March 6, 2013
As I previously blogged, I have recently read Priceless: The Hidden Psychology of Value by William Poundstone. One of the important insights looks at how a buyer perceives a price increase and what he considers to be “fair.” Understanding the perception of fairness is critical in setting the correct price. Poundstone devised little scenarios to test reactions:
After a snowfall, a hardware store increases the price of snow shovels from $15 to $20. 82% of the survey recipients felt this “unfair.” Supply and demand was no excuse.
Another question had a football team selling limited seats for a cup game. They had three choices: auction them, run a lottery or make people wait in a queue for hours. The subjects overwhelmingly rated the queue as “fairest” and the auction as the “least fair.” Even though it is surely known that standing in a queue is a waste of thousands of hours of otherwise productive time, and that a lottery produces windfall winners how can sell their tickets in a secondary market to the fans who really want them.
On the other hand is the recent allocation of Olympic tickets. The Organising Committee had the goal of perceived fairness above revenue maximisation or making sure the tickets went to the people who valued them most. So they chose a lottery: at least it was “fair.”
So what do buyers think is fair? Passing on increased costs is seen as fair, and this is why rebates are such a common practice. When my plumber shows me the invoice from the Plumbing Supplies shop for the boiler he just fitted (£1250), it seems reasonable to reimburse him that amount, even though he gets a large annual rebate from the distributor who practically collude in keeping the invoice shown to me artificially high. If his rationale was: “It’s -5 Celcius out and you have no heating,” I would feel more aggrieved.
The cardinal rule of fairness seems to be “don’t increase your profit at my expense.”
Another way of saying this is that conventional economics assumes that excess demand will create an opportunity for suppliers to raise prices, a bit like water finding its own level. But the public fundamentally does not share this indifference. People’s view of what is fair and what is “gouging” can be surprising. And the buyers that we meet in our B2B negotiating cycles will bring their prejudices to the negotiating table.
So how does the pricer use this study of fairness?
Support your customers’ requests for rebate programs; this will allow them to position a supply increase with their customers. The survey says that their customers will more likely accept a price increase if they can point to increase supply (as with my plumber).
Where possible, link your price increase to publicly available indices which account for the price rise: this could be ocean shipping, energy, petroleum derivatives or Foreign Currency.
Avoid appearing to link your price rise to pricing power. Although you may internally use pricing power as a way of targeting price increases (and in fact this is good practice), you should scrupulously avoid giving this impression. As the survey says, even though this is rational business sense (and your customer for sure does it to their customers), people react very unfavourably to any hint that they are being taken advantage of.
Adam Smith may be on the £20 note here in the UK, but don’t think that the buyer across the table is a cold, rational economist.