To Be or Not To Be, That is the Question…
A hard question to answer in a business school professor’s teaching life. Am I just teaching common sense? Is This Material Too Simple? Existential questions. And then comes evidence that actually rather basic knowledge is quite helpful. Witness the startling article “Real-Life Lessons in the Delicate Art of Setting Prices” in the NYT.
Lesson 1: Inelastic Demand
‘About three years ago a computer error caused all of the prices on Headsets.com to be displayed at cost rather than retail. With the lower prices on display for a weekend, Mike Faith, the chief executive, expected sales to soar. Instead, the increase was marginal. “It was a big lesson for us,” Mr. Faith said’
Lesson 2: Vertical Differentiation and Market Power
(1) Math tutor Kronenberg:
‘I learned it’s a misconception that if you raise prices too much, you’ll have no business,” Mr. Kronenberg said. “There are many customers who shop based on quality, not lowest price.’
(2) Headsets.com:
‘[Mike Faith] realized that sales for his company, which is based in San Francisco, were far less dependent on price than on what he now says differentiates his business: customer service. “Every call we get is answered by a human being within four rings,” he said, “and our reps are well trained and know a lot about the headsets.”
Since the incident, Mr. Faith has raised prices once, by 8 percent and without much fanfare, although regular customers were told in advance. The result? Revenue rose about 8 percent as well.’
(3) Artisan wheat flour producer:
`Naomi Poe, founder of Better Batter Gluten Free Flour near Altoona, Pa., learned that it is important to try to understand how your customers value your product.
In the food industry, Ms. Poe said, customers generally look for the cheapest price, but because her flour and baking mixes contain no gluten, they cost more to manufacture. She initially tried to compete with products that contain gluten on price but lost money on every sale. To raise prices, she had to convince customers her products offered added value. “In blind taste tests on regular people — not just those who are gluten-free — we heard consistently that our cakes were superior,” she said. “We also offer an unconditional guarantee as well as education and counseling.”
Her first year in business, 2008, she raised prices 20 percent, increasing her gross profit margin — the profit on each item she sells — about 11 percent and increasing sales revenue 25 percent, she said.“This helped us cover our expansion costs in 2008,” Ms. Poe said. After that, the business grew about 250 percent year to year.’
(3) Lesson 3: Price Discrimination
‘Last year [Footsyrolls, a company producing roll-up flat shoes] changed their offerings, going to two tiers of products and pricing. The Everyday Collection sells for $20 a pair and a higher-end category, Lux, for $30 a pair. “We actually have had the most interest in our higher-priced shoes,” Ms. Caplan said.
Because they brought one line down $5 and another up $5, the average price per unit remained about the same, but the impact was immediate. “We introduced the Lux line in summer 2010 and had a 100 percent increase in revenue,” she said. “We actually ran out of stock.”’
Lesson 4: These people need more lessons.
(1) Mike Faith: ‘The truth about pricing is it’s an art with a little bit of science, rather than a science with a little bit of art.’
No, Mike! It’s the other way round.
(2) Naomi Poe: ‘In January she raised prices an additional 10 percent, this time to cover broker and distributor fees as well as the rising cost of fuel and ingredients. Far from losing customers, she saw her revenue double and her gross margins leap to about 36 percent from 20 percent.’
Revenue is not the same as sales. Sales can go down when you raise price and revenue go up. If this happens, your price is in “negative marginal revenue” territory so your pricing strategy is horribly wrong. Perhaps a short exec ed course at the Kellogg School of Management taught by me for a large but well worth it fee will help you learn what marginal revenue means and make you hundreds of thousands in profits.
Cheap Talk 
8 comments
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April 21, 2011 at 8:06 am
Joshua Gans
I see the NYT has written about the virtues of higher prices and that customers may not flee. Hmm. Wishful thinking perhaps?
April 21, 2011 at 8:35 am
Sandeep Baliga
Yes, they do not mention the impact of their own subscription plan and its impact on their profits
April 21, 2011 at 8:11 am
michael webster
This is the type of post, and stance, which makes you irrelevant to most small business operators.
They don’t care that there is a mathematical topic called inelastic demand – what they care about is treading very carefully around the edges of such demand fearing that one small change could have catastrophic effects.
No small business operator is going to think that they have anything to learn from you or similarly situated academics. (You are demonstrating a tin ear and perhaps your intended audience is simply other academics, and if so I should have passed over this post in silence.)
April 21, 2011 at 3:36 pm
Frank
Stringer Bell, a fictional small business owner on The Wire cares about elasticity: http://www.youtube.com/watch?v=gGgRtiCVo2w
April 21, 2011 at 10:29 am
Sean
Sandeep, I don’t follow your last paragraph. I assume I can substitute “quantity demanded” for your use of the word “sales”. If you raise price and sales go down, you’ve verified the law of demand for your product. If revenues increase as a consequence, you are in an inelastic portion of your demand curve, where marginal revenue and price are positively related. But how can we know if this is good or bad without marginal cost information? I suppose you are making an assumption about marginal cost before the price change (e.g., MR=MC). But even if this is true, by assumption her cost curve has shifted up (from increasing fuel costs, etc), which implies that she should raise prices in response to return to a level of sales where MR=MC.
Michael, your gripe flies in the face of evidence from the socal winery where Uri Gneezy ran his wine pricing field experiment. A lot of good, small businesses are could improve their profits tremendously with the straightforward application of undergrad-level micro and behavioral economics. The winery learned a lot about improving their business model from a “similarly situated academic.”
April 21, 2011 at 10:54 am
Sandeep Baliga
Yes, sales = quantity demanded. If revenue goes down when you sell more (by cutting the price) it means it goes up when you sell less by raising the price. That is, MR is negative at the price you are currently setting. Hence raising price and selling less increases revenue. It must also (weakly) lower costs as you save on variable costs when you sell less. Hence profits must go up.
April 21, 2011 at 10:46 am
k
Sandeep
I see a source of confusion from this post – the way price is treated in the examples you mention it feels like a variable that any firm can determine but additionally that they use price to cover costs or raise revenues.
The academic way of thinking about prices is that they serve to allocate resources, and/or from mechanism design thinking, the institutional rule you use to generate prices serves to promote more efficient use of resources – i.e you may not use more or less of input A, but you will try to use it with greater efficiency.
I am almost surely convinced that the first way to think about prices is wrong. Yet this is how people appear to operate, or say they do. So is there more subtle reasoning going on that people themselves are unaware of? this last seems like a ridiculous thing to say, but I am not so sure…
April 21, 2011 at 10:49 am
k
Or I’ve misunderstood completely.