • Customer 3 was going to buy Wine B anyway but is equally happy to buy for 10p less.  No reason to stock up for a 10p saving though.
  • Customer 4 is and remains completely uninterested unless £4.90 is now the absolute cheapest wine in the store in which case they will buy a bottle of Wine B not caring too much whatever it is.
  • Even if the same customers visit each week customers 1 and 4 may behave differently next week as opinions and other prices vary.

Of course after the sales results come in each ‘pricer’ can still calculate an elasticity value they apparently saw in action and make a careful record for future planning.  But will that same figure work reliably in reverse to magically predict next weeks sales or performance or in another store ?  If not then the record is of Return on Investment rather than a true pricing elasticity.  Moreover we could have worked most of the above out without ever having heard of elasticity.

Sin 3  –  How retail price points make a mockery of elasticity theory

One of the additional details around the elasticity formula I quoted in Sin 1 is that it should  – according to the high priests of pricing – be applied only over a ‘small’ range of change.  This is interesting because it is therefore unsuitable for calculating half price offers etc which is where the formula is frequently wheeled out.   The reason is that in the real world many products – like our wine – have complicating factors like customer perceptions and those pesky competitors that deflect the maths over larger ranges.    But at least we still know Elasticity works over small range.   Or DO we?    Lets see:

We are in a store where £x.99 pricing is usual.  The elasticity theory suggests a move from £4.99 to 4.98   will drive the same scale of volume change as a change from £4.99 to £5.00.  Well it won’t.
We know instinctively why retailers like £x.99 prices.  Although 99p’s supposedly started to force crooked cashiers to ring up sales on the cash register to get the 1p change out; retailers had, or quickly did, notice that our eye looks at the Pounds first and more carefully than at the pence.  So £4.99 looks a lot less painful than £5.00 or £5.01.
Curiously some stores do always price in round pounds.  Some believe the extra p is pure profit, which it may indeed be at high tickets and with no tantalising .99’s nearby.  Others believe that round pounds somehow invoke a ‘Pound Store’ value perception (althougn what that perception might be is another subject altogether!).

Dropping to .98 has no beneficial effect in most retail shopping environments – in fact if you see £199.98 or .97 or .90 in an electrical retailer it is probably a retailers ‘secret’ code alerting sales staff that the price is promotional or on a discontinued or low stock line.

So the ‘rule’ might be re-written to say “elasticity works for a small change in price that doesn’t change the price’s visual relationship to a common price point”.

Sin 4  –  Forgetting Cross Elasticity and good old Mr Porter

In my wine example I pointed to cross elasticity as a huge complication to simple elasticity.  One reason is that the human brain is way better at assessing cross elasticities than simple or direct ones.  Especially as the Cross Elasticity may be to a ‘landmark’ price point OR to another product.

Example:

How much is a car parking space at a major airport worth to a leisure traveller?

A direct answer is really hard to find, and at the entry barrier 10% variation on the tariff makes little difference to behaviour so it is inelastic in the extreme  isn’t it?  Spend a few more seconds thinking about it   This is where Porter’s forces come in :   Specifically Rivals and Substitutes.  The presence of an equally good equally near park at 10% less, or a park served by a slightly longer free bus shuttle at 25% of the price will both cut heavily into the volumes of the first park.  A short Taxi journey from your home may change the comparison totally – making the answer very customer specific as well as price-map specific.

We see cross elasticity in other areas and in many it actually helps the buyer along to see reference prices and points around the product or service they are trying to evaluate.  Is that hi fi good value for money ?  hmmm.  But see surrounding shelves full of similar HiFi’s – we get immersed in feature comparisons, decision reinforcements and completely forget the absolute utility value/price of music in a room.    Cross elasticities to different rivals and substitutes are however notoriously hard to separate from the relative standing of the brands involved though – a pure price comparison is invalid unless we can map it onto a brand positioning framework – a kind of  “elasticity plus”  tool for truly savvy buyers and sellers that maps the customers perceptions and price -map  into price premium elasticities.

Sin 5  –  Neglecting the other marketing P’s

and yet again there are way more than the 5 you first learnt about

It was once held that there were 5P’s that described the remit of a product marketeer.

Product, Price, Promotion, Position and Place (Distribution), plus I will add ‘People’  the service aspect and as I will show Period.

(Actually I can extend the list to more than 7 P s and throw in some C s like Context and Competitors)

The area I want to focus on here however  is one of those less quoted P’s :    Period

When we buy things our brain sort them into various groupings.  For some of us it is the big expenses we hate – we take a monthly payment alternative to a £80 ticket  even if that will see us pay £180 in the end.  For example we stand in a mobile phone store deliberating whether to pay £35 per month ‘for a free phone today’ and a very slightly cheaper calling rate each month,  or pay £80 for the phone today and ‘only £25 per month’.
It’s not too hard to see that over an 18 month contract those slightly reduced call costs might in some cases not balance the books.

Yet many people go for the free today and a bit more each month option.  Also in all my time watching people shop for mobile I have hardly ever seen a calculator pulled out.  . .  so either mental maths is improving or the decision is as much emotionally and perceptually led as it is factual.

The second application of period applies to random periodic purchases.  Unless we are very regular in our ways or on a strict budget we have trouble tracking the total cost of pre-pay mobile usage or petrol.

They are both items that we top-up as needed.   I know quite precisely how much it costs to fill my car’s tank but have no idea how often I have done it this year.   Likewise I know I generally buy £10 top-ups for a mobile but I’m not sure if the last was one week ago or two . .

With such confusion is elasticity going to be the dominant factor or are habit, available cash and price perception probably more important ?

Sin 6 – Underestimating Perception

I touched on this in earlier sins.  It is a quick one.

We have seen perception applied to a price -value decision on wine and to a monthly payment vs one-off mobile charge.  The key in each is that we cannot actually make a fully informed decision as we don’t have all the facts.

This would stop a  ‘computerised decison’  in it’s tracks.  But we are human so we just carry on.  Marketing people and pricing managers use this trait and it leaves us with some interesting puzzles.

I go to the shops to buy some batteries for my radio.  The rechargeable batteries are marked with their storage capacity in mAh, and generally the larger the capacity the higher the price.  However the only consequence of this capacity is how often I will need to recharge them, a reasonable concern I suppose.    So we have established that batteries store a particular amount of energy and it can be quoted on a label.

Now I look at the disposable battery rack.  Disposable batteries are a one-off purchase of a particular amount of energy, so you might imagine the amount of energy would be even more key on the package.  A bit like mentioning how much sugar is in this sugar packet.

In the disposable battery section  I see a wider range of batteries.  AA cells from big brands, mid brands right down to low and own brands.  They are priced over a 2:1 range BUT nowhere is a capacity rating marked – almost unique for an EU consumer good by the way.    So is the top priced battery twice as good as the cheapest?  Nowhere on the shelf will you find the answer to that question although each battery has comparisons to its predecessors and sketchy use-cases involving cameras and rabbits.
We have busy lives and other shopping to do so we ASSUME the pricing is that way, and the products are stocked alongside each other because there is a product difference and it must be by a factor of 2:1 or better.  And we may think that other shoppers or the shop may be better informed than us.  You can research the answer online but many people are quite happy to buy on perception of a price based ranking – believing in this case that increasing price means increasing value over quite a wide range.  Hopefully this is true as otherwise elasticity is upside down and out of the window !     Price promotions on top and bottom brands also play havoc with volume – price – perception behaviours but that’s yet another topic.

Sin 7 –  Forgetting Inertia

The insurance industry uses this regularly.  I get my car insurance renewal.  £501.  ouch,  way too much.

So I’m in the market for insurance.

In store or on line I look for quotes :   Suspiciously cheap up to more than my new quote.
So I probably won’t go for the cheapest, but it will probably take a saving of at least 15% to actually make me take action and do all the admin.  This is hard to describe as an elasticty value but very understandable in real life.

So I change company to save 15%.  The next year the insurance renewal comes back increased by 9%, and another 7% the following year.  If I stop to think, I’m now close to where I was before; but I’m not going to swap at this point – and the new company may have been clever enough to capture my last quote during the comparison/sale process so they even know the figure at which my inertia can be overcome and I most probably will switch . .

Note

I do hope this has added something to the charts and curves and formulae you generally find in pricing discussions, and if anyone woud like to let me know of any additional ‘favourite sins’ I’ve missed I would be pleased to start a new page !

(c) 2011 Bruce Akhurst

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