Monday, September 22, 2014

Price Sensitivity (or, the $16.72 Quart of Ice Cream)

Last week, as you may recall, I wrapped up my $1-a-day local shopping challenge with a trip to the library, where I picked up a copy of The Economic Naturalist by Robert H. Frank. I'd paged through the book before, so I was familiar already with a lot of the ideas discussed in it. When I read through the whole thing at once, however, I found one concept that seemed to come up over and over again was "price sensitivity." What this means, in a nutshell, is that some shoppers—like me, and, if you're reading this blog, probably like you as well—care much more about how much things cost than other shoppers. But it's a bit more complicated than that, and it has a great deal of influence on the actual prices we pay for just about everything.

Here's an example. Let's say the World Wide Wicket company (famously portrayed in the musical How to Succeed in Business Without Really Trying) can produce wickets for $1 apiece. Their factories are capable of producing 5 million wickets a year, and their goal, obviously, is to make as much money as they possibly can for those wickets. The problem is, not all buyers are willing to pay the same price for a wicket. There may be as many as 2 million potential buyers out there who just want the best-quality wickets they can get, and they're willing to pay as much as $10 per wicket for them. However, there are an equal number of buyers who aren't willing to pay that much. Maybe they're on a tighter budget, or maybe they just don't have as urgent a need for wickets, but for whatever reason, these "price-sensitive" buyers won't spend more than $5 per wicket. And there may even be another million shoppers out there who normally wouldn't want to buy wickets at all, but they could be persuaded to if they were an especially good deal—say, $2 per wicket.

What should the company do in this case? If they set the highest possible price for their wickets, $10 each, then they'll only sell 2 million of them, making a $9 profit on each one, for a total of $18 million. If they drop the price to $5 each, they'll sell twice as many, but for only half as much per wicket. Minus their production costs, they'll make only $4 each on the 4 million wickets they sell, for a profit of only $16 million. And if they drop the price to $2 each, they can sell all 5 million wickets they make, but they'll only make a dollar on each one, for a measly $5 million profit.

Under the circumstances, it looks like the $10 price is the best one. But that will leave an awful lot of the World Wide Wicket company's production capacity going to waste, and an awful lot of buyers who would be willing to buy wickets at a lower price will be going without them. What the company would really like to do is charge customers different prices based on what they're willing to pay—$10, $5, or $2 per wicket. Then they could sell all the wickets they make and earn the maximum possible profit. But they can't just mark some wickets at $10 and others at $2 and pile them all on the same shelf, or everyone will buy the $2 wickets and leave the $10 ones. So how can World Wide Wicket charge the appropriate price to each buyer?

Well, as it turns out, there are a lot of different tricks companies can use to squeeze the maximum profit out of non-price-sensitive buyers while still selling their products, at a lower profit, to price-sensitive ones. For example:
  • They could set the regular price of their wickets at $10 each, but also hold sales once or twice a year in which the price drops to $5 or lower. Non-price-sensitive buyers, who don't mind paying $10 a wicket, will buy at retail price, while price-sensitive ones will wait for the wickets to go on sale before they buy. This is why so many department stores seem to have sales on different items every month; they can rope in the deal-seekers during these sales and still sell the same items at full price to the spendthrifts during the rest of the year.
  • They could offer their wickets for $10 each, but charge a special reduced rate for slightly damaged wickets. You may have seen the "scratch and dent rooms" at major appliance retailers, where they keep the still-working appliances that have been damaged during shipping or display. Price-sensitive buyers will happily accept a fridge with a small dent on one side (which may end up against the wall anyway) in order to get it for half price. In fact, Frank notes that back when Sears pioneered the scratch-and-dent sale, there were rumors that Sears had employees in the warehouses deliberately hammering small dents into perfectly good appliances so that they could be included in the sale. These appliances could have been sold at full price, but only if there were enough non-price-sensitive shoppers willing to buy them; by deliberately scuffing them up, the store could sell them to price-sensitive buyers without lowering the price they charged to non-price-sensitive ones.
  • They could set the regular price of their wickets at $5 each, but sell them at an inflated price of $10 each in locations where non-price-sensitive shoppers are likely to find themselves in need of wickets (such as, presumably, on croquet courses). This is the same technique used by hotels when they stock their minibars with $3 chocolate bars that you could buy at the corner drugstore for 50 cents. Price sensitive buyers will shake their heads at these ridiculous prices and trot round the corner to the drugstore, while non-price-sensitive ones will just pay the inflated price to avoid the trouble. By hitting the less price-sensitive lodgers with higher prices on extras like minibar items (or dry cleaning, or other services), hotels can in effect charge these customers a higher rate for the room, while still advertising a low rate to attract the price-sensitive folks. Similarly, airlines will advertise low fares to appeal to price-sensitive travelers, but then charge extra for meals and headphones.
  • They could charge $10 for their wickets but offer a $5 mail-in rebate. Less price-sensitive buyers will consider it too much trouble to mail in the rebate form, while price-sensitive ones will use it to get the wickets at a price they consider reasonable.
After reading this book, I found myself noticing examples of this sort of differential pricing in my daily life. For example, on Friday, as I passed by the local Baskin-Robbins, I noticed a sign outside offering "pre-packed quarts, 2 for $9.99." It only took a moment of mental math to realize that this worked out to $5 per quart. By contrast, a 1.5-quart container of ice cream at the local supermarket sells for anywhere from $2.49 for the store brand to $4.49 for Edy's—that is, $1.67 to $3 per quart. However, as Brian pointed out, customers at Baskin-Robbins wouldn't be comparing the price of the ice cream quarts to the supermarket price; they'd be comparing it to the price they'd pay buying it by the scoop, which is $2.09 for a 4-ounce scoop. Since 4 ounces is half a cup, that works out to $16.72 per quart. Compared to that, $10 for 2 quarts looks like a real bargain.

This price structure separates the price-sensitive chaff from the non-price-sensitive wheat; the least price-sensitive buyers will just go in and order a cone apiece, because they came here to go out for ice cream and, by gum, they are going out for ice cream, even if it costs 10 bucks to feed the family that way. More price-sensitive buyers may decide instead to pick up a couple of packed quarts; that way, for that same $10, the whole family can have double scoops tonight and tomorrow, too. And the most price-sensitive buyers of all will see the "2 for $9.99" sign, realize that's more than twice what they'd pay at the supermarket, and make a half-mile detour to pick up a container of the store brand ice cream for $2.49.

So the good news, for all us price-sensitive folks, is that there's usually a way to pay less than full price for just about anything. It may involve waiting for a sale, or comparison shopping online, or going half a mile out of your way for ice cream, but it's usually there if you look for it. The bad news is that the lower price almost certainly won't be easy to find—because it if were, everyone would be paying it. But that's actually good news too, because it means that the bargains are being distributed in the fairest possible way. To get the lowest prices, you don't have to be rich (which would be absolutely unfair, since rich people need them least) or have special connections (which would still be somewhat unfair, because most people would still be shut out from the lower price). Instead, the best deals go to those who are most willing to work for them.

In other words, when it comes to bargains, seek and ye shall find—because it's in the seller's interest if you do.
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